Chapter 30 - Financial Reporting Mechanics

Chapter 30 – Financial Reporting Mechanics

Classification of business activities

· Operating activities – They are part of the day-to-day business functioning of an entity. Ex – Accepting deposits by banks.

· Investing activities – They are associated with acquisition and disposal of long term assets. Ex – Purchase / Sale of an office building, Sale of store (Sale of property is not business of the company)

· Financing activities – They are related to obtaining or repaying capital. 2 important sources of funds are owners and creditors. Ex – Issue of bonds, common shares.

Preference is given when company’s profits come from its operating activities.

Elements of Financial Statement

· Assets –

Ø Economic resources of company / Resources controlled by the company

Ø Future economic benefits are expected to flow in

· Liabilities –

Ø Creditor’s claim on the resources of a company

Ø Obligation of a company from past events

Ø Settlement of obligation will result in outflow of economic benefit

· Equity –

Ø Owner’s Equity

Ø Residual claim on the above resources

Ø A-L = E

· Revenues – Inflow of economic resources to the company

· Expenses – Outflow of economic resources to the company

Income (Bottom Line) –

· Revenue (Top line) - From main business

· Gain (Top Line) – From secondary / peripheral resource (Increase / Decrease in resources)

Expense –

· Expense (Top Line) – From main business

· Loss – From secondary business

Accounts –

· They are individual records.

· They show increase / decrease in specific element of FS (like Assets, Liabilities ….)

Contra account – It is an account which is offset or deducted from another account. Example – Allowance for bad debts offsets uncollectable amount of a/c receivable. Sales returns and allowances offset reduction in revenue due to cash refund, discounts due to product deficiency.

Asset Classification

· Current Asset (=<1 Year)

o Expected to be consumed / converted to cash within 1 year.

o Example –

§ Cash and cash equivalent – Cash is cash in hand (not deposited in bank); Cash equivalent are liquid short term investments maturing in 90 days or less

§ Inventory (Stock) – Unsold units of product on hand

§ Accounts receivable (Trade Receivable / Commercial Receivable) – Sales made on credit.

· Non Current Asset (>1 Year)

o Expected to benefit company over extended time, which is more than 1 year.

o Example –

§ PPE (Property, plant and equipment) – Land, Building

§ Intangible Assets – Goodwill (Price paid to actually purchase the asset – Value of Net asset acquired)

§ Other Property held for investment

§ Investment in securities of other companies

Accounting Equations & Statements

Statement of Retained Earnings (Reserves and Surplus) –

· Component of statement of Stockholder’s equity

· Shows changes in owner’s equity due to changes –

ü In Retained earnings

ü From Share issuance / repurchase

· Shows linkage between BS and IS. Profit / Income not distributed goes to Retained Earnings in BS.

Balance Sheet (Statement of Financial Position)–

ü Represents a company’s financial position at a particular point in time

ü It lists company’s assets (Uses of Funds) and claims on those assets (Liability and Equity - Source of Funds)

ü Basic Accounting Equation - Owner’s Equity = Assets – Liabilities

ü 2 years BS are usually presented for easy comparison

ü Unclassified BS -

o Does not show subtotal of CA and CL

o Assets are listed in order of liquidity (Most liquid first which is Cash)

o Liabilities are listed in order in which they are to be paid off

ü Equity (Net Worth)

· It is RESIDUAL claim – Claim met after the liabilities are paid.

· Owner’s Equity / Shareholder’s Equity / Stock-holder’s equity / Equity / Net Assets / Net Worth / Net book Value / Partner’s Capital

· Owner’s Equity = Contributed Capital + Retained Earnings

· Treasury Stock – It arises when company repurchases and holds its own stock. Stock repurchased is not destroyed, but kept as treasury stock, which can be re-issued in future.

· Other Comprehensive Income – Not reported on IS. Changes in value of assets or liabilities not reflecting on IS. Ex – Foreign Currency translation adjustment.

