Auditing

Certified Financial Audit
Dr. Dimitrios P. Kamsaris

Key Accounting Terms

• Accounting: The systematic recording, reporting, and
analysis of financial transactions of a business.
– It allows a company to analyze the financial performance
of the business, and look at statistics such as net profit.
• Balance Sheet: quantitative summary of company's
financial condition at a specific point in time, including
assets, liabilities and net worth.
– First part of a balance sheet shows all the productive
assets a company owns,
– Second part shows all the financing methods (liabilities
and shareholders' equity).

• Asset: Any item of economic value owned by
an individual or corporation, especially that
which could be converted to cash.
– Cash, securities, accounts receivable, inventory,
office equipment, real estate, a car, and other
property.
– On a balance sheet, assets are equal to the sum of
liabilities, common stock, preferred stock, and
retained earnings.

• From an accounting perspective, assets are
divided into the following categories:
– current assets (cash and other liquid items),
– long-term assets (real estate, plant, equipment),
– prepaid and deferred assets (expenditures for
future costs such as insurance, rent, interest),
– intangible assets (trademarks, patents, copyrights,
goodwill).

• Income Statement: An accounting of sales,
expenses, and net profit for a given period.
– An income statement depicts what happened over
a month, quarter, or year. It is based on a
fundamental accounting equation
– (Income = Revenue - Expenses)
– shows the rate at which the owners equity is
changing for better or worse.

• Revenue: total amount of money received by
the company for goods sold or services
provided during a certain time period.
– It includes all net sales, exchange of assets;
interest and any other increase in owner's equity
and is calculated before any expenses are
subtracted.
• Expense: Any cost of doing business resulting
from revenue-generating activities.

• Cash Flow Statement: A summary of the actual or
anticipated incomings and outgoings of cash in a firm
over an accounting period (month, quarter, year).
– It answers the questions:
• Where the money came (will come) from?
• Where it went (will go)?
• Cash flow statements assess the amount, timing, and
predictability of cash-inflows and cash-outflows, and
are used as the basis for budgeting and business-
planning.

• The accounting data is presented usually in
three main sections:
– Operating-activities (sales of goods or services),
– Investing-activities (sale or purchase of an asset),
– Financing-activities (borrowings, or sale
of common stock).
• Together, these sections show the net change
in the firm's cash-flow for the period the
statement is prepared.

• Accounting Method: A process used by a
business to report income and expenses.
– Companies must choose between two methods
acceptable to the IRS, cash accounting or accrual
accounting.
• Cash Basis Accounting:
– An accepted form of accounting that records all
revenues and expenditures at the time when
payments are actually received or sent.
– This method of accounting is appropriate for small or
newer businesses that conduct business on a cash
basis or that don't carry inventories.

• Accrual Basis Accounting:
– An accepted form of accounting that reports income
when earned and expenses when incurred.
– Under the accrual method, companies do have some
discretion as to when income and expenses are
recognized, but there are rules governing the
recognition.
– Companies are required to make prudent estimates
against revenues that are recorded but may not be
received, called a bad debt expense.

• Accounts Payable:
– Money which a company owes to vendors for products and
services purchased on credit.
– This item appears on the company's balance sheet as a
current liability, since the expectation is that the liability
will be fulfilled in less than a year.
– When accounts payable are paid off, it represents a
negative cash flow for the company.
• Accounts Receivable:
– Money which is owed to a company by a customer for
products and services provided on credit.
– This is treated as a current asset on a balance sheet.
– A specific sale is generally only treated as an account
receivable after the customer is sent an invoice.

Purpose of Auditing
• Objective
– The objective of external audit is for the auditor to
express an opinion on the truth and fairness of
financial statements.

Purpose of Auditing
• Accountability
The main necessity for conducting the audit of financial statements
stems from the fact that the persons responsible for the
preparation of financial statements are often different from the
owners of large corporations.
• In large corporations, shareholders appoint directors to run the
enterprise on their behalf. This separation of ownership and control
creates the need for external audit.
• Financial statements are the main source of accountability of
management performance by the shareholders.
• As the management is responsible for the preparation of financial
statements, shareholders have to rely on external verification by
auditors in order to gain reasonable assurance that the accounts are
free from material misstatements and can therefore be relied upon
to be presenting true and fair view of the affairs of the company.

Purpose of Auditing
• Reliability
• Apart from the needs of owners, other users
of financial statements may need to place
reliance on the financial statements.
• External audit is a means of providing a
reasonable basis for the users to place
reliance on financial statements.

Purpose of Auditing
• Stakeholders that rely on audited financial statements
include the following:
– Tax authorities rely on audited financial statements to
determine the accuracy of tax returns filed by the
companies.
– Financial institutions require audited accounts of
prospective borrowers for assessing the credit risk by
analyzing their liquidity and financial position.
– Management uses the audit exercise to re-evaluate the
company's risk management processes and internal
control system by considering the feedback given by
external auditors during the course of the audit in this
regard.

Purpose of Auditing
• Scope
• Financial audit is intended to provide a 'reasonable'
assurance over the accuracy of financial statements.
• It therefore does not provide absolute assurance that the
financial statements are free from all misstatements.
• The purpose of audit is confined to provide reasonable
assurance in order to avoid excessive time and cost in the
performance of the audit that may outweigh any benefit
that may be derived from the enhanced assurance.
• Absolute assurance is also impossible to guarantee in most
cases due to the inherent limitations of audit.

Types of Audits
• Audit is an appraisal activity:
– undertaken by an independent practitioner
(external auditor)
– to provide assurance to a principal (shareholders)
– over a subject matter (financial statements)
– which is the primary responsibility of another
person (directors)
– against a given criteria or framework (IFRS and
GAAP).

Types of Audits
• Types of audit engagements and services:
– External Audit
– Internal Audit
– Forensic Audit
– Public Sector Audit
– Tax Audit
– Information System Audit
– Environmental & Social Audit
– Compliance Audit
– Value For Money Audit

External audit
• External audit: involves the examination of the truth
and fairness of the financial statements of an entity by
an external auditor who is independent of the
organization in accordance with a reporting framework
such as the IFRS.
• Company law in most jurisdictions requires external
audit on annual basis for companies above a certain
size.
• The need for an external audit primarily stems from
the separation of ownership and control in large
companies in which shareholders nominate directors
to run the affairs of the company on their behalf.

External audit
• As the directors report on the financial performance and
position of the company, shareholders need assurance over
the accuracy of the financial statements before placing any
reliance on them.
• External audit provides reasonable assurance to the owners
of the company that the financial statements, as reported
by the directors, are free from material misstatements.
• External auditors are required to comply with professional
auditing standards such as the International Standards on
Auditing and ethical guidelines such as those issued by IFAC
in order to maintain a level of quality and trust of all
stakeholders in the auditing exercise.

Internal Audit
• Internal audit: a voluntary appraisal activity undertaken
by an organization to provide assurance over the
effectiveness of internal controls, risk management and
governance to facilitate the achievement of
organizational objectives.
• Internal audit is performed by employees of the
organization who report to the audit committee of the
board of directors as opposed to external audit which
is carried out by professionals independent of the
organization and who report to the shareholders via
audit report.

Internal Audit
• Unlike external audit, whose scope is primarily
restricted to matters that concern the
financial statements, the scope of work of an
internal audit is very broad and can
encompass any matters which can affect the
achievement of organizational objectives.

Internal Audit
• Internal audit is typically centered around certain key
activities which include:
– Monitoring the effectiveness of internal controls and
proposing improvements
– Investigating instances of fraud and theft
– Monitoring compliance with laws and regulations
– Reviewing and verifying where necessary the financial and
operating information
– Evaluating risk management policies and procedures of the
company
– Examining the effectiveness, efficiency and economy of
operations and processes

Forensic Audit
• Forensic Audit involves the use of auditing and
investigative skills to situations that may involve legal
implications. Forensic audits may be required in the
following instances:
– Fraud investigations involving misappropriation of funds,
money laundering, tax evasion and insider trading
– Quantification of loss in case of insurance claims
– Determination of the profit share of business partners in
case of a dispute
– Determination of claims of professional negligence relating
to the accountancy profession
• Findings of a forensic audit could be used in the court
of law as expert opinion on financial matters.

Public Sector Audit
• State owned companies and institutions are
required by law in several jurisdictions to have
their affairs examined by a public sector
auditor. In many countries, public sector
audits are conducted under the supervision of
the auditor general which is an institute
responsible for strengthening public sector
accountability and governance and promoting
transparency.

