1. Revsine/Collins/Johnson/Mittelstaedt: Chapter 1 The Economic and Institutional Setting for Financial Reporting McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Learning objectives- After studying this chapter, you will understand: 1.Why financial statements are a valuable source of information. 2.How the demand for financial information comes from its ability to improve decision making and monitor managers’ activities. 3.How the supply of financial information is influenced by cost and benefit considerations. 4.How accounting rules are established, and why those rules still allow managers some accounting discretion. 5.Why financial reporting philosophies and detailed accounting practices sometimes differ across countries. 6.The reasons for the increased importance of the IASB and why IFRS may soon alter the accounting practice of U.S. Countries 1-2

3. WorldCom  First Quarter, 2002, an analyst reported: “The company has $2.3 billion in cash, which translates into a $20.50 book value per share, And you have to pay only $2 for this gem!”  Third quarter of 2002, WorldCom made a $3.8 billion reclassification from assets to expenses  CFO fired, Controller resigned  Stock lost 90% of its value  Could you have seen it? 1-3

4. 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: 1-4

5. Epilogue to WorldCom  In June 2002, WorldCom says $3.8 billion in line cost expenses were wrongly transferred to the balance sheet.  Shares fall to $0.06.  $11 billion of improper transfers are eventually uncovered. In July 2002, the company declares bankruptcy. $3.8 b ? FUTURE BENEFITS NO FUTURE BENEFITS ASSET EXPENSE 1-5

6. Consequences:  Five executives indicted for fraud.  Four plead guilty.  Chief Executive Officer and Chief Financial Officer sentences to lengthy prison sentences.  Profits restated downward by $74.4 billion.  Became the largest bankruptcy ever in the United States, far bigger than Enron. 1-6

7. Lessons learned  Financial statement fraud is rare—but investors, analysts and others should not simply accept the numbers at face value.  Instead, financial statement readers must: Understand current financial reporting standards and guidelines. Recognize that management can shape the financial information. Distinguish between financial statement information that is highly reliable and information that is judgmental.  In other words, accounting is not an exact science! 1-7

8. Economics of accounting information Information Asymmetry Provide a way for company management to transfer information about business activities to people outside the company Contract Efficiency Financial statement information is often included in contracts between the company and other parties The financial statements of business enterprises serve two key functions: 1-8

9. Economics of accounting information Financial statements are demanded because of their 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 1-9

10. 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 1-10

11. Disclosure incentives and the supply of financial information  Mandated reporting (e.g., SEC and FASB) is designed to insure minimum levels of reporting  Companies frequently make voluntary disclosures that go beyond the minimum requirements.  Voluntary disclosure is guided by cost/benefit considerations.  Companies that confront different financial reporting costs and benefits are likely to choose different accounting and reporting practices. Disclosure costs Information production. Competitive disadvantage. Litigation exposure. Political exposure. Disclosure benefits Low cost access to capital. Avoid the “ lemons” problem. 1-11

12. Reg FD  SEC Reg passed in 1999  FD = “Fair Disclosure”  Designed to prevent selective disclosures to analysts or certain shareholders  Important financial information MUST be disclosed to all interested parties AT THE SAME TIME 1-12

13. 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 1-13

14. 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 1-14

15. 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.” 1-15

16. 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 and SEC or IASB Securities and Exchange Commission PCAOB Public SectorPrivate Sector Financial Accounting Standard Board International Accounting Standard Board Public Company Accounting Oversight Board IASB U.S. Congress SECFASB 1-16

17. Auditing Standards  Prior to Sarbanes/Oxley, AICPA set auditing standards  Now the Public Companies Accounting Oversight Board (PCAOB) set the standards  Two central roles of the PCAOB: Set standards for auditing and ethics. Investigate auditing practices of auditing firms. 1-17

18. FASB Accounting Standards Codification In 2009, the FASB completed a five-year effort to distill the existing GAAP literature into a single database by creating the Accounting Standards Codification (ASC) The ASC is an online filing cabinet that groups all authoritative rules into roughly 90 topics and reduces the complexity of accounting standards. 1-18

19. ASC Topical Structure and Referencing The ASC uses a structure in which the FASB’s authoritative accounting guidance is organized into topics, subtopics, sections, subsections, and paragraphs. Topics are grouped into four areas: Presentation, Financial statement accounts, Broad transactions, Industries Subtopics represent subdivisions of a topic and are distinguished by type or scope Sections are subdivisions such as Recognition, Measurement, or Disclosure that denote the nature of the content in a subtopic. Subsections and Paragraphs allow further segregation and navigation of content 1-19

20. 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. 1-20

21. Computer Associates International  3 rd largest software company in the world  $7 billion in revenues, $700 million profit, 40% operating margin  1,400% return to stockholders  Issued 2 sets of Financial Statements, a GAAP set and a “Pro - forma” set GAAP net income was $342 million LOSS Pro-forma showed $247 million PROFIT 1-21

22. Daily stock price 1-22

23. What went on?  Double counted revenues  Back-dated sales to a prior period  Issued pro-forma statements that did not follow GAAP, and confused even sophisticated readers 1-23

24. Epilog  Justice & SEC sued  Computer Associates paid $225 million in restitution to shareholders  Seven former executives pleaded guilty to civil charges of securities fraud  Two other execs confessed, face up to 30 years in prison, each. 1-24

25. An international perspective 1-25

26. International Financial Reporting  Stock exchanges around the world now offer domestic investors the opportunity to purchase securities issued by foreign companies. Foreign companies comprise: Nearly 20% of stocks listed on the NYSE Over 20% of those listed on the London Stock Exchange (LSE) 1-26

27. Why do Reporting Philosophies Differ Across Countries?  A country’s financial reporting philosophy evolves from legal, political and financial institutions within the country as well as social customs  Differences in financial reporting practices arise from differences in how companies obtain financial capital 1-27

28. International Accounting Standards Board (IASB) The IASB has four stated goals: To develop a single set of high-quality, understandable, enforceable, and globally accepted IFRS To promote the use and rigorous application of those standards To take account of the financial reporting needs of emerging economies and small and medium sized entities To bring about the convergence of national accounting standards and IFRS to high-quality solutions 1-28

29. 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.  Investors, creditors, and other interested parties demand financial statements because the information is useful. 1-29

30. 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.  Analysts must maintain a healthy skepticism about the numbers. 1-30