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;
- Operating activities are those activities that are part of the day-to-day business functioning of an entity.
- Investing activities are those activities associated with acquisition and disposal of long term assets
- Financing activities are those activities related to obtaining or repaying capital. The two primary sources for such funds are owners or creditors.
Understanding the nature of activities helps the analyst understand where the company is doing well and where it is not doing so well. Ideally an analyst would prefer that most of company’s profits (and cash flow) come from its operating activities.
b. Explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements;
Business activities resulting in transactions are reflected in the broad groupings of financial statements elements: Assets, Liabilities, Owner’s Equity, Revenue and Expenses. Accounts are individual records of increases and decreases in specific elements.
Assets are the economic resources of the company; Liabilities are the creditor’s claims on the resources of a company; owners’ equity is the residual claim on those resources; revenues are inflows of economic resources to the company; and expenses are outflows of economic resources or increase in liabilities.
The actual accounts used in a co’s accounting system will be set forth in a chart of accounts. Generally the chart of accounts is far more detailed than the information presented in financial statements.
Any account that is offset or deducted from another account is called a “contra account”. Common contra assets accounts include allowance for bad debts, accumulated depreciation and sales returns and allowances.
For presentation purposes assets (and liabilities) are sometimes categorized as “current” or “noncurrent”. Noncurrent are assets (or liabilities) that are expected to benefit (or cost) the company over an extended period of time (usually more than one year). Current are those that are expected to be consumed (or repaid) in the near future (less than one accounting cycle).
c. Explain the accounting equation in its basic and expanded forms;
Assets = Liabilities + Owner’s Equity
Owner’s Equity = Contributed capital + retained earnings
Net Income (Loss) = Revenue – Expenses
รจ Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses - Dividends
The statement of retained earnings shows the linkage between the balance sheet and income statement.
d. Explain the process of recording business transactions using an accounting system based on the accounting equations;
An accounting system will translate the company’s business activities into usable financial records. Every transaction has to be entered twice (hence double-entry accounting). e.g. increase in one asset and decrease in another; or increase in one asset and decrease in liabilities
To record transaction the following steps are taken:
- identify which accounts are affected, by what amount and whether the accounts are increased or decreased; - determine the element type for each account and whether it fits in the basic accounting equation; - using information from previous steps enter amounts in the appropriate column of the spreadsheet; - verify that the accounting equation is still in balance
e. Explain the need for accruals and other adjustments in preparing financial statements;
Accrual accounting requires that revenue be recorded when earned and that expenses be recorded when incurred, irrespective of when the related cash movements occur. The purpose of accrual entries is to report revenue and expense in the proper accounting period.
Cash movement may occur before or after accounting recognition, in which case accrual are required. There are four types of accrual entries:
- Unearned (deferred) revenue – arises when a company receives cash prior to earning the revenue;
- Unbilled (accrued) revenue – arises when a company earns revenue prior to receiving cash but has not yet recognized the revenue at the end of accounting period;
- Prepaid expense – arises when a company makes a cash payment prior to recognizing an expense;
- Accrued expenses – arise when a company incurs expenses that have not yet been paid as of the end of an accounting period;
Valuation adjustments are made to a company’s assets or liabilities only when required by accounting standards, so that the accounting records reflect the current market value rather than the historical costs.
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;
This point cannot be easily summarized. I strongly recommend referring to the optional part of the prescribed book pp 72 -87. It is a very good example on how to create “T” type accounts and convert them into various statements.
Note that balance sheet will show position at the time of preparing the statements. Other statements such as income, cash flow and changes in owner’s equity show activities throughout the given accounting period.
g. Describe the flow of information in an accounting system;
1. Journal entries and adjusting entries – The business transactions are recorded chronologically as they occur. Adjusting journal entries, a subset of journal entries, typically made at the end of accounting period to record items such as accrual that are not yet reflected in the accounting system.
2. General ledger and T-accounts - A ledger is a document or computer file that shows all business transactions by account. T-accounts are representations of ledger accounts and are frequently used to describe or analyze accounting transactions.
3. Trial balance and adjusted trial balance – A trial balance is a document that lists account balances at a particular point in time. It shows total ending balances of each account. Adjusted trial balance is the same but included all the adjusting entries.
4. Financial statements – Financial statements, final product of accounting system are prepared based on the account totals from an adjusted trial balance.
h. Explain the use of the results of the accounting process in security analysis.
Analysts typically will not have access to the accounting system or individual entries. They will need to infer what transactions were recorded by examining the financial stmts. Analysts may need to make adjustments to reflect times not reported in the statements; analysts may also need to assess the reasonableness of mgmt judgment.
- The use of judgment in account entries
- Misrepresentations – entries could be structured in a way to create nonexistent liabilities / assets that cover fictitious money amounts.
