Chapter 1: Financial Accounting and its Economic Context

Question 1

Describe financial reporting’s role in making investment decisions (4-part loop)

Answer 1

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

Question 2

What 2 perspectives do managers need to understand regarding financial reports?

Answer 2

Economic consequences perspective, and the user orientation perspective

Question 3

Economic Consequences Perspective (how does my spending look?)

Answer 3

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

Question 4

User Orientation Perspective (manager financial literacy)

Answer 4

managers need to know how to evaluate, read, and analyze financial statements so they know what companies to do business with

Question 5

What two avenues do you have with regard to cash?

Answer 5

CONSUME or INVEST

Question 6

Consumption of funds

Answer 6

spending $/assets immediately, eliminating any future value

Question 7

Investment of funds

Answer 7

trade immediate consumption of assets for more consumption later

Question 8

Demand for financial information: User’s Orientation

Answer 8

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

Question 9

auditor’s report

Answer 9

short letter that describes the activity of the audit and comments on the financial position of the company

Question 10

management letter

Answer 10

signed by upper level management, which accepts responsibility of the statements made in the auditor’s report

Question 11

What are the 3 overall rules that audited financial statements need to follow?

Answer 11

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

Question 12

internal control system

Answer 12

safeguards assets and reasonably ensures that transactions are properly recorded/reported

Question 13

balance sheet

Answer 13

list of assets, liabilities, and shareholder’s equity; the company’s financial position at a certain date

Question 14

income statements

Answer 14

expenses are subtracted from the revenues to produce the “net-income”

Question 15

shareholder’s equity (common stock figures)

Answer 15

includes the beginning and ending common stock and retained earnings balance, net income, and dividends

Question 16

cash flow statements

Answer 16

includes the beginning and ending balance of cash and net cash flows from operating, investing, and financing activities

Question 17

footnotes

Answer 17

explain in more detail the figures on a balance sheet

Question 18

assets

Answer 18

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

Question 19

liabilities

Answer 19

represent current obligations,; consist of the amount currently owed by the company to its creditors

Question 20

common stock

Answer 20

represents the company’s initial investments by the owners

Question 21

retained earnings

Answer 21

measure of the company’s past profits that have been retained in the business

Question 22

net income

Answer 22

the difference between revenue and expenses (measure of the company’s success in operations over a certain period)

Question 23

revenue

Answer 23

a measure of assets generated from products or services sold

Question 24

expenses

Answer 24

measure of asset outflows (costs) associated with selling those products and services

Question 25

dividends

Answer 25

assets paid to the company’s owners as a return for their initial investments (these are subtracted from the end retained earnings)

Question 26

investment activities

Answer 26

include the purchase and sales of assets (equipment/land)

Question 27

financing activites

Answer 27

refers to the cash collections and payments related to the company’s capital resources

Question 28

operating activities

Answer 28

associated with actual products and services provided by the company to the customers

Question 29

earning power

Answer 29

the ability to grow and provide a substantial return to its owners

Question 30

characteristics of a debt investment

Answer 30

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

Question 31

What will tell a creditor how well a company can generate cash over time?

Answer 31

The statement of cash flows

Question 32

equity investment

Answer 32

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

Question 33

solvency

Answer 33

a company’s ability to generate enough cash to meet the debt obligations as they come due

Question 34

In debt and equity investment, what two roles do financial reports play?

Answer 34

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

Question 35

corporate governance

Answer 35

mechanisms encouraging management to act in the interest of the shareholders

Question 36

What are the three reporting industries in financial accounting?

Answer 36

service, retail, and manufacturing

Question 37

2002 Sarbanes-Oxley Act

Answer 37

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

Question 38

Other than private and public companies, who else needs to prepare their financial statements?

Answer 38

Schools, cities, school boards, municipalities, charitable funds, and non-profits

Question 39

What are three big regulatory legal bodies in the financial accounting industry?

Answer 39

SEC (securities and exchange commission), FASB (financial accounting standards board), and IASB (international accounting standards board).

Question 40

SEC

Answer 40

governs implementation and enforcement of financial reporting for publicly traded companies (congress heavily influences this)

Question 41

FASB

Answer 41

establishes GAAP, generally accepted accounting principles

Question 42

IASB

Answer 42

international accounting standards board

Question 43

What are the 4 main SEC required filings?

Answer 43

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

Question 44

What are equity investors entitled to?

Answer 44

1) oversee management

2) the rights to the profits of the shares they own

Question 45

stock brokers

Answer 45

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

Question 46

What is the status of debt investors in a company?

Answer 46

• 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

Question 47

capital markets

Answer 47

equity, debt, and securities are held by individuals and entities, many of which are listed on stock exchanges globally

Question 48

debt covenants and management compensation contracts

Answer 48

are in place to reduce the risk+encourage decision-making consistent with capital-provider interests

Question 49

a company’s audit committee

Answer 49

works with management to choose an auditor and manages the quality of the audit as it happens