FAR SEC 2 Flashcards
Are the financial statement formats required by GAAP?
No. Specific names and formats for these statements are not specified under GAAP. Instead, the formats of these statements have evolved to fulfill the requirements of GAAP
The left side of the accounting equation shows:
Assets (the entity’s resource structure)
The right side of the accounting equation shows:
Liabilities + Equity (the entity’s financing structure)
What are three items that primary users can assess about an entity based on the Balance Sheet?
Liquidity, Flexibility, Risk
Assets =
Liabilities + Equity
Assets are generally reported in order of:
Liquidity. Liquidity decreases moving from top to bottom on the assets section.
Current Assets
An asset is classified as current on the statement of financial position if it is expected to be realized within the entity’s operating cycle or 1 year, whichever is longer.
Operating Cycle
The operating cycle is the average time between the acquisition of resources and the final receipt of cash from their sale as the culmination of revenue generating activities. If the cycle is less than a year, 1 year is the period used for segregating current from noncurrent assets.
Operating Cycle = Inventory Period + Accounts Receivable Period
An asset is classified as current on the statement of financial position if
if it is expected to be liquidated or used up within the entity’s operating cycle or 1 year, whichever is longer.
Current assets include (6 elements)
1) Cash and cash equivalents;
2) Certain individual trading, available-for-sale, and held-to-maturity debt securities;
3) Certain individual investments in equity securities.
4) Receivables;
5) Inventories;
6) Prepaid expenses
Noncurrent Assets (basic definition, not examples)
Noncurrent assets are those not qualifying as current. Noncurrent assets are expected to be held for a longer period than 1 year or the length of the operating cycle.
What is the definition of Investments and Funds? Give the definition and four examples of types of Investments and Funds.
DEFINITION: NONOPERATING & NONCURRENT. Investments and funds include nonoperating items intended to be held beyond the longer of 1 year or the operating cycle. The following assets are typically included:
1) INVESTMENTS FOR CORPORATE EVENTS. Investments in equity securities made to control or influence another entity
2) NONCURRENT DEBT/EQUITY SECURITIES. Other noncurrent equity securities held as investments.
- Certain individual available-for-sale and held-to-maturity debt securities may be noncurrent.
3) NONOPERATING SPECIAL PUPROSE FUNDS. Funds restricted as to withdrawal or use for other than current operations, for example, to
- Retire long-term debt,
- Satisfy PENSION obligations, or
- Pay for the acquisition or construction of noncurrent assets
4) NONOPERATING CAPITAL ASSETS. Capital assets not used in current operations, such as
- Idle facilities or
- Land held for a future plant site
Noncurrent Assets (5 major categories)
Major categories of noncurrent assets include:
1) Investment and Funds,
2) Property, Plant, & Equipment (PPE),
3) Intangible Assets,
4) Other Noncurrent Assets,
5) Deferred Charges
Current Liabilities
Current liabilities generally are expected to be settled or liquidated in the ordinary course of business during the longer of 1 year or the operating cycle.
Current liabilities are “obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities.”
Current Liabilities include (5 elements):
1) Trade payables for items entering into the operating cycle, e.g., for materials and supplies used in producing goods or services for sale.
2) Other payables arising from operations, such as accrued wages, salaries, rentals, royalties, and taxes.
3) Unearned revenues (contract liabilities) arising from collections in advance of delivering goods or performing services, e.g., ticket sales revenue.
4) Other current liabilities include
Short-term notes given to acquire capital assets
Payments on the current portion of serial bonds or other noncurrent debt-
5) Noncurrent obligations callable by the creditor because of the debtor’s violation of the debt agreement at the balance sheet date are classified as current.
Working Capital =
Working Capital = Current Assets - Current Liabilities
Current liabilities do not include (2 elements):
Current liabilities do not include:
1) Current obligations if an entity (a) intends to refinance them on a noncurrent basis and (b) demonstrates an ability to do so.
- The ability to refinance may be demonstrated by
(i) Entering into a financing agreement meeting all conditions before the balance sheet is issued.
