Accounting: The Language of Business - Vol. 2 [(Intermediate) Part 1]

I don't mean to sugarcoat the figure on restatements, but I think it is positive - it shows a healthy system. The general impression of the public is that accounting rules are black and white. They are often anything but that, and in many instances the changes in earnings came after new interpretations by the chief accountant of the SEC.

Steve Odland

The Financial Reporting Environment

(Part A)

by

Charles Lamson

Introduction

Well developed accounting standards enable worldwide capital markets to function effectively by providing credibility to published financial information used by investors, creditors, and others. Transparent financial information included in the financial statements allows these parties to make rational investment and credit decisions that direct capital to corporations that develop new products and technology, create employment, and encourage growth and development.

Consider Twitter, Inc., the social networking company, which raised capital of over $2.09 billion by issuing 80.5 million shares of stock in its initial public offering. Investors subsequently traded over 194 million shares of Twitter stock valued at $8.2 billion during

the first month after the initial public offering (Twitter, Inc. Is traded on the New York Stock Exchange. It made its initial public offering on November 7th, 2013.) These investors based their decisions on the financial information provided by Twitter. The capital provided by such investment fuels the overall economy and directs capital to its most productive uses.

Multiple factors in the overall accounting environment influence economic decisions at the firm level. For example, user groups such as investors and creditors impact the demand for accounting information and influence the standard-setting bodies. Financial reporting encompasses much more than the financial statements: Other key elements include the footnote to the financial statements, the letter to the owners, management's discussion and analysis, the auditor's report, the management report, and press releases. Financial statement users rely on all categories of financial information to make rational economic decisions.

In the next several posts, we first define financial accounting and discuss the demand and supply of financial information. We identify the economic entities that prepare financial information as well as the users of financial information. We then explore factors that shape accounting information. We also overview the historical development of the U.S. and international standard-setting bodies and discuss the standard-setting processes. We conclude the next several posts with a review of recent trends in standard-setting.

Overview of Financial Reporting

Financial accounting is the process of identifying, measuring, and communicating financial information about an economic entity in various user groups within the legal, economic, political, and social environment. This definition contains four major elements:

1. Financial information

2. Economic entity

3. User groups

4. Legal, economic, political, and social environment

We will examine these elements in the following sections.

Financial Information

Financial information falls into two categories: information that is or that is not governed by rules set forth by the accounting standard-setting bodies. Firms prepare the financial statements and the footnotes to the financial statements (also referred to as footnote disclosures) based on accounting standard-setters rules. In contrast, the letter to the owners, management's discussion and analysis, the auditor's report, the management report, and press releases are not governed by the accounting standard-setting bodies, although they are regulated to some degree by other authoritative bodies.

Demand for financial information. The form, content, and extent that firms provide financial information is based on market participant demand. Financial accounting provides information that enables users to evaluate economic entities and make efficient resource allocation decisions based on the risks and returns of a particular investment. This process directs capital flows to their most productive uses. In this way, the demand for financial information is linked to the allocation of scarce resources, as Illustrated in Exhibit 1.1.

EXHIBIT 1.1 Demand for Financial Information

Capital is a scarce resource. How do investors and creditors make decisions regarding the amount of capital to invest in a given entity? Accountants report the economic performance and financial position of the firm so that potential debt and equity investors can adequately assess the risks and returns of investing in the entity. Similarly, lenders can use the financial statements to assess the potential for payment. For example, a bank limited in the number of loans that it can make would clearly prefer to lend to a business that has been profitable over the last five years rather than one that has not.

Transparent and complete financial statements aid investors in assessing the amount and timing of future cash flows, as well as the uncertainty of cash flow realization. However, financial statement users should be aware that performance-based compensation can create an incentive for managers to strategically manage or to misreport financial statements. Compensating managers based upon reported net income provides a financial incentive to inflate net income. For example, when the Securities and Exchange Commission found that the Computer Sciences Corporation (CSC) committed accounting fraud that increased net earnings in 2010 and 2011, CSC's CEO agreed to pay back 3.7 million dollars of compensation he received based on the fraudulent earnings. Financial accounting standards seek to limit this type of management behavior. Most managers faithfully report their financial statements, but it is important for standard-setters and auditors to be aware of incentives to alter net income. 

*GORDON, RAEDY, & SAMNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 1-3*

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