Chapter 2
Introduction to
Financial Statements and
Other Financial
Reporting Topics
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Forms of Business Entities
Sole
Proprietorship
Number of owners
Legally separate from
owners
Owners liable for
business debts
Partnership
2 or more
(partners)
Corporation
Numerous
(shareholders)
No
No
Yes
Yes
Yes
No
1
To the
owners
Profits taxable
To the owner
Modified form
“LLC”
limits liability of owner; may
increase income tax
exposure
Chapter 2, Slide #2
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
To the
corporation as
earnings;
to the owners
when dividends
are received
“Subchapter S”
profits are
taxed at
ownership level
only
The Financial Statements
•
•
•
•
•
Income statement
Statement of stockholders’ equity
Balance sheet
Statement of cash flows
Support for the financial statements is
provided by notes
Chapter 2, Slide #3
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Income Statement
• Dated for a specific
period
• Summarizes
revenues and
expenses
• Reports net income
Income Statement
Revenue
$ 120,000
Expenses
(100,000)
Net Income
$ 20,000
– Excess of revenues
over expense
• Net income
increases retained
earnings
Chapter 2, Slide #4
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Statement of Stockholders’ Equity
• Dated for a specific
period
• Reconciles
beginning and
ending balances of
the stockholders’
equity accounts
– Capital Stock
– Retained Earnings
– Etc.
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
• Links the income
statement and the
balance sheet
Chapter 2, Slide #5
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Balance Sheet
Income Statement
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
Revenue
Expenses
Net Income
$ 120,000
(100,000)
$ 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
Balance Sheet
Assets
Liabilities
Stockholders’ Equity
Capital Stock
Retained Earnings
Chapter 2, Slide #6
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
$110,000
25,000
50,000
35,000
$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
Chapter 2, Slide #7
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #8
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
The Accounting Cycle
1. Recording transactions
2. Recording adjusting entries
3. Preparing the financial statement
Chapter 2, Slide #9
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #10
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Account Title
Debit
Credit
Accounting System Components
Permanent
Account
types
Balances
Assets
Liabilities
Equity
Carry forward to
the next fiscal
period
Represent the
accounting
equation
Temporary
Revenues, Gains
Expenses, Losses
Dividends
Closed to retained
earnings at year-end
Chapter 2, Slide #11
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #12
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #13
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #14
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #15
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #16
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #17
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #18
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #19
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #20
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #21
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #22
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Auditor’s Report on Internal Control
• Required by Sarbanes-Oxley
• May be combined with audit opinion report
• Paragraphs
1.
2.
3.
4.
Scope
Responsibility and procedures
Opinion
Reference to financial statement audit
Chapter 2, Slide #23
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #24
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #25
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #26
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #27
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #28
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Ethics
Essential values in interpersonal relationships
Caring
Loyalty
Honesty
Fairness
Accountability
Integrity
Promise keeping
Respect for others
Pursuit of excellence
Responsible citizenship
Chapter 2, Slide #29
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
AAA Ethical Decision Framework
1.
2.
3.
4.
5.
Determine the facts
Define the ethical issues
Identify major principles, rules, and values
Specify the alternatives
Compare norms, principles, and values with
alternatives
6. Assess the consequences
7. Make your decision
Chapter 2, Slide #30
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #31
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #32
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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 decisionmaking ability
Chapter 2, Slide #33
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 2, Slide #34
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.