Building a better income statement – according to McKinsey
McKinsey have a nice web article which highlights the problems with GAAP reporting versus the needs of investors and analysts. The kernel of their article is that financial statements, with some small adjustments, could save investors a lot of re-working of figures. They provide the following example:
Two things come to my mind. First, in my first real management accounting job almost 20 years ago now, we prepared an income statement which was not too far away from the one on the right above. And, most management accounting courses would teach students to draw up some kind so similar profit statement – at least separating direct and indirect costs.
Second, the articles does not mention XBRL at all. With tagged data from GAAP financial statements, XBRL could re-draw financial statements in any format. I am not saying all XBRL tags are there to do what McKinsey suggest, but it is certainly possible technically.
You can read the full article at the link below. It is worth a read.
What is a parntership? How does it change financial statements prepared?
In business, a partnership refers to the coming together of two or more persons to conduct a business. Normally, there is a maximum number of partners with exceptions made in cases like accounting practices and legal practices. A partnership is usually formed to take advantage of the combining of skills and resources. The objective is normally to make a profit, and this profit is shared out in some agreed way among partners. Losses too are borne by the partners.
As essential element in the formation of a partnership is the Partnership Agreement. This is a legal agreement (which ideally should be written) which contains items such as the following:
- the capital to be contributed by each partner
- how profits are to be divided
- any interest to be paid on capital contributions
- any interest to be paid by the partners on monies withdrawn
- salaries to be paid to partners
- arrangements for admission of new partners
- arrangements to dissolve the partnership, and procedures on the retirement/death of a partner.
In the absence of a partnership agreement, in the UK and Ireland, the Partnership Act 1890 applies (see here).
In terms of preparing financial statements, there are some differences. First, any adjustments to profit are made in a profit and loss appropriation account – which is in effect an addendum to the income statement/profit and loss a/c. For example, any interest due to or to be paid by partners, salaries etc are made here. The resulting adjusted profit is then shared among the partners as agreed. In the statement of financial position (balance sheet), each partner will have their own separate capital account. Some partnerships used a combination of capital and current accounts. The former shows only the fixed capital contributions, the latter shows profits, drawings, interest, salaries etc. This approach is probably better as the any negative balances on the current account will signify that perhaps a partner is taking out more from the business than they should.
Financial reporting apps – now and the future
The October 2011 issue of CIMA’s Financial Management had a good article summarising the development to date of iphone/ipad/android apps for financial reporting. Since the advent of the internet, most public companies (and many other organisations) now publish their financial statements on their websites. Some just provide a static PDF file, while others offer more dynamic PDF files, Excel downloads and even XBRL formats. I suppose it is only logical that some firms are now providing a corporate reporting app, which not only make financial information more readily available, but also available in an offline format. According to the article, only a few companies have taken the “ground-breaking” step to develop and provide an app solely for financial information. Nestle launched the first such app (30,000 downloads), which incorporates news, financial reports, presentations and share prices. The article also mentions (just) two other firms, Shell (3,000 downloads) and Cemex – i think Tesco also have an app. There are obvious benefits of an app – reducing distribution and print costs, faster information dissemination – but the objective according to the article is to make the user’s experience far more interactive than web pages currently do. At present, given the infancy of such apps, interaction is their biggest downfall too. According to the author, only increased interactivity and a more user-friendly approach will increase the use of financial reporting apps. But, no matter what way these apps develop over the coming years, one thing is for sure – mobile communication will increase. Perhaps these early adopters of financial reporting apps may become the leaders in the field soon – only time will tell.
Using ratio analysis – an introduction
Over the coming weeks, I’ll be writing a number of posts on using ratios to analyse financial statements. First though, let me give an outline of what ratio analysis is about.
If you want to compare the financial statements on a business from one year to another, or, compare two businesses you cannot use direct comparisons of figures. Here’s a simple example:
Company A has a profit in 2010 of €1m according to its income statement. Company B has a profit of €5m. Which company is the most profitable?
