Chapter 1: Financial Accounting and Its Economic Context 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  Financial Reporting and Investment Decisions Content of Financial Reports   The Management Letter The Financial Statements: – – – –  Balance Sheet Income Statement Statement of Shareholders’ Equity Statement of Cash Flows The Footnotes – integral part of the financials, and explain many of the policies and assumptions used to prepare the financials  The Auditor’s Report 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 The Auditor’s Report  The auditor’s 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 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  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 10 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 11 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 12 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 13 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 14 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 15 The Accounting Policymaking Process Policymakers Congress, White House, government agencies SEC Public hearings, letters FASB Generally Accepted Accounting Principles Public Input (GAAP) Actual Accounting Practices Economic Consequences Perceived economic consequences 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 17 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 Qwest 18 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 19 Four Kinds of Accounting 20 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein 21 [...]...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 11 Corporate Governance Financial Information Users  Financial statements used by a variety of groups – Equity investors:... 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... 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 15 The Accounting Policymaking Process... agencies SEC Public hearings, letters FASB Generally Accepted Accounting Principles Public Input (GAAP) Actual Accounting Practices Economic Consequences Perceived economic consequences 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... of the company 12 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 13 Debt Covenants and Management Compensation... 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 14 Regulations and Standards  The Securities and Exchange Commission (SEC) governs financial reporting for... the failure  Many recent examples of management and audit failure exist: Enron, WorldCom, HealthSouth, Xerox, Rite Aid, and Qwest 18 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... additional responsibilities on management to ensure that adequate internal controls are in place 17 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... ethical conduct is imperative to their continued success 19 Four Kinds of Accounting 20 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the... should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein 21