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P5-18
Obj. 3 Sheik, Speer, and Love are three companies in similar industries. Five years of summarized
cash flow data are available for each firm. Year 5 is the most recent.

Year 5 Year 4 Year 3 Year 2 Year 1
Sheik Company:
Operating activities $ 30 $ 31 $ 28 $ 26 $ 28
Investing activities 3 1 6 5 4
Financing activities (31) (28) (33) (30) (32)
Speer Company:
Operating activities (15) (3) 7 14 26
Investing activities 8 4 (9) (17) (35)
Financing activities 6 0 3 4 11
Love Company:
Operating activities 9 6 3 2 (1)
Investing activities (13) (12) (11) (10) (10)
Financing activities 8 7 8 10 9

Study the information carefully. What clues can you find in the information concerning
what is (or has been) going on with each firm? Do their business histories appear similar or
dissimilar? Does the situation of one or more firms appear more favorable than one or more
of the others?

Required For each firm, describe and discuss what you have learned from reviewing its sum-
marized cash flow information.

Interpreting the Cash Flow Statement
P5-19
Obj. 3 Embarcadero Company’s most recent statement of cash flows is shown on the next page.

Required Use Embarcadero’s statement of cash flows to answer the following questions.
A. What was the primary source of cash inflow for the company?
B. Why was the company able to report a net cash inflow from operations when it in-
curred a net loss for the period?
C. What were the primary uses of cash during the period?
D. Did Receivables, Inventories, and Accounts Payable increase or decrease during the
year?
E. If revenues (as reported on the income statement) were $3,960 for the year, how much
cash was collected from customers during the year?
F215
CHAPTER F5: Reporting Cash Flows
215
Reporting Cash Flows


Embarcadero Company
Consolidated Statement of Cash Flows
For the Year Ended December 31, 2004

Operating activities
Net loss $ (682)
Adjustments to reconcile NI to cash flows:
Depreciation and amortization 592
Noncash gains and losses, net (136)
Changes in:
Accounts receivable 172
Inventories 110
Other current assets (24)
Accounts payable 98
Other current liabilities 148
Cash provided by operations 278
Investing activities
Investments and acquisitions (424)
Capital expenditures (42)
Sales of investments 206
Cash used by investing activities (260)
Financing activities
Increase in long-term debt 1,014
Repurchase of common stock (740)
Dividends paid (402)
Cash provided by financing activities (128)
Decrease in cash $ (110)




P5-20 Interrelationships among the Income Statement, Balance Sheet, and
Statement of Cash Flow
Objs. 2, 3
Frontera Corporation reported the following income statement and comparative balance sheet
for the year ended December 31, 2004.


Income Statement (for the Year Ended December 31, 2004)
(In thousands)

Sales revenue $6,930
Cost of goods sold 3,660
Gross profit on sales 3,270
Operating expenses:
Wages 855
Depreciation 102
Rent 546
Advertising 1,224
Operating income 543
Other revenues and expenses:
Interest revenue 84
Interest expense (24)
Income before taxes 603
Income tax expense 210
Net income $ 393




(Continued)
F216 ReportingSECTION F1: The Accounting Information System
216 Cash Flows


Balance Sheet (at December 31) 2004 2003

Assets:
Cash $ 482 $ 318
Accounts receivable 246 189
Inventory 471 483
Prepaid advertising 54 21
Total current assets 1,253 1,011
Buildings and equipment 2,811 1,974
Accumulated depreciation (922) (820)
Land 350 300
Investments, long-term 250 400
Total assets $3,742 $2,865
Liabilities and stockholders’ equity:
Rent payable $ 450 $ 478
Wages payable 32 24
Total current liabilities 482 502
Notes payable, long-term 1,150 750
Common stock 1,400 1,100
Retained earnings 710 513
Total liabilities and equity $3,742 $2,865




Frontera Corporation used the indirect format to prepare the statement of cash flows, but it
has been misplaced and is not available.

Required Use your knowledge of financial statements to answer each of the questions that
follow. For each item you list as part of your answer, describe fully why the item appears on
the statement of cash flows.
A. Which line items from the income statement will also be found in the operating activi-
ties section of the statement of cash flows?
B. Which line items from the balance sheet contain information that will be reflected in
the operating activities section?
C. Which line items from the income statement will also be found in the investing activi-
ties section?
D. Which line items from the balance sheet contain information that will be reflected in
the investing activities section?
E. Which line items from the income statement will also be found in the financing activi-
ties section?
F. Which line items from the balance sheet contain information that will be reflected in
the financing activities section?

Evaluating Income and Cash Flows
P5-21
Obj. 3 Selected financial statement information is reported on the next page for Beltway Distribu-
tors, Inc.

Required
A. Prepare a statement of cash flows (indirect format) for Beltway Distributors, assuming
that all important cash flow activities are reflected in the information provided.
B. Assume this has been the pattern of cash flows for several years. What does this imply
about the firm’s business situation?
F217
CHAPTER F5: Reporting Cash Flows
217
Reporting Cash Flows


For the Fiscal Year Ended January 30, 2004
(In thousands)

Sales revenue $35,400
Cost of goods sold 22,700
Operating expenses (except depreciation) 4,500
Depreciation expense 2,900
Net income 5,300
Dividends declared and paid 5,000

For January 30 2004 2003

Cash $ 2,050 $ 1,950
Accounts receivable 8,600 13,400
Inventories 23,500 27,100
Accounts payable 8,600 8,800
Bank loan payable 18,700 30,000




Excel in Action
P5-22
The following information is available for The Book Wermz for November, 2004. All num-
bers are dollar amounts.

Cash balance, November 30 $12,307.99
Cash balance, October 31 15,389.55
Cash paid for debt repayment 1,122.77
SPREADSHEET Cash paid for dividends 1,500.00
Cash paid for equipment 2,000.00
Cash paid for interest 932.03
Cash paid for merchandise 33,243.92
Cash paid for rent 1,738.15
Cash paid for supplies 2,576.93
Cash paid for taxes 897.45
Cash paid for wages 4,073.79
Cash received from customers 45,003.48
Decrease in accounts receivable 125.00
Depreciation expense 817.20
Increase in accounts payable 6,131.77
Increase in inventory 8,438.37
Increase in supplies 165.40
Increase in wages payable 623.56
Net income 2,447.45

Required Use the data provided to prepare a statement of cash flows for The Book Wermz
for November using a spreadsheet. Prepare the statement using both the direct and indirect
formats. Show cash outflows as negative amounts. Use the appropriate formatting buttons to
include commas and dollar signs as needed. Use the Merge Cells and Bold buttons to posi-
tion and format titles. The captions for the direct format statement should appear in column
A and the amounts should appear in column B. The captions for the indirect format should
appear in column D and the amounts should appear in column E. Use functions to sum subto-
tals and totals, such as SUM(B5:B8), so that changes to any of the amounts being totaled
will be automatically recalculated.
Suppose net income had been $2,600 and the amount of cash received from customers
had been $45,156.03. What would operating cash flow have been?
F218 ReportingSECTION F1: The Accounting Information System
218 Cash Flows

P5-23 Multiple-Choice Overview of the Chapter
1. The primary difference between a statement of cash flows prepared in direct format
and one prepared in indirect format is
a. in how net cash flow from operations is computed.
b. that the indirect approach always results in higher net cash flow.
c. in how net cash flow from investing activities is reported.
d. that the beginning-of-the-year cash balance is included in direct format but not in
indirect.

