CMA P1

Lecture 1
External Financial Statements
Unit 1 Gliem
Mr. Ahmed Shehatta
• external financial reporting decisions. The
relative weight assigned to this major topic in Part 1 of
the exam is 15%. The six study units are:

- Study Unit 1: External Financial Statements

- Study Unit 2: Measurement, Valuation, and
Disclosure: Assets -- Short-Term Items
- Study Unit 3: Measurement, Valuation, and
Disclosure: Assets -- Long-Term Items
- Study Unit 4: Measurement, Valuation, and
Disclosure: Liabilities
- Study Unit 5: Revenue and Impairment
Recognition
- Study Unit 6: Integrated Reporting
Full set of financial statements
4- Financial Statement Relationships
a. Financial statements complement each other. They describe different aspects of the sametransactions, and more than one statement is
necessary to provide information for a specific economic decision.
b. The components (elements) of one statement relate to those of other statements. Amongthe relationships are those listed below.
1) Net income or loss from the statement of income is reported and accumulated in theretained earnings account, a component of the
equity section of the statement of financial position.
2) The components of cash and equivalents from the statement of financial position arereconciled with the corresponding items in the
statement of cash flows.
3) Items of equity from the statement of financial position are reconciled with thebeginning balances on the statement of changes in
equity.
4) Ending inventories are reported in current assets on the statement of financial position and are reflected in the calculation of cost of
goods sold on the statementof income.
5) Amortization and depreciation reported in the statement of income also are reflectedin asset and liability balances in the statement of
financial position.
1. Accrual Basis of Accounting
a. Financial statements are prepared under the accrual basis of accounting. Accrual accounting records the financial effects of
transactions and other events and circumstances when they occur rather than when their associated cash is paid orreceived.
1) Revenues are recognized in the period in which they were earned even if the cashwill be received in a future period.
2) Expenses are recognized in the period in which they were incurred even if the cashwill be paid in a future period.
Accrual accounting reports the effects of transactions and other events and circumstances even if the resulting cash flows occur
in a different period. The advantage of accrual accounting is that information about an entity’s economic resources and claims
and changes in them during a period provides a better basis for assessing past and future performance than information solely
about cash flows
1.2 STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)
- The statement of financial position, also called the balance sheet, reports the amounts of assets (items of
value), liabilities (debt), and equity (net worth) and their relationships at a moment in time, such as at the end of
the fiscal year.
a. The basic accounting equation presents a perfect balance between the entity’s resources and its
capital structure.
1) The entity’s resources consist of the assets the entity deploys in its attempts to earn a return.

2) The capital structure consists of the amounts contributed by creditors (liabilities) and investors (equity).

- Assets = Liabilities + Equity

- The equation is based on the proprietary theory. According to this theory, equity in an enterprise is what
remains after the economic obligations of the enterprise are deducted from its economic resources
- Elements of the Balance Sheet
- Assets are resources controlled by the entity as a result of past events
- Examples include inventory; accounts receivable; investments; and property, plant, and equipment
- Liabilities are present obligations of the entity arising from past events
- Examples include loans payable, bonds issued by the entity, and accounts payable.
- Equity is the residual interest in the assets of the entity after subtracting all its liabilities
- Examples include a company’s common stock, preferred stock, and retained earnings.
1) Equity is affected not only by operations but also by transactions with owners, suchas dividends and contributions.
a) Investments by owners are increases in equity of a business entity. They result from transfers of something of value to increase
ownership interests.Assets are the most commonly transferred item, but services also can be exchanged for equity interests.
b) Distributions to owners are decreases in equity. They result from transferring assets to owners. A distribution to owners decreases
the ownership interest inthe company.
Assets and liabilities are separated in the statement of financial position into current and
• noncurrent categories.
1) Assets are generally reported in order of liquidity.
• Current assets:
• Cash available for current operations, including coins, currency, undeposited checks
• Cash equivalents. Short-term, highly liquid investments that are convertible to known amounts of cash without a
significant loss in value and have maturities of 3 months or less from the date of purchase
• Marketable securities classified as current assets
(Marketable securities classified as trading securities are almost always current asset, Marketable securities other
than trading securities may or may not be classified as current assets, depending on management’s intention.
Marketable debt securities classified as available-for-sale are current assets if they are considered working capital
available for current operations, regardless of their maturity dates. Marketable debt securities classified as held-to-
maturity are current assets only if their maturity is within one year or the length of the firm’s operating cycle
• Receivables. Trade accounts receivable, notes receivable. Receivables from officers, employees, affiliates and
others are also current assets if they are collectible in the ordinary course of business within one year or the firm’s
operating cycle
• Contract assets classified as current assets. Under the revenue recognition standard, ASC 606, contract assets
represent an entity’s right to consideration in exchange for goods or services that the entity has transferred to a
customer when that right is conditional on something other than the passage of time, for example the entity’s
future performance, before the entity can invoice the customer. Contract assets may be current assets or non-
current assets or both, depending on the facts and circumstances such as when receipt of payment is expected,
based on the agreement with the customer. Contract assets are explained in the Revenue Recognition topic in this
volume.
• Inventories
• Prepaid expenses.
• Funds that are restricted for current purposes.
Non-Current
Liability
a. Current liabilities do not include short-term debt if an entity
1) Intends to refinance them on a noncurrent basis and
2) Demonstrates an ability to do so.

