BUS103: Introduction to Financial Accounting

The calculation of dollar and/or percentage changes from one year to the next in an item on financial statements is horizontal analysis. For instance, in the following data taken from the 2000 annual report of Hewlett-Packard Company, the amount of inventory increased by USD 836 million from 1999 October 31, to 2000 October 31. This amount represented a 17 per cent increase. To find the amount of the increase or decrease, subtract the 1999 amount from the 2000 amount. To find the percentage change, divide the increase or decrease by the 1999 amount.

Knowing the dollar amount and percentage of change in an amount is much more meaningful than merely knowing the amount at one point in time. By analyzing the data, we can see that cash and cash equivalents declined in 2000. Their decline at least partially explains the increases in some of the other current assets. We can also see that the company invested in property, plant and equipment. Any terms in Hewlett-Packard's list of assets that you do not understand are explained in later chapters. At this point, all we want you to understand is the nature of horizontal and vertical analyses.

Vertical analysis shows the percentage that each item in a financial statement is of some significant total such as total assets or sales. For instance, in the Hewlett-Packard data we can see that cash and cash equivalents were 15.3 per cent of total assets as of 1999 October 31, and had declined to 10.0 per cent of total assets by 2000 October 31. Total current assets (cash plus other amounts that will become cash or be used up within one year) increased from 61.3 per cent of total assets to 68.3 per cent during 2000. Long-term investments and other non-current assets accounted for 18.4 per cent of total assets as of 2000 October 31.

Management performs horizontal and vertical analyses along with other forms of analysis to help evaluate the wisdom of its past decisions and to plan for the future. Other data would have to be examined before decisions could be made regarding the assets shown. For instance, if you discovered the liabilities that would have to be paid within a short time by Hewlett-Packard were more than USD 30 billion, you might conclude that the company is short of cash even though current assets increased substantially during 2000. We illustrate horizontal and vertical analyses to a much greater extent later in the text.

An accounting perspective: Business insight

Many companies have been restructuring their organizations and reducing the number of employees to cut expenses. General Motors, AT&T, IBM, and numerous other companies have taken this action. One could question whether companies place as much value on their employees as in the past. In previous years it was common to see the following statement in the annual reports of companies: "Our employees are our most valuable asset". Companies are not permitted to show employees as assets on their balance sheets. Do you think they should be allowed to do so?

What you have learned in this chapter is basic to your study of accounting. The entire process of accounting is based on the double-entry concept. Chapter 3 explains that adjustments bring the accounts to their proper balances before accurate financial statements are prepared.

Understanding the learning objectives 

• An account is a storage unit used to classify and summarize money measurements of business activities of a similar nature. 
  
• A firm sets up an account whenever it needs to provide useful information about a particular business item to some party having a valid interest in the business. 
  
• A T-account resembles the letter T. 
  
• Debits are entries on the left side of a T-account. 
  
• Credits are entries on the right side of a T-account. 
  
• Debits increase asset, expense, and Dividends accounts. 
  
• Credits increase liability, stockholders' equity, and revenue accounts. 
  
• Analyze transactions by examining source documents. 
• Journalize transactions in the journal. 
  
• Post journal entries to the accounts in the ledger. 
  
• Prepare a trial balance of the accounts and complete the work sheet. 
  
• Prepare financial statements.
  
• Journalize and post adjusting entries. 
  
• Journalize and post closing entries. Prepare a post-closing trial balance. 
  
• A journal contains a chronological record of the transactions of a business. An example of a general journal is shown in Exhibit 11. Journalizing is the process of entering a transaction in a journal. 
  
• Posting is the process of transferring information recorded in the journal to the proper places in the ledger. 
  
• Cross-indexing is the placing of (1) the account number of the ledger account in the general journal and (2) the general journal page number in the ledger account. 
  
• An example of cross-indexing appears in Exhibit 10. 
  
• A trial balance is a listing of the ledger accounts and their debit or credit balances. 
  
• If the trial balance does not balance, an accountant works backward to discover the error. 
  
• A trial balance is shown in Exhibit 13. 
  
• Horizontal analysis involves calculating the dollar and/or percentage changes in an item from one year to the next. 
  
• Vertical analysis shows the percentage that each item in a financial statement is of some significant total.