CLEP Financial Accounting Quick Review

GAAP is the common set of accounting standards and principles issued by the FASB so that U.S. companies' financial statements are comparable, reliable, and consistently prepared.

Key assumptions/principles: economic entity, going concern, monetary unit, periodicity, historical cost, revenue recognition, expense recognition (matching), full disclosure; fundamental qualities: relevance and faithful representation; enhancing qualities: comparability, verifiability, timeliness, understandability. FASB issues GAAP through the Accounting Standards Codification (ASC); the SEC holds statutory authority over public-company reporting; the IASB issues IFRS internationally.

GAAP (FASB, U.S., historical-cost/rules-based) vs.\ IFRS (IASB, international, more principles-based, permits some asset revaluation).

Assuming "conservatism" means understating everything --- it only applies when genuine uncertainty exists: recognize losses/liabilities as soon as probable, but never anticipate revenues/gains early.

FASB writes GAAP $arrow$ codified in the ASC $arrow$ SEC enforces it for public companies.

Every transaction is recorded so total debits equal total credits, which keeps the fundamental accounting equation in balance at all times.

$Assets = Liabilities + Owner's\ Equity$; expanded: $Assets = Liabilities + Common\ Stock + Retained\ Earnings + Revenues - Expenses - Dividends$. Normal balances: Assets, Expenses, and Dividends increase with debits; Liabilities, Equity, and Revenues increase with credits.

Debit (a left-side entry) vs.\ credit (a right-side entry) --- neither inherently means "increase"; the effect depends entirely on the account type.

Treating "debit" as always meaning increase --- true only for assets, expenses, and dividends; a debit actually decreases liabilities, equity, and revenue accounts.

$A = L + E$ --- debits must equal credits on every single entry.

Transactions flow from source documents into the journal, are posted to ledger accounts, and are summarized in a trial balance that proves debits equal credits.

Journal entry format: date; debited account and amount listed first (left); credited account and amount listed second (indented, right); brief explanation. Posting transfers each entry into its T-account in the general ledger. The unadjusted trial balance lists every account balance --- total debits must equal total credits.

A trial balance (a working list of ending balances proving debits = credits) vs.\ a balance sheet (a formal, classified financial statement for external users).

Assuming a trial balance that "balances" is error-free --- offsetting errors, omitted transactions, and postings to the wrong account of the correct type still leave debits equal to credits.

Journalize $arrow$ post $arrow$ trial balance $arrow$ debits = credits (but balance $≠$ no errors).

Adjusting entries are recorded at period end under accrual accounting to recognize revenues when earned and expenses when incurred, regardless of when cash actually changes hands.

Four types: (1) accrued revenues --- earned, not yet received/recorded; (2) accrued expenses --- incurred, not yet paid/recorded; (3) unearned (deferred) revenues --- cash received in advance, earned over time; (4) prepaid (deferred) expenses --- cash paid in advance, expensed over time (e.g., prepaid insurance, depreciation). Every adjusting entry touches one income-statement account and one balance-sheet account.

Accrual basis (revenue recognized when earned, expense when incurred --- required by GAAP) vs.\ cash basis (recorded only when cash moves).

Forgetting to reduce unearned revenue or prepaid-expense balances as they are earned/used, which overstates a liability or asset and understates the matching revenue or expense.

Accrued $arrow$ record before cash moves; Deferred $arrow$ cash moves first, recognize later.

Closing entries zero out all temporary accounts at year-end and transfer net income (or loss) into Retained Earnings so the books are ready for the next period.

Temporary (nominal) accounts --- revenues, expenses, dividends --- are closed to zero each period; permanent (real) accounts --- assets, liabilities, equity --- carry forward. Sequence: close revenues to Income Summary, close expenses to Income Summary, close Income Summary (net income/loss) to Retained Earnings, close Dividends to Retained Earnings. $Ending\ RE = Beginning\ RE + Net\ Income - Dividends$.

Closing entries (zero out temporary accounts, done only at period end) vs.\ adjusting entries (update balances before statements are prepared, can affect any account type).

Closing Dividends through the Income Summary account --- Dividends close directly to Retained Earnings and never appear on the income statement.

Revenues & Expenses $arrow$ Income Summary $arrow$ Retained Earnings; Dividends $arrow$ Retained Earnings directly.

