Accounting analysis

University Of Central Punjab F13

Executive SummaryIn accounting, account analysis is quite complex and involves in-depth understanding of both the data and the company. It is usually performed by an experienced cost accountant, possibly with the help of one of the company's managers, who deals closely with the company's costs.Accounting analysis is basically done for checking the accuracy of financial statements for accurate financial analysis, in this repot we cover the wide concept of accounting analysis by discussing basic pillars of accounting ASSESTS & LIABILITIES (CAPITAL) and INCOME & EXPENCES which also known as components of financial statements. Accuracy of financial activities which start from vouching to preparing of financial statements is important for further financial analysis. Accuracy of financial statements depends upon accuracy financial equation:ASSETS = OWNER’S EQUITY+LIABILITIESWe try our best to cover the concept of accounting analysis by explaining the above mentioned components.

Analysis Of Financial Statements


“Accounting is the language of business”What is Accounting?

According to ACCOUNTING STANDARDS COUNCIL (ASC):It is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities, that is intended to be useful in making economic decisions.

According to AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AICPA):

Accounting is an art or recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are in part at least of a financial character and interpreting the results thereof.

According to AMERICAN ACCOUNTING ASSOCIATION (AAA):Accounting is the process of identifying, measuring and communicating economic information to permit informed judgment and decision by users of the information.

What is Analysis?A systematic examination of data and facts, by breaking it into its component parts to uncover and understand cause-effect relationships, thus providing basis for problem solving and decision making.

What is Accounting analysis?Definition:

Accounting analysis is the process of evaluating the extent to which a company’s accounting numbers reflect economic reality.

Importance:In accounting analysis, analysts also adjust the financial statements to better reflect the economic reality. Accounting analysis involves a number of different tasks, such as evaluating a company is accounting risk and earning quality, estimating earning power, and making necessary adjustments to financial statements to both better reflect economic reality and assist in financial analysis. Accounting analysis is the process an analyst uses to identify and access accounting distortions in a company’s financial statements. It also includes the necessary adjustments to financial statements that reduce distortions and make the statements amenable to financial analysis.

Why do we accounting analysis?Accounting analysis done to see that is all the components are calculated & written properly. These components are used for preparing the financial statements.There are the following components:

• Assets• Liabilities• Expenses• Income• Capital


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• Asset: Resource controlled as a result of past events and from which future economic benefits are expected to flow

• Liability: Present obligation arising from past events, the settlement of which is expected to result in outflow of resources embodying economic benefits

• Equity: Assets minus liabilities• Income (expense): Increases (decreases) in economic benefits during period from

inflows or enhancements (outflows or depletions) of assets (liabilities) or decreases (incurrence’s) of liabilities from in increases (decreases) in equity, other than contributions from (distributions to) equity

Accounting analysis is an important precondition for effective financial analysis. This is because the quality of financial analysis, and the inferences drawn, depends on the quality of the underlying accounting information, the raw material for analysis.

Process Of Accounting AnalysisFollowing is the process of accounting analysis


Journal

Transaction according to rules

Ledger Accounts

Unadjusted Trial Balance

Adjusting Entries

Adjusted Trial Balance


JournalJournal Entries

Journal entries are the first step in the accounting analysis and are used to record all business transactions and events in the accounting system. As business events occur throughout the accounting period, journal entries are recorded in the general journal to show how the event changed in the accounting equation. For example, when the company spends cash to purchase a new vehicle, the cash account is decreased or credited and the vehicle account is increased or debited.

Identify TransactionsThere are generally three steps to making a journal entry. First, the business transaction has to be identified. Obviously, if you don't know a transaction occurred, you can't record one. Using our vehicle example above, you must identify what transaction took place. In this case, the company purchased a vehicle. This means a new asset must be added to the accounting equation.

Analyze TransactionsAfter an event is identified to have an economic impact on the accounting equation, the business event must be analyzed to see how the transaction changed the accounting equation. When the company purchased the vehicle, it spent cash and received a vehicle. Both of these accounts are asset accounts, so the overall accounting equation didn't change. Total assets increased and decreased by the same amount, but an economic transaction still took place because the cash was essentially transferred into a vehicle.

Journalizing TransactionsAfter the business event is identified and analyzed, it can be recorded. Journal entries use debits and credits to record the changes of the accounting equation in the general journal. Traditional journal entry format dictates that debited accounts are listed before credited accounts. Each journal entry is also accompanied by the transaction date, title, and description of the event. Here is an example of how the vehicle purchase would be recorded.Since there are so many different types of business transactions, accountants usually categorize them and record them in separate journal to help keep track of business events. For instance, cash was used to purchase this vehicle, so this transaction would most likely be recorded in the cash disbursements journal. There are numerous other journals like the sales journal, purchases journal, and accounts receivable journal.

