Interpreting financial statements requires knowledge of how these statements are

Question

Interpreting financial statements requires knowledge of how these statements are prepared. Because the Balance Sheet, Income Statement, and Statement of Retained Earnings are all influenced by management assumptions, it is critical to not take the figures on these statements at face value and instead perform a thorough examination of these assumptions. For this week’s discussion question, provide an example of a management assumption that could have a significant impact on one of the aforementioned financial statements and explain how you would scrutinize this assumption.

Explanation / Answer

The management assumption which could have a significant impact on the Balance Sheet is the valuation of inventories, which could either increase the value of closing inventories or reduce the same. Suppose the Company assumes that the costing of inventories is made on the basis of weighted average cost instead of lower of cost-or-market-value, the auditor who is checking the financial statements has to verify the reason for such an assumption. Based on the trends in the market for Companies doing business on similar lines, the method of valuation needs to be checked and verified by him. Further, the valuation statements of the Company under scrutiny need to be checked in totality, and ensured that the variation from the regularly followed method does not have a major impact on the bottom line in the profits of the Company, or the inventory values as posted in the Balance Sheet. Any major variation is required to be disclosed by him as a separate note in the Audit Report and the Financial Statements both.

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