An analyst does not have access to the detailed information that flows through a company's accounting system, butseesonly the end product, the financial statements.
An analyst needs to understand the various accruals, adjustments, and management assumptions that go into the financial statements. Much of this detail is contained in the foomotes tothe statements and Management's Discussion and Analysis, so itis crucial for an analyst to review these parts of the financial statements. With this information, the analyst can better judge how wen the financial statements reflect the company's true performance and what adjustments to the data are necessary for appropriate analysis.
Because adjustments and assumptions within the financial statements are, at least to some extent, at the discretion of management, the possibility exists that management may attempt to manipulate or misrepresent the company's financial performance. A good understanding of the accounting process can hel p an analyst identify financial statement entries that appear to be our of line.
Page 26 ©2008Schweser
,)[udy Sc"ioll l Cross-Reference [0CFA Institute Assigned Reading #30 - Financial Reportingl\tlechanic~
1. Business transactions can be categorized as operating activities, the firm's
ordinary business; investing activities, purchasing, selling, and disposingof'long- term assets; andfinancing activities, raising and repaying capital.
2. Transactions are recorded in accounts that form the financial statement elements of assets, liabilities, owners' equity, revenues, and expenses.
3. Assets are the firm's economic resources. Liabilities are creditors' claims on the firm's resources.
4. Owners' equity includes paid-in capital (common and preferred stock), retained earnings, and cumulative other comprehensive income.
5. Revenue includes sales, investment income, and gains. Expenses include the cost of goods sold, selling and administrative expenses, depreciation, interest
expense, tax expense, and losses.
6. The basic accounting equation is:
assets =liabilities +owners' equity The expanded accounting equation is:
assets =liabilities + contributed capital +ending retained earnings
7. To keep the accounting equation in balance, each transaction has to be recorded in at least two accounts.
8. A firm must recognize revenues when they are earned and expenses when they are incurred. Accruals are required when the timing of cash payments does not match the timing of the revenue or expense.
9. The balance sheet shows a company's financial position at a point in time.
Changes in the balance sheet during an accounting period are reflected in the income statement, the cash flow statement. and the statement of owners' equity.
10. Information enters an accounting system as journal entries; which are socred by account into a general ledger. Trial balances are formed at the end of an
accounting period. Accounts are then adjusted and presented in financial statements.
11. A security analyst must understand the accounting process used to produce the financial statements, including management's adjustments and assumptions. in order to determine whether the data are reasonable.
Srudy Session -::
Cross-Reference toCFA instituteAssigned Reading#30 - Financial Reporting Mechanics
Page 28
1.
2.
3.
4.
5.
5.
Richland Paper is a manufacturer of folding carrons for packaging retail items.
This year the company acquired a new cuning machine that it expects to use for the next eight years. This purchase should be classified as a(n):
A. operating activity.
B. investing activity.
C. financingactivit~"
D. economic activity.
Sparra Distributors, a wholesaler. has obtained a $5 million lO-year loan from Stoddard National Bank. How should each firm bestc1assifv this transaction?
Sparra Distriburors Sroddard Nat'! Bank A. Investing activity Financing activity B. Investing activity Operating activity C. Financing activity Financing activity D. Financing activity Operating activity
Accounts receivable and accounts payable aremost likeL), classified as which financial statement elements?
Accounts receivable Accounts pa~'able
A. Assets Liabi!i ties
B. Assets Expenses
C. Revenues Liabilities
D. Revenues Expenses
Annual depreciation and accumulated depreciation are most Likelyclassified as which financial statement elements?
Depreciation Accumulated depreciation A. ::'xpenses Contra liabilities
B. Expenses Contra assets C. Liabilities Contra liabilities D. Liabilities Contra assets
The accounting equation is Leastaccurate~J' stared as:
A. owners' equity=liabilities - assets.
B. liabilities =assets - contributed capital - ending retained earnings.
C. ending retained earnings = assets - contributed capital - liabilities.
D. assets =liabilities +contributed capital + beginning retained earnings + revenue - expenses - dividends.
A decrease in assets would Least Like£v be consistent with a(n):
A. increase in expenses.
B. decrease in revenues.
C. decrease in liabilities.
D. increase in contributed capital.
(1;J200HSchwcscr
Study Session 7 Cross-Reference to CFA Institute Assigned Reading #30 - Financial Reporting Mechanics 7. An electrician repaired the light fixcures in a retail shop on October 24 and
sept the bill to the shop on November 3. If both the electrician and the shop prepare financial statements under the accrual method on OCtober 31, how will they each record this transaction?
Electrician Retail shop A. Accrued revenue Accrued expense B. Accrued revenue Prepaid expense C. Unearned revenue Accrued expense D. Unearned revenue Prepaid expense
8. If a firm raises $10 million by issuing new common stock, which of its financial statements will reflect the transaction?
A. Income statement and statement of owners' equity.
B. Balance sheet, income statement, and cash flow statement.
C. Balance sheet, cash flow statement, and statement of owners' equity.
D. Balance sheet, income statement, cash flow statement, and statement of owners' equity.
9. An auditor needs to review all of a company's transactions that took place between August 15 and August 17 of the current year. To find this information, she would most!ike!yconsult the company's:
A. general ledger.
B. general journal.
C. financial statements.
D. adjusted trial balance.
10. Paul Schmidt, a representative for WeStby Investments, is explaining how securiry analysts use the results of rhe accounting process. He states, "Analysts do not have access to all the enrries that went into creating a compcmy's financial statements. If the analyst carefully reviews the auditor's report for any instances where the financial statements deviate from the appropriate
accounting principles, he can then be confident that management is not manipulating earnings." Schmidt is:
A. correct.
B. incorrect, because the entries that went into creating a companv's financial statements are publicly available.
C. incorrect, because management can manipulate earnings even within the confines of generally accepted accounting principles.
