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Balance sheet and income statement

FAR Chapter 1 · Area I · Blueprint I.A.1–2

Area I is 30 to 40% of FAR, and it begins with the two statements every other topic feeds into. The Blueprint asks you to prepare each one from a trial balance, to correct errors in them, and to find discrepancies by agreeing the numbers to source data. It also places foreign currency transactions here. Expect a simulation that hands you a trial balance and a list of adjustments.

In this chapter

  1. From trial balance to statements
  2. The classified balance sheet
  3. Current or noncurrent? The debt rules
  4. The income statement: single-step and multi-step
  5. Discontinued operations and unusual items
  6. Foreign currency transactions
  7. Correcting errors and finding discrepancies

This chapter has 7 lessons, 50 practice MCQs with explanations and 11 simulations, plus flashcards and a recall sheet.

What this chapter covers

Chapter 1 is free to read in full. Here are its lessons.

From trial balance to statements

A trial balance is a list of every ledger account with its debit or credit balance. It proves only that debits equal credits. The financial statements sort those same accounts into a story.

Accounts with balances that carry forward go to the balance sheet: assets, liabilities and equity. Accounts that restart at zero each year go to the income statement: revenues, expenses, gains and losses.

Before sorting, adjust. Accruals record what has been earned or incurred but not yet recorded, such as wages owed at year end. Deferrals push out what has been recorded but not yet earned or used, such as rent paid in advance. Estimates record things like depreciation and expected credit losses.

The balance sheet equation must hold after every entry: assets = liabilities + equity.

Example. On December 31 the trial balance shows prepaid insurance of $24,000, paid on October 1 for 12 months of cover. Three months have been used: $24,000 x 3/12 = $6,000 is expense, and $18,000 remains a prepaid asset.

Step up. On November 1 a software company receives $36,000 for a 12-month support contract and credits unearned revenue. At December 31 two months have been earned: $36,000 x 2/12 = $6,000. The entry is debit unearned revenue $6,000, credit revenue $6,000. The balance sheet shows unearned revenue of $30,000, all current because the service will be delivered within a year.

Exam level. Unadjusted net income is $210,000. Three items were missed: wages of $9,000 owed at year end, interest of $2,500 earned on a note but not yet received, and $4,000 of a $12,000 prepaid rent balance that has expired. Each is taken in turn. Wages reduce income by $9,000. Interest raises it by $2,500. Rent reduces it by $4,000. Adjusted pretax income is $210,000 - $9,000 + $2,500 - $4,000 = $199,500. On the balance sheet, liabilities rise by $9,000, receivables rise by $2,500 and prepaid rent falls by $4,000, so net assets fall by $10,500, the same as income.

Watch out. A trial balance that balances can still be wrong. An entry posted to the wrong account, or left out entirely, does not disturb the totals.

The classified balance sheet

A classified balance sheet groups assets and liabilities into current and noncurrent, so a reader can judge liquidity at a glance.

Current assets are cash and other assets expected to be turned into cash, sold or used up within one year or the operating cycle, whichever is longer. They are listed in order of liquidity: cash, short-term investments, receivables, inventory, prepaid expenses.

Noncurrent assets follow: long-term investments, property, plant and equipment net of accumulated depreciation, intangible assets, and other assets.

Current liabilities are obligations expected to be settled with current assets or by creating other current liabilities, generally within one year or the operating cycle: accounts payable, accrued expenses, unearned revenue, and the current portion of long-term debt. Noncurrent liabilities are everything due later. Equity comes last.

Two totals are used constantly. Working capital is current assets minus current liabilities. The current ratio is current assets divided by current liabilities.

Example. For Delta Co, working capital is $675,000 - $220,000 = $455,000, and the current ratio is $675,000 / $220,000 = 3.07. Receivables appear at $285,000: the gross $300,000 less the $15,000 allowance for credit losses.

