Accounting Analysis

Accounting falls into two main categories; financial accounting and cost accounting. Financial accounting is an information system which records, classifies and summarizes financial transactions of business entities and reports the results to interested parties in the form of financial statements. Cost accounting is also an information system, however its focus is on unit cost calculation, cost planning and cost control.

Businesses record their financial transactions by using accrual 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.

Financial accounting’s main objective is to report financial position, financial success (performance) and cash flows of an entity in an understandable manner which is achieved through formal reports called “financial statements”. Financial accounting focuses on external users and tries to satisfy external users’ information needs about the entity

Cost accounting is also an information system, however its focus is on unit cost calculation, cost planning and cost control. Cost accounting supports financial accounting, but it also provides information that will be used in decision making to the managers of an entity. Cost accounting’s main focus is internal users of financial information.

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.

As a matter of fact, income statement does not give an idea of cash flows, or how successful cash management is. The cash in- and outflows are reported on a cash flow statement, which organizes and reports the cash in- and outflows under three sections; cash flow from business operations, cash flow from investments, and cash flow financing. In financial reporting, accrual basis is used for balance sheet and income statement, but cash basis is used for cash flow statement.

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.

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.

In the scope of accounting analysis, the related activities are summarized under three main groups of activity. These are; Business Activities, Investment Activities and Financing Activities.

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. Income statement is the most important tool to understand and evaluate the efficiency of operations. It reports what the business earned and consumed. What the business earned shows the revenues; and what the business consumed shows expenses.

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.

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.

Every business entity’s main goal is to earn more than its sacrifice; in other words, the revenues must exceed the expenses so that there is a net increase in the owner’s equity.

gross margin is a very important figure in understanding the business’s financial performance. If a business is not able to sell its goods or services on a profit margin, soon it will be in trouble. It is the most essential point that gross margin shall be a positive figure. Furthermore, all other expenses are expected to be covered by this gross margin, therefore it must be on such a level to meet this expectation.

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. A business may report a loss figure; however, it is not enough to come to a conclusion. If the operating income is positive, it can be argued that this business can recover sooner or later, because it still has the ability to cover its cost of sales and operating expenses.

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.

Non-current assets are divided into three subgroups; tangible non-current assets, intangible non-current assets, and financial non-current assets.

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.

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.