1. READING 22 FINANCIAL REPORTING MECHANICS
FRA
READING 22
FINANCIAL REPORTING MECHANICS
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2. 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
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3. 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
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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
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4. 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
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5. 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
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6. 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
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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
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12. 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
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13. 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)
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14. 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
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15. 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
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