Financial Accounting

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CHAPTER 1

FInANCIAL ACCOUNTING AND

ITS ECONOMIC CONTEXT

ISSUES FOR DISCUSSION

ID1–1

Security analysts and stockholders: These users would use financial statements to try to estimate the future earnings and cash flow potential of the company, which would be used to project a value for the company’s stock.

Bank loan officers: These users would use the financial statements to determine the ability of a company to repay loans to the bank.

A company’s customers and suppliers: These users would use financial statements to determine whether to extend credit to the company (suppliers) or whether to rely upon the company to be a supplier (customers). Both suppliers and customers would also use the financial statements to monitor the company’s profit margins.

Public utilities: This group would use the financial statements to determine the company’s growth rate and how that might impact upon the company’s utility needs. Also, they would evaluate the company’s ability to pay its bills.

Labor unions: These groups would use the financial statements to monitor the profitability of the company to help determine the amount of pay raises and benefits that it will negotiate for from the company.

A company’s managers: The company’s managers will use the financial statements to assess the overall financial health of the company. This could impact the managers in a number of ways: raises, promotion opportunities, performance of other departments, etc.

ID1–2

The board of directors serves various functions for a company. One is to represent and protect the interests of the stockholders who are not on the board. Another is to provide oversight and input to management. The managers are involved in running the business on a day-to-day basis whereas the board is more focused on the bigger, long-term picture. A weak board may not ask probing questions of management but instead may take everything at face value and believe anything that management says to them. A healthy management team would want a strong board that delivers valuable input. A management team that wants a weak board of directors may be trying to hide something (management fraud).

Auditors are concerned with management fraud because, if there is a problem, in many cases the auditors will be sued by the stockholders on the basis that the auditors should have detected the fraud.

ID1–3

The function of the audit committee is to provide a channel whereby the auditors report their findings and concerns, if any, to the board of directors. Typically there are outside members of the board that are on the audit committee so that if the auditors have concerns about management’s financial statements or activities, then the auditors have a way to speak directly to the board of directors.

The auditors are in a sensitive position because the financial statements and activities that they are auditing are prepared by the same people who hire and pay the auditors. Therefore, they may be reluctant to jeopardize their relationship with the company by being too negative.

ID1–4

Since Pepsi’s profits increased by a greater percentage than sales increased, it must mean that expenses as a percentage of sales dropped. Pepsi was able to improve its profitability per dollar of sales.

The growth in equity was larger than the growth in assets, indicating that Pepsi reduced its liabilities. The financing activities verify that Pepsi used a significant amount of cash, partially to reduce debt. In addition to the reduction in liabilities, the strong cash flow from operations was used to purchase additional assets for the company.

ID1–5

Creditors would impose these types of restrictions on Continental Airlines so that the creditors would be protected for their loans. These types of restrictions are fairly common and act as a trip wire to warn the creditors that...
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