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Financial statements- A formal presentation of the financial activities of a business which provide an overview of its financial condition. The four standard financial statements are the balance sheet, income statement, statement of retained earnings and cash flow statement.
Income statement (also known as Profit & Loss statement, or Statement of Operations)- The financial statement which reports the results of operating activities of a business entity for a specific period of time, consisting of all the revenues and expenses applicable to that period of time.
Interpretation of financial statements- Chartered accountants interpret financial statements by various means. Probably the most common technique is to compare each line item on the balance sheet and income statement to the previous year, both in absolute dollars and percent change. The assumption is that the prior year has already been evaluated, and now forms a benchmark against which comparisons can be made. For example, if prior year sales were $5 million and current year sales are $4.5 million, then sales in the current year have declined by 10%, which raises questions as to the reason for the decline. A Chartered Accountant will have investigated and determined that the reason is either increased competition, economic influences on the marketplace, delay in introduction of new products, etc. Another technique for interpretation of financial statements is ratio analysis, which means that the ratio of two line items is calculated and compared to prior year. An example is the current ratio, the term used for current assets divided by current liabilities. The traditional acceptable ratio is 2:1, meaning that current assets are double the amount of current liabilities. This is certainly considered to be a ratio that would please bankers or investors, since it indicates good liquidity for the company. When compared to the prior year’s current ratio, it is necessary to investigate the reason for the increase or decrease in the ratio. This helps to interpret the overall performance of the company and its progress in the current year versus the prior year.
Variance analysis- This term normally refers to the reasons for the variances between actual financial statement data and the corresponding budget or prior year data. For example, the income statement contains different kinds of revenue and expense items such as office expense and cost of sales, which may be disclosed on the statement alongside the original budgeted amounts for the same time period, as well as the prior year amounts for the same line items. The purpose for this kind of disclosure is to indicate the extent of change versus prior year and budget, which of course raises questions if the change is significant. If sales have increased by 5% over the prior year but cost of sales has increased by 22%, this would seem to indicate that the cost of production has gone up for some reason, on every unit produced. Variance analysis consists of two stages: first the identification of the variances, and secondly the explanation of the reasons for the variances. Variance analysis is also used for the balance sheet to explain differences in the assets and liabilities. For example, the current liabilities may have increased significantly over the prior year, but analysis may show that it is not the accounts payable that is the culprit, but rather the creation of a new line of credit that was set up to finance the acquisition of new equipment. Variance analysis is not normally disclosed as an integral part of the financial statements in Canada although it is a requirement to disclose the prior year column for comparison purposes. Chartered accountants will do the variance analysis as part of the audit or review requirements, and maintain the conclusions in their file as evidence of having conducted an appropriate degree of investigation of unusual numbers on the financial statements. Internal accountants will also do the variance analysis in even more depth so that trends can be explained to management as a tool for running the business and making decisions based on current information. This is especially true for monthly financial statements. In such cases, the analysis is normally done versus the same month in the prior year, and also versus the prior month in the same year and the budget for the current month.