CFE Notes
Section 2: Financial Transactions
Accounting Concepts
Accounting is “the system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results” for an enterprise’s decision-makers and other interested parties.
The accounting model or accounting equation, as shown below, is the basis for all double-entry accounting:
Assets = Liabilities + Owners’ Equity
Assets consist of the net resources owned by an entity. Liabilities are the obligations of an entity or outsider’s claims against a company’s assets. Owners’ equity represents the investment of a company’s owners plus accumulated profits (revenues minus expenses). Owners’ equity is equal to assets minus liabilities.
-Account format occurs in different ways. The simplest, most fundamental format is the use of a large letter T, often referred to as a T account.
Entries to the left side of a T account are debits (dr), and entries to the right side of a T account are credits (cr). Debits increase asset and expense accounts while credits decrease them. Conversely, credits increase liability, owners’ equity, and revenue accounts; debits decrease them. The accounting equation, in the form of T accounts, looks like the following:
Accounting Methods: There are two primary methods of accounting: cash basis and accrual basis. The main difference between the two methods is the timing in which revenue and expenses are recognized.
Cash-basis accounting involves recording revenues and expenses based on when a company receives or pays cash. The process is the same with expenses: The expenses are recorded when paid without consideration to the accounting period in which they were incurred. The advantage of cash-basis accounting is its simplicity—the accounting system only tracks cash that is being received or paid. Thus, cash-basis accounting is often used by individuals or small businesses. Using this method makes it easier for companies to track their cash flow.
Accrual-basis accounting requires revenues to be recorded when they are earned (generally, when goods are delivered or services are provided to a customer) without regard to when cash is exchanged. The results of the accounting cycle are summarized in consolidated reports, or financial statements, that present the financial position and operating results of an entity. It is important to have a basic understanding of how financial
statements work because they are often the means through which fraud occurs.
The following is a list of typical financial statements:
Balance sheet
Income statement
Statement of changes in owners’ equity
Statement of cash flows
1 BALANCE SHEET The balance sheet, or statement of financial position , provides insight into a company’s financial
situation at a specific point in time, generally the last day of the accounting period. The balance sheet is an expansion of accounting equation, Assets = Liabilities + Owners’ Equity . Assets presented in order of liquidity, includes notes payable, current assets, earnings, and accumulated depreciation
INCOME STATEMENT While the balance sheet shows a company’s financial position at a specific point in time, the income statement, or statement of profit or loss and other comprehensive income , details how much profit (or loss) a company earned during a period of time, such as a quarter or a year. Two basic types of accounts are reported on the income statement: revenues and expenses.
STATEMENT OF CHANGES IN OWNER’S EQUITY The statement of changes in owners’ equity details the changes in the total owners’ equity amount listed on the balance sheet. Because it shows how the amounts on the income statement flow to the balance sheet, it acts as the connecting link between the two statements . STATEMENT OF CASH FLOWS The statement of cash flows reports a company’s sources and uses of cash during the accounting period. The statement of cash flows has three sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Used in tandem with income statement to determine financial performance
While the balance sheet shows a company’s financial position at a specific point in time, the income statement, or statement of profit or loss and other comprehensive income , details how much profit (or loss) a company earned during a period of time, such as a quarter or a year.
The statement of changes in owners’ equity details the changes in the total owners’ equity amount listed on the balance sheet. The statement of cash flows reports a company’s sources and uses of cash during a particular period of time.
Generally accepted accounting principles (GAAP) are the rules by which a company’s financial transactions are recorded into their appropriate account classifications and properly reported as part of the entity’s financial statements. Currently, there is not a universally accepted accounting recording and reporting system in existence.
GAAP = rules based framework IFRS = principle based framework
The following is a list of qualitative characteristics of useful financial information for accountants when creating financial statements in accordance with IFRS:
Faithful representation
Comparability and consistency
Going concern
Faithful Representation: Financial information must faithfully represent the economic data of the enterprise that it purports to represent. Every effort shall be made to maximize the qualities of perfectly faithful representation: complete, neutral, and free from error. A complete representation includes all information necessary to understand
the data presented. A neutral representation is without bias in the selection or presentation of financial information. Free from error means there are no material errors or omissions in the financial reporting data and that
the process used to produce the reported information has been selected and applied with no errors.
Comparability is the qualitative characteristic that enables users to identify and understand similarities and differences between such items.
Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal.
A company’s management is required to provide disclosures when existing events or conditions indicate that it is more likely than not that the entity might be unable to meet its obligations within a reasonable period after the financial statements are issued. There is an underlying assumption that an entity will continue as a going concern; that is, the life of the entity will be long enough to fulfill its financial and legal obligations
2 Matching principle = requires corresponding expenses and revenue to be recorded in the same accounting period
An entity’s management is permitted to change an accounting policy if one of the following circumstances applies:
The change is required by a standard or interpretation.
The change would result in the financial statements providing more reliable and relevant information about the effects of transactions; other events; or conditions on the entity’s financial position, financial performance, or cash flows.
The entity’s financial statements must include full disclosure of any such changes. The desire to project an artificially
strong performance is not a justifiable reason for a change in accounting principle.
According to IFRS, recognition is the process of incorporating an item that meets the definition of an element (found on financial statements, such as an asset or liability) and satisfies the criteria for recognition into the balance sheet or income statement. That is, recognition is the process of capturing an asset or a liability for inclusion in the financial statements.
Measurement of the Elements of Financial Statements: Several different measurement bases are employed to different degrees and in varying combinations in financial statements. The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost, whereby assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition.
The question of when it is appropriate to deviate from GAAP is a matter of professional judgment; there is not a precise set of circumstances that justifies such a departure. However, departures from GAAP can be justified in the following circumstances:
There is concern that assets or income would be overstated and expenses or liabilities would be understated (the conservatism constraint requires that when there is any doubt, one should avoid overstating assets and income or understating expenses and liabilities).
It is common practice in the entity’s industry for a transaction to be reported in a particular way.
The substance of the transaction is better reflected (and, therefore, the financial statements are more fairly presented) by not strictly following GAAP.
A departure produces results that are reasonable under the circumstances, especially if following GAAP produces misleading financial statements and the departure is properly disclosed.
If a transaction is considered immaterial (i.e., it would not affect a decision made by a prudent reader of the financial statements), then it need not be reported.
The expected costs of following GAAP exceed the expected benefits of compliance. However, the fact that complying with GAAP would be more expensive or would make the financial statements look weaker is not a reason to use a non-GAAP method of accounting for a transaction.
A company’s net profit (also known as net income or net earnings) for the period is determined after subtracting operating expenses from gross profit. If a company’s total expenses were greater than its total revenues and the bottom line is negative, then it had a net loss for the period.
The accounting equation, Assets = Liabilities + Owners’ Equity , is the basis for all double-entry accounting. If an asset (e.g., cash) is stolen, the equation can be balanced by increasing another asset, reducing a liability, reducing an owners’ equity account, reducing revenues (and thus retained earnings), or creating an expense (and thus reducing retained earnings).
Historical cost basis of asset measurement = cost at time it was acquired
According to the revenue recognition principle, revenue should not be recognized for work that is to be performed in subsequent accounting periods, even though the work might currently be under contract.
Gross profit = net sales minus cost of goods sold
Gross revenue = total sales for period before any deductions made
Net = company’s total minus any refunds, returns, discounts and allowances
Most companies present net sales or net service revenues as the first line item on the income statement.
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