Learning To Crunch The Numbers

Foreword from ShareInvestor

This article “Learning To Crunch The Numbers” by Cai HaoXiang was first published in The Business Times on 01 Sep 2014 and is reproduced in this blog in its entirety.

Investors have to be aware of issues that relate to the construction and use of financial statements, says CAI HAOXIANG

INVESTING can be hard work, and learning how to read and analyse financial statements is just the beginning.

It is already a challenge to understand how and why certain numbers are presented in a certain order on the page.

Beyond the numbers, investors have to grapple with a company’s business fundamentals that financial statements can shed light on.

They also have to maintain a healthy level of scepticism over the numbers presented, and be alert to red flags that financial statements can throw up.

This week’s topic is on macro issues around financial statements.

Next week, we begin a refresher on the three main financial statements investors have to examine: the income statement, the balance sheet and the cash flow statement.

Readers following this column will remember that, last year, we used the statements of BreadTalk Group, Qian Hu Corp and The Hour Glass.

These are businesses Singaporeans would be familiar with. Newcomers to financial statements are advised to look at those of companies they have heard of.

Financial statements are generally published once every three months for bigger companies and once every six months for smaller ones, giving investors a frequent snapshot of the financial health of the company.

There is an ongoing debate over whether once every three months is too frequent.

Opponents, usually chief executives and chief financial officers, say that quarterly reporting consumes too much resources that can be better used running the business.

After all, sometimes not much happens in three months. Minor fluctuations in the business cycle can show up in the statements and be misconstrued as pressing profitability problems.

Managers worry that quarterly reporting encourages a short-term mindset among investors, who rush to buy and sell. Managers are also concerned about being pressured into sacrificing long-term thinking to meet short-term earnings targets set by analysts.

New investors should be aware of these issues when reading financial statements for the first time.

On the other side of the fence, proponents of the three-month reporting period say that more frequent disclosures improve transparency of information in the marketplace. Seasoned, serious and long-term investors know better than to adopt a short-term mentality.

Under Singapore Exchange (SGX) rules, a company with a market cap of more than S$75 million is generally expected to announce financial statements no later than 45 days after every three months in their financial year.

A company with a market cap below S$75 million is relatively small, but there are a lot of those around.

Smaller companies are riskier for investors, but offer potentially greater opportunities for price appreciation. This is because they are usually ignored by the investment community.

As at last week, there were over 300 such companies listed on the SGX, making up more than two-fifths of companies listed here.

In our financial statements refresher next week, we will focus on the statements of one such small-cap company.

Read between the lines: After full-year financial statements comes the annual report, where audited statements and an auditor’s report make an appearance. It usually comes out in March to April for companies whose financial years end on Dec 31. FILE PHOTO

The 45-day timeframe, within which companies must report their quarterly earnings after the quarter has ended, also gives investors an idea of when companies will report their earnings.

Under a typical financial year that begins on Jan 1 and ends on Dec 31, a first quarter reporting period will last from April to May 15, a second quarter reporting period from July to Aug 15, and a third quarter reporting period from October to Nov 15.

For the full financial year, SGX rules state that an issuer must announce statements immediately after the figures are available, but not later than 60 days after the relevant financial period.

Full-year statements thus usually come in February for companies with a regular financial year that ends in December.

These periodic statements published on the SGX company disclosure page are “unaudited”, meaning they have not been independently verified by an external party.

After full-year financial statements comes the annual report, where audited statements and an auditor’s report make an appearance.

The annual report usually comes out in March to April for companies whose financial years end on Dec 31.

This is because of SGX rules stating that an annual general meeting (AGM) must be held within four months of the end of a financial year, and that the annual report must be issued to shareholders at least 14 days before the meeting.

All this means is that investors can expect to be very busy in the first few months of the year: digesting full-year financial statements in February, attending AGMs in April, and perusing first-quarter results in May.

A full audit by an external public accounting firm is generally required only once a year.

This is due to the time and costs involved.

If the company’s accountants get things right, there are usually few discrepancies between the audited and the unaudited statements.

Any discrepancies should be explained by the company in a subsequent announcement.

During an audit, after running a company’s financial statements through audit procedures, auditors might find that the statements were improperly presented such that significant sums of money are involved. In other words, there are material misstatements.

In these cases, they will propose adjustments to the financial statements.

Companies have a choice whether to accept the proposed adjustments or not.

Adjustments are quite common for listed companies here.

Adjustments To Statements

A recent study has shown that S$33.9 billion worth of adjustments had to be proposed for a third of all listed companies here, for the year ended Dec 31, 2013.

The study was published by the Accounting and Corporate Regulatory Authority (Acra) and the Singapore Management University last Wednesday.

Out of the more than 3,000 adjusting entries proposed by the auditors, about two thirds – representing S$30 billion – were accepted. This means that the bulk of the proposed adjustments in the study were accepted.

Expense account items were the most frequently adjusted.

Manufacturing companies also had more proposed adjustments.

Financial statements expressed in renminbi also made up three-fifths of all adjustments. It is believed that this was because Chinese companies adopt Generally Accepted Accounting Principles (GAAP) as their financial reporting standard, as opposed to the Singapore Financial Reporting Standards (SFRS) used here.

The most common accounting standards in the world are the International Financial Reporting Standards (IFRS), which the SFRS are based on, and the US-based GAAP. We will investigate these differences between the two in a future article.

Coming back to audit adjustments, what happens if companies do not accept the proposed adjustments?

The auditor might be less inclined to give the company a clean bill of health – otherwise known as an unqualified opinion – in the auditor’s report.

To conclude, companies usually put out financial statements quarterly. The statements are audited annually. The job of the auditor is to make sure statements are accurately and fairly presented according to accounting standards.

But, as we will see, investors will still need a basic understanding of accounting. Auditors serve an important, though still limited function in evaluating a company’s financial health.