Financial Reporting Mechanism Notes

Financial Reporting Mechanism

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Definition

Financial Reporting Mechanics is a system of concepts and principles that supports the preparation of financial statements.

In other words

Financial Reporting Mechanics are the detailed guidelines for accountants who prepare the financial statements, these mechanics supports in the preparation of F/S.

Why is it important?

Most preparers and users of F/S identifies that there is a need for a certain reporting mechanism and that this can be useful in following ways

• help the accounting bodies to set accounting standards

• assist the national accounting bodies to develop accounting standards for their country

• provide guidance to accountants in preparing financial statements (F/S)

• help auditors to form an opinion

• assist users in understanding F/S

Note: Accounting standards is a separate topic, see the relevant lesson

Lecture Notes

The five elements

The Financial reporting mechanics identifies three elements relating to the statement of financial position, being assets, liabilities and equity, and two relating to the income statement, being income and expenses.

The definitions and recognition criteria of these elements are very important and these are considered in detail below . (given by International accounting framework)

An asset is defined as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Assets are presented on the statement of financial position. Examples of assets include long lived assets, Debtors (receivables) and inventory.

A liability is defined as an obligation of the entity arising from past events. Liabilities are also presented on the statement of financial position Examples of liabilities include trade payables, tax payable and loans.

Equity is defined as the residual interest in the assets of the entity after deducting all its liabilities. Equity includes the original capital introduced by the owners, ie share capital and share premium, the accumulated retained profits, i.e. retained earnings.

Income is defined as the increases in economic benefits during the accounting period in the form of inflows. Most income is revenue generated from the normal activities of the business in selling goods and services

Expenses are defined as decreases in economic benefits during the accounting period in the form of outflows. Examples of expenses include depreciation, rent, insurance and purchases.

The Accounting Equation

Assets = Liabilities + Capital

Example:

Assets = Liabilities + Capital

1000 = 200 + 800

Expanded Accounting Equation

(Noncurrent Assets + Current Assets) = (Noncurrent Liabilities + Current Liabilities) + (Opening capital + profit - drawings)

Example:

Noncurrent Assets ?

Current Assets 10000

Noncurrent Liabilities 2000

Current Liabilities 10000

Opening capital 12000

profit for the year 35000

drawings 12000

Solution:

Rearrange the equation

Noncurrent assets = (Noncurrent Liabilities + Current Liabilities) + (Opening capital + profit - drawings) - Current Assets

Noncurrent assets = (2000 + 10000) + (12000 + 35000 - 12000) - 10000

Noncurrent assets = 37000

There are many ways of presenting accounting equation but the equation must be balanced on both sides.

Double Entry Bookkeeping

According to dual aspect concept of accounting, every financial transaction has equal effects in at least two different accounts. It is used to satisfy the equation

Assets = Liabilities + Equity

There are two sides in bookkeeping known as DEBIT and CREDIT, following summary will help to understand which items to be recorded on debit / credit

Financial Statements Mechanics - Accruals Accounting

Accrual accounting means that revenues should only be recognised in the F/S when it is earned not when it is received, and expenses should be recorded when it is occurred and not when it is paid, Following are the different categories of accrual accounting.

Accrued Revenues: means revenues are earned but the payment is not yet received from customers. The company records the revenue in the income statement when the goods are delivered/ invoiced and records accounts receivable (current asset) in the balance sheet until the payment received from customers.

Unearned Revenue: Some businesses receive money in advance but the revenue in income statement is not recognized until the goods are delivered. In this situation the entity records a liability for unearned income in the balance sheet. Unearned income is decreased as revenue is earned over time.

Accrued Expenses: Many organizations purchase goods or services on credit and pay for them at later. When the goods or services are delivered the amount is recorded as expense in the income statement and accounts payable (current liability) in the balance sheet. When the company pays the expense, the accounts payable account is decreased.

Prepaid Expenses: Some businesses pays in advance. A prepaid expense account (current asset) is recorded in...

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