ACG 3171 Exam 1 Study Guide Theory Chapter 1 The Economics and Institutional Setting for Financial Reporting WorldCom Summary If a company spends a dollar today buying equipment that will be used for the next five years future benefit the dollar spent should be shown as a balance sheet asset Worldcom allocated its line costs rent as assets while they had no future benefit whatsoever All line costs should have been shown as current expenses 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 Additionally Lessons learned Sued by SEC for accounting fraud 5 executives indicted for fraud 4 pleaded guilty CEO and CFO sentenced to lengthy prison sentences Profits restated downward by 74 4 billion Became the largest bankruptcy ever in the United States far bigger than Enron Financial statement fraud is rare but investors analysts and others should not simply accept the numbers at face value Instead financial statement readers must I II III 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 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 Consequently a company s financial statements can be used for a various purposes I II III IV V As an analytical tool As a management report card As an early warning signal As a basis for prediction As a measure of accountability 1 Economics of accounting information The Financial Statements of business enterprises serve two key functions 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 Supply and 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 Managers have a stewardship responsibility to investors and creditors The company s resources belong to investors and creditors but the managers are stewards of those resources and thus responsible for ensuring their efficient use and protecting them from adversity Demand for Financial Statements Shareholders and investors Managers and employees Investment decisions risk return dividend yield liquidity Proxy Contests election of new slate of directors by shareholders Performance assessment Compensation contracts mainly for executive compensation including bonuses and long tern pay components Company sponsored pension plans Lending decision loan amount interest rate and security Covenant compliance minimum levels of working capital debt to assets etc Lenders and suppliers Customers Seller s health financial health Repeat purchases Warranties support Government Regulators Mandatory reporting SEC reports 10 K annual 10 Q quarterly Taxing authorities government Regulated industries government agencies and legislators 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 Companies that confront different financial reporting costs and benefits are likely to choose different accounting and reporting practices Disclosure benefits Low cost access to capital Avoid the lemons problem 2 Disclosure Costs Information production Competitive disadvantage Litigation exposure Political exposure REG FD Regulation Fair Disclosure 1999 Passed by SEC in 1999 Designed to prevent selective disclosures to analysts or certain shareholders Important financial information MUST be disclosed to all interested parties AT THE SAME TIME 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 Investors Creditors Fundamental value discounted cash flow estimate Liquidation value the value the company s assets would yield if sold individually Credit Risk compare required principal and interest payments to estimates of company s current and future assets Financial Flexibility the ability to raise additional cash by selling assets issuing stock or borrowing more Independent Auditors Fraud Risk factors Analytical Review Analysts Information Needs Quarterly and annual financial statements along with nonfinancial operating and performance data Management s discussion and analysis MD A of financial and nonfinancial data key trends and changes 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 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 Decision Usefulness Relevance the financial information is capable of making a difference in a decision I Predictive Value The information improves the decision maker s ability to forecast eh future outcome of past or present events 3 II I II III Confirmatory value The information confirms or alters the decision maker s earlier beliefs Faithful Representation The financial information actually depicts the underlying economic event Completeness Financial information can be false or misleading if the important facts are omitted Neutrality Information cannot be selected to favor