Introduction To Financial Statements and Other Financial Reporting Topics

Chapter 2
Introduction to Financial
Statements and Other
Financial Reporting Topics
COPYRIGHT ©2011 South-Western, a part of Cengage Learning.

Forms of Business Entities
Sole
Proprietorship Partnership Corporation
2 or more Numerous
Number of owners 1
(partners) (shareholders)
Legally separate from
No No Yes
owners
Owners liable for
Yes Yes No
business debts
To the
corporation as
To the earnings;
Profits taxable To the owner
owners to the owners
when dividends
are received
“Subchapter S”
“LLC”
profits are
limits liability of owner; may
Modified form taxed at
increase income tax
ownership level
exposure
only
Copyright 2011 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 2, Slide #2
The Financial Statements
• Income statement
• Statement of stockholders’ equity
• Balance sheet
• Statement of cash flows
• Support for the financial statements is
provided by notes
Income Statement
• Dated for a specific Income Statement

For the Year Ended Dec. 31, 2011
period Revenue $ 120,000
• Summarizes Expenses (100,000)
revenues and Net Income $ 20,000
expenses
• Reports net income
– Excess of revenues
over expense
• Net income increases
retained earnings
Statement of Stockholders’ Equity
• Dated for a specific Income Statement

period For Year Ending December 31, 2011
Revenue $ 120,000
• Reconciles Expenses (100,000)
beginning and Net Income $ 20,000
ending balances of Statement of Stockholders’
the stockholders’ Equity
For Year Ending December 31,
equity accounts 2011
– Capital Stock Capt. Stk. Ret. Earn.
– Retained Earnings Beginning Balance $40,000 $ 25,000
– Etc. Issue stock 10,000
Net income 20,000
• Links the income Dividends (10,000)
statement and the Ending Balance $50,000 $ 35,000
balance sheet
Statement of Stockholders’ Equity
Income Statement
Revenue $ 120,000
Shows the financial condition
Expenses (100,000)
of an entity as of a particular Net Income $ 20,000
date Statement of Stockholders’ Equity
– Assets: the resources of Capt. Stk. Ret. Earn.
the business Beginning Balance $40,000 $ 25,000
– Liabilities: the debts of Issue stock 10,000
the business Net income 20,000
– Equity: the owners’ Dividends (10,000)
interest in the business Ending Balance $50,000 $ 35,000
The Accounting Equation: Balance Sheet

Assets = Liabilities + Assets $110,000
Stockholders’ Equity Liabilities 25,000
Stockholders’ Equity
Assets = Liabilities + Capital Stock 50,000
Capital Stock + Retained Earnings 35,000
Retained Earnings Tot Liab. & Equity $110,000
Statement of Cash Flows
• Covers the same period as the income

statement
• Three sections
– Cash flows from operating activities
– Cash flows from investing activities
– Cash flows from financing activities
Notes
• An integral part of the financial statements

• Required presentation
– Summary of significant accounting policies
– Contingent liabilities
– Subsequent events relating to conditions that
existed at the balance sheet date
• Disclose and adjustment of the financial statements
– Subsequent events relating to conditions that did
not exist at the balance sheet date
• Disclosure but no adjustment of the financial statements
The Accounting Cycle
1. Recording transactions
2. Recording adjusting entries
3. Preparing the financial statement
Recording Transactions
• Internal or external event that causes a

change in a company’s assets, liabilities, or
stockholders’ equity
• Recorded in a journal (journal entry)
• Posted to general ledger accounts
• Double-entry system
 Debit: left side of an account Account Title
 Credit: right side of an account
Debit Credit
 Debits = Credits
Accounting System Components
Permanent Temporary
Account Assets Revenues, Gains
types Liabilities Expenses, Losses
Equity Dividends
Balances Carry forward to Closed to retained
the next fiscal earnings at year-end
period
Represent the
accounting
equation
Accounting System Components
• Required by the accrual basis of accounting

• Prepared at the end of the fiscal period
• Records (recognizes) for the current period
– Expenses incurred
– Revenues earned
• Recorded in the general journal
• Posted to the general ledger
Preparing the Financial Statements
• The output of the accounting system

• Based on the adjusted general ledger
account balances
• Directly from the general ledger
– Income statement
– Balance sheet
• From analysis of general ledger accounts
– Statement of cash flows
Treadway Commission
• Voluntary private sector organization (Treadway)

• Committee of Sponsoring Organizations (COSO)
– Internal control reports
– Standard framework for evaluating internal control
• Need for internal control emphasized by
– Sarbanes-Oxley Act §404
– Management's Report on Internal Control
– Independent auditor’s opinion on management’s
assessment of internal control
Auditor’s Opinion
• Audit is conducted by CPAs

• The audit report is the formal statement of
audit opinion
– Unqualified opinion
– Qualified opinion
– Adverse opinion
– Disclaimer of opinion
Unqualified Opinion
• The financial statements present fairly

– The financial position
– Results of operations
– Cash flows
• In conformity with generally accepted
accounting principles
• For the user: the highest degree of reliability
Qualified Opinion
• Except for the matter to which the exception

relates
• The financial statements present fairly
– Cash flows
• In conformity with generally accepted accounting
principles
• For the user: determine the significance of the
exception
Adverse Opinion
• The financial statements do not present

fairly
– Cash flows
• In conformity with generally accepted
accounting principles
• For the user: reliability of financial statements
need to be seriously questioned
Disclaimer of Opinion
• The auditor does not express an opinion

