Financial Reporting: The Institutional Setting

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Financial Reporting The Institutional Setting
Hughes Ayers Hoskin John Wiley Sons, Inc.
2004

• Chapter One
• Prepared by Sarita Sheth
• Santa Monica College, CA

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Chapter One Objectives

• Identify three types of business activities.
• Explain the regulation of financial reporting.
• Describe the role of independent audits.
• Recognize the economic impact of accounting
  choices link between owners managers wealth
  to financial statements.
• Understand that a potential relationship exists
  between the value of a firms stock financial
  reporting information.

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Its all about Earnings

• Earnings Statement reports the Revenues and
  Expenses for a specific period
• Earnings Revenue Expenses
• Revenues- collected or to be collected from
  customers for services/goods that have been
  provided
• Expenses- paid or to be paid to vendors for
  resources that go into production and marketing
  of goods/services.

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Investors and Earnings

• 1. Stock/Share gives ownership to investors
  IN

2. A corporation which makes
4.Dividends to investors
3. Earnings/income and pays
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What makes a Corporation Public?

• Public corporation trades its shares on a public
  stock exchange (market)
• An investor can earn profit when a shares value
  increases on the market

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Analyst Impact

• Analysts recommendations can influence investors
  decision
• In turn, stock prices can be affected
• Analyst says
• BUY SELL

Stock goes UP DOWN
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Basic Activities

• 1. Financing activities- are directed at raising
  funds (capital) for the firm. There are two ways
  to generate capital

Investors Lenders

• Called Debt Capital
• Sign a Promise to pay with terms

• Called Equity Capital
• Purchase Shares/Stock

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Basic Activities

• Investing activities- consists of the purchase of
  property equipment to enable the firm to
  conduct business.
• 3. Operating activities- includes anything a
  firm has to do to make and sell its
  goods/services.

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Accounting Process

• The three basic activities have financial
  effects captured in the accounting process.
• Transactions (economic events) begin the process.
• The effects of transactions are recorded over a
  specific period of time and communicated through
  financial statements.
• Financial statements help users make decisions
  about the company.

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Regulation of Financial Reporting
To ensure investors have good information to make
decisions, financial reporting is regulated.

• Who are the regulators?
• Securities and Exchange Commission (SEC) created
  in 1933, the ultimate authority for regulating
  financial reports on public companies.
• Financial Accounting Standards Board (FASB)
  formed in 1973 creates accounting standards.
• Congress

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The SEC

• The SEC created a reporting structure for all
  public firms.
• Public firms must submit an annual report (10K),
  quarterly reports (10Q), and announce significant
  events (8K).
• All reports are filed with the SEC and can be
  accessed electronically http//www.sec.gov/edgar.
  shtml
• SEC can also release standard setting material.

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The FASB

• The FASB regulates through statements that guide
  reporting practices.
• Statements of Financial Accounting Concepts
  (SFACs) make the conceptual framework for
  reporting.
• Statements of Financial Accounting Standards
  (SFAS) address specific valuation and income
  issues.

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Conceptual Framework

• Generally Accepted Accounting Principles (GAAP)
  includes all the concepts, standards, guidelines,
  and conventions for reporting.
• FASB has developed this framework to guide
  standard setting and practice

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Conceptual Framework (cont.)

• Relevance and reliability are constantly being
  weighed against each other.
• The economic event dictates which of these
  qualities takes precedence for reporting.

• Other important concepts to note
• Materiality
• Conservatism

Reliability
Relevance
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New Guidelines Process

• If there is a need for new guidelines, the FASB
• Analyzes the issue in need of additional
  guidance, and prepares a Discussion Memorandum
  for the public response.
• Taking comments into account, FASB issues an
  Exposure Draft for further public comment.
• FASB incorporates all comments and issues the
  pronouncement in the form of SFAS.

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Audit of Financial Statements

• Independent audits are required to safeguard
  investors from misleading statements.
• An audit report states if the statements are fair
  and comply with GAAP.
• The independent audit report must accompany the
  financial statements.

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The Auditor

• performs the procedures to test a companys
  compliance with GAAP and is usually a Certified
  Public Accountant (CPA).
• tests internal controls, determines a firms
  ability to continue as a going concern, looks for
  unusual changes in a firms financial statements.
• uses materiality to test the statements.
• follows Generally Accepted Auditing Standards
  (GAAS) put forth by the American Institute of
  Certified Public Accountants (AICPA).

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Why are audits necessary?

• Managers have an incentives to use flexible
  accounting methods to manipulate the statements.
  
• Some of the reasons for manipulating financial
  data include
• To avoid violating debt covenants
• Management bonuses and compensation are tied to
  firm performance
• Impending litigation
• To avoid higher tax liability