Lecture Notes

For the exclusive use of Dr. Charles R. Pryor & his students.

ACCT 547
Corporate Financial Reporting & Analysis

Financial Reporting Environment

Forms of Business Entities

Financial Reporting: Fundamentals

What Are Consolidated Statements?

What Are the Effects of Acquisitions?

Additional Considerations: Cash vs Accrual Accounting

Financial Reporting Environment (Legal)

Important SEC Filings

International Financial Reporting Standards (IFRS)

Conceptual Framework Fundamentals

U.S. GAAP vs IFRS:

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For the exclusive use of Dr. Charles R. Pryor & his students. Financial Reporting Environment

Forms of Business Entities

1. Sole Proprietors
a. Single owner
b. Business is not a separate legal entity (profits flow-through to owner)
c. Unlimited liability for owner
d. May qualify as Limited Liability Corporation (LLC)
e. More of these than any other form of business in the U.S.
2. Partnership
a. Co-owned by more than one person
b. Business is not a separate legal entity (profits flow-through to owners)
c. Joint and Several Liability
d. May qualify as LLC
3. S-Corporation
a. Special form of corporation that some smaller firms can quality for.
b. Flow through entity like proprietorships, partnerships and LLC but there is
limited liability for owners, unlike proprietorships and partnerships. So, it is a
separate legal entity for liability purposes but not for tax purposes.
c. Cannot be owned by other entities like C-Corps, Trusts, or other S-Corps, unlike
LLC, which can be owned by these other entities.
d. Number of shareholders is restricted and they must all be from the U.S. (unlike
LLC)
4. C-Corporation
a. Publicly traded companies are C-Corps.
b. Usually has many owners (shareholders) but not necessarily
c. Separate legal entity
d. Shareholders liability limited to investment (or theoretically par value of stock)
e. Double taxation—the corporation pays tax on earnings AND the stockholders
pay tax again on their investment income.
f. By virtue of their size, they collectively generate more revenues and profits
than any other form of business in the U.S. despite their being far more
proprietorships.
g. If publicly traded, they come under the authority of the SEC and have to
meet their financial reporting requirements.

Financial Reporting: Fundamentals

1. Capital markets are the primary mechanism by which the U.S. achieves allocative
efficiency and information like, financial reports, is needed to make that happen.
a. Primary Markets - markets where firms sell their own securities.
b. Secondary Markets - markets where investors sell to each other.
i. Market participants in secondary markets include firms, but the firms
aren’t selling their own stock. They could be buying it back, however.

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For the exclusive use of Dr. Charles R. Pryor & his students. Financial Reporting Environment

2. Publicly traded firms are required by law to provide certain accounting/financial

information.
a. Financial reports must be filed with the SEC, and the SEC makes them publicly
available.
b. Among other things, financial reports contain the 4 financial statements:
i. Balance Sheet
1. Has three sections: Assets, Liabilities, and Stockholders’ Equity
2. Shows resources and claims on those resources in the form of
the accounting equation.
3. The accounting equation is: Assets = Liabilities + Stockholders’
Equity
a. The accounting equation can be algebraically
rearranged; it’s still the accounting equation.
4. Also called Statement of Financial Position
ii. Statement of Stockholders’ Equity
1. Explains changes in Stockholders’ Equity section of the balance
sheet from one balance sheet date to the next
2. Changes in Equity come from:
a. Sale or repurchase of stock
b. Changes in Accumulated Other Comprehensive
Income
c. Changes in Retained Earnings, which are caused by:
i. Net Income increases Retained Earnings
ii. Net Losses decrease Retained Earnings
iii. Dividends decrease Retained Earnings
iii. Income Statement
1. Contains Revenues, Expenses, Gains, and Losses
2. Ends with Net Income or Net Loss (results of operations)
3. Gets closed to Retained Earnings on the Balance Sheet, which
makes Retained Earnings the link between the income
statement and balance sheet
4. Together with Dividends explains changes in Retained Earnings
from one Balance Sheet date to the next
5. Is be combined with “Other Comprehensive Income” to form a
Statement of Comprehensive Income.
iv. Statement of Cash Flows
1. Has 3 sections appearing in the following order:
a. Cash Flows from Operating Activities
b. Cash Flows from Investing Activities
c. Cash Flows from Financing Activities
2. Explains changes in Cash account from one Balance Sheet
date to the next

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For the exclusive use of Dr. Charles R. Pryor & his students. Financial Reporting Environment

c. Financial statements are always accompanied by notes (disclosure notes,

footnotes) that are much more extensive that the financial statements
themselves, which only provide highly aggregated, summary information.

What Are Consolidated Statements?

