CFA Level 1 (2009) - 3

Sludy Session 7

Cross-Reference to CFA Institute Assigned Reading. #30 - Financial Reporting Mechanics

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LOS 50.b: Explain the relationship of financial statcment clements and accoullts, and classil)! accoullts into the financial statcIllc'nt clemcnts.

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Financial statement clements arL: lhL: major classifications of asselS, liabilitics, owners' L:ljuily, rcvenucs, and expL:nses. Accounts arc the spL:cific records within L:ach demcnt wherc various transactions arc entered. On the financial statcments, accounts arc typically prcscnted in groups such as "inventory" Ot "accounts payable." A company's chart of accounts is a detailed list of the accounts that make up the fivc financial statement elements and the linc items presented in the financial statements.

Contra accounts arc used for entries that offset some parr of the value of another account. For nample, equipment is typically valued on the balance sheer at acquisition (historical) cost, and the estimated decrease in its value over time is recorded in a contra account tided "accumulated depreciation."

Classifying Accounts Into the Financial Statcment Elcmcnts

Assets are the firm's economic resources. Examples of assets include:

Cash and cash equilJalents. Liquid securities with maturities of90 days or less are

considered cash equivalents.

Accounts receivable. ACCOUIHS receivable often have an "allowance for had debt expense" or "allowance for doubtful accounts" as a contra account.

Invelllory.

Financial assets such as marketable securities.

Prepaid expenses. Items that will be expenses on furure income statemenrs.

•Propert)', plant, and equipment. Includes a contra-assn account for accumulated depreciation.

Inuestment in affiliates accounted for using the equity method.

•Deferred tax assets.

•Intangible assets. Economic resources of the firm that do nor have a physical form, such as patents, trademarks, licenses, and goodwill. Except for goodwill, these values may be reduced by "accumulated amortization."

Liabilities arc creditor claims on the company's resources. Examples of liabilities include:

•Accounts payable and trade payables.

•Long-term debt such as bonds payable.

•Deferred tax liabilities.

Owners' equity is the owners' residual claim on a firm's resources, which is the amount by which assets exceed liabilities. Owners' equity includes:

•Capital. Par value of common srock.

•Additional paid-in capital. Proceeds from common srock sales in excess of par value. (Share repurchases that the company has made arc represented in the contra accoullt, treasury stock.)

•Retained earnings. Cumulative net income that has llot been distributcd as dividends.

Study Sessioll 7

Cross-Reference \0 eFA Institute Assigned Reading #30 - Financial Reporting Mechanics

Othl'l" romprehcl/Jivc iJlromc. Changes resulting from foreign currency translation, minimum pension liability adjustmenrs, or unrealized gains alld lossl's on D

Investmen ts.

Revenue represents inflows of economic resources alld includes:

Salt'S. Revenue from the firm's day-to-day activities.

(r/lil/J. Increases in assets or equity from transactions incidenral to the firm's day-to·· day activities.

Investment iI/come such as interest and dividend income.

Expenses arc outHows of economic resources and include:

Cost olgoods sole/.

•Selling, gcncm!, find (uill/inistmlive t'xpt'l!Ses, These include such expenses as advertising, management salaries, rent, and utilities,

•Dcprfl'ifltioJl and llIlIOi'tizatioll. To reflect the "using up" of LlIlgihlc and inLlngihle asscts.

l;lx {'.\ji('lIse. II/Ierot nj!t'llse.

I_osses, Decreases ill assets or equity frOI1l transaClions incidenral to the Erm's day-to- dayacrivities.

LOS .HLc: Explain rhe :lccounting equation III its basic and cxpallckd forms.

The basic accounting equation is the relationship among the three balance sheet elements:

assets = liabilities + owners' equity

Owners' equity consists of capital contrihuted by the firm's owners and the cumulative earnings the firm has retained. With that in mind, we can state the expanded accounting equation:

assets = liabilities + contributed capital + ending retained earnings

Ending retained earnings for an accounting period is the result of adding that period's retained earnings (revenues minus expenses minus dividends) to beginning retained earnings. So the expanded accounting equation can also be stated as:

+Contributed Capital

+Beginning Retained Earnings

+Revenue

-Expenses

-- Dividends

Study Sessioll 7

Cross-Reference to CFA Institute Assigned Reading #30 - Financial Reporting Mechanics

LOS ,:HLd: ExpLlin (he process of recording husiness transact ions ustng an accounting system based on the accounting equations.

Keeping the accounting equation in balance requires double-entry accounting, in ,vhich a tL1l1s:luion has to be n:cordl'd in al k'ast two accounts, /\/1 inCleasl' in an ~ISSe{ aCl"llllnt, for example, must be halanced by a Jecn.:ase in another asset account or by ;1l1 increase in a liability or owners' equity aCCount.

