Reading 22 - Financial Reporting Mechanics Flashcards
Business activities are classified into three categories for financial reporting purposes:
Operating activities
Investing activities
Financing activities
Define business activities and what are the typical activities that fall into this category?
These are related to the day‐to‐day business activities of a company. Typical activities that fall in this category are:
- Sales of goods and services to customers.
- Costs associated with the provision of goods and services.
- Income tax expenses.
- Investments in working capital to support the firm’s ordinary business.
Define investing activities and what are the typical activities that fall into this category?
These are related to the acquisition and disposal of long‐term assets. Examples of transactions that fall in this category include:
- Acquisition or disposal of fixed assets like property, plant, and equipment (PP&E).
- Purchase or sale of other corporations’ equity and debt securities.
Define financing activities and what are the typical activities that fall into this category?
These are related to raising and repaying capital. Examples of financing activities include:
- Issuance or repurchase of common or preferred stock.
- Issuance or redemption of debt.
- Dividend payments on common and preferred stock.
The nature of a firm’s operations dictates where certain transactions fall within business activity classifications. Explain.
For example, interest received on an investment in a debt instrument by a music store is classified as an investing activity, but interest received by a bank is classified as an operating activity. The sale of an oven by an oven manufacturer is an operating activity, while the sale of an oven by a restaurant is an investing activity.
For Typical Business Activities and Financial Statement Elements Affected, based on the following OPERATING activities, which element is affected?
- Sale of goods and services to customers
- Cost of providing the goods and services
- Income tax expense
- Holding short‐term assets or incurring short‐term liabilities directly related to operating activities
- Sale of goods and services to customers : Revenue
- Cost of providing the goods and services : Expenses
- Income tax expense : Expenses
- Holding short‐term assets or incurring short‐term liabilities directly related to operating activities: Assets, liabilities
For Typical Business Activities and Financial Statement Elements Affected, based on the following INVESTING activities, which element is affected?
- Purchase or sale of assets such as property, plant, and equipment
- Purchase or sale of other entities’ equity and debt securities
- Purchase or sale of assets such as property, plant, and equipment: Assets
- Purchase or sale of other entities’ equity and debt securities: Assets
For Typical Business Activities and Financial Statement Elements Affected, based on the following FINANCING activities, which element is affected?
- Issuance or repurchase of the company’s own preferred or common stock
- Issuance or repayment of debt
- Payment of distributions (i.e., dividends to preferred or common stock holders)
- Issuance or repurchase of the company’s own preferred or common stock: Owner’s equity
- Issuance or repayment of debt: Liabilities
- Payment of distributions (i.e., dividends to preferred or common stock holders): Owner’s equity
What are the five financial statement elements?
Assets
Liabilities
Owners’ equity or shareholders’ equity
Revenues
Expenses
How are the increases or decreases in any of the five financial statement elements recorded?
An increase or a decrease in any of these elements is recorded in a specific account. For example, accounts receivable is an account that falls under the financial element of assets.
How do financial statements and actual accounts compare?
Financial statements present condensed information regarding financial statement elements and accounts. The actual accounts used in a company’s accounting system are listed in a chart of accounts.
Define assets and what they include.
Assets are a company’s economic resources.
They include:
Current assets
Noncurrent assets
What are included in current assets?
- Cash and cash equivalents.
- Accounts receivable, trade receivables.
- Prepaid expenses.
- Inventory.
What are included in noncurrent assets?
- Property, plant, and equipment.
- Investment property.
- Intangible assets (patents, trademarks, licenses, copyrights, and goodwill).
- Financial assets, trading securities, and investment securities.
- Investments accounted for by the equity method.
Why are contra accounts used and what are some contra asset accounts?
Sometimes contra accounts are used to reduce the balance of certain assets. Common contra asset accounts include allowance for bad debts (offset against accounts receivable) and accumulated depreciation (offset against PP&E).
Define liabilities and what they include.