You’re probably thinking Company B, as its profit is five times that of Company A. However, this comparison is mis-leading. Now let’s assume Company A has capital of €2m, but Company B has capital of €25m. Now we can do a quick calculation as follows::
Return on investment Company A €1m/€2m = 50%
Return in investment Company B €5m/€25m – 20%.
Looking at the figures this way, we can see that Company A actually manages to make 2.5 times the return of Company B. This simple shows one problem of compare raw numbers, that is scale. However if we use financial ratios, which express figures in relative terms, we are able to make more direct comparisons between businesses. Over the next few weeks, I ‘ll be writing a number of posts detailing some individual ratios, so keep an eye out. By the way, if you already know how to do ratios and/or want your accounts analysed, here’s a great website where you can plug in your data for a free analysis.
What organisations need to prepare acccounts?
One of the first few things that I would typically teach students that are new to accounting is that all most organisations need to control what they do in some way. Control can be of a financial nature, i.e. preparing financial statements, and this is something we typically associate with “for-profit” organisations.
However, many not-for-profit organisations also need to keep accounting records and have intricate financial/accounting based control systems. For example, a charity might like to know its sources of funding and keep a detailed trace on all expenditures. Similarly, any sovereign state needs to keep track of its income (usually taxes) and its outgoings e.g. expenditure on schools, roads and social welfare. A few months ago, a number of articles on the annual financial report of the Vatican State caught my eye (see here and here). In brief, the Vatican State had a surplus of about €10 million for 2010. The Vatican is a peculiar organisation in that it is somewhere between a Church and a State. I can’t find the annual report on-line, but as far as know one main source of income for the Vatican is the traditional “Peter’s Pence” collection held annually at all catholic churches across the world. The press releases surrounding the 2010 Vatican financial report seems to suggest that deliberate efforts were made compared to previous years to control costs and keep within budget. So, even the Vatican has a use for accounting information – both financial statements of some kind, and management accounting. By the way, if you do find the annual reports of the Vatican on-line, do get in touch
New code for Irish charities
In March 2011, the Irish Times reported on a new voluntary code for charities in Ireland. Yes, it’s a while ago and has been on my “to do” list for quite a while. Following the enacting of the Charities Act 2009, all Irish charities must submit an annual activity report to the Charities Regulatory Authority. Larger charities also have to complete and file audited accounts. The new proposed code aims to make charities more transparent financially, going beyond the requirements of the Act. The five key elements of the code are:
- charities commit to good practice and ensure fundraising activities are open and legal
- a donor charter will be introduced
- a complaints and feedback procedure
- a monitoring group will monitor code compliance
- an annual report and a statement of annual accounts will be publicly available
XBRL on the up
According to CIMA Insight (December 2010), XBRL (the html-type languages used to electronically transmit financial reports) is becoming very common place. XBRL is an XML type language (used on web pages and e-business) used specifically for financial reporting. The increasing use of IFRS, and a XBRL file which encompasses IFRS is undoubtedly helping the rise of XBRL. It is also a free to use language, which helps too. So does XBRL do or offer?
The key advantage is that is provides a common and agreed method to file financial reports in all kinds of places. Using the main statements required under IFRS for example, anyone with a web-browser can make sense of the data in the financial statements and manipulate the data as required. The US stock exchange and the UK tax authorities are just two who already use XBRL. Indeed many authorities are likely to make it mandatory in the near future. By filing financial reports in XBRL format, many agencies could in theory use the one filing for multiple purposes – simply because the filing is electronic.
Although XBRL is being driven by regulators and external financial reporting, it could also streamline internal accounting processes. For example, a large organisation may have non-standardised financial reports, which could be standardised used XBRL – assuming of course a standard reporting mechanism/format could be agreed.
For more detailed information, check out http://xbrl.org/
Reading a cash flow statement
A cash flow statement is a financial statement that describes the sources of cash in a business and how that cash was spent. It does not include non-cash items seen in other financial statements such as depreciation. This makes it useful for determining the short-term viability of a company, particularly liquidity and solvency.
