Financial accounting 9th jamie pratt chapter 01

Chapter 1:
Financial Accounting
and
Its Economic Context

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The Role of Financial Reporting in
Investment Decisions
• 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 because of the need
for capital
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Financial Reporting and Investment
Decisions

4


Content of Financial Reports
•
•
•

The Auditor’s Report
The Management Letter
The Financial Statements:
Balance Sheet
Income Statement
Statement of Shareholders’ Equity
Statement of Cash Flows
• The Footnotes

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The Auditor’s Report
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

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The Management Letter
• 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.
•

•

•

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Financial
Statements

Financial Statements

For Microline
Figure 1-4

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The Footnotes
Integral part of the financials, and explain
many of the policies and assumptions used
to prepare the financials.

FIGURE 1–5 (Partial)
Notes to the financial
statements

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Make a Decision
 Analysis of Financial Statements
o Cash position
o Earning power
o Ratio Analysis

 Form of Investment
o Debt (Loan)
o Equity (Ownership)


Providers of Capital - Roles

•

•

•
•

•

Provide capital
o equity capital through stock investments
o debt capital through bond and loan investments
(creditors)
Receive returns
o equity investors receive dividends
o creditors and bond investors receive interest
Stock (Equity) investors choose board of directors
Board of directors
o Select corporate officers (management)
o Set company policy
o Select audit committee
Management – runs the company
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The Economic Environment of
Financial Reports
•
•
•

•
•
•
•

Providers of capital - debt and equity investors
Reporting entities
Corporate governance
o Financial information users and capital
markets
o Debt covenants and management
compensation
Financial reporting regulations & standards
o the accounting policymaking process
Sarbanes-Oxley Act
Legal liability
Professional reputation and ethics
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Reporting Entities and Industries
• 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.
• Industries are important to understand
when analyzing financials statements
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Corporate Governance
Financial Information Users

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.
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Corporate Governance
and Capital Markets
•

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.
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Debt Covenants and Management
Compensation Contracts
•

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.

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Regulations and Standards
•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.

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The Accounting Policymaking Process
Policymakers
SEC

FASB

Generally Accepted
Accounting Principles
(GAAP)
Actual Accounting
Practices
Economic Consequences

Congress, White House,
government agencies

Public
Input

Public hearings, letters

Perceived
economic
consequences


Independent Auditors
Audit reports provide
assurance on the fair
presentation of the
financial statements
and effectiveness of
internal controls.

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Sarbanes-Oxley Act
•

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.

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Legal Liability
•

Management is legally responsible to the
shareholders to act in their interest.

•

Auditors are legally responsible to the
shareholders 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 Qwest Communications
International.
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Professional Reputation and Ethics
•

Ethical behavior is in the long-run interest of
managers, shareholders, 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.

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*Appendix 1A
• There are three other types of accounting

besides, Financial accounting:
o Not-for-profit accounting
o Managerial accounting
o Tax accounting


Four Kinds of Accounting

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