Liabilities are creditors’ claims on a company’s economic resources. They include:
- Accounts payable and trade payables.
- Financial liabilities such as notes payable.
- Deferred tax liabilities.
- Long‐term debt.
- Unearned revenue.
Define owners’ equity and what they include.
Owners’ equity represents owners’ residual claim on a company’s resources. It includes:
- Capital in the form of common and preferred stock.
- Additional paid‐in capital.
- Retained earnings.
- Other comprehensive income.
- Minority interest
Define revenues and what they include.
Revenues represent the flow of economic resources into the company and include:
- Sales.
- Gains.
- Investment income.
Define expenses and what they include.
Expenses represent the flow of economic resources out of the company, and include:
- Cost of goods sold.
- Selling, general, and administrative expenses.
- Depreciation and amortization expenses.
- Interest expense.
- Tax expense.
- Losses.
Define noncurrent assets.
Noncurrent assets are expected to benefit the company over an extended period of time (usually over one year).
Define current assets
Current assets are expected to be used by the company or converted into cash in the short term (less than one year). Current assets include:
- Inventories: Unsold products on hand (also called inventory stock).
- Trade receivables: Amounts customers owe the company for products that have been sold.
- Cash on hand and at the bank.
The basic accounting equation is:
Assets = Liabilities + Owners’ equity
The owners’ equity definition and equation is:
Owners’ equity is the residual claim of the owners on a company’s assets after all liabilities have been paid off.
Owners’ equity = Assets − Liabilities
Owners’ equity can be further divided into its two components:
Owners’ equity = Contributed capital + Ending retained earnings
Ending retained earnings are calculated as:
Ending retained earnings = Beginning retained earnings + Net income – Dividends declared
The equation for ending retained earnings can also be stated as:
Ending retained earnings = Beginning retained earnings + Revenue − Expenses − Dividends declared
The basic accounting equation can be expanded into the following forms: (Long equation)
Assets = Liabilities + Contributed capital + Ending retained earnings
and:
Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue − Expenses − Dividends declared
Define double-entry accounting
The process of recording business transactions is based on double‐entry accounting (i.e., every transaction affects at least two accounts). If an asset account increases, either a liability or an equity/capital account will also increase, or another asset account will decrease to keep the accounting equation in balance.
Remembering the basic accounting equation and understanding which direction the financial elements will move given a certain transaction is EXTREMELY important to do well on the exam.
How are financial statements prepared?
Financial statements are prepared from the data provided by the accounting system.
Accounts that fall under revenues and expenses become a part of what?
The income statement
Accounts that fall under assets, liabilities, and owners’ equity are used to do what?
Construct the balance sheet.
Define accrual entries
Accrual accounting is based on the principle that revenues should be recognized when earned and expenses should be recognized when incurred, irrespective of when the actual exchange of cash occurs. The timing difference between cash movements and recognition of revenues or expenses explains the need for accrual entries. When cash is transferred in the period that the related revenue/expense is recognized, there is no need for accrual entries.
What are the four types of accrual entries:
Unearned (or deferred) revenue
Unbilled or accrued revenue
Prepaid expenses
Accrued expenses
In accrual entries, define unearned (or deferred) revenue.
Unearned (or deferred) revenue arises when a company receives a cash payment before it provides a good or a service to the customer. Because the company still has to provide the good/service, unearned revenue is recognized as a liability. Unearned revenue is subsequently earned once the good is sold or the service is provided.
In accrual entries, unbilled or accrued revenue
Unbilled or accrued revenue arises when a company provides a good or service before receiving the cash payment. Because the company is owed money, accrued revenue is recognized as an asset.
In accrual entries, prepaid expenses
Prepaid expenses arise when a company makes a cash payment before recognizing the expense. Expenses that have been paid in advance are an asset of the company.
In accrual entries, accrued expenses
Accrued expenses arise when a company recognizes an expense in its books before actually making a payment for it. Because the company owes a payment, the accrued expense is treated as a liability.
