Section 8.1: Income statement analysis
Accountants may analyze the income statement of a particular business in a number of different ways:
(1) Comparative analysis (changes from year to year - horizontal analysis)
When comparing individual items (account balances or totals) on the income statement of a single business over two consecutive years, accountants may calculate:
(a) the dollar change (increase or decrease) from the first year to the second year
Year 2 - Year 1
(b) the percentage change (increase or decrease) from the first year to the second year
Year 2 - Year 1 x 100%
Year 1
......................................... Year 1 ..... Year 2 ..... dollar change ... percentage change
Sales ............................. $500 ....... $600 ........... + $100 ............................ + 20%
Total Revenues ....... $500 ....... $400 ............ - $100 ............................ - 20%
(2) Trend analysis (changes over multiple years - horizontal analysis)
Accountants may also wish to examine individual income statement items (account balances or totals) of a single business over several consecutive years.
Trends are most often viewed over a three, five or ten-year period.
Trend analysis always uses the year 1 figure as the base figure (100%). Figures from subsequent years (years two, three, etc.) are then expressed as a percentage of the year 1 base figure.
* Please note that percentages are rounded to one decimal point in the below example.
Year 2 x 100%
Year 1
........................................Year 1 ..... Year 2 .... Year 3 ..... Year 4 ...... Year 5
Rent Expense ....... $1000 ..... $1100 ...... $1200 ...... $800 .... $657.30
........................................100% ....... 110% .......... 120% ...... 80% ......... 65.7%
(3) Common-size analysis (vertical analysis)
Finally, accountants often prepare common-size income statements to compare all of the individual items on the end-of-period income statement (account balances and totals) to a base figure (100%), which is always the Total Revenue figure. (Of course when there is only one revenue account, that single account - Sales, Fees Earned, etc. - is equivalent to Total Revenue.)
Accordingly, on a common-size income statement, each and every figure is expressed as a percentage of the total revenue figure.
Rent x 100%
Sales
.......Sales ................ $1000 ....... 100%
...... Rent .................. $200 ......... 20%
...... Wages .............. $500 ......... 50%
...... Total Exp. ........ $700 ......... 70%
...... Net Income ... $300 ......... 30%
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Section 8.2: Balance sheet analysis
Each of the analytical methods utilized with respect to income statements may also be employed when examining balance sheets.
That is to say, accountants may also use comparative analysis, trend analysis and common-size analysis when reviewing the balance sheet of a particular firm.
Comparative analysis with respect to the balance sheet is identical to its usage with respect to income statement account balances and totals.
Similarly, trend analysis with respect to the balance sheet is identical to its usage with respect to income statement account balances and totals.
However, please note that on a common-size balance sheet, the base figure (100%) is always Total Assets or Total Liabilities and Equity (identical amount).
Accordingly, each and every item (account balances and totals) on the common-size balance sheet should be expressed as a percentage of Total Assets or Total Liabilities and Equity.
e.g. ...... Bank .......................... $1000 ..... 67%
............. Supplies .................... $ 500 ...... 33%
............. Total Assets ............. $1500.....100%
............. Bank Loan ................. $ 500 ...... 33%
............. B. Gold, Capital ........ $1000 ...... 67%
............. Total Liab. & Equity $1500 .... 100%
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Comparative analysis – general perspective
The term "comparative analysis" has many meanings within the larger context of financial statement analysis.
In the general sense, comparative analysis refers to any process whereby one company's figures are compared to
(i) a competing company's figures for the same time period or (see below)
(ii) industry averages for the same time period or (see below)
(iii) that same company's own figures over many prior time periods (see below)
(i) Sometimes it is useful to compare the figures of one company (dollar figures or percentages) to the figures of another competing company within the same industry over the same period of time (e.g., Coke 2020 vs. Pepsi 2020)
(ii) At other times, company figures may even be compared to industry averages over the same period of time (e.g., Coke 2020 vs. American soft drink industry 2020)
(iii) And as you have already seen in this chapter, it is always useful to compare account figures or totals of a single company over two consecutive years (comparative analysis) or over three, five or ten consecutive years (trend analysis) in order to measure the degree of improvement (or lack of improvement) in company performance (e.g., Coke 2020 vs. Coke 2019)
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Classified report form balance sheet
In previous chapters, you worked with an account form balance sheet in which data was presented in a horizontal, or left to right, format.
