Gibson, C. ( 2001 ) . Introduction to financial statements and other financial reporting topic.

En Financial reporting
and analysis:using financial accounting information (pp.37-75)(643p.)(8a ed). Ohio : South-Western College. (C24058)

INTRDDUCTIDN TO
FINANCIAL STATEMENTS
ANO DTHER FINANCIAL
REPORTING TDPICS

THIS CHAPTER lNTRODUCES FINANCI.'\L S'IXl'E-
ments. Subsequent chapters present a det::úled
review of the principal financial statements.
Chapter 3 covers the bala.nce sheet, Chapter 4
covers the income statement, and Chapter 10
covers the statement of cash flows.
Tbis chapter · also reviews the forms of
business enciti.es, and the sequence of account-
ing proCedures (cilled the accounring cycle).
Other financial reporting topics included in
this chapter tb.at contribute to the undemand-
ing of financial reporting are: the audñ:or's
repon, mamgement's responsibility far finan-
cia! statements, the SEC's integrated disclosure
system, the sumwry =ual report, ethics,
international accounting standards, consoli-
dated statements, and accounting for business
combinations.
38 CHAPTER 2 Introducrion to Fin:mciaI Statements and Other FinancUI Repon:ing Topics CHAPTER 2
Introduction to Fmanchl Smtements and Other FID.<Ulcial Reporting To pies

F°ORMS OF' A business entity may be asole proprietorship, a partnership, or :1 corpora.tion. A so le

AllC COMPANY THE INTERRELATIONSHIP OF
8USINESS proprietorship, a business owned by one person, is nota legal en:city separ:i:ce from its owner, FINANCIAL STATEME!'<iS
ENT1T1ES
but the accounr.ant treats tb.e business as a separate accounting encity. Tb.e profit or loss of
the proprietorship goes on the income t:lX retum of the owner. The owner is responsiOle for &lance Sheet Statement of C:ish E1ows for the B:Uance Sheet
the debts of the sole propriewrship. December 31, 2000 Ye::arEnded DecCJDher 31, 2001
In the United St:ates, a sole proprietorship may qualify to be treated as a lim.ited lia.b:il- December 31, 2001
ity company (LLC). Asan LLC, tb.e owner may limit the liability of tb.e sale proprietor, but As>etS Cash tlows from
e,,¡, ÁSSets
may incre:ise tb.e ta."X exposure of tb.e proprietorship. $25,000 oper:i.ting activities:
Reccivables C.h $40,000
A partnership is a busiD.ess owned by two or more individuals. Each owner, called a 20,000 Netlncome $20,000
Inventory Reccivables 20,000
30,000 + Decrease in inventory 10,000
partner, is persooo:llyresponsible for the debts of the parmersh.ip. The accountant treats the Lmd lnv<n'°'J' 20,000
10,000 - Dec:re:tse in. accounts Lmd
partners and the business as separa.te accounring entiries. The profit or loss of the partner-
º'""'= 10,000 pay:ible 20,000

-
(5,000) Othor=ts 10,000
sbip goes on tbe individual income t:lX retu:rn of tbe partners. Llke a proprietorship, a Total

-
:issers $95,000 Net cas.h flow from Tot:il :issers $110.000
pmnersbip may qualify to be treated as an LLC As an LLC, the owners may limit the operating activities (25,000)
liability of the p:umers, but ro.ay increase tb.e taX e:cposure of tb.e p:trmership. Ll:Wilities
Liabllities
In the United St:ates, a business cocporation is a legal entity incorpor::i.ted in a panic- Accounts pay:ilile $25,000 Cash tl.ow from
AcCOUD.tS payable $20,000
Wages pay:ible
ular St:lte. Ownersbip is evidenced by shares of stock. ~A.. corpor::rtion is considered to be ~ investing act:i.vities:
sep:irate and distinct from the stock:holders. The stockholders risk only tb.eir investment;
tb.ey are not responsible for tb.e debts of tb.e corpor.i.tioo.
Since a corporarion is a legal encity, the profu:s or losses are treated as a separa.te entity
Tot:il li:i.bilities

Stockholders' equity
Capital stock
-
$30,000

$40,000
- Increa.se in Iand
Net cash flow from
iuvesting activiries
(10,000)

(10,000)
Wages pay.tble
Total liabilities

Stoekholders' equity
----1,QQQ

-$25.000

on an in.come taX retUrD.. The owners are not tu.-ed until profits are clistributed to the owners Ret:ained earni:ngs C:tsb. flow from Capital stOCk $50,000
25.000
(dividends). In the United States, some corpor::itions qualify to be treated as a subcha.pter S
Corpontion. These corporations do not paya corpor:J.te in.come tlX. The profits or losses
go directly on the income w.:: returns of the owners.
Tot:U stockhol_ders' equity
Total li:i.bilities and
stockholders' equity
--
S65.óOO fio..ancing acdvities;
+ Capital srock
-Dividends
10,000
(10,000)
Retained earn.in.gs

Tot:il liabilities and -

~
Total stockb.olders' equity $85,000

-
$95.000
In the Uoited Sci.tes, most businesses operate as proprietorships, but corporations Net cish flow from stockholders' equity $110.000
perform the bulk of business acti:vity. Since tb.e bul.k of business activity. is cm:ied on in firut:ncing activities -0-
corpora:tions and beca.use much of financia! accounting is concerned with reporting to tb.e
public, this book focuses on the corponi.te form ofbusiness. Netincrease in cash $15,000
Accounting for corporations, sole proprietorships, and parmersltips is tbe same, except Cash at beginning of ye:tr ~
Cash at end of year
fer tbe o>VD.ers' equity section of tbe balance sheet. The owners' equity section fer a sole ~
proprietership consists of the owner's capital account, wbíle the o-.vners' equity section fer
a parmexship has a capital account for e:i.ch part:o.er. The more complicated o-.vners' equity Income Statero.ent for the Year
secrion for a corporation will be described in detlll in this book. Ended December 31, 2001

Reveo.ues $120,000
-E.'<P"'= (100,000)
THE F'lNANCIAL
5TATEMENTS
The principal firumcial statements of a corporation are the balance sheet, income srate-
ment, and statement of cash flows. Foom.otes (notes) accompany these D.nancial sratements.
To ev:tluate the fina.ncW condition, the profitability, and cash flows of an entity, the user
-Netlncome
-$20.000

Statement: ofRet:ained Earnin.gs for

the Year Ended Decem.ber 31, 2001
needs to undet:5t:llld the statements and rehted notes.
E."Chibit 2-1 illustr:ltes the interrelationship of the balance sheet, income sratement, and ¡ Begimring balance $25,000
statement of cash fiows. The most basic statement is the balánce sheet. The other srate- ·---+Net!ncome 20,000
ments exphin the changes benveen tw"O balánce sheet dates. -Dividends MOOO)
Ending balance
~
Balance Sheet (Statement ofFina:ncial Position)
A balance sheet shows the financia! condition of an accounting entity as of a particular
date. The balance sheet consists of three major secri.ons: assets, the resources of the firm; . At any point ~time, the total 3SSetS amount must equal the total amount of the contri-
li:ibilities, the debts of the firrn; and stocl:holders' equity, the owners' interest in the firm. bunons of the creditors :md owners. This is cxpressed in the accounting equation:
Assets =Liabilities + Stockholders' Equity
40 Introducrion to Fin:mci:tl St:atements and Otb.er Fin:tncial Reporting Topics
In simplistic forro, the stockholders' equity of a corporation appears as follo'WS:
Stockholders' Equity
Common Stock $200,000
Ret:ained e:i:rnings 50,000
$250,000
Th.is indic:ites that stockholders contributed (mvested) $200,000, and prior eamings
less prior dividends have been retained in the entity in tb.e net amount of $50,000 (ret:i:ined
e=ing,;).
Statement of Stockholders' Equity (Reconciliarion of Stockholders'
Equity Accounts)
Fmns are required to present reconcili'1tions of the beginning and encüng balances of
their stockholders' equity accounts. 1bis is accomplished by presenting a "statement of
stockholders' equity." Remined earnings is one of the accounts in stockholders' equity.
Retained eamings links the babnce sheet to the income statement. Retained earnings
is increased by net income and decreased by net losses and dividends paid to stockholders.
There are some other possible increases or decreases to retained e:rrnings besides income
Oosse.s) and dividends. For the purposes of this cliapter, retained earnings will be described
as prior ea:rnings less prior dMdends.
Fmns usu:illy present the reconciliation of ret:ri.ned earnings within a "statement of
stockholders' equity." Some firms present the reconciliation of retai.ned e:amings at the
bottom of tbe íncome st:i.tement (combined income st:ltement and retained e:mllngs). In
tbis case, tbe other stockholders' equity accounts may be reconciled in a statement tbat
e.."Ccludes retained e:i.rnings.•A..n additional review of the smtement of stockholders' equity is
in Chapter 3.
Income Statement (Statement ofEa:rnings)
The income st:atement summ.arizes revenues :llld e:<penses and g:Uns and losses,
ending with net income. lt surru:narizes the results of oper:i.tions for a panicular period of
time. Net income is included in retained earn:in.gs in tbe stoc:kholders' equity section of tbe
balance sheet. (This is necessary for the balance sheet to balance.)
Statement of Cash Flows (Statement oflnflows and Outflows of Cash)
The st:ltement of cash flows details tbe inflows and outllows of cash during a speci-
fied period of time--the same period that is used for tbe income statement. The st:ltement
of c:ish flows consists of tbree sections: cash flows from oper:i.ting activities, C$li fl.ows from
investing accivities, and c:ish flows from financing activities.
Foomotes (Notes)
The foomotes to tb.e financia! smtements are used to present additional information
about items included in tb.e financial smtements and to present additional financia! in:for-
mation. Foomotes :ire an integral part of financial smtements. A detailed review of foomotes
is essential to underswlding the :financi:tl SCJ.tements.
Cert:rin information must be presented in foomotes. Accounting policies are to be
disclosed :lS the first note or be d.isclosed in a separate summary of signific:m.t accounting
C:HAPTER 2
Introduction to Financia! Statements and Other Financia! Reporting Tapies 41
policies (preceding tb.e fust note). Accounting policies in.elude such items as tb.e metbod of
inventocyvaluation and depreciation policies. Other information specific:illy requiring foot-
note disclosure is the existence of contingent liabilities and some subsequent events.
CO'lftingmt liabi!it:ies are dependent upon the occurrence or nonoccurrence of one or
more·future events to con.fu:m the liability. The settlement oflitigation or che ruling of a t:J.."'(
coun would be ex::unples of tb.e conñnnation of a contingent liability. Signing as gu.ar::i.ntor
on a loan creates another type of contingent liability.
An estim.ated loss from a contingenc liability should be charged to íncome, and be
established as a liability only if tb.e loss is conside:red probable and tb.e amount is reasonably
detenninable. A contingent liability tb.at is recorded is al.so frequently descnbed ín a foot-
note. A loss contlni:,<l1mcy tb.at is reasonably possible, but not probable, must be disclosed
even if the loss is not reasonably estimable. (This loss contingency is not charged to income
or est:J.blished as a liabilicy.) A loss contingency tb.at is less tb.an reasonably poSSlble does not
need to be disclosed, but disclosure may be desirable if there is an unusually large potentia1
loss. fu::hibit 2-2 illustrates a contingent liability foomote.
Subsequent events occur after the balance sheet date, but befare tb.e smtements are
issued. Two varieti.es of snbsequent events occu.r. The first type con..sisG of events related to
conditi.ons that ex:isted at tb.e balance sheet date, affect the esti.rrui.tes in the statements, and
requ.ire adju.stment of the statements befo re issuance. For example, if :additional infonnation
is obt:l.ioed indiC1ting that a major customer's account receivable is not collectible, an :adjust-
ment would be made. The second type consists of events that provide evidence about
conditi.ons that did not exist ::i.t tb.e balance sheet date and do not require adjusonent of the
st:atements. Hf.ailure to dlsclose these events would be misleading, disclosure should take the
forro of foomotes or supplemeniary schedules. Examples of the second type of such events
in elude che sale ofsecuriti.es, the settlement of li~""<ltion, or casu.:alty loss. Othe:r examples of
subsequent events might be debt incurred. reduced, or refinanced; busIDess combinati.ons
pending or effected; discontinued opera.tions; employee benefit plans; and capital stock
issued or purchased. Exhibit 2-3 on tb.e nexc page descnbes a subsequent event for
ÑÜcrosoft, whose year-end was June 30, 1998.
lNTERNATIONAL BUSINESS MACHINES
Con~e-ent Liabilities
CONTINGENCIES
The company is subjed to a variety of claims aD.d suits that arÍse from time ro time out
of the ordin:iry course ofits business, including_ actions with respect to com:racts, íntellecru.:tl
propeny, product li:tbility and environment::tl m.aners. The company does not belleve that
any such current acrion will b.ave a material impacr on the company's. business, frnancial
condition or results of oper:itíons.
. On Feb:nmry' ~5, 1993, a d.::iss action comphin: was filed against the company in the
Uruted So.tes DlStnct Court for the Southern Distnct ofNew York alleging, :llllong other
~tters, ~t the con::~r diss~ted ~ and misleading Statements conceming: its tinan-
~ condit1.on and diviclends during certam. periods of 1992. On Febmu:y 3, 1997, Judge
Rakoff issued an orcler granting the company's motion for Stimtllar}'judgment in tbis case in
its entirety. Phiirtiffu filed :in :i.ppe:tl and on Novem.ber 17, 1998, the Second Circuit Court
of Appe:Us upheldJudge Rakoff's decision for tb.e comp:i.ny.
 CHAPTE:R. 2 Intr0duction to Financia! St:ltements and Other Fm.ancial Reporting Topics C:HAPTE:R 2
Introduction to Fmancial St:ltements and Other Fmancial Reporcing Tapies 43

