Note: References to the relevant sections of the FASB’s Accounting Standards Codification® and to other publications of the FASB are provided throughout Section A. The references are supplied for candidates who wish to do further research on the topics. Candidates are not expected to memorize the relevant reference numbers.
Financial accounting is the process of reporting the results and effects of the financial transactions a business undertakes. The objective of financial reporting is to provide useful financial information about the entity for decision-making. Those using the financial information to make decisions include present and potential equity investors, lenders, and other creditors who need to make decisions about providing resources to the entity. The decisions relate to buying, selling, or holding debt or equity instruments and providing credit. The investors, lenders, and other creditors need information that will help them assess the amount of, timing of, and prospects for future net cash inflows to the entity to make their decisions.2 Other users who may or may not be providing capital to the firm—such as management, employees, financial analysts, and regulators—may find financial statements useful as well.
The types of decisions potential investors, lenders, and other creditors are making are numerous and varied. It is not possible for accounting information to provide all the information that all users need to make their decisions. Users need to access information from other sources as well, such as economic forecasts, the political climate, and industry outlooks.3 However, the financial statements do attempt to provide as much useful information as possible. Users of Financial InformationPublished financial information must comply with the established accounting standards because outside users will rely on it to make a variety of decisions. Accounting standards are in place to protect outside users by ensuring that the information is accurate and useful and can be understood by everyone. Because so many people are using financial information for so many diverse purposes, the reasons people need the financial information are also diverse, such as:
• Making investment decisions.• Extending or withholding credit.• Assessing areas of strength and weakness within the company.• Evaluating management performance.• Determining whether or not the company is complying with regulatory requirements.
Users of financial information can be classified by various distinctions:Direct and Indirect Users. Direct users are directly affected by the results of a company. Direct users include investors and potential investors, employees, management, suppliers, and creditors. Direct users stand to lose money if the company has financial problems.Indirect users are people or groups who represent direct users. They include financial analysts and advisors, stock markets, and regulatory bodies.
Internal and External Users. Internal users make decisions within the firm. External users make decision from outside of the firm about whether or not to begin a relationship, continue a relationship, or change their relationship with the firm.
Note: Users of financial statements are assumed to have a reasonable knowledge of business and economic activities and to be willing to study the information with reasonable diligence. Those assumptions are important because they mean that, in the preparation of financial statements, a reasonable level of competence on the part of users can be assumed. Someone who has a “reasonable understanding” of business, accounting, and economic activities should be able to read the financialinformation and understand it.
The Financial Statements The five financial statements used by business entities under U.S. Generally Accepted Accounting Principles (GAAP) are:1) Balance sheet (also called the statement of financial position)2) Income statement3) Statement of comprehensive income4) Statement of changes in stockholders’ equity5) Statement of cash flows
Note: The notes to financial statements are also considered an integral part of the financial statements but are not an actual financial statement. The purpose of the notes is to provide informative disclosuresrequired by U.S. GAAP.
Note: A company can also prepare prospective financial statements. Prospective financial statements are financial statements based on a set of assumptions that present projected information about a future period. Whenever prospective financial statements are prepared, the significant accounting policies and significant assumptions used need to be disclosed.
Differences Between IFRS and U.S. GAAP
IFRS stands for “International Financial Reporting Standards,” a widely accepted set of accounting principles used in many countries around the world. IFRS is primarily a principles-based set of accounting standards with few practical examples and limited interpretative guidance. Neither acting as a tax standard nor applying to government organizations, IFRS is intended for multiple countries with different cultural, legal, and commercial standards.
IFRS’s main objective is to be more open and flexible; therefore, the standard-setters leave interpretation to companies and their auditors, resulting in greater flexibility. As a result, companies and their auditorscan interpret IFRS differently. The significance of these differences in interpretation will vary from company to company, depending on factors such as the nature of the company’s operations, the industry in which it operates, and the accounting policies it chooses.
U.S. GAAP, on the other hand, is largely a rules-based body of standards with extensive interpretive guidance for individual industries and specific examples for auditors and practitioners. It applies to United States-based entities and foreign companies that participate in the U.S. financial markets. In addition, the standard-setters actively interpret the standards. This active participation often results in a proscriptive approach in U.S. GAAP that reflects the strong regulatory environment in the United States.