The cash flow statement is similar to the income statement in that it records a company’s performance over a specified period of time – normally a year. A difference is that the income statement also takes into account some non-cash accounting items such as depreciation, accrued expenses and provisions for bad debts. The cash flow statement excludes all non-cash items and shows exactly how much actual cash the a business has generated. Cash flow statements show how companies have performed in managing inflows and outflows of cash. It provides a sharper picture of a company’s ability to pay creditors, and finance growth.
It is possible for a company that is profitable to fail if there isn’t enough cash on hand to pay bills. Comparing the amount of cash generated to outstanding debt, known as the “operating cash flow ratio,” illustrates the company’s ability to service its loans and interest payments.
Unlike the varying treatments on some transactions in accounting , there is little a company can do to manipulate its cash flow. Analysts will look closely at the cash flow statement of any company in order to understand its overall health.
The cash flow statement
Cash flow statements classify cash receipts and payments according to whether they are operating, investing, or financing cash flows. A cash flow statement is divided into sections by these same three functional areas within the business:
• Cash from Operations – this is cash generated from day-to-day business operations.
• Cash from Investing – cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment, or other non-current assets.
• Cash from Financing – cash paid or received from issuing and borrowing of funds. This section also includes dividends paid – although dividends can be listed under cash from operations.)
• Net Increase or Decrease in Cash – increases in cash from previous year will be written normally, and decreases in cash are typically written in (brackets). The net movement in cash should be the differences between the opening and closing balances on the bank account (as per the balance sheet).
There are two ways to prepare a cash flow statement according to International Accounting Standard (IAS7) – the direct method and the indirect methods. The direct methods means looking at the cash records of the business and classifying according to the headings above (operations, finance and investing, which are specified by IAS7). While the direct methods seems practical, most of the time the indirect method is used. This is because IAS7 only requires a cash flow statement to be produced annually (this does not mean internal cash flow forecasts won’t be needed). The indirect method uses the income statement and balance sheet to extract cash flows. While this takes a bit of work, the information is easily available.
Reading a balance sheet
A balance sheet (or statement of financial position) is an accounting report that provides a snapshot of a business’s position at a given point in time, including its assets, its liabilities and its total or net worth (assets less liabilities). “A balance sheet does not aim to depict ongoing company activities,” wrote Joseph Simini in Balance Sheet Basics for Nonfinancial Managers. “It is not a movie but a freeze-frame. Its purpose is to depict the dollar value of various components of a business at a moment in time.”
Balance sheets are typically presented in a vertical report form. Asset accounts are listed first, with the liability and owners’ equity accounts listed in sequential order directly below the assets. The term “balance sheet” originates from the the fact that the balance sheet is a representation of the accounting equation (assets=liabilities + capital), thus the two totals should balance.
Contents of a balance sheet
Most of the contents of a business’s balance sheet are classified under one of three categories: assets, liabilities, and (owners) equity.
Assets are items owned by the business, whether fully paid for or not. These items can range from cash to inventories, equipment, patents, and deposits held by other businesses. Assets are further categorized into current assets and non-current assets.
Current assets include cash, accounts receivable, inventories, prepaid expenses, and any other item that could be converted to cash in the normal course of business within one year.
Non-current assets include property,equipment (from office equipment to heavy operating machinery), vehicles, fixtures, and other assets that can reasonably be assumed to have a life expectancy of several years. In practice most non-current assets—excluding land—will lose value over time. This is reflected in accounts through a a process called depreciation. Non-current assets are reported net of depreciation in the balance sheet.
Non-current assets also include intangibles like the value of trademarks, copyrights, and a difficult category known as “goodwill.” When someone buys a company and pays more for it than the worth of its assets, the difference is written into the books of the acquired entity as “goodwill.”
Liabilities are the business’s obligations to other entities as a result of past transactions. Liabilities may be due to employees (salaries), investors ( for loans) or to other companies (who have supplied goods or services). Liabilities are typically divided into two categories: current liabilities and non-current liabilities.
