Financial accounting in an economic context 8e chapter 01

The Role of Financial Reporting in Investment Decisions prepare reports for owners of the companies.. Financial Reporting and Investment Decisions... Content of Financial Reports The

Chapter 1:

Financial Accounting

and Its Economic Context

The Role of Financial Reporting in

Investment Decisions

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

Content of Financial Reports

 The Management Letter

 The Financial Statements:

– Balance Sheet

– Income Statement

– Statement of Shareholders’ Equity

– Statement of Cash Flows

 The Footnotes

– integral part of the financials, and explain many of

the policies and assumptions used to prepare the

financials.

 The Auditor’s Report

The Management Letter

 The management letter is the statement

of management to the investors.

 It indicates:

– 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 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 information users and capital markets

– Debt covenants and management compensation

 Financial reporting regulations & standards

– the accounting policymaking process

 Legal liability

Providers of Capital

 Provide capital

– equity capital through stock investments

– debt capital through bond and loan investments

(creditors)

 Receive returns

– equity investors receive dividends

– creditors and bond investors receive interest

 Stock investors choose board of directors

 Board of directors

– Select corporate officers (management)

– Set company policy

– Select audit committee

 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

Policymakers

SEC FASB

Actual Accounting

Practices

Actual Accounting

Practices

Public hearings, letters

Congress, White House, government agencies

Congress, White House,

Input

Public Input

Perceived economic consequences

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

shareholders to act in their interest

 Auditors are legally responsible to the

shareholders 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 Qwest

Professional Reputation and Ethics

 Ethical behavior is in the long-run interest of

managers, shareholders, 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

Four Kinds of Accounting

20

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