Financial Statement Analysis and Recent Types of Accounting

Horizontal or trend analysis of financial statements

Horizontal analysis (also known as trend analysis) is a financial statement analysis technique
that shows changes in the amounts of corresponding financial statement items over a period of
time. It is a useful tool to evaluate the trend situations.

The statements for two or more periods are used in horizontal analysis. The earliest period is
usually used as the base period and the items on the statements for all later periods are compared
with items on the statements of the base period.

Please refer your text book for detailed content.

Advantages of Trend Analysis or Horizontal Analysis :

(a) Possibility of making Inter-firm Comparison:
Trend analysis helps the analyst to make a proper comparison between the two or more firms
over a period of time. It can also be compared with industry average. That is, it helps to
understand the strength or weakness of a particular firm in comparison with other related firm in
the industry.
(b) Usefulness:
Trend analysis (in terms of percentage) is found to be more effective in comparison with the
absolutes figures/data on the basis of which the management can take the decisions.
(c) Useful for Comparative Analysis:
Trend analyses is very useful for comparative analysis of date in order to measure the financial
performances of firm over a period of time and which helps the management to take decisions
for the future i.e. it helps to predict the future.
(d) Measuring Liquidity and Solvency:
Trend analysis helps the analyst/and the management to understand the short-term liquidity
position as well as the long-term solvency position of a firm over the years with the help of
related financial Trend ratios.
(e) Measuring Profitability Position:
Trend analysis also helps to measure the profitability positions of an enterprise or a firm over the
years with the help of some related financial trend ratios (e.g. Operating Ratio, Net Profit Ratio,
Gross Profit Ratio etc.).
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Disadvantages of Trend Analysis:
The trend analysis is not free from snags.
Some of them are:
(a) Selection of Base Year:
It is not so easy to select the base year. Usually, a normal year is taken as the base year. But it is
very difficult to select such a base year for the propose of ascertaining the trend. Otherwise,
comparison or trend analyses will be of no value.
(b) Consistency:
It is also very difficult to follow a consistent accounting principle and policy particularly when
the trends of business accounting are constantly changing.
(c) Useless in Inflationary Situations:
Analysis of trend percentage is useless at the time of price-level change (i.e. in inflation). Trends
of data which are taken for comparison will present a misleading result.
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COMMON SIZE STATEMENT OR VERTICAL ANALYSIS

A company financial statement that displays all items as percentages of a common base figure.
This type of financial statement allows for easy analysis between companies or between time
periods of a company.
The values on the common size statement are expressed as percentages of a statement component
such as revenue. While most firms don't report their statements in common size, it is beneficial
to compute if you want to analyze two or more companies of differing size against each other. ​
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Formatting financial statements in this way reduces the bias that can occur when analyzing
companies of differing sizes. It also allows for the analysis of a company over various time
periods, revealing, for example, what percentage of sales is cost of goods sold and how that
value has changed over time.
Common Size Income Statement
Common-Size​
Income Statement
Income Statement

Revenue 70,134 100%

Cost of Goods Sold 44,221 63.1%
Gross Profit 25,913 36.9%
SG&A Expense 13,531 19.3%
Operating Income 12,382 17.7%
Interest Expense 2,862 4.1%
Provision for Taxes 3,766 5.4%
Net Income 5,754 8.2%

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For the balance sheet, the common size percentages are referenced to the total assets. The
following sample balance sheet shows both the dollar amounts and the common size ratios:
Common Size Balance Sheet
Common-Size ​
Balance Sheet
Balance Sheet
ASSETS
Cash & Marketable
6,029 15.1%
Securities
Accounts Receivable 14,378 36.0%
Inventory 17,136 42.9%
Total Current Assets 37,543 93.9%
Property, Plant, & Equipment 2,442 6.1%
Total Assets 39,985 100%

LIABILITIES AND SHAREHOLDERS' EQUITY

Current Liabilities 14,251 35.6%
Long-Term Debt 12,624 31.6%
Total Liabilities 26,875 67.2%
Shareholders' Equity 13,110 32.8%
Total Liabilities & Equity 39,985 100%

The above common size statements are prepared in a vertical analysis, referencing each line on
the financial statement to a total value on the statement in a given period.
The ratios in common size statements tend to have less variation than the absolute values
themselves, and trends in the ratios can reveal important changes in the business. Historical
comparisons can be made in a time-series analysis to identify such trends.
Common size statements also can be used to compare the firm to other firms.

