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Study guide · Area I

Financial Reporting

30 to 40% of FAR · 6 groups · 47 tasks

Financial Reporting is about producing and fixing the statements themselves: the business set, the not-for-profit set, the government fund view, SEC filings, special purpose frameworks and the ratios built from them. Most tasks ask you to prepare a statement, correct an error or trace a figure back to its support, so practice the mechanics until classification and sign are automatic.

A study feature written by ExamDragon, not part of the real exam. Each heading is one of the AICPA's content groups for this area, in our own words. US GAAP as codified in the FASB Accounting Standards Codification, cited by topic; for-profit business entities unless a section says otherwise.

At a glance

Area I
30 to 40%

of the FAR section (AICPA)

Groups
6
Tasks
47
Key terms
19

What this guide covers, group by group

  1. ABusiness financial statements
  2. BNot-for-profit financial statements
  3. CGovernment funds and bases
  4. DSEC filings and earnings per share
  5. ESpecial purpose frameworks
  6. FRatios, metrics and budget variances

ABusiness financial statements

  • A classified balance sheet splits assets and liabilities into current (due or used within 12 months or the operating cycle, if longer) and noncurrent; the current portion of long-term debt moves to current liabilities.
  • A multi-step income statement shows gross profit and operating income before nonoperating items; a single-step statement totals all revenues and gains, then all expenses and losses. Discontinued operations (a disposal that is a strategic shift with a major effect) appear net of tax below income from continuing operations (ASC 205-20).
  • Other comprehensive income holds items kept out of net income: unrealized gains and losses on available-for-sale debt securities, foreign currency translation adjustments, pension and postretirement gains, losses and prior service cost, and the effective part of cash flow hedges (ASC 220).
  • A receivable or payable in a foreign currency is remeasured at the spot rate on each balance sheet date and on settlement; the change is a transaction gain or loss in net income, not OCI (ASC 830).
  • Indirect method: start with net income, add back noncash charges, remove gains and losses on investing or financing items, then adjust for changes in operating working capital. Interest paid and dividends received are operating; dividends paid are financing. Disclose interest and income taxes paid and noncash investing and financing activities (ASC 230).
  • Consolidation eliminates intercompany balances, sales and unrealized profit, replaces the investment account with the subsidiary's assets and liabilities, and shows the noncontrolling interest within equity and its share of net income separately (ASC 810).
  • The equity statement reconciles each component (stock, additional paid-in capital, retained earnings, accumulated OCI, treasury stock, noncontrolling interest) from the opening to the closing balance.
  1. Worked exampleKestrel Tools reports net income of $250,000. Depreciation is $40,000, it sold equipment at a gain of $12,000, accounts receivable rose by $18,000 and accounts payable rose by $9,000. Cash from operating activities = $250,000 + $40,000 - $12,000 - $18,000 + $9,000 = $269,000. The full cash proceeds from the equipment sale go to investing activities.
  2. Where questions turnAdding the gain on a sale to operating cash, or reporting only the gain in investing: subtract the gain in operating activities and report the whole cash proceeds in investing activities.
Other comprehensive income
Gains and losses recognized in equity outside net income, later reclassified for some items.
Noncontrolling interest
The part of a subsidiary's equity not owned by the parent, shown within consolidated equity.
Discontinued operation
A disposed or held-for-sale component whose exit is a strategic shift with a major effect on results.
Operating cycle
The time from paying cash for inventory to collecting cash from customers.
The 21 tasks of this group, in our words
  1. FR.1.1Build a classified balance sheet from ledger balances
  2. FR.1.2Fix errors found in a balance sheet
  3. FR.1.3Trace balance sheet figures to records and resolve gaps
  4. FR.1.4Lay out an income statement in one step or several
  5. FR.1.5Fix errors found in an income statement
  6. FR.1.6Compute gains and losses on foreign currency transactions
  7. FR.1.7Trace income statement figures to records and resolve gaps
  8. FR.1.8Know what comprehensive income reporting is for and how it looks
  9. FR.1.9Spot which items belong in other comprehensive income
  10. FR.1.10Build the equity statement from ledger balances
  11. FR.1.11Fix errors found in an equity statement
  12. FR.1.12Trace equity statement figures to records and resolve gaps
  13. FR.1.13Build an indirect-method cash flow statement with disclosures
  14. FR.1.14Fix errors found in a cash flow statement
  15. FR.1.15Trace cash flow figures to records and resolve gaps
  16. FR.1.16Work out how a transaction moves operating, investing or financing cash
  17. FR.1.17Prepare consolidation entries and eliminations
  18. FR.1.18Fix errors in consolidated statements
  19. FR.1.19Trace consolidated figures to records and resolve gaps
  20. FR.1.20Correct mistakes and gaps in the notes
  21. FR.1.21Test the notes against the statements and the records
Practise group A