(ii) Issuing a noncurrent obligation or equity securities after the end of the reporting period but before issuance of the balance sheet.
- The amount excluded from current liabilities must not exceed the proceeds from the new obligation or equity securities issued.
2) Debts to be paid from funds accumulated in noncurrent asset accounts. Thus, a liability for bonds payable in the next period will not be classified as current if payment is to be from a noncurrent fund.
Noncurrent Liabilities (8 elements)
1) DEFINITION: Noncurrent liabilities are those not qualifying as current. The noncurrent portions of the following items are reported in this section of the balance sheet:
2) Noncurrent notes and bonds
3) Lease liability
4) Most postretirement benefit obligations
5) Obligations under product or service warranty agreements
6) Advances for noncurrent commitments to provide goods or services
7) Deferred revenue (payments collected for goods or services not yet earned)
8) Deferred tax liabilities arising from interperiod tax allocation are classified as noncurrent.
Noncurrent Liabilities (7 elements)
DEFINITION: Noncurrent liabilities are those not qualifying as current. The noncurrent portions of the following items are reported in this section of the balance sheet:
1) Noncurrent notes and bonds
2) LEASES. Long-term operating expense payment agreements, e.g., lease liability
3) PENSIONS. Most postretirement benefit obligations
4) WARRANTIES. Obligations under product or service warranty agreements
5) ADVANCES. Advances for noncurrent commitments to provide goods or services
6) Deferred revenue
7) ALL Deferred tax liabilities arising from interperiod tax allocation are classified as noncurrent.
Equity
Equity is the residual after total liabilities are subtracted from total assets.
Equity (4 major categories)
Equity consists of the following:
1) Capital contributed by owners (par value of common and preferred stock issued and additional paid-in capital)
2) Retained earnings (income reinvested)
3) Accumulated other comprehensive income (all comprehensive income items not included in net income)
4) The noncontrolling interest in a consolidated entity (covered in Study Unit 14)
Treasury Stock
Treasury stock is the entity’s own common stock that it has repurchased. Treasury stock is presented as a reduction of total equity (discussed in Study Unit 13).
Treasury Stock is a reduction of ___________.
Treasury stock is presented as a reduction of total equity.
Temporary vs. Permanent Accounts
The accounts presented on the balance sheet are real or permanent accounts. They report an entity’s resources and financing elements that exist from period to period. The accounts presented on the income statement are nominal or temporary accounts. They are reported for a period of time, closed at the end of the period, and reopened at the beginning of the next period with zero balances.
(Nominal) Temporary Accounts
The accounts presented on the income statement are nominal or temporary accounts. They are reported for a period of time, closed at the end of the period, and reopened at the beginning of the next period with zero balances.
(Real) Permanent Accounts
The accounts presented on the balance sheet are real or permanent accounts. They report an entity’s resources and financing elements that exist from period to period.
Permanent Accounts appear on the ________________.
Permanent accounts appear on the Balance Sheet.
Temporary Accounts appear on the _____________.
Temporary Accounts appear on the Income Statement.
What is reported on the Income Statement?
Revenues, Expenses, Gains, & Losses
Fundamental Equation of Net Income
Revenues - Expenses + Gains - Losses = Net Income
Should the accountant close each transaction in a temporary account directly to equity?
No. Income statement elements are reported in temporary (nominal) accounts that are periodically closed to permanent (real) accounts. The accountant need not close each transaction directly to equity.
What is the permanent accounting treatment of income or loss?
Income or loss is closed to retained earnings at the end of the period.
What are Discontinued Operations?
Discontinued operations is an accounting term for parts of a firm’s operations that have been divested or shut down.
Any recognized amounts not included in continuing operations are reported in a separate section for discontinued operations.
The term “continuing operations” is used only when a discontinued operation is reported.
The transactions not included in net income are (5 elements):
1) Transactions with owners (distributions/contributions)
2) Error corrections,
3) Items reported INITIALLY in other comprehensive income,
4) Transfers to and from appropriated retained earnings, and
5) Effects on prior periods of accounting changes.
What are the three Income Statement formats?
