Chapter 1
True-False
1. A firm’s annual report contains only two pieces of information: the financial
statements and the notes to the financial statements.
F:
Annual report;
Financial statements
Public relations material
Sent to shareholders and prospective investors
2. The SEC regulates U.S. companies that issue securities to the public and
requires the issuance of a prospectus for any new security offering.
T
3. The FASB has congressional authority to set accounting policies.
F: The SEC has congressional authority to set accounting policies
4. The European Union began requiring publicly traded companies to use U.S.
GAAP in 2005.
F:
The European Union began requiring publicly traded companies to use IFRS in
2005 and over 100 other countries had adopted IFRS or a version of IFRS by
2009
5. External auditors are required to audit the internal control assessment of the
company as well as the financial statements.
T
6. Congress passed the Sarbanes-Oxley Act of 2002 in hopes of ending future
accounting scandals and renewing investor confidence in the marketplace.
T
7. The Management Discussion and Analysis is of potential interest to the
analyst because it contains information that cannot be found in the financial
data.
T
8. Information that is significant enough to make a difference in a decision is
considered to be immaterial.
F:
Information that is not significant enough to make a difference in a decision is
considered to be immaterial
9. The time period assumption assumes a two year time frame with interim
reporting occurring daily and weekly.
The time period assumption assums a one-year time frame with interim
reporting occurring monthly and quarterly
10. GAAP-based financial statements are prepared according to the accrual basis
of accounting.
T
Fill in the Blank
1. The
SEC requires all public companies to file a Form 10-K report
annually.
all publicly held companies must file a Form 10-K annually with the SEC
2. A corporate annual report contains
four basic financial statements.
1.
The balance sheet or statement of financial position shows the financial position—
assets, liabilities, and stockholders’ equity—of the firm on a particular date, such as the end
of a quarter or a year.
2.
The income or earnings statement presents the results of operations—revenues,
expenses, net profit or loss, and net profit or loss per share—for the accounting period.
3.
The statement of stockholders’ equity reconciles the beginning and ending balances of
all accounts that appear in the stockholders’ equity section of the balance sheet. Some firms
prepare a statement of retained earnings, frequently combined with the income statement,
which reconciles the beginning and ending balances of the retained earnings account.
Companies choosing the latter format will generally present the statement of stockholders’
equity in a footnote disclosure.
4.
The statement of cash flows provides information about the cash inflows and outflows
from operating, financing, and investing activities during an accounting period.
3.
Management is responsible for the preparation of the financial
statements, including the notes, and the
the auditor’s report attests to the
fairness of the presentation.
4. The
Sarbanes-Oxley act
was passed in 2002 and was one of the
most sweeping corporate reforms since the Securities Act of 1934.
The collapse of Enron and Worldcom was a catalyst for some of the most
sweeping corporate reforms since the Securities act of 1934 was passed.
congress was quick to pass the Sarbanes-Oxley act of 2002 in hopes of ending
future accounting scandals and renew- ing investor confidence in the
marketplace
5. The proxy statement is a document used to solicit shareholder votes.
6. The
Monetary Unit
Assumption is the assumed unit of measurement
when preparing financial statements.
7. The cash basis of accounting recognizes revenues
and recognizes
expenses when cash is paid.
when cash is received
8. The sharper and clearer the picture presented through the financial data and
the closer that picture is to financial reality, the higher is the quality of the
financial statements and reported earnings.
9. One of the generally accepted accounting principles that provide the
foundation for preparing financial statements is the
matching
principle.
expenses are matched with the generation of revenues to determine net income
for an accounting period
10. Management exercises control over the budget level and timing of
expenditures.
Management exercises control over the budget level and timing of expenditures
for the repair and maintenance of machinery and equipment, marketing and
advertising, research and development, and capital expansion
Multiple Choice
1. What information would not be found in a firm’s annual report?
a. Notes to the financial statements.
b. Financial Reporting Rulings.
c. Auditor’s report.
d. High and low stock prices.
2. Which agency requires the filing of Form 10-Ks, Form 10-Qs and Form 8Ks?
a. FASB.
b. IASB.
c. SEC.
d. GAAP.
3. Which of the following statements is true?
a. Foreign firms registered with the SEC may file reports based on
IFRS.
b. U.S. firms registered with the SEC may file reports based on IFRS.
c. The European Union requires firms to report based on GAAP.
d. Foreign firms registered with the SEC may file reports based on IFRS
only if they reconcile all amounts to GAAP.
4. Which financial statement presents the results of operations?
a. Balance sheet.
b. Statement of financial position.
c. Income statement.
d. Statement of cash flows.
5. Which financial statement shows the assets, liabilities and stockholders’
equity of the firm on a particular date?
a. Statement of stockholders’ equity.
b. Statement of cash flows.
c. Earnings statement.
d. Balance sheet.
