Commonwealth Bank Group Performance and Return on Equity Values - Case Study Example

Part 1 Professional accounting in judgement refers involves application of professional knowledge as well as experience to unique and potentially uncertain facts and conditions so as to reach a conclusion or make a decision (Gramling, Johnstone & Rittenberg 2011, p. 79). Simply put, accounting judgement refers to the process of making an accounting decision where there are a number of possible alternatives (Sogoloff 2012, p. 1). The purpose of applying judgment in accounting is to produce information that is reasonable in the circumstances of the company. The key areas of accounting judgement include use by management in preparing financial statements, application by auditors in auditing financial statements, and use by regulators in assessing management and auditor judgements (Sogoloff 2012, p. 1). During the preparation of financial statements, entities may have to make some decisions that are uncertain or objective. For instance, with deferred income taxes, the person preparing financial statements may have to make a decision in the context of estimates and assumptions made in the preparation of the estimate of income tax expense in a given year. During the process of auditing financial statements, accounting judgement is required in the context of the following situations: deciding what to audit, determining the purpose of the audit; determining the scope of audit; determining the criteria to be used; determining the review and consultation procedures to be used in the audit and how the advice will be dealt with; deciding which findings are adequately significant to report, determining the nature, timing, and extent of the audit procedures; assessing whether adequate appropriate audit evidence has been obtained, and whether more should be done to conclude against the objectives; deciding the recommendations to be made; and drawing conclusions from the audit evidence obtained against the purpose (Office of the Auditor General of Canada 2012). For regulators, critical judgements have to be made with regard to decisions made by management and auditors. For example, Ford Motor Company is regularly involved in litigation and thus its auditor has to make a decision as to when the amounts to be settled in litigation should be estimated (Rittenberg, Johnstone & Gramling 2011, p. 958). The auditor needs to evaluate disclosures about whether the company has changed plans on which they are going to close, or which line of business the organisation may discontinue. All this information is important for the regulator in regard to making decision such as those involving taxation. The implication of accounting judgement is that many items are left to the personal discretion of an accountant. For instance, stock valuation, provision of depreciation, provision of bad debts and so forth depend on the personal discretion of an account. Thus, on account of the convention of conservation, the income statement may not disclose the true financial position of the business since probable losses are taken into consideration whereas probable incomes are ignored Part 2 Background information about Commonwealth Bank Commonwealth Bank if one of Australia’s leading providers of integrated financial services that include retail banking, business banking, premium banking, insurance, institutional banking, funds management, investment, superannuation and sharebroking services and products (Commonwealth Bank 2013a). Key operating areas results The Commonwealth Bank has had a strong financial position and delivered a good result in 2012 in spite of the existing subdued underlying credit growth. The Group’s net profit after tax on a cash basis increased by 4 percent compared to the 2011 results to $7.1 billion. Further details about Commonwealth Bank’s net profit are shown in table 1. Table 1: Commonwealth Bank Group performance highlights for 2011 and 2012 Full year ended Half year ended Net profit after tax 30 June 2012 30 June 2011 30 June 2012 31 Dec. 2011 $m $m $m $m Statutory 7090 6394 3466 3624 Cash basis 7113 6835 3537 3576 Source: Commonwealth Bank (2012, p. 6) The group also delivered a strong return on equity (ROE) performance at 18.6 per cent on a cash basis. The following are the key highlights of Commonwealth Bank’s performance in 2012 according to the Commonwealth Bank annual report of 2012 (Commonwealth Bank 2012, p. 2). Net income grew by 4 per cent to $13157 million, which showed a 5 per cent increase in average interest earning assets partially counterbalanced by a three basis point decline in net interest margin. Other banking income declined by a margin of 2 per cent to $3927 million due to lower markets trading income, partially offset by higher credit interchange income as well as institutional lending fee growth. Funds management income decreased by 4 per cent to 1957 million. This can be attributed to declining equity markets, a higher percentage of customer funds invested into lower margin cash and fixed interest