j;:!>!~:f t;=i1f§j MICROSOFT .<\ssets = Liabilities + Stocldlolders' Equity

Subsequent Events _With the do~ble~ sysrem, debit merely me:ms the left side of an account, while
credit means .the n~t side. Each tra:nsaction recorded must have an equal number of dollars
5USSEQUENT SALE
on the I:Et side as it do:S on the ri~ht side. Severa! accounts could be involved in a single
In August 1998, the Compmy solda wholly-owned subsiaiazy. Softimage. Inc. to A.vid
tr.m.saco.on, but the dehxts and credits must still be equal.
Teclmology, Inc. A pret:1..x g:iin of $160 mili.ion will be recognize:d in the first quart:er of 1999. . The ~ebit an~ credit ª?proa.ch is a technique tb.at has gained acceptance over a long
~A.s pan of a ttansitional service ag:reement, .M:icrosoft :i.greed to toake cem.in devdopment penad o~ome. ~ book~ not ~e you competent in the use of the double.-eno:y (debit
rools and m:ID;J.geroent systems :i.v.iihble to Avid for use in the Softinuge business. and cre~t) techn.ique. Tbis book will enh.ance your understanding of the end result of the
~ccounnng process and en:.i.ble you to use the financia! accounting inform.ation in a mean-
mgful way.
Asset, liability, and stockb.olders' equity accounts are referred to as permanent
a~un.ts beoi.us_e the balances in these accounts carry forward to the next: accounting
THE The sequence of accounting procedures completed during each accounting period is penod. Balances m revenue, expense, gain, loss, and dividend accounts, described as tempo-
ACCOUNT!NG called the accounting cycle. A broad suramuy of the steps of the accounting cycle in.elude: r.uy acc~~~ a:e closed to retained earnings and not c:uried into the next: period.
CYCLE 1. Recording transacrions E.xhibit--4 illustrates the double-entry system. No rice tb.at the permanent accounts are
Recording adjusting entries represented by the accounting equation: assets = liabilities + stockholders' equity. The
-'· Preparing the financia! statements

