Financial Statement
Analysis
CHARLES H. GIBSON
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Chapter
2
Introduction to Financial
Statements and Other
Financial Reporting Topics
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Forms of Business Entities
Number of owners
Legally separate from
owners
Owners liable for
business debts
Sole
Proprietorship
Partnership
Corporation
1
2 or more
(partners)
Numerous
(shareholders)
No
No
Yes
Yes
Yes
No
To the
owners
Profits taxable
To the owner
Modified form
“LLC”
limits liability of owner; may
increase income tax
exposure
To the corporation
on earnings;
to the owners on
dividends
“Subchapter S”
profits are taxed
at ownership level
only
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The Financial Statements
• Balance Sheet (Statement of Financial Position)
• Statement of Stockholders’ Equity
(Reconciliation of Stockholders’ Equity
Accounts)
• Income Statement (Statement of Earnings)
• Statement of Cash Flows (Statement of Inflows
and Outflows of Cash)
• Notes
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Balance Sheet
• Shows the financial position of an entity as of a
particular date
– Assets
– Liabilities
– Stockholders’ Equity
• Accounting Equation:
Assets = Liabilities + Stockholders’ Equity
Assets = Liabilities + Capital Stock + Retained Earnings
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Statement of Stockholders’ Equity
• Reconciles beginning and ending balances of
the stockholders’ equity accounts
– Capital Stock
– Retained Earnings, etc.
• Links the balance sheet to the income statement
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Income Statement
• Summarizes revenues and expenses and gains
and losses, for a specified period
• Reports net income
– Excess of revenues over expense
• Net income is included in retained earnings
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Statement of Cash Flows
• Details the inflows and outflows of cash during a
specified period of time—same period as the
income statement
• Three sections
– Cash flows from operating activities
– Cash flows from investing activities
– Cash flows from financing activities
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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
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The Accounting Cycle
• Sequence of accounting procedures completed
during each accounting period
– Recording transactions
– Recording adjusting entries
– Preparing the financial statement
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Recording Transactions
• Transaction is an internal or external event that
causes a change in a company’s assets,
liabilities, or stockholders’ equity
• Recorded in a journal (book of original entry)
• Posted to general ledger
• Double-entry system
– Debit is the left side of an account
– Credit is the right side of an account
Account Title
– Debits = Credits
Debit
Credit
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Accounting System Components
Account
types
Balances
Permanent
• Assets,
Liabilities, and
Stockholders’
Equity
• Carry forward to
the next fiscal
period
• Represented by
the accounting
equation
Temporary
• Revenues, Gains,
Expenses,
Losses, and
Dividends
• Closed to retained
earnings at yearend
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product or service or otherwise on a password-protected website for classroom use.
Exhibit 2-4—Double Entry System
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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 when incurred
– Revenues when earned
• Recorded in the general journal and posted to
the general ledger before financial statements
are prepared
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Preparing the Financial Statements
• The output of the accounting system
• Two statements are prepared directly from the
adjusted accounts
– Income statement
– Balance sheet
• From analysis of general ledger accounts
– Statement of cash flows
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Treadway Commission (National
Commission on Fraudulent Reporting)
• Voluntary private sector organization (1985)
• Committee of Sponsoring Organizations (COSO)
– Released reports detailing internal control systems
• Represent standards for evaluating internal control systems
• Need for internal control emphasized by Section
404 of Sarbanes-Oxley Act
– Independent auditor’s opinion on management’s
assessment of internal control is required
• Management's Report on Internal Control over Financial
Reporting refers to the criteria established by COSO
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Auditor’s Opinion
• Audit is conducted by CPAs
• An auditor’s report is the formal statement of the
auditor’s opinion of the financial statements
– Unqualified opinion
– Qualified opinion
– Disclaimer of opinion
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Unqualified Opinion
• The financial statements present fairly
– The financial position
– Results of operations
– Cash flows
• Financial statements are in conformity with
generally accepted accounting principles
• For the user—highest degree of readability
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Qualified Opinion
• Except for the effects to which the qualification
relates, the financial statements present fairly
– The financial position
– Results of operations
– Cash flows
• Financial statements are in conformity with
generally accepted accounting principles
• For the user—determine the significance of the
exception
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Adverse Opinion
• The financial statements do not present fairly
– The financial position
– Results of operations
– Cash flows
• Financial statements are not in conformity with
generally accepted accounting principles
• For the user—reliability of financial statements
need to be seriously questioned
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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
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Unqualified Auditor’s Opinion
• The typical unqualified (or clean) opinion for
private companies has three paragraphs
• Paragraph #1
– Financial statements have been audited
– Financial statements are responsibility of company’s
management
– Auditors have responsibility to either express or
disclaim an opinion
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Unqualified Auditor’s Opinion—
Continued
• Paragraph #2
– Audit conducted in accordance with the standards of
the Public Company Accounting Oversight Board
(U.S.)
