Chapter 1: The Canadian Financial Reporting Environment Lecture 1 ...
Chapter 1: The Canadian Financial Reporting Environment Lecture 1 Financial Statements and Financial Reporting • Accounting: identification, measurement and communication of financial information about economic entities to interested persons • Financial accounting: process that culminates in the preparation of financial reports that cover all of the enterprise’s business activities and that are used by both internal and external parties • Managerial accounting: process of identifying, measuring, analyzing, and communicating financial information to internal decision makers Accounting and Capital Allocation • Efficient use of resources increase our standard of living • Accounting professions measure company performance on accurate, fair, timely basis •
• • •
\
Effective capital markets promote productivity, encourage innovation, provide a platform for buying and selling securities and obtaining and granting credit Unreliable and irrelevant information leads to poor capital allocation which hurts securities markets and economic growth Credit rating agencies give investors and creditors independent information to use when making decisions
Stakeholders • Stakeholders: parties who have something at risk in the financial reporting environment • Key stakeholders i.e. traditional users • Users: anyone who prepares, relies on, reviews, audits or monitors financial information i.e. investors, creditors, analysts, managers, employees, customers etc • Securities commissions and stock exchanges monitor the financial statements to ensure full and plain disclosure of material information and to determine whether companies can continue to list their shares on stock exchanges • Problem with subprime mortgages: lent money to people not credit worthy, interest rates were too low, when interest rates increased, borrower could not afford it, investors in SPE (special purpose entity) did not understand risks Objective of Financial Reporting • Objective of general purpose financial reporting: to provide info about reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers • Stewardship: management is accountable to investors for the custody and safekeeping of the company’s economic resources and for their efficient and profitable use • Entity perspective: when companies are viewed as separate and distinct from their owners • Proprietary perspective: inappropriate perspective that focuses only on the needs of shareholders • Investors are interested in assessing: 1) the company’s ability to generate net cash flows 2) Management’s ability to protect and enhance the capital providers’ investment
•
Institutional investors put a lot of resources into managing their investment portfolios; very difficult to provide info as investors have different needs and levels of knowledge
Information Asymmetry • All stake holders should have equal access to all relevant information • Information symmetry: when there should be symmetry to access information; does not exist • Management feels disclosure of all information may hurt company’s competitive advantage/position • Information asymmetry: when management has more access to info than others since they run the company • Why information asymmetry exists: 1) Capital markets not fully efficient; not all info is incorporated into stock prices of company, prices may not reflect hidden or insider information 2) Human behaviour results in individuals and companies acting to maximize their own wellbeing at cost of other capital market participants • Efficient markets hypothesis: market prices reflect all information about the company • Information asymmetry problems: 1) Adverse selection: where asymmetry exists, capital marketplace may attract the wrong type of company (companies that have the most to gain from not disclosing information), those who fully disclose information may not choose to enter the capital market place because they know their share prices may be discounted because of the known existence of information asymmetry 2) Moral Hazard/management bias : concept that people will often shirk their responsibilities if no one is watching; related to management bias Aggressive accounting: when managers downplay the negative and focus on the positive (i.e. overstating assets, income, understating liabilities or expenses, or note disclosing to emphasize only positive events Conservative accounting (the opposite)
Standard Setting Need for Standards • Accounting standards reduce information asymmetry problems • Do this by requiring that transactions and events be recognized, measured, presented and disclosed in a specific way • GAAP: common set of standards and procedures • “GA” means that an authoritative rule making body has created a reporting principle in a particular area Parties Involved in Standard Setting • Canadian Accounting Standards Board (AcSB) GAAP for private companies (ASPE) i.e. pension plans, notforprofits Primary responsibility for setting GAAP in Canada
Objectives of AcSB
•
Two basic premises that underlie the process of establishing financial accounting standards: o Should respond to needs and viewpoints of entire economic community, not just public accounting profession o Should operate in full public view through a due process that gives interested persons and opportunity to make their views known AcSOC (Accounting Standards Oversight Council) oversees AcSB, provides input to AcSB activities and reporting to public International Accounting Standards Board (IASB) IASB aims:
•
Governing structure of IASB
IFRS monitors, reviews effectiveness of, appoints members to and funds IASB IFRIC (International Financial Reporting Interpretation Committee) studies issues where guidance in IASB is insufficient or nonexistent
Financial Accounting Standards Board (FASB) & SEC
•
FASB major standardsetting body, but does not have final authority over standards, SEC does SEC believes private sector(FASB) should stay responsible for establishing and improving accounting standards, but SEC should still oversee it Provincial Securities Commissions Oversee, monitor capital marketplace in jurisdiction Ensure participants in capital markets respect securities law and legislation (make sure markets are fair) Reviews and monitors financial statements of companies whose shares are publicly traded on TSX so that it can judge whether the statements present the financial position and results of operations of these companies fairly
Generally Accepted Accounting Principles • Includes specific rules, practices procedures, broad principles, conventions, underlying concepts GAAP Hierarchy • Identifies sources of GAAP and lets users know which ones should be consulted first • Primary sources of GAAP tell you how to treat an issue • GAAP hierarchies rank sources and consider certain sources as more important • Grounded in conceptual framework • Establish value and expect the use of professional judgement Professional Judgement • Important as there cannot be a rule for every situation Challenges and Opportunities for the Accounting Profession Oversight in the Capital Marketplace • Legislation’s key provisions due to accounting scandals: o Accounting oversight board was established and given oversight and enforcement authority; mandated to establish auditing, quality control and independence standards and rules known as Public Company Accounting Oversight Board (PCAOB) o Stronger independence rules o CEOs and CFOs were required to certify that the financial statements were appropriate and represented fairly; must forfeit bonuses and profits if there is a restatement of companies’ accounting disclosures o Company management must report on effectiveness of financial reporting internal control systems Principles versus Rules • US GAAP has a rulesbased approach system o There is a rule for everything, resulting a large body of knowledge o However, rules can get interpreted literally or in a very narrow sense and doesn’t always emphasize the importance of communicating the bet information for users • IFRS and ASPE are more principlesbased o Body of knowledge is smaller and the idea is that one or more principles form the basis for decision making • Standard setters must ensure the body of knowledge o Is based on a set of principles and conceptual framework that are consistently applied o Is sufficiently flexible to be applied in differing business situations o Is sufficiently detailed to provide guidance, but not too large as to be difficult to manage
• • •
\
Effective capital markets promote productivity, encourage innovation, provide a platform for buying and selling securities and obtaining and granting credit Unreliable and irrelevant information leads to poor capital allocation which hurts securities markets and economic growth Credit rating agencies give investors and creditors independent information to use when making decisions
Stakeholders • Stakeholders: parties who have something at risk in the financial reporting environment • Key stakeholders i.e. traditional users • Users: anyone who prepares, relies on, reviews, audits or monitors financial information i.e. investors, creditors, analysts, managers, employees, customers etc • Securities commissions and stock exchanges monitor the financial statements to ensure full and plain disclosure of material information and to determine whether companies can continue to list their shares on stock exchanges • Problem with subprime mortgages: lent money to people not credit worthy, interest rates were too low, when interest rates increased, borrower could not afford it, investors in SPE (special purpose entity) did not understand risks Objective of Financial Reporting • Objective of general purpose financial reporting: to provide info about reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers • Stewardship: management is accountable to investors for the custody and safekeeping of the company’s economic resources and for their efficient and profitable use • Entity perspective: when companies are viewed as separate and distinct from their owners • Proprietary perspective: inappropriate perspective that focuses only on the needs of shareholders • Investors are interested in assessing: 1) the company’s ability to generate net cash flows 2) Management’s ability to protect and enhance the capital providers’ investment
•
Institutional investors put a lot of resources into managing their investment portfolios; very difficult to provide info as investors have different needs and levels of knowledge
