CHAPTER 2

FINANCIAL REPORTING MECHANICS

Lecture by: Say Vichheka

 LEARNING OUTCOMES
- Explain the relationship of financial statement elements and accounts,
and classify accounts into the financial statement elements.
- Explain the accounting equation in its basic and expanded forms.
- Describe the process of recording business transactions using an
accounting system based on the accounting equation.
- Describe the need for accruals and other adjustments in preparing
financial statements.
- Describe the relationships among the income statement, balance
sheet, statement of cash flows, and statement of owners’ equity.
- Describe the flow of information in an accounting system.
- Describe the use of the results of the accounting process in security
analysis.

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 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
1–5: financial statement elements

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 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.

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 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

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 LIABILITY ACCOUNTS

• Accounts payable, trade

payables
• Debt payable
• Bonds (payable)

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 ASSETS AND LIABILITIES

Borrower

$€₤

Asset: Liability:
Loan Receivable 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).
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 EQUITY ACCOUNTS
• Capital (such as common stock)
• Additional paid-in capital
• Retained earnings
• Accumulated other comprehensive income

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 REVENUE AND EXPENSE ACCOUNTS

REVENUE EXPENSE
• Revenue, sales • Cost of goods sold
• Gains • Selling, general, and
• Investment income administrative expenses
(e.g., interest and (SG&A; e.g., rent, utilities,
dividends) salaries, advertising)
• Depreciation and
amortization
• Interest expense
• Tax expense
• Losses

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 BASIC ACCOUNTING EQUATION

ASSETS = LIABILITIES + OWNERS’ EQUITY

• This is the equation that underlies the balance sheet.

• This equation reflects a company’s 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

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 BASIC AND EXPANDED ACCOUNTING EQUATION:
COMPONENTS OF OWNERS’ EQUITY

Assets = Liabilities + Owners’ Equity

Ending
Contributed Retained
Assets = Liabilities + Capital + Earnings

Beginning
Contributed Retained Net
Assets = Liabilities + Capital + Earnings + Income - Dividends
Beginning
Contributed Retained
Assets = Liabilities + Capital + Earnings + REV - Expenses - Dividends

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 BASIC AND EXPANDED ACCOUNTING
EQUATION: RETAINED EARNINGS

Assets = Liabilities + Owners’ Equity

Ending
Contributed Retained
Assets = Liabilities + Capital + Earnings
Beginning
Contributed Retained Net
Assets = Liabilities + Capital + Earnings + Income - Dividends
Beginning
Contributed Retained
Assets = Liabilities + Capital + Earnings + REV - Expenses - Dividends

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 BASIC AND EXPANDED ACCOUNTING
EQUATION: NET INCOME

Assets = Liabilities + Owners’ Equity

Ending
Contributed Retained
Assets = Liabilities + Capital + Earnings
Beginning
Contributed Retained Net
Assets = Liabilities + Capital + Earnings + Income – Dividends
Beginning
Contributed Retained
Assets = Liabilities + Capital + Earnings + Revenue –Expenses – Dividends

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 BASIC AND EXPANDED
ACCOUNTING EQUATION

Assets = Liabilities + Owners’ Equity

Ending
Contributed Retained
Assets = Liabilities + Capital + Earnings

Beginning
Contributed Retained Net
Assets = Liabilities + Capital + Earnings + Income – Dividends

Beginning
Contributed Retained
Assets = Liabilities + Capital + Earnings + Revenue –Expenses – Dividends

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 EXAMPLE: ABC COMPANY
FINANCIAL STATEMENT LINKS

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 EXAMPLE
ABC COMPANY
ABC Company, Inc.
(Beginning) Balance Sheet
As of 31 December 20X0

Assets 2,000

Liabilities 500
Contributed equity 1,250
Retained earnings 250
Owners’ equity 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.

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 EXAMPLE: ABC COMPANY
INCOME STATEMENT AND RETAINED EARNINGS
ABC Company, Inc.
Income Statement
For the Year Ended 31 December 20X1

Revenue 250

Expense 50
Net income 200

ABC Company, Inc.

Statement of Retained Earnings
Year Ended 31 December 20X1

Beginning retained earnings 250

Plus net income 200
Minus dividends 0
Ending retained earnings 450

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 EXAMPLE: ABC COMPANY
ENDING BALANCE SHEET

ABC Company, Inc.

