Financial Reporting and Analysis Chapter Solutions …

1 1-1 Financial Reporting and AnalysisChapter 1 SolutionsThe Economic and institutional Setting for Financial ReportingProblemsProblemsP1-1 .Demand for accounting informationRequirement 1:a) Existing shareholders use Financial accounting information as part of theirongoing investment decisions should more shares of common or preferred stockbe purchased, should some shares be sold, or should current holdings bemaintained? Financial statements help investors assess the expected risk andreturn from owning a company s common and preferred stock.

2 They areespecially useful for investors who adopt a fundamental Analysis also use Financial accounting information to decide how to vote oncorporate matters like who should be elected to the board of directors, whether aparticular management compensation plan should be approved, and if thecompany should merge with or acquire another company. Acting on behalf ofshareholders, the Board of Directors hires and fires the company s top statement information helps shareholders and the board assess theperformance of company executives.

3 Dismissals of top executives often occurfollowing a period of deteriorating Financial ) Financial statement information helps potential (prospective) investorsidentify stocks consistent with their preferences for risk, return, dividend yield, andliquidity. Here too, Financial statements are especially useful for those investorsthat adopt a fundamental approach. c) Financial analysts demand accounting information because it is essential fortheir jobs. Buy-side and sell-side analysts provide a wide range of servicesranging from producing summary reports and recommendations about companiesand their securities to actively managing portfolios for investors that prefer todelegate buying and selling decisions to professionals.

4 Analysts rely oninformation about the economy, individual industries, and particular companieswhen providing their services. As a group, analysts constitute probably the largestsingle source of demand for Financial accounting information without it, their jobswould be difficult, if not impossible, to do ) Managers demand Financial accounting information to help them carry outtheir responsibilities and because their compensation often depends onfinancial statement numbers like earnings per share, return on equity, return oncapital employed, sales growth, and so on.

5 Managers often use a competitor s1-2financial statements to benchmark profit performance, cost structures, financialhealth, capabilities, and ) Current employees demand Financial accounting information to monitorpayouts from profit-sharing plans and employee stock ownership plans(ESOPs). Employees also demand Financial accounting information to gauge acompany s long-term viability and the likelihood of continued employment, aswell as payouts under company-sponsored pension and health-care employees have other reasons to demand Financial statements, andthose are described in Requirement 2 which ) Lenders use Financial accounting information to help determine the principalamount, interest rate, term, and collateral required on loans they make.

6 Loanagreements often contain covenants that require a company to maintainminimum levels of various accounting ratios. Because these covenants containaccounting ratios, lenders demand Financial accounting information so they canmonitor the borrower s compliance with loan ) Suppliers demand Financial accounting information about current andpotential customers to determine whether to grant credit, and on what incentive to monitor a customer s Financial condition and operatingperformance does not end after the initial credit decision.

7 Suppliers monitor thefinancial condition of their customers to ensure that they are paid for theproducts, materials, and services they ) Debt-rating agencies like Moodys or Standard & Poor s help lenders andinvestors assess the default risk of debt securities offered for sale. Ratingagencies need Financial accounting information to evaluate the level andvolatility of the company s expected future cash ) Taxing authorities (one type of government regulatory agency) use financialaccounting information as a basis for establishing tax policies.

8 Companies orindustries that appear to be earning excessive profits may be targeted forspecial taxes or higher tax rates. Keep in mind, however, that taxing authoritiesin the United States and many other countries are allowed to set their ownaccounting rules. These tax accounting rules, and not GAAP, determine acompany s taxable government agencies are often the customer. In this setting, financialinformation can serve to help resolve contractual disputes between thecompany and its customer (the agency) including claims that the company isearning excessive profits.

9 Financial accounting information can also be used todetermine if the company is financially strong enough to deliver the orderedgoods and accounting information is also used in rate-making deliberations andrate monitoring of regulated monopolies such as public 2:Student responses will vary, but examples are shareholder activist groups(CalPERS), labor unions, and customers. Shareholder activist groups demand Financial accounting information to helpdetermine how well the company s current management team is doing, andwhether the managers are being paid appropriately.

10 Labor unions demand Financial accounting information to help formulate orimprove their bargaining positions with employer companies. Unionnegotiators may use Financial statements showing sustained or improvedprofitability as evidence that employee wages and benefits should beincreased. P1-2. Incentives for voluntary disclosure Requirement 1: a) Companies compete with one another for Financial capital in debt and equitymarkets. They want to obtain financing at the lowest possible cost. If investorsare unsure about the quality of a company s debt and equity securities therisks and returns of investment they will demand a lower price (higher rate ofreturn) than would otherwise be the case.