Single-step, Multiple-step, & Condensed
Define Single-step Income Statement
The single-step income statement provides one grouping for revenues and gains and one for expenses and losses. The single step is the one subtraction necessary to arrive at net income.
Define Multiple-step Income Statement
The multiple-step income statement reports operating revenues and expenses in a section separate from nonoperating items. It enhances disclosure by presenting subtotals.
Define Condensed Income statement
The condensed income statement is the most common method of presentation. It includes only the section totals of the multiple-step format. The enhanced disclosure of each line item is presented in the notes to the financial statements.
What is the most commonly used type of Income Statement?
Condensed Income Statement
Single-step Income Statement Formula
[Total Revenues & Gains] - [Total Expenses & Losses] = Net Income
Do all Income Statement formats end with earnings per common share?
Yes.
Multiple-step Income Statement Formula
Net Sales - COGS = Gross Profit
Gross Profit - Total Operating Expenses = Income from Operations
Operating Income + Other [Revenues/Gains - Expenses/Losses] = Income Before Taxes
Income Before Taxes - Tax Expense = Net Income
Gross Profit = ?
Gross Profit = Net Sales - COGS
Net Sales = ?
Net Sales = Gross Sales - Sales Discounts - Sales Returns & Allowances
Note: Allowances would mainly be the allowance for uncollectible accounts
COGS = ?
COGS = Beginning FG Inventory + Net Purchases + COGM - Ending FG Inventory
Operating Expenses = ?
Operating Expenses = Selling Expenses + General & Administrative Expenses
Condensed Income Statement
The condensed income statement is the most common method of presentation. It includes only the section totals of the multiple-step format. The enhanced disclosure of each line item is presented in the notes to the financial statements.
Define COGS
Cost of goods sold equals purchases for a retailer or cost of goods manufactured (COGM) for a manufacturer, adjusted for the change in finished goods (FG) in inventory. Beginning FG inventory + Purchases or COGM - Ending FG Inventory = COGS Beginning FG inventory + Purchases or COGM = Goods available for sale
Cost of Goods Manufactured
Adjusted COGM = Beginning FG Inventory + Period COGM - Ending FG Inventory
Cost of goods manufactured equals the period’s manufacturing costs adjusted for the change in work-in-process. It also may be stated as cost of goods sold adjusted for the change in finished goods inventory.
COGM Formulas
COGM = Beginning WIP + Periodic Manufacturing Costs - Ending WIP
COGM = Ending FG Inventory + COGS - Beginning FG Inventory
What is WIP?
WIP is work-in-process. May refer to work-in-process inventory.
Selling Expenses (Definition and 3 examples)
DEFINITION: Selling expenses are incurred in selling or marketing.
Examples include
1) Sales representatives’ salaries, commissions, and traveling expenses;
-Sales department rent, salaries, and depreciation; and
2) Communications (e.g., Internet) costs.
3) Shipping costs also may be classified as selling costs.
When should selling expenses be recognized (2 elements)?
1) GENERAL RULE: Advertising costs should be expensed either as incurred or when advertising first occurs.
2) SPECIAL RULE: COLLABORATIVE ADVERTISING: Sellers may agree to reimburse customers for the customers’ advertising costs (cooperative advertising). The revenues related to the transactions that created such obligations generally are recognized before reimbursement. Accordingly, the obligations must be accrued and the advertising costs expensed when the related revenues are recognized.
What is Cooperative Advertising?
Sellers may agree to reimburse customers for the customers’ advertising costs (cooperative advertising). The revenues related to the transactions that created such obligations generally are recognized before reimbursement, e.g., the revenue from cooperative advertising for sales from Auto manufacturer to Auto dealer are recognized immediately when the cars are sold to the dealer, so the expense from cooperative advertising is simultaneously recognized.. Accordingly, the obligations must be accrued and the advertising costs expensed when the related revenues are recognized.
