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Chapter 2

Introduction to
Financial Statements and
Other Financial
Reporting Topics
Income Statement

• Covers a period of time Income Statement


Revenue $ 120,000
• Summarizes revenues Expenses (100,000)
and expenses Net Income $ 20,000
• Reports net income
– Excess of revenues
over expense
• Net income increases
retained earnings (B/S)
• Net Loss will decrease
retained earnings (B/S)
Statement of Owners’ Equity

• Covers a specific Income Statement


period of time Revenue $ 120,000
Expenses (100,000)
• Reconciles Net Income $ 20,000
beginning and
ending balances of Statement of Owners' Equity
Capt. Stk. Ret. Earn.
the owners' equity Beginning Balance $20,000 $ 5,000
accounts Net income 20,000
– Capital Stock Dividends (10,000)
– Retained Earnings Ending Balance $20,000 $ 15,000
– Etc.
• Links the income
statement and the
balance sheet
Balance Sheet
Income Statement
Shows the financial condition Revenue $ 120,000
of an entity as of a particular Expenses (100,000)
date Net Income $ 20,000
– Assets: the resources of Statement of Owners' Equity
the business Capt. Stk. Ret. Earn.
– Liabilities: the debts of Beginning Balance $20,000 $ 5,000
the business Net income 20,000
– Equity: the owners’ Dividends (10,000)
interest in the business Ending Balance $20,000 $ 15,000
The Accounting Equation: Balance Sheet
Assets = Liabilities + Assets $110,000
Owners’ Equity Liabilities 25,000
Owners' Equity
Capital Stock 50,000
Retained Earnings 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
• Buying and selling assets
– Cash flows from financing activities
• Financing cash from banks and dividends
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
The Accounting Cycle

1. Recording transactions
2. Recording adjusting entries
3. Preparing the financial statement
Recording Transactions

• Internal or external event that causes a


change in a company’s assets, liabilities, or
owners' equity
• Recorded in a journal (journal entry)
• Posted to general ledger accounts
• Double-entry system
 Debit: left side of an account Account Title
 Credit: right side of an account
Debit Credit
 Debits = Credits
Effects of Debits and Credits on Accounts

• Assets & Expenses


– Normally have debit balances
– Debits increase account balance
– Credits decrease account balance
• Liabilities, Revenue, & Owners’ Equity
– Normally have credit balances
– Credits increase account balance
– Debits decrease account balance
Accounting System Components

Permanent Temporary
Account Assets Revenues, Gains
types Liabilities Expenses, Losses
Equity Dividends
Balances Carry forward to Closed to retained
the next fiscal earnings at year-end
period
Start with $0 balance
in the next period
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
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
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
Qualified Opinion

• Except for the matter to which the exception


relates
• The financial statements present fairly
– The financial position
– Results of operations
– Cash flows
• For the user: determine the significance of
the exception
Adverse Opinion

• The financial statements do not present


fairly
– The financial position
– Results of operations
– Cash flows
• For the user: reliability of financial statements
need to be seriously questioned
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
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
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
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
Auditor’s Report on Internal Control

• Required by Sarbanes-Oxley
• May be combined with audit opinion report
• Paragraphs
1. Scope
2. Responsibility and procedures
3. Opinion
4. Reference to financial statement audit
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
The SEC’s Integrated Disclosure System
Required filings
– 10-K: annual filing (audited) (Due within three Months)
• Includes financial statements plus
– Information on the business entity
– Market information (high and low sales price, frequency and amount of dividends,
and number of shares.)
– Management discussion and analysis
– Directors, executive officers, and their compensation
– Related party transactions
– 10-Q: quarterly filing (unaudited)
– 8-K: “current report” ( Due within !5 days of event)
• To report the occurrence of any material events or corporate
changes(changes in principal stockholders, changes in auditors, acquisitions and
divestitures, bankruptcy, and resignation of directors.)
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
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
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 decision-
making ability
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

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