What is the difference between Horizontal and Vertical Analysis?

Horizontal vs Vertical Analysis

Horizontal analysis is a procedure in the Vertical analysis is the method of
fundamental analysis in which the amounts of analysis of financial statements where
financial information over a certain period of each line item is listed as a percentage
time is compared line by line in order to make of another item to assist decision
related decisions. making.
Main Purpose
The main purpose of horizontal analysis is to Main purpose of vertical analysis is to
compare line items to calculate the changes over compare changes in percentage terms.
time.

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 Usefulness
Horizontal analysis becomes more useful when Vertical analysis is more useful in
comparing company results with previous comparing company results with other
financial years. companies.

Comparative Financial Statements

Every business needs to prepare basic financial statements that summarize its
operating results and financial position for a particular period. These statements
primarily include income statements, balance sheets, and cash flow statements.
Thus, the purpose of preparing these statements is to ascertain the profitability and
financial soundness of a business. But the detailed information reflected in such
statements alone is not sufficient to reach meaningful managerial conclusions.
Therefore, detailed financial analysis and interpretation of these statements is required
using various tools and techniques.
This analysis helps to understand the relationship between various components
showcased in each of these statements. So, one of the tools commonly used to
undertake financial statement analysis is creating comparative financial
statements. Other techniques include:

●​ Common Size Statement Analysis

●​ Ratio Analysis
●​ Cash Flow Analysis

What Are Comparative Financial

Statements?
Preparing Comparative Financial Statements is the most commonly used technique for
analyzing financial statements. This technique determines the profitability and financial
position of a business by comparing financial statements for two or more time periods.
Hence, this technique is also termed as Horizontal Analysis. Typically, the income
statements and balance sheets are prepared in a comparative form to undertake such
an analysis.

Furthermore, there is a provision attached to comparing the financial data showcased

by such statements. This relates to making use of the same accounting principles for
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preparing each of the comparative statements. In case the same accounting principles
are not followed to prepare such statements, then the difference must be disclosed in
the footnote below.
Comparative Balance Sheet
A comparative balance sheet showcases:

●​ Assets and liabilities of business for the previous year as well as the current year

●​ Changes (increase or decrease) in such assets and liabilities over the year both in
absolute and relative terms
Thus, a comparative balance sheet not only gives a picture of the assets and liabilities
in different accounting periods. It also reveals the extent to which the assets and
liabilities have changed during such periods.

Furthermore, such a statement helps managers and business owners to identify trends
in the various performance indicators of the underlying business.

What to Study While Analyzing A Comparative Balance

Sheet?
A business owner or a financial manager should study the following aspects of a
comparative balance sheet:
1. Working Capital
Working capital refers to the excess of current assets over current liabilities.This helps a
financial manager or a business owner to know about the liquidity position of the
business.
2. Changes in Long-Term Assets, Liabilities, and Capital
The next component that a financial manager or a business owner needs to analyze is
the change in the fixed assets, long-term liabilities and capital of a business. This
analysis helps each of the stakeholders to understand the long-term financial position
of a business.
3. Profitability
Working capital refers to the excess of current assets over current liabilities.This helps a
financial manager or a business owner to know about the liquidity position of the
business.
Steps To Prepare a Comparative Balance Sheet
1. Step 1
Firstly, specify absolute figures of assets and liabilities relating to the accounting
periods considered for analysis. These amounts are mentioned in Column I and
Column II of the comparative balance sheet.

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2. Step 2
Find out the absolute change in the items mentioned in the balance sheet. This is done
by subtracting the previous year’s item amounts from the current year ones. This
increase or decrease in absolute amounts are mentioned in Column III of the
comparative balance sheet.
3. Step 3
Finally, calculate the percentage change in the assets and liabilities of the current year
relative to the previous year. This percentage change in assets and liabilities is
mentioned in Column V of the comparative balance sheet.