General & Administrative Expenses (Definition and 6 examples)
DEFINITION: General and administrative expenses are incurred for the direction of the entity as a whole and are not related entirely to a specific function, e.g., selling or manufacturing. They include:
1) Accounting, legal, and other fees for professional services; 2) Officers’ salaries; 3) Insurance; 4) Wages of office staff; 5) Miscellaneous supplies; and 6) Office occupancy costs.
How is Interest Expense Recognized?
Interest expense is recognized based on the passage of time. In the case of bonds, notes, and finance leases, the effective interest method is used.
Effective Interest Method
Step (1) use annuity formula to find the effective interest rate.
Step (2) Interest Income (in current period) = Effective Interest Rate*Carrying Value
Step (3) Accreted Discount/Premium = Effective Interest - Coupon Payment
Step (4) Update the ending carrying amount at the end of each periodic application of the Effective Interest Method
Unusual or Infrequent Items (5 elements)
1) Material items that are unusual in nature, infrequent in occurrence, or both are reported as a separate component of income from continuing operations.
2) These items must not be reported net of taxes.
3) Gains or losses of a similar nature that are not individually material must be aggregated.
4) The nature and financial effect of each item is disclosed in the notes to the financial statements or reported in the income statement.
5) The effects of such items on earnings per share must not be presented on the income statement.
Discontinued Operations (3 elements)
1) REPORTED SEPARATELY NET OF TAX ON INCOME STATEMENT. The operating results of a discontinued operation are reported separately net of tax in the income statement. This section is presented after the results of continuing operations.
2) INCOME/LOSS REPORTED SEPARATELY FROM NET TAX BENEFIT/EXPENSE. The discontinued operations section presents separately the (a) income or loss from operations of the component and (b) income tax expense or benefit.
3) BASIC & DILUTED EPS AMOUNTS FOR DISCONTINUED OPERATIONS ARE REPORTED ON INCOME STATEMENT OR IN THE NOTES. If a discontinued operation is reported, basic and diluted earnings per share amounts for the discontinued operation are presented on the face of the income statement or in the notes (discussed in Study Unit 3, Subunit 2).
Gain or Loss on Disposal of Discontinued Operations
If a component of an entity (discontinued operation) is disposed of during the period, any gain or loss on disposal must be disclosed on the face of the income statement or in the notes.
Discontinued Operation Held for Sale (3 elements)
1) MEASUREMENT. When a component (discontinued operation) is classified as held for sale, it is measured at the lower of its carrying amount or fair value minus cost to sell (discussed in Study Unit 8, Subunit 9).
2) TIMEFRAME. Operating results reported in discontinued operations include any income earned or loss incurred during the entire reporting period (i.e., before and after the component was classified as held for sale).
3) INCLUDE ANY LOSS ON WRITE-DOWN TO FAIR VALUE FOR DISCONTINUED UNIT.
Operating results also include any loss for a write-down to fair value minus cost to sell recognized on the initial classification as held for sale and subsequently.
Discontinued Operations: Intraperiod Tax Allocation
Intraperiod tax allocation is required. Thus, income tax expense or benefit is allocated to
-Continuing operations,
–Discontinued operations,
Other comprehensive income, and
-Items debited or credited directly to other components of equity.
The operating results of a discontinued operation also must be reported in the comparative financial statements.
Comprehensive Income
Comprehensive Income = Net Income + OCI
Comprehensive Income excludes owner contributions/draws
Comprehensive income includes all changes in equity of a business during a period except those from investments by and distributions to owners. It includes all components of
Net income and
Other comprehensive income (OCI).
Other Comprehensive Income
OCI: Sum of: 1) unrealized holding gains/losses, 2) derivative cash flow hedges, 3) foreign currency adjustments, 4)credit risk adjustment for debt securities under fair value option.
OCI includes all items of comprehensive income not included in net income. Under existing accounting standards, items of OCI include, among others,
- Unrealized holding gains and losses on available-for-sale debt securities (Study Unit 5).
- Gains and losses on derivatives designated and qualifying as cash flow hedges (Study Unit 15).
- Certain foreign currency items (Study Unit 15).
- Changes in fair value attributable to instrument-specific credit risk of financial liabilities for which the fair value option is elected (Study Unit 5).