The legal form of a business --- sole proprietorship, partnership, or corporation --- determines the structure of its equity section, how it is taxed, and the owners' personal liability exposure.

Sole proprietorship: one owner, unlimited personal liability, equity titled "Owner's Capital." Partnership: two or more owners, unlimited liability for general partners, a separate capital account per partner. Corporation: separate legal entity, limited liability for shareholders, equity = Common/Preferred Stock + Retained Earnings, subject to double taxation (corporate tax, then shareholder dividend tax). An LLC combines limited liability with pass-through taxation.

Partnership capital accounts (multiple, one per partner) vs.\ corporate stockholders' equity (Common Stock, Additional Paid-in Capital, Retained Earnings).

Assuming every business form faces "double taxation" --- only C corporations do; proprietorships, partnerships, and most LLCs are pass-through entities taxed once at the owner level.

Proprietorship/partnership: unlimited liability, one layer of tax. Corporation: limited liability, two layers of tax.

Reliable financial reporting depends on ethical behavior and independent oversight, because the managers who prepare statements have incentives to misstate results.

The Sarbanes-Oxley Act (SOX, 2002) requires CEO/CFO certification of financial statements, strengthens internal-control requirements, and created the PCAOB to oversee audits of public companies. Independent external auditors issue an opinion on whether statements are fairly presented "in accordance with GAAP" --- this provides reasonable, not absolute, assurance.

An unqualified ("clean") audit opinion (statements fairly presented, no material misstatement found) vs.\ a guarantee of accuracy (auditors offer reasonable assurance, not a warranty against all error or fraud).

Assuming the external auditor prepares the financial statements --- management prepares them; the auditor only expresses an opinion on them.

SOX $arrow$ CEO/CFO certify $arrow$ PCAOB oversees audits $arrow$ auditors give an opinion, not a guarantee.

The required financial statements articulate with one another: net income flows into retained earnings, ending retained earnings flows into the balance sheet, and ending cash ties the cash flow statement to the balance sheet.

(1) Income Statement: Revenues $-$ Expenses $=$ Net Income, for a period. (2) Statement of Retained Earnings: Beginning RE $+$ Net Income $-$ Dividends $=$ Ending RE. (3) Balance Sheet: $Assets = Liabilities + Equity$, at a point in time. (4) Statement of Cash Flows: Operating $+$ Investing $+$ Financing $=$ Net change in cash, for a period. Notes to the financial statements provide required disclosures.

A "point in time" statement (balance sheet --- "as of" a date) vs.\ a "period of time" statement (income statement, retained earnings statement, cash flow statement --- "for the year/month ended").

Labeling the balance sheet heading "for the year ended" instead of "as of" a specific date --- a frequently tested phrasing distinction.

Income Statement $arrow$ Retained Earnings Statement $arrow$ Balance Sheet; ending cash on the SCF = cash on the balance sheet.

A multi-step income statement separates operating from nonoperating activity and shows subtotals (gross profit, operating income) that a single-step format collapses into one bottom line.

Single-step: $Total\ Revenues - Total\ Expenses = Net\ Income$ (one subtraction). Multi-step: $Net\ Sales - COGS = Gross\ Profit$; $Gross\ Profit - Operating\ Expenses = Operating\ Income$; $Operating\ Income ± Nonoperating\ Items = Income\ before\ Tax$; $- Tax\ Expense = Net\ Income$.

Gross profit (Net Sales $-$ COGS only) vs.\ operating income (Gross Profit $-$ all operating expenses, including SG&A).

Including nonoperating items (interest expense, gains/losses on asset sales) when calculating operating income.

Multi-step shows Gross Profit and Operating Income; single-step shows only Net Income.

Under accrual accounting, revenue is recognized when it is earned --- when goods or services are transferred to the customer --- not necessarily when cash is collected.

Core principle: recognize revenue when (or as) the performance obligation is satisfied, in the amount expected to be collected. Sale on account: Debit Accounts Receivable, Credit Sales Revenue at the point of transfer. Cash received before delivery is Unearned (Deferred) Revenue, a liability, until earned.

Cash received in advance (Unearned Revenue --- a liability) vs.\ revenue earned but not yet collected (Accounts Receivable --- an asset, revenue already recognized).

Recording revenue at the moment cash is received on a deposit or advance payment, instead of recording a liability until the performance obligation is satisfied.

