CMA Part 1 Section B - Study Unit 1: External Financial Statements

1.1 Concepts of Financial Accounting

  • Objective of General-Purpose Financial Reporting
    • Report financial information useful for decision-making about providing resources to the entity.
    • Information relates to economic resources, claims to resources (financial position), and changes in resources/claims.
    • Users differentiate changes from performance (income statement) vs. other transactions (balance sheet).
    • Financial performance information helps in:
      • Understanding return on economic resources, variability, and components.
      • Evaluating management.
      • Predicting future returns.
    • Financial statements must conform to Generally Accepted Accounting Principles (GAAP).
    • CMA exam also tests knowledge of International Financial Reporting Standards (IFRS).
      • Appendix B details significant differences between GAAP and IFRS.
      • If exam questions do not distinguish, use GAAP.
    • Financial accounting vs. management accounting:
      • Financial accounting: Directed to external users.
      • Management accounting: Assists management decision-making, planning, and control (internal).

Users of Financial Statements

  • External users are primary users.
    • Financial statements help them determine if business with the firm is beneficial.
    • Examples of users:
      • Investors: Decide to increase, decrease, or obtain investment.
      • Creditors: Determine whether to extend credit and under what terms.
      • Financial advisors/analysts: Help investors evaluate investments.
      • Stock exchanges: Evaluate firms for listing or suspension of trading.
      • Regulatory agencies: Evaluate conformity with regulations and determine price levels.
  • Internal users (management, employees, board of directors) also use financial statements.

Features of Financial Statements

  • Primary means of communicating financial information.
  • Additional information: financial statement notes, supplementary information, and other disclosures.
    • Notes are essential to understanding the financial statements and are an integral part of statements prepared in accordance with GAAP.
    • First footnote describes significant accounting policies, estimates, assumptions, revenue recognition, and allocation of asset costs.

Full Set of Financial Statements

  • Statement of financial position (balance sheet)
  • Income statement
  • Statement of comprehensive income
  • Statement of changes in equity
  • Statement of cash flows
  • Information must be relevant and faithfully represented to be useful.
    • Usefulness is enhanced by comparability (with other entities/periods).
  • Financial statements are prepared under the going-concern assumption (entity will continue operating indefinitely).

Financial Statement Relationships

  • Statements complement each other, describing different aspects of the same transactions.
  • Net income/loss from the income statement 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.

Accrual Basis of Accounting

  • Financial statements are prepared under the accrual basis of accounting.
  • Accrual accounting records transactions when they occur, not when cash is paid/received.
    • Revenue Recognition Principle: Revenues are recognized when earned, regardless of when cash is received.
    • Matching Principle: Expenses are recognized in the same period as related revenue.
      • Associates cause and effect
      • Systematic and rational allocation
      • Immediate recognition.
  • Cash basis: Revenues are recognized when cash is received, and expenses when cash is paid.
  • GAAP prohibits the preparation of financial statements under the cash basis of accounting.

1.2 Statement of Financial Position (Balance Sheet)

  • Reports assets, liabilities, and equity at a specific point in time.
  • Helps users assess liquidity, financial flexibility, efficiency of asset use, capital structure, and risk.
  • Basic Accounting Equation
    • Assets = Liabilities + Stockholders’ Equity
    • The equation is based on the fund theory.
    • Proprietary Theory: Assets – Liabilities = Stockholders’ Equity
      • Equity is what remains after economic obligations are deducted from economic resources.

Transaction Analysis

  • Transactions impact at least two elements of the accounting equation.
  • The accounting equation must remain balanced with each transaction.

