What is Analysis of Accounts Method?

Analysis of Accounts Method is a way for a company to guess what its financial statements will look like. Financial statements are essential reports that show how much money a company made and spent and what it owns and owes. The two main financial statements are:

1. Balance Sheet: Shows what a company owns (assets) and owes (liabilities) at a specific point in time
2. Income Statement: Shows how much money a company made (revenue) and spent (expenses) over some time

Companies want to predict what their future financial statements will look like. This helps them plan and make sound business decisions. That is where the Analysis of Accounts Method comes in.

How the Analysis of Accounts Method Works

Here are the main steps in the Analysis of Accounts Method:

1. Figure out how much cash the company thinks it will get and spend. This is called cash budgeting.
2. For each thing, the company owns (asset), owes (liability), makes money from (revenue), and spends money on (expense); figure out how the cash coming in and going out will change those things. This uses something called debits and credits.
3. Add all the changes to assets, liabilities, revenue, and expenses. This estimates their total at the end of the period.
4. Using those estimates, create a new balance sheet and income statement. These are called a pro-forma balance sheet and pro-forma income statement. “Pro forma” means it is a prediction of the future.

An example of an Analysis of Accounts Method

To help understand, let’s look at a simple made-up example. Imagine a small company that sells toys.

Step 1: Cash budgeting

The company’s accountant does cash budgeting and figures out:

• They think they will get $100,000 in cash from selling toys over the next year
• They believe they will spend $60,000 on buying toy supplies, $20,000 on rent, and $10,000 on other expenses

Step 2: Figuring out debits and credits

The accountant looks at each financial statement item:

• Cash (an asset): Getting $100,000 will increase some money. Spending $90,000 will decrease some cash. So, the net change to money is an increase of $10,000.
• Inventory (an asset): Spending $60,000 on toy supplies will increase inventory by that amount.
• Accounts Payable (a liability): $30,000 of the toy supplies will be bought on credit and paid for later, increasing Accounts Payable by $30,000.
• Revenue: Selling $100,000 worth of toys means revenue increases by that amount.
• Expenses: The company had expenses of $30,000, including $20,000 on rent and $10,000 on other things. So expenditures increased by $30,000.

Step 3: Adding up the changes

• Cash increased by $10,000
• Inventory increased by $60,000
• Accounts Payable increased by $30,000
• Revenue increased by $100,000
• Expenses increased by $30,000

Step 4: Make pro-forma statements

The accountant takes the company’s statements from the start of the year and adds the changes:

Pro-forma Balance Sheet:

• Cash: $50,000 + $10,000 = $60,000
• Inventory: $80,000 + $60,000 = $140,000
• Accounts Payable: $20,000 + $30,000 = $50,000

Pro-forma Income Statement:

• Revenue: $0 + $100,000 = $100,000
• Expenses: $0 + $30,000 = $30,000
• Profit: $100,000 – $30,000 = $70,000

Why the Analysis of Accounts Method is Useful

Analysis of Accounts Method helps companies in several ways:

1. Planning: By predicting future financial statements, companies can make plans based on how much money they think they will make and spend.
2. Making decisions: The predictions can help companies decide whether they can afford to buy something new or hire more people.
3. Setting goals: Companies can set financial goals and then use Analysis of Accounts to see if they are on track to meet them.
4. Finding problems early: If the predictions show the company might not have enough cash or might even lose money, it can take steps to fix those problems before they happen.

Limitations of Analysis of Accounts Method

Analysis of Accounts is functional, but it also has some limitations:

1. It is based on guesses: The predictions come from a company’s guesses about the future. If those guesses are wrong, the predictions will be wrong, too.
2. Things change: Even if the guesses are correct at the time, things can change. A company might lose a significant customer, or costs might increase unexpectedly.
3. It is simple: Analysis of Accounts is a simple way to predict the future. More complex methods might make better predictions, but they are more challenging.
4. It doesn’t give the complete picture: Financial statements don’t tell you everything about a company’s health. Customer satisfaction, employee morale, and market conditions also matter.

Closing Summary

The analysis of the Accounts Method allows a company to predict its future financial statements based on cash budgeting. It helps companies plan, make decisions, set goals, and spot problems early.

However, it is based on guesses, doesn’t account for changes, is relatively simple, and doesn’t give the complete picture of a company’s health. Despite these limitations, it is a valuable tool for many companies.