FINANCIAL ACCOUNTING AND REPORTING IN NORTH AMERICA Presented at School of Management, UESTC By George Lan, PhD Associate Professor of Accounting University Of Windsor Windsor, Ontario, Canada March 19, 2003
Outline of Presentation -1 • Roles of standard setting bodies (FASB, CICA), Managers, Auditors and Suppliers of Capital (Investors and Creditors or lenders) [See Diagram] • Information Economics Approach and Efficiency of capital markets • WorldCom, Enron and Arthur Andersen • Incentives of Management to Manage Earnings
Outline of Presentation -2 • Steps to prevent scandals from occurring in the future? • Some Ethical Principles • An Ethical Case • Questions regarding presentation or any other (accounting) questions.
Information Economics Approach • Information Asymmetry exists between the parties in business transactions. The managers ( agents) have more information than the investors (principals). • Managers may attempt to select policies or to release biased information that benefit themselves to the expense of the owners . • Role of Accounting: to provide information useful for rational decision-making.
Decision Usefulness Approach • Section 1000 of CICA Handbook (par. 1000.15): • The objective of financial statements is to communicate information that is useful to investors, members, contributors, creditors and other users…in making their resource allocation decisions and/or assessing management stewardship.
Objectives of Financial Statements • Statements of Financial Accounting Concepts (1978) (SFAC 1): • To provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. • To provide information to help present and potential investors and creditors in assessing the amounts , timing and uncertainty of prospective cash receipts from dividends or interest.
Relevance and Reliability • To be useful, accounting information should provide an informative information system that links current financial statements with future state realizations and payoffs. • Accounting information should be relevant I.e. has the capacity to affect investors’ beliefs about future returns. • Accounting information should be reliable i.e. should faithfully represents what it purports to measure. It should be precise and free from bias.
Elements of Financial Statements • Assets: Probable future economic benefits obtained or controlled as a result of past transactions. • Liabilities: Probable future sacrifices of economic benefits • Owner’s Equity: residual Interest in assets after deducting liabilities i.e. A= L + O.E. or O.E = A – L. • Revenues: inflows of assets (or settlement of liabilities) arising from the entity’s major or ongoing activities.
Accounting Principles -1 • Historical Cost Principle i.e. recognise (record and report) assets and liabilities initially at the cash-equivalent cost. • Revenue Recognition Principle i.e. recognise revenues when earned (earning process is complete and an exchange has taken place ). All necessary costs have been incurred and collection is assured – usually at point at sale.
Accounting Principles -2 • Matching Principle i.e. recognise all expenses incurred in producing revenues in the same period as the revenues. • Full Disclosure Principle i.e. disclose all relevant information.
LAN’S CLOTHING COMPANY • Invest 10,000 Yuans (Y) to start the business • Buy 1000 shirts at 5 Y each. • Pay wages of 1000 Y for the first month. • Sell 400 shirts at 20 Y each. • Pay rent of 600 Y for the first 6 months. • Incurred miscellaneous expenses of 500 Y. • Borrowed 4800 Y and bought a truck. Truck will last for 4 years. • What is my net income for first month?
Lan’s ClothingNet Income for first month • Net Income before taxes = Revenues – Expenses = 400 X 20 (sales)- 400 X 5(cost of shirts sold) – 1000(wages expense) – 600/6 (rent for one month) – 500 (miscellaneous expenses) - 4800/48 (amortisation expense for 1 month) = 4,300 Yuans
Standard Setting & Auditing -1 • Standard setting or regulation is necessary to protect the investors (conflicting interests of investors and managers). The FASB (Financial Accounting Standards Board and the CICA ( Canadian Institute of Chartered Accountants) are independent bodies.
Standard Setting & Auditing -2 • Auditing (external) ensures that a third independent party has examined the financial statements and that they are in accordance to GAAP( Generally Accepted Accounting Principles).
Efficient Securities Markets • The prices of securities (stocks) “properly reflect” all information that is publicly known about these securities. • Investors will quickly adjust to new or corrected information as it becomes available. • Investors cannot expect to earn abnormal returns i.e. a return on a security in excess of its normal expected return.
