978-0078025679 Chapter 1 Solution Manual Part 1

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Education.

Financial Reporting and Analysis (6th Ed.)

Chapter 1 Solutions

The Economic and Institutional Setting for Financial Reporting

Problems

P1–1. Demand for accounting information

Requirement 1:

a) Existing shareholders use financial accounting information as part of

their ongoing investment decisions—should more shares of common or

preferred stock be purchased, should some shares be sold, or should current

on corporate matters like who should be elected to the board of directors,

whether a particular management compensation plan should be approved,

and if the company should merge with or acquire another company. Acting on

behalf of shareholders, the Board of Directors hires and fires the company’s

top executives. Financial statement information helps shareholders and the

and liquidity. Here too, financial statements are especially useful for those

investors that adopt a “fundamental approach.”

c) Financial analysts demand accounting information because it is essential

for their jobs. Equity (stock) and credit (debt) analysts provide a wide range of

services ranging from producing summary reports and recommendations

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d) Managers demand financial accounting information to help them carry out

their responsibilities to shareholders. Financial accounting information is used

by managers to assess the profitability and health of individual business units

and the company as a whole. Their compensation often depends on financial

statement numbers like earnings per share, return on equity, return on capital

(ESOPs). Employees also demand financial accounting information to gauge

a company’s long–term viability and the likelihood of continued employment,

as well as payouts under company-sponsored pension and health-care

programs. Unionized employees have other reasons to demand financial

statements, and those are described in Requirement 2 which follows.

accounting information so they can monitor the borrower’s compliance with

loan terms.

g) Suppliers demand financial accounting information about current and

potential customers to determine whether to grant credit, and on what terms.

The incentive to monitor a customer’s financial condition and operating

agencies need financial accounting information to evaluate the level and

volatility of the company’s expected future cash flows.

i) Taxing authorities (one type of government regulatory agency) use

financial accounting information as a basis for establishing tax policies.

Companies or industries that appear to be earning “excessive” profits may be

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Other government agencies are often customers of the company. In this

setting, financial information can serve to help resolve contractual disputes

between the company and its customer (the agency) including claims that the

company is earning excessive profits. Financial accounting information can

P1–2. Incentives for voluntary disclosure

Requirement 1:

a) Companies compete with one another for financial capital in debt and

equity markets. They want to obtain financing at the lowest possible cost. If

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current health, and its prospects is useful to current and potential employees

who are interested in knowing about long-term employment opportunities,

present and future salary and benefit levels, and advancement opportunities

at the company. To attract the best talent, companies have incentives to

provide financial information that allows prospective managers and

information that raises the bid price. Examples include forecasts of increased

sales and earnings growth. Managers of companies that are the target of

unfriendly (hostile) offers—deals they don’t want done—have incentives to

disclose information that shows the company is best left in the hands of

current management. Hostile bidders often put a different spin on the same

are voluntarily disclosing information about order backlogs, customer

turnover, or other key performance indicators).

Demands by financial analysts for expanded or increased disclosure by

the firm.

Demands by shareholder activist groups such as CalPERS.

Commission from mandating more detailed disclosures at a later date.

Demands from institutional investors (e.g., mutual funds, pension funds,

insurance companies, etc.) that hold the company’s securities.

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current quarter or annual sales; forecasts of earnings growth for the next 3 to

5 years; forecasts of sales growth for the next 3 to 5 years; capital

expenditure plans or budgets; research and development plans or budgets;

new product developments; patent applications and awards; changes in top

P1–3. Costs of disclosure

Requirement 1:

a) Information costs include costs to obtain, gather, collate, maintain,

summarize, and communicate financial statement data to external users.

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d) Political costs arise when, for example, regulators and politicians use

profit levels to argue that a company is earning excessive profits. Regulators

and politicians advance their own interests by proposing taxes on the

company or industry in an attempt to reduce the level of “excessive”

P1–4. Determining why financial reporting rules differ

A country’s financial reporting philosophy evolves from and reflects the

specific legal, political, and financial institutions within the country. External

investors are a much more important source of financial capital in Canada

P1–5. Generally accepted accounting principles (GAAP)

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Requirement 1:

What are generally accepted accounting principles (GAAP)? GAAP refers to

the network of conventions, rules, guidelines and procedures that shape the

financial reporting practices of businesses and non-profit organizations. GAAP

comes from two main sources: (1) written pronouncements by designated

implementation guidelines are provided by industry trade groups and the

AICPA through its various industry guides.