– Confirms whether the audit provided a reasonable
basis for opinion
• Paragraph #3
– Gives an opinion on the statement that they are in
conformity with GAAP
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product or service or otherwise on a password-protected website for classroom use.
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 as provided by
management
– No opinion or any other assurance is given
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product or service or otherwise on a password-protected website for classroom use.
Auditor’s Report on the Firm’s
Internal Controls
•
•
•
•
Required by Sarbanes-Oxley
May be combined with audit opinion report
Exhibit 2-5 – Unqualified opinion
Exhibit 2-6 – Auditor’s report on T.Rowe Price
Group, Inc.’s internal control
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product or service or otherwise on a password-protected website for classroom use.
Management’s Responsibility for
Financial Statements
• Management is responsible for
– The preparation of the financial statements
– The integrity of the financial statements
• Report of management’s responsibility for
financial statements may be included in the
annual report (Exhibit 2-8 – Kellogg Company’s
2010 annual report)
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product or service or otherwise on a password-protected website for classroom use.
The SEC’s Integrated Disclosure
System
• Required filings
– Form10-K—annual filing (audited)-60,75 or 90 days
• Includes financial statements plus
– Information on the business entity
– Market information
– Management discussion and analysis (MDA)
– Disclosure of the domestic and foreign components of
pre-tax income
– Form 10-Q—quarterly filing (unaudited) 40 or 45 days
– Form 8-K 15days
• To report the occurrence of any material events or corporate
changes
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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 reasonable analysis
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product or service or otherwise on a password-protected website for classroom use.
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Ethics
Essential values in interpersonal relationships
•
•
•
•
•
Caring
Honesty
Accountability
Promise keeping
Pursuit of excellence
•
•
•
•
•
Loyalty
Fairness
Integrity
Respect for others
Responsible
citizenship
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product or service or otherwise on a password-protected website for classroom use.
American Accounting Association
Ethical Decision Framework
• Determine the facts—what, who, where, when,
how
• Define the ethical issues
• Identify major principles, rules, and values
• Specify the alternatives
• Compare norms, principles, and values with
alternatives
• Assess the consequences
• Make your decision
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SEC Requirements—Code of
Ethics
• Enacted under Sarbanes-Oxley Act
• Requires disclosure of a company’s code of
ethics
– Applicable to company’s principal officers
• Code is published in the annual report or on the
company’s web site
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Consolidated Statements
• Parent company consolidates with subsidiary
– Report results of operations separately, or
– 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
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product or service or otherwise on a password-protected website for classroom use.
Accounting for Business
Combinations
• Effected through merger or acquisition
• Accounted for using the purchase method
– Record identifiable assets and liabilities acquired at
their fair values
• Excess of purchase price over fair value of net
assets acquired is reported as goodwill
• Income of the acquired firm is considered from
the date of acquisition
• Retained earnings of the acquired firm do not
continue
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.