CMA Study Unit 1 Outline PDF

1 Study Unit One External Financial Statements 1.1 Concepts of Financial Accounting................................................................................... 2 1.2...

1 Study Unit One External Financial Statements 1.1 Concepts of Financial Accounting................................................................................... 2 1.2 Statement of Financial Position (Balance Sheet)............................................................ 6 1.3 Income Statement and Statement of Comprehensive Income........................................ 12 1.4 Statement of Changes in Equity and Equity Transactions............................................... 18 1.5 Statement of Cash Flows................................................................................................ 27 1.6 Consolidation Accounting................................................................................................. 35 This study unit is the first of six on external financial reporting decisions. The relative weight assigned to this major topic in Part 1 of the exam is 15%. The six study units are Study Unit 1: External Financial Statements Study Unit 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items Study Unit 3: Measurement, Valuation, and Disclosure: Assets -- Long-Term Items Study Unit 4: Measurement, Valuation, and Disclosure: Liabilities Study Unit 5: Revenue and Impairment Recognition Study Unit 6: Integrated Reporting This study unit discusses the basic concepts underlying financial accounting, which are important to understand before moving on to Study Units 2 through 5. Topics covered in this study unit include Users of accounting Accrual accounting Basic financial statements The accounting equation and transaction analysis Equity transactions Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 1: External Financial Statements 1.1 Concepts of Financial Accounting The Objective of General-Purpose Financial Reporting The objective of general-purpose financial reporting is to report financial information that is useful in making decisions about providing resources to the reporting entity. The information reported relates to the entity’s economic resources and claims to them (financial position) and to changes in those resources and claims. Information about economic resources and claims helps to evaluate liquidity, solvency, financing needs, and the probability of obtaining financing. Users need to differentiate between changes in economic resources and claims arising from the entity’s performance (income statement) and other events and transactions, such as issuing debt and equity (balance sheet). Information about financial performance is useful for Understanding the return on economic resources, its variability, and its components Evaluating management Predicting future returns For general-purpose financial statements to be useful to external parties, they must be prepared in conformity with accounting principles that are generally accepted in the United States (GAAP). The CMA exam also tests some knowledge of International Financial Reporting Standards (IFRS). Significant differences between international standards and U.S. GAAP are detailed in Appendix B. If an exam question does not distinguish between GAAP and IFRS, use GAAP. Financial accounting differs from management accounting. Management accounting assists management decision making, planning, and control. Management accounting information is therefore primarily directed to specific internal users. Management accounting topics are covered in Study Units 7 through 16. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 3 Users of Financial Statements External users are the primary users of financial statements. External users use financial statements to determine whether doing business with the firm will be beneficial. Investors need information to decide whether to increase, decrease, or obtain an investment in a firm. Creditors need information to determine whether to extend credit and under what terms. Financial advisors and analysts need financial statements to help investors evaluate particular investments. Stock exchanges need financial statements to evaluate whether to accept a firm’s stock for listing or whether to suspend the stock’s trading. Regulatory agencies may need financial statements to evaluate the firm’s conformity with regulations and to determine price levels in regulated industries. Internal users also use financial statements to make decisions affecting the operations of the business. These users include management, employees, and the board of directors. Features of Financial Statements Financial statements are the primary means of communicating financial information to external parties. Additional information is provided by financial statement notes, supplementary information (such as management’s discussion and analysis), and other disclosures. Information typically disclosed in notes is essential to understanding the financial statements. The notes are considered part of the basic financial statements. They amplify or explain information recognized in the statements and are an integral part of statements prepared in accordance with GAAP. The first footnote accompanying any set of complete financial statements is generally one describing significant accounting policies, such as the use of estimates and assumptions, and policies relating to, among others, revenue recognition and allocation of asset (tangible and intangible) costs to current and future periods. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 1: External Financial Statements A full set of financial statements includes the following statements: Statement of financial position (also called a balance sheet) Income statement Statement of comprehensive income Statement of changes in equity Statement of cash flows To be useful, information presented in the financial statements must be relevant and faithfully represented. Usefulness is enhanced when the information is comparable with similar information for other entities and the same entity for another period or date. Comparability allows users to understand similarities and differences. Financial statements are prepared under the going-concern assumption, which means that the entity is assumed to continue operating indefinitely and that it will not be liquidated in the near future. Financial Statement Relationships Financial statements complement each other. They describe different aspects of the same transactions, and more than one statement is necessary to provide information for a specific economic decision. The components (elements) of one statement relate to those of other statements. Among the relationships are: Net income or loss from the statement of income is reported and accumulated in the retained earnings account, a component of the equity section of the statement of financial position. The components of cash and equivalents from the statement of financial position are reconciled with the corresponding items in the statement of cash flows. Items of equity from the statement of financial position are reconciled with the balances on the statement of changes in equity. Ending inventories are reported in current assets on the statement of financial position and are reflected in the calculation of cost of goods sold on the statement of income. Amortization and depreciation reported in the statement of income also are reflected in asset and liability balances in the statement of financial position. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 5 Accrual Basis of Accounting Financial statements are prepared under the accrual basis of accounting. Accrual accounting records the financial effects of transactions and other events and circumstances when they occur rather than when their associated cash is paid or received. Revenues are recognized in the period in which they were earned even if the cash will be received in a future period. This is referred to as the revenue recognition principle. Expenses are recognized in the period in which they were incurred even if the cash will be paid in a future period. Under the matching principle, expenses are recognized in the same period as the related revenue. Expense recognition principles associate cause and effect, systematic and rational allocation, and immediate recognition. Under the cash basis, revenues are recognized when cash is received and expenses are recognized when cash is paid. Under GAAP, financial statements cannot be prepared under the cash basis of accounting. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 1: External Financial Statements 1.2 Statement of Financial Position (Balance Sheet) The statement of financial position, also called the balance sheet, reports the amounts of assets (items of value), liabilities (debt), and equity (net worth) and their relationships at a moment in time, such as at the end of the fiscal year. It helps users assess liquidity, financial flexibility, the efficiency with which assets are used, capital structure, and risk. The basic accounting equation presents a perfect balance between the entity’s resources and its capital structure. The entity’s resources consist of the assets used in its attempts to earn a return. The capital structure consists of the amounts contributed by creditors (liabilities) and investors (stockholders’ equity). Assets = Liabilities + Stockholders’ Equity The equation is based on the fund theory. The basic equation can be derived to form the proprietary theory: Assets – Liabilities = Stockholders’ Equity ► According to this theory, equity in an enterprise is what remains after the economic obligations of the enterprise are deducted from its economic resources. Transaction Analysis Using the basic accounting equation, all transactions of the entity can be illustrated based on the impact of the transaction to the accounting equation. Every transaction will have a dual effect, impacting at least two elements of the equation. The accounting equation must remain in balance with each accounting transaction. Although financial accounting typically uses debits and credits to record transactions in journal entries, the CMA exam has traditionally used increases and decreases to refer to a transaction’s impact on the elements of the accounting equation. This text therefore presents transactions with increases and decreases. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 7 Example 1-1 Transaction Analysis Examples of transaction analysis include the following: Borrowing cash from a bank with a note payable Assets = Liabilities + Stockholders’ Equity Cash ↑ Notes payable ↑ Receiving cash when providing services for customers Assets = Liabilities + Stockholders’ Equity Cash ↑ Service revenue ↑ Paying a supplier an amount owed on account Assets = Liabilities + Stockholders’ Equity Cash ↓ Accounts payable ↓ Purchasing inventory on account from a supplier Assets = Liabilities + Stockholders’ Equity Inventory ↑ Accounts payable ↑ Purchasing equipment with cash Assets = Liabilities + Stockholders’ Equity Cash ↓ Equipment ↑ Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 1: External Financial Statements Elements of the Balance Sheet Assets are resources controlled by the entity as a result of past events. They represent probable future economic benefits to the entity. Examples include inventory; accounts receivable; investments; and property, plant, and equipment. Liabilities are present obligations of the entity arising from past events. Their settlement is expected to result in an outflow of economic benefits from the entity. Examples include loans payable, bonds issued by the entity, and accounts payable. Equity is the residual interest in the assets of the entity after subtracting all its liabilities. Examples include a company’s common stock, preferred stock, and retained earnings. Equity is affected not only by operations but also by transactions with owners, such as dividends and contributions. Assets and liabilities are separated in the statement of financial position into current and noncurrent categories. Assets are generally reported in order of liquidity, which means the order in which the assets are expected to be converted to cash. NOTE: In some parts of the world, assets are listed in the order of reverse liquidity with intangibles and property, plant, and equipment listed first. This is known as the “production order.” This method is not used in the United States. Some variation of the following classifications is used by most entities: Assets Liabilities Current assets: Current liabilities: Cash Accounts payable Certain investments Current notes payable Accounts receivable Current maturities of noncurrent liabilities Inventories Noncurrent liabilities: Prepaid expenses Noncurrent notes payable Noncurrent assets: Bonds payable Certain investments and funds Equity Property, plant, and equipment (PPE) Common stock Intangible assets Retained earnings Other noncurrent assets Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 9 Current and Noncurrent Assets An asset is classified as current on the statement of financial position if it is expected to be realized in cash or sold or consumed within the entity’s operating cycle or 1 year, whichever period is longer. The following are the major categories of current assets: Cash and cash equivalents Certain individual trading, available-for-sale, and held-to-maturity debt securities Receivables Inventories Prepaid expenses Certain individual investments in equity securities Noncurrent assets (long term assets) are those not qualifying as current. The following are the major categories of noncurrent assets: 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: Investments in equity securities made to control or influence another entity and other noncurrent securities. Certain available-for-sale and held-to-maturity debt securities may be noncurrent. Property, plant, and equipment (PPE) are tangible operating items recorded at cost and reported net of any accumulated depreciation. They include Land and natural resources subject to depletion, e.g., oil and gas Buildings, equipment, furniture, fixtures, leasehold improvements, land improvements, a lessee’s right-of-use assets held under finance and operating leases, noncurrent assets under construction, and other depreciable assets Intangible assets are nonfinancial assets without physical substance. Examples are patents and goodwill. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 10 SU 1: External Financial Statements Current and Noncurrent Liabilities Current liabilities are expected to be settled or liquidated in the ordinary course of business during the longer of the next year or the operating cycle. Generally speaking, current liabilities are expected to be settled or liquidated within 1 year from the balance sheet date. The following are the major categories of current liabilities: Accounts (or trade) payables for items entering into the operating cycle, e.g., for materials and supplies used in producing goods or services for sale. Other payables arising from operations, such as accrued wages, salaries, rentals, royalties, and taxes. Unearned revenues arising from collections in advance of delivering goods or performing services, e.g., ticket sales revenue. Other obligations expected to be liquidated in the ordinary course of business during the longer of the next year or the operating cycle. These include Short-term notes given to acquire capital assets Payments on the current portion of serial bonds or other noncurrent debt Long-term obligations that are or will become callable by the creditor because of the debtor’s violation of a provision of the debt agreement at the balance sheet date Possible obligations for warranties (guarantees) and estimated returns Current liabilities do not include short-term debt if an entity intends to refinance them on a noncurrent basis and demonstrates an ability to do so. The ability to refinance may be demonstrated by entering into a refinancing agreement before the balance sheet is issued. Noncurrent liabilities (long term liabilities) are those not qualifying as current. The noncurrent portions of the following items are reported in this section of the balance sheet: Noncurrent notes and bonds A lessee’s liabilities under finance and operating leases Deferred tax liabilities arising from interperiod tax allocation Obligations under product or service warranty agreements Deferred revenue Advances for noncurrent commitments to provide goods or services Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 11 Equity Equity represents ownership interest in a firm. Owners of corporations are referred to as stockholders or shareholders. The following are