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Understanding Financial Statements

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14Part One: Financial Accounting

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• Independent, outside public accountants

• Certified public accountants (CPAs) who meet prescribed professional standards

• Licensed to practice by the state in which they do business

• Their task is to examine financial statements (including notes) and to express an opinion

• Independent, outside public accountants

• Certified public accountants (CPAs) who meet prescribed professional standards

• Licensed to practice by the state in which they do business

• Their task is to examine financial statements (including notes) and to express an opinion

Who are auditor? Slide 14-1

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• It is a paragraph required by the AICPA expressing the results of the auditors’ examination of the financial statements

• Under certain circumstances, additional paragraphs are required

What is the auditors’ opinion? Slide 14-2

In our opinion, such financial statements present fairly, in all material respects, the financial position of X Company as of

December 31, 1998, and 1997, and the results of its operations for each of the three years in the period ended December 31, 1998, in

conformity with generally accepted accounting principles.

Standard Opinion ParagraphStandard Opinion Paragraph

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A lack of consistencyExistence of a major

uncertaintyDoubt as to the entity’s ability

to continue as a going concern

A lack of consistencyExistence of a major

uncertaintyDoubt as to the entity’s ability

to continue as a going concern

Qualified Opinion Slide 14-3

Qualification may occur for any of three reasons:

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Qualified Opinion Slide 14-4

Consistency

A company changed an accounting method from the method used in the

preceding year.

Consistency

A company changed an accounting method from the method used in the

preceding year.

Uncertainty

Auditors are required to call attention to major uncertainties in an additional paragraph following the

opinion paragraph, without making a prediction of the eventual outcome.

Uncertainty

Auditors are required to call attention to major uncertainties in an additional paragraph following the

opinion paragraph, without making a prediction of the eventual outcome.Going-Concern Doubt

Auditors determine if there is substantial doubt about the

company’s ability to continue as a going concern over the next year.

Going-Concern Doubt

Auditors determine if there is substantial doubt about the

company’s ability to continue as a going concern over the next year.

If not If not justified, it is justified, it is a violation of a violation of consistencyconsistency

If not If not justified, it is justified, it is a violation of a violation of consistencyconsistency

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Disclaimer Slide 14-5

I can’t issue an opinion... I’ll

have to issue an disclaimer.

A disclaimer may result because

limitations were placed on the scope

of the audit by management.

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Adverse Opinion Slide 14-6

If the auditors conclude than the financial

statements do not “present fairly” the situation, they write an adverse opinion.

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• Summaries of the accounting policies the company has followed in preparing the statement

• Details on long-term debt• Description of stock option plans• Description of postretirement benefits• Details about the composition of inventories and

depreciable assets• Discussion of major contingencies• Discussion of the company’s financial condition and

results of operations

Notes to Financial Statements Slide 14-7

Typical notes to financial statements provide:

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Revenues from external and intercompany customers

Operating profit or loss Interest expense Identifiable assets, including depreciation expense

on these assets

Revenues from external and intercompany customers

Operating profit or loss Interest expense Identifiable assets, including depreciation expense

on these assets

Segment Reporting Slide 14-8

For each operating segment, the company reports:

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Accounting information should be relevant Accounting information should be

objective The reporting of accounting information

should be feasible

Basic Accounting Criteria Slide 14-9

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Basic Financial Accounting Concepts Slide 14-10

Money Measurement

Accounting records only those facts that can be

expressed in monetary terms.

Money Measurement

Accounting records only those facts that can be

expressed in monetary terms.Entity

Accounts are kept for entities, as distinguished from

the persons who are associated with those entities.

Entity

Accounts are kept for entities, as distinguished from

the persons who are associated with those entities.

Going Concern

Accounting assumes that an entity will continue to operate indefinitely and that it is not

about to be liquidated.

Going Concern

Accounting assumes that an entity will continue to operate indefinitely and that it is not

about to be liquidated.

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Basic Financial Accounting Concepts Slide 14-11

Cost

An asset is ordinarily entered in the accounts at the amount

paid to acquire it.

Cost

An asset is ordinarily entered in the accounts at the amount

paid to acquire it.Dual Aspect

The total amount of assets equals the total amount of

liabilities and owners’ equity.

