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1 Financial Reporting Mechanics

Chapter 2 (Reading 30)


The mechanics of the accounting process is the
foundation for financial reporting. Understanding those
mechanics enables an analyst to understand the
interrelationships of financial accounts and statements
and, therefore, to better assess a company’s financial
performance.

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
2

1. identify the groups (operating, investing, and financing activities) into


which business activities are categorized for financial reporting
Learning purposes and classify any business activity into the appropriate group.
Outcomes 2. explain the relationship of financial statement elements and accounts,
and classify accounts into the financial statement elements.
3. explain the accounting equation in its basic and expanded forms.
4. explain the process of recording business transactions using an
accounting system based on the accounting equations.
5. explain the need for accruals and other adjustments in preparing
financial statements.
6. prepare financial statements, given account balances or other
elements in the relevant accounting equation, and explain the
relationships among the income statement, balance sheet, statement
of cash flows, and statement of owners’ equity.
7. describe the flow of information in an accounting system.
8. explain the use of the results of the accounting process in security
analysis.

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
identify the groups into which business activities are categorized for financial
reporting purposes and classify any business activity into the appropriate group.
3

Classification  Operating activities are those activities


of Business that are part of the day-to-day business
Activities
functioning of an entity.
 Investing activities are the ones
associated with acquisition and disposal
of long term assets.
 Financing activities are related to
obtaining or repaying capital – equity
and debts.
Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics
Financial Reporting Mechanics
identify the groups into which business activities are categorized for financial
reporting purposes and classify any business activity into the appropriate group.
4

Operating  Sale of goods &services (R)


Activities  Cost of providing the goods & services (X)
 Income tax expense (X)
 Investment in short term assets (A) (L)

Investing  Purchase or sale of plant, property, land, building (A)


Activities  Purchase or sale of equity of another entity – shares (A)
 Purchase or sale of bonds, TFCs, SUKUK – (A)

Financing  Issuance or repurchase of own shares (E)


Activities  Issuance or repayment of debt (L)
 Paying Dividends (E)
Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics
Financial Reporting Mechanics
identify the groups into which business activities are categorized for financial
reporting purposes and classify any business activity into the appropriate group.
5

Operating  Not everything falls in this classification as


Activities neatly as expected., e.g.,
 Interest received by a bank on one of the loans it
has advanced is classified as operating activity.

Investing
 Interest received by a manufacturing concern on a
Activities bond investment is classified as an investing
activity.
 How a transaction is classified depends on the
Financing nature of the firm, rather than the nature of
Activities the transaction.

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the relationship of financial statement elements and accounts, and classify
accounts into the financial statement elements.
6

Financial  Accounts – individual records pertaining


Statements to economic activities.
Elements and
Accounts  Chart of Accounts – a detailed division of
actual accounts used in a company.
 Contra Account – any account that is
offset or deducted from another
account, e.g., bad debt losses from
receivables

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the relationship of financial statement elements and accounts, and classify
accounts into the financial statement elements.
7

 Assets are the firm’s economic resources. Examples of


Financial
assets include:
Statements
Elements and  Cash and cash equivalents. Liquid securities with maturities of
Accounts 90 days or less are considered cash equivalents.
 Accounts receivable. Accounts receivable often have an
“allowance for bad debt expense” or “allowance for doubtful
accounts” as a contra account.
Assets
 Inventory – Raw Material, WIP, Finished Goods
 Financial assets such as marketable securities.
 Prepaid expenses. Items that will be expenses on future income
statements.
 Property, plant, and equipment. Includes a contra-asset
account for accumulated depreciation.
Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics
Financial Reporting Mechanics
explain the relationship of financial statement elements and accounts, and classify
accounts into the financial statement elements.
8

 Investment in affiliates accounted for using the equity method.


Financial
Statements  Deferred tax assets.
Elements and  Intangible assets. Economic resources of the firm that do not
Accounts have a physical form, such as patents, trademarks, licenses, and
goodwill. Except for goodwill, these values may be reduced by
“accumulated amortization.”

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the relationship of financial statement elements and accounts, and classify
accounts into the financial statement elements.
9

 Liabilities are creditor claims on the company’s


Financial
resources. Examples of liabilities include:
Statements
Elements and  Accounts payable and trade payables.
Accounts
 Financial liabilities such as short-term notes payable.
 Unearned revenue. Items that will show up on future income
statements as revenues.
Liabilities
 Income taxes payable. The taxes accrued during the past year
but not yet paid.
 Long-term debt such as bonds payable.
 Deferred tax liabilities.

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the relationship of financial statement elements and accounts, and classify
accounts into the financial statement elements.
10

 Owners’ equity is the owners’ residual claim on a firm’s


Financial
resources, which is the amount by which assets exceed
Statements
liabilities. Owners’ equity includes:
Elements and
Accounts  Capital. Par value of common stock.
 Additional paid-in capital. Proceeds from common stock sales
in excess of par value.
Equity  (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.

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the relationship of financial statement elements and accounts, and classify
accounts into the financial statement elements.
11

Financial
Statements
Elements and
Accounts

Exhibit 4 Study the Exhibit 4 at page 43.

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the accounting equation in its basic and expanded forms.