DOUBLE-ENTRY SYSTEM
Recording T r:ms::tctions (llluso:ating Relationslñp BetWeen Penrument and Temponu:y A<x:ounts)
A transaction is an event that CJ.uses a change in a company's assetS, liabilities, or stock-
holders' equity, thus chonging the company's financia! position. Tunsactions may be Penrument Accounts (Assets, Liabilities, and Stockholders' fu¡uity)
extemal or intemal to the company. External mmsactions involve outside parries, while
Assets = Liabilities + Stockholders' Equity
internal transactions are confined witbin the company. For ex:::unple, sfiles is an extemal
t:ranSaction, wbile the use of equipment is intemal. Asset Accounts""' Liability Accounts... Common Stock-
Transactions must be recorded in a journal (book of original eno:y). Ali transactions
could be recorded in the general joarn:tl. However, companies use a number of special jour- Debir" Credit Debit Credit" Debit Credit*
nals to record most transactions. The special joumals are designed to improve record !ncreases Decreases Decreases !ncreases Decreases lncreases
keeping efficiency that could not be obt:rined by using only the general jau.mal. The general
journal is then used only to record tr.m.sactions for wbich the company does not have a Retained Eamings"""
special journal. }1. rransaction recorded in a jouma.l is referred to as a journal entry.
Ali tr:msacrions are recorded in a journ:tl Gournal eno:y) and are later posted from the Debrr Credit'
joumals to a general l~aer (group of accounts for a company). After posting, the general Temponu:y A<x:ounts / D e c r e a s e s !ncreases
ledger accounts cont:lln the same information as the journals, but the inforroa:tion has been (Revenues, Expenses, and Dividends)
summarized by account.
Accounts store tbe monetary information from the recording of transactions. fumples
of accounts include Cash, Land, and Buildings. A.n accounting system can be computerized Dividends (Loss) lncome
or manual A manual system using T-accounts is usually used for tel'.tbook exphmations Debit' Credrr
because a T-account is a logical format. _ lncreases Decreases
T-accounts have a left (debit) side and a right (credit) side. A.n example T-account
followso Revenues Expenses = lncome
C.Sh Revenue Accounts Expense Accounts or (Loss)
Debit 1 Credit Debo Credit" Debit~ Credit
lncreases Decreases Decreases lncreases
A double.-eno:y sysrem has been devised to b.andle the recording of tr:mSactions. In a
double-eno:y system, each tranSacrion is recorded with the total dallar amount of the debits .... Permanent accounts
equal to the total dallar amount of the credits. The scheme of die double-eno:y system .. Normal balance
revolves around tbe accounring equation:
44 C:HAPTER 2 Introduction to Financi:il Statements and Other Flllfillcial Reporting Topics
temporary accounts are represented by revenue, expense, and dividends. (Gains and losses
would be treated like revenue :md expense, respectively.) The balance sheet will not balance
until the temporary accounts are closed to retained earcings.
Recording A.djusting Enoi.es
Earlier a distinction was made betWeen the accroal basis of accouncing and the cash
basis. It was indicated that the accrual basís reqillres that revenue be recognized when real-
ized (realization concept) and expenses recognized when incurred (matching concept). The
point of cash receipt for revenue and cash disbursement for expenses is not import:antunder
th.e accrual basís when determinmg income. Usually a company must use the accrua1 basis
to achieve a reasonable result for the balance sheet and the income statement.
The accroal basis needs numerous adjustments to account balances at the end of the
accounting period. Fer ex:imple, $1,000 paid for i:nsurance on October 1 for a one-year
period (October 1-September 30) could have been recorded as a debit to Insurance Expense
($1,000) and a credit to Cash ($1,000). lf thls company prepares financia! statement; on
December 31, it would be necessary to adjust Insurance Expense because not ali of the
insur:mce expense should be recognized in the tbree-month period October 1-December
31. The adjustment would debit Prepaid Insurance, an asset account, fer $i50 and credit
Insurance Expense fer $750. Thus, insurance e."<flense would be presented on the il;icome
st:ltement for tbis period as $250, andan asset, prepaid insura.nce, would be presented on
the b'1ance sheet at $750.
Adjusting entries are recorded in th.e general journal and then posted to the general
ledger. Once the accounts are adjusted to the accrual basis, the financial statements can be
prepared.
ii3ih:iif%-j
Preparing the Financia! Statements
The accountant uses the accounts after the adjustments have been made to prepare the
financial st:atements. These st:ltements represent the output of the accounting system. Two
of the principal financial st:ltements, the income st:atement and the balance sheet, can be
prepared directly from the adjusted accounts. Preparation of the st:atement of cash flows
requires further analysis of the accounts.
AUDlTOR'S An auditor (certified public accountant) conducts an independent examination of the
accounting information presented by the business and issues a report thereon. An auditor's
REPORT
report is the formal st:ltement of the auditor's opin.ion of the financial st:ltements after
conducting an audit. Audit opinions are classified as follows:
l. Unqualified opinion.. This opinion states that the financial statements present fairly;
in ali m::iterial respecrs, the financia} position, results of operations, and cash flows of
the entity, in conform.ity with generally accepted accounting principles.
2. Quali.fied opinion.. A qualified opinion st:ates that, except for the effecrs of the
matter(s) to which tb.e qualification relates, the financial st:ltements present fuirly, in all
material respects., the financia! position, results of operations, and cash flows of the
entity, in conformity with generally accepted accounting principles.
3. Adverse opiDion.. This opinion states tb.at tb.e financial statements do wt present fuirly
the financial position, results of operations, and c:lSh flows of the ent:i.ty, in conformity
witb. generally accepted accounting principles.
CHAPTER 2 Introduction to Financia! Statements ::md Otb.er Financial Reporting To pies 45
4. Disclaimer of opinion. A disclaimer of opinion states that the auditor <loes not express
an opinion on the fin:i.ncial statements. A disclaimer of opinion is rendered when tbe
auditor has not performed an audit su:fficient in scope to forman opinion.
. . The typical imqualified (or cle:m) opinion has tlrree paragraphs. The first par:igraph
mdicates the foumdai statements "that have been auditeJ and states that these statanents are tbr:
rr:spcmsibilif()i ofthe compttn:y'smanagement. This paragraph indicates that the auditors have the
responsibilicy to express an opinion on these statements based on the auditor to disclaim an
opinion.
The second paragraph indicates that the audit has been conducted in accurdtmce witb
generaUy accepted auditing Jta'mÍllrds. Auditing standards define the required level of audit
qua.lity. These standards are classified as to "general standar~" "fieldwork standards," and
"reporting standards. "The paragraph goes on to state that these standards require the audi-
tor to plan and perform the audit to obtain reasoD.:lble assur:ince that the financia!
st:atements are free of material misst:itement. The second paragraph also includes a brief
description of what is included in an audit.
The third paragraph gives an opin.ion on the st:ltements-that they are in conformir:ywith
GAAP. In certain circumstances, an unqualified opinion on the financia} statements may
require thatthe auditor add an explanatory paragraph after the opinion par:igraph. In this para-
grap~ the auditor may express a¡,"Teement with a depanure from a designated principle,
descnbe a material uncertaincy, describe a change in accounting principle, or express doubt as
to the ability of the entity to continue as a going concem. An expbnatory paragraph may also
be added to emphasize a matter. Exbibit 2-5 illustrates a typical unqualified report.
TOYS "R" US Report Unqualified Opinion
REF'ORT OF' INOE?E:NOENT AUOlTORS
The.Board ofDirectors :md Steekholders
Toys ".R." Us, Inc.
~e have audited the accompanying. consolidated balance sheei:s ofToys "R" Us, Inc. and subsidiaries as of J:muary 30, 1999
:md J:muary 31, .-199$, an~ the related consolida red St::ltementS of e:irnings, stockholders' equíty and CtSh &ws fur e:i.ch of
the three years m the penad :n~ed Janu::uy 30, 19_9~. These financial ~ti:rnents are the responsióility of the Comp:my's
man:i.gement. Our respoDSlbility is to express an opiruon on these financi:il st:i.tements b::ised on our audits.
We conducteá o~ audi.ts ~ accordance with genera.Uy accepterl auditing st:andards. Tb.ose standards require that we plan and
perform the _audit to obt:un reasona.ble-:i.ssur:mce about whether the fin:mcial mtements are free of material misstatement.
An :iudir includes ex:uniníng, on a teSt basis, evidence supporting the amounts :md disclosures in the financi:J..! mtements. An
audit also includes ::issessing the accounting principies used and signific:mt estimares made by management, ::is well ::is evalu-
ating the over:ill financial St::ltement presentation. We believe th::tt ouraudits ptovide a re:isonable b:J.Sis for our opinion.
In our opinion, the financfal Statements referred to above present f.ürly, in ali material respCcrs, the consolidated financial
position ofToys_ "R" Us. Inc. and subsidiarles atJanu:uy 30, 1999 andJanuary 31, 1998, and the consolidated results of their
operations :ind their C:J.Sh flows for·e:i.ch _of the tbree years in the period endedJ:mu:uy 30, 1999, in conformity with gener-
ally:iccepted :iccounting principies. · •
í/"-Sf r1'7 u.t
Enm & Yo>mg LLP
Nr:w York, New York
Mirch 10, 1999
46 Introduction to Firumcial Statements and Other Financial Reporting Tapies
VVhen e:c1mining fin:mcial statements, review the independent auditor's report. lt can
be import.ant to your analysis. From the point of view of :lll<llysis, financia! statements
accomp:mied by an unqualified opinion without an explanatory paragraph or explanatory
language carry the highest degree of reliability. This type of report indícates tb.at the finan-
cia! st:J.tements do not contaln a Jll:lterial departure from GAAP and tb.at the audit was not
limited as to scope.
When an unqua.Iiñed opinion contaios an expla.natory paragraph or explanatory
language, rr¡ to decide how seriously to regm-d the departure from a straig:ht unqu:tlified
opinion. For example, an exphmatory paragraph because of a change in accounting princi-
ple would not usuaJ]y be regarded as serious, although it would be important to your
arui!ysis. M. explanatory parograph beC'1use of a materutl uncert:rinry would often be
regarded as a serious matter.
You are likely to regard a qualified opinion or an adverse opinion as casting serious
doubts on the reliability of the financial statements. In ea.ch case, you must read the audi-
tor's repon carefully to form your opinion.
A dischimer of opinion indicates tb.at you should not look to the auditor's reportas an
indication of the reliability of the st:ltements. \Vhen rendering tbis type of report, the audi-
tor has not performed an audit sufficient in scope to fonn an opinion, or the auditor is not
independent.
In some cases, outside account:mts are :issociated with financia! st:J.tements when they
have perforroed less tb.an an audit. The accountant's report then indicates that the firumci:ll
st:J.tements have been reviewed or compiled.
A review consists principally of inquiries made to company personnel and analytical
procedures applied to :financi:ll data. It has subsmntially less scope tb.an an examination in
accordance with generally accepted auditing st:mdards, the objective of which is the expres-
sion of an opinion regarding the fin:ancial smtements t:aken as a whole. According:ly, the
account:mt does not express an opio.ion. The accounr.ant's report will indicate that tb.e
accountants are not aware of any material mo<lifications that should be made to the ñn:m-
cial st:ltements in order for them to be in cooformitywith GAAP; or the report"Will indicate
deparrores from GAAP. A departure from GAAP may result from using one or more
accounting principies without re:isonable justification, the omission of necessary foomote
disclosures, or the omission of the st:ltement of cash flows.
In general, the reliance that can be placed on financial rutements accompanied by an
account:mtl: revíew report is substantially less th:m those accompanied by an audit report.
Remember that the accountant's report <loes not express an opinion on reviewed financia!
statements.
'When the outside accountant presents only financia! information as provided by
manágemen:t, he or she is said to have compiled the financia! st:J.tements. The compilation
report rutes that the account:mt has not audited or reviewed the financia! st:ltements.
Therefore, the accountant <loes not express an opinion or any other forro of assur:mce about
them. If an accountant performs a compilation and becomes aware of deficiencies in tbe
statements, then the accountant's report ch:rra.cterizes the deficiencies as follows:
Omission of subst:Jntialiy ali disclosures
Omission of statement of cash flows
Accounri:og principies not generall:y accepted
Sometimes financial St:J.tements are presented without an accompanying accoun-
tant's report. Tbis means that the st:J.tements have not been audited, reviewed, or compiled.
Such statements are solely the representation of m:magement.
Cl-IAF'TE:R 2 Inttoduction to Fm:mcial Statements :md Other F.in:mcial Reporting Tapies 47
M:magement's Responsibility for Financhl Statements
. The respoDSJ.Oility for the preparation and for tbe integrity of financia! statements restS
'\Vl.th ma:n.agem.ent. The auditor is responsible for conductin.g an independent e.~tion
of the statements :md expressing an opinion on the financia! rucements based on the audit.
To make financi:ll rutement users aware of management's respoOSIDilicy; companies have
presented managem:ent st:ltements to shareholders as part of the annual report. Exbibit 2-6
shows an ex:unple.
The SEC's Integnted Disclosure System
. In ger:-eral, in ~e United Sta.tes, the SEC has the authority to prescribe external fio.an-
CJ~ :ep?i:m~ reqwrements for companies with securities sold to the general public. Under
tbis ¡unsdicnon, the SEC requires that cert:ain financia! st:ltement information be included
~ the ~ual report to ~eholders. ~ annUll report, alongwith certain supplemencuy
informa.non, must then be mcluded, or mcorporated by referen.ce, in the annual filing to the
SEC, lmown as the 10-K repOrt or Form 10-K. The Forro 10-K is due t:hree months
following the end of the company's fiscal year. The annual repon and the Forro 10-K
include audited financia! statements.
TOYS "R"US
Management's Respon.sfüility for F=cial Reporting
REPCRT CF' MANAGEMENT
Respoosibility for the .integrity :md objettivity of the financial informru:ion prerented in tb.is
Annual Re¡xirt rests with the m:magement of Toys "R" Us. The accompanying fin:tnci:ll stlte-
ments have been. prep:ired from accounting records which. nun::i.gement believes fu.irlv :md
:CCUI:ltely reflect ~e opentions :ind fin:mcia.l posirion of the Comp:my. Mana.gement has ~b­
lished a system of mterna.I controls to provide reasonable :issut:mce tb.at assets a.re maio:r:rined
:md accounted for in accord:mce with its policies and that trans:lctions are recorded accurately
on the Comp:my's books and records.
The Company's comprehe.nsive intem:il audit progr:im procides for constant evalu:ition of the
ad~~ of the adherence to ~gern~t's established policies and procedures. The Company
has distributed to key employees lts polio:es for conducting business :llf.iirs in a lawful and ethi-
c:il manner.
The !'-udit Co~ttee of the B~d of D~ecrors, which is comprised solelyof outside directors,
provtdes OVel'Slght to the fimu:io:al reporong process through periodic meetings 'With our inde-
pendent auditors, interna.l auditors and managcmenL
The mi:mcial .mtements of th~ Company ha.ve been :iudited by Ernst & Young LLP, independ-
ent au.ditors, m. accord:uice witJ:. generally accepted auditing stmdards, including a review of
ñnancial reportmg m:ttters and mtem:ú contro!s to the extenr necessary ro e:cpress :m opinion
on the consoli&ted füunci::U st:itements.
Robert: C. Nakasone Loois Llpxhitz
ChiefExecurive Of:!icer Executive Vice President
:md Chief Fin.:mci::U Officer
48 Im:roduction to F.in:mci:i.l Sta.tements :md Otb.er Financicl Reporti.ng Topics
The SEC promores an intt;;,"!ated disclosure system between the annu:tl report and the
Form 10-K. The ~are to improve the quality of disclosure, lighten the disclosure load,
st:mdardize inform:ztion requirements, and achieve uniformity of annu:tl reportS and Form
l 0-K filings.
In :i.ddition to the company's primary financial statements, tbe Form 10-K must include
the followingo
l. Information on the Dl:ll'ket for holders of common stock and related securities, includ-
ing high and low sales price, frequency and amount of dividends, and number of sh.ues.
2. Fwe-year summ.ary of selected financia! data, including net sales or oper.icingrevenues,
income from continuing opera.tions, tot:tl assets, long-tenn oblig:i.tions, redeemable
preferred stock, and c:i.sh dividends per share. (Some companies elect to present data.
for more than fi.ve years and/or expand the disclosure.) Trend m:tlysis is empb.:tsized.
3. M.an:lgement's discussion and analysis (MDA) of financial condition and results of oper-
ations. Specificfilly required is discussion of liquidity, capit:tl resources, and results of
operations.
4. Two years of audited balance sheets and tb.ree ye:rrs of audited income statements and
smtements of c:J.Sh flow.
5. Disclosure of the domesric and foreign components of preta.'< income, unless foreign
components are considered to be imrnaterial.
SEC requirements force management to focos on the financia! statements :is a whole,
nther than on just the income sta.tement and opera.tions. VVhere ttend infonnation is rele-
vant, discussion should center on the five-year summary. Emphasis should be on fuvonble
or unfuvorable ttends and on identifiotion of signific:tnt events or uncett:linties. T1is
discussion should provide the analyst with a reasonable summary of the posítion of the fum.
Exhibit 2-7 presents a summary of the m.ajor p:trts of the Form 10-K. ln poetice, much
of tbe required information in the Form 10-Kis incorporated by reference. Incorponted by
GENERU. SUMMARY OF FORM 10-K
PART 1
Itcm. l. Business.
Itcm. 2. Properties.
Itero 3. Leg'-tl l'ro<oeclings.
ltem.4. Submiss:ion of!vlatters to a-Vote ofSecurity Holders.
PART 11
Itcm 5. Mar"ket for Regist:rnnt's Common Equity and _Rel.a.ted Stockholder Ivlatters.
Item6. Se!ected Fina.acial Data.
ltem 7. Management's Discussion aniAnfilysis ofFmanci:U Condition and Resul.ts
of Oper:i.ti.ons. ,
Item 8. Financfal Stai:i:ments and Supplem.Cnt:iry Dat:i.
Itern 9. Ch:mges in :md Disagreements with Accountants on Accounting and Fm:znci:tl
DiscloSW"e.
PART 111
Itero 10. . DirecterS an.d_ Executive Officers of Registrant.
Item 11. Exi:cmive Compensati.on. ·
Item 12. Security Owner.iliip of Cert::Un Beneficia! Owners :md .Marugement.
Itero 13. Certa.in Rel.a.tionships :md Rehted Tr:msactions.
Item. 14. Exhibits, F~ Sotement Schedules, an.d Reports on Form 8-K.
Inuoduction to Fmancia.l Sotements and Otb.er Financia! ReportingTopics 49
reference mea.ns tb.at the information is presented outside tbe Form 10-K, anda reference
in the Form 10-K indiotes where the infonnation can be found. Usually the -fin:mcial st:lte-
ments are_incorporated into the Form 10-K by referencing the annual report.
Areview of a company's Form 10-K can reveal information tb.at is not av:ailable in the
annual repon. For C.'talllple, Item 2 of the Form 10-K reve:tls a deta.iled listi.ng of properties
and indicates if the property is leo.sed or owned.
The SEC requires t:hat a quanerly report (Form 10-Q), cont::i.ining fumnci:i.1 statements
and a management discussion :and :malysis, be submitted "Within 45 days following tbe end
of tbe qu:mer. (The Form 10-Q is not required for the fourth quarter of the fi.sc:al year.)
Most companies a.lso issue :i. quanerly repon to stockholders. The Form 10-Q and quanerly
reports are unaudited.
In addition to the Form 10-K and Form 10-Q, a Form 8-K must be submitted to tbe
SEC to repon specia1 events. Special events required to be reported are changes in princi-
pal_ sto~oidei:, changes in auditors, acquisitions and divestit1Jies, bankruptcy, and
resJ.g:nanon of directors. The Form 8-Kis due 15 days following tbe event.
The Forms l 0-K, l 0-Q, and 8-K filings are avoili ble to the public. Typic:illy a company
provides these reportS to stockholders upon request only.
Proxy
The proxy, the solicit:i.ti.on sent to stockholders for the elecrion of directors and for the
appr~ of other corporation acrions, represents the shareholder authorization regarding
the C!lstlng of t:hat shareholder's vote. The proxy cont:tins noti.ce of tbe annual meetin"'
benefi.cia.l ovro.ership (name, address, and share ovro.ership data of shareholders hol~
i:iore ~ 5% of outstmding _sh:ares), board of directors, standing committees, compensa-
non of directors, compensanon of e.xecutive officers, employee benefi.t phns, certain
tr:mSactio_ns -witb officers and directors, rela:tionship with independent account:mts, and
other busmess.
~e pro~ rules provided under the 1934 Securit:ies Exch:mge Act are applicable to ali
secunnes registered under Section 12 of tbe Act. The SEC gaios its influence over the
annu:tl report tb.rough provisions of tbe Act that cover pro:xy starements.
. 1?-e SEC's proxy rules of panicular interest to investors involve execurive compensa-
non dlsclosure, performance gr.tph, and reti.rem.ent plans for execurive officers. These rules
