The Economic and

Institutional Setting for

Financial Reporting

Revsine/Collins/Johnson: Chapter 1
 Learning objectives

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

2. Why analysts (including auditors) 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.

RCJ: Chapter 1 © 2005 2

 WorldCom
 It’s May 2002 and your brother says you should buy WorldCom
shares.

 The shares look “incredibly cheap” at $2.00 because the company

has a book value of $20.50/share and cash of $0.73/share.
 What do you think? Should you invest in worldCom? What
information you need to make your decision? Where can you get
this information from?

RCJ: Chapter 1 © 2005 3

 Why financial statements are
important

 Without adequate information, investors cannot properly judge the

opportunities and risks of investment alternatives.

 Financial statements are 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

RCJ: Chapter 1 © 2005 4

 Conclusion 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

RCJ: Chapter 1 © 2005 5

 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 word, accounting is not an exact science!

RCJ: Chapter 1 © 2005 6

 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.
RCJ: 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.
© 2005 7
 Demand for financial statements

Shareholders • Investment decisions

and investors • Proxy contests

• Performance assessment
Managers and • Compensation contracts
employees • Company-sponsored pension plans

Lenders and • Lending decisions

suppliers • Covenant compliance

• Supplier health
Customers • Repeat purchases
• Warranties & support

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

RCJ: Chapter 1 © 2005 8

 Disclosure incentives and the supply
of financial information
 Mandated reporting (e.g., SEC and FASB) plus 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.

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 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

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 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

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 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

RCJ: Chapter 1 © 2005 12

Qualitative Characteristics of
Accounting Information

 Primary qualities of accounting information

are relevance and reliability.
 Secondary qualities are comparability and
consistency of reported information.

RCJ: Chapter 1 © 2005

Primary Characteristic of
Accounting Information:
Relevance
“Relevance of information means information
capable of making a difference in a decision
context.”

Ingredients of relevant information are:

• Timeliness
• Predictive value
• Feedback value

RCJ: Chapter 1 © 2005

Primary Characteristic of
Accounting Information:
Relevance

Information is reliable when it can be relied on

to represent the true, underlying situation.

The ingredients of reliable information are:

 verifiability
 representational faithfulness
 neutrality (unbiased)

RCJ: Chapter 1 © 2005

Secondary Characteristics of
Accounting Information

Comparability: the similar measurement and

reporting for different enterprises.

Consistency: application of the same

accounting treatment to similar events by an
enterprise period to period.

RCJ: Chapter 1 © 2005

 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

RCJ: Chapter 1 © 2005 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.

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 America Online (AOL)
 Wall Street analysts were uneasy about earnings quality because
of AOL’s unconventional accounting for certain marketing costs.

 Analysts favored a more conservative approach used by other

firms in the industry.

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 AOL’s accounting method change
 Triggered a $385 million balance sheet write-off.

 Produced a net loss of $354 million for the quarter and erased five-
years of reported “profits”.

 Operating cash flows were not affected.

 AOL shares closed up $1 on the day of the announcement.

 Some questions to think about:

 How flexible is GAAP?
 What factors influence the accounting methods that firms use?
 Do companies disclose the methods they use?
 Why didn’t AOL’s stock price fall when the change was announced?
 Did the company violate GAAP and mislead investors?

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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 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.

RCJ: Chapter 1 © 2005 21

 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.

RCJ: Chapter 1 © 2005 22