Intro To Finance - June 2009 - Session 2

Introduction to Finance
PGDM 2009 – 2011 Batch
Session 2 – Introduction to Financial

Statements
Forms of Business Entities
Chapter 2, Slide #2
Number of
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
The Financial Statements
• Income statement
• Statement of stockholders’ equity
• Balance sheet
• Statement of cash flows
• Support for the financial statements is
provided by notes
Chapter 2, Slide #3
Income Statement
• Dated for a specific Income Statement

Revenue $ 120,000
period Expenses (100,000)
• Summarizes Net Income $ 20,000
revenues and
expenses
• Reports net income
– Excess of revenues
over expense
• Net income increases
retained earnings
Chapter 2, Slide #4
Statement of Stockholders’ Equity
• Dated for a specific Income Statement

period Revenue $ 120,000
Expenses (100,000)
• Reconciles Net Income $ 20,000
beginning and
Statement of Stockholders’ Equity
ending balances of
Capt. Stk. Ret. Earn.
the stockholders’ Beginning Balance $20,000 $ 5,000
equity accounts Net income 20,000
– Capital Stock Dividends (10,000)
– Retained Earnings Ending Balance $20,000 $ 15,000
– Etc.
• Links the income
statement and the
balance sheet
Chapter 2, Slide #5
Balance Sheet
Income Statement
Shows the financial condition Revenue $ 120,000
of an entity as of a particular Expenses (100,000)
date Net Income $ 20,000
– Assets: the resources of Statement of Stockholders’ Equity
the business Capt. Stk. Ret. Earn.
– Liabilities: the debts of Beginning Balance $20,000 $ 5,000
the business Net income 20,000
– Equity: the owners’ Dividends (10,000)
interest in the business Ending Balance $20,000 $ 15,000
The Accounting Equation: Balance Sheet
Assets = Liabilities + Assets $110,000
Stockholders’ Equity Liabilities 25,000
Stockholders’ Equity
Assets = Liabilities + Capital Stock 50,000
Capital Stock + Retained Earnings 35,000
Retained Earnings $110,000
Chapter 2, Slide #6
Statement of Cash Flows
• Covers the same period as the income

statement
• Three sections
– Cash flows from operating activities
– Cash flows from investing activities
– Cash flows from financing activities
Chapter 2, Slide #7
Notes
• An integral part of the financial statements

• Required presentation
– Summary of significant accounting policies
– Contingent liabilities
– Subsequent events relating to conditions that
existed at the balance sheet date
• Disclose and adjustment of the financial statements
– Subsequent events relating to conditions that did
not exist at the balance sheet date
• Disclosure but no adjustment of the financial statements
Chapter 2, Slide #8
The Accounting Cycle
1. Recording transactions
2. Recording adjusting entries
3. Preparing the financial statement
Chapter 2, Slide #9
Recording Transactions
• Internal or external event that causes a

change in a company’s assets, liabilities, or
stockholders’ equity
• Recorded in a journal (journal entry)
• Posted to general ledger accounts
• Double-entry system
 Debit: left side of an account Account Title
 Credit: right side of an account Debit Credit
 Debits = Credits
Chapter 2, Slide #10

Accounting System Components
Permanent Temporary
Account Assets Revenues, Gains
types Liabilities Expenses, Losses
Equity Dividends
Balances Carry forward to the Closed to retained
next fiscal period earnings at year-end
Represent the
accounting equation

Recording Adjusting Entries
• Required by the accrual basis of accounting

• Prepared at the end of the fiscal period
• Records (recognizes) for the current period
– Expenses incurred
– Revenues earned
• Recorded in the general journal
• Posted to the general ledger

Preparing the Financial Statements
• The output of the accounting system

• Based on the adjusted general ledger
account balances
• Directly from the general ledger
– Income statement
– Balance sheet
• From analysis of general ledger accounts
– Statement of cash flows

Treadway Commission
• Voluntary private sector organization

• Committee of Sponsoring Organizations (COSO)
– Internal control reports
– Standard framework for evaluating internal control
• Need for internal control emphasized by
– Sarbanes-Oxley Act §404
– Management's Report on Internal Control
– Independent auditor’s opinion on management’s
assessment of internal control

Auditor’s Opinion
• Audit is conducted by CPAs

• The audit report is the formal statement of
audit opinion
– Unqualified opinion
– Qualified opinion
– Adverse opinion
– Disclaimer of opinion

Unqualified Opinion
• The financial statements present fairly

– The financial position
– Results of operations
– Cash flows
• In conformity with generally accepted
accounting principles
• For the user: the highest degree of reliability

Qualified Opinion
• Except for the matter to which the exception relates

• The financial statements present fairly
– Cash flows
• In conformity with generally accepted accounting
principles
• For the user: determine the significance of the
exception

Adverse Opinion
• The financial statements do not present

fairly
– Cash flows
• In conformity with generally accepted
accounting principles
• For the user: reliability of financial statements
need to be seriously questioned

Disclaimer of Opinion
• The auditor does not express an opinion

• Auditor
– Has not preformed an audit sufficient in scope to
form an opinion or
– Is not independent
• For the user: auditor’s statement conveys no
indication of financial statement reliability

Unqualified Auditor’s Report
• Paragraph #1:
– Financial statements have been audited
– Financial statements are responsibility of
management
– Auditors have responsibility to express or disclaim
an opinion

