Solution Manual for Financial Reporting and Analysis 8th Edition by Lawrence Revsine, Daniel Collins, Bruce Johnson, Fred Mittelstaedt, Leonard Soffer Financial Reporting and Analysis ( 8th 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 statements help investors assess the expected risk and return from owning a company’s common and preferred stock. They are especially useful for investors who adopt a ―fundamental analysis‖ approach. 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 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 board assess the performance of company executives. Dismissals of top executives ofte n occur following a period of deteriorating financial performance. b) Financial statement information helps prospective (potential) investors identify stocks consistent with their preferences for risk, return, dividend yield, and liquidity. Here too, fina ncial 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 about companies and their securities to actively managing portfolios for investors that prefer to delegate buying and selling decisions to professionals. Analysts rely on information about the economy, individual industries, and particular companies when providing these services. As a group, analysts constitute probably the largest single source of demand for financial 6-2 Copyright © 2021 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. accounting information —without it, their jobs would be difficult, if not impossible, to do effectively. 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 bu siness 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 employed, sales growth, and so on. Managers often use a competitor’s financial statements to benchmark profit performance, cost structures, financial health, capabilities, and strategies. e) Current employees demand financial accounting information to monitor payouts from profit -sharing plans and employee stock ownership plans (ESOPs). Employe es 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 dema nd financial statements, and those are described in Requirement 2 which follows. 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 require a company to maintain minimum levels of various accounting ratios. Because covenant compliance is measured by accounting ratios, lenders demand financial accounting information so they can monitor the borrower’s compliance w ith 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 performance does no t end after the initial credit decision. Suppliers monitor the financial condition of their customers to ensure that they are paid for the products, materials, and services they sell. h) Debt -rating agencies like Moody’s or Standard & Poor’s help lender s and investors assess the default risk of debt securities offered for sale. Rating 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 gove rnment 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 rates. Keep in mind, however, tha t taxing authorities in the United States and many other countries are allowed 6-3 Copyright © 2021 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. to set 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 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 also be used to d etermine if the company is financially strong enough to deliver the ordered goods and services. Financial accounting information is also used in rate -making deliberations and 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 to help determine how well the company’s current management team is doing , and whether the managers are being paid appropriately. Labor unions demand financial accounting information to help formulate or improve their bargaining positions with employer companies. Union negotiators may use financial statements showing sustained or improved profitability as evidence that employee wages and benefits should be increased. Customers demand financial accounting information to help determine if the company will be able to deliver the product on a timely basis and provide product suppo rt after delivery. 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 investment —they will demand a lower price (higher rate of return) than would otherwise be the case. Companies have incentives to voluntarily provide information t hat allows investors and lenders to assess the expected risk and return of each security. Failing to do so means lenders may charge a higher rate of interest for the added informational risk, and stock investors will give the company less cash for its comm on or preferred stock. 6-4 Copyright © 2021 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. 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 interest ed 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 prospect ive managers and employees 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 merge with other companies. Manag ers 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 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 financial information, arguing that it shows just how poorly current management has run the company. Requirement 2: Student responses will vary, but here are some examples: Competitive forces from within the industry (i.e., other firms in the industry are voluntar ily 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. Demands by debt rating agencies such as Moody’s and Standard & Poor’s. Pressure from governmental regulatory agencies such as the Securities and Exchange Commission. Firms may believe that disclosing certain information voluntarily may prevent the Securities and Exc hange 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. Requirement 3:
