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الجمعة، 23 يناير 2015

EXTERNAL FINANCIAL STATEMENTS AND REVENUE RECOGNITION part1

STUDY UNIT ONE
EXTERNAL FINANCIAL STATEMENTS

AND REVENUE RECOGNITION

assigned to this major topic in Part 1 of the exam is 15%. The three study units are
Study Unit 1: External Financial Statements and Revenue Recognition
Study Unit 1. External Financial Statements and Revenue Recognition
1.1.    Concepts of Financial Accounting........................................................................ 11
1.2.    Statement of Financial Position {Balance Sheet)................................................. 14
1.3.    Income Statement and Statement of Comprehensive Income............................. 17

1.1 CONCEPTS OF FINANCIAL ACCOUNTING
1.       The Objective of General-Purpose Financial Reporting
a.       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.
b.      The information reported relates to the entity’s economic resources and claims to them
(financial position) and to changes in those resources and claims.
1)      Information about economic resources and claims helps to evaluate liquidity, solvency, financing needs, and the probability of obtaining financing.
c.       Users need to differentiate between changes in economic resources and claims
arising from (1) the entity’s performance (income statement) and (2) other events and transactions, such as issuing debt and equity (balance sheet). Information about financial performance is useful for
1)      Understanding the return on economic resources, its variability, and its
components;
2)      Evaluating management; and
3)      Predicting future returns.
d.      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).
NOTE: The CMA exam also tests some knowledge of International Financial Reporting Standards (IFRS). When international standards diverge significantly from U.S. GAAP, the differences are highlighted, if there is no specification between GAAP and IFRS, use GAAP.
e.      Financial accounting differs from management accounting.
1)      Management accounting assists management decision making, planning, and control. Management accounting information is therefore primarily directed to specific internal users, and it ordinarily need not follow GAAP.

2.        Users of Financial Statements
a.       Users may directly or indirectly have an economic interest in a specific business.
Users with direct interests usually invest in or manage the business, and users with indirect interests advise, influence, or represent users with direct interests.
1)     Users with direct interests include
a)      Investors or potential investors
b)      Suppliers and creditors
c)      Employees
d)      Management
2)     Users having indirect interests include
a)      Financial advisors and analysts
b)      Stock markets or exchanges
c)      Regulatory authorities
b.       External users use financial statements to determine whether doing business with the
firm will be beneficial.
1)     Investors need information to decide whether to increase, decrease, or obtain an
investment in a firm.
2)     Creditors need information to determine whether to extend credit and under what
terms.
3)     Financial advisors and analysts need financial statements to help investors
evaluate particular investments.
4)     Stock exchanges need financial statements to evaluate whether to accept a
firm’s stock for listing or whether to suspend the stock’s trading.
5)     Regulatory agencies may need financial statements to evaluate the firm’s
conformity with regulations and to determine price levels in regulated industries.
c.       Internal users use financial statements to make decisions affecting the operations of
the business. These users include management, employees, and the board of directors.  .
1)     Management needs financial statements to assess financial strengths and
deficiencies, to evaluate performance results and past decisions, and to plan for future financial goals and steps toward accomplishing them.
2)     Employees want financial information to negotiate wages and fringe benefits
based on the increased productivity and value they provide to a profitable firm.
3.        Features of Financial Statements
a.       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.
1) 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.
a)      Financial statement notes should not be used to correct improper presentation.

