Intermediate Accounting 9th Canada Edition

Prepared by:

Dragan Stojanovic, CA

Rotman School of Management, University of Toronto

Chapter 1Chapter 1The Canadian Financial Reporting EnvironmentThe Canadian Financial Reporting Environment

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The Canadian Financial The Canadian Financial Reporting EnvironmentReporting Environment

Role of Role of Financial Financial ReportingReporting

• Financial statements and financial reporting

• Accounting and capital allocation

•Stakeholders

Objective of Objective of Financial Financial ReportingReporting

•Management bias

•Users’ needs

Standard Standard SettingSetting

• Need to develop standards

• Parties involved in standard setting

• Standard setting in a political environment

GAAPGAAP

• GAAP hierarchy

•Professional judgement

• Role of ethics

Challenges Challenges Facing Financial Facing Financial ReportingReporting

• Globalization of companies and capital markets

• Impact of technology

• Changing nature of the economy

• Increased requirement for accountability

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•Stakeholders


•Management bias

•Users’ needs





GAAPGAAP

• GAAP hierarchy


• Role of ethics






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• Accounting identifies, measures, analyses, and communicates financial information to various users (decision makers)

• Accounting has two broad classifications:

1. Financial accounting

2. Managerial accounting

• Accounting theory and practice have evolved and will continue to evolve to meet changing demands and influences

Characteristics of Characteristics of AccountingAccounting

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Characteristics of AccountingCharacteristics of Accounting

1. Identification, measurement, and communication of financial information about;

2. Economic entities to;

3. Interested persons.

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Financial ReportingFinancial Reporting

• Financial accounting provides historical information

• Financial reporting is used by both internal and external users

• External users include such decision makers as investors, creditors, unions, and government agencies

• Managerial accounting provides both historical and forecast information

• Managerial reporting information is used by management (internal users only)

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Financial Statements and Financial Statements and Other Means of Financial Other Means of Financial

ReportingReporting• Major financial statements include:

• Balance Sheet• Income Statement• Statement of Cash Flows• Statement of Shareholders’ (Owners’)

Equity

+ Note Disclosures

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Financial ReportingFinancial Reporting

• Other forms of financial reporting include:• President’s letter• Prospectuses• Government reporting• News releases• Management forecasts

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Flow of Information through Flow of Information through the Financial Statementsthe Financial Statements

Income Income StatementStatement

Statement Statement of Equityof Equity

Balance Balance SheetSheet

Statement Statement of Cash of Cash FlowsFlows

Reports Net Reports Net IncomeIncome

Ending Ending balance balance reportedreported

Change in cash as Change in cash as reported displays the reported displays the change in cash change in cash positionposition

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Financial reporting aids users in the allocation of scarce resources (capital)

Accounting and Capital Accounting and Capital AllocationAllocation

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• The accounting profession has the responsibility of measuring a company’s performance accurately, fairly, and on a timely basis

• These measurements enable investors and creditors to compare the income and assets employed by companies

• Investors can then assess the relative risks and returns associated with companies

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Capital Allocation ProcessCapital Allocation Process

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FinancialReporting

aids

Users(present and

potential)

CapitalAllocationdecisions

Financialstatements andother forms offinancialreporting

Users include:investors,creditors,unions, governmentagencies, andother

Involvesdetermininghow funds areallocated amongcompetinginterests


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• In Canada, the primary exchange mechanisms for allocating resources are:– Debt and equity markets (e.g. TSX)– Financial institutions (e.g. banks)

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Sources of CapitalSources of Capital

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• An effective process of capital allocation is critical to a healthy economy

• Unreliable information leads to poor capital allocation

• Credit rating agencies use accounting to rate companies’ financial stability

• This gives investors and creditors additional independent information

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Stakeholders in Financial Stakeholders in Financial ReportingReporting

• Stakeholders: parties who have something at risk (stake) in the financial reporting environment

• Key stakeholders include traditional users of financial information

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Stakeholders in Financial Stakeholders in Financial ReportingReporting

• Broader definition of users is: anyone who prepares, relies on, reviews, audits, or monitors financial information

• Includes both internal and external parties• Key stakeholders include:

– investors, creditors, auditors, regulators, analysts, management, standard setters, and others

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Stakeholders in Financial Stakeholders in Financial AccountingAccounting

• Investors and creditors rely on the financial statements to make decisions

• Standard setters set Generally Accepted Accounting Principles (GAAP) for direction on accounting

• GAAP is used to help reduce management bias and to ensure the information is useful to users

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What is at Stake for Each What is at Stake for Each StakeholderStakeholder

Stakeholder

• Investors & creditors

• Management

• Securities commissions and stock exchanges

What is at Stake?

• Investment / loan

• Job, bonus, reputation, salary increase, access to capital markets by company

• Reputation, effective and efficient capital marketplace

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What is at Stake for Each What is at Stake for Each StakeholderStakeholder

Stakeholder

• Analysts & credit rating agencies

• Auditors

• Standard setters

What is at Stake?

• Reputation and profits

• Reputation and profits (companies are their clients)

• Reputation

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•Stakeholders


•Management bias

•Users’ needs





GAAPGAAP

• GAAP hierarchy


• Role of ethics






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• The overall objective of financial reporting is to provide information that is:1. useful to users, and

2. decision relevant

• Financial statements should provide information about:1. the entity’s economic resources and claims to those

resources, and

2. changes in those resources and claims

• Resource allocation decisions are assumed to include assessment of management stewardship (i.e. management role in maximizing shareholder value)

Objective of Financial Objective of Financial ReportingReporting

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Objectives of Financial Objectives of Financial ReportingReporting

YesWas income earned to generate future cash?