Information Asymmetry • All stake holders should have equal access to all relevant information • Information symmetry: when there should be symmetry to access information; does not exist • Management feels disclosure of all information may hurt company’s competitive advantage/position • Information asymmetry: when management has more access to info than others since they run the company • Why information asymmetry exists: 1) Capital markets not fully efficient; not all info is incorporated into stock prices of company, prices may not reflect hidden or insider information 2) Human behaviour results in individuals and companies acting to maximize their own wellbeing at cost of other capital market participants • Efficient markets hypothesis: market prices reflect all information about the company • Information asymmetry problems: 1) Adverse selection: where asymmetry exists, capital marketplace may attract the wrong type of company (companies that have the most to gain from not disclosing information), those who fully disclose information may not choose to enter the capital market place because they know their share prices may be discounted because of the known existence of information asymmetry 2) Moral Hazard/management bias : concept that people will often shirk their responsibilities if no one is watching; related to management bias Aggressive accounting: when managers downplay the negative and focus on the positive (i.e. overstating assets, income, understating liabilities or expenses, or note disclosing to emphasize only positive events Conservative accounting (the opposite)
Standard Setting Need for Standards • Accounting standards reduce information asymmetry problems • Do this by requiring that transactions and events be recognized, measured, presented and disclosed in a specific way • GAAP: common set of standards and procedures • “GA” means that an authoritative rule making body has created a reporting principle in a particular area Parties Involved in Standard Setting • Canadian Accounting Standards Board (AcSB) GAAP for private companies (ASPE) i.e. pension plans, notforprofits Primary responsibility for setting GAAP in Canada
Objectives of AcSB
•
Two basic premises that underlie the process of establishing financial accounting standards: o Should respond to needs and viewpoints of entire economic community, not just public accounting profession o Should operate in full public view through a due process that gives interested persons and opportunity to make their views known AcSOC (Accounting Standards Oversight Council) oversees AcSB, provides input to AcSB activities and reporting to public International Accounting Standards Board (IASB) IASB aims:
•
Governing structure of IASB
IFRS monitors, reviews effectiveness of, appoints members to and funds IASB IFRIC (International Financial Reporting Interpretation Committee) studies issues where guidance in IASB is insufficient or nonexistent
Financial Accounting Standards Board (FASB) & SEC
•
FASB major standardsetting body, but does not have final authority over standards, SEC does SEC believes private sector(FASB) should stay responsible for establishing and improving accounting standards, but SEC should still oversee it Provincial Securities Commissions Oversee, monitor capital marketplace in jurisdiction Ensure participants in capital markets respect securities law and legislation (make sure markets are fair) Reviews and monitors financial statements of companies whose shares are publicly traded on TSX so that it can judge whether the statements present the financial position and results of operations of these companies fairly
Generally Accepted Accounting Principles • Includes specific rules, practices procedures, broad principles, conventions, underlying concepts GAAP Hierarchy • Identifies sources of GAAP and lets users know which ones should be consulted first • Primary sources of GAAP tell you how to treat an issue • GAAP hierarchies rank sources and consider certain sources as more important • Grounded in conceptual framework • Establish value and expect the use of professional judgement Professional Judgement • Important as there cannot be a rule for every situation Challenges and Opportunities for the Accounting Profession Oversight in the Capital Marketplace • Legislation’s key provisions due to accounting scandals: o Accounting oversight board was established and given oversight and enforcement authority; mandated to establish auditing, quality control and independence standards and rules known as Public Company Accounting Oversight Board (PCAOB) o Stronger independence rules o CEOs and CFOs were required to certify that the financial statements were appropriate and represented fairly; must forfeit bonuses and profits if there is a restatement of companies’ accounting disclosures o Company management must report on effectiveness of financial reporting internal control systems Principles versus Rules • US GAAP has a rulesbased approach system o There is a rule for everything, resulting a large body of knowledge o However, rules can get interpreted literally or in a very narrow sense and doesn’t always emphasize the importance of communicating the bet information for users • IFRS and ASPE are more principlesbased o Body of knowledge is smaller and the idea is that one or more principles form the basis for decision making • Standard setters must ensure the body of knowledge o Is based on a set of principles and conceptual framework that are consistently applied o Is sufficiently flexible to be applied in differing business situations o Is sufficiently detailed to provide guidance, but not too large as to be difficult to manage
