Chapter 10: Conceptual Framework Chapter 10 · PDF file1 © 1991–2009 ... analyze...

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© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson

Chapter 10: Conceptual Framework

Chapter 10 NavigatiNg aCCouNtiNg’s CoNCeptual Framework

TABLE OF CONTENTS

Introduction 3

Business Decisions and Performance 4

Introduction 4

What Does it Mean to Say that a Business Performs? 4

Performance Challenges 5

Goals and Strategies 7

Resources 7

Performance Units 8

Organized by Functional Specialty 9

Organized by Lines of Business 9

Organized by Location 10

Organized by Key Processes 10

Internal Alignment 11

Management Structures and Internal Reports 12

External Alignment 13

Legal Structures and External Reports 13

Timing 15

Business Decisions Review-Preview 16

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Navigating Accounting ®

Accounting Decisions 23

Introduction 23

Decision-Making Hierarchies 23

Tax Reporting 24

Financial Reporting 24

Managerial Reporting 24

Purposes of Reports 25

Structure of Reports 25

Timing of Recognition 26

Record Keeping Systems 27

Accounting Decisions Review-Preview 28

User Decisions 37

Introduction 37

Assess Usefulness 38

Usefulness Criteria and User Decisions 38

The Challenge Outsiders Confront When They Assess Usefulness 39

Risk and Divergent Beliefs Amplify the Challenge 43

Auditor and Regulator Validations and Restrictions on Insider Accounting Judgments 44

The Consequences of Restrictions on Usefulness 44

Assess Performance 45

Construct Measures 45

Compare to Benchmarks 45

Corroborate with Other Facts 46

Assess Confidence 47

Is refinement cost effective? 47

Employ Decision Models 47

Make Decisions 48

Conceptual Framework Review 49

Exercise 10.01 51

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INTRODUCTIONThis chapter builds on the foundation laid in the prior chapters to help you meet Navigating Accounting’s first goal — to help you acquire a broad conceptual framework for understanding and preparing financial, managerial, and tax reports that will serve as a solid foundation for your career and other courses.

You will need to understand the concepts presented here to critically analyze financial statements. But these concepts also apply to many other accounting and tax reports that you will likely use or create.

To develop this groundwork, we will dissect in considerable detail the three decisions in the conceptual framework that affect and are affected by accounting reports: business decisions, accounting decisions, and user decisions. We begin in the next section with business decisions and their performance consequences. Before doing so, we will quickly review the big-picture perspective of the framework that was covered in the Preface:

• Reportingentitiesmakebusinessdecisionsthatleadtoeconomicoutcomes that affect the entities’ resources and obligations.

• Accountingdecisionsdeterminewhether,where,when,andhowthese events are measured and reported. The resulting accounting reports help individuals and organizations, who are often outsiders, make user decisions, meaning decisions made by users of accounting reports.

• Users’decisionscanaffecttheirownwelfareandthewelfareofother stakeholders, including the insiders who make accounting and business decisions.

• Theanticipatedconsequencesofuserdecisionsonvariousstakeholders can cause insiders to change their business and accounting decisions.

BusinessDecisions

AccountingDecisions

EconomicOutcomes

UserDecisions

Reporting Entity Insiders

AccountingReports

Consequences ofUser Decisions

Outsider or Insider Report Users

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BUSINESS DECISIONS AND PERFORMANCEiNtroduCtioNCommon sense suggests that your capacity to prepare or interpret accounting reports depends on your understanding of the events they portray. As obvious as this sounds, newcomers to accounting often struggle unduly because they try to learn accounting before they adequately grasp the related business decisions and their consequences.

You already may have on-the-job experience with business decisions or have studied them in other courses such as marketing, strategy, operations, ethics, organizational behavior, finance, and economics. If so, then you know that business decisions can be analyzed at several levels.

To grasp relatively simple accounting procedures, you will need only to have a big-picture comprehension of the associated events. For instance, you will often need to know only who got what, from whom, and when they got these things. This is the level of understanding you have needed thus far to grasp discussions about how events affect financial statements.

To understand complex accounting issues, you will need a more profound understanding of the related events. In particular, you will need to understand how risks and rewards associated with numerous economic, political, legal, and social factors influence business decisions, events, and performance.

As you progress through Navigating Accounting, you will learn a good deal about companies’ day-to-day business decisions and how they affect performance — the primary concept that accountants try to measure reliably.

This section prepares you for these discussions by defining performance in business settings and describing how companies organize to perform.

what does it meaN to say that a BusiNess perForms?Business entities perform to the extent their decisions, and other factors that are beyond their control and influence, lead to outcomes that meet their objectives and priorities.

Thus, when an entity determines its objectives and priorities, it orients other business decisions and creates a context for assessing performance. It also orients accounting decisions since they largely connect events

BusinessDecisions

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to reports that indicate, albeit imperfectly, how well the entity has performed or will perform against its objectives.

Entities generally establish objectives in terms of their stakeholders’ interests and designate one stakeholder group as their highest priority. Those entities whose highest priority is to maximize the value of their owners’ stakes are called for-profit businesses. Examples include for-profit partnerships, corporations, and sole proprietorships. Those entities whose highest priority is to maximize a broader social objective are called not-for profit organizations. Examples include charitable organizations and government agencies.

Navigating Accounting focuses on for-profit corporations and these are businesses that seek first and foremost to maximize shareholder value. This overarching objective is a compass that orients corporate business decisions.

perFormaNCe ChalleNgesKnowing where you are going does not guarantee that you will get there. Once an entity determines its objectives and priorities, it must create an infrastructure to try to accomplish them.

This involves several challenging business decisions, including (among other things) determining goals, strategies, performance units, management structures, legal structures, information systems, and incentives. This section examines these business decisions and their consequences for accounting reports.

Objectives, goals, and strategies influence the way companies organize, perform, and develop performance measures. To further facilitate performance, companies subdivide into performance units, such as credit and sales departments, and coordinate activities across these subentities.

The significance of these issues to accounting is that large multinational corporations can have hundreds of entities that include performance measures in their accounting reports. These reports are used internally and aggregated to produce company-wide performance measures, which are reported to shareholders.

Corporate performance goals and strategies should be consistent with maximizing shareholder value, and employees should be provided with incentives and guidance to reach them. Corporations perform to the extent they meet this management challenge by making business decisions that increase their net assets (assets - liabilities).

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A sports analogy might help you appreciate the magnitude of this challenge. If you have played sports or are a fan, then you know how difficult it is to organize a small group of 5 to 50 players into a winning team.

You also realize that coaching makes a big difference in the way players perform individually and collectively and that coaching becomes increasingly challenging as the number of players and rules increase.

The coaching challenges at major corporations are mind-boggling when compared to sports. Corporations have thousands of players spread around the world who are running millions of plays each year and competing in tough, fast-moving leagues. There are countless rules that are changing continuously, and they are often extremely vague.

If you agree that coaching quality makes a difference in sports, imagine the value that can be created or destroyed by the ways corporations organize and manage this complexity.

Like coaches, corporate executives and other managers face several daunting business decisions that greatly influence their team’s success:

• Howshouldthecorporationsetgoalsandstrategiesthatareconsistentwith the broader corporate objectives and priorities?

• Whatresourceswillthecorporationneedtoimplementthesestrategies, and how should these be acquired?

• Howshouldthecorporationorganizeintoperformanceunits?

• Howshouldthecorporationplan,coordinate,andcontroleventsamong these performance units to ensure the best collective performance?

• Howshouldthecorporationalignemployeeactionswiththecorporate objectives and, in particular, with maximizing shareholder value?

• Howshouldthecorporationalignitsdecisionswithsociety’sintereststo ensure that it meets its social objectives and legal requirements?

• Howshouldthecorporationcreateasenseofurgencytoensurethat the organization performs quickly enough to gain competitive advantages?

These business decisions are studied in courses in strategy and organizational studies. Let’s take a brief look at how they affect performance.

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goals aNd strategies How should the corporation set goals and strategies that are consistent with the broader corporate objectives and priorities?

To gain competitive advantages in the markets where they participate, corporations need to set goals that are consistent with maximizing shareholder value and develop strategies to achieve them.

For example, they need goals and strategies to gain competitive advantage in the company’s product markets. To win in these markets they must offer customers more value than customers can get from the company’s competitors — their next best opportunity.

The challenge is to continuously give customers more value than they can get elsewhere in the form of lower prices and better products, without sacrificing shareholder value: Strictly speaking, give them just enough to reach this goal, but no more. This is a formidable balancing act, and there are no recipes for success.

Similarly, management needs goals and strategies to gain competitive advantages in the labor markets where they hire employees. They must continually offer employees more job satisfaction than they can get elsewhere, yet motivate them to maximize shareholder value. Coaches face a similar balancing act when they try to set individual and team goals and devise strategies and incentives to achieve them.

More generally, corporations need goals and strategies that maximize shareholder value while making their other stakeholders at least as well off as their next best opportunity.

resourCesWhat resources will the corporation need to implement these strategies, and how should these be acquired?

Management needs resources to execute its strategies. Resources are expected to provide corporations with future economic benefits. They include public goods, private goods (possessions), and human resources (services).

Public goods are resources that belong to society. They include roads, schools, water and sewage, legal systems, parks, and other resources that are financed by taxes or charitable contributions. Countries, states, cities, and other government entities try to attract companies by offering public goods that meet their needs at competitive prices (taxes, duties, etc.). While corporations do not own these resources, they can control the costs of receiving them and the benefits they receive by where they locate activities.

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Private goods differ from public goods in that these resources are owned and thus controlled by individuals, corporations, or other entities. They include cash, inventory, buildings, and other resources that facilitate performance. Companies can develop, acquire, or lease them.

When a company owns or controls a private good and one or more financial measures of this resource are deemed reliable, the resource is recognized as an asset on the company’s balance sheets.

Human resources include employees and outside contractors. Their services can be acquired for wages, stock options, promised future benefits (pensions, deferred compensation, etc.) or other types of compensation.

A company’s strategies determine the private, human, and public resources it needs to acquire the right to use through ownership, rental, or employment agreements or by other means; the ways it acquires and pays for these rights; and the ways it combines them to create value for its stakeholders.

In contrast to private goods, with the exceptions of sports franchises, companies do not recognize their human resources as assets. Sports teams often have exclusive rights to players’ services in a league. By contrast, with limited restrictions associated with non-compete clauses, beyond sports employers, companies generally do not control employees ability to apply their talents elsewhere.

Thus, some private resources meet the criteria to be recognized as assets, while other private resources and all human and public resources do not get recognized, even though they help the entity perform.

perFormaNCe uNitsHow should the corporation organize into performance units?

Just as sports teams are divided into subunits by specialty (offense and defense) and these are further subdivided (quarterback, punter, etc.), corporations are divided into specialized performance units. For example, Intel’s credit department specializes in credit decisions.

Organizing by specialty allows companies and other entities to develop centers of expertise, to focus goals and strategies, and to share specialized resources. However, the activities in the various subunits must be coordinated to ensure that the broader organizational performance goals are achieved.

By assigning decision rights and responsibilities to specialized subunits, companies and other entities largely determine the way they are governed and the way power is distributed throughout the organization.

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An employee in a large multinational corporation typically belongs to more than one type of performance unit. Let’s take a brief look at four of the more common ways to classify performance units: by functional specialty, by lines of business, by location, and by key processes.

Organized by Functional SpecialtyCompanies are generally organized into departments by functional specialty. For example, to make the credit decisions credit-department analysts need to be specialists in finance. They also need expertise about the credit risks associated with customers.

In addition to having common expertise, credit department employees likely will use similar specialized equipment, databases, and other resources. A corporation’s overall performance often can be improved by sharing these resources.

For example, if credit analysts were spread out haphazardly throughout the organization, a company might purchase multiple site licenses for specialized credit software, resulting in idle capacity (unused resources) and hampering performance by unduly increasing input costs. Alternatively, in anticipation of these huge costs, the company might not purchase the software, and thus its performance benefits would not be achieved.

But, if the company’s credit analysts are organized into a single performance unit (department) that has unique decision rights and responsibilities, the company might purchase a single-site license for use of the software in the credit department, even if each analyst uses the software sporadically.

Organized by Lines of BusinessLarge companies such as General Electric and Siemens often compete in several distinct industries. For example, both of these companies have large medical equipment businesses that operate in regulated environments that differ significantly from their other businesses.

Lines of business are usually defined by similarities in product lines, customers, manufacturing capabilities, or technologies. Just as members of functional departments develop and share common knowledge about their disciplines (accounting, marketing, etc.) and require similar resources (equipment, databases, etc.), members in the same line of business share expertise and resources related to industries, technologies, or customers.

Housing these types of expertise and common resources within the same organizational structure and endowing it with decision rights and responsibilities can facilitate coordination, and thus performance.

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For example, combining medical equipment and pharmaceuticals units can help a company develop and apply expertise at moving products through the regulatory approval process.

Speeding up the regulatory approval process without sacrificing quality can improve performance significantly: Beating your competitors to the market with an innovative new product is a key success factor for most high-tech companies.

Organized by LocationMost larger companies are also organized by location. As companies expand into new states or countries, they frequently form geographic units that share resources and expertise. For example, a European unit endowed with decision rights and responsibilities can create a common distribution center for all of a company’s European sales. Also, its managers might have local expertise about the laws, regulations, and cultures of European countries.

Organized by Key ProcessesTo improve coordination across functional specialties, companies have developed cross-functional teams around a few key processes. As the name suggests, key processes are sequences of events that occur frequently and that are critical to the company’s overall performance.

Product generation is an example of a key process that is especially important for high-tech companies that must continually create new and innovative products that meet the ever-changing needs of their customers. A product generation team might include members from the research and development, marketing, finance, manufacturing, legal, and customer service departments.

By owning the responsibility for inventing and developing the product and the related decision rights, this team can ensure that these experts coordinate their specialties more effectively. However, to this end, each member must have general knowledge about the process and team skills.

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iNterNal aligNmeNtHow should the corporation plan, coordinate, and control events among its performance units to ensure the best collective performance?

How should the corporation align employee actions with the corporate objectives and, in particular, with maximizing shareholder value?

Corporations try to align the actions of their performance units and employees with the broader corporate objectives and, in particular, with the overarching objective of maximizing shareholder value.

A benefit of performance units is that they are highly specialized and have decision rights that permit them to respond quickly and appropriately to changes in their environments.

However, this specialization and decision-rights leeway can lead to situations in which performance units take actions that are not in the corporations’ best interests. This is more likely to occur when performance units do not communicate effectively with one another or do not have goals and rewards that are aligned with the broader corporate objectives.

We have already seen that key processes can reduce these problems. Strategic plans, budgets, reporting requirements, controls, and internal audits also help mitigate them. In these initiatives, performance units are the focal point.

By contrast, employees are the focal point of initiatives that seek to align employees’ actions with shareholders’ interests. However, initiatives that are targeted at individuals also can help facilitate planning and coordination among performance units.