Dual Aspect

The total amount of assets equals the total amount of

liabilities and owners’ equity.Accounting Period

Accounting measures activities for a specified interval of time,

usually one year.

Accounting Period

Accounting measures activities for a specified interval of time,

usually one year.

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Basic Financial Accounting Concepts Slide 14-12

Conservatism

Revenues are recognized only when they are reasonably

certain, whereas expenses are recognized as soon as they are

reasonably possible.

Conservatism

Revenues are recognized only when they are reasonably

certain, whereas expenses are recognized as soon as they are

reasonably possible.

Realization

The amount recognized as revenue is the amount that is

reasonably certain to be realized, that is, paid by

customers.

Realization

The amount recognized as revenue is the amount that is

reasonably certain to be realized, that is, paid by

customers.

Matching

When a given event affects both revenues and expenses, the effect on each should be recognized in

the same accounting period.

Matching

When a given event affects both revenues and expenses, the effect on each should be recognized in

the same accounting period.

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Basic Financial Accounting Concepts Slide 14-13

Consistency

Once an entity has decided on a certain accounting method,

it should use the same method for all subsequent events of the same character unless it

has a sound reason to change methods.

Consistency

Once an entity has decided on a certain accounting method,

it should use the same method for all subsequent events of the same character unless it

has a sound reason to change methods.

Materiality

Insignificant events may be disregarded, but there must

be full disclosure of all important information.

Materiality

Insignificant events may be disregarded, but there must

be full disclosure of all important information.

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• Requirements imposed by regulatory agencies in certain industries

• The latitude that exists within GAAP

• Judgments and estimates that must be made in applying a given principle

• Requirements imposed by regulatory agencies in certain industries

• The latitude that exists within GAAP

• Judgments and estimates that must be made in applying a given principle

Accounting Alternatives Slide 14-14

Differences in how certain transactions may be recorded result from:

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Accounting Alternatives Slide 14-15

Should allthe diversity in accounting be

permitted?

Should allthe diversity in accounting be

permitted?

A business is a complexorganism, so there has to been some diversity. The

consistency concept preventsdiversity from becoming chaos.

A business is a complexorganism, so there has to been some diversity. The

consistency concept preventsdiversity from becoming chaos.

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• Accounting reports are necessarily monetary

• They are necessarily influenced by estimates of future events

Inherent Limitations Slide 14-16

Accounting has two inherent limitations that

no foreseeable accountingpractice can overcome.

Accounting has two inherent limitations that

no foreseeable accountingpractice can overcome.

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Income Statement Slide 14-17

CLOUD, INC. Income StatementFor the year ended December 31, 1998

Sales $250,000Cost of goods sold 130,000Gross margin 120,000Operating expenses:

Rent $20,000Wages 35,000Utilities 14,000Advertising 6,000Supplies 3,000Depreciation 4,000 Total expenses 82,000

Income for taxes 38,000Income taxes 15,000Net income $23,000

The income statementis the dominant financial

statement.

The income statementis the dominant financial

statement.

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Effect on Income of Alternative Practices Slide 14-18

Cost itemCost item$1,000$1,000

Cost itemCost item$1,000$1,000 ?

Expense (period cost)

Income Statement

Current year

Next year

Future years

$1,000

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Effect on Income of Alternative Practices Slide 14-19

Cost itemCost item$1,000$1,000

Cost itemCost item$1,000$1,000 ?

Product cost

Income Statement

Current year

Next year

Future years

$1,000

$400 $600

Expense (period cost)

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Effect on Income of Alternative Practices Slide 14-20

Cost itemCost item$1,000$1,000

Cost itemCost item$1,000$1,000 ?

Product cost

Capital cost

Income Statement

Current year

Next year

Future years

$1,000

$400 $600

$0 $100 $100 $100

Expense (period cost)

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Monetary assets and liabilities

Unexpired costs Inventories Investments Other liabilities and

owners’ equity

Monetary assets and liabilities

Unexpired costs Inventories Investments Other liabilities and

owners’ equity

Types of Balance Sheet Items Slide 14-21

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Chapter 14

The End