the major items of equity: Capital contributions by owners (par value of common and preferred stock issued and additional paid-in capital). Additional paid-in (contributed) capital (APIC) is the amount received in excess of par value at the time stock was sold. Retained earnings is the accumulated net income not yet distributed to owners. Dividends can be paid when retained earnings has a balance. A payment in excess of this balance is a return of capital, not a dividend. Occasionally, the board of directors restricts retained earnings to prevent payment of dividends. The usual reason is that the board plans to reinvest the earnings in the business. Treasury stock is the firm’s own stock that has been repurchased. It is reflected in shareholders’ equity as a contra account (which reduces the balance of a related account). Accumulated other comprehensive income (all comprehensive income items not included in net income). Detailed equity transactions are covered in Subunit 1.4. Limitations of the Balance Sheet Limitations of using the balance sheet for decision making include the following: The balance sheet shows a company’s financial position at a single point in time. Accounts may vary significantly a few days before or after the publication of the balance sheet. Many balance sheet items, such as property, plant, and equipment, are recorded at historical costs, which may not equal their fair value. The preparation of the balance sheet requires estimates and management judgment. The balance sheet omits many items that cannot be recorded objectively but have financial value to the company. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 12 SU 1: External Financial Statements 1.3 Income Statement and Statement of Comprehensive Income Income Statement Elements The income statement reports the results of an entity’s operations over a period of time, such as a year. The Income Equation Income (Loss) = Revenues + Gains – Expenses – Losses The following are the elements of an income statement: Revenues are inflows or other enhancements of assets or settlements of liabilities (or both) from delivering or producing goods, providing services, or other activities that qualify as ongoing major or central operations. Gains are increases in equity (or net assets) other than from revenues or investments by owners. Expenses are outflows or other usage of assets or incurrences of liabilities (or both) from delivering or producing goods, providing services, or other activities that qualify as ongoing major or central operations. Losses are decreases in equity (or net assets) other than from expenses or distributions to owners. All transactions affecting the net change in equity during the period are included in income except Transactions with owners Prior-period adjustments (such as error correction or a change in accounting principle, which are covered in Subunit 1.4) Items reported initially in other comprehensive income Transfers to and from appropriated retained earnings Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 13 Cost of Goods Sold and Cost of Goods Manufactured Cost of goods sold is an expense account reported on the income statement. For a retailer, cost of goods sold represents the cost of the items being sold to customers and is calculated based on changes in inventory: Beginning inventory $10,000 Plus: Net purchases 14,000 Plus: Freight-in 1,000 Goods available for sale $25,000 Minus: Ending inventory (5,000) Cost of goods sold $20,000 For a manufacturer, cost of goods sold represents the cost of items that were produced (manufactured) by the firm and are being sold to customers. Manufacturers must calculate the cost of goods manufactured in order to calculate the cost of goods sold. The cost of goods manufactured is the cost of goods completed during the current year. It represents the cost of goods transferred out of work-in-process inventory to finished goods inventory. Manufacturers calculate cost of goods sold as follows: Beginning direct materials inventory $3,000 Purchases during the period 3,000 Ending direct materials inventory (1,000) Direct materials used in production $5,000 Direct labor costs 5,000 Manufacturing overhead costs* (Fixed + Variable) 4,000 Total manufacturing costs $14,000 Beginning work-in-process inventory 5,000 Ending work-in-process inventory (4,000) Cost of goods manufactured $15,000 Beginning finished goods inventory 6,000 Ending finished goods inventory (11,000) Cost of goods sold $10,000 *Study Unit 7, Subunit 1, has details about what is included in manufacturing overhead. Cost of goods sold is recognized at the time the goods are sold, which follows the matching principle. Gross profit is the net difference between sales revenue and cost of goods sold. Gross profit margin as a percentage of sales is calculated as follows: Gross profit margin (%) = Gross profit ÷ Sales Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 14 SU 1: External Financial Statements Example 1-2 Cost of Goods Sold and Cost of Goods Manufactured The following information was taken from the accounting records of Amy’s Manufacturing. Inventory January 1 December 31 Raw materials $ 65,000 $ 58,000 Work-in-process (WIP) 100,000 120,000 Finished goods 30,000 26,000 Other Information Purchase of raw materials $240,000 Direct labor 300,000 Factory rent 80,000 Factory utilities 25,000 Advertising expense 40,000 Administrative salaries 200,000 1. Find the direct materials used in production. Beginning raw materials $ 65,000 Add: Purchases during the period 240,000 Materials available $305,000 Less: Ending raw materials (58,000) Materials used in production $247,000 2. Find the total manufacturing cost. Materials used in production $247,000 Direct labor 300,000 Manufacturing overhead Factory rent $80,000 Factory utilities 25,000 Total manufacturing overhead 105,000 Total manufacturing costs $652,000 3. Calculate the cost of goods manufactured. Total manufacturing costs $652,000 Add: Beginning WIP inventory 100,000 Less: Ending WIP inventory (120,000) Cost of goods manufactured $632,000 4. Calculate the cost of goods sold. Cost of goods manufactured $632,000 Add: Beginning finished goods inventory 30,000 Less: Ending finished goods inventory (26,000) Cost of goods sold $636,000 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 15 Other Expenses General and administrative expenses are incurred for the benefit of the enterprise as a whole and are not related wholly to a specific function, e.g., selling or manufacturing. They include accounting, legal, and other fees for professional services; officers’ salaries; insurance; wages of office staff; miscellaneous supplies; and office occupancy costs. Selling expenses are those incurred in selling or marketing. Examples include sales representatives’ salaries, commissions, and traveling expenses; sales department salaries and expenses, including rent; advertising; and credit and collection costs. Shipping costs are also often classified as selling expenses. 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. Income Statement Formats The single-step income statement provides one grouping for revenue items and one for expense items. The single step is the one subtraction necessary to arrive at net income. The multiple-step income statement presents operating revenues and expenses in a section separate from nonoperating items. The most common way to present the income statement is the condensed format of the multiple- step income statement, which includes only the section totals. Example 1-3 Multiple-Step Income Statement Net sales $ 200,000 Cost of goods sold (150,000) Gross profit $ 50,000 Selling expenses (6,000) Administrative expenses (5,000) Income from operations $ 39,000 Other revenues and gains 3,500 Other expenses and losses (2,500) Income before taxes $ 40,000 Income taxes (16,000) Net income $ 24,000 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 16 SU 1: External Financial Statements Discontinued Operations When an entity reports a discontinued operation, it must be presented in a separate section between income from continuing operations and net income. Because these items are reported after the presentation of income taxes, they must be shown net of tax. The term “continuing operations” is used only when a discontinued operation is reported. Discontinued operations, if reported, may have two components: 1. Gain or