Public Sector Audit
• Public sector audit involves the scrutiny of the financial affairs of
the state owned enterprises to assess whether they have been
operated in way which is in the best interest of the public and
whether standard procedures have been followed to comply with
the requirements in place to promote transparency and good
governance (e.g. public sector procurement rules).
• Public sector audit therefore goes a step further than the financial
audit of private organizations which primarily focuses on the
reliability of financial statements
• Audits of public sector companies are becoming increasingly
concerned with the efficiency, effectiveness and economy of
resources used in state organizations which has given way for the
development of value for money audits.

Tax Audit
• Tax audits are conducted to assess the accuracy
of the tax returns filed by a company and are
therefore used to determine the amount of any
over or under assessment of tax liability towards
the tax authorities.
• In some jurisdictions, companies above a certain
size are required to have tax audits after regular
intervals while in other jurisdictions random
companies are selected for tax audits through the
operation of a balloting system.

Information System Audit
• Information system audit involves the assessment of the
controls relevant to the IT infrastructure within an
organization. Information system audits may be performed
as part of the internal control assessment during internal or
external audit.
• Information system audit generally comprises of the
evaluation of the following aspects of information system:
– Design and internal controls of the system
– Information security and privacy
– Operational effectiveness and efficiency
– Information processing and data integrity
– System development standards

Environmental & Social Audits
• Environmental & Social Audits involve the assessment of
environmental and social footprints that an organization leaves as a
consequence of its economic activities.
• The need for environmental auditing is increasing due to higher
number of companies providing environment and sustainability
reports in their annual report describing the impact of their
business activities on the environment and society and the
initiatives taken by them to reduce any adverse consequences.
• Environmental auditing has provided a means for providing
assurance on the accuracy of the statements and claims made in
such reports.
• If a company discloses the level of CO2 emissions during a period in
its sustainability report, an environment auditor would verify the
assertion by gathering relevant audit evidence.

Compliance
• In many countries, companies are required to conduct
specific audit engagements other than the statutory
audit to comply with the requirements of particular
laws and regulations. Examples of such audits include:
– Verification of reserves available for distribution to
shareholders before the declaration of interim dividend
– Audit of the statement of assets and liabilities submitted
by a company at the time of liquidation
– Performance of cost audit of manufacturing companies to
verify the cost of production in order for a regulator to
determine the maximum price to be allowed after
allowing a reasonable profit margin to companies
operating in a sensitive sector (e.g. pharmaceuticals
industry)

Value For Money Audit
• Value for money audits involves the assessment
of the efficiency, effectiveness and economy of an
organization's use of resources.
• Value for money audits are increasingly relevant
to sectors which do not have profit as their main
objective such as the public sector and charities.
• They are performed as part of internal audit or
public sector audit.

Role of the Auditor
• The independent auditor is engaged to render an opinion on
whether a company’s financial statements are presented fairly, in all
material respects, in accordance with financial reporting
framework.
• The audit provides users such as lenders and investors with an
enhanced degree of confidence in the financial statements. An
audit conducted in accordance with GAAS and relevant ethical
requirements enables the auditor to form that opinion.
• To form the opinion, the auditor gathers appropriate and sufficient
evidence and observes, tests, compares and confirms until gaining
reasonable assurance.
• The auditor then forms an opinion of whether the financial
statements are free of material misstatement, whether due to fraud
or error.

Auditing procedures
• Inquiring of management and others to gain an understanding of
the organization itself, its operations, financial reporting, and
known fraud or error
• Evaluating and understanding the internal control system
• Performing analytical procedures on expected or unexpected
variances in account balances or classes of transactions
• Testing documentation supporting account balances or classes of
transactions
• Observing the physical inventory count
• Confirming accounts receivable and other accounts with a third
party
• At the completion of the audit, the auditor may also offer objective
advice for improving financial reporting and internal controls to
maximize a company’s performance and efficiency.

What auditors don’t do
• Authorize, execute or consummate transactions on behalf of a client
• Prepare or make changes to source documents
• Assume custody of client assets, including maintenance of bank accounts
• Establish or maintain internal controls, including the performance of
ongoing monitoring activities for a client
• Supervise client employees performing normal recurring activities
• Report to the board of directors on behalf of management
• Serve as a client’s stock or escrow agent or general counsel
• Sign payroll tax returns on behalf of a client
• Approve vendor invoices for payment
• Design a client’s financial management system or make modifications to
source code underlying that system
• Hire or terminate employees

What auditors don’t do
• Analyze or reconcile accounts
• “Close the books”
• Locate invoices, etc., for testing
• Prepare confirmations for mailing
• Select accounting policies or procedures
• Prepare financial statements or footnote disclosures
• Determine estimates included in financial statements
• Determine restrictions of assets
• Establish value of assets and liabilities
• Maintain client permanent records, including loan documents, leases,
contracts and other legal documents
• Prepare or maintain minutes of board of directors meetings
• Establish account coding or classifications
• Determine retirement plan contributions
• Implement corrective action plans
• Prepare an entity for audit

Management’s responsibilities in audit
• Management’s responsibility is the underlying foundation on which
audits are conducted.
• Without management having responsibility for the financial
statements, the demarcation line that determines the auditor’s
independence and objectivity regarding the client and the audit
engagement would not be as clear.
• It is important for a company’s management to understand exactly
what an audit is – and what an audit does and does not do.
• The auditor’s responsibility is to express an independent, objective
opinion on the financial statements of a company.
• This opinion is given in accordance with auditing standards that
require the auditors to plan certain procedures and report on the
results of the audit, while considering the representations,
assertions and responsibility of management for the financial
statements.

Management’s responsibilities in audit
• As one of their required procedures, auditors ask
management to communicate management’s
responsibility for the financial statements to the
auditor in a representation letter.
• The auditor concludes the engagement by using
those same words regarding management’s
responsibility in the first paragraph of the
auditor’s report.
• Auditors cannot require management to do
anything or to make any representation.

Fundamental responsibilities to the
conduct of an audit
• 1. To prepare and present the financial
statements in accordance with an applicable
financial reporting framework, including the
design, implementation and maintenance of
internal controls relevant to the preparation
and presentation of financial statements that
are free from material misstatements,
whether from error or fraud

Fundamental responsibilities to the
conduct of an audit
• 2. To provide the auditor with the following information:
– All records, documentation and other matters relevant to the
preparation and presentation of the financial statements
– Any additional information the auditor may request from
management
– Unrestricted access to those within the organization if the
auditor determines it necessary to obtain audit evidence
objectivity.
• It is not uncommon for the auditor to make suggestions
about the form and content of the financial statements, or
even assist management by drafting them, in whole or in
part, based on information provided by management.
• In those situations, management’s responsibility for the
financial statements does not diminish or change.

Audit Basics & Process
Planning the Audit
• Confirm that you are suitable for performing the
audit.
– It needs to be certain that any auditor is absolutely
objective in their assessment.
– It is required that the auditor be completely independent
from the company.
– The auditor can have no relationship with the company
outside of the audit.
• The auditor: Not hold any interest in the company (not own any of
the company's stock or bond offerings)
• Not work for the company in any other capacity.
• Be rotated regularly during the audit process to get fresh opinions
on the material.

Planning the Audit
• Assess the size of the audit.
• Before entering into the audit process, the auditor or
auditing team should analyze the company and assess
the scope of the work.
• This includes:
– an estimate of how many team members should work on
the audit and how long it will take.
– an assessment of any special or work-intensive
investigations that must be made during the audit.
• Figuring this out can help the auditor assemble a team,
if necessary, and can provide the company being
audited with a timeframe for the process.

Planning the Audit
• Identify potential mistakes.
• Before beginning the audit, the auditor should
use their past experience and industry knowledge
to attempt to predict areas where the company
may have misstated financial information.
• This require an in-depth knowledge of both the
company and its current operating environment.
– This is a very subjective assessment, so the auditor
will have to rely on their own judgment.

Planning the Audit
• Build an audit strategy.
• Once preliminary assessments have been made, you
will need to create a plan to carry out the audit.
• Lay out all of the different actions that need to be
taken, including areas that you think may be of the
most interest.
• Assign team members to each task, if applicable.
• Then, create a timeline for when each action needs to
be completed.
– Know that this timeline may be changed significantly
throughout the auditing process in response to new
information.

Conducting the Audit• Give advance notice. You will need to give the organization being
audited plenty of time for them to get their records ready.
• Tell them the time period to be audited (the fiscal year, for
example), and a list of documents that they need to have ready for
review. These include:
– Bank statements for the year being audited
– Bank account reconciliation reports. This is where bank statements
were compared to cash receipts and disbursements.
– Check register for the time period being audited
– Canceled checks
– A list of transactions that were posted to the general ledger (a manual
or online system that tracks a company's transactions, including
income and expenditures).
– Check request and reimbursement forms, including receipts and
invoices for all expenditures
– Deposit receipts
– The annual budget and monthly treasurer reports

Conducting the Audit
• Verify that all outgoing checks were properly
signed, accounted for and posted to the
correct accounts.
• If they can be substantiated, all the better.
• However, as an external auditor, that's not in
your scope of influence.
• You just need to make sure everything was
posted to the proper account.

Conducting the Audit
• Ensure that all deposits were properly
posted.
• They were entered into the correct accounts
and ledger line in the general ledger.
• Very basically, these would be accounts
receivables, but they should be further broken
down into specific receivables, depending
upon the complexity of the organization.

Auditing Financial Statements and
Reports• Review all financial statements.
• These include balance sheets and income statements for the time
period being audited.
• Ensure that all transactions are properly recorded and accounted
for in the general ledger.
• Any unusual deposits or withdrawals must be noted and ensured
that they were properly accounted for and legitimate.
• Check that all these accounts were reconciled monthly.
• An unusual deposit might be a very large amount or one from a
business located outside the country.
• Unusual withdrawals would be if substantial amounts of money are
going to one person or business over a long period of time.

Reports• Reconciling means comparing two different reports or
documentation.
– cash and investments are compared to bank and brokerage firms'
statements.
• Additionally, receivable and payable accounts should be compared
to customer orders and bills, respectively.
• For inventory, a physical count and valuation can be done at least
once a year to make sure the information in the general ledger is
accurate.
• For reconciliation, the auditor doesn't need to look at every single
transaction.
• Taking a statistical sample of the total number of transactions
(analyzing a small number and applying the percentage error to the
whole set) can provide similar results in a shorter time.

Reports
• Ensure compliance with all state and federal
requirements.
– If you are auditing a non-profit organization, verify
their 501 tax-exempt status and that the proper
forms have been filed.
– Ensure federal and state taxes returns,
incorporation renewal and state sales tax forms,
example, have been filed as necessary.

Reports
• Review all the treasurer's reports.
• Make sure that what was reported was
recorded and the totals from report to ledger
books match accurately.
• Check to see that an annual treasurer's report
was prepared and filed

Completing the Audit and Making
Recommendation
• Complete the financial review worksheet.
This is a summary of all the activity for the
period (annually, quarterly). This includes:
– The cash balance at the beginning of the period
– All of the receipts during that time
– Any and all of the payouts during that time
– The cash at the end of the period

Recommendation
• Suggest improvements to internal controls.
• Make sure to especially note when
improprieties exist.
• If you are asked to do so, assess the
organization's performance against their
budget or other metrics.

Recommendation• Determine your audit opinion.
• At the conclusion of the audit, the auditor must draft an audit
opinion.
• This document states whether or not the financial information
provided by the company is free of error and reported correctly
under generally accepted accounting principle (GAAP) standards.
• Whether or not the reports meet these criteria is up to the
judgment of the auditor.
– If they are reported correctly and free or error, the auditor issues a
clean opinion.
– If not, the auditor issues a modified opinion.
• Modified opinions are also used if the auditor feels as though they
were unable to issue a complete audit (for any reason).

Recommendation
• Submit your signed document.
• This is a statement that you have completed the audit
and you have found that either the ledgers are
accurate or that there are issues.
• If you found any issues, such as missing checks or
receipts (without explanation) or otherwise a math
discrepancy, you should point those out in the report.
• It is also helpful to include any information you deem
appropriate to assist in fixing those issues or
preventing their recurrence for the next audit period

Accounting Rules, Equations & Basic
Principles
• The golden rules of accounting allow anyone
to be a bookkeeper.
• They only need to understand the types of
accounts and then diligently apply the rules.

Accounting Rules
• Debit The Receiver, Credit The Giver This
principle is used in the case of personal
accounts.
– When a person gives something to the
organization, it becomes an inflow and therefore
the person must be credit in the books of
accounts.
– The converse of this is also true, which is why the
receiver needs to be debited.

Accounting Rules
• Debit What Comes In, Credit What Goes Out:
– This principle is applied in case of real accounts.
Real accounts involve machinery, land and
building etc.
– They have a debit balance by default.
– When you debit what comes in, you are adding to
the existing account balance.
– When you credit what goes out, you are reducing
the account balance when a tangible asset goes
out of the organization.

Accounting Rules
• Debit All Expenses And Losses, Credit All
Incomes And Gains:
– This rule is applied when the account in question
is a nominal account.
– The capital of the company is a liability.
– When you credit all incomes and gains, you
increase the capital and by debiting expenses and
losses, you decrease the capital.
– This is what needs to be done for the system to
stay in balance.

Basic Accounting Principles
• Since GAAP is founded on the basic
accounting principles and guidelines, we can
better understand GAAP if we understand
those accounting principles.
• The following is a list of the ten main
accounting principles and guidelines together
with a highly condensed explanation of each.

• Economic Entity Assumption
• The accountant keeps all of the business
transactions of a sole proprietorship separate
from the business owner's personal
transactions.
• For legal purposes, a sole proprietorship and
its owner are considered to be one entity, but
for accounting purposes they are considered
to be two separate entities.

• Monetary Unit Assumption
• Economic activity is measured in U.S. dollars,
and only transactions that can be expressed in
U.S. dollars are recorded.
• Because of this basic accounting principle, it is
assumed that the dollar's purchasing power
has not changed over time.
• As a result accountants ignore the effect of
inflation on recorded amounts.

• Time Period Assumption
• This accounting principle assumes that it is possible to report the
complex and ongoing activities of a business in relatively short,
distinct time intervals such as the five months ended May 31, 2016,
or the 5 weeks ended May 1, 2016.
• The shorter the time interval, the more likely the need for the
accountant to estimate amounts relevant to that period. For
example, the property tax bill is received on December 15 of each
year.
• On the income statement for the year ended December 31, 2015,
the amount is known; but for the income statement for the three
months ended March 31, 2016, the amount was not known and an
estimate had to be used.

• 4. Cost Principle
From an accountant's point of view, the term "cost" refers to the amount
spent when an item was originally obtained, whether that purchase
happened last year or thirty years ago.
• For this reason, the amounts shown on financial statements are referred
to as historical cost amounts.
• Because of this accounting principle asset amounts are not adjusted
upward for inflation.
• As a general rule, asset amounts are not adjusted to reflect any type of
increase in value.
• Hence, an asset amount does not reflect the amount of money a company
would receive if it were to sell the asset at today's market value. (An
exception is certain investments in stocks and bonds that are actively
traded on a stock exchange.)
• If you want to know the current value of a company's long-term assets,
you will not get this information from a company's financial statements–
you need to look elsewhere, perhaps to a third-party appraiser.

• 5. Full Disclosure Principle
If certain information is important to an investor or lender using the
financial statements, that information should be disclosed within
the statement or in the notes to the statement.
• It is because of this basic accounting principle that numerous pages
of "footnotes" are often attached to financial statements.
• As an example, let's say a company is named in a lawsuit that
demands a significant amount of money. When the financial
statements are prepared it is not clear whether the company will be
able to defend itself or whether it might lose the lawsuit.
• As a result of these conditions and because of the full disclosure
principle the lawsuit will be described in the notes to the financial
statements.
• A company usually lists its significant accounting policies as the first
note to its financial statements.

• 6. Going Concern Principle
This accounting principle assumes that a company will
continue to exist long enough to carry out its
objectives and commitments and will not liquidate in
the foreseeable future.
• If the company's financial situation is such that the
accountant believes the company will not be able to
continue on, the accountant is required to disclose this
assessment.
• The going concern principle allows the company to
defer some of its prepaid expenses until future
accounting periods.

• 7. Matching Principle
The matching principle requires that expenses be matched with
revenues. For example, sales commissions expense should be
reported in the period
• when the sales were made (and not reported in the period when
the commissions were paid).
• Wages to employees are reported as an expense in the week when
the employees worked and not in the week when the employees
are paid. If a company agrees to give its employees 1% of its 2016
revenues as a bonus on January 15, 2017, the company should
report the bonus as an expense in 2016 and the amount unpaid at
December 31, 2016 as a liability. (The expense is occurring as the
sales are occurring.)
• Because we cannot measure the future economic benefit of things
such as advertisements (and thereby we cannot match the ad
expense with related future revenues), the accountant charges the
ad amount to expense in the period that the ad is run.

• 8. Revenue Recognition Principle
Under the accrual basis of accounting revenues are
recognized as soon as a product has been sold or a service
has been performed, regardless of when the money is
actually received.
• Under this basic accounting principle, a company could
earn and report $20,000 of revenue in its first month of
operation but receive $0 in actual cash in that month.
• For example, if ABC Consulting completes its service at an
agreed price of $1,000, ABC should recognize $1,000 of
revenue as soon as its work is done—it does not matter
whether the client pays the $1,000 immediately or in 30
days.

