Understanding Business Accounting For Dummies, 2nd Edition (58 page)

3.
Sales, Administration, and General (SA&G) Expenses and Prepaid Expenses:
This business's ending balance of prepaid expenses is three weeks of the total of these annual operating expenses. The manager should know what the normal ratio of prepaid expenses should be relative to the annual SA&G operating expenses (excluding depreciation expense). If the ending balance is too high, the manager should investigate which costs have been paid too far in advance and take action to bring these prepaids back down to normal.

4.
Sales, Administration, and General (SA&G) Expenses and Creditors:
This business's ending balance of creditors is five weeks of its annual operating expenses. Delaying payment of these liabilities is good from the cash flow point of view (refer to Chapter 7) but delaying too long may jeopardise the company's good credit rating with its key suppliers and vendors. If this ratio is too high, the manager should pinpoint which specific liabilities have not been paid and whether any of these are overdue and should be paid immediately. Or, the high balance may indicate that the company is in a difficult short-term solvency situation and needs to raise more money to pay the amounts owed to suppliers and vendors.

5. Sales, Administration, and General (SA&G) Expenses and Accrued Expenses Payable:
This business's ending balance of this operating liability is eight weeks of the business's annual operating expenses. This ratio may be consistent with past experience and the normal lag before paying these costs. On the other hand, the ending balance may be abnormally high. The manager should identify which of these unpaid costs are higher than they should be. As with creditors, inflated amounts of accrued liabilities may signal serious short-term solvency problems.

These five key connections are very important ones, but the manager should scan all basic connections to see whether the ratios pass the common sense test. For example, the manager should make a quick eyeball test of interest expense compared with interest-bearing debt. In Figure 8-1, interest expense is £750,000 compared with £10 million total debt, which indicates a 7.5 per cent interest rate. This seems OK. But if the interest expense were more than £1 million, the manager should investigate and determine why it's so high.

There's always the chance of errors in the accounts of a business. Reviewing the vital connections between the profit and loss account items and the balance sheet items is a very valuable final check before the financial statements are approved for inclusion in the business's financial report. After the financial report is released to the outside world, it becomes the latest chapter in the official financial history of the business. If the financial statements are wrong, the business and its top managers are responsible.

Statement of Changes in Owners' Equity and Comprehensive Income

In many situations a business needs to prepare one additional financial statement - the
statement of changes in owners' equity.
Owners' equity consists of two fundamentally different sources - capital invested in the business by the owners, and profit earned by and retained in the business. The specific accounts maintained by the business for its total owners' equity depend on the legal
organisation of the business entity.
One of the main types of legal organisation of business is the
company
, and its owners are
shareholders
because the company issues ownership
shares
representing portions of the business. So, the title
statement of changes in shareholders' equity
is used for companies. (Chapter 11 explains the corporation and other legal types of business entities.)

First, consider the situation in which a business does
not
need to report this statement - to make clearer why the statement is needed. Suppose a company has only one class of share and it did not buy any of its own shares during the year and it did not record any gains or losses in owners' equity during the year due to
other comprehensive income
(explained below). This business does not need a statement of changes in shareholders' equity. In reading the financial report of this business you would see in its cash flow statement (Figure 7-2 shows an example) whether the business raised additional capital from its owners during the year and how much in
cash dividends
(distributions from profit) was paid to the owners during the year. The cash flow statement contains all the changes in the owners' equity accounts during the year.

In sharp contrast, larger businesses - especially publicly-traded corporations - generally have complex ownership structures consisting of two or more classes of shares; they usually buy some of their own shares and they have one or more technical types of gains or losses during the year. So, they prepare a statement of changes in stockholders' equity to collect together in one place all the changes affecting the owners' equity accounts during the year. This particular ‘mini' statement (that focuses narrowly on changes in owners' equity accounts) is where you find certain gains and losses that increase or decrease owners' equity but which are
not
reported in the profit and loss account. Basically, a business has the option to bypass the profit and loss account and, instead, report these gains and losses in the statement of changes in owners' equity. In this way the gains or losses do not affect the bottom-line profit of the business reported in its profit and loss account. You have to read this financial summary of the changes in the owners' equity accounts to find out whether the business had any of these gains or losses and the amounts of the gains or losses.

The special types of gains and losses that can be reported in the statement of owners' equity (instead of the profit and loss account) have to do with foreign currency translations, unrealised gains and losses from certain types of securities investments by the business, and changes in liabilities for unfunded pension fund obligations of the business.
Comprehensive income
is the term used to describe the normal content of the profit and loss account
plus
the additional layer of these special types of gains and losses. Being so technical in nature, these gains and losses fall in a ‘twilight zone' as it were, in financial reporting. The gains and losses can be tacked on at the bottom of the profit and loss account or they can be put in the statement of changes in owners' equity - it's up to the business to make the choice. If you encounter these gains and losses in reading a financial report, you'll have to study the footnotes to the financial statements to learn more information about each gain and loss.

Keep on the lookout for the special types of gains and losses that are reported in the statement of changes in owners' equity. A business has the option to tack such gains and losses onto the bottom of its profit and loss account - below the net income line. But, most businesses put these income gains and losses in their statement of changes in shareholders' equity, or in a note or notes to their accounts. So, watch out for any large amounts of gains or losses that are reported in the statement of changes in owners' equity.

The general format of the statement of changes in shareholders' equity includes a column for each class of stock (ordinary shares, preference shares, and so on); a column for any shares of its own that the business has purchased and not cancelled; a column for retained earnings; and one or more columns for any other separate components of the business's owners' equity. Each column starts with the beginning balance and then shows the increases or decreases in the account during the year. For example, a comprehensive gain is shown as an increase in retained earnings and a comprehensive loss as a decrease. Thepurchase of its own shares is shown as an increase in the relevant column and if the business reissued some of these shares (such as for stock options exercised by executives), the cost of these shares reissued is shown as a decrease in the column.

We have to admit that reading the statement of changes, or Notes to the Accounts in shareholders' equity can be heavy going. The professionals - stock analysts, money and investment managers, and so on - carefully read through and dissect this statement, or at least they should. The average, non-professional investor should focus on whether the business had a major increase or decrease in the number of shares during the year, whether the business changed its ownership structure by creating or eliminating a class of stock, and the impact of stock options awarded to managers of the business.