ExampleWe are following Paul around for the first year as he starts his guitar store called Paul's Guitar Shop, Inc. Here are the events that take place.



Journal Entry 1 -- Paul forms the corporation by purchasing 10,000 shares of $1 par stock.

Journal Entry 2 -- Paul finds a nice retail storefront in the local mall and signs a lease for $500 a month.

Journal Entry 3 -- PGS takes out a bank loan to renovate the new store location for $100,000 and agrees to pay $1,000 a month. He spends all of the money on improving

and updating the store's fixtures and looks.

Journal Entry 4 -- PGS purchases $50,000 worth of inventory to sell to customers on account with its vendors. He agrees to pay $1,000 a month.

mintis due

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Journal Entry 6 -- PGS has a grand opening and makes it first sale. It sells a guitar for $500 that cost $100

Journal Entry 7 -- PGS sells another guitar to a customer on account for $300. The cost of this guitar was $100.

Journal Entry 8 -- PGS pays electric bill for $200.

Journal Entry 9 -- PGS purchases supplies to use around the store.



Journal Entry 10 -- Paul is getting so busy that he decides to hire an employee for $500 a week. Pay makes his first payroll payment.

Journal Entry 11 -- PGS's first vendor inventory payment is due of $1,000.

Journal Entry 12 -- Paul starts giving guitar lessons and receives $2,000 in lesson income.

Journal Entry 13 -- PGS's first bank loan payment is due.

Journal Entry 14 -- PGS has more cash sales of $25,000 with cost of goods of $10,000.



Journal Entry 15 -- In lieu of paying himself, Paul decides to declare a $1,000 dividend for the year.

Now that these transactions are recorded in their journals, they must be posted to the T-accounts or ledger accounts.

Recording of transaction according to rulesThese transactions are recorded in a journal, using a double entry bookkeeping system. The transactions in a journal are always recorded in chronological order, the journals are, therefore, also known as ‘Books of original entry.’

Post Journal Entries to T-Accounts or Ledger AccountsOnce journal entries are made in the general journal or subsidiary journals, they must be posted and transferred to the T-accounts or ledger accounts. This is the second step in the accounting cycle.The purpose of journalizing is to record the change in the accounting equation caused by a business event. Ledger accounts categorize these changes or debits and credits into specific accounts, so management can have useful information for budgeting and performance purposes.Since management uses these ledger accounts, journal entries are posted to the ledger accounts regularly. Most companies have computerized accounting systems that update ledger accounts as soon as the journal entries are input into the accounting software. Manual accounting systems are usually posted weekly or monthly. Just like journalizing, posting entries is done throughout each accounting period.

T-AccountLedger accounts use the T-account format to display the balances in each account. Each journal entry is transferred from the general journal to the corresponding T-account. The debits are always transferred to the left side and the credits are always transferred to the right side of T-accounts.Since most accounts will be affected by multiple transactions, there are usually several numbers in both the debit and credit columns. Account balances are always calculated at the bottom of each T-account. Notice that these are account balances—not column balances. The total difference between the debit and credit columns will be displayed on the bottom of the corresponding side. In other words, an account with a credit balance will have a total on the bottom of the right side of the account.As a refresher of the accounting equation, all asset accounts have debit balances and liability and equity accounts have credit balances. All contra accounts have opposite balances.


http://www.myaccountingcourse.com/accounting-cycle/t-accounts


Since so many transactions are posted at once, it can be difficult post them all. In order to keep track of transactions, I like to number each journal entry as its debit and credit is added to the T-accounts. This way you can trace each balance back to the journal entry in the general journal if you have any questions later in the accounting cycle.

ExampleLet's post the journal entries that Paul's Guitar Shop, Inc. made during the first year in business to the ledger accounts



Now these ledgers can be used to create an unadjusted trial balance

Unadjusted Trial BalanceAn unadjusted trial balance is a listing of all the business accounts that are going to appear on the financial statements before year-end adjusting journal entries are made. That is why this trial balance is called unadjusted.This is the third step in the accounting cycle. After the all the journal entries are posted to the ledger accounts, the unadjusted trial balance can be prepared.

