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CFA Fundamentals—The Schweser Study Guide to Getting StartedChapter-3 (Fundamentals of Financial Statements)occurred during the period. It is important to note that the 12-month reporting period (i.e., the fiscal year) chosen bymanagement does not have to coincide with the calendar year ending December 31.Chapter Objective: Describe the double entry system of accounting and how this system relates to the basicaccounting equation.Double Entry Accounting: Debits And CreditsAll accounting is based on a double entry system, where there are at least two sides to every transaction. When anytransaction is entered into an accounting system, there must be at least two accounts affected (there can be more),one for each side of the transaction. This is a result of the basic accounting equation, which is the underlying basisof the statement of financial position or balance sheet. The equation is as follows:assets liabilities owner’s equityAs with any equation, a change to one side must be offset by either an equal change in the same direction on theother side, or an opposite and offsetting change on the same side. Otherwise, the “equals” sign is violated and theequation fails. The accounting equation tells us what assets are owned or used by the firm, as well as where theycame from. All of a firm’s assets must be financed either with some form of debt or equity. This should make sense. Ifyou start a business, you must have capital in order to acquire assets. You might use your own money (equity), or youmight borrow money (liabilities).We use the terms debit and credit in double entry accounting, which are simply Latin for left side and right side. Andbecause we are referring to the left and right sides of an equation, the left side must equal the right side, or the debitsmust equal the credits. Debits and credits should not be viewed in terms of positives, negatives, good, bad, indifferent,or otherwise. How each of the different types of accounts is increased, whether on the left or right, is outlined in Figure1.Open table as itiesIncreaseOwner’s sIncreaseLossesIncreaseDividendsIncreaseFigure 1: Debits and CreditsFor the sake of simplicity, the decreases to each account were left blank. Obviously, if you know how an accountincreases, its decrease will be just the opposite.The basic accounting procedure begins by recording a business’s economic events or financial transactions. Thisrecord keeping begins in the general journal, which is also called the book of original entry. Initially, raw data iscaptured in chronological order and entered in the journal in a format called the journal entry. Like the accountingequation, journal entries also have a left and right side. How raw data is captured on the books, whether on the debit(left) or credit (right) side of a journal entry is how it will remain not only on the books, but also in the final accountingoutput or financial statements. We will look at some basic examples of journal entries shortly.5

CFA Fundamentals—The Schweser Study Guide to Getting StartedChapter-3 (Fundamentals of Financial Statements)The second step in the process is to take the raw data that was captured in the general journal and classify or sort theinformation into a useable format. This is done through a process called posting. In this process, each journal entry isliterally taken apart and sorted to its respective account in the general ledger. The general ledger is a book ofaccounts with debit and credit columns. However a transaction was recorded in the general journal, whether as adebit or credit, it should be transferred in exactly the same way to the general ledger. Once this is done, specificaccount totals can be determined at any time by totaling the debit and credit columns within specific accounts in thegeneral ledger and taking the difference. Depending on the type of account, one column will represent increases,while the other will show decreases.Let’s look at an example. Assume that a hardware store buys a case of hammers from a supplier for 100. Thistransaction is a purchase of inventory (goods for resale) and is considered an asset exchange since inventory went upwhile cash went down by the same amount. The accounting entry for this sale would be to debit one account,Inventory, and credit another account, Cash.NoteThe words debit and credit are for demonstration purposes only. They typically are not included in ajournal or T-account entry.The debit or left-hand recording to an asset account produces an increase to the left side (asset side) of theaccounting equation. In this case, we are showing an increase in inventory. At the same time, the balance of cashdecreased. In order to show this equal and offsetting change to assets, the change is recorded on the right or creditside, specifically within the cash account. Any transaction that increases an asset is recorded on the left or debit sideof the transaction, while decreases to assets are recorded on the right.What if the hardware store did not want to spend cash to buy the hammers and instead asked the hammer supplier tofinance the purchase? In this situation, the hardware store would owe the supplier 100. The account that results iscalled accounts payable, which represents a liability that must be satisfied at some point in the near future. In thiscase, instead of cash decreasing to offset the increase in inventory, liabilities (on the other side of the equation) wouldincrease in the credit side of the entry to complete the balancing offset. Consistent with the accounting equation, anincrease in an asset is recorded with a debit, while an increase in an equity or liability account will be recorded with acredit.Chapter Objective: Differentiate between accrual basis accounting and cash basis accounting.Accrual Basis AccountingThe financial reporting system depends on data stemming from accounting events or transactions and selectedeconomic events. The following principles are the foundation of accrual accounting: Recognition principle: revenue is recognized when goods are delivered or services are performed and theassociated expenses are recorded, not necessarily when cash is received for the goods or services. Matching principle: revenues and expenses are matched to the period in which the goods are sold or servicesare performed. Historical cost: represents a transaction’s original value. For example, the historical cost of a fixed asset is itsoriginal purchase price plus any installation and shipping fees. One advantage to historical cost is that it isobjective and verifiable.The general definition of accrual basis accounting says that revenues are recorded when earned, regardless ofwhen cash is collected. Likewise, expenses are recorded when incurred regardless of when they are paid. As a result,the cash flow that results from a transaction may occur before, during, or after the transaction takes place. Forexample, when sales are made on credit a company delivers goods or services but allows the customer to pay later.The fact that goods or services have been rendered fixes the company’s right to collect, and revenue has beencreated. It also follows that net income, the difference between all revenues and expenses, is not a cash-equivalentfigure.6