Percentage Change = (Absolute Increase or Decrease)/Absolute Figure of the Previous

Year’s Item) * 100

So, let’s understand a comparative balance sheet through an example. Consider the
following balance sheets of M/s Kapoor and Co as on December 31st, 2017 and
December 31st, 2018 for the illustration.
Balance Sheet of M/s Kapoor and Co. as of December 31, 2017,
and December 31, 2018.

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Comparative Balance Sheet of M/s Kapoor and Co. as on
December 31, 2017, and December 31, 2018.

Analysis
As we can see in the comparative balance sheet above, the current assets of Kapoor
and Co. have decreased by Rs 35,200 in the year 2018 over 2017.

On the other hand, the current liabilities have decreased by Rs 27,000 only. Now, such
a change does not have a negative impact on the liquidity position of M/s Kapoor and
Co. This is because current assets have decreased by 33.9% whereas current liabilities
have declined by 51.5%.

Secondly, the cash and bank balance of Kapoor and Co. have decreased by 91.5%.
This indicates a negative cash position of the company. It further hints towards the fact
that the company might find it challenging to meet its short-term obligations.

Next, the long-term debt of M/s Kapoor and Co. has increased by 62.5%. On the other
hand, the owner’s equity has improved by only 34%. This indicates that the company is

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way too dependent on the external lenders thus leading to a great financial risk for the
firm.

Finally, there is a considerable increase seen in the fixed assets of the company.
Accordingly, the fixed assets increased by Rs 79,000 or 64.9% from the year 2017 to
2018. This was on account of the huge addition made to the plant and machinery by
the company in the given accounting periods.

Plant and machinery increased by Rs 95,200 that is by 153.5%. Such additional

machinery leads to an incredible improvement in the production capacity of the
company during the year. This expenditure was provided for by the company
proprietors and the external lenders.

Comparative Income Statement

A comparative income statement showcases the operational results of the business for
multiple accounting periods. It helps the business owner to compare the results of
business operations over different periods of time. Furthermore, such a statement
helps in a detailed analysis of the changes in line-wise items of the income statement.

Comparative Balance Sheet Format

The format of the comparative income statement puts together several income
statements into a single statement. This helps the business owner in understanding the
trends and measuring the business performance over different time periods.

Apart from comparing income statements of its own business over different time
periods, a business owner can compare the operating results of its competitor firms as
well.

Thus, this analysis helps the business owner to compare his business performance with
other businesses in the industry. So, business owners can also understand the various
causes that lead to changes in different accounting periods. This is achieved by
comparing the operating results of the business over multiple accounting periods.
What To Study While Analyzing A Comparative Income
Statement?
1. Comparing Sales With Cost of Goods Sold
Changes in the sales in the given accounting periods should be compared with the
changes in the cost of goods sold for the same accounting periods.
2. Change in Operating Profits
Change in the operating profits should be analyzed.
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3. The profitability of a Business
Understanding the overall profitability of a business concern taking into consideration
the changes in the net profit of the given accounting periods.
Steps To Prepare A Comparative Income Statement
1. Step1
Firstly, specify absolute figures of items such as cost of goods sold, net sales, selling
expenses, office expenses, etc. relating to the accounting periods considered for
analysis. These amounts are mentioned in Column I and Column II of the comparative
income statement.
2. Step 2
Find out the absolute change in the items mentioned in the income statement. This is
done by subtracting the previous year’s item amounts from the current year ones. This
increase or decrease in absolute amounts is mentioned in Column III of the
comparative income statement.
3. Step 3
Finally, calculate the percentage change in the income statement items of the current
year relative to the previous year. This percentage change in items is mentioned in
Column V of the comparative income statement.

Now given this, let’s try to understand how a comparative statement is interpreted
using an example. Consider the following income statement for M/s Singhania for the
years ended December 31st, 2017 and December 31st, 2018.

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Income Statement of M/s Singhania as of December 31, 2017,
and December 31, 2018.

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Comparative Income Statement of M/s Singhania For The Years
Ended December 31, 2017, and December 31, 2018.

