CHAPTER 2: FINANCIAL REPORTING MECHANISMS

Department of Management and Law CHAPTER 2: FINANCIAL REPORTING MECHANISMS Prof. Sandro Brunelli, Ph.D. brunelli@economia.uniroma2.it

BUSINESS ACTIVITIES AND FINANCIAL STATEMENT ELEMENTS Business Activities - Operating - Sell products or services to generate revenue 1 - Incur expenses 2 while generating revenue - Investing - Use (longer-term) assets 3 to operate the business - Financing - Borrow from creditors, creating a liability 4 - Sell ownership interest (equity 5 ) to shareholders Firms use financial reports to communicate about these activities and their results 1 5: financial statement elements Copyright 2013 CFA Institute 2

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. Copyright 2013 CFA Institute 3

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 Copyright 2013 CFA Institute 4

LIABILITY ACCOUNTS Accounts payable, trade payables Debt payable Bonds (payable) Copyright 2013 CFA Institute 5

ASSETS AND LIABILITIES Borrower $ Asset: Loan Receivable Liability: 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). Copyright 2013 CFA Institute 6

EQUITY ACCOUNTS Capital (such as common stock) Additional paid-in capital earnings Accumulated other comprehensive income Copyright 2013 CFA Institute 7

REVENUE AND EXPENSE ACCOUNTS REVENUE Revenue, sales Gains Investment income (e.g., interest and dividends) EXPENSE Cost of goods sold Selling, general, and administrative expenses (SG&A; e.g., rent, utilities, salaries, advertising) Depreciation and amortization Interest expense Tax expense Losses Copyright 2013 CFA Institute 8

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 Copyright 2013 CFA Institute 9

BASIC AND EXPANDED ACCOUNTING EQUATION: COMPONENTS OF OWNERS EQUITY Assets = Liabilities + Owners Equity Assets = Liabilities + Capital + Ending Earnings Assets = Liabilities + Capital + Beginning Earnings + Net Income - Dividends Assets = Liabilities + Capital + Beginning Earnings + REV - Expenses - Dividends Copyright 2013 CFA Institute 10

BASIC AND EXPANDED ACCOUNTING EQUATION: RETAINED EARNINGS Assets = Liabilities + Owners Equity Assets = Liabilities + Capital + Ending Earnings Assets = Liabilities + Capital + Beginning Earnings + Net Income - Dividends Assets = Liabilities + Capital + Beginning Earnings + REV - Expenses - Dividends Copyright 2013 CFA Institute 11

BASIC AND EXPANDED ACCOUNTING EQUATION: NET INCOME Assets = Liabilities + Owners Equity Assets = Liabilities + Assets = Liabilities + Assets = Liabilities + Capital Capital Capital + + + Ending Earnings Beginning Earnings + Net Income Dividends Beginning Earnings + Revenue Expenses Dividends Copyright 2013 CFA Institute 12

BASIC AND EXPANDED ACCOUNTING EQUATION Assets = Liabilities + Owners Equity Assets = Liabilities + Capital + Ending Earnings Assets = Liabilities + Capital + Beginning Earnings + Net Income Dividends Assets = Liabilities + Capital + Beginning Earnings + Revenue Expenses Dividends Copyright 2013 CFA Institute 13

EXAMPLE: ABC COMPANY FINANCIAL STATEMENT LINKS Copyright 2013 CFA Institute 14

EXAMPLE ABC COMPANY ABC Company, Inc. (Beginning) Balance Sheet As of 31 December 20X0 Assets 2,000 Liabilities 500 equity 1,250 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. Copyright 2013 CFA Institute 15

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 Earnings Year Ended 31 December 20X1 Beginning retained earnings 250 Plus net income 200 Minus dividends 0 Ending retained earnings 450 Copyright 2013 CFA Institute 16

EXAMPLE: ABC COMPANY ENDING BALANCE SHEET ABC Company, Inc. (Ending) Balance Sheet As of 31 December 20X1 Assets 2,200 Liabilities 500 equity 1,250 earnings 450 Owners equity 1,700 Total liabilities and equity 2,200 Copyright 2013 CFA Institute 17

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. Copyright 2013 CFA Institute 18

EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM Assets = Liabilities + Owners Equity Cash Payable Capital Earnings Beginning balance 2,000 500 1,250 250 Received cash for services 250 250 Revenue Paid cash for expenses 50 50 Expense Subtotal 2,200 500 1,250 450 Copyright 2013 CFA Institute 19

EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM Assets = Liabilities + Owners Equity Cash Payable Capital Earnings Beginning balance 2,000 500 1,250 250 Received cash for services 250 250 Revenue Paid cash for expenses 50 50 Expense Subtotal 2,200 500 1,250 450 Copyright 2013 CFA Institute 20

EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM Assets = Liabilities + Owners Equity Cash Payable Capital Earnings Beginning balance 2,000 500 1,250 250 Received cash for services 250 250 Revenue Paid cash for expenses 50 50 Expense Subtotal 2,200 500 1,250 450 Copyright 2013 CFA Institute 21

EXAMPLE: ABC COMPANY TABULAR ACCOUNTING SYSTEM Assets = Liabilities + Owners Equity Cash Payable Capital Earnings Beginning balance 2,000 500 1,250 250 Received cash for services 250 250 Revenue Paid cash for expenses 50 50 Expense Subtotal 2,200 500 1,250 450 Total = $2,200 Copyright 2013 CFA Institute 22

EXAMPLE: ABC COMPANY. TABULAR ACCOUNTING SYSTEM WITH CLOSING ENTRY Assets = Liabilities + Owners Equity 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 Copyright 2013 CFA Institute 23

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. Copyright 2013 CFA Institute 24

ACCRUALS: REVENUE Cash Movement prior to Accounting Recognition UNEARNED (DEFERRED) REVENUE Originating entry: Record cash receipt and establish liability (e.g., unearned revenue) Adjusting entry: Reduce the liability while recording revenue Cash Movement in the Same Period as Accounting Recognition Settled transaction no accrual entry needed Cash Movement after Accounting Recognition UNBILLED (ACCRUED) REVENUE Originating entry: Record revenue and establish an asset (e.g., unbilled revenue) Adjusting entry: When billing occurs, reduce unbilled revenue and increase accounts receivable. When cash is collected, eliminate receivable. Copyright 2013 CFA Institute 25

ACCRUALS: EXPENSE Cash Movement prior to Accounting Recognition PREPAID EXPENSE Originating entry: Record cash payment and establish an asset (such as prepaid expense) Adjusting entry: Reduce the asset while recording expense Cash Movement in the Same Period as Accounting Recognition Settled transaction no accrual entry needed Cash Movement after Accounting Recognition ACCRUED EXPENSES Originating entry: Establish a liability (such as accrued expenses) and record an expense Adjusting entry: Reduce the liability as cash is paid Copyright 2013 CFA Institute 26

FLOW OF INFORMATION IN AN ACCOUNTING SYSTEM Journal Journal Entries and Adjusting Entries Ledger General Ledger and T- Accounts Trial Balance Trial Balance and Adjusted Trial Balance Financial Statements Financial Statements Copyright 2013 CFA Institute 27

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. Copyright 2013 CFA Institute 28

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 Note 26 Discontinued operations and assets held for sale and liabilities directly associated with assets held for sale Valuation of assets Copyright 2013 CFA Institute 29

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 + Capital + Beginning 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. Copyright 2013 CFA Institute 30