For cash movement PRIOR to accounting recognition, what is the originating entry and adjusted entry for unearned (deferred) revenue?
Unearned (deferred) Revenue
Originating Entry
Record cash receipt and establish a liability
Adjusted Entry
Reduce the liability and recognize revenue
For cash movement PRIOR to accounting recognition, what is the originating entry and adjusted entry for prepaid expense?
Prepaid Expense
Originating Entry
Record cash payment and establish an asset
Adjusting Entry
Reduce the asset and recognize the expense
For cash movement AFTER accounting recognition, what is the originating entry and adjusted entry for unbilled (accrued) revenue?
Unbilled (accrued) Revenue
Originating Entry
Record revenue and establish an asset
Adjusted Entry
When billing occurs, reduce unbilled revenue and increase accounts receivable. When cash is collected, eliminate the receivable.
For cash movement AFTER accounting recognition, what is the originating entry and adjusted entry for accrued expenses?
Accrued Expenses
Originating Entry
Establish a liability and record an expense
Adjusted Entry
Reduce the liability as cash is paid
Define valuation adjustments
Most assets and liabilities are recorded on the balance sheet at their historical cost. However, accounting standards require certain items to be shown on the balance sheet at their current market values. The upward or downward adjustments to the values of these assets and liabilities are known as valuation adjustments. For example, if there is a decline in the value of an asset, the new decreased value is recorded on the balance sheet and the amount of the decrease in value is recognized as a loss either on the income statement or in other comprehensive income.
In an accounting system, information flows through four stages:
Journal entries
General ledger
Trial balance
Financial statements
In an accounting system, information flows through four stages, define journal entries.
Journal entries: The amount and relevant accounts affected by transactions are chronologically recorded in journals. At the end of the accounting period, adjusting entries are made to journal entries to account for accruals that had not been recorded earlier.
In an accounting system, information flows through four stages, define general ledger.
General ledger: The general ledger sorts all the entries posted in journals into accounts. For example, the general ledger contains an inventory account where all inventory-related journal entries are listed.
In an accounting system, information flows through four stages, define trial balance.
Trial balance: An initial trial balance lists all the ending balances of general ledger accounts. Adjustments to record accruals and prepayments that had not been considered in constructing the initial trial balance are made in the adjusted trail balance.
In an accounting system, information flows through four stages, define financial statements.
Financial statements: The account balances in the adjusted trial balance are used to construct financial statements.
Describe the use of the results of the accounting process in security analysis.
Financial statements provide the basis for equity and credit analysis. However, analysts must make adjustments to reflect the effects of items not reported in the statements. Analysts must also evaluate management’s assumptions regarding accruals and valuations. Information related to most of these assumptions can be found in the significant accounting policies footnote and in the management discussion and analysis (MD&A) section of the annual report.
Since assumptions within the accounting process are, to an extent, in the hands of management, financial statements can be manipulated to misrepresent a company’s true financial performance. Companies can recognize fictitious assets and liabilities on the financial statements in an attempt to cover aggressive accounting practices or even fraud. For example, if management wanted to inflate reported revenue, it would also recognize a fictitious asset (a receivable) to balance the accounting equation. On the other hand, if the company has received cash but management does not want to recognize the related revenue, it could create a fictitious liability to keep the accounting equation in balance. We will study incentives for accounting manipulation and keys to detecting such fraudulent practices in later readings.
Operating activities
Operating activities are those activities that are part of the day-to-day business functioning of an entity. Examples include the sale of meals by a restaurant, the sale of services by a consulting firm, the manufacture and sale of ovens by an oven-manufacturing company, and taking deposits and making loans by a bank.
Investing activities
Investing activities are those activities associated with acquisition and disposal of long-term assets. Examples include the purchase of equipment or sale of surplus equipment (such as an oven) by a restaurant (contrast this to the sale of an oven by an oven manufacturer, which would be an operating activity), and the purchase or sale of an office building, a retail store, or a factory.
