23. Financial Reporting Mechanics
A. Relationship of financial statement elements and accounts and classification :
Financial statement elements are the major classification of assets, liabilities, equity, revenues and expenses.
A chart of accounts is a detailed list of the accounts that make up the five financial statement elements and the line items presented in the financial statements.
Contra accounts are used for entries that offset other accounts.
Assets are the firm’s economic resources. Examples include :
- Cash and cash equivalents.
- Accounts receivable. They often have an “allowance for bad debt expense” or “allowance for doubtful accounts” as contra account.
- Inventory.
- Financial assets (marketable securities).
- Prepaid expenses.
- PP&E. Includes a contra-asset account for accumulated depreciation.
- Investment in affiliates.
- Deferred tax assets.
- Intangible assets.
Liabilities are creditor claims on the company’s resources. Examples include :
- Accounts payable and trade payable.
- Financial liabilities (notes payable).
- Unearned revenue.
- Income taxes payable.
- Long-term debt (bonds payable).
- Deferred tax liabilities.
Owner’s equity is the owner’s residual claim on the firm’s resources. Include :
- Capital (par value of common stock).
- Additional paid-in capital: proceeds from common stock sales in excess of par value. (Share repurchases are represented in the contra account treasury stock).
- Retained earnings.
- Other comprehensive income: Foreign currency translation...
Revenue represents inflows of economic resources and includes :
- Sales.
- Gains. Increases in assets from transactions.
- Investment income such as interest and dividend income.
Expenses are outflows of economic resources and includes :
- COGS (COst of Goods Sold).
- SG&A (Selling, General & Administrative expenses).
- Depreciation & amortization.
- Tax expense.
- Interest expense.
- Losses.
B. Basic and expanded accounting equation:
The basic accounting equation:
assets = liabilities + owner’s equity
The expanded accounting equation:
assets = liabilities + contributed capital + ending retained earnings
assets = liabilities + contributed capital + beginning retained earnings + net income (revenue – expenses) – dividends
C. Process of recording business transactions using the accounting equation system :
Keeping the accounting equation (A = L + E) in balance requires double-entry accounting, in which a transaction is recorded in at least two accounts. An increase in an asset account, for example, must be balanced by a decrease in another asset account or by a increase in a liability or owner’s equity account.
D. Need for accruals and other adjustments :
A firm must recognize revenues when they are earned and expenses when they are incurred. Accruals are required when the timing of cash payments made and received does not match the timing of the revenue or expense recognition on the financial statements.
Unearned revenue: The firm receives cash before it provides a good or service. Cash increases and unearned revenue (liability) increases by the same amount.
Accrued revenue: The firm provides a good or service before cash payment. Revenue increases (net income -> retained earning -> equity increases) and accounts receivable (asset) increases as well.
Prepaid expenses: The firm pays cash ahead of time for anticipated expense. Cash decreases and prepaid expense (asset) increases by the same amount.
Accrued expenses: The firm owes cash for expenses it has incurred. Expenses increase (net income -> retained earning -> equity decreases) and accrued expenses (liability) increases.
In some cases, accounting standards require balance sheet values of certain assets to reflect their current market values. Accounting entries that update these assets’ values from their historical cost are called valuation adjustment.
E. Relationship between income statement, balance sheet, statement of cash flows, and statement of owners’ equity :
The balance sheet shows a company’s financial position at a point in time.
Changes in balance sheet accounts during an accounting period are reflected in the income statement, and the statement of owner’s equity.
F. Flow of information in an accounting system :
Information flows through an accounting system in four steps :
- Journal entries record every transaction, showing which accounts are changed and by what amount. A listing of all journal entries in order of their dates is called the general journal.
- The general ledger sorts the entries in the general journal by account.
- At the end of the accounting period, an initial trial balance is prepared that shows the balances in each account. If any adjusting entries are needed, they will be recorded and reflected in an adjusted trial balance.
- The account balances from the adjusted trial balance are presented in the financial statements.
G. Use of results of the accounting process in security analysis :
An analyst does not have access to the detailed information that flows through a company’s accounting system but sees only the end product.
An analyst needs to understand the various accruals, adjustments and management assumptions that go into the financial statements (footnotes and MD&A).
Even if the firm conforms to appropriate accounting principles, there is still room for management discretion.
Understanding the accounting process may assist an analyst in identifying earnings manipulation of management’s judgment of accruals and valuation, but it will not prevent the manipulation of earnings by management.
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