Analysis
As is evident from the above comparative income statement, the sales of M/s
Singhania increased by Rs 20,400 during 2018 as against 2017. However, the cost of
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goods sold for the company increased by just Rs 15,000 in the same period. If you see
carefully, sales increased by 12% whereas the cost of goods sold increased by 14.3%.
Thus, the Gross Profit for M/s Singhania did not increase significantly. Now, there can
be several reasons for accounting lower Gross Profit during the year:
Increase In Cost of Goods Sold
Firstly, a higher increase in the cost of goods sold can be on account of either
increased sales volume or higher input cost. Furthermore, it is evident that the cost of
goods sold for the company improved as an outcome of increased sales volume. This is
because the sales increased during the year.

Now, the sales value would have increased significantly if the company would have
made sales at the previous sales price. But that is not the case as sales value did not
change to a greater extent. This hints towards the fact that incremental sales have been
made at a price lower than the sales price.

Furthermore, this analysis is supported by the increase in the advertisement expenses

of the company for the year 2018. These increased by 33% which is much higher as
against the increase in net sales that was just 12%. Thus, this entire scenario indicates
that it was quite challenging to sell the goods during 2018.

Hence, the company increased its advertisement cost significantly and reduced the
selling price in order to achieve higher sales volume. Also, This scenario could be an
outcome of a new product launch. In such a case, the company had to spend a huge
amount on the advertisement and reduce the selling price for market penetration.
Increase In Other Income and Decrease in Other Expenses
There has been a significant increase in “Other Income” both in absolute and relative
terms. Also, there has been a substantial decrease in “Other Expenses” both in
absolute and relative terms. Thus, these items on the income statement lead to an
improvement in the Profit Before Tax for the year 2018 as against 2017.

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 Human Resource Accounting

Employees are the greatest assets of an organization and it is no denying the fact that the success
and failure of an organization depends on the quality of its manpower. However good technology
you may be using but if the quality of manpower is poor the product will not be good. But the
worst part is that the quality, caliber, quantity and commitment of manpower of a company are
not given any place in the balance sheet. Just by studying the balance sheet of a company and
without having to know the quality of its manpower will be quite misleading for the analyst.

The accounting system fail to give any value for this most valuable asset of an orgnisation i.e.,
the human resources.

The financial and cost accounting is silent on this aspect. All expenses incurred on recruitment,
training and development of employees are charged against revenue for that period in which they
are incurred.

But the increase in the value and caliber of ‘manpower assets’ due to this expenditure does not
find any place.

This seems to be a clear violation of the Matching and Accrual concept of accounting.

The irony is that a typical balance sheet does not disclose human assets at all.
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According to Prof. Rensis Likert, expenses incurred on human resources are fixed costs, which
do not give immediate return.

Instead the return is spread over the time the employee stays with the firm. Therefore these costs
should be capitalized and amortized over the entire period.

By not capitalizing these expenses, accountants are concealing assets and net worth to that
extent.

The current practice tends to create secret reserves.

This is gross negation of the cardinal principle of ‘true and fair disclosure” in published
accounts.

Meaning of Human Resource Accounting (HRA)

Human resource accounting is the measurement and reporting of the costs incurred to:

​ Recruit,
​ Hire,
​ Train and
​ Develop

The employees and their present value to the organization.

It involves assessment of the costs and value of the people as organizational resources.

According to American Accounting Association, “ HRA is the process of identifying and

measuring data about human resources and communicating this information to the interested
people”.

Thus HRA is a management tool that informs the management about the changes that are taking
place in the human resources of an organization.

The basic purpose of HRA is to facilitate the effective and efficient management of human
resources by providing information required to:

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 ​ Acquire
​ Develop
​ Allocate
​ Conserve
​ Utilize
​ Evaluate and
​ Reward human resources

Objective of HRA

Rensis Likert, one of the earliest proponents of HRA, has specified the following objectives of
HRA system:

1.​ To provide cost value information for managerial decisions about acquiring, developing,
allocating and maintaining human resources so as to attain cost effective organizational
objectives.

2.​ To enable the management personnel to monitor effectively the use of human resources.

To provide a determination of assets control, i.e., whether human assets are

conserved, depleted or appreciated.

3.​ To assist in the development of effective management practices related to valuable

human resource..

Advantages of HRA

1.​ HRA provides useful information about the value of human capital, which is essential to
managers for taking right decisions.

E.g. choice between:

(a)​ Direct recruitment and promotion.

(b)​ Transfer and retention and
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 (c)​ retrenchment and retention, etc.

