ACCOUNTING OUTLINE
CHAPTER 1:
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FASB- Financial Accounting Standards Board- U.S. GAAP
o Seven Members
o Responsible for making the accounting rules
 Identify needed additions or changes
 Propose those changes
 Solicit public comment
 Debate the changes
 Adopt new rules or changes to old one
AICPA- American Institute of Certified Public Accountants
o Professional standards
o Advocates for members
IASB- International Accounting Standards Board- IFRS
o Similar to the FASB
o Issue International Financial Reporting Standards
Securities and Exchange Commission
o Ultimate authority on accounting rules for public companies
 Delegated our authority to the FASB
 Are times where we issued our own rules
o Requires use of US GAAP or IFRS (as promulgated by FASB and IASB)
o Generally influences FASB through informal approval of FASB standards
o SEC observer attends all FASB emerging task force meetings
o Certain SEC regulations differ depending on whether domestic or foreign
preparer
PCAOB
o Independent organization, non profit created to:
 Establish auditing standards
 Public companies only
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 Private companies follow rules established by the AICPA
o Key aspects approved by the SEC
 Annual budget
 Auditing standards
 Board of directors
o SEC and PCAOB regularly work together on issues impacting audit firms
Objective of GAAP
o Provide information useful to present and potential external users
o Provide information about an entity’s cash flows
o Provide information related to the assets, liabilities and equity including changes
in a given period
o Information needs to be:
 Relevant and reliable
 Comparable and consistent
Key Principals
o Going concern
o Realization principal
o Matching principal
o Conservatism
Balance Sheet
o Assets
o Liabilities
o Owners’ Equity
Income Statement
o Revenues
o Expenses
o Net income
o Earnings per share
Statement of Changes in Equity
Statement of Cash Flows
THE FUNDAMENTAL EQUATION
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The governing law that enables accountants to prepare the financial statements from
the underlying bookkeeping
Assets: probable future economic benefits obtained or controlled by an entity resulting
from past transactions or events. Properties, resources and claims owned by the entity
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Liabilities: probable future sacrifices of economic benefits arising from present
obligations to transfer assets. Amounts owed by the entity to others.
Equity: the amount of the owners interest in the entity
Debit means left side entry. Credit means right side entry. They must always be equal
Debits and credits are the components of a journal entry
What happened? Which accounts are affected? Which direction are the affected
accounts moving?
The fundamental equation is collectively the balance sheet
Chapter 2:
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To make a JOURNAL ENTRY, ask…
o 1. What happened?
 State the transaction
o 2. Which Accounts Affected?
 Asset, liability, equity
o 3. Which Direction do Accounts Move?
 Up or down
Then, use map of fundamental equation to make entries in correct places
Journal entries: debit to the left, credit to the right
Creating the Income Statement
 Concepts: revenues-expenses = profit (or loss)
 Profit (aka net income) increases owner’s equity
 Linking profit to owner’s equity is linking income statement to balance sheet
THE CLOSING PORCESS (CLOSING INCOME STATEMENT ACCOUNTS INTO BALANCE SHEET)
 Close each revenue and expense account into the nominal account called P&L (Profit &
Loss) Account, in turn closed to Owners’ Equity
 Ex: close expense accounts to P&L; close revenue accounts to P&L; and then close P&L
to Owner’s Equity.
