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INT / INC - 1

Users of Financial Statements

What you look for in the statements depends on your objectives

�Equity investment profitability, risk, cash generating ability

live paper help

�Merger and acquisition profitability, risk, price to pay, impact on financial


�Credit extension/Customer health short-term vs. long-term, ability to pay interest &

-principal, liquidity.

�Supplier health (supplier of key raw material, suppliers quality, JIT) cash

generating ability, profitability.

�Employer health (employees, unions) long-term viability & ability to meet pension

liabilities, profitability, risk.

�Internal operation analysis analysis of business segments performance, cost,

profit, budgeting, and business strategy.

�Antitrust regulations monopoly power (profitability, market share), cost of capital,

justifying merger through failing company doctrine disregarding monopoly


�Competitors analysis profitability, profit margins, market share (aids in pricing,

product mix).

�Audit tests going concern judgements by auditors.

�Legal judgement fraudulent conveyance.

Concentrate on investors and creditors

(Covers most users).


Financial statements (the reports produced by the financial accounting system), in

theory, aim at providing information useful for these two groups, while limiting the

information available for competitors.

What information is considered useful to investors and creditors?

1 Information that helps in predicting future cash flows. Investors are primarily

interested in valuing firms.

Information relating to a firm’s risk characteristics - liquidity, solvency

Information that may serve as an observable on which contracts are written.

Two simple examples

Example 1

Corporate lending contracts typically contain certain restrictions on the

borrowing party in order to reduce its risk of default. These restrictions

are typically based on accounting variables such as debt-equity, ratios

and working capital.


Managers compensation is tied to firm performance that is often

measured by reported earnings.

Does this however hold true in practice?


The Adversarial Nature of Financial Reporting

Corporations and Management have substantial incentives to exploit the fact that

accounting principles are neither fixed nor precise as to be open to only one

interpretation. (e.g., SEC requires companies to disclose information if it is material

but does not define materiality with great precision.) The simple fact that preparers

of financial statements spend time contemplating issues such as the accounting

methods to be used (e.g., LIFO or FIFO), what is to be disclosed, the timing of the

disclosure, etc., indicates that they believe that their choice makes a difference.

The incentives to exploit the nature of financial reporting are twofold

1. As part of the fiduciary duty to shareholders

A corporation exists for the benefit of its shareholders, not for the purpose of

educating the public about its financial condition. Bearing in mind this fiduciary

responsibility, corporate managers may ask themselves whether they are acting

responsibly if they do not take advantage of legal opportunities to maximize

shareholder’s wealth.

. For self-serving reasons as management compensation and perhaps their

job itself is tied to financial results

These reasons lead to the following conclusion on the part of management






FASB and SEC prohibit companies from going too far in this direction, but once

managers accept the premise that financial statements are instruments for

maximizing shareholders’ wealth, they will realize the benefits by preparing the

statements so as to

1. lower cost of capital (risk)

. create higher earnings expectations

. downplay real and contingent liabilities

INT / INC - 5

Accounting Definitions of Income - Review

A major problem in measuring firm performance for a specific accounting

period arises in situations where a transaction is started in one period but will

be completed in a future period.

Two approaches to determine the timing of earnings recognition exist

Cash basis of accounting

Accrual basis of accounting

The difference between these two methods is in the time when they

consider a transaction as completed, namely, when they recognize earnings.

(i.e., the question is when revenues and/or expenses are reported (i.e.,

recognized) in the income statement.). Over the life of the firm, income and

cash flows converge. They differ only as to timing of recognition.

Accounting concept of income

Purpose . Informational . Future Cash Flows

Question If purpose of accounting is to forecast future cash flows why not

just provide cash flows or cash basis income.

Answer Accrual accounting “better” forecaster of future cash flows

�e.g. spend $10 to purchase asset which is sold for $1 on account

What is better forecast of profitability ($10) or $?

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