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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- Other financial reporting topics included in
ments. Subsequent chapters present a det::úled this chapter tb.at contribute to the undemand-
review of the principal financial statements. ing of financial reporting are: the audñ:or's
Chapter 3 covers the bala.nce sheet, Chapter 4 repon, mamgement's responsibility far finan-
covers the income statement, and Chapter 10 cia! statements, the SEC's integrated disclosure
covers the statement of cash flows. system, the sumwry =ual report, ethics,
Tbis chapter · also reviews the forms of international accounting standards, consoli-
business enciti.es, and the sequence of account- dated statements, and accounting for business
ing proCedures (cilled the accounring cycle). 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 C:HAPTER 2
Introduction to Financia! Statements and Other Financia! Reporting Tapies 41

In simplistic forro, the stockholders' equity of a corporation appears as follo'WS:


policies (preceding tb.e fust note). Accounting policies in.elude such items as tb.e metbod of
Stockholders' Equity inventocyvaluation and depreciation policies. Other information specific:illy requiring foot-
Common Stock $200,000 note disclosure is the existence of contingent liabilities and some subsequent events.
Ret:ained e:i:rnings 50,000 CO'lftingmt liabi!it:ies are dependent upon the occurrence or nonoccurrence of one or
$250,000 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
Th.is indic:ites that stockholders contributed (mvested) $200,000, and prior eamings on a loan creates another type of contingent liability.
less prior dividends have been retained in the entity in tb.e net amount of $50,000 (ret:i:ined An estim.ated loss from a contingenc liability should be charged to íncome, and be
e=ing,;). 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-
Statement of Stockholders' Equity (Reconciliarion of Stockholders' note. A loss contlni:,<l1mcy tb.at is reasonably possible, but not probable, must be disclosed
Equity Accounts) 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
Fmns are required to present reconcili'1tions of the beginning and encüng balances of need to be disclosed, but disclosure may be desirable if there is an unusually large potentia1
their stockholders' equity accounts. 1bis is accomplished by presenting a "statement of loss. fu::hibit 2-2 illustrates a contingent liability foomote.
stockholders' equity." Remined earnings is one of the accounts in stockholders' equity. Subsequent events occur after the balance sheet date, but befare tb.e smtements are
Retained eamings links the babnce sheet to the income statement. Retained earnings issued. Two varieti.es of snbsequent events occu.r. The first type con..sisG of events related to
is increased by net income and decreased by net losses and dividends paid to stockholders. conditi.ons that ex:isted at tb.e balance sheet date, affect the esti.rrui.tes in the statements, and
There are some other possible increases or decreases to retained e:rrnings besides income requ.ire adju.stment of the statements befo re issuance. For example, if :additional infonnation
Oosse.s) and dividends. For the purposes of this cliapter, retained earnings will be described is obt:l.ioed indiC1ting that a major customer's account receivable is not collectible, an :adjust-
as prior ea:rnings less prior dMdends. ment would be made. The second type consists of events that provide evidence about
Fmns usu:illy present the reconciliation of ret:ri.ned earnings within a "statement of conditi.ons that did not exist ::i.t tb.e balance sheet date and do not require adjusonent of the
stockholders' equity." Some firms present the reconciliation of retai.ned e:amings at the st:atements. Hf.ailure to dlsclose these events would be misleading, disclosure should take the
bottom of tbe íncome st:i.tement (combined income st:ltement and retained e:mllngs). In forro of foomotes or supplemeniary schedules. Examples of the second type of such events
tbis case, tbe other stockholders' equity accounts may be reconciled in a statement tbat in elude che sale ofsecuriti.es, the settlement of li~""<ltion, or casu.:alty loss. Othe:r examples of
e.."Ccludes retained e:i.rnings.•A..n additional review of the smtement of stockholders' equity is subsequent events might be debt incurred. reduced, or refinanced; busIDess combinati.ons
in Chapter 3. 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
Income Statement (Statement ofEa:rnings) ÑÜcrosoft, whose year-end was June 30, 1998.

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.)
lNTERNATIONAL BUSINESS MACHINES
Con~e-ent Liabilities
Statement of Cash Flows (Statement oflnflows and Outflows of Cash)
CONTINGENCIES
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
The company is subjed to a variety of claims aD.d suits that arÍse from time ro time out
of c:ish flows consists of tbree sections: cash flows from oper:i.ting activities, C$li fl.ows from of the ordin:iry course ofits business, including_ actions with respect to com:racts, íntellecru.:tl
investing accivities, and c:ish flows from financing activities. 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.
Foomotes (Notes) . 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
The foomotes to tb.e financia! smtements are used to present additional information ~tters, ~t the con::~r diss~ted ~ and misleading Statements conceming: its tinan-
about items included in tb.e financial smtements and to present additional financia! in:for- ~ condit1.on and diviclends during certam. periods of 1992. On Febmu:y 3, 1997, Judge
mation. Foomotes :ire an integral part of financial smtements. A detailed review of foomotes Rakoff issued an orcler granting the company's motion for Stimtllar}'judgment in tbis case in
is essential to underswlding the :financi:tl SCJ.tements. its entirety. Phiirtiffu filed :in :i.ppe:tl and on Novem.ber 17, 1998, the Second Circuit Court
Cert:rin information must be presented in foomotes. Accounting policies are to be of Appe:Us upheldJudge Rakoff's decision for tb.e comp:i.ny.
disclosed :lS the first note or be d.isclosed in a separate summary of signific:m.t accounting
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 CHAPTER 2 Introduction to Financia! Statements ::md Otb.er Financial Reporting To pies 45

