Financial Reporting Mechanics

Chapter 2 (Reading 30)

The mechanics of the accounting process is the

foundation for financial reporting. Understanding those

mechanics enables an analyst to understand the

interrelationships of financial accounts and statements

and, therefore, to better assess a company’s financial

performance.

Financial Reporting Mechanics1

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics

Financial Reporting Mechanics

Learning Outcomes

1. identify the groups (operating, investing, and financing activities) into which business activities are categorized for financial reporting purposes and classify any business activity into the appropriate group.

2. explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements.

3. explain the accounting equation in its basic and expanded forms.

4. explain the process of recording business transactions using an accounting system based on the accounting equations.

5. explain the need for accruals and other adjustments in preparing financial statements.

6. prepare financial statements, given account balances or other elements in the relevant accounting equation, and explain the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners’ equity.

7. describe the flow of information in an accounting system.

8. explain the use of the results of the accounting process in security analysis.

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identify the groups into which business activities are categorized for financial reporting purposes and classify any business activity into the appropriate group.

Classification of Business Activities

Operating activities are those activities that are part of the day-to-day business functioning of an entity.

Investing activities are the ones associated with acquisition and disposal of long term assets.

Financing activities are related to obtaining or repaying capital – equity and debts.

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Sale of goods &services (R)

Cost of providing the goods & services (X)

Income tax expense (X)

Investment in short term assets (A) (L)

Purchase or sale of plant, property, land, building (A)

Purchase or sale of equity of another entity – shares (A)

Purchase or sale of bonds, TFCs, SUKUK – (A)

Issuance or repurchase of own shares (E)

Issuance or repayment of debt (L)

Paying Dividends (E)

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Operating Activities

Investing Activities

Financing Activities



Not everything falls in this classification as neatly as expected., e.g.,

Interest received by a bank on one of the loans it has advanced is classified as operating activity.

Interest received by a manufacturing concern on a bond investment is classified as an investing activity.

How a transaction is classified depends on the nature of the firm, rather than the nature of the transaction.

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Operating Activities

Investing Activities

Financing Activities


explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements.

Financial Statements Elements and Accounts

Accounts – individual records pertaining to economic activities.

Chart of Accounts – a detailed division of actual accounts used in a company.

Contra Account – any account that is offset or deducted from another account, e.g., bad debt losses from receivables

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Assets

Assets are the firm’s economic resources. Examples of assets include:

Cash and cash equivalents. Liquid securities with maturities of 90 days or less are considered cash equivalents.

Accounts receivable. Accounts receivable often have an “allowance for bad debt expense” or “allowance for doubtful accounts” as a contra account.

Inventory – Raw Material, WIP, Finished Goods

Financial assets such as marketable securities.

Prepaid expenses. Items that will be expenses on future income statements.

Property, plant, and equipment. Includes a contra-asset

account for accumulated depreciation.

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Investment in affiliates accounted for using the equity method.

Deferred tax assets.

Intangible assets. Economic resources of the firm that do not have a physical form, such as patents, trademarks, licenses, and goodwill. Except for goodwill, these values may be reduced by “accumulated amortization.”

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Liabilities

Liabilities are creditor claims on the company’s resources. Examples of liabilities include:

Accounts payable and trade payables.

Financial liabilities such as short-term notes payable.

Unearned revenue. Items that will show up on future income statements as revenues.

Income taxes payable. The taxes accrued during the past year but not yet paid.

Long-term debt such as bonds payable.

Deferred tax liabilities.

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Equity

Owners’ equity is the owners’ residual claim on a firm’s resources, which is the amount by which assets exceed liabilities. Owners’ equity includes:

Capital. Par value of common stock.

Additional paid-in capital. Proceeds from common stock sales in excess of par value.

(Share repurchases that the company has made are represented in the contra account, treasury stock.)

Retained earnings. Cumulative net income that has not been distributed as dividends.

Other comprehensive income. Changes resulting from foreign currency translation, minimum pension liability adjustments, or unrealized gains and losses on investments.

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Exhibit 4 Study the Exhibit 4 at page 43.

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explain the accounting equation in its basic and expanded forms.


The Accounting Equation

Double Entry Accounting – Debits & Credits

Assets = Equity + Liabilities

Assets = liabilities + contributed capital + ending retained earnings

Assets = Liabilities

+ Contributed Capital

+ Beginning Retained Earnings

+ Revenue

– Expenses

– Dividends

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explain the process of recording business transactions using an accounting system based on the accounting equations.