2.​ It facilitates human resource planning by highlighting the strength and weakness in the
workforce.
For example management can judge adequacy of the human resources and need for further
recruitment.

3.​ Managements can evaluate the effectiveness of its policies relating to human resources.
For instance high costs of hiring and training may induce the need for changes in policy
for reducing labour turnover.

4.​ HRA provides valuable information for present and potential investors.

Investors and other users of financial statements want to know the value of firm’s human
assets.

The present law does not require a management to show the value of human assets in the
balance sheet.

But if two companies earning same return.Information about human assets can enable
investors in choosing the better investment opportunity.

5.​ HRA may help to improve the motivation and morale of the employees by creating a
feeling that the organization cares for them.

Limitation of HRA

No doubt HRA provides valuable information both for management and investors, yet its
application and development has not been very encouraging due to the following reasons:

1.There are no specific and clear-cut guidelines for ‘cost’ and ‘value’ of human resources of
an organization.

The existing valuation systems suffer from various draw backs.

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 2.The life of human resources in an organization is uncertain and therefore valuing them
under uncertainty seems unrealistic.

3.​ Human resources unlike physical assets are not capable of being owned, retained and
utilized at the pleasure of the organization.
Hence treating them, as ‘assets’ in the strict sense of the term would not be appropriate.

4.​ There is constant fear of opposition from the trade unions. Placing a value on employee
would prompt them to seek rewards compensation based on such valuations.

The lower valued employees though sincere will feel de-motivated.

5.​ In what form and manner should their value be included in the financial statements, is
another question on which there is no consensus in the accounting profession.

6.If the valuation has to be placed on human resources, how should it be amortized?

Should the rate of amortization to be decreasing, constant or increasing?

Should it be same or different for different category of personnel?

FORENSIC ACCOUNTING
What is forensic accounting?

The integration of accounting, auditing and investigative skills yields the speciality known as
Forensic Accounting.

"Forensic", according to the Webster's Dictionary means, "Belonging to, used in or suitable to
courts of judicature or to public discussion and debate."

"Forensic Accounting", provides an accounting analysis that is suitable to the court which will
form the basis for discussion, debate and ultimately dispute resolution.

As Forensic Accountants, we utilize accounting, auditing and investigative skills when

conducting an investigation. Equally critical is our ability to respond immediately and to
communicate financial information clearly and concisely in a courtroom setting.

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Forensic Accountants are trained to look beyond the numbers and deal with the business reality
of the situation.

Forensic accountants analyze, interpret and summarize complex financial and business matters.
They may be employed by insurance companies, banks, police forces, government agencies or
public accounting firms. Forensic accountants compile financial evidence, develop computer
applications to manage the information collected and communicate their findings in the form of
reports or presentations.

​
Litigation Support

Forensic accounting is utilized in litigation when quantification of damages is needed. Parties

involved in legal disputes use the quantifications to assist in resolving disputes via settlements or
court decisions. For example, this may arise due to compensation and benefit disputes. The
forensic accountant may be utilized as an expert witness if the dispute escalates to a court
decision.
Investigation
Forensic accounting also encompasses the determination of whether criminal matters occurred.
Such crimes may include employee theft, securities fraud, falsification of financial statement
information, identify theft or insurance fraud. Forensic accountants may assist in searching for
hidden assets in divorce cases or provide their services for other civil matters such as breach of
contracts, tort, disagreements relating to company acquisitions, breaches of warranty or business
valuation disputes.
Forensic accounting assignments include investigating construction claims, expropriations,
product liability claims or trademark or patent infringements. Forensic accounting can be used to
determine the economic results of the breach of a nondisclosure or noncompetition agreement.
Forensic Accounting in the Insurance Industry
A forensic accountant may be asked to quantify the economic damages arising from a vehicle
accident or a case of medical malpractice. The accountant must be knowledgeable about the
legislative process relating to these cases. Forensic accounting encompasses the review of
insurance policies to determine coverage issues and methods of calculating potential losses.
Forensic accounting may be utilized for either the insured or insurer’s case.

List of Advantages of Forensic Accounting

1.​ It helps solve financial crimes.

