Explanatory Notes and Other Financial Information CHAPTER 10 Explanatory Notes and Other Financial Information

Explanatory Notes Because of the complexities related to financial reporting and because of the number of alternative generally accepted accounting principles that can be used, explanatory notes to the financial statements are included as an integral part of the financial statements.

Management Discussion and Analysis Many corporations are required to include a section called Management Discussion and Analysis in its annual report. This section describes the firm’s activities for the year, including comments about its financial condition and results of operations.

Summary of Significant Accounting Policies Explanatory Notes Summary of Significant Accounting Policies Typical accounting policies that are disclosed in the notes to the financial statements include: Depreciation method used. Inventory valuation method used. Basis of consolidation of subsidiary information. Reconciliation of taxes paid to tax expense. The cost of employee benefit plans. Treatment of goodwill and intangible assets. Earnings per share information. Stock option and stock purchase plans.

Depreciation Method Impact of Income Sum-of-the-Years’- Digits Method Declining Balance Method Impact of Income Straight-Line Method Units-of-Production Method Disclosure of the depreciation method permits informed readers to make comparisons of companies in the same industry.

Impact on Income Statement and Balance Sheet Inventory Valuation FIFO LIFO Average Cost Impact on Income Statement and Balance Sheet The selection of an inventory valuation method may influence the reported income and the inventory amount shown on the balance sheet.

Basis of Consolidation This disclosure indicates consolidated financial statements include data from substantially all subsidiary companies. Parent Company $ Subsidiary Company 1 Subsidiary Company 2 Subsidiary Company 3

Income Taxes A reconciliation of the statutory income tax rate with the effective tax rate. The Internal Revenue Code is the set of rules for preparing tax returns. Financial statement income tax expense. IRS income taxes payable. GAAP is the set of rules for preparing financial statements. Usually. . . Results in . . .

Employee Benefits The cost of employee benefit plans included as an expense in income is disclosed. Present value of benefits at present pay levels. Present value of nonvested benefits at present pay levels. Present value of additional benefits related to projected pay increases. Accumulated Benefit Obligation Projected Benefit Obligation Vested Benefit Obligation

Intangibles Including Goodwill When the balance sheet contains intangible assets, the method of recognizing initial cost will be described. Any amortization or impairment in value of the intangibles must be shown. Patent ® © Copyright Trademark ™

Earnings Per Share An explanation of the calculation of EPS may include the details of the computation of weighted-average number of common shares outstanding and the adjustments made to net income for preferred stock, options, and convertible securities.

Stock Option and Purchase Plans A stock option plan is designed to encourage managers to meet company goals by providing an incentive. The incentive may be measured by the difference between the exercise price per share and the market price per share of stock. Stock purchase plans permit employees to purchase shares of the company’s stock at a slight discount from market value. The plans are designed to help employees become owners of the company.

Details of Financial Amounts Many financial statement amounts are report in the aggregate. Note disclosure permits companies to show more details

Reporting to the SEC Instead of an annual report, companies that are registered with the SEC file an annual form 10-K. The form 10-K includes most of the information in the company’s annual report and goes on to comply with additional SEC reporting requirements.

Other Disclosures A change in accounting principal may have a significant impact on reported income. To promote comparability, companies with accounting changes are required to show what income would have been reported if the new principal had been used all the time. This is referred to as “proforma income.”

Other Disclosures Mergers and acquisitions are accounted for using purchase accounting. Under this method, net assets are recorded at fair value on the date of acquisition. Any amount paid in excess of fair value is the intangible asset goodwill.

Other Disclosures Contingencies Claims or rights to receive or pay assets whose existence is uncertain but which may become valid eventually. Typical gain contingencies include: Possible receipts of monies from gifts or donations. Possible refunds from the government in tax disputes. Pending court cases with probable favorable outcome. Typical loss contingencies include: Possible payments resulting from litigation. Possible additional payments resulting from tax disputes. Possible fines or penalties.

Financial Statements Issued Subsequent Events Financial Statements Issued Company Year-End Subsequent Period 12/31/04 2/19/05 Some significant events that occur in the subsequent period may be required to be included on the year 2004, other events may be disclosed in the notes.

Impact of Inflation Reporting the effects of inflation is a controversial and complex area of accounting. If the economy experiences high rates of inflation in the future, efforts to reflect the impact of inflation directly in the financial statements are likely to be renewed.

Segment Information Most large corporations operate several lines of business and operate in many geographical areas. Segment Information should include: Sales to unaffiliated customers. Operating profit. Capital expenditures. Depreciation expense. Identifiable assets.

Management Statement of Responsibility Management of the company bears the ultimate responsibility for the financial information, not the auditors who express an opinion on the fairness of presentation of the financial information.

Management Discussion and Analysis (MD&A) Nature of operations. Economic outlook for the company. Important factors that may influence profitability. Summary of operating results.

Summary of Financial Data Most corporate annual reports contain a 5-year or 10-year summary of key financial data. This information often includes significant ratios and stock market price of its common stock.

Independent Auditors’ Report Usually divided into three paragraphs. Introductory Paragraph – Describes the financial statements audited and states that management is responsible for the financial statements.  Scope Paragraph – Describes the nature and extent of the audit process. The auditors wish to obtain reasonable assurance that the financial statements are free from material misstatements.  Opinion Paragraph – Auditors express an opinion on the fairness of the financial presentation. Corporations wish to get an unqualified report. 

Compilation Engagement For companies that are not registered with the SEC and do not have publicly traded securities, accountants may provide a service by compiling financial statements. A compilation is merely the presenting in the form of financial statements information that is prepared by management. A compilation report does not provide any assurance about the fairness of the financial information.

End of Chapter 10