Step up. A whisky maker ages its product for three years before sale. Its operating cycle is about three years, so barrels that will be sold in 30 months are still current inventory. The test is one year or the operating cycle, whichever is longer. A retailer with a 60-day cycle uses one year.

Exam level. A draft balance sheet shows current assets of $900,000 and current liabilities of $400,000, a current ratio of 2.25. Review finds two problems. Cash includes $150,000 held in a sinking fund to repay bonds due in six years. Accounts payable is shown net of a $50,000 receivable from an unrelated customer. The sinking fund is restricted for a noncurrent purpose, so it leaves current assets: $900,000 - $150,000 = $750,000. There is no right of setoff with an unrelated party, so both sides are grossed up: current assets $800,000 and current liabilities $450,000. The corrected ratio is $800,000 / $450,000 = 1.78, and working capital falls from $500,000 to $350,000.

Watch out. Contra accounts reduce the account they belong to. Accumulated depreciation and the allowance for credit losses are deducted from assets. They are never shown as liabilities.

Current or noncurrent? The debt rules

Most classification is obvious. Debt is where the exam sets its traps. Four rules cover it.

Current maturities. The part of long-term debt due within one year is a current liability.

Debt payable on demand. If the lender can call the debt within one year, it is current even if no call is expected.

Covenant violations. If the borrower has broken a covenant at the balance sheet date and that gives the lender the right to demand payment, the debt is current, unless the lender has waived that right for more than one year from the balance sheet date.

Short-term debt to be refinanced. A short-term obligation may be shown as noncurrent only if the entity intends to refinance it on a long-term basis and has shown the ability to do so. Ability is shown in one of two ways before the statements are issued: actually issuing long-term debt or equity, or signing a financing agreement that clearly permits long-term refinancing. The amount excluded from current liabilities cannot be more than the amount actually refinanced or available under the agreement.

Example. At December 31 a company has a $500,000 note due on March 31. On February 10, before the statements are issued, it issues $380,000 of 5-year bonds and uses the cash to pay down the note. It can classify $380,000 as noncurrent. The remaining $120,000 stays current.

Step up. At December 31 a borrower's debt-to-equity ratio breaches a covenant on a $2,000,000 loan due in four years. On January 25, before the statements are issued, the bank waives its right to call the loan until February 28 of the following year, 14 months after the balance sheet date. The loan stays noncurrent. Had the waiver run only six months, the whole $2,000,000 would be current.

Exam level. A company has $800,000 of commercial paper due in April. In February, before issuing its statements, it signs a three-year revolving credit agreement. Borrowing is limited to 80% of eligible receivables. Receivables are expected to range from $600,000 to $900,000 during the year. The amount available will swing between $480,000 and $720,000, so only the lowest amount expected to be available, $480,000, is treated as refinanced. Noncurrent: $480,000. Current: $320,000. If the agreement could be cancelled by the lender for a subjective reason such as a 'material adverse change', none of it would qualify.

Watch out. Intent alone is not enough. Without a completed refinancing or a signed agreement before the statements are issued, short-term debt stays current.

The income statement: single-step and multi-step

The income statement can be laid out in two ways. Both reach the same net income.

A single-step statement adds all revenues and gains, adds all expenses and losses, and subtracts one total from the other. It is simple and shows no subtotals.

A multi-step statement separates operating from nonoperating activity and shows subtotals that analysts use: net sales, gross profit, operating income, income before income taxes and income from continuing operations.

The order of a multi-step statement is: sales less returns and discounts gives net sales; less cost of goods sold gives gross profit; less operating expenses, usually split into selling and general and administrative, gives operating income; plus or minus other items such as interest and gains or losses on asset sales gives income before taxes; less income tax expense gives income from continuing operations.

Example. Gross profit margin is $750,000 / $1,950,000 = 38.5%. Operating margin is $300,000 / $1,950,000 = 15.4%. A single-step statement would show total revenues and gains of $1,970,000 and total expenses of $1,752,500, giving the same $217,500.