temporary accounts are represented by revenue, expense, and dividends. (Gains and losses 4. Disclaimer of opinion. A disclaimer of opinion states that the auditor <loes not express
would be treated like revenue :md expense, respectively.) The balance sheet will not balance an opinion on the fin:i.ncial statements. A disclaimer of opinion is rendered when tbe
until the temporary accounts are closed to retained earcings. 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
Recording A.djusting Enoi.es mdicates the foumdai statements "that have been auditeJ and states that these statanents are tbr:
Earlier a distinction was made betWeen the accroal basis of accouncing and the cash rr:spcmsibilif()i ofthe compttn:y'smanagement. This paragraph indicates that the auditors have the
basis. It was indicated that the accrual basís reqillres that revenue be recognized when real- responsibilicy to express an opinion on these statements based on the auditor to disclaim an
ized (realization concept) and expenses recognized when incurred (matching concept). The opinion.
point of cash receipt for revenue and cash disbursement for expenses is not import:antunder The second paragraph indicates that the audit has been conducted in accurdtmce witb
th.e accrual basís when determinmg income. Usually a company must use the accrua1 basis generaUy accepted auditing Jta'mÍllrds. Auditing standards define the required level of audit
to achieve a reasonable result for the balance sheet and the income statement. qua.lity. These standards are classified as to "general standar~" "fieldwork standards," and
The accroal basis needs numerous adjustments to account balances at the end of the "reporting standards. "The paragraph goes on to state that these standards require the audi-
accounting period. Fer ex:imple, $1,000 paid for i:nsurance on October 1 for a one-year tor to plan and perform the audit to obtain reasoD.:lble assur:ince that the financia!
period (October 1-September 30) could have been recorded as a debit to Insurance Expense st:atements are free of material misst:itement. The second paragraph also includes a brief
($1,000) and a credit to Cash ($1,000). lf thls company prepares financia! statement; on description of what is included in an audit.
December 31, it would be necessary to adjust Insurance Expense because not ali of the The third paragraph gives an opin.ion on the st:ltements-that they are in conformir:ywith
insur:mce expense should be recognized in the tbree-month period October 1-December GAAP. In certain circumstances, an unqualified opinion on the financia} statements may
31. The adjustment would debit Prepaid Insurance, an asset account, fer $i50 and credit 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,
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 descnbe a material uncertaincy, describe a change in accounting principle, or express doubt as
the b'1ance sheet at $750. to the ability of the entity to continue as a going concem. An expbnatory paragraph may also
Adjusting entries are recorded in th.e general journal and then posted to the general be added to emphasize a matter. Exbibit 2-5 illustrates a typical unqualified report.
ledger. Once the accounts are adjusted to the accrual basis, the financial statements can be
prepared.
ii3ih:iif%-j TOYS "R" US Report Unqualified Opinion
Preparing the Financia! Statements
REF'ORT OF' INOE?E:NOENT AUOlTORS
The accountant uses the accounts after the adjustments have been made to prepare the
financial st:atements. These st:ltements represent the output of the accounting system. Two The.Board ofDirectors :md Steekholders
of the principal financial st:ltements, the income st:atement and the balance sheet, can be Toys ".R." Us, Inc.
prepared directly from the adjusted accounts. Preparation of the st:atement of cash flows ~e have audited the accompanying. consolidated balance sheei:s ofToys "R" Us, Inc. and subsidiaries as of J:muary 30, 1999
requires further analysis of the accounts. :md J:muary 31, .-199$, 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
AUDlTOR'S An auditor (certified public accountant) conducts an independent examination of the perform the _audit to obt:un reasona.ble-:i.ssur:mce about whether the fin:mcial mtements are free of material misstatement.
accounting information presented by the business and issues a report thereon. An auditor's An :iudir includes ex:uniníng, on a teSt basis, evidence supporting the amounts :md disclosures in the financi:J..! mtements. An
REPORT
report is the formal st:ltement of the auditor's opin.ion of the financial st:ltements after 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.
conducting an audit. Audit opinions are classified as follows:
In our opinion, the financfal Statements referred to above present f.ürly, in ali material respCcrs, the consolidated financial
l. Unqualified opinion.. This opinion states that the financial statements present fairly; position ofToys_ "R" Us. Inc. and subsidiarles atJanu:uy 30, 1999 andJanuary 31, 1998, and the consolidated results of their
in ali m::iterial respecrs, the financia} position, results of operations, and cash flows of 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-
the entity, in conform.ity with generally accepted accounting principles. ally:iccepted :iccounting principies. · •
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
í/"-Sf r1'7 u.t
entity, in conformity with generally accepted accounting principles. Enm & Yo>mg LLP
Nr:w York, New York
3. Adverse opiDion.. This opinion states tb.at tb.e financial statements do wt present fuirly Mirch 10, 1999
the financial position, results of operations, and c:lSh flows of the ent:i.ty, in conformity
witb. generally accepted accounting principles.
46 Introduction to Firumcial Statements and Other Financial Reporting Tapies Cl-IAF'TE:R 2 Inttoduction to Fm:mcial Statements :md Other F.in:mcial Reporting Tapies 47

VVhen e:c1mining fin:mcial statements, review the independent auditor's report. lt can M:magement's Responsibility for Financhl Statements
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 . The respoDSJ.Oility for the preparation and for tbe integrity of financia! statements restS
language carry the highest degree of reliability. This type of report indícates tb.at the finan- '\Vl.th ma:n.agem.ent. The auditor is responsible for conductin.g an independent e.~tion
cia! st:J.tements do not contaln a Jll:lterial departure from GAAP and tb.at the audit was not of the statements :md expressing an opinion on the financia! rucements based on the audit.
limited as to scope. To make financi:ll rutement users aware of management's respoOSIDilicy; companies have
When an unqua.Iiñed opinion contaios an expla.natory paragraph or explanatory presented managem:ent st:ltements to shareholders as part of the annual report. Exbibit 2-6
language, rr¡ to decide how seriously to regm-d the departure from a straig:ht unqu:tlified shows an ex:unple.
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 The SEC's Integnted Disclosure System
arui!ysis. M. explanatory parograph beC'1use of a materutl uncert:rinry would often be
regarded as a serious matter. . In ger:-eral, in ~e United Sta.tes, the SEC has the authority to prescribe external fio.an-
You are likely to regard a qualified opinion or an adverse opinion as casting serious CJ~ :ep?i:m~ reqwrements for companies with securities sold to the general public. Under
doubts on the reliability of the financial statements. In ea.ch case, you must read the audi- tbis ¡unsdicnon, the SEC requires that cert:ain financia! st:ltement information be included
tor's repon carefully to form your opinion. ~ the ~ual report to ~eholders. ~ annUll report, alongwith certain supplemencuy
A dischimer of opinion indicates tb.at you should not look to the auditor's reportas an informa.non, must then be mcluded, or mcorporated by referen.ce, in the annual filing to the
indication of the reliability of the st:ltements. \Vhen rendering tbis type of report, the audi- SEC, lmown as the 10-K repOrt or Form 10-K. The Forro 10-K is due t:hree months
tor has not performed an audit sufficient in scope to fonn an opinion, or the auditor is not following the end of the company's fiscal year. The annual repon and the Forro 10-K
independent. include audited financia! statements.
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 TOYS "R"US
procedures applied to :financi:ll data. It has subsmntially less scope tb.an an examination in Management's Respon.sfüility for F=cial Reporting
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 REPCRT CF' MANAGEMENT
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- 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-
cial st:ltements in order for them to be in cooformitywith GAAP; or the report"Will indicate ments have been. prep:ired from accounting records which. nun::i.gement believes fu.irlv :md
deparrores from GAAP. A departure from GAAP may result from using one or more :CCUI:ltely reflect ~e opentions :ind fin:mcia.l posirion of the Comp:my. Mana.gement has ~b­
accounting principies without re:isonable justification, the omission of necessary foomote lished a system of mterna.I controls to provide reasonable :issut:mce tb.at assets a.re maio:r:rined
disclosures, or the omission of the st:ltement of cash flows. :md accounted for in accord:mce with its policies and that trans:lctions are recorded accurately
In general, the reliance that can be placed on financial rutements accompanied by an on the Comp:my's books and records.
account:mtl: revíew report is substantially less th:m those accompanied by an audit report. The Company's comprehe.nsive intem:il audit progr:im procides for constant evalu:ition of the
Remember that the accountant's report <loes not express an opinion on reviewed financia! ad~~ of the adherence to ~gern~t's established policies and procedures. The Company
statements. has distributed to key employees lts polio:es for conducting business :llf.iirs in a lawful and ethi-
c:il manner.
'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 The !'-udit Co~ttee of the B~d of D~ecrors, which is comprised solelyof outside directors,
report rutes that the account:mt has not audited or reviewed the financia! st:ltements. provtdes OVel'Slght to the fimu:io:al reporong process through periodic meetings 'With our inde-
pendent auditors, interna.l auditors and managcmenL
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 The mi:mcial .mtements of th~ Company ha.ve been :iudited by Ernst & Young LLP, independ-
statements, then the accountant's report ch:rra.cterizes the deficiencies as follows: 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
Omission of subst:Jntialiy ali disclosures on the consoli&ted füunci::U st:itements.
Omission of statement of cash flows
Accounri:og principies not generall:y accepted
Sometimes financial St:J.tements are presented without an accompanying accoun- Robert: C. Nakasone Loois Llpxhitz
tant's report. Tbis means that the st:J.tements have not been audited, reviewed, or compiled. ChiefExecurive Of:!icer Executive Vice President
Such statements are solely the representation of m:magement. :md Chief Fin.:mci::U Officer
48 Im:roduction to F.in:mci:i.l Sta.tements :md Otb.er Financicl Reporti.ng Topics Inuoduction to Fmancia.l Sotements and Otb.er Financia! ReportingTopics 49

