Financial Accounting - Study Unit 1

External Financial Statements - Study Unit 1

• Financial Accounting Objectives: Report financial information useful for decisions related to providing resources. This includes assessing the reporting entity's financial position (economic resources and claims), changes to those resources and claims, and evaluating liquidity, solvency, financing needs, and financing probability.
• GAAP and IFRS: General-purpose financial statements must adhere to generally accepted accounting principles in the US (GAAP). The CMA exam also tests knowledge of International Financial Reporting Standards (IFRS); use GAAP unless otherwise specified.
• Difference between Financial and Management Accounting: Financial accounting provides information for external users like investors, creditors, and regulators while management accounting aids internal decision-making.
• Financial Statement Users (External): Investors, creditors, financial advisors, stock exchanges, and regulatory agencies use statements to assess business viability.
• Financial Statement Users (Internal): Management, employees, and the board of directors use for intra-operational decisions.
• Financial Statement Features: Includes basic financial statements (balance sheet, income statement, statement of comprehensive income, statement of changes in equity, and statement of cash flows) and accompanying notes. Significant accounting policies are a key part of the disclosure requirements, amplifying the statements' information.
• Going-Concern Assumption: Financial statements are prepared assuming the entity will continue operating indefinitely, not liquidating shortly.
• Financial Statement Relationships: Statements are interconnected. Components, like net income, relate between statements.
• Accrual Accounting: Records transactions when they occur, not when cash changes hands. This includes revenue recognition and expense recognition.
• Cash Basis Accounting: Revenue is recognized when cash is received and expenses when paid; not allowed under GAAP.

Statement of Financial Position (Balance Sheet)

• Balance Sheet Concept: Reports assets, liabilities, and equity at a specific point in time. It assesses liquidity, financial flexibility, asset efficiency, capital structure, and risk.
• Accounting Equation: Assets = Liabilities + Stockholders' Equity. This is based on the fund theory (and its variation, the proprietary theory, showing that equity accounts for remaining assets after liability deduction).
• Transaction Analysis: Any transaction has dual effects, affecting at least two components in the accounting equation. The equation must maintain balance.
• Elements of the Balance Sheet:
• Assets: Resources controlled by the entity with probable future economic benefit (e.g., inventory, receivables, PPE).
• Liabilities: Present obligations of the entity expected to result in an outflow of economic benefits (e.g., loans payable, accounts payable).
• Equity: Residual interest in assets after deducting liabilities (e.g., common stock, retained earnings, treasury stock).
• Current vs. Noncurrent: Assets and liabilities are categorized into current (expected to be converted or settled within one year or operating cycle) and noncurrent (longer-term). Common categories include cash, investments, receivables, inventory, prepaid expenses, PPE, intangible assets, accounts payable, notes payable, and equity items.

Income Statement and Statement of Comprehensive Income

• Income Equation: Income (Loss) = Revenues + Gains - Expenses - Losses
• Income Statement Elements:
• Revenues: Inflows from goods, services, or other activities representing ongoing operations.
• Gains: Increases in equity other than revenues or investments.
• Expenses: Outflows from goods, services, or ongoing activities.
• Losses: Decreases in equity other than from expenses or distributions.
• Cost of Goods Sold (Retailer): Beginning inventory plus net purchases plus freight-in, less ending inventory.
• Cost of Goods Sold (Manufacturer): Calculated via cost of goods manufactured.
• Cost of Goods Manufactured: Beginning direct materials + purchases – ending direct materials + direct labor + manufacturing overhead = cost of goods manufactured. Then, cost of goods manufactured plus beginning finished goods inventory – ending finished goods inventory= cost of goods sold.
• Other Expenses (General & Administrative, Selling): Examples are general administrative and selling expenses, interest expenses, which are often categorized separately.
• Income Statement Formats: Single-step (one category each for revenue and expenses) and multiple step (separate operating from nonoperating items).
• Discontinued Operations: Reported separately, if applicable, including any gains or losses from operations or disposal, net of tax.
• Statement of Comprehensive Income: Includes all changes in equity except from owners' investments and distributions. Comprised of net income and other comprehensive income (OCI).
• OCI Components: Examples include gains/losses on hedging instruments (cash flow hedge), available-for-sale securities, foreign currency translation, and postretirement plans.

Statement of Changes in Equity and Equity Transactions

• Statement of Changes in Equity: Reconciles beginning and ending balances of equity components.
• Common Equity Components & Changes: Examples include net income (increases retained earnings), net loss (decreases retained earnings), dividends (decreases retained earnings), issuance of stock (increases stock accounts), and treasury stock (decreases equity).
• Prior-Period Adjustments: Include changes in accounting principles and corrections to prior periods' errors; require retrospective application. Changes in estimates are not prior-period adjustments and are applied prospectively.
• Stock Terminology: Definitions for authorized, issued, and outstanding stock.
• Common Stock: Ownership interest with voting rights, liquidating distributions (after all other debts), and potentially preemptive rights.
• Preferred Stock: Equity with elements of debt, fixed dividends (often cumulative), without voting rights, and with prioritized liquidation rights before common stock.
• Treasury Stock: Firm's repurchased shares, treated as a reduction to total equity (using cost or par value method), with no voting or dividend rights.
• Dividends: Often include cash dividends, affecting retained earnings and dividends payable. Property dividends remeasure property at fair value, with gain/loss recognition.
• Stock Dividends/Splits: Stock dividends are reclassifications between retained earnings and equity accounts. Small stock dividends may result in no change to elements. Large stock dividends or stock splits may result in no change to elements, but can adjust par value.

Statement of Cash Flows

• Statement of Cash Flows Purpose: Reports cash inflows and outflows from operating, investing, and financing activities. It evaluates the entity's liquidity, solvency, and financial flexibility to generate future positive cash flows.
• Cash Flow Activities: Includes operating (primary revenue activities), investing (generating future income resources), and financing (issuing/redeeming debt and equity) activities.
• Indirect Method: Reconciles net income to net cash flow from operating activities by adjusting for noncash items (depreciation, amortization, gains/losses, deferred income, and accruals). Increases in current liabilities add to net income; increases in current assets subtract from net income; inversely, decreases in liabilities and assets have the opposite effect.

This quiz covers essential concepts from the first study unit of financial accounting. Topics include financial information reporting, GAAP and IFRS standards, and the differences between financial and management accounting. Assess your understanding of the key users of financial statements and their implications.