Elements of the Balance Sheet

  • Assets: Resources controlled by the entity due to past events, representing probable future economic benefits.
    • Examples: inventory, accounts receivable, investments, and property, plant, and equipment.
  • Liabilities: Present obligations arising from past events, expected to result in an outflow of economic benefits.
    • Examples: loans payable, bonds issued by the entity, and accounts payable.
  • Equity: Residual interest in assets after subtracting all liabilities.
    • Examples: common stock, preferred stock, and retained earnings.
    • Affected by operations and transactions with owners (dividends and contributions).
  • Assets and liabilities are separated into current and noncurrent categories.
  • Assets are generally reported in order of liquidity.
    • NOTE: "Production Order" is not used in the United States.
  • Assets:
    • Current assets: Cash, certain investments, accounts receivable, inventories, prepaid expenses.
    • Noncurrent assets: Certain investments and funds; property, plant, and equipment (PPE); intangible assets; other noncurrent assets.
  • Liabilities:
    • Current liabilities: Accounts payable, current notes payable, current maturities of noncurrent liabilities.
    • Noncurrent liabilities: Noncurrent notes and bonds.
  • Equity:
    • Common stock
    • Retained earnings

Current and Noncurrent Assets

  • Current asset: Expected to be realized in cash, sold, or consumed within the entity’s operating cycle or 1 year.
    • Cash and cash equivalents
    • Certain trading, available-for-sale, and held-to-maturity debt securities
    • Receivables
    • Inventories
    • Prepaid expenses
    • Certain investments in equity securities
  • Noncurrent assets (long term assets): Those not qualifying as current.
    • Investments and funds: Held beyond the longer of 1 year or the operating cycle.
      • Investments in equity securities to control/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): Tangible operating items recorded at cost, net of accumulated depreciation.
      • 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: Nonfinancial assets without physical substance (patents, goodwill).

Current and Noncurrent Liabilities

  • Current liabilities: Expected to be settled or liquidated in the ordinary course of business during the longer of the next year or the operating cycle.
    • Accounts (or trade) payables for items entering into the operating cycle.
    • 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.
      • Short-term notes given to acquire capital assets
      • Payments on the current portion of serial bonds or other noncurrent debt
      • Long-term obligations callable by the oreditor at the balance sheet date due to debtor’s violation of 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.
    • Refinancing agreement before the balance sheet is issued is a demonstration of ability.
  • Noncurrent liabilities (long term liabilities): Those not qualifying as current.
    • 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

Equity

  • Represents ownership interest in a firm.
  • Owners of corporations are referred to as stockholders or shareholders.
  • 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): the amount received in excess of par value at the time stock was sold.
    • Retained earnings: accumulated net income not yet distributed to owners
      • Dividends can be paid when retained earnings has a balance.
      • Board of directors may restrict retained earnings to prevent payment of dividends.
    • Treasury stock: firm’s own stock that has been repurchased
      • Reflected in shareholders’ equity as a contra account
    • Accumulated other comprehensive income (all comprehensive income items not included in net income).

Limitations of the Balance Sheet

  • Shows financial position at a single point in time; accounts may vary significantly soon after.
  • Many items (e.g., PPE) recorded at historical costs may not equal fair value.
  • Requires estimates and management judgment.
  • Omits items that cannot be recorded objectively but have financial value.

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–LossesIncome (Loss) = Revenues + Gains – Expenses – Losses
  • 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 net change in equity during the period are included in income except:
      • Transactions with owners
      • Prior-period adjustments
      • Items reported initially in other comprehensive income
      • Transfers to and from appropriated retained earnings

Cost of Goods Sold and Cost of Goods Manufactured

  • Cost of goods sold is an expense account reported on the income statement.
    • Retailer: cost of the items being sold to customers
      • Beginning inventory + Net purchases + Freight-in – Ending inventory = Cost of goods sold
    • Manufacturer: cost of items that were produced (manufactured) by the firm and are being sold to customers
      • Must calculate cost of goods manufactured first
      • Cost of goods manufactured: Cost of goods completed during the current year; cost of goods transferred out of work-in-process inventory to finished goods inventory.
  • Gross profit is net difference between sales revenue and cost of goods sold.
    • Gross profit margin (%) = Gross profit ÷ Sales.