Unqualified Auditor’s Report (cont’d)
• Paragraph #2
– Audit conducted in accordance with the standards
of the (U.S.) Public Accounting Oversight Board
– Auditor is required to plan and perform the audit
• Obtain reasonable assurance
• Financial statements are free from material
misstatement
– Audit provides a reasonable basis for opinion
• Examining evidence
• Assessing accounting principles and estimates

Unqualified Auditor’s Report (cont’d)
• Paragraph #3
– Opinion: in conformity with generally accepted
(U.S.) accounting principles
• Also: for public companies, reference to the
audit of internal control effectiveness
– In accordance with the the (U.S.) Public
Accounting Oversight Board
– Based on criteria established by COSO

Auditor’s Report on Internal Control
• Required by Sarbanes-Oxley
• May be combined with audit opinion report
• Paragraphs
1. Scope
2. Responsibility and procedures
3. Opinion
4. Reference to financial statement audit

Other Types of Engagements
• Review
– Less in scope than an audit
– An opinion is not expressed
– Provides negative assurance
• “Not aware of any material misstatements or required
modifications”
• Compilation
– Presents only financial information provided by
management
– No opinion or any other assurance is given

Management’s Responsibility
• Management is responsible for

– The preparation of the financial statements
– The integrity of the financial statements
• Management’s Statement of Responsibility
– May be included in the annual report

The SEC’s Integrated Disclosure System
Required filings
– 10-K: annual filing (audited)
• Includes financial statements plus
– Information on the business entity
– Market information
– Management discussion and analysis
– Directors, executive officers, and their compensation
– Related party transactions
– 10-Q: quarterly filing (unaudited)
– 8-K: “current report”
• To report the occurrence of any material events or corporate
changes

Additional Reporting Venues
• Proxy
– Notice and authorization of shareholder voting
rights on corporate actions
– Content and form governed by the SEC
• Summary Annual Report
– Highly condensed financial information
– Must be accompanied by a proxy containing full
financial information
– Not adequate for financial analysis

The Efficient Market Hypothesis
• Capital markets generate security prices that reflect

worth
• Publicly available information is reflected in share prices
• Investors will be harmed if full disclosure is not made
• Method of disclosure does not impact value
– Body of the financial statements
– Notes to the financial statements
• Benefit of making disclosure outweighs the cost

Ethics
Essential values in interpersonal relationships
Caring Loyalty
Honesty Fairness
Accountability Integrity
Promise keeping Respect for others
Pursuit of excellence Responsible citizenship

AAA Ethical Decision Framework
1. Determine the facts

2. Define the ethical issues
3. Identify major principles, rules, and values
4. Specify the alternatives
5. Compare norms, principles, and values with
alternatives
6. Assess the consequences
7. Make your decision

SEC Requirement: A Code of Ethics
• Enacted under Sarbanes-Oxley Act

• Applicable to chief financial officers
• Disclosure requirements
– Whether a code of ethics has been adopted
– If not, why not
– Code is published in the annual report or on the
firm’s web site

Harmonization of International
Accounting Standards
• Accounting standards can vary by country
– Development is often in response to domestic
needs
• International accounting standards set by
– IASC (1973 – 2001)
– IASB (2001 to present) has no enforcement
power
• In the U.S.
– SEC requires registrants to report in U.S. GAAP
– FASB is participating in the harmonization project

Consolidated Financial Statements
• Parent consolidates with subsidiary

– Report results of operations separately
– Sum subsidiary and parent results of operations
• Legal control vs. effective control
• Consolidation occurs when parent has
effective control over the subsidiary
– Holds a majority of risks, rewards, and decision-
making ability

Accounting for Business Combinations
• Effected through merger or acquisition

• Purchase method of accounting
• Record assets and liabilities acquired at their
fair values
• Excess of purchase price over fair value of
net assets acquired is reported as goodwill


Intro To Finance - June 2009 - Session 2

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Intro To Finance - June 2009 - Session 2

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Introduction to Finance

PGDM 2009 – 2011 Batch

Session 2 – Introduction to Financial

• Dated for a specific Income Statement

• Dated for a specific Income Statement

• Covers the same period as the income

• An integral part of the financial statements

• Internal or external event that causes a

Chapter 2, Slide #10

Chapter 2, Slide #11

• Required by the accrual basis of accounting

Chapter 2, Slide #12

• The output of the accounting system

Chapter 2, Slide #13

• Voluntary private sector organization

Chapter 2, Slide #14

• Audit is conducted by CPAs

Chapter 2, Slide #15

• The financial statements present fairly

Chapter 2, Slide #16

• Except for the matter to which the exception relates

Chapter 2, Slide #17

• The financial statements do not present

Chapter 2, Slide #18

• The auditor does not express an opinion

Chapter 2, Slide #19

Chapter 2, Slide #20

Chapter 2, Slide #21

Chapter 2, Slide #22

Chapter 2, Slide #23

Chapter 2, Slide #24

• Management is responsible for

Chapter 2, Slide #25

Chapter 2, Slide #26

Chapter 2, Slide #27

• Capital markets generate security prices that reflect

Chapter 2, Slide #28

Essential values in interpersonal relationships

Chapter 2, Slide #29

1. Determine the facts

Chapter 2, Slide #30

• Enacted under Sarbanes-Oxley Act

Chapter 2, Slide #31

Chapter 2, Slide #32

• Parent consolidates with subsidiary

Chapter 2, Slide #33

• Effected through merger or acquisition

Chapter 2, Slide #34

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