Earned $arrow$ record revenue; cash first, not yet earned $arrow$ Unearned Revenue (liability).

The matching principle requires expenses to be recognized in the same period as the revenues they helped generate, not necessarily when cash is paid.

Product costs (COGS) are expensed when the related inventory is sold --- matched to sales revenue. Period costs (e.g., rent, administrative salaries, advertising) are expensed in the period incurred, since they cannot be tied to specific revenue. Prepaid expenses are capitalized as assets and expensed over the periods benefited.

Product costs (attach to inventory, expensed via COGS upon sale) vs.\ period costs (expensed immediately, never inventoried).

Expensing the full cost of inventory purchased during the period instead of only the cost of units actually sold (COGS).

Costs follow revenue (product costs) or follow time (period costs).

COGS links the balance sheet's inventory account to the income statement, and the chosen costing method changes both figures whenever unit costs change over time.

$COGS = Beginning\ Inventory + Purchases - Ending\ Inventory$. FIFO: earliest (oldest) costs assigned to COGS first; ending inventory reflects the most recent costs. LIFO: most recent costs assigned to COGS first (allowed under GAAP, not under IFRS); ending inventory reflects the oldest costs. Weighted-average cost per unit $= /Cost\ of\ Goods\ Available\ for\ SaleTotal\ Units\ Available$.

FIFO (in rising prices: lower COGS, higher net income, higher ending inventory) vs.\ LIFO (in rising prices: higher COGS, lower net income, lower ending inventory, lower income tax).

Assuming FIFO/LIFO describe the physical flow of goods off the shelf rather than the assumed flow of costs through the accounting records.

Rising prices: FIFO $arrow$ higher profit; LIFO $arrow$ lower profit, lower taxes.

Nonoperating items sit outside a company's core operations and are reported separately, below operating income, so users can judge core profitability on its own.

Common nonoperating items: interest revenue/expense, dividend revenue, gains/losses on disposal of long-term assets or investments. $Gain/Loss\ on\ Disposal = Proceeds\ Received - Book\ Value$; $Book\ Value = Cost - Accumulated\ Depreciation$.

Revenue (from central, ongoing operations, e.g., product sales) vs.\ Gain (from a peripheral or incidental transaction, e.g., selling old equipment above book value) --- both increase net income but are reported differently.

Reporting the entire sale proceeds of a disposed asset as a gain, instead of only the excess of proceeds over the asset's remaining book value.

Gain/Loss = Proceeds $-$ Book Value, never Proceeds $-$ Original Cost.

Profitability ratios convert raw income-statement dollars into percentages so users can compare performance across companies of different sizes and across time.

$Gross\ Profit\ Margin = /Gross\ ProfitNet\ Sales$; $Operating\ Margin = /Operating\ IncomeNet\ Sales$; $Net\ Profit\ Margin = /Net\ IncomeNet\ Sales$; $ROA = /Net\ IncomeAverage\ Total\ Assets$; $ROE = /Net\ IncomeAverage\ Stockholders'\ Equity$; $EPS = /Net\ Income - Preferred\ DividendsWeighted-Average\ Common\ Shares\ Outstanding$.

ROA (return relative to all assets, funded by both debt and equity) vs.\ ROE (return relative to owners' investment only) --- ROE typically exceeds ROA when leverage is used profitably.

Forgetting to subtract preferred dividends from net income before computing EPS available to common shareholders.

Margin ratios divide by Net Sales; ROA/ROE divide by average assets/equity.

A classified balance sheet separates assets and liabilities into current and noncurrent categories so users can judge short-term liquidity at a glance.

Current assets (convert to cash/consumed within one year or the operating cycle, whichever is longer), listed by liquidity: Cash, Short-term Investments, Accounts Receivable, Inventory, Prepaid Expenses. Noncurrent assets: Long-term Investments, Property/Plant/Equipment (net), Intangible Assets. Current liabilities (due within one year): Accounts Payable, current portion of Notes Payable, Accrued Liabilities, Unearned Revenue. Noncurrent liabilities: long-term Bonds/Notes Payable. Equity: Common Stock, Additional Paid-in Capital, Retained Earnings (less Treasury Stock).

The current portion of long-term debt (reported as a current liability) vs.\ the remaining balance (stays in noncurrent liabilities).

