1. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Accounting: What The Numbers Mean
Tenth Edition
Marshall, McManus, and Viele

2. Chapter 10
Corporate Governance, Notes to the Financial Statements, and Other Disclosures
Chapter 10: Corporate Governance, Notes to the Financial Statements, and Other Disclosures
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

3. Learning Objectives
After studying this chapter you should understand and be able to:
Discuss the significance of corporate governance.
Identify the types of financial reporting misstatements that have occurred in recent years.
Explain why the notes are an integral part of the financial statements.
Discuss the kinds of significant accounting policies that are explained in the notes.
Describe the nature and content of various note disclosures.
Explain the role of the Securities and Exchange Commission and some of its reporting requirements.
Explain why a statement of management’s responsibility is included with the notes.
Describe the significance of management’s discussion and analysis of the firm’s financial condition and results of operations.
Identify what is included in the five-year (or longer) summary of financial information.
Discuss the meaning and content of the independent auditors’ report.
After studying this chapter you should understand and be able to:
Discuss the significance of corporate governance.
Identify the types of financial reporting misstatements that have occurred in recent years.
Explain why the notes are an integral part of the financial statements.
Discuss the kinds of significant accounting policies that are explained in the notes.
Describe the nature and content of various note disclosures.
Explain the role of the Securities and Exchange Commission and some of its reporting requirements.
Explain why a statement of management’s responsibility is included with the notes.
Describe the significance of management’s discussion and analysis of the firm’s financial condition and results of operations.
Identify what is included in the five-year (or longer) summary of financial information.
Discuss the meaning and content of the independent auditors’ report.
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4. Corporate Governance Business ethics Social responsibility
L O 1
Business ethics
Social responsibility
Equitable treatment of shareholders
Disclosures and transparency
Board of directors’ responsibility
Learning Objective 1: Discuss the significance of corporate governance.
Business ethics, social responsibility, equitable treatment of shareholders, disclosures and transparency, and board of directors’ responsibility are examples of the significance of corporate governance.
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5. Corporate Governance
L O 1
The most powerful legislation to date has been the Sarbanes–Oxley Act (SOX) of 2002, which created the Public Company Accounting Oversight Board (PCAOB) as the authoritative watchdog over the accounting and auditing profession.
The SOX legislation was aimed primarily to curtail the misbehavior of senior management of corporate
entities: Chief executive officers (CEOs) and chief financial officers (CFOs) are required under SOX to attest (in front of a notary) to the correctness of their company’s financial statements.
The registrant must also report in a separate section of its annual
10-K report any “Changes in and Disagreements with Accountants on Accounting and Financial Disclosure” as an added measure of transparency and management accountability.
The most powerful legislation to date has been the Sarbanes–Oxley Act (SOX) of 2002, which created the Public Company Accounting Oversight Board (PCAOB) as the authoritative watchdog over the accounting and auditing profession. The SOX legislation was aimed primarily to curtail the misbehavior of senior management of corporate entities: Chief executive officers (CEOs) and chief financial officers (CFOs) are required under SOX to attest (in front of a notary) to the correctness of their company’s financial statements. The registrant must also report in a separate section of its annual 10-K report any “Changes in and Disagreements with Accountants on Accounting and Financial Disclosure” as an added measure of transparency and management accountability.
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6. Corporate Governance
L O 1
In response to the financial crisis of 2007–2008, Congress passed the Wall Street Reform and Consumer Protection Act of 2010 (referred to as the Dodd-Frank Act ). Although most of the act deals with financial regulation, several Dodd-Frank provisions impose new corporate governance rules not just on Wall Street banks but also on Main
Street public corporations.
Dodd-Frank Act contains the “say on pay” mandate requiring periodic
shareholder advisory votes on executive compensation and golden parachute provisions.
Dodd-Frank provision requires companies to disclose the reasons that they have chosen to have either the same person or separate people serve as the CEO and chairman of the board.
