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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Statements and Business Decisions Chapter 1

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Understanding the Business


Founders of the business who also function as managers are called OwnerMangers. Owner-Managers Creditors lend money for a specific period of time and gain by charging interest on the money they lend. Creditors

Investors buy ownership in the company in the form of stock. Investors

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Understanding the Business


Investors purchase stock (or ownership) in businesses hoping to gain in two ways:
Sell ownership interest in the future for more than they paid.

Receive a portion of the companys earnings in cash (dividends).

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The Business Operations


Manufacturers either make the parts needed to produce its products or buy the parts from suppliers.
Manufacturer Final Product Customer

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Learning Objectives
Recognize the information conveyed in each of the four basic financial statements and the way that it is used by different decision makers (investors, creditors, and managers).

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The Accounting System

Collects and processes financial information

Reports information to decision makers

Managers (internal decision makers)

Investors and Creditors (external decision makers)

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The Accounting System


Accounting System

Financial Accounting System


Periodic financial statements and related disclosures

Managerial Accounting System


Detailed plans and continuous performance reports

External Decision Makers


Investors, creditors, suppliers, customers, etc.

Internal Decision Makers


Managers throughout the organization

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The Four Basic Financial Statements


Statement of Cash Flows
Statement of Retained Earnings

Balance Sheet

Income Statement

Financial statements summarize the financial activities of the business.

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The Four Basic Financial Statements


Companies can prepare financial statements at the end of the year, quarter or month.

Financial statements prepared at the end of the year are called annual reports.

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Lets look at MAXIDRIVE CORP.s financial statements.

1. Name of entity 2. Title of statement 3. Specific date 4. Unit of measure

MAXIDRIVE CORP. Balance Sheet At December 31, 2006 (in thousands of dollars) Assets Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Stockholders' Equity Liabilities Accounts payable Notes payable Total liabilities Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 2,000 9,105 $ 7,156 9,000 $

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The Balance Sheet reports the financial position of an entity at a particular point in time.

4,895 5,714 8,517 7,154 981 $ 27,261

$ 16,156

11,105 $ 27,261

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The Balance Sheet

Basic Accounting Equation


Assets = Liabilities + Stockholders Equity Economic Resources

Sources of Financing for Economic Resources

Assets are economic resources owned by the business as a result of past transactions.

MAXIDRIVE CORP. Balance Sheet At December 31, 2006 (in thousands of dollars) Assets

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Cash $ 4,895 Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets $ 27,261 Liabilities and Stockholders' Equity companys bank Amount of cash in the Cash Liabilities accounts. Accounts payable $ 7,156 Accounts Amounts owed by customers from prior Notes payable receivable

9,000 sales. Total liabilities Parts and completed but unsold$ 16,156 Assets are listed Inventories Stockholders' Equity products. by their ease of Contributed capital $ 2,000 Plant and conversion into Retained earnings Factories and production 9,105 machinery. equipment cash. Total stockholders' equity 11,105 Land on which equity Total Land liabilities and stockholders'factories are built. 27,261 $

MAXIDRIVE CORP. Balance Sheet At December 31, 2006 (in thousands of dollars) Assets

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Liabilities are debts or obligations of the business that result from past transactions.

Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Stockholders' Equity Liabilities Accounts payable Notes payable Total liabilities $ 7,156 9,000

4,895 5,714 8,517 7,154 981 $ 27,261

$ 16,156 $ 2,000 9,105 11,105 $ 27,261

Accounts Amounts owed to Stockholders' Equity suppliers for prior Contributed capital payable purchases. Retained earnings Notes Amounts owed on written debt Total stockholders' equity payable contracts.

Total liabilities and stockholders' equity

Equity is the amount of financing provided by owners of the business and earnings.
Contributed capital Retained earnings

MAXIDRIVE CORP. Balance Sheet At December 31, 2006 (in thousands of dollars) Assets Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Stockholders' Equity Liabilities $ 7,156 9,000 $

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4,895 5,714 8,517 7,154 981 $ 27,261

Amounts invested in the business by Accounts payable stockholders. Notes payable Past earnings not distributed to Total liabilities stockholders.

$ 16,156 $ 2,000 9,105 11,105 $ 27,261

Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

MAXIDRIVE CORP. Balance Sheet At December 31, 2006 (in thousands of dollars) Assets

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Use $ on the first item in a group and on the group total.

Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Stockholders' Equity Liabilities Accounts payable Notes payable $ 7,156 9,000

4,895 5,714 8,517 7,154 981 $ 27,261

Assets = LiabilitiesTotal Stockholders Equity + liabilities


Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 2,000 9,105

$ 16,156

11,105 $ 27,261

MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 2006 (in thousands of dollars) Revenues Sales revenue $ 37,436 1. Name of entity 2. Title of Expenses statement 3. Specific period Cost of goods sold of time (Unlike the balance $ 26,980 sheet, this statement covers a Selling, general and administrative specified 3,624 period of development Research andtime.) 1,982 4. Unit of measure Interest expense 450 Total expenses 33,036 Pretax income Income tax expense Net income $ 4,400 1,100 $ 3,300

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MAXIDRIVE CORP. The Income Statement reports the Income Statement revenues minus expenses of2006 For the Year Ended December 31, the accounting period. (in thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total expenses 33,036 Pretax income Income tax expense Net income $ 4,400 1,100 $ 3,300

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MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 2006 (in thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Revenues are earnings from the sale of goods or Cost of goods sold $ 26,980 services to customers. Revenue is recognized in the Selling, general and administrative 3,624 period in which goods and services are sold, not Research and development 1,982 necessarily the period in which cash450received. is Interest expense Total expenses 33,036 Pretax income Income tax expense Net income $ 4,400 1,100 $ 3,300

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Revenues

Earnings from the sale of goods or services.

When will the revenue from this transaction be recognized?


$1,000 sale made on May 25th. Cash from sale collected on June 10th.

May 2006

June 2006

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Revenues

Earnings from the sale of goods or services.

When will the revenue from this transaction be recognized?


$1,000 sale made on May 25th.

May 2006

MAXIDRIVE CORP. Income Statement For are the Ended December 31, 2003 Expensesthe Yeardollar amount of resources used (in earn revenues during up by the entity tothousands of dollars) a period. An expense is recognized in the period in which goods used, Revenues and services are used, not necessarily the Sales revenue period in which cash is paid. $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total expenses 33,036 Pretax income Income tax expense Net income $ 4,400 1,100 $ 3,300

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MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 2006 (in thousands of dollars) Revenues Cost of The cost to produce products sold this Sales revenue period. $ 37,436 goods sold Expenses Selling, Operating expenses not directly related Cost of goods sold $ 26,980 general and to production. Selling, general and administrative 3,624 administrative Research and development 1,982 Research and Expenses incurred to develop new Interest expense 450 development products. Total expenses 33,036 Interest Pretax income The cost of using borrowed funds.4,400 $ expense Income tax expense 1,100 Income tax Income taxes on current periods pretax Net income $ 3,300 expense income.

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Expenses
The dollar amount of resources used up by the entity to earn revenues during a period. When will the expense for this transaction be recognized?
May 11 paid $75 cash for newspaper ad. Ad appears on June 8th.

X May 2006

June 2006

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Expenses
The dollar amount of resources used up by the entity to earn revenues during a period. When will the expense for this transaction be recognized?
Advertising expense recorded in June.

June 2006

MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 2006 (in thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total expenses 33,036

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If expenses exceed revenues, Pretax income $ 4,400 we report net loss.


Income tax expense Net income

1,100 $ 3,300

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MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 2006 (in thousands of dollars) Retained earnings, January 1, 2006 $ 6,805 1. income for 2006 NetName of entity 3,300 2. Title of for 2006 Dividends statement (1,000) 3. Specific period of time (Like the income$ 9,105 Retained earnings, December 31, 2006 statement, this statement covers a specified period of time.) 4. Unit of measure

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MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 2006 (in thousands of dollars) Retained earnings, January 1, 2006 Net income for 2006 Dividends for 2006 Retained earnings, December 31, 2006 $ 6,805 3,300 (1,000) $ 9,105

The Statement of Retained Earnings reports the way that net income and the distribution of dividends affect the financial position of the company during a period.

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Statement of Cash Flows

Because revenues reported do not always equal cash collected. . .

. . . and expenses reported do not always equal cash paid . . .

net income is usually not equal to the change in cash for the period.