CFA Fundamentals—The Schweser Study Guide to Getting StartedChapter-3 (Fundamentals of Financial Statements)An extremely important characteristic of accrual based financial statements is the matching principle, requiring relatedrevenues and expenses to be matched or recorded within the same accounting period. Expenses that cannot bespecifically identified to particular revenues should simply be recorded in the period they are incurred. A goodexample might be the utility bill for heating and cooling office space. It is desirable to match expenses to revenues todetermine whether you actually earned a profit. If revenues and expenses are not properly matched, it is difficult toidentify which products or services are profitable and which ones are not.A good example of how accrual-based accounting works can be seen with credit sales. When a firm allows itscustomers to pay later rather than collecting cash at the time of sale, accounts receivable are created. Sales arereported on the income statement even though they have not actually been collected, and the amount owed by thecustomer is included in accounts receivable on the balance sheet. To illustrate the concept of accounts receivable,assume that a firm has an accounts receivable balance of 1,000. This means that the firm has sold 1,000 inproducts without collecting the cash. Credit sales of 1,000 would be recorded as follows:As the firm collects cash from their previous credit sales, the collections will be recorded as a debit (increase) to cashand a credit (decrease) to accounts receivable. Once the firm has received 1,000 in payments for credit sales, thebalance of accounts receivable will be zero (Unless the firm has sold additional goods on credit). [2]The accrual basis of accounting is more useful for financial analysis because it relates reported financial informationto the economic events that generated the results. Generally, accrual basis accounting results in a more accurate measurement of net income for the periodthan cash basis accounting. The accrual basis accounting reflects an understanding that the economic effect of revenue generally occurswhen it is earned and not when cash is received. The economic effect of an expense is incurred when the benefit expires or is used up, not when cash is paid. Accrual accounting enhances the comparability of income statements and balance sheets from one period tothe next.Cash Basis AccountingContrary to accrual basis accounting, cash basis recognizes revenues when cash is received and expenses whencash is paid. Net income, under cash basis accounting, is the difference of all cash collections and payments madeduring the period.The recognition of revenues and expenses on a cash basis can cause confusing and misleading financial statements.For example, assume that a firm purchases goods during December of 2004 paying 1,000. If the goods are sold for 3,000 during January of 2005, the revenue and its related expense will be recorded in two separate accountingperiods. Assuming this was the only transaction, and without accrual accounting, 2004 would report a 1,000 losswhile 2005 would show a 3,000 profit. Realistically, this transaction should show a 2,000 profit in 2005, the year inwhich the goods were sold.[1]. Financial Accounting Standards Board, Statement of Financial Concepts 1, Objectives of Financial Reporting byBusiness Enterprise, paragraph 34.7

CFA Fundamentals—The Schweser Study Guide to Getting StartedChapter-3 (Fundamentals of Financial Statements)[2]. Goods are continually sold on account while payments for prior purchases are received. In this way accountsreceivable usually never gets to zero.Section 2: Four Primary Financial StatementsChapter Objective: List and describe the accounts found in a typical balance sheet, and demonstrate how theseaccounts are arranged in a classified balance sheet.The Balance SheetThe balance sheet is built upon the underlying accounting equation. As previously stated, it shows the company’sresources at a give point in time, as well as those who have claim to those resources. Claims can be categorized asdebt (lender’s and creditor’s claims) and equity (owners’ claims). The balance sheet is also commonly referred to asthe statement of financial position. The following sample balance sheet illustrates the format along with a smallvariety of account types.Just as shown in our simple accounting equation, assets are on the left side of the balance sheet, while liabilities andowners’ equity (claims against the assets) are on the right. And, as must be the case, total assets equal total liabilitiesplus owners’ equity.The sample balance sheet for AAA Company, Inc. is also commonly referred to as a classified balance sheet. As wehave already seen, the word classified in this context means organized or sorted. For example, the assets andliabilities are divided into categories that are current and long term. Current assets and liabilities are those that will beconverted to cash, used up, or satisfied (in the case of liabilities) within one year or within the operating cycle,8

