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Chapter 1: Financial Accounting and Its Economic Context Profit-seeking companies - managers prepare reports for owners of the companies. Owners and other interested parties (Users) - use reports to assess financial condition and performance of companies.

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Presentation Transcript
the role of financial reporting in investment decisions
Profit-seeking companies - managers prepare reports for owners of the companies.

Owners and other interested parties (Users) - use reports to assess financial condition and performance of companies.

User decisions - users obtain information from reports to make investment decisions.

Effects of user decisions - decisions affect the company and its managers.

The Role of Financial Reporting in Investment Decisions
financial reporting and investment decisions

Users assess

Investment and

credit decisions

are made

Decisions affect

company and

managers

Financial Reporting and Investment Decisions

Managers prepare

content of financial reports
The Management Letter

The Financial Statements:

Balance Sheet

Income Statement

Statement of Stockholders’ Equity

Statement of Cash Flows

The Footnotes

The Auditor’s Report

Content of Financial Reports
the management letter
The management letter is the statement of management to the investors.

It indicates:

management is responsible for the preparation and content of the financial report.

the statements were prepared in accordance with generally accepted accounting principles (GAAP).

the company maintains a system of internal controls to safeguard assets.

The Management Letter
the financial statements
Include a balance sheet, income statement, statement of stockholders’ equity, and a statement of cash flows (discussed in a later chapter).

The footnotes to the financials are considered an integral part of the financials, and explain many of the policies and assumptions used to prepare the financials.

The Financial Statements
the auditor s report
The auditor’s report is a statement to the board of directors of the company and to the shareholders of the company.

It expresses an opinion as to whether the financial statements present fairly the financial activities of the company and whether the financials were prepared in accordance with GAAP

The Auditor’s Report
the economic environment of financial reporting
Providers of capital - debt and equity investors

Reporting entities

Corporate governance

Financial information users and capital markets

Debt covenants and management compensation

Financial reporting regulations & standards

the accounting policymaking process

Sarbanes-Oxley Act

Legal liability

Professional reputation and ethics

The Economic Environment of Financial Reporting
providers of capital
Provide capital

equity capital through stock investments

debt capital through bond and loan investments (creditors)

Receive returns

equity investors receive dividends

creditors and bond investors receive interest

Stock investors choose board of directors

Board of directors

Select corporate officers (management)

Set company policy

Select audit committee

Management – runs the company

Providers of Capital
reporting entities
Reporting entities are called companies, businesses and firms.

The companies may be further divided into segments and subsidiaries, which may provide their own financials.

Consolidated financials are prepared when subsidiaries are combined with the parent’s financials.

Reporting Entities
corporate governance financial information users
Financial statements used by a variety of groups.

Equity investors: purchase shares of stock, which represent ownership in the company. The financials are used by investors to analyze management’s decisions.

Debt investors (creditors): provide capital through loans. The financials are used by creditors to assess likelihood of default.

Management: uses other companies financials to asses the competition.

Others, including government bodies, labor unions, employees, use financials to assess the financial status of the company.

Corporate GovernanceFinancial Information Users
corporate governance and capital markets
Capital markets value the publicly traded equity and debt securities.

The financials are a component of the information that the markets use to value companies securities, along with a number of nonfinancial measures.

The market reacts to financial and other information as it is released by management.

Corporate Governanceand Capital Markets
debt covenants and management compensation contracts
Debt covenants are part of debt contracts between the company and creditors. Violation of debt covenants may lead to more costly debt terms.

Management compensation contracts often base pay on certain income or stock price goals.

Such goals are designed to encourage certain management behavior.

Debt Covenants and Management Compensation Contracts
regulations and standards
The Securities and Exchange Commission (SEC) governs financial reporting for publicly traded companies. Congress and other regulatory agencies have influence with the SEC.

The Financial Accounting Standards Board (FASB) is responsible for the promulgation of generally accepted accounting principles (GAAP) for financial statements. The FASB accepts input from all interested parties, including accountants, corporations, academics, and governmental entities.

Regulations and Standards
the accounting policymaking process

Policymakers

SEC

FASB

Public Input

Congress, White House, government agencies

Public hearings, letters

Generally Accepted Accounting Principles

(GAAP)

Perceived economic consequences

Actual Accounting Practices

Economic Consequences

The Accounting Policymaking Process
sarbanes oxley act
Passed by Congress in 2002, in response to a series of corporate scandals.

Requires principal executive and financial officers to certify a number of statements regarding the financials.

Places additional responsibilities on management to ensure that adequate internal controls are in place.

Sarbanes-Oxley Act
legal liability
Management is legally responsible to the stockholders to act in their interest.

Auditors are legally responsible to the stockholders to conduct a thorough and independent audit.

If management or auditors fail in their duties, investors and others may sue to recover any losses that might occur as a result the failure.

Many recent examples of management and audit failure exist: Enron, WorldCom, HealthSouth, Xerox, Rite Aid, and Quest.

Legal Liability
professional reputation and ethics
Ethical behavior is in the long-run interest of managers, stockholders, and auditors.

Many companies,universities, and professional organizations have enacted increased emphasis on ethics.

Auditors’ reputations are integral to their ability to perform their duties. High ethical conduct is imperative to their continued success.

Professional Reputation and Ethics
the four kinds of accounting figure 1a 1

Economic Entity

Managers

System

Financial Information

Recipients

Decisions

The Four Kinds of Accounting (Figure 1A-1)

Financial Accounting

Profit-making companies

Finance or accounting department

GAAP

  • Income statement
  • Balance sheet
  • Statement of stock-
  • holders’
  • equity
  • Statement of cash flows
  • Other disclosures
  • Auditor report
  • External
  • Investors
  • Creditors
  • Suppliers
  • Employees
  • Managers
  • Government
  • General public
  • Equity and debt investments
  • Contract negotiations
  • Regulation
  • Dividend payments
the four kinds of accounting figure 1a 120

Economic Entity

Managers

System

Financial Information

Recipients

Decisions

The Four Kinds of Accounting (Figure 1A-1)

Managerial Accounting

All entities

Finance or accounting department

GAAP

  • Manager
  • reports
  • Production
  • costs
  • Performance
  • evaluation,
  • etc.
  • Internal
  • Managers
  • Operating
  • decisions
the four kinds of accounting figure 1a 121

Economic Entity

Managers

System

Financial Information

Recipients

Decisions

The Four Kinds of Accounting (Figure 1A-1)

Not-for-profit Accounting

Nonprofit

entities

Finance or accounting department

Fund accounting principles

  • Balance sheet
  • Funds flow
  • statements
  • External
  • Creditors
  • Government
  • General public
  • Debt investments
  • Budget allocations
the four kinds of accounting figure 1a 122

Economic Entity

Managers

System

Financial Information

Recipients

Decisions

The Four Kinds of Accounting (Figure 1A-1)

Tax Accounting

All entities

Finance or accounting department

Internal revenue code

  • Official tax forms:
  • 1040 for individuals
  • 1120 for corporations
  • External
  • Internal Revenue Service
  • Collection of government revenues
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