Business Enterprise Contracts
Three types of contracts.
Compensation contracts with managers who work for the company.
Debt contracts with bankers who loan money to the company.
Royalty contracts with investors who license products for the
company to sell to its customers.
Often contains language which references verifiable financial statement
numbers, such as “operating profit” for calculating managers’ bonuses,
“free cash flows” for determining the company’s loan compliance, and
“product sales” for computing the company’s royalty payments.
Business Enterprise Financial Statements
Two key purposes.
Allow managers to transfer the information about their business
activities to outside parties without a significant problem known as
information asymmetry.
Improve contract efficiency by restricting the managers’ decisions and
aligning their incentives with those of the other contracting party(ies).
Capital Market
Two important features.
Investors are uncertain about the quality (riskiness) of each stock or
debt instrument for sale because its ultimate return depends on future
events.
Companies which offer a low-quality (“high-risk”) stock or debt
instruments to investors must pay a “lemon” penalty.
Company owners and managers have an economic incentive to supply
the necessary amount and type of financial information to raise capital at
the lowest possible cost.
Some forces, such as legal penalties and the requirements for audited
financial statements, offset the tendency for companies to mask their
high-risk stock or debt instruments.
Cost of Capital
The price which a company must pay for new money.
Reduced uncertainty about a company’s opportunities and risks can lead
to a lower cost of capital.
The Securities and Exchange Commission (SEC), the Financial
Accounting Standards Board (FASB), and the International Accounting
Standards Board (IASB) influence the amount and type of financial
information which companies can disclose, as well as how it is disclosed.
Customers
Two reasons for demanding financial statements.
To assess whether a seller can provide high-quality products on an
agreed-upon schedule.
To assess whether a seller can provide potential replacement parts
and technical support after the sale.
Disclosure Benefits
Two benefits.
Companies might be able to obtain cheaper capital and receive better
terms from suppliers.
Creates incentives for managers to reveal “good financial news” about
their company, such as new product introductions, increased
customer demand for an existing product, effective quality
improvements, or other matters which are favorable to the financial
perception of the company.
Disclosure Costs
Companies often cannot obtain disclosure benefits at zero cost.
Four types of costs.
Competitive disadvantage costs.
Information collection, processing, and dissemination costs.
Liquidation costs.
Political costs.
Disclosures
The SEC and FASB regulate financial reporting in the United States.
Companies frequently communicate more financial information than is
required because they believe that the benefits outweigh the costs.
Efficient Markets Hypothesis
A stock’s current market price reflects the knowledge and expectations
of all investors. Therefore, searching for undervalued or overvalued
stock and forecasting stock price movements using financial statements
or other public data is pointless because any new developments are
quickly and correctly reflected in a company’s stock price.
Financial statements provide a basis for shareholders and investors to
assess a company’s dividend yield, risk, or other important attributes for
portfolio selection decisions.
Financial Statement Demand
Financial statements are demanded because of their value as a source of
information about a company’s performance, financial condition, and
resource stewardship, which improves decision-making.
The supply of financial statements is guided by weighing the costs of
providing and disseminating them against the benefits which will be
provided to the company.
Examples of external users who demand financial statements.
Customers.
Government and regulatory agencies.
Lenders and suppliers.
Managers and employees.
Shareholders and investors.
Government and Regulatory Agencies
Five reasons for demanding financial statements.
To achieve economies of scale by regulating companies.
To enhance social welfare by establishing tax policies.
To monitor a company’s compliance with security laws through
mandatory reporting.
To protect individual customers and society from insolvency losses by
regulating companies.
To resolve contractual disputes between companies.
The SEC requires publicly traded companies to compile annual financial
reports (called 10-Ks) and quarterly financial reports (called 10-Qs).
These periodic financial reports are then filed with the SEC and made
available to investors and other interested parties.
Congress passed the 2010 Dodd-Frank Act to require that the SEC
tighten financial regulations to prevent another 2007-2008 financial
crisis.
Information Asymmetry
The managers of a company can access more or better information about
their company than can its outside parties.
Prevents any outside parties from being able to accurately assess a
company’s past economic performances, resource availability, future
prospects, and risks.
Lenders and Suppliers
Two reasons for lenders to demand financial statements.
To assess the loan amount, the interest rate, and the security
(collateral) necessary for a business loan.
To monitor adherence to contractual provisions (covenants), which
require that the borrower maintain a minimum level of working
capital, debt-to-assets ratio, or other key accounting variables which
provide a safety net to the lender. Any violations of these loan
provisions can result in technical default and allow the lender to
accelerate payment, request additional security, or raise interest
rates.
Two reasons for suppliers to demand financial statements.
To assess whether the customers can pay for shipped goods.
To continuously monitor the financial health of companies with which
they have a significant business relationship.
Managers and Employees
Although managers regularly make operating and financing decisions for
their company based on information that is much more detailed and
timelier than the information in their company’s financial statements,
they also demand financial statement data. Their demands arise from
contracts (such as executive compensation agreements) that are linked
to the company’s financial statements.
Executive compensation contracts usually contain annual bonuses and
long-term pay components, which are tied to the company’s financial
statement results. Using accounting data in this manner increases the
efficiency of executive compensation contracts. Rather than trying to
determine firsthand whether a manager has performed capably during
the period, the company’s board of directors looks only at its reported
profitability or some other accounting measure that summarizes the
company’s performance.
Employees demand financial statements for four reasons.
To assess their company’s current and potential future solvency.
To learn about union contracts which may link negotiated wage
increases to their company’s financial performance.
To monitor the health of company-sponsored pension plans and gauge
the likelihood that the promised benefits will be provided.
Proxy Contests
The focal point often becomes the company’s performance as described
in its recent financial statements.
Managers defend their records of their company’s past accomplishments
while, perhaps, acknowledging the needs for improvements in some
areas of their company. However, the company’s dissident shareholders
point to its past failures and the need to hire new executives.
Both sides point to the same financial statements.
Undecided shareholders must form their own opinions.
Shareholders and Investors
Use financial statements for two purposes.
To choose a portfolio of securities that meets their preferences for
dividend yield, liquidity, return, and risk.
To evaluate the performance of a company’s top executives. This use
of a company’s financial statements is referred to as the stewardship
function of financial statements. When a company’s earnings and
share price fall below their acceptable level, the distinguished
shareholders voice their complaints in letters and phone calls to the
company’s managers and outside directors. Then, if that approach
fails, the dissident shareholders may launch a campaign, referred to
as a proxy contest, to elect a new board of directors at the company’s
next annual meeting. New investors often view underperforming
companies as buying opportunities because they hope to gain by
joining forces with the company’s existing shareholders to replace its
managers.
Financial statements are crucial in investment decisions that use
fundamental analysis to identify mispriced securities: stocks and bonds
which sell for substantially more or less than what they seem to be
worth. This method requires that investors consider a company’s past
sales, earnings, cash flows, product acceptances, and management
performances to predict the future trends in these financial drivers of the
company’s economic success or failure. Then, the investors assess
whether a particular stock or stock group is undervalued (favorable) or
overvalued (unfavorable) at its current market price.