are designed to improve shareholders' underst:mding of the compaisation paid to senior
execurives and directors, the criteria used in reaching compensation decisions, and the rela-
tionship between compensation and corporate performance.
Among otber matters, the execurive compensation rules c:tlJ. for four highly form::i.tted
d.isclosure tables and the disclosure of the compensation committee's basis for compensation
decisions.
The four t:i.bles disclosing execurive compensacion are:
A summary execucive compensation ta.ble coveriug compensation for the company's
chief executive offi.cer and its four other most highly compen.sated executives for the
last three years.
Two tables detailing options and stock appreciation rights.
A long-term incentive plan award ta.ble.
The performance graph is a line gr::iph comparing the cumula.tive tottl shareholder
return -with performance indicators of the over:ill stock market and either the published
indusrry inde.i: or the registrant-determined peer comparison. This performance gra.ph must
be presented for a :five-year period.
50 CHAPTE:R 2 Introduction to Flitlllcial St:1.tements and Odter Fmancial Reporti.ng Topics
The pension plan table for executive officers disclos~ the estiro:i.ted ~ual benefits
payable upen reti.rement for any defined benefit or actuanal plan under ~hich benefits are
determined prirnarily by final compensation (or average final :omp~o.on) ~d_rears of
service. Immediately following the table, additioo.al. disclosure IS 1:qw.red. This dísclo~
in.eludes items such as the relationship of the covered compensa.non to the compensanon
reported in the summary compensation t::1.ble and the estimated credited ye:J.I"S of service for
ea.ch of the named executi.ve o:fficer$.
5UMMARY A reporting option available to public comp:mies is to is.we a S\llllJll.3l'y :n":uaI ~rt.
ANNUAL A summary ann:ual report, a condensed report, omits much of the financial ~nnao.on
REPORT typicilly included in an annu:.ú repon. A typical full annual reporthas more ~cal pag~
thon non!irumcial pages. A SUillJllaI)' aonual report generally has more non!irumcial pages.
When a company issues a summ:ary 3ll!l.ual report, the proxy materials it se:z1ds to sJiai:-
holders must include a set of fully audited statements and other requrred financia}
disclosures.
A summary annual report is 1u1t adequate for reasonable 3ll3.lysis. For companies that
issue a summary annual report, request a copy of their pro.xy and the Form 10-K. Even far
compan:ies that issue a full annual report, it is aiso good to obt:ain a copy of the prox:y ma~e­
rials and the Form 10-K. Some compa.nies issue a joint annwl report :w.d Form 10-K, while
other compa.nies issue a joint annual repon :w.d prox:y.
THE EF'FIC!ENT Tue efficient market hypothesis (EMH) relates t-O the ability of capital mirkers t-0
MARKET generate prices far securities that reflect worth. The ~ implies t:Mt ?ub~cly available
infotm:ltion is fully refl.ected in share prices. The m.arket will not be ef.ti.cient if the .rn:rrket
HYPDTHESIS
does not have access to relevant information or if fraudulent information is provided.
There seeros to be little doubt that the FASB and the SEC assess the ímpact of their
actions on security prices. The SEC has been particularly sensitive to insider tradin.g
because abnormal rerurns could be achieved bj the use of in.si.der information.
If tb.e market is efficient, irrvestors may be hanned when fu.ros do not follow a full
disclosure policy. In an efficient market, the method of disclosure is ~ot ~ im:POrt:lllt '.15
whether ar not tbe itero is disclosed. It should not matter whether :m 1tem is disclosed m
tbe body of the firumcial statements or in the foomotes. It is the disclosure rather th:m ~
to disclose that is the subst:mtive .issue.
Usually there is a cost to disclose. AJJ. attempt should be made to determine the v:tluc
of additional disclosure in relation to the additional cost. Disclosure should be made whei
the perceived benefits exceed the additional cost .to provide ~e disclosure. . . 7. .M::ike your decision.
It is generally recognized that the market is more efficrent when dealing 'Wlth ~
fu:ms trading on large organized stock markets than it is for sm:ill fi:rms that are not tradin¡
on large orgmlli:ed stock markets. . . . . .
Although the research evidence reg:irding the Ei\IH is conflicong, this hypothesis 1"l
taken on an importan.e role in ñnanci:tl reporti:ag in the United Smtes.
ETHICS "Ethics and morals are synonymous. Wbile ahi.cs is derived from Greek, mqraJs i·
derived from Latin. They are interchangeable terms referring to idea.Is of chsr:i.cter an<.
CHAPTE:R 2
Introduction to Financia! Statements :w.d Other Financia.1 Reporcing Tapies 51
conduct. These ideals, in the form of codes of conduct, furnish criteria far distingcishing
2
between right and wrong." Etbics has been a subject of investig::i.cion far hundreds of years.
Indiv:iduals in financial positions mu.st be able to recognize ethical issues and resolve them
in an appropriate :m;umer.
Ethics affioct ali mdividuals-from the financia! clerk to the high-levd financia! exeou-
tive. Individual.s make daily decisions based on thcir individual v:tlues. Some companies and
professionaI organizations have formula.red a code of ethics as a statement of aspirations and
a standard of integrity beyond tb.at required by law (which can be viewed as the mínimum
standard of ethics).
Ten essential values can be considered central to relations hetWeen peopJe.3
l. Caring
2. Honesty
3. Accounmbility
4. Promise keeping
5. Pursuit of excellence
6. Loyalty
7. Fairness
S. !ntegrity
9. Respecr for others
1O. Responsible citizenship
Etbics can be a particular problem with fin.a.ncial reports. Accepted accounting pr:inci-
ples leave ample room for arriving at different results in the short ron. High.ly subjective
~tes cm subsi:anrially influence e:irnID.gs. VVhat provision should be made for warr:mty
coses? ivhat should be the loan loss reserve? 'YVhat should be the allowance for doubtful
accounts?
The American Accounting Association :initiated a projecr in 1988 on professionalism
and ethics. One of tb.e goals of tbis project was to provide stu.dentS with a fumework far
evaluating their courses of action when encouncering ethical dilemm.as. The .4.mericm
Accounting Association developed a decision model for focusing on ethic:tl issues.4
1. Determine the factS-what, who, where, when, how.
2. Define the ethical issues (includes identifying the identifiable porties affected by the
decision .made or action taken).
3. ldent:ifyma.jor principles, rules, and values.
'i. Specify the altematives.
5. Compare norms, principles, and values with altematives to see if o. clear decisjon can be
reached.
6. .As.5ess tb.e consequences.
E.umplc 1: Qucsrionablc Ethics in Savings a.nd Loans In connection with the savings
and loan (S & L) sc:mdal, it was revealed that several auditors of thrift institutions borrowed
subst:mtia.l. amounts from the S & L t:Mt their firm was audicing. lt was charged that some
of the loans involved specia.l. consider:ltion.5 In one case, dozens of partners of a major
accounting fu:m borrowed money for commercial real estate loa.os, and some of the partners
defu.ulted on thcir loans when the real est::ate market collapsed.6 lt was not clear whether
these particuhr lo:ms violated professional etbics st:l.D.dards. The AICPA subsequently
changed its ethics st:l.D.dards to han all such loans.
sz C:HAPTER 2 Introduction to Fi.nancial Sti.tements and Other Fmancial Reporting Topics
In another case, m accounting firm paid $1.5 million to settle charges by the California
State Board of Accountancy that the accounting firm was grossly negligent in its 1987 audit
ofLlncoln Savings & Loan. The accounting board charged that the firm Md agreed to the
improper recognition of approrimarely $62 million in profits.7
E.xample 2: Questionable Ethics in the Moti.en Picture Indusrry Hollywood's account-
ing pracrices have often been labeled "mysterious."8 A case in point is Art Bucb.wald's lawsuit
against Pararnount Pictures for breach of contract regarding the film Caming to A'J'IU:ficd,.
Par:unount took an option on Buchwald's story "King for a Day" in 1983 and promised
Buchwald 1.5% of the net profits of the film. BuchwaldS attomey, Pierce O'Doonell,
accused Paramount Studios of "fatal subtraction" in deternllnmg the amount of profit.
Although the film grossed $350 million worldwide, Par:unount claimed an $18 million net
Joss. As a result of the srudio's accounting practices, Buchwald was to get 1.5% of nothing. 9
Buchwald was eventually awarded $150,000 in a 1992 court decision. 1 º the harmonization of internacional accounting standards. Some of these organizations
Man.y Hollywood celebrities, in addition to Art Buchwald, luve sued over Hollywood-
style accounting. These include Wmston Groom over the movie rights to Forres& Gump,
Jane Fonda overa larger slme of profits rehtingto On Gol.den Porui, andJam.es Gamer over
his slme of profits from The R.ockford Files (a television program). Some of the best creative
work in Hollywood is in accounting.
HARMONIZATION The imperus for changes in accounting practice has come from the needs of the busi-
OF ness community and governments. With the expansion of international business and global
1 NTERNAT1 ONAL. capital markets, the business community and governments have sho'\VD. an increased inter-
est in tb.e harmonization of internacional accounting standards.
AccouNT1NG
Suggested problems caused by hck of harmonization of internati.onal accouncing stan-
5TANDARD5
dards include'
1. A need for employment of key personnd in mulcinational companies to bridge the
"gap" in accounting requirements betWeen countries.
2. Difficulties in reconciling local standards for access to other capital markets.
3. Difficulties in accessing capital. markets for companies from less developed countries. ll
4. Negative effect on the international trade of accounting practice and services. 12
Internacional interest in harmonization of intemational accounting standards has been
especially scrong since the early l 970s. In 1973, nine countries, including the United St::i.tes,
formed the Intemational Accouncing Standards Committee (IASQ. IASC includes approx-
imately 100 member nacions and well over 100 professiónal accounting bodies. The IASC
is the only priva.te sector body involved in setting intema~onal accounting standards.
The IASC's objectives include:
1. Devdoping international accouncing standards and disclosure to meet the needs of
internacional capital. markets and the internacional business community.
2. Developing accounting standards to meet the needs of developing and newly industri-
alized couno:ies.
3. \,i\torking toward increased comparability betWeen nacional and international account-
ing standards. 13
The IASC does not have authority to enforce its standards, but these standards have
been adopted in whole or in part by many countries. Some see the lack of enforcement
C:HAPTER 2 Inrroduction to Financi:tl Statements and Other Financi:U Reporting Topics 53
authority as a positive factor beca.use it enables the passing-of standards that would not ha.ve
had the necess:uy votes if they could be enforced. This allows standards to be more ideal
than they would otherwise be if they were enforceable.
IASC follows a due-process procedure similar to that of the FASB. This ineludes expo-
sure drafts and a comment period. A..ll proposed standards :md guidelines are e.""Cposed for
comment fer about six months. 14
The United Nations (UN) has shown a substantial interest in harmonization of inter-
n:i.cional accounting standards. The UN appointed a group to smdy harmooizacion of
intemational accounting standards in 1973. This has evolved into an ad hoc work:iDg group.
Members of the working group represent governments and not the priva.te sectar. The
working group does not issue scmdards but rather facilitates their development. The UN's
concern is with how multinacional corporations affect the devdoping countries. 15
!v1any other organizations, in additi.on to the IASC and the UN, have played a role in
include the. Financia! Accounting Standards Board (FASB), the European Economic
Community (EEC), the Organiza.ñon for Economic Corporation and Development
(OECD), and the lnternational Federation of Aocountants (IFAC).
Domestic accounting standards have developed to meet the needs of domestic envi-
ronments. A few of the factors that in±luence accounting standards locally are:
1. A litigious envirorunent in tb.e United St::i.res th::it has led to a demand for more detailed
standards in many cases.
2, High rates of inflation in some countries that have resulted in perio<lic revaluation of
:fi.xed assets and other price-level adjustments or disclosures.
3. More emphasis on financial reportingfmcome tax conformity in cen:ain countties (for
example, Ja.pan and Germany) that no doubt greatly influences domestic financia!
reporting.
4. Reliance. on open markets as the principal means of intermediating capital flows that
has increased the demand for information to be included in financial reports in the
United Sta.tes and sorne other developed countties.16
The following have been observed to ha.ve an impact on a country's fin;mcial account-
ing operation:
l. \Vho the investors and creditors-tb.e information users-are (individuals, banks, the
govemment).
2. How many investors and creditors there are.
3. How clase the relationship is between businesses and the investor/creditor group.
4. How developed the stock e.xchanges and bond mnrkets are.
5. The e.xtent of use of intemacional financia! markets.1 7
With this backdrop of fragmentation, it v.rill be clifficult in the short run, if not impos~
sible, to bring n:itional standards into agreement with a meaningful body of internacional
standards. But many see benefits to harmonizati.on of interna.tional accounting standards
and feel th::it accouncing must move in that direction. In the short run, ways exist to cope
with incomparable standards. One possible interim solution involves dual standards.
Inremational companies would prepare t\VO sets of financial stJ.tem.ents. One would be
prepared under domestic GAA.P, while the other would be prepared under intemational
GAAP. 1bis would likely put pressure on domestic GAAP to move towards international
GAAP.
54 CHAPTE:R 2 Int:roduction to Financia! Statements and Other Fm:mcial Reporting Topics CHAPTE:R 2
In the United St:i.tes, a conflict exists between the SEC and the securities exchanges,
such as the New York Stock E.xchange (NYSE). In general, the SEC requires foreign regis-
tnmts to conform to U.S. GMP, either directly or byreconciliation. This approach achieves
a degree of compar.J.bility in the U.S. c:ipit.a.l market, but it does not achi.eve comparability
for investors who want to invest in several nacional capital Jllfil"kets. This approach poses a
problem for U.S. securities exchanges, because the U.S. st:alldards are perceived to be the
most sttingent. This puts exchanges su.ch as the NYSE at a competi:cive disadvantage with
foreign exchanges tbt have lower st:J.D.dards. The development of international standards
would alleviate this problem..
In the United Sti.tes, the FASB did not show a critica! interest in hannonization of
internationa.l accounti.ng standards until the early 1990s. The FASB now actively partici-
pates in the harmoniz.ation of internati.onal accountin.g stand:ards. This includes cooperating
with the !ASC and the UN.
CDNSOLIDATED Financia! statements of legill.y separate entities may be issued to show financial posi-
5T.A.TEMENTS tion, income, and cash flow as chey would appear if che companies were a single entity
(consolidated). Such st:J.tements reflect an economic, racher than a legal, concept of the
entity. For consolidated si:atements, ali cransacrions between the entities being consoli-
dated-intercompany transactions-must be eliminated.
One corporation can own stock in anocher corpor:ition in an amount sufficient to hold
subst:mtial voting rights in that corporation. The corporation owcing the stock is the ptZmlt
corpordtWn. The corporation whose srock. is owned is the sukUJiary corporatüm. The financial
si:atements of che parent and the subsidimy are cOnsolidated for ali majority-owned
subsidiaries unless control is tempor::uy or does not rest wich the m.ajority owner. These are
5UMMARY
termed consolidated financial st:J.tements. An U1U0nS0lidated subsidia.ry is accounted foras
an investment on the parent's balance sheet.
\iVhen a subsidiary is less than 100% owned and its statements are consolidated, minor-
ity shareholders must be recognized in che consolidated financial statements by showing che
roinority interest in net assets on che balance sheet and the minority share of e:i.mings on
che income statement. .Minority-related accounts are discussed in detail in Chapter 3.
The consolidation of financia! statements has been a pracrice in che United Sta.tes for
years; however, tb.is has not been the case for many other nations. In some countries like
Japan, parent-only financia! statements are the norm.. In other countries like Germany,
consolidation only includes domestic subsidiarles.
The 14..SC passed a standard that requires ·that ali conttolled subsidiarles be consoli-
dated. Although !ASC scmdards cannot be enforced, this scmdard will !ikely increase the
acceptance of consolidation.
ACCOUNTlNG The combination ofbusiness erltitieS by merger or acquisition is very frequent. There
are many possible reasonS for this e."<ternal business C."q)ansion, including achieving
F"OR
economies of sc:tle and savings of time in entering a new nmket.
BUSINESS
There are two methods of accounting for a business combination-the pooling of
C O M S 1NATlClN5
interests method and che pu:rchase method. The accounting for a merger or acquisition is
guided by 12 specific criteria to judge a combination. If the 12 criteria are met, tb.en che
acquisition must be accounted foras a pooling of interests. The criteria leave some room for
iudgment in determining if che pooling method should be used.
Introduction to Financia! Statements and Other Financial Reporring To pies 55
Apooling of interests involves an e."<change of voting common stock. \Vith tb.e pooling
method, the recorded assets and liabilities of the firms involved are carried forward to the
combined entity at tb.eir previous recorded amounts. Income of the combined firm ineludes
income of the constituents for che entire period. The prior years are restated to show the
combined firms :is merged (pooled).
Since che pooling mechod results in the acquired assets and liabilities being carried
forward at tb.e amount that chey were previously recorded, chis results in a net understate-
ment of assets, liabilities, and equity in relation to the acquisicion values. This will lead to a
subsequent overstatement of income because of the reduced e.""tpenses subsequently recog-
nized. \Vith the pooling method, the resulting retained e:mtings in stockholders' equity
represents che prior retained eanrings ofboth companies.
The purchase method views the business combination as the acquisition of one entity
by anocher. The firm doing the acquiring records the identifiable assets and liabiliti.es at fuir
value at che date of acquisition. Tb.e difference benveen the fuir value of the identifiable
assets and liabilities and che a.mount paid is recorded as goodwill (an asset). Since goodwill
must be amortized to expense, this can result in substancial subsequent expense.
\Vith a purcb.ase, the acquiring firm picks up the income of che acquired firm from tb.e
date of acquisition. Ret.ained earnings of the acquired firm do not continue.
The Daimler-Benz/Chrysler Corp. merger depicts the adv:antage of pooling over che
purchase method. Chrysler had a book value of approximately $12 billion, while the trans-
action valued Chrysler at approximately $39 billion. The purchase method would have
resulted in appro:cimately $27 billion of goodwill. Tbis would have been a subsequent $27
billion drag on euniags. 18
This chapter includes an introduction to the basic financial statements. Later chap-
ters will cover these sta.tements in detail.
AJ:i understanding of the sequence of accounting procedures completed during e:ich
accounting period, called tb.e accouncing cycle, will help in understanding the end
result-financial statements.
This chapter describes che forros of business entities, which are sole proprietorship,
partnership, and corporation.
Management is responsible for financia! sta.tements. These sta.tements are examined
by auditors who express an opinion regarding the statements' conformity to GA.AP in the
auditor's report. The auditor's report often points out key :fuctors that can affect financial
statement analysis. The SEC has begun a program to integra.te the Forro 10-Krequíre-
ments 'With tb.ose of the annual repon.
*A¡. reporting option available to public companies, a summary annual report (a
condensed annual report), omits much of the financia} information included in a typical
annual repon..
The EMH. relates to the ability of capital markets to genera.te prices for securiries
that reflect worth. The market will not be efficient if the market <loes not have access to
relevant information or if fraudulent information is provided.
Ind.ividuals in fina.ricial posicions must be able to recognize ethical issues and resolve
them appropriately.
\Vith the e:tpaDSion of internatianal business and global capital markets, the business
community and governments have shown an increased interest in the harm.onization of
intemational accounting standards.
The combination of business entities by merger or acquisition is very frequent. AJ:i
understanding of how a business combination can impact the basic sta.tements is impor-
tant to che analyst.
56 CHAPTER 2 Inttoduction to F:inanci:tl Statements and Other F:inancial. Reporring Topics CHAPTER 2 Introduction to Fmancial Statements and Other Fmanci:il Reporting Topics 57

