Limitations of Financial Analysis: Window Dressing, Creative Accounting, Groups and Specialised Entities

A ratio looks precise and objective. It is neither. It is built from figures that rest on accounting policies and estimates, taken at one date, from a year that is already over. It can be influenced by the people who prepare the statements. The skill of analysis includes knowing where the ratios can mislead.

This topic covers the limitations of ratio analysis: differences in accounting policy, the use of historical figures, year-end snapshots, inflation, the exclusion of non-financial information, and the particular problems with groups.

It then covers creative accounting, including window dressing, with the techniques that candidates are asked to name, and ends with the interpretation of the financial statements of specialised, not-for-profit and public sector entities, where profit is not the main objective. It uses the Zaria Plc figures from the previous topics. The next topic starts the part of the syllabus on sustainability reporting.

These points are examined directly. In May Diet, 2026, Question 3(d) asked for six techniques of creative accounting (3 marks) and Question 3(c) for limitations of earnings per share and return on capital employed (8 marks). In November Diet, 2023, Question 6 (15 marks) asked for four techniques of creative accounting identified and discussed (8 marks), useful non-financial information (3 marks) and the use of technology in financial reporting (4 marks). Read earnings per share and cash flow information first.

Limitations of ratio analysis

• Differences in accounting policy. Two companies with the same business can report different profits and assets because of different depreciation, inventory valuation or revaluation policies. A company may also change its policies. Ratios of different companies, or of the same company before and after a change, are not strictly comparable.
• Historical information. Statements show what has happened, not what will. Ratios from past figures are a guide, not a forecast, and conditions may have changed since the year end. The financial statements are also available some time after the year end.
• Year-end figures. The statement of financial position is a snapshot on one day. For a seasonal business it may be unrepresentative, and balances can be arranged for the day (see window dressing). Averages are more reliable.
• Inflation. Historical cost figures are not adjusted for changing prices, so the comparison of figures over time, and asset values, can mislead. High inflation overstates growth and understates the replacement cost of assets.
• Other limits of ratios. Ratios are only a number: the figures behind them may be misstated, there are no universal ideal values, different analysts define ratios differently, one ratio rarely tells the story (read them together), and companies with several businesses average unlike activities.
• Non-financial information. The most important facts about a business, such as the quality of management, customer satisfaction, market position, technology, staff morale and environmental and social performance, are not in the figures.

Groups

In a group the consolidated ratios combine the results of different businesses, so they may hide a weak subsidiary behind a strong one. Acquisitions and disposals during the year distort the comparison with last year. The non-controlling interest, goodwill and the share of associates affect the ratios (capital employed includes non-controlling interest and goodwill, and the share of profit of an associate is not backed by cash).

Intra-group trading is eliminated, so the group’s ratios may differ from those of the individual companies.

Creative accounting

Creative accounting is the manipulation of the view given by the financial statements while complying with the standards and regulations. It uses choices, estimates and the timing and structure of transactions. It is different from fraud, which breaks the rules, but it can mislead readers in the same way.

Management may wish to improve profit, to improve the balance sheet ratios, to meet targets or loan covenants, or to support the share price. The usual techniques are:

1. Window dressing. A transaction is entered into just before the year end and reversed just after it, solely to improve the view of the statements. For example, goods are sold on the understanding that they will be returned immediately after the year end, which appears to improve profits and liquidity.
2. Off statement of financial position finance. Transactions are arranged so that significant assets, and particularly liabilities, stay out of the statement of financial position. This improves gearing and return on capital employed. Examples are sale and repurchase agreements and some forms of leasing and special purpose vehicles.
3. Changes in accounting policies or estimates. Changing depreciation methods or lives, revaluing assets (or changing from the cost model to the revaluation model) to improve gearing, or releasing provisions.
4. Profit smoothing. Reported profits are made to look stable by creating artificial assets or liabilities (such as excessive provisions in good years) and releasing them in poor years.
5. Aggressive earnings management. Artificially improving earnings by recognising revenue before it is earned, for example at the point of order and not delivery.
6. Capitalising expenses. Recognising assets that do not meet the definition in the Conceptual Framework or the recognition criteria, such as advertising, training or internally generated brands, so that expenses are taken out of profit.

