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CHAPTER 2FINANCIAL REPORTING MECHANICS
Copyright © 2013 CFA Institute 2
BUSINESS ACTIVITIES AND FINANCIAL STATEMENT ELEMENTS
• Business Activities
- Operating
- Sell products or services to generate revenue1
- Incur expenses2 while generating revenue
- Investing
- Use (longer-term) assets3 to operate the business
- Financing
- Borrow from creditors, creating a liability4
- Sell ownership interest (equity5) to shareholders
• Firms use financial reports to communicate about these activities and their results
1–5: financial statement elements
Copyright © 2013 CFA Institute 3
FINANCIAL STATEMENT ELEMENTS
• Financial statement elements defined in general terms
- Assets: economic resources of a company
- Liabilities: creditors’ claims on the resources of a company
- Owners’ equity: residual claim on the resources of a company
- Revenue: inflows of economic resources to the company
- Expenses: outflows of economic resources or increases in liabilities
• Financial statements are constructed using these elements.
• Accounts provide individual records of increases and decreases in a specific asset, liability, component of owners’ equity, revenue, or expense.
Copyright © 2013 CFA Institute 4
ASSET ACCOUNTS
• Cash and cash equivalents
• Accounts receivable, trade receivables
• Prepaid expenses
• Inventory
• Property, plant, and equipment
• Investment property
• Intangible assets (patents, trademarks, licenses, copyright, goodwill)
• Financial assets, trading securities, investment securities
Copyright © 2013 CFA Institute 5
LIABILITY ACCOUNTS
• Accounts payable, trade payables
• Debt payable
• Bonds (payable)
Copyright © 2013 CFA Institute 6
ASSETS AND LIABILITIES
Borrower
$ € ₤
When a bank lends money to a borrower, it creates an asset for the bank (loan receivable) and a liability for the borrower (loan payable).
Asset:Loan Receivable
Liability:Loan Payable
Copyright © 2013 CFA Institute 7
EQUITY ACCOUNTS
• Capital (such as common stock)
• Additional paid-in capital
• Retained earnings
• Accumulated other comprehensive income
Copyright © 2013 CFA Institute 8
REVENUE AND EXPENSE ACCOUNTS
REVENUE
• Revenue, sales
• Gains
• Investment income (e.g., interest and dividends)
EXPENSE
• Cost of goods sold
• Selling, general, and administrative expenses (SG&A; e.g., rent, utilities, salaries, advertising)
• Depreciation and amortization
• Interest expense
• Tax expense
• Losses
Copyright © 2013 CFA Institute 9
BASIC ACCOUNTING EQUATION
ASSETS = LIABILITIES + OWNERS’ EQUITY
• This is the equation that underlies the balance sheet.
• This equation reflects a company’s financial position.
• The amount of assets equals the claims on those assets:
- Liability claims and
- Owners’ equity, the residual claim.
• The slightly rearranged balance sheet equation reflects the concept of equity as the residual claim.
ASSETS – LIABILITIES = OWNERS’ EQUITY
Copyright © 2013 CFA Institute 10
BASIC AND EXPANDED ACCOUNTING EQUATION: COMPONENTS OF OWNERS’ EQUITY
Assets = Liabilities + Owners’ Equity
Assets = Liabilities +Contributed Capital
Ending Retained Earnings
Assets = Liabilities +Contributed Capital +
Beginning Retained Earnings +
Net Income - Dividends
Assets = Liabilities +Contributed Capital +
Beginning Retained Earnings + REV - Expenses - Dividends
+
Copyright © 2013 CFA Institute 11
BASIC AND EXPANDED ACCOUNTING EQUATION: RETAINED EARNINGS
Assets = Liabilities + Owners’ Equity
Assets = Liabilities +Contributed Capital
Ending Retained Earnings
Assets = Liabilities +Contributed Capital +
Beginning Retained Earnings +
Net Income - Dividends
Assets = Liabilities +Contributed Capital +
Beginning Retained Earnings + REV - Expenses - Dividends
+
Copyright © 2013 CFA Institute 12
BASIC AND EXPANDED ACCOUNTING EQUATION: NET INCOME
Assets = Liabilities + Owners’ Equity
Assets = Liabilities +Contributed Capital
Ending Retained Earnings
Assets = Liabilities +Contributed Capital
Beginning Retained Earnings +
Net Income – Dividends
Assets = Liabilities +Contributed Capital
Beginning Retained Earnings + Revenue –Expenses – Dividends
+
+
+
Copyright © 2013 CFA Institute 13
BASIC AND EXPANDED ACCOUNTING EQUATION
Assets = Liabilities + Owners’ Equity
Assets = Liabilities +Contributed Capital
Ending Retained Earnings
Assets = Liabilities +Contributed Capital
Beginning Retained Earnings +
Net Income – Dividends
Assets = Liabilities +Contributed Capital
Beginning Retained Earnings + Revenue –Expenses – Dividends
+
+
+
Copyright © 2013 CFA Institute 14
EXAMPLE: ABC COMPANY FINANCIAL STATEMENT LINKS
Copyright © 2013 CFA Institute 15
EXAMPLE ABC COMPANY
ABC Company, Inc.(Beginning) Balance SheetAs of 31 December 20X0
Assets 2,000 Liabilities 500Contributed equity 1,250Retained earnings 250Owners’ equity 1,500
Total liabilities and equity 2,000
During the year 20X1:ABC earned $250 in revenues, for which it received cash.ABC incurred $50 expenses, for which it paid cash.