​
As mentioned above, forensic accounting can greatly help in solving financial crimes. These can
involve bribery within government offices as well as fraud and money laundering within
business organizations. Forensic accounting not only helps with gathering evidence for crimes
but can also be used in detecting and identifying crimes.
2.​ It helps monitor professionals.​

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 Forensic accounting can be used to assess the work of professionals, including accountants
themselves. The findings from this assessment, in turn, can be used to file professional
negligence claims against those who have been proven to have made critical errors (whether
intentionally or not).
3.​ It helps businesses with their finances.
​
Businesses can use forensic accounting to detect anomalies among their staff and with
third parties they’re working with. For instance, a company can ask a forensic accountant
to check an employee’s purchasing records to see if all of his purchases were for business
use or if he diverted some for his personal use.
​
List of Disadvantages of Forensic Accounting

1. It takes a lot of time. ​

Forensic accounting is never easy. It requires accountants to go through every piece of document
to ensure that their investigation is complete and that they’ll uncover every evidence that will
solve the case. This can take many days and can even stretch to many weeks or months,
depending on the magnitude of the case, the size of the organization involved, and the number of
documents to review.
2. It can be expensive.​
Because of the lengthy period of time needed, forensic accounting can turn out to be expensive.
This isn’t a problem for huge corporations that have more than enough funds, but it can be an
issue for smaller businesses that have limited budgets.
3. It can be distracting.​
Forensic accounting can cause a distraction among employees, particularly when outside
accountants are brought in. The process can disrupt the staff’s normal routine and cause their
productivity and efficiency to suffer.
4. It can affect employee morale.​
Forensic accounting can cause employees to feel like their integrity is doubted, which can lead to
lower staff morale. It’s the responsibility of managers and business owners to make their people
understand that forensic accounting is done not as a sign of distrust but as a way to improve
business efficiency.

Accounting for Corporate Social Responsibility

What do you mean by Corporate Social Responsibility?

●​ Corporate Social Responsibility means various social activities carried out by medium
to big sized corporate houses, businesses and MNCs for the benefit of
under-privileged sections of society.
●​ As per the Companies Act 2013, Corporate Social Responsibility is a set of mandatory
guidelines, which a company must follow.

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Which company need to constitute a Corporate Social Responsibility Committee

If a company satisfied any of the following condition during any financial year shall constitute a
Corporate Social Responsibility Committee of the Board consisting of three or more directors,
out of which at least one director shall be an independent director.

The conditions are as follows:

●​ net worth of Rs500crore or more,

●​ turnover of Rs1000crore or more
●​ net profit of Rs5crore or more
Minimum amount of expenditure on Corporate Social Responsibility

The board shall ensure that the company spends, in every financial year at least 2% of the
average net profits of the company made during the three immediately preceding financial years,
in pursuance of its corporate social responsibility policy.

What activities should be included by companies in their Corporate Social Responsibility?

●​Encouraging education under poor sections of society

●​Promoting gender equality
●​Promoting women empowerment
●​Eradicating extreme hunger and poverty
●​Reducing child mortality and improving maternal health
●​Combating human immunodeficiency virus, acquired immune deficiency syndrome,
malaria and other diseases
●​ Ensuring environmental sustainability
●​ Employment enhancing vocational skills
●​ Social business projects
●​ Contribution to Prime Minister’s National Relief Fund
Accounting treatment of Corporate Social Responsibility expenditure

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Schedule VII to the company’s bill, 2013 specifies a list of CSR activities. The accounting of
CSR activities will be done as under:

Any amount spent on CSR activities through option (a) or (b) is recognised
as expense in Statement of Profit & Loss immediately when they are incurred.

●​ In case a contribution is made to a fund specified in Schedule VII to the Act, the same
would be treated as an expense for the year and charged to the statement of profit and
loss.
●​ In case the company incurs any expenditure on any of the activities as per schedule
VII on its own, the company needs to analyse the nature of the expenditure keeping in
mind the “Framework for Preparation and Presentation of Financial Statements issued
by ICAI.
●​ In case the company incurs any expenditure on any of the activities as per schedule
VII is of revenue nature, the same should be charged as an expense to the statement of
profit or loss.
●​ In case the company incurs any expenditure, which give rise to an asset, the company
need to analyse whether the expenditure qualifies the definition of the term asset as
per the Framework i.e. whether it has control over the asset and derives future
economic benefits from it.

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