6. Which financial statement provides information about operating, financing
and investing activities?
a. Statement of financial position.
b. Statement of cash flows.
c. Statement of stockholders’ equity.
d. Income statement.
7. What information can be found on a statement of stockholders’ equity?
a. A reconciliation of the cash account and the retained earnings account.
b. A reconciliation of the beginning and ending balances of all
accounts that appears in the stockholders’ equity section of the
balance sheet.
c. A reconciliation of the operating, investing and financing activities of a
firm.
d. A reconciliation of net profit or loss and the cash account.
8. What basic financial statements can be found in a corporate annual report?
a. Balance sheet, income statement, statement of shareholders' equity,
and statement of cash flows.
b. Balance sheet, auditor's report and income statement.
c. Earnings statement and statement of retained earnings.
d. Statement of cash flows and five-year summary of key financial data.
9. What is an unqualified audit report?
a. A report stating that the auditors are not qualified to report on a firm.
b. A report that states the financial statements are in violation of GAAP.
c. A report that states that departures from GAAP exist in the firm’s
financial statements.
d. A report that states the financial statements are presented fairly, in
all material respects, and are in conformity with GAAP.
10. What is a qualified report?
a. A report stating that the auditors are not qualified to report on a firm.
b. A report that states the financial statements are in violation of GAAP.
c. A report that states that departures from GAAP exist in the firm’s
financial statements.
d. A report that states the financial statements are presented fairly, in all
material respects, and are in conformity with GAAP.
11. What organization has the authority to register, inspect, and discipline
auditors of all publicly owned companies?
a. Public Company Accounting Oversight Board.
b. SOX.
c. Congress.
d. FASB.
12. According to Section 302 of the Sarbanes-Oxley Act, who must certify the
accuracy of the financial statements of a public company?
a. Public Company Accounting Oversight Board.
b. SEC.
c. External auditor.
d. CEO and CFO.
13. All of the following items should be discussed in the management
discussion and analysis except for:
a. Anticipated changes in the mix and cost of financing resources.
b. The market value of all assets.
c. The internal and external sources of liquidity.
d. Unusual or infrequent transactions that affect income from continuing
operations.
14. Which of the following is an internal source of liquidity?
a. Borrowing.
b. Sales of stock.
c. Gifts and donations.
d. Sales of products or services.
15. Which of the following is an external source of liquidity?
a. Sales of services.
b. Repurchase of stock.
c. Borrowing.
d. Sales of products.
16. Which of the following is not a condition that must be met for an item to be
recorded as revenue?
a. Revenues must be earned.
b. The amount of the revenue must be measurable.
c. The revenue must be received in cash.
d. The costs of generating the revenue can be determined.
17. How are revenues and expenses recognized under the accrual basis of
accounting?
a. Revenues are recognized when cash is received and expenses are
recognized when cash is paid.
b. Revenues and expenses are recognized equally over a twelve month
period.
c. Revenues and expenses are recognized based on the choices of
management.
d. Revenues are recognized in the accounting period when the sale is
made and expenses are recognized in the period in which they relate
to the sale of the product.
18. In what industry would it be expected that companies would spend a
significant amount on research and development activities?
a. Pharmaceutical.
b. Clothes retailer.
c. Groceries.
d. Wholesale distributor of computer parts.
19. Which of the following items is a discretionary expenditure?
a. Union wages.
b. Factory building to produce inventory.
c. Advertising.
d. Taxes.
20. Which of the following statements is false with regard to quality of financial
reporting?
a. Financial statements should reflect an accurate picture of a company’s
financial condition and performance.
b. It is unlikely that management can manipulate the bottom line due
to the
regulations in place to enforce GAAP.
c. Financial information should be useful both to assess the past and
predict
the future.
d. The closer that the picture presented through the financial data is to
reality, the higher the quality of financial reporting.
Short Answer
1. Write a short essay explaining the following statement: “Unfortunately, there
are mazelike interferences in financial statement data that hinder understanding
the valuable information they contain.”