Listing inventory or prepaid expenses ahead of Accounts Receivable in order of liquidity --- the standard order is cash, investments, receivables, inventory, then prepaids.

$A = L + E$, each split current vs.\ noncurrent, listed most-to-least liquid.

Because cash is the most liquid and most easily misappropriated asset, strong internal controls --- especially segregation of duties --- are essential, and bank reconciliations catch timing differences and errors.

Internal control components: segregation of duties, physical safeguards, independent verification, proper authorization, documentation. Bank reconciliation: adjust the BANK balance for deposits in transit ($+$) and outstanding checks ($-$); adjust the BOOK balance for items like bank service charges ($-$), NSF checks ($-$), interest earned ($+$), and recording errors --- both sides must reach the same true adjusted cash balance.

Deposits in transit (recorded on the books, not yet on the bank statement --- add to the bank balance) vs.\ outstanding checks (recorded on the books, not yet cleared the bank --- subtract from the bank balance).

Adjusting the bank-side balance for NSF checks or bank service charges instead of the book-side balance --- those items are unknown to the depositor until the statement arrives, so they adjust the book balance.

Bank side: $+$deposits in transit, $-$outstanding checks. Book side: adjust for fees, NSF checks, interest, errors.

GAAP requires uncollectible receivables to be estimated and matched to the revenue that created them (allowance method), rather than waiting to write off specific accounts (direct write-off).

Allowance method: estimate bad debt expense at period end --- Debit Bad Debt Expense, Credit Allowance for Doubtful Accounts (contra-asset). $Net\ Realizable\ Value\ of\ AR = Accounts\ Receivable - Allowance\ for\ Doubtful\ Accounts$. Two estimation approaches: percentage of credit sales (income-statement approach) and percentage of receivables/aging of receivables (balance-sheet approach). Writing off a specific account: Debit Allowance, Credit Accounts Receivable --- this does not change total assets or expense.

Allowance method (GAAP-required, matches expense to the period of sale, uses estimates) vs.\ direct write-off method (expenses only when an account is proven uncollectible, not GAAP-compliant for material amounts).

Recording a write-off as a debit to Bad Debt Expense --- under the allowance method a write-off only reduces the Allowance account and Accounts Receivable; it does NOT create a new expense.

Estimate up front (Allowance method) $arrow$ write-offs hit the Allowance, never a new expense.

Inventory is reported at the lower of its cost (under the chosen costing method) or market/net realizable value, so assets are never overstated when values decline.

Lower of Cost or Market (LCM): compare inventory's recorded cost to its market value and report the lower figure, recognizing a loss immediately if market $<$ cost. Weighted-average cost per unit $= /Cost\ of\ Goods\ Available\ for\ SaleTotal\ Units\ Available\ for\ Sale$. Specific identification is used for unique, high-cost items.

A lower-of-cost-or-market write-down (conservatism --- losses recognized immediately when value drops below cost) vs.\ holding inventory at cost when market value has risen (GAAP does not allow write-ups above original cost).

Writing inventory up to market value when market exceeds cost --- conservatism only permits write-downs, never write-ups above original cost.

Inventory is reported at the lower of cost or market --- never above original cost.

A plant asset's capitalized cost includes every reasonable and necessary cost to get it ready for its intended use, not just the purchase price.

Capitalized cost $=$ purchase price $+$ sales tax $+$ freight $+$ installation $+$ testing. Ordinary repairs/maintenance that merely keep the asset in normal operating condition are expensed; costs that extend useful life or increase capacity are capitalized. On disposal: remove both the asset's cost and its accumulated depreciation, then recognize $Gain/Loss = Proceeds - Book\ Value$.

Capital expenditures (extend life/increase capacity --- capitalized, added to the asset's book value) vs.\ revenue expenditures (ordinary repairs/maintenance --- expensed immediately).

Expensing costs like freight-in, installation, or testing on a newly purchased asset instead of capitalizing them as part of the asset's cost.

Cost to get it ready for use $arrow$ capitalize; cost to keep it running normally $arrow$ expense.

Depreciation, amortization, and depletion all systematically allocate the cost of a long-lived asset to expense over its useful life, matching cost to the periods that benefit from its use.

