Prepared by:

Patricia Zima, CAMohawk College of Applied Arts and Technology

Chapter 1Chapter 1 The Canadian Financial Reporting The Canadian Financial Reporting

EnvironmentEnvironment

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The Canadian Financial The Canadian Financial Reporting EnvironmentReporting Environment

Role of Role of Financial Financial ReportingReporting

• Financial Financial statements statements and financial and financial reportingreporting

• Accounting Accounting and capital and capital allocationallocation

•StakeholdersStakeholders

Objective of Objective of Financial Financial ReportingReporting

•Management Management biasbias

•Users’ needsUsers’ needs

Standard Standard SettingSetting

• Need to Need to develop develop standardsstandards

• Parties Parties involved in involved in standard standard settingsetting

• Standard Standard setting in a setting in a political political environmentenvironment

GAAPGAAP

• GAAP GAAP hierarchy hierarchy

•Professional Professional judgementjudgement

• Role of Role of ethicsethics

Challenges Challenges Facing Financial Facing Financial ReportingReporting

• Globalization of Globalization of companies and companies and capital marketscapital markets

• Impact of Impact of technologytechnology

• Changing nature Changing nature of the economyof the economy

• Increased Increased requirement for requirement for accountabilityaccountability

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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:

1. Balance Sheet

2. Income Statement

3. Statement of Cash Flows

4. 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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Accounting and Capital Accounting and Capital AllocationAllocation

• 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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FinancialFinancialReportingReporting

aidsaids

UsersUsers(present and(present and

potential)potential)

CapitalCapitalAllocationAllocationdecisionsdecisions

FinancialFinancialstatements andstatements andother forms ofother forms offinancialfinancialreportingreporting

Users include:Users include:investors,investors,creditors,creditors,unions, unions, governmentgovernmentagencies andagencies andotherother

InvolvesInvolvesdeterminingdetermininghow funds arehow funds areallocated amongallocated amongcompetingcompetinginterestsinterests

Accounting and Capital Accounting and Capital AllocationAllocation

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Accounting and Capital Accounting and Capital AllocationAllocation

• 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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Accounting and Capital Accounting and Capital AllocationAllocation

• 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 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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• The CICA Handbook, Section 1000, par. 15 outlines the overall objective as:

““The objective … is to communicate information that is useful The objective … is to communicate information that is useful to … users in making their to … users in making their resource allocation decisions resource allocation decisions and/or assessing management stewardship and/or assessing management stewardship .… financial .… financial statements provide information about:statements provide information about:

1.1. an entity’s economic resources, obligations and an entity’s economic resources, obligations and equity/net assets;equity/net assets;

2.2. changes in an entity’s economic resources, changes in an entity’s economic resources, obligations and equity/net assets; andobligations and equity/net assets; and

3.3. the economic performance of the entity.”the economic performance of the entity.”

Objectives of Financial Objectives of Financial ReportingReporting

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Objectives of Financial Objectives of Financial ReportingReporting

Was income Was income earned to earned to generate generate future cash?future cash?

YesYesAble to meet obligations Able to meet obligations and pay a return on and pay a return on investmentinvestment

Resource Allocation DecisionsResource Allocation Decisions

Assess Management StewardshipAssess Management Stewardship

Did management’s decisions Did management’s decisions on resource acquisition and on resource acquisition and allocation increase allocation increase shareholder wealth?shareholder wealth?

YesYes

Investor and creditor Investor and creditor confidence continuesconfidence continues

Capital Capital continues to continues to be availablebe 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 Prepare the reportsreports

Use the reports for Use the reports for investment/lending investment/lending decisionsdecisions

Use the reports Use the reports to acquire capitalto acquire capital

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

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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 Institute of Chartered Accountants (CICA) www.cica.ca– Accounting Standards Board (AcSB) of the CICA

• Primarily responsible for setting GAAP in Canada• Two underlying premises for development of standards

1. Be responsive to the needs and viewpoints of the entire economic community

2. Operate in full public view through due process– Ensures that companies listed on the exchange prepare

their statements in accordance with GAAP– Key objective to ensure framework for measurement and

reporting facilitates the global flow of capital and serves the public interest

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

InvolvedInvolved• Provincial Securities Commission

(e.g. Ontario – www.osc.gov.on.ca)– To oversee and monitor capital marketplace– Ensure strict adherence to securities law/legislation

• Financial Accounting Standards Board (FASB) www.fasb.org and the Securities and Exchange Commission www.sec.gov– Major standard setting body in the U.S.

• International Accounting Standards Board (IASB) www.iasb.org– Major international standard setting body

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

• The profession has developed GAAP, which aids in presenting fairly, clearly, and completely the financial operations of the enterprise

• GAAP consists of authoritative pronouncements issued by certain accounting bodies

• The CICA Handbook is the foremost source for GAAP

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The GAAP HierarchyThe GAAP Hierarchy

• Primary sourcesPrimary sources• OOther sourcesther sources

Considered only after primary sources have been researched

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GAAP Hierarchy–Primary GAAP Hierarchy–Primary SourcesSources

• Section 1100 of the Handbook (in order of authority)

1. Handbook Sections (1300-4460)

2. Accounting Guidelines

3. Background Information and Basis for Conclusions

4. EIC Abstracts

5. Illustrative Examples (of the above)

6. Implementation Guides

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GAAP Hierarchy–Other GAAP Hierarchy–Other SourcesSources

• Other sources include:

1. Pronouncements in other jurisdictions

2. Research studies

3. Accounting textbooks, journals, studies, and articles

4. Other

Must be consistent with primary sources and conceptual framework

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Professional JudgementProfessional Judgement

• There cannot be a rule for every situation• Rules vs. principles• 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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Sarbanes-Oxley Act (SOX)Sarbanes-Oxley Act (SOX)

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

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

(PCAOB)– Independence rules– Bonus/profit forfeiture– CEO/CFO certification– Independent audit committees– Codes of ethics

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Challenges Facing Challenges Facing AccountingAccounting

•GlobalizatioGlobalizationn

•TechnologyTechnology

•New New economyeconomy

•AccountabiliAccountabilityty

Need for international Need for international harmonization of harmonization of standardsstandardsAbility to produce and Ability to produce and access timely informationaccess timely information

A move from the A move from the traditionaltraditional ‘resource-‘resource-based’based’ to a to a ‘knowledge-‘knowledge-based’based’ economyeconomyDriven by more Driven by more sophisticated and varied sophisticated and varied investorsinvestors

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