Solution Manual for Financial Reporting and Analysis, 6th Edition
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CHAPTER 1
THE ECONOMIC AND INSTITUTIONAL SETTING
FOR FINANCIAL REPORTING
CHAPTER OVERVIEW
Financial statements contain information about a company, its economic health, and its products that
help users in their decision making, and make it possible to monitor managers’ activities. Therein lies
the demand for financial statements. Specifically, equity investors, analysts, and brokers use financial
statements to form opinions about the value of a company as a basis for their investment decisions or
recommendations to others. Creditors use financial information to assess the company’s ability to make
its debt payments and comply with loan covenants. Auditors use financial statements to help design
more effective audits by identifying areas of potential reporting abuses. Other users that demand
financial information include managers, employees, suppliers, customers, and government and regulatory
agencies. Flexibility and consistency are both desired when preparing financial statements. The changing
economic environment demands the revision of standards and best practices that will best serve these two
diverse results.
Investors, creditors, and other interested parties demand financial statements because the information
is useful. What governs the supply of financial information? Two answers are mandatory reporting and
the advantages of voluntary disclosure. Most companies in the U.S. and other developed countries are
required to produce, distribute, and file financial reports with a governmental agency—the Securities and
Exchange Commission (SEC) in the U.S.—so that interested parties can view the statements. Voluntary
financial information that goes beyond the minimum requirements can benefit the company, its managers,
and its owners. Voluntary disclosure benefits and costs are likely to affect accounting policies and
reporting strategies. Therefore, the flexibility and discretion inherent in financial reporting standards
provide managers with opportunities to shape financial statements to achieve specific reporting goals.
Users of this information that understand financial reporting, managers’ incentives, and accounting
flexibility are better informed and more likely to be able to use financial statements to their advantage in
the decision-making process.
The accountant’s and analyst’s job is more challenging when financial reporting measurement and
disclosure rules differ across countries. Those rules may underscore the reporting culture that may have
evolved to reflect firms’ underlying economic performance. The FASB and IASB are working together to
converge U.S. GAAP and IFRS.
CHAPTER OUTLINE
I. WORLDCOM’S CURIOUS ACCOUNTING
A There are several “facts” to consider (stepping back in time to May 2002).
1. The market price of WorldCom is $2.00 per share and declining.
a. Stock analysts state that WorldCom is doing “surprisingly well despite tough times
throughout the industry.”
b. The company has $2.3 billion in cash, which translates into $20.50 book value
per share.
2. The first-quarter results indicate sales of $8,120 million and $240 million in pre-tax
operating profits – a decline of 16% in sales and 40% in profits while other firms in the
industry are reporting even steeper sales and earnings decreases.
3. The company has $104 billion in assets and $44 billion in debt.
4. WorldCom’s “line costs” are holding steady at about 42% of sales while other
companies are experiencing rising line costs as a percentage of sales.
a. Does this suggest that WorldCom is adept at managing its excess capacity
THE ECONOMIC AND INSTITUTIONAL SETTING
FOR FINANCIAL REPORTING
CHAPTER OVERVIEW
Financial statements contain information about a company, its economic health, and its products that
help users in their decision making, and make it possible to monitor managers’ activities. Therein lies
the demand for financial statements. Specifically, equity investors, analysts, and brokers use financial
statements to form opinions about the value of a company as a basis for their investment decisions or
recommendations to others. Creditors use financial information to assess the company’s ability to make
its debt payments and comply with loan covenants. Auditors use financial statements to help design
more effective audits by identifying areas of potential reporting abuses. Other users that demand
financial information include managers, employees, suppliers, customers, and government and regulatory
agencies. Flexibility and consistency are both desired when preparing financial statements. The changing
economic environment demands the revision of standards and best practices that will best serve these two
diverse results.
Investors, creditors, and other interested parties demand financial statements because the information
is useful. What governs the supply of financial information? Two answers are mandatory reporting and
the advantages of voluntary disclosure. Most companies in the U.S. and other developed countries are
required to produce, distribute, and file financial reports with a governmental agency—the Securities and
Exchange Commission (SEC) in the U.S.—so that interested parties can view the statements. Voluntary
financial information that goes beyond the minimum requirements can benefit the company, its managers,
and its owners. Voluntary disclosure benefits and costs are likely to affect accounting policies and
reporting strategies. Therefore, the flexibility and discretion inherent in financial reporting standards
provide managers with opportunities to shape financial statements to achieve specific reporting goals.
Users of this information that understand financial reporting, managers’ incentives, and accounting
flexibility are better informed and more likely to be able to use financial statements to their advantage in
the decision-making process.
The accountant’s and analyst’s job is more challenging when financial reporting measurement and
disclosure rules differ across countries. Those rules may underscore the reporting culture that may have
evolved to reflect firms’ underlying economic performance. The FASB and IASB are working together to
converge U.S. GAAP and IFRS.
CHAPTER OUTLINE
I. WORLDCOM’S CURIOUS ACCOUNTING
A There are several “facts” to consider (stepping back in time to May 2002).
1. The market price of WorldCom is $2.00 per share and declining.
a. Stock analysts state that WorldCom is doing “surprisingly well despite tough times
throughout the industry.”
b. The company has $2.3 billion in cash, which translates into $20.50 book value
per share.
2. The first-quarter results indicate sales of $8,120 million and $240 million in pre-tax
operating profits – a decline of 16% in sales and 40% in profits while other firms in the
industry are reporting even steeper sales and earnings decreases.
3. The company has $104 billion in assets and $44 billion in debt.
4. WorldCom’s “line costs” are holding steady at about 42% of sales while other
companies are experiencing rising line costs as a percentage of sales.
a. Does this suggest that WorldCom is adept at managing its excess capacity
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