b.      A full set of financial statements includes the following statements:
1)      Statement of financial position (also called a balance sheet)
2)      Income statement
3)      Statement of comprehensive income
4)      Statement of changes in equity
5)      Statement of cash flows
c.       To be useful, information presented in the financial statements must be relevant and
faithfully represented. To enhance the usefulness, the information should be comparable with similar information for (1) other entities and (2) the same entity for another period or date. Thus, comparability allows users to understand similarities and differences.
d.      Financial statements are prepared under the going-concern assumption, which
means that the entity is assumed to continue operating indefinitely. As a result, liquidation values are not important. It is assumed that the entity is not going to be liquidated in the near future.
4.       Financial Statement Relationships
a.       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.
b.      The components (elements) of one statement relate to those of other statements.
Among the relationships are those listed below:
1)      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.
2)      The components of cash and equivalents from the statement of financial position
are reconciled with the corresponding items in the statement of cash flows.
3)      Items of equity from the statement of financial position are reconciled with the
beginning balances on the statement of changes in equity.
4)      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.
5)      Amortization and depreciation reported in the statement of income also are
reflected in asset and liability balances in the statement of financial position.
NOTE: See Appendix A for a complete set of financial statements. The complementary relationships among these statements are lettered.
5.       Accrual Basis of Accounting
a.       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.
1)      Revenues are recognized in the period in which they were earned even if the
cash will be received in a future period.
2)      Expenses are recognized in the period in which they were incurred even if the
cash will be paid in a future period.
NOTE: 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.
Stop and review! You have completed the outline for this subunit. Study multiple-choice questions 1 through 3 beginning on page 34.

1.2    STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)
1.       Overview
a.       The statement of financial position, also called the balance sheet, reports the amounts
of assets, liabilities, equity, and their relationships at a moment in time, such as at the end of the fiscal year. It helps users to assess liquidity, financial flexibility, and risk.
b.       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 the entity deploys in its attempts to earn a return. The capital structure consists of the amounts contributed by outsiders (liabilities) and insiders (equity).
Assets = Liabilities + Equity
2.       Elements of Balance Sheet
a.       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.
b.       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, bonds issued by the entity, and accounts payable.
c.       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.
1)     Investments by owners are increases in equity of a business entity. They result
from transfers of something of value to increase ownership interests. Assets are the most commonly transferred item, but services also can be exchanged for . equity interests.
2)     Distributions to owners are decreases in equity. They result from transferring
assets, providing services, or incurring liabilities. A distribution to owners decreases the ownership interest in the company.
d.       Assets and liabilities are separated in the statement of financial position into current
and noncurrent categories.
1)     Assets are generally reported in order of liquidity.
e.      Some variation of the following classifications is used by most entities:





NOTE: A comprehensive example of statement of financial position can be found in Appendix A.
3.       Current and Noncurrent Assets
a.       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 is longer.

b.      The following are the major categories of current assets: (1) cash and cash
equivalents; (2) certain individual trading, available-for-sale, and held-to-maturity securities; (3) receivables; (4) inventories; and (5) prepaid expenses, etc.
c.      Noncurrent assets are those not qualifying as current.
d.      The following are the major categories of noncurrent assets:
1)      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:
a)      Investments in securities made to control or influence another entity and
other noncurrent securities.
b)      Certain individual trading, available-for-sale, and held-to-maturity securities
may be noncurrent.
c)      Funds restricted as to withdrawal or use for other than current operations,
for example, to (1) retire long-term debt, (2) satisfy pension obligations, or (3) pay for the acquisition or construction of noncurrent assets.
2)      Property, plant, and equipment (PPE) are tangible operating items recorded at
cost and reported net of any accumulated depreciation. They include
a)      Land and natural resources subject to depletion, e.g., oil and gas
b)      Buildings, equipment, furniture, fixtures, leasehold improvements, land
improvements, assets held under capital leases, noncurrent assets under construction, and other depreciable assets
3)      Intangible assets are nonfinancial assets without physical substance. Examples
are patents and goodwill.
4.       Current and Noncurrent Liabilities
a.      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.
1)      Generally speaking, current liabilities are expected to be settled or liquidated within 1 year from the balance sheet date.
b.      The following are the major categories of current liabilities:
1)      Trade payables for items entering into the operating cycle, e.g., for materials
and supplies used in producing goods or services for sale.
2)      Other payables arising from operations, such as accrued wages, salaries,
rentals, royalties, and taxes.
3)      Unearned revenues arising from collections in advance of delivering goods or
performing services, e.g., ticket sales revenue.
4)      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
a)      Short-term notes given to acquire capital assets
b)      Payments required under sinking-fund provisions
c)      Payments on the current portion of serial bonds or other noncurrent debt
d)      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
c.      Current liabilities do not include short-term debt if an entity
1)      Intends to refinance them on a noncurrent basis and
2)      Demonstrates an ability to do so.
a) The ability to refinance may be demonstrated by entering into a refinancing agreement before the balance sheet is issued.

