CMA Assumed Knowledge. Volume 2. Financial Accounting

Transcription

1 CMA Assumed Knowledge Volume 2 Financial Accounting

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3 Fifth Edition CMA Preparatory Program CMA Assumed Knowledge Volume 2 Financial Accounting Brian Hock, CMA, CIA and Lynn Roden, CMA

4 HOCK international, LLC P.O. Box 204 Oxford, Ohio (866) 807-HOCK or (866) (281) Published February 2010 Acknowledgements Acknowledgement is due to the Institute of Certified Management Accountants for permission to use questions and problems from past CMA Exams. The questions and unofficial answers are copyrighted by the Certified Institute of Management Accountants and have been used here with their permission. The authors would also like to thank the Institute of Internal Auditors for permission to use copyrighted questions and problems from the Certified Internal Auditor Examinations by The Institute of Internal Auditors, Inc., 247 Maitland Avenue, Altamonte Springs, Florida USA. Reprinted with permission. The authors also wish to thank the IT Governance Institute for permission to make use of concepts from the publication Control Objectives for Information and related Technology (COBIT) 3rd Edition, 2000, IT Governance Institute, Reproduction without permission is not permitted HOCK international, LLC No part of this work may be used, transmitted, reproduced or sold in any form or by any means without prior written permission from HOCK international, LLC.

5 Thanks The authors would like to thank the following people for their assistance in the production of this material: All of the staff of HOCK Training and HOCK international for their patience in the multiple revisions of the material, The students of HOCK Training in all of our classrooms and the students of HOCK international in our Distance Learning Program who have made suggestions, comments and recommendations for the material, Most importantly, to our families and spouses, for their patience in the long hours and travel that have gone into these materials. Editorial Notes Throughout these materials, we have chosen particular language, spellings, structures and grammar in order to be consistent and comprehensible for all readers. HOCK study materials are used by candidates from countries throughout the world, and for many, English is a second language. We are aware that our choices may not always adhere to formal standards, but our efforts are focused on making the study process easy for all of our candidates. Nonetheless, we continue to welcome your meaningful corrections and ideas for creating better materials. This material is designed exclusively to assist people in their exam preparation. No information in the material should be construed as authoritative business, accounting or consulting advice. Appropriate professionals should be consulted for such advice and consulting.

6 Dear Future CMA: Welcome to HOCK international! You have made a wonderful commitment to yourself and your profession by choosing to pursue this prestigious credential. The process of certification is an important one that demonstrates your skills, knowledge and commitment to your work. We are honored that you have chosen HOCK as your partner in this process. We know that this is a great responsibility, and it is our goal to make this process as painless and efficient as possible for you. To do so, HOCK has developed the following tools for your use: A Study Plan that guides you, week by week, through the study process. You can also create a personalized study plan online to adapt the plan to fit your schedule. Your personalized plan can also be ed to you at the beginning of each week. The Textbook that you are currently reading. This is your main study source and contains all of the information necessary to pass the exam. This textbook follows the exam contents and provides all necessary background information so that you don t need to purchase or read other books. The Flash Cards include short summaries of main topics, key formulas and concepts. You can use them to review whenever you have a few minutes, but don t want to take your textbook along. ExamSuccess contains original questions and questions from past exams that are relevant to the current syllabus. Answer explanations for the correct and incorrect answers are also included for each question. Practice Questions taken from past CMA Exams that provide the opportunity to practice the essay-style questions on the Exam. Teacher Support via our online student forum, , and telephone throughout your studies to answer any questions that may arise. Class Recordings are audio recordings of classes conducted and taught by HOCK lecturers. With the Class Recordings you are able to have the benefits of attending classes without actually being required to be near a location where classes are held. We understand the commitment that you have made to the exams, and we will match that commitment in our efforts to help you. Furthermore, we understand that your time is too valuable to study for an exam twice, so we will do everything possible to make sure that you pass the first time. I wish you success in your studies, and if there is anything I can do to assist you, please contact me directly at brian.hock@hockinternational.com. Sincerely, Brian Hock, CMA, CIA President and CEO

7 CMA Assumed Knowledge, Vol. 2 Table of Contents Table of Contents Introduction to the CMA Assumed Knowledge Book Financial Accounting Environmental Assumptions 11 The Financial Statements 13 The Balance Sheet 13 The Income Statement 17 The Statement of Cash Flows (SCF) 19 Statement of Comprehensive Income 20 U.S. Accounting Regulations Users of Financial Information 21 History of the Accounting Standard Setting Process 22 The IASB (International Accounting Standards Board) Statements of Financial Accounting Concepts SFAC 1 Objectives of Financial Reporting 25 SFAC 2 Qualitative Characteristics of Accounting Information 26 SFAC 5 Recognition and Measurement Concepts 28 SFAC 6 Elements of the Financial Statements 30 Limitations of Financial Statements Cash Cash Equivalents 34 Accounts Receivable Discounts and Initial Recording of the A/R 35 Trade Discounts 35 Cash Discounts 35 Sales Returns 38 Immaterial Amount of Returns 38 Material Amount of Returns 38 Customer Deposits 38 Determining the Receivable Amount and Valuing the Receivable 39 Percentage-of-Sales Method 43 Percentage-of-Outstanding-Receivables Method 44 Receivables as an Immediate Source of Cash Notes Receivable Presentation on the Balance Sheet 52 Valuation of Short-Term Notes Receivable 53 Long-Term Notes Receivable With Reasonable Interest Rate 53 Unreasonable Interest Rate Long-Term Notes Receivable 53 Non Interest Bearing Notes Receivable 54 i