a) The ability to refinance may be demonstrated by entering into a refinancing agreement before the

balance sheet is issued.

b. Noncurrent liabilities are those not qualifying as current. The noncurrent portions of the following items are
reported in this section of the balance sheet:
1) Noncurrent notes and bonds
2) A lessee’s liabilities under finance and operating leases
3) Most postretirement benefit obligations
4) Deferred tax liabilities arising from interperiod tax allocation
5) Obligations under product or service warranty agreements
6) Deferred revenue
7) Advances for noncurrent commitments to provide goods or services
Equity
a. Any recognized transaction that does not have equal and offsetting effects on total assets and total liabilities changes
equity. The following are the major items of equity:
1) Capital contributions by owners (par value of common and preferred stock issued and additional paid-in capital).
a) Additional paid-in (contributed) capital is the amount received in excess of parvalue at the time stock was sold.
2) Retained earnings are the accumulated net income not yet distributed to owners. Dividends can be paid when
retained earnings has a credit balance. A payment inexcess of this balance is a return of capital, not a dividend.
a)Occasionally, the board of directors restricts retained earnings to prevent payment of dividends. The usual reason
is that the board plans to reinvest theearnings in the business.
3) Treasury stock is the firm’s own stock that has been repurchased.
a)It is reflected in shareholders’ equity as a contra account (which reduces thebalance of a related account). Thus,
it is not an asset.
4) Accumulated other comprehensive income (all comprehensive income items notincluded in net income).
Balance Sheet Elements Are Permanent Accounts
• Assets, liabilities, and equity are recorded in permanent (real) accounts. Their balancesat the end of one
accounting period (the balance sheet date) are carried forward as the beginning balances of the next accounting
period.
Limitations of the Balance Sheet
a. The balance sheet shows a company’s financial position at a single point in time; accountsmay vary significantly a few days before or after the
publication of the balance sheet.
b. Many balance sheet items, such as property, plant, and equipment, are recorded athistorical costs, which may not equal their fair value.
c. The preparation of the balance sheet requires estimates and management judgment.
d. The balance sheet omits many items that cannot be recorded objectively but havefinancial value to the company.
Off-balance-sheet financing is an accepted accounting method for recording assets and liabilities so that they are not
shown on the balance sheet. Examples would include factoring receivables with or without recourse, establishing special
purpose entities, and participating in joint ventures
Off-balance-sheet financing will make a company appear less risky than it really is because some liabilities exist but are
not shown on the balance sheet.
 1.3 INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME
• Income Statement Elements
a. The following are the elements of an income statement:
1) Revenues are inflows or other enhancements of assets or settlements of liabilities (or both) from delivering or
producing goods, providing services, or other activitiesthat qualify as ongoing major or central operations.
2) Gains are increases in equity (or net assets) other than from revenues orinvestments by owners.

3) Expenses are outflows or other usage of assets or incurrences of liabilities (or both) from delivering or producing
goods, providing services, or other activities that qualify as ongoing major or central operations.
4) Losses are decreases (which may or may not occur) in equity (or net assets) other than from expenses or distributions
to owners.
b. All transactions affecting the net change in equity during the period are included in incomeexcept
1) Transactions with owners
2) Prior-period adjustments (such as error correction or a change in accounting principle)

3) Items reported initially in other comprehensive income

4) Transfers to and from appropriated retained earnings

c. Revenues, expenses, gains, and losses are recorded in temporary (nominal) accounts because they record the
transactions, events, and other circumstances during a period of time. These accounts are closed (reduced to zero) at the
end of each accounting period, and their balances are transferred to real accounts.
For example, income or loss for the period (a nominal account) is closed to retained earnings (a real account)
1)
at the end of the reporting period.
1. Gross profit is the net difference between sales revenue and cost of goods sold.
a. Gross profit margin as a percentage of sales is calculated as follows:

• Gross profit margin (%) = Gross profit ÷ Sales

Extra ordinary item is
no longer be used
Reporting Irregular Items
a. Discontinued Operation

1) When an entity reports a discontinued operation, it must be presented in a separate section between income from
continuing operations and net income.
a) Because these items are reported after the presentation of income taxes, they must be shown net of tax.
b) The term “continuing operations” is used only when a discontinued operation isreported.

2) Discontinued operations, if reported, may have two components:

A) Gain or loss from operations of the component that has been disposed of or is classified as held for sale
from the first day of the reporting period until the date of disposal (or the end of the reporting period if it is classified
as held forsale)
b) Gain or loss on the disposal of this component
Limitations of the Income Statement
1- The income statement does not always show all items of income and expense. Some of the
items are reported on a statement of other comprehensive income and not included in the
calculation of net income.
2- The financial statements report accrual-basis results for the period. The company may
recognize revenue and report net income before any cash was actually received.
- For example, the data from the income statement itself is not sufficient enough for assessing
liquidity. This statement must be viewed in conjunction with other financial statements, such as
the balance sheet and statement of cash flows.
3- The preparation of the income statement requires estimates and management judgment
Share-Based Payments and Employee Benefits
1) Common share-based payment arrangements between employers and employees include

a) Call options that give employees the right to purchase an entity’s shares in exchange for their services,

b) Share appreciation rights that entitle employees to cash payments calculatedby reference to increases in

the market price of an entity’s shares, and

c) Share ownership plans that distribute shares to employees in exchange for their services.

• ASC 718, Compensation—Stock Compensation, requires all entities to recognize compensation expense in an
amount equal to the fair value of share-based payments (e.g., stock options and restricted stock) granted to
employees.
• Statement of Comprehensive Income
a. Comprehensive income includes all changes in equity (net assets) of a business during a period except those
from investments by and distributions to owners.
1) It consists of
a) Net income or loss (the bottom line of the income statement) and
b) Other comprehensive income (OCI).
2) Certain income items are excluded from the calculation of net income and instead are included in
comprehensive income. The following are the major items included in other comprehensive income:
a) The effective portion of a gain or loss on a hedging instrument in a cash flowhedge
b) Unrealized holding gains and losses due to changes in the fair value of available-for-sale debt
securities
c) Translation gains and losses for financial statements of foreign operations
d) Certain amounts associated with accounting for defined benefit postretirement plans
b. All items of comprehensive income are recognized for the period in either
1) One continuous financial statement that has two sections, net income and OCI, or
2) Two separate but consecutive statements.
a) The first statement (the income statement) presents the components of net income and total net
income.
b) The second statement (the statement of OCI) is presented immediately after the first. It presents a
total of OCI with its components and a total of comprehensive income.
•
1. Equity Transactions – Issuance of Stock
a. The par value of stock is an arbitrary amount assigned by the issuer. Common and preferred stock are reported in the
financial statements at par value.
b. Cash is increased (debited), the appropriate stock account is increased (credited) for the total par value of stock issued,
and additional paid-in capital (paid-in capital in excess of par) is increased (credited) for the difference.
1. Equity Transactions – Stock Dividend and Stock Split
a. A stock dividend involves no distribution of cash or other property. Stock dividends areaccounted for as a
reclassification of different equity accounts, not as liabilities.
1) The recipient does not recognize income. It has the same proportionate interest inthe entity and the same total
carrying amount as before the stock dividend.
b. The accounting for stock dividends depends on the percentage of new shares to beissued.
1) An issuance of shares less than 20% to 25% of the previously outstanding commonshares should be recognized
as a stock dividend.
Stock splits are issuances of shares that do not affect any aggregate par value of shares issued and outstanding or total
equity. Stock split reduces the par value of each stock and increases the number of shares outstanding.
1) No entry is made, and no transfer from retained earnings occurs.
2) The primary purpose of a stock split is to improve the stock’s marketability by reducing its market price and proportionally
increasing the number of sharesoutstanding
Subunit 2: Statement of Financial Position (Balance Sheet)
Subunit 3: Income Statement and Statement of Comprehensive Income
Subunit 4: Equity statement
5- Statement of cashflow
End Of lecture • Thank you