The following items make it more difficult for a user of financial statements to
understand financial data:
Quality of information
Clean audit reports do not mean the firm will not fail
Complex accounting policies that may be confusing
Accounting rules are constantly changing
Management has discretion in presenting financial information
Some information is not available or is difficult to find in the financial
statements
2. Describe the relationship between the FASB and the SEC.
In the U.S. there is a close relationship between the Securities and Exchange
Commission (SEC), a governmental agency legally responsible for setting
accounting standards, and the Financial Accounting Standards Board (FASB), a
private sector body to whom the SEC has delegated this responsibility. The
FASB and the SEC work together in developing accounting policies. The SEC
plays a large supportive role in all of this. Pressure from the private sector have
caused controversy at times. Congress has given accounting rulemaking
authority to the SEC, who, in turn, has passed that role to the FASB. The SEC
maintains veto power over any rule written by the FASB. The Securities and
Exchange Commission (SEC) designated the FASB as the organization
responsible for setting accounting standards for public companies in the US. the
U.S. Securities and Exchange Commission [the S.E.C.] has statutory authority to
establish financial accounting and reporting standards for publicly held
companies under the Securities Exchange Act of 1934, the SEC relies on the
Financial Accounting Standards Board [a seven member quasi governmental
entity] to develop accounting rules and standards to keep financial reporting
accurate and honest.
Putting it all together, financial statements filed with the S.E.C. by public
companies follow the GAAP accounting guidelines established by the FASB providing a consistent overview of the view of how companies have performed
financially at least in terms of GAAP accounting rules.
3. Explain why the notes are an integral part of the financial statements.
If the income statement, balance sheet, and statement of cash flow are the heart
of the financial statements, then the footnotes are the arteries that keep
everything connected. If you aren't reading the footnotes you're missing out on a
lot of information.
The footnotes list important information that could not be included in the actual
ledgers. Could you imagine if the company listed out individual expenses on the
income statement instead of putting them under one or two neat headings? The
income statement would be 20 pages long!
The notes will list relevant things like outstanding leases, the maturity dates of
outstanding debt, and even details on where the revenue actually came from.
Generally speaking there are two types of footnotes:
Accounting Methods - This type of footnote identifies and explains the major
accounting policies of the business. This portion of the footnotes will tell you
the nature of the company's business, when its fiscal year starts and ends, how
inventory costs are determined, and any other significant accounting policies
that the company feels that you should be aware of. This is especially important
if a company has changed accounting policies. It may be that a firm is practicing
"cookie jar accounting" and is changing policies only to take advantage of
current conditions to hide poor performance.
Disclosure - The second type of footnote provides additional disclosure that
simply could not be put in the financial statements. The financial statements in
an annual report are supposed to be clean and easy to follow. To maintain this
cleanliness, other calculations are left for the footnotes. For example, details of
long-term debt such as maturity dates and the interest rates at which debt was
issued, can give you a better idea of how borrowing costs are laid out. Other
areas of disclosure include everything from pension plan liabilities for existing
employees to details about ominous legal proceedings the company is involved
in.
The majority of investors and analysts read the balance sheet, income statement,
and cash flow statement. But for whatever reason, the footnotes are often
ignored. What sets informed investors apart is digging deeper and looking for
information that others typically wouldn't. No matter how boring it might be,
read the fine print, it'll make you a better investor.
For a breakdown of financial data by individual operating seg- ments, the
analyst must use information in notes to the financial statement.
the Enron collapse highlighted that some companies use complicated financing
schemes that may or may not be completely revealed in the notes to the financial
statements. Even with notes available, most average users may find these items
beyond their comprehension unless they acquire a ph.D. in accounting or
finance or read the authors’ discussion of Enron in their other book
4. Discuss the impact that the Sarbanes-Oxley Act of 2002 had on internal
auditing.
the Sarbanes-Oxley Act (SOX) was enacted in July 2002 to restore investors'
confidence in the financial markets and close loopholes that allowed public
companies to defraud investors. The act had a profound effect on corporate
governance in the U.S. The Sarbanes-Oxley Act requires public companies to
strengthen audit committees, perform internal controls tests, make directors and
officers personally liable for the accuracy of financial statements, and strengthen
disclosure. The Sarbanes-Oxley Act also establishes stricter criminal penalties
for securities fraud and changes how public accounting firms operate.
The costliest part of the Sarbanes-Oxley Act is Section 404, which requires
public companies to perform extensive internal control tests and include an
internal control report with their annual audits. Testing and documenting manual
and automated controls in financial reporting requires enormous effort and
involvement of not only external accountants but also experienced IT personnel.
The compliance cost is especially burdensome for companies that heavily rely
on manual controls. The Sarbanes-Oxley Act has encouraged companies to
make their financial reporting more efficient, centralized, and automated. Even
so, some critics feel all these controls make the act expensive to comply with,
distracting personnel from the core business and discouraging growth.
5. Define internal and external sources of liquidity. What is a material deficiency
in liquidity? If a firm has a material deficiency in liquidity what should be
reported in the management discussion and analysis?
Internal sources of liquidity include short-term, high-quality assets that are
readily convertible to cash at a reasonable cost.
External sources of liquidity include borrowings from related offices of the
foreign banking organization (FBO), other financial institutions, and overnight
or short-term depositors.
Material deficiency in liquidity: If the firm does not have enough cash to
continue to operate in the long term, what is it doing to obtain cash and prevent
bankruptcy?
