Chapter 1: Financial Accounting and its Economic Context Flashcards
Describe financial reporting’s role in making investment decisions (4-part loop)
1) Managers of profit-seeking companies prepare reports for the owners (bs, is, cfs, se)
2) users assess financial condition+performance of the company and its managers
3) Investment/credit decisions are made based on finance reports/other data
4) user decisions affect the financial condition/perf. of the company+the economic well-being of management
What 2 perspectives do managers need to understand regarding financial reports?
Economic consequences perspective, and the user orientation perspective
Economic Consequences Perspective (how does my spending look?)
financial reports are how private and public companies attract capital, so managers need to be aware of how their spending choices could effect the financial statements of the company
User Orientation Perspective (manager financial literacy)
managers need to know how to evaluate, read, and analyze financial statements so they know what companies to do business with
What two avenues do you have with regard to cash?
CONSUME or INVEST
Consumption of funds
spending $/assets immediately, eliminating any future value
Investment of funds
trade immediate consumption of assets for more consumption later
Demand for financial information: User’s Orientation
1) Consume v. invest
2) Where to invest the $
3) Demand for documentation - one needs a company’s statements prior to making an investment decision
4) Demand for ind. audit - have a CPA audit the financial statements of the company so you know the reports are sound
5) Know that the owner of the business and their CPA have different interests w/ regard to the financial reports
6) Auditor’s report, management letter, financial statements, and footnotes
auditor’s report
short letter that describes the activity of the audit and comments on the financial position of the company
management letter
signed by upper level management, which accepts responsibility of the statements made in the auditor’s report
What are the 3 overall rules that audited financial statements need to follow?
1) you want to be sure that the financial statements were prepared according to GAAP
2) the reports fairly represent the company’s financial condition/operation
3) ensure that the financial reports generated resulted from an effective internal control system
internal control system
safeguards assets and reasonably ensures that transactions are properly recorded/reported
balance sheet
list of assets, liabilities, and shareholder’s equity; the company’s financial position at a certain date
income statements
expenses are subtracted from the revenues to produce the “net-income”
shareholder’s equity (common stock figures)
includes the beginning and ending common stock and retained earnings balance, net income, and dividends
cash flow statements
includes the beginning and ending balance of cash and net cash flows from operating, investing, and financing activities
footnotes
explain in more detail the figures on a balance sheet
assets
items that will bring future economic benefit (includes the cash balance, dollar amounts due from the company’s customers, and the original cost of the equipment/land purchased by the companies
liabilities
represent current obligations,; consist of the amount currently owed by the company to its creditors
common stock
represents the company’s initial investments by the owners
retained earnings
measure of the company’s past profits that have been retained in the business
net income
the difference between revenue and expenses (measure of the company’s success in operations over a certain period)
revenue
a measure of assets generated from products or services sold
expenses
measure of asset outflows (costs) associated with selling those products and services
dividends
assets paid to the company’s owners as a return for their initial investments (these are subtracted from the end retained earnings)
investment activities
include the purchase and sales of assets (equipment/land)
financing activites
refers to the cash collections and payments related to the company’s capital resources
operating activities
associated with actual products and services provided by the company to the customers
earning power
the ability to grow and provide a substantial return to its owners
characteristics of a debt investment
the loan contract specifies the following:
1) the maturity date of the loan, or the date the loan is to be paid back
2) the annual interest payment/rate, or the amount of interest to be paid each year on the loan
3) collateral, or the assets to be passed to you in case the principal or interest on the loan is in default
4) any other debt restrictions you feel you should impose on the company to protect your investment
* debt investment is a safer alternative to equity, but it’s upside is limited to interest
* * if the company is going downhill, the creditors are paid prior to the shareholders
What will tell a creditor how well a company can generate cash over time?
The statement of cash flows
equity investment
When you buy equity in a company, you become part owner:
- returns are mainly in the form of stock appreciation and dividends
- dividend payments occur at the discretion of the board of directors, which is elected annually by the shareholders to represent their interests
- board meetings occur at least once quarterly where company policies are set, dividends are declared, and the performance/compensation of the company’s upper level management are reviewed
- the board has the power to hire/fire upper level management and to determine the form/amount of their compensation
solvency
a company’s ability to generate enough cash to meet the debt obligations as they come due
In debt and equity investment, what two roles do financial reports play?
1) help creditors and shareholders evaluate management’s past business decisions and predict future performance
2) it contains numbers used in debt and compensation contracts that influence management behavior
corporate governance
mechanisms encouraging management to act in the interest of the shareholders
What are the three reporting industries in financial accounting?
service, retail, and manufacturing
2002 Sarbanes-Oxley Act
this was congress’ response to the Enron scandal and other. It mandated strict reforms to to improve financial disclosures from big corporations and preventing accounting fraud
Other than private and public companies, who else needs to prepare their financial statements?
Schools, cities, school boards, municipalities, charitable funds, and non-profits
What are three big regulatory legal bodies in the financial accounting industry?
SEC (securities and exchange commission), FASB (financial accounting standards board), and IASB (international accounting standards board).
SEC
governs implementation and enforcement of financial reporting for publicly traded companies (congress heavily influences this)
FASB
establishes GAAP, generally accepted accounting principles
IASB
international accounting standards board
What are the 4 main SEC required filings?
S-1: initial registration statement to be able to sell equity or debt
10-K: ANNUAL filing for financial statements
10-q: quarterly financial statements
20-f: filing for nonUS companies
What are equity investors entitled to?
1) oversee management
2) the rights to the profits of the shares they own
stock brokers
becoming obsolete due to the expansion of financial models and algorithms, but they need financial reports to ascertain whether or not management of a certain company is making good decisions
What is the status of debt investors in a company?
- they have limited influence over the company (bound by the loan contract)
- they use financial information to assess the likelihood of default
- they can change the terms of the loan if the company is showing it can’t pay the principal/interest
capital markets
equity, debt, and securities are held by individuals and entities, many of which are listed on stock exchanges globally
debt covenants and management compensation contracts
are in place to reduce the risk+encourage decision-making consistent with capital-provider interests
a company’s audit committee
works with management to choose an auditor and manages the quality of the audit as it happens
