Financial Accounting: In an Economic Context

THE ECONOMIC ENVIRONMENT IN WHICH FINANCIAL REPORTS ARE PREPARED AND USED

Recent and significant financial disasters perpetrated by poor risk assessment and sometimes even fraudulent financial statements underscore the importance of accurate and credible financial reporting for the United States and the world economy. Financial statements provide measures of firm performance that support decisions by a wide variety of individuals and entities leading to billions of dollars in resource transfers each year. Indeed, the world economy depends to an important extent on the reliability and validity of financial statements.

Figure 1-6 illustrates the key elements of the financial accounting environment introduced earlier in the Microline scenario. In that scenario, as a potential investor you acted as a provider of capital, Martin Wagner and Microline represented the company (manager), and Arthur Price was the auditor. The figure shows that providers of capital (debt investors and equity investors) invest in (send funds to) companies operated by managers. In return, creditors (debt investors) expect to receive interest and principal payments, and equity investors expect to receive returns in the form of dividends and/or stock price appreciation. Company managers (1) hire auditors to attest to the financial information and (2) enter into debt and/or compensation contracts. Auditors add credibility to the financial statements by attesting to whether they were prepared in conformance with ...