Q!JESTIONS Q 2-20.· Can cash dividends be paid from retained earnings? Comment.

Q 2-1. Name the type of opinion indicated by e:ich of the following siruarions: Q 2-21. 'VVhy review footnotes to financia! statements?
a. There is a material uncenainty. Q 2-22. 'í/Vhere do we find a description of a firmS accounting policies?
b. There W3S a change in accounting principle.
c. There is no material scope limication or material departure from G.AAP. Q 2-23. Describe the relationship between the terms ethics and morals.
d. The financia.! statements do not present fairly the financi.al position, results of oper- Q 2-24. Wb.at is the relationship between ethics and law?
ations, or cash flows of the entity in conformity with GAAP.
e. Except far the effecrs of the matter(s) to which the qualification relates, the financial Q 2-25. Identify the basic accounting equation.
st:atements present fairly, in all material respecrs, the financial position, results of
oper::i:tions, and cash flows of che entity, in conformity with GA...\P. Q 2-26. What is the relationship bet'Neen the accounting equation and the double-entry system
of recording transactions?
Q 2-2. VVhat are the roles of management and the auditor in the preparation and integrity of the
financia! st:atements? Q 2-27. Define the followingo
a. Permanent accounts b. Temporary accounts
Q 2-3. VVhat is the purpose of the SEC's integrated disclosure system far financia! reporting?
Q 2-28. A typical accrual recognition for salaries is as follows:
Q 2-4. VVhy do sorne unqualified opinions have explanatory paragraphs? Salaries Expense $1,000 (increase)
Salaries Payable 1,000 (incre:ise)
Q 2-5. Describe an auditor's review of financia! statements.
Explain how the matching concept applíes in this situation.
Q 2-6. Wtll the accountant express an opinion on reviewed financia! st:atements? Describe the
accoun:tant's report for reviewed financia! statements. Q 2-29. \iVhy are adjusring entries necessaxy?

Q 2-7. Wb.at type of opinion is expressed on a compiktion? Q 2-30. Why are not ali transactions recorded in the general journal?

Q 2-8. Are ali financia! statements presented with sorne kind of an account:m:r's report? Explain. Q 2-31. The NYSE has trouble competing with :many foreign exchanges in the listing of foreign
stocks. Discuss.
Q 2-9. YV'b.at are the three principal financia! st:atements of a corporarion? Briefly describe the
purpose of each statement. Q 2-32. Idenrify the usual forros of a business entity and describe the ownership cbaracteristic of
each.
Q 2-10. Why are footnotes to scatements necessary?
Q 2-33. W"hy would the use of insider inform:ition be of concem if the market is efficient?
Q2-ll. VVhat are contingent liabilities? Are lawsuits against the firm contingent liabilities?
Q 2-34. Considering the EMH, it is best if financia! disclosure is made in the body of the finan-
Q 2-12. VVhich of the follo'Wing events, occurring subsequent to the balance sheet date, would cia! statements. Comment.
require a foomote?
a. .Major fire in one of the firm's plants d. Inttoduction of new Q 2-35. Considering the fil.fil, how could abnormal rerurns be achieved?
h. Increase in competitor's advertising management tecbniques Q 2-36. Describe the pooling of interestS method and the purchase method of accounting for a
c. Purchase of another company e. Death of the córporate treasurer business combination. .
Q 2-13. Describe a proxy st:atement. Q 2-37. Consolidated st:atements may be issued to show financia! position as it would appear if
Q 2-14. Briefly describe a summa.ry annual repon. two or more companies were one enrity. VVb.at is the objective of these statements?

Q 2-15. If a company issues a summary annwl report, where can che more extensive financia! Q 2-38. \Vhat is the basic guideline for consolidation?
information be found?
Q 2-16. Comment on the typical number of financial pages in a summary annwl report as
compared to a full annual repon.
Q 2-17. VVhat are the major secrions of a scatement of cash flows?
Q 2-18. VVhich two principal financia! st:atements explain the difference between two balance
sheet dates? Describe how these financial statements exEJ.ain the difference between two
balance sheet dates.
Q 2-19. VVhat are the three major categories on a balance sheet?
SS CMAPTER 2 Introductlon to Financial St:ltements and Other Financia! Reporting Topícs Introduction to Fmanci:tl Statements and Other Fin:mci:tl Reporting Topics 59

PROBLEMS 6. As ofDecember 31, Gaffney Company had provided services in the amount of$400
for the Jones Company. An ass~ account receivable, needs to be recognized along
p 2-1. The Mike Szabo Company engaged in the following tr:msactions during the month of with the revenue.
December:
Required Record the adjusting entries at December 31, using T-accounts.
December 2 Made credit sales of $4,000 (accepted accounts receiv:.i.ble).
6 Made cash sales of $2,500. p 2-4. The DeCort Company had these adjusting enny situations at the end ofDecember:
10 Paid office salaries of$500. !. On May 1, the DeCort Company paid $960 for a two-y= insurance policy The
14 Sold land that originally cost $2,200 for $3,000 cash. policy was for the period May 1 through April JO (2 years). This is the first y= of
17 Paid $6,000 for equipmenc the policy. The tran.saction was recorded as insurance expense.
21 Billed clients $900 far serví.ces (accepted accounts receivable). 2. On December 1, the DeCort Company purchased $400 of supplies for cash. The
24 Collected $1,200 on an account receivable. purchase was recorded asan asset, supplies. On December 31, it was determined that
28 Paid an account payable of $700. various supplies had been consumed in operations and that supplies casting $300
remained on hand.
Required Record tb.e t:ra.nsactions, using T-accounts.
3. DeCort Company holds a note receivable for $4,000. Tb.is note is interest-bearing.
p 2-2. The Darlene Cook Company engaged in tb.e following t:ra.nsactions during the montb. of The interest will be received when the note matures. The note is a one-year note
Jull" receivable made onJune 30, bearing 5% simple interest.
4. DeCort Company owes salaries in the amount of $800 at the end of December.
July 1 Acquired land for $10,000. The company paid cash.
5. As of December 31, DeCort Company had received $600 for services to be
8 Billed customers far $3,000. This represenr.s an incre:ise in revenue.
performed. These services had not been performed as of December 31. A liability,
The customer has been billed and will pay ata la.ter date. An asset,
uneamed revenue needs to be recognized, and revenue needs to be reduced.
accounts receivable, has been created.
6. On December 20, DeCort Company received a $400 bill for advertising in
12 Incurred a repair expense for repairs of $600. Darlene Cook Company
December. The liability account, accounts payable, needs to be recognized along
agreed to pay in 60 days. This transa.ction involves an increase in
with the related expense.
accounts payable and repair expense.
15 Received a check for $500 from a customer who was previously billed. Required Record the adjusting entries at December 31, using T-accounts.
This is a reduction in accounts.receivable.
20 Paid $300 for supplies. This was previouso/ established as a liability, p 2-5.
account ~ble. Required Answer the follo-wing multiple-choice questions:
24 Pa.id wages in the amount of $400. This was for work performed during a. The balance sheet equation can be defined as which of the following?
July. !. AssetS + Stockholders' Equity = Liabilities
2. Assets + Llabilit:i.es = Stockholders' Equity
Required Record the tranSactions, using T-accounts. 3. Assets =Llabilities -Stockholders' Equity
4. Assets - Llabilities = Stockholders' Equity
p 2-3. The Gaffuey Company had these adjusting entry situations at the end ofDecember.
5. None of the above
!. OnJuly 1, Gaffney Company paid $1,200 for a one·y= iosur:mce policy. The policy b. If assets are $40,000 and stockholders' equity is $10,000, how much are liabilities?
was for the periodJuly 1 throughJune 30. The tran.saction was recorded as prepa.id !. $30,000
insurance and a reduction in cash. 2. $50,000
2. On September 10, Gaffney Company purcb=d $500 of supplies for casb. The 3. $20,000
purchase was recorded as supplies. On December 31, it was determined that various 4. $60,000
supplies h:i.d been consumed in operations and that supplies costing $200 remained 5. $10,000
on hand. c. If assets are $100,000 and liabilities are $40,000, how much is stockholders' equity?
3. Gaffney Company recei.ved $1,000 on December 1 for services to be performed in l. $40,000
the follo'Wing year. Thi.s was recorded on December 1 as an increase in cash and as 2. $50,000
revenue. As of December 31, tb.is needs to be recognized as une::uned revenue, a J. $60,000
liability accounc · 4. $30,000
4. As of December 31, interest charges of $200 h:i.ve been incurred bec:iuse of borrowed 5. $140,000
funds. Payment will not be made until February. A liability for the interest needs to d. Which is a pernw.nent account?
be recognized as <loes the interest expense. l. Revenue
5. As of December 31, a $500 liability for salaries needs to be recognized. 2. Adven:ising Expense
3. Accounts Receivable
4. Dividends
5. Insurance Expense
60 CHAPTE.R Z Introducrion to Fin.ancial Scatements and Other Flrul.Dcial Reporting Topics CHAPTER 2 Introduction to FlllüD.cial Smtemen.ts and Other Fm:ancial Reporting Topics 61

e. VVb.ich is a temporary account? f.\/Vhi.ch of tb.ese is nota suggested problem caused by lack ofharmonization of inter-
l. Cash 4. Accounts Paya.ble national accounting standards?
2. Accounts Receivable 5. Notes Payable l. Positive effect on the international trade of accounting practice and services.
3. Insurance Expense 2. ~A.. need for employment of key personnel in multinational companles to bridge
f. In terms of debits and credits, which accounts have the same normal balances? the "gap" in accouncing requirements between countries.
l. Dividends, retained earnings, liabilities 3. Difficulties in reconciling local standards for access to other capital markets.
2. Capital stock, liabilities, expenses 4. Difficulties in accessing c::i.pitalmarkets for companies from less developed coun-
3. Revenues, capital stock, expenses tries.
4. Expenses, assetS, dividends 5. Negative effect on the international trade of accounting pracrice and services.
5. Dividends, assets, liabilities g. \/Vhi.ch of tb.ese organizations has not played a role in the harmonization of intema-
tional accounting standards?
p 2-6. l. United Nations (UN)
Required Answer the following multiple-choice questions: 2. Interna! Revenue Service (IRS)
a. Audit opinions cannot be classified as which of the following? 3. lnternational Accounting Scandards Committee (IASC)
l. All-putpose 4. Qualifi.ed opinion 4. Financia! Accounting Scmdards Board (FASB)
2. Disclaimer of opinion 5. Unqualified opinion 5. Euro pean Economic Communicy (EEO
3. Adverse opinion h. The Form 10-K is submitted to the
b. From the point of view of analysis, which classification of an audit opinion indicates l. American Institute of Certified Public Accountant5
that tbe financia! statements cany tbe highest degi:ee of reliability? 2. Securities and Exchange Commission
l. Unqualified opinion 4. Qualliied opinion 3. Interna! Revenue Service
2. All-purpose 5. Ad.verse opinion 4. American Accounting A.ssociation
3. Disclallner of opinion 5. Emetging Issues Task Force
c. \Vhich one of the following statements is fulse?
l. The reliance that can be placed on financial statements that have been reviewed p 2-7. The following are selected account5 of the Laura Gibson Company on December 31:
is substmtiallv less man for those that ha.ve been audited.
2. An accouncm:ts report de.scribed as a compilation presents only financia! infor- Nonnal
mation as provided by management. Permanent (P) Balance
3. A disclaimer of opinion indicares that you should not look to the auditor~ report or Temporary (T) (De.) or (Cr.)
as an indication of the reliability of the statements. Cash
4. A review has subst:m.Wlly less scope tban an examination in accordance with
Account5 Receivable
generally accepted auditing standards.
5. The typical unqwlliied opinion lliis one paragraph. Equipment
d. If an accountmt performs a compilation and becomes aware of deficiencies in the
statements, the accountant's report characterizes the deficiencies by ali but one of the Account5 Payable
following: Coro.man Stock
l. Omission of suhstantially aJl disclosures
2. Omission of statement of cash fl.ows Sales
3. Accounting principles not generally accepted
4. Ali of the above Purchases
5. None of the above
Rent Expense
e. In addition to the company's principal financia! st:atements, the Form 10-K and
shareholder annual reports must include ali but one of the following: Utility Expense
l. Information on the market for holders of common stock and related securities,
including bigh and low sales price, frequency and amount of dividends, and Selling Expense
number of shares. Required In the space provided:
2. Five-ye:rr swrrma:ry of sdected financia! data.
3.. Management's discussion and analysis of financia! condition and tesults of oper-
l. Indicate if the account is a permanent (P) or temporary en
account.
2. Indicare tbe nonnal balance in tenns of debit (De.) oc credit (Cr).
ations.
4. Two years of audited balance sheets, three years of audited statements of income, p 2-8. An auditor's report is che formal presentation of ali che effort that goes into an audit.·
and two years of statements of cash fl.ows. Below is a list of the classifications of audit opinions that can be found in an auditor's
5. Disclosure of the domestic and foreign components of pretax: income. reportas well as a list of pb.rases describing the opinions.
62 CHAPTER 2 Introduction to Fmanci:tl Statements and Other Fllmncial Reporting Topics t:HAPTER 2 Inttoduction to Frnancia.l St:i.rements and Other Fmancial ReportingTopics 63

