Professional Documents
Culture Documents
Revsine/Collins/Johnson/Mittelstaedt: Chapter 1
McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
WorldCom
Market Price is $2.00 a share and declining, but doing better than others in the industry $104 billion in assets; $44 billion in debt line costs holding steady; most in industry are rising 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! You call your broker: share price at $1.75 in early trading.
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WorldCom
Do you buy?
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?
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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.
ASSET $3.8 b ? EXPENSE
NO FUTURE BENEFITS FUTURE BENEFITS
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Consequences:
Five executives indicted for fraud. Four plead guilty. Chief Executive Officer and Chief Financial Officer sentences to lengthy prison sentences. Profits restated downward by $74.4 billion. Became the largest bankruptcy ever in the United States, far bigger than Enron.
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Lessons learned
Financial statement fraud is rarebut 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!
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Information Asymmetry
Provide a way for company management to transfer information about business activities to people outside the company
Contract Efficiency
Financial statement information is often included in contracts between the company and other parties
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DEMAND
Financial statements are demanded because of their value as a source of information about company performance, financial condition, and stewardship of resources.
The supply of financial information is guided by the costs of producing and disseminating it and the benefits it will provide to the company.
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Lending decisions Covenant compliance Sellers health Repeat purchases Warranties & support
Customers
Mandatory reporting Taxing authorities Regulated industries
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Disclosure costs
Information production. Competitive disadvantage. Litigation exposure. Political exposure.
Companies that confront different financial reporting costs and benefits are likely to choose different accounting and reporting practices.
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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
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Creditors
Independent auditors
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Private Sector
PCAOB
Public Company Accounting Oversight Board
SEC
Securities and Exchange Commission
FASB
Financial Accounting Standard Board
IASB
International Accounting Standard Board
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Auditing Standards
Prior to Sarbanes/Oxley, AICPA set auditing standards Now the Public Companies Accounting Oversight Board (PCAOB) set the standards Two central roles of the PCAOB: Set standards for auditing and ethics. Investigate auditing practices of auditing firms.
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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.
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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
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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.
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An international perspective
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Nearly 20% of stocks listed on the NYSE Over 20% of those listed on the London Stock Exchange (LSE)
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A countrys financial reporting philosophy evolves from legal, political and financial institutions within the country as well as social customs Differences in financial reporting practices arise from differences in how companies obtain financial capital
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To take account of the financial reporting needs of emerging economies and small and medium sized entities
To bring about the convergence of national accounting standards and IFRS to high-quality solutions
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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 companys 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.
Investors, creditors, and other interested parties demand financial statements because the information is useful.
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Summary concluded
But what governs the supply of financial information?
Benefit and cost considerations influence voluntary disclosure. Financial accounting standards (GAAP) are often imprecise and open to interpretation.
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.
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