1.1.1: Financial Reporting Overview

Hello, I'm professor Brian Bouche. And welcome to the first video in An Introduction to Financial Accounting. In this video, we're going to provide an overview of the financial reporting landscape. What's required in financial reporting, who makes the rules, who enforces the rules, what are the basic set of financial statements. We've got a lot to get to in this course, and I'm really excited, so let's get started.

Let's start with a definition. Accounting is a system for recording information about business transactions to provide summary statements of a company's financial position and performance to users who require such information.

Wow, please tell me the whole video won't be this boring.

I sure hope not, but to spice things up a little bit, I will bring in some virtual students every now and then to ask questions or to make pithy comments.

Anyway, this definition has three parts. The first part is recording transactions. This part turns out to be a big deal, as not everything a business does gets recorded in the financial statements, and sometimes it'll seem like nothing's happening, yet we'll need to record a transaction anyway.

The second part is about providing summary statements. Large companies have billions and billions of transactions every year. If they made them available to you in a gigantic database, your first question would be, how can I summarize all this into one or two summary numbers? And the third part focuses on users, because different user groups would want different summary numbers. So most companies have to keep three sets of books. Our focus in this course will be the first set of books, or financial accounting. This standardized set of statements is geared toward external users like investors, creditors, customers, suppliers, competitors and any other stakeholder or person that has interest in the company.

However, these financial statements are not used to determine taxes. There is a separate set of books based upon tax rules that are used to compute how much taxes a company has to pay. These rules are often quite different from what we do in the financial statements. Finally, there's managerial accounting. This provides customized reports for internal decision making. We're not going to cover this topic in this course, but I wanted to make you aware of the fact that the financial accounting that we do talk about it is generally not used for internal decision making. Instead, there are other kinds of numbers that are looked at.

So what are the financial reporting requirements? The Securities and Exchange Commission, or SEC, requires periodic financial statement filings. Companies must file an annual report, or 10-K once a year. This includes a full set of financial statements with a substantial amount of additional disclosure. This thing generally runs 200-300 pages. The other three-quarters of the year, firms must file a quarterly report, or 10-Q, which has a full set of financial statements but less required disclosure than the annual report. If anything material happens between quarter ends, companies must file an 8K, or current report. Material information is generally viewed as anything important enough to move stock price, which means companies file these quite often.

They don't require the financial statements, just an update of whatever major corporate event has happened, something like a top manager resigns or you lose a big customer or there's a lawsuit or something along those lines.

All of these filings have to be prepared in accordance with generally accepted accounting principles, or GAAP.

Excuse me, does this stuff only apply to US companies?

That's a good question. I should note that this will be a US-centric course because I'm at a US business school. However, the things that we cover will be applicable globally. So for instance, even though we're talking about SEC filing requirements in the US, every country in the world that has a securities market has filing requirements like an annual report. The only difference you might see internationally is instead of a quarterly report, some countries require semi-annual reporting.

This also only formally applies to public companies. But private companies that need to go to a bank to borrow money oftentimes are required to provide financial statements on a quarterly or annual frequency because the banks are so used to getting financial statement information in that format and in that frequency. So this is a pretty universal set of filing requirements that apply to public and private companies around the world.

These periodic filing requirements create much of the tension in financial accounting. For example, let's say we ship goods to a customer in one quarter, but we collect cash in the next quarter. When did the sale occur? Was it when we shipped the goods or collected the cash? And let's say we buy some equipment in one quarter, and then use it to manufacture goods over the next 23 quarters. When does the expense occur? When we pay cash to buy the equipment or as we use it over the next 23 quarters? A lot of what we're going to do in this course is try to figure out what quarter to put various business activities into when we put together the financial statements.

So who makes the rules? Generally accepted accounting principles, or GAAP, are established by the US Congress, but they're usually too busy trying to do things like investigating steroids in baseball or figuring out whether they should shut down the US government again. They don't have time to deal with accounting standards, so they delegate to the Securities and Exchange Commission. But they're often too busy trying to catch the bad guy, so they don't have time to make the rules. So they delegate to the Financial Accounting Standards Board, of FASB, which is a seven-person board in Norwalk, Connecticut, that has the authority to make the accounting rules in the US. And sometimes they're even too busy to make all the rules, and so there's an emerging issues task force and the AICPA that can also have a hand in making accounting rules, or US GAAP. Now this is just in the US. Internationally, there are international financial reporting standards, or IFRS, that are established by the International Accounting Standards Board, or IASB, which is based in London, and are now required in over 100 countries including all of the EU.