(Ending) Balance Sheet
As of 31 December 20X1

Assets 2,200

Liabilities 500
Contributed equity 1,250
Retained earnings 450
Owners’ equity 1,700
Total liabilities and equity 2,200

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 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.

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 EXAMPLE: ABC COMPANY
TABULAR ACCOUNTING SYSTEM

Assets = Liabilities + Owners’ Equity

Contributed Retained
Cash Payable Capital Earnings
Beginning balance 2,000 500 1,250 250
Received cash for
services 250 250Revenue
Paid cash for
expenses –50 –50Expense
Subtotal 2,200 500 1,250 450

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 EXAMPLE: ABC COMPANY
TABULAR ACCOUNTING SYSTEM

Assets = Liabilities + Owners’ Equity

Contributed Retained
Cash Payable Capital Earnings
Beginning balance 2,000 500 1,250 250
Received cash for
services 250 250 Revenue
Paid cash for
expenses –50 –50Expense
Subtotal 2,200 500 1,250 450

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 EXAMPLE: ABC COMPANY
TABULAR ACCOUNTING SYSTEM

Assets = Liabilities + Owners’ Equity

Contributed Retained
Cash Payable Capital Earnings
Beginning balance 2,000 500 1,250 250

Received cash for

services 250 250Revenue
Paid cash for
expenses –50 –50Expense
Subtotal 2,200 500 1,250 450

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 EXAMPLE: ABC COMPANY
TABULAR ACCOUNTING SYSTEM

Assets = Liabilities + Owners’ Equity

Contributed Retained
Cash Payable Capital Earnings
Beginning balance 2,000 500 1,250 250
Received cash for
services 250 250Revenue
Paid cash for
expenses –50 –50Expense
Subtotal 2,200 500 1,250 450

Total = $2,200

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 EXAMPLE: ABC COMPANY.
TABULAR ACCOUNTING SYSTEM
WITH CLOSING ENTRY

Assets = Liabilities + Owners’ Equity

Contributed Retained
Cash Payable Capital Earnings Revenue Expenses
Beginning
balance 2,000 500 1,250 250
Received cash
for services 250 250
Paid cash for
expenses –50 –50
Subtotal
(pre-closing) 2,200 500 1,250 250 250 -50
Closing 200 –250 50
Post closing 2,200 500 1,250 450 0 0

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 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.

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 ACCRUALS: REVENUE
Cash Movement Cash Movement Cash Movement
prior to Accounting in the Same Period as after Accounting
Recognition Accounting Recognition Recognition

UNEARNED Settled transaction – no UNBILLED

(DEFERRED) REVENUE accrual entry needed (ACCRUED) REVENUE
Originating entry: Originating entry:
Record cash receipt and Record revenue and
establish liability (e.g., establish an asset (e.g.,
unearned revenue) unbilled revenue)
Adjusting entry: When
billing occurs, reduce
Adjusting entry: Reduce unbilled revenue and
the liability while increase accounts
recording revenue receivable. When cash
is collected, eliminate
receivable.

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 ACCRUALS: EXPENSE

Cash Movement Cash Movement Cash Movement

prior to Accounting in the Same Period as after Accounting
Recognition Accounting Recognition Recognition

Settled transaction – no
PREPAID EXPENSE ACCRUED EXPENSES
accrual entry needed

Originating entry: Record Originating entry:

cash payment and Establish a liability (such
establish an asset (such as accrued expenses)
as prepaid expense) and record an expense

Adjusting entry: Reduce Adjusting entry:

the asset while recording Reduce the liability as
expense cash is paid

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 FLOW OF INFORMATION IN AN
ACCOUNTING SYSTEM

Journal
• Journal Entries and Adjusting Entries

Ledger
• General Ledger and T- Accounts

Trial • Trial Balance and Adjusted Trial Balance

Balance

Financial • Financial Statements

Statements

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 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
management’s commentary (also referred to as management’s
discussion and analysis, or MD&A) and the significant accounting
policies footnote, both found in the annual report.

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 USING THE RESULTS OF THE ACCOUNTING
PROCESS IN SECURITY ANALYSIS
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

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 USING THE RESULTS OF THE ACCOUNTING
PROCESS IN SECURITY ANALYSIS
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 Receivable—Trade
• 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.

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 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.

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