Chissifications of Audit Opinions

a. Unqualified opinion lllffHff. The CEO Retires*
b. Qualified opinion
c. Adverse opinion Dan Murphy awoke at 5:45 a.m., just like he <lid everyworkday moming. No matter
d. Disclaimer of opinion tb.at he went to sleep ocly fuur hours ago. The Oran.ge Bowl game had gane late into the
evening, and tbe New Year's Day pany was so good, no one wanted ro leave. At least Dan
Ph:r:ises could awake easily tbis morning. Some of his gtiests had lost a little control celebr~:cing
l. This opinion states that the financia! st:atements do not present fuirly the · the first <lay of the new year, and Dan was nota person who ever lost control.
financia! position, results of operations, or cash flows of che entity, in The drive to the office was easier tb.an most days. Perhaps there were a great many
confor:mity "With generally accepted accounting principies. parties last night. .Ali the better as it gave Dan rime to think. The da:wn of a new year; bis
__ 2. Tbis type of report is rendered when che auditor has not performed an last year. Dan would turn 65 next December, and the company had a mandatory retire-
audit sufficient in scope to forman opinion. ment policy. A good idea he thought; to get new blood in the organizati.on. At least that's
__ 3. This opinion states that, except for the effects of the matters to which che what he thought on the climb up. From just another college graduate within tb.e corpo-
qualification relates, the financia! statements present fairly, in ali material r:i.te Staff, ali the way to tb.e Chief Executive Officer's suite. It certainly is a magnificent
respecrs, che financia! position, results of operations, and cash flows of the view from tb.e top.
entity, in conformity with generally accepted accouncing principles. To be CEO ofbis own company. Well not really, as it was tb.e stockholders' company,
4. This opinion states that the financia! st:atements present fuirly, in ali mate- but he had been CEO for the past eight years. Now he too must turn the reins over.
rial respects, the financia! position, results of operarions, and cash flows of "MUSt," now that's the operative word. He lmew it was the best thing for the company.
the entity; in conformity with generally accepted accounting principles. Tumover kept middle management aggressive, but he also lmew that he wouldn't leave if
he hada choice. So Dan resolved to make his last year the company's best year ever.
Required Place the appropriate letter identifying ea.ch type of opinion on the line in It was that thought which kept his attention, yet the focas of consideration and
front of the statement or phrase descn"bing che type of opinion. related motivations supporting such a scrat~"Y changed as he continued to strategize. At
p 2-9. A company prepares financial st:atements in order to summarize financia! information. first, Dan tb.ought that it would be a fine way to give something back to a company that
Below is a Iist of financia! statements and a list of descriptions. had given him so much. His 43 years wich tb.e company had given him challenges which
filled bis life with meaning and satisfaction, provided him with a good living, and made
Financia! St:ltements him a man respected and Iistened to in che business community. Bue the thought that the
a. Balance sheet company ms also forcing him to give ali that up made his thoughts tura more inward.
b. Income st:atement Of course, the company had done many things for him, but what of ali tb.e sacrifices
c. St:ltement of cash flows he had made? His whole he:m and soul were tied to the company. In fu.et, one could
d. St:atement of stockholders' equity hardly tbink of Dan Murphy without thinking of the company, in much the same way os
prominent corporate leaders and cheir firms are intrinsically linked. But che company
Descriptions would still be here this time ne.\'.tyear, and what ofhim? Yes, he would le:ive the company
l. Details the sources and uses of cash during a specified period of time. strong, because by leavlllg it strong, it would strengtb.en bis reputation as a great leader.
2. Summary of revenues and expenses and gains and losses for a speci±ic His legacy would carry and SUStain him over the years. But would it? One must al.so live
period of time. in a manner consistent with such esteem.
__ 3. Shows the financia! condition of an accounting entity as of a specific date. Being che CEO of a major company also has its creature comforts. Dan was accus-
__ 4. Presenrs reconciliation of the beginning and ending balances of the stock- tomed to a certaID scyie of living. How much will that suffer after che salary, bonuses, and
holders' equity accounts. stock options are no more?
Arriv:i.ng at che office by 7:30 a.m., he left a note for bis secretary that he was not to
Required Match each financia! statement with irs description. be disturbed until 9 a.m. He pulled out the compensation file and examined the incentive
clauses in bis own contract. The contract was creaced by tb.e compensation committee of
the Board of Direccors. Ali of the committee members were outsiders; that is, not a part
of the company's ~uement. Tbis lends the appear:ance of independence, but most
were CEOs of cheir O'Wll companies, and Dan lmew that, by and large, CEOs take care of
cheir own. His suspicions were confumed.. If the company's financia! resulrs were the best
ever this year, chen so too would be his own personal compensation.
Yet what if there were uncontrollable problems? The general economy appeared
fuirly st:able. However, anotlier oil shock, sorne more bank fuilures, ora list of otb.er dis:s-

Prepared by Professor Wtlliam H. Coyle, B:tbson College. /..,.

"Note: From "Eth.ics in the Accounting Cuxriculum: Cases & Re:idings," American Accounting Associ:ition, llfcluded
with pennission.
64 Cl-IAPTE:R 2 Inrroduction to Fm.:i.nci:tl St:rtements and Other Fm:ancial. Reporting Topics C:HAPTE:R 2
ters could tum things into a downward spiral quickly. Economies are easily influenced and
consumer and corporate psychology C'lD. play a large part in detennining outcomes. But
even in apparently uncom:rollable circumst:J..Dces, Dan lmew he coultl protect himself and
the financia} fortunes of bis company during the short-term, which aft:er ali, was the only
thing that mattered.
Upon further review of his compensati.on contract, Dan saw that a large portian ofhis
bonus and stock options was a funccion of operating income levels, e:irnings per share, and
retum on assetS. So the trick was to ma."cimize those items. Ifhe did~ the company would
appear vibrant and posed far future growth at the time of bis forced retirement, he
reminded himself. Furthermore, bis total compensation in the lastyear ofhis employment
would reach record proportions. Additionally, since bis pension is based on the average of
bis last three ye:irs' compensation, Dan will continue to reap tb.e benefi:rs of this year's
results for hopefully a long time to come. And who says CEOs don'~ think long-term?
Two remaining issues needed to be addressed. Those were (1) how to ensure a
record-breaking year and (2) how to overcome any objections raised in atti.ining those
results? Actually, the former was a relatively simple goal to achieve. Since accounting
allows so many altematives in the w:r¡ financia! events are me:i.sured, Dan could just select
a package of alternatives which would m.aximize the company's eamings and return on
assets. Some altematives may result in changing an accounting method, but since the new
auditing st:mdards were issued., bis company could sti1l receive an unqualified opinion
from bis auditors, 'With only a passing reference to any accounting changes in the audi-
tor's opinion and its effecrs disclosed in the foomotes. As long as tbe alternative was
allowed by generally accepted accounting principles, and tbe justification for the change
was rea.sonable, tbe auditors should not object. If there were objections, Dan could always
threaten to change auditors. But scill the best avenue to pursue would be a change in
accounting estiro.ates, since those changes did not ev'en need to be e..-plicitly disclosed.
So Dan bC::,o-an to mull over what changes in estimates or methods he could employ
in order to maximize his firm's :financia! appearance. In the area of accounting estimares,
Dan could lower the rate of estima.ted default on bis accounts receivable, thus lowering
bad debt expense. The estimated useful lives of bis plant and equipment could be
extended., thus lowering depreciation expense. In arguing that quality improvements h:ive
been implemented in the manufactu.ring process, the wamnty expense on the producrs
sold could also be lowered. In e.xam..in.ID.g pension expense, he noted th.at the assumed rate
of return on pension assets was ata modest 6.5%, so if that rate could be increased, the
corresponding pension expense could be reduced.
Other possíbilities occurred to Murphy. Perhaps items normally expensed, such as
• fff1f4
repairs, could be capit:ilized. Those repairs that could not be capitilized could simply be
deferred. The company could also defer short-term expenses for the training of staff.
Since research and development CostS must now be fully expensed as incurred, a reduc-
tion in those expenditures would increase net income. Return on assets would be
increa.sed by not acquiring any new :fixed assets. Production levels for inventory could be
increased, tbus spreading fu.ed costs overa ireater number of units and reducing the total
average cost per unit. Therefore, gross profit per unit wil1 increase. Inventory levels
would be a little bloated, but that should be easily handled by Dan's successor.
The prior examples are subtle chaiiges that could be made. As a last resort, a change
in accounting methods could be employed. This would require explicit foomote disclo-
sure and a comment in the auditor's report, but if it ca.me to that, it would sti1l be
tolera.ble. Examples of such changes would be to switch from accelerated to st:raight-line
depreciation orto change from LIFO to FIFO.
How to make changes to the :financia! results of the company appeared easier than he
first thought. Now back to the other potencial problem of "getting awaywith it." At first
tbought, Dan considered the degree of resistan.ce by the other members of top manage-
Inttoducrion to Financial Statements and Other Financial Reporring To pies 65
ment. Ñlike Hmington, Dan's chief financia! officer, would have to review any account-
ing changes that he suggested. Since Dan had brought Ñlike up the organization with
him, Dan didn't foresee any strong resistan ce from .Mike. As for the others, Dan believed
he liad two things going for him. One w:is their ambition. Dan knew that 1hey ali coveted
his job, and a clear successor to Dan had yet to be chosen. Dan would only make a
recommendation to the promotion committee of the Board of Directors., but everyone
knew his recommendation carried a great <leal of weight. Therefore, resistance to any
accounting changes by any individual would surely end bis or her hope to succeed him as
CEO. Secondly, although notas lucrative as Dan's, their bonus package is tied to the e..'\2.ct
same accounting numbers. So any actions taken by Dan to increase bis compensation wil1
also increase theirs.
Dan was actually beginning to enjoy this siru.ation, even consideringit one ofhis final
challenges. Dan realized that any changes he implemented would have the tendency to
reverse themselves over time. That would undoubtedly hurt the company's performance
down the road., but ali of bis potencial successors were in their mid-to-late 50s, so there
would be plenty of time for them to tura things around in the years ahead. Be.5ides, any
near-term reversals would merely enhance bis reputation as an excellent corporate Ieader,
as problems would arise after his departure.
At that moment, his secretary called to inform him that :Mike Harrington wanted to
see him. Mlke was just the man Dan wanted to see.
VVhat are the etlrictl issues?
What should Mike do?
Required a. Determine the facts-what, who, where, when, how.
b. Define the etbical issues.
c. Identify ma.jor principies, rules, and values.
d. Specify the alternatives.
e. Compare norms, principles, and values with altematives to see if a
clear decision can be reached.
f. Assess the consequences.
g. Make your decision.
The Dangerous Morality of Managing Eamings*
The Majority of Managers Surveyed Say lt's Not Wrong to Mana,,-e ~°"
Occasionally, the morals and ethics executives use to man.age their businesses are
examined and discussed. Unforrunately, the morals that guide the timing of nonopera.ting
events and choices of accounting policies largely have been ignored.
The etbical fnunework used by managers in reporting short-term emiings prohably
has received less attention than its operating counterpan because accountants prepare
financia! disclosures consistent with laws and generally accepted accounting principies
(GAAP). Those disclosures are reviewed by objective auditors.
lvianagers determine the short·term reponed eanrings of their companies by:
"Note: Prepared by Wtlliam.J. Brons,Jr., Professor ofBmess .'\dministr::i.tion, ~ Univer.rity Gr:idu:i.te School of
Business Administ:ratiou, md Kenneth A. Merch:mt, Professor of Ac:counring, University of Southern California. Reprinted
fromMímage:ment ACCO'lmting, August 1990. Copyright by N:i.tional Awciation of A.ccount:mts, Montvale, NJ.
66 C:1-1APTER z Inttoducrion to Fmancial Statements :ind Other Flll:lllcial Reporting Tapies C::l-IAPTE:R 2 Introduction to Financi::il Statements and Other Fmancial Reporting Topics 67

