1.1 Accounting Principles

Why FMVA Candidates Still Need Accounting

The Corporate Finance Institute (CFI) FMVA final exam is an open-book, three-hour assessment: 50 randomized multiple-choice questions, including Excel modeling case studies. Accounting is about 10% of the estimated exam weight. That share is small on purpose. The FMVA credential is not a CPA license, and CFI does not test FASB codification numbers or year-end closing-checklist trivia.

Accounting still decides whether you survive the modeling questions. Every three-statement case starts from accrual financial statements. If you cannot tell revenue from cash collected, or net income from cash from operations, you will build a model that balances by accident — or not at all. CFI's prep path puts Accounting Fundamentals and Reading Financial Statements in front of Introduction to 3-Statement Modeling for that reason. The exam question is almost never "which account is debited." It is "if this booking is made, what happens to EBIT, net working capital, and cash?"

Treat accounting as the wiring diagram of the model, not as a separate trivia section. The rest of this section is the wiring.

Accrual Accounting Versus Cash Accounting

Accrual accounting records economic events when they occur, not when cash moves. Cash accounting records the same events only when cash is received or paid. Public companies and almost every FMVA case company use accrual GAAP or IFRS. Your model must do the same.

Worked example: $40,000 credit sale

Apex Industrial sells $40,000 of equipment on December 20 with 30-day terms. Cash arrives on January 19.

On an accrual income statement, December revenue is $40,000 even though December cash from the sale is $0. January has no revenue from this sale; the collection is a working-capital unwind and a cash inflow. If an FMVA case gives you a December revenue forecast and you treat it as cash, you overstate cash and understate accounts receivable. The balance sheet will not articulate.

Cash accounting is not "wrong." It is the wrong basis for a three-statement model of an accrual business. You still forecast cash — you just forecast it on the cash flow statement and through working-capital accounts, not by pretending the income statement is a cash statement.

Revenue Recognition: Control Transfer, Not the Invoice

Under both US GAAP (ASC 606) and IFRS 15, revenue is recognized when the company transfers control of a good or service to the customer, for the amount it expects to be entitled to. An invoice is evidence, not the recognition event.

Control usually transfers when the customer can direct the use of the asset and obtain substantially all remaining benefits. For a product sale, that is often shipment or delivery under the contract. For a service, it may be over time as performance obligations are satisfied.

Exam trap: invoicing early does not create revenue. If Apex invoices $40,000 on December 1 for equipment that ships January 5, December has a contract liability (deferred revenue), not revenue. Cash may rise in December if the customer prepaid; that cash is a liability, not income.

Worked example: cash collected before control transfers

Apex invoices $120,000 on 15 December and collects cash the same day. The customer requested delayed delivery. Apex still holds the goods, and the customer cannot redirect them yet. Control has not transferred. Books at 31 December:

• Cash +$120,000
• Deferred revenue (liability) +$120,000
• Revenue $0
• Inventory still on the balance sheet

When the goods ship on 8 January and control transfers, deferred revenue is reversed, revenue of $120,000 is recognized, cost of goods sold is booked, and inventory is removed. A model that books revenue on invoice date overstates December EBIT, understates January EBIT, and misstates net working capital. Cash is up in December, but a liability must sit on the balance sheet until delivery.

The Matching Principle

Matching pairs expenses with the revenues they help produce, in the same period. Cost of goods sold is the textbook case: inventory sits as an asset until the related sale is recognized, then it hits the income statement as COGS.

Matching also drives:

• Depreciation of property, plant, and equipment (PP&E) over useful life, not a full write-off at purchase
• Accrued expenses such as wages earned in December and paid in January
• Prepaid expenses such as insurance paid in December covering the first quarter

Worked example: December wages paid in January

December payroll earned is $80,000. Employees are paid on January 5.

• December (accrual): wage expense $80,000; accrued wages (current liability) $80,000. EBIT falls in December. Cash does not.
• January: accrued wages reversed; cash -$80,000. No income-statement expense in January for this amount.

If you expense wages when paid, December EBIT is overstated and January EBIT is understated. The cash flow statement still has to show the January outflow. Matching keeps the income statement on an economic basis and pushes the timing difference into working capital.

Going Concern

Going concern is the assumption that the company will continue operating long enough to realize assets and settle liabilities in the ordinary course of business. Historical-cost PP&E, deferred tax assets, and multi-year revenue contracts only make sense under that assumption.

