Why financial statements are a valuable source of information.
How the demand for financial information comes from its ability to improve decision making and monitor managers’ activities.
How the supply of financial information is influenced by cost and benefit considerations.
How accounting rules are established, and why those rules still allow managers some accounting discretion.
Why financial reporting philosophies and detailed accounting practices sometimes differ across countries.
Why International Financial Reporting Standards (IFRS) influence the accounting practices of U.S. companies.
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Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 1The Economic and Institutional Setting for Financial Reporting Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill EducationLearning objectives- After studying this chapter, you will understand:Why financial statements are a valuable source of information.How the demand for financial information comes from its ability to improve decision making and monitor managers’ activities.How the supply of financial information is influenced by cost and benefit considerations.How accounting rules are established, and why those rules still allow managers some accounting discretion.Why financial reporting philosophies and detailed accounting practices sometimes differ across countries.Why International Financial Reporting Standards (IFRS) influence the accounting practices of U.S. companies.1-*WorldCom’s Curious AccountingFirst Quarter, 2002, an analyst reported: “The company has $2.3 billion in cash, which translates into a $20.50 book value per share, And you have to pay only $2 for this gem!” Third quarter of 2002, WorldCom made a $3.8 billion reclassification from assets to expensesCFO fired, Controller resignedStock lost 90% of its valueCould you have seen it?1-*Why financial statements are importantWithout adequate information, investors cannot properly judge the opportunities and risks of investment alternatives.Financial statements are the first and often the best source of information about a company’s past performance, current health, and prospects for the future.Analytical toolManagement report cardEarly warning signalBasis for predictionMeasure of accountabilityFinancial statements can be used for various purposes:1-*Epilogue to WorldComIn June 2002, WorldCom says $3.8 billion in line cost expenses were wrongly transferred to the balance sheet.Shares fall to $0.06.$11 billion of improper transfers are eventually uncovered. In July 2002, the company declares bankruptcy.$3.8 b?FUTUREBENEFITSNO FUTUREBENEFITSASSETEXPENSE1-*Consequences:Five executives indicted for fraud.Four plead guilty.Chief Executive Officer and Chief Financial Officer sentences to lengthy prison sentences.Profits restated downward by $74.4 billion.Became the largest bankruptcy ever in the United States, far bigger than Enron.1-*Lessons learnedFinancial statement fraud is rare—but investors, analysts and others should not simply accept the numbers at face value.Instead, financial statement readers must:Understand current financial reporting standards and guidelines.Recognize that management can shape the financial information.Distinguish between financial statement information that is highly reliable and information that is judgmental.In other words, accounting is not an exact science!1-*Economics of accounting informationThe financial statements of business enterprises serve two key functions:1-*Economics of accounting informationFinancial statements are demanded because of their value as a source of information about company performance, financial condition, and resource stewardship.The supply of financial information is guided by the costs of producing and disseminating it and the benefits it will provide to the company.DEMANDSUPPLY1-*Demand for financial statementsShareholdersand investors Investment decisions Proxy contestsManagers andemployees Performance assessment Compensation contracts Company-sponsored pension plansLenders andsuppliers Lending decisions Covenant complianceCustomers Seller’s health Repeat purchases Warranties & supportGovernment ®ulators Mandatory reporting Taxing authorities Regulated industries1-*Disclosure incentives and the supply of financial informationMandated reporting (e.g., SEC and FASB) is designed to insure minimum levels of reportingCompanies frequently make voluntary disclosures that go beyond the minimum requirements.Voluntary disclosure is guided by cost/benefit considerations.Companies that confront different financial reporting costs and benefits are likely to choose different accounting and reporting practices.Disclosure costs Information production. Competitive disadvantage. Litigation exposure. Political exposure.Disclosure benefits Low cost access to capital. Avoid the “lemon” problem.1-*Reg FDSEC Reg passed in 1999FD = “Fair Disclosure”Designed to prevent selective disclosures to analysts or certain shareholders Important financial information MUST be disclosed to all interested parties AT THE SAME TIME1-*A closer look at professional analystsFinancial statement users (“analysts”) have diverse information needs because they face different decisions or use different approaches to make the same decision.Analysts include investors, lenders, financial advisors, customers, suppliers, managers, employeeseven auditors Fundamental value Liquidation valueEquityinvestors Fraud risk factors Analytical reviewIndependent auditors Credit risk Financial flexibilityCreditors1-*Rules of the financial reporting gameGAAP: evolving conventions, rules, guidelines and procedures that govern financial reporting.