investments, and the continued runoff of the CommInsure closed investment portfolios. Income from insurance increase 12 per cent to $960 million. This was caused by 10 per cent inforce premium growth as well as favourable claims cases witnessed in New Zealand life insurance business, partially offset by hostile domestic claims incidences. Operating expenses grew by a margin of 3 per cent to $9196 million. This situation was caused by inflation-related salary increases, property transition costs linked to the new Sydney central business district offices premises as well as higher compliance costs. This was partially counterbalanced by the continued focus on productivity strategies to improve customer experience and group efficiency. Loan impairment cost declined by 15 per cent to $1089 million, depicting the progressive improvement in asset quality with economic overlays sustained at current levels. From the figures above, it is evident that Commonwealth Bank is likely to have a high profits margin since high net income is an indicator of high profitability. Net income divided by sales is a good indicator of a company’s profitability (Porter & Norton 2012, p. 72), hence the significance of the increased net income figures. For Commonwealth Bank’s case, the net profit after tax (NPAT) for the half year ended 31 December 2012 was $3,661, which embodies a 1 per cent rise compared with a similar period in the preceding year. In addition, cash NPAT for 2013 half year was $3,780 million, which was an increase of about 6 percent (Commonwealth Bank 2013b). Ratio analysis The fact that the group delivered a strong return on equity (ROE) is also an indicator of strong performance since return on equity is the amount of income returned as a percentage of shareholders’ equity. Essentially, return on equity is the net profit margin after interest and tax expressed as a percentage of shareholders’ funds (Morrell 2007, p. 59). In this case the numerator is before the deduction of minority interests and the denominator includes the capital belonging to these interests. This percentage is an indicator of how successful company’s management is in using the capital entrusted to it by the owners of the company or equity shareholders. Return on equity values of the company between 2012 and 2012 are shown in the figure below. Figure 1: Commonwealth Bank return on equity values of the company between 2012 and 2012 Source: Commonwealth Bank (2012, p. 7) The figures above are also enforced by the fact that Commonwealth Bank’s return on equity based on 2013 half year result was 18.1 per cent (Commonwealth Bank 2013b). This cements the fact that fact that Commonwealth Bank has a strong performance with regard to earnings on shareholders’ equity. Another important ratio is return on assets. Return on assets (ROA) is defined as the ratio of net income to average total assets. Return on assets is an indicator of how well an organisation’s invested capital is generating earnings. The higher the value of return on assets, the better an organisation is leveraging its assets in the generation of earnings, and presumably the generation of cash (Stahl 2004, p. 489). For Commonwealth Bank, the return on assets has been on an increasing trend since 2006. See figure 2. Figure 2: Commonwealth Bank Group return on assets for the period between 2006 and 2012 Source: Commonwealth Bank (2012, p. 7). According to Stahl (2004, p. 289), is an important ratio for a number of reasons. To start with, the ration informs shareholders and creditors of public companies about how well the company’s assets are being deployed in the generation of income. Return on assets is also significant during the evaluation of new investments or investment in new projects. Together with return on investment (ROI), return on assets is important for organisations deciding whether or not to initiate new projects. The premise of this ratio is such that if an organisation is going to commence a project and expects to earn a return on the same project, return on assets is the return it should receive. From figure 2, it can be seen that Commonwealth Bank’s return on assets has been increasing progressively, and this is indicative that should the company diversify in more services as it has been doing, it is likely to earn more return on the assets that it deploys in the various projects. The ratios highlighted above also affect share performance and hence it is important to look at Commonwealth Bank’s share performance. In 2012, the group’s final dividend declared was $1.97 per share, an increase of 5 per cent relative to the preceding year. This indicates a strong performance of the share in 2012. The same trend is also highlighted in Commonwealth Bank’s latest information on share price as indicated in figure 3 below which show share price for the period between September 2012 and March 2013. Figure 3: Commonwealth Bank of Australia’s price history chart showing data between September 2012 and March 2013 Source: Australian Securities Exchange (ASX) (2013) Analysis