The SEC promores an intt;;,"!ated disclosure system between the annu:tl report and the reference mea.ns tb.at the information is presented outside tbe Form 10-K, anda reference
Form 10-K. The ~are to improve the quality of disclosure, lighten the disclosure load, in the Form 10-K indiotes where the infonnation can be found. Usually the -fin:mcial st:lte-
st:mdardize inform:ztion requirements, and achieve uniformity of annu:tl reportS and Form ments are_incorporated into the Form 10-K by referencing the annual report.
l 0-K filings. Areview of a company's Form 10-K can reveal information tb.at is not av:ailable in the
In :i.ddition to the company's primary financial statements, tbe Form 10-K must include annual repon. For C.'talllple, Item 2 of the Form 10-K reve:tls a deta.iled listi.ng of properties
the followingo and indicates if the property is leo.sed or owned.
l. Information on the Dl:ll'ket for holders of common stock and related securities, includ- The SEC requires t:hat a quanerly report (Form 10-Q), cont::i.ining fumnci:i.1 statements
ing high and low sales price, frequency and amount of dividends, and number of sh.ues. and a management discussion :and :malysis, be submitted "Within 45 days following tbe end
2. Fwe-year summ.ary of selected financia! data, including net sales or oper.icingrevenues, of tbe qu:mer. (The Form 10-Q is not required for the fourth quarter of the fi.sc:al year.)
income from continuing opera.tions, tot:tl assets, long-tenn oblig:i.tions, redeemable Most companies a.lso issue :i. quanerly repon to stockholders. The Form 10-Q and quanerly
preferred stock, and c:i.sh dividends per share. (Some companies elect to present data. reports are unaudited.
for more than fi.ve years and/or expand the disclosure.) Trend m:tlysis is empb.:tsized. In addition to the Form 10-K and Form 10-Q, a Form 8-K must be submitted to tbe
3. M.an:lgement's discussion and analysis (MDA) of financial condition and results of oper- SEC to repon specia1 events. Special events required to be reported are changes in princi-
ations. Specificfilly required is discussion of liquidity, capit:tl resources, and results of pal_ sto~oidei:, changes in auditors, acquisitions and divestit1Jies, bankruptcy, and
operations. resJ.g:nanon of directors. The Form 8-Kis due 15 days following tbe event.
4. Two years of audited balance sheets and tb.ree ye:rrs of audited income statements and The Forms l 0-K, l 0-Q, and 8-K filings are avoili ble to the public. Typic:illy a company
smtements of c:J.Sh flow. provides these reportS to stockholders upon request only.
5. Disclosure of the domesric and foreign components of preta.'< income, unless foreign
components are considered to be imrnaterial. Proxy
SEC requirements force management to focos on the financia! statements :is a whole, The proxy, the solicit:i.ti.on sent to stockholders for the elecrion of directors and for the
nther than on just the income sta.tement and opera.tions. VVhere ttend infonnation is rele- appr~ of other corporation acrions, represents the shareholder authorization regarding
vant, discussion should center on the five-year summary. Emphasis should be on fuvonble the C!lstlng of t:hat shareholder's vote. The proxy cont:tins noti.ce of tbe annual meetin"'
or unfuvorable ttends and on identifiotion of signific:tnt events or uncett:linties. T1is benefi.cia.l ovro.ership (name, address, and share ovro.ership data of shareholders hol~
discussion should provide the analyst with a reasonable summary of the posítion of the fum. i:iore ~ 5% of outstmding _sh:ares), board of directors, standing committees, compensa-
Exhibit 2-7 presents a summary of the m.ajor p:trts of the Form 10-K. ln poetice, much non of directors, compensanon of e.xecutive officers, employee benefi.t phns, certain
of tbe required information in the Form 10-Kis incorporated by reference. Incorponted by 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
GENERU. SUMMARY OF FORM 10-K 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.
PART 1 . 1?-e SEC's proxy rules of panicular interest to investors involve execurive compensa-
Itcm. l. Business. non dlsclosure, performance gr.tph, and reti.rem.ent plans for execurive officers. These rules
Itcm. 2. Properties. are designed to improve shareholders' underst:mding of the compaisation paid to senior
Itero 3. Leg'-tl l'ro<oeclings. execurives and directors, the criteria used in reaching compensation decisions, and the rela-
ltem.4. Submiss:ion of!vlatters to a-Vote ofSecurity Holders. tionship between compensation and corporate performance.
PART 11 Among otber matters, the execurive compensation rules c:tlJ. for four highly form::i.tted
Itcm 5. Mar"ket for Regist:rnnt's Common Equity and _Rel.a.ted Stockholder Ivlatters. d.isclosure tables and the disclosure of the compensation committee's basis for compensation
Item6. Se!ected Fina.acial Data. decisions.
ltem 7. Management's Discussion aniAnfilysis ofFmanci:U Condition and Resul.ts The four t:i.bles disclosing execurive compensacion are:
of Oper:i.ti.ons. ,
Item 8. Financfal Stai:i:ments and Supplem.Cnt:iry Dat:i. A summary execucive compensation ta.ble coveriug compensation for the company's
Itern 9. Ch:mges in :md Disagreements with Accountants on Accounting and Fm:znci:tl
DiscloSW"e. chief executive offi.cer and its four other most highly compen.sated executives for the
last three years.
PART 111 Two tables detailing options and stock appreciation rights.
Itero 10. . DirecterS an.d_ Executive Officers of Registrant. A long-term incentive plan award ta.ble.
Item 11. Exi:cmive Compensati.on. ·
Item 12. Security Owner.iliip of Cert::Un Beneficia! Owners :md .Marugement. The performance graph is a line gr::iph comparing the cumula.tive tottl shareholder
Itero 13. Certa.in Rel.a.tionships :md Rehted Tr:msactions. return -with performance indicators of the over:ill stock market and either the published
Item. 14. Exhibits, F~ Sotement Schedules, an.d Reports on Form 8-K.
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 CHAPTE:R 2
Introduction to Financia! Statements :w.d Other Financia.1 Reporcing Tapies 51