2. The statement of cash flows for the Halyard Exploration Company reported the follow-
ing:
Cash paid for equipment $ 300,000
Cash paid to employees 400,000
Cash paid to owners 150,000
Cash paid to suppliers 560,000
Cash received from creditors 200,000
Cash received from customers 1,200,000

What were Halyard’s net cash flows from operating, investing, and financing activities?
Operating Investing Financing
a. $240,000 ($300,000) $ 50,000
b. $500,000 ($860,000) $200,000
c. $640,000 ($860,000) $200,000
d. $240,000 ($860,000) $200,000

3. Haddad Company is a well-established, growing company. Which categories of activi-
ties would you generally expect to generate positive cash flows?
a. Operating activities only
b. Financing activities only
c. Investing activities only
d. Both operating activities and financing activities
e. Both financing activities and investing activities

4. A statement of cash flows has been prepared in the indirect format. Depreciation ex-
pense has been added back to net income because depreciation is
a. not really an expense and to list it as such understates profitability.
b. an investing activity and should be reported in that section.
c. a source of cash for the company.
d. a noncash expense.

5. Zeff Company reports positive operating cash flows, near zero investing cash flows, and
negative financing cash flows. This may indicate that the company
a. is raising new capital to purchase long-term assets for expansion.
b. does not have many good growth opportunities.
c. has severe cash flow problems caused by too-rapid growth.
d. is unable to provide goods and services that customers want.

6. A statement of cash flows prepared using the indirect format would report an increase
in Accounts Receivable as
a. an addition to cash flow from financing activities.
b. a subtraction from cash flow from financing activities.
c. an addition to net income in computing cash flow from operating activities.
d. a subtraction from net income in computing cash flow from operating activities.

7. Flag Ship Company reported depreciation and amortization expense of $300,000 for
the latest fiscal year. The depreciation and amortization expense
a. increased cash flow for the year $300,000.
b. decreased cash flow for the year $300,000.
c. had no effect on cash flow for the year.
d. had an effect on cash flow if assets were purchased during the year.
F219
CHAPTER F5: Reporting Cash Flows
219
Reporting Cash Flows

8. Rust Iron Company purchased a three-month insurance policy on March 1, 2004. The
company paid $3,000 for the policy. The amount of insurance expense and cash out-
flow the company should report for March would be
Insurance Expense Cash Outflow
a. $3,000 $3,000
b. 3,000 1,000
c. 1,000 3,000
d. 1,000 1,000
9. Micro Fish Company recognized $10,000 of interest expense in 2002. The balance of
the company’s interest payable account decreased $2,000. The amount of cash paid by
the company for interest in 2002 was
a. $10,000.
b. $12,000.
c. $2,000.
d. $8,000.
10. Operating activities are reflected on a company’s balance sheet primarily in
a. plant assets.
b. current assets and liabilities.
c. income from operations.
d. cash flow from operating activities.


Projects
CASES
General Mills, Inc., Statement of Cash Flows
C5-1
Objs. 2, 3 The General Mills 2002 Annual Report is reproduced in Appendix B at the end of the text.

Required Answer the following questions about the General Mills Consolidated Statement
of Cash Flows.
A. What are the three categories of cash flows shown on the company’s cash flow statement?
B. Compare the net income figure to the amount of net cash provided by operating activi-
ties for each of the three years. What do you observe?
C. Has the net cash provided by operating activities been large enough to meet the net in-
vesting cash outflow? Explain where the difference came from (or went).
D. Compare the dividend payments to the income amounts for the current year. (Note: You
may find it helpful to calculate the dividend payout ratio, which is the total dividends for
the period Ă· net income for the period. This ratio is explained further in Ch. F10.)

Analysis of Corporate Financial Statements
C5-2
Obj. 3 The 2002 financial statements for General Mills, Inc. are provided in Appendix B near the
end of this text. Examine these statements and answer the following questions.

Required
A. What were General Mills’ major operating activities during 2002? What were the major
differences between the accrual and cash flow effects of these activities?
B. What were the company’s returns on total assets (net income total assets) for 2002
and 2001? Did the return improve or deteriorate from 2001?
C. If you owned 10,000 of the company’s common stock, what would be your claim on
the company’s earnings for 2002? Was this a larger or smaller claim than you would
have had for 2001?
D. What were the company’s major sources of cash for 2002? In general, what did the
company do with the cash it received?
E. What were the major financing activities during 2002? In general, how would you de-
scribe the company’s financing activities overall during the last three years?
F. What major investing activities occurred in 2002?
G. As of the end of 2002, what were the company’s most important reported assets? What
other resources may be important to the company that are not reported on its balance
sheet?
F220 ReportingSECTION F1: The Accounting Information System
220 Cash Flows

C5-3 Interpreting Cash Flows
Obj. 3
Review the financial report of General Mills, Inc., in Appendix B.

Required Prepare a short report analyzing each of the following issues.
A. What were the accrual and cash basis results of operating activities for 2002? Explain
any major differences between the two results.
B. Inspect the balance sheet to identify which current assets and liabilities increased and
decreased during 2002. What was the amount of cash collected from customers during
2002?
C. What have been the relative amounts and trends in net income and cash flow from op-
erating activities over the 2000–2002 period? What accounts for the differences you ob-
serve?
D. How would you assess the company’s financial performance for 2002?


Comparing Direct Format and Indirect Format Statements of
C5-4
Cash Flow
Objs. 1, 2, 3
ABM Industries, headquartered in San Francisco, sells a wide variety of industrial and com-
mercial services. Its 2001 statement of cash flows (direct format) is shown below exactly as it
appeared in the firm’s annual report. If ABM Industries had chosen to use the indirect for-
mat, it would have appeared as shown on page F221. All amounts are in thousands of dollars.




ABM Industries Incorporated and Subsidiaries
Consolidated Statements of Cash Flows

YEARS ENDED OCTOBER 31 2001 2000 1999
(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Cash received from customers $ 1,918,558 $ 1,739,297 $ 1,589,775
Other operating cash receipts 5,523 2,347 1,491
Interest received 859 580 870
Cash paid to suppliers and employees (1,822,629) (1,686,988) (1,522,495)
Interest paid (2,991) (3,209) (2,025)
Income taxes paid (33,524) (33,102) (32,311)
Net cash provided by operating activities 65,796 18,925 35,305
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property, plant and equipment (16,922) (18,717) (19,451)
Proceeds from sale of assets 1,253 1,164 922
Decrease (increase) in investments
and long-term receivables 49 370 (1,885)
Purchase of businesses (23,401) (14,191) (10,980)
Proceeds from sale of business 12,000 — —
Net cash used in investing activities (27,021) (31,374) (31,394)
CASH FLOWS FROM FINANCING ACTIVITIES:
Common stock issued, including tax benefit 26,688 16,381 17,178
Common stock purchases — (8,390) (5,448)
Preferred stock redemption (6,400) — —
Dividends paid (16,202) (14,539) (13,055)
(Decrease) increase in bank overdraft (15,952) 10,985 2,492
Long-term borrowings 108,000 126,000 57,064
Repayments of long-term borrowings (133,857) (118,127) (61,847)
Net cash (used in) provided by financing activities (37,723) 12,310 (3,616)
Net increase (decrease) in cash
and cash equivalents 1,052 (139) 295
Cash and cash equivalents beginning of year 2,000 2,139 1,844
CASH AND CASH EQUIVALENTS
END OF YEAR $ 3,052 $ 2,000 $ 2,139
F221
CHAPTER F5: Reporting Cash Flows
221
Reporting Cash Flows


Reconciliation of Net Income to Net Cash
Provided by Operating Activities:

Net income $ 32,826 $ 44,343 $ 39,667
ADJUSTMENTS:
Depreciation 13,710 12,265 10,815
Amortization 12,618 11,259 9,883
Provision for bad debts 6,134 2,971 2,257
Gain on sale of assets (41) (265) (160)
Gain on sale of business (718) — —
Increase in deferred income taxes (12,138) (5,517) (6,537)
Increase in trade accounts receivable (24,340) (65,555) (39,304)
Increase in inventories (3,223) (2,217) (331)
Increase in prepaid expenses and other current assets (3,045) (1,200) (1,950)
(Increase) decrease in other assets 40 2,475 (3,295)
(Decrease) increase in income taxes payable (1,267) 765 1,791
(Decrease) increase in retirement plans accrual (903) 3,092 3,320
Increase in insurance claims liability 18,872 7,155 4,500
Increase in trade accounts payable and other accrued liabilities 27,271 9,354 14,649
Total adjustments to net income 32,970 (25,418) (4,362)
NET CASH PROVIDED BY OPERATING ACTIVITIES $ 65,796 $ 18,925 $ 35,305
SUPPLEMENTAL DATA:
Non-cash investing activities:
Common stock issued for net assets of business acquired $ 1,666 $ 1,581 $ 1,710


Required Study the two statements of cash flow and answer the following questions.
A. Describe how the statements are similar. Be specific.
B. Describe how the statements are dissimilar. Be specific.
C. Note the reconciliation of net income to net cash provided by operating activities that
appears at the bottom of the direct format statement. Of what does this disclosure re-
mind you? What information does it provide?
D. What questions can be answered by reading one of the statements that cannot be an-
swered by reading the other?
E. Which statement format do you believe presents more understandable information?
Describe and discuss your beliefs.
F. If you had the power to dictate that one format should be used in financial reporting
instead of the other, which would you recommend? Why?
If the indirect format had been used:

Years Ended October 31 2001 2000 1999
(In thousands)
Cash flows from operating activities:
Net income $ 32,826 $ 44,343 $ 39,667
Adjustments to reconcile net income to cash flow from
operating activities:
Depreciation and amortization 26,328 23,524 20,698
Provision for bad debts 6,134 2,971 2,257
Gain on sale of assets (41) (265) (160)
Gain on sale of business (718) — —
Increase (decrease) in deferred income taxes (12,138) (5,517) (6,537)
Increase in accounts receivable (24,340) (65,555) (39,304)
Increase in inventories (3,223) (2,217) (331)
Increase in prepaid expenses and other current assets (3,045) (1,200) (1,950)
Decrease (increase) in other assets 40 2,475 (3,295)
Increase (decrease) in income taxes payable (1,267) 765 1,791
(Decrease) increase in retirement plans accrual (903) 3,092 3,320
Increase (decrease) in insurance claims liability 18,872 7,155 4,500
Increase in accounts payable and other accrued liabilities 27,271 9,354 14,649
Net cash provided by operating activities 65,796 18,925 35,305

(Continued)
F222 ReportingSECTION F1: The Accounting Information System
222 Cash Flows


Years Ended October 31 2001 2000 1999
(In thousands)
Cash flows from investing activities:
Additions to property, plant and equipment (16,922) (18,717) (19,451)
Proceeds from sale of assets 1,253 1,164 922
Increase (decrease) in investments and long-term receivables 49 370 (1,885)
Purchase of businesses (23,401) (14,191) (10,980)
Proceeds from sale of business 12,000 — —
Net cash used in investing activities (27,021) (31,374) (31,394)
Cash flows from financing activities:
Common stock issued 26,688 16,381 17,178
Common stock purchases — (8,390) (5,448)
Preferred stock redemption (6,400) — —
Dividends paid (16,202) (14,539) (13,055)
Increase (decrease) in bank overdraft (15,952) 10,985 2,492
Long-term borrowings 108,000 126,000 57,064
Repayments of long-term borrowings (133,857) (118,127) (61,847)
Net cash (used in) provided by financing activities (37,723) 12,310 (3,616)
Net (decrease) increase in cash and cash equivalents $ 1,052 $ (139) $ 295
Cash and cash equivalents beginning of year 2,000 2,139 1,844
Cash and cash equivalents end of year $ 3,052 $ 2,000 $ 2,139




COMPREHENSIVE REVIEW
Preparing Financial Statements
CR5-1
Alice Springs Merchandise is a retail company that sells general household products. Account
balances for the company’s fiscal years ended January 31, 2004, and 2005 are provided on the
next page. Changes in balance sheet account balances also are provided. Additional informa-
tion for the 2005 fiscal year includes the following:
• The company paid $38,802 for additional property and equipment and received cash from
the sale of equipment of $1,967.
• Amounts borrowed or repaid are equal to changes in Notes Payable, Current and changes
in Notes Payable, Long-Term.
• The change in Common Stock is the amount of stock issued or repurchased during the
year.
• The balance of Retained Earnings includes the effects of net income and dividends.

Required From the information provided, prepare the following in good form.
A. An income statement containing separate columns for 2005 and 2004.
B. A balance sheet containing separate columns for 2005 and 2004.
C. A schedule like Exhibit 3 in this chapter (page F183) that includes the adjustments nec-
essary to calculate operating cash flow. The adjustments should be the changes in the
appropriate account balances.
D. A statement of cash flows for 2005 using the direct method.
E. A statement of cash flows for 2005 using the indirect method.
F223
CHAPTER F5: Reporting Cash Flows
223
Reporting Cash Flows


2005 2004 Change

Sales Revenue $ 589,351 $ 530,666
Cost of Goods Sold (359,504) (328,343)
Wages Expense (123,764) (117,136)
Rent Expense (30,116) (28,052)
Depreciation Expense (24,871) (22,628)
Supplies Expense (13,555) (10,751)
Cash 63,172 57,845 5,327
Accounts Receivable 48,386 43,106 5,280
Merchandise Inventory 130,247 117,202 13,045
Prepaid Rent 2,530 2,314 216
Supplies 1,129 952 177
Property and Equipment 365,398 328,563 36,835
Accumulated Depreciation (43,848) (18,977) (24,871)
Accounts Payable 25,953 23,674 2,279
Wages Payable 10,272 9,500 772
Unearned Revenue 12,966 11,675 1,291
Notes Payable, Current 47,249 44,249 3,000
Notes Payable, Long-Term 214,838 222,467 (7,629)
Common Stock 102,629 95,581 7,048
Retained Earnings 153,105 123,860 29,245
Dividends Paid 8,297 5,250
F6 6
FULL AND FAIR
REPORTING
How do we ensure that reports to external users fairly
present business activities?

P revious chapters examined how businesses collect and record information about their
activities and report this information in the form of financial statements. Maintain-
ing a reliable accounting system and reporting information that fairly presents a com-
pany’s business activities is an important task. Because stockholders and other external users
rely on a corporation’s managers to provide this information, the financial reporting process
is regulated. Corporations and other businesses must conform with regulations and standards
that describe accounting procedures, the content and format of financial statements, and other
information that must accompany those statements.

Maria and Stan, like other managers, must ensure that their corporation conforms with these re-
quirements. Maintaining an accounting system and producing financial statements is not suffi-
cient. Maria and Stan must be aware of the requirements that ensure that businesses fairly present
their activities and make sure they conform with those requirements.



FOOD FOR THOUGHT
As a stockholder, what information, in addition to financial statements, do you and other external users need to
understand the business activities of Mom’s Cookie Company? How can you be sure information provided by
the business is accurate and reliable? Maria and Stan are discussing these issues with Ellen, their accountant.


