Chapter 1: Financial Accounting and Its Economic Context

1. Chapter 1:Financial AccountingandIts Economic Context

2. Profit-seeking companies - managers prepare reports for owners of the companies. Owners and other interested parties (Users) - use reports to assess financial condition and performance of companies. User decisions - users obtain information from reports to make investment decisions. Effects of user decisions - decisions affect the company and its managers. The Role of Financial Reporting in Investment Decisions

3. Users assess Investment and credit decisions are made Decisions affect company and managers Financial Reporting and Investment Decisions Managers prepare

4. The Management Letter The Financial Statements: Balance Sheet Income Statement Statement of Stockholders’ Equity Statement of Cash Flows The Footnotes The Auditor’s Report Content of Financial Reports

5. The management letter is the statement of management to the investors. It indicates: management is responsible for the preparation and content of the financial report. the statements were prepared in accordance with generally accepted accounting principles (GAAP). the company maintains a system of internal controls to safeguard assets. The Management Letter

6. Include a balance sheet, income statement, statement of stockholders’ equity, and a statement of cash flows (discussed in a later chapter). The footnotes to the financials are considered an integral part of the financials, and explain many of the policies and assumptions used to prepare the financials. The Financial Statements

7. The auditor’s report is a statement to the board of directors of the company and to the shareholders of the company. It expresses an opinion as to whether the financial statements present fairly the financial activities of the company and whether the financials were prepared in accordance with GAAP The Auditor’s Report

8. Providers of capital - debt and equity investors Reporting entities Corporate governance Financial information users and capital markets Debt covenants and management compensation Financial reporting regulations & standards the accounting policymaking process Sarbanes-Oxley Act Legal liability Professional reputation and ethics The Economic Environment of Financial Reporting

9. Provide capital equity capital through stock investments debt capital through bond and loan investments (creditors) Receive returns equity investors receive dividends creditors and bond investors receive interest Stock investors choose board of directors Board of directors Select corporate officers (management) Set company policy Select audit committee Management – runs the company Providers of Capital

10. Reporting entities are called companies, businesses and firms. The companies may be further divided into segments and subsidiaries, which may provide their own financials. Consolidated financials are prepared when subsidiaries are combined with the parent’s financials. Reporting Entities

11. Financial statements used by a variety of groups. Equity investors: purchase shares of stock, which represent ownership in the company. The financials are used by investors to analyze management’s decisions. Debt investors (creditors): provide capital through loans. The financials are used by creditors to assess likelihood of default. Management: uses other companies financials to asses the competition. Others, including government bodies, labor unions, employees, use financials to assess the financial status of the company. Corporate GovernanceFinancial Information Users

12. Capital markets value the publicly traded equity and debt securities. The financials are a component of the information that the markets use to value companies securities, along with a number of nonfinancial measures. The market reacts to financial and other information as it is released by management. Corporate Governanceand Capital Markets

13. Debt covenants are part of debt contracts between the company and creditors. Violation of debt covenants may lead to more costly debt terms. Management compensation contracts often base pay on certain income or stock price goals. Such goals are designed to encourage certain management behavior. Debt Covenants and Management Compensation Contracts

14. The Securities and Exchange Commission (SEC) governs financial reporting for publicly traded companies. Congress and other regulatory agencies have influence with the SEC. The Financial Accounting Standards Board (FASB) is responsible for the promulgation of generally accepted accounting principles (GAAP) for financial statements. The FASB accepts input from all interested parties, including accountants, corporations, academics, and governmental entities. Regulations and Standards

15. Policymakers SEC FASB Public Input Congress, White House, government agencies Public hearings, letters Generally Accepted Accounting Principles (GAAP) Perceived economic consequences Actual Accounting Practices Economic Consequences The Accounting Policymaking Process

16. Passed by Congress in 2002, in response to a series of corporate scandals. Requires principal executive and financial officers to certify a number of statements regarding the financials. Places additional responsibilities on management to ensure that adequate internal controls are in place. Sarbanes-Oxley Act

17. Management is legally responsible to the stockholders to act in their interest. Auditors are legally responsible to the stockholders to conduct a thorough and independent audit. If management or auditors fail in their duties, investors and others may sue to recover any losses that might occur as a result the failure. Many recent examples of management and audit failure exist: Enron, WorldCom, HealthSouth, Xerox, Rite Aid, and Quest. Legal Liability

18. Ethical behavior is in the long-run interest of managers, stockholders, and auditors. Many companies,universities, and professional organizations have enacted increased emphasis on ethics. Auditors’ reputations are integral to their ability to perform their duties. High ethical conduct is imperative to their continued success. Professional Reputation and Ethics

19. Economic Entity Managers System Financial Information Recipients Decisions The Four Kinds of Accounting (Figure 1A-1) Financial Accounting Profit-making companies Finance or accounting department GAAP • Income statement • Balance sheet • Statement of stock- • holders’ • equity • Statement of cash flows • Other disclosures • Auditor report • External • Investors • Creditors • Suppliers • Employees • Managers • Government • General public • Equity and debt investments • Contract negotiations • Regulation • Dividend payments

20. Economic Entity Managers System Financial Information Recipients Decisions The Four Kinds of Accounting (Figure 1A-1) Managerial Accounting All entities Finance or accounting department GAAP • Manager • reports • Production • costs • Performance • evaluation, • etc. • Internal • Managers • Operating • decisions

21. Economic Entity Managers System Financial Information Recipients Decisions The Four Kinds of Accounting (Figure 1A-1) Not-for-profit Accounting Nonprofit entities Finance or accounting department Fund accounting principles • Balance sheet • Funds flow • statements • External • Creditors • Government • General public • Debt investments • Budget allocations

22. Economic Entity Managers System Financial Information Recipients Decisions The Four Kinds of Accounting (Figure 1A-1) Tax Accounting All entities Finance or accounting department Internal revenue code • Official tax forms: • 1040 for individuals • 1120 for corporations • External • Internal Revenue Service • Collection of government revenues