The Accounting Process

Use of T-Accounts will help you organize the final results in financial statements.

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explain the need for accruals and other adjustments in preparing financial statements.

Accounting Process

Other Adjustments

Most assets are recorded on the financial statements at their historical costs.

However, accounting standards require balance sheet values of certain assets to reflect their current market values.

Accounting entries that update these assets’ values are called ‘valuation adjustments’.

To keep the accounting equation in balance, changes in asset values also change owners’ equity, through gains or losses recorded on the income statement or in “other comprehensive income.”

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prepare financial statements and explain the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners’ equity.

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Income Statement for 20X8

Sales 100,000

Expenses

Cost of goods sold 40,000

Wages 5,000

Depreciation 7,000

Interest 500

Total expenses 52,500

Income from continuing operations 47,500

Gain from sale of land 10,000

Pretax income 57,500

Provision for taxes 20,000

Net income 37,500

Common dividends declared 8,500

Cash Flow Statement 20X8

Cash collections 99,000

cash inputs (34,000)

cash expenses (8,500)

cash interest -

cash taxes (14,000)

Cash flow from operations 42,500

Cash from sale of land 15,000

Purchase of plant and equipment (25,000)

Cash flow from investments (10,000)

Sale of bonds 5,000

Repurchase of stock (10,000)

Cash dividends (3,500)

Cash flow from financing (8,500)

Total cash flow 24,000



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Balance Sheet for 20X7 and 20X8 20X8 20X7

Assets

Current assets

Cash 33,000 9,000

Accounts receivable 10,000 9,000

Inventory 5,000 7,000

Noncurrent assets

Land 35,000 40,000

Gross plant and equipment 85,000 60,000

less: Accumulated depreciation (16,000) (9,000)

Net plant and equipment 69,000 51,000

Goodwill 10,000 10,000

Total assets 162,000 126,000

Liabilities and Equity 20X8 20X7

Current liabilities

Accounts payable 9,000 5,000

Wages payable 4,500 8,000

Interest payable 3,500 3,000

Taxes payable 5,000 4,000

Dividends payable 6,000 1,000

Noncurrent liabilities

Bonds 15,000 10,000

Deferred taxes 20,000 15,000

Stockholders’ equity

Common stock 40,000 50,000

Retained earnings 59,000 30,000

Total liabilities & equity 162,000 126,000

The cash flow statement shows a $24,000 net increase in cash. On the balance sheet,

cash increased by $24,000, from $9,000 in 20X7 to $33,000 in 20X8.



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Statement of Owners’ Equity for 20X8

Capital Retained

Earnings Total

Balance, 12/31/20X7 50,000 30,000 80,000

Repurchase of stock (10,000) (10,000)

Net income 37,500 37,500

Distributions (8,500) (8,500)

Balance, 12/31/20X8 40,000 59,000 99,000



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The income statement shows that net income was $37,500 in 20X8. The company

declared $8,500 of that income as dividends to its shareholders. The remaining

$29,000 is an increase in retained earnings. Retained earnings on the balance sheet

increased by $29,000, from $30,000 in 20X7 to $59,000 in 20X8.

The cash flow statement shows a $24,000 net increase in cash. On the balancesheet, cash increased by $24,000, from $9,000 in 20X7 to $33,000 in 20X8.

One of the uses of cash shown on the cash flow statement is a repurchase of stockfor $10,000. The balance sheet shows this $10,000 repurchase as a decrease incommon stock, from $50,000 in 20X7 to $40,000 in 20X8.

The statement of owners’ equity reflects the changes in retained earnings andcontributed capital (common stock). Owners’ equity increased by $19,000, from$80,000 in 20X7 to $99,000 in 20X8. This equals the $29,000 increase in retainedearnings less the $10,000 decrease in common stock.


describe the flow of information in an accounting system.

Accounting Process

Flow of Information in accounting system

1. Journal entries record every transaction, showing which accounts are changed and by what amounts. A listing of all the journal entries in order of their dates is called the “general journal.”

2. The general ledger sorts the entries in the general journal by account.

3. 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.

4. The account balances from the adjusted trial balance are presented in the financial statements.

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explain the use of the results of the accounting process in security analysis.

Use of Judgment in Accounts

Understanding that there has to be another

side to every entry is the key in detecting

inappropriate because – usually in the course

of “fixing” one account – there will be another

account with a balance that does not make

sense.

WorldCom recorded its operating expenses as

capital assets, i.e., recording revenue expenses

as capital expenses.

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Documents

Financial Reporting Mechanics