Straight-line: $Depreciation\ Expense = /Cost - Salvage\ ValueUseful\ Life$. Units-of-production: $/Cost - Salvage\ ValueTotal\ Estimated\ Units × Units\ Produced\ This\ Period$. Double-declining-balance (accelerated): $Depreciation\ Expense = /2Useful\ Life × Beginning-of-Year\ Book\ Value$ (ignore salvage until the final year; never depreciate below salvage value). Amortization applies to finite-life intangibles; depletion applies to natural resources.

Depreciation (tangible plant assets) vs.\ amortization (finite-life intangibles, e.g., patents) vs.\ depletion (natural resources, e.g., timber, oil, minerals) --- same allocation idea, different asset category.

Subtracting salvage value before applying the double-declining-balance rate --- DDB is applied to the full beginning book value each year; salvage value only acts as a floor, never depreciate below it.

Straight-line = even each year; DDB = accelerated, ignores salvage until the end; units-of-production = tied to usage.

Intangible assets lack physical substance but provide future economic benefit; finite-life intangibles are amortized, while goodwill and indefinite-life intangibles are tested annually for impairment instead.

Common intangibles: patents, copyrights, trademarks, franchises, goodwill. $Goodwill = Purchase\ Price\ of\ Acquired\ Business - Fair\ Value\ of\ Net\ Identifiable\ Assets\ Acquired$; goodwill is recorded only in a purchase/acquisition, never self-generated internally. Goodwill and indefinite-life intangibles are NOT amortized --- tested at least annually for impairment (written down if carrying value exceeds fair value).

Purchased goodwill (recorded as an asset when one company acquires another for more than net identifiable asset value) vs.\ internally generated goodwill/brand value (never recorded on the balance sheet under GAAP).

Amortizing goodwill on a fixed schedule like a patent --- goodwill is impairment-tested, not amortized, under current GAAP.

Finite-life intangibles amortize; goodwill and indefinite-life intangibles get impairment-tested, not amortized.

Current liabilities are obligations expected to be settled within one year (or the operating cycle), and interest-bearing notes require separating principal from interest expense.

Accounts Payable: short-term, non-interest-bearing trade obligations. Notes Payable: may bear interest; $Interest\ Expense = Principal × Rate × /Time12\ (or\ 360/365)$. At year-end, accrue interest incurred but not yet paid: Debit Interest Expense, Credit Interest Payable. Other current liabilities: accrued wages, taxes payable, unearned revenue, current portion of long-term debt.

Accounts Payable (routine trade credit, typically no explicit interest) vs.\ Notes Payable (formal written promise, typically bears stated interest).

Computing a full year of interest on a note outstanding for only part of the year --- always prorate interest for the actual time elapsed.

Interest = Principal $×$ Rate $×$ Time --- always prorate for partial periods.

A bond's issue price depends on comparing its stated (coupon) interest rate to the market interest rate at issuance, and any premium or discount is amortized to interest expense over the bond's life.

Stated rate $>$ market rate $arrow$ issues at a premium (price $>$ face value); stated rate $<$ market rate $arrow$ issues at a discount (price $<$ face value); stated rate $=$ market rate $arrow$ issues at face (par) value. $Carrying\ Value = Face\ Value ± Unamortized\ Premium/Discount$. Straight-line amortization per period $= /Premium\ or\ DiscountNumber\ of\ Interest\ Periods$; discount amortization increases interest expense above cash interest paid, premium amortization decreases it below cash interest paid.

Discount on Bonds Payable (contra-liability, subtracted from face value) vs.\ Premium on Bonds Payable (adjunct liability, added to face value).

Reversing the direction of amortization's effect --- discount amortization INCREASES interest expense over time as carrying value rises toward face value; premium amortization DECREASES it as carrying value falls toward face value.

Stated $>$ Market $arrow$ premium; Stated $<$ Market $arrow$ discount; carrying value always converges to face value by maturity.

Stockholders' equity records how much capital owners have contributed (paid-in capital) separately from how much profit the company has retained (retained earnings), and treasury stock reduces total equity.

Issuing stock above par: Debit Cash (full proceeds), Credit Common Stock (par value $×$ shares), Credit Additional Paid-in Capital (excess over par). Treasury stock (a company's own reacquired shares) is recorded at cost as a contra-equity account, reducing total stockholders' equity; treasury shares receive no dividends and have no voting rights.

Par value (an arbitrary legal/statutory amount per share, unrelated to market value) vs.\ market value (the price shares actually trade for) --- Common Stock is recorded at par; the excess goes to Additional Paid-in Capital.