Copyright © 2013 CFA Institute 16
EXAMPLE: ABC COMPANY INCOME STATEMENT AND RETAINED EARNINGS
ABC Company, Inc.Income Statement
For the Year Ended 31 December 20X1
Revenue 250 Expense 50Net income 200
ABC Company, Inc.Statement of Retained EarningsYear Ended 31 December 20X1
Beginning retained earnings 250Plus net income 200Minus dividends 0Ending retained earnings 450
Copyright © 2013 CFA Institute 17
EXAMPLE: ABC COMPANY ENDING BALANCE SHEET
ABC Company, Inc.
(Ending) Balance Sheet
As of 31 December 20X1
Assets 2,200
Liabilities 500
Contributed equity 1,250
Retained earnings 450
Owners’ equity 1,700
Total liabilities and equity 2,200
Copyright © 2013 CFA Institute 18
ACCOUNTING SYSTEM BASED ON THE ACCOUNTING EQUATION
• The basic structure of an accounting system mirrors the basic accounting equation: Assets = Liabilities + Owners’ Equity.
• As each transaction is recorded, the accounting equation remains in balance.
• An account is a record of increases and decreases in a specific asset, liability, or owners’ equity item.
• In a tabular summary, each transaction is entered on a new row.
• Columns are organized by account (and sometimes grouped for display considerations).
• At any point, subtotals provide information to prepare financial statements.
Copyright © 2013 CFA Institute 19
EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM
Assets = Liabilities + Owners’ Equity
Cash PayableContributed
CapitalRetained Earnings
Beginning balance 2,000 500 1,250 250
Received cash for services 250 250Revenue
Paid cash for expenses –50 –50Expense
Subtotal 2,200 500 1,250 450
Copyright © 2013 CFA Institute 20
EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM
Assets = Liabilities + Owners’ Equity
Cash PayableContributed
CapitalRetained Earnings
Beginning balance 2,000 500 1,250 250
Received cash for services 250 250 Revenue
Paid cash for expenses –50 –50Expense
Subtotal 2,200 500 1,250 450
Copyright © 2013 CFA Institute 21
EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM
Assets = Liabilities + Owners’ Equity
Cash PayableContributed
CapitalRetained Earnings
Beginning balance 2,000 500 1,250 250
Received cash for services 250 250Revenue
Paid cash for expenses –50 –50Expense
Subtotal 2,200 500 1,250 450
Copyright © 2013 CFA Institute 22
EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM
Assets = Liabilities + Owners’ Equity
Cash PayableContributed
CapitalRetained Earnings
Beginning balance 2,000 500 1,250 250
Received cash for services 250 250RevenuePaid cash for expenses –50 –50ExpenseSubtotal 2,200 500 1,250 450
Total = $2,200
Copyright © 2013 CFA Institute 23
EXAMPLE: ABC COMPANY. TABULAR ACCOUNTING SYSTEM
WITH CLOSING ENTRY
Assets = Liabilities + Owners’ Equity
Cash PayableContributed Capital
Retained Earnings Revenue Expenses
Beginning balance 2,000 500 1,250 250Received cash for services 250 250Paid cash for expenses –50 –50Subtotal (pre-closing) 2,200 500 1,250 250 250 -50Closing 200 –250 50Post closing 2,200 500 1,250 450 0 0
Copyright © 2013 CFA Institute 24
ACCRUALS
• In the ABC example, the company received cash for all revenues when they were earned and paid cash for all expenses when they were incurred.
• In practice, a company may
- Earn revenue before it receives cash or earn revenue after it receives cash.
- Incur an expense before it pays cash or incur an expense after it pays cash.