One of the more formidable challenges faced by coaches is getting players to perform as a team rather than a collection of individuals.

Similarly, the board of directors, who are the shareholders’ elected representatives, must convince employees and other stakeholders that maximizing shareholder value does not preclude creating value for themselves. Indeed, to attract and retain employees and other stakeholders, corporations must make them at least as well off as their next best opportunity.

Still, conflicts of interest often occur when employees or others can take actions that improve their own welfare at the shareholders’ expense, or vice-versa. For example, conflicts of interest occur when employees can play on the job without being detected and would rather do so than work. This behavior benefits the employee at shareholders’ expense.

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More generally, to the extent conflicts of interest are not resolved in the shareholders’ favor, the corporate goal of maximizing shareholder value is not achieved — performance declines relative to this ideal benchmark.

Many business and accounting problems arise because of conflicts of interest. For example, most of the accounting scandals that occurred in 2002 were associated with conflicts of interest — managers pursing their own interests when these conflicted with shareholders’ interests.

Boards of directors often take steps to align employees’ and shareholders’ interests. Among other things, they give employees an opportunity to become part owners by offering them shares or stock options.

Boards also use accounting information to monitor, control, motivate, evaluate, and reward corporate executives, who in turn use accounting information to monitor, control, motivate, evaluate, and reward other employees.

maNagemeNt struCtures aNd iNterNal reportsInternal alignment is facilitated by management reporting structures. These specify who works for whom and how the various performance units are related. The chain of command ultimately links everyone to the board of directors, who are the shareholders’ representatives. Thus, management structures in for-profit corporations are oriented toward maximizing shareholder value.

For example, a credit analyst might report to the controller, who reports to the chief financial officer, who reports to the chief executive officer and founder, who is the chairperson of the board of directors.

In larger companies, employees generally report directly to one boss, who is primarily responsible for evaluating them and helping them improve their performance. They report indirectly to others who provide input to their evaluations and access to resources and expertise that can facilitate their performance.

A critical issue in organizational design is deciding the dimensions of expertise (lines of business, functional specialities, key processes, or location) that define these direct and indirect reporting relationships.

For example, a credit analyst in Germany for a sales division of an American company might report directly to the head of the German division’s credit department and indirectly to the head of its order generation process. His boss, in turn, might report directly to the general manager of the German division and indirectly to the corporate controller.

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This example demonstrates the potential complexity of management reporting structures and the challenges executives confront when they try to align employees’ and shareholders’ interests.

Performance units are reporting entities. They issue accounting reports that help managers monitor, control, motivate, evaluate, and reward individuals and performance units that report to them. These managerial or internal accounting reports are important elements of the information system that facilitates communication within management reporting structures and thus improves performance.

exterNal aligNmeNtHow should the corporation align its decisions with society’s interests to ensure that it meets its social objectives and legal requirements?

Corporations have many legal responsibilities that are specified by the laws and regulations of the jurisdictions where they operate (cities, states, countries, etc.).

Most corporations also have high-level objectives that are expressed in terms of community responsibilities. These objectives seek to promote socially responsible behavior that exceeds the legal requirements.

Just as management structures and internal reporting seeks to align employee actions with shareholder interests, legal structures and external reports seek to align corporate actions with society’s interests. As demonstrated vividly by the 2002 accounting scandals, these efforts are not always successful.

Legal Structures and External ReportsCorporations generally have numerous legal subentities. These and the company itself are required to provide external accounting reports to government agencies such as tax authorities, and in many cases they are required to issue financial statements to the general public. Examples include the financial statements of the publicly traded companies that we have studied thus far.

Entities that are part of the management reporting structure may or may not be legal entities. For example, General Motors Acceptance Corporation, the entity that might give you a car loan, is a separate legal entity that is a “child” or subentity of General Motors Corporation. In contrast, the production department at a General Motors assembly plant is a subentity that is probably not a legal entity.

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Thus far we have seen that entities in the management structure may or may not be legal entities. The opposite is also true. Companies have legal entities that are not part of their management structures. In fact, they have hierarchical legal structures that generally differ from their management structures.

These structures are also called chains of ownership. You might be surprised to learn that multinationals often own hundreds of corporations throughout the world that are linked hierarchically by these chains.

For example, Hewlett-Packard’s shareholders own stock in a corporation that resides in the state of Delaware. This parent corporation must comply with the Delaware state laws, which among other things regulates the way HP interacts with its shareholders. Many companies’ parent corporations are located in Delaware because it has numerous laws that are deemed to be business-friendly.

Most of these Delaware companies have their corporate headquarters located elsewhere. For example, HP’s corporate headquarters is in Palo Alto, California. Thus, its management and legal reporting structures do not coincide.

Delaware parent companies usually own other corporations that are incorporated outside of Delaware and thus must comply with different laws of incorporation. These child corporations, in turn, own other corporations and so on.

The design of this chain of ownership is determined by a host of legal issues (limited liability and other rights and responsibilities) and by considerations involving taxes, duties, and tariffs.

While chains of ownership are not as important in day-to-day activities as the management reporting system, they have a significant impact on accounting reports. Companies generally report separate income tax reports for each entity in the chain, and they are often required to provide financial statements for these subentities.

There is another reason to have a general understanding of legal structures. Employees who are unaware of them can inadvertently trigger taxes, duties, or other consequences. This is especially likely to occur when a company’s legal structure differs from its management structure.

Chains of ownership also includes joint ventures, which are entities that are partly owned by other companies. For example, Merck has a joint venture with Johnson and Johnson that is included in the ownership chains of both companies. The legal structure of these ventures has significant consequences for financial and tax reporting.

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The legal entities in the chain of ownership are one aspect of a company’s legal structure. Companies are involved in numerous formal or informal agreements with outside entities. Formalizations of these agreements are called contracts.

For example, the credit agreement between a company and a customer will be formalized in a contract that specifies, among other things, the performance requirements for both parties. Contractual performance requirements are often expressed in terms of accounting measures.

Contracts also specify the recourse the parties have if the other party fails to meet these criteria. Contracts are carefully written to guarantee that they can be enforced by the courts if one of the parties fails to comply with the agreement.

To summarize:

A company’s capacity to perform is largely influenced by its management and legal structures. These structures give rise to a web of subentities that issue and use accounting reports.

You likely will study accounting reports for many types of entities during your personal and professional experiences. While our primary focus will be on corporations such as Intel, the concepts we will explore generalize to other reporting entities.

timiNgHow should the corporation create a sense of urgency to ensure that the organization performs quickly enough to gain competitive advantages?

In creating an infrastructure for performance, many corporations put a special emphasis on urgency. Performance has two timing aspects, whether it pertains to sports or business.

First, performance is generally measured and reported over time intervals of varying lengths. Second, performance goals must be achieved quickly to gain competitive advantage.

Sports performance is measured during intervals of varying lengths: during games by keeping score; during the regular season by win-loss records; and at the end of the season by final standings.

Fans want frequent updates to feed their emotions, reassess their loyalty, or determine how they should place their bets, and coaches want periodic reports to assess the team’s progress and respond when necessary.

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Fans and coaches both want recent results to get better predictions of future performance. A team that has won the last five games is more likely to win the next one than a team with the same win-loss record for the season but five recent losses. Again, corporations are similar to sports teams:

• Corporations report quarterly and annual performance measures to shareholders and potential investors for similar reasons. Investors want timely information when deciding whether to buy, hold, or sell stock. Indeed, they would prefer performance measures measured over even shorter periods and sometimes may get them.

