Summary (Catch-up)

So I haven't been on top of my weekly summaries as I should be.  Here is we covered through last week...

Theory of the Firm
We started with discussion of some big questions - what is a firm, why is there accounting, and does it matter if accounting is any good. I characterized the firm as a collection of contracts, and highlighted the importance of the contract between managers and owners. This is the classic agency relationship, where principals (shareholders) hire a set of agents (managers) to run the firm for them. This gives rise to agency costs given that it is unlikely that the managers will work as hard working for someone else as they would while working for themselves. Agency costs were defined as the loss in productive output because of the agency relationship.

Principals do have some options to try and limit agency costs - they can engage in monitoring by directly observing output, offer incentives linking pay to performance (through bonuses and stock options), or by bonding employees through an external review like an audit. Even if a principal chooses to do these things, there will be some agency costs left over, which we call residual losses (the only way to truly get the employee to work as hard as an owner would be to give them the firm, which doesn't make any sense). These actions do come at a cost though, and we formally defined net agency costs as the cost of actions (monitoring, incentives, bonding), plus any residual losses.

The public corporation involves separation of ownership (shareholders) and control (managers), and the board of directors is the body that tries to make sure the two sides play nice, thereby reducing agency costs.

We discussed the idea that the accounting scandals from 2002 (Enron, Worldcom) represented agency costs, because managers took actions that were not in the best interest of shareholders. Funny that the strategy intended to reduce agency costs (incentive compensation) created a whole set of other problems.  We also went through an exercise that highlighted why this might be.

We walked through a bit on the Sarbanes-Oxley Act of 2002 (SOX). The primary things accomplished by the act were 1) Creation of the Public Company Accounting Oversight Board (PCAOB) designed to oversee auditing standards; 2) More defined auditor independence rules that limit the services that firms can offer to financial statement audit clients; 3) Requirement that CEOs and CFOs “certify” financial statements (increasing accountability); and 4) increased disclosure rules regarding internal control under Section 404.

With regard to internal control, it represents things firms do to make sure that a particular process works as intended. In terms of financial reporting, this means that we are trying to make sure that financial statements are in line with GAAP.

We think about internal control in terms of to COSO framework, which defines internal control as “…a process, effected by an entity’s board of directors, management, and other key personnel, designed to provide reasonable assurance regarding the achievement of objectives in financial reporting (i.e. GAAP)…” Note that internal control has nothing to do with profitability, at least directly. Firms that are losing money can have solid internal controls – it is really about telling the correct story in the financial statements, even if the story is lousy.

SOX includes changes in reporting requirements for both management and external auditors. Managers have to 1) State on a yearly basis that they are responsible for internal control over financial reporting; 2) Document their internal controls over financial reporting, then test to see if things are actually happening the way they say they do/should; and 3) Provide an assessment of their internal control process. Then, external auditors need to basically do things to get comfortable with what management did (review work, perform additional tests) so they can issue a formal report on their take regarding the firm’s internal control structure over financial reporting.

SOX has some pros and cons. On the pros side, you could argue that the additional transparency returned money to the capital markets, which helped to lower borrowing costs for everyone. Also, if the legislation made firms think critically about how they wanted to do things, then there is the possibility for better decision-making. On the cost side, 404 documentation was expensive (especially for small firms), it may have limited risk taking because of fears about having to write down everything you do, and it likely caused there to be fewer public companies, either because foreign firms not wanting to deal with SOX have incentives to see listing exchanges outside the US (London, Singapore, etc.) or because firms have chosen to “go private”.

Intro to Processes
We began with some definitions. A system is a set of two or more interrelated components that interact to achieve a goal, and it usually involves a series of subsystems that perform specific functions. Good systems make effective use of integration, by trying to eliminate doing things twice.

Good information has value, but it needs to be thought of by comparing costs and benefits. Benefits include better decisions and reduced uncertainty, while the costs are preparing and disseminating the info. There are 7 characteristics of good information: 1) relevance (on point); 2) reliability (dependable); 3) complete (getting everything); 4) timely; 5) understandability; 6) verifiability (can be re-calculated by someone else), and 7) availability

An AIS in a nutshell is supposed to be able to 1) Collect and store data; 2) process those data into information useful for decision making (both externally and internally), and 3) provide controls to ensure that data are accurate and that assets are safeguarded. It consists of more than just computer stuff, it includes people and policies and procedures as well.

We introduced the business cycles by formally defining what a transaction. Transactions are economic events that can be measured. This involves some sort of exchange of resources (selling something) or something that involves the passage of time (like depreciating equipment)

There are 5 major transaction cycles.
Revenue cycle: Selling stuff and getting paid
Expenditure cycle: Buying stuff and paying for it
Production cycle: Making stuff
Human resources/payroll cycle: Interacting with employees (hire, train, pay, evaluate promote, and fire)
Financing cycle: Borrowing money and paying it back

Everything gets tied together in the general ledger and reporting system (GLARS). We need to be comfortable with how data are input stored, processed, and output to be able to move forward.

Whenever we deal with data input, we need to capture details on Resources, Events, and Agents. Data are entered into our system, and are stored in three layers of detail. The first layer involves journals, which is where you will store the detail of individual transactions. Transactions that are “routine” (meaning they are part of the day-to-day operations of the firm) will have their own specific journal (i.e. one for sales, purchases, cash collections, etc.). Transactions that are “non-routine” (i.e things that don’t happen every day) will get grouped into what is known as the general journal. The next layer of detail up involves a subsidiary ledger, which summarizes transaction detail according to a meaningful category. For example, there will be a subsidiary ledger for each customer that owes us money, for each supplier to which we owe money, or each item inventory. The top level of detail involves the ledger, which stores cumulative information about resources and agents. It is basically a running tab of each account that shows up on the financial statements.

We also briefly distinguished batch processing, where transactions are saved up and processed all at once, from on-line processing where transactions are processed in real time.

More and more companies are relying on Enterprise Resources Planning (ERP) systems that are designed to integrate operations in with the accounting system. We’ll discuss more on ERP systems as we move forward in the class.