1. Most, if not all, publicly traded firms own major portions of other firms. Ownership of
another firm often results in Consolidated Financial Statements.
a. Consolidated Statements—show a parent and its subsidiaries as if they were a
single entity (better reflection of economic reality—not legal reality)
i. Parent—company that owns greater than 50% of the voting stock of
another company giving it control over the company it owns.
ii. Subsidiary—company owned by a parent company.
iii. Only the parent consolidates; the subsidiary prepares its own financial
statements without any of the financial information of its parent.
2. Non-controlling interests—minority shareholders’ interest in any consolidated
subsidiaries have to be shown on the parent’s Balance Sheet and Income Statement
to reflect the fact that a portion of income and stockholders’ equity does not belong
to the parent’s shareholders.
3. Ownership interest in firms that do not qualify as subsidiaries is accounted for as
Investments and appear as investments on the Balance Sheet of the investor and
investment income either on the income statement or statement of comprehensive
income of the investor.

What Are the Effects of Acquisitions?

1. Mergers of companies and acquisitions of other companies are very frequent
occurrences and can dramatically impact the financial statements, which can
make comparing multiple years difficult.
2. Financial Statement Impact: In the U.S. acquisitions are accounted for using the
Purchase Method so the acquiring firm does the following.
a. Record all assets and liabilities of firm being purchased at fair value.
b. Record the excess of purchase price above the fair value of net assets as
Goodwill (an intangible asset).
c. Acquiring firm picks up income of acquired firm from date of purchase;
Retained Earnings of acquired firm do not continue after acquisition.

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For the exclusive use of Dr. Charles R. Pryor & his students. Financial Reporting Environment

Additional Considerations: Cash vs Accrual Accounting

1. The conceptual framework, including the definitions of the elements of financial
statements, incorporate and support the key concepts of “accrual” accounting.
2. Research shows that “accrual-based” income is more useful for predicting future
cash flows than “cash-based” income and is therefore more useful for investment
and credit decisions.
a. Accrual accounting is more timely.
b. Accrual accounting better approximates economic reality.
c. Accrual accounting better matches expenses to revenues.
3. Cash Accounting—records transactions only when cash changes hands.
a. Records revenue only when cash is collected from customers.
b. Records expenses only when cash is paid.
4. Accrual Accounting—records the economic substance of transactions when they
happen.
a. Records revenues when earned AND realized or realizable in accordance
with the 5-step framework used to measure and recognize revenue.
b. Records expenses when incurred whether paid for or not.
5. Publicly traded firms MUST use accrual accounting for financial reporting (SEC), so
all the financial statements you retrieve for research will have been prepared using
accrual accounting.
a. Tax reporting to the IRS follows something much closer to cash accounting
(not quite cash accounting but much closer).

Financial Reporting Environment (Legal)

1. Publicly Traded Firms—are those whose securities (stock/bonds) are listed on public
exchanges, like the NYSE, NASDAQ, etc.…
2. 1933 Securities Act—was the first public regulation of financial reporting in the U.S.
and governs accounting disclosures for initial public offerings (IPO)
3. 1934 Securities Exchange Act—created the SEC and gave it authority to govern
financial reporting for firms whose securities are publicly traded, including secondary
market transactions.
4. Securities Exchange Commission (SEC)—public-sector agency created by the 1934
Securities Exchange Act to police the trading of securities offered by publicly traded
firms.
a. Regulates information exchange in many ways.
b. Has the LEGAL AUTHORITY to promulgate accounting standards.
c. Has always relied on the private sector to ACTUALLY set standards.

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For the exclusive use of Dr. Charles R. Pryor & his students. Financial Reporting Environment

5. Generally Accepted Accounting Principles (GAAP)—the set of accounting rules that

publicly traded firms must follow when preparing the financial reports that they are
required to file with the SEC.
a. SEC has the authority to determine GAAP but has always allowed the private
sector to do most standard setting.
b. Financial Accounting Standards Board (FASB)—is the current private-sector
body that promulgates most U.S. GAAP.
c. Accounting Standards Codification (ASC)—accounting standards have been
codified into a single source document to facilitate locating needed
information.
6. Public Company Accounting Oversight Board (PCAOB)—established by the
Sarbanes-Oxley Act of 2002 to set audit standards.
a. Generally Accepted Audit Standards (GAAS)—rules that guide the collection
of evidence needed to support the independent auditor’s opinion on the
veracity of financial statements.
b. External, independent auditors help add credibility to financial reports.
i. The primary responsibility for preparing the financial statements in
accordance with GAAP belongs to the firm’s management (not the
independent auditor).
7. Sarbanes-Oxley Act (SOX)—legislation passed by the U.S. Congress in 2002 in
response to some of the largest corporate accounting frauds in history.
a. SOX resulted in significant changes in the financial reporting environment,
including:
i. Created the Public Company Accounting Oversight Board (PCAOB)
to promulgate Generally Accepted Audit Standards (GAAS) taking
the responsibility away from the accounting profession. Standards
were previously set by the AICPA.
ii. Certification Requirement—SOX dramatically increased criminal
sanctions for CEOs and CFOs who certify fraudulent financial reports.
iii. Section 404—requires that management document and issue an
opinion on the efficacy of their internal controls over the financial
reporting process. It also required that independent auditors issue an
opinion on management’s opinion.
1. The PCAOB quickly followed this by requiring that auditors issue
their own opinion on the efficacy of internal controls.
iv. One provision of SOX required the SEC to conduct a comparative
study of rules-based vs principles-based accounting.
1. The SEC report released in 2003 recommended principles-
based accounting.
a. What are the arguments for and against principles-
based accounting?
2. Principles-based accounting is also referred to as objectives-
based accounting.

