1 THE FINANCIAL REPORTING SYSTEM Understanding the conceptual bases of the financial reporting system and the preparation of the financial statements is an essential prerequisite to financial analysis Remember: Financial Statements are issued by corporate management--not by the auditors or government agency. Management selects accounting methods, compiles the data, and prepares the financial statements.

22 THE FINANCIAL REPORTING SYSTEM The accounting process or financial reporting system, which generates financial information for external users encompasses four financial statements: Balance Sheet –Statement of Financial Position Income Statement –The Profit and Loss Statement (P&L Statement) –The Operating Statement (Statement of Earnings)

3 THE FINANCIAL REPORTING SYSTEM The accounting process or financial reporting system, which generates financial information for external users encompasses four financial statements: Statement of Shareholders’ Equity Statement of Cash Flow

4 THE FINANCIAL REPORTING SYSTEM Augmented with footnotes (further describing the financial statements) and supplemental data, which are all interrelated, collectively--the financial statements should provide: Relevant Reliable timely Information essential to making investment, credit, and similar decisions, thus meeting the objectives of financial reporting.

5 General Principles and Measurement Rules Financial statements provide information on company’s: Assets (resources) Liabilities (obligations) Stockholders’ equity Balance Sheet Revenue (Sales) Expenses Gains and Losses Income Statements

6 General Principles and Measurement Rules Financial statements provide information on company’s: Report on capital transactions with owners Statement of Shareholders’ Equity Operating, investing, and financing inflows and outflows Statement of Cash Flow

7 General Principles and Measurement Rules The financial reporting system is based on data generated from accounting events and selected economic event: Recognizing events/transactions that meet certain criteria. Exchange transactions--exchange cash or another assets for a different assets, or to create a liability, or settle a liability

8 General Principles and Measurement Rules The financial reporting system is based on data generated from accounting events and selected economic event: Recognizing events/transactions that meet certain criteria. Exchange transactions--exchange cash or another assets for a different assets, or to create a liability, or settle a liability Passage of time--ie, depreciation of an asset, accrual interest, use of service

9 General Principles and Measurement Rules The financial reporting system is based on data generated from accounting events and selected economic event: Note: Exchange transactions is not necessarily recognized as revenue or expense. Important: Under accrual accounting, revenues are recognized when goods are delivered and services are performed. Expenses are recorded when services are used.

10 General Principles and Measurement Rules The financial reporting system is based on data generated from accounting events and selected economic event: The Matching Principle--accrual accounting rests on the principle that revenues and expenses are measured only if the related revenues and cost are accounted in the same period

11 General Principles and Measurement Rules The Matching Principle--accrual accounting rests on the principle that revenues and expenses are measured only if the related revenues and cost are accounted in the same period Example: Bought 100 apples for $20.00 September 30th Sold 100 apples for $30.00 October 1st Sales Cost of Sales Profit $ $10.00 Both revenue and expense recognized

12 THE U.S. FINANCIAL REPORTING SYSTEM Publicly traded companies are governed by the U.S. Securities and Exchange Commission (SEC), a government agency Much of the accounting principles used have been delegated to the Financial Accounting Standards Board (FASB), a non-governmental organization

13 THE U.S. FINANCIAL REPORTING SYSTEM Publicly traded companies are mandated to report their financial results to the SEC. Such reports include: --10-K Annual Report (Required to be audited by an independent accounting firm)--due 3-months after fiscal year --8-K Quarterly Report (Does not require audited financial data-due 45 days after end of quarter --8-K Current Report (Reports significant changes in the company)-due 15 days after event

14 The Financial Accountings Standards Board (FASB) Non-government body with seven members Not all FASB members are accountants No FASB members have ties to their former employer All FASB pronouncements are considered authoritative New pronouncements are called Statement of Financial Accounting Standards (SFAS) Prior to FASB The American Institute of Certified Public Accountants Issued Accounting Principle Board (APB) statements

15 The Financial Accountings Standards Board (FASB) Recently FASB pronouncements have been moving closer to pronouncements issued by the International Accounting Standards Committee (IASC)

16 FASB Conceptual Framework U.S. GAAP is developed on the FASB Conceptual Framework It is an important building block in understanding the information provided by financial statements. FASB Statements and Interpretation APB Opinions AICPA accounting research bulletin Highest Level of Authority All Develop using the FASB Conceptual Framework

FASB Concept Framework Decision Makers and Their Characteristics Predictive Value Predictive Value Feedback Value Feedback Value Timeliness Verifiability Benefits > Cost Understandability Decision Usefulness Representational Faithfulness Representational Faithfulness Neutrality Reliability Relevance Comparability (Including Consistency) Comparability (Including Consistency) Materiality Users of Accounting Information Pervasive Constraints User-Specific Qualities Primary Decision-Specific Qualities Ingredients of Primary Qualities Secondary and Interactive Qualities Thresholds for Recognition A Hierarchy of Accounting Qualities FASB Concept Statement No. 2, Copyright by FASB, Norwalk, CT

FASB Concept Framework Decision Makers and Their Characteristics Predictive Value Predictive Value Feedback Value Feedback Value Timeliness Verifiability Benefits > Cost Understandability Decision Usefulness Representational Faithfulness Representational Faithfulness Neutrality Reliability Relevance Comparability (Including Consistency) Comparability (Including Consistency) Materiality Users of Accounting Information Pervasive Constraints User-Specific Qualities Primary Decision-Specific Qualities Ingredients of Primary Qualities Secondary and Interactive Qualities Thresholds for Recognition A Hierarchy of Accounting Qualities FASB Concept Statement No. 2, Copyright by FASB, Norwalk, CT The capacity of information to make a difference in a decision.

FASB Concept Framework Decision Makers and Their Characteristics Predictive Value Predictive Value Feedback Value Feedback Value Timeliness Verifiability Benefits > Cost Understandability Decision Usefulness Representational Faithfulness Representational Faithfulness Neutrality Reliability Relevance Comparability (Including Consistency) Comparability (Including Consistency) Materiality Users of Accounting Information Pervasive Constraints User-Specific Qualities Primary Decision-Specific Qualities Ingredients of Primary Qualities Secondary and Interactive Qualities Thresholds for Recognition A Hierarchy of Accounting Qualities FASB Concept Statement No. 2, Copyright by FASB, Norwalk, CT Concerned with whether financial data have been measured accurately and whether they are what they report.

FASB Concept Framework Decision Makers and Their Characteristics Predictive Value Predictive Value Feedback Value Feedback Value Timeliness Verifiability Benefits > Cost Understandability Decision Usefulness Representational Faithfulness Representational Faithfulness Neutrality Reliability Relevance Comparability (Including Consistency) Comparability (Including Consistency) Materiality Users of Accounting Information Pervasive Constraints User-Specific Qualities Primary Decision-Specific Qualities Ingredients of Primary Qualities Secondary and Interactive Qualities Thresholds for Recognition A Hierarchy of Accounting Qualities FASB Concept Statement No. 2, Copyright by FASB, Norwalk, CT Whether financial data are biased