8 Table of Contents CMA Assumed Knowledge, Vol. 2 Calculation of Interest Revenue 54 Calculation of Interest Receivable 54 Amortization of the of Premium or Discount 54 Calculating the Gain or Loss on Sale of the Asset 54 Impairment of Long-Term Notes Receivable 56 Investments in Marketable Securities Classification of Securities 58 Determination of Cost 58 Subsequent Changes in Market Value of Trading and Available-for-Sale Securities 58 Realized Gain or Loss on Sale of Security 60 Transferring Securities between Categories 63 Marketable Securities Summary 63 Financial Instruments and Derivatives Inventory Classifications of Inventory 67 Valuing the Inventory When It Is Purchased 67 What Goods Are Included in Inventory 68 Determining Which Item Is Sold 70 First in First Out (FIFO) 71 Last in First Out (LIFO) 71 Weighted Average 72 Effect of the Different Methods 73 The Frequency of Determining Inventory Balances 73 Periodic System 73 Perpetual System 74 Errors in Inventory 78 The Physical Inventory Count Gross Profit Calculation 80 Dollar-value LIFO 82 The DVLIFO Calculations 83 Recognizing Permanent Declines through the Lower of Cost or Market (LCM) 88 LIFO and LCM 89 Estimating Inventory 90 Gross Profit Method 90 Retail Method 91 Other Inventory Items 104 Property, Plant and Equipment Measurement at Acquisition 106 Method of Payment at Acquisition 107 Internally Constructed Assets - The Capitalization of Interest 108 Qualifying Assets 108 ii

9 CMA Assumed Knowledge, Vol. 2 Table of Contents When Can Interest Be Capitalized 109 Calculating the Interest to Capitalize 109 Depreciation 112 Calculation of Depreciation 113 Depreciation Methods 113 Depreciation in the Year of Acquisition and Disposal 116 Subsequent Expenditures 118 Disposals of Fixed Assets 119 Involuntary Disposals 119 Disposal by Donation 120 Acquisition and Disposals by Exchange 121 Accounting for Exchanges that Have Commercial Substance 122 Accounting for Exchanges That Lack Commercial Substance 122 Recognition of the Loss from a Noncommercial Exchange 123 Summary 127 Impairment of Property, Plant and Equipment 130 Intangible and Other Assets Impairment of Intangible Assets 133 Research and Development (R&D) 134 Prepaid Expenses 136 Computer Software 136 Capitalize 137 Expense 137 Inventory 137 Bonds Issuance of the Bonds Calculating the Selling Price 139 Recording the Sale of the Bond in the Books 142 How the Premium or Discount Is Created 142 Amortizing the Premium or Discount 144 Amortization of a Bond Discount 144 Example 145 Amortization of a Bond Premium 146 Financial Statements Issued on Dates Other Than Interest Payment Dates 147 A Bond Paying Interest Semi-Annually 148 Journal Entry to Record Issuance 149 Straight-line Amortization of Bond Premium or Discount 151 Investments in Bonds 153 Example 154 Bonds Issued or Purchased Between Interest Payment Dates 155 Bond Issue Costs 158 Early Extinguishment of Debt (Bonds Payable) 159 Convertible Bonds 162 iii

10 Table of Contents CMA Assumed Knowledge, Vol. 2 Book Value Method 162 Market Value Method 162 Types of Bonds 164 Term Bonds vs. Serial Bonds 164 Debenture Bonds vs. Guaranteed Bonds 164 Registered Bonds vs. Coupon Bonds 164 Callable, Convertible and Other Bonds 165 Bond Disclosures for Issuer of Bonds 166 One-page Summary of Bonds 168 Leases Two Types of Leases 169 Operating Leases 169 Capital Leases 169 Pensions Accounting for Income Taxes Presentation of Taxes on the Income Statement 174 Temporary Timing Differences The Cause of Deferred Taxes 174 Other Liabilities Current Liabilities 175 Definitely Determinable Liabilities 175 Accounts Payable (A/P) 175 Short-Term Notes Payable (N/P) 175 Zero Interest Bearing Notes 176 Current Maturities of Long-Term Debt 176 Dividends Payable 177 Unearned Revenue 177 Estimated Liabilities Compensated Absences 177 Contingencies 178 Contingent Liabilities 178 Warranties 181 Premiums or Coupons 183 Refinancing of Short-Term Obligations 185 Troubled Debt Restructurings 186 Owners Equity Corporate Shareholders Equity 191 Common Stock Rights and Expectations of Common Shareholders 192 Issuing Common Stock 193 Common Stock Dividends Stock Dividends 199 iv

