CHAPTER 1 Value Creation, Financial Statements, and the Environment of Financial Reporting

Value Creation and Successful Management Financial reports help a firm’s stake- holders assess the value created by the firm’s managers for its owners. 2

Stakeholders Investors Directors Employees Suppliers Regulators Other interested parties 3

Measures of Value Creation Play an important role in management’s attempts to attract capital. Help indicate the extent to which management’s decisions create value. Encourages management to emphasize in value-creation activities. 4

Fundamental Activities Involved in Managing a Business Operating activities – managing the producing and operating assets Investing activities – acquiring (and disposing) of producing assets Financing activities – raising capital by providing a return to capital providers 5

Value Creation Value creation occurs when Operating and investing activities produce a return for shareholders, and The return exceeds the cost of financing activities 6

Return on Equity (ROE) Net Income Net Investment Provided by Shareholders where Equity Capital + Retained Earnings - Treasury Stock = Net Investment 7

Cost of Equity Risk free rate of return + Risk premium 8

The Financial Statements Balance Sheet Income Statement Statement of Shareholders’ Equity Statement of Cash Flows

Is ROE > Cost of Equity? Value Creation Shareholder value is created when, over the life of the enterprise, return on equity exceeds the cost of equity capital. Is ROE > Cost of Equity? 10

Dollar Amount of Shareholder Value Created $ Net Income - $ (Avg. Equity Capital x Cost of Equity Capital) ____________________________________ = $ Shareholder Value Created 11

The Economic Context of Financial Reporting Providers of capital - debt and equity investors Reporting entities Corporate governance Financial information users and capital markets Debt covenants and management compensation Financial reporting regulations & standards the accounting policymaking process Sarbanes-Oxley Act Legal liability Professional reputation and ethics

Providers of Capital Provide capital Receive returns 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.

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 Quest.

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 success.

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.

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