• For internal purposes, management needs timely information to plan, coordinate, and control operations. In some situations, they measure performance continuously. For example, retailers often use point-of-sale information systems that permit them to continuously monitor sales. In other situations, measuring performance accurately over short intervals is often too costly or impossible, and using unreliable measures can have negative consequences.

BusiNess deCisioNs review-previewThis section gradually builds a detailed graphic of how business decisions and economic events occur in broader business-decision environments. In the process, it reviews business decisions that we have examined in this chapter and previews factors that influence them and, more generally, influence economic outcomes.

If you are reading a paper hard copy of Chapter 10, you should consider viewing the graphics that follow in color by opening and magnifying the Adobe PDF file: Navigating Accounting CD > Chapters >Chapter 10 > Chapter_10.pdf.

The figure at the top of the next page zooms in on the upper-left corner of the conceptual framework (as indicated by the box that straddles the framework icon).

This figure illustrates five elements of business-decision environments that are discussed frequently in Navigating Accounting because they profoundly affect and are affected by accounting decisions.

1. Business decisions

2. Economic outcomes

3. Consequences of user decisions

4. Key external factors affected by user decisions

5. Other key external factors

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The figure below builds on the previous one by illustrating how reporting entities set objectives and priorities, organize to perform, and perform. These decisions determine the purposes and structures of internal and external accounting reports.

Set objectives, priorities, and strategies: We have seen that for-profit corporations and their subunits perform to the extent their business decisions lead to outcomes that maximize shareholder value.

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To accomplish this goal, they must continually create strategies that beat their competition by offering customers, employees, and other stakeholders more value than they can receive from their next best opportunities.

Organize to perform: In seeking to optimize their own interests, customers, employees, suppliers, and governments have incentives to maximize their shares of the value that is created through competitive advantages (e.g., innovative products and efficient processes). To gain competitive advantage and mitigate these conflicts of interest, shareholders (through their board of directors) must organize to perform, meaning to maximize shareholder value and meet other objectives.

This entails setting long-term and short-term goals at all levels of the organization, creating strategies and performance units to achieve them, and developing and implementing management reporting structures that align other stakeholders’ actions with shareholders’ interests through controls, reporting requirements, monitoring mechanisms, and rewards and penalties.

Perform: Once this organizational structure is in place performance units must perform — make the day-to-day operating, investing, and financing decisions studied throughout Navigating Accounting.

The figure on the next page builds on the previous one by illustrating the first of three types of external factors that are affected by users’ decisions and profoundly affect economic outcomes, either indirectly through business decisions or directly in ways that are not controlled by the reporting entity: private and human resources.

Shareholders, bankers, suppliers and others provide private resources to reporting entities, and employees provide human resources. Their willingness to provide these resources, the costs they charge for them, and the other requirements they seek have important consequences for the reporting entity’s events, either directly or indirectly through their effects on business decisions.

Resource decisions and consequences are frequently influenced by accounting reports. For example, when a company announces lower than anticipated earnings, current and prospective shareholders often react adversely, causing the companies’ stock price to decline. This increases the company’s financing costs, which can cause the company to cancel proposed projects.

Similarly, suppliers are less likely to extend credit to firms that report losses and are financially inflexible. Furthermore, when suppliers rely

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strongly on the reporting company, they will be less likely to invest in property, plant, and equipment to meet the reporting company’s future demand.

Likewise, salary and benefit negotiations and the morale of employees (suppliers of human resources) can also be influenced by decisions that are partly based on internal and external accounting reports.

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The figure on the next page builds on the one above by illustrating the second type of external factor that is affected by users’ decisions and greatly affects economic outcomes: product markets.

Product-market factors such as customer preferences and credit risks, rates of change in product innovation, regulatory climates, competitor strategies, and the degree of competition (e.g., monopoly, oligopoly, pure competition, etc.) profoundly affect business decisions and economic outcomes.

Although generally to a lesser degree than discussed earlier for providers of private and human resources, the decisions of customers, competitors, and regulators that determine these consequences are frequently affected by accounting reports. Customers’ purchasing decisions can be affected by firms’ accounting reports, especially if customers rely on the entity for future service.

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For example, customers might expect a price discount or be reluctant to buy computer hardware, customized software, or cars from companies in financial distress.

Likewise, competitors’ strategic responses also can be influenced by firms’ financial reports and other disclosures. For example, companies that report high profits might attract new entrants and those that report low costs might motivate their competitors to reevaluate their production processes.

Alternatively, when companies report low profits and demonstrate other signs that they are having trouble financing operations, competitors might cut prices and steal market share in response, which compounds the firm’s cash flow problems and drives it into bankruptcy.

The figure on the next page builds on the one above by illustrating the third type of external factor that is affected by users’ decisions and greatly affects economic outcomes: alignment efforts. Three important aspects of alignment efforts are illustrated in the figure.

Outsider performance and compliance assessments: Business decisions are influenced by outsiders’ efforts to align a reporting entity’s decisions with their own interests. Shareholders and other stakeholders such as regulators, bankers, and labor unions seek ways to align the

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entity’s actions with their self interests. They establish performance criteria that center on their missions and depend on accounting measures. When these alignment efforts are made on shareholders’ behalf by the board of directors or senior management, they are closely related to the internal alignment issues discussed earlier. They have the same goal (to align employees’ actions with shareholders’ interests) and use similar means to accomplish it, but they are designed and implemented by outsiders, such as external auditors, rather than by insiders.

Consequences: The consequences of stakeholders’ performance assessments can severely restrict the reporting entity’s business decisions and thus hamper management’s ability to maximize shareholder value. For example, boards of directors can fire employees or reduce their compensation and bank regulators can restrict banks’ lending latitude.

Employee Incentives: Significantly, these alignment efforts, which are called corporate governance, often include rewards and penalties that are based on accounting measures. For example, when tied to compensation (through earnings bonuses, stock options etc.), performance measures can provide management with incentives to work harder, smarter, and more cooperatively. However, they can also provide them with incentives to manipulate business or accounting decisions.

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The figure below builds on the one on the previous page and completes the business-decision environment part of the conceptual framework. It illustrates two additional types of external factors that affect business decisions and economic outcomes:

Public resources: The availability and quality of legal systems, court systems, police and military protection, schools and universities, social services, and other public resources can greatly affect business decisions and economic outcomes.

Other political, social, and economic factors including political stability, labor laws, property rights, interest rates, exchange rates, and stock-market fluctuations also significantly influence business decisions and economic outcomes.

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ACCOUNTING DECISIONSiNtroduCtioNAccounting decisions connect events (outcomes) to financial, managerial, and tax reports by determining the purposes and structures of these reports, and whether, when, where, and how events are mapped onto them.

In economic terms, user decisions create demands for information about events, and accounting decisions determine the corresponding supply. Seldom does supply meet demand in the sense that users learn all they would like to know about events.

Some events are not reported because they are relatively insignificant or overlooked (usually inadvertently). Remember, events are defined very broadly to include everything that affects a reporting entity’s resources or the claims on them, including its business decisions and changes in its business environment.

Other events are not reported because they do not meet the recognition criteria. Furthermore, many events that are reported are measured imperfectly, or their measures are aggregated in ways that make it impossible to differentiate their separate effects.

The result is that large multinational companies condense information about millions of events that occur in numerous currencies and subentities into three or four pages of financial statements. Accounting decisions profoundly influence the usefulness of this information and thus its value.

