Discussion Questions for Chapter 1

Transcription

1 Discussion Questions for Chapter 1 1. Capital providers include both equity and debt investors. Purchasing 100 shares of IBM common stock is an example of an equity investment. Bank loans and extensions of credit represent debt investments. a. What are the basic differences between equity and debt investments? Which kind of investment entails greater risk? Which has the potential for greater returns? b. What kind of financial information would you consider when deciding to purchase IBM common stock? Would you consider the same kind of information if you were a banker considering a loan to IBM? 2. What does it mean to be solvent? What kind of information would be useful in assessing solvency? Would debt or equity investors be more likely to take a greater interest in assessing a company s solvency position? Why? 3. What is the purpose of the audit and the auditor s report? What benefits do audits provide managers and investors? Under what conditions would managers choose not to have audited financial statements? 4. What is meant by independent when describing auditors? Why is it important that they be independent? What incentives do they have to be independent? Are there pressures on auditors not to be independent? If so, from where? 5. We have stated that financial statements must contain objective and verifiable numbers if they are to be useful. Yet, we have also pointed out that many estimates and subjective assumptions are required for the preparation of these reports. Can you reconcile these apparently inconsistent statements? 6. What incentives might managers have to manipulate the numbers on the financial statements by choosing various estimates, assumptions and accounting methods? Are generally accepted accounting principles (GAAP) broad enough to allow for such manipulation? How does this present problems for financial statement users?

2 Discussion Questions for Chapter 2 1. If financial statements are to encourage the exchange of capital among investors, creditors and managers, of what two general concepts must they provide measures? Explain the similarities and differences between the two concepts. 2. The balance sheet is associated with a specific date. The income statement, statement of retained earnings and statement of cash flows are each associated with a period of time. What does this mean in terms of the kind of information each statement provides, and how is each statement related to the accounting equation? 3. Suppose a manager is choosing between debt and equity as a means of financing a large investment. Describe the financial statement effects of these two forms of financing and/or any associated economic consequences. 4. From what three sources do a company s assets come from? Define each source and explain how the right side of the balance sheet provides a summary of them. 5. What is a prepaid expense and what liability account represents the reverse of a prepaid expense? Do these accounts represent cash inflows and outflows, respectively? 6. What is the difference between short-term investments, listed in the asset section of the balance sheet, and capital stock, which can be found in the contributed capital portion of the balance sheet? 7. What income statement account is closely related to plant and equipment on the balance sheet? 8. What two asset accounts are closely related to the income statement account Sales? Can you name a liability account that relates to sales? Go down the income statement and relate each income statement account to one or more balance sheet accounts. 9. Net cash flow from operating activities is listed on the statement of cash flows. This number is similar to, yet different from, net income, which appears on the income statement. Explain the similarities and differences between these two numbers. How do these two measures of operations relate to earnings power and solvency?

3 Answers to the Discussion Questions for Chapter 1 1a. A debt investment arises when an investor loans money to a company. In order words, a debt investor is a creditor of the company. Alternatively, an equity investment arises when an investor purchases an ownership interest in a company. Debt investments usually involve a formal contract, and these contracts specify the maturity date of the investment, require periodic interest payments, collateral for the loan (if any), and any other restrictions. Equity investments rarely give rise to a formal contract, and equity investors are not entitled to any pre-specified periodic payments. Instead, equity investors receive dividend payments at the discretion of the company s Board of Directors. In addition, if the company goes bankrupt, a debt investor can claim the collateral and equity investors will only receive something after the claims of the creditors have been satisfied. Taken together, these items imply that equity investments entail greater risk than debt investments. However, as compensation for bearing increased risk, equity investors have the potential to earn greater returns than debt investors. The return on a debt investment is typically limited to the return specified in the debt contract. Alternatively, an equity investor, as the residual owner of the company, is entitled to all returns in excess of that paid to the debt investors. This means that an equity investor has unlimited upside potential. 1b. As owners of the company, equity investors share in the company s profits (or lack thereof). Consequently, if a company performs well over the long run, the equity investors should receive a larger return, but if the company performs poorly over the long run, the equity investors should receive a lower return. Potential equity inventors in IBM would be interested in financial information that would allow them to evaluate IBM s future earnings power. On the other hand, debt investors are more concerned with whether IBM will have sufficient cash to make principal and interest payments. This focus is more concerned with IBM s short-term cash availability. Consequently, potential debt investors in IBM would desire financial information that would allow them to evaluate IBM s solvency position. 2 Solvency refers to a company s ability to meet its debts as they become due. Debt investors loan money to a company for a limited period of time, so debt investors are concerned with whether the company will have sufficient cash to make interest payments and repay the principal. Alternatively, equity investors are the owners of the company and, hence, invest their money for a longer period of time. The equity owners are more interested in the company s long-run performance. Debt investors are more interested in a company s solvency position than equity investors. Debt investors would be interested in several types of information. First, they would desire information on how much cash and cash equivalents the company currently

