Accounting System Reporting

Accounting systems have been around long before computers came on the scene. The basic reports and ratios are the same regardless of whether they are manually prepared or are generated from a computer system. In this chapter, we will cover a few of the basic reports every accounting system should produce.

Balance Sheet

The Balance Sheet is a listing of all of the assets, liabilities, and equity accounts (recall that these are the permanent accounts) and their balance at a given point in time. Typically, a Balance Sheet is prepared after the closing entry has moved the revenue (or loss) for the period into the retained earnings account:

When the report is prepared immediately after the books are closed, the Balance Sheet will be in balance. However, an interim Balance Sheet could also be prepared, in which case the revenues minus expenses are placed into retained earnings for reporting purposes (i.e., no actual journal entry). In essence, the “closing entry” is made just to simulate what the Balance Sheet will look like. Interim reports should always include a footnote or comment indicating that this is an interim report.

Income Statement

While the Balance Sheet is a snapshot of the business at a given point in time, the Income Statement is a report about how a company did over a period of time. The Income Statement heading should also be labeled “For period ending mm/dd/yyyy.” This makes it clear that it represents a period of time, not a snapshot:

If any unusual income or expense charges occur on the report, they are generally noted in a footnote on the bottom of the statement.

Income Statements can be summarized with expenses minimized (this is useful to see the big picture) or expanded in detail, showing a manager exactly where money was spent. Often, comparative income statements show multiple periods in separate columns so that a reader can compare income/expense results between accounting periods.

Statement of Changes in Financial Position

The Statement of Changes in Financial Position report shows why the assets and liabilities have changed between periods. The report basically measures cash flow that occurs over a period of time. The report is sometimes called the Cash Flow or Fund Flow Statement or the Sources and Uses of Cash.

There are two sections in the report; the first is the Source of Cash (i.e., what activities brought cash into the business) and the second is Use of Cash (i.e., what activities took cash out of the business).

Source of Cash

The most common Source of Cash should be the net income from business operations. Often, this section of the report looks like a mini-income statement. However, non-cash expenses such as depreciation are added back in. So, our income statement from above would look like:

We might also receive cash from financing (money we borrowed), and from investments, etc. These items would also be listed as a Source of Cash. For the sake of our example, let’s assume that we had the following transactions during the year:

• Borrowed $7,500 from a bank
• Made $2,800 from investments and dividends
• Purchased a new computer system for $9,000
• Paid $3,500 of debt back

The following statement shows how the net income and transactions above would appear:

If we were to compare balances at the beginning of the year and at the end of the year, we should see an increase in the cash balance of $8,525 and the report would provide an overview of where this cash came from.

In the example report above, we summarized the cash flow from operations although a company might have a more detailed version of the report that includes how that number was calculated.

Statement of Changes in Retained Earnings

The Statement of Changes in Retained Earnings is generally only prepared for a corporation. It provides an explanation for the difference in the retained earnings account between two periods. For sole proprietorships and partnerships, retained earnings always increases by the net income for the period.

However, corporations can pay dividends from retained earnings so this report provides a breakdown between income and possible dividends that are paid out:

These four financial reports are now standard reporting requirements for publicly held companies in the U.S. Taken together, they provide a good snapshot of how a business is doing. When you read a company’s financial report, you will typically find these reports as well as footnotes to explain any out-of-the-ordinary events that occurred during the financial period.

Other countries, particularly those that use International Financial Reporting Standards (IFRS) may have a different set of required reports. However, regardless of the requirements, the goal is to ensure that people who are reading the reports can get an accurate picture of the health of the company. This is particularly true for companies seeking investment capital.

Ratios and Formulas

In addition to the four primary reports, there are a number of commonly used ratios to provide quick snapshots of the business. In this section, we will discuss a few examples, why they are used, and how to calculate them.

Balance Sheet Ratios

The following ratios are derived from numbers on the balance sheet. They primarily focus on whether or not the company is in a position to pay its current bills. If you just look at the numbers, they can be misleading. For example, the company with $1,000,000 in their checking account may look much stronger than the company with $50,000. But, if the first company has $990,000 in current debt, and the second company has $5,000 in debt, the second company is actually in a stronger financial position.