Current Liabilities are due to be paid within a year. These include payments to suppliers, payable taxes and accrued expenses (like wages and salaries). Current liabilities also include the “current” portion of long-term debt payable within the coming year. Non-current liabilities are amounts owed to lenders, mortgage holders, and other creditors payable over more than one year
Once a business has determined its assets and liabilities, it can then determine (owners’) equity i.e. the book value of the business. Owners’ equity, Or shareholders equity in the case of a limited company, is in essence the company’s net worth.
A balance sheet, if studied closely, can tell the any business owner much about the enterprise’s health. In Balance Sheet for Nonfinancial Managers, for instance, Simini points out that “in a well-run company current assets should be approximately double current liabilities.” He goes on: “By analyzing a succession of balance sheets and income statements, managers and owners can spot both problems and opportunities. Could the company make more profitable use of its assets? Does inventory turnover indicate the most efficient possible use of inventory in sales? How does the company’s administrative expense compare to that of its competition? For the experienced and well-informed reader, then, the balance sheet can be an immensely useful aid in an analysis of the company’s overall financial picture.”
(Some of the material in this post has been adapted from inc.com, the original post can be found here http://www.inc.com/guides/2010/06/how-to-read-a-balance-sheet.html)
Reading an income statement
This is the first of three posts which give you a quick guide to reading the three key financial statements – the income statement, balance sheet and statement of cash flows. This post deals with the income statement, with the other two coming over the next few weeks.
The Income Statement
An income statement presents the results of a company’s operations for a given period—usually a year. The income statement presents a summary of the revenues, expenses, profit or loss of an entity for the period. This statement is similar to a moving picture of the entity’s operations during the time period specified. Along with the balance sheet and the statement of cash flows, the income statement is one of the primary means of reporting financial performance. The key item listed on the income statement is the profit or loss.
Within the income statement there’s a good bit of information. If you’re knowledgeable about reading financial statements, in a company’s income statement you’ll find information about return on investment, risk, financial flexibility, and operating capabilities.
The current view of the income statement (in line with International Financial Reporting Standards (IFRS)) is that income should reflect all items of profit and loss recognised during the accounting period. The following summary income statement illustrates the format under IAS 1 – Presentation of Financial Statements (image from http://www.accaglobal.com):
This example above is fairly typical of the income statement of a large public company. I’ll explain some items below.
Some terms on the income statement explained
According to the IASB’s IAS 18, revenue is defined as “the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends)”. This means that revenue is typically the figure for sales of goods or provision of services for the period of the income statement.
Cost of sales.
The cost of sales figure includes all expenses incurred in buying to making the product or service which generates revenue.
This is income from sources like interest or investment income.
Expenses are classified as either distribution cost, administrative expenses, other expenses or finance costs. No further detail is needed.
Share of profit of associates
This figure is the share of the profits made in an associate company – one where 20-49% is owned by the company (or group of companies) the income statement is prepared for.
The final item in the example above represents a loss made in a section of a business which is discontinued. This separate disclosure is required by accounting standards. Additionally, IAS1 also requires a short statement of comprehensive income, which shows unrealised gains (like unrealised asset revaluations, or currency gains/loses on translation). I don’t include it here, but it is usually no more than a few lines.
Investors call for clearer business reporting
CIMA commented recently (see here) on an IFAC report which suggests that financial reports have become too complex with the result that the underlying financial performance of a business is hidden. Add to this the increasingly complex nature of businesses and you get some idea if the problems in compiling clear concise and meaningful reports. The IFAC report quotes Tanya Branwhite, executive director of strategy research at Macquarie Securities in Australia: ‘If financial accounts are not prepared with the users in mind, then we risk a whole area of unaudited “shadow reporting” being provided directly to investors that doesn’t go through the rigorous financial accounting process,’ she warns.
I remember from my early accounting lectures that a ‘knowledgeable’ investor in seen as the defining user of accounting reports. If you are prepared to stick your money where your mouth is, you’ll want to know all the detail. But the problem is that financial statements just can’t provide this, or as the IFAC report highlights, are too complex. According to the IFAC report, business reporting suffers from a number of significant issues at present: information overload, fair value accounting, operational performance, convergence of accounting standards, real time reporting, management commentary and sustainability reporting. The big questions is how can financial reporting help solve these? One simple answer suggested is that investors might become more actively involved in the standard setting process (i.e. IFRS) and discussions about the presentation and content of financial reports.
