Financial Statement Structure and Composition
Q: How important is it for analysts to understand specific accounting entries involved in individual transactions (debits and credits), given that analysts are primarily consumers of accounting information as opposed to producers of accounting information?
A: That’s a very good question.
An understanding of specific accounting entries enables an analyst to understand the impact a transaction has on an income statement balance or a balance sheet balance – or on both.
It allows an analyst to quickly spot errors in company prepared statements, especially, in which abnormal or negative balances may appear for balance sheet accounts, such as receivables or payables. If such abnormal or negative balances appear, they signal a faulty set of accounting entries, which means the balance is incorrect and any performance ratio using the balance or balances is incorrect. The analyst needs to understand how the errors may have occurred and how the fix would impact various income statement and balance sheet accounts.
Further, an understanding of specific accounting entries is essential for understanding how to create a true cash flow statement for a borrower, such as the Uniform Credit Analysis (UCA) cash flow statement. Without an understanding of specific accounting entries for specific transactions, an analyst cannot properly identify balance sheet counterpart accounts to income statement and expense accounts, which is a critical step in constructing a UCA cash flow statement.
In sum, we might conclude that a lack of understanding of specific accounting entries and their impact on income statement and balance sheet amounts leaves the analyst processing data for which he or she has little understanding or appreciation.
Q: If Sequoia Properties and Clovis Supply were not related parties, would we still account for the transactions in the same way?
A: Yes, the transactions would be accounted for the same way. A “due from” account is an asset account, a receivable from a third party, whether related or not. A “due to” account is a liability account, an amount owed to a third party, whether related or not.
The issue is whether the amounts due from or due to another party are to be repaid within the next time period and, therefore, represent a current asset or current liability. If an amount due from or due to another party is due and payable beyond the next period, it is classified as a long-term asset or liability. If a payment schedule is associated with such a long-term asset or liability, the amount due and payable in the next operating period would be reported as a current portion, with the remaining balance classified as a long-term asset or liability.
Course overview: Financial Statement Structure and Composition