Because many of the countries in the world have adopted IFRS, think of IFRS as “International” GAAP compared to “U.S.” GAAP. Despite their differences, the general principles, conceptual framework, and accounting results between U.S. GAAP and IFRS are often very similar, if not the same, because the two standards are more alike than different for most common transactions.For the exam, candidates need to know what IFRS is and some specific differences between U.S. GAAP and IFRS.
These specific differences appear in orange boxes following the related U.S. GAAP coverage of the topic.
1) The Balance Sheet (Statement of Financial Position)
Note: Guidance in the Accounting Standards Codification® on presentation of the balance sheet is in ASC 210.
The balance sheet, also called a statement of financial position, provides information about an entity’s assets, liabilities, and owners’ equity at a point in time (usually the end of a reporting period). The balance sheet shows the entity’s resource structure—the major classes and amounts of its assets—and its financing structure—the major classes and amounts of its liabilities and equity. The balance sheet provides a basis for computing rates of return4, evaluating the capital structure of the business, and predicting a company’s future cash flows. It helps users to assess the company’s liquidity, financial flexibility, solvency, and risk.
• Liquidity refers to the time expected to elapse until an asset is converted into cash or until a liability needs to be paid. The greater a company’s liquidity is, the lower will be its risk of failure.
• Financial flexibility is the ability of a business to take actions to alter the amounts and timing of its cash flows that enable the business to respond to unexpected needs and take advantage ofopportunities.
• Solvency refers to the company’s ability to pay its long-term obligations when they are due. A company with a high level of long-term debt relative to its assets has lower solvency than a company with a lower level of long-term debt.
• Risk refers to the unpredictability of future events, transactions and circumstances that can affect the company’s cash flows and financial results.
The statement of financial position can also be used in financial statement analysis to assess a company’s ability to pay its debts when due and its ability to distribute cash to its investors to provide them an adequaterate of return.
A balance sheet is not intended to show the value of a business. However, along with other financial statements and other information, a balance sheet should provide information that will be useful to someone who wants to make his or her own estimate of the business’s value.
Balance sheet accounts are permanent accounts. Balance sheet accounts are not closed out at the end of each accounting period as income statement accounts are, but rather their balances are cumulative. They keep accumulating transactions and changing with each transaction, year after year.
Elements of the Balance Sheet
Elements of the balance sheet include assets, liabilities, and stockholders’ (or owners’) equity.
Assets are probable future economic benefits that have been obtained or are controlled by an entity as a result of past transactions or events. Thus, an asset:
• Arose from a past transaction
• Is presently owned by the company
• Will provide a probable future economic benefit to the company
Note that the preceding definition encompasses three time periods: the past, the present owned, and the future.
Liabilities are probable future sacrifices of economic benefits due to present obligations of an entity to transfer assets or provide services in the future, resulting from past transactions or events.
Thus, a liability:• Arose from a past transaction
• Is presently owed by the company
• Will lead to a probable future sacrifice of economic benefits by the company
As with the definition of an asset, the definition of a liability encompasses the past, the present and the future.
Equity represents the entity’s net assets, or the residual (remaining) interest in the assets of the entity after deducting its liabilities from its assets.
For a business entity, equity is the ownership interest.
Current and Non-Current Classification of Assets and Liabilities
On the balance sheet, assets and liabilities are classified as either current or non-current. Generally, current assets and liabilities are short-term and non-current assets and liabilities are long-term, but the more correct terminology is “current” and “non-current” for both assets and liabilities. Whether an asset or liability is classified as current or non-current depends on the time frame in which the entity expects an asset to be converted into cash or a liability to be settled.
Current Assets
Current assets are cash and other assets or resources that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.
Note: The operating cycle is defined in the Master Glossary in the FASB’s Accounting Standards Codification ® as the average time between the acquisition of materials or services and their final cash realization.
Per ASC 210-10-45-3, a one-year time period is to be used as the basis for the segregation of current assets when an entity has several operating cycles occurring within a year. However, if the period of an entity’s operating cycle is greater than twelve months, for example as in the tobacco, distillery, andlumber businesses, the longer period is used as the entity’s operating cycle. If an entity has no clearly defined operating cycle, the one-year rule governs.