Proposals to improve the financial reporting of leases
The IASB and the FASB (respective International and US accounting standard setters) have recently published proposals (see here) to change the way leases are reporting in financial statements, i.e. the income statement and balance sheet. A lease is a contract for the use of an asset, and in accounting terms a lease can be either an operating lease or a finance lease. Without going into detail, a finance lease is capitalised in the balance sheet, meaning the asset subject to the lease is included as a business asset, with a corresponding liability for the amount owed to the lease company or bank. An operating lease on the other hand does not appear on the balance sheet, with any lease payments going through the income statement as an expense. The new proposals are suggesting that all leases must be accounted for as assets of a business, with a liability shown for the amounts owed on the lease. The argument from the standard setters is that a balance would show the true future liabilities of the business. How would this affect a business? Well, it might not affect the business at all if it had no operating leases, but some firms use operating leases quite a lot. If these leases suddenly were capitalised to the balance sheet, an immediate increase in long-term debt occurs. This might put businesses beyond the capacity to raise more debt. Airlines typically lease aircraft, which are normally treated as an operating lease. For example, Aer Lingus (an Irish airline) has about a €50m operating lease charge on their balance sheet annually. Let’s assume this is a 10 year lease, so if this were to be capitalised to the balance sheet, an increase in debt of €500m happens overnight. On a smaller scale, many retailers in capital cities might have expensive 21 year leases on prime retailer sites. Putting these leases on the balance sheet might cripple the borrowing capacity of smaller companies. It looks like a debate on this proposal will be quite heated.
The profit and loss account (income statement)
This brief post covers the basics of the profit and loss account. The profit and loss accounts lists all income and expenditure, with the difference being they profit or loss made by the business. The profit and loss account has two parts, albeit in the same statement. The first part account calculates the profit earned from buying and selling goods. This is called the Trading account.
Here’s an example of the layout.
Trading account for Red Books for year ended 31/12/2009
|LESS COST OF SALES||
|Less closing stock||
|Cost of sales||
Here’s a brief explanation of each of the some of the items and terms above. First, there is the title of the account. It informs the user of the name of the statement (what), the name of the business (who) and the time period involved (when).
Sales: The amount of money earned by the business selling books in the past year i.e. Income. Sales returns/returns in may have to be subtracted to get this figure.
LESS COST OF SALES: this is a heading, which indicates that this calculation is going to be completed. This calculation will work out the cost of all the books that were sold in the year. It is calculated as follows
Cost of sales = opening stock + purchases – closing stock.
Opening stock: This is the value of stock left over from the previous year. This stock will be the first to be sold in the this year, thus it is a cost for this year (c.f. the accruals concept)
Purchases: This is the cost of all the new books bought during the year. (Additional costs like carriage in and import duty might be added to the purchase cost). Purchase returns/returns out may have to be subtracted.
Closing stock: This is the value of all the books left at the end of the year. It is subtracted from opening stock and purchases, as it does not form part of the goods sold during this year (c.f. accruals concept).
Cost of sales: This is the answer to the calculation of the cost of sales.
Gross profit: This measures the profit the business makes by buying and selling books. It is calculated as follows:
Gross profit = Sales – Cost of Sales
The second part, the profit and loss account calculates the profit the business has earned after allowing for all the expenses incurred in running the business. Here’s an example following on from the trading account above
Profit and loss account for Red Books for year ended 31/12/2009
|Wages and salaries||40,000|
|Light, heat and telephone||10,000||70,000|
As you can see, the profit and loss account starts with the Gross Profit and deducts expenses to arrive at Net Profit. Net profit is the profit that is owed to the owner(s) of the business. In the case of a sole trader, this forms part of the capital of the business, whereas with a company the shareholders may be paid a dividend from available profits.
All other elements from the Trial Balance i.e. assets, liabilities and capital do not appear on the Profit and Loss account, but the balance sheet.