THE ECONOMIC AND

1
CHAPTER 1

• THE ECONOMIC AND
• INSTITUTIONAL SETTING
• FOR FINANCIAL REPORTING

2
Roadmap

• Economic Setting
• Demand
• Supply
• Institutional Setting
• What kind of rules are desirable?
• Who sets the rule?

3
Demand for accounting information

• Investors
• Managers and employees
• Creditors and suppliers
• Consumers
• Governmental agencies

4
Determinants of Supply of Accounting Information

• Disclosure Benefits
• More information enable firms to raise capital
  on the best possible terms.

5

• Disclosure Costs
• a. Costs associated with collecting, processing,
  and disseminating financial information can be
  large.
• b. Competitors may use the information against
  the company providing the disclosure (competitive
  disadvantage).
• c. Litigation costs result when financial
  statement users initiate court actions against
  the company and its management for financial
  misrepresentations.
• d. Highly profitablebut politically
  vulnerablefirms may be subject to political
  initiatives designed to impose taxes on them.

6
The Rules of the Financial Reporting Game

• Generally accepted accounting principles (GAAP)
  are a network of conventions, rules, guidelines,
  and procedures.

7
Desirable qualities

• 1. Financial information is relevant if it
  makes a difference in the decision-making
  process.2. Financial information is timely if it
  reaches decision makers before it loses its
  capacity to influence their decisions.3. Financia
  l information is reliable if it is verifiable and
  reasonably free of error and bias.

8
Desirable qualities

• 4. Financial information is representationally
  faithful when it represents what it purports to
  represent.
• 5. Financial information is neutral when it does
  not favor one set of interested parties over
  another.

9
Desirable qualities

• 6. Financial information is comparable when it
  is measured and reported in a similar manner
  among different companies.
• 7. Financial information is consistent when
  the same accounting methods are used from period
  to period.

10
Who sets the rule?

• 1. The SEC has the ultimate legal authority to
  determine the rules to be followed in preparing
  financial statements by publicly traded
  companies, but has largely delegated its
  authority to the accounting professions
  Financial Accounting Standards Board
  (FASB).2. GAAP may also evolve from accounting
  practices over time.

11
Central theme

• Managers frequently have reasons to exploit the
  flexibility and discretion allowed by accounting
  standards since their interests may conflict with
  the interests of creditors and shareholders.
• 2. The flexibility of GAAP financial reporting
  standards provides opportunities to use
  accounting tricks

12
Roadmap

• Economic Setting
• Demand
• Supply
• Institutional Setting
• What kind of rules are desirable?
• Who sets the rule?