Chapter 3: The Accrual System of Accounting
There are 2 primary methods of accounting for Revenues and Expenses:
1. Cash basis
a. Most of us use the cash basis
b. Record transactions when:
i. Money received (revenue)
ii. Money paid (expense)
c. Generally used by individuals and for tax purposes by small businesses
d. NOT RECOGNIZED FOR GAAP
2. Accrual basis
a. Uses matching principle:
i. Records revenue when earned
ii. Records expense when incurred
b. Receipt or payment of money is irrelevant with regard to recognition
Accruals and Deferrals
 Accruals: an event should be recorded during one period even though the cash will
follow (either in or out) in a subsequent period
 Deferrals: cash is received during one period yet the event should be recognized in a
subsequent period
 Expenses paid in advance create assets; when used, the asset becomes an expense
 Assets are almost always pre-paid expenses- they will be used in the business somehow
or another and sooner or later
 HENCE,
o The balance sheet (listing assets) is a set of permanent accounts, “as of” a
certain date (Dec 31, 2015)
o The income statement (listing expenses) is a set of periodic accounts, “for” a
period of time (the year 2015)
Four Combinations
 You performed work before you were paid
o Initial journal entry:
 Debit accounts receivable, credit revenue
o Once you received the cash:
 Debit cash, credit accounts receivable
 You incurred an expense before you paid for the expense
o Initial journal entry:
 Debit rent expense, credit rent payable
o Once you paid the expense:
 Debit rent payable, credit cash
 You were paid for work before you performed the work
o Initial journal entry:
 Debit cash, credit deferred revenue
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o Once you performed the work:
 Debit deferred revenue, credit fee revenue
You paid an expense before you incurred the expense
o 1) record prepayment of rent as an asset (called “prepaid lease”)
 Debit prepaid lease, credit cash
 Then will need an adjusting entry
 Debit lease expense, credit prepaid lease
o 2) record prepayment of rent as an expense (called “lease expense”)
 Debit lease expense, credit cash
 Then will need an adjusting entry
 Debit prepaid lease, credit lease expense
o 3) split up to reflect proportions of expense and asset
 Debit lease expense, debit prepaid lease, credit cash
 No adjusting entry needed
Chapter 4: Inventory and the Cost of Goods Sold
Inventory Issues
1. Recording COGS
a. The timing of when COGS is recorded. Either at the time the goods are sold or at
the end of the period
b. Perpetual vs Periodic
i. Perpetual: when the transaction occurs
ii. Periodic: not in real time; inventory and COGS are updated periodically
2. Determining COGS and Inventory
Perpetual Method
 For PURCHASE of inventory
o Debit inventory (at cost), credit cash
 For each SALE of inventory, two entries:
o 1. Debit cash or A/R, credit sales
o 2. Debit COGS, credit inventory (recording the reduction in inventory)
PERIODIC METHOD
 For PURCHASE of inventory
o Debit inventory (at cost), credit cash
 For each SALE of inventory, one entry:
o Debit cash, credit sales
 Sales are recorded when they occur
 At period-end, a physical count is necessary to determine what’s left, assume all else
sold, and that measures COGS
MEASURING COGS/INVENTORY
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Were the goods sold on Friday from,
o Monday’s lot,
o Tuesday’s lot,
o Some earlier day?
o The prices you bought the goods vary depending on the day you purchased
them- so how do we decide which goods were actually sold?
Specific Identification Method
o Actual cost of each item specifically identified to goods during merchandising
process, from acquisition to sale
o When goods are sold, exact cost is known
Cost Flow Assumption Methods
o Not practical to value each item so it’s done in lots
o Three alternatives: FIFI, LIFO and average
FIFE: First in, First out
o Assumes for purposes of calculating COGS that the first goods in inventory to be
purchased or produced are also the first goods in inventory sold
LIFO: Last in, First out
o Assumes for purposes of calculating COGS that the last goods in inventory to be
purchased or produced are the first goods in inventory sold
Implications:
o FIFO: more accurate in balance sheet than in income statement (current costs on
balance statement, old costs on income statement)
 Higher asset value, lower COGS, higher profit
o LIFO: more accurate in income statement than in balance sheet (current costs on
income statement, old costs on balance sheet)
 Lower asset value, higher COGS, lower profit
Chapter 5: Fixed Assets and Depreciation
Long-lived assets
 Issue: expense or capitalize?
 Resolution: matching principle (match costs to benefits)
DEPRECIABLE BASIS
 Depreciable basis = historical cost of the asset less scrap value
ASSET’S SCRAP/SALVAGE VALUE
 Expected value at end of useful life to the reporting business
JOURNAL ENTRIES
 Upon acquisition:
o Debit Fixed Asset; Credit Cash/ AP
 Periodic Depreciation:
o Debit Depreciation Expense; Credit Accumulated Depreciation
Asset’s Useful Life
 Building: 15, 30, 31.5, 35?
 Equipment: 5, 10, 15?
 Vehicles: 3,5,7?
