chapter 1

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Chapter 1

The Economic & Institutional Setting for Financial Reporting

Authored by Brian Leventhal, University of Illinois at Chicago

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A.There are several “facts” to consider before making an investment.

1. Your brother calls you with a hot stock tip: California Micro Devices has been a rocket stock since he bought it at $5 per share. The stock is now trading at $21 per share.

I. California Micro Devices Example

It’s going to go up more! You got to get in.

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a. Seven analysts following Cal Micro continue to rate the company as a “strong buy”.

b. Cal Micro has a solid management team, a strong financial track record, and it is a leader in an expanding market.


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2. The financial statements confirmed a 45 percent increase in net sales and a 400 percent increase in profits. This year is off to a great start as well—sales and earnings have increased more than 50% on a quarterly basis!!!!

3. The company also inked a strategic alliance with Hitachi Ltd. that should fuel growth for the next several years.


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You bought the stock…


And Then……

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4. A negative article appeared in the

morning paper.

a. The company has high inventory and negative cash flows for four out of five fiscal years.

b. Cal Micro has high receivables that suggest that the company is borrowing against future sales.

c. Cal Micro blames its high receivables on favorable credit terms.


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5. Your broker confirms that the stock has declined $2 in early trading. What do you do?


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B. Investors need adequate information to judge properly the opportunities and risks of investment alternatives.

1. A company’s own financial statements are the best source of information about a company, its current health, and its prospects for the future.

2. Financial statements can be used as an analytical tool, a management report card, an early warning signal, a basis for prediction, and as a measure of accountability.


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While financial statements are not as

timely as press releases, they do

provide an economic history and are

indispensable in developing an accurate

profile of ongoing performance and

prospects.

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C. What happened with Cal Micro?

1. A new audit team uncovered fraud in the financial reporting by senior corporate officers.

2. The record $5.0 million profit should have been a loss of $15.2 million! Sales had been overstated by 73%!!


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Authors’ Note……

This text does not focus on assisting readers of financial

statements in detecting fraud. Rather, the purpose of this text is to

assist readers in understanding the financial flexibility and

discretion inherent in financial accounting rules in order that they

may make more informed decisions.

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A. Financial accounting information facilitates economic transactions and fosters efficient allocation of resources.

II. Economics of Accounting Information

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B. Financial statements are demanded because of their value as a source of information about the company’s performance, financial condition, and stewardship of its resources.

1. Shareholders and investors use financial information to decide on a portfolio consistent with their individual preferences for risk, return, dividend yield, and liquidity.

a. Financial statements are crucial in fundamental analysis.

b. Technical analysis does not concern itself with financial statement numbers.


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2. Managers and employees use financial information to monitor contracts such as bonus plans, profit-sharing plans, stock ownership plans, and to monitor the health of company-sponsored pension plans.


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3. Lenders and suppliers use financial information to assess the financial strength of a business to determine whether to make a loan (or extend credit), and then the amount, interest rate, and security (if any) that is needed.


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4. Customers use financial information to monitor a supplier’s financial health as part of the process of checking out a product and the company that stands behind it.


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5. Government and regulatory agencies demand financial statement information for various reasons.a. Taxing authorities may use financial statement information as a basis for establishing tax policies designed to enhance social welfare. b. As customers of businesses, government agencies may use financial statement information to settle contractual payments.c. Regulatory intervention may be another source of demand for financial statement information.


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C. The supply of financial information is guided by the costs of producing and disseminating it and the benefits it will provide to the company.

1. Voluntary disclosure occurs so long as the incremental benefits to the company from supplying that information exceed the incremental costs of supplying that information.


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2. Financial reporting in the U.S. is regulated.a. Some users, such as creditors, may have enough bargaining power to compel companies to deliver financial information that they need for analysis. b.Most financial statement users are less fortunate. c. Regulated financial reporting is designed to ensure that companies meet certain minimum levels of financial disclosure.


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3. Disclosure Benefits: Managers have an incentive to supply the amount and type of financial information that will enable them to raise capital on the best possible terms.


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4.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 profitable—but politically vulnerable—firms may be subject to political initiatives designed to impose “taxes” on them.