Current assets are perhaps the easiest of the various sections of the balance sheet to identify. They include:
• Cash available for current operations, including coins, currency, undeposited checks (checks that have been received but have not yet been deposited in the bank), money orders and drafts, and demand deposits.
• Cash equivalents. Short-term, highly liquid investments that are convertible to known amounts of cash without a significant loss in value and have maturities of 3 months or less from the date of purchase.
• Marketable securities classified as current assets. Marketable debt and equity securities that represent the investment of cash available for current operations.7 Marketable securities classified as trading securities are almost always current assets. Marketable securities other than trading securities may or may not be classified as current assets, depending on management’s intention. Marketable debt securities classified as available-for-sale are current assets if they are considered working capital available for current operations, regardless of their maturity dates. Marketable debt securities classified as held-to-maturity are current assets only if their maturity is within one year or the length of the firm’s operating cycle, whichever is longer. Marketable equity securities may or may not be classified as current assets, depending on management’s intention.
• Receivables. Trade accounts receivable, notes receivable, and acceptances receivable. Receivables from officers, employees, affiliates and others are also current assets if they are collectible in the ordinary course of business within one year or the firm’s operating cycle.
• Contract assets classified as current assets. Under the revenue recognition ASC 606, contract assets represent an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditional on something other than the passage of time, for example the entity’s future performance, before the entity can invoice the customer. Contract assets may be current assets or non-current assets or both, depending on the facts and circumstances such as when receipt of payment is expected, based on the agreement with the customer. Contract assets are explained in the Revenue Recognition topic in this volume.
• Short-term notes receivable if they conform generally to normal trade practices and terms within the business.
• Inventories. Merchandise on hand and available for sale and, for a manufacturer, raw materials and work-in-process as well as finished goods. Operating supplies and ordinary maintenance material and parts are also inventories.
Prepaid expenses. Amounts paid in advance for the use of assets such as rent paid at the beginning of a rental period or amounts paid for services to be received at a future date. An insurance premium paid at the beginning of a policy period for insurance coverage to be received during the portion of the future policy period that will occur during the coming operating cycle is a current prepaid expense. Prepaid expenses are not convertible to cash, but they are classified as current assets because they would have required the use of current assets during the coming operating cycle if the expenses had not been prepaid.
• Funds that are restricted for current purposes. If cash or cash equivalents are being held for a current purpose, such as for payment of current obligations due within a year or the operating cycle, whichever is longer, or as a compensating balance to support short-term borrowing, the cash should be reported on a separate line in the current assets section of the balance sheet.
Non-Current AssetsNon-current assets are assets or resources other than those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.Non-current assets include:
• Cash and claims to cash that are restricted as to withdrawal or use for other than current operations, that are designated for the acquisition or construction of non-current assets, or that are segregated for the liquidation of long-term debts. The restricted cash should be reported on a separate line in the investments or other assets section as non-current assets.
• Marketable securities, including stocks, bonds, and long-term notes receivable that do not represent the investment of cash available for current operations. Even though a security may be readily marketable, if management does not intend to convert it to cash within one year or the company’s operating cycle, whichever is longer, it should be classified as a non-current asset. An available for sale debt security with a maturity date that would otherwise cause it to be classified as a current asset should also be classified as a non-current asset if management does not consider it to be available for current operations. A held-to-maturity debt security is normally classified as a noncurrent asset until its maturity date is within one year or the length of the firm’s operating cycle, whichever is longer.
• Long-term investments or advances, whether marketable or not, made for the purpose of obtaining control, for affiliation, or other continuing business advantage.
• Property, plant, and equipment.
• Right-of-use assets obtained under lease agreements.
Note: The FASB has not specified whether right-of-use assets obtained under lease agreements are to be considered tangible or intangible assets.
• Intangible long-term assets.
• Other long-term assets such as long-term prepaid expenses, prepaid pension cost, and receivables arising from unusual transactions not expected to be collected within twelve months.
• Contract assets under ASC 606 that are not expected to be converted to cash within one year or the operating cycle, whichever is longer.
• Net deferred tax assets.
• The cash surrender value of life insurance policies on the lives of key employees.
• Other non-current assets not included in other categories, such as non-current receivables, long term prepayments, and restricted cash or securities or assets in special funds.
