Study Session 7 - Financial Reporting and Analysis

Classification of Business Activities

• Operating Activities = day-to-day business activities
• Investing Acvitivies = investment in long term assets (inc. securities/physical plant)
• Financing Activities = borrowing or repaying capital

Within each of these any activity can be classified as (OREAL):

• Owner's Equity = residual claim on the resources of the company, partner's capital
• Revenue* = inflows of economic resources to the company
• Expenses* = outflows of economic resources or increase in liabilities
• Assets = economic resources of a company
• Liabilities = creditors' claims on resources of a company

* Gains and Losses are like Revenue and Expenses but arise from secondary activities outside of operating activities e.g. selling excess equipment for more than its value would be a gain, decline in the value of inventory would be a loss

Accounts are subcategories under each of the OREAL headings e.g. under assets might be the accounts of cash, accounts receivable, inventory etc. These may then be grouped under each of the OREAL headings to further summarise the books.

Actual accounts are set forth in a chart of accounts

contra accounts = accounts that are used to offset other accounts e.g.

• allowance for bad debts offsets trade receivables,
• accumulated depreciation offsets property, plant and equipment,
• sales and allowances offsets revenue and reflects discounts etc. for unsatisfactory goods etc.

COMMON ACCOUNTS

Assets (tend to be listed in the order of liquidity)

• Cash and cash equivalents
• Accounts receivable, trade receivables
• pre-paid expenses
• inventory
• property, plant and equipment - noncurrent
• investment property - noncurrent
• intangible assets (patents, trademarks, licenses, copyright, goodwill) - noncurrent
• financial assets, trading securities, investment securities
• investments accounted for by the equity method
• current and deferred tax assets
• [for banks, loans receivable - b/c that is their business
• noncurrent assets benefit company over extended period of time (over one year)
• current assets expected to be consumed within a year or converted into cash

Liabilities

• Accounts payable, trade payables
• provisions or accrued liabilities
• financial liabilities
• current and deferred tax liabilities
• reserves
• minority interest [equity owned in subsidiaries?]
• unearned revenue
• debt payable
• bonds (payable0
• [for banks, deposits - b/c these are the amounts the bank is 'borrowing']

Owner's Equity

• Capital such as common stock par value
• additional paid-in capital
• retained earnings
• other comprehensive income

Revenue

• Revenue, sales
• Gains
• Investment income (e.g. interest and dividends)

Expenses

• Cost of goods sold
• Selling, general, and administrative expenses (SG&A) e.g. rent, utilities, salaries, advertising
• depreciation
• interest expense
• tax expense
• losses

Accounting Equations

balance sheet

• Assets = Liabilities + Owner's Equity
• Assets - Liabilities = Owner's Equity
• Owner's Equity = Contributed Capital + Retained Earnings
• Expanded: Assets = Liabilities + Contributed Capital + Beginning retained earnings + Revenue - Expenses - Dividends
• A = L + CC + RE(beg) + R - Ex - Div

income statement

• Revenue - Expenses = Net income

ending retained earnings

• ending retained earnings = beg. RE + Net Income - Dividends
• ending retained earnings = beg. RE + (Revenues - Expenses) - Dividends

Retained earnings = the net income retained by the company and not distributed as dividends; usually kept for investment. RE is a component of owner's equity and links the "as of" balance sheet equation with the "activity" equation of the income statement, so

• Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Revenue - Expenses - Dividends
• if asked to calculate this remember Assets = everything else - (expenses + liabilities)

Retained Earnings is the net earnings not distributed as dividends and as such shows up on the Balance Sheet (under shareholder's equity). The income statement will tell you how much net income has increased during a period and the net income will be added to existing retained earnings.

Income Statement and Statement of Retained Earnings show movement over a period (in and out, plus and minus) whereas balance sheet just shows snapshot

Rules of Thumb:

• selling something for x that cost y has two parts:
  • the cash received increases cash (asset) by x and revenue (income) by x and
  • decreases inventory (asset) by y : offset by increase in COGS (expense) by y
  • so in balance sheet cash asset is increased, inventory asset is decreased, difference between the two is profit (retained earnings)
  • in income statement revenue is increased under income and COGs is increased under expenses and difference is reflected in net income
• when you purchase something that will last over multiple periods, you are just converting one asset (cash) into another - so you reduce cash asset and increase the bought asset total
• when you purchase a something that you will consume in the current period, it is an expense
• when you purchase something on credit, the asset is offset in liabilities (accounts payable)
• unearned fees are identical to unearned premiums therefore liabilities which are earned incrementally e.g. each month you might earn one more month's worth of the unearned premiums so liabilities would decrease by one month value and fee revenue would increase by one month value
• contributed capital is both an asset (cash) and owners' equity (since the owners have a claim on this economic resource); liabilities reduce the owners' equity since liabilites represent creditors claims on the resources (which supercede the shareholders)
• Receiving cash for services not yet rendered adds cash to the assets but adds the same amount in liabilities (unearned fees)
• Receiving cash for services rendered counts as revenue (if it is from operations)
• Assets and Liabilities = balance sheet
• Revenues and Expenses = income statement
• Borrowing increases cash and adds liability of bank debt
• pre-paid rent and rent deposits are assets; when rent is paid, pre-paid rent asset is decreased by x and logged as an expense of x
• anything paid before it is billed is recorded as an asset until such time as the bill is received and the money is recorded as an outflow
• wages earned but not paid are recorded in b/s as accrued wages and in income statement as payroll expense
• investment gains are logged as unrealised gains under revenue
• interest income is revenue and asset (investment)
• interest from debt owed is logged as liability (interest payable) and an expense (income statement). If monthly accounts, then annual interest is divided by compounding periods
• equipment is logged as an asset (say $120) and then depreciated over time. Say it has a year's usefulness then depreciation will be $10 per month ($120/12) which will be logged as a contra asset (balance sheet) and an expense (income statement) each month

Relationships

• Balance sheet contains Assets, Liabilities and Shareholders' Equity
• Cash is broken down in the Statement of Cash Flows
• Income Statement breaks down all cash flows e.g. net income from Owners' Equity Statement, revenues/expenses on statement of cash flows
• Shareholders' Equity is broken down in the Statement of Owners' Equity

Definitions and Purpose of Statements

• Balance Sheet is a snapshot of assets, liabilities and b
• Income Statement shows profitability over time through details of revenue, expense and resulting net income
• Statement of Cash Flows provides info about cash flows over a period from operating, financing and investing activities
• Statement of Owners' Equity provides information about the composition and changes in equity during a period

Accruals

Unearned (deferred) revenue

• originating recorded as cash receipt and as a liability
• adjusting reduce liability while recording revenue

Prepaid Expense

• originating record cash payment and establish an asset
• adjusting reduce asset while recording the expense

Unbilled (accrued) revenue

• originating record revenue, establish an asset
• adjusting when billing occrus, reduce unbilled revenue and increase accounts receivable; when cash is collected, eliminate accounts receivable

Accrued Expenses

• originating establish a liability and record an expense
• adjusting reduce the liability as cash is paid

Accounting Systems

Flow of information in an accounting system:
Journal entries > GL and T-Accounts > Trial Balance > Financial Statements

Cooking books if you want to cook the books, you must find an offset e.g. if you want to report more revenue then you need to create an asset to generate the revenue, if you want to conceal a cost then you need to create a liability to be the cause of that cost