Their effect on the ratios

• Window dressing. Zaria repays ₦50m of payables on the last day with cash and the cash is replaced the following day.
  Current assets become ₦400m − ₦50m = ₦350m and current liabilities ₦250m − ₦50m = ₦200m.
  The current ratio rises from 1.60 to 350 ÷ 200 = 1.75, although nothing has changed in the business.
  (The quick ratio is unaffected at 1.00, which is why the quick ratio helps to detect it.)
• Capitalising expenses.
  If ₦20m of advertising is capitalised, profit before interest and tax becomes ₦180m + ₦20m = ₦200m and capital employed ₦1,070m. return on capital employed (ROCE) rises from 17.1% to 200 ÷ 1,070 = 18.7%.
• Off statement of financial position finance.
  If ₦100m of the ₦330m loans is moved off the statement of financial position, gearing falls from 31.4% to 230 ÷ (720 + 230) = 24.2%, with the same business.

Non-financial information

Useful non-financial information would include:

• a description of the business, its objectives and strategies
• a narrative review of its performance in the period
• its main risks and uncertainties and how they are managed
• significant factors that may affect future performance and cash flows
• key relationships with other entities, and related party transactions
• research and development and material intangible assets, including internally generated ones not recognised in the statement of financial position
• explanations of amounts based on estimates
• policies on the environment, employees and social and community issues

Much of this is in the management commentary (see the topic on group disclosures).

Specialised, not-for-profit and public sector entities

Specialised entities (for example, banks, insurers, cooperatives), not-for-profit organisations such as charities and clubs, and public sector bodies differ from ordinary companies in their objectives: their purpose is to provide a service, to serve members or to manage public resources, not to maximise profit. So ROCE or earnings per share (EPS) may be meaningless.

The users of their statements include donors, members, beneficiaries, regulators, taxpayers and the legislature, whose needs are accountability and value for money.

• Compare the actual with the budget, and the surplus or deficit with the plan.
• Use financial ratios that suit the entity: liquidity, the proportion of income spent on administration, reserves in months of expenditure, and the proportion of costs covered by income from services.
• Use non-financial ratios: cost per beneficiary, number of beneficiaries served, pupils per teacher, bed occupancy, or response times, which measure the outputs.
• Look at regulatory ratios where relevant (capital adequacy for banks, solvency margins for insurers).

The ideas in more depth

Why the quick ratio helps detect window dressing

Repaying a payable with cash reduces both sides of the current ratio by the same amount, which raises the ratio when it is above 1. It does not affect the quick ratio when it equals 1, and the analysis should look at the cash and the borrowing shortly after the year end.

Why creative accounting is a concern for the analyst

Every technique moves the ratios in the direction management wants, so a favourable change is less reliable when management has the incentive and the means to produce it. The warning signs are profit rising while cash from operations falls, frequent changes in policy, unusual transactions close to the year end and complex structures.

Sources and references

• The Conceptual Framework for Financial Reporting (definitions of assets and liabilities); International Accounting Standard (IAS) 8 Accounting Policies, Changes in Accounting Estimates and Errors; International Financial Reporting Standard (IFRS) 16 Leases (for leasing structures); IFRS 15 Revenue from Contracts with Customers.

These points are stated as at 5 November 2026.

Worked examples

1. Before.
   400 ÷ 250 = 1.60.
2. After.
   350 ÷ 200 = 1.75, with no change in the business.

1. Before.
   180 ÷ 1,050 = 17.1%.
2. After.
   200 ÷ 1,070 = 18.7%.

1. Before.
   330 ÷ 1,050 = 31.4%.
2. After.
   230 ÷ 950 = 24.2%.

How to answer in the exam

• Name each technique and explain it in a sentence, with an example; the marks are usually one for the name and one for the discussion.
• For limitations, give the limitation, why it matters, and what the analyst can do about it.
• For specialised entities, say what the objective is and which measures replace profit.
• Link to the ratios that each technique improves.

Common mistakes in the exam

• Naming techniques without explanation.
• Describing creative accounting as fraud.
• Listing limitations of ratios without saying why each matters.
• Applying return on capital employed and earnings per share to a charity.
• Forgetting non-financial information in a question on the limits of the statements.
• Ignoring the effect of acquisitions on group ratios.

Quick revision

• Limits: policies, historical figures, year-end snapshot, inflation, non-financial gaps, groups.
• Creative accounting: window dressing, off statement of financial position finance, policy and estimate changes, profit smoothing, aggressive revenue recognition, capitalising expenses.
• Not-for-profit and public sector: budget comparison, value for money, non-financial ratios.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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