Financial Statements & Basics

FAR rarely asks “what is GAAP” outright; the tell is usually a question about authority — which source governs a transaction. The hinge is that the Codification is the single authoritative source of nongovernmental U.S. GAAP, so anything outside it (textbooks, FASB Concepts Statements, AICPA practice aids) is nonauthoritative. Watch for items pitting U.S. GAAP against IFRS (U.S. GAAP is often framed as more rules-based, IFRS more principles-based; LIFO permitted under GAAP, prohibited under IFRS; development costs generally expensed under GAAP, capitalizable under IFRS) or against a special-purpose framework like cash or tax basis (the current term for what older texts call OCBOA), which is not GAAP.

The classic trap conflates GAAP with the accrual basis it requires or the matching (expense-recognition) rule: accrual is the measurement convention and matching is one recognition rule, while GAAP is the entire authoritative body that mandates them. Remember U.S. state and local governments follow GASB, not FASB — examiners love that swap. Hook: “Codification = the only place GAAP lives.”

FAR loves to test this with a cash-to-accrual conversion: you’re handed cash collected or paid and asked for the GAAP figure. The tell is changes in working capital accounts—add the increase in accounts receivable and the decrease in unearned revenue to convert cash receipts to revenue; for expenses, add the increase in accrued liabilities/payables plus prepaid drawdowns (decreases in prepaid assets). The answer hinges on the revenue recognition trigger—under ASC 606’s five-step model, recognize when a performance obligation is satisfied, i.e., control transfers (the loose “earned” wording traces to the superseded ASC 605/SAB 104 rule)—and the period an expense is incurred, never when cash moves. Watch the trap where an item is paid but unearned: it stays on the balance sheet as a liability, not the income statement.

Don’t conflate the related ideas: accrual basis is the overall measurement system, the matching principle the narrower rule routing expenses to revenue-producing periods, and deferrals the adjusting entries that postpone already-moved cash. Hook: accruals book it before the cash, deferrals after—cash leads the deferral, lags the accrual.

FAR tests this most often through expense-recognition classification: the question hands you a cost and asks when it hits the income statement. The tell is whether the cost has a direct, traceable link to revenue (cost of goods sold, sales commissions — matched in the period the related sale is recognized) versus a cost with no traceable link. Period costs such as most administrative salaries and advertising are expensed as incurred, while asset costs benefiting many periods are systematically allocated. Work the recognition order: associate cause-and-effect first, then systematic-and-rational allocation, then immediate recognition.

The classic trap is conflating matching with accrual basis: accrual is the broad rule (recognize when earned or incurred, ignoring cash); matching is the narrower expense-timing aspect inside it (FASB’s current framework frames it as “matching costs with revenues” rather than a standalone principle, but review banks still call it one). Don’t equate it with depreciation either — depreciation is one application (systematic-and-rational allocation), not the principle, and an impairment write-down is a measurement event, not matching. Hook: match the expense to the revenue it “caused.”

FAR rarely asks you to list the five steps; it hands you a contract and makes you recognize the right amount in the right period. The classic tell is bundled deliverables, so the answer hinges on Step 2 (distinct performance obligations) and Step 4 (allocate by relative standalone selling price) — a $1,000 package with an undelivered service means part of the cash is deferred as a contract liability, not revenue. Watch variable consideration: estimate it (expected value or most-likely-amount), then apply the constraint so you only book amounts where it is highly probable no significant reversal occurs (under US GAAP). Point-in-time vs. over-time turns on control — recognize over time only if one of the three over-time criteria is met.

The trap is gross vs. net (principal vs. agent): an agent reports only its commission, decided by who controls the good before transfer. Don’t reduce this to accrual basis or GAAP generally — ASC 606’s trigger is transfer of control, not “earned and realizable” (the older Concepts-Statement language some banks still echo). Memory hook: ISPAR — Identify, Separate, Price, Allocate, Recognize.

FAR rarely asks “what is a balance sheet” outright; it tests classification and ordering. The classic item lists accounts and asks for total current assets (expected to be realized within one year or the operating cycle, whichever is longer) versus noncurrent, or buries a trap like a noncurrent note misfiled as current. Under U.S. GAAP a classified balance sheet presents assets in decreasing order of liquidity (current before noncurrent — IFRS often reverses this). The answer usually hinges on one reclassification: current maturities of long-term debt moving up, or a debt-covenant violation that makes the obligation callable—so it is current unless a waiver is obtained by the balance-sheet date.

Watch the timing distinction: the balance sheet is a point in time, whereas the income statement and statement of cash flows each cover a period—a common reason students misclassify a flow as a balance. Remember the articulation chain: net income flows through retained earnings into equity, and the statement of cash flows reconciles the change in cash and cash equivalents.

FAR tests this less as a definition than as a classification and presentation drill. The “tell” is an item dropped at the bottom of a fact pattern—a plant disposal, a litigation settlement, a tax-rate change—and you must decide where it lands. The high-yield rule: discontinued operations get their own line, net of tax, presented after income from continuing operations (it’s itself a component of net income). “Extraordinary items” were eliminated by ASU 2015-01, so any choice using that label is a distractor. Know single-step (all revenues/gains grouped, all expenses/losses grouped, netted once) versus multi-step (gross profit, then operating income, then non-operating), and that income statement accounts are nominal/temporary—they close to retained earnings each period.

The classic trap is mixing statements. Unlike the balance sheet, whose permanent accounts carry forward, the income statement resets to zero; net income bridges into retained earnings. Don’t confuse net income with cash—the statement of cash flows reconciles accrual results to cash, because the income statement runs on accrual accounting. Hook: temporary accounts get a fresh start.

FAR loves to make you classify a single transaction or build the indirect-method operating section. The tell: a list of items you must drop into the right bucket. Memorize the boundary cases—under U.S. GAAP, interest paid, interest received, and dividends received are operating, but dividends paid are financing (IFRS currently lets you choose; that choice narrows under IFRS 18). Buying/selling PP&E and investments are investing; issuing stock or debt and repaying principal are financing. A frequent trap: cash flows from securities held for trading are operating, not investing—classification follows the asset’s purpose.

In the indirect method, start with net income and reverse the accrual world: add back depreciation/amortization and losses, subtract gains, then adjust working capital—an increase in a current asset is subtracted, an increase in a current liability is added. Students invert these signs constantly. It reconciles only cash, so watch for noncash investing/financing disclosures.

FAR tests deferrals through adjusting-entry mechanics: you get a journal entry or fact pattern and must compute the year-end balance or the period’s earned/incurred portion. The “tell” is cash that moved first, leaving a balance sheet account (prepaid asset or unearned/deferred-revenue liability) waiting to be drawn down. The answer hinges on the earned-and-incurred test — how much of the prepayment has lapsed by period-end, not when cash changed hands. A frequent twist: the company records the full receipt as revenue (or full payment as expense) immediately, so the adjusting entry must defer the still-unearned (or unexpired) portion back to the balance sheet.

The classic trap is reversing the direction relative to accruals, which sit opposite on the timeline — cash comes later, creating a receivable or payable, not a prepaid or unearned account. Don’t confuse the matching (expense-recognition) principle (the why — pairing an expense with the revenue it helps generate) with the deferral itself (the mechanism). Hook: defer = delay; recognition waits even though the cash already moved.