FINANCIAL ACCOUNTING THEORY
Chapter 1 Introduction
Some Historical Perspective
Organization of the Book
Information Asymmetry
User Decision Problem
Role of Financial Reporting
The Fundamental Problem Of Financial Accounting Theory
ENRON CORP.
Enron, Cont’d.
Enron, Cont’d.
ENRON, Cont’d.
ENRON, Cont’d.
ENRON, Cont’d
ENRON, Cont’d
ENRON, Cont’d
ENRON, Concl.
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Category: financefinance

Financial accounting theory

1. FINANCIAL ACCOUNTING THEORY

• Purpose: To create an awareness of the
financial reporting environment in a
market economy
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2. Chapter 1 Introduction

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3. Some Historical Perspective

• Paciolo, 1494
• English Corporations Acts
– Compulsory audit
• Developments in the United States
– Corporate income tax, 1909
– SEC, 1934
– The search for accounting principles
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4. Organization of the Book

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5. Information Asymmetry

• Two Main Types
– Adverse selection
• Persons with an information advantage exploit
this advantage
– Insider trading
– Moral hazard
• Manager knows his/her actions in managing
firm but shareholders do not
– Manager shirking
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6. User Decision Problem

• In Presence of Adverse Selection
– Rational investment decision
• In Presence of Moral Hazard
– Motivate and evaluate manager performance
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7. Role of Financial Reporting

• To Control Adverse Selection
– Decision usefulness
• Full and timely disclosure
• To Control Moral Hazard
– Net income as a managerial performance
measure
• Sensitive and precise net income
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8. The Fundamental Problem Of Financial Accounting Theory

• The best measure of net income to control
adverse selection not the same as the best
measure to motivate manager performance
– This implies that investor and manager interests
conflict
– Standard setting viewed as mediating the
conflicting interests of investors and managers in
financial reporting
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9. ENRON CORP.

Implications for Accountants
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10. Enron, Cont’d.

• Special Purpose Entities Associated
with Enron
– On Enron Books
• Dr Note Receivable
Cr. Capital Stock
$1.1 (billion)
$1.1
– Capital stock issued to Special Purpose Entity
(SPE) (a limited partnership)
– SPE owned by Enron officers
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11. Enron, Cont’d.

• GAAP requires amounts due from
shareholders be deducted from
shareholders’ equity
– Is a limited partnership, owned by Enron
officers, a shareholder?
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12. ENRON, Cont’d.

• Off-Balance Sheet Financing
– On SPE books:
• Cash
xxx
Debt
xxx
SPE borrows money, using Enron stock as
security.
• Note payable to Enron xxx
Cash
xxx
Cash is paid to Enron to reduce its note
receivable from SPE
– Enron has the cash but debt does not
appear on its books
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13. ENRON, Cont’d.

• Enron Renders Services to the SPE
– A/C receivable
$628 (millions)
Net income
$628
Services rendered to SPE 1997-2000 incl.
– If Ltd. partnership had been consolidated,
revenue only recognized when earned outside
the consolidated entity.
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14. ENRON, Cont’d

• Enron records its share of SPE profits
– Investment in SPE
xxx
Net income
xxx
SPE profits include increases in fair value of its
holdings of Enron shares.
Result: Enron includes increases in the market
value of its shares in its net income.
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15. ENRON, Cont’d

• In 3rd quarter, 2001, Enron Recognized
that the SPE should be Consolidated:
– Dr Shareholders’ equity $1.1
Cr Notes receivable
$1.1
To deduct loan to SPE from shareholders’
equity
– Also, restate previous 4 years’ earnings to
reduce by $628 millions
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16. ENRON, Cont’d

• Impacts of the Writeoffs






No effect on operating cash flow
Debt/equity ratio, debt covenants affected
Loss of investor confidence
Share price falls from $90 to 66¢
bankruptcy protection 2 Dec/01
SEC, Dep’t of Justice, Congressional
Investigations
– Where were the auditors? The Board?
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17. ENRON, Concl.

• Points to Think About
– Crucial role of investor confidence in
financial information
– Role of auditor in adding credibility to
financial information
– Off-balance sheet financing
– Earnings management
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