ACG3171 CH. 1

Analysts>>Creditors

**Credit risk, financial flexibility - Assess company's ability to meet its debt-related financial obligations through the timely payment of interest and principal or through asset liquidation in the event interest and principal cannot be repaid - Form educated opinions about company's credit risk - Financial flexibility: the ability to raise additional cash by selling assets, issuing stocks, or borrowing more

Adversarial Nature of Financial Reporting

- GAAP permits alternatives (ex LIFO vs FIFO for inventory valuation), requires estimates (ex useful life of depreciable assets), & incorporates management judgments - Managers have incentives to sometimes exploit the flexibility of GAAP. Here are some ways they can do it: - Smoothing reported earnings numbers by strategically timing the recognition of revenues and expenses to dampen the normal ups and downs of business activity - Manipulating revenues or expenses to achieve bonus goals - Downplaying the significance of contingent liabilities **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

Shareholders & Investors (using financial information)

- Help decide on a portfolio of securities that meets their preferences for risk, return, dividend yield, and liquidity (investment decisions, proxy contests- campaign launch to elect their own slate of directors at next annual meeting) - When evaluating the performance of the company's top executives- use is referred to as the stewardship function of financial reports

Financial statement information has value because

- Reduces uncertainty about a company's future profitability or economic health - Provides evidence about the quality of its management, about its ability to fulfill its obligations under supply agreements or labor contracts, or about other facets of the company's business activities

Disclosure Costs: Litigation

- Result when shareholders, creditors, and other financial statement users initiate court actions against the company and its management for alleged financial misrepresentations - Ex: sudden drop in stock price after company has released new financial information

ASC Topical Structure and Referencing

- Topics are grouped into four areas: Presentation, financial statement accounts, broad transactions, industries - Subtopics represent subdivisions of a topic and are distinguished by type or scope - Sections are subdivisions such as recognition, measurement, or disclosure that denote the nature of the content in a subtopic - Subsections and paragraphs allow further segmentation and navigation of content

Statements readers must:

- Understand current financial reporting standards and guidelines - Recognize that management can shape the financial information communicated to outside parties - Distinguish between financial statement information that is highly reliable and information that is judgmental

Capital market has two important features

1. Investors are uncertain about the quality (riskiness) of each company's debt or equity offerings because the ultimate return from the security depends on future events 2. It's costly for a company to be mistakenly perceived as offering investors a low-quality (high-risk) stock or deny instrument ("lemon"- hidden risks)

Analysts' need 3 types of financial information

1. Quarterly and annual financial statements along with non financial operating and performance data (such as backlogs and customer retention rates) 2. Management's discussion and analysis (MD&A) of financial and non financial data- key trends and changes (including reasons for 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

Differences between U.S. GAAP and IFRS (3 examples)

1. Reversal of inventory write-downs 2. Extraordinary items 3. Research and development cost **FASB & IASB are working toward eliminating differences between the two

People outside the company whose decisions demand financial statement information as a key input include

1. Shareholders and investors 2. Managers and employers 3. Lenders and suppliers 4. Customers 5. Government and regulatory agencies

GAAP comes from two main sources

1. Written pronouncements by designated organizations such as the FASB and SEC for U.S. companies or the International Accounting Standards Board (IASB) for many non-U.S. companies 2. Accounting practices that have evolved over time

International Accounting Standards Board (IASB)

4 goals: 1. To develop a single set of high-quality, understandable, enforceable, and globally accepted IFRS 2. To promote the use and rigorous application of those standards 3. To take account of the financial reporting needs of emerging economies and small and medium-sized entities 4. To bring about convergence of national accounting standards and IFRS to high-quality solutions 50 standards, >27 interpretations

(Summary) Stock analysts, brokers, and portfolio managers use financial statements

As the basis for their recommendations to investors and creditors

Voluntary disclosure is guided by cost/benefit considerations

DISCLOSURE BENEFITS - Low cost access to capital - Avoid the "lemons" problem DISCLOSURE COSTS (arise from informative financial decisions) - Information collection/processing costs (can be high) - Competitive disadvantage costs - Litigation exposure costs - Political exposure costs

Company's financial reporting decisions are driven by

Economic considerations and thus by cost-benefit trade-offs

American Institute of Certified Public Accountants (AICPA)

Prior to establishment of FASB, had primary responsibility for setting accounting standards in the United States through Accounting Principles Board

Public Company Accounting Oversight Board (PCAOB)

Private-sector, nonprofit corporation created by Sarbanes-Oxley Act of 2002

(Financial statements of business enterprises serve two key functions) 1. Information Asymmetry

Provide a way for company management to transfer information about business activities to people outside the company, (which helps solve this problem)

Financial statements are demanded because

Provide information that helps improve decision making or makes it possible to monitor managers' activities

Efficient Market Hypothesis

Says a stock's current market price reflects the knowledge and expectations of all investors. Any new development is quickly and correctly reflected in a firm's stock price

If you want to know more about a company, its past performance, current health, and prospects for the future

The best source of information is the company's own financial statements

The supply of financial statement information is guided by

The costs of producing and disseminating it and the benefits it will provide to the company

Quality of information

The degree to which the financial statements are grounded in facts and sound judgements and thus are free from distortion

Financial statements are demanded because of

Their value as a source of information about the company's: - Performance - Financial condition - Stewardship of its resources

Financial statement users ("analysts") have diverse information needs because

They face different decisions or use different approaches to make the same decision

(Summary) Equity investors use financial statements

To form opinions about the value of a company and its stock

(Summary) Creditors use statement information

To gauge a company's ability to repay its debt and to check whether the company is complying with loan covenants