D. incorrect, because the entries that went into creating a company's financial statements are publicly available and because management can manipulate earnings even within the confines of the accounting principles.
©211118 S.:hwc:scr
SIULh S"",iol1 -
Cross-Refcrcncc!(1 CFA Institutc A,;sigllcJ Reading #30 - Financial Rcporting Mechanics
For each aL'('ounr listed, indicate whether the aCCOUIH should be classined asAssets (A), Liabilities (L), Ownets' Equit~,(0), Re\'enues (R), or Expenses (X),
ACCOllIH Financial statement e1emenr
Accountspa~'able A L 0 R X
Accounrs receivable A L 0 R X
Accumulated depreciation A L 0 R X
Additional paid-in capital A L 0 R X
Allowance for bad debts A L 0 R X
Bonds payable A L 0 R X
Cash equivalents A L 0 R X
Common srock A L 0 R X
Cost of goods sold A L 0 R X
Currenr porricm of long-term debt A L 0 R X
Deferred tax items A L 0 R X
Depreciation A L 0 R X
Dividends payable A L 0 R X
Dividends received A L 0 R X
Gain on sale of assets A L 0 R X
Goodwill A L 0 R X
Invenron' A L 0 R X
Investment securities A L 0 R X
Loss on sale of assets A L 0 R X
Notespa~'able A L 0 R X
Other comprehensive income A L 0 R X
Prepaid expenses A L 0 R X
Property, plant and equipment A L 0 R X
Retained earnings A L 0 R X
Sales A L 0 R X
Unearned revenue A L 0 R X
Page 30 ©2008Schweser
Study Session 7 Cross-Reference to CFA Institute Assigned Reading #30 - Financial Reporting Mechanics
ANSWERS - CONCEPT CHECKERS ,: . '~ .' "-':', < .
~. ~ .> . . . ' ,
" -. . , ' . -
1. B Purchasing properry, plant and equipment is an investing activity,
2. D Obtaining a long-term loan is a financing activity for the wholesaler. For a Sank, however, providing loans is its primary business, so making the loan would be best classified as an operating activity.
3. A Accounts receivable are an asset and accounts payable are a liability.
4. B Annual depreciation is an expense. Accumulated depreciation is a contra asset account that typically offsets the historical COSt of property, plant, and equipment.
5. A Owners' equity is equal to assets minus liabilities.
6, D The expanded accounting equation shows that assets =liabilities+contributed capital + beginning retained earnings +revenue - expenses - dividends. A decrease in assets is consistent with an increase in expenses, a decrease in revenues, or a decrease in liabilities, but not with an increase in contributed capital.
7. A The service is performed before cash is paid. This transaction represents accrued revenue to the electrician and an accrued expense to the retail shop. Since the invoice has not been sent as of the statement date, it is not shown in accounts receivable or accounts payable.
8. C The $10 million raised appears on the cash flow statement as a cash inflow from financing and on the statement of owners' equity as an increase in contributed capital.
Both assets (cash) and equity (common stock) increase on the balance sheet. The income statement is unaffected by stock issuance.
9. B The general journalll.srs all of the company's transactions by date. The general ledger lists them by account.
10. C Schmidt is correct in stating that analysts do not have access to the detailed accounting entries that went into a company's financial statements. However, he is incorrect in stating that an analyst can be sure management is not manipulating earnings if the audit report does not list deviations from accounting principles. Because accruals and many valuations require management's judgment, there is considerable room within the accounting standards for management to manipulate earnings.
©2008 S.:hweser Page 31
~llld\' ~cssi"l1 -
Cross-Referenceto eFA l11stillltc Assi[!;ned Reading#30 - Financial Reporting Mechanics
:"ccollnt Financial statement element
:"ccounts payable L
,"'ccounts receivable A
Accumulated depreciation A
COlmatothe asset being depreciated.
Additional paid-in capital 0
Allowance for bad debts A
Contra to accounts receivable.
Bonds payable L
Cash equivalents A
Common srock 0
COSt of goods sold X
Current ponion oflong-term debt L
Deferred tax items A L
Both deferred tax assets and deferred tax liabilities are recorded.
Depreciation X
Dividends pa:'able L
Dividends received R
Gain on sale of assets R
Goodwill A
In;angible asset.
Inventor\, A
Investment securities A
Loss on sale of assets X
Notes payable L
Other comprehensive income 0
Prepaid expenses A
Accrual account.
Property, plant and equipment A
Retained earnings 0
Sales R
Unearned revenue L
Accrual account.
Page 32 ©2008Schwescr
The following is a review of the Financial Statement Analysis principles designed toaddress the learning outcome statements set forth by CFA Instituter". This topic is also covered in:
FINANCIAL REpORTING STANDARDS
Study Session 7 EXAM Focus
This copic review covers accounring standards: why they exist, who issues them, and who enforces them. Know the difference between the roles of private standard-serring bodies and government regulacory aurhorities and be able co name the most important organjzations of both kinds. Become familiar with the framework for Inrernational Financial Reporting Standards, including
qualitative characteristics, constraints and assumptions, and principles for preparing and presenting financial statements. Be able co identify barriers co convergence of national accounting standards (such as U.S. GAAP) with IFR5, key differences between the IFR5 and GAi\.P frameworks, and elements of and barriers to creating a coherent financial reporting network.