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

RCJM: Chapter 1 © 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.

RCJM: Chapter 1 © 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 tool Management report card Early warning signal Basis for prediction Measure of accountability Financial statements can be used for various purposes:

RCJM: Chapter 1 © 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

RCJM: Chapter 1 © Demand for financial statements Shareholders and investors Managers and employees Customers Lenders and suppliers 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

RCJM: Chapter 1 © 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 Equity investors Independent auditors Creditors

RCJM: Chapter 1 © 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

RCJM: Chapter 1 © 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

RCJM: Chapter 1 © 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 SectorPrivate Sector Financial Accounting Standard Board International Accounting Standard Board American Institute of Certified Public Accountants IASB U.S. Congress SECFASB

RCJM: Chapter 1 © Hierarchy of GAAP

RCJM: Chapter 1 © 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.

RCJM: Chapter 1 © 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

RCJM: Chapter 1 © 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.

RCJM: Chapter 1 © 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.