Each component of OCI must be presented net of tax, or one amount must be presented for the aggregate tax effect on the total of OCI. In either case, the tax effect on each component must be disclosed.
Must each component of Other Comprehensive Income be presented net of tax?
Yes.
Must an entity always report Other Comprehensive Income?
No. An entity that presents a full set of financial statements but has no items of OCI need not report OCI or Comprehensive Income.
What are the two options for reporting Other Comprehensive Income?
An entity that presents a full set of financial statements but has no items of OCI need not report OCI or comprehensive income. Otherwise, an entity must present all items of comprehensive income recognized for the period either
- In one continuous financial statement or
- In two separate but consecutive statements.
Note: In the continuous presentation, an Income Statement is merged with a statement of OCI. In two separate statements, the Income Statement is the first disclosure, followed immediately by a Statement of OCI where Net Income is the first line.
Reporting Other Comprehensive Income in one continuous statement
One continuous statement must have two sections: net income and OCI. It must include
A total of net income with its components,
A total of OCI with its components, and
A total of comprehensive income.
Reporting Other Comprehensive Income in separate but consecutive statements
Separate but consecutive statements must be presented as follows:
The first statement (the income statement) presents the components of net income and total net income.
The second statement (the statement of OCI) is presented immediately after the first. It presents
The components of OCI,
The total of OCI, and
A total for comprehensive income.
The entity must begin the second statement with net income.
How does the Statement of Other Comprehensive Income relate to the Income Statement?
The final component of the statement of net income is net income.
The first component of the statement of OCI is net income, and the final component is comprehensive income.
How is Other Comprehensive Income closed to a permanent account?
The components of OCI are recorded initially in a temporary (nominal) account. At the end of each reporting period, the total OCI for a period is closed to accumulated OCI, a permanent account that is reported in the equity section of the balance sheet.
Other comprehensive income for the period increases accumulated OCI.
Other comprehensive loss for the period decreases accumulated OCI.
Statement of Changes in Equity
A statement of changes in equity is presented as part of a full set of financial statements. This statement provides disclosure of changes during the accounting period in the separate equity accounts. These are retained earnings, common stock, preferred stock, additional paid-in capital, accumulated OCI, and noncontrolling interest.
What are the equity accounts shown on a Statement of Changes in Equity?
These are retained earnings, common stock, preferred stock, additional paid-in capital, accumulated OCI, and noncontrolling interest.
Is the Statement of Retained Earnings a separate financial statement?
No. The Statement of Retained Earnings is now a column of the Statement of Changes in Equity.
Statement of Retained Earnings
Statement of Retained Earnings
A statement of retained earnings reconciles the beginning and ending balances of the account. This statement is not separately reported. Instead, it is reported as part of the statement of changes in equity in a separate column.
The changes in retained earnings can result from the following adjustments:
Net income (loss) for the period;
Any prior-period adjustments, net of tax (discussed in Study Unit 3);
Dividends declared; and
Certain other rare items, e.g., reissuance of treasury stock under the cost method (discussed in Study Unit 13).
Retained earnings are sometimes appropriated (restricted) to a special account to disclose that earnings retained in the business (not paid out in dividends) are being used for special purposes (discussed in Study Unit 13).
Pension Plan
A pension plan is a separate legal entity to which a sponsoring employer makes contributions. It invests the assets and makes payments to beneficiaries.
Defined Contribution Pension Plan
A defined contribution plan provides an individual account for each participating employee. Pension benefits depend only on (a) the amount contributed to the plan by the employer and the employee and (b) the returns earned on investments of those contributions. Because the employer does not guarantee the amount of benefits that the employees will receive during retirement, employees bear the investment risk.
Defined Benefit Pension Plan
A defined benefit plan defines an amount of pension benefits to be provided to each employee. The employer is responsible for providing the agreed benefits and therefore bears actuarial risk and investment risk.
The benefits that the employer is required to pay are estimated by using actuarial assumptions. They depend on such factors as (1) how long an employee or any survivor lives, (2) how many years of service the employee renders, and (3) the employee’s compensation before retirement.
