Financial Reporting And Analysis, 7th Edition Solution Manual

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Financial Reporting and Analysis (7thEd.)Chapter1SolutionsThe Economic and Institutional Setting for Financial ReportingProblemsProblemsP1-1.Demand for accounting information (LO 1-1)Requirement 1:a)Existing shareholdersuse financial accounting information as part oftheir ongoing investment decisions—should more shares of common orpreferred stock be purchased, should some shares be sold, or should currentholdings be maintained? Financial statements help investors assess theexpected risk and return from owning a company’s common and preferredstock. They are especially useful for investors who adopt a “fundamentalanalysis” approach.Shareholders also use financial accounting information to decide how to voteon 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 onbehalf of shareholders, the Board of Directors hires and fires the company’stop executives. Financial statement information helps shareholders and theboard assess the performance of company executives. Dismissals of topexecutives often occur following a period of deteriorating financialperformance.b) Financial statement information helpsprospective(potential) investorsidentify stocks consistent with their preferences for risk, return, dividend yield,and liquidity. Here too, financial statements are especially useful for thoseinvestors that adopt a “fundamental approach.”c)Financial analystsdemand accounting information because it is essentialfor their jobs. Equity (stock) and credit (debt) analysts provide a wide range ofservices ranging from producing summary reports and recommendationsabout companies and their securities to actively managing portfolios forinvestors that prefer to delegate buying and selling decisions to professionals.Analysts rely on information about the economy, individual industries, andparticular companies when providing these services. As a group, analystsconstitute probably the largest single source of demand for financialaccounting information—without it, their jobs would be difficult, if notimpossible, to do effectively.

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d)Managersdemand financial accounting information to help them carry outtheir responsibilities to shareholders. Financial accounting information is usedby managers to assess the profitability and health of individual business unitsand the company as a whole. Their compensation often depends on financialstatement numbers like earnings per share, return on equity, return on capitalemployed, sales growth, and so on. Managers often use a competitor’sfinancial statements to benchmark profit performance, cost structures,financial health, capabilities, and strategies.e)Current employeesdemand financial accounting information to monitorpayouts from profit-sharing plans and employee stock ownership plans(ESOPs). Employees also demand financial accounting information to gaugea company’s long-term viability and the likelihood of continued employment,as well as payouts under company-sponsored pension and health-careprograms. Unionized employees have other reasons to demand financialstatements, and those are described in Requirement 2 which follows.f)Lendersuse financial accounting information to help determine theprincipal amount, interest rate, term, and collateral required on loans theymake. Loan agreements often contain covenants that require a company tomaintain minimum levels of various accounting ratios. Because covenantcompliance is measured by accounting ratios, lenders demand financialaccounting information so they can monitor the borrower’s compliance withloan terms.g)Suppliersdemand financial accounting information about current andpotential customers to determine whether to grant credit, and on what terms.The incentive to monitor a customer’s financial condition and operatingperformance does not end after the initial credit decision. Suppliers monitorthe financial condition of their customers to ensure that they are paid for theproducts, materials, and services they sell.h)Debt-rating agencieslike Moody’s 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 flows.i)Taxing authorities(one type of government regulatory agency) usefinancial accounting information as a basis for establishing tax policies.Companies or industries that appear to be earning “excessive” profits may betargeted for special taxes or higher tax rates. Keep in mind, however, thattaxing authorities in the United States and many other countries are allowedtoset their own accounting rules. These tax accounting rules, and not GAAP,determine a company’s taxable income.Other government agencies are often customers of the company. In thissetting, financial information can serve to help resolve contractual disputes

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between the company and its customer (the agency) including claims that thecompany is earning excessive profits. Financial accounting information canalso be used to determine if the company is financially strong enough todeliver the ordered goods and services.Financial accounting information is also used in rate-making deliberationsand monitoring of regulated monopolies such as public utilities.Requirement 2:Student responses will vary, but examples are shareholder activist groups(CalPERS), labor unions, and customers.Shareholder activist groups demand financial accounting information tohelp determine how well the company’s current management team isdoing, and whether the managers are being paid appropriately.Labor unions demand financial accounting information to helpformulate 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.Customers demand financial accounting information to help determine ifthe company will be able to deliver the product on a timely basis andprovide product support after delivery.

