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Financial Reporting, Financial Statement Analysis and Valuation 9th Edition

Financial Reporting, Financial Statement Analysis and Valuation (9th Edition)

Book Edition9th Edition
Author(s)Wahlen
ISBN9781337614689
PublisherCengage
SubjectFinance
Chapter 4, End of Chapter, Questions and Exercises, Exercise 4.1
Page 243

Common-Size Analysis. 

 

Common-size analysis is a simple way to make financial statements of different firms comparable. What are possible shortcomings of comparing two different firms using common-size analysis?

Explanation

Common Size Statement, also known as a component percentage statement, is a financial tool for studying the key changes and trends in the financial position and operational result of a company. Here, each item in the statement is stated as a percentage of the aggregate, of which that item is a part. For example, each line item in the income statement may be expressed as a percentage of revenue.

 

The limitation of common sizing, while comparing two firms are:

  • Different firms may practice different accounting principles, even the same company may use multiple accounting standards throughout time. As a result, modifications will be required in order to compare the ratios.
  • Each firm may have its own financial fiscal year, and by having a different fiscal year, it becomes difficult to compare the financial statements as the calculation and the values differ for both the firms. So, this leads to different income statements and balance sheets.
  • Different firms may adopt different formats of presenting financial statements. For e.g. Under an income statement, a firm in country U may contain only 6 expense line items under non-operational expenses, while another firm in country NZ may have 15 line items under the non-operational expenses. The variation in statements requires grouping of expenses under common expense heads, which may not be accurate.

Verified Answer

The shortcomings of comparing two different firms using common sizing are:

 

  • Different firms may practice different accounting principles and practices such as inventory valuation, depreciation methods etc, which leads to differences in accounting ratios.
  • Each firm may have its own financial fiscal year, so this leads to different income statements and balance sheets.
  • Different firms may adopt different revenues and expenses reporting lines as per their discretion, which makes comparison difficult due to the lack of a common format of financial statements.
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