Solution Manual For Financial Reporting and Analysis 5th Edition By Revsine – SM

Chapter  1  Solutions

The Economic and Institutional Setting for Financial Reporting

Problems

Problems  

P1-1.   Demand for accounting information (LO 1-1)

Requirement 1:

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 often occur following a period of deteriorating financial performance.

1. b) Financial statement information helps prospective (potential) investors identify stocks consistent with their preferences for risk, return, dividend yield, and liquidity. Here too, financial statements are especially useful for those investors that adopt a “fundamental approach.”

1. 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 accounting information—without it, their jobs would be difficult, if not impossible, to do effectively.

1. 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. 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.

1. 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 the likelihood of continued employment, as well as payouts under company-sponsored pension and health-care programs. Unionized employees have other reasons to demand financial statements, and those are described in Requirement 2 which follows.

1. 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 with loan terms.

1. 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 not 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.

1. h) Debt-rating agencies like Moody’s or Standard & Poor’s help lenders 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.