INT / INC - 1 Users of Financial Statements What you look for in the statements depends on your objectives ^u Equity investment: profitability, risk, cash generating ability ^u Merger and acquisition: profitability, risk, price to pay, impact on financial statements. ^u Credit extension/Customer health: short-term vs. long-term, ability to pay interest & -principal, liquidity. ^supplier health (supplier of key raw material, supplier's quality, JIT): cash generating ability, profitability. ^u Employer health (employees, unions): long-term viability & ability to meet pension liabilities, profitability, risk. ^u Internal operation analysis: analysis of business segments performance, cost, profit, budgeting, and business strategy.
^u Antitrust regulations: monopoly power (profitability, market share), cost of capital, justifying merger through "failing company doctrine" disregarding monopoly consideration. ^u Competitors analysis: profitability, profit margins, market share (aids in pricing, product mix). ^u Audit tests: going concern judgements by auditors. ^u Legal judgement: fraudulent conveyance. Concentrate on investors and creditors (Covers most users). INT / INC - 2 Financial statements (the reports produced by the financial accounting system), in theory, aim at providing information useful for these two groups, while limiting the information available for competitors.
What information is considered useful to investors and creditors? 1 Information that helps in predicting future cash flows. Investors are primarily interested in valuing firms. 2 Information relating to a firm's risk characteristics - liquidity, solvency 3 Information that may serve as an observable on which contracts are written. Two simple examples: Example 1: Corporate lending contracts typically contain certain restrictions on the borrowing party in order to reduce its risk of default.
These restrictions are typically based on accounting variables such as debt-equity, ratios and working capital. Example 2: Managers' compensation is tied to firm performance that is often measured by reported earnings. Does this however hold true in practice? INT / INC - 3 The Adversarial Nature of Financial Reporting Corporations and Management have substantial incentives to exploit the fact that accounting principles are neither fixed nor precise as to be open to only one interpretation. (e. g. , SEC requires companies to disclose information if it is material but does not define materiality with great precision.
) The simple fact that preparers of financial statements spend time contemplating issues such as the accounting methods to be used (e. g. , LIFO or FIFO), what is to be disclosed, the timing of the disclosure, etc. , indicates that they believe that their choice makes a difference. The incentives to exploit the nature of financial reporting are twofold: 1. As part of the fiduciary duty to shareholders: A corporation exists for the benefit of its shareholders, not for the purpose of educating the public about its financial condition.
Bearing in mind this fiduciary responsibility, corporate managers may ask themselves whether they are acting responsibly if they do not take advantage of legal opportunities to maximize shareholder's wealth. 2. For self-serving reasons as management compensation and perhaps their job itself is tied to financial results These reasons lead to the following conclusion on the part of management: THE BEST KIND OF FINANCIAL STATEMENT IS THE ONE THAT RESULTS IN THE HIGHEST POSSIBLE PRICE FOR ITS STOCK AND/OR PERSONAL COMPENSATION FASB and SEC prohibit companies from going too far in this direction, but once managers accept the premise that financial statements are instruments for maximizing shareholders' wealth, they will realize the benefits by preparing the statements so as to: 1. lower cost of capital (risk) 2. create higher "earnings" expectations 3. downplay "real' and contingent liabilities INT / INC - 5 Accounting Definitions of Income - Review A major problem in measuring firm performance for a specific accounting period arises in situations where a transaction is started in one period but will be completed in a future period.
Two approaches to determine the timing of earnings recognition exist: Cash basis of accounting Accrual basis of accounting The difference between these two methods is in the time when they consider a transaction as completed, namely, when they recognize earnings. (i. e. , the question is when revenues and / or expenses are reported (i. e. , recognized) in the income statement.
). Over the life of the firm, income and cash flows converge. They differ only as to timing of recognition. Accounting concept of income: Purpose. Informational. Future Cash Flows Question: If purpose of accounting is to forecast future cash flows why not just provide cash flows or cash basis income.
Answer: Accrual accounting "better" forecaster of future cash flows: ^ue. g. spend $10 to purchase asset which is sold for $12 on account What is better forecast of profitability ($10) or $2?