4 possesses. Second, they would desire information on the magnitude and timing of future debt payments. Third, they would desire information on the value of assets that could be sold to satisfy their and other creditors claims. 3 The purpose of an audit is to provide assurances to the debt and equity owners that the financial statements have been prepared according to generally accepted accounting principles (GAAP) and are free from material misstatements. The audit opinion conveys these assurances. By providing these assurances to the owners, managers can attract capital to the company. Companies whose securities are publicly traded are required by the SEC to have their financial statements audited by independent auditors. If the companies securities are not publicly traded, there is no requirement that the financial statements be prepared in accordance with GAAP. However, such nonpublic companies may have debt investors that require audited financial statements. In this case, though, the accounting principles used to prepare the financial statements can be negotiated between the creditor and the company; hence, the financial statements are not required to be prepared in accordance with GAAP. If a company does not prepare its financial statements in accordance with GAAP, the auditor will give the company a qualified opinion. 4 Independent, in reference to auditors, means that the auditor is not biased towards the company s management. If auditors were not independent, the debt and equity owners would not place any reliance upon the auditors assurances as to the fairness of the company s financial statements. This lack of reliance would, in turn, result in lower levels of capital being provided to companies (at a higher cost). Management hires and pays an auditor to audit the company s financial statements. Since management pays the auditor, the auditor has incentives to bow to management s wishes. In the extreme, managers may threaten to shop for a new auditor that will be more compliant. These incentives not to be independent are offset by (1) the auditor s legal liability to the debt and equity investors and (2) the auditor s professional reputation. If the auditor attests to the fairness of financial statements and the financial statements are later proved to be materially misstated, the auditor is liable for the losses incurred by investors. In addition, the auditor s

5 reputation would be damaged, which may impair the auditor s ability to attract and retain clients. 5 Financial statement users want information that is useful for making decisions, which means that the information should be both reliable and relevant. In order to be reliable, the information needs to be objective and verifiable. However, obtaining completely objective and verifiable information may take so long that the information is no longer relevant. That is, the information is not received when the financial statement users want to make a decision. Thus, there is a tradeoff between reliably information and timely information. The solution to this tradeoff is to use objective and verifiable numbers where possible, and use estimates and assumptions to generate other numbers in order to make the financial statements more timely. Thus, estimates and assumptions are necessary to provide financial statement users with timely information for decision-making purposes. In addition, estimates and assumptions allow managers to prepare financial statements that reflect the economic environment faced by the company. 6 Managers are parties to a multitude of explicit and implicit contracts in their role as managers. For example, many managers are paid incentive compensation equal to a certain percentage of net income and companies (and, hence, managers) are often parties to debt covenants with the company s creditors. Many of these contracts provide managers with incentives to manipulate the financial statements. If a manager can increase earnings, the manager can increase his or her incentive compensation. Or if a manager can increase the company s working capital ration, decrease the company s debt/equity ratio, or increase the company s net income,

6 the manager can decrease the probability of violating the company s debt covenants. GAAP provide some limits on a manager s ability to manipulate financial statements. The SEC requires publicly held companies to adhere to GAAP; consequently, a manager of a publicly held company must select accounting principles from within the principles acceptable under GAAP. Managers can make estimates and assumptions and select acceptable accounting principles that serve their interests. GAAP simply sets constraints on managers ability to manipulate financial statements. It does not prevent the manipulation. Since managers still possess some discretion in selecting accounting principles and in making estimates and assumptions, financial statement users must by wary. Financial statement users must consider management s incentives to bias the financial statements when relying on financial statement information for decisionmaking purposes. Answers to the Discussion Questions for Chapter 2 1. Investors desire information that will help them evaluate a company s solvency position and earnings power. Solvency refers to a company s ability to meet its debt payments (principal and interest) as they become due and earnings power refers to a company s ability to generate net assets in the future through operations. Both concepts address the company s ability to exist into the future and to generate sufficient cash. That is, in order for a company to have earnings power, the company must exist, and to continue to exist, the company must be solvent. Similarly, in order for a company to be solvent in the long term, the company must have earnings power so that it can generate assets to make the debt payments. Of the two concepts, solvency focuses more on a short-term horizon while earnings power focuses more on a long-term horizon. 2. Since the balance sheet is associated with a specific date, it provides information on the company s financial position as of that specific date. Alternatively, the income statement, the statement of retained earnings and the statement of cash flows are associated with a period of time. Thus, these three statements provide information on the inflows and outflows associated with transactions during that period of time. The balance sheet is a statement of the accounting equation. The income statement provides information on the flow of net assets from operations into the company during the period. The statement of retained earnings and the statement of cash flows both provide information on components of the accounting equation. The statement of retained earnings explains the changes during the accounting period in the retained earnings balance, a stockholders equity account. The statement of

