The Economic and

Institutional Setting
for Financial
Reporting

Revsine/Collins/Johnson/Mittelstaedt: Chapter 1

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, All

 Learning objectives- After studying
this chapter, you will understand:

1. Why financial statements are a valuable source of information.

2. How stakeholders use financial statements.

3. How accounting rules are established, and why those rules still
allow managers some accounting discretion.

4. How the demand for financial information comes from its ability to
improve decision making and monitor managers’ activities.

5. How the supply of financial information is influenced by cost and

benefit considerations.

RCJM: Chapter 1 © 2009 1-2

 WorldCom

 First Quarter, 2002, an analyst reported: “The company has $2.3

billion in cash, which translates into a $20.50 book value per
share, And you have to pay only $2 for this gem!”
 Third quarter of 2002, WorldCom made a $3.8 billion
reclassification from assets to expenses
 CFO fired, Controller resigned
 Stock lost 90% of its value
 Could you have seen it?

RCJM: Chapter 1 © 2009 1-3

 Why financial statements are
important

 Without adequate information, investors cannot properly judge the

opportunities and risks of investment alternatives.

 Financial statements are the first and often the best source of
information about a company’s past performance, current health,
and prospects for the future.

Financial statements can be
used for various purposes:
Analytical tool
Management report card
Early warning signal
Basis for prediction
Measure of accountability

RCJM: Chapter 1 © 2009 1-4

 Epilogue to WorldCom
 In June 2002, WorldCom says $3.8
billion in line cost expenses were
wrongly transferred to the balance
sheet.

 Shares fall to $0.06.

 $11 billion of improper transfers

are eventually uncovered. In July
2002, the company declares
bankruptcy.

FUTURE
ASSET
BENEFITS

$3.8 b ?

NO FUTURE
EXPENSE BENEFITS

RCJM: Chapter 1 © 2009 1-5

 Consequences:

 Five executives indicted for fraud.

 Four plead guilty.
 Chief Executive Officer and Chief Financial Officer sentenced to
lengthy prison terms.
 Profits restated downward by $74.4 billion.
 Became the largest bankruptcy ever in the United States, far
bigger than Enron.

RCJM: Chapter 1 © 2009 1-6

 Lessons learned

 Financial statement fraud is rare—but investors, analysts and

others should not simply accept the numbers at face value.

 Instead, financial statement readers must:

 Understand current financial reporting standards and guidelines.
 Recognize that management can shape the financial information.
 Distinguish between financial statement information that is highly
reliable and information that is judgmental.

 In other words, accounting is not an exact science!

RCJM: Chapter 1 © 2009 1-7

 Economics of accounting
information
DEMAND
Financial statement is
demanded because of its value
as a source of information
about company performance,
financial condition, and
stewardship of resources.
RCJM: Chapter 1
SUPPLY
The supply of financial
information is guided by the
costs of producing and
disseminating it and the
benefits it will provide to the
company.
© 2009 1-8
 Demand for financial
statements
Shareholders • Investment
and investors decisions
• Proxy contests
• Performance assessment
Managers and • Compensation contracts
employees • Company-sponsored pension plans

Lenders and • Lending decisions

suppliers • Covenant compliance

• Seller’s health
Customers • Repeat purchases
• Warranties & support

• Mandatory reporting
• Taxing authorities Government &
• Regulated industries regulators

RCJM: Chapter 1 © 2009 1-9

 Disclosure incentives and the
supply of financial information
 Mandated reporting (e.g., SEC and FASB) is designed to insure minimum
levels of reporting
 Companies frequently make voluntary disclosures that go beyond the
minimum requirements.
 Voluntary disclosure is guided by cost/benefit considerations.

Disclosure benefits Disclosure costs

• Low cost access to capital. • Information production.
• Avoid the “ lemons” problem. • Competitive disadvantage.
• Litigation exposure.
• Political exposure.

 Companies that confront different financial reporting costs and benefits are
likely to choose different accounting and reporting practices.

RCJM: Chapter 1 © 2009 1-10

 Reg FD

 SEC Reg passed in 1999

 FD = “Fair Disclosure”

 Designed to prevent selective disclosures to analysts or certain

shareholders

 Important financial information MUST be disclosed to all

interested parties AT THE SAME TIME

RCJM: Chapter 1 © 2009 1-11

 A closer look at professional
analysts

 Financial statement users (“analysts”) have diverse information

needs because they face different decisions or use different
approaches to make the same decision.

 Analysts include investors, lenders, financial advisors, customers,

suppliers, managers, employees…even auditors
Equity • Fundamental value
investors • Liquidation value

• Credit risk
Creditors • Financial flexibility

Independent • Fraud risk factors

auditors • Analytical review

RCJM: Chapter 1 © 2009 1-12

 Analysts need three types of
financial information

1. Quarterly and annual financial statements along with nonfinancial

operating and performance data.