Other Expenses

  • General and administrative expenses are incurred for the benefit of the enterprise as a whole and are not related to a specific function.
    • They include accounting, legal, 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: 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

  • Single-step income statement: one grouping for revenue items and one for expense items.
  • Multiple-step income statement: operating revenues and expenses are 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.

Discontinued Operations

  • Reported in a separate section between income from continuing operations and net income, net of tax.
  • Two components:
    1. Gain or loss from operations of the component has been disposed of or is classified as held for sale from the first day of the reporting period until the date of disposal
    2. Gain or loss on the disposal of this component

Statement of Comprehensive Income

  • Includes all changes in equity (net assets) of a business during a period except those from investments by and distributions to owners.
  • Consists of:
    • Net income or loss
    • Other comprehensive income (OCI)
  • Major items included in OCI:
    • 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 (with net income and OCI sections)
    • Two separate but consecutive statements (income statement and statement of OCI)
Limitations of the Income Statement
  • Does not always show all items of income and expense (some are reported on a statement of other comprehensive income).
  • Reports accrual-basis results; revenue and income may be reported before cash receipt.
  • Preparation requires estimates and management judgment.

1.4 Statement of Changes in Equity and Equity Transactions

  • 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
    • 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
    • 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.
    • Retained earnings beginning balance + Net income (loss) for the period – Dividends distributed during the period + Positive (negative) prior-period adjustments Retained earnings ending balance

Prior-Period Adjustments

  • Prior-period adjustments include the cumulative effect on the income statement of the following two items:
    1. Changes in accounting principle
    2. Corrections of prior-period financial statement errors
  • Require retrospective application; not included in current-period net income.
  • Changes in accounting estimate are not prior-period adjustments
    • Require prospective application

Common and Preferred Stock

  • Most widely used classes of stock are common and preferred.
  • 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
  • Common shareholders: owners of the firm, have voting rights.
    • Not entitled to dividends unless declared by the board.
    • Entitled to liquidating distributions only after all other claims have been satisfied
    • Ordinarily have preemptive rights
  • Preferred stock: features of debt and equity.
    • Fixed charge, but payment of dividends is not an obligation.
    • Shareholders do not have voting rights.
    • Have the right to receive dividends at a specified fixed rate before common shareholders may receive any.
    • Distribution before common shareholders, but after creditors, in the event of firm bankruptcy (liquidation)
  • Common features of preferred stock:
    • Cumulative preferred stock accumulates unpaid dividends (called dividends in arrears).
    • Holders of convertible preferred stock have the right to convert the stock into shares of another class 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.

Equity Transactions

  • Issuance of Stock
    • The par value of stock is an arbitrary amount assigned by the issuer.
    • 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.
  • 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.
      2. Under the par value method, treasury stock is recorded for the par value of the stock.
    • Treasury stock reduces the shares outstanding, not the shares authorized.
    • Has no voting rights, receives no distributions in liquidation, and receives no dividends when the entity declares a dividend
  • Cash Dividend
    • The most common form of dividend is a cash dividend.
    • On the declaration date, the board of directors formally approves a dividend.
    • All holders of the stock on the record date are legally entitled to receive the dividend.
    • The payment date is the date on which the dividend is paid.
  • 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
      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
  • Stock Dividends and Stock Splits
    • A stock dividend involves no distribution of cash or other property.
    • Small stock dividend: recognized as a stock dividend of less than 20% to 25% of the previously outstanding common shares
    • Large stock dividend: recognized as a stock split in the form of a dividend that is greater than 20% to 25% of the previously outstanding common shares.
    • Stock splits are issuances of shares that do not affect any aggregate par value of shares issued and outstanding or total equity.
      Item| Par value per share
      ---|---|
      Small stock dividend | No change
      Large stock dividend | No change
      Stock split| Decrease
      *| Common Stock| Additional Paid-In Capital| Retained Earnings| Total Stockholders’ 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 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.

