ACG 3171 Exam 1 Study GuideTheoryChapter 1: The Economics and Institutional Setting for Financial ReportingWorldCom 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 valueAdditionally:- 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.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:I. Understand current financial reporting standards and guidelines.II. Recognize that management can shape the financial information.III. 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’spast performance, current health, and prospects for the future.- Consequently a company’s financial statements can be used for a various purposes:I. As an analytical toolII. As a management report cardIII. As an early warning signalIV. As a basis for predictionV. As a measure of accountability1Economics 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 partiesSupply 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 StatementsShareholders and investors - Investment decisions – risk, return, dividend yield, liquidity.- Proxy Contests – election of new slate of directors by shareholdersManagers and employees- Performance assessment- Compensation contracts – mainly for executive compensation (including bonuses and long tern pay components_- Company-sponsored pension plansLenders and suppliers- Lending decision – loan amount, interest rate, and security.- Covenant compliance – minimum levels of working capital, debt to assets, etc.Customers- Seller’s health – financial health- Repeat purchases- Warranties & supportGovernment & Regulators- Mandatory reporting – SEC reports (10-K annual; 10-Q quarterly)- Taxing authorities - government- Regulated industries – government agencies and legislatorsDisclosure 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.2Disclosure 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 TIMEA 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 auditorsEquity Investors- Fundamental value – discounted cash flow estimate- Liquidation value - the value the company’s assets would yield if sold individuallyCreditors- 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 ReviewAnalysts 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 decisionI. Predictive Value – The information improves the decision maker’s ability to forecast eh future outcome of past or present events.3II. Confirmatory value – The information confirms