Accounting Fundamentals
Investment advisers must understand basic accounting concepts to properly analyze financial statements and identify potential red flags in company financials.
Cash vs. Accrual Accounting
Two fundamentally different methods exist for recording transactions:
Cash Basis Accounting
| Feature | Description |
|---|---|
| Revenue Recognition | Recorded when cash is received |
| Expense Recognition | Recorded when cash is paid |
| Advantages | Simple, easy to understand |
| Disadvantages | Doesn't match revenues to related expenses |
| Who Uses It | Small businesses, individuals |
Accrual Basis Accounting
| Feature | Description |
|---|---|
| Revenue Recognition | Recorded when earned (regardless of when cash received) |
| Expense Recognition | Recorded when incurred (regardless of when paid) |
| Advantages | Better matching of revenues and expenses |
| Disadvantages | More complex, requires estimates |
| Who Uses It | Public companies (required by GAAP) |
Example: Understanding the Difference
A company delivers $100,000 of products in December but doesn't receive payment until January:
| Accounting Method | December Revenue | January Revenue |
|---|---|---|
| Cash Basis | $0 | $100,000 |
| Accrual Basis | $100,000 | $0 |
Under accrual accounting, revenue is recorded when earned (December, when goods delivered), not when cash is received (January). This provides a more accurate picture of business performance.
Generally Accepted Accounting Principles (GAAP)
GAAP is the standard framework for financial accounting in the United States:
| Aspect | Description |
|---|---|
| Set By | Financial Accounting Standards Board (FASB) |
| Required For | U.S. public companies |
| Purpose | Ensures consistency and comparability |
| Approach | Rules-based (specific guidelines) |
Key GAAP Principles
| Principle | Meaning |
|---|---|
| Matching | Match expenses to the revenues they generate |
| Materiality | Disclose items significant enough to affect decisions |
| Conservatism | When in doubt, recognize losses sooner, gains later |
| Consistency | Use the same methods period to period |
International Financial Reporting Standards (IFRS)
IFRS is used by companies in most countries outside the United States:
| Aspect | GAAP | IFRS |
|---|---|---|
| Set By | FASB | International Accounting Standards Board (IASB) |
| Approach | Rules-based | Principles-based |
| Inventory Methods | LIFO allowed | LIFO prohibited |
| Where Used | United States | Most other countries |
Audited vs. Unaudited Financial Statements
Audited Financial Statements
| Feature | Description |
|---|---|
| Examiner | Independent CPA firm |
| Purpose | Provides assurance that statements are materially accurate |
| Requirement | Required for public companies (SEC mandate) |
| Output | Auditor issues an opinion on the statements |
Types of Audit Opinions
| Opinion Type | Meaning | Investor Implication |
|---|---|---|
| Unqualified (Clean) | Statements are fairly presented in accordance with GAAP | Best outcome; high confidence |
| Qualified | Generally accurate with specific exceptions | Review the exceptions carefully |
| Adverse | Statements are NOT fairly presented | Major concern; statements unreliable |
| Disclaimer | Auditor could not form an opinion | Auditor couldn't complete work; significant uncertainty |
Key Point: An unqualified opinion is the best type—also called a "clean opinion." This means the auditor believes the financial statements are fairly presented with no material issues.
Going Concern Opinion
A going concern opinion indicates the auditor has substantial doubt about the company's ability to continue operating. This is a serious red flag that the company may face financial distress or bankruptcy.
Unaudited Financial Statements
| Feature | Description |
|---|---|
| Examiner | May be reviewed, compiled, or completely unexamined |
| Reliability | Less reliable than audited statements |
| Who Uses | Private companies, interim reports |
| Investor Caution | Exercise more skepticism when analyzing |
Depreciation and Amortization
Depreciation
Depreciation allocates the cost of tangible assets over their useful lives:
| Method | Description | Effect |
|---|---|---|
| Straight-line | Equal amounts each year | Consistent expense over time |
| Accelerated (MACRS) | Higher depreciation early, lower later | Higher early expenses, tax deferral |
Example: A $100,000 machine with 10-year life:
- Straight-line: $10,000 depreciation per year
- Accelerated: Maybe $20,000 year 1, declining thereafter
Amortization
Amortization is similar to depreciation but applies to intangible assets:
- Patents, copyrights, goodwill
- Spreads cost over useful life or legal life
In Practice: How Investment Advisers Apply This
Evaluating financial statement reliability:
- Always check the auditor's opinion before relying on statements
- Be more skeptical of unaudited interim reports
- Watch for changes in accounting methods (compare notes year over year)
- Understand that different industries have different typical accounting treatments
Red Flags in Accounting:
- Changes in auditors (especially if company-initiated)
- Qualified or adverse audit opinions
- Going concern opinions
- Unusual accounting policy changes
On the Exam
The Series 65 exam tests your understanding of:
- Cash vs. accrual accounting and when revenue is recognized
- Audit opinions and what each type means
- GAAP vs. IFRS differences
- Going concern opinions and their significance
- Unqualified opinion as the "clean" opinion
Expect 2-3 questions on accounting fundamentals. A common question format asks what type of audit opinion represents the best outcome.
Key Takeaways
- Accrual accounting recognizes revenue when earned, expenses when incurred (required for public companies)
- Cash accounting recognizes transactions only when cash changes hands
- GAAP (rules-based) is used in the U.S.; IFRS (principles-based) is used internationally
- An unqualified (clean) opinion is the best audit opinion—statements fairly presented
- Going concern opinions signal serious financial distress
- Audited statements are more reliable than unaudited statements
- Investment advisers should always review the auditor's opinion before relying on statements
Under accrual basis accounting, when is revenue recorded?
An auditor's "unqualified opinion" on financial statements means:
Which of the following is TRUE regarding GAAP and IFRS?
2.3 SEC Filings & Annual Reports
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