11 CMA Assumed Knowledge, Vol. 2 Table of Contents Stock Splits 200 Preferred Stock Preferred Dividends 202 Share Issuance Costs 203 Treasury Stock Classification of Shares 204 Authorized Shares 204 Issued Shares 204 Outstanding Shares 204 Accounting for Treasury Stock 205 Recognition of Gain or Loss on Share Transactions 205 The Cost Method 206 The Par Value Method 207 Retirement of Shares 212 Stock Rights Employees and Share-Based Payment Plans (formerly Stock Compensation Plans) 215 Classified as Liabilities or Equity? 215 Accounting for Grants Classified as Equity 216 Retained Earnings Accounting for Appropriated Retained Earnings 219 Accumulated Other Comprehensive Income Statement of Stockholders Equity 221 The Income Statement Income from Continuing Operations 224 Classification of Expenses 226 Revenue Recognition Goods in Transit 228 Unearned Revenue 228 Revenue Recognized at the Completion of Production 229 Installment Method of Profit Recognition 231 Presentation of Deferred Gross Profit in the Financial Statements 231 Cost Recovery Method of Profit Recognition 236 The Deposit Method 238 Revenue Recognition When the Right of Return Exists 238 Consignment Sales 239 Accounting for the Consignor 239 Accounting for the Consignee 240 Royalties 240 Long-Term Contracts 241 Completed Contract Method 241 v

12 Table of Contents CMA Assumed Knowledge, Vol. 2 Percentage-of-Completion Method 242 Other Income Statement Items After Continuing Operations Discontinued Operations Extraordinary Events Insurance and Extraordinary Events 255 Reporting of Other Events in Retained Earnings 257 Accounting Changes and Corrections 257 Three Methods of Accounting for Changes or Corrections 257 Accounting for Changes in Accounting Principles Retrospective Adjustment 258 Accounting for a Change in Reporting Entity Retrospective Adjustment 259 Correction of Errors Restatement 259 Accounting for Changes in Accounting Estimates Prospective Adjustment 261 A Change in Accounting Estimate Effected by a Change in Accounting Principle 261 Required Disclosures When a Change in Accounting Principle is Made 262 Earnings Per Share Income Available to Common Shareholders (IAC) 263 The Impact of Dividends on IAC 263 Weighted Average Number of Common Shares Outstanding (WANCSO) 264 Basic EPS 266 Diluted EPS 268 1) Calculate BEPS 268 2) Calculate the Impact of Warrants and Options 268 3) Calculate the EPS Effect of Convertible Bonds or Convertible Preferred Shares 270 4) Add in the EPS Effects of Convertible Bonds or Convertible Preferred Shares 271 5) Calculate the Final DEPS 271 Table for the Calculation of the EPS Effects 272 EPS Disclosure Notes The Statement of Cash Flows Classification of Items within the Statement of Cash Flows 276 Operating Activities 277 Investing Activities 277 Financing Activities 277 Noncash Investing and Financing Activities 278 Cash Equivalents and Foreign Currencies 279 Preparing the Statement of Cash Flows Format of the Statement of Cash Flows 281 The Direct Method Cash Flows From Operating Activities Under the Direct Method 282 Cash Collected from Customers 282 Items Recognized as Revenue but Not Collected: Receivables 283 Items Collected, but Not Recognized as Revenue: Unearned Revenue 283 vi

13 CMA Assumed Knowledge, Vol. 2 Table of Contents Accounts Receivable Written Off 284 Cash Paid to Suppliers 284 Cash Paid for Operating Expenses 286 Gains and Losses 287 Deferred Taxes 287 Amortization of Bond Premium or Discount 288 Other Revenue or Expense Items 289 The Indirect Method Cash Flows from Operating Activities Under the Indirect Method 290 Elimination of Noncash Income Statement Items 290 Elimination of Non-Operating Activity Events 291 Individual Account Adjustments 291 Rule for Increases and Decreases in Asset and Liability Accounts 292 Preparing the SCF Under the Indirect Method 293 Calculation of Investing Activities Calculation of Financing Activities Large SCF Question Accounting for Foreign Operations Restatement of Non-U.S. GAAP Financial Statements into U.S. GAAP 301 Translation of Foreign Currency Financial Statements 301 Remeasurement 303 Translation 304 Foreign Currency Transactions Foreign Currency Hedges 310 Table of Gains and Losses Calculations 310 Accounting for Investments Chain of Investment 312 The Cost Method 313 Acquisition of the Investment 313 Change in Fair Value of the Investment 313 Dividends Received 313 Income of the Investee Company 314 Intercompany Receivables and Payables 314 Disposal of the Investment 314 The Equity Method 316 Post Acquisition Events 316 Investee s Earnings 316 Cash Dividends 316 Stock Dividends and Stock Splits 316 Intercompany Profits and Losses 317 Intercompany Receivables and Payables 317 vii

