Chapter 1 The Canadian Financial Reporting Environment Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology

The Canadian Financial Reporting Environment Role of Financial Reporting Financial statements and financial reporting Accounting and capital allocation Stakeholders Objective of Financial Reporting Management bias Users’ needs Standard Setting Need to develop standards Parties involved in standard setting Standard setting in a political environment Challenges Facing Financial Reporting Globalization of companies and capital markets Impact of technology Changing nature of the economy Increased requirement for accountability GAAP GAAP hierarchy Professional judgement Role of ethics

Characteristics of Accounting Accounting identifies, measures, analyses, and communicates financial information to various users (decision makers) Accounting has two broad classifications: Financial accounting Managerial accounting Accounting theory and practice have evolved and will continue to evolve to meet changing demands and influences

Characteristics of Accounting Identification, measurement, and communication of financial information about; 2. Economic entities to; 3. Interested persons.

Financial 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)

Financial Statements and Other Means of Financial Reporting Major financial statements include: Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ (Owners’) Equity + Note Disclosures

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

Flow of Information through the Financial Statements Income Statement Balance Sheet Change in cash as reported displays the change in cash position Reports Net Income Ending balance reported Statement of Equity Statement of Cash Flows

Accounting and Capital Allocation Financial reporting aids users in the allocation of scarce resources (capital)

Accounting and Capital Allocation 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

Capital Allocation Process

Accounting and Capital Allocation Financial Reporting aids Users (present and potential) Capital Allocation decisions Financial statements and other forms of financial reporting Users include: investors, creditors, unions, government agencies, and other Involves determining how funds are allocated among competing interests

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

Sources of Capital

Accounting and Capital Allocation 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

Stakeholders in Financial Reporting Stakeholders: parties who have something at stake in the financial reporting environment Key stakeholders include traditional users of financial information

Stakeholders in Financial Reporting 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

Stakeholders in Financial Accounting 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

What is at Stake for Each 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

What is at Stake for Each Stakeholder Analysts & credit rating agencies Auditors Standard setters What is at Stake? Reputation and profits Reputation and profits (companies are their clients) Reputation

Objectives of Financial Reporting The CICA Handbook, Section 1000, par. 15 outlines the overall objective as: “The objective … is to communicate information that is useful to … users in making their resource allocation decisions and/or assessing management stewardship .… financial statements provide information about: an entity’s economic resources, obligations and equity/net assets; changes in an entity’s economic resources, obligations and equity/net assets; and the economic performance of the entity.”

Objectives of Financial Reporting Resource Allocation Decisions Was income earned to generate future cash? Yes Able to meet obligations and pay a return on investment Capital continues to be available Assess Management Stewardship Did management’s decisions on resource acquisition and allocation increase shareholder wealth? Yes Investor and creditor confidence continues

Management 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?

Understanding User Needs in the Financial Reporting Process Management Users Use the reports to acquire capital Use the reports for investment/lending decisions Prepare the reports Financial Statements Aggressive financial reporting has a direct impact on the user’s decision-making process

The Need to Develop Standards 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

The Standard Setting Process in Canada – Parties Involved Canadian Institute of Chartered Accountants (CICA) Accounting Standards Board (AcSB) of the CICA Primarily responsible for setting GAAP in Canada 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 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

The Standard Setting Process in Canada — Parties Involved 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

Generally Accepted 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

The GAAP Hierarchy Primary sources Other sources Considered only after primary sources have been researched

GAAP Hierarchy–Primary Sources Section 1100 of the Handbook (in order of authority) Handbook Sections (1300-4460) Accounting Guidelines Background Information and Basis for Conclusions EIC Abstracts Illustrative Examples (of the above) Implementation Guides

GAAP Hierarchy–Other Sources Other sources include: Pronouncements in other jurisdictions Research studies Accounting textbooks, journals, studies, and articles Other Must be consistent with primary sources and conceptual framework

Professional 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

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

Challenges Facing Accounting Need for international harmonization of standards Globalization Technology New economy Accountability Ability to produce and access timely information A move from the traditional ‘resource-based’ to a ‘knowledge-based’ economy Driven by more sophisticated and varied investors

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