CPA Exam: FAR Concept Review

Overview

This chapter is about the set of reports a business gives to outside readers such as lenders and investors. A complete set includes a balance sheet, an income statement, a statement of comprehensive income, a statement of changes in equity, a statement of cash flows, and the notes. Each report answers a different question: what the company owns and owes, how it performed, how its owners' stake changed, and where its cash came from and went.

On the balance sheet, assets and liabilities are split into current and noncurrent. An item is current if it will be used up, collected, or paid within one year or one operating cycle, whichever is longer. Comprehensive income adds certain gains and losses that skip net income, called other comprehensive income, such as unrealized gains and losses on available-for-sale debt securities and foreign currency translation adjustments. Companies may show it in one continuous statement or in two statements placed back to back.

The statement of cash flows sorts every cash movement into operating, investing, or financing activities. Under US GAAP, interest paid, interest received, and dividends received are operating, while dividends paid are financing. Operating cash flow can be shown by the direct method or the indirect method, and the indirect method starts from net income and removes noncash items like depreciation. Large noncash deals, such as buying a building by signing a note, are disclosed rather than shown as cash flows.

Overview

This chapter covers private not-for-profit organizations such as charities, private colleges, and hospitals. Their statements are a statement of financial position, a statement of activities, a statement of cash flows, and an analysis of expenses by function and nature. Because there are no owners, the equity section is called net assets.

Net assets are split into two classes: with donor restrictions and without donor restrictions. When a donor's purpose or time restriction is met, the amount is released and moved from with donor restrictions to without donor restrictions. Unconditional promises to give are recorded as revenue when made, even before cash arrives, but conditional promises are not recorded until the conditions are met.

Expenses are always reported as decreases in net assets without donor restrictions. The organization must show expenses by function, such as program services, management and general, and fundraising, and by nature, such as salaries and rent, in one place. Contributed services are recorded only if they create or improve nonfinancial assets or need specialized skills the organization would otherwise buy.

Overview

This chapter explains how states, cities, counties, and school districts report. A government keeps its records in separate funds, each a self-balancing set of accounts for a purpose. The annual report has two layers: fund financial statements, which show each major fund, and government-wide statements, which show the government as a whole.

Governmental funds, such as the general fund and special revenue funds, use the current financial resources measurement focus and the modified accrual basis. Revenue is recognized when it is measurable and available, meaning collected soon enough to pay this period's bills, and expenditures are recognized when the liability is incurred, with exceptions like debt service on long-term debt recorded when due. Capital assets and long-term debt are not reported in governmental fund balance sheets.

Government-wide statements use the economic resources measurement focus and full accrual accounting, much like a business. They include capital assets, depreciation, and long-term debt. Because the two layers use different rules, a reconciliation explains the differences, such as capital outlays that are expenditures in the funds but assets government-wide, and bond proceeds that are an other financing source in the funds but a liability government-wide.

Overview

This chapter covers the most liquid assets: cash, money owed by customers, and investments in other companies' debt and stock. Cash includes currency and bank balances available for use, while cash equivalents are short-term, highly liquid investments with original maturities of three months or less. A bank reconciliation brings the bank's balance and the company's book balance to the same correct figure.

Receivables are reported at the amount expected to be collected. Under the current expected credit loss model, a company estimates losses over the whole life of the receivable from the start and records them in an allowance account, rather than waiting until a loss is probable. Writing off a specific bad account reduces both the receivable and the allowance, so it does not change the net amount.

Debt securities are classified as trading, available-for-sale, or held-to-maturity. Trading securities are at fair value with changes in net income, available-for-sale are at fair value with changes in other comprehensive income, and held-to-maturity are at amortized cost. Equity securities are generally measured at fair value with changes in net income, but an investor with significant influence, usually presumed at 20 to 50 percent ownership, uses the equity method.

Overview

This chapter covers the long-lived and operating assets that a business uses to make sales: inventory, property, plant, and equipment, and intangible assets. The common question for all three is what goes into cost, how that cost is moved to expense, and what happens if the asset loses value.

Inventory cost includes the price paid plus costs to get the goods ready for sale, such as freight-in. Cost flow methods include FIFO, LIFO, and average cost. Inventory measured by FIFO or average cost is carried at the lower of cost and net realizable value, while LIFO and the retail method still use lower of cost or market.

Property, plant, and equipment is recorded at all costs needed to get the asset ready for its intended use, including freight, installation, and testing, and is then depreciated over its useful life. If events suggest an asset held and used may not be recoverable, the company compares its carrying amount with undiscounted future cash flows; if those are lower, it writes the asset down to fair value.

Intangibles with finite lives are amortized, while goodwill and indefinite-life intangibles are not amortized but are tested for impairment, though private companies may elect to amortize goodwill. Research and development costs are generally expensed as incurred.

Overview

This chapter covers what a business owes and what its owners own. Liabilities range from short-term items like accounts payable and accrued wages to long-term bonds and notes. Equity covers stock issued, retained earnings, treasury stock, and dividends.

Bonds are recorded at the cash received, which is the present value of the future payments at the market rate. When the stated rate is below the market rate, the bonds sell at a discount; when above, at a premium. Interest expense each period equals the carrying amount times the market rate at issuance, which is the effective interest method, and debt issuance costs reduce the carrying amount of the debt. When debt is paid off early, the difference between the amount paid and the carrying amount is a gain or loss in income.

In equity, buying back the company's own shares under the cost method records treasury stock at the price paid, which reduces total equity. Cash dividends reduce retained earnings and become a liability on the declaration date. Stock dividends only move amounts within equity: a small stock dividend is recorded at fair value, and a large one at par value, so total equity does not change.

Overview

This chapter covers two standards that shape most business transactions: revenue from contracts with customers and leases. Revenue follows one five-step model for all industries, and lease accounting puts nearly all leases on the lessee's balance sheet.

The five revenue steps are: identify the contract, identify the separate performance obligations, determine the transaction price, allocate the price to the obligations based on standalone selling prices, and recognize revenue when or as each obligation is satisfied. Variable consideration is included in the price only to the extent a significant reversal of revenue is not probable. Revenue is recognized over time when certain criteria are met; otherwise it is recognized at the point control passes to the customer.

A lessee records a right-of-use asset and a lease liability for both finance and operating leases, except where it elects not to for short-term leases of 12 months or less. A lease is a finance lease if any one of five criteria is met, such as ownership transfer or a lease term for the major part of the asset's remaining economic life. A finance lease shows interest expense and amortization separately, while an operating lease shows one straight-line lease cost.

Overview

This chapter gathers several topics that cut across many accounts: accounting changes and error corrections, contingencies, income taxes, fair value measurement, and subsequent events. Each one is about timing and judgment: when and how to reflect information in the statements.

A change in accounting principle is generally applied retrospectively, recasting prior periods shown. A change in accounting estimate, such as a new useful life, is applied prospectively in the current and future periods. A change in depreciation method is treated as a change in estimate effected by a change in principle, so it is also prospective. Correction of an error in previously issued statements is a restatement of prior periods.

A loss contingency is accrued when a loss is probable and can be reasonably estimated, and disclosed when only reasonably possible; gain contingencies are not recognized until realized. Income tax expense is current tax plus deferred tax. Deferred tax assets and liabilities come from temporary differences between book and tax bases, measured at enacted tax rates for the years they reverse, and are classified as noncurrent.

A valuation allowance reduces deferred tax assets when it is more likely than not that some will not be realized. Fair value is an exit price measured with a three-level input hierarchy, and subsequent events are either recognized, when they give evidence about conditions that existed at the balance sheet date, or only disclosed, when the condition arose afterward.