Financial Accounting: In an Economic Context

CONTROL AND PREDICTION

Financial accounting numbers are useful in two fundamental ways: (1) they help investors and creditors influence and monitor the business decisions of a company's managers, and (2) they help to predict a company's future earnings and cash flows.

Financial Accounting Numbers and Management Control

Investors and creditors, who provide a company with its capital, can direct and monitor the actions of its managers by requiring that their contracts be written in terms of financial accounting numbers. Shareholders have incentives to encourage management to act in ways that maximize future dividend payments and stock price appreciation. Since such returns depend on a company's earning power and long-term profitability, shareholders want management to make business decisions that maintain high levels of earning power. A common method used to attain such a goal is to base management's compensation on reported profits. Such compensation schemes, which are set by a company's board of directors, can lead to payments in the form of either cash or shares of stock. Exxon Mobil Corporation, for example, has implemented a management incentive program that pays eligible employees a percentage of the company's earnings if net income in a given year exceeds 6 percent of invested capital (as defined in the bonus plan). These bonuses have been paid in both cash and shares of Exxon Mobil common stock.¹

Creditors are also interested in protecting their investments by influencing ...