Financial Statements and Reporting Topics PDF - Guimaras State University

**MODULE 2** **INTRODUCTION TO FINANCIAL STATEMENTS AND OTHER FINANCIAL REPORTING TOPICS**. **Learning Outcomes:** - Describes the forms of business entities and introduces financial reports. - Reviews the sequence of accounting procedures completed during each accounting period. -...

**MODULE 2** **INTRODUCTION TO FINANCIAL STATEMENTS AND OTHER FINANCIAL REPORTING TOPICS**. **Learning Outcomes:** - Describes the forms of business entities and introduces financial reports. - Reviews the sequence of accounting procedures completed during each accounting period. - Learns the efficient market hypothesis, ethics, harmonization of international accounting standards, consolidated statements, and accounting for business combinations. **Forms of Business Entities** 1. Sole proprietorship - a business owned by one person, is not a legal entity separate from its owner, but the accountant treats the business as a separate accounting entity. The profit or loss of the proprietorship goes on the income tax return of the owner. The owner is responsible for the debts of the sole proprietorship. 2. Partnership - is a business owned by two or more individuals. Each owner, called a partner, is personally responsible for the debts of the partnership. The accountant treats the partners and the business as separate accounting entities. The profit or loss of the partnership goes on the individual income tax return of the partners. 3. Corporation - is a legal entity incorporated in a particular state. Ownership is evidenced by shares of stock. A corporation is considered to be separate and distinct from the stockholders. The stockholders risk only their investment; they are not responsible for the debts of the corporation. Since a corporation is a legal entity, the profits or losses are treated as a separate entity on an income tax return. The owners are not taxed until profits are distributed to the owners (dividends). 1. Recording Transactions 2. Recording Adjusting Entries 3. Preparing The Financial Statements **RECORDING TRANSACTIONS** A **transaction** is an event that causes a change in a company's assets, liabilities, or stockholders' equity, thus changing the company's financial position. Transactions may be external or internal to the company. External transactions involve outside parties, while internal transactions are confined within the company. For example, sales is an external transaction, while the use of equipment is internal. Transactions must be recorded in a **journal (book of original entry)**. All transactions could be recorded in the general journal. However, companies use a number of special journals to record most transactions. The special journals are designed to improve record-keeping efficiency that could not be obtained by using only the general journal. The general journal is then used only to record transactions for which the company does not have a special journal. A transaction recorded in a journal is referred to as **a journal entry.** All transactions are recorded in a journal (journal entry) and are later posted from the journals to a **general ledger** (group of accounts for a company). After posting, the general ledger accounts contain the same information as the journals, but the information has been summarized by account. Asset, liability, and stockholders' equity accounts are referred to as **permanent accounts** because the balances in these accounts carry forward to the next accounting period. Balances in revenue, expense, gain, loss, and dividend accounts, described as **temporary accounts**, are closed to retained earnings and not carried into the next period. **RECORDING ADJUSTING ENTRIES** Earlier, a distinction was made between the accrual basis of accounting and the cash basis. It was indicated that the accrual basis requires that revenue be recognized when realized (realization concept) and expenses recognized when incurred (matching concept). The point of cash receipt for revenue and cash disbursement for expenses is not important under the accrual basis when determining income. Usually, a company must use the accrual basis to achieve a reasonable result for the balance sheet and the income statement. The accrual basis needs numerous adjustments to account balances at the end of the accounting period. For example, \$1,000 paid for insurance on October 1 for a one-year period (October 1--September 30) could have been recorded as a debit to Insurance Expense (\$1,000) and a credit to Cash (\$1,000). If this company prepares financial statements on December 31, it would be necessary to adjust Insurance Expense because not all of the insurance expense should be recognized in the three-month period October 1--December 31. The adjustment would debit Prepaid Insurance, an asset account, for \$750 and credit Insurance Expense for \$750. Thus, insurance expense would be presented on the income statement for this period as \$250, and an asset, prepaid insurance, would be presented on the balance sheet as \$750. **PREPARING THE FINANCIAL STATEMENTS** The accountant uses the accounts after the adjustments have been made to prepare the financial statements. These statements represent the output of the accounting system. Two of the principal financial statements, the income statement and the balance sheet, can be prepared directly from the adjusted accounts. Preparation of the statement of cash flows requires further analysis of the accounts. **AUDITOR'S OPINION** An **auditor** (certified public accountant) conducts an independent examination of the accounting information presented by the business and issues a report thereon. An auditor's report is the formal statement of the auditor's opinion of the financial statements after conducting an audit. Audit opinions are classified as follows: 1. **Unqualified opinion**. This opinion states that the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity, in conformity with generally accepted accounting principles. 2. **Qualified opinion**. A qualified opinion states that, except for the effects of the matter(s) to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity, in conformity with generally accepted accounting principles. 3. **Adverse opinion**. This opinion states that the financial statements do not present fairly the financial position, results of operations, and cash flows of the entity, in conformity with generally accepted accounting principle. 4. **Disclaimer of opinion**. A disclaimer of opinion states that the auditor does not express an opinion on the financial statements. A disclaimer of opinion is rendered when the auditor has not performed an audit sufficient in scope to form an opinion. Since the passage of Sarbanes-Oxley, the form of the audit opinion can vary substantially. Private companies are not under Sarbanes-Oxley, but an increasing number of private companies are complying with parts of the law. Some of the reasons for private companies to follow the law are the following: 1. Owners hope to sell the company or take it public. 2. Directors who sit on public-company boards see the law's benefits. 3. Executives believe strong internal controls will improve efficiency. 4. Customers require strong internal controls. 