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

2. 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

3. Stakeholders Investors Directors Employees Suppliers Regulators
Other interested parties 3

4. 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

5. 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

6. 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

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

8. Cost of Equity Risk free rate of return + Risk premium8

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

10. 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

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

12. 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

13. 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

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. Copyright
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