14 Table of Contents CMA Assumed Knowledge, Vol. 2 Goodwill 317 Specific Investee Assets 317 Deferred Income Taxes 318 Losses in Excess of Carrying Value of an Equity Method Investment 318 Changing Levels of Investments to Different Classifications 321 Business Combinations Recording Assets and Liabilities 324 Recording Equity 324 Goodwill 325 Negative Goodwill 325 Consolidation of Financial Statements The Elimination of Intercompany Receivables and Payables 327 The Elimination of the Effect of Intercompany Sales of Inventory 327 The Elimination of the Effect of Intercompany Sales of Fixed Assets 328 Elimination of the Parent s Investment Account 328 Noncontrolling Interests 328 Other Eliminations 328 Other Topics Segment Reporting Accounting for Natural Resources Development Stage Enterprises (DSE) Accounting Legislation in the United States The Securities Act of The Securities Exchange Act of The Annual Report The Financial Statements 336 The Notes to the Financial Statements 336 Auditor s Reports 337 The Report of Management 339 The Letter to Shareholders 339 The Management Discussion and Analysis 339 The Statement on Social Responsibility 341 The SEC and Its Reporting Requirements The Integrated Disclosure System 342 The Basic Information Package (BIP) 342 Registration (Filing) Requirements 343 Shelf Registration 344 Filing Procedures 344 Reporting Requirements 345 Proxy Solicitations 346 Shareholder Proposals 347 viii

15 CMA Assumed Knowledge, Vol. 2 Table of Contents Sarbanes-Oxley Act of Audit Committee Requirements, Responsibilities and Authority 351 Requirements for Audit Committee and Audit Committee members 351 Responsibilities of the Audit Committee: 352 Authority of the Audit Committee 353 Answers to Questions ix

16 Introduction CMA Assumed Knowledge, Vol. 2 Introduction to the CMA Assumed Knowledge Book The CMA exams introduced in 2010 are focused on the critical skills of financial planning, analysis, control, and decision support. This is a little different from the focus of prior CMA exams, which was broader. Although some topics are no longer specifically tested on the exams, that does not mean that candidates do not need to know that material. In their literature regarding the 2010 CMA exams, the Institute of Certified Management Accountants states that the topics of economics, basic statistics and financial accounting are now assumed knowledge. Candidates are assumed to have a strong background in these topics, and the ICMA highly recommends prior college-level courses in accounting and finance. This book has been prepared to assist candidates who may need help with these assumed knowledge topics. Economics and basic statistics were covered in Volume 1, and financial accounting is covered here in Volume 2. Your use of this book should depend on what you need. If you already have a strong background in a particular topic, then you may not need to spend time on that topic. If you have virtually no background in a given topic, then this book can give you the background you need, and we suggest you spend some time on it. Or, you may prefer to use this book as a reference book to research specific topics you find you need more information about as you are working through the primary study materials in preparing for your exams. The information in the Assumed Knowledge Book qualifies for HOCK teacher support the same as the regular study materials. If there is something in this book that you need help understanding, please do not hesitate to contact us or post a question on our website forums. 10

17 Financial Accounting The Financial Statements Financial Accounting Financial accounting is the process of reporting the results and effects of the financial transactions that a business undertakes. The information that is provided through financial accounting and reporting is supposed to be useful to those individuals who are using this information to make some sort of decision. The types of decisions that these individuals are making are varied and numerous. As a result, it is not really possible for accounting information to provide all of the necessary information that every user would like to have. However, the financial statements do attempt to provide as much useful information as possible to the users. Before we look at the details of how this information is accounted for and reported, we will start by discussing some of the assumptions that we make about the environment in which businesses operate. Without these assumptions, it would be difficult to provide useful information in a cost effective manner. Environmental Assumptions There are four environmental assumptions that are made (you do not need to memorize this as a specific list, but you do need to be familiar with the concepts). It is assumed that: 1) The entity for which the accounting information is being prepared/reported is a specific economic entity and that its operations can be separated from the activities of other entities; 2) The business is a going concern, which means that it is expected to remain in business and operational for the foreseeable future; 3) There is a standard unit of measurement used to measure the transactions that this company undertakes. This unit of measurement is a monetary unit and in the U.S. and the Exam, it is assumed to be the U.S. dollar; and 4) The entity provides financial information on a periodic basis. This period is almost always one year, but may include shorter periods when interim financial statements are presented. In addition to these environmental assumptions, there are some basic accounting principles that you need to know (but, again, you do not need to memorize these items as a specific list). These principles will be seen again and again throughout the course because they are, in a sense, the basis for our accounting process and decision-making. All assets and liabilities are recorded at their historical cost. This is the cost that was paid when the company originally acquired the asset. If an asset is acquired in an unusual or related party transaction, it is recorded at the cost that would have been paid if acquired in an arm s-length transaction with an unrelated third party. Revenue is recognized when it is earned and an exchange has taken place. In order to properly state its income, a company needs to match expenses that are incurred with the revenue that is generated by them or with the benefits received from them. Expenses that are matched with revenue should be recorded in the same period as the revenue is recorded. Depreciation is the allocation of expenses over several periods when an asset provides benefits over several periods. This matching principle is accomplished through accrual accounting. Accounting information needs to be objective and verifiable. There will still be estimates that are made, but they must be reasonable meaning that another person would come to a similar conclusion. Accountants are going to focus on and include those items that are material. Material is a difficult term to specifically define, but it can generally be defined as an amount of money (or misstatement) that would change the decision of a user of the financial statements. Immaterial items will be ignored or may be accounted for in a different, less strict, manner than material items. 11