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MAXIDRIVE CORP. Statement of Cash Flows For the Year Ended December 31, 2006 (in thousands of dollars) Cash flows from operating activities: Cash collected from customers $ 33,563 Cash paid to entity (30,854) 1. Name of suppliers and employees Cash paid for interest (450) 2. Title offor taxes statement Cash paid (1,190) 3. Specific period of time (Like the income $ 1,069 Net cash flow from operating activities Cashstatement, this activities: flow from investing statement covers a specified Cash paid to purchase equipment $ (1,625) period of from investing activities time.) Net cash flow (1,625) 4. flow of measure CashUnit from financing activities: Cash received from bank loan Cash paid for dividends Net cash flow from financing activities Net decrease in cash during the year Cash at beginning of the year Cash at end of the year $ $ $ 1,400 (1,000) 400 (156) 5,051 4,895

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MAXIDRIVE CORP.

The Statement of Cash Flows reports the inflows and For the Year Ended December 31, 2006 outflows of cash during the period in the categories of (in thousands of dollars) operating, investing, operating, investing, and financing. financing.
Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: Cash received from bank loan Cash paid for dividends Net cash flow from financing activities Net decrease in cash during the year Cash at beginning of the year Cash at end of the year $ $ $ 33,563 (30,854) (450) (1,190) $ $ (1,625) (1,625) $ 1,400 (1,000) 400 (156) 5,051 4,895 1,069

Statement of Cash Flows

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MAXIDRIVE CORP. Statement of Cash Flows For the Year Ended December 31, 2006 (in thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities:

33,563 (30,854) (450) (1,190) $ 1,069

$ (1,625) Cash flows directly related to (1,625) earning income are shown in the Cash received from bank loan $ 1,400 operating section.(1,000) section. Cash paid for dividends Net cash flow from financing activities 400 $ $ (156) 5,051 4,895

Net decrease in cash during the year Cash at beginning of the year Cash at end of the year

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MAXIDRIVE CORP. Statement of Cash Flows For the Year Ended December 31, 2006 (in thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities:

33,563 (30,854) (450) (1,190) $ 1,069

(1,625) (1,625)

Cash flows bank loan to the$ acquisition Cash received from related 1,400 Cash paid for dividends (1,000) or sale of productive assets are 400 Net cash flow from financing activities Net decrease in cash during theinvesting section. $ shown in the year section. (156)
Cash at beginning of the year Cash at end of the year $ 5,051 4,895

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MAXIDRIVE CORP. Statement of Cash Flows For the Year Ended December 31, 2006 (in thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: Cash received from bank loan Cash paid for dividends Net cash flow from financing activities Net decrease in cash during the year Cash at beginning of the year Cash at end of the year $ $

Cash flows from or to investors or $ 1,069 creditors are shown in the financing section. section. $ (1,625) (1,625)
$ 1,400 (1,000) 400 (156) 5,051 4,895

33,563 (30,854) (450) (1,190)

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MAXIDRIVE CORP. Statement of Cash Flows For the Year Ended December 31, 2006 (in thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: Cash received from bank loan

33,563 (30,854) (450) (1,190) $ 1,069

(1,625) (1,625)

The statement ends$with a 1,400 Cash paid for dividends (1,000) reconciliation of Cash. Cash.
Net cash flow from financing activities $ $

400 (156) 5,051 4,895

Net decrease in cash during the year Cash at beginning of the year Cash at end of the year

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Relationship Among the Financial Statements


MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 2006 (in thousands of dollars) Revenues Sales revenue Expenses Cost of goods sold Selling, general and administrative Research and development Interest expense Total expenses Pretax income Income tax expense Net income

$ 37,436 $ 26,980 3,624 1,982 450 33,036 $ 4,400 1,100 $ 3,300

Net income from the income statement increases ending retained earnings on the statement of retained earnings.
MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 2006 (in thousands of dollars) Retained earnings, January 1, 2006 $ 6,805 Net income for 2006 3,300 Dividends for 2006 (1,000) Retained earnings, December 31, 2006 $ 9,105

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Relationship Among the Financial Statements


MAXIDRIVE CORP. Balance Sheet At December 31, 2006 (in thousands of dollars) Assets Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Stockholders' Equity Liabilities Accounts payable Notes payable Total liabilities Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 2,000 9,105 11,105 $ 27,261 $ 7,156 9,000 $ 16,156 4,895 5,714 8,517 7,154 981 $ 27,261 $

