In this video, we're going to provide an overview of the economic environment in which financial reporting takes place. This is going to be useful because it's going to provide some perspective for why financial reporting is the way that it is. Let's start with the definition of accounting. Accounting is a system for recording business transactions and events. Now because there are thousands, if not millions of these that happen for a firm during a year, an important thing that an accounting system has to do is classify or organize these in useful ways. We put together summary statistics to do this, balance sheets, income statements, things like that. Many people are surprised to learn that there's not just one set of books that does this. Most companies have multiple sets of books, one for shareholder purposes, one for tax purposes. And they may have their own to keep track of things internally. You might think that it's unethical or even illegal to keep multiple sets of books. But in fact, this is not only allowed, it's required in most countries. That is, the first two sets of books, the financial reporting books and the tax books, are regulated heavily by the government. And in almost all countries, the rules for putting them together are different. This is because the purpose for what you're trying to do with the financial statements is different for tax purposes versus shareholder purposes. And so the way that you want to put them together is different as well. We're going to be concentrating on this first one, what we refer to as financial accounting. These are the reports that are going to go to external parties, investors, and creditors. Every country has its own rules for what you've gotta do in terms of financial reporting. In the US, you file the reports with the Securities and Exchange Commission or the SEC. What do you have to file? Well, you have to file an annual report, sometimes that's referred to as a 10-K, quarterly reports, 10-Qs, and other reports depending on specific activities that you're undertaking. The proxy statement, for example, will go with the annual report, and will describe things that shareholders will find useful in voting on different proposals. Registration statements are filed when a company is going to issue new securities, so we want more details then, those kinds of things. In the US, we file quarterly. In many other countries, they file semi-annually, okay, so not as many interim reports in other countries. The financial reporting requirements within a country specify the minimum that you've gotta disclose. Companies are allowed to go beyond this, so they're allowed to provide voluntary disclosure, and many companies choose to do that. That can be in the form of conference calls that follow-up annual and quarterly reports, or press releases, or those kinds of things. In the US, Congress actually has the authority to authorize what the rules are, but they delegate that to the SEC. And the SEC actually delegates that further down to a board called the FASB, the Financial Accounting Standards Board or FASB. That's a private sector body. They actually determine the rules, but because they're overseen by Congress, politics sometimes gets involved. So if companies see rules being proposed that they think is going to make them look worse, they can lobby congress to lobby the SEC to lobby the FASB, and perhaps get the rules changed. And we've seen that happen over time. Internationally, many countries have chosen to follow a common set of rules called IFRS, or International Financial Reporting Standards. IFRS rules and GAAP rules are very similar, but they're not the same. Okay, and if you're going to look at financial statements from different countries, it's important to understand what the differences are. The two sets of rules are getting closer to each other, but it doesn't look like they're ever going to be exactly the same in the near future. Now, what do we provide information about? Well, it's the business activities that the firm is engaging in. So if we think about what firms do, they raise capital from investors. These are creditors and shareholders, amongst other people. They then take this capital and acquire resources. They hire people, they invest in property, plant, and equipment. They do R and D, those kinds of things, in order to produce goods and services. They then try to sell those goods and services to customers and collect from those customers. So now we've got cash, we have to do something with that cash. We can distribute it back to our investors or we can reinvest it in the company. Usually companies do a little bit of both. Now if we waited till this process was completely done, accounting would be easy. We could count up how much went in, how much went out, and we would know the profitability of the firm. Unfortunately, that's too late for any useful decisions to be made. And so what we try to do in the financial reporting environment is basically to slice the firm's history up into some arbitrary periods, years and quarters, and produce more timely information by requiring reporting at these interim stages. But there's going to be a lot more estimation that's gotta happen when you do that. At any given point in time, the firm's financial activities and business activities are not done. Many activities you've started haven't finished yet. And so the big challenge in financial reporting is, what do you want to say about activities that have started, but haven't yet finished? How are you going to look into the future at all to try to assess what the future period consequences are going to be? How do we do that? In annual reports, we first of all have a big section where management gets to talk about what its strategies are, what its products are, what its competitive environment is. They'll also talk about financial statistics. They'll talk about capital that they're trying to raise, cash issues, those kinds of things, risks. There's also the financial statements. The financial statements are a relatively short part of the annual report, four to five pages in a report that might be hundreds of pages. And then the annual report typically ends with a big section called the footnotes. The footnotes lay out all the assumptions that the company is using to put together the financial statements. What are the required financial statements? Well a big one is the balance sheet. The balance sheet gives you the firm's financial position at a point in time. Key components, assets, liabilities, and owners' equity. Then there's the income statement. The income statement talks about the profitability of the firm, not at a point in time, but over a period of time. Revenues and expenses are the big components in the income statement. The cash flow statement, that tracks inflows and outflows of cash, okay. And as we'll see, breaks it up into operating cash flows, investing cash flows, and financing cash flows. The fact that there's a separate income statement and cash flow statement must mean that income is not the same thing as cash flow. Okay, so this is an important distinction many people aren't aware of, okay, that we're going to develop in a lot more depth. Lastly, there's a statement of stockholders' equity. This is going to reconcile the beginning and ending balance of each account within the stockholders' equity section to explain how it changed over the course of the year. Now, we could talk about accounting as if what it does is take economic events and process them using a set of rules to produce the financial statements. And we could get pretty far in our discussion of accounting if we did it that way. But it's important to remember the economic environment that it takes place in. Who actually puts together the financial statements? It turns out that the answer is management, okay, not the auditor. Management is the team that puts together the financial statements. And the reason that we give that responsibility to management is because, when the financial statements are put together, things aren't done. There are many future period consequences that still have to be played out. Who's in the best position to know what those future period consequences are likely to be? Management, so we give them the authority to put together the financial statements. But who are they actually reporting on? Well in some sense, they're reporting on their firm. In another sense, they're reporting on themselves. That is, it's management's strategic decisions that gave rise to the economic events that they're now reporting on. So while management might be the most knowledgeable, they're also the least objective in terms of financial reporting. To address that concern, there's a lot of oversight and regulation about the financial reporting process. We've got, within the Board of Directors, an audit committee that is composed only of outside directors, okay, that work with the firm and the external auditors. There are external auditors. External auditors, their job is to provide an independent assessment of the firm's financial statements and whether or not they're correct and in conformity with generally accepted accounting principles. Shareholders and other groups are overseeing, looking at the financial reports, checking for inconsistencies and holes and deficiencies as well. Regulators, the SEC, the IRS, other people are looking at the financial statements as well. So there's a lot of oversight designed to try to keep in check management's incentives to distort things. Often it's effective, not always. Enron may be the most famous example of that. Now the financial statements put together is not the end. The financial statements put together then have real resource consequences. When the financial statements come out, real dollars change hands, stock prices change. Capital flows to the firms that did well, less so to the firms that didn't do well. Management gets raises or gets fired, those kinds of things. So there's a big feedback loop between the financial statements and the resources that the firm has to make decisions for the next period. So accounting doesn't take place in a vacuum. It takes place in a real economic and political environment. Real resources change hands when the numbers come out. So management has big incentives to try to make those numbers look good. We let managers try to convey that, despite that incentive, because they also have the most information about how things might turn out. We try to let oversight occur to try to keep management's incentives to distort in check. And the hope is that the end result combines two objectives. One is to provide useful information to help decision makers. And the second is to provide some assurance that the information that we're providing is reliable as well.