BNot-for-profit financial statements

  • Net assets fall into two classes: without donor restrictions and with donor restrictions (ASC 958-210). The statement of financial position reports totals for the entity as a whole and information about liquidity.
  • The statement of activities reports the change in each class. Revenue goes to the class the donor's terms dictate; when a purpose or time restriction is met, a release moves the amount from with to without donor restrictions.
  • All expenses are reported as decreases in net assets without donor restrictions, never in the with donor restrictions column.
  • Expenses must be shown by both nature (salaries, rent, depreciation) and function (program services, management and general, fundraising) in one place: the face of the statement of activities, a separate statement or the notes.
  • The cash flow statement may use the direct or indirect method; the indirect method reconciles the change in net assets, not net income, to operating cash. Cash gifts restricted for long-term purposes such as buildings or endowment are financing inflows.
  • The notes must give qualitative information on how the entity manages liquidity and quantitative information on financial assets available for general spending within one year.
  1. Worked exampleBrightwater Literacy Center receives $400,000 of unrestricted gifts and $60,000 restricted to a summer reading program, and spends $45,000 of the restricted gift on that program. Expenses total $460,000 (programs $380,000, management and general $50,000, fundraising $30,000). Without donor restrictions: $400,000 + $45,000 released - $460,000 = $(15,000). With donor restrictions: $60,000 - $45,000 = $15,000. Total change in net assets: $0.
  2. Where questions turnRecording the $45,000 program cost as an expense of the with donor restrictions class. The expense is always in the without class; the release is the bridge.
Net assets with donor restrictions
Resources whose use is limited by a donor's purpose or time stipulation, including endowment.
Release from restriction
A reclassification from with to without donor restrictions when the stipulation is met.
Functional classification
Grouping expenses into program services and supporting activities.
The 11 tasks of this group, in our words
  1. FR.2.1Know what a nonprofit's financial position statement shows
  2. FR.2.2Build a nonprofit's statement of financial position
  3. FR.2.3Fix errors in a nonprofit's financial position statement
  4. FR.2.4Know what a nonprofit's statement of activities shows
  5. FR.2.5Build a statement of activities with restricted gifts and releases
  6. FR.2.6Fix errors in a nonprofit's statement of activities
  7. FR.2.7Present nonprofit expenses by nature and by function
  8. FR.2.8Know what a nonprofit's cash flow statement is for
  9. FR.2.9Build a nonprofit's indirect-method cash flow statement
  10. FR.2.10Fix errors in a nonprofit's cash flow statement
  11. FR.2.11Correct mistakes and gaps in a nonprofit's notes
Practise group B