Ending retained earnings from the statement of retained earnings is one of the components of stockholders equity on the balance sheet.
MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 2006 (in thousands of dollars) Retained earnings, January 1, 2006 $ 6,805 Net income for 2006 3,300 Dividends for 2006 (1,000) Retained earnings, December 31, 2006 $ 9,105

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Relationship Among the Financial Statements


MAXIDRIVE CORP. Balance Sheet At December 31, 2006 (in thousands of dollars) Assets Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Stockholders' Equity Liabilities Accounts payable Notes payable Total liabilities Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 2,000 9,105 11,105 $ 27,261 $ 7,156 9,000 $ 16,156 4,895 5,714 8,517 7,154 981 $ 27,261 $
MAXIDRIVE CORP. Statement of Cash Flows For the Year Ended December 31, 2006 (in thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Cash flow from investing activities: Cash paid to purchase equipment Net cash flow from investing activities Cash flow from financing activities: Cash received from bank loan Cash paid for dividends Net cash flow from financing activities Net decrease in cash during the year Cash at beginning of the year Cash at end of the year $ $

33,563 (30,854) (450) (1,190) $ 1,069

(1,625) (1,625)

1,400 (1,000) 400 (156) 5,051 4,895

The change in cash on the statement of cash flows added to the beginning of the year balance in cash equals the ending balance in cash on the balance sheet.

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Notes
 Notes provide supplemental information about the financial condition of a company.  Three basic types of notes:
 Description of accounting rules applied.  Presentation of additional detail about an item on the financial statements.  Provide additional information about an item not on the financial statements.

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Management Uses of Financial Statements


Marketing managers and credit managers use customers financial statements to decide whether to extend credit.

Purchasing managers use suppliers financial statements to decide whether suppliers have the resources to meet our demand for products.

Employees union and human resource managers use the companys financial statements as a basis for contract negotiations over pay rates.

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Price/Earnings Ratio

Price/Earnings Ratio =

Market Price (of the Company) Net Income

This ratio is one method for estimating the value of a company.

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Learning Objectives
Identify the role of generally accepted accounting principles (GAAP) in determining the content of financial statements.

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Responsibilities for the Accounting Communication Process Effective communication means that the recipient understands what the sender intends to convey.

Decision makers need to understand accounting measurement rules.

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How are Generally Accepted Accounting Principles Determined?


Our accounting system has a long and distinguished history. An Italian monk named Luca Pacioli, published the first elements of doubleentry bookkeeping in 1494. Prior to 1933, the management of most companies were free to choose the accounting principles used to keep track of its transactions.

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Generally Accepted Accounting Principles (GAAP)


Securities Act of 1933 Securities and Exchange Act of 1934

The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements.

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Generally Accepted Accounting Principles (GAAP)


The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP.

Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate GAAP.

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Generally Accepted Accounting Principles (GAAP)


Companies incur the cost of preparing the financial statements and bear the following economic consequences . . .

Effects on the selling price of stock. Effects on the amount of bonuses received by managers and other employees. Loss of competitive information to other companies.

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International Perspective
Since 2002, there has been substantial movement to develop international financial reporting standards by the International Accounting Standards Board (IASB).

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Learning Objectives

Distinguish the roles of managers and auditors in the accounting communication process.

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Management Responsibility and the Demand for Auditing


To ensure the accuracy of the companys financial information, management:  Maintains a system of controls.  Hires outside independent auditors.  Forms a board of directors to review these two safeguards.

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Independent Auditors


Auditors express an opinion as to the fairness of the financial statement presentation. Independent auditors have responsibilities that extend to the general public.

Overall, I believe these financial statements are fair.

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Independent Auditors
An audit involves . . .


Examining the financial reports to ensure compliance with GAAP. Examining the underlying transactions incorporated into the financial statements. Expressing an opinion as to the fairness of presentation of financial information.

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Learning Objectives

Appreciate the importance of ethics, reputation, and legal liability in accounting.

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Ethics, Reputation, and Legal Liability


The American Institute of Certified Public Accountants requires that all members adhere to a professional code of ethics.

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Ethics, Reputation, and Legal Liability


A CPAs reputation for honesty and competence is his/her most important asset.

Like physicians, CPAs have liability for malpractice.

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End of Chapter 1

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