 Judgment, analogy, precedent, tax code
DEPRECITATION METHODS
Straight-line
 Annual depreciation: (cost-scrap value)/useful life
 Book value: historical cost-total expense since acquired
 Book value will never go below the scrap value, we stop depreciating before it reaches
lower than that
Two types of Accelerated Depreciation
Accelerate: allocate/expense larger amounts of fixed asset’s net cost in earlier years of expected
useful life and smaller amounts in later years. Increase fraction for earlier periods/decrease for
later periods.
1. Sum-of-the-Years’ Digits
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Formula: depreciable basis* fraction= annual depreciation expense
2. Declining Balance
Chapter 6: Other Asset and Liability Issues
A. Accounts Receivable- Charge Offs
 Accounts receivables are assets until they are deemed uncollectible
 When deemed uncollectible, the accounts receivable is no longer an asset but an
expense of extending credit
 Uncollectible accounts are called charge offs
 Matching Principle requires that the uncollectible accounts be recorded in the period of
the original sale
o For example, a sale is recorded in January but deemed uncollectible in July.
GAAP’s matching principle requires the uncollectible expense should be recorded
in January.
 To implement the matching principle, an estimate of uncollectible accounts should be
recorded at the end of each month
 Estimates of uncollectible accounts are based on past experience, macroeconomic
conditions, specific customer information and the conservatism principle
B. Intercompany Ownership
 Investing into other companies
 Debt or equity instruments
o Debt examples: treasury bills, municipal bonds, corporate bonds
o Equity: voting shares of common stock
o Accounted for differently
 Debt categories:
o Held to maturity, trading securities and available for sale
 Equity categories:
o Cost method investments, equity method investment and consolidated
investments
Chapter 7: Capital Accounts
Three basic categories:
1. Equity contributed to the entity by owners
2. Equity generated over time
3. “other comprehensive income”
ISSUANCE OF STOCK
 Stock
o Specific ownership interest in a company
o Recorded at par value
 Additional Paid in Capital (APIC)
o Difference between the amount of cash received and the par value
 Journal Entry
o Debit cash
 Credit capital stock
 Credit additional paid in capital
RETAINED EARNINGS
 Amounts earned by the company over time that have been retained
 Close out the income statement to retained earnings
o Debit P/L
 Credit retained earnings
 OR
o Debit retained earnings
 Credit P/L
CASH DIVIDENDS
 Board of directors declares a dividend:
o Debit retained earnings
 Credit dividends payable (contra account)
 Dividend is actually paid
o Debit dividends payable
 Credit cash
STOCK DIVIDEND
 Four types
o Large stock dividend
o Small stock dividend
o Stock split
o Reverse stock split
 Large Stock Dividend
o 20% or more of outstanding stock prior to dividend
o Rearrange based upon par value of stock
o Journal entry
 Debit retained earnings
 Credit capital stock
Small Stock Dividend
o Less than 20% of outstanding stock prior to dividend
o Rearrange based upon market value of stock
o Journal Entry
 Debit retained earnings
 Credit capital stock
 Credit additional paid in capital
STOCK SPLITS & REVERSE STOCK SPLITS
 Expressed as a relationship
 Effect on balance sheet
 Purposes
OTHER EQUITY TRANSACTIONS
 Treasury Stock
o Recorded at the price paid by the company
 Debit Treasury Stock (contra account0
 Credit cash
 Retiring Stock
o Debit capital stock (par value)
o Debit additional paid in capital
o Debit retained earnings (plug)
 Credit treasury stock
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CHAPTER 8- Financial Statement Analysis
 Variance Analysis
o Year vs. Year
o Quarter vs. Quarter
 Financial Ratios
o Performance
o Liquidity
 Account Relationships
 If accounts receivable have been building, is this because sales have increased or
collections have been slowing?
 The financial health of a business over the short term can be stated in terms of an
entity’s ability to pay its debts as they come due
 A significant mismatch between the short-term assets and short-term liabilities can
create short-term liquidity problems
 Tests to gauge relative liquidity
o Working Capital
 Measure of the resources an entity has available to operate its business
on a day-to-day basis
 The amount by which current assets exceed current liabilities
 Too low:
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Threat to the ability to operate in the ordinary course over the
immediate future
 Threatens ability to pay its debts as they come due
 Too high: resources are not being deployed in optimal ways
 One way to determine how much working capital is needed and to assess
its adequacy is to compare the working capital to sales
 Typically, a retailing business that generates substantial sales of
low-cost items such as a supermarket needs less working capital
per dollar of sales (10-15%), than does an industrial manufacturer
of high-ticket items such as airplanes(25-35%)
 Then, compare it to other entities in the same line of business; or
compare to fixed assets, total, debt, and owner’s equity
Current Ratio
 Ratio of current assets to current liabilities
 Compare the time periods.
