Ifsa Chapter2

CHAPTER 2
FINANCIAL REPORTING MECHANICS
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
15: financial statement elements
Copyright 2013 CFA Institute
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
Asset:
Loan Receivable
Liability:
Loan Payable
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).
EQUITY ACCOUNTS
Capital (such as common stock)
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income
REVENUE AND EXPENSE ACCOUNTS

REVENUE
Revenue, sales
EXPENSE
Cost of goods sold
Gains
Selling, general, and

administrative expenses
(SG&A; e.g., rent, utilities,
salaries, advertising)
Depreciation and
amortization
Interest expense
Investment income
(e.g., interest and
dividends)
Tax expense
Losses
BASIC ACCOUNTING EQUATION

ASSETS = LIABILITIES + OWNERS EQUITY
This is the equation that underlies the balance sheet.
This equation reflects a companys 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

Ending
Contributed
Retained
+ Earnings
Assets = Liabilities + Capital
Contributed
Assets = Liabilities + Capital +
Beginning
Retained
Earnings +
Net
Income - Dividends
Contributed
Beginning
Retained
Earnings +
REV -
Expenses - Dividends
10
BASIC AND EXPANDED ACCOUNTING

EQUATION: RETAINED EARNINGS

Contributed
Ending
Retained
Earnings
Contributed
Beginning
Retained
Earnings +
Net
Income - Dividends
Contributed
Beginning
Retained
Earnings +
REV -
Expenses - Dividends
11
BASIC AND EXPANDED ACCOUNTING

EQUATION: NET INCOME
Ending
Contributed
Retained
+ Earnings
Beginning
Contributed
Retained
Net
+ Earnings + Income Dividends
Beginning
Contributed
Retained
+ Earnings + Revenue Expenses Dividends
12
BASIC AND EXPANDED

ACCOUNTING EQUATION

Ending
Contributed
Retained
+ Earnings
Beginning
Contributed
Retained
Net
+ Earnings + Income Dividends
Beginning
Contributed
Retained
+ Earnings + Revenue Expenses Dividends
13
EXAMPLE: ABC COMPANY

FINANCIAL STATEMENT LINKS
14
EXAMPLE
ABC COMPANY
ABC Company, Inc.
(Beginning) Balance Sheet
As of 31 December 20X0
Assets
2,000
Liabilities
Contributed equity
Retained earnings
Owners equity
500
1,250
250
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.
15

INCOME STATEMENT AND RETAINED EARNINGS
ABC Company, Inc.
Income Statement
For the Year Ended 31 December 20X1
Revenue
250
Expense
Net income
50
200
ABC Company, Inc.

Statement of Retained Earnings
Year Ended 31 December 20X1
Beginning retained earnings
Plus net income
Minus dividends
Ending retained earnings
250
200
0
450
16

ENDING BALANCE SHEET
ABC Company, Inc.
(Ending) Balance Sheet
As of 31 December 20X1
Assets
2,200
Liabilities
Contributed equity
Retained earnings
Owners equity
Total liabilities and equity
500
1,250
450
1,700
2,200
17
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.
18

TABULAR ACCOUNTING SYSTEM

Cash
Payable
2,000
Received cash for

services
250
250Revenue
Paid cash for

expenses
50
50Expense
2,200
500
1,250
Retained
Earnings
Beginning balance
Subtotal
500
Contributed
Capital
1,250
250
450
19


Cash
Payable
2,000
Received cash for

services
250
250 Revenue
Paid cash for

expenses
50
50Expense
2,200
500
1,250
Retained
Earnings
Beginning balance
Subtotal
500
Contributed
Capital
1,250
250
450
20


Cash
Payable
2,000
Received cash for

services
250
250Revenue
Paid cash for

expenses
50
50Expense
2,200
500
1,250
Retained
Earnings
Beginning balance
Subtotal
500
Contributed
Capital
1,250
250
450
21


Contributed
Retained
Cash
Payable
Capital
Earnings
Beginning balance
Received cash for
services
Paid cash for
expenses
2,000
Subtotal
2,200
500
1,250
250
250
250Revenue
50
50Expense
500
1,250
450
Total = $2,200
22
EXAMPLE: ABC COMPANY.

WITH CLOSING ENTRY
Contributed Retained
Cash
Payable Capital
Earnings Revenue Expenses
Beginning
balance
Received cash
for services
Paid cash for
expenses
Subtotal
(pre-closing)
Closing
Post closing
2,000
500
1,250
250
250
250
50
2,200
2,200
50
500
500
1,250
250
250
-50
1,250
200
450
250
0
50
0
23
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.
24
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.
25
ACCRUALS: EXPENSE
Cash Movement
prior to Accounting
Recognition
Cash Movement
in the Same Period as
Accounting Recognition
Cash Movement
after Accounting
Recognition
PREPAID EXPENSE
Settled transaction no
accrual entry needed
ACCRUED 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
26
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
27
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 managements
commentary (also referred to as managements discussion and analysis, or
MD&A) and the significant accounting policies footnote, both found in the
annual report.
28

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 measurement
Note 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
Discontinued operations and assets held for sale and liabilities directly associated with
Note 26 assets held for sale Valuation of assets
29

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 ReceivableTrade
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.
30
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.
31

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CHAPTER 2

FINANCIAL REPORTING MECHANICS

BUSINESS ACTIVITIES AND FINANCIAL

Copyright 2013 CFA Institute

FINANCIAL STATEMENT ELEMENTS

Copyright 2013 CFA Institute

Cash and cash equivalents

Copyright 2013 CFA Institute

Accounts payable, trade

Copyright 2013 CFA Institute

ASSETS AND LIABILITIES

When a bank lends money to a borrower, it creates

Copyright 2013 CFA Institute

REVENUE AND EXPENSE ACCOUNTS

Selling, general, and

BASIC ACCOUNTING EQUATION

ASSETS LIABILITIES = OWNERS EQUITY

Copyright 2013 CFA Institute

BASIC AND EXPANDED ACCOUNTING EQUATION:

Assets = Liabilities + Owners Equity

Copyright 2013 CFA Institute

BASIC AND EXPANDED ACCOUNTING

Assets = Liabilities + Owners Equity

Copyright 2013 CFA Institute

BASIC AND EXPANDED ACCOUNTING

Copyright 2013 CFA Institute

BASIC AND EXPANDED

Assets = Liabilities + Owners Equity

Copyright 2013 CFA Institute

EXAMPLE: ABC COMPANY

Copyright 2013 CFA Institute

Total liabilities and equity

During the year 20X1:

Copyright 2013 CFA Institute

EXAMPLE: ABC COMPANY

ABC Company, Inc.

EXAMPLE: ABC COMPANY

Copyright 2013 CFA Institute

ACCOUNTING SYSTEM BASED ON THE

Copyright 2013 CFA Institute

EXAMPLE: ABC COMPANY

Assets = Liabilities + Owners Equity

Received cash for

Paid cash for

Copyright 2013 CFA Institute

EXAMPLE: ABC COMPANY

Assets = Liabilities + Owners Equity

Received cash for

Paid cash for

Copyright 2013 CFA Institute

EXAMPLE: ABC COMPANY

Assets = Liabilities + Owners Equity

Received cash for

Paid cash for

Copyright 2013 CFA Institute

EXAMPLE: ABC COMPANY

Assets = Liabilities + Owners Equity

Copyright 2013 CFA Institute