Financial Accounting

1. Financial Accounting John Shon

2. 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

3. RETURNS FINANCING ACTIVITIES Investors But how can investors be assured that managers: - Choose the right projects/investments? - Exert sufficient effort? - Adequately disclose relevant information? - Ultimately repay investors? Managers Value creation INVESTING ACTIVITIES OPERATING ACTIVITIES Investment

4. RETURNS FINANCING ACTIVITIES Investors Financial Accounting serves an essential informational role for decision makers Managers Value creation “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 INVESTING ACTIVITIES OPERATING ACTIVITIES Investment

5. 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”

6. Is Accounting the only source of information? • 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… Source: Ball and Brown (1968)

7. 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?

8. Other, 2% EVA, 1% Free cash flows, 12% Operating cash flows, 12% Earnings, 52% Revenues, 12% Pro-forma earnings, 12% CFOs: What is the most important performance measure reported to outsiders? Based on survey of 401 CFOs and financial executives of publicly traded companies Source: Rajgopal et al. (2005)

9. Build credibility with market Maintain/increase stock price External reputation of management Convey future growth prospects Maintain/reduce volatility Assure customers/suppliers Help achieve employee bonuses Achieve/maintain credit rating Avoid violating debt covenants CFOs: Why do you try to meet earnings benchmarks? Based on survey of 401 CFOs and financial executives of publicly traded companies Source: Rajgopal et al. (2005)

10. Creates uncertainty about future prospects Outsiders suspect unknown problems Waste time explaining why we missed Leads to increased scrutiny of other financial data Increases probability of lawsuit CFOs: Why do you try to avoid missing earnings benchmarks? Based on survey of 401 CFOs and financial executives of publicly traded companies Source: Rajgopal et al. (2005)

11. Decrease discretionary spending Delay starting new project Speed up booking revenues Incentivize customers to buy now Draw down on reserves Postpone taking accounting charge Sell assets to recognize gains Repurchase common shares Alter accounting assumptions CFOs: What might you do to achieve earnings benchmark? Based on survey of 401 CFOs and financial executives of publicly traded companies Source: Rajgopal et al. (2005)

12. CFOs: How much value would you sacrificeto achieve smooth earnings? Large, 2% None, 22% Moderate, 24% Small, 52% Based on survey of 401 CFOs and financial executives of publicly traded companies Source: Rajgopal et al. (2005)

13. Other, 19% Increase expenses, 25% Business combos, 13% Decrease revenues, 4% Decrease expenses, 22% Increase revenues, 17% Auditors: How do your publicly-traded clients try to manage earnings? Based on survey of 253 Big Five auditors Source: Elliott et al. (2003)

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

15. Total accruals Accounts payable Accrued liabilities Special items Accounts receivable Inventory Depreciation Researchers: How do companies that “avoid earnings decreases” manage earnings? Source: Marquardt and Wiedman (2004)

16. All other mega-settlements Enron WorldCom Cendant AOL Time Warner Nortel Networks Royal Ahold McKesson HBOC Lucent Bristol-Myers Squibb Millions Does it matter? Settlement of securities class action lawsuits in excess of $100 million (1995-2006*) $33.9 billion total * As of February 16, 2006 Source: Stanford Law School Securities Class Action Clearinghouse (2006)

17. 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)

18. Perceived economic consequences Public input* Congress SEC FASB GAAP Political climate 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” * Public hearings, letters, exposure drafts, media, lobbying

19. Financial Accounting process GAAP • 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 Financial statements Economic events “Accrual” accounting system Management’s incentives and judgment

20. Annual report • 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 • 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)

21. 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

22. Articulation of financial statements Balance sheet 12/31/2005 Statement of Owners’ equity 12/31/2005 Assets Liabilities Beginning balance Net income Owners’ equity Ending balance Statement of cash flows Year ended 12/31/2005 Income statement Year ended 12/31/2005 Operating cash flows Investing cash flows Financing cash flows Net income Change in cash balance* * The change in cash from the statement of cash flows helps us to arrive at the balance sheet’s final balance in cash

23. 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!