Step up. A wholesaler has sales of $900,000, sales discounts of $18,000, purchases of $520,000, freight-in of $12,000, opening inventory of $70,000 and closing inventory of $82,000. Net sales are $882,000. Cost of goods sold is $70,000 + $520,000 + $12,000 - $82,000 = $520,000. Gross profit is $882,000 - $520,000 = $362,000. Freight-out of $9,000 does not enter this figure. It is a selling expense.

Exam level. A trial balance gives: net sales $3,200,000, gross profit margin 35%, selling expenses $410,000, general and administrative expenses $330,000, interest expense $60,000, loss on sale of equipment $25,000, dividend income $15,000, tax rate 25%. Work down the statement. Gross profit is 35% x $3,200,000 = $1,120,000, so cost of goods sold is $2,080,000. Operating income is $1,120,000 - $410,000 - $330,000 = $380,000. Other items net to -$60,000 - $25,000 + $15,000 = -$70,000. Income before taxes is $310,000. Tax is $77,500. Income from continuing operations is $232,500. The loss on equipment is not an operating expense even though the equipment was used in operations.

Watch out. Interest expense and gains on selling equipment are nonoperating. They sit below operating income in a multi-step statement.

Discontinued operations and unusual items

Some items are pulled out so readers can see what the continuing business earned.

A discontinued operation is a component of the entity that has been disposed of or is classified as held for sale, where the disposal is a strategic shift with a major effect on the company's operations and results, now or in the future. Examples are leaving a major line of business or a major geographical area.

Its results are reported in a separate section after income from continuing operations, net of tax. The section includes the component's operating income or loss for the period and the gain or loss on disposal, or the write-down to fair value less cost to sell if it is held for sale. Prior periods presented are reclassified to match.

Items that are unusual in nature or infrequent in occurrence, or both, are not given a section of their own. They are reported within income from continuing operations as a separate line, before tax, or disclosed in the notes. The old category of extraordinary items no longer exists.

Example. The division lost $80,000 from operations and $40,000 on disposal. The pretax total is $120,000. Tax saved at 25% is $30,000, so the loss shown is $90,000. Net income is $217,500 - $90,000 = $127,500.

Step up. A restaurant chain with 300 outlets closes 4 that were losing money. The 4 outlets have separate results, so they are components, but closing them is not a strategic shift with a major effect. Their losses and closure costs stay in continuing operations. If the chain sold its entire catering division, which earned a third of revenue, that would be a discontinued operation.

Exam level. On October 1 a company commits to sell its plastics division, a major line of business, and the held-for-sale criteria are met. The division lost $300,000 pretax from January to September and $120,000 from October to December. Its net assets have a carrying amount of $2,000,000 and a fair value of $1,750,000, with expected costs to sell of $50,000. The sale has not happened by year end. Operating loss for the whole year is $420,000. The write-down is $2,000,000 - ($1,750,000 - $50,000) = $300,000. Pretax loss from discontinued operations is $720,000. At a 25% tax rate the amount reported is $540,000, net of a $180,000 tax benefit. The division's assets are shown separately at $1,700,000 and are no longer depreciated.

Watch out. Discontinued operations are shown net of tax. Unusual or infrequent items are shown before tax inside continuing operations.

Foreign currency transactions

A foreign currency transaction is one that must be settled in a currency other than the entity's own functional currency: buying goods priced in euros, or lending in yen.

Three dates matter. On the transaction date, record the item at the spot exchange rate that day. At each balance sheet date, remeasure any unsettled monetary balance, such as a receivable or payable, at the current rate. The change is a foreign currency transaction gain or loss in net income. On the settlement date, record a further gain or loss for the change in rate since the last balance sheet date.

A simple way to get the direction right: if you owe foreign currency and it gets more expensive, you lose. If you are owed foreign currency and it gets more valuable, you gain.

Nonmonetary items, such as the inventory purchased, stay at the rate on the transaction date. Only the receivable or payable is remeasured.

