READING 22 FINANCIAL REPORTING MECHANICS FRA READING 22 FINANCIAL REPORTING MECHANICS CF INSTITUTE

INTRODUCTION Financial Statements are end products There is an ‘accounting process’ that converts business transactions into periodic reports For analysis and forecasting purpose, understanding the ‘Financial Reporting Mechanics’ is necessary Analysts are users. They need to know the accounting principles from the users perspective. Detailed, technical accounting skills are not required CF INSTITUTE

Main business functions Business activities EXAMPLE Producing & selling stoves by stove manufacturer Buying stoves by a snacks maker Borrowing loan to buy stoves or issuing equity to raise capital Operating Activities Main business functions Investing activities Acquisition & disposal / buying & selling of long term assets Financing activities Obtaining or repaying capital R22 LOS a Other example: Interest received by bank – operating activity Interest received on bond investments made by the snacks maker company – investing activity These are classification of business activity to record transactions. Same names are used to classify cash flow in cash flow statement. Understand the context to which the classifications are used. *understanding the type of business & then classifying CF INSTITUTE

Business activity & financial statement elements (examples) Transaction Element Operating Activities Sales of goods & services Revenue Cost to produce and sell the goods & services Expense Holding short-term assets Assets Borrowing loan for 10 days for operating purposes Liability Investing activities Acquiring another company Purchasing oil fields Financing activities Repurchasing equity Issuing debt securities Dividend payment CF INSTITUTE

All business transactions are classified into these 5 elements Financial elements All business transactions are classified into these 5 elements ASSETS LIABILITIES OWNER’S EQUITY REVENUE EXPENSES CF INSTITUTE

Financial accounts basic definitions records within each elements Transactions already done in the business Journal entries Ledger Trial balance Charts of accounts Detailed list of all the accounts of the company Contra accounts Accounts used to offset value from other accounts CF INSTITUTE

COMMON ACCOUNTS UNDER EACH ELEMENT ASSETS Cash & cash equivalent Accounts receivables Prepaid expenses Inventory Plant and machinery Financial assets LIABILITIES Accounts payable Provisions Unearned revenue Debt payable Reserves Financial liability OWNER’S EQUITY Capital Additional paid-in capital Retained earnings Other comprehensive income Minority interest REVENUE Sales Gains Investment income EXPENSE COGS SG&A Depreciation Interest expense Tax loss CF INSTITUTE

ACCOUNTING EQUATION AND ITS EXPANDED FORM Basic equation ASSET = LIABILITY + OWNER’S EQUITY ASSET = LIABILITY + CONTRIBUTED CAPITAL + ENDING RETAINED EARNINGS ASSET = LIABILITY + CONTRIBUTED CAPITAL + BEGINNING RETAINED EARNINGS + REVENUE – EXPENSES - DIVIDENDS CF INSTITUTE

In journals, ledgers, memos ACCOUNTING PROCESS Business transaction Recording For future reference In journals, ledgers, memos Final presentation B/S P/L Cash flow Business transactions are recorded in an accounting system that is based on the basic and expanded form of equation. Both sides of the ‘=’ must balance Double-entry accounting system is used to record transactions. One transaction > effect in two accounts CF INSTITUTE

Accruals adjustments Require that the revenues be recorded when ‘earned’ the expenses be recorded when ‘incurred’ Necessary part of the accounting process Allocates the business activity to appropriate time period for reporting purposes Accrual entries occur due to difference in timing of Actual cash movements and Accounting recognition ACCRUAL ACCOUNTING LOS e CF INSTITUTE

UNEARNED REVENUE ACCRUED REVENUE PREPAID EXPENSE ACCRUED EXPENSE CASH MOVEMENT Prior to accounting recognition Same period After accounting recognition REVENUE Unearned (deferred) revenue No accrual entry Accrued (unbilled) revenue EXPENSE Prepaid expense Accrued expense UNEARNED REVENUE Cash received before goods/ service provided Cash increase : unearned revenue (liability) increase After goods/ service provided, revenue increases; liability decreases ACCRUED REVENUE goods/ service provided; cash yet to be received Revenue increases : Accounts Receivables (assets) increases After cash received, eliminate receivables PREPAID EXPENSE Company pays cash prior to recognizing expense Cash decreases(A) : Prepaid expenses increases (A) After expense incurred, prepaid expense decreases : expense increases ACCRUED EXPENSE Expense already incurred; cash yet to be paid Expense increases : Accrued expenses (L) increases When cash paid, liability decreases LOS e CF INSTITUTE

Valuation adjustments made to the Assets and Liabilities only only where required by accounting standards for accounting records to reflect current value mostly required for assets Value of asset increases (A) : Gain (I) Value of asset decreases (A) : Loss (I) Gain/ Loss in Income statement or Other comprehensive income statement LOS e CF INSTITUTE

Relationship among the financial statements As discussed earlier, each business transaction has effects in any 2 of the key elements. This inter-links each of the financial statements. For example: Dividend declared: Dividend paid to shareholders is subtracted from Net Income (I S); leftover is Retained earnings (B S); [subtracted from I S, added to B S] Share repurchase: Cash paid to repurchase the Common stock (CFS); decrease in outstanding shares (B S) LOS f CF INSTITUTE

FLOW OF INFORMATION a document or computer file JOURNAL ENTRIES a document or computer file Business transactions are 1st recorded here In chronological order <date> <accounts affected> <amount> GENERAL LEDGER T-accounts Shows transactions account-wise TRAIL BALANCE List of account balances At a point in time Prepared at the end of accounting period FINANCIAL STATEMENTS LOS g CF INSTITUTE

Using financial statements for security analysis Foundation for security valuation Analysts do not have access to the other records of the flow To judge the financial health of the company, analysts use financial statements Statements can be manipulated (by the management) Analyst can detect such ‘misrepresentation’ by cross-referring the statements LOS h CF INSTITUTE