I’ve noticed that many corporations produce elaborate annual reports for their stockholders. Is this
Maria:
something we need to do for Mom’s Cookie Company?
Providing financial statements is not all you have to do to report to your stockholders. An annual report
Ellen:
that contains those statements is necessary. It does not have to be elaborate, but it does have to contain
certain information.
Our financial statements describe our business activities. Why aren’t these adequate?
Stan:
You need to help your stockholders understand the information in your statements. You must discuss and
Ellen:
analyze the financial statement information to identify activities that are key to understanding the
performance of your company. And, you must provide disclosures about assumptions you made and
methods you used in preparing the statements. In some cases, the statements may not fully inform users
about your activities. You may need to provide details about some of your business activities.
Once we prepare all this information, do we simply have it printed and mail it to our stockholders?
Maria:
Before you send any financial information to external users for your fiscal year, you must have that
Ellen:
information audited.
Who do we get to do the audit?
Stan:
The audit must be performed by an independent Certified Public Accountant. The CPA must be someone
Ellen:
who is not employed by your company and who has no financial ties to your company. I’ll help you identify
someone for the job. First, let’s examine the broader picture of corporate financial reporting and the
regulations that govern that activity.
F225
CHAPTER F6: Full and Fair Reporting
226 Full and Fair Reporting


OBJECTIVES

Once you have completed this chapter, you 4 Identify supplementary information to the
should be able to: financial statements in a corporate annual
report.
1 Explain the purpose of accounting
regulation. 5 Describe the purpose of internal controls
and types of controls that should be
2 Describe how accounting standards are
evident in business organizations.
established in the United States.
3 Explain the purpose of the Financial
Accounting Standards Board’s conceptual
framework.




THE PURPOSE ACCOUNTING REGULATION
OF
Decision makers who are not managers of a business have limited access to informa-
OBJECTIVE 1
tion about the business. These external users rely on financial reports for much of the
Explain the purpose of information they need to make decisions. Stockholders and creditors use accounting
accounting regulation. information to decide whether to purchase or sell stock and whether to make loans to
a company. Suppliers also make decisions about whether to sell goods and provide ser-
vices to a business on credit. Government authorities use accounting information to
determine taxes owed by businesses and whether companies have met legal require-
ments and regulations. Even customers and employees may use accounting informa-
tion to determine the financial viability of a company from which they purchase goods
and services or for which they work.
Accounting regulations protect the interests of external decision makers by ensur-
ing that information for evaluating the performance and financial condition of a busi-
ness is available and that the information is prepared according to specific guidelines.
These guidelines provide assurance that the information is reliable and comparable over
time and across companies.
Though many accounting regulations apply to any business that provides financial
reports to external users, they are particularly applicable to publicly traded corpora-
tions. These are businesses whose stock can be bought and sold in stock markets. Be-
cause owners of these businesses are not involved in their day-to-day operations, they
have special information needs. Shareholders of most corporations do not manage the
companies in which they invest. They elect members of a corporation’s board of di-
rectors, who then hire professional managers to run the corporation. Investors can own
part of a corporation or parts of many corporations without having to participate in
the day-to-day decisions of running those companies. Many Americans own stock in
corporations through personal investments and retirement plans, but they are not re-
quired to commit large amounts of their individual time to these businesses.
Corporations have continuous lives apart from those of their owners. If a propri-
etor or partner dies or sells her or his share of a business, the business ceases to exist
as a legal entity. The new owner of the business must reestablish the business as a new
legal entity. Most corporations, however, continue unchanged if current owners sell
their stock. Thus, while proprietorships and partnerships are separate accounting enti-
ties from their owners, most are not separate legal entities. They have no legal identity
apart from their owners. Most corporations are separate accounting and legal entities.
The purchaser of a corporation’s stock needs assurance that the shares are reason-
ably priced and represent a legitimate business. To ensure access to capital markets,
corporations prepare accounting information in conformity with generally accepted ac-
counting principles (GAAP). Accounting regulations assure investors of the financial
F226 SECTION F1: The Accounting Information System
227
Full and Fair Reporting

integrity of a corporation. Compliance with these regulations is costly. Large corpora-
tions maintain large staffs to handle financial reporting requirements and pay large fees
to independent auditors who report on the reliability of financial information reported
to external users.


Sources of Accounting Regulation
Accounting regulation involves both government and private organizations. The first
significant regulation of accounting and financial reporting in the United States was
provided by the New York Stock Exchange (NYSE). The NYSE was formed in 1792 to
facilitate the growing trade in corporate stocks. By the early 1900s the exchange required
listed companies to provide accounting information to their stockholders. Listing re-
http://ingram. quirements have changed over time. Today, corporations listed on exchanges must con-
swlearning.com form with GAAP and government regulations for the sale of securities.
Adoption of the 16th Amendment to the U.S. Constitution in 1913 permitted fed-
Learn more about the
eral taxation of individual and corporate income. Taxation of income is not possible
NYSE.
without rules and reporting requirements that determine how income will be com-
puted. Consequently, the U.S. government and state governments have an interest in
ensuring that businesses comply with accounting standards.
The early 1900s was a period of intense corporate activity. Many corporations were
created, and many individuals invested in stock. During the 1920s the average price of
corporate shares increased dramatically for many companies. That growth ended
abruptly in late 1929, when stock prices plummeted to levels below those of the early
1920s. Many stockholders lost their life savings, and many companies were forced out
of business. The collapse of the stock market in 1929 resulted in a demand for increased
regulation of corporate financial reporting. Many people believed a cause of the col-
lapse was a lack of sufficient information about corporate activities and a lack of gov-
ernment oversight of the stock markets.
In response to these concerns, the U.S. Congress passed the Securities Act of 1933.
This legislation required most corporations to file registration statements before sell-
ing stock to investors. As a part of these statements, corporations were required to pro-
vide financial reports containing balance sheets and income statements. Additional
legislation, the Securities Exchange Act of 1934, required corporations to provide an-
http://ingram. nual financial reports to stockholders. The legislation also required that these reports
swlearning.com be audited by independent accountants. The 1934 act also created the Securities and
Exchange Commission (SEC), a federal agency that reports to Congress. The SEC was
Learn more about the
given responsibility for overseeing external financial reporting by publicly traded
SEC.
corporations.
Currently, the SEC requires publicly traded corporations to publish annual and
quarterly financial reports. In addition, annual and quarterly registration statements
must be filed by corporations with the SEC. Annual registration statements filed by cor-
porations with the SEC are known as Form 10-K reports. They are required by Section
10-K of the 1934 act. Quarterly statements are known as 10-Q reports.
During the twentieth century, financial accounting has become a highly regulated
and formalized process. Publicly traded corporations must provide audited financial
reports to stockholders. The managers and auditors of companies who fail to provide
this information, or who do so fraudulently, are subject to civil and criminal prosecu-
tion. The SEC reviews corporate reports to ensure they conform with GAAP. The SEC
can require corporations that do not conform with GAAP to restate their financial state-
ments. Under extreme circumstances, the SEC can halt the trading of a company’s stock.
If it believes a corporation’s managers have attempted to mislead stockholders by their
reports, the SEC can refer the matter to the Justice Department for criminal and civil
proceedings. An announcement that the SEC is opening an investigation of a company’s
accounting practices often has a major impact on the company’s stock price. Evidence
of improper accounting practices is a major cause of lawsuits by investors against cor-
porate managers and their auditors.
F227
CHAPTER F6: Full and Fair Reporting
228 Full and Fair Reporting


Case in Point
In
The Effect of an SEC Investigation
In October 2001, Enron Corporation announced that it was being investigated by the
SEC for its accounting and reporting practices. On the day of the announcement, its
stock price dropped 20%.
http://ingram. USA Today reported that, on October 22, Enron’s stock closed at $20.65 per share,
swlearning.com a drop of $5.40 or 21%. That effectively decreased the company’s market capitaliza-
tion by $4.1 billion, which was the NYSE’s largest percentage loser that day. The stock
Learn more about
price actually fell below $20 per share at one point during the day. Enron’s stock had
Enron.
not traded that low for almost four years.
Enron’s stock had experienced very heavy losses throughout the prior week. The
closing price on October 22 reflected a 75% drop for the year to date. This was very
different from the same time during 2000 when the stock price rose by 87%.*