 If your ratio is 2.24, that means that for every dollar of liabilities come
due in the next year, there are $2.24 in relatively liquid assets to cover
them
 For most entities the optimal current ratio is around 2- may imply there is
some cushion in the entity’s ability to pay its debts as they come due
 A substantially higher current ratio, of 3 or 4, is a sign of potential
efficiency problems
 It implies that current assets may not be being deployed in their
most productive manner but are instead sitting idle, not producing
profits.
 A current ration or 1 or less is a warning signal that an entity may face
difficulties in paying its debts as they come due in the short term
Quick Ratio
 Limiting the sorts of current assets included in the calculation will give
you a more precise gauge of liquidity
 Eliminate inventory, prepaid expenses, and anything else that won’t be
converted into cash is less than one year, maybe six months. Use cash and
accounts receivable.
 Current assets-longer term current assets/current liabilities
 A minimum quick ratio of 1 is desirable, and higher ratios are generally
better.
 If this year’s ratios are better, it suggests the company corrected any
liquidity problems it had
Inventory Turnover
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Measuring how often a stock of inventory turns over (sold during a
period)
Allows you to examine the relationship between the cost of goods sold
during the period and the average level of inventory during that period
COGS/average inventory
 (beginning inventory + ending inventory)/2
Take this number and divide it into the number of days in a year, so
365/ratio, to get how often the inventory turned over this year in how
many days. Once every 86 days is relatively liquid
Can also use the inventory turnover ratio to assess how well inventory
levels are being managed
 Longer it sits around, the less value it is adding to the business,
since the cash into which it could be converted could be deployed
to more productive uses
Other problems with large inventory levels
 Increasing the risk of its obsolescence or spoilage, requiring large
amounts of bank borrowings to finance it, absorbing large
amounts of cash, or posing the risk of loss if the market price at
which it can be sold declines materially
Important to compare to other businesses selling the same kind of goods
 Be careful of what type of accounting conventions they use- LIFO,
FIFO
 Type of business- confectioners increase sales around Valentine’s
Day, etc.
Accounts Receivable Turnover
 The speed with which accounts receivable are collected during a period
indicate by definition their relative liquidity and also give a basis for
appraising the integrity of the entity’s credit and collection policies
 Dollar amount of sales made on credit/average accounts receivable
outstanding
 Divide the number of days in a year by this ratio to determine the speed
of collection of accounts receivable
 The result expresses the average number of days the receivables
are outstanding- days sales uncollected
 Before concluding this number is relatively liquid, compare to the
terms of the accounts. If the number is 44 and payments are due
within 60 days, this record is fine; if payments are due within 30
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days, this raises questions about the entity’s credit-extension and
debt-collection practices
Debt-to-Equity
 Measures the entity’s borrowing capacity; the level of comfort a lender or
potential lender can have in the entity’s ability to repay indebtedness
 Entities with relatively high debt to equity ratios are characterized as
highly-leveraged, meaning that the debt level in relation to the
investment level of the owners in the business is very high
Profit Margin/Operating Margin
 We want to investigate the relationship of the operating income
generated to the sales level that generated it
 Operating income/net sales
 Profit margin increasing from the previous years is a good sign
 Suggest the business is constantly improving the efficiency of its
operations and its sales efforts
 It could however be due to other factors that either have nothing
to do with efficient operations or which may be counterproductive
long term
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Effective Tax Rate
o Shows the percentage of earnings before taxes that is paid in taxes
o Expenses that are allowed as deductions or credits for tax purposes may cause
variances in these two documents. If a company is effectively utilizing tax
deductions and credits, then its effective tax rate will be lower
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Variation analysis
o Examines changes in items of financial data between periods with a view toward
determining trends in an entity’s financial condition and performance
o The level of expenses in every income statement expense account over the
comparison years should be examined
 A significant reduction in an expense for R&D would have the effect of
significantly increasing operating income in a period. But, growth in
operating income due to the reduction would not mean the entity is
being managed more efficiently, and could mean there are reasons to
