FAR january 2019 study text overview general purpose financial statements

General—Purpose Financial Statements Overview—General Purpose Financial Statements After studying this lesson, you should be able to: Describe the form and content of the Income Statement Describe the form and content of the Balance Sheet Describe the form and content of the Statement of Cash Flows I Summary of the Primary Financial Statements—Here we present an overall summary of the basic financial statements Later lessons will cover each statement in more depth A Income Statement—Statement of Profit or Loss The income statement measures the performance of the firm for the period It is dated for the entire period (e.g., for the year ended December 31, 20xX) The income statement is prepared by applying the all-inclusive approach That is, almost all revenues, expenses, gains, and losses are shown on the income statement and are included in the calculation of net income A major exception here is prior period adjustments, which are the effects of corrections of errors affecting prior year net income Prior period adjustments are shown on the Statement of Retained Earnings as adjustments to the beginning balance of retained earnings in the year the error is discovered There are other items that would appear to be income items but are not reflected in net income These include unrealized gains and losses on investments in securities available-for-sale, certain pension cost adjustments, and foreign currency translation adjustments These items are included in comprehensive income, which now is a required disclosure However, except for items included in comprehensive income but not also in net income, prior period adjustments, and a few other items, the reporting of net income in the income statement reflects an all-inclusive approach B Statement of Comprehensive Income The statement of comprehensive income reports all non-owner changes in equity over a period of time—the same time period as the income statement This statement is also dated for the year ended December 31, 20xX The statement of comprehensive income includes net income (or loss) and the items included in comprehensive income that are not part of net income Those items include: a Unrealized gains and losses on available-for-sale securities b Adjustments in the calculation of the pension liability c Foreign currency translation adjustments d Deferrals of certain gains or losses on hedge accounting C Balance Sheet—Statement of Financial Position The balance sheet discloses the resources of the firm at a point in time It is dated as of a specific date (e.g., December 31, 20xX) The balance sheet is formally referred to as the Statement of Financial Position, but balance sheet is the more commonly used term A business enterprise discloses its economic resources (assets) and the manner of financing the acquisition of those resources (creditors, owners’ contributions, and prior year’s earnings) in the balance sheet State and Local Governments Formats for presentation a The presentation format for a balance sheet is typically one of two formats: the account format or the report format b In the account format, the assets are shown on the left side of the page, and the liabilities and owners’ equity are shown on the right side This format emphasizes the balance sheet equation: A = L + OE Account Format c Debits Credits Assets Liabilities Stockholders’ Equity In the report format, which is the most popular form, the three categories of accounts are listed from top to bottom, as in a report, with assets always shown first Report Format Assets Liabilities Stockholders’ Equity Classification of accounts a Regardless of balance sheet format, assets, liabilities, and equities are presented on the balance sheet in a prescribed order, which is summarized below i Assets are presented in order of decreasing liquidity The most liquid assets (such as cash) are shown first, and less liquid assets are shown last (such as property, plant, and equipment) ii Liabilities are shown in order of maturity Current liabilities are presented first and then long-term liabilities are presented iii Owners’ Equity (also referred to as Shareholders’, Stockholders’, or Shareowners’ Equity) items are shown in order of permanence Example For a corporation, the contributed capital accounts are shown first and retained earnings are typically shown as the final item in Stockholders’ Equity Retained earnings are thought to be less permanent due to the fact that dividends are a distribution of earnings Balance sheet presentation a Balance sheet presentation reflects the classification of assets and liabilities The classification criteria used for each is indicated below and is affected by the firm’s operating cycle The operating cycle of a firm is the period of time required to purchase or produce inventory, sell the inventory, and collect cash from the resulting receivables For most firms, the operating cycle is significantly less than one year For firms in some industries, such as construction, the operating cycle is longer than one year Overview—General Purpose Financial Statements b Current assets—Assets that are in the form of cash, or will be converted into cash, or consumed within one year or the operating cycle of the business, whichever is longer Example Cash, accounts receivable, short-term investments, inventory, and prepaid assets are current assets c Current liabilities—Liabilities that are due in the upcoming year or in the operating cycle of the business, whichever is longer, and that will be met through the transfer of a current asset or the creation of another current liability Both criteria must be met in order for a liability to be classified as current Example