978-1259722653 Chapter 1 Solution Manual Part 1

Unlock access to all the studying documents.

View Full Document

Financial Reporting and Analysis (7th Ed.)

Chapter 1 Solutions

The Economic and Institutional Setting for Financial

Reporting

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.