Working Capital

The Working Capital formula is simply:

Current Assets - Current Liabilities

It simply indicates whether or not there is enough money to pay the bills on time. The larger the working capital value, the more likely current bills will be covered.

Current Ratio

The Current Ratio measures how much more current assets there are than current liabilities. Its formula is:

Current Assets ÷ Current Liabilities

The Working Capital number makes it tough to compare companies since the amount of available funds can vary substantially based on the company size. The Current Ratio makes it easier to compare companies. A ratio of 2:0 indicates that the company has twice the current assets it needs to pay its bills.

Quick Ratio

A drawback to the Current Ratio is that “inventory items waiting to be sold” is considered a current asset. Depending upon how long the inventory takes to sell, it might not be a viable source of funds to pay current liabilities. If the inventory sells quickly, it is likely to be available for current bills. However, if a factor such as a shipping company strike or damage to the store happens, making inventory unavailable for sale, current liabilities might not be met.

The Quick Ratio formula pulls the inventory out of the equation, essentially asking, if nothing is sold for the next period, can the company still pay its current bills? The formula is:

(Current Assets - Inventory) ÷ Current Liabilities

There are some ratios used to determine how quickly inventory sells, which we will cover in a later chapter when we cover inventory. Similarly, we need to know how quickly our customers pay their bills because that number can also impact how much funds are really available in the current assets bucket.

Standards

The ratios by themselves help you compare two companies but there are also published Standard ratios based upon the industry the company is in. If a company is close to or above the current ratio that is average for their industry, that can be a good sign. However, if they are too much above (say, 4.0 vs. 1.3 industry average), it would indicate poor money management (or that the company is saving cash for a reason). If the quick ratio is below 1, it means the company does not have enough current assets to pay bills so you’d have to expect that inventory will be quickly converted to cash.

Income Statement Formulas

The following ratios are derived from numbers on the income statement. They primarily focus on how the company is doing each period and how much profit is being made. The numbers are often compared with standards and other businesses to help focus on what areas might need improvement.

Gross Margin

When a company sells goods, there is an associated cost with obtaining (either through purchase or manufacturing) the goods to be sold. The Gross Margin shows the percentage of sales dollars that can be used to pay operating expense after the cost of the good is subtracted. The formula is simply:

• Gross Profit = (Sales - Cost of Goods Sold)
• Gross Margin = Gross Profit / Net Sales

If a company has sales of $800,000 and a gross profit of $350,000 on those sales, the gross margin would be 43.75 percent. This is typically compared with other similar businesses. If the goods being sold are purchased, a company might be able to negotiate better terms from vendors. If the goods are being manufactured, better production machinery and techniques might be available.

Profit Margin

Profit Margin is similar to Gross Margin except that it includes all of the expenses, not just Cost of Goods Sold. It is typically computed as an after-tax, net income figure. If our company has $800,000 in sales and a net income (after taxes) of $48,000, the profit margin is six percent. This number is typically compared to other businesses to see whether or not operating expenses can be lowered.

Earnings per Share (EPS)

For corporations, another common ratio is Earnings per Share. This is computed by taking the net income after tax and dividing it by the number of outstanding shares of stock. It is an indication of profitability of the corporation.

The net income amount is reduced by any dividends paid on preferred stock:

• (Net Income - Dividends on Preferred) / Average number of outstanding shares

The Average number of outstanding shares can simply be computed as:

• Number of shares at beginning of the year * 50 percent
• Number of shares at end of year * 50 percent

You can also compute the number of shares as a weighted average, particularly if a large volume of stock shares are sold during the year.

Note: The above example is basic EPS; only shares outstanding (i.e., owned by stockholders) are considered. Companies can also compute diluted EPS which factors outstanding shares PLUS how many shares could be outstanding if all stocks options, warrants, etc., were converted. It tends to give a much more conservative EPS value but it is a complex calculation that is beyond the scope of this book.

Summary

The four reports and the variety of ratios allow a person to look objectively at how a company is doing (via the reports) and to compare the company with other companies and/or with industry standards. While there will often be exceptions and special situations, the basic reports of an accounting system should reflect a solid picture of how the company is doing, and can affect whether or not you are interested in investing in the company, working for them or doing business with them.