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P1-2.Incentives for voluntary disclosure (LO 1-3)Requirement 1:a) Companies compete with one another for financial capital in debt andequity markets. They want to obtain financing at the lowest possible cost. Ifinvestors are unsure about the “quality” of a company’s debt and equitysecurities—the risks and returns of investment—they will demand a lowerprice (higher rate of return) than would otherwise be the case. Companieshave incentives to voluntarily provide information that allows investors andlenders to assess the expected risk and return of each security. Failing to doso means lenders may charge a higher rate of interest for the addedinformational risk, and stock investors will give the company less cash for itscommon or preferred stock.b) Companies compete with one another for talented managers andemployees. Information about a company’s past financial performance, itscurrent health, and its prospects is useful to current and potential employeeswho are interested in knowing about long-term employment opportunities,present and future salary and benefit levels, and advancement opportunitiesat the company. To attract the best talent, companies have incentives toprovide financial information that allows prospective managers andemployees to assess the risk and potential rewards of employment.c) Companies and their managers also compete with one another in the“market for corporate control.” Here companies make offers to buy or mergewith other companies. Managers of companies that are the target of afriendlymerger or tender offer—a deal they want done—have incentives to discloseinformation that raises the bid price. Examples include forecasts of increasedsales and earnings growth. Managers of companies that are the target ofunfriendly(hostile) offers—deals they don’t want done—have incentives todisclose information that shows the company is best left in the hands ofcurrent management. Hostile bidders often put a different spin on the samefinancial information, arguing that it shows just how poorly currentmanagement has run the company.

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Requirement 2:Student responses will vary, but here are some examples:Competitive forces from within the industry (i.e., other firms in the industryare voluntarily disclosing information about order backlogs, customerturnover, or other key performance indicators).Demands by financial analysts for expanded or increased disclosure bythe firm.Demands by shareholder activist groups such as CalPERS.Demands by debt rating agencies such as Moody’s andStandard &Poor’s.Pressure from governmental regulatory agencies such as the Securitiesand Exchange Commission. Firms may believe that disclosing certaininformation voluntarily may prevent the Securities and ExchangeCommission 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.Requirement 3:The following examples are press release items that could be disclosedvoluntarily: forecasts of current quarter or annual earnings; forecasts ofcurrent quarter or annual sales; forecasts of earnings growth for the next 3 to5 years; forecasts of sales growth for the next 3 to 5 years; capitalexpenditure plans or budgets; research and development plans or budgets;new product developments; patent applications and awards; changes in topmanagement; details of corporate restructurings, spin-offs, reorganizations,plans to discontinue various divisions and/or lines-of-business;announcements of corporate acquisitions and/or divestitures; announcementsof new debt and/or equity offerings; and announcements of short-termfinancing arrangements such as lines of credit. Other student responses arepossible.The advantage of releasing such information in press releases is that thenews is made available to external parties on a far more timely basis than ifdisclosure occurred in quarterly or annual financial statements. Pressreleases also give management an opportunity to help shape how the factsare interpreted.

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P1-3.Costs of disclosure (LO 1-3)Requirement 1:a)Information costsinclude 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 auditfinancial statement data, salaries and wages paid to corporate accountingstaff in charge of the firm’s financial accounting system, and costs to print andmail annual reports to shareholders or make them available electronically onthe company’s web site.b)Competitive disadvantagecosts occur when competitors are able to usethe information in ways detrimental to the company. Examples includehighlighting highly profitable products and services or geographical areas,technological innovations, new markets or product development plans, andpricing or advertising strategies.c)Litigation costsare costs to defend the company against actions broughtby shareholder and creditor lawsuits. These suits claim that previousinformation about the company’s operating performance and health wasmisleading, false, or not disclosed in a timely manner. Examples include thedirect costs paid to lawyers to defend against the suits, liability insurancecosts, loss of reputation, the productive time lost by managers andemployees as they prepare to defend themselves and the company againstthe suit.d)Political costsarise when, for example, regulators and politicians useprofit levels to argue that a company is earning excessive profits. Regulatorsand politicians advance their own interests by proposing taxes on thecompany or industry in an attempt to reduce the level of “excessive”profitability. These taxes represent a wealth transfer from the company’sshareholders to other sectors of the economy. Managers of companies inpolitically sensitive industries sometimes adopt financial reporting practicesthat reduce the level of reported profitability to avoid potential political costs.Requirement 2:Student responses to this question may vary. One possible cost is whendisclosure commits managers to a course of action that is not optimal for thecompany. For example, suppose a company discloses earnings and salesgrowth rate goals for a new product or market. If these projections becomeunreachable, managers may drop selling prices, offer “easy” credit terms, oroverspend on advertising in an attempt to achieve the sales and earningsgrowth goals.