FormatAn unadjusted trial balance is displayed in three columns: a column for account names, debits, and credits. Accounts with debit balances are listed in the left column and accounts with credit balances are listed on the right.Accounts are usually listed in order of their account number. Most charts of accounts are numbered in balance sheet order, so the unadjusted trial balance also displays the account numbers in balance sheet order starting with the assets, liabilities, and equity accounts and ending with income and expense accounts.Both the debit and credit columns are calculated at the bottom of a trial balance. As with the accounting equation, these debit and credit totals must always be equal. If they aren't equal, the trial balance was prepared incorrectly or the journal entries weren't transferred to the ledger accounts accurately. As with all financial reports, trial balances are always prepared with a heading. Typically, the heading consists of three lines containing the company name, name of the trial balance, and date of the reporting period


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PreparationPosting accounts to the unadjusted trial balance is quite simple. Basically, each one of the account balances is transferred from the ledger accounts to the trial balance. All accounts with debit balances are listed on the left column and all accounts with credit balances are listed on the right column. That's all there is to it.

ExampleAfter Paul's Guitar Shop, Inc. records its journal entries and posts them to ledger accounts, it prepares this unadjusted trial balance.


http://www.myaccountingcourse.com/accounting-cycle/journal-entries


As you can see, all the accounts are listed with their account numbers with corresponding balances. In accordance with double entry accounting, both of the debit and credit columns are equal to each other.Managers and accountants can use this trial balance to easily assess accounts that must be adjusted or changed before the financial statements are prepared.After the accounts are analyzed, the trial balance can be posted to the accounting worksheet and adjusting journal entries can be prepared

Adjusting EntriesAdjusting entries, also called adjusting journal entries, are journal entries made at the end of a period to correct accounts before the financial statements are prepared. This is the fourth step in the accounting cycle. Adjusting entries are most commonly used in accordance with the matching principle to match revenue and expenses in the period in which they occur.

Adjusting Entry TypesThere are three different types of adjusting journal entries. Each one adjusts income or expenses to match the current period. This concept is based on the time period principle, which states that accounting records and activities can be divided into separate time periods. In other words, we are dividing income and expenses into the amounts that were used in the current period and deferring the amounts that are going to be used in future periods.

AJEs are used to record:Prepaid expenses or unearned revenues –

Prepaid expenses are goods or services that have been paid for by a company but have not been consumed yet. Insurance is a good example of a prepaid expense. Insurance is usually prepaid at least six months. This means the company pays for the insurance but doesn't actually get the full benefit of the insurance contract until the end of the six-month period. This transaction is recorded as a prepayment until the expenses are incurred. The same is true at the end of an accounting period. Only expenses that are incurred are recorded, the rest are booked as prepaid expenses.

Unearned revenues These are also recorded because these consist of income received from customers, but no goods or services have been provided to them. In this sense, the company owes the customers a good or service and must record the liability in the current period until the goods or services are provided.

Accrued expenses and accrued revenues – Many times companies will incur expenses but won't have to pay for them until the next month. Utility bills are a good example. December's electric bill is always due in January. Since the expense was incurred in December, it must be recorded in December regardless of whether it was paid or not. In this sense, the expense is accrued or shown as a liability in December until it is paid.


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Non-cash expenses – Adjusting journal entries are also used to record paper expenses like depreciation, amortization, and depletion. These expenses are often recorded at the end of period because they are usually calculated on a period basis. For example, depreciation is usually calculated on an annual basis. Thus, it is recorded at the end of the year. This also relates to the matching principle where the assets are used during the year and written off after they are used.

Recording AJEsRecording adjusting journal entries is quite simple. The process includes three main steps:-- Determine current account balance-- Determine what current balance should be-- Record adjusting entryThese adjustments are then made in journals and carried over to the account ledgers and accounting worksheet in the next accounting cycle step.

ExampleFollowing our year-end example of Paul's Guitar Shop, Inc., we can see that his unadjusted trial balance needs to be adjusted for the following events.

Paul pays his $1,000 January rent in December.

Paul's December electric bill was $200 and is due January 15th.

Paul's leasehold improvement depreciation is $2,000 for the year.



On December 31, a customer prepays Paul for guitar lessons for the next 6 months.

Paul's employee works half a pay period, so Paul accrues $500 of wages.

Now that all of Paul's AJEs are made in his accounting system, he can record them on the accounting worksheet and prepare an adjusted trial balance

Adjusted Trial BalanceAn adjusted trial balance is a listing of all company accounts that will appear on the financial statements after year-end adjusting journal entries have been made.Preparing an adjusted trial balance is the fifth step in the accounting cycle and is the last step before financial statements can be produced.