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 conduct. These ideals, in the form of codes of conduct, furnish criteria far distingcishing
2
determined prirnarily by final compensation (or average final :omp~o.on) ~d_rears of between right and wrong." Etbics has been a subject of investig::i.cion far hundreds of years.
service. Immediately following the table, additioo.al. disclosure IS 1:qw.red. This dísclo~ Indiv:iduals in financial positions mu.st be able to recognize ethical issues and resolve them
in an appropriate :m;umer.
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 Ethics affioct ali mdividuals-from the financia! clerk to the high-levd financia! exeou-
ea.ch of the named executi.ve o:fficer$. 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).
5UMMARY A reporting option available to public comp:mies is to is.we a S\llllJll.3l'y :n":uaI ~rt. Ten essential values can be considered central to relations hetWeen peopJe.3
ANNUAL A summary ann:ual report, a condensed report, omits much of the financial ~nnao.on l. Caring
REPORT typicilly included in an annu:.ú repon. A typical full annual reporthas more ~cal pag~ 2. Honesty
thon non!irumcial pages. A SUillJllaI)' aonual report generally has more non!irumcial pages. 3. Accounmbility
When a company issues a summ:ary 3ll!l.ual report, the proxy materials it se:z1ds to sJiai:- 4. Promise keeping
holders must include a set of fully audited statements and other requrred financia} 5. Pursuit of excellence
disclosures. 6. Loyalty
A summary annual report is 1u1t adequate for reasonable 3ll3.lysis. For companies that 7. Fairness
issue a summary annual report, request a copy of their pro.xy and the Form 10-K. Even far S. !ntegrity
compan:ies that issue a full annual report, it is aiso good to obt:ain a copy of the prox:y ma~e­ 9. Respecr for others
rials and the Form 10-K. Some compa.nies issue a joint annwl report :w.d Form 10-K, while 1O. Responsible citizenship
other compa.nies issue a joint annual repon :w.d prox:y.
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
THE EF'FIC!ENT Tue efficient market hypothesis (EMH) relates t-O the ability of capital mirkers t-0 coses? ivhat should be the loan loss reserve? 'YVhat should be the allowance for doubtful
accounts?
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 The American Accounting Association :initiated a projecr in 1988 on professionalism
HYPDTHESIS
does not have access to relevant information or if fraudulent information is provided. and ethics. One of tb.e goals of tbis project was to provide stu.dentS with a fumework far
There seeros to be little doubt that the FASB and the SEC assess the ímpact of their evaluating their courses of action when encouncering ethical dilemm.as. The .4.mericm
actions on security prices. The SEC has been particularly sensitive to insider tradin.g Accounting Association developed a decision model for focusing on ethic:tl issues.4
because abnormal rerurns could be achieved bj the use of in.si.der information. 1. Determine the factS-what, who, where, when, how.
If tb.e market is efficient, irrvestors may be hanned when fu.ros do not follow a full 2. Define the ethical issues (includes identifying the identifiable porties affected by the
disclosure policy. In an efficient market, the method of disclosure is ~ot ~ im:POrt:lllt '.15 decision .made or action taken).
whether ar not tbe itero is disclosed. It should not matter whether :m 1tem is disclosed m 3. ldent:ifyma.jor principles, rules, and values.
tbe body of the firumcial statements or in the foomotes. It is the disclosure rather th:m ~ 'i. Specify the altematives.
to disclose that is the subst:mtive .issue. 5. Compare norms, principles, and values with altematives to see if o. clear decisjon can be
Usually there is a cost to disclose. AJJ. attempt should be made to determine the v:tluc reached.
of additional disclosure in relation to the additional cost. Disclosure should be made whei 6. .As.5ess tb.e consequences.
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¡
E.umplc 1: Qucsrionablc Ethics in Savings a.nd Loans In connection with the savings
on large orgmlli:ed stock markets. . . . . .
Although the research evidence reg:irding the Ei\IH is conflicong, this hypothesis 1"l and loan (S & L) sc:mdal, it was revealed that several auditors of thrift institutions borrowed
taken on an importan.e role in ñnanci:tl reporti:ag in the United Smtes. 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
ETHICS "Ethics and morals are synonymous. Wbile ahi.cs is derived from Greek, mqraJs i· these particuhr lo:ms violated professional etbics st:l.D.dards. The AICPA subsequently
derived from Latin. They are interchangeable terms referring to idea.Is of chsr:i.cter an<. 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 C:HAPTER 2 Inrroduction to Financi:tl Statements and Other Financi:U Reporting Topics 53

In another case, m accounting firm paid $1.5 million to settle charges by the California authority as a positive factor beca.use it enables the passing-of standards that would not ha.ve
State Board of Accountancy that the accounting firm was grossly negligent in its 1987 audit had the necess:uy votes if they could be enforced. This allows standards to be more ideal
ofLlncoln Savings & Loan. The accounting board charged that the firm Md agreed to the than they would otherwise be if they were enforceable.
improper recognition of approrimarely $62 million in profits.7 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
E.xample 2: Questionable Ethics in the Moti.en Picture Indusrry Hollywood's account- comment fer about six months. 14
ing pracrices have often been labeled "mysterious."8 A case in point is Art Bucb.wald's lawsuit The United Nations (UN) has shown a substantial interest in harmonization of inter-
against Pararnount Pictures for breach of contract regarding the film Caming to A'J'IU:ficd,. n:i.cional accounting standards. The UN appointed a group to smdy harmooizacion of
Par:unount took an option on Buchwald's story "King for a Day" in 1983 and promised intemational accounting standards in 1973. This has evolved into an ad hoc work:iDg group.
Buchwald 1.5% of the net profits of the film. BuchwaldS attomey, Pierce O'Doonell, Members of the working group represent governments and not the priva.te sectar. The
accused Paramount Studios of "fatal subtraction" in deternllnmg the amount of profit. working group does not issue scmdards but rather facilitates their development. The UN's
Although the film grossed $350 million worldwide, Par:unount claimed an $18 million net concern is with how multinacional corporations affect the devdoping countries. 15
Joss. As a result of the srudio's accounting practices, Buchwald was to get 1.5% of nothing. 9 !v1any other organizations, in additi.on to the IASC and the UN, have played a role in
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- include the. Financia! Accounting Standards Board (FASB), the European Economic
style accounting. These include Wmston Groom over the movie rights to Forres& Gump, Community (EEC), the Organiza.ñon for Economic Corporation and Development
Jane Fonda overa larger slme of profits rehtingto On Gol.den Porui, andJam.es Gamer over (OECD), and the lnternational Federation of Aocountants (IFAC).
his slme of profits from The R.ockford Files (a television program). Some of the best creative Domestic accounting standards have developed to meet the needs of domestic envi-
work in Hollywood is in accounting. 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
HARMONIZATION The imperus for changes in accounting practice has come from the needs of the busi-
:fi.xed assets and other price-level adjustments or disclosures.
OF ness community and governments. With the expansion of international business and global
3. More emphasis on financial reportingfmcome tax conformity in cen:ain countties (for
1 NTERNAT1 ONAL. capital markets, the business community and governments have sho'\VD. an increased inter-
example, Ja.pan and Germany) that no doubt greatly influences domestic financia!
est in tb.e harmonization of internacional accounting standards.
AccouNT1NG reporting.
Suggested problems caused by hck of harmonization of internati.onal accouncing stan-
5TANDARD5 4. Reliance. on open markets as the principal means of intermediating capital flows that
dards include'
has increased the demand for information to be included in financial reports in the
1. A need for employment of key personnd in mulcinational companies to bridge the United Sta.tes and sorne other developed countties.16
"gap" in accounting requirements betWeen countries.
The following have been observed to ha.ve an impact on a country's fin;mcial account-
2. Difficulties in reconciling local standards for access to other capital markets.
ing operation:
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 l. \Vho the investors and creditors-tb.e information users-are (individuals, banks, the
govemment).
Internacional interest in harmonization of intemational accounting standards has been
2. How many investors and creditors there are.
especially scrong since the early l 970s. In 1973, nine countries, including the United St::i.tes,
3. How clase the relationship is between businesses and the investor/creditor group.
formed the Intemational Accouncing Standards Committee (IASQ. IASC includes approx-
4. How developed the stock e.xchanges and bond mnrkets are.
imately 100 member nacions and well over 100 professiónal accounting bodies. The IASC
5. The e.xtent of use of intemacional financia! markets.1 7
is the only priva.te sector body involved in setting intema~onal accounting standards.
The IASC's objectives include: 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
1. Devdoping international accouncing standards and disclosure to meet the needs of
standards. But many see benefits to harmonizati.on of interna.tional accounting standards
internacional capital. markets and the internacional business community.
and feel th::it accouncing must move in that direction. In the short run, ways exist to cope
2. Developing accounting standards to meet the needs of developing and newly industri-
with incomparable standards. One possible interim solution involves dual standards.
alized couno:ies.
Inremational companies would prepare t\VO sets of financial stJ.tem.ents. One would be
3. \,i\torking toward increased comparability betWeen nacional and international account-
prepared under domestic GAA.P, while the other would be prepared under intemational
ing standards. 13
GAAP. 1bis would likely put pressure on domestic GAAP to move towards international
The IASC does not have authority to enforce its standards, but these standards have GAAP.
been adopted in whole or in part by many countries. Some see the lack of enforcement
54 CHAPTE:R 2 Int:roduction to Financia! Statements and Other Fm:mcial Reporting Topics CHAPTE:R 2 Introduction to Financia! Statements and Other Financial Reporring To pies 55