Financing activities
Financing activities are those activities related to obtaining or repaying capital. The two primary sources for such funds are owners (shareholders) or creditors. Examples include issuing common shares, taking out a bank loan, and issuing bonds.
Assets
assets are the economic resources of a company;
Liabilities
liabilities are the creditors’ claims on the resources of a company;
Owners Equity
owners’ equity is the residual claim on those resources;
Revenues & Expenses
revenues are inflows of economic resources to the company; and
expenses are outflows of economic resources or increases in liabilities.
Accounts
With the accounting systems, a formal record of increases and decreases in a specific asset, liability, component of owners’ equity, revenue, or expense.
Chart of accounts
A list of accounts used in an entity’s accounting system.
Allowance for bad debts
An offset to accounts receivable for the amount of accounts receivable that are estimated to be uncollectible.
Accumulated depreciation
An offset to property, plant, and equipment (PPE) reflecting the amount of the cost of PPE that has been allocated to current and previous accounting periods.
Contra account
An account that offsets another account.
Sales returns and allowances
An offset to revenue reflecting any cash refunds, credits on account, and discounts from sales prices given to customers who purchased defective or unsatisfactory items.
Non-current assets
Assets that are expected to benefit the company over an extended period of time (usually more than one year).
Current assets
Assets that are expected to be consumed or converted into cash in the near future, typically one year or less. Also called liquid assets.
Inventory
The unsold units of product on hand.
Trade receivables
Amounts customers owe the company for products that have been sold as well as amounts that may be due from suppliers (such as for returns of merchandise) Also called commercial receivables or accounts receivable.
Commercial receivables
Amounts customers owe the company for products that have been sold as well as amounts that may be due from suppliers (such as for returns of merchandise). Also called trade receivables or accounts receivable.
Accounts receivable
Amounts customers owe the company for products that have been sold as well as amounts that may be due from suppliers (such as for returns of merchandise). Also called commercial receivables or trade receivables.
Other receivables
Amounts owed to the company from parties other than customers.
Cash
In accounting contexts, cash on hand (e.g., petty cash and cash not yet deposited to the bank) and demand deposits held in banks and similar accounts that can be used in payment of obligations.
Cash equivalents
Very liquid short-term investments, usually maturing in 90 days or less.
Balance sheet
The financial statement that presents an entity’s current financial position by disclosing resources the entity controls (its assets) and the claims on those resources (its liabilities and equity claims), as of a particular point in time (the date of the balance sheet). Also called statement of financial position or statement of financial condition.
Residual claim
The owners’ remaining claim on the company’s assets after the liabilities are deducted.
Comprehensive income
The change in equity of a business enterprise during a period from nonowner sources; includes all changes in equity during a period except those resulting from investments by owners and distributions to owners; comprehensive income equals net income plus other comprehensive income.
Other comprehensive income
Items of comprehensive income that are not reported on the income statement; comprehensive income minus net income.
Income statement
A financial statement that provides information about a company’s profitability over a stated period of time. Also called statement of operations or profit and loss statement.
Net income (loss)
The difference between revenue and expenses; what remains after subtracting all expenses (including depreciation, interest, and taxes) from revenue.
Note that net income (loss) is the difference between two of the elements: revenue and expenses. When a company’s revenue exceeds its expenses, it reports net income; when a company’s revenues are less than its expenses, it reports a net loss. Other terms are used synonymously with revenue, including sales and turnover (in the United Kingdom). Other terms used synonymously with net income include net profit and net earnings.
Statement of retained earnings
A financial statement that reconciles beginning-of-period and end-of-period balance sheet values of retained income; shows the linkage between the balance sheet and income statement.
Double-entry accounting
The accounting system of recording transactions in which every recorded transaction affects at least two accounts so as to keep the basic accounting equation (assets = liabilities + owners’ equity) in balance.
Salvage value
The amount the company estimates that it can sell the asset for at the end of its useful life. Also called residual value.
Unclassified balance sheet
A balance sheet that does not show subtotals for current assets and current liabilities.
