Financial Reporting And Analysis, 7th Edition Class Notes

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CHAPTER 1THE ECONOMIC AND INSTITUTIONAL SETTING FORFINANCIAL REPORTINGCHAPTER OVERVIEWFinancial statements are an extremely important source of information about a company,its economic health, and its prospects. They help improve decision making and make itpossible to monitor managers’ activities.Equity investors use financial statements to form opinions about the value of acompany and its stock.Creditors use statement information to gauge a company’s ability to repay its debtand to check whether the company is complying with loan covenants.Stock analysts, brokers, and portfolio managers use financial statements as thebasis for their recommendations to investors and creditors.Auditors use financial statements to help design more effective audits by spottingareas of potential reporting abuses.Investors, creditors, and other interested parties demand financial statements because theinformation is useful. But what governs the supply of financial information?Mandatory reporting is a partial answer. Most companies in the United States andother developed countries are required to compile and distribute financialstatements to shareholders and to file a copy with a government agency (in theUnited States, that agency is the SEC). This requirement allows all interestedparties to view the statements.The advantages of voluntary disclosure are the rest of the answer. Financialinformation that goes beyond the minimum requirements can benefit thecompany, its managers, and its owners. For example, voluntary financialdisclosures can help the company obtain capital more cheaply or negotiate betterterms from suppliers. But benefits like these come with potential costs:information collection, processing, and dissemination costs; competitivedisadvantage costs; litigation costs; and political costs. This means that twocompanies with different financial reporting benefits and costs are likely tochoose different accounting policies and reporting strategies.Different companies choose different accounting policies and reporting strategies becausefinancialreportingstandardsareoftenimpreciseandopentointerpretation.Thisimprecision gives managers an opportunity to shape financial statements in ways thatallow them to achieve specific reporting goals.Most managers use their accounting flexibility to paint a truthful economicpicture of the company.Other managers mold the financial statements to mask weaknesses and to hideproblems.

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