CFA Fundamentals - Chapter 3 Finacial Repor & Analy

Question 1

What are the body of account standard-setting bodies?

Answer 1

1. International = International Accounting Standards Board (IASB)
   
   1. International Financial Reporting Standards (IFRS)
2. United States = Financial Accounting Standards Board (FASB)
   
   1. Generally Accepted Accounting Principles (GAAP)

The IASB and FASB have been working over time to converge their accounting principles into one uniform set, but as of this writing some key differences remain

Question 2

What is the point of financial statements?

What are some financial statements?

Answer 2

1. Snapshot of the firm’s assets, liabilities, and equity at a point in time (the balance sheet),
2. A summary of the firm’s operating performance over a specified time period (the income statement).
3. They show the firm’s operating, investing, and financing cash flows over a specified period (the statement of cash flows)
4. the amounts of and changes in ownership (the statement of owners’ equity).
5. General Ledger:
   
   1. That part of the accounting system which contains the balance sheet and income statement accounts used for recording transactions.

Question 3

Chart of Accounts?

Answer 3

1. A chart of accounts is a listing of the names of the accounts that a company has identified and made available for recording transactions in its general ledger. A company has the flexibility to tailor its chart of accounts to best suit its needs, including adding accounts as needed.

Question 4

General Ledger

Answer 4

Within the chart of accounts you will find that the accounts are typically listed in the following order:

Balance Sheet:

1. Assets
2. Liabilities
3. Owner’s (Stocholders’) Equity

Income Statement Accounts:

1. Operating Revenues
2. Operating Expenses
3. Non-operating Revenues and Gains
4. Non-operating Expenses and Losses

Question 5

Assets

Answer 5

Balance Statement Account

1. Resource owned by company that have future economic value measured and expressed in dollars.
2. Examples
   
   1. Cash
   2. Investments
   3. Accounts Receivable
   4. Inventory
   5. Supplies
   6. Land
   7. Buildings
   8. Equipment
   9. Vehicles
3. Some valuable items that cannot be measured and expressed in dollars include the company’s outstanding reputation, its customer base, the value of successful consumer brands, and its management team.

Question 6

Liabilities

Answer 6

Balance Sheet Statement

1. Obligations of a company or organization.
2. Amounts owed to lenders and suppliers.
3. Liabilites often have the word payable in the account title.
4. Liabilities also include amounts received in advance for a future sale or for a future service to be performed.

Question 7

Owner’s (Stockholders) Equity)

Answer 7

Balance Sheet Statement

1. Book value (or market value) equal to the recorded amounts of assets minus the recorded amounts of liabilities.

Question 8

Revenue

Answer 8

Income Statement

1. Revenue accounts are credited when services are performed/billed and therefore will usually have credit balances

Examples

1. Sales
2. Services Revenues
3. Fees Earned
4. Interest Revenue
5. Interest Income

At the time that a revenue account is credited, the account debited might be Cash, Accounts Receivable, or Unearned Revenue depending if cash was received at the time of the service, if the customer was billed at the time of the service and will pay later, or if the customer had paid in advance of the service being performed.If the revenues earned are a main activity of the business, they are considered to be operating revenues. If the revenues come from a secondary activity, they are considered to be nonoperating revenues. For example, interest earned by a manufacturer on its investments is a nonoperating revenue. Interest earned by a bank is considered to be part of operating revenues.

Question 9

Expenses

Answer 9

Income Statement

1. Costs that are matched with revenues on the income statement.

Example

1. Cost of Goods Sold is an expense caused by Sales.
2. Insurance Expense
3. Wages Expense
4. Advertising Expense
5. Interest Expense are expenses matched with the period of time in the heading of the income statement.

Under the accrual basis of accounting, the matching is NOT based on the date that the expenses are paid.Expenses associated with the main activity of the business are referred to as operating expenses. Expenses associated with a peripheral activity are nonoperating or other expenses. For example, a retailer’s interest expense is a nonoperating expense. A bank’s interest expense is an operating expense.Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)

Question 10

Gains

Answer 10

Income Statement

1. Gains result from the sale of an asset (other than inventory).
2. A gain is measured by the proceeds from the sale minus the amount shown on the company’s books.
3. Since the gain is outside of the main activity of a business, it is reported as a nonoperating or other revenue on the company’s income statement.

Question 11

Losses

Answer 11

Income Statement

1. Losses result from the sale of an asset (other than inventory) for less than the amount shown on the company’s books.
2. Since the loss is outside of the main activity of a business, it is reported as a nonoperating or other loss.
3. The term losses is also used to report the writedown of asset amounts to amounts less than cost. It is also used to refer to several periods of net losses caused by expenses exceeding revenues.

Question 12

The Double Entry System

Answer 12

All accounting is based on a double entry system, where there are two sides to every transaction. When any transaction is entered into an accounting system, there must be at least two accounts affected (there can be more), one for each side of the transaction.

Question 13

Debit and Credit

Answer 13

After you have identified the two or more accounts involved in a business transaction, you must debit at least one account and credit at least one account.

We use the terms debit and credit in double entry accounting, which are Latin for “left side” and “right side.”

