Chapter 1: Financial Accounting and Its Economic Context

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Chapter 1Financial AccountingandIts Economic
Context

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The Role of Financial Reporting in Investment
Decisions

• Profit-seeking companies - managers 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.

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Financial Reporting and Investment Decisions
Managers prepare
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Content of Financial Reports

• The Management Letter
• The Financial Statements
• Balance Sheet
• Income Statement
• Statement of Stockholders Equity
• Statement of Cash Flows
• The Footnotes
• The Auditors Report

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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.

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The Financial Statements

• Include a balance sheet, income statement,
  statement of stockholders equity, and a
  statement of cash flows (discussed in a later
  chapter).
• The footnotes to the financials are considered an
  integral part of the financials, and explain many
  of the policies and assumptions used to prepare
  the financials.

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The Auditors Report

• The auditors 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

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The Economic Environment 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

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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

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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 parents
  financials.

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Corporate GovernanceFinancial 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
  managements 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.

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Corporate Governanceand 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.

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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.

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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.

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The Accounting Policymaking Process
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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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Legal Liability

• Management is legally responsible to the
  stockholders to act in their interest.
• Auditors are legally responsible to the
  stockholders 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.

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Professional Reputation and Ethics

• Ethical behavior is in the long-run interest of
  managers, stockholders, 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.

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The Four Kinds of Accounting (Figure 1A-1)
Financial Accounting
Profit-making companies
Finance or accounting department
GAAP

• Income statement
• Balance sheet
• Statement of stock-
• holders
• equity
• Statement of cash flows
• Other disclosures
• Auditor report

• External
• Investors
• Creditors
• Suppliers
• Employees
• Managers
• Government
• General public

• Equity and debt investments
• Contract negotiations
• Regulation
• Dividend payments

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The Four Kinds of Accounting (Figure 1A-1)
Managerial Accounting
Finance or accounting department
GAAP

• Manager
• reports
• Production
• costs
• Performance
• evaluation,
• etc.

• Internal
• Managers

• Operating
• decisions

All entities
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The Four Kinds of Accounting (Figure 1A-1)
Not-for-profit Accounting
Nonprofit entities
Finance or accounting department
Fund accounting principles

• Balance sheet
• Funds flow
• statements

• External
• Creditors
• Government
• General public

• Debt investments
• Budget allocations

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The Four Kinds of Accounting (Figure 1A-1)
Tax Accounting
All entities
Finance or accounting department
Internal revenue code

• Official tax forms
• 1040 for individuals
• 1120 for corporations

• External
• Internal Revenue Service

• Collection of government revenues