“There’s virtually no standard that the FASB has ever written that is free from judgment in its application.”1-*Who determines the rules?Prior to the establishment of the FASB, AICPA set auditing standardsNow the Public Companies Accounting Oversight Board (PCAOB) set the standardsTwo central roles of the PCAOB:Set standards for auditing and ethics.Inspect and investigate auditing practices of auditing firms.1-*FASB Accounting Standards Codification In 2009, the FASB completed a five-year effort to distill the existing GAAP literature into a single database by creating the Accounting Standards Codification (ASC)The ASC is an online filing cabinet that groups all authoritative rules into roughly 90 topics and reduces the complexity of accounting standards.1-*ASC Topical Structure and ReferencingThe ASC uses a structure in which the FASB’s authoritative accounting guidance is organized into topics, subtopics, sections, subsections, and paragraphs.1-*Adversarial nature of financial reportingGAAP permits alternatives, requires estimates, and incorporates management judgments.Managers have incentives to sometimes exploit the flexibility of GAAP. Here are some ways they can do it:Smoothing the reported earnings numbers.Manipulating revenues or expenses to achieve bonus goals.Downplaying the significance of contingent liabilities.The SEC and FASB, along with auditors and the courts, serve to counterbalance opportunistic financial reporting practices.However, financial disclosures sometimes conceal more than they reveal.1-*Computer Associates International3rd largest software company in the world$7 billion in revenues, $700 million profit, 40% operating margin1,400% return to stockholdersIssued 2 sets of Financial Statements, a GAAP set and a “Pro -forma” setGAAP net income was $342 million LOSSPro-forma showed $247 million PROFIT1-*Daily stock price1-*Figure 1.3What went on?Double counted revenuesBack-dated sales to a prior periodIssued pro-forma statements that did not follow GAAP, and confused even sophisticated readers1-*Epilog Justice & SEC suedComputer Associates paid $225 million in restitution to shareholdersSeven former executives pleaded guilty to civil charges of securities fraudTwo other execs confessed, face up to 30 years in prison, each. 1-*An international perspective1-*International Financial ReportingStock exchanges around the world now offer domestic investors the opportunity to purchase securities issued by foreign companies. Foreign companies comprise:Nearly 20% of stocks listed on the NYSEOver 20% of those listed on the London Stock Exchange (LSE)Two approaches to financial reporting:Economic performance approachCommercial and tax law approach1-*Why do Reporting Philosophies Differ Across Countries?A country’s financial reporting philosophy evolves from legal, political and financial institutions within the country as well as social customsDifferences in financial reporting practices arise from differences in how companies obtain financial capital1-*International Accounting Standards Board (IASB)The IASB has four stated goals:1-*SummaryFinancial statements are an important source of information about a company, its economic health, and its prospects.Financial statements help improve decision making and make it possible to monitor managers’ activities.Equity investors use financial statements to form opinions about the value of a company and its stock.Creditors use statement information to gauge a company’s ability to repay its debts and to check whether the company is complying with loan covenants.Auditors use financial statements to help design more effective audits.Investors, creditors, and other interested parties demand financial statements because the information is useful.1-*Summary concludedBut what governs the supply of financial information?Mandatory reporting and voluntary disclosure.Benefit and cost considerations influence voluntary disclosure.Financial accounting standards (GAAP) are often imprecise and open to interpretation.This imprecision gives managers an opportunity to shape financial statements:Most managers use their accounting flexibility to paint a truthful economic picture of the company.Other managers mold the financial statements to mask weaknesses and to hide problems.Analysts must maintain a healthy skepticism about the numbers.1-*