Recording the purchase or reissuance of treasury stock as a gain or loss on the income statement --- treasury stock transactions only affect equity accounts, never net income.

Common Stock = par $×$ shares; everything above par $arrow$ Additional Paid-in Capital; Treasury Stock = contra-equity.

Retained earnings is the cumulative net income a corporation has kept (not distributed) since inception, and it is reduced by both cash and stock dividends declared.

$Ending\ RE = Beginning\ RE + Net\ Income\ (-Net\ Loss) - Dividends\ Declared$. Cash dividend: declaration date (Debit Retained Earnings, Credit Dividends Payable --- a liability is created), record date (no entry), payment date (Debit Dividends Payable, Credit Cash). Stock dividends transfer an amount from Retained Earnings to paid-in capital accounts; they do not reduce total equity or create a liability.

Cash dividend (reduces total assets and total equity, creates a liability between declaration and payment) vs.\ stock dividend (reduces Retained Earnings but increases paid-in capital by the same amount --- total equity is unchanged).

Recording dividends declared as an expense --- dividends are a distribution of earnings to owners and never appear on the income statement.

Declare $arrow$ liability created; Pay $arrow$ liability settled; Dividends never touch the income statement.

Liquidity ratios test the ability to meet short-term obligations with current assets, while solvency ratios test the ability to meet long-term obligations and reveal the extent of financial leverage.

$Current\ Ratio = /Current\ AssetsCurrent\ Liabilities$; $Quick\ (Acid-Test)\ Ratio = /Cash + Short-term\ Investments + Accounts\ ReceivableCurrent\ Liabilities$; $Debt\ Ratio = /Total\ LiabilitiesTotal\ Assets$; $Debt-to-Equity = /Total\ LiabilitiesTotal\ Stockholders'\ Equity$; $Times\ Interest\ Earned = /EBITInterest\ Expense$.

Current ratio (includes inventory --- a broader liquidity measure) vs.\ quick ratio (excludes inventory and prepaid expenses --- a stricter, more immediate liquidity measure).

Including inventory or prepaid expenses in the numerator when computing the quick/acid-test ratio.

Quick ratio = Current ratio's numerator minus inventory (and prepaids).

Activity ratios measure how efficiently a company converts its assets --- inventory, receivables --- into sales and cash; lower turnover signals slower conversion and cash tied up longer.

$Inventory\ Turnover = /COGSAverage\ Inventory$; $Days'\ Sales\ in\ Inventory = /365Inventory\ Turnover$; $Receivables\ Turnover = /Net\ Credit\ SalesAverage\ Net\ Receivables$; $Days'\ Sales\ Outstanding = /365Receivables\ Turnover$; $Asset\ Turnover = /Net\ SalesAverage\ Total\ Assets$.

Inventory turnover (uses COGS in the numerator, since inventory is carried at cost) vs.\ receivables turnover (uses Net Credit Sales, since receivables arise from sales at selling price).

Using ending balances instead of average balances $≤ft(/Beginning+Ending2)$ in turnover-ratio denominators when both figures are available.

Inventory turnover uses COGS; Receivables turnover uses Net Credit Sales; both convert to "days" via $365 $ turnover.

The statement of cash flows explains the change in cash during the period by classifying every cash inflow and outflow into operating, investing, or financing activities.

Operating: cash effects of transactions that determine net income (customer collections, payments to suppliers/employees, interest and dividends received). Investing: buying/selling long-term assets and investments (PP&E, securities, making/collecting loans). Financing: transactions with owners and creditors regarding capital (issuing/repurchasing stock, borrowing/repaying debt principal, paying dividends). $Net\ Change\ in\ Cash = Operating + Investing + Financing$; ending cash must equal the balance-sheet cash balance.

Interest paid/received and dividends received (classified as OPERATING under GAAP) vs.\ dividends PAID (classified as FINANCING).

Classifying dividends paid to shareholders as an operating or investing activity --- under GAAP, dividends paid are always financing, while interest paid/received and dividends received are operating.

Operating = day-to-day income effects; Investing = long-term assets; Financing = debt & equity capital, incl.\ dividends paid.

The indirect method starts with accrual-basis net income and reconciles it to cash generated by operations by reversing non-cash items and adjusting for changes in working-capital accounts.