The Rise and Fall of Enron’s Stock Price




$100
90
80
70
60
Share
50
Price
40
30
20 Announcement of
SEC investigation
10
0
2002
2000 2001
1998 1999
Year

1.5
Number of
1
Shares
Traded
0.5
(in Billions)
0
2002
2000 2001
1998 1999
Year




The decline in stock price was one of the major causes of Enron’s bankruptcy and the
primary cause of lawsuits against the company by its stockholders. The restatement
resulted in a reduction in Enron’s stockholders’ equity of approximately $1.2 billion re-
sulting from a write-down of earnings from 1997 through 2000. In addition, the com-
pany’s reported debt increased by over $600 million.†

*Source: USA Today, 10/22/01, www.usatoday.com/money/energy/2001-10-22-enron.htm.
†Source: www.enron.com/corp/pressroom/releases/2001/ene/78-SECReleaseLtr.html.
F228 SECTION F1: The Accounting Information System
229
Full and Fair Reporting

The failure of corporations to report fairly their activities to stockholders is a ma-
jor concern in a capitalistic economy. The stock markets are a primary mechanism for
the allocation of financial resources. Society benefits when resources are allocated to
the most efficient and effective companies. Misleading information can result in mar-
kets allocating resources to companies that are not efficient or effective. When investors
become aware that information is misleading, they may suffer losses as many investors
attempt to sell their shares.
These problems can lead to a crisis of confidence in the markets if investors are un-
sure of whom they can trust and whether they are being treated fairly. Improper and
inadequate reporting affect everyone. The economy suffers because resources are not
being properly allocated. The decrease in economic activity has a ripple effect that leads
to decreased sales and profits for other companies, loss of jobs for employees, and loss
of taxes for government organizations.
Accounting regulations are important because they provide standards for deter-
mining whether corporations are reporting their activities fairly to stockholders. The
next section examines the processes and organizations associated with establishing ac-
counting standards.




1 SELF-STUDY PROBLEM Abe Milton is the owner and sole proprietor of Honest Abe’s Used
Cars. Abe needs a loan to help finance an expansion of his busi-
ness. You are the loan manager of a local bank where Abe has applied for a loan. The
loan application requires financial statements, which Abe has supplied. You asked Abe
whether the statements were prepared according to GAAP and whether they have been
independently verified. Abe says he doesn’t know anything about GAAP and that he
does not permit anyone else to examine his financial information because he is afraid
competitors will find out how well he is doing. He notes, however, that he is “Honest”
Abe and that the financial statements are accurate.

Required Briefly explain to Abe why GAAP is important and why moral hazard is an
issue of concern in making a loan decision.


CREATING ACCOUNTING STANDARDS
This section considers organizations responsible for setting accounting standards in the
United States and the organization that coordinates accounting standards among many
OBJECTIVE 2
of the world’s most developed countries.
Describe how accounting
The Securities and Exchange Commission is authorized by law to establish and en-
standards are established
force accounting standards in the United States. From time to time, the SEC uses that
in the United States.
authority to issue standards on matters it considers to be important and in need of au-
thoritative guidance. For the most part, however, the SEC has delegated the setting of
accounting standards to private (non-government) organizations. The United States
differs from most other countries in this respect. In most countries, accounting stan-
dards are set by the country’s central government.


Standard-Setting Organizations
Several organizations are responsible for establishing accounting standards in the
INTERNATIONAL
United States. Different organizations set standards
for businesses and other non-governmental organi-
LEARNING NOTE
zations than the ones that establish standards for
Accounting standards are established by the government in most
governments. In addition, an international organi-
countries. These standards are part of the nation’s laws and are
zation exists for coordinating standards across coun-
the responsibility of government agencies.
tries and for establishing standards that are used in
some countries.
F229
CHAPTER F6: Full and Fair Reporting
230 Full and Fair Reporting

The Financial Accounting Standards Board (FASB) has been the primary orga-
nization for setting accounting standards for businesses in the United States since
1973. The FASB has seven full-time members and is privately funded. It is not a gov-
ernment organization. The FASB also sets accounting and financial reporting standards
for nonprofit organizations other than governmental units. It is headquartered in Nor-
http://ingram. walk, Connecticut. The FASB employs a research staff to study accounting problems.
swlearning.com It periodically issues Statements of Financial Accounting Standards, which are authori-
tative guidelines for accounting and financial reporting in the United States.
Learn more about the
The Governmental Accounting Standards Board (GASB) sets accounting stan-
FASB.
dards for state and local governmental units. Like the FASB, the GASB is a private
rather than a governmental organization. The GASB also is headquartered in Norwalk,
Connecticut, and shares staff and facilities with the FASB. The federal government is
not subject to FASB or GASB standards but establishes its own accounting rules. The
General Accounting Office (GAO) is the primary federal government agency that over-
sees accounting in the federal government.
http://ingram.
The regulation of financial accounting and reporting is an international activity.
swlearning.com
Considerable diversity exists in accounting standards among nations. The International
Learn more about the Accounting Standards Committee (IASC) was created in 1973 as an international ef-
GASB and the GAO. fort to study accounting issues and to reduce the diversity of standards. The IASC was
reconstituted as the International Accounting Standards Board (IASB) in 2001. The
IASB recommends accounting standards that it believes are appropriate for a broad
range of global activities involving companies in many nations. The IASB describes
itself on its website (http://www.iasb.org.uk) as follows:

. . . [A]n independent, privately-funded accounting standard setter based in
http://ingram.
London, UK. Board Members come from nine countries and have a variety of
swlearning.com
functional backgrounds. The Board is committed to developing, in the public
Learn more about the
interest, a single set of high quality, understandable and enforceable global ac-
IASB.
counting standards that require transparent and comparable information in
general purpose financial statements. In addition, the Board cooperates with
national accounting standard setters to achieve convergence in accounting
standards around the world.

Accounting standards are important to protect the interests of investors, managers,
and the general public. Therefore, the standards must be perceived as being reasonable
INTERNATIONAL
and responsive to the needs of different constituents.
Arbitrary and unnecessary standards do not serve the
LEARNING NOTE
needs of society. For these reasons, accounting stan-
The IASB has issued accounting standards that identify preferred
dards are established through a political process. This
accounting methods. Many countries have adopted these stan-
process gives interested parties an opportunity to ex-
dards for accounting and financial reporting.
press their opinions and to provide information that
may have a bearing on prospective standards. The fact
that accounting standards are referred to as generally accepted accounting principles is
not accidental. To serve the needs of society, accounting standards must be accepted
by those who are affected by them.


The Standard-Setting Process
The process used by the FASB to create accounting standards is typical of that used by
other organizations, such as the GASB and the IASB. The process consists of the fol-
lowing steps:
1. Accounting issues are identified and evaluated for consideration.
2. A discussion memorandum is issued and responses are solicited.
3. Public hearings are held.
4. An exposure draft is issued and responses are solicited.
5. Additional public hearings are held as needed.
F230 SECTION F1: The Accounting Information System
231
Full and Fair Reporting

6. A standard is issued.
7. Existing standards are reviewed and modified as needed.
Accounting issues may be identified by accounting professionals, managers, in-
vestors, or the FASB staff. The staff evaluates the issues, and the board determines those
issues that appear to be important enough to address.
A discussion memorandum is a document that identifies accounting issues and
alternative approaches to resolving the issues. All interested parties are encouraged to
respond to a discussion memorandum. The board develops a proposed standard after
reviewing responses to a discussion memorandum and issues its proposal in the form
of an exposure draft. An exposure draft is a document that describes a proposed ac-
counting standard. It identifies requirements that may be contained in an actual stan-
dard. Responses again are solicited, and public hearings sometimes are held.
Once the board reviews responses to an exposure draft, it may modify and reissue
the exposure draft or issue a standard. An accounting standard is an official pro-
nouncement establishing acceptable accounting procedures or financial report con-
tent. FASB standards are known as Statements of Financial Accounting Standards.
To issue a standard, at least five of the seven members of the board must agree to it.
Once a standard has been issued, it becomes part of GAAP. Standards can be reviewed
at any time to determine if they are serving their intended purposes and can be mod-
ified or replaced if they are found to be ineffective.

