Transparency Master 12-10

INDEPENDENT AUDITORS' REPORT

Unqualified or "Clean" Opinion

1. Introductory Paragraph

a. Lists financial statements audited

b. States management's responsibility for the financial statements

c. States auditors' responsibility is to express an opinion on financial statements

2. Scope Paragraph

a. Audit conducted using generally accepted auditing standards

b. Audit tests provide "reasonable assurance" that financial statements do not include material misstatements

3. Opinion Paragraph

a. Financial statements present fairly, in all material respects, the company's financial position, results of operations, and cash flows.

b. Financial statements conform to generally accepted accounting principles

Transparency Master 12-11

INDEPENDENT AUDITORS' REPORT

Types of Opinions

1. Unqualified or "Clean" Financial statements "present fairly, in all material aspects. . ."

2. Qualified Some aspects of the financial statements do not conform to generally accepted accounting principles

3. Adverse or Negative The financial statements have serious departures from generally accepted accounting principles

4. Disclaimer Auditors unable to reach an opinion on the financial statements

Handout 12 -1

ACCOUNTING CONCEPTS

BUSINESS ENTITY CONCEPT -From an accounting perspective, a business is a separate entity from its owner, Therefore, the financial transactions of a business are maintained separately from those of its owner ,

GOING CONCER.CONCEPT --Unless there is evidence to the contra!)', assume that a business will continue its operations indefinitely ~.hen recording and reporting accounting data,

OBJECTIVITY PRINCIPLE--Accounting entries should be made using objective (verifiable) evidence.

UNIT OF MEASUREMENT CONCEPT -All transactions are recorded in dollars.

ACCOUNTING PERIOD CONCEPT -Managers. owners, and others need periodic reports on the operations and financial condition of a business in order to make informed decisions.

MATCIUNG PRINCIPLE.- To determine a business' profit (net income), you must recognize all revenues earned and all expenses necessary to run the business and earn this revenue, Therefore, expenses are "matched.' against the revenues they generate.

ADEQUATE DISCLOSTRE CONCEPT --Financial statements and the accompanying notes should disclose all the relevant information needed to understand a company's financial condition.

CONSISTENCY CONCEPT --Financial statement users consider changes in a company's earnings and financial position from year to year when judging its success. Therefore, accounting principles used to prepare financial statements should be the same from year to year.

MATERIALITY CONCEPT--Accountants must follow generally accepted accounting principles (GAAP) for all material items reported in a company's financial statements.Immaterial items may be reported using the easiest method available; this method does not have to follow GAAP . An item is material if its omission or misstatement would influence or change the judgments of a reasonable person.

CONSERV A TISM CONCEPT -Accountants strive to ensure that financial statements do not suggest that a company is financially stronger that it really is. Therefore, when choosing between alternative accounting principles, the method that yields the lowest net income or asset value should be chosen.

Transparency Master 1 2-1

FINANCIAL ACCOUNTING FOUNDATION

Financial Accounting

Foundation (FAF)

Independent!nonprofit organization

Appoints members to F ASB and GASB

Raises funds to support FASB and GASB

Financial Accounting Standards Board (FASB)

Govern mental Accounting Standards Board (GASB)

Establishes accounting standards for financial reporting by profit and nonprofit organizations

Establishes accounting standards for state and municipal governments

Transparency Master 12-2

FINANCIAL ACCOUNTING STANDARDS BOARD

Securities and Exchange Commission (SEC)

SEC has authority to regulate accounting practices of publicly traded corporations

SEC has delegated authority for setting accounting standards to FASB

Financial Accounting Standards Board (FASB)

Publicly Traded Corporations

Transparency Master 12-3

FINANCIAL ACCOUNTING STANDARDS BOARD

and

American Institute of Certified Public Accountants (AICP A)

State Boards of Accountancy

Certified Public Accountants

(CPAs)

Companies Requiring Audited Financial Statement

Financial Accounting Standards Board

AICPA and State Boards of Accountancy recognize FASB as the organization with authority to establish GAAP

CPAs practice under the jurisdiction of the AICPA and their state board of accountancy

A business must follow GAAP to receive a "clean" audit report

Transparency Master 12-4

INFLUENTIAL ACCOUNTING ORGANIZATIONS

Financial Accounting Standards Board (FASB)The primary accounting principle-setting body in the United States.