loss from operations of the component that has been disposed of or is classified as held for sale from the first day of the reporting period until the date of disposal (or the end of the reporting period if it is classified as held for sale) 2. Gain or loss on the disposal of this component Example 1-4 Discontinued Operations Net sales $ 200,000 Cost of goods sold (150,000) Gross profit $ 50,000 Selling expenses (6,000) Administrative expenses (5,000) Income from operations $ 39,000 Other revenues and gains 3,500 Other expenses and losses (2,500) Income before taxes $ 40,000 Income taxes (16,000) Income from continuing operations $ 24,000 Discontinued operations Gain from operations of component (including loss on disposal of $5,000) $10,000 Income taxes (4,000) Gain from discontinued operations $ 6,000 Net income $ 30,000 Statement of Comprehensive Income Comprehensive income includes all changes in equity (net assets) of a business during a period except those from investments by and distributions to owners. It consists of Net income or loss (the bottom line of the income statement) Other comprehensive income (OCI) Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 17 Certain income items are excluded from the calculation of net income and instead are included in other comprehensive income. The following are the major items included in other comprehensive income: The effective portion of a gain or loss on a hedging instrument in a cash flow hedge Unrealized holding gains and losses due to changes in the fair value of available-for-sale debt securities Translation gains and losses for financial statements of foreign operations Certain amounts associated with accounting for defined benefit postretirement plans All items of comprehensive income are recognized for the period in either One continuous financial statement that has two sections, net income and OCI, or Two separate but consecutive statements. 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 a total of OCI with its components and a total of comprehensive income. Example 1-5 Separate Statement of Comprehensive Income Net income $70,000 Other comprehensive income (net of tax): Loss on defined benefit postretirement plans $(15,000) Gains on foreign currency translation 6,000 Gains on remeasuring available-for-sale securities 4,000 Effective portion of losses on cash flow hedges (3,000) Other comprehensive income (loss) (8,000) Total comprehensive income $62,000 Limitations of the Income Statement The income statement does not always show all items of income and expense. Some of the items are reported on a statement of other comprehensive income and not included in the calculation of net income. The financial statements report accrual-basis results for the period. The company may recognize revenue and report net income before any cash was actually received. For example, the data from the income statement itself is not sufficient enough for assessing liquidity. This statement must be viewed in conjunction with other financial statements, such as the balance sheet and statement of cash flows. The preparation of the income statement requires estimates and management judgment. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 18 SU 1: External Financial Statements 1.4 Statement of Changes in Equity and Equity Transactions Statement of Changes in Equity A statement of changes in equity presents a reconciliation for the accounting period of the beginning balance for each component of equity to the ending balance. Each change is disclosed separately in the statement. The following are the common changes in the equity component balances during the accounting period: Item Equity Component and Direction Net income Retained earnings ↑ Net loss Retained earnings ↓ Distributions to owners (dividends) Retained earnings ↓ Issuance of common stock Common stock ↑ Issuance of common stock – portion above par Additional paid-in capital (APIC) ↑ Total change in other comprehensive income (OCI) Accumulated OCI ↑ or ↓ Repurchase treasury stock Total stockholders’ equity ↓ Statement of Retained Earnings A statement of retained earnings reconciles the beginning and ending balances of the account. This statement is reported as part of the statement of changes in equity in a separate column. The following is a common example of retained earnings reconciliation: Retained earnings beginning balance + Net income (loss) for the period – Dividends distributed during the period + Positive (negative) prior-period adjustments Retained earnings ending balance Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 19 Prior-Period Adjustments Prior-period adjustments include the cumulative effect on the income statement of the following two items: 1. Changes in accounting principle (e.g., change in inventory valuation method) 2. Corrections of prior-period financial statement errors These items require retrospective application (i.e., adjustment of the carrying amounts of assets, liabilities, and retained earnings at the beginning of the first period reported for the cumulative effect of the new principle or the error on the prior periods). Correction of prior-period errors and the cumulative effect of changes in accounting principle must not be included in the calculation of current-period net income. Figure 1-1 Changes in accounting estimate are not prior-period adjustments. Examples include a change in the percentage used for the estimation of credit losses or the change in the estimated remaining life of a depreciable asset. Changes in accounting estimate require prospective application. The effect of the change is accounted for only in the period of the change and any future periods Figure 1-2 It may be impracticable to determine the cumulative effect of a new principle on any prior period. The new principle then must be applied as if the change had been made prospectively at the earliest date practicable. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 20 SU 1: External Financial Statements Common and Preferred Stock The most widely used classes of stock are common and preferred. If only one class of stock is issued, it is treated as common, and each shareholder must be treated equally. The following basic terminology is related to stock: Stock Term Definition Authorized Maximum amount of stock that a corporation may issue Issued Stock that has been sold to stockholders by the corporation Outstanding Stock currently held by stockholders The common shareholders are the owners of the firm. They have voting rights, and they select the firm’s board of directors and vote on resolutions. Common shareholders are not entitled to dividends unless declared by the board of directors. A firm may choose not to declare any. Common shareholders are entitled to receive liquidating distributions only after all other claims have been satisfied, including those of preferred shareholders. Common shareholders ordinarily have preemptive rights. Preemptive rights give current common shareholders the right to purchase any additional stock issuances in proportion to their ownership percentages. This way the preemptive rights safeguard a common shareholder’s proportionate interest in the firm. Preferred stock has features of debt and equity. It is classified as an equity instrument and presented in the equity section of the firm’s balance sheet. Preferred stock has a fixed charge, but payment of dividends is not an obligation. The payment of dividends is at the firm’s discretion. Preferred shareholders tend not to have voting rights. Preferred shareholders have the right to receive Dividends at a specified fixed rate before common shareholders may receive any Distributions before common shareholders, but after creditors, in the event of firm bankruptcy (liquidation) The following are common features of preferred stock: Cumulative preferred stock accumulates unpaid dividends (called dividends in arrears). Dividends in arrears must be paid before any common dividends can be paid. Holders of convertible preferred stock have the right to convert the stock into shares of another class (usually common stock) at a predetermined ratio. Treasury stock is the entity’s own stock that was repurchased by the entity subsequent to its initial issuance to shareholders. Treasury stock reduces the shares outstanding, not the shares authorized. Dividends are never paid to these shares. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 21 Equity Transactions Issuance of Stock The par value of stock is an arbitrary amount assigned by the issuer. Common and preferred stock are reported in the financial statements at par value. Additional paid-in capital (paid-in capital in excess of par) is increased for the difference between the cash received and the par value of the stock issuance. Example 1-6 Issuance of Stock A company issued 50,000 shares of its $1 par value common stock. The market price of the stock was $17 per share on the day of issue. Assets = Liabilities + Stockholders’ Equity Cash $850,000 ↑ Common stock $50,000 ↑ Additional paid-in capital $800,000 ↑ Cash: 50,000 shares × $17 market price = $850,000 Common stock: 50,000 shares × $1 par value = $50,000 Additional paid-in capital: $850,000 cash – $50,000 common stock = $800,000 Treasury Stock Treasury stock is reported using one of two methods: 1. Under the cost method, treasury stock is recorded at the cost of the purchase. Treasury stock is treated as a reduction to total stockholders’ equity. 2. Under the par value method, treasury stock is recorded for the par value of the stock. Treasury stock reduces total stockholders’ equity. Additional paid-in capital is reduced. Retained earnings is decreased if the acquisition price is greater than the original issue price. Treasury stock Has no voting rights Receives no distributions in liquidation Receives no dividends when the entity declares a dividend CMA candidates should be familiar with both methods to account for treasury stock. However, candidates should not expect questions that relate to comparing the results of the two methods. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 22 SU 1: External Financial Statements Example 1-7 Treasury Stock -- Acquisition Price > Original Issue Price Parvenu reacquired 5,000 shares of its $1 par value common stock for $20 per share. This stock had originally been issued at $17 per share. Parvenu had no prior treasury stock transactions. Cost method Assets = Liabilities + Stockholders’ Equity Cash $100,000 ↓ Treasury stock $100,000 ↓ 5,000 shares × $20 market price = $100,000 Par value method Assets = Liabilities + Stockholders’ Equity Cash $100,000 ↓ Treasury stock $5,000 ↓ Additional paid-in capital $80,000 ↓ Retained earnings $15,000 ↓ Cash payment: 5,000 shares × $20 market price = $100,000 Treasury stock: 5,000 shares × $1 par value = $5,000 Additional paid-in capital: 5,000 shares × $16 original issue excess = $80,000 Retained earnings -- difference: $100,000 cash payment – $5,000 treasury stock – $80,000 additional paid-in capital = $15,000 Example 1-8 Treasury Stock -- Acquisition Price < Issue Price Parvenu reacquired 5,000 shares of its $1 par value common stock for $10 per share. Cost method Assets = Liabilities + Stockholders’ Equity Cash $50,000 ↓ Treasury stock $50,000 ↓ 5,000 shares × $10 market price = $50,000 Par value method Assets = Liabilities + Stockholders’ Equity Cash $50,000 ↓ Treasury stock $5,000 ↓ Additional paid-in capital $45,000 ↓ Cash payment: 5,000 shares × $10 market price = $50,000 Treasury stock: 5,000 shares × $1 par value = $5,000 Additional paid-in capital -- difference: $50,000 cash payment – $5,000 treasury stock = $45,000 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 23 Cash Dividend The most common form of dividend is a cash dividend. An entity declares a dividend based on a dollar amount per share. Each shareholder receives cash as the form of distribution. On the declaration date, the board of directors formally approves a dividend. A declaration of a dividend decreases the retained earnings account. All holders of the stock on the record date are legally entitled to receive the dividend. There is no impact on the firm’s accounting equation on the record date. The payment date is the date on which the dividend is paid. Example 1-9 Cash Dividend On September 12, a company’s board of directors declared a $3 per-share dividend to be paid on October 15 to all holders of common stock. On the date of declaration, 40,000 shares of common stock were outstanding. Declaration date Assets = Liabilities + Stockholders’ Equity Dividends payable $120,000 ↑ Retained earnings $120,000 ↓ 40,000 shares outstanding × $3 per share = $120,000 Payment date Assets = Liabilities + Stockholders’ Equity Cash $120,000 ↓ Dividends payable $120,000 ↓ Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 24 SU 1: External Financial Statements Property Dividend When an entity declares a dividend consisting of tangible property, 1. The property is remeasured to fair value as of the date of declaration, and any gain or loss on the remeasurement is recognized in the statement of income. 2. The carrying amount of retained earnings is decreased for the fair value of the property to be distributed. 3. The property is distributed as a dividend. Example 1-10 Property Dividend On August 1, a company’s board of directors declared a property dividend (land) to be distributed on December 1 to holders of common stock. On August 1, the carrying amount of the land to be distributed is $50,000 and its fair value is $80,000. The journal entries to record the declaration and distribution of the property dividend are as follows: August 1 -- Declaration date Assets = Liabilities + Stockholders’ Equity Land $30,000 ↑ Property dividend payable $80,000 ↑ Gain on land remeasurement $30,000 ↑ Retained earnings $80,000 ↓ December 1 -- Payment date Assets = Liabilities + Stockholders’ Equity Land $80,000 ↓ Property dividend payable $80,000 ↓ Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 25 Stock Dividends and Stock Splits A stock dividend involves no distribution of cash or other property. Stock dividends are accounted for as a reclassification of different equity accounts, not as liabilities. The accounting for stock dividends depends on the percentage of new shares to be issued. Small stock dividend: An issuance of shares less than 20% to 25% of the previously outstanding common shares should be recognized as a stock dividend. Large stock dividend: An issuance of more than 20% to 25% of the previously outstanding common shares should be recognized as a stock split in the form of a dividend. In accounting for a stock dividend, the fair value of the additional shares issued is reclassified from retained earnings to common stock (at par value) and the difference to additional paid-in capital. Example 1-11 Small Stock Dividend On May 1, a company’s board of directors declared and paid a 10% stock dividend on the 45,000 shares of common stock outstanding ($1 par value). The stock was trading for $15 per share at the declaration date. May 1 -- Declaration and payment date Assets = Liabilities + Stockholders’ Equity Common stock $4,500 ↑ APIC $63,000 ↑ Retained earnings $67,500 ↓ 45,000 shares × 10% = 4,500 shares Retained earnings: 4,500 shares × $15 market price = $67,500 Common stock: 4,500 shares × $1 par value = $4,500 Additional paid-in capital -- difference: $67,500 retained earnings – $4,500 common stock = $63,000 For a stock dividend that is accounted for as a stock split in the form of a dividend, the par value of the additional shares issued is reclassified from retained earnings to common stock. Example 1-12 Large Stock Dividend Continuing from Example 1-11, assume that a 40% stock split in the form of a dividend was declared. May 1 -- Declaration and payment date Assets = Liabilities + Stockholders’ Equity Common stock $18,000 ↑ Retained earnings $18,000 ↓ 45,000 shares × 40% = 18,000 shares 18,000 shares × $1 par value = $18,000 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 26 SU 1: External Financial Statements Stock splits are issuances of shares that do not affect any aggregate par value of shares issued and outstanding or total equity. Stock split reduces the par value of each stock and increases the number of shares outstanding. No entry is made, and no transfer from retained earnings occurs. The primary purpose of a stock split is to improve the stock’s marketability by reducing its market price and proportionally increasing the number of shares outstanding. The following table summarizes the impact on the par value per share: Item Par value per share Small stock dividend No change Large stock dividend No change Stock split Decrease The following table summarizes the impact on the elements of the accounting equation: Additional Retained Total Stockholders’ Item Common Stock Paid-In Capital Earnings Equity Small stock dividend Increase Increase Decrease No change Large stock dividend Increase No change Decrease No change Stock split No change No change No change No change Limitations of the Statement of Changes in Equity The financial statements report accrual-basis results for the period. The company may recognize revenue and/or expense and report net income before any cash was actually received and/or paid. The data for retained earnings is not sufficient for assessing the amount actually available to be reinvested in the company or to pay debt. The statement of changes in equity illustrates a company’s equity based on a specific time period, which means equity may vary significantly a few days before or after publication of the statement. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 27 1.5 Statement of Cash Flows The primary purpose of the statement of cash flows is to provide relevant information about the cash receipts and cash payments of an entity during the period. To achieve this purpose, the statement should provide information about cash inflows and outflows from the operating, investing, and financing activities of an entity. This is the accepted order of presentation. The statement of cash flows should help users assess the entity’s ability to generate positive future net cash flows (liquidity), its ability to meet obligations (solvency), and its financial flexibility. The statement of cash flows explains the change in cash and cash equivalents during the period. It reconciles the period’s beginning balance of cash and cash equivalents with the ending balance. Example 1-13 Summary of Cash Flow Statement The following is an example of the summarized format of the statement of cash flows (only the headings). The amounts of cash and cash equivalents at the beginning and end of the year are taken from the balance sheet. Entity A’s Statement of Cash Flows for the Year Ended December 31, Year 1 Net cash provided by (used in) operating activities $20,000 Net cash provided by (used in) investing activities (5,000) Net cash provided by (used in) financing activities 9,000 Net increase (decrease) in cash and cash equivalents during the year $24,000 Cash and cash equivalents at beginning of year (January 1, Year 1) 6,000 Cash and cash equivalents at end of year (December 31, Year 1) $30,000 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 28 SU 1: External Financial Statements Operating Activities Operating activities are all transactions and other events that are not financing or investing activities. Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the entity. They generally result from transactions and other events that enter into the determination of net income. The following are examples of cash inflows from operating activities: Cash receipts from the sale of goods and services (including collections of accounts receivable) Cash receipts from royalties, fees, commissions, trading debt securities, and other revenue Cash received in the form of interest or dividends The following are examples of cash outflows from operating activities: Cash payments to suppliers for goods and services Cash payments to employees Cash payments to government for taxes, duties, fines, and other fees or penalties Payments of interest on debt Investing Activities Cash flows from investing activities represent the extent to which expenditures have been made for resources intended to generate future income and cash flows. The following are examples of cash outflows (and inflows) from investing activities: Cash payments to acquire (cash receipts from sale of) property, plant, and equipment; intangible assets; and other long-lived assets Cash payments to acquire (cash receipts from sale and maturity of) equity and debt instruments (such as held-to-maturity securities and available-for-sale debt securities) of other entities for investing purposes Cash advances and loans made to other parties (cash receipts from repayment of advances and loans made to other parties) Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 29 Financing Activities Cash flows from financing activities generally involve the cash effects of transactions and other events that relate to the issuance, settlement, or reacquisition of the entity’s debt and equity instruments. The following are examples of cash inflows from financing activities: Cash proceeds from issuing shares and other equity instruments (obtaining resources from owners). Cash proceeds from issuing loans, notes, bonds, and other short-term or long-term borrowings. The following are examples of cash outflows from financing activities: Cash repayments of amounts borrowed Payments of cash dividends Cash payments to acquire or redeem the entity’s own shares Cash payments by a lessee for a reduction of the outstanding liability relating to a finance lease Major Statement of Cash Flows Note Disclosures Information about all noncash investing and financing activities (i.e., investing and financing activities that affect recognized assets or liabilities but not cash flows) must be disclosed in the notes. The following are examples of noncash investing and financing activities: Conversion of debt to equity Acquisition of assets either by assuming directly related liabilities or by a lessee’s recognition of a finance or operating lease Exchange of a noncash asset or liability for another Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 30 SU 1: External Financial Statements Indirect Method of Presenting Operating Cash Flows Under the indirect method (also called the reconciliation method), the net cash flow from operating activities is determined by adjusting the net income of a business for the effect of the following: Noncash revenue and expenses that were included in net income, such as depreciation and amortization expenses, impairment losses, undistributed earnings of equity-method investments, and amortization of discount and premium on bonds Items included in net income whose cash effects relate to investing or financing cash flows, such as gains or losses on sales of property and equipment (related to investing activities) and gain or losses on extinguishment of debt (related to financing activities) All deferrals of past operating cash flows, such as changes during the period in inventory and deferred income All accruals of expected future operating cash flows, such as changes during the period in accounts receivable and accounts payable The net income for the period as it is reported in the income statement was calculated using the accrual method of accounting. Therefore, adjustments must be made to reach the amount of cash flow from operating activities. The following rules will help reconcile net income to net cash flow from operating activities under the indirect method: Increase in current operating liabilities Added to net income Decrease in current operating assets Added to net income Increase in current operating assets Subtracted from net income Decrease in current operating liabilities Subtracted from net income Noncash losses and expenses included in net income Added to net income Losses and expenses whose cash effects are Added to net income related to investing or financing cash flows Noncash gains and revenues included in net income Subtracted from net income Gains and revenues whose cash effects are Subtracted from net income related to investing or financing cash flows Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 31 Example 1-14 Statement of Cash Flows -- Indirect Method Dize Corp’s consolidated balance sheet accounts as of December 31, Year 6 and Year 5, are presented below. Information relating to Year 6 activities is to the left. Information Relating to Year 6 Activities Cash dividends of $240,000 were declared December 31 and paid by Dize in Year 6. Assets Year 6 Year 5 The accounts receivable balances at the Cash $ 195,000 $ 100,000 beginning and end of Year 6 were net of Current investments 300,000 0 allowances for credit losses of $50,000 and Accounts receivable (net) 480,000 510,000 $60,000, respectively. Dize wrote off $40,000 Inventory 680,000 600,000 of accounts receivable during Year 6. Prepaid expenses 15,000 20,000 Current investments consist of Treasury bills Equity method investment 215,000 300,000 maturing on 6/30/Year 7. They were acquired Plant assets 1,730,000 1,000,000 for cash on December 31, Year 6. Accumulated depreciation (480,000) (450,000) Goodwill 90,000 100,000 Equipment costing $400,000 and having a Total assets $3,225,000 $2,180,000 carrying amount of $140,000 was sold on January 1, Year 6, for $150,000 in cash. Liabilities and Equity Additional plant assets were purchased in Year 6 for cash. Accounts payable $ 825,000 $ 720,000 Interest payable 15,000 10,000 Dize accounts for its interest in Thrice Corp. Income tax payable 20,000 30,000 under the equity method. Its equity in Thrice’s Current debt 325,000 0 Year 6 earnings was $25,000. During Year 6, Deferred taxes 250,000 300,000 Dize received a $10,000 cash dividend from Common stock, $10 par 800,000 700,000 Thrice. At the end of Year 6, Dize sold part of Additional paid-in capital 370,000 250,000 its investment in Thrice for $135,000 in cash. Retained earnings 620,000 170,000 Significant influence over Thrice was not lost Total liabilities & equity $3,225,000 $2,180,000 as a result of the sale. The provision for Year 6 income taxes was $210,000. 