2.2 Financial Reporting Mechanics
** This note is summarized by Hui Wang.
Learning Outcomes
The candidate should be able to:
a. Identify the groups (operating, investing, and financing activities) into which
business activities are categorized for financial reporting purposes and classify
any business activity into the appropriate group;
b. Explain the relationship of financial statement elements and accounts, and
classify accounts into the financial statement elements;
c. Explain the accounting equation in its basic and expanded forms;
d. Explain the process of recording business transactions using an accounting
system based on the accounting equations;
e. Explain the need for accruals and other adjustments in preparing financial
statements;
f. 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;
g. Describe the flow of information in an accounting system;
h. Explain the use of the results of the accounting process in security analysis.
The classification of business activities
Typical Business Activities and Financial Statement Elements Affected
Operating
 Sales of goods and services to customers: (R)
activities
 Costs of providing the goods and services: (X)
 Income tax expense: (X)
 Holding short-term assets or incurring short-term liabilities
directly related to operating activities: (A), (L)
Investing
 Purchase or sale of assets, such as property, plant, and
activities
equipment: (A)
 Purchase or sale of other entities’ equity and debt securities: (A)
Financing
 Issuance or repurchase of the company’s own preferred or
activities
common stock: (E)
 Issuance or repayment of debt: (L)
 Payment of distributions (i.e., dividends to preferred or common
stockholders): (E)
Assets (A), Liabilities (L), Owners’ Equity (E), Revenue (R), and Expenses (X).
-From CFA Curriculum
Financial accounts
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Assets
Liabilities
Owners’ equity
Revenues
Expenses
Any item of economic value owned by a company
Financial obligation, debt, claim or potential loss
Residual claim on a company’s economic resources
Amount generated from sale of goods or services
Cost incurred in a company’s efforts to generate revenue
Contra asset accounts
A contra asset accounts accumulate amounts that are reductions of assets. The most
common contra asset accounts include:
a. Allowance for bad debts- an estimate must be made at the end of each accounting
period to account for expected losses related to uncollectible accounts. This
account is shown as a reduction of the accounts receivable balance on the balance
sheet.
b. Accumulated depreciation- as an asset is depreciated over its useful life, the
amount of depreciation is recorded in the accumulate depreciation account. This
account is shown as a reduction of assets on the balance sheet.
c. Sales returns and allowances- an account to accumulate price reductions given to
customers because of goods returned and defective merchandise not suited to the
customers’ needs.
Assets
Liabilities
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Common 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
 Investments accounted for by the equity method
 Current and deferred tax assets
 [for banks, Loans (receivable)]
 Accounts payable, trade payables
 Provisions or accrued liabilities
 Financial liabilities
 Current and deferred tax liabilities
 Reserves
 Minority interest
 Unearned revenue
 Debt payable
 Bonds (payable)
 [for banks, Deposits]
Owners’ equity
Revenue
Expense
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Capital, such as common stock par value
Additional paid-in capital
Retained earnings
Other comprehensive income
Revenue, sales
Gains
Investment income (e.g., interest and dividends)
Cost of goods sold
Selling, general, administrative expenses “SG&A”
(e.g., rent, utilities, salaries, advertising)
Depreciation and amortization
Interest expense
Tax expense
Losses
-From CFA Curriculum
Current assets
In accounting, any asset expected to last or be in use for less than one year is considered a
current asset:
 Cash- cash on hand
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Cash equivalents- highly liquid, very safe investments which can
be easily converted in to cash, such as Treasury Bills and money market funds
 Inventories- merchandise, raw materials, and finished and unfinished products
which have not yet been sold
 Trade receivables- due from customers for merchandise sold or services
performed in the ordinary course of business, can be either accounts receivable or
notes receivable
 Other receivables- amounts owed to the company from parties other than
customers
Noncurrent assets
Noncurrent asset is an asset that is not expected to be turned into cash within one year
during the normal course of business. Noncurrent assets include buildings, land,
equipment, and other assets held for relatively long periods.
Goodwill
Goodwill is an intangible asset which provides a competitive advantage, such as a strong
brand, reputation, or high employee morale. In an acquisition, goodwill appears on the
balance sheet of the acquirer in the amount by which the purchase price exceeds the net
tangible assets of the acquired company.
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Current liabilities
Current liabilities are a company’s debts or obligations that are due within one year:
 Accounts payable- debts resulting from purchasing assets or receiving services on
credit or on an open account
 Accrued liabilities- also referred to as accrued expenses, are expenses that arise
form unpaid balances that exist based on contractual obligations or tax laws
 Short-term debt- is comprised of any debt incurred by a company that is due
within one year
Basic accounting equations
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Assets = Liabilities + Owners’ equity
Owners’ equity = Contributed capital + Retained earnings
Net income (loss) = Revenue – Expenses
Ending retained earnings = Beginning retained earnings + Net income – dividends
Unclassified balance sheet
An unclassified balance sheet is a balance sheet has the assets, liabilities, and equity
groupings but does not further show the breakout between short term and long term assets
and liabilities.
Depreciation
Depreciation is a noncash expense that reduces the value of an asset as a result of ear and
tear, age, or obsolescence. Most assets lose their value over time and must be replaced
once the end of their useful life is reached.
Cost of goods sold
Cost of goods sold (COGS) is an income statement figure which reflects the cost of
obtaining raw materials and producing finished goods that are sold to consumers.
Cost of goods sold = Beginning Merchandise Inventory + Net Purchases of Merchandise
– Ending Merchandise Inventory
Accrual accounting
Accrual accounting is an accounting method that measures the performance and position
of a company by recognizing economic events regardless of when cash transactions occur.
The general idea is that economic events are recognized by matching revenues to
expenses (the matching principle) at the time in which the transaction occurs rather than
when payment is made (or received). This method allows the current cash
inflows/outflows to be combined with future expected cash inflows/outflows to give a
more accurate picture of a company’s current financial condition.
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Unearned revenue
Unearned revenue represents payment received by a company before its goods are sold or
its service is provided. Unearned revenue is classified as a current liability on the balance
sheet until it is recognized as earned when goods or services are delivered.
Unbilled revenue
Unbilled revenue is revenue which has been recognized but which has not been billed to
the purchasers.
Prepaid expense
Prepaid expense is an accounting term signifying money paid for goods or services
upfront. A prepaid expense is considered an asset on the balance sheet. As the goods and
services are delivered, this prepaid expense will be transferred to expenses and thus will
appear on the income statement as an expense. An example of a prepaid expense is
prepaid rent, since the tenant pays money upfront for the right to use the property over a
period of time in the future.
Accrued expenses
Accrued expense is an expense that is incurred, but not yet paid for, during a given
accounting period.
Accounting system flow and related documents
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A journal is a document or computer file in which business transactions are
recorded in the chronological order.
 A ledger is a document or computer file that shows all business transactions by
account.
 A trial balance is a document that lists account balances at a particular point in
time.
The only difference between a journal and a ledger is that the data are sorted by date in a
journal and by account in the ledger. A key difference between a trial balance and a
ledger is that the trial balance shows only total ending balances.
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Exercise Problems: (provided by Stalla PassMaster for CFA Exams.)
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EXPLANTATION
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