FormatAn adjusted trial balance is formatted exactly like an unadjusted trial balance. Three columns are used to display the account names, debits, and credits with the debit balances listed in the left column and the credit balances are listed on the right.Like the unadjusted trial balance, the adjusted trial balance accounts are usually listed in order of their account number or in balance sheet order starting with the assets, liabilities, and equity accounts and ending with income and expense accounts.Both the debit and credit columns are calculated at the bottom of a trial balance. As with the accounting equation, these debit and credit totals must always be equal. If they aren't equal, the trial balance was prepared incorrectly or the journal entries weren't transferred to the ledger accounts accurately.As with all financial reports, trial balances are always prepared with a heading. Typically, the heading consists of three lines containing the company name, name of the trial balance, and date of the reporting period.


http://www.myaccountingcourse.com/accounting-cycle/adjusted-trial-balance



PreparationThere are two main ways to prepare an adjusted trial balance. Both ways are useful depending on the site of the company and chart of accounts being used.You could post accounts to the adjusted trial balance using the same method used in creating the unadjusted trial balance. The account balances are taken from the T-accounts or ledger accounts and listed on the trial balance. Essentially, you are just repeating this process again except now the ledger accounts include the year-end adjusting entries.You could also take the unadjusted trial balance and simply add the adjustments to the accounts that have been changed. In many ways this is faster for smaller companies because very few accounts will need to be altered.Note that only active accounts that will appear on the financial statements must to be listed on the trial balance. If an account has a zero balance, there is no need to list it on the trial balance.

Example



Once all the accounts are posted, you have to check to see whether it is in balance. Remember that all trial balances' debit and credits must equal.Now that the trial balance is made, it can be posted to the accounting worksheet and the financial statements can be prepared.

Need for a Accounting Analysis Coherence in rules and standards. Quick solutions to new and emerging practical problems by reference to an

existing framework of basic theory. Increased user understanding of and confidence in financial reporting. Enhanced comparability among companies’ financial statements.

Qualitative characteristics: The overriding criterion for evaluating accounting information is that it must be useful for decision-making. To be useful, it must be understandable.

a. Primary qualities of useful accounting information.Relevance. Accounting information is relevant if it is capable of making a difference in a decision. Relevant information has(a) Predictive value.(b) Feedback value.(c) Timeliness.

Reliability. Accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent. Reliable information has(a) Verifiability.(b) Representational faithfulness.(c) Neutrality.

b. Secondary qualities of useful accounting information.Comparability. Accounting information that has been measured and reported in a similar manner for different enterprises is considered comparable.Consistency. Accounting information is consistent when an entity applies the same accounting treatment from period to period to similar accountable events.We need accounting analysis to remove accounting distortion.

Accounting Distortions Definition

The term ‘accounting distortions’ refers to any kind of deviation and divergence between information reported by financial statements and the reality of the business (Gandevani, 2010). It is the process of using accounting alternatives (usually unintended alternatives within the accounting standard) inconsistently to increase or decrease the flow of items through the income statement (usually by affecting the timing of the flows) in order to increase or decrease reported profit for a specific period (Tosen, 2006).Distortions Caused by Accounting Procedures


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While most people think that accounting rules are pretty black or white, there are actually many places where small business owners are given choices on how to account for transactions. Usually these choices must be disclosed to users of the financial statements, but that doesn't remove the distortion that differing procedures cause. Understanding some of the common areas subject to distortion can help you be a more savvy user, and creator, of financial statements.

Inventory Cost FlowsU.S. GAAP allows companies a choice as to which way they assume that inventory costs move through the accounting records. Most companies use the first inventory in, before using newer purchases. However, companies are not required to account for inventory costs that way. For example, small business owners can choose to have the accounting records move the newest costs out first, before using older products. When an owner chooses to have the books show a different path through the company than the goods actually move through the system, the company's inventory costs can become distorted.

Depreciation MethodUnder U.S. GAAP, small business owners are given the option to choose different methods to depreciate assets. The straight-line method spreads expense evenly over time by charging an equal amount of depreciation expense each year. The units of production method assume that each unit manufactured is responsible for a small part of the wear and tear on the machine. Therefore, expense is spread evenly over the units manufactured. Lastly, accelerated methods reflect the assumption that machinery rapidly declines in value and uses a multiple of the straight-line depreciation rate to depreciate quickly. Like any other estimate, none of the three allowed methods reflects the actual market value of the machinery being depreciated. As such, the amount of distortion depends on how close these methods are to the manner that the equipment actually declines in value.

