Accounting: The Language of Business (Part 19)

“There is no accounting for tastes.” —Ann Radcliffe

Completing the Accounting Cycle (Part C)

by

Charles Lamson 

Fiscal Year

In the NetSolutions illustration, operations began on November 1 and the accounting period was for two months, November and December. A proprietorship is required by the federal income tax law, except in rare cases, to maintain the same accounting period as its owner. Since Chris Clark maintains a calendar year accounting period for tax purposes, NetSolutions must also close its account on December 31, 2022. In future years, the financial statements for NetSolutions will be prepared for 12 months ending on December 31 each year. 

The annual accounting period adopted by a business is known as its fiscal year. Fiscal years begin with the first day of the month selected and end on the last day of the following 12 months. The period most commonly used is the calendar year. Other periods are not unusual, especially for businesses organized as corporations. For example, a corporation may adopt a fiscal year that ends when business activities have reached the lowest point in its annual operating cycle. Such a fiscal year is called the natural business year. At the low point in its operating cycle, a business has more time to analyze the results of operations and to prepare financial statements.

Because companies with fiscal years often have highly seasonal operations, investors and others should be careful in interpreting partial year reports for such companies. That is, you should expect the results of operations for these companies to vary significantly throughout the fiscal year.

The financial history of a business may be shown by a series of balance sheets and income statements for several fiscal years.

You may think of the income statements, balance sheets, and financial history of a business as similar to the record of a football team. The final score of each football game is similar to the net income reported on the income statement of a business. The team's season record after each game is similar to the balance sheet. At the end of the season, the final record of the team measures its success or failure. Likewise, at the end of a life of a business, its final balance sheet is a measure of its financial success or failure. 

Financial Analysis and Interpretation

The ability of a business to pay its debts is called solvency. Two financial measures for evaluating a business's short-term solvency are working capital and the current ratio. Working capital is the excess of the current assets of a business over its current liabilities, as shown below.

Working capital = Current assets - Current liabilities

An excess of the current assets over the current liabilities implies that the business is able to pay its current liabilities. If the current liabilities are greater than the current assets, the business may not be able to pay its debts and continue in business. To illustrate, we see by looking at the balance sheet in Exhibit 8 from part 18 that Netsolutions' working capital at the end of 2022 is $6,455, as computed below. This amount of working capital implies that NetSolutions can pay its current liabilities.

Working capital = Current assets - Current liabilities

 Working capital = $7,845 - $1,390

 Working capital = $6,455

The current ratio is another means of expressing the relationship between current assets and current liabilities. The current ratio is computed by dividing current assets by current liabilities, as shown below.

Current ratio = Current assets/Current liabilities

To illustrate, the current ratio for NetSolutions at the end of 2022 is 5.6, computed as follows: 

Current ratio = Current assets/Current liabilities

 Current ratio = $7,845/$1,390 = 5.6

The current ratio is useful in making comparisons across companies and with industry averages. To illustrate, assume that as of December 31, 2022, the working capital of a company that competes with NetSolutions is much greater then $6,455, but its current ratio is only 1.3. Considering these facts alone, NetSolutions is in a more favorable position to obtain short-term credit, even though the competing company has a greater amount of working capital. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 153-154*

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