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Financial Reporting and Analysis (7th Ed.)
Chapter 1 Solutions
The Economic and Institutional Setting for Financial
Reporting
Problems
Problems
P1-1. Demand for accounting information (LO 1-1)
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 holdings be maintained? Financial
Shareholders also use financial accounting information to decide
how to vote 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
b) Financial statement information helps prospective (potential)
investors identify stocks consistent with their preferences for risk,
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 about companies and their securities
to actively managing portfolios for investors that prefer to delegate
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.
e) Current employees demand financial accounting information to
monitor payouts from profit-sharing plans and employee stock
ownership plans (ESOPs). Employees also demand financial
accounting information to gauge a company’s long-term viability and
f) Lenders use financial accounting information to help determine
the principal amount, interest rate, term, and collateral required on
loans they make. Loan agreements often contain covenants that
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
h) Debt-rating agencies like Moody’s or Standard & Poor’s help
lenders and investors assess the default risk of debt securities
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 targeted for special taxes or higher tax
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
Financial accounting information is also used in rate-making
Requirement 2:
Student responses will vary, but examples are shareholder activist
groups (CalPERS), labor unions, and customers.
Shareholder activist groups demand financial accounting
information to help determine how well the company’s current
Labor unions demand financial accounting information to help
formulate or improve their bargaining positions with employer
companies. Union negotiators may use financial statements
Customers demand financial accounting information to help
P1-2. Incentives for voluntary disclosure (LO 1-3)
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 investors are unsure about the “quality” of a
company’s debt and equity securities—the risks and returns of
b) Companies compete with one another for talented managers and
employees. Information about a company’s past financial
performance, its current health, and its prospects is useful to current
and potential employees who are interested in knowing about
c) Companies and their managers also compete with one another in
the “market for corporate control.” Here companies make offers to
buy or merge with other companies. Managers of companies that
are the target of a friendly merger or tender offer—a deal they want
done—have incentives to disclose information that raises the bid
price. Examples include forecasts of increased sales and earnings
Requirement 2:
Student responses will vary, but here are some examples:
Competitive forces from within the industry (i.e., other firms in
Demands by debt rating agencies such as Moody’s and
Pressure from governmental regulatory agencies such as the
Securities and Exchange Commission. Firms may believe that
Demands from institutional investors (e.g., mutual funds,
Requirement 3:
The following examples are press release items that could be
disclosed voluntarily: forecasts of current quarter or annual
earnings; forecasts of current quarter or annual sales; forecasts of
new product developments; patent applications and awards;
changes in top management; details of corporate restructurings,
spin-offs, reorganizations, plans to discontinue various divisions
The advantage of releasing such information in press releases is
that the news is made available to external parties on a far more
P1-3. Costs of disclosure (LO 1-3)
Requirement 1:
a) Information costs include costs to obtain, gather, collate,
maintain, summarize, and communicate financial statement data to
external users. Examples are the cost of computer hardware and
software, fees paid to audit financial statement data, salaries and
b) Competitive disadvantage costs occur when competitors are
able to use the information in ways detrimental to the company.
c) Litigation costs are costs to defend the company against
actions brought by shareholder and creditor lawsuits. These suits
claim that previous information about the company’s operating
performance and health was misleading, false, or not disclosed in a
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
Requirement 2:
Student responses to this question may vary. One possible cost is
when disclosure commits managers to a course of action that is not
optimal for the company. For example, suppose a company
P1-4. Determining why financial reporting rules differ (LO 1-5)
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 and the United States than they have
Financial accounting and reporting standards in German and Japan
tend to reflect the commercial and tax law approach described in
the chapter. In Germany and Japan, only a small amount of capital
has been provided by individual investors through public financial
markets. The primary source of capital for German companies has
been several large banks—and the government itself. Labor unions
P1-5. Generally accepted accounting principles (GAAP) (LO 1-4)
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 standards-setting
organizations such as the FASB, IASB and SEC; and (2) accounting
Requirement 2:
Why is GAAP important to independent auditors and to external
users? Independent auditors provide reasonable assurance that the
financial statements of the companies they audit “present fairly, in all
material respects” the financial position, results of operations, and
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
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. Today, the
The FASB follows a “due process” procedure in developing
accounting standards and updates that involves three steps: (1)
Requirement 4:
Describe the IASB organization and its role in establishing new
accounting standards. The International Accounting Standards
Board, formed in 1973, works to formulate accounting standards,
promote their worldwide acceptance, and achieve greater
Requirement 5:
How does the Securities and Exchange Commission (SEC) influence
the financial reporting practices of U.S. companies? The SEC retains
statutory power over the financial accounting and reporting practices
SEC.