5. Lenders are more likely to approve loans. A **review** consists principally of inquiries made to company personnel and analytical procedures applied to financial data. It has substantially less scope than an examination in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, the accountant does not express an opinion. The accountant's report will indicate that the accountants are not aware of any material modifications that should be made to the financial statements in order for them to be in conformity with GAAP; or the report will indicate departures from GAAP. A departure from GAAP may result from using one or more accounting principles without reasonable justification, the omission of necessary note disclosures, or the omission of the statement of cash flows. When the outside accountant presents only financial information as provided by management, he or she is said to have **compiled** the financial statements. The compilation report states that the accountant has not audited or reviewed the financial statements. Therefore, the accountant does not express an opinion or any other form of assurance about them. If an accountant performs a compilation and becomes aware of deficiencies in the statements, then the accountant's report characterizes the deficiencies as follows: - Omission of substantially all disclosures - Omission of statement of cash flows - Accounting principles not generally accepted **REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING** Under Sarbanes-Oxley, management of public companies must present a Report of Management on Internal Control over Financial Reporting. Exhibit 2-7 presents the internal control report of management for T. Rowe Price Group, Inc., that was presented with its 2006 annual report. **Management's Responsibility for Financial Statements** The responsibility for the preparation and for the integrity of financial statements rests with management. The auditor is responsible for conducting an independent examination of the statements and expressing an opinion on the financial statements based on the audit. To make financial statement users aware of management's responsibility, some companies have presented management statements to shareholders as part of the annual report. Exhibit 2-8 shows an example of a report of management's responsibility for financial statements as presented by Kellogg Company in its 2006 annual report. **PROXY** The **proxy**, the solicitation sent to stockholders for the election of directors and for the approval of other corporation actions, represents the shareholder authorization regarding the casting of that shareholder's vote. The proxy contains notice of the annual meeting, beneficial ownership (name, address, and share ownership data of shareholders holding more than 5% of outstanding shares), board of directors, standing committees, compensation of directors, compensation of executive officers, employee benefit plans, certain transactions with officers and directors, relationship with independent accountants, and other business. **Summary Annual Report** A reporting option available to public companies is to issue a **summary annual report**. A summary annual report, a condensed report, omits much of the financial information typically included in an annual report. A typical full annual report has more financial pages than nonfinancial pages. A summary annual report generally has more nonfinancial pages. When a company issues a summary annual report, the proxy materials it sends to shareholders must include a set of fully audited statements and other required financial disclosures. **ETHICS** "Ethics and morals are synonymous. While ethics is derived from Greek, morals is derived from Latin. They are interchangeable terms referring to ideals of character and conduct. These ideals, in the form of codes of conduct, furnish criteria for distinguishing between right and wrong."4 Ethics has been a subject of investigation for hundreds of years. Individuals in financial positions must be able to recognize ethical issues and resolve them in an appropriate manner. Ten essential values can be considered central to relations between people. 1. Caring 2. Honesty 3. Accountability 4. Promise keeping 5. Pursuit of excellence 6. Loyalty 7. Fairness 8. Integrity 9. Respect for others 10. Responsible citizenship **Harmonization of International Accounting Standards** The impetus for changes in accounting practice has come from the needs of the business community and governments. With the expansion of international business and global capital markets, the business community and governments have shown an increased interest in the harmonization of international accounting standards. Suggested problems caused by the lack of harmonization of international accounting standards include the following: 1. A need for employment of key personnel in multinational companies to bridge the "gap" in accounting requirements between countries. 2. Difficulties in reconciling local standards for access to other capital markets. 3. Difficulties in accessing capital markets for companies from less-developed countries. 4. Negative effect on the international trade of accounting practice and services. The FASB and IASB also agreed on major joint topics. Those topics are as follows: 1. Business combinations 2. Consolidations 3. Fair value measurement guidance 4. Liabilities and equity distinctions 5. Performance reporting 6. Postretirement benefits 7. Revenue recognition 8. Derecognition 9. Financial instruments **CONSOLIDATED STATEMENTS** Financial statements of legally separate entities may be issued to show financial position, income, and cash flow as they would appear if the companies were a single entity (consolidated). Such statements reflect an economic, rather than a legal, concept of the entity. For consolidated statements, all transactions between the entities being consolidated---intercompany transactions---must be eliminated. **Consolidated statements** are financial statements that a parent company produces when its financial statements and those of a subsidiary are added together. This portrays the resulting financial statements as a single company. The parent company concept emphasizes the interests of the controlling shareholders (the parent's shareholders). A subsidiary is a company controlled by another company. An unconsolidated subsidiary is accounted for as an investment on the parent's balance sheet. **ACCOUNTING BUSINESS COMBINATIONS** The combination of business entities by merger or acquisition is very frequent. There are many possible reasons for this external business expansion, including achieving economies of scale and savings of time in entering a new market. The combination must be accounted for using **the purchase method.** The purchase method views the business combination as the acquisition of one entity by another. The firm doing the acquiring records the identifiable assets and liabilities at fair value at the date of acquisition. The difference between the fair value of the identifiable assets and liabilities and the amount paid is recorded as goodwill (an asset). With a purchase, the acquiring firm picks up the income of the acquired firm from the date of acquisition. Retained earnings of the acquired firm do not continue.