The FASB’s Conceptual Framework
The conceptual framework was developed by the FASB in the late 1970s and early 1980s
OBJECTIVE 3
to provide guidance in the development of accounting standards. The FASB concep-
Explain the purpose of tual framework is a set of objectives, principles, and definitions to guide the devel-
the Financial Accounting opment of new accounting standards.
Standards Board’s The FASB conceptual framework includes four major components:
conceptual framework.
1. Objectives of financial reporting
2. Qualitative characteristics of accounting information
3. Elements of financial statements
4. Recognition and measurement in financial statements
Objectives of financial reporting provide an overall purpose for financial reports.
The purpose of financial reports is to provide information useful to current and po-
tential investors, creditors, and other users. Financial reports should help these deci-
sion makers assess the amounts, timing, and uncertainty of prospective cash flows.
Financial reports should also provide information about resources, claims to resources,
and changes in resources for business organizations.
Qualitative characteristics are attributes that make accounting information useful.
Understandability and usefulness for decision making are the most important charac-
teristics. Relevance and reliability are considered to be the two primary qualities that
result in accounting information being useful. To be relevant, information should be
timely and have predictive or feedback value. To be reliable, information should faith-
fully represent economic events and should be verifiable and neutral. Information
about an organization is more valuable when it can be compared with information from
other organizations and when it is prepared using consistent methods over time.
Elements of financial statements provide definitions of the primary classes of items
contained in financial statements. Elements include as-
LEARNING NOTE sets, liabilities, equity, investments by owners, distrib-
utions to owners, revenues, expenses, gains, and losses.
The accounting systems of most organizations report periodically
Recognition and measurement criteria identify
the estimated results of financing, investing, and operating ac-
information that should be contained in financial
tivities. Such periodic measurement is needed to ensure the
statements. The primary financial statements are de-
timely reporting of financial information that is needed for effec-
scribed in the conceptual framework, along with the
tive decision making.
items that should be contained in each statement.
F231
CHAPTER F6: Full and Fair Reporting
232 Full and Fair Reporting


DISCLOSURE FAIR REPRESENTATION
AND
In addition to establishing acceptable accounting procedures and methods and guide-
OBJECTIVE 4
lines for the format and content of financial statements, GAAP require companies to
Identify supplementary include information in addition to their financial statements in annual reports to stock-
information to the holders. This information includes management’s discussion and analysis of the com-
financial statements in a pany’s business activities and disclosures about methods used in determining
corporate annual report. accounting information and details about those activities that are not evident in the fi-
nancial statements.
Corporate annual reports usually include the following:
• a letter from the president or chief executive officer of the company
• a description of the company’s products and business activities
• a summary of selected business data
• a discussion by management of the company’s performance
• financial statements
• notes to the financial statements
• a statement of management responsibility for the financial statements
• an audit report
The president’s letter and the description of a company’s products and business are
not part of the financial section of a company’s annual report. Management has a fair
amount of discretion in what to include in these sections. The president’s letter often
summarizes the company’s financial performance for the year. As long as information
contained in the letter is consistent with that reported in the financial section, it is not
subject to accounting regulation.
The following paragraphs describe the financial section items contained in an an-
nual report, with the exception of financial statements that were examined in Chapters
4 and 5. Appendix B of this book contains the financial section of General Mills’ 2002
annual report. You may wish to refer to the appendix for a better idea of the contents
of each item in the financial section.


Summary Business Data
Financial and non-financial data often are included for various periods beyond those
covered by the primary financial statements. For example, Exhibit 1 provides a five-
year summary reported in Krispy Kreme’s annual report.
Krispy Kreme, like Mom’s Cookie Company, sells products through stores. The
amount the company sells depends on the number of stores selling its products. Some
of these stores are stand-alone businesses that specialize in Krispy Kreme’s products.
Others are small shops that are part of another business. These shops are located in ser-
vice stations, grocery stores, and similar locations.
The summary data reported in Exhibit 1 is useful for determining trends in Krispy
Kreme’s business activities. The data indicate a steady growth in sales, income, assets,
and stores over the five years. The company has grown substantially over this period in
most categories.


Management’s Discussion and Analysis
Corporate annual reports should include discussion and analysis of the company’s fi-
nancial performance. This section, known as management’s discussion and analysis
(MD&A), explains important events and changes in performance during the years
presented in the financial statements.
Typical issues considered in the MD&A include the following:
• a comparison of operating results among the data provided in the company’s in-
come statement
F232 SECTION F1: The Accounting Information System
233
Full and Fair Reporting

Exhibit 1 Summary Business Data from a Corporate Report

In Thousands, Except Per Share Data and Store Numbers
Feb. 1 Jan. 31 Jan. 30 Jan. 28 Feb. 3
YEAR ENDED 1998 1999 2000 2001 2002

Statement of Operations Data:
Total revenues $158,743 $180,880 $220,243 $300,715 $394,354
Operating expenses 140,207 159,941 190,003 250,690 316,946
General and administrative expenses 9,530 10,897 14,856 20,061 27,562
Depreciation and amortization expenses 3,586 4,278 4,546 6,457 7,959
Provision for restructuring — 9,466 — — —
Income (loss) from operations 5,420 (3,702) 10,838 23,507 41,887
Interest expense (income), net, and other 895 1,577 1,232 (1,698) (2,408)
Equity loss in joint ventures — — — 706 602
Minority interest — — — 716 1,147
Income (loss) before income taxes 4,525 (5,279) 9,606 23,783 42,546
Provision (benefit) for income taxes 1,811 (2,112) 3,650 9,058 16,168
Net income (loss) $ 2,714 $ (3,167) $ 5,956 $ 14,725 $ 26,378
Net income (loss) per share:
Basic $ .09 $ (.09) $ .16 $ .30 .49
Diluted .09 (.09) .15 .27 .45
Shares used in calculation of net income (loss)
per share:
Basic 29,136 32,996 37,360 49,184 53,703
Diluted 29,136 32,996 39,280 53,656 58,443
Cash dividends declared per common share $ .04 $ .04 $ — $ — $ —

Operating Data (Unaudited):
Systemwide sales $203,439 $240,316 $318,854 $448,129 $621,665
Number of stores at end of period:
Company 58 61 58 63 75
Franchised 62 70 86 111 143
Systemwide 120 131 144 174 218
Average weekly sales per store:
Company $ 42 $ 47 $ 54 $ 69 $ 72
Franchised 23 28 38 43 53

Balance Sheet Data (at end of period):
Working capital $ 9,151 $ 8,387 $ 11,452 $ 29,443 $ 49,236
Total assets 81,463 93,312 104,958 171,493 255,376
Long-term debt, including current maturities 20,870 21,020 22,902 — 4,643
Total shareholders’ equity 38,265 42,247 47,755 125,679 187,667
Source: Krispy Kreme 2002 annual report.




