ISL459U-FINANCIAL STATEMENT ANALYSIS
Chapter 2: Accounting Analysis
Accounting Analysis
One of the most important aspects of accounting analysis is use of accrual basis instead of cash basis. Another one is the financial statements are prepared for the use of various interest groups, not to satisfy one or some groups.
Accrual Basis and Cash Basis
Accrual basis requires that any transaction shall be recorded at the time of accrual, in other words when the transaction is actualized, rather than the time of cash payment or cash collection. Cash collection can be before delivery, which will create a liability such as an “advances taken account”, cash collection can be at the same time with delivery, or cash collection can be after the delivery, which will create a “trade receivable account”. The expenses are recorded based on the actualization, not based on the payment date.
In accordance with the periodicity principle, the revenues of a time period are matched to the expenses of that period, which is the matching principle. Periodicity and matching principles are closely related to each other and sometimes used even interchangeably. These two principles are the main fundamentals of the accrual basis. That is the main reason why the accounting transactions are not recorded on the cash basis, but on the basis of actualization; accrual basis.
In the cash basis, revenue from the sale of goods and services is recorded when the cash from the customer is collected. On the other hand, expenses like salaries, utilities (electricity, water, heating etc.), insurance are only recorded when the payments for these expenses are made. If their revenues and expenses are recorded on the cash basis, the financial performance (profit or loss) cannot be measured correctly.
Example 2.1 This example is for comparing the effect of accrual basis and cash basis on the income statement of a business. A wholesaler was established at the beginning of 2020. It sold merchandise inventory amounting $1,200,000 during 2020. Of this amount, 600,000 was collected during 2020. Total purchases for 2020 were $900,000, and all of the purchases were in cash. There was no ending inventory at the end of 2020. There was no prepaid expense at the end of year, either
The accrual basis allows the user to see the entire picture in evaluating the financial performance, however the cash basis only shows the cash in-and outflows. Cash management is without doubt an important issue for businesses, however it is not a representative of financial performance. Financial performance shall be measured by the revenues and expenses recognized in accrual basis. Under accrual basis, revenues and expenses are related to owner’s equity; revenues are increases in owner’s equity (except for the contributions of owners), and expenses are decreases in owner’s equity (except for the distributions to owners such as dividends). The ultimate goal of a business
is to maximize the owner’s equity, not to increase cash flows.
Users of Information and Stakeholders of the Business
Accounting analysis is made for satisfying information needs of all users of information, not one or some of them. Users of information are those parties who make a decision about the business. In general, these are defined as stakeholders or interest groups of the business. The stakeholders are; shareholders (owners), management, creditors (lenders), suppliers, customers, employees, state, regulatory bodies, and competitors. Accounting analysis is important for all of the stakeholders, because it helps them to have a better understanding of the financials of the business.
Types of Activities
Business entities conduct various types of activities in order to achieve their goals. The outcome of these activities are transmitted to users of information via financial statements. The main function of financial statements is to summarize and communicate business activities. In the scope of accounting analysis, the related activities are summarized under three main groups of activity. These are;
• Business Activities • Investment Activities
Business Activities Analysis
Business activities are production and sale of goods and services. Business activities are the reason for the existence of the business. It is the main field of activity. The business activities are analyzed by using the income statement. Income statement (also called profit or loss statement) reports the financial performance of a period, which is usually one year. It also reports what the business earned and consumed. Income statement reports the revenues and expenses in an organized manner. The main elements of income statement are as follows:
The income statement starts with gross sales. This is the total amount of goods and services sold during 2020.
From the gross sales, sales discounts are deducted. Sales discounts are discounts used to encourage the customers to make an early payment. If a customer accepts to pay in the discount period, then the customer pays less than the gross amount.
From the gross sales, sales returns and allowances are also deducted. As the name indicates, sales returns are those sales the customer wants to cancel later.
After deducting the sales discounts and sales returns and allowances from the gross sales, net sales are obtained. Net sales is a very important sign of the business’s size of operations.
From the net sales, the cost of sales (cost of goods sold or cost of services sold) is deducted. Cost of sales is the total
amount sacrificed to sell and earn a revenue. The difference between net sales and cost of sales is called gross margin or gross profit.
After the gross margin, the operating expenses follow. Operating expenses are those expenses that are needed to run a business. They are expenses such as general administrative expense, marketing expense, selling expense, research and development expense. When operating expenses are deducted from the gross margin, operating income is computed. Operating income is also very important because it is the best indicator of efficiency of operations. After the operating income, other income or expense items follow. These are revenues and expenses arising from valuation differences, losses for obsolete inventory, losses for doubtful accounts, and extraordinary gains or losses from various transactions. These may substantially fluctuate along the financial markets, or some them incurs only once and will not be repeated.
Then, the other income or expense, interest and tax are deducted and net income figure is computed. The ultimate goal of a business is to be able to report net income, however accounting analysis requires a more detailed analysis on the points mentioned above.
Investment Activities Analysis
Businesses conduct their operations on a day-to-day basis. They are continuously repeating their business activities mentioned above. However, businesses also have to make investments from time to time. This investment is mainly related to purchases and disposal of current and non- current assets. Assets are economic resources acquired by the business and expected to provide benefits to the business, in other words to be used in operations. Assets are classified as current and non-current assets.
Current Assets
Current assets are cash and those assets that are expected to be collected, sold, used, consumed within one year, starting from the balance sheet date. Those assets which are not called current assets are non-current assets, which are expected to be used or consumed beyond one year.
Non-current Assets
Non-current assets are those assets that are expected to be used beyond one year, for example machinery, equipment, motor vehicles, building etc. They also include receivables due more than one year. Non-current assets are divided into three subgroups; tangible non-current assets, intangible non-current assets, and financial non-current assets.
Acquiring non-current assets often requires strategic planning, for example buying an expensive machinery is a strategic decision and must be carefully planned before such a purchase. Non-current assets, especially tangible non-current assets in particular, are mostly bought on credit, they are financed by using a long term debt or equity financing.
Depreciation: Tangible non-current assets are depreciated throughout the years. That means their cost becomes an expense by using a depreciation method. An appropriate depreciation method shall be chosen, otherwise the depreciation expense will provide misleading information. Another important type of non-current asset is intangible non-current assets. These are assets without a physical substance, but providing certain benefits to the business.
Financing Activities Analysis
The assets of a business are crucial in conducting its operations and generating revenue. However, they must be financed. They are either financed by external sources or internal sources. External sources are liabilities. Liabilities fall into two categories, current (short term) and long term liabilities. Current liabilities are due within one year; in other words, they shall be paid within one year. They are usually used for financing current assets.
External financing requires an interest. Interest is the excess of the initial amount and is recognized as an expense. If the business heavily relies on external financing, it may face a high amount of interest. However, if the business is able to sell goods and services with a profit margin to cover all of its expenses including interest, it is not an important issue.
In financing non-current assets, equity financing can also be used. In this case, either current owners make additional investment or new shareholders join the company. This type of financing does not require interest; however, partnership structure is affected. In making accounting analysis, the composition of liabilities and equity must be carefully analyzed. This analysis includes the interest rates of the liabilities and computing cost of capital.