In this chapter however, you will now examine a report form balance sheet in which data is presented in a vertical, or top to bottom, format.
Furthermore, the balance sheet introduced in this chapter is a little different because it is known as a classified report form balance sheet.
A classified balance sheet lists data according to major categories or sections or classifications.
You will notice that assets are now divided into two subcategories:
current assets (assets used up or converted into cash within a relatively short period of time, usually within one year)
fixed assets (assets held for a considerable length of time, typically more than one year, because of their usefulness in producing goods or services; sometimes known as long-term assets, long-lasting assets, capital assets, PPE - property, plant, equipment)
You will also notice that liabilities are now divided into two subcategories, as well:
current liabilities (short-term debts that must be repaid relatively soon, typically within one year)
long-term liabilities (debts that are not due within one year)
Finally, you will notice that the Owner’s Equity section is considerably different in the classified report form balance sheet. Specifically,
the subheading is J.Otto, Capital and not Owner`s Equity, and most importantly
the equity equation (BC + R - E [NI] - DR = EC) is employed:
Owner, Capital
beginning capital (BC)
+ net income (NI)
- drawings (DR)
increase/decrease in equity (unnecessary subtotal -> NI - DR)
= ending capital (EC)
Current assets
Cash
A/R
Supplies
Merchandise Inventory *
Prepaid Expenses (rent, license, insurance) *
Fixed Assets
Automobile
Equipment
Furniture
Land and Building (Property and Plant)
Current Liabilities
A/P
HST/GST/PST Payable
HST/GST Recoverable (contra liability)
Bank Loan (unlikely but depends on due date)
Mortgage Payable (unlikely but depends on due date)
Long-Term Liabilities
Bank Loan (likely but depends on due date)
Mortgage Payable (likely but depends on due date)
Summary of classified, report-form balance sheet format rules
Four left - seven right - everything else in between: Note how the new balance sheet contains three columns of financial data.
Only GST (or HST) Payable/Less GST (or HST) Recoverable and Net Income/Drawings (four figures) appear in the left column. And note that the left column is reserved exclusively for calculations involving subtraction leading to subtotals.
On the other hand, only final totals (seven figures) appear in the right column.
Finally, note that all of the other figures on the balance sheet (everything else, namely the account balances) appear in the middle column.
Also note that there is no Total Liabilities figure calculated in the new classified balance sheet, only Total Assets and Total Liabilities and Owner's Equity.
Similarly, while figures for total current assets, total fixed assets, total current liabilities and total long-term liabilities do appear in the classified balance sheet, the terms indicating those figures do not appear.
And remember that you must underline all five sub-subheadings (Current Assets, Fixed Assets, Current Liabilities, Long-Term Liabilities, B. Gold, Capital) in the new balance sheet.
For a look at an expertly conceived classified report form balance sheet, click here: ch 8 balance sheet.pdf
And for a look at the actual consolidated balance sheets of Second Cup Ltd. for the years 1999 and 2000, click here: ch 8 Second Cup balance sheet.pdf
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Financial ratios: Working capital and working capital (current) ratio
Ratios refer to mathematical formulas used to evaluate the financial performance of a particular company in terms of common measurement factors. Ratios are often expressed as actual ratios (3:1), percentages (12.4%) or dollar figures ($12,500).
Two of the most common ratios used by corporations today are "working capital" and "working capital ratio."
A classified balance sheet can be used to calculate the
(i) working capital and
(ii) working capital ratio (also known as current ratio)
of a particular business on a particular date.
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(i) The working capital for a business involves the use of two totals found on the classified balance sheet:
Working capital = current assets – current liabilities
Example
working capital = current assets - current liabilities
= $40,000 - $30,000
= $10,000
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(ii) The working capital ratio (or current ratio) for a business involves the same two figures:
Working capital ratio = current assets / current liabilities : 1
Example
working capital ratio = current assets / current liabilities : 1
= $40,000 / $30,000 : 1
= 1.3 : 1 (rounded to one decimal place)
The above ratio means that for every dollar of current liabilities, the business currently has approximately $1.30 of current assets.