• liquidity and cash flows as indicated by cash and short-term investments and the
statement of cash flows
• major business risks
• financial risks such as foreign currency exchange rates, equity security prices, and
interest rate changes on debt securities
• changes in accounting methods used by the company
• subsequent events
Exhibit 2 provides excerpts from the MD&A section of Krispy Kreme’s 2002 annual
report. The items in this section of the annual report describe the company’s perfor-
mance for the last year compared with previous years. Business risk issues, such as Krispy
Kreme’s exposure to changes in interest rates, are identified. The section also identifies
new accounting standards the company has adopted and the effects of these standards.
F233
CHAPTER F6: Full and Fair Reporting
234 Full and Fair Reporting

Exhibit 2
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
Management’s
RESULTS OF OPERATIONS
Discussion and Analysis
from a Corporate Report
OVERVIEW
As noted above, we operate on a 52 or 53-week fiscal year. Our operations for
fiscal 2002 contained 53 weeks while fiscal 2001 contained 52 weeks.
Systemwide sales for the fiscal year increased 38.7% to $621.7 million
compared to $448.1 million in the prior year. The increase was comprised of an
increase of 24.6% in Company Store sales, to $266.2 million, and an increase of
51.6% in Franchise Store sales, to $355.5 million. The increase was the result of
sales from new stores opened during the fiscal year and an increase in systemwide
comparable sales. . . . The total number of stores at the end of the fiscal year was
218. Of those, 52 are Associate franchise stores, 91 are Area Developer franchise
stores and 75 are Company stores. Systemwide comparable store sales increased
12.8% in the fiscal year. We believe continued increased brand awareness and
growth in off-premises sales contributed significantly to this increase in our
systemwide comparable store sales. Adjusting for the number of weeks in fiscal
2002, the increase in systemwide sales was 35.8%.

LIQUIDITY AND CAPITAL RESOURCES
We funded our capital requirements for fiscal 2000, 2001 and 2002 primarily
through cash flow generated from operations, as well as proceeds from the initial
public offering completed in April 2000 and follow on public offering completed in
early February 2001. Over the past three years, we have greatly improved the
amount of cash we generate from operations. We believe our cash flow generation
ability is becoming a financial strength and will aid in the expansion of our business.

CASH FLOW FROM OPERATIONS
Net cash flow from operations was $8.5 million in fiscal 2000, $32.1 million in fiscal
2001 and $36.2 million in fiscal 2002. Operating cash flow in each year has
benefited from an improvement in our net income and was offset by additional
investments in working capital, primarily accounts receivable and inventories.

QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS
We are exposed to market risk from changes in interest rates on our outstanding
bank debt. Our revolving line of credit bears interest at either our lender’s prime
rate minus 110 basis points or a rate equal to LIBOR [London InterBank Offered
Rate] plus 100 basis points. We can elect the rate on a monthly basis.

RECENT ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (the “FASB”) issued SFAS
No. 141, “Business Combinations”. SFAS No. 141 addresses financial accounting
and reporting for business combinations and supersedes APB Opinion No. 16,
“Business Combinations”, and SFAS No. 38 “Accounting for Preacquisition
Contingencies of Purchased Enterprises”. All business combinations in the scope
of this Statement are to be accounted for using one method, the purchase method.
The Company adopted the provisions of this pronouncement for all business
combinations subsequent to June 30, 2001. Its adoption did not have a significant
impact on the consolidated financial statements.




Notes to the Financial Statements
Notes to the financial statements are important for helping readers interpret the state-
ments. They describe how some of the numbers were computed and provide additional
information about items reported in the statements. Exhibit 3 contains example notes
F234 SECTION F1: The Accounting Information System
235
Full and Fair Reporting

Exhibit 3
NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
Notes to the Financial
Statements from a NATURE OF BUSINESS. Krispy Kreme Doughnuts Inc. and its subsidiaries (the
Corporate Report “Company”) are engaged principally in the sale of doughnuts and related items
through Company-owned stores. The Company also derives revenue from
franchise and development fees and the collection of royalties from franchisees.
Additionally, the Company sells doughnutmaking equipment and mix and other
ingredients and supplies used in operating a doughnut store to Company-owned
and franchised stores.

BASIS OF CONSOLIDATION. The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries. All significant
intercompany accounts and transactions are eliminated in consolidation.

FISCAL YEAR. The Company’s fiscal year is based on a fifty-two/fifty-three week
year. The fiscal year ends on the Sunday closest to the last day in January. The
years ended January 30, 2000 and January 28, 2001 contained 52 weeks. The year
ended February 3, 2002 contained 53 weeks.

PROPERTY AND EQUIPMENT. Property and equipment are stated at cost less
accumulated depreciation. Major renewals and betterments are charged to the
property accounts while replacements, maintenance, and repairs which do not
improve or extend the lives of the respective assets are expensed currently.
Interest is capitalized on major capital expenditures during the period of
construction.

USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS. The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.

ADVERTISING COSTS. All costs associated with advertising and promoting
products are expensed in the period incurred.

REVENUE RECOGNITION. A summary of the revenue recognition policies for each
segment of the Company is as follows:
• Company Store Operations revenue is derived from the sale of doughnuts and
related items to on-premises and off-premises customers. Revenue is
recognized at the time of sale for on-premises sales and at the time of delivery
for off-premises sales.
• Franchise Operations revenue is derived from: (1) development and franchise
fees from the opening of new stores; and (2) royalties charged to franchisees
based on sales. Development and franchise fees are charged for certain new
stores and are deferred until the store is opened. The royalties recognized in
each period are based on the sales in that period.




from the 2002 annual report of Krispy Kreme. These notes identify when certain rev-
enues and expenses were recognized and the amounts of certain expenses that were not
reported individually in the financial statements. We will examine other notes in fu-
ture chapters as we examine specific accounting and reporting issues.
Notes to the financial statements provide information about how amounts reported
in the financial statements were determined and provide more detailed information
about some income statement items. Exhibit 3 contains only a few of these notes. They
describe such matters as when revenue is recognized, how the company’s fiscal year is
F235
CHAPTER F6: Full and Fair Reporting
236 Full and Fair Reporting

defined, and how advertising expenses are determined and reported. Other notes pro-
vide similar information about other financial statement items. These notes are intended
to assist readers in understanding and interpreting the information reported in the fi-
nancial statements. They are an important part of the financial statement presentation
and should be included when audited financial statements are presented.


The Auditors’ Report
The auditors’ report is an important item accompanying a company’s financial statements.
Auditors issue an audit report upon completion of their audit work. An audit involves a
detailed, systematic investigation of a company’s accounting records and procedures for
the purpose of determining the reliability of financial reports. The auditor attempts to
verify that the numbers and disclosures made by management in its financial reports are
consistent with the company’s actual financial position, operating results, and cash flows.
Records, operating procedures, contracts, resources, and management policies and deci-
sions are examined to provide evidence of the fairness of financial report information. Au-
ditors determine if control procedures to ensure the integrity of accounting information
exist and are being used. They compare the information in financial reports with infor-
mation from prior years and other sources to confirm the fairness of the reports.
Attestation occurs when an auditor affirms the fairness of financial statements
and other information. The audit report, or audit opinion, provides public notice of
the auditors’ belief about the fairness of the accompanying financial information. Ex-
hibit 4 provides the auditors’ report from Krispy Kreme’s annual report.