But as of now, US GAAP is still required for US firms. So basically there are two big sets of accounting standards in the world. But the good news is, for almost all of the introductory accounting topics that we look at in this course, there's a very high degree of overlap in the two standards. 6:23

Why doesn't the US just switch to IFRS? Do you think there will ever be one global accounting standard?

Actually, in the summer of 2008, the SEC came out with a roadmap that would move US firms to IFRS by basically now. But then what happened was, Lehman Brothers went bankrupt, the financial crisis hit and the roadmap dropped way off the SEC's radar screen. So for the foreseeable future, we're going to have two big sets of standards in the world, US GAAP and IFRS. But as I just mentioned, the good news is the two standards are getting closer to each other all the time. The FASB and IASB are working together on any new standards. So, all the stuff that we talk about that's under US GAAP in this course will be very similar to what you would see under IFRS.

So who's responsible for financial reporting? Management is responsible for preparing financial statements.

Wait! What? That is like a professor allowing students to give themselves their own grade. Everyone gets an A plus.

Yes, that's correct. We allow managers to put together their own financial statements because they have the most information about what happened in the company. And we hope that they use their discretion in financial reporting to better communicate their activities. However, it is important to remember that they may use this discretion to try to manipulate the perceptions, and we need to be on the lookout for such opportunistic behavior.

So we put in a number of checks and balances to try to curb managers' opportunistic behavior. First, the Audit Committee of the Board of Directors provides oversight of management's accounting process. However, this is not a foolproof check on managers' behavior. You know, one of the biggest finance statement frauds ever was Enron, and the head of their audit committee was, was a guy whose full-time job was accounting professor. Which means you could put someone like me on the board and still have these kinds of problems.

So then the auditors are hired by the board to express an opinion about whether the statements are prepared in accord, accordance with GAAP. This again is not foolproof, because in the case of Enron, their au, auditor, Arthur Anderson, signed off on some of the more aggressive things they did, and part of the reason was because they were being hired by Enron to approve their accounting. If they lost Enron because of a disagreement over their accounting, then they would have lost the biggest company in Houston and would have had to go to the second biggest company in Houston which is uhh. Exactly! Who knows what the second biggest company in Houston is? And that's why they want to make sure to keep Enron. The next line of defense is the SEC and other regulators who will take action against the firm if any violations of GAAP or other rules are found. Now these bodies tend to be very reactive instead of proactive, and it's oftentimes after someone else has brought the fraud to the public's attention that they launch their investigation. So by and large, it's information intermediaries like stock analysts, institutional investors and the media that provide the biggest check on managers' behavior by either exposing or fleeing firms with questionable accounting.

But by the time one of these parties get involved, it's a very public issue, the stock price drops and you're in bad shape if you're an investor or employee of the company. So in the end, the only party that's really going to look out for your interest in terms of understanding and trusting financial statements is you. Which is why it is really important that you learn some basics in terms of reading financial statements.

So what are the required financial statements? Well, there's four of them. First, there's a balance sheet, which gives a company's financial position, which is its listing of all its resources and obligations on a specific date.

Then there's the income statement, which provides the results of operations over a period of time using accrual accounting. By over a period of time we mean between two balance sheets, so either a quarter or a year. And by accrual accounting, it means we're going to recognize things in the income statement based on business activities, not based on cash flows. Because we have a separate statement for cash flows, the statement of cash flows, which will give you all the sources and uses of cash over a period of time. And then finally, there's the statement of stockholder's equity, which provides changes in stockholder's equity over a period of time.

Okay. Could we get an example? This is pretty abstract.

Yes, in fact I have an extended example where we go through a simple business and see what the different financial statements can tell us about what's going on at the business. But it takes another ten minutes or so, so to avoid this being a long first video, why don't we cut it off here and we'll pick it up in the next video. I'll see you then