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P1-4.Determining why financial reporting rules differ (LO 1-5)A country’s financial reporting philosophy evolves from and reflects thespecific legal, political, andfinancial institutions within the country. Externalinvestors are a much more important source of financial capital in Canadaand the United States than they have historically been in Germany andJapan. Consequently, financial accounting and reporting standards inCanada and the U.S. have evolved to meet this public financial marketdemand for information—what the chapter describes as the economicperformance approach.Financial accounting and reporting standards in German and Japan tend toreflect the commercial and tax law approach described in the chapter. InGermany and Japan, only a small amount of capital has been provided byindividual investors through public financial markets. The primary source ofcapital for German companies has been several large banks—and thegovernment itself. Labor unions have also played an important corporategovernance role in German companies. Large banks provide much of thefinancing in Japan. Along with the German labor unions, these few importantcapital providers wield great power including the ability to acquire informationdirectly from the firm. Because of this concentrated power and theinsignificance of the public financial market in these two countries, financialreporting standards tend to conform to income tax rules or commercial law.

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P1-5.Generally accepted accounting principles (GAAP) (LO 1-4)Requirement 1:What are generally accepted accounting principles (GAAP)? GAAP refers tothe network of conventions, rules, guidelines and procedures that shape thefinancial reporting practices of businesses and non-profit organizations. GAAPcomes from two main sources: (1) written pronouncements by designatedstandards-setting organizations such as the FASB, IASB and SEC; and (2)accounting practices that have evolved over time as preparers and auditorsdealt with new business transactions and circumstances not yet described inwritten pronouncements. The FASB’s Accounting Standards Codification isnow the sole authoritative source for written GAAP, although suggestedimplementation guidelines are provided by industry trade groups and theAICPA 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 financialstatements of the companies they audit “present fairly, in all material respects”the financial position, results of operations, and cash flows “in conformity withU.S. generally accepted accounting principles.” It is therefore essential thatindependent auditors possess a thorough understanding of GAAP and how itapplies to each specific client.The goal of GAAP in the United States and most other developed countries isto ensure that a company’s financialstatements represent faithfully itseconomic condition and performance. GAAP achieves this goal by providing aframework for determining when to record a business transaction or event(recognition), what dollar amount to record (measurement), how summaryinformation is to be displayed in financial statements (presentation), and whatadditional information to provide in the notes (disclosure). External usersbenefit when the GAAP framework ensures that the resulting statements andnotes accurately convey information about a company’s true economiccondition and performance.Requirement 3:Describe the FASB organization and how it establishes new accountingstandards. Although the Securities and Exchange Commission (SEC) hasultimate legal authority to determine accounting principles in the United States,it has looked to private-sector organizations to establish these principles.Today, the private sector standards setting organization is the FASB. It existsas an independent group with seven full-time members and a large staff.Board members are appointed for five-year terms and are required to sever allties with the companies and institutions they served prior to joining the board.The FASB follows a “due process” procedure in developing accountingstandards and updates that involves three steps: (1) Discussion-memorandumstage; (2) Exposure-draft stage; and (3) Voting stage. Public comments on

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discussion memoranda and exposure drafts are invited, and public hearingsare sometimes held.Requirement 4:Describe the IASB organization and its role in establishing new accountingstandards. The International Accounting Standards Board, formed in 1973,works to formulate accounting standards, promote their worldwide acceptance,and achieve greater convergence of financial reporting regulations, standards,and procedures across countries. Members are drawn from professionalaccounting organizations and businesses around the world.Requirement 5:How does the Securities and Exchange Commission (SEC) influence thefinancial reporting practices of U.S. companies? The SEC retains statutorypower over the financial accounting and reporting practices of registrantcompanies. This power includes the ability to issue financial accounting andreporting rules as well as to enforce compliance with the rules it issues or thoseissued by standards-setting organizations (e.g., FASB) as designated by theSEC.