Some typical examples of double entry accouI1ling include:

1)lIl'chrlse crt II ip/llfll t jt!r' $1 (), (JOO ({Ish, Pro perry, p Iant and e(1U iIWle nt (a nasset)

increases by $10,000. Cash (an asset) decreases by $10,000.

Borro1lJ $1(),OOO to pllrcht1Sc cquipmCllt. PP&F increases hy $!O,OOO. Notes payabk (a liability) increases by $10,000.

BIIY 0U/a slIpplies/or $100 cml;. Clsh decreases by $100. Supply expense inucases b\

$ 100. /\11 expense reduces retained e:trnings, so owners' l'quit)' dl'Cll'ases hy $lOO. lI!!,!' illl'l'iIlOr)! jill' $8, ()()() Old) tllld sri! it/ti/' $/ (), ()()() ca.dl. The purchasl' deCleases lash by ,~I-\,OOO and il1l1eases inveiHory (an asset) by $1-\,000. The sale inCI'l.:aSl:S cash

by $10,000 and decreases inventory by $1-\,000, .so assels increase by $2,000. At the same time, sales (a revenue account) increase hy $1 o,oao and "COSt of goods sold" (an expense) increases by the $8,000 COSt of inveI1lory. The $2,000 difference is

an increase in net income and, therefore, in retained earnings and owners' equity (ignoring taxes).

LC)S 30.c: l~.xplain the need for accruals and other adjusttncnts in preparing

flnancial statements.

Rl:vcnues and expenses are not always recorded at the same rime that cash receipts and paYlllents are made. The principle of accrual accounting requires Ih:ll 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:

1.Ullearl1cd }'('l}('l1l1C. Tlte firm receives cash hefore it provides a good or service ro

customers. Cash increases and unearned revenue, a liability, increases by the same amount. When the firm provides the good or service, revenue increases and the liability decreases. For example, a newspaper or magazine subscription is typically paid in advance. The publisher records the cash received and increases the unearned revenue liability account. The firm recognizes revenues and decreases the liability as it fulfills the subscription obligation.

2.Accrucd re1JCllue. The firm provides goods or services before it receives cash paymenl. Revenue increases and accounts receivable (an asscr) increases. When the customer pays cash, accounrs receivable decreases. A typical example would be a manufacturer that sells goods to retail stores "on accounr." The manufacturer records revenue when it delivers the goods bur does not receive cash until after rhe retailers sell the goods to consumers.

Study Session 7

Cross-Reference ro CFA Institute Assigned Reading #30 - financial Reporting Mechanics

3.Prepaid expmst's. The firm pays cash ahead of time for an al1licipated expense. Cash (an asset) decreases and prepaiH expense (also an asset) increases. Prepaid expense decreases and expenses increase when the expense is actually incurred. For l:xample,

a retail SlOre that rents space in a shopping mall will often pay its rel1l in advance.

4.Accrued e.xjJt'wt's. The firm owes cash Cor expenses it has incurred. Expenses increase and a liahility for accrued expenses increases as well. The liability decreases when the firm pays cash (0 satisfy it. Wages payable are a common exam pie of an accrued expense, as companies typically pay their employees at a later date for work they performed in the prior week or month.

Accruals require an accounting entry when the earliest event occurs (paying or receiving Glsh, providing a good or service, or incurring:m 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, lhe effect of accrual accoul1ling is to recognil.e revenues or expenses in the appropriate period.

Other Adjustments

Most assets are recorded on the financial statements at their historical costs. However, accounting standards require balance sheet values of certain assets to reAect their current market values. Accounting entries that update these assets' values are called valuation adjustments. To keep the a.ccounting 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."

LOS .')0.[: 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 £lows, and statement of owners' equity.

Figures 1 through 4 contain the financial statements for a sample corporation. The balance sheet summarizes the company's financial position at the end of the current accounting period (and in this example, it also shows the company's position at the end of the previous fiscal period). The income statement, cash flow statement, and statement of owners' equity show changes that occurred during the most recent accounting period.

Note these key relationships among the financial statements:

•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.

Study Session 7

Cross-Reference to CrA Institute Assigned Reading #30 - Financial Reporting Mechanics

One of the uses of cash shown on the cash flow statement is a repurchase of slOck for $10,000. The balance sheer shows this $1 o.doo repurchase as a decrease in common slOck, from $'50,000 in 20X? to $40,000 in 20X8.

The statement of owners' equity relleCls the changes in retained earnings and contributed capital (common srock). Owners' equity increased by $19,000, from

$80,000 in 20X? ro $99,000 in 20X8. This equals lhe $29,000 increase in retained earnings less the $10,000 decrease in common srock.

Figure I: Income Statement for 20X8

Study Session 7

Cross-Reference to CFA Institute Assigned Reading #30 - Financial Reporting Mechanics

Study Session 7

Cross-Reference to CFA Institutc Assigncd Reading #30 - Financial Reponing Mcchanics

Figure 4: Statement of Owners' Equity for 20X8

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Ins .:lO.g: Describe the How of information ill dn accoullting system.