Property, Plant, and Equipment (Fixed Assets)
Property, plant, and equipment (PP&E) are tangible assets used in operations that will continue to be used beyond the end of the current period. When the fixed assets are purchased, they are recorded at their cost, including shipping-in and installation costs needed to bring the asset to usable condition. The cost is then expensed over the life of the asset through depreciation, amortization, or depletion (except for land, which is not depreciated).
Examples of property, plant, and equipment include:
• Land, buildings, machinery, furniture, equipment, and vehicles
• Leasehold improvements, or improvements made to leased property at the lessee’s expense
• Assets obtained by means of a lease agreement
• Natural resources, such as gas, minerals, or timberland Natural resources other than land are depleted; property, plant, and equipment other than land are depreciated; and leasehold improvements are amortized. Land is not depreciated, amortized, or depleted because land is not used up and does not wear out.
Intangible Long-term Assets
Intangible assets do not have physical substance, but they provide benefit to the firm. Intangible assets may be either purchased or developed internally. However, because an asset recorded on the balance sheet comes about only by means of a prior transaction, internally generated intangible assets are not recorded on the balance sheet.
Examples of intangible assets are copyrights, patents, goodwill, trademarks, and franchises. An intangible asset with a limited life is amortized over its useful life. An intangible asset with an indefinite life, such as goodwill, is assessed periodically for impairment.
Current Liabilities
Current liabilities are obligations that will be settled through the use of current assets or by the creation of other current liabilities.Examples of current liabilities include:
• Accounts payable and trade notes payable due to suppliers for purchase of goods and services.
• Cash dividends payable.
• Contract liabilities representing an entity’s obligation under ASC 606, the revenue recognition standard, to transfer goods or services to a customer for which the entity has received consideration from the customer. Contract liabilities may be current liabilities or non-current liabilities or both, depending on the facts and circumstances such as when the entity expects to satisfy its performance obligations and how it satisfies its performance obligations—over time or at a point in time.
• Other deposits received from customers such as a security deposit on a lease.
• Agency collections such as employee tax withholdings and sales taxes, where the company acts as agent for another party (the government) and is obligated to remit the payments.
• Obligations due on demand according to their terms, such as demand notes.
• Short-term (30-, 60-, 90-day) notes.
• Current portions of long-term debt and lease liabilities (the portions of the principal due within the operating cycle, usually twelve months).
• Taxes payable, wages payable, and other accruals.
• Long-term obligations callable at the balance sheet date due to some violation by the company such as a violation of a loan covenant.9
• Assurance-type warranties10 for which the term of the warranty extends only into the next accounting period or the portion of a longer-term warranty that extends only into the next period.
Current liabilities do not include:
• Debts to be paid by funds in accounts classified as non-current.
• The portion of a short-term obligation intended to be refinanced by a long-term obligation, subject to fulfilling requirements as noted below.
Note: If the company can demonstrate that it has the intent and the ability to refinance an obligation that is coming due in the next twelve months, it may reclassify that obligation on the balance sheet as a non-current liability. Having a commitment from a bank for long-term financing of the obligation is an example of a way to demonstrate the ability to refinance it.
For example, when a company can show that it has the intent and the ability to refinance an obligation that is due in nine months, the company can show the obligation on its balance sheet as a non-current liability because management knows it will use the funds received from the future long-term financing to settle the existing debt. The company is replacing one kind of debt with another kind of debt.
Bank Overdrafts: An Item That Could Be Reported by Netting Against the Current Asset “Cash” or by Adding to the Current Liability “Accounts Payable”
Bank overdrafts are amounts by which a company’s checking account is in a negative position due to checks written that exceed the amount in the account. The management of the bank has discretion over whether a non-sufficient funds check will be honored, allowing the overdraft, or whether the non-sufficient funds check will be returned to the payee unpaid. If the bank honors the check and allows the overdraft in the payor’s account, the overdraft amount should be added to the payor’s accounts payable and reported as a current liability, unless the payor has cash in an amount greater than the overdraft in another account in the same bank. If enough cash is present in another account in the same bank, the net amount of cash available (the positive balance minus the negative balance) in that bank should be reported as part of cash, a current asset.