In the United St:i.tes, a conflict exists between the SEC and the securities exchanges, Apooling of interests involves an e."<change of voting common stock. \Vith tb.e pooling
such as the New York Stock E.xchange (NYSE). In general, the SEC requires foreign regis- method, the recorded assets and liabilities of the firms involved are carried forward to the
tnmts to conform to U.S. GMP, either directly or byreconciliation. This approach achieves combined entity at tb.eir previous recorded amounts. Income of the combined firm ineludes
a degree of compar.J.bility in the U.S. c:ipit.a.l market, but it does not achi.eve comparability income of the constituents for che entire period. The prior years are restated to show the
for investors who want to invest in several nacional capital Jllfil"kets. This approach poses a combined firms :is merged (pooled).
problem for U.S. securities exchanges, because the U.S. st:alldards are perceived to be the Since che pooling mechod results in the acquired assets and liabilities being carried
most sttingent. This puts exchanges su.ch as the NYSE at a competi:cive disadvantage with forward at tb.e amount that chey were previously recorded, chis results in a net understate-
foreign exchanges tbt have lower st:J.D.dards. The development of international standards ment of assets, liabilities, and equity in relation to the acquisicion values. This will lead to a
would alleviate this problem.. subsequent overstatement of income because of the reduced e.""tpenses subsequently recog-
In the United Sti.tes, the FASB did not show a critica! interest in hannonization of nized. \Vith the pooling method, the resulting retained e:mtings in stockholders' equity
internationa.l accounti.ng standards until the early 1990s. The FASB now actively partici- represents che prior retained eanrings ofboth companies.
pates in the harmoniz.ation of internati.onal accountin.g stand:ards. This includes cooperating The purchase method views the business combination as the acquisition of one entity
with the !ASC and the UN. 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.
CDNSOLIDATED Financia! statements of legill.y separate entities may be issued to show financial posi- \Vith a purcb.ase, the acquiring firm picks up the income of che acquired firm from tb.e
5T.A.TEMENTS tion, income, and cash flow as chey would appear if che companies were a single entity date of acquisition. Ret.ained earnings of the acquired firm do not continue.
(consolidated). Such st:J.tements reflect an economic, racher than a legal, concept of the The Daimler-Benz/Chrysler Corp. merger depicts the adv:antage of pooling over che
entity. For consolidated si:atements, ali cransacrions between the entities being consoli- purchase method. Chrysler had a book value of approximately $12 billion, while the trans-
dated-intercompany transactions-must be eliminated. action valued Chrysler at approximately $39 billion. The purchase method would have
One corporation can own stock in anocher corpor:ition in an amount sufficient to hold resulted in appro:cimately $27 billion of goodwill. Tbis would have been a subsequent $27
subst:mtial voting rights in that corporation. The corporation owcing the stock is the ptZmlt billion drag on euniags. 18
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 This chapter includes an introduction to the basic financial statements. Later chap-
termed consolidated financial st:J.tements. An U1U0nS0lidated subsidia.ry is accounted foras ters will cover these sta.tements in detail.
an investment on the parent's balance sheet. AJ:i understanding of the sequence of accounting procedures completed during e:ich
\iVhen a subsidiary is less than 100% owned and its statements are consolidated, minor- accounting period, called tb.e accouncing cycle, will help in understanding the end
ity shareholders must be recognized in che consolidated financial statements by showing che result-financial statements.
roinority interest in net assets on che balance sheet and the minority share of e:i.mings on This chapter describes che forros of business entities, which are sole proprietorship,
che income statement. .Minority-related accounts are discussed in detail in Chapter 3. partnership, and corporation.
The consolidation of financia! statements has been a pracrice in che United Sta.tes for Management is responsible for financia! sta.tements. These sta.tements are examined
years; however, tb.is has not been the case for many other nations. In some countries like by auditors who express an opinion regarding the statements' conformity to GA.AP in the
Japan, parent-only financia! statements are the norm.. In other countries like Germany, auditor's report. The auditor's report often points out key :fuctors that can affect financial
consolidation only includes domestic subsidiarles. statement analysis. The SEC has begun a program to integra.te the Forro 10-Krequíre-
The 14..SC passed a standard that requires ·that ali conttolled subsidiarles be consoli- ments 'With tb.ose of the annual repon.
dated. Although !ASC scmdards cannot be enforced, this scmdard will !ikely increase the *A¡. reporting option available to public companies, a summary annual report (a
acceptance of consolidation. 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
ACCOUNTlNG The combination ofbusiness erltitieS by merger or acquisition is very frequent. There relevant information or if fraudulent information is provided.
are many possible reasonS for this e."<ternal business C."q)ansion, including achieving Ind.ividuals in fina.ricial posicions must be able to recognize ethical issues and resolve
F"OR
economies of sc:tle and savings of time in entering a new nmket. them appropriately.
BUSINESS \Vith the e:tpaDSion of internatianal business and global capital markets, the business
There are two methods of accounting for a business combination-the pooling of
C O M S 1NATlClN5 community and governments have shown an increased interest in the harm.onization of
interests method and che pu:rchase method. The accounting for a merger or acquisition is
intemational accounting standards.
guided by 12 specific criteria to judge a combination. If the 12 criteria are met, tb.en che
The combination of business entities by merger or acquisition is very frequent. AJ:i
acquisition must be accounted foras a pooling of interests. The criteria leave some room for
understanding of how a business combination can impact the basic sta.tements is impor-
iudgment in determining if che pooling method should be used. 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 Inttoducrion to Financial Statements and Other Financial Reporring To pies 65

