Accounting Methods’ Effect on Financial Statement Analysis
Accounting methods refer to rules and principles that are adopted during the preparation of income reports, evaluation of expenses in books, and treatment of income tax returns. The accounting method adopted by a business has a great influence on the taxes payable as well as the ability of a firm to source for external finance.
This is attributable to the effect experienced by the common accounting methods such as cash and accrual methods. Under the cash methods, income is reported when based on the amount of cash received. At the same time, expenses are recognized when payments are made. On the contrary, accrual accounting considers the income earned regardless of whether payments have been made or not. Similarly, it recognizes the expenses incurred by the business at the time, even if they have not been paid. These two methods depict great difference, which affects the elements of financial statements.
During the analysis of financial methods, different techniques are adopted to analyze the performance and position of the business. The most common financial analysis techniques include horizontal, vertical, and ratio analysis. In this case, the accounting method used will reflect the unique rating of the business even if identical analysis methods are used. The horizontal analysis reflects the trend of performance of a business over a period.
Through this analysis, it is possible to identify whether the business has been growing or not. The vertical analysis involves the determination of the percentage of the components of financial statements of a single component, such as sales or total assets. In this regard, it is possible to figure out the proportion of each component in the business. Ratio analysis is also another critical financial analysis technique, which uses ratios such as profitability, liquidity, activity, and leverage ratios. These ratios reflect the level of performance of the company using different dimensions. Consequently, the financial position of the business can be established.
The financial statement techniques are affected by the accounting methods since they portray varied results during measurements. The cash accounting method portrays the liquidity position of the firm. Businesses adopting this method are likely to have significant liquidity, although other elements of the business could be deteriorating. Through the financial analysis techniques, the practices of the firm and other critical business processes may not be taken into consideration.
As such, the actual performance of the business in terms of total revenues and expenses is not covered adequately. On the other hand, the accrual accounting method may portray the real picture of the business when the financial analysis process is undertaken. In spite of the weaknesses in addressing the liquidity position of the company, it appropriately captures other financial aspects of the business. Therefore, it is critical to understand that the nature of the accounting method adopted by a business has a significant impact on the financial analysis outcomes.