Introduction to Financial Statements and Other
Financial Reporting Topics
Chapter 2
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Chapter 2, Slide #2
Sole Proprietorship Partnership Corporation
Number of owners 1 2 or more (partners)
Numerous (shareholders)
Legally separate from owners
No No Yes
Owners liable for business debts
Yes Yes No
Profits taxable To the owner To the owners
To the corporation as
earnings; to the owners
when dividends are received
Modified form
“LLC” limits liability of owner; may
increase income tax exposure
“Subchapter S” profits are
taxed at ownership level
only
Forms of Business Entities
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Chapter 2, Slide #3
• Income statement• Statement of stockholders’ equity• Balance sheet• Statement of cash flows• Support for the financial statements is
provided by notes
The Financial Statements
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Chapter 2, Slide #4
• Dated for a specific period
• Summarizes revenues and expenses
• Reports net income– Excess of revenues
over expense
• Net income increases retained earnings
Income StatementFor the Year Ended Dec. 31, 2011
Revenue $ 120,000Expenses (100,000)Net Income $ 20,000
Income Statement
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Chapter 2, Slide #5
Income StatementFor Year Ending December 31, 2011
Revenue $ 120,000Expenses (100,000)Net Income $ 20,000 Statement of Stockholders’ Equity
For Year Ending December 31, 2011
Capt. Stk. Ret. Earn.Beginning Balance $40,000 $ 25,000Issue stock 10,000Net income 20,000Dividends (10,000)Ending Balance $50,000 $ 35,000
• Dated for a specific period
• Reconciles beginning and ending balances of the stockholders’ equity accounts– Capital Stock– Retained Earnings– Etc.
• Links the income statement and the balance sheet
Statement of Stockholders’ Equity
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Chapter 2, Slide #6
Shows the financial condition of an entity as of a particular date
– Assets: the resources of the business
– Liabilities: the debts of the business
– Equity: the owners’ interest in the business
The Accounting Equation:Assets = Liabilities +
Stockholders’ Equity
Assets = Liabilities +Capital Stock +Retained Earnings
Balance SheetAssets $110,000Liabilities 25,000Stockholders’ Equity
Capital Stock 50,000Retained Earnings 35,000
Tot Liab. & Equity $110,000
Income StatementRevenue $ 120,000Expenses (100,000)Net Income $ 20,000Statement of Stockholders’ Equity
Capt. Stk. Ret. Earn.Beginning Balance $40,000 $ 25,000Issue stock 10,000Net income 20,000Dividends (10,000)Ending Balance $50,000 $ 35,000
Statement of Stockholders’ Equity
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Chapter 2, Slide #7
• 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
Statement of Cash Flows
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Chapter 2, Slide #8
• 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
Notes
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Chapter 2, Slide #9
1. Recording transactions
2. Recording adjusting entries
3. Preparing the financial statement
The Accounting Cycle
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Chapter 2, Slide #10
• 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 accountCredit: right side of an accountDebits = Credits
Account Title
Debit Credit
Recording Transactions
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Chapter 2, Slide #11
Permanent Temporary
Account types
AssetsLiabilitiesEquity
Revenues, Gains Expenses, Losses Dividends
Balances Carry forward to the next fiscal period
Closed to retained earnings at year-end
Represent the accounting equation
Accounting System Components
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Chapter 2, Slide #12
• 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
Accounting System Components
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Chapter 2, Slide #13
• 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
Preparing the Financial Statements
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Chapter 2, Slide #14
• 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
Treadway Commission
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Chapter 2, Slide #15
• Audit is conducted by CPAs• The audit report is the formal statement of
audit opinion– Unqualified opinion– Qualified opinion– Adverse opinion– Disclaimer of opinion
Auditor’s Opinion
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Chapter 2, Slide #16
• 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
Unqualified Opinion
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Chapter 2, Slide #17
• Except for the matter to which the exception relates
• The financial statements present fairly– The financial position– Results of operations– Cash flows
• In conformity with generally accepted accounting principles
• For the user: determine the significance of the exception
Qualified Opinion
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Chapter 2, Slide #18
• The financial statements do not present fairly– The financial position– Results of operations– Cash flows
• In conformity with generally accepted accounting principles
• For the user: reliability of financial statements need to be seriously questioned
Adverse Opinion
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Chapter 2, Slide #19
• 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
Disclaimer of Opinion
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Chapter 2, Slide #20
• 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
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Chapter 2, Slide #21
• 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)
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Chapter 2, Slide #22
• 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 (U.S.) Public Accounting
Oversight Board– Based on criteria established by COSO
Unqualified Auditor’s Report (cont’d)
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 2, Slide #23
• 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
Auditor’s Report on Internal Control
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Chapter 2, Slide #24
• 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
Other Types of Engagements
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Chapter 2, Slide #25
• 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
Management’s Responsibility
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Chapter 2, Slide #26
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
The SEC’s Integrated Disclosure System
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Chapter 2, Slide #27
• 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
Additional Reporting Venues
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Chapter 2, Slide #28
• 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
The Efficient Market Hypothesis
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Chapter 2, Slide #29
Caring
Honesty
Accountability
Promise keeping
Pursuit of excellence
Loyalty
Fairness
Integrity
Respect for others
Responsible citizenship
Essential values in interpersonal relationships
Ethics
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Chapter 2, Slide #30
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
AAA Ethical Decision Framework
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Chapter 2, Slide #31
• 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
SEC Requirement: A Code of Ethics
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Chapter 2, Slide #32
• 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
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Chapter 2, Slide #33
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.
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Chapter 2, Slide #34
• 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
Consolidated Financial Statements
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Chapter 2, Slide #35
• 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
Accounting for Business Combinations
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