BUS103: Introduction to Financial Accounting

In 1929 the Dow Jones Industrial Average fell 40 percent over the period fromSeptember 3rd to October 29th. The Dow bottomed out in July 1932, after losing 89 percent of its value. Some blamed accounting for the run-up in prices and the subsequent crash. Stocks may have been overpriced because companies engaged in "window dressing" to enhance their reported income. At the time, accounting practices and reporting procedures were not well-established. As investors began to understand this, confidence fell. Investors panicked and sold stocks in a frenzy. This action contributed to the Great Depression of the 1930s. The Dow did not reach precrash levels again until 1954.

In response to the financial crisis, the Securities and Exchange Commission (SEC) was established in 1934 to regulate the filing requirements of firms listed on US stock exchanges. The SEC requires all listed firms in each year to prepare financial statements in accordance with generally accepted accounting principles (GAAP) and to have those financial statements audited by an independent party. This independent verification was meant to restore investor confidence and provide ongoing integrity in the capital market system. If a company fails to follow GAAP, it can be delisted from the stock exchange.

For many reasons, managers have incentives to manipulate income to enhance reported performance. It is the job of auditors to use their understanding of accounting principles and business practices to provide reasonable assurance that financial statements are free from such manipulation. One possible indication of income manipulation occurs when accrual earnings are high relative to cash flows from operating activities, sometimes referred to as "cash earnings". Accrual earnings are typically easier to manipulate because they employ estimates, whereas cash earnings are tied to actual cash receipts and payments from operations. Accrual earnings can be managed upward by recognizing earnings prematurely (or falsely) or by underestimating expenses such as depreciation expense or bad debts expense.

In addition to the challenges of verifying the accuracy of financial statements, a career in auditing provides a variety of options. Students can work for global auditing firms or small local firms, choose to travel frequently or on a limited basis, and decide to live in any geographic area around the world. A career in auditing also provides an excellent springboard for future opportunities. Companies realize that their auditors can be a valuable part of the management team. Auditors have expertise about the firm, its industry, and its accounting practices. Auditors commonly leave the auditing profession to work for one of their many clients.

The income statement, statement of stockholders' equity (or statement of retained earnings), and the balance sheet do not answer all the questions raised by users of financial statements. Such questions include: How much cash was generated by the company's operations? How can the Cash account be overdrawn when my accountant said the business was profitable? Why is such a profitable company able to pay only small dividends? How much was spent for new plant and equipment, and where did the company get the cash for the expenditures? How was the company able to pay a dividend when it incurred a net loss for the year?

In this chapter, you will learn about the statement of cash flows, which answers these questions. The statement of cash flows is another major required financial statement; it shows important information not shown directly in the other financial statements.