worry about growth prospects
o Compare the average number of days required to collect AR
 Maybe part of any growth in sales during the period is due to a relaxation
in credit collection policies, rather than business efficiency
All line items on the income statement can be analyzed in each period as a
percentage of sales and then those percentages could be compared over time
 COGS as a percentage of sales, EBIT as a percentage of shares, net income
as a percentage of sales
 Compare them to prior years, to determine what trends are taking
place in the business
 Compare to other businesses to gauge how well the subject
business is being managed compared to other businesses
Interest coverage ratio
o Compares earnings to interest payment obligations
o Expresses the number of times interest obligations are covered by earnings
Fixed charge coverage ratio
o Also tests for earnings coverage of fixed charges such as lease obligations
Earnings per share
o What results the company is producing for its shareholders
Price earnings ratio
o Compares the market price per share of common stock with the earnings per
share of that common stock
o Market price/EPS
o In general, higher PE ratios suggest that investors are more optimistic about an
entity’s prospects than comparable entities with lower PE ratios
o However, the relative levels of PE ratios also very according to its growth outlook,
industry, relative maturation, and the accounting policies used in arriving at its
calculation of net income
Return on Equity, Investment and Assets
o Return on equity: amount the business earned on the capital owned by its
shareholders
 Owner’s equity is equal to total assets minus total liabilities
o Return on investment: the amount a business earned on both the equity held by
its shareholders and the capital supplied by lenders on a long term basis
o Return on assets: amount a business earned on all its resources
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CHAPTER 9 STATEMENT OF CASH FLOWS
 Can use direct or indirect method when making statement of cash flows
 Apple uses indirect
 Only difference is the operating section
 GAAP gives you the option to use either method, but state a preference for companies
to use the direct method
 What percentage of companies use the direct method? Almost no companies use the
direct method because it is more complicated
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Have to determine:
o Does the transaction affect cash?
o If it is, is it classified as operating, investing, or financing?
 In part, the GAAP requirement of a statement of cash flows as part of its financial
statements seeks to reverse the consequences of the accrual system of accounting and
permit a user of financial statements to evaluate directly the way the entity manages
cash.
 Difficulties can arise in determining whether a financial instrument is functionally
equivalent to cash
 Intended to enable users of financial statements to assess the entity’s ability to:
o Generate positive cash in the future
o To assess its ability to pay its debts as they come due
o To pay dividends
o To obtain financing
o To understand the reasons for differences between net income and cash flows
o To assess the effects of investing and financing activities on an entity’s overall
business and financial condition
 Statement of cash flows separately reports transactions involving cash flows according
to three categories:
o Operating
o Investing
o Financing
 Operating activities: transactions arising in connection with the daily operation of the
business in the ordinary course
o The activities that generate items of revenue and expense
o Ex: making sales to customers, paying suppliers and employers, taxes, the receipt
of interest and dividends, the payment of interest
 Investing activities: transactions arising in connection with the purchase and sale of
items for purposes of generating returns not directly related to the daily operations of
the business in the ordinary course
Indirect Method
 You don’t go transaction by transaction
 You use the info in the balance sheet and income statement to create your statement of
cash flows
 Start with net income and make adjustments for non cash items
o Depreciation
o Amortization
o Allowance for doubtful accounts
o Obsolescence in inventory
o Impairment
 Net income is an accrual based number
 Adjustments- need to add back all of these expenses
 Next part is changes in working capital
 Source and use of cash- assets
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When an asset account increase- like accounts receivable, inventory, prepaid expenses,
etc. that is a use of cash, so we bring the negative amount into the operating activities
section of the statement of cash flows
Decreasing accounts payable is a use of cash.
Decreases in liabilities accounts is a use of cash, so bring the negative amount to the
operating section of statement of cash flows
Increase in liabilities in cash is a source of cash, so add the positive amount to the
statement of cash flows
Asset goes negative- source of cash. Asset goes positive- use of cash, negative amount
in SOCF
Decrease in liability is a use of cash; increase in liability is a source of cash.
