Reading 22 - Financial Reporting Mechanics Flashcards
Business activities are classified into three categories for financial reporting purposes:
Operating activities
Investing activities
Financing activities
Define business activities and what are the typical activities that fall into this category?
These are related to the day‐to‐day business activities of a company. Typical activities that fall in this category are:
- Sales of goods and services to customers.
- Costs associated with the provision of goods and services.
- Income tax expenses.
- Investments in working capital to support the firm’s ordinary business.
Define investing activities and what are the typical activities that fall into this category?
These are related to the acquisition and disposal of long‐term assets. Examples of transactions that fall in this category include:
- Acquisition or disposal of fixed assets like property, plant, and equipment (PP&E).
- Purchase or sale of other corporations’ equity and debt securities.
Define financing activities and what are the typical activities that fall into this category?
These are related to raising and repaying capital. Examples of financing activities include:
- Issuance or repurchase of common or preferred stock.
- Issuance or redemption of debt.
- Dividend payments on common and preferred stock.
The nature of a firm’s operations dictates where certain transactions fall within business activity classifications. Explain.
For example, interest received on an investment in a debt instrument by a music store is classified as an investing activity, but interest received by a bank is classified as an operating activity. The sale of an oven by an oven manufacturer is an operating activity, while the sale of an oven by a restaurant is an investing activity.
For Typical Business Activities and Financial Statement Elements Affected, based on the following OPERATING activities, which element is affected?
- Sale of goods and services to customers
- Cost of providing the goods and services
- Income tax expense
- Holding short‐term assets or incurring short‐term liabilities directly related to operating activities
- Sale of goods and services to customers : Revenue
- Cost of providing the goods and services : Expenses
- Income tax expense : Expenses
- Holding short‐term assets or incurring short‐term liabilities directly related to operating activities: Assets, liabilities
For Typical Business Activities and Financial Statement Elements Affected, based on the following INVESTING activities, which element is affected?
- Purchase or sale of assets such as property, plant, and equipment
- Purchase or sale of other entities’ equity and debt securities
- Purchase or sale of assets such as property, plant, and equipment: Assets
- Purchase or sale of other entities’ equity and debt securities: Assets
For Typical Business Activities and Financial Statement Elements Affected, based on the following FINANCING activities, which element is affected?
- Issuance or repurchase of the company’s own preferred or common stock
- Issuance or repayment of debt
- Payment of distributions (i.e., dividends to preferred or common stock holders)
- Issuance or repurchase of the company’s own preferred or common stock: Owner’s equity
- Issuance or repayment of debt: Liabilities
- Payment of distributions (i.e., dividends to preferred or common stock holders): Owner’s equity
What are the five financial statement elements?
Assets
Liabilities
Owners’ equity or shareholders’ equity
Revenues
Expenses
How are the increases or decreases in any of the five financial statement elements recorded?
An increase or a decrease in any of these elements is recorded in a specific account. For example, accounts receivable is an account that falls under the financial element of assets.
How do financial statements and actual accounts compare?
Financial statements present condensed information regarding financial statement elements and accounts. The actual accounts used in a company’s accounting system are listed in a chart of accounts.
Define assets and what they include.
Assets are a company’s economic resources.
They include:
Current assets
Noncurrent assets
What are included in current assets?
- Cash and cash equivalents.
- Accounts receivable, trade receivables.
- Prepaid expenses.
- Inventory.
What are included in noncurrent assets?
- Property, plant, and equipment.
- Investment property.
- Intangible assets (patents, trademarks, licenses, copyrights, and goodwill).
- Financial assets, trading securities, and investment securities.
- Investments accounted for by the equity method.
Why are contra accounts used and what are some contra asset accounts?
Sometimes contra accounts are used to reduce the balance of certain assets. Common contra asset accounts include allowance for bad debts (offset against accounts receivable) and accumulated depreciation (offset against PP&E).
Define liabilities and what they include.
Liabilities are creditors’ claims on a company’s economic resources. They include:
- Accounts payable and trade payables.
- Financial liabilities such as notes payable.
- Deferred tax liabilities.
- Long‐term debt.
- Unearned revenue.
Define owners’ equity and what they include.
Owners’ equity represents owners’ residual claim on a company’s resources. It includes:
- Capital in the form of common and preferred stock.
- Additional paid‐in capital.
- Retained earnings.
- Other comprehensive income.
- Minority interest
Define revenues and what they include.
Revenues represent the flow of economic resources into the company and include:
- Sales.
- Gains.
- Investment income.
Define expenses and what they include.
Expenses represent the flow of economic resources out of the company, and include:
- Cost of goods sold.
- Selling, general, and administrative expenses.
- Depreciation and amortization expenses.
- Interest expense.
