Chapter 1 - Financial Statements and Financial Reporting

Financial Statements and Financial Reporting

Accounting is shaped by spectacular business failures,
capital market failures, near bankruptcies of several
countries, globalization, technology and information
access.
Accounting has 3 essential characteristics:
The identification, measurement and communication
of financial information (2) about economic entities
(3) to interested persons
o Accounting and Capital Allocation
It measures company performance and compares
incomes/assets of companies to assess relative risks and
returns. Efficient uses of resources lead to increased living
standards. Based on this, investors or creditors give them
resources and vice versa. This is capital allocation
We usually use debt and equity markets (e.g. stock
markets) and financial institutions (e.g. banks)
Effective systems are needed to facilitate good capital
allocation.
Transfer of resources are affected by accounting numbers
and credit rating agencies; it gives investors/creditors
additional independent info
o Stakeholders
Traditional users of financial information, including those
who directly rely on it for resource allocation (e.g. investors
and creditors) but also financial analysts and regulators
User: anyone who prepares, relies on, reviews, audits or
monitors financial information
Auditors act on behalf of shareholders to ensure
management is accounting properly for economic
transactions, and review that accounting choices are sound
Standard setters set GAAP, securities commissions and
stock exchanges monitor financial statements to ensure
full and plan disclosure of material information to
determine whether to have a firm traded, and credit rating
agencies and analysts monitor and analyze the information
produced by the company looking for signs of financial
change
o Objective of Financial Reporting
Decision-Usefulness Approach: to provide financial
information about the reporting entity that is useful to

present and potential equity investors, lenders, and other

creditors in making decisions in their capacity as capital
providers.
General-purpose financial statements are provided at the
least cost to the most useful information possible
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 - viewing a company as separate and
distinct from owners (present shareholders)
Proprietary perspective - focus only on the needs of
shareholders; it is not considered appropriate
We use accrual accounting because over the long run,
trends in revenues and expenses are generally more
meaningful than trends in cash receipts and disbursements
Different needs and levels of knowledge make it
challenging to provide information that is useful to users
Institutional investors - those who hold an increasing
percentage of equity share holdings and put a lot of
resources into managing their investment portfolio
o Information Asymmetry
Information symmetry - all stakeholders should have equal
access to all relevant information. However, in practice, it
is not perfect as it is not always beneficial for this to
happen (e.g. during a lawsuit.) This is known as
Information Asymmetry
Asymmetry can exist for 2 reasons however:
Capital markets are not necessarily fully efficient
Human behaviour sometimes results in individuals
and companies acting in ways that will maximize
their own well-being at the cost of other capital
market participants
Efficient Markets Hypothesis - predicts that market prices
reflect all information about a company
Asymmetry problems typically exist in 2 common types:
Adverse Selection - when asymmetry exists, it will
attract the wrong types of company (e.g. a company
who will gain from not disclosing information)
Moral Hazard - also known as management bias, it is
when human nature kicks in and one is willing to
shrink their stewardship responsibilities.
Downplaying the negative and pushing the positive is
called aggressive accounting (e.g. overstated assets

and understated liabilities) or the opposite being

Conservative Accounting

Standard Setting
o Needs for Standards
Standards help reduce information asymmetry, but is
tough to say whose rules to play by and what should they
be because users of financial statements have both similar
and conflicting needs.
In GAAP, the "generally accepted" means either that an
authoritative rule-making body in accounting has created a
reporting principle in a particular area or that, over time, a
specific practice has been accepted as appropriate
because it is used universally.
o Parties Involved in Standard Setting
Canadian Accounting Standards Board (AcSB)
International Accounting Standards Board (IASB)
The Financial Accounting Standards Board (FASB) and the
U.S. Securities and Exchange Commission (SEC)
Provincial securities commissions such as the Ontario
Securities Commission (OSC)
Generally Accepted Accounting Principles
GAAP include not only specific rules, practices and
procedures for each situation but also broad principles and
conventions that apply generally
o GAAP Hierarchy - lets users know what should be consulted first
in a question
There exist Primary Sources and Other Sources. Based on
the CICA Handbook, Part II, Section 1100:
Primary Sources:
Handbook
Accounting Guidelines
Other Sources:
Background information and basis for conclusion
documents issued by the AcSB
Pronouncements by accounting standard-setting
bodies in other jurisdictions
Approved drafts of primary sources of GAAP
Research studies
Accounting textbooks, journals, studies and articles
Other sources, including industry practice
Under IFRS, GAAP incorporates:

IFRS
International Accounting Standards (IAS)
Interpretations (IFRIC or the former Standards
Interpretation Committee [SIC])
When not applicable, judgment is used and the following
sources would be considered, in descending order:
Pronouncements of other standard-setting bodies
Other accounting literature
Accepted industry practices
o Professional Judgment
It is especially important in ASPE and IFRS as there cannot
be a rule for every situation (since we are based on
principle rather than specific rules)
The principles-based system means conceptual framework
underlies standards (i.e. accountants either apply specific
standards or use conceptual framework/judgment if none
exists)
Challenges and Opportunities for the Accounting Profession
o Oversight in the Capital Marketplace
1. The SOX enacted in 2002 to help fight poor business
practices
2. Public Company Accounting Oversight Board (PCAOB)
established to oversight and reinforce authority
3. Independence rules for auditors were strengthened
4. CEOs and CFOs must certify financial statements and must
forfeit bonuses and profits if there is restatement of
accounting disclosures
5. Audit committees must have independent members and
members with financial expertise
6. Codes of ethics must be disclosed (if applicable) for their
senior financial officers
In Canada, similar questions were faced and now many of
the SOX requirements have a place in Canada as well
1. Canadian Public Accountability Board (CPAB) was formed
(like PCAOB)
2. Canadian Securities Administrators issued rules that
require company management to take responsibility for the
appropriateness and fairness of the financial statements,
public companies to have independent audit committees,
and public accounting forms to be subject to the CPAB
3. The CSA issued a harmonized statement that requires
greater disclosures, including ratings from rating agencies,
payments by companies to stock promoters, legal

proceedings and details about directors, including previous

involvement with bankrupt companies
4. Ontario made amendments to its Securities Act
This all lead to more government and less self-regulation.
o Centrality of Ethics
Management biases (internal or externally promoted) are
the starting point of many ethical dilemmas.
Doing the right thing is not always clear as self and firm
interests must be balanced. There is yet to be a consensus
as to what constitutes comprehensive ethical systems.
Ethical sensitivity and choosing among alternatives can be
very complicated through various pressures.
o Standard Setting in a Political Environment
Accounting standards result as much from political action
as they do from careful logic or research findings (although
there is a "formal voice" through process many parties
comment and have a say.)
Whoever makes themselves loudest, however, may have
more say to the detriment of others
Standard making cannot avoid politics and usually has no
economic consequences; therefore it must always listen to
voices but pay attention to follow research and a
conceptual framework
One big political factor includes how standard-setting
bodies (such as international ones) are financed. Funding
should be:
Broad-based - it should not rely on one or a few
sources
Compelling - constituents should not be allowed to
benefit from the standards without contributing to
the process of standard setting
Open-ended - financial commitments for funding
should not be contingent upon any particular
outcomes that may infringe upon independence in
the standard-setting process
Country-specific - funding should be shared by the
major economies on a proportionate basis
The trick is to find a balance between letting stakeholders
have a voice while not bowing to undue political pressures
o Principles versus Rules
In a rules-based approach, there is a rule for most things
(even though the rule may be based on a principle.) People

tend to then interpret things directly and if there is no rule

they will do whatever they want within reason.
Unfortunately, it doesn't always emphasize the importance
of communicating the best information for users (just
because a practice is defensible doesn't mean it provides
the best information)
IFRS and ASPE are more principles-based; Bright-line tests
are numeric benchmarks for determining accounting but
the problem is they create distinctive thresholds which
make it not-so-clear-cut in reality
The challenge for standard setters to ensure that the body
of knowledge:
1. rests on a cohesive set of principles and conceptual
framework that are consistently applied
2. is sufficiently flexible to be of use in many differing
business situations and industries
3. is sufficiently detailed to provide good guidance but
not so big as to be unwieldy
o Impact of Technology
Technology helps identify, measure and communicate
useful information to users. We can analyze, aggregate and
target information and users.
Drawbacks include possible inability to access information
by all, will it be equal to all, whether it is quality and
reliable (if unaudited) and are certain sources more or less
reliable than others, along with whether this will increase
theft/manipulation
The challenge is to embrace technological opportunities
without losing the quality and content of traditional
financial reporting
o Integrated Reporting
A company's ability to articulate its strategic vision and
carry out that vision affects financial performance.
Accounting is part of a larger system of info management
which contains a significant amount of non-financial
information
The International Integrated Reporting Committee (IIRC)
was created to look at broader views of reporting within all
kinds of membership corporations (investors, accountants,
regulators, academics, etc.) in attempt to work toward a
more integrated framework for integrated reporting
The opportunity is to view financial reporting as part of a
larger integrated system and not in isolation

Financial Accounting
Users

External persons who

make final decisions

Time focus
Verifiability vs.
Relevance
Precision vs. Timeliness
Subject

Historical perspective
Emphasis on objectivity
and verifiability
Emphasis on precision
Primary focus is on
companywide reports
Must follow GAAP/IFRS
and prescribed formats

Rules

Requirement

Mandatory for external

reports

Managerial
Accounting
Managers who plan for
and control an
organization
Future emphasis
Emphasis on relevance
Emphasis on timeliness
Focus on segment
reports
Not bound by
GAAP/IFRS or any
prescribed format
Not mandatory