Contingent LiabilitiesContingent liabilities are liabilities that may or may not be incurred by the company depending on the outcome of a future event. For example, a company may be sued by another company. Because the trial hasn't been settled, management must make an estimate of the likelihood of the company losing the lawsuit and the amount that the company will eventually owe. This mix of management estimate and uncertainty makes these situations ripe for distorted financial statements. To help guard against distortion, auditors will ask the company's attorneys for their opinion on the most likely outcome and range of loss. If the figures differ from those of management, the auditors may question the estimates made by management.

Book vs. TaxAccounting procedures differ greatly between U.S. GAAP and accounting for income tax purposes. For example, under tax accounting a company can only reduce net income for uncollectible accounts at the time the write-off occurs. However, GAAP



requires that net income be reduced much earlier. Because of differences like these, two sets of books need to be reconciled. In most cases, financial accounting records are reconciled to the company's 890tax books. This is done on IRS form M-3. This allows small business owners, or most often their tax accountants, to move between the two accounting systems. While this seems to indicate that tax books are a distortion of GAAP income, it depends on which perspective you take. The takeaway here is that no matter which set of books you have completed, you'll still have some additional work to do.

How to remove these distortions?Undo Accounting Distortions

A firm’s cash flow statement provides a reconciliation of its performance based on accrual accounting and cash accounting. Financial statement footnotes also provide a lot of information that is potentially useful in restating reported accounting numbers. The tax footnote usually provides information on the difference between a firm’s accounting policies for shareholder reporting and tax reporting.

Conclusion:By doing this report we conclude following steps:

Step 1; Identify key accounting policies:The goal of accounting analysis is to identify key accounting policies that show and measure the success and risk factors that affect a firm with maximum accuracy.For example: key success factors in banking industry are interest and credit risk management, for the manufacturing industry are and D and product innovation.

Step2: Acess Accounting Flexibility: Different firms operate on different of accounting flexibility. Firms accounting freedom may be constrained by accounting conversion.

For example: R&D although is a success factors for biotech firms, it is not permitted to be shown on the accounting statements, similarly marketing expenditure for retail firms.

Step3: Evaluate Accounting Strategy: How do the firms accounting policies compare o the norms in the Industry? Has the firm changed any of its policies or estimates? What is the justification?

What is the impact of adequate these changes?

Step4: Evaluate the Quality of Disclosure: So does the company provide adequate disclosure to access the firm business

strategy and its consequences? Do the footnotes adequately explain the key accounting policies assumptions and

their policies? Does the firm adequately additional disclosure to help outsider to understand

how these factors are being managed?



Step 5: Analysis of red Flags:Red Flags point to questionable accounting quality. These indicators suggest that the analyst should examine certain items more closely more information on them .Some common red flags is: Unexplained changes in accounting, especially when performance is poor. Unexplained transactions that boost profits. Unusual increase in account in accounts receivable in relations to sales increase. An increase gap between s firms reported income and its cash flow from

operating activities. Unexpected large assets Large fourth-quarter adjustments

Step 6: Undo Accounting Distortions: A firm’s cash flow statement provides a reconciliation of its performance based

on accrual accounting and cash accounting. Financial statement footnotes also provide a lot of information that is potentially

useful in restating reported accounting numbers. The tax footnote usually provides information on the difference between a firm’s

accounting policies for shareholder reporting and tax reporting.

References:https://www.google.com.pk/search?biw=1440&bih=799&noj=1&q=undo+accounting+distortions&oq=accounting+distortions&gs_l=serp.3.0.0i7i30l5j0l2j0i30l2.410486.411232.0.419878.7.4.0.0.0.0.618.618.5-1.1.0.msedr...0...1c.1.62.serp..6.1.616.XW_muYYyqQIhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1428202http://maaw.info/Chapter7.htmhttp://www.myaccountingcourse.com/accounting-cycle/journal-entrieshttp://www.myaccountingcourse.com/accounting-cycle/t-accounts


http://www.myaccountingcourse.com/accounting-cycle/t-accounts

http://www.myaccountingcourse.com/accounting-cycle/journal-entries

http://maaw.info/Chapter7.htm

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1428202

https://www.google.com.pk/search?biw=1440&bih=799&noj=1&q=undo+accounting+distortions&oq=accounting+distortions&gs_l=serp.3.0.0i7i30l5j0l2j0i30l2.410486.411232.0.419878.7.4.0.0.0.0.618.618.5-1.1.0.msedr...0...1c.1.62.serp..6.1.616.XW_muYYyqQI



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