In the introductory chapters, we studied accounting decisions that related to financial statements and those who make these decisions. This section reviews and extends those discussions. In particular, we will examine more closely the environment in which accounting decisions are made and identify several factors that profoundly influence them.

deCisioN-makiNg hierarChiesRecall that accounting decisions are made by a host of organizations and individuals in hierarchies that stretch from the highest seats of government to individual bookkeepers.

Decisions at higher levels in these hierarchies guide or restrict those at lower levels. Occasionally, these restrictions are so stringent that decision makers at lower levels have almost no flexibility. At other times, they are less restrictive and substantial judgment is required to implement them.

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Tax Reporting Reporting decisions pertaining to U.S. income taxes are made throughout legislative, judicial, and corporate hierarchies. The legislative hierarchy starts with broad tax laws passed by Congress, which restrict or guide more specific regulations developed by the U.S. Treasury, which further restrict or guide rulings written by the Internal Revenue Service, which restrict or guide policies established by corporate boards of directors, chief executive officers, and chief financial officers, which increasingly restrict or guide procedures and decisions at various levels in tax departments and operating divisions.

Similarly, a tax judicial hierarchy starts at the U.S. Supreme Court and extends through the judicial system to boards of directors, and then through the corporation via procedures and policies. Thus, U.S. corporate income tax procedures and policies are restricted and guided by tax decisions made by the legislative and judicial branches of government.

There are comparable tax hierarchies for each of the legal entities in a corporation’s chain of ownership. For instance, the income tax decisions of a French subsidiary are restricted and guided by French laws and court cases.

Financial Reporting Recall that there are similar hierarchies for financial reporting that also have components inside and outside corporate boundaries. Similar to that of tax reporting, in the U.S. the legislative hierarchy for financial reporting has its pinnacle in Congress. However, Congress delegates most of this responsibility to the SEC, which in turn delegates most financial reporting decisions to the FASB.

GAAP encompasses standards and practices that are widely accepted including, among other things: (1) FASB Standards, (2) SEC pronouncements, (3) AICPA pronouncements, and (4) industry guidelines and norms.

While corporate financial reporting decisions are guided and restricted by GAAP, some GAAP principles have more authority than others. For example, FASB standards and SEC pronouncements have strong legal authority, while norms and industry standards have less authority.

Managerial Reporting In contrast to tax and financial reporting, management reporting hierarchies are completely inside the corporation, and follow the management reporting structures outlined in the Business Decision section of this chapter.

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purposes oF reportsAccounting decisions map events into reports that are structured to meet purposes. We have seen that the purposes of balance sheets, income statements, and cash-flow statements dictated their structures. But what dictates their purposes and, more generally, the purposes of accounting reports?

Report purposes are expressed in terms of the informational demands (needs) of users:

• Taxreportsaimtohelptaxauthoritiesdecidewhetheracompany’slegal entities are complying with tax laws and regulations.

• Regulatoryreportsarespecialpurposeexternalreportsthataimtohelp insurance, banking, utility, and other regulators make regulatory decisions.

• Financialreports,ormorepreciselygeneralpurposeexternalfinancialreports, aim to help all other external parties make decisions that depend on a company’s events.

• Managerialreportsaimtohelpperformanceunitsinacompany’smanagement reporting structure make more informed decisions.

struCture oF reportsAs we saw in the earlier chapters on the financial statements, the structure of accounting reports conform to their purposes and are characterized by their elements and the way these elements are defined and classified.

For instance, financial reports include the three primary financial statements (balance sheets, income statements, and cash flow statements), footnotes, and other supplementary information. Each financial statement has one or more objective that is consistent with the broader purpose of financial reports, and each has distinct elements that are organized hierarchically.

For example, assets, liabilities and owners’ equities are primary elements of balance sheets and customer receivables is a type of asset.

You will be mapping events into this hierarchy of elements throughout Navigating Accounting. To this end, you will need to know the elements’ definitions and how they relate to events, that are mapped to the three primary financial statements.

The structures of management reports, by contrast, differ considerably across companies and are described in company documents.

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Once the purpose and structure of reports have been established, recognition, measurement, classification, disclosure, and record keeping decisions determine whether, when, and how events are mapped into them, whether supplementary information is reported in footnotes or elsewhere, and how information is recorded in accounting systems. We have already spent considerable time discussing these decisions. For example, we discussed recognition and measurement criteria for assets, liabilities, revenues, and expenses. However, there are a few more points to be made about recognition.

timiNg oF reCogNitioN Based on the discussion thus far, you might have the false impression that recognition decisions are made each time events occur. In practice, scrutinizing a business in this way would be far to costly, if not impossible.

Instead, there are two kinds of recognition decisions that collectively determine whether, where, and when significant events that occur during a reporting period, or perhaps earlier, are mapped into reports. Recognition decisions are triggered by:

1. Events as they occur during the reporting period (typically transactions with outsiders or internal transfers), or

2. The need to prepare a report at the end of a period.

Loosely speaking, you can think of these end-of-the-period recognition decisions as “catchup adjustments” that try to compensate for events that were overlooked during the period or perhaps earlier. In fact, the corresponding record keeping entries are called adjusting entries.

Purchasing a building and paying suppliers are examples of events that trigger recognition when these events occur. In contrast, bad-debt estimates are related to end-of-the period recognition decisions and may result in adjusting entries.

For instance, a company’s credit analysts receive information about the collectibility of its receivables from various sources continually throughout each reporting period. However, typically they create bad debt estimates only when internal or external reports are prepared.

For internal purposes, estimates are often made at the end of each month. At this time, the controller and credit analysts typically estimate the bad debts associated with the month-end receivables following their corporate procedures for managerial reporting. That is, they decide the amount of bad debts that will be recognized in these reports.

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This estimate should reflect the consequences of significant events that occurred during the month and those overlooked or measured incorrectly earlier. Strictly speaking, recognizing this estimate is not an event as defined earlier. Rather, estimating bad debts is a recognition decision that involves measuring the consequences of prior events.

When discussing end-of-period recognition decisions, the prior events often are not mentioned. A manager might say “we recognized a $3 million increase in our pension liability,” rather than “we recognized a $3 million increase in our pension liability related to prior employee service.”

Deciding whether to recognize events as they occur or at the end of the reporting period is a timing issue that affects record keeping but does not alter reports. By contrast, deciding whether to recognize a cost as an asset (and thus capitalize the cost) or whether to recognize it as an expense can have a dramatic impact on reports, as can revenue recognition.

reCord keepiNg systemsRecord-keeping decisions determine how financial measures are entered and stored in accounting systems after the related recognition and measurement decisions have been made.

Companies need systems to record the thousands of events that occur each year in such a way that accounting reports can readily be produced. We will not study the details of how these general ledger systems store and retrieve information.

Instead, we will portray accounting systems using two record keeping models and apply them throughout Navigating Accounting. This will help you meet the record keeping part of the record keeping and reporting challenge discussed shortly.

Record keeping is precise: once the subjective judgments related to recognition, measurement, classification, and disclosure decisions have been made, including the assumptions to apply a measurement procedure, there are right and wrong answers.

Thus, strictly speaking record keeping and reporting is a procedure rather than a decision since there is nothing to decide.

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aCCouNtiNg deCisioNs review-previewIn this section, we will gradually build a graphic that presents the five accounting decisions: recognition, measurement, classification, disclosure, and record keeping. We will also explore the key factors that influence these decisions and discuss five learning challenges that are integral to Navigating Accounting:

You will learn how to meet these challenges through exercises as you assume outsider and insider roles. For this reason, the challenges are described from both perspectives.