- Tax expense.
- Losses.
Define noncurrent assets.
Noncurrent assets are expected to benefit the company over an extended period of time (usually over one year).
Define current assets
Current assets are expected to be used by the company or converted into cash in the short term (less than one year). Current assets include:
- Inventories: Unsold products on hand (also called inventory stock).
- Trade receivables: Amounts customers owe the company for products that have been sold.
- Cash on hand and at the bank.
The basic accounting equation is:
Assets = Liabilities + Owners’ equity
The owners’ equity definition and equation is:
Owners’ equity is the residual claim of the owners on a company’s assets after all liabilities have been paid off.
Owners’ equity = Assets − Liabilities
Owners’ equity can be further divided into its two components:
Owners’ equity = Contributed capital + Ending retained earnings
Ending retained earnings are calculated as:
Ending retained earnings = Beginning retained earnings + Net income – Dividends declared
The equation for ending retained earnings can also be stated as:
Ending retained earnings = Beginning retained earnings + Revenue − Expenses − Dividends declared
The basic accounting equation can be expanded into the following forms: (Long equation)
Assets = Liabilities + Contributed capital + Ending retained earnings
and:
Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue − Expenses − Dividends declared
Define double-entry accounting
The process of recording business transactions is based on double‐entry accounting (i.e., every transaction affects at least two accounts). If an asset account increases, either a liability or an equity/capital account will also increase, or another asset account will decrease to keep the accounting equation in balance.
Remembering the basic accounting equation and understanding which direction the financial elements will move given a certain transaction is EXTREMELY important to do well on the exam.
How are financial statements prepared?
Financial statements are prepared from the data provided by the accounting system.
Accounts that fall under revenues and expenses become a part of what?
The income statement
Accounts that fall under assets, liabilities, and owners’ equity are used to do what?
Construct the balance sheet.
Define accrual entries
Accrual accounting is based on the principle that revenues should be recognized when earned and expenses should be recognized when incurred, irrespective of when the actual exchange of cash occurs. The timing difference between cash movements and recognition of revenues or expenses explains the need for accrual entries. When cash is transferred in the period that the related revenue/expense is recognized, there is no need for accrual entries.
What are the four types of accrual entries:
Unearned (or deferred) revenue
Unbilled or accrued revenue
Prepaid expenses
Accrued expenses
In accrual entries, define unearned (or deferred) revenue.
Unearned (or deferred) revenue arises when a company receives a cash payment before it provides a good or a service to the customer. Because the company still has to provide the good/service, unearned revenue is recognized as a liability. Unearned revenue is subsequently earned once the good is sold or the service is provided.
In accrual entries, unbilled or accrued revenue
Unbilled or accrued revenue arises when a company provides a good or service before receiving the cash payment. Because the company is owed money, accrued revenue is recognized as an asset.
In accrual entries, prepaid expenses
Prepaid expenses arise when a company makes a cash payment before recognizing the expense. Expenses that have been paid in advance are an asset of the company.
In accrual entries, accrued expenses
Accrued expenses arise when a company recognizes an expense in its books before actually making a payment for it. Because the company owes a payment, the accrued expense is treated as a liability.
For cash movement PRIOR to accounting recognition, what is the originating entry and adjusted entry for unearned (deferred) revenue?
Unearned (deferred) Revenue
Originating Entry
Record cash receipt and establish a liability
Adjusted Entry
Reduce the liability and recognize revenue
For cash movement PRIOR to accounting recognition, what is the originating entry and adjusted entry for prepaid expense?
Prepaid Expense
Originating Entry
Record cash payment and establish an asset
Adjusting Entry
Reduce the asset and recognize the expense
For cash movement AFTER accounting recognition, what is the originating entry and adjusted entry for unbilled (accrued) revenue?
Unbilled (accrued) Revenue
Originating Entry
Record revenue and establish an asset
Adjusted Entry
When billing occurs, reduce unbilled revenue and increase accounts receivable. When cash is collected, eliminate the receivable.
For cash movement AFTER accounting recognition, what is the originating entry and adjusted entry for accrued expenses?
Accrued Expenses
Originating Entry
Establish a liability and record an expense
Adjusted Entry
Reduce the liability as cash is paid
Define valuation adjustments
Most assets and liabilities are recorded on the balance sheet at their historical cost. However, accounting standards require certain items to be shown on the balance sheet at their current market values. The upward or downward adjustments to the values of these assets and liabilities are known as valuation adjustments. For example, if there is a decline in the value of an asset, the new decreased value is recorded on the balance sheet and the amount of the decrease in value is recognized as a loss either on the income statement or in other comprehensive income.
In an accounting system, information flows through four stages:
Journal entries
General ledger
Trial balance
Financial statements