10,000 shares of common stock were issued in Year 6 for $22 a share. The following computations are necessary to determine the net cash flows from operating, investing, and financing activities: Net income. The starting point for presenting the net cash flow from operating activities is net income (loss) for the period. Net income can be calculated as follows: Ending retained earnings $620,000 Dividends declared 240,000 Beginning retained earnings (170,000) Year 6, net income $690,000 The $240,000 of cash dividends paid in Year 6 are a cash outflow from financing activities. -- Continued on next page -- Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 32 SU 1: External Financial Statements Example 1-14 -- Continued Accounts receivable. The easiest way to determine the reconciling adjustment for accounts receivable is to calculate the change in their net amount (Accounts receivable – Allowance for credit losses). Net accounts receivable are current operating assets. A decrease in net accounts receivable of $30,000 ($510,000 – $480,000) is added to net income to determine the net cash flow from operating activities. Plant assets. The items that affect the presentation of cash flow from operating activities are depreciation expense, gain or loss on disposal, and impairment loss. Depreciation expense for Year 6 can be calculated as follows: Ending accumulated depreciation $480,000 Accumulated depreciation on items sold 260,000 Beginning accumulated depreciation (450,000) Depreciation expense $290,000 Depreciation expense is a noncash expense included in net income. Thus, $290,000 is added to net income in determining the net cash flows from operating activities. The gain on disposal of the equipment is $10,000 ($150,000 cash received – $140,000 carrying amount). The cash effect is related to investing activities. Thus, it is subtracted from net income to determine the net cash flow from operating activities. The $150,000 of cash proceeds from sale of equipment is a cash inflow from investing activities. Plant assets purchased in Year 6 (cash outflow from investing activities) can be calculated as follows: Ending plant assets at cost $1,730,000 Plant assets sold at cost 400,000 Beginning plant assets at cost (1,000,000) Plant assets purchased $1,130,000 NOTE: The following equation may be useful for deriving the required information if the data given in the question are for the carrying amount (Cost – Accumulated depreciation) of the PPE item. Beginning carrying amount $XXX Purchases during the period XXX Depreciation expense (XXX) Disposals during the period (XXX) Ending carrying amount $XXX Equity-method investment. The carrying amount of the equity-method investment sold can be calculated as follows: Beginning carrying amount $300,000 Equity in Thrice’s current year earnings 25,000 Dividends received from Thrice (10,000) Ending carrying amount (215,000) Carrying amount of investment sold $100,000 -- Continued on next page -- Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 33 Example 1-14 -- Continued NOTE: Accounting for equity method investments is covered in detail in Study Unit 3, Subunit 2. The gain on sale of the investment is $35,000 ($135,000 cash received – $100,000 carrying amount). The cash effect is related to investing activities. Thus, it is subtracted from net income in determining the net cash flows from operating activities. Undistributed earnings on equity-method investment. Under the equity method, the investor’s share of the investee’s earnings is recorded to the investment account and reported as income. A cash dividend from the investee is a return of an investment that results in an increase to cash and a decrease to the investment. The undistributed earnings on the equity- method investments equal $15,000 ($25,000 share in earnings – $10,000 dividends received). This amount is a noncash revenue included in net income. Thus, it is subtracted from net income in determining the net cash flow from operating activities. The cash received on the sale of the investment of $135,000 is a cash inflow from investing activities. Goodwill. Goodwill is not amortized. Thus, the $10,000 decrease in the amount of goodwill ($100,000 beginning balance – $90,000 ending balance) must be a result of impairment. A loss on impairment of goodwill is a noncash loss included in net income. Thus, it is added to net income in determining the net cash flow from operating activities. Goodwill is covered in detail in Subunit 1.6 and Study Unit 3, Subunit 5. Current investments. The purchase of current investments for $300,000 is a cash outflow from investing activities. Common stock. The proceeds from issuing common stock were $220,000 (10,000 × $22). This cash inflow from financing activities equals the sum of the increases in the common stock and additional paid-in capital accounts. Inventory is a current operating asset. Inventory increased by $80,000 ($680,000 – $600,000). This amount is subtracted from net income in determining the net cash flow from operating activities. Prepaid expenses are current operating assets. Prepaid expenses decreased by $5,000 ($15,000 – $20,000). This amount is added to net income in determining the net cash flow from operating activities. Accounts payable is a current operating liability. Accounts payable increased by $105,000 ($825,000 – $720,000). This amount is added to net income in determining the net cash flow from operating activities. Interest payable is a current operating liability. Interest payable increased by $5,000 ($15,000 – $10,000). This amount is added to net income in determining the net cash flow from operating activities. Income tax payable is a current operating liability. Income tax payable decreased by $10,000 ($20,000 – $30,000). This amount is subtracted from net income in determining the net cash flow from operating activities. Current debt. The issuance of $325,000 of current debt ($325,000 – $0) is a cash inflow from financing activities. The deferred tax liability decreased by $50,000 ($250,000 – $300,000). The decrease in the deferred tax liability increases net income by decreasing income tax expense. This decrease is a noncash item included in net income. Thus, it is subtracted from net income in determining the net cash flow from operating activities. Deferred taxes are covered in Study Unit 4, Subunit 3. -- Continued on next page -- Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 34 SU 1: External Financial Statements Example 1-14 -- Continued Dize Corp. Consolidated Statement of Cash Flows -- Indirect Method for the Year Ended December 31, Year 6 Cash flows from operating activities: Net income for Year 6 $ 690,000 Decrease in accounts receivable 30,000 Depreciation expense 290,000 Gain on disposal of equipment (10,000) Gain on sale of investment (35,000) Undistributed earnings of equity-method investment (15,000) Loss on impairment of goodwill 10,000 Increase in inventories (80,000) Decrease in prepaid expenses 5,000 Increase in accounts payable 105,000 Increase in interest payable 5,000 Decrease in income tax payable (10,000) Decrease in deferred tax liability (50,000) Net cash provided by operating activities $ 935,000 Cash flows from investing activities: Proceeds from sale of equipment $ 150,000 Purchases