• 9. Materiality
Professional judgement is needed to decide whether an amount is
insignificant or immaterial.
• An example of an obviously immaterial item is the purchase of a $150
printer by a highly profitable multi-million dollar company.
• Because the printer will be used for five years, the matching principle
directs the accountant to expense the cost over the five-year period.
• The materiality guideline allows this company to violate the matching
principle and to expense the entire cost of $150 in the year it is purchased.
• The justification is that no one would consider it misleading if $150 is
expensed in the first year instead of $30 being expensed in each of the
five years that it is used.
• Because of materiality, financial statements usually show amounts
rounded to the nearest dollar, to the nearest thousand, or to the nearest
million dollars depending on the size of the company.

• 10. Conservatism
If a situation arises where there are two acceptable alternatives for
reporting an item, conservatism directs the accountant to choose the
alternative that will result in less net income and/or less asset amount.
• Conservatism helps the accountant to "break a tie." It does not direct
accountants to be conservative. Accountants are expected to be unbiased
and objective.
• The basic accounting principle of conservatism leads accountants to
anticipate or disclose losses, but it does not allow a similar action for
gains.
• For example, potential losses from lawsuits will be reported on the
financial statements or in the notes, but potential gains will not be
reported.
• Also, an accountant may write inventory down to an amount that is lower
than the original cost, but will not write inventory up to an amount higher
than the original cost.

Accounting Equation
• The accounting equation is the basis upon
which the double entry accounting system is
constructed. In essence, the accounting
equation is:
• Assets = Liabilities + Shareholders' Equity
• The assets in the accounting equation are the
resources that a company has available for its
use, such as cash, accounts receivable, fixed
assets, and inventory.

Accounting Equation
• The company pays for these resources by either incurring
liabilities (which is the Liabilities part of the accounting
equation) or by obtaining funding from investors (which is
the Shareholders' Equity part of the equation).
• Thus, you have resources with offsetting claims against
those resources, either from creditors or investors. All three
components of the accounting equation appear in
the balance sheet, which reveals the financial position of a
business at any given point in time.
• The Liabilities part of the equation is usually comprised of
accounts payable that are owed to suppliers, a variety of
accrued liabilities, such as sales taxes and income taxes,
and debt payable to lenders.

Accounting Equation
• The Shareholders' Equity part of the equation is more complex than simply
being the amount paid to the company by investors.
• It is actually their initial investment, plus any subsequent gains, minus any
subsequent losses, minus any dividends or other withdrawals paid to the
investors.
• You can see this relationship between assets, liabilities, and shareholders'
equity in the balance sheet, where the total of all assets always equals the
sum of the liabilities and shareholders' equity sections.
• The reason why the accounting equation is so important is that is always
true - and it forms the basis for all accounting transactions.
• At a general level, this means that whenever there is a recordable
transaction, the choices for recording it all involve keeping the accounting
equation in balance.
• The accounting equation concept is built into all accounting software
packages, so that all transactions that do not meet the requirements of
the equation are automatically rejected.

Purpose of Journal Entries
• Journal entries provide foundational
information for all other financial reports and
are used by auditors to analyze how financial
transactions impact a business.
• Journal entries are assigned to specific
accounts using a Chart of Accounts, and the
journal entry is then recorded in a ledger
account.

Financial Accounting Standards Board
- FASB
• What is the 'Financial Accounting Standards Board -
FASB‘
• The Financial Accounting Standards Board (FASB) is a
seven-member independent board consisting of
accounting professionals who establish and
communicate standards of financial accounting and
reporting in the United States.
• FASB standards, known as generally accepted
accounting principles (GAAP), govern the preparation
of corporate financial reports and are recognized as
authoritative by the Securities and Exchange
Commission (SEC).

Breaking Down 'Financial Accounting
Standards Board - FASB'
• Accounting standards are crucial in an efficient market, as
information must be transparent, credible and understandable.
• The FASB sets out to improve corporate accounting practices by
enhancing guidelines set out for accounting reports, identifying and
resolving issues in a timely manner, and creating a uniform standard
across the financial markets.
• The FASB was established in 1973 as the designated organization for
championing the financial standards that govern accounting
practices and the preparation of financial reports in the private
sector.
• It is the SEC itself that gives the FASB its governing authority.
• The SEC technically has statutory authority to establish and manage
financial reporting standards under the Securities Exchange Act of
1934 but has chosen to give that power to the privately held FASB
to self-manage the private sector.

The Mission of the FASB
• The stated mission of the FASB is to establish and improve financial
accounting and reporting standards and to provide useful
information to investors and other people who use financial
reports.
• The FASB seeks to actively achieve this mission by facilitating an
open and independent reporting process that allows broad
participation from company stakeholders.
• The mission and activity of the FASB are overseen by the Financial
Accounting Foundation’s (FAF) Board of Trustees.
• As of 2016, the current and primary priority of the FASB is to
integrate U.S. GAAP with the International Financial Reporting
Standards (IFRS).
• This allows for more transparent and translatable financial practices
internationally. Specifically, the FASB aims to address the
differences in reporting between revenue recognition, leases,
financial instruments and insurance.

Financial Statements

• Financial statements for businesses usually include income statements,
balance sheets, statements of retained earnings and cash flows.
• It is standard practice for businesses to present financial statements that
adhere to generally accepted accounting principles (GAAP) to maintain
continuity of information and presentation across international borders.
• Financial statements are often audited by government agencies,
accountants, firms, etc. to ensure accuracy and for tax, financing or
investing purposes.
• Financial analysts rely on data to analyze the performance of, and make
predictions about, the future direction of a company's stock price. One of
the most important resources of reliable and audited financial data is the
annual report, which contains the firm's financial statements. The three
main financial statements are the income statement, balance sheet and
cash flow statement.

• Balance Sheet
• The balance sheet provides an overview of assets, liabilities
and stockholders' equity as a snapshot in time. The date at
the top of the balance sheet tells you when the snapshot
was taken, which is generally the end of the fiscal year. The
balance sheet equation is assets equals liabilities plus
stockholders' equity, because assets are paid for with either
liabilities, such as debt, or stockholders' equity, such as
retained earnings and additional paid-in capital. Assets are
listed on the balance sheet in order of liquidity. Liabilities
are listed in the order in which they will be paid. Short-term
or current liabilities are expected to be paid within the year,
while long-term or noncurrent liabilities are debts expected
to be paid after one year.

• Income Statement
• Unlike the balance sheet, the income
statement covers a range of time, which is a
year for annual financial statements and a
quarter for quarterly financial statements. The
income statement provides an overview of
revenues, expenses, net income and earnings
per share. It usually provides two to three
years of data for comparison.

• Cash Flow Statement
• The cash flow statement merges the balance sheet and the
income statement. Due to accounting convention, net
income can fall out of alignment with cash flow. The cash
flow statement reconciles the income statement with the
balance sheet in three major business activities. These
activities include operating, investing and financing
activities. Operating activities include cash flows made
from regular business operations. Investing activities
include cash flows due to the buying and selling of assets
such as real estate and equipment. Financing activities
include cash flows from debt and equity. This is where
analysts can also find the amount of dividends paid and/or
dollar value of shares repurchased.

Characteristics of Financial
Statements
• The following points highlight the nine
characteristics of financial statements, i.e, 1.
Depict True Financial Position 2. Effective
Presentation 3. Relevance 4. Attractive 5.
Easiness 6. Comparability 7. Analytical
Representation 8. Brief 9. Promptnes

Characteristics
• 1. Depict True Financial Position: The information contained in the
financial statements should be such that a true and correct idea is
taken about the financial position of the concern. No material
information should be withheld while preparing these statements.
• 2. Effective Presentation: The financial statements should be
presented in a simple and lucid way so as to make them easily
understandable. A person who is not well versed with accounting
terminology should also be able to understand the statements
without much difficulty. This characteristic will enhance the utility
of these statements.
• 3. Relevance: Financial statements should be relevant to the
objectives of the enterprise. This will possible when the person
preparing these statements is able to properly utilize the
accounting information. The information which is not relevant to
the statements should be avoided, otherwise it will be difficult to
make a distinction between relevant and irrelevant data.

Characteristics
• 4. Attractive: The financial statements should be prepared in such a way
that important information is underlined so that it attracts the eye of the
reader.
• 5. Easiness: Financial statements should be easily prepared. The balances
of different ledger accounts should be easily taken to these statements.
The calculation work should be minimum possible while preparing these
statements. The size of the statements should not be very large. The
columns to be used for giving the information should also be less. This will
enable the saving of time in preparing the statements.
• 6. Comparability: The results of financial analysis should be in a way that
can be compared to the previous years statements. The statement can
also be compered with the figures of other concerns of the same nature.
Sometimes budgeted figures are given along with the present figures. The
comparable figures will make the statements more useful. The Indian
Companies Act, 1956 has made it obligatory to give previous years figures
in the balance sheet. The comparison of figures will enable a proper
assessment for the working of the concern.