If you are reading a black and white hard copy of this chapter, you should consider viewing it in color by opening and magnifying the file:

Navigating Accounting CD > Chapters > Chapter 10 > Chapter_10.pdf.

The figure on the next page zooms in on the lower-left corner of the conceptual framework, as indicated by the box straddling the framework. It illustrates four high-level elements of accounting-decision environments.

1. Economic outcomes.

2. Accounting decisions requiring judgment.

3. Accounting decisions not requiring judgment.

4. Accounting reports.

While the financial statements are illustrated in the figure on the next page, and will be our primary focus, the framework applies, more generally, to all accounting reports.

Usage Search

Judgment

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of ConsolidationThe accompanying consolidated financial statements include the accounts and transactions of the Company together with its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in the consolidation.

Use of EstimatesThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates.

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The figure on the next page builds on the one above by illustrating how the insider judgment challenge fits into the conceptual framework.

From a preparer-insider perspective, the judgment challenge asks the following: Given an insider’s knowledge about factors that influence recognition, measurement, classification, and disclosure decisions, how should the insider make these decisions?

We will illustrate how the outsider judgment challenge fits into the conceptual framework later when we study user decisions. However, the insider and outsider challenges are closely related so we introduce the outsider challenge here:

From a user-outsider perspective, the judgment challenge asks: Given outsiders’ limited knowledge about the factors that likely influenced insider-preparers’ accounting decisions, how useful are the resulting numbers for outsiders’ decisions?

Essentially, the outsider judgment challenge is Navigating Accounting’s first goal.

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Use of EstimatesThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts and related disclosures.

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The figure on the next page builds on the one above by illustrating the logical flow of decisions that can require considerable judgment by those who establish and implement GAAP (or comparable principles for tax and management reporting):

1. Report Design, including determining report purposes in terms of users’ informational demands, and specifying their structures by defining their primary elements and the relationships of these elements to one another, business decisions, and events.

2. Recognition decisions, which determine whether events are mapped into report elements and, if so, when and where they are mapped into them. This entails determining whether the various aspects of an event meet the definitional and measurability criteria of specific report elements.

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3. Measurement decisions, which determine how events, resources, and other items are measured and also the best measure or measurement procedure among those that meet the recognition criteria.

4. Classification decisions, which assign items to categories that have different recognition and/or measurement consequences.

5. Disclosure decisions, which determine whether measures recognized in accounting reports are visible rather than aggregated with other measures.

We have seen that the decisions in the figure on the previous page are made throughout hierarchies that stretch from the highest seats of government power to preparers inside corporations. We have also seen that the latitude preparers have when making these decisions can vary

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significantly across accounting decisions, report elements, economic events, industries, and countries. In fact, in some situations preparers of accounting reports have little or no room for judgment.

Still, a distinctive feature of these accounting decisions is that there is at least one point in the decision-making hierarchy where considerable judgment is required.

This figure below builds on the one on the previous page by illustrating how the insider computation challenge fits into the conceptual framework.

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The insider computation challenge is to compute measures, conditional on measurement decisions that have already specified the related formulas and parameter values.

The outsider computation challenge will be discussed later after we complete sufficient groundwork.

The figure below builds on the previous one by illustrating how the record keeping component of the record keeping and reporting challenge discussed earlier fits into the conceptual framework.

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The logical flow of information in the record keeping icon in this figure is reinforced throughout Navigating Accounting.

The figure on the next page builds on the one above by illustrating how the insider record keeping and reporting challenge fits into the conceptual framework.

• The insider record keeping and reporting (R&R) challenge is to record measures of various aspects of an event into an accounting system and then trace these measures to the three primary financial statements.

• By design, the computation challenge and record keeping and reporting challenge always have unique answers. The related judgments have already been made when insiders tackle these challenges.

• This unique-answer design feature will facilitate your learning by separating procedural tasks (where there is a correct answer) from other tasks where experts disagree.

• However, this feature also reflects the leeway various decision makers have in the hierarchies discussed earlier. Standard-setters and regulators face tremendously complex decisions relative to those confronted by record keepers, and they have considerably more latitude when making decisions.

In the figure on the next page, the arrows from the record keeping icon to the financial statements demonstrate how information flows from accounting systems to reports.

We have also seen how the record keeping and reporting challenge relates to reverse engineering — determining the accounting decisions and events and circumstances behind reported numbers.

The outsider R&R challenge is to try and reverse engineer the insider process: to try to recreate recorded measures from reported numbers. For example, financial analysts often try to “back into numbers” using information in footnotes, financial statements, and other sources. A later figure shows how the outsider R&R challenge fits into the framework.

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The figure on the next page builds on the one above and completes the accounting-decision-environment. It illustrates factors besides economic outcomes that affect reports design, recognition, measurement, classification, and disclosure decisions to various degrees depending on the context.

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We have indicated that accounting decisions requiring judgment tend to be significantly influenced by the underlying economic events and related uncertainty and thus by business decisions and external factors. We also have indicated that other factors besides economic events affect accounting judgments. While it is not possible to identify all of these, the six factors highlighted below are particularly influential in many situations:• Management’sincentivesandability• Users’conflictingdemandsforinformation• Informationacquisitionandprocessingcosts• Anticipatedconsequencesofusers’decisionsonthereportingentity• Externalandinternalregulations,policiesandenforcement• Auditorsandotherunrelatedpartiesthatenhancereports’credibility

These factors are central to understanding the decisions behind the accounting scandals that occurred in 2002.

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USER DECISIONSiNtroduCtioNUser decisions determine the demand for accounting reports, and they have consequences for business and accounting decisions. As we transition from studying insiders’ decisions to studying outsiders’ decisions, keep in mind that each side would like to know as much as possible about the other’s decisions.

We have already seen that when insider-preparers are making accounting decisions, they try to anticipate the consequences of user decisions. Next, we move to the other side of this information asymmetry, where outsider-users seek to learn all they can about insiders’ private information.

This section will help you meet the learning challenges you will face in the exercises when you assume the role of an outsider. From an outsider perspective, the usage icon that has appeared next to earlier exercises relates to everything you will learn in this section.

• The outsider usage challenge is to determine how to use accounting numbers when making decisions.

• The insider usage challenge is to identify and assess the information that users want (their demand for information) and the consequences of user decisions on the reporting entity.

Thus, essentially the insiders’ challenge is to reverse engineer the outsiders’ decisions and assess their consequences. This is the challenge that Chief Financial Officers at major corporations confront when they try to assess how investors will respond to accounting disclosures.

In Navigating Accounting, user decisions and thus, the outsider usage challenge is divided into the four stages in the figure on the next page:

1. Assess Usefulness: Users assess the usefulness of reported numbers for their decisions by trying to recreate insiders’ business and accounting decisions.

2. Assess Performance: Users create performance measures based on reported numbers and other information and compare them to benchmarks.

3. Employ Decision Models: Users employ formal and informal decision models that are based on their performance assessments and other information.

4. Make Decisions: Users make decisions based on what they learn from their decision models and other sources.

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assess useFulNessTo assess the usefulness of a reported number, users must know what the number is intended to measure (its measurement objective, which is often expressed as a measurements’ attribute such as historical cost), how reliably it meets this objective, and how relevant this objective is to their decisions.

Usefulness Criteria and User Decisions

Users’ decisions are often based on predictions about future performance. For example, corporate controllers who are deciding whether budgets are appropriate and investors who are deciding whether to buy stock analyze current and historical performance, but they are principally interested in predicting future performance.

Users who employ decision models that are based on forecasts of future performance variables (such as cash flows or earnings) have a specific usefulness criterion: current accounting numbers are useful to the extent that they help them forecast these future performance variables more reliably.

