Accounting: The Language of Business - Vol. 2 (Intermediate: Part 3)

When a manufacturing engineer is hired to create new products but insists on sharing his "wisdom" in accounting with the company controller, he is not going to last long in that company.

Chin-Ning Chu

The Financial Reporting Environment

(Part C)

by

Charles Lamson

Creditors and other debt investors. Creditors and other debt investors are entities, including banks and other financial institutions, that lend money to the company. Debt can either be public or privately held. In the case of publicly traded debt, market participants invest in the entity's debt---specifically, the entity's bonds. In the case of privately-held debt, companies obtain capital directly from lenders, such as commercial banks. Creditors typically receive a return on their investment in the form of interest income. However, in the case of public debt, they may also receive a return in the form of an increase in the price of the bonds.

Creditors use financial information to determine whether the principal and interest on their loans will likely be paid by debtors when due. Creditors are also concerned with the priority of claims against the assets of the debtor company. Some lenders have priority over others when determining the order of repayment. Finally, creditors can use financial information to access the entity's current and future profitability and growth prospects.

Competitors. Competitors use financial information to determine their market position relative to the reporting entity. Companies analyze a competitor's financial information to identify its strategy and determine if it is possible to successfully compete with the company. An analysis of a competitor's financial information enables a financial statement user to identify that entity's objectives, assumptions, overall business strategy, and capabilities. For example, a pharmaceutical company would be interested in any increase in a rival's research and development expenses that could indicate new and competing products in the future. 

Financial Analysts. Financial analysts employed at investment banks, commercial banks, and brokerage houses use financial information to provide guidance to individuals and other entities in making investment and credit decisions. Analysts use various techniques to estimate the value of an entity based on information obtained from the annual report and other publicly available information, as well as from interviews with company officers and outside industry or economic experts. Some financial analysts are equity analysts who follow an industry or certain companies and provide their opinions or recommendations on a regular basis. These reports result in a recommendation as to whether investors should buy or sell the stock of that company. For example, in the first quarter of 2017, there were 39 analyst recommendations issued for Twitter---4 of which were buys, 27 were holds, and 8 were sells or underperforms [In a down market, a stock that is a falling faster than the broader market is an underperformer. "Underperform" is also an analyst recommendation assigned to a stock when shares are expected to do slightly worse than the market return. The designation is also known as market "moderate sell" or "weak hold." (investopedia.com)]. Financial analysts act as market intermediaries and they are trained to examine an extensive volume of financial data and reduce it to a manageable amount of information for you by investors.

Employees and Labor Unions. Employees and labor unions use financial statements to assess the economic performance and liquidity of entities employing members of the union. For example, the United Auto Workers represents employees in the automobile industry. Financial statement information can be useful during the negotiation of new labor agreements and compensation contracts.

Suppliers and Customers. Suppliers and customers use financial statements to determine a company's financial position. For suppliers, it is critically important to assess the company's ability to pay for goods and services provided. A company's financial condition indicates the quality of its products and its ability to honor warranties to potential customers. General Motors (GM) lost many prospective customers when it was in bankruptcy during the economic crisis of 2008. In this case, auto buyers were concerned that GM would not be in business long enough to fulfill its warranty obligation to its customers.

Government Agencies. Government agencies review the financial statements of publicly traded companies for a variety of reasons. For example, the US Federal Trade Commission may review publicly available financial information to identify a potential monopoly or an entity in violation of antitrust laws.

Other Parties Involved in the Preparation and Use of Financial Information

Another important group involved in the financial reporting process is the preparers themselves. Financial statement preparers are the companies that issue the financial statements.

In addition to preparers and users of the financial statements, other parties involved in the financial reporting process include:

• Auditors

• Accounting standard setters such as the Financial Accounting Standards Board and the International Accounting Standards Board

• Regulatory bodies such as the Securities and Exchange Commission and the Public Company Accounting Oversight Board

• Professional organizations such as the American Institute of Certified Public Accountants

 Auditors can be external or internal. External auditors are independent of the company and are responsible for ensuring that management prepares and issues financial statements that comply with accounting standards and fairly present the financial position and economic performance of the company. Because external auditors are independent parties, they lend a significant amount of credibility in the financial statements. Internal auditors are employees of the company serving in an advisory role to management and providing information regarding the company's operations and proper functioning of its internal controls.

Accounting standard setters develop and promulgate accounting concepts, rules, and guidelines that provide information that is relevant and faithfully represents the economic performance and the financial position of the reporting entity. The Financial Accounting Standards Board (FASB), the primary standard center in the United States, promulgates U.S. Generally Accepted Accounting Principles (U.S. GAAP). The International Accounting Standards Board (IASB) set International Financial Reporting Standards (IFRS). We discuss the standard-setters roll and the standard-setting process in more depth later.

Regulatory bodies protect investors and oversee the accounting standard-setting process. In the United States, the U.S. Securities and Exchange Commission (SEC) regulates publicly traded companies. Privately held companies are not required to comply with the SEC regulations. The SEC gives the FASB the authority to issue U.S. GAAP. In addition, the SEC reviews the filings of public companies in the United States. The Public Company Accounting Oversight Board (PCAOB) sets auditing standards and oversees the audits of public companies in the United States.

Professional organizations such as the American Institute of Certified Public Accountants (AICPA) are also involved in the financial reporting process. The AICPA is the national professional association for Certified Public Accountants (CPAs) in the United States. The AICPA prepares and grades the uniform CPA examination. This organization also supports accounting professionals throughout their careers by providing training, professional skills development, and other resources.

Exhibit 1.3 summarizes the various groups involved in the financial reporting process. 

EXHIBIT 1.3 Parties Involved in the Financial Reporting Process in the United States

Legal, Economic, Political, and Social Environment

Financial reporting takes place in a complex and dynamic world: Financial statement users' information needs change as business evolves. So, it is natural that environmental factors---legal, economic, political, and social---shape and influence the financial reporting process. The environment is the fourth element of the financial accounting definition, from part 1. Financial accounting interacts with its environment in both a reactive and proactive fashion.

Reactive Factors. Financial accounting reacts to pressure (lobbying) from various groups and changes in an environment. Accounting theories and procedures evolve to meet the dynamic changes and demands from the environment. For example, FASB made changes in the accounting for all balance sheet subsidiaries following the discovery of the massive fraud scheme at Enron in the early 2000s.

In addition, accounting conforms to economic conditions, legal standards, and social values. Today, accounting disclosures highlight a company's policies regarding pollution control, community service, and diversity in business.

The development of accounting standards is also a political process that is heavily influenced by the various groups within the reporting environment. Lobby groups include investors, creditors, financial analysts, the financial community, academics, accounting organizations, and industry associations.

Proactive Factors. Financial accounting is proactive in that it can change or influence its environment by providing feedback information that is used by organizations and individuals to reshape the economy. Accounting information is used to efficiently allocate resources throughout the economy by directing capital flows to their most productive uses. For example, startup capital is needed to develop new technology such as solar power and electric vehicles.

Accounting Standards can also influence managerial behavior. For example, expensing research and development costs may slow investment and research during economic downturns because this accounting treatment usually results in lower earnings figures.

*GORDON, RAEDY, & SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 5-8*

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