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P1-6.Relevanceversus faithfulrepresentation (LO 1-1)Requirement 1:The Blue Book average price is morerelevantto the car buying decision thanis the list (or “sticker”) price shown on the manufacturer’s web site. Why?Because it better represents the price you can expect to pay for theautomobile.The Blue Book price describes the average price actually paid by recentbuyers for comparably equipped automobiles. Actual prices are the result ofarms-length negotiations between willing buyers and sellers, and thus reflectwhat you can expect to pay (on average) when you negotiate your automobilepurchase. The list (“sticker”) price is just a suggested retail price—the actualnegotiated price is often considerably less (but sometimes can be more) thanthe manufacturer’s list price.Requirement 2:The Blue Book price of $19,500 is lessrepresentationally faithfulthan themanufacturer’s list price. To understand why, notice that recent selling priceshave ranged from $18,000 to $22,000. This means that while you can expectto pay $19,500 on average for the automobile, it may cost you as little as$18,000 or as much as $22,000. On the other hand, there is little (if any)variation in the manufacturer’s list price—comparably equipped cars haveessentially the same list price.In this setting, reliability refers to price variation and there is morevariation(less reliability) in the underlying Blue Book prices than there is in themanufacturer’s list price.

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P1-7.Accounting Information Characteristics (LO 1-1)Requirement 1:“Cash” and “Net accounts receivable” are bothrelevantto the loan decisionbecause they provide information about cash flows and thus about thecompany’s ability to make principal and interest payments as they come due.The balance in “Accumulated depreciation”, on the other hand, says nothingabout the company’s current or future cash. Consequently, this information isnot relevant to the loan decision.Requirement 2:“Cash” is the mostrepresentationally faithfulbalance sheet item. Theamount of cash on hand and in the bank at a particular moment in time canbe determined with a high degree of accuracy. “Net accounts receivable” isless so because its determination requires estimates of future sales returnsand bad debts. These estimates, which are essential to the accountingprocess, reduce the faithful representation of this balance sheet item.“Accumulated depreciation” is also less representationally faithful than “Cash”because its measurement requires estimates of salvage (residual) value anduseful life.P1-8.Accounting Conservatism (LO 1-1)Requirement 1:Accounting conservatism requires that the land now be shown on the balancesheet at the lower amount $3 million, its estimated fair market value, ratherthat at the $5 million you paid two months ago. Conservatism is the practiceof recording possible losses—in this case, the decline in value of the land—as soon as they become probable and measurable.Requirement 2:Accounting conservatism requires that the land continue to be shown on thebalance sheet at the price paid two months ago ($3 million) rather than thehigher estimated fair value ($5 million). Conservatism records losses as soonas they are probable and measurable, but additional requirements must bemet to record gains (as you will soon discover in Chapter 2).

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P1-9.Factors Affecting Financial Reporting(LO1-2, LO 1-3, LO1-4)1) Accounting isnotan exact science. One reason this is the case is thatmany financial statement numbers are based on estimates of futureconditions (e.g., future bad debts and warranty claims). Another reason is thatthere is no single accounting method that is best for all companies andsituations. Thus, different companies use different methods to account forsimilar transactions (e.g., depreciation of property and the valuation ofinventory).2) While some managers may select accounting methods that produce themost accurate picture of a company’s performance and condition, othermanagers may make financial reporting decisions that are self-serving andstrategic. Consider the following examples:Managers who receive a bonus based on reported earnings or return onequity may make financial reporting decisions that accelerate revenuerecognition and delay expense recognition in order to maximize thepresent value of their bonus payments.Managers who must adhere to limits on financial accounting ratios in debtcovenants may make reporting decisions designed to avoid violation ofthese contracts.More generally, managers are likely to make financial reporting decisionsthat portray them in a good light.The moral is that financial analysts should approach financial statements withsome skepticism because management has tremendous influence over thereported numbers.3) This is probably true. Financial accounting is a slave to many masters.Many different constituencies have a stake in financial accounting andreporting practices—existing shareholders, prospective shareholders,financial analysts, managers, employees, lenders, suppliers, customers,unions, government agencies, shareholder activist groups, and politicians.The amount and type of information that each group demands is likely to bedifferent. As a result, accounting standards in the United States reflect theoutcome of a process where each constituency tries to advance its interests.Examples illustrating the politics of accounting standards are interspersedthroughout this book.4) This is false. Even without mandatory disclosure rules by the FASB andSEC, companies have incentives to voluntarily disclose information that helpsthem obtain debt and equity financing at the lowest possible cost. Failure todo so results in higher cost of debt and equity capital.