Characteristics
• 7. Analytical Representation: The information should be
analyzed in such a way that similar data is presented at the
same place. A relationship can be established in similar
type of information. This will be helpful in analysis and
interpretation of data.
• 8. Brief: If possible, the financial statements should be
presented in brief. The reader will be able to form an idea
about the figures. On the other hand, if figures are given in
details then it will become difficult to judge the working of
the business.
• 9. Promptness: The financial statements should be
prepared and presented at the earliest possible.
Immediately at the close of the financial year, statements
should be ready.

Components of Financial Balance
Sheet
• Total Assets
Total assets on the balance sheet are composed of:
• 1. Current Assets - These are assets that may be converted into cash, sold or consumed within a year or less. These usually include:
• Cash - This is what the company has in cash in the bank. Cash is reported at its market value at the reporting date in the respective currency in which
the financials are prepared. (Different cash denominations are converted at the market conversion rate.
• Marketable securities (short-term investments) - These can be both equity and/or debt securities for which a ready market exist. Furthermore,
management expects to sell these investments within one year's time. These short-term investments are reported at their market value.
• Accounts receivable - This represents the money that is owed to the company for the goods and services it has provided to customers on credit.
Every business has customers that will not pay for the products or services the company has provided. Management must estimate which customers
are unlikely to pay and create an account called allowance for doubtful accounts.Variations in this account will impact the reported sales on the
income statement. Accounts receivable reported on the balance sheet are net of their realizable value (reduced byallowance for doubtful accounts).
• Notes receivable - This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory
notes" (usually a short term-loan that carries interest). Furthermore, the maturity of notes receivable is generally longer than accounts receivable but
less than a year. Notes receivable is reported at its net realizable value (what will be collected).
• Inventory - This represents raw materials and items that are available for sale or are in the process of being made ready for sale. These items can be
valued individually by several different means - at cost or current market value - and collectively by FIFO (first in, first out), LIFO (last in, first out) or
average-cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets.
• Prepaid expenses - These are payments that have been made for services that the company expects to receive in the near future. Typical prepaid
expenses include rent, insurance premiums and taxes. These expenses are valued at their original cost (historical cost).

• 2. Long-term assets - These are assets that may not be converted into cash, sold or consumed within a year or less. The heading "Long-Term Assets"
is usually not displayed on a company's consolidated balance sheet. However, all items that are not included in current assets are long-term Assets.
These are:
• Investments - These are investments that management does not expect to sell within the year. These investments can include bonds, common stock,
long-term notes, investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in
special funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are reported at their historical cost or
market value on the balance sheet.
• Fixed assets - These are durable physical properties used in operations that have a useful life longer than one year. This includes:
– Machinery and equipment - This category represents the total machinery, equipment and furniture used in the company's operations. These assets are
reported at their historical cost less accumulated depreciation.
– Buildings (plants) - These are buildings that the company uses for its operations. These assets are depreciated and are reported at historical cost less
accumulated depreciation.
– Land - The land owned by the company on which the company's buildings or plants are sitting on. Land is valued at historical cost and is not depreciable
under U.S. GAAP
• Other assets - This is a special classification for unusual items that cannot be included in one of the other asset categories. Examples include deferred
charges (long-term prepaid expenses), non-current receivables and advances to subsidiaries.
• Intangible assets - These are assets that lack physical substance but provide economic rights and advantages: patents, franchises, copyrights,
goodwill, trademarks and organization costs. These assets have a high degree of uncertainty in regard to whether future benefits will be realized.
They are reported at historical cost net of accumulated depreciation.
• The value of an identifiable intangible asset is based on the rights or privileges conveyed to its owner over a finite period, and its value is amortized
over its useful life. Identifiable intangible assets include patents, trademarks and copyrights. Intangible assets that are purchased are reported on the
balance sheet at historical cost less accumulated amortization.
• An unidentifiable intangible asset cannot be purchased separately and may have an infinite life. Intangible assets with infinite lives are not
amortized, and are tested for impairment annually, at least. Goodwill is an example of an unidentifiable intangible asset. Goodwill is recorded when
one company acquires another at an amount that exceeds the fair market value of its net identifiable assets. It represents the premium paid for the
target company's reputation, brand names, customers, suppliers, human capital, etc. When computing financial ratios, goodwill and the offsetting
impairment charges are usually removed from the balance sheet.
• Certain intangible assets that are created internally such as research and development costs are expensed as incurred under U.S. GAAP. Under IFRS, a
firm must identify if the R&D cost is in the research and development stage. Costs are expensed in the research stage and capitalized during the
development stage.

Income Statement
• The income statement is one of the major financial statements used
by accountants and business owners. (The other major financial
statements are the balance sheet, statement of cash flows, and the
statement of stockholders' equity.) The income statement is
sometimes referred to as the profit and loss statement (P&L),
statement of operations, or statement of income. We will use
income statement and profit and loss statement throughout this
explanation.
• The income statement is important because it shows the
profitability of a company during the time interval specified in its
heading. The period of time that the statement covers is chosen by
the business and will vary. For example, the heading may state:

• Keep in mind that the income statement shows revenues, expenses,
gains, and losses; it does not show cash receipts (money you
receive) nor cash disbursements (money you pay out).
• People pay attention to the profitability of a company for many
reasons. For example, if a company was not able to operate
profitably—the bottom line of the income statement indicates a net
loss—a banker/lender/creditor may be hesitant to extend
additional credit to the company. On the other hand, a company
that has operated profitably—the bottom line of the income
statement indicates a net income—demonstrated its ability to use
borrowed and invested funds in a successful manner. A company's
ability to operate profitably is important to current lenders and
investors, potential lenders and investors, company management,
competitors, government agencies, labor unions, and others.

• The format of the income statement or the profit and loss statement will
vary according to the complexity of the business activities. However, most
companies will have the following elements in their income statements:
• A. Revenues and Gains
1. Revenues from primary activities
2. Revenues or income from secondary activities
3. Gains (e.g., gain on the sale of long-term assets, gain on lawsuits)
• B. Expenses and Losses
1. Expenses involved in primary activities
2. Expenses from secondary activities
3. Losses (e.g., loss on the sale of long-term assets, loss on lawsuits)
• If the net amount of revenues and gains minus expenses and losses is
positive, the bottom line of the profit and loss statement is labeled as net
income. If the net amount (or bottom line) is negative, there is a net loss.

• A. Revenues and Gains
• 1. Revenues from primary activities are often referred to as operating revenues.
The primary activities of a retailer are purchasing merchandise and selling the
merchandise. The primary activities of a manufacturer are producing the products
and selling them. For retailers, manufacturers, wholesalers, and distributors the
revenues resulting from their primary activities are referred to as sales revenues or
sales. The primary activities of a company that provides services involve acquiring
expertise and selling that expertise to clients. For companies providing services,
the revenues from their primary services are referred to as service revenues or
fees earned. (Some people use the word income interchangeably with revenues.)
• It's critical that you don't confuse revenues with receipts. Under the accrual basis
of accounting, service revenues and sales revenues are shown at the top of the
income statement in the period they are earned or delivered, not in the period
when the cash is collected. Put simply, revenues occur when money is earned,
receipts occur when cash is received.

• For example, if a retailer gives customers 30 days to pay, revenues occur
(and are reported) when the merchandise is sold to the buyer, not when
the cash is received 30 days later. If merchandise is sold in December, the
sale is reported on the December income statement. When the retailer
receives the check in January for the December sale, the retailer has a
January receipt—not January revenues.
• Similarly, if a consulting company asks clients to pay within 30 days of
receiving their service, revenues occur (and are reported) when the
service is performed (earned), not 30 days later when the consulting
company receives the cash from the client.
• If an attorney requires a client to prepay $1,000 before beginning to
research the client's case, the attorney has a receipt, but does not have
revenues until some of the research is done.
• If a company sells an item to a buyer who immediately pays for it with
cash, the company has both a receipt and revenues for that day—it has a
cash receipt because it received cash; it has sales revenues because it sold
merchandise.