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Authors’ Note…… Small businesses are often subject to less comprehensive reporting requirements because of the prohibitive costs referred to in a. above.

Likewise, political costs (d. above) may encourage firms to use accounting

methods that appear less profitable. Much of the book is devoted to providing

you with the skills necessary to undo accounting methods or to convert from

one method to another so that more meaningful comparisons between companies may be made. Therefore,

gaining insight into managers’ incentives and become more informed readers of

financial statements.

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III.A Closer Look at Professional Analysts

A. Financial statement users have diverse information needs because they face different decisions or may use different approaches to making the same kind of decision.

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B. The text focuses on analysts, defined broadly to include investors, creditors, financial advisors, and auditors.


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1. Quarterly and annual financial statements and nonfinancial operating and performance data.

2. Management’s analysis of financial and nonfinancial data including reasons for change (management discussion and analysis).

3. Information making it possible to identify future opportunities and risks.


C. Information needs of analysts include:

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IV. The Rules of the Financial Reporting Game

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

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1. Professional analysts are forward looking. GAAP reports what has occurred.

2. Therefore, analysts must first understand the accounting measurement rules used to produce the data before extrapolating financial statement data into the future.


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B. Financial statements should possess certain qualitative characteristics.

1. Financial information is relevant if it makes a difference in the decision-making process.


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2. Financial information is timely if it reaches decision makers before it loses its capacity to influence their decisions.


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3. Financial information is reliable if it is reasonably free of error and bias and truthfully represents what it purports to represent.


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4. Financial information is representationally faithful when the accounting actually represents the underlying transaction or economic event.


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5. Financial information is neutral when it does not favor one set of interested parties over another.


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6. Financial information is comparable when it is measured and reported in a similar manner among different companies.


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7. Financial information is consistent when the same accounting methods are used from period to period.


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Authors’ Note…… You often want to know

which accounting alternative is “best.” Qualitative trade-offs make it difficult to identify “good” accounting methods and disclosure practices. For example, market value may be relevant to the decision at hand, but reliability may be questionable.


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1. Materiality is established when an omission or misstatement is important enough that the judgment of a reasonable person is influenced by the omission or misstatement. (Ex. Expensing garbage cans not depreciating)


C. Two additional conventions affect whether financial statements are complete, understandable, and helpful.

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C. Two additional conventions affect whether financial statements are complete, understandable, and helpful.

2. Conservatism in accounting involves trying to ensure that business risks and uncertainties are adequately reflected in the financial reports. (Ex. Contingent losses reported not contingent gains)

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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 profession’s Financial Accounting Standards Board (FASB).


D. Where does GAAP come from?

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2. GAAP may also evolve from accounting practices over time.



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3. Financial reporting standards outside the U.S. are determined in some countries by professional accounting organizations, in other countries by commercial law and/or tax law requirements, and on a worldwide basis by the International Accounting Standards Committee (IASC).



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E. There is an adversarial nature to financial reporting.

1. 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.


Means they want their bonus any way they can get it!

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2.The flexibility of GAAP financial reporting standards provides opportunities to use accounting “tricks” to make a company appear less risky than it really is, or to “smooth” earnings by strategically timing the recognition of revenues and expenses.



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2.The flexibility of GAAP financial reporting standards provides opportunities to use accounting “tricks” to make a company appear less risky than it really is, or to “smooth” earnings by strategically timing the recognition of revenues and expenses.



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2. The flexibility of GAAP financial reporting standards provides opportunities to use accounting “tricks” to make a company appear less risky than it really is, or to “smooth” earnings by strategically timing the recognition of revenues and expenses.

IV. The Rules of the Financial Reporting GameFor example, the choice to capitalize, rather than expense amounts, will make firms appear to be larger, more profitable, and less risky. Therefore, naïve acceptance of financial statement data may be dangerous.

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F.America Online Inc. (AOL) embraces aggressive financial reporting practice.


1. There are several facts to the case.a. This company is a global leader in the expanding market for online consumer services, Internet, multimedia and other interactive services for consumers and businesses.

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1. There are several facts to the case. b. Under its initial accounting method, if AOL spent $24 million on advertising and free trials to lure new customers, the company would offset the cash outflow with a corresponding increase to its deferred assets.