18 The Financial Statement CMA Assumed Knowledge, Vol. 2 Accounting standards must be applied and consistently used so that the information presented in one period is consistent and comparable to the information that was presented in a previous period. In the financial statements there must be full disclosure of all of the relevant events of the company. This disclosure may take place in either the financial statements themselves or in the notes to the financial statements. The nature and amount of information should reflect a balance between (1) giving enough detail so that matters that make a difference to users are disclosed and (2) sufficient condensation to make the information understandable. Accountants are basically conservative. This means that accountants will recognize gains and profits only when they occur, but they will recognize losses and expenses when they are incurred (the expense is accrued). This includes recognizing known losses and expenses that will occur at some point in the future. Note: It is also possible to present financial statements that are prospective, showing projected information about the future. In this case, information about significant accounting policies and assumptions must be disclosed. Question 1: All of the following support the objectives of financial reporting except providing information that a) is useful for making investment and credit decisions. b) helps management evaluate alternative projects. c) concerns enterprise resources and claims to those resources. d) helps investors and creditors predict future cash flows. (CMA Adapted) The accounting model that you must know is the formula that is present in the balance sheet, which is: Assets = Liabilities + Owners Equity You also need to be familiar with the formula for the income statement: Revenues Expenses = Net Income 12

19 Financial Accounting The Financial Statements The Financial Statements In U.S. GAAP, there are five financial statements, which are: 1) Balance Sheet also called the Statement of Financial Position), 2) Income Statement, 3) Statement of Cash Flows, 4) Statement of Comprehensive Income, and 5) Statement of Retained Earnings. Note: The notes to the financial statements are also considered an integral part of the financial statements, but not an actual financial statement. The purpose of the notes is to provide informative disclosures that are required by GAAP. Note: A company can also prepare prospective financial statements. These are financial statements that are based on a set of assumptions and cover a future period. Whenever prospective financial statements are prepared, the significant accounting policies and significant assumptions that were made need to be disclosed. The Balance Sheet The balance sheet, also called a statement of financial position, provides information about an entity s assets, liabilities and owners equity as well as their relationships to each other at a point in time. The balance sheet is a picture of what the company owns and owes at a particular point in time (usually the end of a period). Note: The balance sheet helps users to assess the liquidity, financial flexibility, profitability and risk of a company. It helps users in predicting the amounts, timing, and uncertainty of future cash flows. The balance sheet presents three of the elements (there are ten elements that are discussed in the section on U.S. GAAP) of the financial statements assets, liabilities and equity. It presents them in what is called the proprietary theory. This means that net assets are viewed as belonging to the owner or proprietor. Before looking in more detail at the elements of the balance sheet, we first need to cover the definition of an asset and a liability. An asset is something that: 1) Arose from a past transaction, 2) Is currently owned by the company, and 3) Will provide future benefit to the company, There are three time periods in this definition the past, the present and the future. A liability is something that: 1) Arose from a past transaction, 2) Is currently owed by the company, and 3) Will lead to future economic outflow from the company. There are the same three time periods in this definition as in assets the past, the present and the future. 13

20 The Financial Statement CMA Assumed Knowledge, Vol. 2 Current and Noncurrent Classification of Assets and Liabilities In the balance sheet, assets and liabilities are classified as either current or noncurrent. (This is the same split as between short-term and long-term, but the more correct terminology is current and noncurrent.) The distinction between current and noncurrent is based upon the time frame in which the asset or liability is expected to be settled (for liabilities) or converted into cash (for assets). Note: The operating cycle is average time between the acquisition of resources (or inventory) and the final receipt of cash from their sale. Question 2: A statement of financial position provides a basis for all of the following except a) computing rates of return. b) evaluating capital structure. c) assessing liquidity and financial flexibility. d) determining profitability and assessing past performance. (CMA Adapted) Current Assets Current assets are those that will be converted into cash or sold or consumed within 12 months or within one operating cycle if the operating cycle is longer than 12 months. This means that an asset that will be converted in 18 months may be classified as a current asset, but all assets that will be converted in less than 12 months will always be classified as current assets. Current assets are perhaps the easiest of the different sections of the balance sheet and include: Cash Coins, currency, undeposited checks, money orders and drafts, and demand deposits. Cash equivalents Short-term, highly liquid investments that are convertible to known amounts of cash and have maturities of 3 months or less from the date of purchase. Inventories Goods on hand and available for sale. Receivables Trade accounts receivable, notes receivable, receivables from affiliates and officer and employee receivables. Short-term investments maturing in less than one year Marketable securities purchased with temporarily idle cash that can be sold to meet current cash needs, or investments maturing within one year or the operating cycle, if longer. Prepaid expenses Amounts paid in advance for the use of assets (such as rent) or for the receipt of services at a future date. These are not convertible to cash, but they are classified as current assets because they would have required the use of current assets during the coming operating cycle if they had not been prepaid. Noncurrent Assets Noncurrent assets are those assets that will not be converted into cash within one year, or during the operating cycle if the operating cycle is longer than one year. There are a number of different categories of noncurrent assets. The accounting issues surrounding noncurrent assets are slightly more involved than current assets. We will look at the accounting issues for these items in more detail later. Here we are just identifying what the items are. 14