Assets: do the opposite; if the amount is negative, positive in SOCF, if the amount is
positive, negative in SOCF
Liabilities: do the same; if the amount is negative, negative in SOCF, if the amount is
positive, positive in SOCF
Net income and dividends go through retained earnings
o If retained earnings and net income aren’t the same, the only possible difference
could be because of dividends.
DIVIDENDS: ANNUAL NET INCOME-CHANGE IN RETAINED EARNINGS
BAD DEBT EXPENSE UNDER DEPRECIATION
FINANCING SECTION: INCLUDE ALL SECTIONS UNDER OWNER’S EQUITY. DIVIDEDS PAID IS
NEGATIVE, THE REST IS THE LIKE LIABILITIES- IF POSITIVE GO POSITIVE, IF NEGATIVE GO
NEGATIVE
FOR AR, USE NET OR G
CHAPTER 11 AUDITING
 Role of the SEC
o SEC gave FASB authority over GAAP and AICPA over GAAS
 Before Sarbanes-Oxley Act
o Auditors were regulating each other through peer reviews
o Auditors performed significant consulting services for clients
o Audit partners had no requirement to rotate off of clients
o Auditors often left audit firms for senior leadership roles at former clients
 Sarbanes-Oxley Act of 2002
o Creation of the Public Company Accounting Oversight Board (PCAOB)
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Primary responsibilities of the PCAOB include:
o Issuing auditing standards
o Registering audit firms
o Inspecting audit firms
o Conducting investigations
Impact of Sarbanes-Oxley Act
o Audit committee consists of independent directors that oversee financial
processes and audit
o Auditors now prohibited from providing certain consulting services
o Conflict of interest rules prevent certain post-employment activities
o Lead audit partners must rotate off client account after 5 years for at least 5
years
o SEC Registrants must have audit report by a firm that is registered with the
PCAOB
o Now audit reports refer to “standards of the PCAOB” rather than GAAS
Types of Audit Opinions
o Unqualified (“Clean Opinion” “Present Fairly”/GAAP)
o Explanatory Language – going concern
 Important assumption underlying GAAP is that an entity will continue
 FASB in 2016 requires management to evaluate whether there is
substantial doubt about an entity’s ability to continue as a going concern
and provide footnote disclosure
 Substantial doubt: probable the entity won’t be able to meet its
obligations as they become due within one year after financial statements
are issued
o Qualified- “Subject to”
 Lack of evidence
 Departure from GAAP
 Material Change
o Adverse- “Do not present fairly”/Not GAAP
o Disclaimer- “The scope was not sufficient to express opinion”
Internal Controls over Financial Reporting
o ICFR procedures have a dual purpose
 Reliance for purposes of the audit plan
 To opine on the effectiveness of the entity’s internal controls at year-end
o ICFR audits test the process; not the numbers
o Controls cover a range of activities throughout the organization
o Sampling is an essential part of ICFR testing
Auditor’s Liability
o Section 11 of the 1933 Securities Act
o Section 10A of the 1934 Exchange Act- 10A Letter
o Section 10B of the 1934 Exchange Act
o Criminal Liability
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How does an auditor limit exposure to liability under the Federal Securities Laws?
o The Audit
 Issuers largely required to follow PCAOB auditing and independence
standards
 PCAOB standards outline requirements throughout the lifecycle of the
audit
o Management’s Representation Letter
 Management’s representations are an important part of the audit
 Representations are “audit evidence,” although inquiry alone is not the
basis for forming the audit opinion
 Examples:
 Financial statements are in conformity with GAAP
 Complete records were provided to auditor
 No side agreements exist
 All fraud, violations of law, noncompliance with contracts have
been disclosed
 Material future plans and/or subsequent events have been
disclosed
CHAPTER 12 LAWYERING
 Loss Contingencies & Lawyers’ Letters
o Professional Tension/Conflict
 Auditor: public watchdog, disclosure
 Lawyer: private advocate, confidentiality
NOTES FROM PAST EXAMS:
 Impairment is an asset account.
 Amortization is an expense account
 SECURITY DEPOSIT: LONG TERM ASSET