Financial Accounting

John Shon

Financial Accounting

• Financial Accounting– Process by which the economic performance and financial position of

the company are recorded and communicated to decision-makers outside the company

– Benefits:• Helps decision-makers

• Facilitates contracting between parties: Between management and ...?

• Managerial Accounting– Process by which information is communicated internally

– Not covered in this course

Investors

Investment

ManagersValue creation

FINANCINGACTIVITIES

INVESTINGACTIVITIES

OPERATINGACTIVITIES

RETURNS

But how can investors be assured that managers:

- Choose the right projects/investments?

- Exert sufficient effort?

- Adequately disclose relevant information?

- Ultimately repay investors?

Investors

Investment

ManagersValue creation

FINANCINGACTIVITIES

INVESTINGACTIVITIES

OPERATINGACTIVITIES

RETURNS

“If you look at the history of the American capital markets, there’s probably no innovation more important than the idea of Generally Accepted Accounting Principles [GAAP].”

- Lawrence Summers, Former Secretary of the US Treasury & President of Harvard University

Financial Accounting serves anessential informational role for decision makers

Decision makers

• Who uses information provided by Financial Accounting? – Individual investors, institutional investors, hedge funds

– Creditors, credit agencies

– Financial analysts, brokers, rating agencies,

– Media, general public

– Employees, customers, suppliers

– Auditors, audit committee, board of directors, SEC, FASB

– Compensation committee, potential employers

– Competitors, labor unions

– IRS, government regulators

• Corporate governance and contracting: Each of these decision makers helps keep the company “in check”

Is Accounting the only source of information?

Source: Ball and Brown (1968)

• There are clearly limitations to what Financial Accounting can achieve

• Many other sources of information exist– Firm’s other filings (e.g.,

10Q, 8K)– Firm’s own voluntary

disclosures– Firm’s other “signals”– Analysts, brokers– Media

• Yet…

Accounting is the language of business

• “Without a comprehension of [the fundamentals of Accounting], there can be no real understanding of the economics of enterprise.”– Paul Samuelson, 1970 Nobel Prize in Economic Sciences

• So…– What do CFOs and financial executives think?

– What do auditors think?

– What do academic researchers think?

CFOs: What is the most important performance measure reported to outsiders?

Earnings, 52%

Pro-forma earnings, 12%

Revenues, 12%

Operatingcash flows, 12%

Free cash flows, 12%

Other, 2% EVA, 1%

Based on survey of 401 CFOs and financial executives of publicly traded companiesSource: Rajgopal et al. (2005)

CFOs: Why do you try to meet earnings benchmarks?

Based on survey of 401 CFOs and financial executives of publicly traded companiesSource: Rajgopal et al. (2005)

26%

39%

40%

58%

67%

74%

77%

82%

86%

0% 20% 40% 60% 80% 100%

Build credibility with market

Maintain/increase stock price

Maintain/reduce volatility

Assure customers/suppliers

Achieve/maintain credit rating

Convey future growth prospects

External reputation of management

Avoid violating debt covenants

Help achieve employee bonuses

CFOs: Why do you try to avoid missing earnings benchmarks?

26%

38%

58%

60%

81%

0% 20% 40% 60% 80% 100%

Outsiders suspect unknown problems

Waste time explaining why we missed

Leads to increased scrutiny of other financial data

Increases probability of lawsuit

Creates uncertainty about future prospects

Based on survey of 401 CFOs and financial executives of publicly traded companiesSource: Rajgopal et al. (2005)

CFOs: What might you do to achieve earnings benchmark?

Based on survey of 401 CFOs and financial executives of publicly traded companiesSource: Rajgopal et al. (2005)

8%

12%

20%

21%

28%

39%

40%

55%

80%

0% 20% 40% 60% 80% 100%

Delay starting new project

Speed up booking revenues

Draw down on reserves

Sell assets to recognize gains

Repurchase common shares Alter accounting assumptions

Postpone taking accounting charge

Incentivize customers to buy now

Decrease discretionary spending

CFOs: How much value would you sacrificeto achieve smooth earnings?

Based on survey of 401 CFOs and financial executives of publicly traded companiesSource: Rajgopal et al. (2005)

None, 22%

Small, 52%

Moderate, 24%

Large, 2%

Auditors: How do your publicly-traded clients try to manage earnings?

