1. Financial Accounting
John Shon

2. Financial Accounting Financial Accounting Managerial Accounting
Process by which the economic performance and financial position of the company are recorded and communicated to decision-makers outside the company
Benefits:
Helps decision-makers
Facilitates contracting between parties: Between management and ...?
Managerial Accounting
Process by which information is communicated internally
Not covered in this course

3. Investors Value creation Managers Investment
RETURNS
FINANCING
ACTIVITIES
Investors
But how can investors be assured that managers:
- Choose the right projects/investments?
- Exert sufficient effort?
- Adequately disclose relevant information?
- Ultimately repay investors?
Value
creation
Managers
OPERATING
ACTIVITIES
INVESTING
ACTIVITIES
Investment

4. Financial Accounting serves an
RETURNS
FINANCING
ACTIVITIES
Investors
Financial Accounting serves an
essential informational role for decision makers
Value
creation
Managers
“If you look at the history of the American capital markets, there’s probably no innovation more important than the idea of Generally Accepted Accounting Principles [GAAP].”
- Lawrence Summers, Former Secretary of the US
Treasury & President of Harvard University
OPERATING
ACTIVITIES
INVESTING
ACTIVITIES
Investment

5. Decision makers Who uses information provided by Financial Accounting?
Individual investors, institutional investors, hedge funds
Creditors, credit agencies
Financial analysts, brokers, rating agencies,
Media, general public
Employees, customers, suppliers
Auditors, audit committee, board of directors, SEC, FASB
Compensation committee, potential employers
Competitors, labor unions
IRS, government regulators
Corporate governance and contracting: Each of these decision makers helps keep the company “in check”

6. Is Accounting the only source of information?
There are clearly limitations to what Financial Accounting can achieve
Many other sources of information exist
Firm’s other filings (e.g., 10Q, 8K)
Firm’s own voluntary disclosures
Firm’s other “signals”
Analysts, brokers
Media
Yet…
Source: Ball and Brown (1968)

7. Accounting is the language of business
“Without a comprehension of [the fundamentals of Accounting], there can be no real understanding of the economics of enterprise.”
Paul Samuelson, 1970 Nobel Prize in Economic Sciences
So…
What do CFOs and financial executives think?
What do auditors think?
What do academic researchers think?

8. Source: Rajgopal et al. (2005)
CFOs: What is the most important performance measure reported to outsiders?
Earnings, 52%
Pro-forma earnings, 12%
Revenues, 12%
Operating
cash flows, 12%
Free cash flows, 12%
Other, 2%
EVA, 1%
Based on survey of 401 CFOs and financial executives of publicly traded companies
Source: Rajgopal et al. (2005)

9. CFOs: Why do you try to meet earnings benchmarks?
Build credibility with market
Maintain/increase stock price
Maintain/reduce volatility
Assure customers/suppliers
Achieve/maintain credit rating
Convey future growth prospects
External reputation of management
Avoid violating debt covenants
Help achieve employee bonuses
Based on survey of 401 CFOs and financial executives of publicly traded companies
Source: Rajgopal et al. (2005)

10. CFOs: Why do you try to avoid missing earnings benchmarks?
Outsiders suspect
unknown problems
Waste time explaining
why we missed
Leads to increased scrutiny
of other financial data
Increases probability
of lawsuit
Creates uncertainty about
future prospects
Based on survey of 401 CFOs and financial executives of publicly traded companies
Source: Rajgopal et al. (2005)

11. CFOs: What might you do to achieve earnings benchmark?
Delay starting new project
Speed up booking revenues
Draw down on reserves
Sell assets to recognize gains
Repurchase common shares
Alter accounting assumptions
Postpone taking accounting charge
Incentivize customers to buy now
Decrease discretionary spending
Based on survey of 401 CFOs and financial executives of publicly traded companies
Source: Rajgopal et al. (2005)