In response to the financial crisis of 2007–2008, Congress passed the Wall Street Reform and Consumer Protection Act of 2010 (referred to as the Dodd-Frank Act ). Although most of the act deals with financial regulation, several Dodd-Frank provisions impose new corporate governance rules not just on Wall Street banks but also on Main Street public corporations. Dodd-Frank Act contains the “say on pay” mandate requiring periodic shareholder advisory votes on executive compensation and golden parachute provisions. Dodd-Frank provision requires companies to disclose the reasons that they have chosen to have either the same person or separate people serve as the CEO and chairman of the board.
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7. Recent Financial Misstatements
L O 2
Recent Financial Misstatements
Learning Objective 2: Identify the types of financial reporting misstatements that have occurred in recent years.
Earnings Manipulation Shenanigans
1. Recording revenue too soon.
• Recording revenue before completing any obligations under the contract.
• Recording revenue far in excess of work completed on the contract.
• Recording revenue before the buyer’s final acceptance of the product.
• Recording revenue when the buyer’s payment remains uncertain or unnecessary.
2. Recording bogus revenue.
• Recording revenue from transactions that lack economic substance.
• Recording revenue from transactions that lack a reasonable arm’s-length process.
• Recording revenue on receipts from non-revenue-producing transactions.
• Recording revenue from appropriate transactions, but at inflated amounts.
3. Boosting income using one-time or unsustainable activities.
• Boosting income using one-time events.
• Boosting income through misleading classifications.
4. Shifting current expenses to a later period.
• Improperly capitalizing normal operating expenses.
• Amortizing costs too slowly.
• Failing to write down assets with impaired value.
• Failing to record expenses for uncollectible receivables and devalued investments.
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8. Recent Financial Misstatements
L O 2
Recent Financial Misstatements
Cash Flow Shenanigans
1. Shifting financing cash inflows to the operating section.
• Recording bogus cash flows from operations from a normal bank borrowing.
• Boosting cash flows from operations by selling receivables before the collection
date.
• Inflating cash flows from operations by faking the sale of receivables.
2. Shifting normal operating cash outflows to the investing section.
• Inflating cash flows from operations with boomerang transactions.
• Improperly capitalizing normal operating costs.
• Recording the purchase of inventory as an investing outflow.
3. Inflating operating cash flow using acquisitions or disposals.
• Inheriting operating inflows in a normal business acquisition.
• Acquiring contracts or customers rather than developing them internally.
• Boosting cash flows from operations by creatively structuring the sale of a business.
4. Boosting operating cash flow using unsustainable activities.
• Boosting cash flows from operations by paying vendors more slowly.
• Boosting cash flows from operations by collecting from customers more quickly.
• Boosting cash flows from operations by purchasing less inventory.
• Boosting cash flows from operations with one-time benefits.
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9. Notes to the Financial Statements
L O 3
Notes to the Financial Statements
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 are included as an integral part of the financial statements.
Learning Objective 3: Explain why the notes are an integral part of the financial statements.
The explanatory notes are an integral part of the financial statements; the notes provide detailed disclosure of information needed by users wishing to gain a full understanding of the financial statements.
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 are included as an integral part of the financial statements.
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10. Notes to the Financial Statements
L O 4
Notes to the Financial Statements
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 subsidiaries.
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.
Learning Objective 4: Discuss the kinds of significant accounting policies that are explained in the notes.
A summary of significant accounting policies is a required disclosure. 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, cost of employee benefit plans, treatment of goodwill and intangible assets, earnings per share information, and stock option and stock purchase plans.
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11. Other Disclosures Accounting changes. Business combinations.
Contingencies and commitments.
Events subsequent to the balance sheet date.
Impact of inflation.
Segment information.
