#cfa-level-1 #reading-23-financial-reporting-mechanics #summary
The accounting process is a key component of financial reporting. The mechanics of this process convert business transactions into records necessary to create periodic reports on a company. An understanding of these mechanics is useful in evaluating financial statements for credit and equity analysis purposes and in forecasting future financial statements. Key concepts are as follows:
Business activities can be classified into three groups: operating activities, investing activities, and financing activities.
Companies classify transactions into common accounts that are components of the five financial statement elements: assets, liabilities, equity, revenue, and expense.
The core of the accounting process is the basic accounting equation: Assets = Liabilities + Owners’ equity.
The expanded accounting equation is Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends.
Business transactions are recorded in an accounting system that is based on the basic and expanded accounting equations.
The accounting system tracks and summarizes data used to create financial statements: the balance sheet, income statement, statement of cash flows, and statement of owners’ equity. The statement of retained earnings is a component of the statement of owners’ equity.
Accruals are a necessary part of the accounting process and are designed to allocate activity to the proper period for financial reporting purposes.
The results of the accounting process are financial reports that are used by managers, investors, creditors, analysts, and others in making business decisions.
An analyst uses the financial statements to make judgments on the financial health of a company.
Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.