12.1. Recognizing Management's Role

Whether a business is a small private company or a large public corporation, its annual financial report consists of

  • The three basic financial statements: income statement, balance sheet, and statement of cash flows.

  • A statement of changes in owners' equity (if needed). Although it's called a "statement," this item is more properly described as a supplementary schedule. It reports certain information regarding changes in owners' equity accounts during the year that is not included in its three primary financial statements. (See "Statement of Changes in Owners' Equity" later in the chapter.)

  • And more.

In deciding what "more" means, the business's CEO and top lieutenants play an essential role — which they (and outside investors and lenders) should understand. The CEO does certain critical things before a financial report is released to the outside world:

  1. Confers with the company's chief financial officer and controller (chief accountant) to make sure that the latest accounting and financial reporting standards and requirements have been applied in its financial report. (The president of a smaller private company may have to consult with a CPA on these matters.) In recent years, we've seen a high degree of flux in accounting and financial reporting standards and requirements. The private sector Financial Accounting Standards Board (FASB) and the governmental regulatory agency, the Securities and Exchange Commission (SEC), have been very busy in recent years — to say nothing of the federal Sarbanes-Oxley Act of 2002 and the creation of the Public Company Accounting Oversight Board.

    NOTE

    A business and its auditors cannot simply assume that the accounting methods and financial reporting practices that have been used for many years are still correct and adequate. A business must check carefully whether it is in full compliance with current accounting standards and financial reporting requirements.

  2. Carefully reviews the disclosures in the financial report. The CEO and financial officers of the business must make sure that the disclosures — all information other than the financial statements — are adequate according to financial reporting standards, and that all the disclosure elements are truthful but, at the same time, not damaging to the business.

    This disclosure review can be compared with the notion of due diligence, which is done to make certain that all relevant information is collected, that the information is accurate and reliable, and that all relevant requirements and regulations are being complied with. This step is especially important for public corporations whose securities (stock shares and debt instruments) are traded on securities exchanges. Public businesses fall under the jurisdiction of federal securities laws, which require very technical and detailed filings with the SEC.


  3. Considers whether the financial statement numbers need touching up. The idea here is to smooth the jagged edges off the company's year-to-year profit gyrations or to improve the business's short-term solvency picture. Although this can be described as putting your thumb on the scale, you can also argue that sometimes the scale is a little out of balance to begin with and the CEO should approve adjusting the financial statements in order to make them jibe better with the normal circumstances of the business.

When I discuss the third step later in this chapter, I'm venturing into a gray area that accountants don't much like to talk about. Some topics are, shall I say, rather delicate. The manager has to strike a balance between the interests of the business on the one hand and the interests of the owners (investors) and creditors of the business on the other. The best analogy I can think of is the advertising done by a business. Advertising should be truthful, but, as I'm sure you know, businesses have a lot of leeway regarding how to advertise their products and have been known to engage in hyperbole. Managers exercise the same freedoms in putting together their financial reports. Financial reports may have some hype, and managers may put as much positive spin on bad news as possible without making deceitful and deliberately misleading comments.


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