Not surprisingly, working capital ratio is also commonly referred to as current ratio given the use of current assets and current liabilities within the formula.
A business requires an adequate working capital in order to pay its short-term debts (current liabilities) as they become due. This is because businesses typically rely on their current assets to satisfy (pay off) their current liabilities. The ability to pay one's debts as they become due is known as liquidity or solvency.
And please note that sometimes working capital and working capital ratio can even lead to negative figures or dangerously low figures which indicates difficulties in terms of meeting one's short-term debts as they become due.
Example
wc = ca - cl
= $10,000 - $50,000
= ($40,000)
Example
wcr = ca / cl : 1
= $10,000 / $50,000 : 1
= 0.2 : 1
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Section 8.3: Accountability
Accountability refers to the obligation of a company’s executives (directors and high-ranking officers) to demonstrate to stakeholders (those interested in the success of a particular firm) just how well they have been managing the firm. The proof of strong performance can usually be found in the financial statements (income statement and balance sheet) of the firm. Put another way, company stakeholders will often look to the financial statements in order to measure the success or failure of the firm's top executives in the performance of their duties.
Users/readers of financial statements
The most common users/readers of financial statements (who also typically happen to be stakeholders of the company) include:
Many small and medium-sized business owners (sole proprietors and partners) are not directly involved in the day-to-day operations of their firms. As a result, owners rely on financial statements to measure the performance of the individuals who are running the company on their behalf. Similarly, the owners of a public corporation (shareholders) must also be provided with financial information on a regular basis, as per the law, in order to protect their investments.
Company managers and employees review financial statements to improve results, increase productivity, eliminate weaknesses and make decisions.
Potential investors in corporate shares and their advisors (stockbrokers and financial consultants) can often determine in which corporations they wish to invest (buy shares) based on a comparison of corporate financial statements.
Creditors (those to whom money is owed), including banks and suppliers, often ask to review financial statements in order to determine the capacity of a borrowing firm to meet its debt obligations as they become due.
Competitors (companies within the same industry) are interested in learning of rival company's strengths and weaknesses so as to allow them to better position themselves for success.
Canada Revenue Agency tax officials are interested in reviewing corporate financial statements in order to ensure proper amounts of corporate income taxes and sales taxes are being paid or remitted.
Note that customers/clients are typically the only stakeholders who do not use the financial statements of a company they patronize on a regular basis.
Quality of financial statements – GAAP and IFRS/ASPE
Financial statements must be accurate, complete, up-to-date and reliable in order to have any usefulness to the users of those statements. To this end and as previously discussed, the accounting profession has developed a set of reporting standards known as Generally Accepted Accounting Principles (GAAP), which have since been replaced by International Financial Reporting Standards (IFRS) and Accounting Standards for Private Enterprises (ASPE) in Canada and much of the rest of the world.
To ensure that these standards are being met, most public companies are required to undergo a formal inspection known as an audit at least once a year. An audit is an impartial review of a company’s internal controls and accounting records carried out by an independent, third-party public accountant such as a CPA. Auditors measure the practices and procedures of a company against the standards laid out in the various GAAP or IFRS/ASPE and then provide their written opinion of the company's performance in light of those benchmarks.
Some of the more significant GAAPs that are designed to ensure the fairness and accuracy of a public company’s financial statements include:
1. The consistency principle requires businesses to employ the same accounting methods and procedures (e.g., depreciation methods, inventory valuation methods) in the preparation of financial statements from period to period so as to ensure consistency (apples to apples) in terms of cross-period comparisons. If, however, there is a change in accounting methods or procedures within a firm, the financial statements must clearly disclose the nature of the change and the reasons therefore. Furthermore, any change in accounting methods or procedures must be carried out for legitimate accounting objectives and not simply to artificially improve the financial outlook of the firm. The consistency principle prevents managers from manipulating figures on financial statements by arbitrarily altering accounting methods in order to improve the bottom line.