ü Capital

· Contributed Capital / Common Shares / Common Stock / Member’s Capital / Partner’s Capital

Income Statement (P&L)

· Also called Statement of Operations / Profit and Loss Account Statement

· Revenue – Expense = Net Income (Loss) …….. From Primary Business

Cash Flow Statement

· Shows company’s cash flow over a period of time

· Types – Operating, Investing, Financing

Statement of Owner’s Equity

· Shows composition and changes in owner’s equity during a period of time

· Also called Statement of Retained Earnings

Equation

Ending Retained Earnings = Beginning Retained Earnings (BRE) + Net Income (NI) – Dividends = BRE + Revenue – Expense – Dividends

Now,

Assets = Liability + Equity

Equity = Capital + Retained Earnings (Ending)

Hence,

Assets = Liabilities + Capital + Beginning retained earnings + Revenue – Expense – Dividends

Double-Entry Accounting – Every financial transaction affects at least 2 accounts. Ex – Cash paid to buy plant. Cash reduces and PPE Increases. Only Asset side is affected, but 2 accounts are affected.

Salvage Value / Residual Value – After the end of useful life of an asset, the selling price of that asset.

Unearned fees – (Liability) – Fees not yet earned, but cash received. Example – Advance Rent. Newspaper subscription fees paid in advance.

Capitalized – Recording as an asset

Negative Retained Earnings = Retained Deficit

Advance Rent = Pre-Paid Rent (CFA)

Financial Statement

· Direct Format – It refers to the operating cash section appearing simply as operating cash receipts less operating cash disbursements.

· Indirect Format – Begins with net income, shows adjustments to arrive at operating cash flow.

Accrual and Valuation adjustments

Accrual –

· Recording revenue as and when it occurs, irrespective cash received or not.

· Purpose – Report revenue and expense in the proper accounting period

Each accrual entry has an originating and then adjusting entry

	Originating Entry	Adjusting Entry	Example
Unearned / Deferred Revenue (Company RECEIVES)	- Cash increases - Liability (unearned revenue) increases	- Liability reduces - Revenue increases	Newspaper subscription, received from customer, 1 year in advance (Good liability in BS – ensures future business from customer till liability exists)
Pre-paid Expense (Company PAYS)	- Cash Increases - Asset / Pre-paid expense increases	- Asset reduces - Expense increases	They are assets which will be subsequently expenses. Company pays rent for the entire year in advance.
Cash movement PRIOR TO Accounting Recognition

	Originating Entry	Adjusting Entry	Example
Unbilled (Accrued) Revenue (Company RECEIVES)	- Revenue increases - Asset (unbilled revenue; a/c receivable) increases	- Asset (unbilled revenue; a/c receivable) reduces - Cash increases	Selling goods on credit to customer, customer pays in installment
Accrued Expenses / liability (Company PAYS)	- Expense Increases - Liability increases (Wage Payable)	- Liability (Wage payable) reduces - Cash reduces	Wages recorded for 31st, but paid on 1st of subsequent month (Cash NOT paid, but expense incurred)
Cash movement AFTER Accounting Recognition

Valuation Adjustments

ü Trading securities - Recorded at current market value

ü Investment held till maturity – Recorded at historical cost

ü Other comprehensive income

· Recorded directly in shareholder’s equity, bypassing the IS

· Changes in value of security due to change in market condition

Accounting system flow and related documents

· Journal Entry (JV) – Sorting of all transactions by DATE

· General Ledger (GL) / T-Accounts – Sorting of all transactions by ACCOUNT

· Trial Balance (TB) – Lists account balance at a particular point in time

· TB Vs GL –

ü TB – Gives total / net ending balance for an a/c

ü GL – Gives all entries for an a/c

Debits and Credits

Debit of funds (Money going out of business) –

ü Asset is created (Money going out buys asset)

ü Expense occurs

Credit of funds (Money coming into the business) –

ü Liability / Equity is created

ü Revenue occurs

If a company reported fictitious revenue, it could try to cover up its fraud by creating a fictitious asset