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For the exclusive use of Dr. Charles R. Pryor & his students. Financial Reporting Environment

8. Standard setting is an extremely political process.

9. It is important to note that the responsibility for preparing financial reports in
accordance with GAAP belongs to MANAGEMENT (not auditors).
a. Auditors only issue an independent opinion on the financial reports, which
adds to the credibility of those statements.
10. Private Company Council (PCC)—was established in 2012 by the Financial
Accounting Foundation (FAF), the parent group of the FASB:
a. to advise the FASB on how changes to standards might affect private
companies and also
b. to identify any modifications/exceptions needed in existing GAAP to better
meet the reporting needs of private companies.
i. Modifications/exceptions must still be endorsed by the FASB before
becoming GAAP.

Important SEC Filings

1. SEC filings can be found in the EDGAR database at www.sec.gov
2. Form 10K—annual filing by firms to SEC
a. Due 60, 75, or 90 days after fiscal year end depending on market
capitalization
b. Includes:
i. Annual Report
ii. Audited Financial Statements
iii. Auditor’s Report
iv. Market information (high/low prices, dividend info, # of shares)
v. 5-year trend analysis of limited amount of select financial data
vi. Management’s Discussion & Analysis (liquidity, capital resources,
operations)
vii. 2 Balance Sheets & 3 Income Statements & 3 Statements of Cash
Flows
viii. Disclosure of foreign vs domestic sources of income (if foreign is
material)
ix. Some items may be incorporated “by reference”
3. Form 10Q—quarterly filing by firms to SEC (only first 3 quarters of year; then 10K is filed
after the 4th quarter)
a. Due 40 or 45 days after quarter ends depending on market capitalization
b. Financial information is NOT audited
4. Form 8K—used to report certain special events to SEC (change in principal
shareholders, change in auditors, resignation of board members)
a. Due 15 days following event.
5. Proxy Statement
a. Used to notify shareholders of annual meeting.
b. Used to solicit votes on Directors

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For the exclusive use of Dr. Charles R. Pryor & his students. Financial Reporting Environment

c. Contains information about executive compensation including retirement

packages (CEO and 4 other most highly paid executives.

International Financial Reporting Standards (IFRS)

1. Historically, all countries that engaged in public, financial reporting conducted the
activity in accordance with national accounting standards (national GAAP), but
there is a movement that began in the 20th century to increase the comparability of
financial reports across countries by having all firms follow uniform GAAP, now called
International Financial Reporting Standards (IFRS).
a. International Accounting Standards Board (IASB)—international body that
promulgates IFRS.
b. Firms listed on U.S. exchanges must publish financial reports prepared in
accordance with U.S. GAAP if they are based in the U.S.
c. Firms listed on U.S. exchanges that are based in other countries may publish
(with the SEC) financial statement prepared in accordance with IFRS IF they
are headquartered in a country that requires IFRS be used there.
2. Standard setting is just as political at the international level as at the country level.

Conceptual Framework Fundamentals

1. The Conceptual Framework developed by the FASB is not GAAP, but is often called
the “Spirit of GAAP”.
a. Cannot easily be used to legally defend accounting positions because it is
not “authoritative” GAAP.
b. However, it is useful for guiding accounting choices when no “authoritative”
guidance exists for a particular situation.
2. The primary purpose of accounting in external financial reporting is to provide
information useful to investors and creditors.
a. Accounting information should help in making investment and credit
decisions. The production of Decision Useful Information is the overarching
goal of financial reporting.
b. Accounting should help in valuing a firm and determining the risk of providing
it with financial capital.
i. Accounting information is NOT meant to directly measure the value of
the firm.
ii. Accounting information should help capital providers assess the
magnitude, timing, and uncertainty of the firm’s future cash flows.
c. There are many secondary, external users of financial reports including
employees, suppliers, taxing authorities, customers, etc.
i. The firm’s management (insiders) also uses financial reports, but the
primary focus of financial reporting is on external users.

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For the exclusive use of Dr. Charles R. Pryor & his students. Financial Reporting Environment

U.S. GAAP vs IFRS:

The conceptual framework serves similar roles in both U.S. GAAP and IFRS. The framework
serves as a guide for standard setters in both instances.
● However, in IFRS, the framework can also serve as a basis for practitioners’
decisions when other IFRS do not apply.
Also, the framework under IFRS goes so far as emphasising the “fair presentation” concept
for financial statements.
● This emphasis is not expressly part of the U.S. framework, but it is expressly included
in U.S. audit standards (GAAS).

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