Exhibit 4
KRISPY KREME DOUGHNUTS, INC.
Independent Auditors’
REPORT OF INDEPENDENT ACCOUNTANTS
Report

To the Board of Directors and Shareholders of Krispy Kreme Doughnuts, Inc.
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of shareholders’ equity and of cash flows
present fairly, in all material respects, the financial position of Krispy Kreme
Doughnuts, Inc. and its subsidiaries (the Company) at January 28, 2001 and
February 3, 2002, and the results of their operations and their cash flows for each
of the three years in the period ended February 3, 2002, in conformity with
accounting principles generally accepted in the United States of America. These
financial statements are the responsibility of the Company’s management; our
responsibility is to express an opinion on these financial statements based on our
audits. We conducted our audits of these statements in accordance with auditing
standards generally accepted in the United States of America, which require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for the opinion expressed
above.




Greensboro, North Carolina
March 8, 2002, except Note 21 for
which the date is March 27, 2002
F236 SECTION F1: The Accounting Information System
237
Full and Fair Reporting

The auditors’ report is addressed to the board of directors and shareholders of the
company. Normally, an audit is performed on behalf of the shareholders and other ex-
ternal parties. Audits may be requested for special purposes also—for example, to se-
cure a bank loan or as part of merger negotiations. In such a case, the auditors’ report
would be addressed to the intended users.
The audit report states the auditor’s opinion. Most audit reports provide an un-
qualified opinion. Such an opinion states that the auditor believes that the financial
statements fairly present the company’s actual economic events for the period covered
by the audited statements. Fair presentation means that the financial statements are
prepared in conformity with GAAP and are free from material omissions and mis-
statements. An unqualified opinion means that the auditor has not stated any qualify-
ing (limiting) conditions or exceptions in the opinion. If the financial statements do
not fully conform to GAAP or if serious concerns exist as to the ability of a company
to continue as a going concern, the auditor lists qualifications to the opinion that the
reader should consider in interpreting the financial information.
The auditors’ report identifies the statements and fiscal periods covered by the au-
dit. A typical audit will cover all the primary financial statements: income statement,
balance sheet, and statement of cash flows. The audit normally covers the most recent
three years of operations. For most large corporations, the audited financial statements
are the consolidated statements of the parent and its subsidiaries.
The auditors’ report describes the responsibilities of auditors and management.
Management is responsible for preparing the statements. Auditors are responsible for
competently using the technology available to them to confirm (or disconfirm) the as-
sertions of management made in its financial statements and related disclosures.
The report summarizes the audit process. Generally accepted auditing standards
(GAAS) include procedures used in conducting an audit to help auditors form an
opinion about the fairness of the audited statements. GAAS are developed in the
United States by the Auditing Standards Board (ASB). The ASB is a division of the
American Institute of Certified Public Accountants (AICPA). Auditing standards are
published and updated periodically by the AICPA. Failure to conform to GAAS in an
independent audit is a major violation of a CPA’s responsibilities.
From evidence collected from applying GAAS, auditors assert that the financial
statements are free of material misstatement. Materiality is a criterion for establishing
the importance of a potential misstatement in audited financial statements. Financial
statements contain estimates and allocations that depend on management judgment.
In addition to finding errors in accounting records, auditors may disagree with man-
agers about their estimates and allocations. Unless these errors and disagreements are
material (important) to the overall amounts reported on the financial statements, how-
ever, auditors are not required to take action on these issues.
Auditors examine accounting records on a “test basis.” Auditors do not examine
100% of a company’s transactions. Instead, they use sampling techniques to select rep-
resentative transactions. By verifying these transactions, auditors form an opinion about
the financial statements as a whole. Sampling is necessary because the cost of auditing
all of a company’s records would be prohibitive.
The content of the auditors’ report is standard
for most corporations. Some audit firms issue an au-
L EARNING NOTE
dit report that contains several paragraphs. The para-
Unless information is found that raises doubts about a company’s
graphs contain the same type of information as that
ability to continue operating in the future, it is assumed to be a
included in the paragraph in Exhibit 4.
going concern. This means the company is an organization
Auditors’ reports must be signed by the public
with an indefinite life that is sufficiently long that, over time,
accounting firm that performed the audit, thus indi-
all currently incomplete transactions will be completed.
cating its responsibility. The date of the auditors’ re-
port is the date on which all audit work was
completed for the periods covered by the report. The auditor is responsible for dis-
closing any material information that might affect a decision maker’s interpretation of
the financial statements through the date of the audit report.
F237
CHAPTER F6: Full and Fair Reporting
238 Full and Fair Reporting

The auditor certifies that financial statements
LEARNING NOTE present fairly a company’s business activities. The
audit is not a guarantee that a company will be suc-
Auditors’ reports for foreign corporations differ from those for U.S.
cessful. If a company is not performing well, the fi-
corporations. Different countries establish their own auditing and
accounting standards. The format of the auditors’ report depends nancial statements should reveal the company’s
on the auditing standards of the country in which a company has problems. It is up to stockholders to interpret the
its principal operations. statements and assess the company’s performance.
Good information should lead to informed deci-
sions about whether to invest in a company or not.
Good information does not mean a company is doing well or that investors are likely
to earn high returns. The audit certifies the quality of financial information, not the
quality of management or the ability of management to make good business deci-
sions.
INTERNATIONAL


Report of Management Responsibilities
In addition to the auditors’ report, the annual report usually contains a statement of
management responsibilities. Exhibit 5 contains a typical statement of management re-
sponsibilities.
Management is responsible for preparing financial statements and related informa-
tion that fairly reports the business activities of a corporation. This information should
be prepared in conformity with GAAP. Management is also responsible for developing
and implementing a system of internal controls. Internal controls are procedures a com-
pany uses to protect its assets and ensure the accuracy of its accounting information.
The next section of this chapter describes internal controls in more detail.


Exhibit 5
The management of Mom’s Cookie Company is responsible for the preparation
Report of Management
and integrity of the financial statements included in this Annual Report to
Responsibilities
Shareholders. The financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America and
include amounts based on management’s best judgment where necessary.
Financial information included elsewhere in this Annual Report is consistent with
these financial statements.
Management maintains a system of internal controls and procedures designed
to provide reasonable assurance that transactions are executed in accordance with
proper authorization, that transactions are properly recorded in the Company’s
records, that assets are safeguarded and that accountability for assets is
maintained. The concept of reasonable assurance is based on the recognition that
the cost of maintaining our system of internal accounting controls should not
exceed benefits expected to be derived from the system. Internal controls and
procedures are periodically reviewed and revised, when appropriate, due to
changing circumstances and requirements.
Independent auditors are appointed by the Company’s Board of Directors and
ratified by the Company’s shareholders to audit the financial statements in
accordance with auditing standards generally accepted in the United States of
America and to independently assess the fair presentation of the Company’s
financial position, results of operations and cash flows. Their report appears in this
Annual Report.
The Audit Committee, all of whose members are outside directors, is
responsible for monitoring the Company’s accounting and reporting practices. The
Audit Committee meets periodically with management and the independent
auditors to ensure that each is properly discharging its responsibilities. The
independent auditors have full and free access to the Committee without the
presence of management to discuss the results of their audits, the adequacy of
internal accounting controls and the quality of financial reporting.
F238 SECTION F1: The Accounting Information System
239
Full and Fair Reporting

A corporation’s board of directors should establish an audit committee. The com-
mittee should be made up of members of the board who are not part of the corpora-
tion’s management. The audit committee is responsible for receiving information from
the independent auditors and from those in the corporation who implement and eval-
uate internal controls. Accounting and auditing problems should be reported to the au-
dit committee. The committee can discuss problems with management and can take
steps to correct the problems if necessary.




2 SELF-STUDY PROBLEM Listed below are statements about auditing:

A. An independent audit guarantees the accuracy of financial information.
B. An auditor does not have to examine all of an audited company’s transactions to
certify the reliability of the company’s financial statements.
C. An auditor must follow generally accepted auditing standards in performing an audit.
D. An auditor is responsible only for the period covered by the financial statements

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