12. CFOs: How much value would you sacrifice to achieve smooth earnings?
Large, 2%
None, 22%
Moderate, 24%
Small, 52%
Based on survey of 401 CFOs and financial executives of publicly traded companies
Source: Rajgopal et al. (2005)

13. Auditors: How do your publicly-traded clients try to manage earnings?
Decrease expenses, 22%
Increase revenues, 17%
Increase expenses, 25%
Decrease revenues, 4%
Business combos, 13%
Other, 19%
Based on survey of 253 Big Five auditors
Source: Elliott et al. (2003)

14. Researchers: What is actual distribution of companies’ reported earnings?

15. Source: Marquardt and Wiedman (2004)
Researchers: How do companies that “avoid earnings decreases” manage earnings?
Total
accruals
Accounts
receivable
Inventory
payable
Accrued
liabilities
Depreciation
Special
items
Source: Marquardt and Wiedman (2004)

16. Does it matter? Settlement of securities class action lawsuits
in excess of $100 million ( *)
$33.9 billion total
Enron
WorldCom
AOL Time Warner
Nortel Networks
Royal Ahold
McKesson HBOC
Lucent
Bristol-Myers Squibb
All other mega-settlements
Cendant
Millions
* As of February 16, 2006
Source: Stanford Law School Securities Class Action Clearinghouse (2006)

17. Economic consequences
Economic consequences of the information conveyed through Financial Accounting and the financial reports it produces
Distribution of wealth among individuals
Allocation of resources among firms
Aggregate production (rate of capital formation) in macroeconomy
Monitoring of managers and corporate control
Use of resources devoted to regulation, publicly available information, and private search for information
Aggregate level of risk and allocation of risk among individuals
These economic consequences affect each decision maker differently (e.g., investors, management, auditors, analysts)

18. Financial reporting standards ( GAAP: Generally Accepted Accounting Principles )
GAAP is not a science. The financial reporting system is a result of tradeoffs among these many constituencies (decision makers); it is a result of “social choice”
No consensus on what is “best”
Political climate
GAAP
Congress
SEC
FASB
Public input*
Perceived economic consequences
* Public hearings, letters, exposure drafts, media, lobbying

19. Financial Accounting process
GAAP
Financial
statements
Economic
events
“Accrual”
accounting
system
Financial Accounting is the process by which the economic performance and financial position of the firm are recorded and communicated to decision-makers outside the firm
Management’s
incentives and
judgment

20. Annual report A typical firm’s annual report contains:
Financial statements (Form 10K)
Balance sheet
Income statement
Statement of cash flows
Statement of stockholders’ equity
Footnotes: The devil is in the details
MD&A: Management discussion and analysis
Discusses key trends and provides important forward-looking information
Letter to shareholders
Financial highlights, general description of business and risk factors
Auditor’s report, with audit opinion
Unqualified: “Clean”
Qualified or modified: Explanatory language added to opinion*
* Due to going concern (e.g., near bankruptcy), material uncertainty (e.g., litigation), inconsistency (e.g., accounting change)

21. Financial statements Balance sheet Income statement
Provides a snapshot of the firm’s financial position: assets, liabilities, and owners’ equity
Income statement
Reports the firm’s operating performance: revenues and expenses
Statement of cash flows
Reports the firm’s cash flow activities: how operating, investing, and financing activities have affected the firm’s cash balance
Statement of stockholders’ equity
Details how various activities have affected the firm’s equity balance

22. Articulation of financial statements
Balance sheet
12/31/2005
Statement of Owners’ equity
12/31/2005
Assets
Liabilities
Beginning balance
Net income
Owners’ equity
Ending balance
Statement of cash flows
Year ended 12/31/2005
Income statement
Year ended 12/31/2005
Operating cash flows
Investing cash flows
Financing cash flows
Net income
Change in cash balance*
* The change in cash from the statement of cash flows helps us to arrive at the balance sheet’s final balance in cash

23. Where to find them Several sources for financial statements
Company’s website, typically under “Investor relations” or “About us”
(international companies)
Other resources
When in doubt, goooogle it!