In{(ll"IlIarion Ho\\'s throu~h an accouIlling srstem in four steps:

1.jo//ntrl/ cllirics record CVCl'y transaction, showing which aCCOUIllS arc changed and by what amounts. A listing of all the journal entries in order of their dates is called the "gencral journal."

The g('/lcut! I('(lgcr sons thc eIHri<:s in lhe gencral journal by accoullt.

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 adjllStcd trifl/ balance.

1/. The acco un t balances from the adj usted trial balance are prescn ted in the fina ncirl! statcmC/lts.

T.ns 30.h: Explain the use of Ihe results of the accounting process in security

;mah·sis.

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An analyst does not have access to the detailed information that flows through a company's accounting system, but sees only the end product, the financial statements. An analyst needs to understand the various accruals, adjustments, and management assumptions that go into the financial statements. 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 financial statements. With this information, the analyst can better judge how well the financial statements reflect the company's rrue performance and what adjustments to the data are necessary for appropriate analysis.

Because adjustments and assumptions within the financial statements are, at least to some extent, at the discretion of management, the possibility exists that management may attempt to manipulate or misrepresent the company's financial performance. A good understanding of the accounting process can help an analyst identify financial statement entries that: appear to be out of line.

Study Session 7

Cross-Reference to CFA Institute Assigned Reading #30 - Financial Reporting Mechanics

l.OS .\O.a

13usine.~s transactions can be categorized as:

Operating activities-the firm's ordinary business.

Investing activities-purchasing, selling, and disposing of long-term assets.

I~inancing activities-raising and repaying capital.

LOS 30.h

Transactions are recorded in accounts that form the financial st,ltemCI1l elements:

Assets-the firm's economic resources.

Liabilities-credirors' claims on the firm's resources.

Owners' equity-paid-in capital (common and preferred srock), retained earnings, and cumulative other comprehensive income.

Revenues--salcs, invesllnCnt income, and gains.

Expenses-cost of gooc.ls soJc.l, selling and ac.lminislrativc expcnses, depreciatiol1, interest, taxes, and losses.

LOS 30.c

The basic accounring equation:

assets" liabilities + owners' equity

Tbe expanded accounting equation:

assets" liabilities + conrributed capital + ending retained earnings

The expanded accounting equation can also be stated as:

assets" liabilities + contributed capital + beginning retained earnings + revenueexpenses - dividends

LOS 30.d

To keep the accounting equation in balance, each transaction has to be recorded in at least two accounts.

LOS 30.e

A firm must recognize revenues when they are earned and expenses when they are incurred. Accruals are required when the timing of cash payments made and received does not match the timing of the revenue or expense recognition on the financial statements.

LOS 30.f

The balance sheet shows a company's financial position at a point in time.

Changes in balance sheet accounts during an accounting period are reflected in the income statement, the cash flow statement, and the statement of ownets' equity.

5mdy Session 7

Cross-Reference to CFA Institute Assigned Reading #30 - Financial Reporting Mechanics

1.0S 30.g

Information enters an accounting system as journal entries, which are sorted by accoullt into a general ledger. Trial balances are formed at the end of an accounting period. ACCOUIlts are then adjusted and presented in financial statements.

LOS 50.11

Since financial reponing requires choices of method, judgment, and estimates, an analyst must understand the accounting process used to produce the financial statements in order to understand the business and the results for the period. Analysts should be

alen to the use of accruals, changes in valuations, and other notable changes that may indicate management judgment is incorrect or, worse, that the financial statements have been deliberately manipulated.

SluJy Session 7

Cross-Rdcrence to eFA Institute Assigned RcaJing 1{30 - Financial Reporting Mechanics

1.Richland Pal1LT is a Illanufacllm:r of /~)Idin~ cartons Cor packaging rctail itcms, This year thc COJ11P;lIlY aClJuired a new CUlling machine that it cxpecrs to usc fIll" the ncxt eight years, This purchase should be classi/ied as a(n):

f\, operating acrivity,

B.investing activity.

C.financing activity.

2.Sparta Distributors, a wholesaler, has obtained a $5 million lO-year loan Crom

Stoddard National Bank, How should cach firm

Accoul1ls reL'l,iv;lble ,1IId aCCOUIIlS payahle arc II/OJt /1f,:"{J' cl;lssillcd ,IS whicil

Ilnancial sUtelJ1Clll clements?

ii.Annual depreci:llion and accumulated depreciation arc most /i!?e!-y classified as which financial stall.:ment c1emems?

A.owners' equity = liabilities - assets.

g, cnding retaincd earnings asscts ~ contriblilcd capital - liabilities.

C.assets = liabilities + contribllled capit:11 + beginning retaincd earnings + revenue - expenses .- dividends.