Able to meet obligations and pay a return on investment

Resource Allocation DecisionsResource Allocation Decisions

Assess Management StewardshipAssess Management Stewardship

YesDid management’s decisions on resource acquisition and allocation increase shareholder wealth? Investor and creditor

confidence continues

Capital continues to be available

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Management BiasManagement Bias

• Preparation of the financial statements are the responsibility of internal management

• May lead to preparing statements that report the enterprise in its best light

• Motives include:– to reflect positive management stewardship (job,

compensation)– meet financial analysts’ expectations, resulting in

a positive reaction in the capital markets• What safeguards are in place to protect financial

users from management bias?

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Understanding User Needs in Understanding User Needs in the Financial Reporting the Financial Reporting

ProcessProcess

ManagemeManagementnt

UsersUsers

Financial Financial StatementsStatements

Prepare the reports

Use the reports for investment/lending decisions

Use the reports to acquire capital

Aggressive financial reporting has a direct impact on the user’s decision-making process

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•Stakeholders


•Management bias

•Users’ needs





GAAPGAAP

• GAAP hierarchy


• Role of ethics






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The Need to Develop The Need to Develop StandardsStandards

• Standards are set to aid preparers and users of financial statements

• They allow the preparers of the financial statements to present fairly the operations of the company

• A single set of financial statements is prepared to meet the majority of the users’ needs

• Standards are not rules, regulations, or laws• Standards are intended to be generally

accepted and universally practised

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TheThe Standard Setting Process in Standard Setting Process in Canada – Parties InvolvedCanada – Parties Involved

• Canadian Accounting Standards Board (AcSB)– Primarily responsible for setting GAAP in Canada

• From 2011, this will be limited to standards for private enterprises, not-for-profit entities, and pension plans only (standards for publicly accountable entities will be set by the International Accounting Standards Board)

– Two underlying premises for development of standards• Be responsive to the needs and viewpoints of the

entire economic community• Operate in full public view through due process

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TheThe Standard Setting Process in Standard Setting Process in Canada – Parties InvolvedCanada – Parties Involved

• International Accounting Standards Board (IASB)– Major international standard setting body– Mission “to develop, in the public interest, a single

set of high quality, understandable and international reporting standards (IFRSs) for general purpose financial statements”

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TheThe Standard Setting Standard Setting Process in Canada — Parties Process in Canada — Parties

InvolvedInvolved• Financial Accounting Standards Board (FASB) and

the Securities and Exchange Commission (SEC)– FASB is the major standard setting body in the

U.S. – SEC has the final authority over accounting

standards in the U.S• Provincial Securities Commission

(e.g. Ontario Securities Commission)– To oversee and monitor capital marketplace– Ensure strict adherence to securities

law/legislation

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•Stakeholders


•Management bias

•Users’ needs





GAAPGAAP

• GAAP hierarchy


• Role of ethics






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Generally Accepted Generally Accepted Accounting Principles (GAAP)Accounting Principles (GAAP)

• For private companies, pension plans, and not-for-profit entities, GAAP consists of :– Primary sources

• CICA Handbook Sections 1400 to 3870• Accounting guidelines

– Other sources• Background documents and implementation guidance issued by

AcSB

• Pronouncements in other jurisdictions• Research studies, accounting textbooks, journals, etc.

Must be consistent with primary sources and in accordance with the conceptual framework (i.e. CICA Handbook Section 1000)

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Generally Accepted Generally Accepted Accounting Principles (GAAP)Accounting Principles (GAAP)

• For public companies (reporting under IFRS), GAAP includes:– IFRS

– International Accounting Standards (IAS)

– Interpretations (IFRIC or SIC)

– If above sources do not specifically apply, other sources may be considered:

• Pronouncements of other standard-setting bodies

• Other accounting literature

• Accepted industry practices

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Professional JudgementProfessional Judgement

• There cannot be a rule for every situation• Standards in Canada are based primarily on

principles rather than specific rules• Therefore, must use professional judgement • The United States uses a rules-based

approach

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Role of EthicsRole of Ethics

• Ethical dilemmas are common in accounting and other areas of business

• It is not always easy to do the right thing or make the right decision

• Ethical decisions often go beyond applying GAAP or rules of the profession

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•Stakeholders


•Management bias

•Users’ needs





GAAPGAAP

• GAAP hierarchy


• Role of ethics






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Sarbanes-Oxley Act (SOX)Sarbanes-Oxley Act (SOX)

• The Sarbanes-Oxley Act (SOX) was enacted in 2002 (in the United States)

• Some of the legislation’s key provisions:– Public Company Accounting Oversight Board

(PCAOB)– Independence rules– Bonus/profit forfeiture– CEO/CFO certification– Management report on effectiveness of internal

controls over financial reporting– Independent audit committees– Codes of ethics

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Canadian ResponseCanadian Response

• The Canadian Public Accountability Board (CPAB)

• Additional rules issued by Canadian Securities Administrators (CSA) including:– Management responsibility for appropriateness

and fairness of financial statements– Independent audit committees– Increased disclosures

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Challenges Facing Challenges Facing AccountingAccounting

Globalization

Technology

New economy

Accountability

Need for international harmonization of standardsAbility to produce and access timely information

A move from the traditional ‘resource-based’ to a ‘knowledge-based’ economyDriven by more sophisticated and varied investors

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Economy & Finance

Intermediate Accounting 9th Canada Edition