Question

Question: (Qualitative Characteristics) Recently, your uncle, Carlos Beltran, who knows that you always have your eye out for a profitable investment, has discussed the possibility of your purchasing some corporate bonds. He suggests that you may wish to get in on the “ground floor” of this deal. The bonds being issued by Neville Corp. are 10-year debentures which promise a 40% rate of return. Neville manufactures novelty/party items.

You have told Uncle Carlos that, unless you can take a look at Neville’s financial statements, you would not feel comfortable about such an investment. Believing that this is the chance of a lifetime, Uncle Carlos has procured a copy of Neville’s most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse these statements, and they are quite impressive. The balance sheet showed a debt-to-equity ratio of 0.10 and, for the year shown, the company reported net income of $2,424,240.

The financial statements are not shown in comparison with amounts from other years. In addition, no significant note disclosures about inventory valuation, depreciation methods, loan agreements, etc. are available.

Instructions

Write a letter to Uncle Carlos explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you. Be sure to explain why these financial statements are neither relevant nor representationally faithful.

Short answer

Answer

Date: XX/XX/XXX

To: Carlos

From: Mr. X

Subject: Why are financial statements are neither relevant nor represented faithfully

The financial statements are not relevant and are not faithfully represented because the methods used for calculating the value of inventory and depreciation are not disclosed. Also, it does not disclose any other relevant information necessary for increasing the transparency and relevancy of the financial statement

Step-by-step solution

Definition of Financial Statement

The financial statement can be defined as asummary report thatincludes all theinformation relating to the financial transactions. It includes reporting all the assets, liabilities, revenue, expenses, and cash inflows and outflows.

Non-relevancy of the financial statement

The financial statement is neither relevant nor representationally faithful because the business entity has not reflected the information relating to loan agreements, depreciation, and inventory valuation. It might be possible that the business entity depreciates its assets at lower rates to report the higher net income, the business entity is using the FIFO method for reporting higher net income and the business entity have loan agreements that are not reflected on the financial statement to reflect improved debt-to-equity ratio.