The deferred asset would then be gradually reduced by an annual charge to earnings, effectively spreading the cost over the average life of a subscription (about 24 months).

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1. There are several facts to the case.

c. AOL then switched accounting methods by adopting the industry practice of recording the entire subscriber acquisition expense immediately.

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1. There are several facts to the case.d. This seemingly minor change produced a net loss of $353 million in the quarter of the accounting change. AOL would have reported quarterly earnings of $19 million under the old accounting method.

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F. America Online Inc. (AOL) embraces aggressive financial reporting practice.


2. The investment community favored the new, more conservative accounting method, and AOL shares closed $1 higher on the day of the announcement.

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F. America Online Inc. (AOL) embraces aggressive financial reporting practice.

3. Revised earnings paint a very different picture of the company’s profit performance and growth when compared to originally reported amounts.


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Authors’ Note…… Analysts could have

converted AOL’s financial statements to reflect more conservative accounting (expensing instead of capitalizing) prior to management’s decision to do so. Therefore, there is much value of being an informed user of this information!


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V. Challenges Confronting the Analyst

A. Financial statements have become increasingly more complex.

B. Service firms and e-commerce companies now represent a major portion of business activities

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C. Global competition for products, services, capital and customers has introduced yet additional diversity into the financial reporting process.


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D. Benefits from increased use and lower cost of technology to assemble and analyze financial data are muted by the increased complexity and dynamic environment in which firms operate.


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Appendix Chapter 1

GAAP in the United States

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VI.Appendix—GAAP in the United States

A. Securities Act of 1933 required companies selling publicly traded stock and debt to provide financial information.1. The Act was amended in 1934 to create the SEC.2. Firms with stock or debt listed on organized exchanges were required to file annual financial reports with the SEC.

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B. The American Institute of Certified Public Accountants (AICPA) Committee on Accounting Procedures issued bulletins between 1938 and 1959 that set forth what the committee believed GAAP to be.

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C. In 1959, the AICPA established the Accounting Principles Board (APB) to develop a conceptual framework and to issue statements to improve external financial reporting and disclosure.1. The force of these pronouncements depended on general acceptance and persuasion.2. Critics cited numerous instances where net income could be manipulated by selecting among several methods that were “generally accepted.”

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D. FASB was created in 1973. It differed from its predecessors in several important ways.1. There were seven board members (APB had eighteen).2. All Board members were required to sever ties with their previous employer.3. Broader representation was achieved since board members did not have to hold CPA licenses.4. Staff support was increased substantially.

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E. SEC still retains broad statutory powers over financial reporting practices, but continues to rely on the accounting profession to set and enforce accounting standards and to regulate the profession.

1.FASB has no authority to enforce compliance with GAAP. That responsibility lies with management, the accounting profession, the SEC, and the courts.

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2. FASB follows a “due process” procedure in developing accounting standards.

a. Discussion-memorandum stage outlines the key issues involved.b. Exposure-draft stage encourages further public comment that is evaluated.c. Voting stage is when the Board votes whether to issue the standard or to revise it and reissue another exposure draft.

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F. Significant differences between U.S. accounting standards and those used abroad are major impediments that foreign companies encounter when looking to register securities in the U.S. markets. 1.The IASC sets international accounting rules. a. The IASC has issued 40 standards and 18 interpretations of existing IAS standards. b. Compared to U.S. GAAP, existing IASC standards typically allow firms greater latitude in their accounting and reporting practices.

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2. The International Organization of Securities Commissions (IOSCO) seeks member cooperation aimed at improving domestic and international financial markets, promoting the development of domestic markets through information exchange, establishing standards and effective surveillance of international securities transactions, and ensuring the integrity of markets by rigorous application of standards and enforcement.

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VI.Appendix—GAAP in the United States a. The SEC is a member of the IOSCO.

b. As part of an agreement with the IOSCO, the IASC developed a core set of International Accounting Standards (IAS) that the IOSCO will consider for endorsement for cross-border capital raising and listing purposes in all global markets.

c. The SEC will consider international accounting standards for use by foreign registrants, without reconciliation to U.S. GAAP, only when the standards are comprehensive, are high quality, and can be rigorously interpreted and applied.

chapter 1

Documents

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