Accounting Fundamentals
To interpret financial statements correctly, you need to know the accounting standards and methods behind the numbers.
Audited vs. Unaudited Statements
| Feature | Audited | Unaudited |
|---|---|---|
| Examination level | Full independent audit by a certified public accountant (CPA) | Review or compilation; no full audit performed |
| Opinion issued | Yes - auditor issues a formal opinion | No formal opinion; may include a review report |
| GAAP compliance verified | Yes - auditor confirms conformity with GAAP | Not confirmed by an independent auditor |
| Required for | SEC annual filings (10-K), public company financial statements | Internal use, interim reports (10-Q is reviewed but not audited), small private companies |
| Reliability | Highest level of assurance | Lower level of assurance |
Exam Tip: Gotchas
A "review" of financial statements provides limited assurance (less than an audit). A "compilation" provides no assurance at all; the accountant merely assembles the financial data into statement format. Only a full audit provides reasonable assurance with a formal opinion.
GAAP
- Generally Accepted Accounting Principles (GAAP) - the standard framework for financial accounting in the United States
- Established by the Financial Accounting Standards Board (FASB)
- Ensures consistency, comparability, and transparency across companies
- Public companies must follow GAAP for SEC filings
PCAOB
- The Public Company Accounting Oversight Board (PCAOB) oversees auditors of public companies
- Created by the Sarbanes-Oxley Act of 2002 (SOX)
- Sets auditing standards for public company audits
Cash vs. Accrual Accounting
| Feature | Cash Basis | Accrual Basis |
|---|---|---|
| Revenue recognition | When cash is received | When revenue is earned (regardless of cash receipt) |
| Expense recognition | When cash is paid | When expense is incurred (regardless of cash payment) |
| Matching principle | Not applied | Applied - expenses matched to the revenue they help generate |
| Used by | Small businesses, sole proprietors | All public companies (required by GAAP), large private companies |
| SEC filings | Not acceptable | Required |
- Accrual accounting is required by GAAP for public companies
- Under accrual accounting, a company records revenue when a sale is made (e.g., goods shipped), even if the customer has not yet paid
- Under cash accounting, that same revenue would not be recorded until payment is received
- The matching principle (accrual basis) requires that expenses be recognized in the same period as the revenue they help generate
Example: XYZ Landscaping completes a $4,500 patio project in March. The customer pays in June.
- Under cash accounting: Revenue is recorded in June (when cash received)
- Under accrual accounting: Revenue is recorded in March (when the work was completed)
Exam Tip: Gotchas
Under accrual accounting, a company can show high revenue and net income on the income statement while having very little cash. This is why the statement of cash flows is essential: it shows the actual cash position regardless of how revenue and expenses are recorded.