1. Debit: an entry in the left hand column of an account to record a debt; debits increase asset (balance sheet) and expense accounts (income statement) and decrease liability (balance sheet), revenue/income (income statement), and equity accounts (balance sheet)
2. Credit: an entry in the right hand column of an account; credits increase liability (balance sheet), income (income statement), and equity accounts (balance sheet) and decrease asset (balance sheets) and expense accounts (income statements)

Question 14

What is the concept of Debit and Credit?

Answer 14

In a nutshell: debits (dr) record all of the money flowing into an account, while credits (cr) record all of the money flowing out of an account.

just remember the words of accountant Charles E. Sprague:

1. “Debit all that comes in and credit all that goes out.”

Think of these as individual buckets full of money representing each aspect of your company. For example:

1. One bucket might represent all of the cash you have in your business bank account (the “cash” bucket)
2. Another bucket might represent the total value of all the furniture your business has in its office (the “furniture” bucket)
3. Another bucket might represent a bank loan you recently took out (the “bank loan” bucket)

Question 15

Asset Side Equation

Let’s say that one day, you visit your friend’s startup. After taking a tour of the office, your friend shows you a beautiful ergonomic standing desk. You’ve been looking for this model for months, but all the furniture stores are sold out. Your friend ordered an extra one, and she can sell it to you for cheap. You agree to buy it from her for $600. How does that affect double entry system?

Answer 15

Asset Side Equation

1. Credit = Move $600 out of your cash bucket. We credit the cash account (money flowing out)
2. Debit = $600 into your furniture bucket. We debit the furniture bucket (value flowing into in form of desk).

Question 16

Liabilities Side Equation

1. Let’s imagine that after buying that expensive desk, you want to get some extra cash for your business. So you take out a $1,000 bank loan…how does this affect the double-entry system?

Answer 16

Liabilities Side Equation

1. Credit = we are crediting the bank loan bucket (money flowing out)
2. Debit = your cash account by $1,000 (money flowing in)

Question 17

Owner’s Equity

1. Let’s say your mom invests $1,000 of her own cash into your company. Using our bucket system, your transaction would look like the following.

Answer 17

Liabilities Side Equation

1. Credit = we are crediting the equity stake (money flowing out)
   
   1. Why is it that crediting an equity account makes it go up, rather than down? That’s because equity accounts don’t measure how much your business has. Rather, they measure all of the claims that investors have against your business.
2. Debit = your cash account by $1,000 (money flowing in)

Question 18

Expense Account

Answer 18

Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)

Costs that are matched with revenues on the income statement. For example, Cost of Goods Sold is an expense caused by Sales. Insurance Expense, Wages Expense, Advertising Expense, Interest Expense are expenses matched with the period of time in the heading of the income statement. Under the accrual basis of accounting, the matching is NOT based on the date that the expenses are paid.

Operating Expenses =

1. Expenses associated with the main activity of the business are referred to as operating expenses
2. For example, a retailer’s interest expense is a nonoperating expense. A bank’s interest expense is an operating expense.

Question 19

Revenue

1. Let’s illustrate revenue accounts by assuming your company performed a service and was immediately paid the full amount of $50 for the service. The debits and credits are presented in the following general journal format.

Account Receivable

1. Let’s illustrate how revenues are recorded when a company performs a service on credit (i.e., the company allows the client to pay for the service at a later date, such as 30 days from the date of the invoice). At the time the service is performed the revenues are considered to have been earned and they are recorded in the revenue account Service Revenues with a credit. The other account involved, however, cannot be the asset Cash since cash was not received. The account to be debited is the asset account Accounts Receivable. Assuming the amount of the service performed is $400, the entry in general journal form is:

Answer 19

Revenue

1. Debit = Cash. Cash is debited as the asset increases.
2. Credit = Revenue. Since the service was performed at the same time as the cash was received, the revenue account Service Revenues is credited, thus increasing its account balance.

Account Receivable

1. Debit = Account Receivable (money coming in)
2. Credit = Revenue. Service Revenues are credited because service credits are being given away (not for free) and are being sent out.

Question 20

Cheat Sheet for Debit and Credit

Answer 20

Generally these types of accounts are increased with a debit.

Debit Increase = “DEAL”

1. Dividends (Draws)
2. Expenses
3. Assets
4. Losses

Credit Increase = “GIRLS”

1. Gains
2. Income
3. Revenues
4. Liabilities
5. Stockholder’s (Owner’s) Equity

Question 21

Debit and Credit Example:

1. Let’s look at an example. Assume that a hardware store buys a case of hammers from a supplier for $100. This transaction is a purchase of inventory (goods for resale). Inventory goes up while cash goes down by the same amount. The accounting entry for this sale would be to debit one account, Inventory, and credit another account, Cash.
2. What if the hardware store did not want to spend cash to buy the hammers and instead asked the hammer supplier to finance the purchase? In this situation, the hardware store would owe the supplier $100. The account that results is called accounts payable, which represents a liability that must be satisfied at some point in the near future.

Answer 21

1. First
   
   1. Debit (left side) Inventory
   2. Credit (right side) Cash
2. Second
   
   1. Debit (left side) Inventory
   2. Credit (right side) Liability