Reading 23 Financial Reporting Mechanics

 

  1. The relationship of financial statement elements & accounts and classify accounts into the financial statement elements

 

  • Financial statement elements are the major classifications: assets, liabilities, owner’s equity, revenue & expenses.
  • Contra accounts are used for entries that offset some part of the value of another account.
  1. Explain the accounting equation in its basic and expanded forms

Basis accounting equation: Assets = Liabilities + owner’s equity

Expand accounting equation:

Assets = Liabilities + Contributed capital + Ending retained earnings

Or:  Assets = Liabilities + Contributed capital + Beginning retained earnings + revenue – expenses – dividend

 

  • Keep the accounting equation in balance requires double-entry accounting, in which a transaction has to be recorded in at least two accounts.
  1. The need for accruals and other adjustments in preparing financial statements

Revenue & expense are not recorded simultaneously. The principle of accrual accounting requires that revenue is recorded when the firm earns it and expenses are recorded as the firm incurs them, regardless of whether cash has actually been paid.

Cash movement prior to accounting recognition        Cash movement after accounting recognition
Revenue Unearned revenue (Deferred)

Received cash before provide goods

Originating(O) entry: record cash receipt & establish a liability

Adjusting(A) entry: reduce liability while recording revenue

Example: newspaper subscription

Unbilled (accrued) revenue

Provided goods before receive cash payment.

O entry: record revenue establish on asset

A entry: when billing occurs, reduce unbilled revenue & increase account receivable. When cash collected,  eliminate the receivable.

Expenses Prepaid expense

Pay cash ahead of time for an anticipated expense.

O entry: record cash payment and establish an asset

A entry: reduce the asset while recording expense

Example: rents space

Accrued expenses

Owe cash for expenses that has occurred.

O entry: establish a liability & record an expense

A entry: reduce the liability as cash is payed

  • Other adjustments: Some assets have variable value, not confirming with accounting standard (as securities on maturity) ⇒ valuation adjustment ⇒ recorded in income statement or in “other comprehensive income”.
  1. The flow of information in an accounting system (4 steps)
  • Journal entries: record every transaction change & amount. A listing of their date ⇒ general journal.
  • The general ledger: sorts general journal ⇒ account.
  • At the end of the accounting  period, initial trial balance ⇒ show balance in each statement. If any adjusting entries are needed, they will be recorded & reflected in an adjusted trial balance.
  • The account balances from the adjusted trial balance ⇒ Financial statement.
  1. The use of the results of the accounting process in security analysis

Since financial reporting requires choices of method, judgment and estimates, an analyst must understand the accounting process used to produce the financial statements in order to understand the business and the results for the period.

Analyst should be alert to the use of accruals, changes in valuations and other notable changes that may indicate management judgment is incorrect or worse that the financial statement have been deliberately manipulated.