Managíng, providing leadership, and directing tb.e use of resources in operarions. The survey respondents' judgments of the acceptability of this practice were distrib-
Selecting the timing of some nonoperating events, su.ch as the sale of excess assets or uted as follows:
the placement of gains or losses in.to a particular reporting period. Ethica! 279
Choosing the accounting methods tb.at are used to measure short-term earnings. Questionable 288
Oi.sual observers of the financial reporting process may assume th:it time, laws, regu- linetbical 82
lacion, and professional standards have restricted accounting practices to tb.ose which are Total 649
moral, ethical, fu.ir, and precise. But most managers and tb.eir accountants lmow other-: Perhaps you are not surprised by these data. The ethical basis of an early shipmentlhOeral
wise-tb.at managing short-term eanllngs can be pan of a m:mager's job. p~ymentprogram may not be sometlllngyou have considered, but, with the prevalence of such
To understand the mor:tls of short-term eami:ngs management, we surveyed gener:tl div~e views, how c:m :my user of a short-rerm earrrings report know the quality of the infor-
managers and finance, contro~ and audit managers. The results are frighteIDng. ma.non?
We found striking disagreements among managers in ali groups. Furthermore, the Although the judgments about ali earnings-management practlces varied consider-
liberal definitions revealed in many responses of what is moral or ethical should raise ably, there are so me other gen~tions that can be made from the findinl!S summarized
profound questions about the quality of financial infol'ID2.tion tb.a.t is used far decision- in Table 2-2. e-
making purposes by parties both inside and outside a company. It seems many managers
are convIDced that if a practi.ce is not explicitly prohibited or is only a slight deviation On aver:.i.ge, the respondents viewed management of short-term earnings by account-
from rules, it is an ethical practi.ce rega.rdless of who might be affected either by the prac- mg methods as signiJicantly less acceptable tban accomplishing the sa:me ends by
tice or the information tb.at flows from it. This means that anyone who uses information changing or manipularing operat:ing dedsiO'TlS or procedures.
on short-term earnings is vulnerable to misinterpretation, manipulation, or deliber:.i.te The direction of the effect on eamings matters. lncreasing earnings is judged less
deteption. acceptable tban redw:ing eaming>.
M:neriality matters. Short-term earnings management is judged less acceptable if the
eaming> effect is Im-ge mther tban small.
The Mor:tls of M:maging Eanúngs The time period of the effect may affect ethical judgments. Managing short-term
To find a "revealed" consensus concerning the morality of eD.eo"'lging in ~­ e:irnings at the end of an interim quarter'Íy reporting period is viewed as somewha~
mana.gement acti.vities, we prepared a questionnaire describing 13 ~"'5-management
situations we had observed either directly or indirectly. The actions described in the inci-
dents were ali legal (altb.ough some were in violation of G.AAP), but each could be
constroed as involving short-term eaming> ~o-ement. *i·i=''*i* Mfu'1AGING SHORT-TER.vl EARNINGS
A total of 649 managers completed our questionnaire. Table 2-1 classifies respon-
dents by job functi.on. T:i.ble 2-2 SUIIlIIlarizes the views on the acceptability of various Proportion of Managers
eamings-management practi.ces. Who Jnd¡,.ae the Pr:icrice
Etlll"1 Questiamble, Unethical, or
ar a.Minar 3 Serious
Infr:¡ction Infu.crion
SURVEY RESPONDENTS
l. M:maging short·term e:inüngs by clunging or manipuhting
Oper:iring decisions or procedmes:
Totil Sample \Vhen the resuh: is to reduce e::ttníngs 79% 19% 2%
Gener:ilM=gers 119 \Vhen the result is t0 incre:ise em:nings 57% 31% 12%
Fmance. Control, & Audit Managers 262
Others ar Pasicion Nat Known ~
2. Manag:ing short-term e:imiogs óy cbanging or m:mipuhting
649
:LCCOuncing methods:
When the ch:mge to e:u-nings is sm:lil 5% 45% 50%
\Vhen the change to e:u:nings is large 3% 21% 76%
3. M:m:iging short-term eamings by defuring discrerionary
A m.ajor finding of the survey was a strilcing lack of agreement. None of the respon- expenditures into the next a.ccounting- period.
dent groups viewed any of tb.e 13 practices un:mi.mously as an ethical or unetlrical To meet an inrerim quarterly budget target 47% 41% 12%
To meet an annu:i.l budget ruget 41% )5% 24%
practi.ce. The dispersion of judgments ·about many of tb.e incidents was great. For exam-
4. Increasin.g short-term e:u:nings t0 meet :i budget t:rrget:
ple, here is one hypothetical earnings-management practi.ce described in the
By selling exc:e$ :i.ssets and reulizíng :i profit 80% 16% 4%
questionnaire: By ordering overcime work :i.t ye:ir-end to ship 3S much. as possiDlC 74% 21% 5%
In September, a general manager realized t:ha.t his division would need a strong By offering customers speci:tl credit rerms to :i.cccpt delivery
performance in the last qu:iner of the year in order to reach its budget targets. He without oblig:i.tion to payuntil the followingye:ir 43% 44% 1 15%
decided to implement a sales program offering hberal payment terms to pull sorne
sales tb.at would normally occur ne.'1: year into the current year. Customers accept-
ing delivery in the fourtb. qU2rter would not have to pay tb.e invoice for 120 days. Percenr:iges :ire c:ikuhted from Hm':Jard B'IJJintss &riaD readers' sample.
68 C>-iAPTER 2 Incroduction to Fmancial St:1.tement'i and Other Fmancial Reporting To pies
more acceptable than engaging in the same activity at the end of an tmnUf1.l reporting
period.
The method of managing eamings has an effect. Increasing profits by offering
extended c:redit termS is seen as less acceptable than accomplisbing the same end by sell-
ing excess asser:s or using overtime to increase shipments.
Managers lnterviewed
Were the survey results simply hypothetical) or did managers recognize they can
mana.ge earnings and choose to do so? To find the answers, we t:tlked to a large number
of the respondents. VVhat they told us was rarely reassuring.
0n accounting manipulations, :i. profit center controller reponed:
"Accounting is grey. Very little is absolute ... You can save your campan.y by
doing things 'With sales and expenses, and, if it's legal, then you are justified in
doing it."
A divisional general manager spoke to us about squeezing reserves to generare addi-
tional reponed profit:
"If we get a call aslcing for additional profit, and tb.at"s not inconceivable, I would
look at our reserves. Our reserves tend to be realistic, but we may have a prod-
uct claim that could range from $50,000 to $500,000. Who knows wbat the right
amount far somethlng like tb.at is? We would review our reserves) and if we felt
some were on the high side, we would not be uncomfortable reducing them."
We al.so heard about operating manipulations. One corporate group conrroller noted:
"[To boost sales] we have paid overtime and"shipped on Sarurday, the last day of
the fiscal quarter. If we totally left responsibility far the shipping function to the
divisions, it could even slip over to 12:30 a.m. Sunday. There are people who
would do tb.at and not know ii's wrong."
Ñlanagers afeen recognize tb.at such actions "move" earnings from one period to
another. Far example, a division conrroller told us:
"Last year we called our customers and asked if they would take early delivery.
We generated an extra $300,000 in sales at the last minute. We were scratching
far everything. We made our plans, but we cleaned out our bacl<log and started
in the hale thi.s year. We missed our first quarter sales plan. We vroI Cltch up by
the end of the second quarter."
And a group vice president said:
"I recently was in.volved in a situation where the manager wanted to delay the
production costS far tb.e advertising tb.at would appear in the fall [so tb.at he could
meet his qwnerly budget]."
Thus, in practice, it appears that a large majority of managers use at least sorne meth-
ods to manage short-term earnings. Altb.ough legal, these methods do not seem to be
consistent with a strict ethical framewOrk. VVhile the ID.aruleaers' actions have the desired
effect on reported eamings, the managers know there are no re:.tl positive economic bene-
fits, and the actions might acroally be quite costly in the long run.. These actions are at
best questionable because they involve deceptions that are not disclosed. Most managers
who manage earnings, however, do not believe they are doing anything wrong.
We see two majar problems. The most import:mt is the generally high toleran.ce far
operating manipulations. The other is the dispersion in managers' views about which
practices are moral and ethical.
CHAPTER 2 Introduction to Fm:mcial St::ttements :md Other Financia! Reporting Tapies 69
The D~o-erous Allure
The essence of a moral or ethicl approach to management is achieving a balance
between individual interestS and obligations ro those who have a stake in what happens in
the corpor:i.tion (ar what happens to a division or group within the corpor:i.tion). These
stakeholders include not only people who work in the furo, but customers, suppliers,
creclitors, sharebolders, and investors as well.
Managers who take unproductive actions to boost short-tenn earnings may be acting
totally within the laws and rules. Also they may be acting in the best interest of the corpo-
r:i.tion. But, if they fail to consider the adverse effects of thcir actions on other
stakeholders, we lllllY conclude that they are acting unetb.ically.
The managers we interviewed explained that they rated accounting manipulations
harshly beCluse in such cases the "truth" has somehow been denied or misstared. The
recipients of the earnings reports do not lmow what eamings would have been if no
manipulation had taken phi.ce. Even if the accounting methods used are consistent with
GAAP, they rea.son, the actions are not ethical beca.use the interests of majar stakeholder
groups-including the recipients of the earnings repons-have been ignored.
The managers judge the operating manipulacions more fu.vorably because the earn-
ings numbers are indiCltive of what actually took place. The operating manipulations
have ch:mged re:ility, and "truth" is fairly reporred.
We see flaws in that reasoning. One is that the truth has not necessarily been
clisclosed completely. VVhen sales and profits are borrowed from the future, far example,
it is :i r:.i.re company that discloses the borrowed narure of sorne of the profits reporred.
A second flaw in the reasoning about the :icceptability of operating manipulations is
that it ignores a few or ali of the effects of some types of operating manipulations on the
full range of stakebolders. Many managers consider operating manipulacions as a kind of
"víctimless crime."
But viccims do e.'rist. Consider, far ex:imple, the relatively common operating manip-
ulation of ea.rly shipments. As one manager told us:
"Would I ship e."(!I'a product if I was fuced with a sales shortfull? You have to be
careful there; you're pfaying with fire. I would let whatever happened fu.11 to the
bottom line. fve been in companies that did whatever they could ro make the
sales number, such as shipping lower quality product. TharS way too short-term.
You have to draw the line there. You must nuintain tb.e level of quality and
customer service. You'll end up payin.g for bad shipments eventually. You11 have
rerorns, repairs, adjustments, ill. will thar will cause you to lose the account ...
[In addition] ii's tough to go to your employees one day and say ship everything
you can and then tura around the next day and say th.at the quality standards
must be maintained."
Anotber reported:
"We've had ro go to [one of our biggesr customers] and say we need an arder.
That b1ls us in the negociations. Our last sale was at :i price just over our cost of
materials."
These comments point out that customers-and sometimes even the corporation-
may be victims.
Without a full analysis of the costs of oper:i.ting manipulations, the d:mgers of such
manipulations ro the corporation are easily underestim.ated. Mistakes will be made
because the quality of information is misjudged. The short term will be emphasized at the
e.\'.flense of the long term. If managers consisrently manage short-term earnings, the
messages sent to other employees creare a corporate culture that lack.5 mutual trUSt,
integrity, and loy:tlty.
70 C1-1APTER z Introducrion to Flll3llcial St1.tements :md Other Fm:mcfal Reporting Topics
A Lack of Moral A,,,oreement
We also are troubled by the IDaD.:locrers' inability to agree on the zypes of earnings-
management activities that are acceptable. Tbis hck of agreement e."cists even within
corporations.
YVb.at tbis suggests is that man.y managers are doing their analyses in different ways.
The danger is obfusc::rcion of the reality behind the financi:tl reports. Because managers
are using different standards, individua.Is who ny to use the information reported may be
una.ble to assess accuntely the quality of that information.
If differences in opinions exist, it is likely that financia! reporting practices will sink
to their lowest and most manipul:i:tive level. As a result, managers with strict definitions
of what is moral and etbical will find it difficult to compete vri.th managers who are not
playing by the same rules. Ethical managers either will loosen their moral st:1I1clards or fail
to be prometed into positions of greater power.
A.ctions for Concerned ~uers
We believe most corporations would benefit if they established clearer accounting
and operating standards for ali employees to follow. The standard-setting process should
involve managers in discussions of the pr:ictices related to short-term earnin.gs measure-
men-ts.
Uno1 these standards are in place, different managers~ use widely v:irying criteria
in assessing the accepta.bility of various earnings-m.anagement practices. These variatioos
will have an ad.verse effect on the quality of the firm's :6.nancial information. Companies
can use a quescionnaire similar to the one in our smdy to encour.lge discussion and to
communicate corporate standards and the re:ison fo.r tbem.
Standards also enable interna! and e.xtemal auditors and management to judge
whether or not the desired quality of earnings is being m.aintained. In most companies,
auditors cm depend on gOod standards to identify and judge the accept:lbility of the oper-
ating manipulations.
illtimately, the line management chain-of-commmd, not auditors or financia! staF:t:
bears the primary responsibility for controlling operating manipulations. Often managers
must rely on their prior experience and good judgment to distinguish betWeen a decision
that will b.ave positive long-term benefits and one that has a positive sbort-term effect but a.
deleterious long-term effect.
Finally, it is important to manage the corporate culture. A culrure that promotes
openness and cooperati.ve problem-solving among managers is likely to result in less
short-tenn e:unings m.anagement than one that is more competi.tive and where :mnual,
and even quarterly, performance shortfalls are punished. A corporate culture that is more
concerned with managing for excellence rather than for reporting shon-term profits ~
