hap2 fs analysis 1

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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.
Chapter
2
Introduction to Financial
Statements and Other
Financial Reporting Topics

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Forms of Business Entities
Sole
Proprietorship
Partnership Corporation
Number of owners 1
2 or more
(partners)
Numerous
(shareholders)
Legally separate from
owners
No No Yes
Owners liable for
business debts
Yes Yes No
Profits taxable To the owner
To the
owners
To the corporation
on earnings;
to the owners on
dividends
Modified form
“LLC”
limits liability of owner; may
increase income tax
exposure
“Subchapter S”
profits are taxed
at ownership level
only

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• 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
The Financial Statements

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• Shows the financial position of an entity as of a
particular date
– Assets
– Liabilities
– Stockholders’ Equity
• Accounting Equation:
Balance Sheet
Assets = Liabilities + Stockholders’ Equity
Assets = Liabilities +
Capital Stock + Retained Earnings

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• Reconciles beginning and ending balances of
the stockholders’ equity accounts
– Capital Stock
– Retained Earnings, etc.
• Links the balance sheet to the income statement
Statement of Stockholders’ Equity

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• 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
Income Statement

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• 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
Statement of Cash Flows

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• 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
Notes

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• Sequence of accounting procedures completed
during each accounting period
– Recording transactions
– Recording adjusting entries
– Preparing the financial statement
The Accounting Cycle

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• 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
– Debits = Credits
Recording Transactions
Account Title
Debit Credit

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Accounting System Components
Permanent Temporary
Account
types
• Assets,
Liabilities, and
Stockholders’
Equity
• Revenues, Gains,
Expenses,
Losses, and
Dividends
Balances • Carry forward to
the next fiscal
period
• Represented by
the accounting
equation
• Closed to retained
earnings at year-
end

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Exhibit 2-4—Double Entry System

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• 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
Recording Adjusting Entries

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• 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
Preparing the Financial Statements

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• Voluntary private sector organization
• 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
Treadway Commission

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• 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
– Adverse opinion
– Disclaimer of opinion
Auditor’s Opinion

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• 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
Unqualified Opinion

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• 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
Qualified Opinion

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• 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
Adverse Opinion

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• 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
Disclaimer of Opinion

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• 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
Unqualified Auditor’s Opinion

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• 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
Unqualified Auditor’s Opinion—Continued

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• 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
Other Types of Engagements

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• Required by Sarbanes-Oxley
• May be combined with audit opinion report
Auditor’s Report on the Firm’s Internal
Controls

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• 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
Management’s Responsibility for
Financial Statements

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• Required filings
– Form10-K—annual filing (audited)
• 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)
– Form 8-K
• To report the occurrence of any material events or corporate
changes
The SEC’s Integrated Disclosure System

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product or service or otherwise on a password-protected website for classroom use.
• 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
Additional Reporting Venues

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• 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
• Disclosure should be made when benefit of
making disclosure outweighs the cost
The Efficient Market Hypothesis

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Ethics
• Caring
• Honesty
• Accountability
• Promise keeping
• Pursuit of excellence
• Loyalty
• Fairness
• Integrity
• Respect for others
• Responsible
citizenship
Essential values in interpersonal relationships

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• 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
American Accounting Association Ethical
Decision Framework

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• 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
SEC Requirements—Code of Ethics

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• 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 decision-
making ability
Consolidated Statements

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• 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
Accounting for Business Combinations