of plant assets (1,130,000) Proceeds from sale of equity-method investment 135,000 Purchases of current investments (300,000) Net cash used in investing activities $(1,145,000) Cash flows from financing activities: Dividends paid $ (240,000) Proceeds from issuing common stock 220,000 Proceeds from current debt 325,000 Net cash provided by financing activities $ 305,000 Net increase in cash $ 95,000 Cash, beginning of year 100,000 Cash, end of year $ 195,000 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 35 Limitations of the Statement of Cash Flows A cash flow statement is not sufficient for forecasting the profitability of a firm as noncash items are not included in the calculation of cash flow from operating activities. A cash flow statement may not represent the true liquid position of an entity. Decisions regarding large expenditures could be based on misconceived information when decisions are based only on the statement of cash flows. This statement must be viewed in conjunction with other financial statements, such as the balance sheet and the income statement. Information can be manipulated in the statement of cash flows. For instance, management can schedule vendor payments to occur after year end to increase net cash flows reported on the statement of cash flows. 1.6 Consolidation Accounting When one entity controls another, consolidated financial statements must be issued by a parent company regardless of the percentage of ownership. Consolidated Financial Statements A business combination is a transaction in which an acquirer obtains control of another business. Control is a controlling financial interest. It is the direct or indirect ability to determine the direction of management and policies of the investee. Control usually is when one entity has direct or indirect ownership of more than 50% of the outstanding voting interests of another entity. A parent is an entity with a controlling financial interest in one or more subsidiaries. Consolidated statements present amounts for the parent and subsidiary(ies) as if they were a single economic entity. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 36 SU 1: External Financial Statements The primary consolidation models are the voting interest entity (VOE) model and the variable interest entity (VIE) model. Under the VOE model, financial control is determined by ownership of a majority voting interest, i.e., more than 50%. Under the VIE model, financial control exists even if the reporting entity does not have more than 50% voting ownership. This occurs when one entity has the power to direct the activities of another entity. The controlling entity absorbs the losses or benefits from the controlled entity. ► The controlled entity does not have sufficient financial resources to support its ongoing operating needs. The controlling interest is generally arranged through a contract, not direct ownership. A parent and subsidiary may exist separately for an indefinite period, but consolidated financial statements must report them as a single economic entity. Required consolidated reporting is an example of substance over form. Even if the two entities remain legally separate, the financial statements are more meaningful to users if they see the effects of control by one over the other. Acquisition Method A business combination must be accounted for using the acquisition method. It Determines the acquirer and the acquisition date. Recognizes and measures at acquisition-date fair value the Identifiable assets acquired, Liabilities assumed, and Any noncontrolling interest in the acquiree. Recognizes goodwill or a gain from a bargain purchase. The consideration transferred in a business combination must be measured at acquisition-date fair value. Calculation of Goodwill or Gain from a Bargain Purchase Goodwill is an intangible asset reflecting the future economic benefits resulting from other assets acquired in a business combination that are not individually identified and separately recognized. At the acquisition date, the acquirer recognizes and measures goodwill or a gain from a bargain purchase. This measure is the difference between the fair value of the consideration transferred minus the fair value of identifiable net assets acquired. If the result is positive, goodwill is recognized. If the result is negative, a gain from a bargain purchase is recognized. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 37 Consolidated Financial Reporting – Acquisition-Date Balance Sheet Acquisition-Date Balance Sheet A balance sheet should be prepared that reports the financial position of the consolidated entity on the acquisition date. Step 1: Determine the amount of goodwill or gain from a bargain purchase recognized on the business combination. Step 2: Prepare the assets section of the consolidated balance sheet by adding the assets of the parent and subsidiary. Assets and liabilities are reported at 100% of their fair value. In Example 1-15, land is revalued to its fair value, and goodwill is recognized. Example 1-15 Assets Section of the Balance Sheet Consolidated assets are calculated as follows: Current assets of parent $140,000 Current assets of subsidiary 40,000 Consolidated current assets $180,000 Noncurrent assets of parent $180,000 Noncurrent assets of subsidiary 80,000 Excess fair value -- land 25,000 Goodwill 25,000 Consolidated noncurrent assets $310,000 Step 3: Prepare the liabilities section of the consolidated balance sheet, adding the liabilities of the parent and subsidiary together. Step 4: Determine the noncontrolling interest (NCI). An NCI (a minority interest) exists when less than 100% of the acquiree was acquired. An NCI is not reported for every asset and liability. The entire NCI is reported as a single component of consolidated equity. Step 5: Because a combination is an acquisition of net assets, the subsidiary’s equity accounts are eliminated. In the absence of a bargain purchase, the equity of the consolidated entity immediately after acquisition is the equity of the parent just prior to acquisition plus the fair value of the noncontrolling interest. Step 6: Prepare the acquisition-date balance sheet. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 38 SU 1: External Financial Statements Candidates are not required to prepare a consolidated balance sheet on the CMA exam. Example 1-16 Calculation of Goodwill Entity C acquired 80% of the outstanding common stock of Entity D for $192,000. Entity D’s acquisition- date fair values of identifiable assets and liabilities were $350,000 and $140,000, respectively. The acquisition-date fair value of NCI was $48,000. The goodwill is calculated as follows: Consideration transferred $192,000 Noncontrolling interest 48,000 Acquisition-date fair value of identifiable net assets (Assets – Liabilities) acquired: Assets $350,000 Liabilities (140,000) (210,000) Goodwill $ 30,000 Example 1-17 Calculation of Goodwill Using the information provided in Example 1-16, assume that the acquisition-date fair value of the identifiable assets acquired was $400,000 (instead of $350,000). The gain from the bargain purchase is calculated as follows: Acquisition-date fair value of identifiable net assets (Assets – Liabilities) acquired: Assets $400,000 Liabilities (140,000) $260,000 Consideration transferred (192,000) Noncontrolling interest (48,000) Gain from bargain purchase $ 20,000 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: External Financial Statements 39 Consolidated Financial Reporting: Subsequent to the Acquisition Date Consolidation Process After the close of the fiscal year in which the combination occurred, the consolidated entity prepares its first full set of consolidated financial statements. The following steps must be performed when preparing consolidated financial statements: All line items of assets, liabilities, revenues, expenses, gains, losses, and other comprehensive income (OCI) of a subsidiary are added item-by-item to those of the parent. These items are reported at the consolidated amounts. No investment in the subsidiary account is presented in the consolidated financial statements. Consolidated statements report the assets and liabilities of the subsidiary and the parent as if they are a single economic entity. All the equity accounts of the subsidiary are eliminated (not presented in the consolidated financial statements). Retaine