Requirement 2:

Why is GAAP important to independent auditors and to external users?

Independent auditors provide reasonable assurance that the financial

The goal of GAAP in the United States and most other developed countries is

to ensure that a company’s financial statements represent faithfully its

economic condition and performance. GAAP achieves this goal by providing a

framework for determining when to record a business transaction or event

(recognition), what dollar amount to record (measurement), how summary

Requirement 3:

Describe the FASB organization and how it establishes new accounting

standards. Although the Securities and Exchange Commission (SEC) has

ultimate legal authority to determine accounting principles in the United States,

it has looked to private-sector organizations to establish these principles.

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stage; (2) Exposure-draft stage; and (3) Voting stage. Public comments on

discussion memoranda and exposure drafts are invited, and public hearings

are sometimes held.

Requirement 4:

P1–6. Relevant versus faithful representation

Requirement 1:

The Blue Book average price is more relevant to the car buying decision than

is the list (or “sticker”) price shown on the manufacturer’s web site. Why?

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variation in the manufacturer’s list price—comparably equipped cars have

essentially the same list price.

P1-7. Accounting Information Characteristics

Requirement 1:

“Cash” and “Net accounts receivable” are both relevant to the loan decision

because they provide information about cash flows and thus about the

P1–8. Accounting Conservatism

Requirement 1:

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Accounting conservatism requires that the land continue to be shown on the

balance sheet at the price paid two months ago ($3 million) rather than the

P1–9. Your position on the issues

1) Accounting is not an exact science. One reason this is the case is that

many financial statement numbers are based on estimates of future

2) While some managers may select accounting methods that produce the

most accurate picture of a company’s performance and condition, other

managers may make financial reporting decisions that are self-serving and

strategic. Consider the following examples:

3) This is probably true. Financial accounting is a slave to many masters.

Many different constituencies have a stake in financial accounting and

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Education.

outcome of a process where each constituency tries to advance its interests.

Examples illustrating the politics of accounting standards are interspersed

throughout this book.

4) This is false. Even without mandatory disclosure rules by the FASB and

6) The best response is that the statement is false because:

Managers have incentives to develop and maintain a good relationship

7) This may be true or false. If a company discloses so little information that

investors and lenders cannot adequately assess the expected return and risk

P1-10. Economic Consequences of Accounting Standards

Requirement 1:

There are several economic consequences that could arise when companies

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violate its lending agreement. The costs associated with violating the

agreement represent an economic consequence of the accounting change.

In response to the possibility of violating the loan agreement, management

may decide to sell some otherwise productive assets. The cash raised could

then be used to pay down debt, and the accounting gain would increase

curtail employee healthcare benefits so that the recorded liability (and

expense) is as small as possible. This benefit reduction becomes an

economic consequence borne by employees of the company.

Requirement 2:

There are widely divergent views on whether the FASB should consider the

another. So, real liabilities cannot remain unrecorded just because recording

them may cause some firms to violate their lending agreements. When

applied to the standard setting process, neutrality means that the FASB

should ignore the economic consequences of alternative accounting

practices.

Even if the FASB was able to quantify all of the potential consequences

associated with a particular proposed accounting change, it would still face

the gargantuan task of deciding whether the total benefits outweighed the

total costs to the various parties involved. For example, should lenders be

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Of course, the interested parties themselves fervently believe the FASB

should consider the economic consequences of alternative accounting

P1–11. Two Sets of Books

Requirement 1:

Companies maintain a set of “tax” books to properly compute taxable income

according to IRS rules. Companies maintain a set of GAAP books to properly

valuation or credit risk assessment.

Political compromises have a substantial impact on tax law, and thus on

P1–12. Accounting quality and the audit committee