12

Financial
 Double Entry Accounting – Debits & Credits
Statements  Assets = Equity + Liabilities
Elements and
Accounts  Assets = liabilities + contributed capital +
ending retained earnings
The  Assets = Liabilities
Accounting + Contributed Capital
Equation
+ Beginning Retained Earnings
+ Revenue
– Expenses
– Dividends
Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics
13
Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics
Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
14

Financial
 Use of T-Accounts will help you organize the
Statements final results in financial statements.
Elements and
Accounts

The
Accounting
Process

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
15

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
16

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
17

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
18

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
19

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
20

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
21

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
22

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.

23

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
24

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
25

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
26

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the process of recording business transactions using an accounting system
based on the accounting equations.
27

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the need for accruals and other adjustments in preparing financial
statements.
28

 Most assets are recorded on the financial


Accounting
Process statements at their historical costs.
 However, accounting standards require balance
sheet values of certain assets to reflect their
Other current market values.
Adjustments
 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 income
statement or in “other comprehensive income.”

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
prepare financial statements and explain the relationships among the income
statement, balance sheet, statement of cash flows, and statement of owners’
equity.
29

Cash Flow Statement 20X8 Income Statement for 20X8


Cash collections 99,000 Sales 100,000
cash inputs (34,000) Expenses
cash expenses (8,500) Cost of goods sold 40,000
cash interest - Wages 5,000
cash taxes (14,000)
Depreciation 7,000
Cash flow from operations 42,500
Interest 500
Cash from sale of land 15,000
Total expenses 52,500

Purchase of plant and equipment (25,000)


Income from continuing operations 47,500
Cash flow from investments (10,000)
Gain from sale of land 10,000
Sale of bonds 5,000
Pretax income 57,500
Repurchase of stock (10,000)
Provision for taxes 20,000
Cash dividends (3,500)
Net income 37,500
Cash flow from financing (8,500)
Common dividends declared 8,500
Total cash flow 24,000

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
prepare financial statements and explain the relationships among the income
statement, balance sheet, statement of cash flows, and statement of owners’
equity.
30

Balance Sheet for 20X7 and 20X8 20X8 20X7 Liabilities and Equity 20X8 20X7

Assets Current liabilities

Current assets Accounts payable 9,000 5,000


Wages payable 4,500 8,000
Cash 33,000 9,000
Interest payable 3,500 3,000
Accounts receivable 10,000 9,000
Taxes payable 5,000 4,000
Inventory 5,000 7,000
Dividends payable 6,000 1,000
Noncurrent assets
Noncurrent liabilities
Land 35,000 40,000
Bonds 15,000 10,000
Gross plant and equipment 85,000 60,000
Deferred taxes 20,000 15,000
less: Accumulated depreciation (16,000) (9,000)
Stockholders’ equity
Net plant and equipment 69,000 51,000 Common stock 40,000 50,000
Goodwill 10,000 10,000 Retained earnings 59,000 30,000
Total assets 162,000 126,000 Total liabilities & equity 162,000 126,000

The cash flow statement shows a $24,000 net increase in cash. On the balance sheet,
cash increased by $24,000, from $9,000 in 20X7 to $33,000 in 20X8.
Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics
Financial Reporting Mechanics
prepare financial statements and explain the relationships among the income
statement, balance sheet, statement of cash flows, and statement of owners’
equity.
31

Statement of Owners’ Equity for 20X8


Retained
Capital Total
Earnings
Balance, 12/31/20X7
50,000 30,000 80,000
Repurchase of stock
(10,000) (10,000)
Net income
37,500 37,500
Distributions
(8,500) (8,500)
Balance, 12/31/20X8
40,000 59,000 99,000

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
prepare financial statements and explain the relationships among the income
statement, balance sheet, statement of cash flows, and statement of owners’
equity.
32

The income statement shows that net income was $37,500 in 20X8. The company
declared $8,500 of that income as dividends to its shareholders. The remaining
$29,000 is an increase in retained earnings. Retained earnings on the balance sheet
increased by $29,000, from $30,000 in 20X7 to $59,000 in 20X8.

The cash flow statement shows a $24,000 net increase in cash. On the balance
sheet, cash increased by $24,000, from $9,000 in 20X7 to $33,000 in 20X8.

One of the uses of cash shown on the cash flow statement is a repurchase of stock
for $10,000. The balance sheet shows this $10,000 repurchase as a decrease in
common stock, from $50,000 in 20X7 to $40,000 in 20X8.

The statement of owners’ equity reflects the changes in retained earnings and
contributed capital (common stock). Owners’ equity increased by $19,000, from
$80,000 in 20X7 to $99,000 in 20X8. This equals the $29,000 increase in retained
earnings less the $10,000 decrease in common stock.
Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics
Financial Reporting Mechanics
describe the flow of information in an accounting system.

33

1. Journal entries record every transaction, showing which


Accounting
accounts are changed and by what amounts. A listing of
Process
all the journal entries in order of their dates is called
the “general journal.”
Flow of 2. The general ledger sorts the entries in the general
Information journal by account.
in accounting
system 3. 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.
4. The account balances from the adjusted trial balance
are presented in the financial statements.

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics


Financial Reporting Mechanics
explain the use of the results of the accounting process in security analysis.

34

Use of  Understanding that there has to be another


Judgment in side to every entry is the key in detecting
Accounts
inappropriate because – usually in the course
of “fixing” one account – there will be another
account with a balance that does not make
sense.
 WorldCom recorded its operating expenses as
capital assets, i.e., recording revenue expenses
as capital expenses.

Shoaib A. Qureshi | NUST Business School | Financial Reporting Mechanics