FINANCIAL REPORTING

MECHANICS

Exam Focus
FSA requires an understanding of how a
company's transactions are recorded in the
various accounts.
Candidates should focus on the FS elements
(assets, liabilities, equity, revenues, and
expenses) and be able to classify any account
into its appropriate element.
Candidates should also learn the basic and expanded
accounting equations and why every transaction must
be recorded in at least two accounts.
The types of accruals, when each of them is used, how
changes in accounts affect the financial statements, and
The relationships among the financial statements

a. Explain the relationship of FS elements

and accounts, and classify accounts into
the FS elements.
Financial statement elements
are the major classifications of assets, liabilities,
owners equity, revenues, and expenses.

Accounts are the specific records within

each element
chart of accounts is a detailed list of the
accounts
Contra accounts are used for entries that
offset some part of the value of another
account.
accumulated depreciation

Assets are the firm's economic

resources
Cash and cash equivalents. Liquid securities with maturities of
90 days or less
Accounts receivable "allowance for bad debt expense" or
"allowance for doubtful accounts
Inventory
Financial assets such as marketable securities.
Prepaid expenses. Items that will be expenses on future
income statements.
PPE includes a contra-asset account for acc depreciation.
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."

Liabilities are creditor claims on

the company's resources
Accounts payable and trade
payables
Financial liabilities
Unearned revenue
Income taxes payable
Long-term debt
Deferred tax liabilities

Owners' equity is the owners'

residual claim on a firm's
resources
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.

b. explain the accounting equation in

its basic and expanded forms;
assets = liabilities + owners' equity
assets = liabilities + contributed capital
+ ending retained earnings
assets = liabilities
+ contributed capital
+ beginning retained earnings
+ revenue
- expenses
- dividends

c. Process of recording business transactions

using an a/c system based on the a/c equation
Keeping the accounting equation in
balance requires double-entry
accounting, in which
a transaction has to be recorded in at least
two accounts.
An increase in an asset account must be
balanced by
a decrease in another asset account or
an increase in a liability or owners' equity
account.

Examples

Purchase equipment for $10,000 cash.

Borrow $10, 000 to purchase equipment
Buy office supplies for $100 cash.
Buy inventory for $8,000 cash and sell it for
$10, 000 cash.

d. Explain the need for accruals and other

adjustments in preparing financial statements
Revenues and expenses are not always recorded
at the same time that cash receipts and
payments are made.
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.

Accruals fall into four categories

Unearned revenue
Accrued revenue
Prepaid expenses
Accrued expenses.

Observations
Accruals require an accounting entry when the
earliest event occurs (paying or receiving cash,
providing a good or service, or incurring an
expense) and require one or more offsetting
entries as the exchange is completed.
With unearned revenue and prepaid expenses, cash
changes hands first and the revenue or expense is
recorded later.
With accrued revenue and accrued expenses, the
revenue or expense is recorded first and cash is
exchanged later.

In all these cases, the effect of accrual accounting

is to recognize revenues or expenses in the
appropriate period.

Other Adjustments
Most assets are recorded on the FS at their
historical costs.
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 IS or
in "other comprehensive income ."

e. describe the relationships among the IS,

BS, CFS, and statement of owners equity

f. describe the flow of information in an

accounting system;
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.
The general ledger sorts the entries in the general
journal by account.
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.
The account balances from the adjusted trial balance
are presented in the financial statements.

g. describe the use of the results of the

accounting process in security analysis.
An analyst does not have access to the detailed
information that flows through a/c system but sees only
the end product (the FS).
An analyst needs to understand the various accruals,
adjustments, and management assumptions that go into
the FS.
Much of this detail is contained in the footnotes to the
statements and Management's Discussion and Analysis,
so it is crucial for an analyst to review these parts of the FS.

With this information from footnotes and MD&A,

the analyst can better judge how well the financial
statements reflect the company's true performance and
what adjustments to the data are necessary for
appropriate analysis.