• Auditor
– Has not preformed an audit sufficient in scope to
form an opinion or
– Is not independent
• For the user: auditor’s statement conveys no
indication of financial statement reliability
Unqualified Auditor’s Report
• Paragraph #1:
– Financial statements have been audited
– Financial statements are responsibility of
management
– Auditors have responsibility to express or disclaim
an opinion
Unqualified Auditor’s Report (cont’d)
• Paragraph #2
– Audit conducted in accordance with the standards
of the (U.S.) Public Accounting Oversight Board
– Auditor is required to plan and perform the audit
• Obtain reasonable assurance
• Financial statements are free from material
misstatement
– Audit provides a reasonable basis for opinion
• Examining evidence
• Assessing accounting principles and estimates
Unqualified Auditor’s Report (cont’d)
• Paragraph #3
– Opinion: in conformity with generally accepted
(U.S.) accounting principles
• Also: for public companies, reference to the
audit of internal control effectiveness
– In accordance with the the (U.S.) Public
Accounting Oversight Board
– Based on criteria established by COSO
Auditor’s Report on Internal Control
• Required by Sarbanes-Oxley
• May be combined with audit opinion report
• Paragraphs
1. Scope
2. Responsibility and procedures
3. Opinion
4. Reference to financial statement audit
Other Types of Engagements
• Review
– Less in scope than an audit
– An opinion is not expressed
– Provides negative assurance
• “Not aware of any material misstatements or required
modifications”
• Compilation
– Presents only financial information provided by
management
– No opinion or any other assurance is given
Management’s Responsibility
• Management is responsible for

– The preparation of the financial statements
– The integrity of the financial statements
• Management’s Statement of Responsibility

– May be included in the annual report
The SEC’s Integrated Disclosure System
Required filings
– 10-K: annual filing (audited)
• Includes financial statements plus
– Information on the business entity
– Market information
– Management discussion and analysis
– Directors, executive officers, and their compensation
– Related party transactions
– 10-Q: quarterly filing (unaudited)
– 8-K: “current report”
• To report the occurrence of any material events or corporate
changes
Additional Reporting Venues
• Proxy
– Notice and authorization of shareholder voting
rights on corporate actions
– Content and form governed by the SEC
• Summary Annual Report
– Highly condensed financial information
– Must be accompanied by a proxy containing full
financial information
– Not adequate for financial analysis
The Efficient Market Hypothesis
• Capital markets generate security prices that reflect

worth
• Publicly available information is reflected in share
prices
• Investors will be harmed if full disclosure is not
made
• Method of disclosure does not impact value
– Body of the financial statements
– Notes to the financial statements
• Benefit of making disclosure outweighs the cost
Ethics
Essential values in interpersonal relationships
Caring Loyalty
Honesty Fairness
Accountability Integrity
Promise keeping Respect for others
Pursuit of excellence Responsible citizenship
AAA Ethical Decision Framework
1. Determine the facts

2. Define the ethical issues
3. Identify major principles, rules, and values
4. Specify the alternatives
5. Compare norms, principles, and values with
alternatives
6. Assess the consequences
7. Make your decision
SEC Requirement: A Code of Ethics
• Enacted under Sarbanes-Oxley Act

• Applicable to chief financial officers
• Disclosure requirements
– Whether a code of ethics has been adopted
– If not, why not
– Code is published in the annual report or on the
firm’s web site
Harmonization of
International Accounting Standards
• Accounting standards can vary by country

– Development is often in response to domestic
needs
• International accounting standards set by
– IASC (1973 – 2000)
– IASB (2001 to present) has no enforcement
power
• In the U.S.
– SEC requires registrants to report in U.S. GAAP
– FASB is participating in the harmonization project
Harmonization of
International Accounting Standards
• IASB issues (IFRS) International Financial

Reporting Standards.
• 2002 Norwalk agreement – FASB and IASB
commit to high-quality, compatible accounting
standards.
• 2007 agreement between US and European
Union to allow companies to drop US GAAP if
financials were prepared by IFRS.
Consolidated Financial Statements
• Parent consolidates with subsidiary

– Report results of operations separately
– Sum subsidiary and parent results of operations
• Legal control vs. effective control
• Consolidation occurs when parent has
effective control over the subsidiary
– Holds a majority of risks, rewards, and decision-
making ability
Accounting for Business Combinations
• Effected through merger or acquisition
• Purchase method of accounting
• Record assets and liabilities acquired at their

fair values
• Excess of purchase price over fair value of

net assets acquired is reported as goodwill

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Chapter 2

COPYRIGHT ©2011 South-Western, a part of Cengage Learning.

• Dated for a specific Income Statement

• Dated for a specific Income Statement

The Accounting Equation: Balance Sheet

• Covers the same period as the income

• An integral part of the financial statements

• Internal or external event that causes a

• Required by the accrual basis of accounting

• The output of the accounting system

• Voluntary private sector organization (Treadway)

• Audit is conducted by CPAs

• The financial statements present fairly

• Except for the matter to which the exception

• The financial statements do not present

• The auditor does not express an opinion

• Management is responsible for

• Management’s Statement of Responsibility

• Capital markets generate security prices that reflect

Essential values in interpersonal relationships

1. Determine the facts

• Enacted under Sarbanes-Oxley Act

• Accounting standards can vary by country

• IASB issues (IFRS) International Financial

• Parent consolidates with subsidiary

• Effected through merger or acquisition

• Purchase method of accounting

• Record assets and liabilities acquired at their

• Excess of purchase price over fair value of

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