Example. On December 1 a US company buys inventory for 100,000 euros when one euro costs $1.08. It records inventory and a payable of $108,000. At December 31 the rate is $1.12, so the payable is $112,000 and there is a $4,000 loss. On January 20 it pays when the rate is $1.10. It hands over $110,000 to clear a payable carried at $112,000, a $2,000 gain.

Step up. On November 15 a US exporter sells goods for 2,000,000 yen when 100 yen cost $0.70, so the receivable is $14,000. At December 31, 100 yen cost $0.66 and the receivable is worth $13,200. The exporter is owed a currency that has weakened: an $800 loss. On January 31 it collects when 100 yen cost $0.68, receiving $13,600 against a carrying amount of $13,200: a $400 gain in the new year. Sales revenue stays at $14,000 throughout.

Exam level. On December 10 a US company buys a machine from a Swiss supplier for 500,000 francs, payable March 10. Rates: December 10 $1.10, December 31 $1.14, March 10 $1.12. The machine is nonmonetary: it is recorded at 500,000 x $1.10 = $550,000 and depreciated from that amount. It is never remeasured. The payable is monetary. At December 31 it is $570,000, a $20,000 loss in year one. At settlement the company pays $560,000 to clear $570,000, a $10,000 gain in year two. The total cost over both years is a net $10,000 loss, equal to the move from $1.10 to $1.12 on 500,000 francs.

Watch out. The gain or loss goes to net income, not to other comprehensive income. Translation of a foreign subsidiary's statements is the item that goes to OCI, and it is a different topic.

Correcting errors and finding discrepancies

Two Blueprint tasks ask you to fix statements. The application task: adjust for identified errors. The analysis task: detect, investigate and correct discrepancies while agreeing amounts to supporting documentation, including source data.

For an error, work out three things. Which accounts are wrong, by how much, and in which direction. Then write the correcting entry and follow it into the subtotals.

Remember that many errors hit two statements. An unrecorded expense overstates net income and, through retained earnings, overstates equity, and it understates a liability. Ending inventory that is overstated understates cost of goods sold and overstates income.

For discrepancies, compare each statement line with its support: the bank reconciliation for cash, the aged listing for receivables, the count sheets for inventory, the fixed asset register, the loan agreement. A difference is a lead. Find the cause before adjusting.

Example. Delta's balance sheet shows accrued liabilities of $30,000. Payroll records show wages of $12,000 earned in the last week of December and paid in January, with no accrual. Corrected accrued liabilities are $42,000. Operating income falls from $300,000 to $288,000, tax at 25% falls by $3,000, and income from continuing operations falls by $9,000 to $208,500.

Step up. Ending inventory for year 1 is overstated by $30,000 and the error is never found. Year 1 cost of goods sold is $30,000 too low, so income is $30,000 too high. The same figure opens year 2, making year 2 cost of goods sold $30,000 too high and income $30,000 too low. Over the two years the error cancels: retained earnings at the end of year 2 is correct. This is a counterbalancing error. A missed depreciation charge does not cancel in this way.

Exam level. A company reports pretax income of $500,000. The reviewer finds: (1) equipment costing $60,000, bought July 1 with a 5-year life and no salvage value, was charged to repairs expense; (2) a $20,000 customer deposit received in December was credited to sales; (3) ending inventory was understated by $14,000. Item 1: remove the $60,000 expense and record half a year of depreciation, $6,000, a net increase of $54,000. Item 2: income falls by $20,000 and a liability appears. Item 3: income rises by $14,000. Corrected pretax income is $500,000 + $54,000 - $20,000 + $14,000 = $548,000. Assets rise by $54,000 + $14,000 = $68,000 and liabilities by $20,000, so equity rises by $48,000 before tax, the same as the change in income.

Watch out. Do not stop at the entry. Carry the correction through gross profit, operating income, tax and net income, and through total liabilities and equity.

Chapter 2: Comprehensive income, changes in equity and the notes