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 Chapter
2

Introduction to Financial
Statements and Other
Financial Reporting Topics

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

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Statement of Stockholders’ Equity
• Reconciles beginning and ending balances of
the stockholders’ equity accounts
– Capital Stock
– Retained Earnings
• 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

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

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

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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

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The SEC’s Integrated Disclosure System

• 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

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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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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
• Disclosure should be made when benefit of
making disclosure outweighs the cost

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

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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
• 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

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IFRS: Elements of Control for
Consolidation
• IFRS 10
Control

Power over Exposure Ability to

investee to variable influence
(from rights) returns returns

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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
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