Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Understanding Financial Statements © The McGraw-Hill Companies, Inc., Part One: Financial Accounting

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 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 Paragraph

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999  A lack of consistency  Existence of a major uncertainty  Doubt as to the entity’s ability to continue as a going concern  A lack of consistency  Existence of a major uncertainty  Doubt 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:

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 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 justified, it is a violation of consistency

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 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.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Adverse Opinion Slide 14-6 If the auditors conclude than the financial statements do not “present fairly” the situation, they write an adverse opinion.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 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 :

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 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:

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999  Accounting information should be relevant  Accounting information should be objective  The reporting of accounting information should be feasible Basic Accounting Criteria Slide 14-9

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Basic Financial Accounting Concepts Slide 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.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Basic Financial Accounting Concepts Slide 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.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Basic Financial Accounting Concepts Slide 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.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Basic Financial Accounting Concepts Slide 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.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 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 Differences in how certain transactions may be recorded result from:

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Accounting Alternatives Slide Should all the diversity in accounting be permitted? Should all the diversity in accounting be permitted? A business is a complex organism, so there has to been some diversity. The consistency concept prevents diversity from becoming chaos. A business is a complex organism, so there has to been some diversity. The consistency concept prevents diversity from becoming chaos.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Accounting reports are necessarily monetary They are necessarily influenced by estimates of future events Inherent Limitations Slide Accounting has two inherent limitations that no foreseeable accounting practice can overcome. Accounting has two inherent limitations that no foreseeable accounting practice can overcome.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Income Statement Slide CLOUD, INC. Income Statement For the year ended December 31, 1998 Sales$250,000 Cost of goods sold130,000 Gross margin120,000 Operating expenses: Rent$20,000 Wages35,000 Utilities14,000 Advertising6,000 Supplies3,000 Depreciation 4,000 Total expenses 82,000 Income for taxes38,000 Income taxes 15,000 Net income$23,000 The income statement is the dominant financial statement. The income statement is the dominant financial statement.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Effect on Income of Alternative Practices Slide Cost item $1,000 $1,000 ? Expense (period cost) Income Statement Current year Next year Future years $1,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Effect on Income of Alternative Practices Slide Cost item $1,000 $1,000 ? Product cost Income Statement Current year Next year Future years $1,000 $400 $600 Expense (period cost)

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Effect on Income of Alternative Practices Slide Cost 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)

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999  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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Chapter 14 The End