• By knowing the difference between receipts and revenues, we make certain that revenues from a transaction are
reported only once—when the primary activities have been completed (and not necessarily when the cash is
collected).
• Let's reinforce the distinction between revenues and receipts with a few more examples. (Keep in mind that all of
the examples below assume the accrual basis of accounting.)
• A company borrows $10,000 from its bank by signing a promissory note due in 90 days. The company will have a
receipt of $10,000 at the time of the loan, but it does not have revenues because it did not earn the money from
performing a service or from a sale of merchandise.
• If a company provided a $1,000 service on January 31 and gave the customer until March 10 to pay for the service,
the company's January income statement will show revenues of $1,000. When the money is actually received in
March, the March income statement will not show revenues for this transaction. (In March the company will
report a receipt of cash and a reduction/collection of an accounts receivable.)
• A company performs a $400 service on December 31 and receives the $400 on the very same day (December 31).
This company will report $400 in revenues on December 31—not because the company had a cash receipt on
December 31, but because the service was performed (earned) on that day.
• On December 10, a new client asks your consulting company to provide a $2,500 service in January. You are
uncertain as to whether or not this client is credit worthy, so to be on the safe side you ask for an immediate
partial payment of $1,000 before you agree to schedule the work for January. Although your consulting company
has a receipt of $1,000 in December, it does not have revenues in December. (In December your company will
record a liability of $1,000.) Your consulting company will report the $1,000 of revenues when it performs $1,000
of services in January.

• 2. Revenues from secondary activities are often referred to
as nonoperating revenues. These are the amounts a
business earns outside of purchasing and selling goods and
services. For example, when a retail business earns interest
on some of its idle cash, or earns rent from some vacant
space, these revenues result from an activity outside of
buying and selling merchandise. As a result the revenues
are reported on the income statement separate from its
primary activity of sales or service revenues.
• As is true with operating revenues, nonoperating revenues
are reported on the profit and loss statement during the
period when they are earned, not when the cash is
collected.

• 3. Gains such as the gain on the sale of long-term assets, or lawsuits result from a transaction that
is outside of the primary activities of most businesses. A gain is reported on the income statement
as the net of two amounts: the proceeds received from the sale of a long-term asset minus the
amount listed for that item on the company's books (book value). A gain occurs when the proceeds
are more than the book value.
• Consider this example: Assume that a clothing retailer decides to dispose of the company's car and
sells it for $6,000. The $6,000 received for the car (the proceeds from the disposal of the car) will
not be included with sales revenues since the account Sales is used only for the sale of
merchandise. Since this retailer is not in the business of buying and selling cars, the sale of the car
is outside of the retailer's primary activities. Over the years, the cost of the car was being
depreciated on the company's accounting records and as a result, the money received for the car
($6,000) was greater than the net amount shown for the car on the accounting records ($3,500).
This means that the company must report a gain equal to the amount of the difference—in this
case, the gain is reported as $2,500. This gain should not be reported as sales revenues, nor should
it be shown as part of the merchandiser's primary activities. Instead, the gain will appear in a
section on the income statement labeled as "nonoperating gains" or "other income". The gain is
reported in the period when the disposal occurred.

• B. Expenses and Losses
• 1. Expenses involved in primary activities are expenses that are incurred
in order to earn normal operating revenues. Under the accrual basis of
accounting sales commissions expense should appear on the income
statement in the same period that the related sales are reported,
regardless of when the commission is actually paid. In the same way, the
cost of goods sold is matched with the related sales on the income
statement, regardless of when the supplier of the merchandise is paid.
• Costs used up (or expiring) in the accounting period shown in the heading
of the income statement are also considered to be expenses of that
period. For example, the utilities used in a retail store in December should
appear on the December income statement, even if the utility's meters
are not read until January 1 and the bill is paid on February 1.
• The above examples reflect the matching principle and show that under
the accrual basis of accounting, expenses on the income statement are
likely to be reported at different times than the cash
expenditures/disbursements.

• It is common for expenses to occur before the company pays for them (e.g., wages earned by
employees, employee bonuses and vacations, utilities, and sales commissions). However, some
expenses occur after the company has paid for them. For example, let's say a company buys a
building on December 31, 2015 for $300,000 (excluding the cost of land). The building is assumed
to have a useful life of 30 years. The company paid cash for the building on December 31, 2015 but
it will record depreciation expense of $10,000 in each of the years 2016 through 2045.
• Cash payments do not always mean that an expense has occurred. For example, a company might
pay $20,000 to the bank to reduce its bank loan. This payment will reduce the company's cash and
its liability to the bank, but it is not an expense.
• Some expenses are matched against sales on the income statement because there is a cause and
effect linkage—the sale of the merchandise caused the cost of goods sold and the sales commission
expense. Other expenses are not directly linked to sales and as a result they are matched to the
accounting period when they are consumed or used—examples include utilities expense, office
salaries expense, and depreciation expense. Some expenses such as advertising expense and
research and development expense can neither be linked with sales nor a specific accounting
period and as a result, they are reported as expenses as soon as they occur.

• The income statements or profit and loss statements of merchandisers and manufacturers will use
a separate line for the cost of goods sold. The other expenses involved in their primary activities
will either be grouped together as operating expenses or subdivided into the categories "selling"
and "administrative."
• 2. Expenses from secondary activities are referred to as nonoperating expenses. For example,
interest expense is a nonoperating expense because it involves the finance function of the business,
rather than the primary activities of buying/producing and selling.
• 3. Losses such as the loss from the sale of long-term assets, or the loss on lawsuits result from a
transaction that is outside of a business's primary activities. A loss is reported as the net of two
amounts: the amount listed for the item on the company's books (book value) minus the proceeds
received from the sale. A loss occurs when the proceeds are less than the book value.
• Let's assume that a clothing retailer decides to dispose of the company's car. The proceeds from the
disposal are $2,800. This is less than the $3,500 amount shown in the company's accounting
records. Since this retailer is not in the business of buying and selling cars (the sale of the car is
outside of the operating activities of buying and selling clothing), the money received for the car
will not be included in sales revenues, and the loss experienced on the sale of the car ($700) will
not be included in operating expenses. Instead, the $700 loss will appear in a section on the income
statement labeled "nonoperating gains or losses" or "other income or losses". The loss is reported
in the time period when the disposal occurs.

• Additional Considerations
• Then vs. Now. The income statement covers a past period of time, and the past
may or may not be indicative of the future. For example, a company supplying a
high-demand fad item for the recent holiday season may have had a great year
financially, but if it does not produce a similarly successful item for the next
holiday season, it may experience a poor year financially.
• Expenses Do Not Equal Economic Reality. Because of the cost principle and
inflation, the expenses shown on the income statement reflect old costs. For
example, assume that a company is operating a forty-year-old manufacturing plant
that had a cost of $400,000. The depreciation expense for this plant may be zero
on the current income statement because the plant was depreciated over 30
years. The cost of a new plant might be $4,000,000 today and the depreciation
expense on the new plant might be $130,000 per year. The cost principle,
however, prohibits showing the depreciation based on the cost of a new plant.
• Using Estimates. An accountant is not allowed the luxury of waiting until things are
known with certainty. In order to recognize revenues when they are earned,
recognize expenses when they are incurred, or match expenses with revenues,
accountants must often use estimates.

• Single-Step Income Statement
• A single-step income statement is one of two commonly used
formats for the income statement or profit and loss statement. The
single-step format uses only one subtraction to arrive at net
income.
• An extremely condensed income statement in the single-step
format would look like this:
• Single-Step Income Statement
• A single-step income statement is one of two commonly used
formats for the income statement or profit and loss statement. The
single-step format uses only one subtraction to arrive at net
income.
• An extremely condensed income statement in the single-step
format would look like this:

• The heading of the income statement conveys critical
information. The name of the company appears first,
followed by the title "Income Statement." The third
line tells the reader the time interval reported on the
profit and loss statement. Since income statements can
be prepared for any period of time, you must inform
the reader of the precise period of time being covered.
(For example, an income statement may cover any one
of the following time periods: Year Ended May 31, Five
Months Ended May 31, Quarter Ended May 31, Month
Ended May 31, or Five Weeks Ended May 31.)

• Multiple-Step Income Statement
• An alternative to the single-step income statement is the
multiple-step income statement, because it uses multiple
subtractions in computing the net income shown on the
bottom line.
• The multiple-step profit and loss statement segregates the
operating revenues and operating expenses from the
nonoperating revenues, nonoperating expenses, gains, and
losses. The multiple-step income statement also shows the
gross profit (net sales minus the cost of goods sold).
• Here is a sample income statement in the multiple-step
format:

• Step 1.
Cost of goods sold is subtracted from net sales
to arrive at the gross profit.

• Step 2.
Operating expenses are subtracted from gross
profit to arrive at operating income.

• Step 3.
The net amount of nonoperating revenues,
gains, nonoperating expenses and losses is
combined with the operating income to arrive
at the net income or net loss.

