Chap 001

Revsine/Collins/Johnson/Mittelstaedt: Chapter 1

The Economic and Institutional Setting for Financial Reporting

Copyright © 2009 by The McGraw-Hill Companies, All Rights Reserved.

McGraw-Hill/Irwin

1-2RCJM: Chapter 1 © 2009

Learning objectives- After studying this chapter, you will understand:

1. Why financial statements are a valuable source of information.

2. How stakeholders use financial statements.

3. How accounting rules are established, and why those rules still allow managers some accounting discretion.

4. How the demand for financial information comes from its ability to improve decision making and monitor managers’ activities.

5. How the supply of financial information is influenced by cost and benefit considerations.


WorldCom

First 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 expenses

CFO fired, Controller resigned Stock lost 90% of its value Could you have seen it?


Why financial statements are important

Without 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 card

Early warning signalBasis for prediction

Measure of accountability

Financial statements can be used for various purposes:


Epilogue to WorldCom

In 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 ?

FUTURE

BENEFITS

NO FUTURE

BENEFITS

ASSET

EXPENSE


Consequences:

Five executives indicted for fraud. Four plead guilty. Chief Executive Officer and Chief Financial Officer sentenced to

lengthy prison terms. Profits restated downward by $74.4 billion. Became the largest bankruptcy ever in the United States, far

bigger than Enron.


Lessons learned

Financial 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!


Economics of accounting information

Financial statement is demanded because of its value as a source of information about company performance, financial condition, and stewardship of resources.

The supply of financial information is guided by the

costs of producing and disseminating it and the

benefits it will provide to the company.

DEMAND

SUPPLY


Demand for financial statements

Shareholdersand investors

Managers andemployees

Customers

Lenders andsuppliers

Government &regulators

• Investment decisions• Proxy contests

• Performance assessment• Compensation contracts• Company-sponsored pension plans

• Lending decisions• Covenant compliance

• Seller’s health• Repeat purchases• Warranties & support

• Mandatory reporting• Taxing authorities• Regulated industries


Disclosure incentives and the supply of financial information

Mandated reporting (e.g., SEC and FASB) is designed to insure minimum levels of reporting

Companies 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 “ lemons” problem.


Reg FD

SEC Reg passed in 1999

FD = “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 TIME


A closer look at professional analysts

Financial 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, employees…even auditors

• Fundamental value• Liquidation value

• Credit risk• Financial flexibility

• Fraud risk factors• Analytical review

Equityinvestors

Independent auditors

Creditors


Analysts need three types of financial information

1. Quarterly and annual financial statements along with nonfinancial operating and performance data.

2. Management’s discussion and analysis (MD&A) of financial and nonfinancial data—key trends and changes.

3. Information useful for identifying the future opportunities and risks confronting each of the company’s businesses and for evaluating management’s plans for the future.

Source: AICPA survey, 1994


Rules of the financial reporting game

GAAP: 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.”

Conceptual Framework


Who determines the rules?

GAAP comes from two main sources:

1. Accounting practices that have evolved over time.

2. Written pronouncements by designated organizations like the FASB or IASB

Securities and Exchange Commission

AICPA

Public Sector Private Sector

Financial Accounting Standard Board

International Accounting Standard Board

American Institute of Certified Public Accountants

IASB

U.S. Congress

SEC FASB


Auditing Standards

Prior to Sarbanes/Oxley, AICPA set auditing standards

Now the Public Companies Accounting Oversight Board (PCAOB)

Two central roles of the PCAOB: Set standards for auditing and ethtics. Investigate auditing practices of auditing firms.


Hierarchy of GAAP


Adversarial nature of financial reporting

GAAP 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.


Computer Associates International

3rd largest software company in the world

$7 billion in revenues, $700 million profit, 40% operating margin

1,400% return to stockholders

Issued 2 sets of Financial Statements, a GAAP set and a “Pro -forma” set

GAAP net income was $342 million LOSS Pro-forma showed $247 million PROFIT


Daily stock price


What went on?

Double counted revenues

Back-dated sales to a prior period

Issued pro-forma statements that did not follow GAAP, and confused even sophisticated readers


Epilog

Justice & SEC sued

Computer Associates paid $225 million in restitution to shareholders

Seven former executives pleaded guilty to civil charges of securities fraud

Two other execs confessed, face up to 30 years in prison, each.


An international perspective


Differences across countries


Convergence?

Toyota: Stock traded on Tokyo exchange Stock traded on New York exchange

So, Japanese GAAP? U.S. GAAP? IFRS?

FASB & IFRS are working together to eliminate (at least minimize) differences


Summary

Financial 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.

This is why there is a demand for financial statement information.


Summary concluded

But 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.

So analysts must maintain a healthy skepticism about the numbers.

Chap 001

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