Chapter 1: Financial Accounting and Its Economic Context
The Role of Financial Reporting in Investment Decisions Profit-seeking companies - managers prepare reports for owners of the companies. Owners and other interested parties (Users) - use reports to assess financial condition and performance of companies. User decisions - users obtain information from reports to make investment decisions.
Effects of user decisions - decisions affect the company and its managers.
Financial Reporting and Investment Decisions Managers prepare Users assess Investment and credit decisions are made Decisions affect company and managers
Content of Financial Reports The Financial Statements:
Statement of Stockholders’ Equity
The Management Letter The management letter is the statement of management to the investors. management is responsible for the preparation and content of the financial report. the statements were prepared in accordance with generally accepted accounting principles (GAAP).
the company maintains a system of internal controls to safeguard assets.
The Financial Statements Include a balance sheet, income statement, statement of stockholders’ equity, and a statement of cash flows (discussed in a later chapter).
The footnotes to the financials are considered an integral part of the financials, and explain many of the policies and assumptions used to prepare the financials.
The Auditor’s Report The auditor’s report is a statement to the board of directors of the company and to the shareholders of the company.
It expresses an opinion as to whether the financial statements present fairly the financial activities of the company and whether the financials were prepared in accordance with GAAP
The Economic Environment of Financial Reporting Providers of capital - debt and equity investors Financial information users and capital markets Debt covenants and management compensation Financial reporting regulations & standards the accounting policymaking process
Professional reputation and ethics
Providers of Capital equity capital through stock investments debt capital through bond and loan investments (creditors) equity investors receive dividends creditors and bond investors receive interest Stock investors choose board of directors Select corporate officers (management)
Management – runs the company
Reporting Entities Reporting entities are called companies, businesses and firms. The companies may be further divided into segments and subsidiaries, which may provide their own financials.
Consolidated financials are prepared when subsidiaries are combined with the parent’s financials.
Corporate Governance Financial Information Users Financial statements used by a variety of groups. Equity investors: purchase shares of stock, which represent ownership in the company. The financials are used by investors to analyze management’s decisions. Debt investors (creditors): provide capital through loans. The financials are used by creditors to assess likelihood of default. Management: uses other companies financials to asses the competition.
Others, including government bodies, labor unions, employees, use financials to assess the financial status of the company.
Corporate Governance and Capital Markets Capital markets value the publicly traded equity and debt securities. The financials are a component of the information that the markets use to value companies securities, along with a number of nonfinancial measures.
The market reacts to financial and other information as it is released by management.
Debt Covenants and Management Compensation Contracts Debt covenants are part of debt contracts between the company and creditors. Violation of debt covenants may lead to more costly debt terms. Management compensation contracts often base pay on certain income or stock price goals.
Such goals are designed to encourage certain management behavior.
Regulations and Standards The Securities and Exchange Commission (SEC) governs financial reporting for publicly traded companies. Congress and other regulatory agencies have influence with the SEC.
The Financial Accounting Standards Board (FASB) is responsible for the promulgation of generally accepted accounting principles (GAAP) for financial statements. The FASB accepts input from all interested parties, including accountants, corporations, academics, and governmental entities.
The Accounting Policymaking Process (GAAP) Generally Accepted Accounting Principles Economic Consequences Policymakers SEC FASB Actual Accounting Practices Public hearings, letters Congress, White House, government agencies Public Input Perceived economic consequences
Sarbanes-Oxley Act Passed by Congress in 2002, in response to a series of corporate scandals. Requires principal executive and financial officers to certify a number of statements regarding the financials.
Places additional responsibilities on management to ensure that adequate internal controls are in place.
Legal Liability Management is legally responsible to the stockholders to act in their interest. Auditors are legally responsible to the stockholders to conduct a thorough and independent audit. If management or auditors fail in their duties, investors and others may sue to recover any losses that might occur as a result the failure.
Many recent examples of management and audit failure exist: Enron, WorldCom, HealthSouth, Xerox, Rite Aid, and Quest.
Professional Reputation and Ethics Ethical behavior is in the long-run interest of managers, stockholders, and auditors. Many companies,universities, and professional organizations have enacted increased emphasis on ethics.
Auditors’ reputations are integral to their ability to perform their duties. High ethical conduct is imperative to their continued success.
The Four Kinds of Accounting (Figure 1A-1) Financial Accounting Profit-making companies Finance or accounting department GAAP Economic Entity Managers System Financial Information Recipients Decisions
Equity and debt investments
The Four Kinds of Accounting (Figure 1A-1) Managerial Accounting Finance or accounting department GAAP All entities Economic Entity Managers System Financial Information Recipients Decisions
The Four Kinds of Accounting (Figure 1A-1) Not-for-profit Accounting Nonprofit entities Finance or accounting department Fund accounting principles Economic Entity Managers System Financial Information Recipients Decisions
The Four Kinds of Accounting (Figure 1A-1) Tax Accounting All entities Finance or accounting department Internal revenue code Economic Entity Managers System Financial Information Recipients Decisions
Collection of government revenues