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.