d.      Noncurrent liabilities are those not qualifying as current. The noncurrent portions of the following items are reported in this section of the balance sheet:
1)      Noncurrent notes and bonds
2)      Liabilities under capital leases
3)      Most postretirement benefit obligations
4)      Deferred tax liabilities arising from interperiod tax allocation
5)      Obligations under product or service warranty agreements
6)      Advances for noncurrent commitments to provide goods or services
7)      Deferred revenue
5.       Equity
a. Any recognized transaction that does not have equal and offsetting effects on total
assets and total liabilities changes equity. The following are the major items of equity:
1)      Capital contributions by owners (par value of common and preferred stock
issued and additional paid-in capital).
a)      Additional paid-in (contributed) capital is the amount received in excess of par value at the time stock was sold.
2)      Retained earnings are the accumulated net income not yet distributed to
owners. Retained earnings can be restricted or unrestricted depending on the board of directors’ intent.
a)      Restriction of retained earnings indicates their unavailability for disbursement as dividends.
3)      Treasury stock is the firm’s own stock that has been repurchased.
a)      Treasury stock is reported either at cost (as a deduction from total equity)
or at par (as a direct reduction of the relevant contributed capital account).
b)      Treasury stock is reported as a reduction of equity.
4)      Accumulated other comprehensive income items not included in net income.
6.       Balance Sheet Elements Are Permanent Accounts
a.       Assets, liabilities, and equity are recorded in permanent (real) accounts. Their balances at the end of one accounting period (the balance sheet date) are carried forward as the beginning balances of the next accounting period.
7.       Major Note Disclosures
a.       The first footnote accompanying any set of complete financial statements is generally
one describing significant accounting policies, such as the use of estimates and rules for revenue recognition.
b.       Footnote disclosures and schedules specifically related to the balance sheet include
1)      Investment securities
2)      Property, plant, and equipment holdings
3)      Maturity patterns of bond issues
4)      Significant uncertainties, such as pending litigation
5)      Details of capital stock issues
8.       Limitations of Balance Sheet
a.       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.
b.       Many balance sheet items, such as fixed assets, are valued at historical costs, which
may bear no resemblance to the current value of those items. Even those assets reported at their current fair values may not always faithfully represent what a company could sell those items for on an open market.

Stop and review! You have completed the outline for this subunit. Study multiple-choice questions 4 through 8 beginning on page 35.
1.3    INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME
1.       Income Statement Elements
a.       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
b.      The following are the elements of income statement:
1)      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.
2)      Gains are increases in equity (or net assets) other than from revenues or
investments by owners.
3)      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.
4)      Losses are decreases in equity (or net assets) other than from expenses or
distributions to owners.
c.       All transactions affecting the net change in equity during the period are included in
income except
1)      Transactions with owners                                      .
2)      Prior-period adjustments (such as error correction or a change in accounting
principle)
3)      items reported initially in other comprehensive income
4)      Transfers to and from appropriated retained earnings
d.      Revenues, expenses, gains, and losses are recorded in temporary (nominal)
accounts because they record the transactions, events, and other circumstances during a period of time. These accounts are closed (reduced to zero) at the end of each accounting period, and their balances are transferred to real accounts.
1) For example, income or loss for the period (a nominal account) is closed to