• There are three benefits to using a multiple-step income statement
instead of a single-step income statement:
• The multiple-step income statement clearly states the gross profit
amount. Many readers of financial statements monitor a company's
gross margin (gross profit as a percentage of net sales). Readers
may compare a company's gross margin to its past gross margins
and to the gross margins of the industry.
• The multiple-step income statement presents the subtotal
operating income, which indicates the profit earned from the
company's primary activities of buying and selling merchandise.
• The bottom line of a multiple-step income statement reports the
net amount for all the items on the income statement. If the net
amount is positive, it is labeled as net income. If the net amount is
negative, it is labeled as net loss.

• Reporting Discontinued Operations
• The term discontinued operations pertains to the elimination of a
significant part of a company's business, such as the sale of an entire
division of the company. (Eliminating a small portion of a product line does
not qualify as a discontinued operation.)
• To learn more about the required presentation of information to be
disclosed see an intermediate accounting textbook. Our focus here is to
show where the results of discontinued operations will appear in the
company's income statement.
• Below is an example of a single-step income statement containing
discontinued operations. (If this were a corporation, income tax expenses
would be part of the income statement and the gain on discontinued
operations would be reduced by the income tax expense associated with
the gain. A loss on discontinued operations would be reduced by the
income tax savings associated with the loss.) See net of tax.

• Note that even in a single-step format shown
above, the amount of the discontinued
operations is separated out and added to the end
of the income statement.
• Below is a multiple-step income statement
containing discontinued operations. (If this were
a corporation, income tax expenses would be
part of the income statement. As a result, the
amount of the gain or loss on discontinued
operations would be reduced by the income tax
effect.)

Key Ratios
• Knowing how to calculate and use financial
ratios is important for not only businesses, but
for investors, lenders and more.
• Ratios allow you to compare a various aspect
of a company's financial statements against
others in its industry, to determine a
company's ability to pay dividends, and more.
• In other words, analysis of ratios simplifies the
comprehension of financial statements.

Preparing financial ratios :
• It provides data for inter – firm comparison. Makes
inter-firm comparison possible.
• Helps to draw conclusions on performance, strengths &
weaknesses of a firm and enables in decision making
process.
• It highlights the factors associated with successful and
unsuccessful firm.
• It helps to reveal the loopholes which are affecting the
performance of the firm. It helps in planning and
forecasting. Ratios can assist management, in its
function of forecasting, planning, co-ordination and
apply control techniques to manage financials.

How to derive Financial Ratios?
• At the very outset, ratios are derived from the
financial statements prepared by the
enterprise. For effective understanding of
values derived from these ratios, ratios are
broadly classified into four categories:

LIQUIDITY RATIOS:
• “liquidity” or “short – term solvency”, measures the
credibility of the concern to pay its short term
liabilities.
• Traditionally, current ratio, quick ratio and operating
cash flow ratio are used to highlight the business
liquidity.
• Current Ratio = Current Assets / Current Liabilities.
• Quick Ratio = (Current Assets – Inventories) / Current
Liabilities.
• Operating Cash Flow Ratio = Operating Cash Flow /
Total Debt

LEVERAGE RATIOS:
• These includes the following ratios:
• Debt - Equity Ratio = Total Liabilities /
Shareholders’ Equity
• It indicates the proportion of debt fund in
relation to equity.
• A high ratio indicates less protection for
creditors.

Debt Service Coverage Ratio
• Debt Service Coverage Ratio = Earnings
available for debt service / (Interest +
Installments)
• “Earnings available for debt service” includes
Net profit + Non-cash operating expenses +
Non operating adjustments.
• It measures the firm’s ability to pay off current
interest and installments.

Interest Coverage Ratio
• Interest Coverage Ratio = Earnings before
interest and taxes / Interest
• A high ratio implies the ability of the
enterprise to meet its fixed liabilities, that is,
interest obligations.

Capital Gearing Ratio
• Capital Gearing Ratio = (Preference Share
Capital + Debentures + Long Term Loans) /
(Equity Share Capital + Reserves & Surplus –
Losses)
• It indicates the proportion of fixed interest
(dividend) bearing capital to funds belonging
to equity shareholders.

Proprietary Ratio
• Proprietary Ratio = Proprietary Fund / Total
Assets
• “Proprietary Fund” includes Equity Share
Capital + Preference Share Capital + Reserves
& Surplus – Fictitious Assets.

ACTIVITY RATIOS
• These ratios are employed to evaluate the performance of the firm in
terms of management and utilization of assets. It includes the following
ratios:
• Working Capital Turnover Ratio = Sales / Working Capital
• Working Capital Turnover is further segregated into Inventory Turnover,
Debtors Turnover and Creditor Turnover.
• Fixed Assets Turnover Ratio = Sales / Capital Assets
• A high ratio indicates efficient utilization of fixed assets in generating
revenue.
• Debtors Turnover Ratio = Credit Sales / Average Accounts Receivable
• It throws light on the collection and credit policies of the firm and the rate
at which the receivables are collected.
• Creditors Turnover Ratio = Credit Purchases / Average Accounts Payable
• Like Debtors Turnover Ratio, it shows the velocity of debt payment by the
firm.

PROFITABILITY RATIOS
• : It measures operational efficiency of the firm based on assets/
investments, on sales, on capital market information or from owners,
point of view.
• Gross Profit Ratio = Gross Profit / Sales X 100
• It is used to compare product profitability.
• Operating Profit Ratio = Operating Profit / Sales X 100
• It is calculated to evaluate the operating performance of business.
• Return on Equity (ROE) = Profit after taxes / Net Worth
• It is one of the most important indicators of a firm’s profitability and
potential growth. It reveals how profitably the owner’s funds have been
utilized by the firm.
• Earnings per Share = Net profit available to equity holders / Number of
Shares outstanding
• It measures the profitability of a firm on the basis of value of each share in
relation to retained profit of the firm.

• Price Earning Ratio = Market price per share / Earnings per
share
• It indicates the expectation of equity investors about the
earnings of the firm. It relates earnings to market price and
is used to measure the growth potential of an investment.
• Return on Investment (ROI) = Return / Capital Employed X
100
• “Return” includes Net Profit +/- Non – trading adjustments
+ interest on long term debts + provision for tax – Interest /
Dividend from non – trade investments.
• “Capital Employed” includes total share capital + Reserves
& Surplus + Long term loans – Miscellaneous expenditure
and losses – Non trade Investments.

Reviewing Financial Statements
• A financial statement review is a service under which the accountant obtains
limited assurance that there are no material modifications that need to be made
to an entity's financial statements for them to be in conformity with the applicable
financial reporting framework (such as GAAP or IFRS). A review does not require
the accountant to obtain an understanding of internal control, or to assess fraud
risk, or other types of audit procedures. Consequently, a review does not provide
the accountant with assurance that he has become aware of all the significant
matters that would normally have been discovered and disclosed in an audit.
• The review is more expensive than a compilation and less expensive than an audit.
It is preferred by those businesses whose lenders and creditors will allow them to
use this approach, thereby saving the cost of a full audit.
• In a review, management takes responsibility for the preparation and presentation
of the entity's financial statements, while the accountant should have a sufficient
level of knowledge of both the industry and the entity to review the financial
statements.
• In a financial statement review, the accountant performs those procedures
necessary to provide a reasonable basis for obtaining limited assurance that no
material changes are needed to bring the financial statements into compliance
with the applicable financial reporting framework. These procedures are more
heavily concentrated in areas where there are enhanced risks of misstatement.

The types of procedures to conduct for
a review
• Conduct a ratio analysis with historical, forecasted, and industry results
• Investigate findings that appear to be inconsistent
• Inquire about the procedures for recording accounting transactions
• Investigate unusual or complex situations that may impact reported results
• Investigate significant transactions occurring near the end of the accounting period
• Follow up on questions that arose during previous reviews
• Inquire about material events that occurred after the date of the financial
statements
• Investigate significant journal entries
• Review communications from regulatory agencies
• Read the financial statements to see if they appear to conform with the applicable
financial reporting framework
• Review the management reports of any accountants who reviewed or audited the
entity's financial statements in prior periods

• There are also a number of review steps that can be utilized in specific areas, such as:
• Cash. Are cash accounts being reconciled? Have checks written but not mailed been classified as liabilities? Is
there a reconciliation of intercompany transfers?
• Receivables. Is there an adequate allowance for doubtful accounts? Are any receivables pledged, discounted, or
factored? Are there any non-current receivables?
• Inventory. Are physical inventory counts performed? Were consigned goods considered during the inventory
count? What cost elements are included in the cost of inventory?
• Investments. How are fair values determined for investments? How are gains and losses recorded following the
disposal of an investment? How do you calculate investment income?
• Fixed assets. How are gains and losses on the disposal of fixed assets recorded? What are criteria for capitalizing
expenditures? What depreciation methods are used?
• Intangible assets. What types of assets are recorded as intangible assets? Is amortization being appropriately
applied? Have impairment losses been recognized?
• Notes payable and accrued expenses. Are there sufficient expense accruals? Are loans properly classified?
• Long-term liabilities. Are the terms of debt agreements properly disclosed? Is the entity in compliance with any
loan covenants? Are loans properly classified as short-term or long-term?
• Contingencies and commitments. Are there guarantees to which the entity has committed itself? Are there any
material contractual obligations? Are there liabilities for environmental remediation?
• Equity. What classes of stock have been authorized? What is the par value of each class of stock? Have stock
options been properly measured and disclosed in the financial statements?
• Revenue and expenses. What is the revenue recognition policy? Are expenses recorded in the correct reporting
period? H

Management Assertions
• Management assertions are claims made by
members of management regarding certain
aspects of a business.
• The concept is primarily used in regard to the
audit of a company's financial statements, where
the auditors rely upon a variety of assertions
regarding the business.
• The auditors test the validity of these assertions
by conducting a number of audit tests.