CGovernment funds and bases

  • Government-wide statements use the economic resources measurement focus and full accrual basis; governmental funds use the current financial resources focus and modified accrual basis (GASB 34).
  • Under modified accrual, revenue is recognized when measurable and available to pay current-period liabilities; expenditures are generally recognized when the liability is incurred, but principal and interest on long-term debt are recognized when due.
  • The five governmental fund types are general, special revenue, capital projects, debt service and permanent. A special revenue fund needs restricted or committed revenue as a substantial source (GASB 54).
  • Proprietary funds (enterprise for services sold to the public, internal service for services to other departments) use full accrual, like a business.
  • Fiduciary funds hold resources for others: pension and other employee benefit trust, investment trust, private-purpose trust and custodial funds (GASB 84). A permanent fund's earnings support the government's own programs; earnings that benefit individuals belong in a private-purpose trust.
  • Governmental funds do not report capital assets or long-term debt; those appear only in the government-wide statement of net position.
  1. Worked exampleThe Town of Millbrook issues $5,000,000 of bonds at par to build a library and spends $1,200,000 in the year. In the capital projects fund: cash $5,000,000 and other financing sources $5,000,000, then expenditures $1,200,000. In the government-wide statements: bonds payable $5,000,000 and construction in progress $1,200,000, with no expense for the construction cost.
  2. Where questions turnRecording the bond liability or the building in the capital projects fund. Governmental funds show bond proceeds as an other financing source and construction as an expenditure.
Modified accrual
The governmental fund basis: revenues when measurable and available, expenditures when the liability is incurred.
Enterprise fund
A proprietary fund for activities financed mainly by fees charged to outside users.
Custodial fund
A fiduciary fund for resources held for others that are not in a trust.
The 2 tasks of this group, in our words
  1. FR.3.1Know the focus and basis for funds and government-wide reports
  2. FR.3.2Choose the right fund for a government activity
Practise group C

DSEC filings and earnings per share

  • Form 10-K is the annual report with audited statements; Form 10-Q covers each of the first three fiscal quarters with reviewed interim statements; Form 8-K reports specified major events, generally within four business days.
  • In Form 10-Q Part I, Item 1 is the financial statements, Item 2 is management's discussion and analysis and Item 3 is market risk disclosures. In Form 10-K Part II, Item 7 is MD&A, Item 7A is market risk and Item 8 is the financial statements and supplementary data.
  • Basic EPS = (net income - preferred dividends) / weighted average common shares outstanding. Subtract the current year's dividend on cumulative preferred whether or not declared; on noncumulative preferred, only if declared. Stock dividends and splits are applied retroactively (ASC 260).
  • Diluted EPS adds potential common shares: options and warrants by the treasury stock method (only when the average market price exceeds the exercise price), convertible preferred and convertible debt by the if-converted method (add back the preferred dividends or the after-tax interest).
  • Bring in dilutive securities from the most to the least dilutive and leave out any that would raise EPS (antidilutive).
  1. Worked exampleHarbor Lane Inc. earns $900,000, owes a $100,000 cumulative preferred dividend (undeclared) and has 400,000 weighted shares. Basic EPS = $800,000 / 400,000 = $2.00. Options on 60,000 shares at $20 with an average price of $30 add 60,000 - ($1,200,000 / $30) = 20,000 shares. 6% convertible bonds of $1,000,000 convert into 50,000 shares; after-tax interest at 25% is $45,000 ($0.90 a share, dilutive). Diluted EPS = $845,000 / 470,000 = $1.80.
  2. Where questions turnSubtracting cumulative preferred dividends only when declared, or subtracting prior years' arrears. Take the current year's cumulative dividend every year, declared or not, and never the arrears.
Treasury stock method
Assumes option proceeds buy back shares at the average market price; only the net new shares count.
If-converted method
Assumes conversion at the start of the year, adding shares and removing the related dividends or after-tax interest.
Antidilutive
A security whose assumed conversion or exercise would increase EPS or reduce a loss per share.
The 3 tasks of this group, in our words
  1. FR.4.1Know what the annual, quarterly and current SEC reports do
  2. FR.4.2Name the key items inside quarterly and annual SEC reports
  3. FR.4.3Compute basic and diluted EPS with options and convertibles
Practise group D