ters could tum things into a downward spiral quickly. Economies are easily influenced and ment. Ñlike Hmington, Dan's chief financia! officer, would have to review any account-
consumer and corporate psychology C'lD. play a large part in detennining outcomes. But ing changes that he suggested. Since Dan had brought Ñlike up the organization with
even in apparently uncom:rollable circumst:J..Dces, Dan lmew he coultl protect himself and him, Dan didn't foresee any strong resistan ce from .Mike. As for the others, Dan believed
the financia} fortunes of bis company during the short-term, which aft:er ali, was the only he liad two things going for him. One w:is their ambition. Dan knew that 1hey ali coveted
thing that mattered. his job, and a clear successor to Dan had yet to be chosen. Dan would only make a
Upon further review of his compensati.on contract, Dan saw that a large portian ofhis recommendation to the promotion committee of the Board of Directors., but everyone
bonus and stock options was a funccion of operating income levels, e:irnings per share, and knew his recommendation carried a great <leal of weight. Therefore, resistance to any
retum on assetS. So the trick was to ma."cimize those items. Ifhe did~ the company would accounting changes by any individual would surely end bis or her hope to succeed him as
appear vibrant and posed far future growth at the time of bis forced retirement, he CEO. Secondly, although notas lucrative as Dan's, their bonus package is tied to the e..'\2.ct
reminded himself. Furthermore, bis total compensation in the lastyear ofhis employment same accounting numbers. So any actions taken by Dan to increase bis compensation wil1
would reach record proportions. Additionally, since bis pension is based on the average of also increase theirs.
bis last three ye:irs' compensation, Dan will continue to reap tb.e benefi:rs of this year's Dan was actually beginning to enjoy this siru.ation, even consideringit one ofhis final
results for hopefully a long time to come. And who says CEOs don'~ think long-term? challenges. Dan realized that any changes he implemented would have the tendency to
Two remaining issues needed to be addressed. Those were (1) how to ensure a reverse themselves over time. That would undoubtedly hurt the company's performance
record-breaking year and (2) how to overcome any objections raised in atti.ining those down the road., but ali of bis potencial successors were in their mid-to-late 50s, so there
results? Actually, the former was a relatively simple goal to achieve. Since accounting would be plenty of time for them to tura things around in the years ahead. Be.5ides, any
allows so many altematives in the w:r¡ financia! events are me:i.sured, Dan could just select near-term reversals would merely enhance bis reputation as an excellent corporate Ieader,
a package of alternatives which would m.aximize the company's eamings and return on as problems would arise after his departure.
assets. Some altematives may result in changing an accounting method, but since the new At that moment, his secretary called to inform him that :Mike Harrington wanted to
auditing st:mdards were issued., bis company could sti1l receive an unqualified opinion see him. Mlke was just the man Dan wanted to see.
from bis auditors, 'With only a passing reference to any accounting changes in the audi- VVhat are the etlrictl issues?
tor's opinion and its effecrs disclosed in the foomotes. As long as tbe alternative was What should Mike do?
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 Required a. Determine the facts-what, who, where, when, how.
threaten to change auditors. But scill the best avenue to pursue would be a change in b. Define the etbical issues.
accounting estiro.ates, since those changes did not ev'en need to be e..-plicitly disclosed. c. Identify ma.jor principies, rules, and values.
So Dan bC::,o-an to mull over what changes in estimates or methods he could employ d. Specify the alternatives.
in order to maximize his firm's :financia! appearance. In the area of accounting estimares, e. Compare norms, principles, and values with altematives to see if a
Dan could lower the rate of estima.ted default on bis accounts receivable, thus lowering clear decision can be reached.
bad debt expense. The estimated useful lives of bis plant and equipment could be f. Assess the consequences.
extended., thus lowering depreciation expense. In arguing that quality improvements h:ive g. Make your decision.
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 The Dangerous Morality of Managing Eamings*
repairs, could be capit:ilized. Those repairs that could not be capitilized could simply be The Majority of Managers Surveyed Say lt's Not Wrong to Mana,,-e ~°"
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- Occasionally, the morals and ethics executives use to man.age their businesses are
tion in those expenditures would increase net income. Return on assets would be examined and discussed. Unforrunately, the morals that guide the timing of nonopera.ting
increa.sed by not acquiring any new :fixed assets. Production levels for inventory could be events and choices of accounting policies largely have been ignored.
increased, tbus spreading fu.ed costs overa ireater number of units and reducing the total The etbical fnunework used by managers in reporting short-term emiings prohably
average cost per unit. Therefore, gross profit per unit wil1 increase. Inventory levels has received less attention than its operating counterpan because accountants prepare
would be a little bloated, but that should be easily handled by Dan's successor. financia! disclosures consistent with laws and generally accepted accounting principies
The prior examples are subtle chaiiges that could be made. As a last resort, a change (GAAP). Those disclosures are reviewed by objective auditors.
in accounting methods could be employed. This would require explicit foomote disclo- lvianagers determine the short·term reponed eanrings of their companies by:
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 "Note: Prepared by Wtlliam.J. Brons,Jr., Professor ofBmess .'\dministr::i.tion, ~ Univer.rity Gr:idu:i.te School of
first thought. Now back to the other potencial problem of "getting awaywith it." At first Business Administ:ratiou, md Kenneth A. Merch:mt, Professor of Ac:counring, University of Southern California. Reprinted
tbought, Dan considered the degree of resistan.ce by the other members of top manage- 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 CHAPTER 2 Introduction to Fm:mcial St::ttements :md Other Financia! Reporting Tapies 69

more acceptable than engaging in the same activity at the end of an tmnUf1.l reporting The D~o-erous Allure
period. The essence of a moral or ethicl approach to management is achieving a balance
The method of managing eamings has an effect. Increasing profits by offering between individual interestS and obligations ro those who have a stake in what happens in
extended c:redit termS is seen as less acceptable than accomplisbing the same end by sell- the corpor:i.tion (ar what happens to a division or group within the corpor:i.tion). These
ing excess asser:s or using overtime to increase shipments. stakeholders include not only people who work in the furo, but customers, suppliers,
creclitors, sharebolders, and investors as well.
Managers lnterviewed 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-
Were the survey results simply hypothetical) or did managers recognize they can r:i.tion. But, if they fail to consider the adverse effects of thcir actions on other
mana.ge earnings and choose to do so? To find the answers, we t:tlked to a large number stakeholders, we lllllY conclude that they are acting unetb.ically.
of the respondents. VVhat they told us was rarely reassuring. The managers we interviewed explained that they rated accounting manipulations
0n accounting manipulations, :i. profit center controller reponed: harshly beCluse in such cases the "truth" has somehow been denied or misstared. The
"Accounting is grey. Very little is absolute ... You can save your campan.y by recipients of the earnings reports do not lmow what eamings would have been if no
doing things 'With sales and expenses, and, if it's legal, then you are justified in manipulation had taken phi.ce. Even if the accounting methods used are consistent with
doing it." 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.
A divisional general manager spoke to us about squeezing reserves to generare addi-
The managers judge the operating manipulacions more fu.vorably because the earn-
tional reponed profit: ings numbers are indiCltive of what actually took place. The operating manipulations
"If we get a call aslcing for additional profit, and tb.at"s not inconceivable, I would have ch:mged re:ility, and "truth" is fairly reporred.
look at our reserves. Our reserves tend to be realistic, but we may have a prod- We see flaws in that reasoning. One is that the truth has not necessarily been
uct claim that could range from $50,000 to $500,000. Who knows wbat the right clisclosed completely. VVhen sales and profits are borrowed from the future, far example,
amount far somethlng like tb.at is? We would review our reserves) and if we felt it is :i r:.i.re company that discloses the borrowed narure of sorne of the profits reporred.
some were on the high side, we would not be uncomfortable reducing them." A second flaw in the reasoning about the :icceptability of operating manipulations is
We al.so heard about operating manipulations. One corporate group conrroller noted: 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
"[To boost sales] we have paid overtime and"shipped on Sarurday, the last day of "víctimless crime."
the fiscal quarter. If we totally left responsibility far the shipping function to the But viccims do e.'rist. Consider, far ex:imple, the relatively common operating manip-
divisions, it could even slip over to 12:30 a.m. Sunday. There are people who ulation of ea.rly shipments. As one manager told us:
would do tb.at and not know ii's wrong."
"Would I ship e."(!I'a product if I was fuced with a sales shortfull? You have to be
Ñlanagers afeen recognize tb.at such actions "move" earnings from one period to careful there; you're pfaying with fire. I would let whatever happened fu.11 to the
another. Far example, a division conrroller told us: bottom line. fve been in companies that did whatever they could ro make the
"Last year we called our customers and asked if they would take early delivery. sales number, such as shipping lower quality product. TharS way too short-term.
We generated an extra $300,000 in sales at the last minute. We were scratching You have to draw the line there. You must nuintain tb.e level of quality and
far everything. We made our plans, but we cleaned out our bacl<log and started customer service. You'll end up payin.g for bad shipments eventually. You11 have
in the hale thi.s year. We missed our first quarter sales plan. We vroI Cltch up by rerorns, repairs, adjustments, ill. will thar will cause you to lose the account ...
the end of the second quarter." [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
And a group vice president said: must be maintained."
"I recently was in.volved in a situation where the manager wanted to delay the Anotber reported:
production costS far tb.e advertising tb.at would appear in the fall [so tb.at he could
meet his qwnerly budget]." "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
Thus, in practice, it appears that a large majority of managers use at least sorne meth- materials."
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 These comments point out that customers-and sometimes even the corporation-
effect on reported eamings, the managers know there are no re:.tl positive economic bene- may be victims.
fits, and the actions might acroally be quite costly in the long run.. These actions are at Without a full analysis of the costs of oper:i.ting manipulations, the d:mgers of such
best questionable because they involve deceptions that are not disclosed. Most managers manipulations ro the corporation are easily underestim.ated. Mistakes will be made
who manage earnings, however, do not believe they are doing anything wrong. because the quality of information is misjudged. The short term will be emphasized at the
We see two majar problems. The most import:mt is the generally high toleran.ce far e.\'.flense of the long term. If managers consisrently manage short-term earnings, the
operating manipulations. The other is the dispersion in managers' views about which messages sent to other employees creare a corporate culture that lack.5 mutual trUSt,
practices are moral and ethical. integrity, and loy:tlty.
70 C1-1APTER z Introducrion to Flll3llcial St1.tements :md Other Fm:mcfal Reporting Topics C:HAPTER 2 Introduction to Fmancial Statements and Other Fmancial Reporting T~pics 71