Non-current Liabilities
Non-current liabilities are liabilities that will not be settled within one year or the operating cycle if the operating cycle is longer than one year.
Examples of non-current liabilities are:
• Contract liabilities classified as non-current.
• Long-term notes or bonds payable.
• The long-term portions of long-term debt and lease liabilities (the portions of the principal due after the operating cycle (usually twelve months).
• Pension obligations.
• Net deferred tax liabilities.
• The non-current portion of assurance-type warranties for which the term of the warranty extends beyond the next accounting period.
Note: Most long-term debt is subject to various covenants and restrictions, requiring a great deal of disclosure in the financial statements.
Equity
Equity is the remaining balance of assets after the subtraction of all liabilities. Equity is the portion of the company’s assets owned by and owed to the owners. If the company were to be liquidated, equity represents the amount that would theoretically be distributable to the owners.
All business enterprises have owners’ equity, but the types of accounts in owners’ equity will differ depending on the type of the entity. The following discussion focuses on corporations, so the elements of owners’ equity discussed here are the elements of a corporation’s equity.
Owners’ equity for corporations is split into six different categories:
• Capital stock. The par or stated value of the shares issued.
• Additional paid-in capital. The excess of amounts contributed by owners from the sale of shares over and above the par or stated value of the shares issued.
• Retained earnings. Net income of the company that has not been distributed as dividends.
• Accumulated other comprehensive income items. Specific items that are not included in the income statement but are included in equity and adjust the balance of equity, even though they do not flow to equity by means of the income statement as retained earnings do.
• Non-controlling interest. A portion of the equity of subsidiaries that the reporting entity owns but does not own wholly.
• Treasury stock. Either the amount paid for shares that have been repurchased or the par value of shares that have been repurchased.11 Treasury stock is a contra-equity account that reduces equity on the balance sheet.
Note: When a corporation repurchases shares of its own stock from the market, the repurchased shares are called treasury shares or treasury stock. Treasury shares purchased reduce owners’ equity, because those shares are no longer outstanding.
Benefits of the Balance Sheet
• Because the balance sheet provides information on assets, liabilities, and stockholders’ equity, it provides a basis for computing rates of return, evaluating the capital structure of the business, and predicting a company’s future cash flows.
• The balance sheet helps users to assess the company’s liquidity, financial flexibility, solvency, and risk. The statement of financial position can also be used in financial statement analysis to assess the company’s ability to pay its debts when due and its ability to distribute cash to its investors to providethem an adequate rate of return.
Limitations of the Balance Sheet
• A statement of financial position (balance sheet) provides only a partial picture of liquidity or financial flexibility unless it is used in conjunction with at least a statement of cash flows.
• A balance sheet reports a company’s financial position at one point in time, but it does not report the company’s true value, for the following reasons:
• Many assets are not reported on the balance sheet, even though they have value and will generate future cash flows, such as employees, human resources, internally generated intangible assets, processes and procedures, and competitive advantages.
• Values of certain assets are measured at historical cost, or the price the company paid to acquire the asset—not the asset’s market value, replacement cost, or value to the firm. For example, property, plant, and equipment (PP&E) are reported on the balance sheet at historical cost minus accumulated depreciation, although the assets’ value in use may be significantly greater.
• Judgments and estimates are used to determine the value of many items reported in the balance sheet. For example, estimates of the balance of receivables the company will collect are used to value accounts receivable; the expected useful life of fixed assets is used to determine the amount of depreciation; and the company’s liability for future warranty claims is estimated by projecting the number and the cost of the future claims.
• Most liabilities are valued at the present value of cash flows discounted at the rate that was current when the liability was incurred, not at the present value of cash flows discounted at the current market interest rate. If market interest rates increase, a liability with a fixed interest rate that is below the market rate increases in its value to the company. If market rates decrease, a liability with a fixed interest rate that is higher than the market interest rate sustains a loss in value. Neither of these changes in values is recognized on the balance sheet.
Note: To counter the limitations related to valuation, fair value is used to measure many items presented on the balance sheet. “Fair value” is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. U.S. GAAP has increasingly called for the use of fair value to measure financial instruments. For example, many items such as derivatives, which previously were not reported on the balance sheet at all, are now being reported at fair value. Entities have an option to measure most financial assets and liabilities at fair value.
