ACG 3171 10/24/13 9:24 AM Chapter 1 Why are financial statements important? • They 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, and measure of accountability Financial statement fraud is rare – but one should not simply accept the numbers at face value 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. 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 Demand of financial statements • Financial statements are demanded because of their value as a source of information about company performance, financial condition, and stewardship of resources • Shareholders and investors use it for investment decisions and proxy contests • Managers and employees use it for performance assessment, compensation contracts, and company-sponsored pension plans • Lenders and suppliers use it for lending decisions and covenant compliance • Customers use it to judge seller’s health, repeat purchases, warranties and support • Government and regulators use it for mandatory reporting, taxing authorities, and regulated industries Supply of financial statements!2!• The supply of financial information is guided by the costs of producing and disseminating it and the benefits it will provide to the company • Mandated reporting (SEC and FASB) is designed to insure minimum levels of reporting • Companies frequently make voluntary disclosures that go beyond the minimum requirements • Disclosure benefits: low cost access to capital and avoid the “lemon” problem • Disclosure costs: information production, competitive disadvantage, litigation exposure and political exposure • Companies that confront different financial reporting costs and benefits are likely to choose different accounting and reporting practices. Reg FD • 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 Analysts • Financial statement users have diverse information needs because they face different decisions or use different approaches to make the same decision Three types of information • 1. Quarterly and annual financial statements along with nonfinancial operating and performance data • 2. Managements 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 plan for the future GAAP: generally accepted accounting practices • Evolving conventions, rules, guidelines and procedures that govern financial reporting!3!• Comes from two main sources o Accounting practices that have evolved over time o Written pronouncements by designated organizations like the FASB and SEC or IASB • Permits alternatives, requires estimates, and incorporates management judgments • Sometimes exploit the flexibility by: o Smoothing the reported earnings numbers o Manipulating revenues or expenses to achieve bonus goals o Downplaying the significance of contingent liabilities • The SEC and FASB, along with auditors and the courts, serve to counterbalance opportunistic financial reporting practices. Financial disclosures conceal more than they reveal (sometimes) Auditing • Prior to Sarbanes-Oxley, AICPA set auditing standards • Now the Public Companies Accounting Oversight Board (PCAOB) set the standards o Set standards for auditing and ethics o Investigate auditing practices of auditing firms FASB • In 2009, completed a five year effort to distill the existing GAAP literature into a single database by creating the Accounting Standards Codification (ASC) o This is an online filing cabinet that groups all authoritative rules into roughly 90 topics and reduces the complexity of accounting standards. o Organized into topics, subtopics, sections, subsections, and paragraphs Foreign companies comprise: • Nearly 20% of all stocks listed on the NYSE • Over 20% of those listed on the London stock exchange • Stock exchanges now offer domestic investors the opportunity to purchase foreign stocks Reporting differs across countries:!4!• A country’s 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 IASB: International Accounting Standards • To develop a single set of high-quality, understandable, enforceable, and globally accepted IFRS • To promote the use and rigorous application of those standards • 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 Summary • Financial statements are an important source of information about a company, its economic health, and its prospects • 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 o These and other interested parties demand financial statements because the information is useful • Mandatory reporting and voluntary disclosure governs the supply of financial information • Benefit and cost considerations influence voluntary disclosure • Financial accounting standards (GAAP) are often imprecise and open to interpretation. • Analysts must maintain a