CFA Fundamentals—The Schweser Study Guide to Getting StartedChapter-3 (Fundamentals of Financial Statements)whichever is longer. They are also listed in a decreasing order of liquidity. Those that are most liquid, at the top, willbe converted to cash or used up sooner than those below them.Classifying the balance sheet in such a way allows users of financial information to quickly determine the firm’s overalllevel of liquidity, or short-term debt-paying ability. While current assets are generally used to pay current liabilities, thedifference between current assets and current liabilities is called working capital. And since current assets arerequired to operate the business on a day-to-day basis, businesses should generally have positive working capital. Ifworking capital is consistently negative, the business must cover the shortfall with long-term debt or additional equityfinancing.Before going any further, we will provide a basic overview of the different types of accounts as well as specificaccounts within each category.AssetsAssets are resources that are owned or used by a business to produce a current or future benefit. The overall goal ofmost any business is to use assets to create more assets or revenues. Understanding the definition of an asset isimportant, as certain account titles have the potential to be somewhat misleading. Beware, however, not to confuseassets with revenues. When you look at the balance sheet in the asset section what you see are those assets ownedor used by the business as of a given point in time (usually December 31 st.) Revenues, on the other hand, are foundin the income statement and represent the sum total of all assets created during the year. We will discuss revenues ingreater detail shortly. Cash. This account not only includes cash available for immediate use, but cash equivalents such ascertificates of deposit (CDs) and short- term government bonds (T bills). Investments that are expected to be heldfor fewer than 90 days are considered cash equivalents. Marketable securities. Short-term investments that will be held for more than 90 days but less that a yearwould fall into this category. These securities can further be classified as trading securities, available for sale, orheld to maturity. Their classification will determine whether they are shown on the balance sheet at currentmarket value or historical cost. Accounts receivable. This account is created when credit sales are made to customers who agree to paylater. Inventory. Goods purchased or produced for resale. Inventory is carried on the balance sheet at the lower ofcost or current market value. Supplies. Supplies differ from inventory in that they are not for resale, but instead consumed by the businessinternally. Examples would include pens, pencils, paper, toner for the copy machine, etc. Prepaid expenses. This particular account can be misleading in its title. Prepaid expenses are assets, notexpenses. They result from advance payment for items such as rent, insurance premiums, subscriptions, fees,etc. They are an asset since they will bring a future benefit, even if not in the form of other assets or revenues.Once prepaid items are either used up or expire, they are then written off to expense. Long-term fixed assets. This category includes those assets that will be used by the business in its day-to-dayoperations for more than one year. It is also commonly referred to as Property, Plant, & Equipment, and is carriedon the balance sheet at a net (generally declining) book value.oLand is the real estate upon which the firm’s buildings sit. Land is valued at its historical cost.oPlant (a.k.a. building) represents the buildings that house the firm’s production or selling activities.Plant is valued at historical cost less accumulated depreciation. Accumulated depreciation is the totalpreviously recorded depreciation expense.oEquipment is the machinery or fixtures used to produce or sell inventory. Equipment is valued athistorical cost less accumulated depreciation. Long-term term investments. Purchases of the debt and equity (bond and stock issues) of other companiesthat will be held for more than one year. Intangibles. Long-term assets that bring current and/or future benefits, but that are lacking in physicalsubstance. Examples include patents, copyrights, franchise agreements, logos, trademarks, and goodwill.9

CFA Fundamentals—The Schweser Study Guide to Getting StartedChapter-3 (Fundamentals of Financial Statements)LiabilitiesLiabilities represent the current and future obligations (debts) of the firm. These obligations can be satisfied bypayment in cash, but also by providing goods and services in some cases. Following are some common types ofliabilities. Accounts payable. Current debts that represent balances due to suppliers. When firms make purchases ofgoods for either use in the business or the manufacture of inventory, they are typically offered trade credit andallowed a period of thirty to forty-five days to make payment without incurring penalties or interest. Notes payable. These debts differ from accounts payable in that they represent outright borrowing fromlenders, typically requiring repayment of principle plus interest. Whereas accounts payable are always classifiedas current liabilities (they are generally due within a month or so), notes payable can be classified as either shortor long term, depending upon how soon they must be repaid. Unearned revenues. Again, this particular account title can be misleading in that it does not represent arevenue. By definition, revenues must be earned, which this is clearly not. Unearned revenues representadvance payments made by customers for whom the company has not yet provided goods or services. Once thecompany fulfills its part of the bargain and the earning process is complete, unearned revenues (liabilities) will bereclassified as revenues. Long-term debt. Obligations that will not be fulfilled within the current year, that arise from leasing,mortgaging, and issuing bonds. Long- term debt is most often used to procure long-term assets and requiresrepayment of principle plus interest.Shareholders’ EquityShareholders’ equity is the owners’ investment and the total earnings retained from the beginning of the business.The terms “stockholder” and “shareholder” are used interchangeably. Contributed capital (paid-in-capital) is the amount of the stockholders’ investment in the firm’s equitysecurities.Common stock is the portion of stockholders’ investment valued at par or stated value.Oth

CFA Fundamentals—The Schweser Study Guide to Getting Started Chapter-3 (Fundamentals of Financial Statements) . Chapter three: Fundamentals of Financial Statements Overview Financial statements are useful in helping investors and creditors evaluate firms. They give a snapshot of the firm's assets, liabilities, and equity at a point in .