A Lack of Moral A,,,oreement


Frequent-Flier Awards-Tick-Tick, Tick-Tick, Tick-Tic..1<
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. In the early l 980s, airlines introduced frequent-flier awards to develop passenger
YVb.at tbis suggests is that man.y managers are doing their analyses in different ways. loyalty to a single airline. Free tickecs and poSSIOly other awards were made av:lllable to
The danger is obfusc::rcion of the reality behind the financi:tl reports. Because managers passengers when they accumulated a cert:ain number of miles or flights on a particular air
are using different standards, individua.Is who ny to use the information reported may be carrier. These progr:uns were potentially good for the passenger and the airline as long as
una.ble to assess accuntely the quality of that information. the awards were not too generous and the airlines could miDimize revenue displacement
If differences in opinions exist, it is likely that financia! reporting practices will sink from a paying passenger.
to their lowest and most manipul:i:tive level. As a result, managers with strict definitions These progr:uns were introduced by Americ:in Airlines in 1981. Originally there
of what is moral and etbical will find it difficult to compete vri.th managers who are not were no restriccions. Anyone with the necessary miles could take any flight that had an
playing by the same rules. Ethical managers either will loosen their moral st:1I1clards or fail available seat. In the late l 980s, most airlines changed their no-restriction programs to
to be prometed into positions of greater power. 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
A.ctions for Concerned ~uers
out frequent-flier miles compensa:ting the airlines in sorne manner for the miles distrib-
We believe most corporations would benefit if they established clearer accounting uted. Airlines also added triple-mileage deals.
and operating standards for ali employees to follow. The standard-setting process should Aconsequence of these expandingfrequent-flier programs was a surge in the number
involve managers in discussions of the pr:ictices related to short-term earnin.gs measure- of passengers flying free and a surge in unused miles. To get a handle on the cost and the
men-ts. unused miles, airlines incre:ised tbe frequent-flier miles needed for a ±light and placed
Uno1 these standards are in place, different managers~ use widely v:irying criteria time limits on the award miles. Thus-tick-tick, tick-tick, tick-tick.
in assessing the accepta.bility of various earnings-m.anagement practices. These variatioos The increased frequent-füer miles needed for a ilight and the time limits prompted
will have an ad.verse effect on the quality of the firm's :6.nancial information. Companies laWsuits. Many of these lawsuits were filed in state couns. One of tb.e suits fi.led in the
can use a quescionnaire similar to the one in our smdy to encour.lge discussion and to District Court in Chicago in 1989 made its way to the United Sta.tes Supreme Court. In
communicate corporate standards and the re:ison fo.r tbem. 1995 the Supreme Court ruled that federal airline deregulation law would not bar the
Standards also enable interna! and e.xtemal auditors and management to judge breach-of-contr.i.ct chrim in the state court. InJune of 1995 a District Court in Dallas
whether or not the desired quality of earnings is being m.aintained. In most companies, ruled in fuvor of the airline in a case involving an increase in miles needed to earn a ttip.
auditors cm depend on gOod standards to identify and judge the accept:lbility of the oper- .'\irlines interprettbis decision as upholding theirrightto make changes to their frequent-
ating manipulations. füer programs.
illtimately, the line management chain-of-commmd, not auditors or financia! staF:t:
bears the primary responsibility for controlling operating manipulations. Often managers Required a. In your opinion, are the outstanding (unused) miles a liability to the
must rely on their prior experience and good judgment to distinguish betWeen a decision airline? (Substant:iate your answer.)
that will b.ave positive long-term benefits and one that has a positive sbort-term effect but a. b. Comment on the potential problems involved in esrimating the dallar
deleterious long-term effect. amounr of any potencial liabiliry.
Finally, it is important to manage the corporate culture. A culrure that promotes c. l. VVhat is a contingent liability?
openness and cooperati.ve problem-solving among managers is likely to result in less 2. In your opinion, are unused miles a contingent Iiability to the fil
short-tenn e:unings m.anagement than one that is more competi.tive and where :mnual, carrier?
and even quarterly, performance shortfalls are punished. A corporate culture that is more 3. Recommend the recognition (:tf any) for unused miles.
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. • SHB • Intematioilal AccouD.ting-Hannonization in Practice
b. Most managers sui-veyed b.ad a conservative, strict interpretation of
what is moral or ethical in financia! reporting. Comment. Dennis R- Beresford, Chairman, Financia! Accounting Standards Board, included
c. The managers surveyed e.-<lribited a surprising agreement as to what tbese cornments in the June, 1995 Financia! Accounting Series of the Fmancial
consritutes an etbical or unethical practice. Comment. Accounting Foundation. This case represents a quote from page 2, Notes from the
d. List the five gener:ilizations from the findings in tbís smdy relating to Cliainrum. (Permission to reprint obt:rined from the Financia! Accounting St:mclards
=ging earnin,,"'1. Board.)
e. Comment on m.anagement's ability to manage earnings in the long ron
by influencing financia! accounting.
72 Introduction to Fmancia1 St::1tements and Other Fmancial ReportingTopics CHAPTER 2 Introduction to Financia1 Sta.tements :md Other Financi:tl Reporting Topics 73