• Accrual accounting requires that revenues be recorded in the period they are earned and that expenses be recorded in the period they are incurred, irrespective of when the related cash movement occurs.
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ACCRUALS: REVENUE
Cash Movement prior to Accounting
Recognition
Cash Movement in the Same Period as
Accounting Recognition
Cash Movement after Accounting
Recognition
UNEARNED (DEFERRED) REVENUE
Settled transaction – no accrual entry needed
UNBILLED (ACCRUED) REVENUE
Originating entry: Record cash receipt and establish liability (e.g., unearned revenue)
Originating entry: Record revenue and establish an asset (e.g., unbilled revenue)
Adjusting entry: Reduce the liability while recording revenue
Adjusting entry: When billing occurs, reduce unbilled revenue and increase accounts receivable. When cash is collected, eliminate receivable.
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ACCRUALS: EXPENSE
Cash Movement prior to Accounting
Recognition
Cash Movement in the Same Period as
Accounting Recognition
Cash Movement after Accounting
Recognition
PREPAID EXPENSESettled transaction – no
accrual entry neededACCRUED EXPENSES
Originating entry: Record cash payment and establish an asset (such as prepaid expense)
Originating entry: Establish a liability (such as accrued expenses) and record an expense
Adjusting entry: Reduce the asset while recording expense
Adjusting entry: Reduce the liability as cash is paid
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FLOW OF INFORMATION IN AN ACCOUNTING SYSTEM
Journal
• Journal Entries and Adjusting Entries
Ledger
• General Ledger and T- Accounts
Trial Balance
• Trial Balance and Adjusted Trial Balance
Financial Statements
• Financial Statements
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USING THE RESULTS OF THE ACCOUNTING PROCESS IN SECURITY ANALYSIS
• Financial statements serve as a foundation for credit and equity analysis, including security valuation.
• The accounting process requires judgments and estimates.
• Examples:
- For depreciation expense, estimating useful life and salvage value of property, plant, and equipment
- For revenue recognition, judging when the revenue has been earned
- For valuing investments, estimating the future cash flows and appropriate discount rate
- For receivables, estimating future uncollectible amounts
• Refer to the critical accounting policies/estimates section of management’s commentary (also referred to as management’s discussion and analysis, or MD&A) and the significant accounting policies footnote, both found in the annual report.
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USING THE RESULTS OF THE ACCOUNTING PROCESS IN SECURITY ANALYSIS
Example disclosure under IFRS. Excerpt from 2011 annual report of Barry Callebaut AG.
The preparation of financial statements requires management to make judgments, estimates and assumptions that affect the application of accounting policies and the reported amounts of assets, liabilities, income and expenses. Actual results may differ from these estimates. . . . In particular, information about significant areas of estimation uncertainty and critical judgments in applying accounting policies that have the most significant effect on the amount recognized in the financial statements are described in the following table:
Note 1 Acquisitions — Fair value measurementNote 18 Goodwill — Measurement of the recoverable amounts of cash-generating units
Note 19 Deferred tax assets and liabilities — Utilization of tax losses
Note 24 Employee benefit obligation — Measurement of defined benefit obligations
Note 26Discontinued operations and assets held for sale and liabilities directly associated with assets held for sale — Valuation of assets
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USING THE RESULTS OF THE ACCOUNTING PROCESS IN SECURITY ANALYSIS
Example disclosure under U.S. GAAP. Excerpt from 2011 annual report of Hershey.
Our consolidated financial statements are prepared in accordance with GAAP. In various instances, GAAP requires management to make estimates, judgments and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We believe that our most critical accounting policies and estimates relate to the following:
• Accounts Receivable—Trade
• Accrued Liabilities
• Pension and Other Post-Retirement Benefits Plans
• Goodwill and Other Intangible Assets
• Commodities Futures Contracts
. . . . While we base estimates and assumptions on our knowledge of current events and actions we may undertake in the future, actual results may ultimately differ from these estimates and assumptions. We discuss our significant accounting policies in Note 1, Summary of Significant Accounting Policies.
Copyright © 2013 CFA Institute 31
SUMMARY
• Financial statements are constructed using elements: assets, liabilities, owners’ equity, revenues, and expenses.
• The basic accounting equation is reflected on the balance sheet
Assets = Liabilities + Owners’ equity
• The accounting equation can be expanded to provide a combined representation of the balance sheet and income statement.
Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Revenue – Expenses – Dividends
• The basic structure of an accounting system mirrors the basic accounting equation, which remains in balance as each transaction is recorded.
• Accrual accounting requires that revenues be recorded in the period they are earned and that expenses be recorded in the period they are incurred, irrespective of when the related cash movement occurs.