Financial Accounting: In an Economic Context

SUMMARY OF KEY POINTS

The key points of the chapter are summarized below.

Using financial accounting numbers to influence management decisions and predict future events.

Financial accounting numbers can be used in two fundamental ways: (1) they help investors, creditors, and other interested parties to influence the business decisions of a company's managers, and (2) they help to predict a company's future cash flows by providing an indication of earning power and solvency.

Investors and creditors use financial accounting numbers to influence managers by requiring that they enter contracts written in terms of financial accounting numbers. Shareholders encourage management to act in their interests by basing management's compensation on profits. Creditors constrain the actions of managers and protect their own interests by writing restrictions, expressed in terms of financial accounting numbers, into loan contracts.

Although financial accounting numbers report on past events, to the extent that past events are an indication of the future, financial accounting numbers can be used to predict a company's future cash flows. The income statement is designed to measure earning power, the balance sheet measures financial condition, and the statement of cash flows can be used to assess solvency—and all of these concepts relate to a company's ability to generate assets in the future.

Five ...