Governmental Accounting Standards Board (GASB)- The organization responsible for setting accounting standards followed by state and municipal governments.

International Accounting Standards Committee (IASC)- The organization working to develop uniform international accounting standards.

Securities and Exchange Commission (SEC)The governmental agency with legal authority to govern companies that issue publicly traded securities. The SEC has delegated its authority to establish accounting principles to the FASB.

(Continued)

Transparency Master 12-5

INFLUENTIAL ACCOUNTING ORGANIZATIONS

(Concluded)

Internal Revenue Service (IRS)-The governmental agency that oversees the laws and regulations for preparing federal tax returns.

American Institute of Certified Public Accountants (AICPA)- The national organization for CPAs.

Institute of Management Accountants (IMA)- The national organization for management accountants and certified management accountants (CMAs).

American Accounting Association (AAA)- The national organization for accounting educators.

NOTE: The AICP A, AAA, and IMA all research and comment on standards proposed by the F ASB.

Transparency Master 12-6

WRITING EXERCISE

Assume that you are a member of the FASB and you have been asked to give your opinion on the following accounting question.

A construction company began work on a $24 million shopping mall during the current year. This mall will take 3 years to build, at a cost of $18 million. At the end of the first year, the mall is one-third complete, and $6 million in costs have been incurred. How much revenue (if any) do you think the construction company should show on its income statement for the first year of work on the mall? State the reasons for your answer.

Transparency Master 12-7

ADEQUATE DISCLOSURE CONCEPT

The following information must be disclosed in the financial statement or the accompanying notes.

1. Accounting Methods Used-State the choice of accounting method when alternatives exist and the selection has a significant effect on financial statements. Examples include the following:

a. Inventory method (LIFO, FIFO, average cost)b. Depreciation method c. Special revenue recognition methods (percentage-of-completion or

installment method)

2. Effect of Change in Accounting Estimates (if material)

3. Contingent Liabilities-Record this information in financial statements if probable and can be reasonably estimated; disclose in footnotes if it cannot be reasonably estimated. Examples include the following:

a. Litigationb. Guarantees ( such as loan guarantees )c. Discounted receivables

(Continued)

Transparency Master 12-8

ADEQUATE DISCLOSURE CONCEPT

( Concluded)

4. Financial Instruments-Cash, accounts receivable, notes receivable, accounts payable, notes payable, bonds payable, and other securities traded in the marketplace are defined as financial instruments. Disclosures should include the following:

a. Fair market value of financial instrumentsb. Unusual risks related to financial instruments c. Unusual credit risks

5. Segment information-Disclose the following information by segment:

a. Revenueb. Income from operationsc. Identifiable assets

6. Events Subsequent to Date of Statements (if material)

Transparency Master 12-9

MATERIALITY CONCEPT

Statement of Financial Accounting Concepts No.2 defines materiality as follows:

The omission or misstatement of an item in a financial report is material if, in light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.

Decide whether or not the following items are material. Be prepared to give your reasons for your answer.

1. An asset purchased last year was not depreciated. Depreciation on that asset should have been $500. The company's net income for the year was $60,000.

2. Early in 1997, before 1996 financial statements are issued, a company discovers that a major customer has unexpectedly filed for bankruptcy.

3. A chain of fast food restaurants discovered an embezzlement scheme used by a few of its employees. The company estimates that $5,000 in cash and food products have been stolen over a 2~year period. The company's yearly net income averages $300,000.

4. A company is being sued by a competitor for patent infringement. If the suit is successful~ the company will have to cease production and sale of the product in question. Sales of this product represent $25;000 out of total sales of $500,000.