Start with Net Income; ADD BACK non-cash expenses (depreciation, amortization, depletion) and losses on asset sales; SUBTRACT gains on asset sales. An INCREASE in a current asset (AR, Inventory, Prepaid) SUBTRACTS from cash flow; a DECREASE ADDS. An INCREASE in a current liability (AP, Accrued Liabilities) ADDS to cash flow; a DECREASE SUBTRACTS.

Indirect method (starts with net income, reconciles to cash) vs.\ direct method (lists actual cash receipts and payments by category) --- both arrive at the same total operating cash flow.

Subtracting an increase in Accounts Payable instead of adding it --- an increase in a current liability means cash was NOT yet paid out, so it ADDS to cash flow, opposite the treatment of an increase in a current asset.

Assets up $arrow$ cash down; Liabilities up $arrow$ cash up (opposite directions).

Significant investing/financing transactions that do not involve cash must still be disclosed, because they affect future cash flows even though no cash moved this period.

Common noncash investing/financing activities: purchasing an asset by issuing stock or a note payable, converting bonds/preferred stock into common stock, acquiring an asset through a capital lease --- disclosed in a supplemental schedule, never included in the three main sections' totals. $Free\ Cash\ Flow = Cash\ Flow\ from\ Operations - Capital\ Expenditures$.

A noncash exchange (e.g., land acquired by issuing stock --- supplemental note only) vs.\ a cash purchase of the same asset (recorded as an investing outflow).

Reporting a noncash transaction (like issuing stock to acquire equipment) as both an investing outflow and a financing inflow --- since no cash moved, it belongs only in the supplemental noncash disclosure.

No cash moved $arrow$ supplemental note disclosure, not in Operating/Investing/Financing totals.

How an investment in another company's debt or equity securities is classified determines whether unrealized gains/losses flow through net income or bypass it through other comprehensive income.

Trading securities: held for short-term profit, reported at fair value, unrealized gains/losses flow through NET INCOME. Available-for-sale (AFS) securities: reported at fair value, unrealized gains/losses go to Other Comprehensive Income (bypass net income, shown in equity). Held-to-maturity (HTM) securities (debt only, positive intent/ability to hold to maturity): reported at amortized cost.

Trading securities (fair value through net income) vs.\ available-for-sale securities (fair value through OCI/equity, not net income) --- both are marked to fair value, but the gain/loss lands in different places.

Running an unrealized gain/loss on an available-for-sale security through the income statement instead of Other Comprehensive Income.

Trading $arrow$ fair value, hits net income; AFS $arrow$ fair value, hits equity (OCI); HTM $arrow$ amortized cost.

A contingent liability is a potential obligation whose existence depends on a future event, and GAAP requires accrual, disclosure, or nothing at all depending on likelihood and estimability.

Probable AND reasonably estimable $arrow$ accrue a liability and expense (e.g., expected warranty costs). Reasonably possible (not probable), or probable but not reasonably estimable $arrow$ disclose in the notes only, no journal entry. Remote $arrow$ no accrual, no disclosure required. Common examples: pending lawsuits, product warranties, guarantees of others' debt.

Probable & estimable (accrue on the balance sheet) vs.\ reasonably possible (disclose in notes only) vs.\ remote (ignore entirely).

Accruing a liability for a lawsuit that is only "reasonably possible" rather than "probable" --- GAAP requires both probability AND reliable estimability before recording a contingent liability.

Probable + estimable $arrow$ record it; possible $arrow$ disclose it; remote $arrow$ ignore it.

Ten formulas, ten anchors --- know every symbol and every denominator cold.

When two terms sound alike on this exam, the question is almost always testing the difference.

Preparer = management; opinion-giver = auditor; rule-writer = FASB; enforcer = SEC.

Four statements $+$ notes, one Codification (GAAP), one watchdog for public-company audits (PCAOB).

Identify accounts $arrow$ classify $arrow$ up or down $arrow$ apply normal balance $arrow$ debits = credits.

$$75 questions, 90 minutes, all MCQ, on-screen four-function calculator provided.

Analyze $arrow$ journalize $arrow$ post $arrow$ trial balance $arrow$ adjust $arrow$ statements $arrow$ close $arrow$ post-closing trial balance.

Net Income $arrow$ add back non-cash items $arrow$ adjust for working-capital changes $arrow$ operating CF.