If going concern is in doubt, measurement shifts toward liquidation values, debt may be classified as current, and extra disclosures appear. FMVA cases almost always assume a going concern. That is why you depreciate a machine over eight years instead of writing it to scrap value tomorrow, and why a discounted-cash-flow terminal period is still a coherent idea.

If a case company is burning cash and a covenant is already breached, do not blindly copy last year's classification. Debt that is callable may need to sit in current liabilities, which wrecks the current ratio and net working capital. That is an accounting classification decision with modeling consequences, not a footnote you can ignore.

Conservatism (Prudence)

Conservatism (prudence under IFRS) means recognizing losses and liabilities as soon as they are probable and estimable, and recognizing gains only when they are reasonably certain. Inventory is carried at the lower of cost and net realizable value. Accounts receivable take an allowance for expected credit losses. Contingent legal losses may be accrued; contingent legal gains are usually not booked as income.

Conservatism is not a license to build cookie-jar reserves. It is a bias against overstating assets and income. In a model it shows up as bad-debt assumptions that haircut AR collections, inventory write-downs that cut gross margin and reduce the inventory asset, and restructuring accruals that hit EBIT now and cash later.

Worked example: receivable allowance

Gross accounts receivable is $500,000. Historical loss rate is 4%. Allowance = $20,000. Net AR on the balance sheet = $480,000. If $20,000 is newly provided this year, the income statement records a $20,000 bad-debt expense (often in SG&A). Cash does not move. Cash from operations under the indirect method starts at net income, which is already after the expense; you do not subtract the allowance again as if it were a cash item.

Materiality

Materiality means a misstatement or omission is material if it could influence the decisions of a reasonable user. Modelers use a practical version: do not forecast every $500 prepaid to three decimals if revenue is $400 million. Do model items that change EBIT, cash, or leverage in a way a credit or equity user would care about.

Materiality does not mean skip the accounting. A $2 million take-or-pay penalty is material even if it is one line. Putting it below EBIT versus in operating expense changes margins, covenants, and sometimes valuation multiples.

The Accounting Equation and Double-Entry

The perpetual identity is:

Assets = Liabilities + Equity

Every transaction has at least two effects so the identity holds. That is double-entry. A three-statement model is double-entry in spreadsheet form: if you increase inventory, you must decrease cash (a cash purchase) or increase accounts payable (a credit purchase) or both. If the balance sheet does not balance, a posting is missing — usually cash, retained earnings, or a plug you have not yet linked.

Worked example: mixed-financed equipment purchase

A $25,000 machine is bought with $10,000 cash and a $15,000 note payable.

Assets net +$15,000; liabilities +$15,000. Equity unchanged. The income statement is unchanged on the purchase date because the spend is capital expenditure, not an expense. Cash flow shows a $10,000 investing outflow. The $15,000 note is a financing inflow, or a non-cash investing and financing disclosure if the lender pays the vendor directly. In a standard three-statement forecast, model the full $25,000 as capex and the $15,000 as a debt draw so cash, PP&E, and debt all move.

Debits, Credits, and Statement Effects

You do not need T-account fluency for a CPA exam. You do need the direction of each change.

Revenue credits increase equity via net income, which closes to retained earnings. Expense debits decrease equity the same way. That is why the income statement and balance sheet articulate.

Worked example: credit sale with COGS

A $40,000 credit sale with $22,000 cost of goods sold:

1. Debit AR $40,000, credit revenue $40,000. Assets up; equity up through net income.
2. Debit COGS $22,000, credit inventory $22,000. Assets down; equity down.
3. Gross profit of $18,000 increases retained earnings when the books close.

Cash has not moved. Operating net working capital rose by $40,000 of AR minus $22,000 of inventory = +$18,000, which is exactly the non-cash portion of that profit. Indirect cash from operations will subtract the AR increase and add the inventory decrease, converting $18,000 of net income into $0 cash from this sale until collection.

What the FMVA Exam Is Actually Testing

CFI's final is open-book. You can look up a definition. You cannot look up whether this case's deferred revenue should sit in current liabilities and whether the related cash is an operating inflow that is not yet earnings. The scoring skill is flow-through: one booking, three statements, no broken identity.

If a question says a company capitalized $1.2 million of software that a peer expenses, do not stop at "assets are higher." Walk EBIT (no expense this period), taxes (higher taxable income unless book and tax differ), the intangible or PP&E balance, later amortization, and cash (the spend is investing if capitalized, operating if expensed). That walk-through is accounting for modelers, and it is the reason this chapter exists.