21 Financial Accounting The Financial Statements Long-term Investments and Funds Long-term investments and funds that are expected to be held for more than one year are included in noncurrent assets. Examples of these items are: Investments in securities made to control or influence the other organization. Available-for-sale and held-to-maturity securities that are not current. This can include stocks, bonds and long-term notes receivable. If management intends to hold them for more than one year, they are classified as long-term. Funds that are restricted for noncurrent purposes (the retirement of debt or to pay for the construction of fixed assets), The cash surrender value of a life insurance policy. (The cash surrender value of a life insurance policy is essentially the amount that the holder of the policy would get from the insurance company if he or she cancelled their insurance.). And fixed assets not used in operations (such as idle facilities or land held for future use). Property, Plant and Equipment (Fixed Assets) These are tangible assets that are used in operations and will be used past the end of the current period. When these items are purchased they are recorded at their purchase price, and this amount is then expensed over the life of the asset through depreciation. Examples of Property, Plant and Equipment (PPE) are buildings, machinery, equipment, cars, leasehold improvements, and assets that have been obtained through a capital lease. Intangible Assets These are assets that do not have a physical presence, but provide benefit to the firm over a period of time. Intangible assets may be either purchased or developed internally. However, because an asset only comes about as a result of a prior transaction, internally generated intangible assets are not recorded on the balance sheet. Examples of intangible assets are copyrights, patents, goodwill, trademarks and franchises. Other Noncurrent Assets This is the other category that gets all of the noncurrent assets that are not included in any other category. Examples of these items are: Long-term receivables, Bond issue costs, Long-term prepayments, and Deferred tax assets. 15

22 The Financial Statement CMA Assumed Knowledge, Vol. 2 Current Liabilities Current liabilities are those liabilities that will be settled within one year, or during the operating cycle if it is longer than one year. Another way of looking at the classification of current liabilities is that they will require either the use of current assets or the creation of other current liabilities to be settled. Examples of current liabilities are: Accounts payable due to suppliers for purchase of goods and services; Trade notes payable arising from the purchase of goods and services; Dividends payable; Unearned revenues (advances and deposits received); Agency collections such as employee tax withholdings and sales taxes, where the company acts as agent for another party and is obligated to remit the payments; Obligations that, by their terms, are due on demand, even if the term of the obligation is greater than one year; Short-term (30-, 60-, 90-day, etc.) notes; Current portion of long-term debt (the portion of the principal due within the current period); and Long-term obligations that are callable at the balance sheet date due to some violation by the company. Current liabilities do not include the following items: Debts to be paid by funds that are in accounts classified as noncurrent. The parts of short-term obligations that are intended to be refinanced by long-term obligations. In order to reclassify these current liabilities into noncurrent the company must have demonstrated the ability to refinance these obligations. Noncurrent Liabilities Noncurrent liabilities are those that will not be settled within one year, or the operating cycle if the operating cycle is longer than one year. Examples of noncurrent liabilities are: Long-term notes or bonds payable, Liabilities from capital leases, Pension obligations, Deferred tax liabilities, Obligations under warranty agreements, Advances for long-term commitments to provide goods and services, and Long-term deferred revenue. 16

23 Financial Accounting The Financial Statements Question 3: Long-term debt should be included in the current section of the statement of financial position if a) it is to be converted into common stock before maturity. b) it matures within the year and will be retired through the use of current assets. c) management plans to refinance it within the year. d) a bond retirement fund has been set up for use in its scheduled retirement during the next year. (CMA Adapted) Owners Equity This is the remaining balance of assets after the subtraction of all liabilities, and this topic is covered in much more detail in the owners equity section. This is the amount of the company s assets owned by and owed to the owners. If the company were to liquidate, this is the amount that would theoretically be distributable to the owners. All business enterprises have owners equity, but the types of accounts in owners equity will differ depending on the type of the entity. We will focus on corporations. Owners equity for corporations is split into three different categories. 1) Capital contributed by owners (from the sale of shares), 2) Retained earnings (profits of the company that have not been distributed through dividends), and 3) Other comprehensive income items (these are specific items that are not included in the income statement, but are included in equity as Other Comprehensive Income items). Note: When a corporation repurchases shares of itself from the market these shares are called treasury shares. The accounting for treasury shares is covered in owners equity. The Income Statement The income statement is created using the accruals method of accounting and applying this method to historical transactions. The income statement gives the results of operations for a period of time and is like a movie recording the events of the business for that period of time. The accounts that are used to record revenues, expenses, gains and losses are temporary accounts. This means that they are closed to a permanent account (retained earnings) at the end of each period (fiscal year), and so at the start of each period, the balance in the income statement accounts is 0. Certain types of events are classified and reported separately on the income statement. The standard income statement format includes the following sections: Sales Cost of Goods Sold (COGS) = Gross Profit Other Expenses and Losses + Other Revenues and Gains = Pretax income from continuing operations Provision for income taxes from continuing operations = Income from continuing operations +/ Discontinued Operations +/ Extraordinary Events = Net Income 17