To the extent a material deficiency is identified, the management discussion and
analysis should include:
1.
the internal and external sources of liquidity.
2.
Any material deficiencies in liquidity and how they will be remedied
3.
a discussion of material commitments for capital expenditures, the
general purpose of any commitments and how these commitments will
be funded, and material trends in the registrant's capital resources,
including expected changes in the mix (equity, debt and any offbalance sheet financing arrangements) and their relative cost.
4.
The discussion should also evaluate the amounts and certainties of
cash flows, as well as whether there has been material variability in
historical cash flows.
If a material deficiency is identified, indicate the course of action that the
registrant has taken or proposes to take to remedy the deficiency. Also identify
and separately describe internal and external sources of liquidity, and briefly
discuss any material unused sources of liquid assets
Any material deficiencies in liquidity
i.Used case in operations 3 years in a row due to net losses
ii.Remedies include:
1.Obtaining new patents
2.Restructuring sales and marketing team to improve revenue
3.Implementing cost cuts
4.Hire an investment banking firm to explore merger and acquisition
opportunities
6. What types of information may be missing or hard to find in the financial
statements?
Internally prepared financial statements provide a static view of your company’s
finances from a singular point in time. They don’t consider past or future
environmental factors, such as changes in market demand for the products or
services you offer, the effects of the COVID-19 crisis, or reputation of the firm
with its customers and changes in consumer perceptions and behavior. Here’s
what else your financial statements may not account for or reflect:
Changes in regulatory requirements, such as revenue recognition, that can
change financial statement presentation as you adopt and implement them.
An accurate market or fair value of your assets or account for the nature of onetime expenses.
How a large buy or sell contract at the end of the accounting period accounts for
a significant increase in inventory, accounts receivable, or accounts payable.
7. Explain why the characteristics of comparability and consistency are
important in financial reporting?
Comparability allows users to compare financial information of an entity to
other entities as well as comparing financial information of that entity to itself
from one time period to another.
Consistency is related to comparability and means that the same accounting
methods and choices should be used from one time period to another. Changes
in accounting choices can distort trends that would be helpful in analyzing
companies
Comparability is one of the enhancing qualitative characteristics of useful
financial information. Comparability allows users to compare financial position
and performance across time and across companies.
Comparability is achieved by consistency. Consistency refers to application of
accounting standards and policies consistently from one period to another and
from one region to another.
Comparability improves usefulness of financial statements because it allows
users to carry out trend analysis, cross-sectional analysis and common-size
analysis. Trend analysis helps us see whether a company's position and/or
performance has improved across time. Cross-sectional analysis compares a
company's performance with its peers.
Comparability does not necessarily mean uniformity. It does not require all
companies to adopt the same accounting policies because doing so would impair
relevance. Comparability is achieved when companies present information such
that knowledgeable users may adjust their financial statements so as to make
them comparable to other periods/companies.
Examples
We can compare 20X2 financial statements of ExxonMobil with its 20X1
financial statements to know whether performance and position improved or
deteriorated.
8. Write an essay discussing the two key principles that are the foundation of the
accrual basis of accounting.
The Accrual Basis of Accounting is based on both the revenue recognition and
the matching principles. The accrual method means that the revenue is
recognized in the accounting period when the sale is made rather than when the
cash is received. Expenses are recognized in the period incurred rather than
when cash is paid.
Revenue Recognition Principle
Revenue is the money a business generates by selling products and services to
customers. The revenue recognition principle states that a business must
recognize revenue in its records in the period in which a sale occurs, even
though the business may collect payment from the customer in a different
period. The result is that a company’s reported revenue for a particular period
typically differs from the cash it collects from customers during that period.
Revenue Recognition Principle Example
Assume your small business sells a product to a customer for $500 at the end of
the current quarter. Assume you bill the customer and expect her to pay you next
quarter. Under the revenue recognition principle, you would recognize the full
$500 as revenue in your records in the current quarter because the sale occurred
in the current quarter. The timing of the payment in the next quarter does not
affect when you record the revenue.
Matching Principle
Expenses are costs that a business incurs to generate revenue. The matching
principle states that a business must record the expenses it incurs in the same
accounting period as the revenue to which those expenses contribute, even
though a business may pay for those expenses in a different accounting period.
The result is that a company’s reported expenses typically differ from the
amount of cash it paid for expenses in a particular period.
Matching Principle Example
Assume your small business paid $50 last quarter to buy products that you sold
in the current quarter. Under the matching principle, you would recognize the
$50 cost of the products as an expense in the current quarter because that is
when the sale occurred. This matches the expense of the products to the same
period as the revenue the products generated. The timing of when you paid for
the products does not affect when you record the expense.