An accounting change is a change in the application of an accounting principle that has a material effect on the comparability of the current period financial statements with those of prior periods. If the firm has been involved in a business combination (a merger, acquisition, or disposition), the transaction(s) involved will be described and the effect on the financial statements will be explained. It is not unusual for a firm to be involved in litigation, the results of which are not known when the financial statements are prepared. If the firm is denying liability in a lawsuit in which it is a defendant, it is appropriate to disclose the fact of the lawsuit to readers of the financial statements. If, subsequent to the balance sheet date, a significant event occurs that has a material impact on the balance sheet or income statement, it is appropriate to provide an explanation of the probable impact of the subsequent event on future financial statements. The FASB encourages, but does not require, companies to provide supplementary information on the effects of changing prices (inflation) in the notes to the financial statements; in practice, very few companies voluntarily do so. The required disclosure of segment, geographic, and major customer information is designed to permit the financial statement user to make judgments about the impact on the firm of factors that might influence specific lines of business, geographic areas, or specific major customers.
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12. Depreciation Method Impact of Income
L O 4
Depreciation Method
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.
The impact of various depreciation methods (units-of-production, declining balance, straight-line, and sum-of-the-years'-digits) on reported income must be disclosed. Disclosure of the depreciation method permits informed readers to make comparisons of companies in the same industry.
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13. Impact on Income Statement and Balance Sheet
L O 4
Inventory Valuation
FIFO
LIFO
Weighted- Average
Impact on Income Statement and Balance Sheet
The selection of an inventory valuation method influences the reported income and the inventory amount shown on the balance sheet.
FIFO, LIFO, and weighted-average inventory valuation methods have an impact on the income statement and the balance sheet. The selection of an inventory valuation method influences the reported income and the inventory amount shown on the balance sheet.
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14. Basis of Consolidation
L O 4
The basis of consolidation disclosure requires that consolidated financial statements include data from substantially all subsidiary companies.
Parent Company $
Subsidiary Company 1
Subsidiary Company 2
Subsidiary Company 3
The basis of consolidation disclose requires that consolidated financial statements include data from substantially all subsidiary companies.
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15. L O 4
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 . . .
A reconciliation of the statutory income tax rate with the effective tax rate is another required disclosure. GAAP is the set of rules for preparing financial statements; GAAP results in financial statement income tax expense. The Internal Revenue Code is the set of rules for preparing tax returns; the IRS Code results in income taxes payable. Income tax expense usually does not equal income tax payable; hence, such a reconciliation is needed by users.
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16. L O 4
Employee Benefits
The cost of employee pension plans included as an expense in the income statement 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
The cost of employee pension plans included as an expense in the income statement is disclosed. Projected benefit obligation (the present value of additional benefits related to projected pay increases), accumulated benefit obligation (the present value of nonvested benefits at present pay levels), and vested benefit obligation (the present value of benefits at present pay levels) are required explanatory note disclosures.
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17. Intangibles Including Goodwill
L O 4
Intangibles Including Goodwill
When the balance sheet contains intangible assets, including goodwill arising from business acquisitions, the method of recognizing initial cost will be described. Any amortization or impairment in value of the intangibles must be shown.
Patent
Copyright
Trademark ™
When the balance sheet contains intangible assets, including goodwill arising from business acquisitions, trademarks, copyrights, and patents, the method of recognizing initial cost will be described. Any amortization or impairment in value of the intangibles must be shown.
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18. L O 4
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, stock options, and convertible securities.
An explanation of the calculation of earnings per share 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.
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19. L O 5
Segment Information
Most large corporations operate in 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.
Most large corporations operate in several lines of business and operate in many geographical areas. Segment information should include: sales to unaffiliated customers, operating profit, capital expenditures, depreciation expense, and identifiable assets.
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20. L O 6
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 must also comply with additional SEC reporting requirements.
Learning Objective 6: Explain the role of the Securities and Exchange Commission and some of its reporting requirements.
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. It must also comply with additional SEC reporting requirements.
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21. Management’s Statement of Responsibility
L O 7
Management’s Statement of Responsibility
The company’s management bears ultimate responsibility for the financial statements and notes, not the auditors who express an opinion on the fairness of the presentation of the financial statements.
Learning Objective 7: Explain why a statement of management’s responsibility is included with the notes.
The company’s management bears ultimate responsibility for the financial statements and notes, not the auditors who express an opinion on the fairness of the presentation of the financial statements.
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22. End of Chapter 10
End of Chapter 10.
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