retained earnings (a real account) at the end of the reporting period.
2.       Typical Items of Cost and Expense
a.       The expense recognition principles are associating cause and effect, systematic
and rational allocation, and immediate recognition.
1) Matching is essentially synonymous with associating cause and effect. Such a direct relationship is found when the cost of goods sold is recognized in the same period as the revenue from the sale of the goods.
b.      Cost of Goods Sold
1) For a retailer, cost of goods sold 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


c.       Other Expenses
1)     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.
a) They include accounting, legal, and other fees for professional services; officers’ salaries; insurance; wages of office staff; miscellaneous supplies; and office occupancy costs.
2)     Selling expenses are those incurred in selling or marketing.
a)      Examples include sales representatives’ salaries, commissions, and
traveling expense; advertising; sales department salaries and expenses, including rent; and credit and collection costs.
b)      Shipping costs are also often classified as selling costs.
d.      Interest expense is recognized based on the passage of time, in the case of bonds,
notes, and capital leases, the effective interest method is used.
3.       Income Statement Formats
a.       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.
b.      The multiple-step income statement matches 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.
1) The following is an example of a condensed multiple-step income statement.
EXAMPLE

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
A more detailed example format can be found in Appendix A; . ;










4.        Reporting Irregular Items
a.       When an entity reports a discontinued operation or an extraordinary item, it must
be presented in a separate section after income from continuing operations.
1)      Because these items are reported after the presentation of income taxes, they
must be shown net of tax.
2)      The term “continuing operations” is used only when a discontinued operation is
reported.
b.      Discontinued operations, if reported, may have two components:
1)      Income 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
c.       Extraordinary items are income statement items that meet the following two criteria:
1)      Unusual in nature and
2)      Infrequent in occurrence in the environment in which the entity operates


a) If an item meets only one of the criteria, it should be presented separately as a component of income from continuing operations.

IFRS Difference
No items are classified as extraordinary, either on the statement of comprehensive income or in the notes.
d.       The following is an example of a condensed income statement that includes discontinued operations and extraordinary items:
EXAMPLE


!. - . . Sales ■ ■

$500,000 . , : . :
. Cost of goods sold . . . ... .

(200,000)
..: \ Gross profit - •• - - - •, • . .•

$ 300,000
: : General and administrative expenses , . . . r v.;

(120,000)
Income before taxes

$180,000
. . . - : . .. . . .: Income taxes . : r ■; v

(40,000)
Income from continued operations Discontinued oneratinns:
Loss from operations of component X, net of taxes-. '
$ (60,000)
$ 140,000
Gain on disposal of component X, net of taxes . Loss on discontinued operations •
10,000
$ (50,000) '
Income before extraordinary items
^xtracrclinarY item;

$ 90,000
Loss from volcanic eruption, net of taxes

(20,000)
Net income - v

$ 70,000
5. Major Note Disclosures





a.       Note disclosures and schedules specifically related to the income statement include the following:
1)      Earnings per share
2)      Depreciation schedules
3)      Components of income tax expense
4)      Components of pension expense

6.       Limitations of the Income Statement
a.       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.
b.      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.
7.       Statement of Comprehensive Income
a.       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 (1) net income or loss (the bottom line of the income statement) and
(2)    other comprehensive income (OCI).
1) Certain income items are excluded from the calculation of net income and instead are included in comprehensive income. The following are the major items included in other comprehensive income:
a)      The effective portion of a gain or loss on a hedging instrument in a cash
flow hedge
b)      Unrealized gains and losses due to changes in the fair value of
available-for-sale securities
c)      Translation gains and losses for financial statements of foreign operations
d)      Certain amounts associated with accounting for defined benefit
postretirement plans
b.      All items of comprehensive income are recognized for the period in either
1)    One continuous financial statement that has two sections, net income and
OCI, or
2)    Two separate but consecutive statements.
a)      The first statement (the income statement) presents the components of net
income and total net income.
b)      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.
c.       The following is an example of a separate statement of comprehensive income:
EXAMPLE


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 avaiiable-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





Stop and review! You have completed the outline for this subunit. Study multiple-choice questions 9 through 15 beginning on page 37.


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