be less b.1.ely to support tbe widespread use of immoral earnings-management praccices.
Required a. T IIDe, laws, regulati o~ and professional standards have restricted
accounting praccices to those that axe moral) ethical, fair, and precise.
Comment.
b. Most managers sui-veyed b.ad a conservative, strict interpretation of
what is moral or ethical in financia! reporting. Comment.
c. The managers surveyed e.-<lribited a surprising agreement as to what
consritutes an etbical or unethical practice. Comment.
d. List the five gener:ilizations from the findings in tbís smdy relating to
=ging earnin,,"'1.
e. Comment on m.anagement's ability to manage earnings in the long ron
by influencing financia! accounting.
C:HAPTER 2 Introduction to Fmancial Statements and Other Fmancial Reporting T~pics 71
Frequent-Flier Awards-Tick-Tick, Tick-Tick, Tick-Tic..1<
In the early l 980s, airlines introduced frequent-flier awards to develop passenger
loyalty to a single airline. Free tickecs and poSSIOly other awards were made av:lllable to
passengers when they accumulated a cert:ain number of miles or flights on a particular air
carrier. These progr:uns were potentially good for the passenger and the airline as long as
the awards were not too generous and the airlines could miDimize revenue displacement
from a paying passenger.
These progr:uns were introduced by Americ:in Airlines in 1981. Originally there
were no restriccions. Anyone with the necessary miles could take any flight that had an
available seat. In the late l 980s, most airlines changed their no-restriction programs to
programs with restrictions and blackout days. Airlines typically compensated passengers
for these ch.anges by cutting mileage requirements. The airlines also added partners in
frequent-flier programs, such as car renta! companies and hotels. These parmers handed
out frequent-flier miles compensa:ting the airlines in sorne manner for the miles distrib-
uted. Airlines also added triple-mileage deals.
Aconsequence of these expandingfrequent-flier programs was a surge in the number
of passengers flying free and a surge in unused miles. To get a handle on the cost and the
unused miles, airlines incre:ised tbe frequent-flier miles needed for a ±light and placed
time limits on the award miles. Thus-tick-tick, tick-tick, tick-tick.
The increased frequent-füer miles needed for a ilight and the time limits prompted
laWsuits. Many of these lawsuits were filed in state couns. One of tb.e suits fi.led in the
District Court in Chicago in 1989 made its way to the United Sta.tes Supreme Court. In
1995 the Supreme Court ruled that federal airline deregulation law would not bar the
breach-of-contr.i.ct chrim in the state court. InJune of 1995 a District Court in Dallas
ruled in fuvor of the airline in a case involving an increase in miles needed to earn a ttip.
.'\irlines interprettbis decision as upholding theirrightto make changes to their frequent-
füer programs.
Required a. In your opinion, are the outstanding (unused) miles a liability to the
airline? (Substant:iate your answer.)
b. Comment on the potential problems involved in esrimating the dallar
amounr of any potencial liabiliry.
c. l. VVhat is a contingent liability?
2. In your opinion, are unused miles a contingent Iiability to the fil
carrier?
3. Recommend the recognition (:tf any) for unused miles.
• SHB • Intematioilal AccouD.ting-Hannonization in Practice
Dennis R- Beresford, Chairman, Financia! Accounting Standards Board, included
tbese cornments in the June, 1995 Financia! Accounting Series of the Fmancial
Accounting Foundation. This case represents a quote from page 2, Notes from the
Cliainrum. (Permission to reprint obt:rined from the Financia! Accounting St:mclards
Board.)
 72 Introduction to Fmancia1 St::1tements and Other Fmancial ReportingTopics
Notes from the Chairman (m Part)
Last montb. Jim Leisenring and I attended what is now becoming more or less
an annual meeting of accounting standards setters from more than a dozen coun-
tries. The first of those meetings, iniciated by the FASB, was held in 1991 in
Brussels, and similar get-togethers have followed in our offices, London, and
now Amsterdam. This year's meeting was held in conjunction with a regular
meeting of tb.e Internacional Accounting Standards Coromittee and the cente-
nary celebrations of Ñ"IVR.A, tb.e professional accounting body in tb.e
Netherlands.
Earlier, tbis gTOup had devoted its attention mainly to conceptual issues and
general communic:iti.ons about what the various countries were worlcing on at
the time. For e..xample, the first gathering concentrated on the objectives of
e.nemal :financial reporting and whether individuo.l countries had explicit or
implicit conceptual frameworks. In London, most of the time was spent on how
future events are considered in accounring recognition and measurement deci-
sions. That discussion was fucilitated by a paper prepared by the FA.SB and our
counterpans from Australia, Canada, the United Kingdom, and the IASC. The
paper later was jointly published as the Special Report, "Future Events--A
Conceptual Study ofTheir Significan.ce for Recognition and Measurement."
In Amsterdam, we spent most of the time on two specific tecbnical issues that are
hot tapies here as well as in the rest of the world: accounting for envirorunental
liabilities and derivative financi:.U instruments. Papers were presented by Canad.a,
Denmark, England, and the European Commission, which covered the current
state-of-the-art reg-arding disclosure of and accounting for environment:tl costs.
.A,s in the U.S., the key issues are deciding when an oblig:ition has been incurred,
under what circumstances can any resulting debit be considered an asset (e.g.,
costs incurred to "improve" a productive fucility), and when an amount is meas-
urable with sufficient reliability.
Required a.Comment on the trend in harmonization of intemational accounti.ng
as represented by tb.e comments included in this case.
b. ea:n we expect harmonization of intemational accounting to be
accomplished in .the foreseeable future? Comment.
•
1
3'Hfl. Materiality: In Practice
Professional st:mdards require auditors to m.ake a preliminaxy judgment about mate-
riality levels during the plann.ing of an audic St:ttement of Anditing Standards (SAS) No.
47 States that "the auditor pbns the audit to obtain reasonable assurance of detecting
misstatements that he/she believes could be large enough, individually or in the aggre-
gate, to be quantitatively material to the financia! statements.,,...
SAS No. 47 indicates that materiality judgments involve both quantimtive and qual-
itative considerations. This statement recognizes that it ordinarily is not practica! to
design procedures to detect misstatements that could be qualiti:ti.vely material.
Note: This c:isc is b:ised on SAS No. 47 :is updated md presented in AV312 of the Ccdifaatim uf State'!r.mts m Auditing
Standards (Ame.-ic:m Insritute of Cercified Public Accounm.ts),Janrory, 1989
CHAPTER 2 Introduction to Financia1 Sta.tements :md Other Financi:tl Reporting Topics 73
li number of rule-of-thumb materiality calcuhtions have emerged, such as percent-
ages ofincome, total assets, revenues, and equity. These rule-of-thumb calculations result
in differing amounts far audit plann.ing purposes. In fuer, sizeable differences c::i.n result,
depending on the rule of thumb and the industry.
Required a. It would seem prudent for auditors to give careful consider.i.tion to
plann.ing materi:ility decisions. Comment.
b. It is difficult to design procedures to detect misstatements that could
be qualitati:vely material. Comment.
c. lt is difficult to design procedures to detect misstatements that could
be quantimtively material. Comment.
d. In your opinion, would the application of materiality be a frequent
issue in court cases involving financia} statements? Comment.
Who is Responsíl:>ie?
REPO!IT OF INDEPENDENT ACCOUNTANTS
To the Shareowners and Board ofDirectors
The Kroger Co.
In our opinion, the accompanying consolidated balance sheet ofThe Kroger Co. and the
related consolidated Statements of operations and accumulated deficit, and cash flows
present fuirly, in ali material respects, the financia! position of the Kroger Co. as of
January 2, 1999 and December 27, 1997, and the coosolidated results of its operations and
its cash &ws for the years endedJanuary 2, 1999, December 27, 1997, and December 28,
1996, in conformity '!Nith gener:illy accepted accounting principles. These financial state-
ments are tb.e responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We conducted our
audits of these Statements in accordance with generally accepted auditing standards wbich
require that we plan and perform. the audit to obtain reasonable assur:mce about whether
the financia! statenients are free of material misstatement. An audit includes e.'CllllÍDing,
on a test basis, evidence supporting the amounts and disclosures in the financia} sta.te-
ments, assessing the accounting principies used and significant estima.tes made by
management, and ev:tluating the overall financia! statement presentation. We believe that
our audits provide a reasonable basis for tb.e opinion expressed above.
As discus.sed in the notes to the consolidated financia! statements, the Company changed
its applicati.on of the LIFO metb.od of accounting for store inventaries as of December
28, 1997.
P~rtt:f'
PricewaterhouseCoopers LLP
Cincinnati, Ohio
January 28, 1999
Required a. Who has the responsibility for the financial statements?
b. YVhat is the role of the accountmt (auditor) as to the financia! state-
ments?
74 C:HAPTE:R 2 Introduction t0 Flll:lil.cial St:i.tements and Other Fmanci:tl Repon:ing Tapies
c. Accountmts (auditors) are often included as defendants in lawsuits
that relate to the financial smtements. Speculate as to why tb.is is the
case.
d. VV"M.t type of auditor's opinion is represented in this case?
e. Would we expect these audited financia! stltements to be free of
misstatement? Comment.
•SHf'• Safe Harbor
In 1995, Congress passed the Private Securities Litig:ition Reform Act (the Acr). The
principal provisions of the Act are intended to curb abusive litigation, and improve the
quality of information available to investors tbrough the creation of a safe harbar far
forward-loo.ldng st:ltements.
Forward-looking statements were defined to include St:atements relating to projec-
rions of revenues and other financial items, plans and objectives, future economic
performance, assumprions, repons issued by outside reviewers, or other projections or
estimates specified by rule of the SEC. The safe harbor applies to both oral and written
st:atements.
Manaoooement frequently uses signals as "we esrimate," "we project," and the like,
where forward-looking st:atements are not otherwise idenrified as su.ch. The forward-
looking stltements must be accompanied by meaningful cautionary st:l.tements. The
caurionary st:atement may be contained in a separ.i.te risk secti.on elsewhere in the disclo-
sure document.
Osmonics included statements that would likelJ be constrUed as forward-loo.ldng in
their 1998 second quaner repon to shareholders. This included a sratement by D. Dean
Spatz, Chairman & ChiefExecutive Officer.
"I am gratified to see our employees enthusiastically embrace the Company's
restrncturing and re-engineering. Their de<lication and ideas will have even greater
impact on our busIDess as we implement streamlined systems and new management
practices. We believe our revitalized organiz:irion, integrated produets, and ration-
alized manufacturing Oper:lrions will enable Osmonics to be a dominant supplier of
high technology water purification and filtration products and cost-effective
components in the years ahead."
The Osmonics repon included this cautionary statement:
"The Prívate Securities Litigation Reform Act of 1995 provides a 's.rfe harbar'
for forward-looking statements. Cena.in information included in tb.is document
and other materials filed or to be filed with the Securities and E.'<change
Commission (as well as information included in oral or other written Statements
made orto be made by the Company) contains st:atements that are forwm-d-look-
ing. Such sratements may relate to plans for future expansion, business
development activities capit:il spending, financing, the effects of regulation and
competition, or anticipated sales or eamings results. Such information involves
risks and uncertainties that could sigcificantly affect results in the future and,
accordingly, such results may differ from those expressed in any forward-looicing
St:atements made by or on behalf of the Company. These risks and uncerta.inties
include, but are not limited to, those relating to product development activities,
computer systems implemencation, dependence on eriscing management, global
economic and market conditions, and cb.anges to federal or state laws."
C:HAPTE!R 2 Introduction to Financial St:itements and Other Fin:m.ci:tl Reporcing Topics 75
Required a. Dem:md for financia! reports e.-cists because users believe th.at the
reports help them in decision making. In your opinion, vrill foI"W'3l"d-
looking statements as provided by the Prívate Securities Litigation
Reform Act aid users of financia! repons in decision maldng?
b. To some e.xtent, investors rights are limited by the curb ofabusive liti-
gation. In your opinion, is there a net benefit to investors from a safe
harbar for forward-loolcing statements?
Endnotes
Charles H. Gibson and Nicholas Schroeder, "How 21 Companies Handled Their
SUillllUt)' Annual Repons," Fintmcial &ecutive (Novcrnber/Deccrnber 1989), pp.
45-46.
2 Mary E. Guy, Ethieal Decisilm MPking in Everyday Work Sit=tiuns (New York, NY'
Quarum Books, 1990), p. 5.
3 Guy, p. 14.
4 Wtlliam W. Miy, ed., Ethics in the Accinmting CurricuJwn, Cases & Readings (Sarasota,
FL: American Accounting Association, 1990), pp. 1-2.
5 "Regulators Investigate Peat on ItS A.uditing of S & L," The Nw York TtmeS (Nfay 23,
1991), p. D-1.
6 "S.E.C. Inquiry Is Reponed on Loans to Accountants," The Ni:w York Trmes
(February 7, 1991), p. D-1.
7 "Ernst & Young Settles Negligence Charge," Business brsurance (J;by 6, 1991), p. 2.
8 Ronald Grover, "Curt:rins for Tmseltown Accounting?" Business Week Q"anu:uy 14,
1991), p. 35.
9 Shahram Victory, "Pierce O'Donnell Pans 'Fatal Subtraction,'" American Lawyer
(Mirch 1991), p. 43.
10 "Buchwald WmsJust $150,000 in Ftlm Lawsuir," The Wall Street ]=al (Mirch 17,
1992), p. B-1.
ll Dennis E. Peavey and Stuart K Webster, "Is GAAP the Gap to !nternatioual
Markets?" Mimagement Accwnting (August 1990), pp. 31-32.
12 John Hag:ui:y, "Why We Can't Let GAJT Die," Journal ofAcc=nry (April 1991),
p. 74.
13 Peavey and Webster, p. 34.
14 Anthony B. Creamer, "Auditing Beyond U.S. Shores' What the U.S. CPA Should
Know," Journal of~ (Novctnber 1987), p. 92.
15 Gerhard G. Mueller, Helen Gernan, and Gary Meek, ACCOWltin!f An bztematianal
Perspective, 2d ed. (Homewood, IL Richard D. lrwin, !ne., 1991), pp. 45-46.
16 Dermis Beresford, "Internationalization of Accounting Standards," Accounting
Hori=<ms (Mirch 1990), p. 1O.
17 Mueller, Gernan, and Meek, pp. l!-12.
18 The FASE is considering a proposal that would require that the purchase method be
the only method used to account for business combinations.