ESpecial purpose frameworks

  • Statements on a special purpose framework carry titles that avoid GAAP names: for the cash basis, a statement of assets and liabilities arising from cash transactions and a statement of revenues collected and expenses paid; for the tax basis, a statement of assets, liabilities and equity (income tax basis) and a statement of revenues and expenses (income tax basis).
  • Cash to accrual revenue: cash collected + ending receivables - beginning receivables + beginning unearned revenue - ending unearned revenue.
  • Cash to accrual expense: cash paid + ending accrued liabilities - beginning accrued liabilities + beginning prepaids - ending prepaids.
  • The modified cash basis adds changes with substantial support, such as capitalizing and depreciating fixed assets or recording payroll withholdings as liabilities.
  • The income tax basis follows the measurement used on the return, such as tax depreciation and the direct write-off of bad debts; the notes describe the basis and its main differences from GAAP.
  1. Worked exampleCedar Row Design collected $320,000 from customers. Receivables rose from $28,000 to $41,000 and unearned revenue fell from $5,000 to $2,000. Accrual revenue = $320,000 + $41,000 - $28,000 + $5,000 - $2,000 = $336,000.
  2. Where questions turnReversing the unearned revenue adjustment. A decrease in unearned revenue means more revenue was earned than collected, so it adds to revenue.
Special purpose framework
A basis other than GAAP, such as cash, modified cash, tax or regulatory basis.
Modified cash basis
The cash basis with selected accrual changes that have substantial support in practice.
Income tax basis
Statements measured the way the entity measures items on its federal return.
The 4 tasks of this group, in our words
  1. FR.5.1Title statements correctly under a special purpose framework
  2. FR.5.2Convert cash or modified cash figures to accrual
  3. FR.5.3Prepare statements on pure or adjusted cash accounting
  4. FR.5.4Prepare statements on the income tax basis
Practise group E

FRatios, metrics and budget variances

  • Profitability: gross margin = gross profit / net sales; return on sales = net income / net sales; return on assets = net income / average total assets; return on equity = net income / average equity.
  • Liquidity: current ratio = current assets / current liabilities; quick ratio = (cash + marketable securities + net receivables) / current liabilities; receivables turnover = net credit sales / average receivables; inventory turnover = cost of goods sold / average inventory; days payable outstanding = average payables / cost of goods sold x 365.
  • Solvency: debt to equity = total liabilities / total equity; total debt ratio = total liabilities / total assets; times interest earned = earnings before interest and taxes / interest expense.
  • Metrics: EBITDA = net income + interest + taxes + depreciation and amortization; price to earnings = market price / EPS; dividend payout = dividends / net income; asset turnover = net sales / average total assets.
  • A variance is actual minus budget: favorable when revenue beats budget or cost comes in under it. A flexible budget restates the budget at actual volume so price and efficiency effects can be separated from volume.
  1. Worked exampleNorthgate Supply has sales of $2,400,000, cost of goods sold of $1,560,000, and inventory of $240,000 at the start and $280,000 at the end of the year. Gross margin = $840,000 / $2,400,000 = 35%. Inventory turnover = $1,560,000 / $260,000 = 6.0 times, about 61 days (365 / 6.0 = 60.8).
  2. Where questions turnUsing sales instead of cost of goods sold for inventory turnover, or a year-end balance where the ratio calls for an average.
Quick ratio
Liquid assets (cash, marketable securities, net receivables) over current liabilities; excludes inventory and prepaids.
EBITDA
Earnings before interest, taxes, depreciation and amortization; a non-GAAP measure.
Flexible budget
A budget recast at the actual level of activity.
The 6 tasks of this group, in our words
  1. FR.6.1Pick the ratio or metric that answers a given question
  2. FR.6.2Compute margins and returns on assets and equity
  3. FR.6.3Compute current, quick and turnover ratios
  4. FR.6.4Compute leverage and interest coverage ratios
  5. FR.6.5Compute EBITDA, price to earnings, payout and asset turnover
  6. FR.6.6Compare budgeted figures with actual results and size the gaps
Practise group F

After this guide: Check yourself: can you prepare each business statement from a trial balance, fix a misclassified cash flow, place a gift in the right net asset class, pick the right government fund and compute diluted EPS without notes?

Practise Financial Reporting

ExamDragon is independent exam preparation. It is not affiliated with, endorsed by or reviewed by the American Institute of Certified Public Accountants (AICPA), the National Association of State Boards of Accountancy (NASBA), any state board of accountancy or Prometric. Uniform CPA Examination and CPA Exam are names of the AICPA, used here only to name the exam. Every question and simulation here is our own, written from the AICPA's published Blueprints; none is adapted from the AICPA's released questions or any review course.