Depreciation
The process of systematically allocating the cost of long-lived (tangible) assets to the periods during which the assets are expected to provide economic benefits.
Unearned fees/Unearned revenue
Unearned fees are recognized when a company receives cash payment for fees prior to earning them.
Costs of goods sold
For a given period, equal to beginning inventory minus ending inventory plus the cost of goods acquired or produced during the period.
Direct format/direct method
With reference to the cash flow statement, a format for the presentation of the statement in which cash flow from operating activities is shown as operating cash receipts less operating cash disbursements. Also called direct method.
Indirect format/indirect method
With reference to cash flow statements, a format for the presentation of the statement which, in the operating cash flow section, begins with net income then shows additions and subtractions to arrive at operating cash flow. Also called indirect method.
Statement of cash flows
A financial statement that reconciles beginning-of-period and end-of-period balance sheet values of cash; provides information about an entity’s cash inflows and cash outflows as they pertain to operating, investing, and financing activities. Also called cash flow statement.
Statement of owners’ equity
A financial statement that reconciles the beginning of-period and end-of-period balance sheet values of shareholders’ equity; provides information about all factors affecting shareholders’ equity. Also called statement of changes in shareholders’ equity.
Statement of retained earnings
A financial statement that reconciles beginning-of-period and end-of-period balance sheet values of retained income; shows the linkage between the balance sheet and income statement.
Unearned revenue/deferred revenue
A liability account for money that has been collected for goods or services that have not yet been delivered; payment received in advance of providing a good or service. Also called deferred revenue or deferred income.
Unbilled revenue/accrued revenue
Revenue that has been earned but not yet billed to customers as of the end of an accounting period. Also called accrued revenue.
Prepaid expense
A normal operating expense that has been paid in advance of when it is due.
Accrued expenses
Liabilities related to expenses that have been incurred but not yet paid as of the end of an accounting period—an example of an accrued expense is rent that has been incurred but not yet paid, resulting in a liability “rent payable.” Also called accrued liabilities.
Debit
With respect to double-entry accounting, a debit records increases of asset and expense accounts or decreases in liability and owners’ equity accounts.
In accounting, debits record increases of asset and expense accounts or decreases in liability and owners’ equity accounts. Credits record increases in liability, owners’ equity, and revenue accounts or decreases in asset accounts.
Credit
With respect to double-entry accounting, a credit records increases in liability, owners’ equity, and revenue accounts or decreases in asset accounts; with respect to borrowing, the willingness and ability of the borrower to make promised payments on the borrowing.
In accounting, debits record increases of asset and expense accounts or decreases in liability and owners’ equity accounts. Credits record increases in liability, owners’ equity, and revenue accounts or decreases in asset accounts.
The Three groups of business activities are?
Business activities can be classified into three groups: operating activities, investing activities, and financing activities.
Companies classify transactions into common accounts that are components of the five financial statement elements:
Companies classify transactions into common accounts that are components of the five financial statement elements: assets, liabilities, equity, revenue, and expense.
The core of the accounting process is the basic accounting equation:
Assets = Liabilities + Owners’ equity.
The expanded accounting equation is:
Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends.
Where are business transactions recorded? What are they based on?
Business transactions are recorded in an accounting system that is based on the basic and expanded accounting equations.
The accounting system tracks and summarizes data used to create the following financial statements?
The accounting system tracks and summarizes data used to create financial statements: the balance sheet, income statement, statement of cash flows, and statement of owners’ equity. The statement of retained earnings is a component of the statement of owners’ equity.
What is the purpose of accruals?
Accruals are a necessary part of the accounting process and are designed to allocate activity to the proper period for financial reporting purposes.
What are the results of the accounting process?
The results of the accounting process are financial reports that are used by managers, investors, creditors, analysts, and others in making business decisions.
Why does an analyst use financial statements?
An analyst uses the financial statements to make judgments on the financial health of a company.
How can analysts fight misrepresentations?
Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.