Accounts payable, wages payable, income tax payable, unearned revenues, and warranty liability are current liabilities (For the last two items, only the portion to be extinguished within one year of the balance sheet would be classified as current.) Also, the current portion of long-term debt is classified as current; it is the amount of debt previously classified as long-term that is now due within one year of the balance sheet date d Long-term assets and long-term liabilities—These are defined by exclusion All assets that not meet the criteria necessary to be classified as current are classified as long-term assets Likewise, all liabilities that not meet the criteria necessary to be classified as current are classified as long-term liabilities Example Long-term investments, plant assets, certain deferred charges, and intangible assets are non-current assets Notes and bonds payable and mortgages payable are long-term liabilities Valuation and measurement Note CPA Exam questions tend to emphasize sections of the balance sheet For example, a question might focus on the property, plant, and equipment section of the balance sheet or on the long-term liability section of the balance sheet As we cover the individual items presented on the balance sheet, these problems will be a primary focus a Balance Sheet Valuation is summarized below but will be emphasized more in the coverage of individual balance sheet items The point here is that the meaning of the dollar amount of an item listed in the balance sheet depends on the account being measured b Several different measurement bases are currently used in the balance sheet For example, an account receivable listed at $10,000 does not necessarily mean the same thing as $10,000 listed for an intangible asset State and Local Governments Account Type Measurement Basis Property, Plant and Equipment, Intangibles Receivables Inventory Historical Cost and Depreciated/Amortized Historical Cost Net Realizable Value Lower of Cost or Market Investments in Marketable Securities Liabilities Market Value Present Value Owners’ Equity Historical Value of Cash Inflows and Residual Valuation D Statement of Stockholders’ Equity—The statement of stockholders’ equity (sometimes referred to as shareholders’ equity) presents the changes in the owners’ equity over a period of time—the same time period as the income statement Like the income statement, this statement is dates for the year ended (e.g., December 31, 20xX) This statement presents the changes in contributed capital, additional paid-in capital, and retained earnings These changes arise from the purchase and sale of shares of the entities stock, the changes in comprehensive income, and the payment of dividends E Statement of Cash Flows The statement of cash flows is the third of the three major financial statements required to be reported It describes the major changes in cash by meaningful category Like the income statement, it is dated for the entire period (e.g., for the year ended December 31, 20xX) The purpose of the Statement of Cash Flows is to explain the change in cash and cash equivalents that has occurred during the past accounting year Cash equivalents are short-term investments that: a Are convertible into a known and fixed amount of cash; and b Have an original maturity to the purchaser of three months or less Example A US treasury obligation purchased when there are three months or less remaining to maturity is a cash equivalent Investments in stocks are not cash equivalents because they have no maturity value and are not convertible into a specific unchanging amount of cash In reviewing the statement of cash flows, it is important to remember the articulation between the balance sheet and the statement of cash flows If the statement of cash flows employs a pure cash definition of funds, the first asset listed on the balance sheet will be cash If the statement of cash flows employs a broader definition of funds (cash and cash equivalents), the first asset listed on the balance sheet will be Cash and Cash Equivalents The presentation of cash flows in the statement of cash flows follows a classification system established by the FASB Cash flows are classified into three categories: operating, investing, and financing a Operating—Those cash flows related to transactions that flow through the income statement Example Operating cash inflows include receipts from customers and interest Cash outflows include payments to suppliers, to employers, and to taxing authorities Overview—General Purpose Financial Statements b Investing—Cash flows related to the acquisition and disposal of long-term assets and investments (other than cash equivalents and trading securities; these are operating) Example Investing cash outflows include purchases of plant assets and investments Cash inflows include proceeds from the sale of these items c Financing—Cash flows related to the liabilities and owners’ equity sections of the balance sheet Example Financing cash inflows include issuing debt and equity securities Cash outflows include retirement of debt and equity securities, and dividend payments ... industries, such as construction, the operating cycle is longer than one year Overview General Purpose Financial Statements b Current assets—Assets that are in the form of cash, or will be converted... outflows include payments to suppliers, to employers, and to taxing authorities Overview General Purpose Financial Statements b Investing—Cash flows related to the acquisition and disposal of long-term... dividends E Statement of Cash Flows The statement of cash flows is the third of the three major financial statements required to be reported It describes the major changes in cash by meaningful category