2. Management’s discussion and analysis (MD&A) of financial and

nonfinancial data—key trends and changes.

3. Information useful for identifying the future opportunities and risks

confronting each of the company’s businesses and for evaluating
management’s plans for the future.

Source: AICPA survey, 1994

RCJM: Chapter 1 © 2009 1-13

 Rules of the financial reporting
game

 GAAP: evolving conventions, rules, guidelines and procedures

that govern financial reporting.
 “There’s virtually no standard that the FASB has ever written that
is free from judgment in its application.”

Conceptual Framework

RCJM: Chapter 1 © 2009 1-14

 Who determines the rules?
Public Sector Private Sector
American Institute of Certified
U.S. Congress AICPA Public Accountants

SEC FASB IASB

Securities and Exchange Financial Accounting International Accounting
Commission Standard Board Standard Board

 GAAP comes from two main sources:

1. Accounting practices that have evolved over time.

2. Written pronouncements by designated organizations like the FASB or IASB

RCJM: Chapter 1 © 2009 1-15

 Auditing Standards

 Prior to Sarbanes/Oxley, AICPA set auditing standards

 Now the Public Companies Accounting Oversight Board (PCAOB)

 Two central roles of the PCAOB:

 Set standards for auditing and ethtics.
 Investigate auditing practices of auditing firms.

RCJM: Chapter 1 © 2009 1-16

 Hierarchy of GAAP

RCJM: Chapter 1 © 2009 1-17

 Adversarial nature of financial
reporting
 GAAP permits alternatives, requires estimates, and incorporates
management judgments.

 Managers have incentives to sometimes exploit the flexibility of GAAP.

Here are some ways they can do it:
 Smoothing the reported earnings numbers.
 Manipulating revenues or expenses to achieve bonus goals.
 Downplaying the significance of contingent liabilities.

 The SEC and FASB, along with auditors and the courts, serve to
counterbalance opportunistic financial reporting practices.

 However, financial disclosures sometimes conceal more than they

reveal.

RCJM: Chapter 1 © 2009 1-18

 Computer Associates
International

 3rd largest software company in the world

 $7 billion in revenues, $700 million profit, 40% operating margin

 1,400% return to stockholders

 Issued 2 sets of Financial Statements, a GAAP set and a “Pro

-forma” set
 GAAP net income was $342 million LOSS
 Pro-forma showed $247 million PROFIT

RCJM: Chapter 1 © 2009 1-19

 Daily stock price

RCJM: Chapter 1 © 2009 1-20

 What went on?

 Double counted revenues

 Back-dated sales to a prior period

 Issued pro-forma statements that did not follow GAAP, and

confused even sophisticated readers

RCJM: Chapter 1 © 2009 1-21

 Epilog

 Justice & SEC sued

 Computer Associates paid $225 million in restitution to

shareholders

 Seven former executives pleaded guilty to civil charges of

securities fraud
 Two other execs confessed, face up to 30 years in prison, each.

RCJM: Chapter 1 © 2009 1-22

 An international perspective

RCJM: Chapter 1 © 2009 1-23

 Differences across countries

RCJM: Chapter 1 © 2009 1-24

 Convergence?

 Toyota:
 Stock traded on Tokyo exchange
 Stock traded on New York exchange
 So,
 Japanese GAAP?
 U.S. GAAP?
 IFRS?
 FASB & IFRS are working together to eliminate (at least
minimize) differences

RCJM: Chapter 1 © 2009 1-25

 Summary
 Financial statements are an important source of information about a
company, its economic health, and its prospects.

 Financial statements help improve decision making and make it

possible to monitor managers’ activities.
 Equity investors use financial statements to form opinions about the
value of a company and its stock.
 Creditors use statement information to gauge a company’s ability to
repay its debts and to check whether the company is complying with
loan covenants.
 Auditors use financial statements to help design more effective audits.

 This is why there is a demand for financial statement information.

RCJM: Chapter 1 © 2009 1-26

 Summary concluded
 But what governs the supply of financial information?
 Mandatory reporting and voluntary disclosure.

 Benefit and cost considerations influence voluntary disclosure.

 Financial accounting standards (GAAP) are often imprecise and

open to interpretation.
 This imprecision gives managers an opportunity to shape financial
statements:
 Most managers use their accounting flexibility to paint a truthful economic
picture of the company.
 Other managers mold the financial statements to mask weaknesses and to
hide problems.

 So analysts must maintain a healthy skepticism about the numbers.

RCJM: Chapter 1 © 2009 1-27