Introduction to Financial Statements and Other Financial Reporting Topics COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 2

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #2 Forms of Business Entities

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #3 The Financial Statements Income statement Statement of stockholders’ equity Balance sheet Statement of cash flows Support for the financial statements is provided by notes

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #4 Income Statement Dated for a specific period Summarizes revenues and expenses Reports net income –Excess of revenues over expense Net income increases retained earnings Income Statement Revenue $ 120,000 Expenses (100,000) Net Income $ 20,000

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #5 Income Statement Revenue $ 120,000 Expenses (100,000) Net Income $ 20,000 Statement of Stockholders’ Equity Capt. Stk.Ret. Earn. Beginning Balance $20,000 $ 5,000 Net income 20,000 Dividends (10,000) Ending Balance$20,000$ 15,000 Statement of Stockholders’ Equity 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #6 Balance Sheet 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 Sheet Assets$110,000 Liabilities25,000 Stockholders’ Equity Capital Stock50,000 Retained Earnings 35,000 $110,000 Income Statement Revenue $ 120,000 Expenses (100,000) Net Income $ 20,000 Statement of Stockholders’ Equity Capt. Stk.Ret. Earn. Beginning Balance $20,000 $ 5,000 Net income20,000 Dividends (10,000) Ending Balance $20,000 $ 15,000

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #7 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #8 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #9 The Accounting Cycle 1.Recording transactions 2.Recording adjusting entries 3.Preparing the financial statement

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #10 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 Credit: right side of an account Debits = Credits Account Title DebitCredit

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #11 Accounting System Components PermanentTemporary Account types Assets Liabilities Equity Revenues, Gains Expenses, Losses Dividends BalancesCarry forward to the next fiscal period Closed to retained earnings at year-end Represent the accounting equation

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #12 Recording Adjusting Entries 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #13 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #14 Treadway Commission Voluntary private sector organization 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #15 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #16 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #17 Qualified Opinion 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #18 Adverse Opinion 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #19 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #20 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #21 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #22 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #23 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #24 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #25 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #26 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #27 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #28 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #29 Ethics Caring Honesty Accountability Promise keeping Pursuit of excellence Loyalty Fairness Integrity Respect for others Responsible citizenship Essential values in interpersonal relationships

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #30 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #31 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #32 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 – 2001) –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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #33 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 2, Slide #34 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