Financial Statement Preparation Under GAAP

The preparation of financial statements under Generally Accepted Accounting Principles (GAAP) forms the foundation of external financial reporting. For the CMA exam, you must understand the conceptual framework, the components of each financial statement, and the presentation requirements that ensure comparability and transparency.

The GAAP Framework

U.S. GAAP is established by the Financial Accounting Standards Board (FASB), and the authoritative guidance is contained in the FASB Accounting Standards Codification (ASC). The Codification is organized into approximately 90 topics, each addressing specific accounting areas such as revenue recognition (ASC 606), leases (ASC 842), and inventory (ASC 330).

Qualitative Characteristics of Useful Financial Information

The FASB Conceptual Framework identifies two fundamental qualitative characteristics and four enhancing characteristics:

Fundamental Characteristics:

1. Relevance - Information that can make a difference in decisions by having predictive value, confirmatory value, or both
2. Faithful Representation - Information that is complete, neutral, and free from error

Enhancing Characteristics:

1. Comparability - Users can identify similarities and differences between entities
2. Verifiability - Different knowledgeable observers could reach consensus
3. Timeliness - Information available when it can influence decisions
4. Understandability - Clear and concise presentation

Exam Tip: Relevance and faithful representation are the fundamental characteristics. The enhancing characteristics improve usefulness but cannot make irrelevant or unfaithful information useful.

The Four Primary Financial Statements

1. Balance Sheet (Statement of Financial Position)

The balance sheet presents assets, liabilities, and stockholders' equity at a specific point in time. The fundamental accounting equation governs its structure:

Assets = Liabilities + Stockholders' Equity

Current vs. Non-Current Classification:

• Current assets: Expected to be converted to cash or used within one year or the operating cycle, whichever is longer
• Current liabilities: Obligations due within one year or the operating cycle

2. Income Statement (Statement of Operations)

The income statement presents revenues, expenses, gains, and losses over a period of time. Two formats are acceptable:

Single-Step Format:

• Total revenues minus total expenses equals net income
• Simpler presentation but provides less analytical information

Multi-Step Format:

• Provides subtotals including gross profit, operating income, and income before taxes
• Preferred for analytical purposes

Comprehensive Income includes net income plus other comprehensive income (OCI) items:

• Foreign currency translation adjustments
• Unrealized gains/losses on available-for-sale securities
• Pension liability adjustments
• Cash flow hedge gains/losses

3. Statement of Cash Flows

The statement of cash flows explains changes in cash during a period, categorized into three activities:

Operating Activities - Two Methods:

1. Direct Method (preferred by FASB):

   • Reports major classes of gross cash receipts and payments
   • Example: Cash received from customers $500,000; Cash paid to suppliers $300,000

2. Indirect Method (most commonly used):

   • Starts with net income
   • Adjusts for non-cash items (depreciation, gains/losses)
   • Adjusts for changes in operating assets and liabilities

Exam Tip: The indirect method reconciles net income to operating cash flow. Add back non-cash expenses (depreciation), subtract gains on asset sales, and adjust for changes in working capital accounts.

4. Statement of Stockholders' Equity

This statement shows changes in each equity account during the period:

• Common stock and additional paid-in capital (stock issuances)
• Retained earnings (net income less dividends)
• Treasury stock (share repurchases)
• Accumulated other comprehensive income

Accrual Basis vs. Cash Basis Accounting

GAAP requires the accrual basis of accounting:

Key Accrual Concepts:

• Matching Principle: Expenses are recognized in the same period as the related revenues
• Revenue Recognition: Revenue is recognized when control transfers to the customer (ASC 606)
• Adjusting Entries: Required at period-end to record accruals, deferrals, and estimates

Notes to Financial Statements

Notes are an integral part of financial statements and provide:

• Summary of significant accounting policies
• Detailed breakdowns of financial statement line items
• Contingencies and commitments
• Related party transactions
• Subsequent events
• Segment information (for public companies)

Error Correction and Changes in Accounting

Types of Accounting Changes:

Exam Tip: A change from LIFO to another inventory method is treated as a change in accounting principle requiring retrospective application. A change in depreciation method is often treated as a change in estimate.