Transaction-level assertions.
• The following five items are classified as assertions related
to transactions, mostly in regard to the income statement:
• Accuracy. The assertion is that the full amounts of all
transactions were recorded, without error.
• Classification. The assertion is that all transactions have
been recorded within the correct accounts in the general
ledger.
• Completeness. The assertion is that all business events to
which the company was subjected were recorded.
• Cutoff. The assertion is that all transactions were recorded
within the correct reporting period.
• Occurrence. The assertion is that recorded business
transactions actually took place.

Account balance assertions.
• The following four items are classified as assertions related
to the ending balances in accounts, and so relate primarily
to the balance sheet:
• Completeness. The assertion is that all reported asset,
liability, and equity balances have been fully reported.
• Existence. The assertion is that all account balances exist
for assets, liabilities, and equity.
• Rights and obligations. The assertion is that the entity has
the rights to the assets it owns and is obligated under its
reported liabilities.
• Valuation. The assertion is that all asset, liability, and equity
balances have been recorded at their proper valuations.

Presentation and disclosure assertions.
• The following five items are classified as assertions related to the
presentation of information within the financial statements, as well
as the accompanying disclosures:
• Accuracy. The assertion is that all information disclosed is in the
correct amounts, and which reflect their proper values.
• Completeness. The assertion is that all transactions that should be
disclosed have been disclosed.
• Occurrence. The assertion is that disclosed transactions have indeed
occurred.
• Rights and obligations. The assertion is that disclosed rights and
obligations actually relate to the reporting entity.
• Understandability. The assertion is that the information included in
the financial statements has been appropriately presented and is
clearly understandable.

Consolidated Financial Statement-level
Reporting
• Consolidated financial statements are the
combined financial statements of a parent
company and its subsidiaries.
• Because consolidated financial statements
present an aggregated look at the financial
position of a parent and its subsidiaries, they
let you gauge the overall health of an entire
group of companies as opposed to one
company's standalone position.

• Consolidated financial statements report the
aggregate of separate legal entities. A parent
company can operate as a separate corporation
apart from its subsidiary companies. Each of
these entities reports its own financial
statements and operates its own business.
However, because the subsidiaries are considered
to form one economic entity, investors,
regulators, and customers find consolidated
financial statements more beneficial to gauge the
overall position of the entity.

• Consolidated Statement of Income
• The consolidated financial statements only report
income and expense activity from outside of the
economic entity. Any revenue earned by the
parent that is an expense of a subsidiary is
omitted from the financial statements. This is
because the net change in the financial
statements is $0. The revenue generated from
one legal entity is offset by the expenses in
another legal entity. To avoid overinflating
revenues, all internal revenues are omitted.

• Consolidated Balance Sheet
• Certain account receivable balances and account
payable balances are eliminated from the
consolidated balance sheet. These eliminated
amounts relate to the amounts owed to or from
parent or subsidiary entities. Similar to the
income statement, this is to simply reduce the
balances reported as the net effect is $0. All cash,
receivables, and other assets are reported on the
consolidated as well as all liabilities owed to
external parties.

• Reporting Requirements
• Consolidated financial statements must be prepared using
the same accounting methods across the parent and
subsidiary entities. If relevant, the parent and subsidiaries
must all be accounted for using generally accepted
accounting principles (GAAP) if the consolidated financial
statements are to be in accordance with GAAP. All
subsidiary equity accounts such as common stock or
retained earnings must be eliminated. A non-controlling
interest account may be used if the subsidiary is not wholly
owned. When preparing the consolidated financial
statements, the subsidiary’s balance sheet accounts are
readjusted to the current fair market value of the financial
assets.

Reporting Audits
• An audit report is an appraisal of a small business’s
complete financial status. Completed by an
independent accounting professional, this document
covers a company’s assets and liabilities, and presents
the auditor’s educated assessment of the firm’s
financial position and future. Audit reports are
required by law if a company is publicly traded or in an
industry regulated by the Securities and Exchange
Commission (SEC). Companies seeking funding, as well
as those looking to improve internal controls, also find
this information valuable. There are four types of audit
reports.

• Unqualified Opinion
• Often called a clean opinion, an unqualified opinion is an audit
report that is issued when an auditor determines that each of the
financial records provided by the small business is free of any
misrepresentations. In addition, an unqualified opinion indicates
that the financial records have been maintained in accordance with
the standards known as Generally Accepted Accounting Principles
(GAAP). This is the best type of report a business can receive.
Typically, an unqualified report consists of a title that includes the
word “independent.” This is done to illustrate that it was prepared
by an unbiased third party. The title is followed by the main body.
Made up of three paragraphs, the main body highlights the
responsibilities of the auditor, the purpose of the audit and the
auditor’s findings. The auditor signs and dates the document,
including his address.

• Qualified Opinion
• In situations when a company’s financial records
have not been maintained in accordance with
GAAP but no misrepresentations are identified,
an auditor will issue a qualified opinion. The
writing of a qualified opinion is extremely similar
to that of an unqualified opinion. A qualified
opinion, however, will include an additional
paragraph that highlights the reason why the
audit report is not unqualified.

• Adverse Opinion
• The worst type of financial report that can be issued to
a business is an adverse opinion. This indicates that the
firm’s financial records do not conform to GAAP. In
addition, the financial records provided by the business
have been grossly misrepresented. Although this may
occur by error, it is often an indication of fraud. When
this type of report is issued, a company must correct its
financial statement and have it re-audited, as investors,
lenders and other requesting parties will generally not
accept it.

• Disclaimer of Opinion
• On some occasions, an auditor is unable to
complete an accurate audit report. This may
occur for a variety of reasons, such as an
absence of appropriate financial records.
When this happens, the auditor issues a
disclaimer of opinion, stating that an opinion
of the firm’s financial status could not be
determined.

Difference between vertical analysis
and horizontal analysis
• Vertical analysis reports each amount on a financial statement as a
percentage of another item. For example, the vertical analysis of
the balance sheet means every amount on the balance sheet is
restated to be a percentage of total assets. If inventory is $100,000
and total assets are $400,000 then inventory is presented as 25
($100,000 divided by $400,000). If cash is $8,000 then it will be
presented as 2 ($8,000 divided by $400,000). The total of the assets
will now add up to 100. If the accounts payable are $88,000 they
will be presented as 22 ($88,000 divided by $400,000). If owner's
equity is $240,000 it will be presented as 60 ($240,000 divided by
$400,000). The restated amounts from the vertical analysis of the
balance sheet will be presented as a common-size balance sheet. A
common-size balance sheet allows you to compare your company's
balance sheet to another company's balance sheet or to the
average for its industry.

• Vertical analysis of an income statement results in
every income statement amount being presented as a
percentage of sales. If sales were $1,000,000 they
would be restated to be 100 ($1,000,000 divided by
$1,000,000). If the cost of goods sold is $780,000 it will
be presented as 78 ($780,000 divided by sales of
$1,000,000). If interest expense is $50,000 it will be
presented as 5 ($50,000 divided by $1,000,000). The
restated amounts are known as a common-size income
statement. A common-size income statement allows
you to compare your company's income statement to
another company's or to the industry average.

• Horizontal analysis looks at amounts on the financial
statements over the past years. For example, the amount of
cash reported on the balance sheet at December 31 of
2012, 2011, 2010, 2009, and 2008 will be expressed as a
percentage of the December 31, 2008 amount. Instead of
dollar amounts you might see 134, 125, 110, 103, and 100.
This shows that the amount of cash at the end of 2012 is
134% of the amount it was at the end of 2008. The same
analysis will be done for each item on the balance sheet
and for each item on the income statement. This allows you
to see how each item has changed in relationship to the
changes in other items. Horizontal analysis is also referred
to as trend analysis.

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