(Summary) Auditors use financial statements

To help design more effective audits by spotting areas of potential reporting abuses

GAAP goal: To ensure that a company's financial statements clearly represent its economic condition and performance

Financial information should possess certain qualitative characteristics that make the reported information useful: - RELEVANCE: helps users form more accurate predictions about the future or allows them to better understand how past economic events have affected the business (confirmatory value) - PREDICTIVE VALUE: improves the decision maker's ability to forecast the future outcome of past/present events - CONFIRMATORY VALUE: confirms or alters the decision maker's earlier beliefs - FAITHFUL REPRESENTATION: the financial information actually depicts the underlying economic event - COMPLETENESS: can be misleading if important facts are omitted - NEUTRALITY: cannot favor one set of interested parties over another - FREE FROM MATERIAL ERROR: should not expect all accounting measurements to be error-free, however, some minimum level of accuracy is also necessary for an estimate to be a faithful representation of an economic event - COMPARIBILITY - VERIFIABILITY - TIMELINESS - UNDERSTANDABILITY - MATERIALITY - CONSERVATISM

(Financial statements of business enterprises serve two key functions) 2. Contract Efficiency

Financial statement information is often included in contracts between the company and other parties (such as lenders or managers), (because doing so improves this)

Know about WorldCom's situation

Improperly transferred a total of $3.8 billion in line cost expenses from the I/S to the B/S - CEO fired, stock lost 90% of value, 5 executives indicted for fraud, 4 guilty - Became largest bankruptcy in U.S.

(Summary) What governs the supply of financial information?

Mandatory reporting and voluntary disclosure (Can benefit company but comes with potential costs)

Accounting Standards Codification (ASC)

Online filing cabinet that groups all authoritative rules into roughly 90 topics

Companies frequently make voluntary disclosures that go beyond the minimum requirements

Owners/managers have economic incentive to supply the amount and type of financial information that will enable them to raise capital at the lowest cost

Ch. 1 Practice Problems

P1-3, 5, 7, 11

International Financial Reporting

**Foreign companies comprise: nearly 20% of stocks listed on NYSE, over 20% of those listed on the LSE - Economic performance approach: reporting philosophy whose financial statements were intended to capture and reflect the underlying economic performance and condition of the reporting entity. Rules were designed to achieve this goal and help investors and creditors make informed decisions - Commercial and tax law approach: financial accounting and reporting rules that did not necessarily try to capture "economic reality". Instead, financial statements in those countries simply conformed to mandated laws or detailed tax rules designed to achieve purposes such as raising tax revenues or fund government activities or stimulate capital investment - Reporting philosophies differ across countries: arise from differences in how companies obtain financial capital - US, UK, Canada: reporting environment has evolved to meet this public financial market demand for information - Germany, Japan: concentrated power and the insignificance of the public financial market makes the demand for economically realistic reporting standards low

Analysts>>Independent auditors

**Fraud risk factors, analytical review procedures "look behind the numbers"

Lenders & Suppliers (using financial information)

**Lending decisions, covenant compliance - Collateral needed, covenants provide lender a safety net

Government & Regulatory Agencies (using financial information)

**Mandatory reporting (SEC), taxing authorities, regulated industries - Info used to regulate businesses (monopoly gas and electric compared to rate of return)

Customers (using financial information)

**Seller's health, repeat purchases, warranties and support - Customer checks whether seller has financial strength to deliver high-quality product on agreed upon schedule

Computer Associates International (CA)

- 3rd largest software company in world - 1400% return ($5 stock>>sell for $75) - $7 billion in revenues, $700 million profit, 40% operating margin - Issued 2 sets of financial statements, GAAP (NI=$342 million LOSS), pro-forma (NI=$247 million PROFIT) What happened? Double counted stock price, back-dated sales to prior period ("the 35-day month"), pro-forma statements did not follow GAAP, confused many - The Justice Department and the SEC sued CA/several top executives (2 other confessed- 30/12 years in prison each) - Agreed to pay $225 million in restitution to shareholders

Generally Accepted Accounting Principles (GAAP)

- Accounting practitioners and standards setters have developed a network of conventions, rules, guidelines, and procedures, collectively referred to as GAAP- the principles that govern financial reporting continue to develop and evolve in response to changing business conditions

A company's financial statements can be used for various purposes

- As an analytical tool - As a management report card - As an early warning signal - As a basis for prediction - As a measure of accountability

Disclosure Costs: Information collection

- Can be high (ex: audits, actuarial computations, future health care projections)

Managers & Employees (using financial information)

- Demand arises from contracts (such as executive compensation agreements) that are linked to financial statement variables Employees - To learn about the company's performance and its impact on employee profit sharing and employee stock ownership plans - To monitor the health of company-sponsored pension plans and to gauge the likelihood that promised benefits will be provided on retirement - To know about union contracts that may link negotiated wage increases to the company's financial performance - To help employees assess their company's current and potential future profitability and solvency **Performance assessment, compensation contracts, company-sponsored pension plans

Disclosure Costs: Competitive disadvantage

- Details about the company's strategies, plans, and tactics, such as new products, pricing strategies, or new customer markets - Etc.

Disclosure Costs: Political

- Ex: oil and pharmaceuticals - Politically vulnerable firms with high earnings are often attacked in the financial and popular press, which alleges that those earnings constitute evidence of anticompetitive business practices

Analysts>>Equity Investors

- Form educated opinion on company value, make investment decision based on opinion - Discounted cash flow estimate (fundamental value) is compared to current price of company's stock. Allows investor to make decisions about whether to buy, hold, or sell - Liquidation value: Investor tries to determine value of company's assets would yield if sold individually and then subtracts any debt the company owes