WORLDCOM(Communications Industry) -1 • Largest Bankruptcy in history. Bankruptcy date = July 21, 2002. Total assets (pre-bankruptcy) = US$103,914,000,000 approximately 850,000 millions Yuans or RMB(assuming 1 us dollar approximately equal to 8.2 Yuans)
WORLDCOM(Communications Industry) -2 • Internal Auditor (Cynthia Cooper- Time Magazine Person of the year for 2002) went to Board of Directors , claiming assets should be written off the balance sheet. • B.O.D. agree with her. On writing off assets, large losses. Stock prices fell down steeply.
Enron Corp ( Energy Industry) • Company went bankrupt on December 2,2001. Total assets pre-bankruptcy = US $63,392,000,000 approximately equal to 520,000 millions Yuans or RMB. • Profits overstated; revenues recognized before they are earned. • Liabilities hidden from balance sheet. • Gambling on energy futures contracts. • Sherri Watkins ( Enron manager) blew the whistle but no one listened.
Arthur Andersen (Former “Big Five”Accounting Firm) • Issued unqualified opinion to financial statements. Did not disclose accounting irregularities. • Shredded documents to hide evidence. • Guilty of obstructing justice.
Management’s Incentives to Manage Earnings • Income taxes—Postpone payment by minimizing reported income • Bonus—Maximize their bonuses by increasing reported income • Debt Agreements– Easier to meet debt agreements (covenants) by increasing income and assets • Stock options (give you the right to purchase a stock at a fixed price in some future period)—maximize share prices (believed to be related to reported income).
Accruals and Earnings Management • Amortization expense • Increase in net receivables • Increase in inventory • Decrease in accounts payable and accrual liabilities
What could be done? • Better accounting standards and better disclosure. Less emphasis on historical cost and more emphasis on current market value of assets and liabilities on balance sheet. • Fore example, record all stock options as an expense on income statement, when issued. • Restrictions on auditors e.g. auditors not allowed to do consulting work for firm they audit • Greater accountability of board of directors and more punishment for wrong doings.
Ethics and accounting • Ethics • Rules Of Professional Conduct • Legal • What is legal or meet the rules of professional conduct may not be considered ethical.
Some Principles to Evaluate One’s Actions -1 • Non-Maleficence: Am I causing harm by failing to do something or agreeing with it? • Beneficence:Do my actions benefit other persons besides myself? • Justice: Do I treat those for whom I am responsible equitably (fairly)?
Some Principles to Evaluate One’s Actions -2 • Fidelity: Do I uphold my part of the relationship? • Act Consciously: Do I know the assumptions on which I base my actions and are they valid? • Utilitarianism • Deontology
Consequences or Nature of Actions? • Utilitarianism: [British Philosopher John Stuart Mill (1806-1873)]—Do my actions promote “the Greatest Good for the Greatest Number of Individuals”? • Deontology: [German Philosopher Immanuel Kant (1724-1804)]– Examine the nature of actions rather than the outcomes achieved. Doing the right thing whatever the consequences.
An Ethical Dilemma (conflict in duties) • Suppose you are the auditor of ABC auditing company and you are doing an audit of XYZ Company (your client).The CFO of XYZ Co refuses to write down some inventory you strongly believe to be obsolete and not worth much. You discuss the situation with your own boss at ABC. Your boss (a good friend of the CFO) tells you to agree with the CFO. What should you do?
An Ethical Case Analysis Framework • What are the facts? Who are the stakeholders (those affected)? • What are the alternatives? • What Ethical Principles Apply? • Examine pros (advantages) and cons (disadvantages) of each alternative. • Make a decision
Applying the Framework • Stakeholders: yourself and family, your boss and company, your client, the public (investors and creditors) who depend on financial statements. • Alternatives: 1. Agree with CFO of XYZ Co I.e. do not write down inventory 2. Disagree with your boss 3. Discuss situation with a senior partner • Pros and Cons
No Easy Answers!!! -1 • AGREE. PROS: Keep boss happy. Position secure for the moment; promotion not affected. CONS: Your integrity and the integrity of the financial statements affected. Investors and other users can lose a lot of money. Potential lawsuit against your company. Your professional certification may be revoked.
No Easy Answers!!! -2 • DISAGREE. PROS: Integrity maintained. Acting equitably. Doing the ‘right thing”. CONS: May harm your career prospects. • CONSULT SENIOR PARTNER.
For Further Information • Email: email@example.com • University of Windsor website: www.uwindsor.ca Odette Business School.