There are other usefulness criteria for which the focus is largely on current performance. For example, managerial reports often are used

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by supervisors and their superiors to monitor and control processes. In these situations, reported measures are useful to the extent they help users identify situations in which processes are not meeting performance expectations.

The Challenge Outsiders Confront When They Assess UsefulnessTo evaluate the usefulness of accounting measures for assessing current performance or predicting future performance, auditors, regulators, and other users must understand how well the numbers reflect the underlying events. To this end, they must try to recreate the factors that influence insiders’ business and accounting decisions.

The figure on the next page starts a graphic build that will illustrate the problem outsiders face because of their limited information. These figures gradually develop the outsider judgment challenge.

From a user-outsider perspective, the judgment challenge asks: Given outsiders’ limited knowledge about the factors that likely influenced insider-preparers’ accounting decisions, how useful are the resulting numbers for outsiders’ decisions?

Considering the multitude of factors that are hidden from outsiders, auditors, regulators, and other users’ analyses of insiders’ decisions can be very challenging.

The figure on the next page zooms in on the Assess Usefulness part of the previous figure, which zooms in on the User Decision portion of the Conceptual Framework. It illustrates that the outsider judgment challenge is to assess the usefulness of reported numbers.

Assessing usefulness is equivalent to assessing relevance and reliability. To meet this challenge, outsiders try to learn as much as possible about insiders’ business and accounting decisions.

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The figure on the next page zooms in on the one above by illustrating ideally what every outsider would like to know when assessing the usefulness of accounting numbers: what insiders know about their business and accounting decisions. This only happens when the users are the insiders who made the business and accounting decisions.

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More generally, what an outsider-user knows about insiders’ decisions and thus the outsider’s capacity to assess the usefulness of accounting numbers is limited by their:

• generalunderstandingofbusinessandaccountingdecisions

• abilitytosearchforpertinentinformation

• abilitytousethisinformationtorecreateinsiders’decisions.

To view more details, magnify the graphic in Adobe Reader.

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The figure on the next page builds on the one above by illustrating what novice users know about insiders’ business and accounting decisions and thus their capacity to assess usefulness when they have a general understanding of the purpose and structure of financial statements but can not connect reported numbers back to the underlying business and accounting decisions.

Again, to view more details, magnify the graphic in Adobe Reader.

Navigating Accounting presumes that most readers start out as novices who have limited experience with financial statements and other reports and seeks to help you connect reported numbers to underlying insider decisions.

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The figure on the next page builds on the one above by illustrating what expert users know about insiders’ business and accounting decisions and thus their capacity to assess usefulness after several years of studies and experience.

Again, to view more details, magnify the graphic in Adobe Reader.

To assess usefulness and performance, expert outsider-users try to recreate insiders’ business and accounting decisions. To this end, they search for related disclosures and make informed conjectures about hidden aspects of insider decisions. Still, their picture of a reporting entity’s business and accounting decisions continues to be blurred relative to insiders’ picture because insiders have access to superior private information about their decisions.

Navigating Accounting will help you gain the requisite skills, concepts, and applications to begin to clarify this picture. However, set reasonable expectations; this is a lifetime endeavor, even for experts.

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Risk and Divergent Beliefs Amplify the ChallengeOutsiders’ assessments of insiders’ decisions are particularly challenging when underlying events have risky future consequences and insider-preparers, auditors, regulators, and users have limited experience with these risks.

In these risky situations, these parties are more likely to have divergent beliefs about the risky future consequences of current events and thus about the reliability of alternative measures that aim to reflect them.

For example, a company and its auditor might have divergent beliefs about the best estimate of its future bad debts and about the level of confidence they have in these estimates.

A central theme of Navigating Accounting is that risk about the consequences of events is necessary (but not sufficient) for divergent beliefs about these consequences, and to the extent there is such divergence, measurement becomes problematic and reported numbers less reliable (but generally more relevant).

An important point to grasp now is that beliefs about the risky future consequences of current events are center stage in business, accounting,

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and user decisions. Thus, regardless of your future plans, you will benefit greatly from knowing how to form, analyze, and discuss these beliefs.

Generally, the greater the divergence of beliefs about the risky future consequences of current resources, events, or claims, the more likely the other factors that affect usefulness will be present, and the greater their potential influence on measurement decisions.

Preparers have greater opportunity to manipulate measures without being detected when there are divergent beliefs about the consequences of underlying events. They also have greater opportunity to make honest mistakes.

Auditor and Regulator Validations and Restrictions on Insider Accounting JudgmentsIn the limit, concerns about honest errors or opportunism, often leads regulators and auditors to impose restrictions. For example, when auditors and regulators cannot validate measurement procedures and assumptions with reasonable assurance, they often prohibit managers from using these procedures or restrict the leeway they have when making assumptions.

Auditors must be able to validate that a recognized number measures what it is intended to measure (its measurement objective) with reasonable assurance, even if this objective is less relevant to users than other measures that cannot be validated.

To this end, GAAP restricts measurement procedures and assumptions to those where there is data or theory that validates that recognized numbers have small measurement errors — are “close” to their measurement objectives.

The Consequences of Restrictions on UsefulnessThese restrictions likely improve the usefulness of numbers that are reported by incompetent or dishonest insiders. However, imposing such restrictions generally prevents the most honest and competent managers from fully disclosing information that permits users to identify their superior performance.

• Indeed, it is precisely when there are pronounced divergent beliefs, and thus concerns about reliability, that reliable performance measures would be most relevant: When there is disagreement about the consequences of underlying risks, insiders often have greater opportunities to gain or lose competitive advantage by managing these risks.

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• Thus, risk can give rise to divergent beliefs about relevant business activities, which can give rise to honest measurement errors and manipulation, which, in turn, can give rise to measurement restrictions that limit preparers to procedures and assumptions that auditors and regulators can validate with reasonable assurance.

assess perFormaNCePerformance assessments were discussed briefly in an earlier chapter when return on equity and other ratios related to income were introduced. Computing performance ratios is part of the outsider computation challenge. More generally, the outsider computation challenge centers on stages 2 and 3 of user decisions: computing performance ratios; forecasting cash flows, earnings, and pro-forma financial statements; and computing present values and formulas related to other decision models.

The figure on the next page illustrates five steps that users typically follow, at least implicitly, when they assess performance:

1. Construct performance measures

2. Compare these measures to benchmarks

3. Corroborate or refute preliminary conclusions from these comparisons with additional facts

4. Assess performance and (the user-assessor’s) confidence in these assessments

5. Refine the assessments to the extent it is cost effective

The figure also shows that computations related to these assessments are part of the outsider computation challenge.

Construct MeasuresUsers generally construct performance measures from reported numbers such as return on equity or other ratios that are related to their decisions and to the reporting entity’s environment, strategy to compete in this environment, and its key success factors (the things it must do well for its strategy to succeed).

Compare to BenchmarksTo facilitate comparisons across different-sized entities, performance measures are often ratios such as sales dollars per employee or expected future bad-debts as a percentage of current receivables.

More generally, users assess performance by comparing the reporting entity’s current-period performance measures to benchmarks (other

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BusinessDecisions

AccountingDecisions

EconomicOutcomes

Insiders

UserDecisions

Outsiders

AccountingReports


Consequences

Accounting Reports

User Decisions:

Assess Usefulness











Assess Performance

Yes No

Construct performance measure

Corroborate with theory or facts

Compare to benchmarks

Assess performance & confidence

Cost effective to refine analysis?