24 The Financial Statement CMA Assumed Knowledge, Vol. 2 Note: In addition to all of this information regarding income, information regarding Earnings per Share (EPS) must also be disclosed on the face of the income statement. Revenues are inflows of assets or a reduction of liabilities as a result of delivering goods or providing services that are the entity s main or central operations. Revenues are usually recognized when the earnings process (the provision of goods or services to the customer) is complete and an exchange has taken place. The exchange does not need to include cash, but may include a promise to pay in the future (a receivable). Additionally, revenue may also be recognized under the following methods in the right circumstances: Percentage-of-completion for long-term contracts, Production basis for agricultural products and precious metals, Installment basis used when we are not certain of the collectibility of the account, and Cost-recovery basis used when we are unable to measure the certainty of collectibility. Expenses are outflows of assets or the incurrence of liabilities as a result of delivering goods or providing services that are the entity s main or central operations. Expenses are recognized based upon one of the following three methods: Cause and effect cost of goods sold are recognized when the item is sold, Systematic and rational allocation such as depreciation, and Immediate recognition if an expense will not provide future benefit, it is immediately recognized. Gains are increases in equity as a result of transactions that are not part of the company s main or central operations and that do not result from revenues or investments by the owners of the entity. Losses are decreases in equity as a result of transactions that are not part of the company s main or central operations and that do not result from expenses or distributions made to owners of the entity. Gains and losses can be classified as either operating or nonoperating, depending on what event it is related to. Question 4: The financial statement that provides a summary of the firm s operations for a period of time is the a) income statement. b) statement of financial position. c) statement of shareholders equity. d) statement of retained earnings. (CMA Adapted) 18

25 Financial Accounting The Financial Statements The Statement of Cash Flows (SCF) The SCF is one of the three main financial statements presented by companies (the other two are the balance sheet and income statement). The SCF must be presented by all businesses (profit and non-profit, public and private) whenever the company presents a balance sheet and income statement. The SCF must be presented for any year in which an income statement is presented. This means that even if a company presents only income statements but no balance sheets for prior periods, they must also present the SCF for each of the prior periods. The primary purpose of the SCF is to provide information regarding receipts and uses of cash for the company during a period of time. The information on the SCF helps users of the financial statements to assess: the ability of the company to generate positive future cash flows and meet obligations as they come due; the liquidity, solvency and financial flexibility of the company; and the company s need for external financing. Classification within the SCF SCF presents all of the receipts and uses of cash of the company during the period. For the purposes of presentation and usefulness, the cash activities are broken down into three main categories of activities for the presentation in the SCF. These three categories are: Operating activities, Investing activities, and Financing activities. The SCF also presents information about noncash investing and financing activities. These transactions are investing or financing activities, but they did not use cash. 19

26 The Financial Statement CMA Assumed Knowledge, Vol. 2 Statement of Comprehensive Income U.S. GAAP has a basis of comprehensive income. Comprehensive income includes all transactions of the company except for those transactions that are made with the owners of the company (such as distribution of dividends or the sale of shares). Comprehensive income is the change in equity (net assets) of an entity during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income includes everything on the income statement plus some things that do not appear on the income statement. Therefore, it is more inclusive than traditional net income. An example of an item that is comprehensive income but which does not appear on the income statement is unrealized holding gains and losses on available-for-sale securities. These are not included in net income but they are included in comprehensive income. Other Comprehensive Income is a line in the equity section of the balance sheet which includes these items that are not reflected on the income statement. There is no required format for the presentation of the Statement of Comprehensive Income, but it is generally done by adding the items of Other Comprehensive Income to the bottom of the income statement. The items that are considered other comprehensive income items are expressly stated in the standards. The four items currently in this group include: 1) Foreign currency translation adjustments, 2) Gains or losses and prior service costs or credits related to a defined benefit pension plan that have not been recognized as components of net periodic benefit cost, 3) Unrealized holding gains or losses on available-for-sale securities, and 4) The effective portion of the gain or loss on a derivative designated as a cash flow hedge. These four items may be shown as either net of tax or not net of tax. However, if they are not shown net of tax, the tax effects of these items must be disclosed separately. A company must report the accumulated balance of the items of other comprehensive income on the balance sheet as an element of owners equity. This should be reported separately from stock, additional-paid-in-capital (APIC) and retained earnings. Note: It is very possible for a company to have none of these items. Therefore this will not be an issue, and the income statement becomes the Statement of Comprehensive Income. For the exam you need to be able to identify the items that are included as Other Comprehensive Income items. Question 5: Comprehensive income is best defined as a) net income excluding extraordinary gains and losses. b) the change in net assets for the period including contributions by owners and distributions to owners. c) total revenues minus total expenses. d) the change in net assets for the period excluding owner transactions. (CMA Adapted) 20

