The cost of capital is the cost a company bears to obtain external financing. A company's cost of capital is critical because it determines which long-term projects are profitable for the entity to undertake. The higher the cost to obtain funds, the

Question

fewer the long-term projects are profitable for a company to pursue. Required: Explain the role of financial statements generally and the roles of the FASB, the AICPA, the SEC, and the IASB in lowering the cost of capital.

Answer 1

The more risk associated with a company, the higher its cost of capital. One risk factor is the information associated with uncertainty about a company's future prospects. A company produces financial statements to better inform investors and creditors of the entity's past performance. The information contained in the financial statements is used as a basis for forecasting the company's future performance. Quality financial statements reduce the uncertainty of investors and creditors. This reduction of uncertainty results in investors and creditors providing financing at a lower cost. Deterioration of the quality and credibility of financial statements does nothing to reduce the information risk associated with a company and results in raising a company's cost of capital.

The FASB and the AICPA help lower the cost of capital in the United States by promulgating uniform recognition and disclosure standards to be applied by U.S. companies. The extensive and high-quality accounting standards of the United States result in the reduction of information risk and thus help to lower the cost of capital for U.S. companies.

The SEC serves to protect investors and to maintain the integrity of securities markets. The SEC plays a specific role in protecting investors as regards financial reporting through is monitoring of the standard-setting process of the FASB and through its quarterly and annual reporting requirements. The SEC also investigates and punishes cases of deceptive financial reporting. The SEC's actions increase the reliability of the financial statements of companies trading on the U.S. securities markets. The SEC's actions contribute toward reducing information risk and lowering the cost of capital.

Transparent and reliable financial information is extremely important to providers of capital internationally. Companies requiring investment capital may be in a different business environment and a different culture than those providing the capital. The efforts of the IASB in developing international accounting standards also serves to lower the cost of capital by lowering information risk.