Notes from the Chairman (m Part) 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
Last montb. Jim Leisenring and I attended what is now becoming more or less in differing amounts far audit plann.ing purposes. In fuer, sizeable differences c::i.n result,
an annual meeting of accounting standards setters from more than a dozen coun- depending on the rule of thumb and the industry.
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 Required a. It would seem prudent for auditors to give careful consider.i.tion to
now Amsterdam. This year's meeting was held in conjunction with a regular plann.ing materi:ility decisions. Comment.
meeting of tb.e Internacional Accounting Standards Coromittee and the cente- b. It is difficult to design procedures to detect misstatements that could
nary celebrations of Ñ"IVR.A, tb.e professional accounting body in tb.e be qualitati:vely material. Comment.
Netherlands. c. lt is difficult to design procedures to detect misstatements that could
be quantimtively material. Comment.
Earlier, tbis gTOup had devoted its attention mainly to conceptual issues and d. In your opinion, would the application of materiality be a frequent
general communic:iti.ons about what the various countries were worlcing on at issue in court cases involving financia} statements? Comment.
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- Who is Responsíl:>ie?
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 REPO!IT OF INDEPENDENT ACCOUNTANTS
paper later was jointly published as the Special Report, "Future Events--A
Conceptual Study ofTheir Significan.ce for Recognition and Measurement." To the Shareowners and Board ofDirectors
The Kroger Co.
In Amsterdam, we spent most of the time on two specific tecbnical issues that are In our opinion, the accompanying consolidated balance sheet ofThe Kroger Co. and the
hot tapies here as well as in the rest of the world: accounting for envirorunental related consolidated Statements of operations and accumulated deficit, and cash flows
liabilities and derivative financi:.U instruments. Papers were presented by Canad.a, present fuirly, in ali material respects, the financia! position of the Kroger Co. as of
Denmark, England, and the European Commission, which covered the current January 2, 1999 and December 27, 1997, and the coosolidated results of its operations and
state-of-the-art reg-arding disclosure of and accounting for environment:tl costs. its cash &ws for the years endedJanuary 2, 1999, December 27, 1997, and December 28,
.A,s in the U.S., the key issues are deciding when an oblig:ition has been incurred, 1996, in conformity '!Nith gener:illy accepted accounting principles. These financial state-
under what circumstances can any resulting debit be considered an asset (e.g., ments are tb.e responsibility of the Company's management; our responsibility is to
costs incurred to "improve" a productive fucility), and when an amount is meas- express an opinion on these financial statements based on our audits. We conducted our
urable with sufficient reliability. 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
Required a.Comment on the trend in harmonization of intemational accounti.ng the financia! statenients are free of material misstatement. An audit includes e.'CllllÍDing,
as represented by tb.e comments included in this case. on a test basis, evidence supporting the amounts and disclosures in the financia} sta.te-
b. ea:n we expect harmonization of intemational accounting to be ments, assessing the accounting principies used and significant estima.tes made by
accomplished in .the foreseeable future? Comment. 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


1

3'Hfl. Materiality: In Practice


its applicati.on of the LIFO metb.od of accounting for store inventaries as of December
28, 1997.
Professional st:mdards require auditors to m.ake a preliminaxy judgment about mate-

P~rtt:f'
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- PricewaterhouseCoopers LLP
gate, to be quantitatively material to the financia! statements.,,... Cincinnati, Ohio
SAS No. 47 indicates that materiality judgments involve both quantimtive and qual- January 28, 1999
itative considerations. This statement recognizes that it ordinarily is not practica! to
design procedures to detect misstatements that could be qualiti:ti.vely material. Required a. Who has the responsibility for the financial statements?
b. YVhat is the role of the accountmt (auditor) as to the financia! state-
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 ments?
Standards (Ame.-ic:m Insritute of Cercified Public Accounm.ts),Janrory, 1989
74 C:HAPTE:R 2 Introduction t0 Flll:lil.cial St:i.tements and Other Fmanci:tl Repon:ing Tapies C:HAPTE!R 2 Introduction to Financial St:itements and Other Fin:m.ci:tl Reporcing Topics 75

c. Accountmts (auditors) are often included as defendants in lawsuits Required a. Dem:md for financia! reports e.-cists because users believe th.at the
that relate to the financial smtements. Speculate as to why tb.is is the reports help them in decision making. In your opinion, vrill foI"W'3l"d-
case. looking statements as provided by the Prívate Securities Litigation
d. VV"M.t type of auditor's opinion is represented in this case? Reform Act aid users of financia! repons in decision maldng?
e. Would we expect these audited financia! stltements to be free of b. To some e.xtent, investors rights are limited by the curb ofabusive liti-
misstatement? Comment. gation. In your opinion, is there a net benefit to investors from a safe
harbar for forward-loolcing statements?

•SHf'• Safe Harbor Endnotes


Charles H. Gibson and Nicholas Schroeder, "How 21 Companies Handled Their
In 1995, Congress passed the Private Securities Litig:ition Reform Act (the Acr). The SUillllUt)' Annual Repons," Fintmcial &ecutive (Novcrnber/Deccrnber 1989), pp.
principal provisions of the Act are intended to curb abusive litigation, and improve the 45-46.
quality of information available to investors tbrough the creation of a safe harbar far 2 Mary E. Guy, Ethieal Decisilm MPking in Everyday Work Sit=tiuns (New York, NY'
forward-loo.ldng st:ltements. Quarum Books, 1990), p. 5.
Forward-looking statements were defined to include St:atements relating to projec- 3 Guy, p. 14.
rions of revenues and other financial items, plans and objectives, future economic 4 Wtlliam W. Miy, ed., Ethics in the Accinmting CurricuJwn, Cases & Readings (Sarasota,
performance, assumprions, repons issued by outside reviewers, or other projections or FL: American Accounting Association, 1990), pp. 1-2.
estimates specified by rule of the SEC. The safe harbor applies to both oral and written 5 "Regulators Investigate Peat on ItS A.uditing of S & L," The Nw York TtmeS (Nfay 23,
st:atements. 1991), p. D-1.
Manaoooement frequently uses signals as "we esrimate," "we project," and the like, 6 "S.E.C. Inquiry Is Reponed on Loans to Accountants," The Ni:w York Trmes
where forward-looking st:atements are not otherwise idenrified as su.ch. The forward- (February 7, 1991), p. D-1.
looking stltements must be accompanied by meaningful cautionary st:l.tements. The 7 "Ernst & Young Settles Negligence Charge," Business brsurance (J;by 6, 1991), p. 2.
caurionary st:atement may be contained in a separ.i.te risk secti.on elsewhere in the disclo- 8 Ronald Grover, "Curt:rins for Tmseltown Accounting?" Business Week Q"anu:uy 14,
sure document. 1991), p. 35.
Osmonics included statements that would likelJ be constrUed as forward-loo.ldng in 9 Shahram Victory, "Pierce O'Donnell Pans 'Fatal Subtraction,'" American Lawyer
their 1998 second quaner repon to shareholders. This included a sratement by D. Dean (Mirch 1991), p. 43.
Spatz, Chairman & ChiefExecutive Officer. 10 "Buchwald WmsJust $150,000 in Ftlm Lawsuir," The Wall Street ]=al (Mirch 17,
"I am gratified to see our employees enthusiastically embrace the Company's 1992), p. B-1.
restrncturing and re-engineering. Their de<lication and ideas will have even greater ll Dennis E. Peavey and Stuart K Webster, "Is GAAP the Gap to !nternatioual
impact on our busIDess as we implement streamlined systems and new management Markets?" Mimagement Accwnting (August 1990), pp. 31-32.
practices. We believe our revitalized organiz:irion, integrated produets, and ration- 12 John Hag:ui:y, "Why We Can't Let GAJT Die," Journal ofAcc=nry (April 1991),
alized manufacturing Oper:lrions will enable Osmonics to be a dominant supplier of p. 74.
high technology water purification and filtration products and cost-effective 13 Peavey and Webster, p. 34.
components in the years ahead." 14 Anthony B. Creamer, "Auditing Beyond U.S. Shores' What the U.S. CPA Should
Know," Journal of~ (Novctnber 1987), p. 92.
The Osmonics repon included this cautionary statement: 15 Gerhard G. Mueller, Helen Gernan, and Gary Meek, ACCOWltin!f An bztematianal
"The Prívate Securities Litigation Reform Act of 1995 provides a 's.rfe harbar' Perspective, 2d ed. (Homewood, IL Richard D. lrwin, !ne., 1991), pp. 45-46.
for forward-looking statements. Cena.in information included in tb.is document 16 Dermis Beresford, "Internationalization of Accounting Standards," Accounting
and other materials filed or to be filed with the Securities and E.'<change Hori=<ms (Mirch 1990), p. 1O.
Commission (as well as information included in oral or other written Statements 17 Mueller, Gernan, and Meek, pp. l!-12.
made orto be made by the Company) contains st:atements that are forwm-d-look- 18 The FASE is considering a proposal that would require that the purchase method be
ing. Such sratements may relate to plans for future expansion, business the only method used to account for business combinations.
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."