7 cash flows explains the change during the accounting period in the cash balance, an asset account. 3. If a company incurred debt to finance the investment, the amount payable would appear in the liability section of the balance sheet, and related maturities, interest rates and covenant restrictions would be disclosed. Several economic consequences are associated with the decision to use debt. A company s level of debt relative to other forms of financing would influence a financial statement user s perception about the company s capacity to incur additional debt. The scheduled repayments of principal and interest represent future short and long-term cash flow requirements. Debt covenants may restrict management s freedom to make certain investing and financing decisions in the future. Also, reported net income is important to many financial statement users and it would be less because of the interest expense on the debt. Equity financing would appear in the stockholders equity section of the balance sheet. An increase in the level of equity relative to other forms of financing would likely have positive consequences in terms of a company s perceived capacity for future borrowings. Future cash flow requirements would be affected to the extent that the company pays dividends. The economic cost of equity is not reflected in the financial statements, and net income would not be affected. An individual shareholder s proportionate interest would be reduced. 4. Assets are acquired through borrowings, owner contributions, and operations. These three sources comprise the right-hand side of the balance sheet. The claims on the assets acquired through borrowings are called liabilities. The claims on the assets acquired through owner contributions are part of stockholders equity called contributed capital. The assets acquired through operations are also part of stockholders equity, with is called earned capital, which is captured in retained earnings. The balance in retained earnings represents the company s cumulative earnings not yet promised to stockholders in the form of dividends. 5. Prepaid expenses represent expenses that the company has paid before using the corresponding service or right. An example would be paying rent on a building before actually using the building. The flip side of a prepaid expense is deferred revenue, a liability. Deferred revenue arises if a company collects cash for a service or right before providing the service or right. 6. Short-term investments represent an equity investment by a company in another company. On the other hand, capital stock represents ownership rights given out by a company. So, if IBM purchases common stock directly from Xerox, IBM would report short-term investments while Xerox would report contributed capital. 7. As the cost of plant and equipment is allocated to periods in which it provides benefits, the cost is allocated to the income statement. The appropriate income statement account is depreciation expense.

8 8. A company should recognize revenue when the company becomes entitled, through operating activities, to collect cash from another entity. The actual cash collection could (1) take place at the same time (which would increase cash when revenue is recognized), (2) take place at a later date (which would give rise to an account receivable when the revenue is recognized), or (3) take place at an earlier date (which would result in a decrease in deferred revenue when revenue is recognized). Thus, the asset accounts that are related to the account Sales are Cash (for cash sales) and Accounts Receivable (for credit sales). The liability account that is related to the account Sales is Deferred Revenue, sometimes called unearned revenue. Every income statement account is associated with at least one balance sheet account. Some of the more common relationships are presented below. Cost of goods sold is related to inventory and accounts payable. Depreciation expense is related to fixed assets, specifically the accumulated depreciation account. Expenses can be related to prepaid expenses or accrued expenses payable. 9. Net cash flow from operating activities and net income both provide a measure of the company s operating performance for a period of time. Net cash flows from operating activities provide information about only those operating transactions that affect cash. Net income provides information on all the operating activities that affect any asset or liability account. Thus, net income is a broader measure of performance than net cash flow from operating activities because net income focuses on all assets and liabilities, not just one asset (cash). Because of its focus on all assets and liabilities, net income is more useful that net cash flows from operating activities for assessing a company s earnings power. Alternatively, because of its focus on cash, which is used to make interest and principal payments, net cash flow from operating activities is more useful than net income for assessing a company s solvency.