CHAPTER 2 FINANCIAL REPORTING MECHANICS. BUSINESS ACTIVITIES AND FINANCIAL STATEMENT ELEMENTS...

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


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.


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


LIABILITY ACCOUNTS

• Accounts payable, trade payables

• Debt payable

• Bonds (payable)


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


EQUITY ACCOUNTS

• Capital (such as common stock)

• Additional paid-in capital

• Retained earnings

• Accumulated other comprehensive income


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


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


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


Beginning Retained Earnings + REV - Expenses - Dividends

+


BASIC AND EXPANDED ACCOUNTING EQUATION: RETAINED EARNINGS






Net Income - Dividends


Beginning Retained Earnings + REV - Expenses - Dividends

+


BASIC AND EXPANDED ACCOUNTING EQUATION: NET INCOME






Net Income – Dividends


Beginning Retained Earnings + Revenue –Expenses – Dividends

+

+

+


BASIC AND EXPANDED ACCOUNTING EQUATION






Net Income – Dividends


Beginning Retained Earnings + Revenue –Expenses – Dividends

+

+

+


EXAMPLE: ABC COMPANY FINANCIAL STATEMENT LINKS


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.


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


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


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.


EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM


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







Received cash for services 250 250 Revenue


Subtotal 2,200 500 1,250 450







Received cash for services 250 250Revenue


Subtotal 2,200 500 1,250 450







Received cash for services 250 250RevenuePaid cash for expenses –50 –50ExpenseSubtotal 2,200 500 1,250 450

Total = $2,200


EXAMPLE: ABC COMPANY. TABULAR ACCOUNTING SYSTEM

WITH CLOSING ENTRY


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


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.


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.


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


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


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.



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



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.


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.

CHAPTER 2 FINANCIAL REPORTING MECHANICS. BUSINESS ACTIVITIES AND FINANCIAL STATEMENT ELEMENTS...

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