1.5 Statement of Cash Flows

  • The statement of cash flows reconciles the period’s beginning balance of cash and cash equivalents with the ending balance

  • Operating activities = all transactions and other events that are not financing or investing 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
    • Cash payments to suppliers for goods and services, cash payments to employees, cash payments to government for taxes/duties/fines
    • Payments of interest on debt

  • Investing activities = the resources intended to generate future income and cash flows

    • Cash payments to acquire/cash receipts from property, plant, and equipment/intangble assets
    • Cash payments to acquire (cash receipts from sale and maturity of) equity and debt instruments made for investment purposes
    • Cash advances and loans made to other parties (cash receipts from repayment of advances and loans)
      Financing activities = issuance, settlement, or reacquisition of the entity’s debt and equity instruments
    • Cash proceeds from issuing shares and other equity instruments
    • Cash proceeds from issuing loans, notes, bonds, and other borrowings.
    • Cash repayments of amounts borrowed
    • Payments of cash dividendsCash payments to acquire/redeem the entity’s own shares; cash payments by a lessee for a reduction of liability relating to a finance lease

  • Major Statement of Cash Flows Note Disclosures

  • Information about all noncash investing and financing activities must be disclosed in the notes.

  • Examples:

    • 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

Indirect Method of Presenting Operating Cash Flows

  • Under the indirect method, the net cash flow from operating activities is 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
      *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 related to investing or financing cash flows| Added to net income|
      *Noncash gains and revenues included in net income| Subtracted from net income|
      *Gains and revenues whose cash effects are related to investing or financing cash flows |Subtracted from net income|

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.
  • Information can be manipulated.

1.6 Consolidation Accounting

  • Consolidated financial statements are issued by a parent company when it controls another entity, regardless of ownership percentage.

  • A business combination is a transaction in which an acquirer obtains control of another business.

  • Control = controlling financial interest = The direct or indirect ability to determine the direction of management and policies of the investee.

  • A parent is an entity with a controlling financial interest in one or more subsidiaries

  • The primary consolidation models: voting interest entity (VOE) = ownership of a majority voting interest, .e., more than 50%; variable interest entity (VIE) = financial control exists through contract.

  • Acquisition Method: A business combination must be accounted for using the acquisition method:

    • 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

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 identified and separately recognized.

  • Goodwill or a gain from a bargain purchase = 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

  • Consolidated Financial Reporting – Acquisition-Date Balance Sheet:

    • Step 1: Determine the amount of goodwill or gain from a bargain purchase
    • Step 2: Prepare the assets section of the consolidated balance sheet by adding the assets of the parent and subsidiary + land revaluation + goodwill. Assets and liabilities are reported at 100% of their fair value
    • 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), reported as a single component of consolidated equity
    • Step 5: subsidiary’s equity accounts are eliminated
    • Step 6: Prepare the acquisition-date balance sheet.

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:
    * 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.
    * 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
    * Goodwill from the acquisition of a subsidiary is presented separately in the noncurrent assets section of the consolidated balance sheet
    * Intraentity balances, transactions, income, and expenses must be eliminated in full
    * NCI is reported separately in one line item in the equity section
  • Consolidated Net Income
    • The consolidated income statement must present separate amounts for the following:
      • Total consolidated net income
      • Net income attributable to the NCI
      • Net income attributable to the shareholders of the parent
        Three Types of Consolidations
        Full| Previous content of consolidations
        ---|---
        Equity| Investor has significant influence over company (investee), i.e., an investment of 20% or more, but not more than 50%, in the voting stock of the investee. Preparing consolidated financial statements is not necessary when applying the equity method.
        Proportionate| Accounts for a joint venture of two or more entities. Assets and liabilities of a joint venture are recorded based on percentage of participation an entity maintains in the joint venture.