Decisions: DecisionModel

entities’ performance ratios, the entity’s own historical performance, or the entity’s strategic goals). For example, suppose that a credit analyst reports $7,500 of expected future bad debts at the end of the first year to his boss and that she is reasonably confident in the accuracy of this estimate.

In assessing his performance as a credit manager, she will seek one or more benchmarks for comparison. She will likely compare the analyst’s performance against budgeted bad debts, historical trends, and industry norms.

Corroborate with Other FactsUsers seek other information to corroborate or refute preliminary performance assessments. For example, the credit manager might ask the analyst probing questions to assess the assumptions behind his forecasts and his general understanding of forecasting concepts and techniques.

Users also seek other evidence to corroborate preliminary forecasts of future financial measures that are based on benchmark comparisons. For example, an analyst’s preliminary forecast of a company’s future sales might be based on a historical trend. But this forecast will likely be refined considerably before it is used in a valuation model with information about new products the company plans to launch, new markets it plans to enter, etc.

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Assess ConfidenceImportantly, users’ confidence in their performance assessments and pro forma statements depends on their usefulness assessments. To the extent they believe that the reported numbers are unreliable, they will be less confident in their performance assessments and pro forma statements and seek other types of information.

Is refinement cost effective? Like the scientific method, performance assessment is a recursive process that can always be refined by additional inquiry. But at some point the marginal benefit of these inquiries is less than the marginal cost. When users are relatively confident about their assessments or unwilling to spend additional resources to refine them, they are ready to make decisions.

employ deCisioN modelsIn the third stage of their decisions, users apply formal or informal models that are based on performance measures and other relevant information.

The present value model often is used at this stage. For now, you only need to know that computing present values has become a rite of passage to receive an MBA or undergraduate degree in business. You will learn how to compute and understand them in finance courses.

However, the real skill is not “running the numbers” but rather it is determining the numbers that will be run. Estimating the inputs to this model, the expected cash flows, and related risks generally requires quantitative and qualitative analyses.

In particular, there is no magic formula to map the factors that affect business and accounting decisions into these inputs. But the theory and skills you learn here and elsewhere will help you gain proficiency at estimating these inputs.

The discounted cash flow models discussed in Chapter 8 are one of several models you will likely study in other courses that are partly based on accounting numbers. Here are some other examples:

• earnings-basedvaluationmodelsareclearlybasedonaccountinginformation;

• optimuminventorylevelmodelsdependoncostsandsalesprojections;

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• break-evenmodelsarebasedoncostsandsalesprojections;and

• modelsoflabornegotiationsaresometimesbasedonaccountinginformation.

make deCisioNsIn the final stage, users make decisions conditional on what they have learned from one or more decision models and from experience, experts’ opinions, or other sources.

This stage is more art than science, and while we will not study this art, it plays an important role in many decision contexts.

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CONCEPTUAL FRAMEWORK REVIEWThe three-decision conceptual framework encompasses many factors studied in undergraduate and MBA business courses.

For example, the business decision discussion emphasized how strategy and organizational design affect performance and the user decision section discussed how finance models that are used to value companies are affected by accounting measures.

There are two reasons for including these elements in the framework and other factors that will be added later from marketing, operations, and research and development:

1. As demonstrated repeatedly in this chapter, the better you understand business decisions and the factors that influence them, the better you will understand the related accounting.

2. Briefly discussing topics that you study in more depth in other courses will help you connect the concepts you learn here to those you learn elsewhere.

As Navigating Accounting progresses and the conceptual framework is further developed, you will learn even more about how the three decisions relate to concepts and theories you are studying in other courses.

Ultimately, you will study business and user decisions in great detail in courses such as marketing, strategy, operations, ethics, organizational behavior, finance, and economics. Navigating Accounting’s comparative advantages center on accounting decisions and its goal is to ensure that you gain the necessary accounting competencies to make better accounting, business, and user decisions.

The some of the exercises and assignments in earlier chapters focused on one aspect of the framework: record keeping and reporting. To master record keeping skills you only need to understand business decisions and economic outcomes in terms of what happened. For example, you need to know who got what from whom and when did they get these things. But you do not need to understand the risks related to these outcomes or the factors that influence them.

Similarly, you will need to understand the accounting alternatives management is permitted under GAAP when learning record keeping and reporting, but you will not need to understand how the numbers

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you record were measured or the factors that influenced these measurements and management’s choices of accounting procedures.

However, the readings and exercises will gradually begin to emphasize the other factors in the conceptual framework as you progress through Navigating Accounting. These in-depth analyses of the framework’s three decisions will help you make more informed accounting decisions, or make more informed assessments of others’ accounting decisions.

You will also learn that your capacity to understand the three decisions and their interdependencies will be determined largely by the decision you least understand - your weakest link.

For example, if you have a shallow understanding of business, you will superficially assess the accuracy of accounting numbers, and thus their usefulness for your decisions. This will be true regardless of your mastery of accounting and finance concepts. Similarly, your analyses will be shallow if your understanding of accounting is superficial, regardless of your mastery of business and finance concepts.

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Exercise 10.01Part 1The Accounting policies footnote explains the company’s accounting choices related to recognition, measurement, and classification decisions that require judgments that affect its financial statements. This footnote is a mandated disclosure that is typically found immediately after the financial statements. Intel’s 2006 Accounting Policies footnote starts on page 53 and ends on page 61.

The Critical Accounting Estimates footnote discloses the company’s accounting policies that require estimates and subjective judgments that have a significant impact on the company’s financial results. Intel’s 2006 Critical Accounting Estimates footnote starts on page 29 and ends on page 32.

Skim the footnotes searching for terms and concepts discussed in this section. Do not get bogged down in terms and concepts that we have not yet covered.

Using Intel’s 2006 Annual Report, locate the following items:

(a) Two places where Intel indicates, or the circumstances suggest, that numbers in the financial statements are based on judgments made by the company.

(b) Three classification decisions.

(c) An asset that is recognized at its fair value.

(d) Two assets that are recognized at their historical cost adjusted for usage.

(e) An asset that is recognized at the lower of cost or market. Create one scenario where the asset would be recognized at cost and another where it would be recognized at market. Contrast lower of cost or market measures with fair value measures. When might they differ?

The Chapter 10 slides provide some of the possible solutions to these questions:

Navigating Accounting CD > Chapters >Chapter 10 > Chapter_10.ppt

You will likely discover others. Be sure to try the problem on your own before checking the solution. Learning how to search for information in annual reports takes considerable practice and your professor will likely expect you to be quite proficient at this skill on exams.

Search IconThis exercise requires you to search for information.

Usage IconThis exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders.

Judgment IconThis exercise helps you learn how judgment affects accounting measures and disclosures.




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Part 2Wal-Mart’s and Starbucks’ 2002 Annual Reports are in the Annual Reports folder of the Navigating Accounting CD (Wal-Mart_AR_02.pdf and Starbucks_AR_02.pdf ).

Wal-Mart and Starbucks both lease most of their stores. One of these companies indicates in footnotes that some of its leases are classified as capital and others as operating. In addition, this company signals rather clearly that all of the leases in its Leases footnote are operating leases. While it is possible for someone who is reasonably knowledgeable to determine that the leases in the other company’s Leases footnote are likely operating leases, the footnote does not mention the way these leases are classified. We say that one company’s lease-classification disclosures are more transparent than the others’.

Which company has the more transparent disclosures regarding lease classifications? Wal-Mart or Starbucks?

The Chapter 10 slides identify the company with the most transparent lease-classification disclosures. Again, search for the information on your own before checking the solution.

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