McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-1 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. CHAPTER 10 Corporate Governance, Explanatory Notes, and Other Disclosures

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-2 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Significance of Corporate Governance  Business ethics  Social responsibility  Equitable treatment of shareholders  Disclosures and transparency  Board of Directors responsibility L O 1

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-3 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Recent Financial Reporting Misstatements L O 2 Recording revenue too soon Recording bogus revenue Boosting income with one time sales Shifting current expenses to a later or earlier period Failure to record or improperly reducing liabilities Shifting current revenue to a later period Shifting future expenses to the current period as a special charge

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-4 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Explanatory Notes Because of the complexities related to financial reporting and because of the number of alternative generally accepted accounting principles that can be used, explanatory notes are included as an integral part of the financial statements. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-5 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Explanatory Notes Summary of Significant Accounting Policies Typical accounting policies that are disclosed in the notes to the financial statements include: 1.Depreciation method used. 2.Inventory valuation method used. 3.Basis of consolidation of subsidiary information. 4.Reconciliation of taxes paid to tax expense. 5.The cost of employee benefit plans. 6.Treatment of goodwill and intangible assets. 7.Earnings per share information. 8.Stock option and stock purchase plans. L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-6 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Depreciation Method Disclosure of the depreciation method permits informed readers to make comparisons of companies in the same industry. Impact of Income Sum-of-the-Years’- Digits Method Units-of-Production Method Straight-Line Method Declining Balance Method L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-7 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Inventory Valuation The selection of an inventory valuation method may influence the reported income and the inventory amount shown on the balance sheet. Impact on Income Statement and Balance Sheet LIFOLIFOFIFOFIFO Average Cost L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-8 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Basis of Consolidation This disclosure indicates consolidated financial statements include data from substantially all subsidiary companies. Parent Company $ $ Subsidiary Company 1 $ $ Subsidiary Company 2 $ $ Subsidiary Company 3 $ $ L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-9 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Income Taxes A reconciliation of the statutory income tax rate with the effective tax rate. The Internal Revenue Code is the set of rules for preparing tax returns. Financial statement income tax expense. IRS income taxes payable. GAAP is the set of rules for preparing financial statements. Usually... Results in... L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Employee Benefits The cost of employee pension plans included as an expense in the income statement is disclosed. Present value of benefits at present pay levels. Present value of nonvested benefits at present pay levels. Present value of additional benefits related to projected pay increases. Accumulated Benefit Obligation Projected Benefit Obligation Vested Benefit Obligation L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Intangibles Including Goodwill When the balance sheet contains intangible assets including goodwill arising from business acquisitions, the method of recognizing initial cost will be described. Any amortization or impairment in value of the intangibles must be shown. © ©Copyright Patent ® ® Trademark ™ ™ L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved An explanation of the calculation of EPS may include the details of the computation of weighted-average number of common shares outstanding and the adjustments made to net income for preferred stock, options, and convertible securities. Earnings Per Share L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Stock Option and Purchase Plans A stock option plan is designed to encourage management to meet company goals by providing an incentive. The incentive may be measured by the difference between the exercise price per share and the market price per share. Stock purchase plans permit employees to purchase shares of the company’s stock at a slight discount from market value. The plans are designed to help employees become owners of the company. L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Details of Financial Amounts Many financial statement amounts are reported in the aggregate. Note disclosure permits companies to show more details L O 4

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Other Disclosures A change in accounting principle may have a significant impact on reported income. To promote comparability, companies with accounting changes are required to show what income would have been reported if the new principle had been used all the time. This is referred to “proforma income.” L O 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Other Disclosures Mergers and acquisitions are accounted for using purchase accounting. Under this method, net assets are recorded at fair value on the date of acquisition. Any amount paid in excess of fair value is the intangible asset goodwill. L O 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Other Disclosures Typical gain contingencies include: Possible receipts of monies from gifts or donations. Possible refunds from the government in tax disputes. Pending court cases with probable favorable outcome. Typical gain contingencies include: Possible receipts of monies from gifts or donations. Possible refunds from the government in tax disputes. Pending court cases with probable favorable outcome. Typical loss contingencies include: Possible payments resulting from litigation. Possible additional payments resulting from tax disputes. Possible fines or penalties. Typical loss contingencies include: Possible payments resulting from litigation. Possible additional payments resulting from tax disputes. Possible fines or penalties. Contingencies Claims or rights to receive or pay assets whose existence is uncertain but which may become valid eventually. L O 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Subsequent Events Company Year-End 12/31/xxxx 2/19 - Next Year Financial Statements Issued Subsequent Period Some significant events that occur in the subsequent period (next year) may be required to be included in the current year statements, other events may be disclosed in the notes. L O 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Impact of Inflation Reporting the effects of inflation is a controversial and complex area of accounting. If the economy experiences high rates of inflation in the future, efforts to reflect the impact of inflation directly in the financial statements are likely to be renewed. L O 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Segment Information Most large corporations operate in several lines of business and operate in many geographical areas. Segment information should include: 1.Sales to unaffiliated customers, 2.Operating profit, 3.Capital expenditures, 4.Depreciation expense, 5.Identifiable assets. Segment information should include: 1.Sales to unaffiliated customers, 2.Operating profit, 3.Capital expenditures, 4.Depreciation expense, 5.Identifiable assets. L O 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Reporting to the SEC Instead of an annual report, companies that are registered with the SEC file an annual form 10-K. The form 10-K includes most of the information in the company’s annual report and must also comply with additional SEC reporting requirements. L O 6

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Management Statement of Responsibility The company’s management bears ultimate responsibility for the financial statements and notes, not the auditors who express an opinion on the fairness of the presentation of the financial statements. L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Management Discussion and Analysis A corporation is required to include a section called “Management Discussion and Analysis” in its annual report. This section describes the firm’s activities for the year, including comments about its financial condition and results of operations. L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Management Discussion and Analysis (MD&A) MD&A 1.Nature of operations. 2.Economic outlook for the company. 3.Important factors that may influence profitability. 4.Summary of operating results. 1.Nature of operations. 2.Economic outlook for the company. 3.Important factors that may influence profitability. 4.Summary of operating results. L O 8

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Summary of Financial Data Most corporate annual reports contain a 5-year or 10-year summary of key financial data. This information often includes significant ratios and stock market prices of it common stock. L O 9

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Independent Auditors’ Report Standard format contains four paragraphs. Introductory Paragraph – Describes the financial statements audited and states that management is responsible for the financial statements and that the auditor’s task is to express an opinion about the financial statements. 1 1 Scope Paragraph – Describes the nature and extent of the audit process. The auditor wish to obtain reasonable assurance that the financial statements are free from material misstatements. Opinion Paragraph – Auditors express an opinion on the fairness of the financial presentation. Corporations wish to get an unqualified report. L O 10 Internal Control Opinion Paragraph – Auditors make reference to the Internal Control Effectiveness Audit and opinion that accompanies the Auditor’s Report as required by the Public Company Accounting Oversight Board

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Compilation Engagement For companies that are not registered with the SEC and do not have publicly traded securities, accountants may provide a service by compiling financial statements. A compilation is merely the presenting in the form of financial statement information that is prepared by management. A compilation report does not provide any assurance about the fairness of the financial information. For companies that are not registered with the SEC and do not have publicly traded securities, accountants may provide a service by compiling financial statements. A compilation is merely the presenting in the form of financial statement information that is prepared by management. A compilation report does not provide any assurance about the fairness of the financial information.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved End of Chapter 10