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5) This is true. If the information is value-relevant—meaning, important forinvestors to know—there is no obvious reason not to disclose the informationexcept when doing so places the company at a competitive disadvantage.6) The best response is that the statement is false because:Managers have incentives to develop and maintain a good relationshipwith financial analysts. Failing to disclose value-relevant information (goodor bad) on a timely basis can damage this relationship.Under the U.S. securities laws, shareholders can sue managers for failingto disclose material financial information on a timely basis. To reducepotential legal liability under shareholder lawsuits, managers haveincentives to disclose even bad news in a timely manner.7) This may be true or false. If a company discloses so little information thatinvestors and lenders cannotadequately assess the expected return and riskof its securities, then its cost of capital will be high. In this case, managers aredoing shareholders a disservice by not disclosing more information tofinancial markets. If, on the other hand, increased disclosure harms thecompany’s competitive advantage, managers have helped shareholders.

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P1-10.Economic Consequences of Accounting Standards (LO 1-3)Requirement 1:There are several economic consequences that could arise when companiesare forced to alter their past accounting methods—in this case, by recording anew liability and corresponding expense.Mandatory changes in accounting methods of this sort can disrupt contractsthat are defined in terms of accounting ratios. One example is a loanagreement that restricts the firm from exceeding some maximum debt-to-equity ratio. The accounting change will add additional dollars to debt andsimultaneously subtract dollars from equity, and thus may cause the firm toviolate its lending agreement. The costs associated with violating theagreement represent an economic consequence of the accounting change.In response to the possibility of violating the loan agreement, managementmay decide to sell some otherwise productive assets. The cash raised couldthen be used to pay down debt, and the accounting gain would increasereported equity. This would soften the adverse effect of the accountingchange on the company’s debt-to-equity ratio. But notice that the asset sale isoccurring only in response to the accounting change—and thus it toorepresents an economic consequence of the change.And, as described in requirement 2, management may decide to reduce orcurtail employee healthcare benefits so that the recorded liability (andexpense) is as small as possible. This benefit reduction becomes aneconomic consequence borne by employees of the company.Requirement 2:There are widely divergent views on whether the FASB should consider theeconomic consequences of its actions when formulating accountingstandards.On the one hand,SFAC No.2states that “neutrality” is a desiredcharacteristic of financial statement information. Neutrality means that theinformation cannot be selected to favor one set of interested parties overanother. So, real liabilities cannot remain unrecorded just because recordingthem may cause some firms to violate their lending agreements. Whenapplied to the standard setting process, neutrality means that the FASBshould ignore the economic consequences of alternative accountingpractices.A more practical problem is that it is exceedingly difficult to quantify thoseconsequences in any meaningful way. How can the FASB determine which

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firms will likely violate their lending agreements or what it will cost them if theydo so? And what about the economic consequences of likely changes inmanagement’s actions (e.g., asset sale, reduced employee benefits, etc.)?Even if the FASB was able to quantify all of the potential consequencesassociated with a particular proposed accounting change, it would still facethe gargantuan task of deciding whether the total benefits outweighed thetotal costs to the various parties involved. For example, should lenders befavored and employees harmed by requiring heath care liabilities to be shownon the balance sheet? Or, should lenders be harmed and employees favoredby keeping health care liabilities off the balance sheet?Of course, the interested parties themselves fervently believe the FASBshould consider the economic consequences of alternative accountingpractices when formulating standards. To do otherwise, they argue, is toignore a simple fact that mandatory accounting changes sometimes have realconsequences.

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