The Economic and Institutional Setting for Financial Reporting

Revsine/Collins/Johnson: Chapter 1

The Economic and Institutional Setting for Financial Reporting

2RCJ: Chapter 1 © 2005

Learning objectives

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

2. Why analysts (including auditors) 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

It’s May 2002 and your brother says you should buy WorldCom shares.

The shares look “incredibly cheap” at $2.00 because the company has a book value of $20.50/share and cash of $0.73/share.

WorldCom has weathered the industry downturn better than other companies.

But an article in this morning’s paper raises a new concern:

Sales

Costs Line%42

Fixed “rental” payment

Message volume

Holding steady despite declining message volume


Why financial statements are important

Without adequate information, investors cannot properly judge the opportunities and risks of investment alternatives.

Financial statements are 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


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 word, 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

• Supplier 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) plus 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.


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


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.


America Online (AOL)

Wall Street analysts were uneasy about earnings quality because of AOL’s unorthodox accounting for certain marketing costs.

Analysts favored a more conservative approach used by other firms in the industry.


AOL’s accounting method change

Triggered a $385 million balance sheet write-off.

Produced a net loss of $354 million for the quarter and erased five-years of reported “profits”.

Operating cash flows were not affected.

AOL shares closed up $1 on the day of the announcement.

Some questions to think about: How flexible is GAAP? What factors influence the accounting methods that firms use? Do companies disclose the methods they use? Why didn’t AOL’s stock price fall when the change was announced? Did the company violate GAAP and mislead investors?


An international perspective

Most revenue comes from North America

Most profit comes from Asia


Differences across countries


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.

The Economic and Institutional Setting for Financial Reporting

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