for shareholders The decision on whether shareholders should increase or lower their investment in an organisation is arrived at by analysing the organisation profitability, which is the primary measure of the overall success of a firm (Walton & Aerts 2006, p. 238). Like most other business entities, Commonwealth Bank’s fundamental goal if to earn a satisfactory profit. However, to analyse any given company’s performance, it is important to look beyond the net profit aspect. Net profit, which is calculated as a percentage of sales, does not take into account the investment that is required to generate the profit. However, analysis of the return on investment (ROI) is able to reveal this (Walton & Aerts 2006, p. 238). Depending on what is mean by investment, different ROI can be used, two of which have been mentioned and discussed in this paper: return on assets and return on equity. As mentioned earlier, return on assets measures how much a company has earned on the funds invested by its shareholders. Funds invested by shareholders are set equal to equity and hence connote both directly invested funds and funds invested indirectly through profits retained by the organisation. Clearly, return on equity reflects a shareholder perspective. This ROE figure is slightly dangerous as it is not a ‘real’ return and should not therefore be compared with, for instance, the rate of interest paid on a bank deposit account. The figure can be used in a time series analysis to show whether profitability is improving or declining, viewed from the equity perspective, as opposed to all finance (Walton & Aerts 2006, p. 238). Therefore, based on the figures presented showing Commonwealth Bank’s performance, an investor is not really able to determine the real return that he or she can earn from investing in the group. Nonetheless, the return on equity figures are important because they can help someone to see the group’s performance over time and then decide whether to increase investment or not. In this case, since Commonwealth Bank’s return on equity has been increasing steadily, it is an indicator for investors to increase their shareholding in the group. The second ratio which was discussed above, that is return on assets, reflects how much an organisation has earned on the investment of all financial resources committed to the organisation. In this case, the investment base is set equal to the sum of equity and all liabilities – that is the total sources of funds invested in the company’s assets. The ROA is indicative of how well the company has used its funds, regardless of the relative magnitudes of the sources of those funds. Since ROA brings in the debt element of the company, it enables comparison between the efficiency of companies with different debt/equity ratios (Walton & Aerts 2006, p. 238). In the current analysis, Commonwealth Bank’s ROA has been seen to be high an increasing progressively over the years. This implies that the Group is not only managing its resources well but it also has a low level of debt. To a shareholder, this means that Commonwealth Bank is a company worthy increasing the level of investment in. according to Walton and Aerts (2006, p. 238), when return on assets is taken in conjunction with return on equity, the ratio shows whether the return to shareholders is changing better or worse than the return on overall financing. This is very important with respect to making shareholding decisions as illustrated above. Finally, Commonwealth Bank’s share performance has been steady in recent times judging by the information available from the Australian Securities Exchange (ASX) as detailed earlier. This indicates a strong performance of the company. For a shareholder, a strong share performance calls for an increase in investment in the company since it implies more earnings per share – that is higher dividends. References Australian Securities Exchange (ASX) 2013, “Commonwealth Bank of Australia (CBA)”, viewed 5th March 2013, Commonwealth Bank 2012, “Annual Report 2012”, viewed 5th March 2013, Commonwealth Bank 2013a, “Commonwealth Bank overview”, viewed 5th March 2013, Commonwealth Bank 2013b, “Results”, viewed 5th March 2013, Gramling, A A, Johnstone, K M & Rittenberg, L E 2011, Auditing, 8th edn, Cengage Learning, New York. Morrell, P S 2007, Airline finance, 3rd edn, Ashgate Publishing, Ltd., London. Office of the Auditor General of Canada 2012, “1042 Applying professional judgment”, viewed 04 March 2012, Porter, G A & Norton, C L 2012, Using financial accounting information: The alternative to debits and credits, 8th edn, Cengage Learning, New York. Rittenberg, L E, Johnstone, K M & Gramling, A A 2011, Auditing: A business risk approach, 8th edn, Cengage Learning, New York. Sogoloff 2012, “Judgment frameworks & applications in practice”, viewed 04 March 2012, Stahl, M J 2004, Encyclopedia of health care management, Sage, London. Walton P J & Aerts, W 2006, Global financial accounting and reporting: principles and analysis, Cengage Learning EMEA, New York. Read More