Accounting analysis

University Of Central Punjab F13
Analysis Of Financial Statements P age 1
Executive Summary
In 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+LIABILITIES
We try our best to cover the concept of accounting analysis by explaining the above
mentioned components.

“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

• 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 Analysis
Following is the process of accounting analysis
Journal
Transaction
according to rules
LedgerAccounts
Unadjusted Trial
Balance
Adjusting Entries
Adjusted Trial
Balance

Journal
Journal 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 Transactions
There 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 Transactions
After 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 Transactions
After 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.
Example
We 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
.

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 rules
These 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 Accounts
Once 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-Account
Ledger 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.

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.
Example
Let'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 Balance
An 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.
Format
An 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

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

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 Entries
Adjusting 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 Types
There 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.

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

Preparation
There 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

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 Flows
U.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 Method
Under 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 Liabilities
Contingent 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. Tax
Accounting 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+ac
counting+distortions&oq=accounting+distortions&gs_l=serp.3.0.0i7i30l5j0l
2j0i30l2.410486.411232.0.419878.7.4.0.0.0.0.618.618.5-
1.1.0.msedr...0...1c.1.62.serp..6.1.616.XW_muYYyqQI
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1428202
http://maaw.info/Chapter7.htm
http://www.myaccountingcourse.com/accounting-cycle/journal-entries
http://www.myaccountingcourse.com/accounting-cycle/t-accounts

Accounting analysis

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