Based on survey of 253 Big Five auditorsSource: Elliott et al. (2003)

Decrease expenses, 22%

Increase revenues, 17%

Increase expenses, 25%

Decrease revenues, 4%

Business combos, 13%

Other, 19%

Researchers: What is actual distribution of companies’ reported earnings?

Researchers: How do companies that “avoid earnings decreases” manage earnings?

Source: Marquardt and Wiedman (2004)

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

Earnings Decrease Avoiders Control

Total

accrualsAccountsreceivable Inventory

Accountspayable

Accruedliabilities Depreciation

Specialitems

Does it matter?

Source: Stanford Law School Securities Class Action Clearinghouse (2006)

Settlement of securities class action lawsuits in excess of $100 million (1995-2006*)

$33.9 billion total

$574

$673

$960

$1,091

$2,474

$2,500

$3,528

$6,156

$7,161

$8,787

$0 $2,000 $4,000 $6,000 $8,000 $10,000

EnronWorldCom

AOL Time WarnerNortel Networks

Royal AholdMcKesson HBOC

LucentBristol-Myers Squibb

All other mega-settlements

Cendant

Millions

* As of February 16, 2006

Economic consequences

• Economic consequences of the information conveyed through Financial Accounting and the financial reports it produces

– Distribution of wealth among individuals

– Allocation of resources among firms

– Aggregate production (rate of capital formation) in macroeconomy

– Monitoring of managers and corporate control

– Use of resources devoted to regulation, publicly available information, and private search for information

– Aggregate level of risk and allocation of risk among individuals

• These economic consequences affect each decision maker differently (e.g., investors, management, auditors, analysts)

Financial reporting standards( GAAP: Generally Accepted Accounting Principles )

• GAAP is not a science. The financial reporting system is a result of tradeoffs among these many constituencies (decision makers); it is a result of “social choice”– No consensus on what is “best”

Political climate

GAAPCongress

SECFASB

Public input*

Perceived economic consequences

* Public hearings, letters, exposure drafts, media, lobbying

Financial Accounting process

GAAP

Management’sincentives and

judgment

“Accrual”accounting

system

Economicevents

Financialstatements

• Financial Accounting is the process by which the economic performance and financial position of the firm are recorded and communicated to decision-makers outside the firm

• A typical firm’s annual report contains:

– Financial statements (Form 10K)• Balance sheet

• Income statement

• Statement of cash flows

• Statement of stockholders’ equity

• Footnotes: The devil is in the details

– MD&A: Management discussion and analysis• Discusses key trends and provides important forward-looking information

– Letter to shareholders

– Financial highlights, general description of business and risk factors

Annual report

• Auditor’s report, with audit opinion

– Unqualified: “Clean”– Qualified or modified:

Explanatory language added to opinion*

* Due to going concern (e.g., near bankruptcy), material uncertainty (e.g., litigation), inconsistency (e.g., accounting change)

Financial statements

• Balance sheet– Provides a snapshot of the firm’s financial position: assets, liabilities,

and owners’ equity

• Income statement– Reports the firm’s operating performance: revenues and expenses

• Statement of cash flows– Reports the firm’s cash flow activities: how operating, investing, and

financing activities have affected the firm’s cash balance

• Statement of stockholders’ equity– Details how various activities have affected the firm’s equity balance

Statement of cash flowsYear ended 12/31/2005

Articulation of financial statements

LiabilitiesAssets

Owners’ equity

Statement of Owners’ equity12/31/2005

Income statementYear ended 12/31/2005

Balance sheet12/31/2005

Beginning balance

Ending balance

Net income

Operating cash flows

Investing cash flows

Financing cash flows

Change in cash balance*

Net income

* The change in cash from the statement of cash flows helps us to arrive at the balance sheet’s final balance in cash

Where to find them

• Several sources for financial statements– Company’s website, typically under “Investor relations” or “About us”

– http://www.sec.gov/edgar.shtml

– http://www.tenkwizard.com

– http://edgarscan.pwcglobal.com/servlets/edgarscan

– http://www.adr.com (international companies)

• Other resources– http://finance.yahoo.com, http://moneycentral.msn.com,

http://finance.google.com

– http://www.nyse.com, http://www.nasdaq.com

• When in doubt, goooogle it!