2. The materiality principle requires businesses to publicly disclose to all stakeholders any events or information that might be deemed material (important) to users of a public company’s current financial statements. According to this principle, any information that has an immediate and significant impact on the current values of the accounts (i.e., assets, liabilities, revenues, expenses) and therefore the current equity and/or net income figures of a public company must be disclosed within the financial statements themselves. As a result, the omission of a $5 sale on a multi-billion-dollar company’s income statement would not be considered material and therefore need not be updated and disclosed as it would not have affected the decision-making of users of that statement. On the other hand, the omission of a $5 billion liability on that same company's balance sheet would, in fact, be considered material and would certainly need to be updated and disclosed to all stakeholders pursuant to this principle. This may even lead to the necessity to recall, fully update and then republish the current financial statements.
3. The full disclosure principle requires all information necessary for a full understanding of a public company’s financial affairs to be publicly disclosed to the stakeholders of that company. Pursuant to this principle, events or information that may potentially and significantly affect the values of the accounts (and therefore the equity and/or net income figures) in the future should be disclosed immediately to all stakeholders in the notes that accompany the financial statements within the annual report. Events and information that are typically disclosed according to this principle include ongoing or threatened lawsuits, active tax disputes involving the CRA, potential mergers or acquisitions, recent or contemplated changes in senior management, and outstanding patent applications.
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Section 8.4: Six column worksheet
The income statement and the balance sheet are always prepared at the end of each fiscal period. The information needed to prepare these formal financial statements comes from the balances found in the ledger accounts which appear on (and are balanced by means of) a formal trial balance.
Prior to the preparation of the formal financial statements, accountants may choose to complete an unofficial, informal business document known as a six column worksheet (page 255) rather than relying on a trial balance alone.
When you look at a worksheet, in the first two columns you will immediately notice all of the accounts and their balances as they appear in the trial balance (trial balance columns).
You will also notice that individual debtors and creditors are no longer listed in the accounts. Instead you will see two control accounts: the Accounts Receivable control account and the Accounts Payable control account. Each control account represents the sum of the balances of all of the individual A/R and A/P accounts.
Steps in preparing a six column worksheet:
1. Write the heading at the top of the page (name of business / name of form / time period).
2. Enter all of the accounts and their balances in the first two columns (trial balance columns) and total the columns ensuring that debits equal credits.
3. Extend each of the account balances to one of the four columns to the right. Revenues and expenses are extended to the income statement columns. Assets, liabilities, capital and drawings are extended to the balance sheet columns.
4. Balance the worksheet in the following manner (page 255):
i. Calculate each of the four remaining columns and write in the totals.
ii. Calculate the difference between the two income statement columns and place the difference (balancing figure) below the smaller total.
iii. Calculate the difference between the two balance sheet columns and place the difference (balancing figure) below the smaller total.
iv. Ensure that the two balancing figures are identical. If they are not, there is a problem.
v. Add the two balancing figures to the totals just above them and place all sums on the final line. Don’t forget to use a double underline at the bottom of all six columns.
Balancing figures
The balancing figures on a worksheet actually represent the net income of the business for the most recent fiscal period. (This explains why "Net Income" is written in the same row as the balancing figures to the far left.) A net profit is earned where revenues are greater than expenses while a net loss is incurred where revenues are less than expenses.
For a look at an expertly-conceived six column worksheet, click ch 8 worksheet.pdf
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Accounting cycle updated
As you already know, the complete set of accounting procedures that must be carried out each and every fiscal period is known as the accounting cycle.
Now that we have learned about the worksheet, the accounting cycle that was first discussed in chapter seven can be updated to include the following steps:
1. Business transactions occur daily
2. Accounting entries are recorded daily (journalizing) in the general journal from source documents
3. Journal entries are posted (transferred) daily to the corresponding ledger accounts using modern accounting software
4. Informal six-column worksheet (containing TB/IS/BS) is prepared at end of fiscal period
5. Formal trial balance (DR = CR) is prepared at end of fiscal period
6. Formal income statement (R - E = NI) prepared at end of fiscal period
7. Formal balance sheet (A = L + OE) prepared at end of fiscal period