27 Financial Accounting U.S. GAAP Hierarchy U.S. Accounting Regulations In this section we are looking at the regulations regarding the reporting of financial information outside of the company. The fact that the information will be used outside of the company is important because it means that it will be governed by the rules of accounting and reporting established in the U.S. by various accountancy bodies during the past 70 years. Accounting and financial information used only inside the company does not need to be in compliance with these standards and rules because it is only used inside the company; therefore, the public at large cannot directly suffer a loss as a result of errors in internal reporting. Users of Financial Information Information that is going outside of the company must be in compliance with the established accounting guidelines because outside users will be relying on this information to make a variety of decisions. These rules and standards are in place for the purpose of protecting outside users by ensuring that everyone understands the information and that it is accurate and useful. We will look later at the characteristics of useful information, but we will start by looking first at the users of the financial information reported by a company. Users are classified by various distinctions: Direct vs. Indirect Users - Direct users, or individuals who are directly affected by the results of a company, include investors and potential investors, employees, management, suppliers and creditors. These are individuals who stand to lose money financially if the company has financial problems. Indirect users are basically those people or groups who represent direct users. They include financial analysts and advisors, stock markets and regulatory exchanges. Internal vs. External This distinction is rather obvious in that internal users are making decisions within the firm whereas external users are making decisions from outside of the firm about whether or not to continue, start or change their relationship with the firm. Because there are so many people who are using the financial information and using it for so many diverse reasons, there are a lot of different types of required information. Some of the key reasons that people need this information are to: Make investment decisions, Extend credit or not, Assess areas of strength and weakness within the company, Evaluate performance of management, or Determine if the company is in compliance with necessary regulatory rules. Users of financial information are presumed to have a reasonable understanding of business and economic activities and to be willing to study the information with reasonable diligence. 21

28 U.S. GAAP Hierarchy CMA Assumed Knowledge, Vol. 2 History of the Accounting Standard Setting Process In this attempt to ensure that good information is provided to the users of the financial statements, there are certain standards that must be followed in the calculation, development, and publication of financial information. These standards are widely known as GAAP (Generally Accepted Accounting Principles). Currently, the Financial Accounting Standards Board (FASB) primarily sets the GAAP. However, because the FASB has not always set the GAAP, we are briefly outlining below the history of the standard setting process. Note: GAAP by itself is a general term that is used for any country s accounting policies. Therefore, there are many different GAAPs in use around the world. Some of the more well-known or better GAAPs are UK, Japanese and International Financial Reporting Standards (IFRS). Prior to the U.S. stock market crash of 1929, there was very little required financial reporting and that reporting was not always reliable. This was due to the different ways used by different companies to calculate the reported amounts. Partly as a response to the stock market crash, the U.S. Government created the Securities Exchange Commission (SEC) in the Securities Act of The SEC was created in order to enforce the Securities Act of The 1933 Act relates to the initial issuance of securities. It is the SEC, created in the 1934 Act, that operates as the policeman and enforcer of the rules in the 1933 Act and other subsequent governmental legislation. Another function of the SEC is the creation of the rules that publicly traded companies are required to follow in their financial reporting. Note: The reporting rules of the SEC do not apply to companies that are not publicly traded. This is because of the fact that in publicly traded companies large numbers of people are potentially relying on this information and at the same time risking their money. If a company is not publicly traded, few people are relying on the information reported by the company. Also, because of the size of the company, the people that are likely to be impacted by any errors in the financial information are probably in a position to know about the errors. After its creation, the SEC delegated authority to the American Institute of Accountants (the predecessor to the American Institute of CPAs AICPA) to carry out the standard setting process. The AIA then formed the Committee on Accounting Procedure (CAP) and then the Accounting Principles Board (APB) to actually determine and set up the standards. These two organizations (CAP and APB) were not completely successful because they failed to provide a conceptual framework for the accounting reporting field, and their pronouncements tended to be very specific and narrowly focused. In the early 1970s, the Financial Accounting Standards Board (FASB) replaced the APB as the accounting standard setter. The SEC has delegated the right to develop standards to the FASB, but has specifically kept the following responsibilities: Identify areas for which additional information is needed, and Determine the appropriate methods of disclosure to meet those needs. The SEC has essentially accepted the FASB as the standard setting body and currently functions largely in an oversight capacity. Note: An example of SEC involvement in the standard setting process is the standards for oil and gas accounting. The standard developed by FASB was not well received and the SEC got involved to allow a second method. Until July 1, 2009, the FASB published Statements of Financial Accounting Standards, or SFASs, as well as Interpretations of Statements, both of which had the highest level of GAAP authority. Effective July 1, 2009, the FASB introduced the Accounting Standards Codification TM which became the sole source of authoritative U.S. GAAP. 22