afm 291 chapter 1.pdf

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University of Waterloo
Accounting & Financial Management
AFM 291
Robert Ducharme

Chapter  1:  The  Canadian  Financial  Reporting  System THE  FINANCIAL  STATEMENTS  AND  FINANCIAL  REPORTING   • Accounting:  the  identification,  measurement,  and  communication  of  financial  information  about   economic  entities   • Financial  accounting/reporting  à  the  process  that  culminates  in  the  preparation  of  financial   reports  that  cover  all  of  the  enterprise’s  business  activities     ⇒ Used  by  internal/external  parties  (investors,  creditors  etc.)   • Managerial  accounting  à  the  process  of  identifying,  measuring,  analyzing,  and  communicating   financial  information  to  internal  decision-­‐makers     ⇒ Cost-­‐benefit  analyses  and  management  forecasts   • Financial  statements  communicates  financial  information  to  people  outside  the  enterprise   ⇒ Statement  of  financial  position   ⇒ Statement  of  income/comprehensive  income   ⇒ Statement  of  cash  flows   ⇒ Statement  of  changes  in  equity   • Note  disclosures  identify  details  that  cannot  be  expressed  in  the  financial  statements     Accounting  and  Capital  Allocation   • Accounting  measures  company  performance  accurately/fairly   o Investors/creditors  can  compare  the  income  and  assets  of  companies,  and   o Assess  relative  risks/returns  of  different  investment  opportunities     • Primary  exchange  mechanism  for  allocating  resources  à  debt  and  equity  markets  (stock   markets/exchanges),  financial  institutions  (banks)     Stakeholders   • Stakeholders:  parties  who  have  something  at  risk  in  the  financial  reporting  environment  à  salary,   job,  investment,  or  reputation   o key  stakeholders:  traditional  users  of  financial  statement,  other  users • users  à  parties  who  rely  directly  on  financial  information  for  resource  allocation,  and  others  who   help  in  the  efficient  allocation  of  resources o anyone  who  prepares,  relies  on,  reviews,  audits,  or  monitors  financial  information   • company  management  prepares  financial  statements     • auditors  audit  and  review  F.S.  and  discuss  economic  events  and  transactions  with  management  à   ensure  info  reflects  sound  accounting  choices   • investors  rely  on  F.S.  to  make  decisions,  securities  commissions  monitor  F.S.  to  ensure  full  and   plain  disclosure  of  material  information   1     • Normal  Securitization  of  mortgage  assets:  lender  lends  money  to  customers  to  buy  homes,  lender   sells  pool  of  mortgage  assets  from  the  above  loans  to  a  SPE,  SPE  sells  units/shares  to  investors       Objective  of  Financial  Reporting   • General  objective:  provide  financial  information  about  the  reporting  entity  that  is  useful  to  present   and  potential  equity  investors,  lenders  and  other  creditors  in  making  decisions  as  capital  providers   à  decision-­‐usefulness  approach   • General-­‐purpose  financial  statements  provide  the  most  useful  information  possible  at  the  least   cost  à  for  a  wide  variety  of  users  (often  focusing  on  investors/creditors)   • Stewardship:  protecting  company’s  economic  resources  from  unfavourable  effects  of  economic   factors,  ensuring  their  efficient  and  profitable  use   • Entity  perspective:  companies  are  viewed  as  separate  and  distinct  from  their  owners  (present   shareholders)     o Proprietary  perspective:  financial  reporting  is  only  focused  on  the  needs  of  shareholders   • Financial  reporting  help  investors  assess  the  amounts,  timing,  and  uncertainty  of  prospective  cash   inflows  from  dividends  or  interests,  and  the  proceeds  from  the  sale,  redemption,  or  maturity  of   securities  and  loans     • Accrual-­‐basis  accounting  recognizes  revenues  when  it  provides  goods/services  rather  than  when  it   receives  cash   • Institutional  investors  hold  an  increasing  percentage  of  equity  holdings  and  generally  put  a  lot  of   their  resources  into  managing  their  investment  portfolios       Information  Asymmetry   • Information  symmetry  –  all  stakeholders  have  equal  access  to  all  relevant  information     o Facilitates  flow  of  capital  in  the  most  efficient  and  effective  manner   o Disclosing  all  information  may  hurt  company’s  competitive  advantage  and  may  lower  profits   o Does  not  exist   • Information  asymmetry  –  management  rightly  has  access  to  more  information  than  others  since   they  run  the  company     o Capital  markets  are  not  fully  efficient  –  not  all  information  is  incorporated  into  stock  prices   of  companies   o Human  nature  results  in  people  and  corporations  trying  to  maximize  their  own  well-­‐being  at   the  cost  of  other  capital  market  participants  –  only  showing  positive  information   • Efficient  markets  hypothesis  proposes  market  prices  reflect  all  information  about  a  company   • Arguments:  information  asymmetry  à  suboptimal/inefficient  market  place   o Investors  may  discount  share  prices  with  higher  cost  of  capital  to  deal  with  lack  of   information  à  choose  to  not  invest  in  market   2     o Can  interfere  with  company’s  ability  to  access  capital/minimize  cost  of  capital     • Adverse  selection  –  with  information  asymmetry,  capital  markets  may  attract  companies  that  have   most  to  gain  from  not  disclosing  information  à  companies  that  fully  disclose  information  may   choose  not  to  enter  capital  market     • Moral  hazard  –  people  shrink  their  responsibilities  when  they  think  no  one  is  watching  à   managers  downplay  negative  and  focus  on  positive  (management  bias/aggressive  accounting)   o Motivations:  evaluation  of  management  performance,  compensation  structures,  access  to   capital  markets  and  meeting  financial  analyst  expectations,  contractual  obligations   o Conservative  accounting  –  bias  in  financial  reporting  results  in  less  useful  information       STANDARD  SETTING   Needs  for  Standards   • Reduces  information  asymmetry  problem  in  financial  reporting  à  transactions/events  recognized,   measured,  presented,  and  disclosed  in  a  specific  way   • GAAP  –  generally  accepted  à  an  authoritative  rule  making  body  created  a  reporting  principle  that   over  time,  a  specific  practice  has  been  accepted  as  appropriate  because  it  is  used  universally     Parties  Involved  in  Standard  Setting   • Financial  reports  emphasized  on  :   o Solvency/liquidity  for  internal  use  or  banks  à  increasing  investment  and  speculation  à   stock  market  crash  -­‐-­‐-­‐>  emphasized  on  standardize  and  increased  corporate  disclosures     Canadian  Accounting  Standards  Board  (AcSB)   • First  official  recommendations  on  standards  of  financial  statement  disclosure  were  published  in   1946  à  Canadian  Institute  of  Chartered  Accountants  (CICA)   • AcSB  has  primary  responsibility  for  setting  GAAP  in  Canada  and  produces  authoritative  material  à   the  CICA  Handbook   o Sets  standards  for  public,  private,  and  not-­‐for-­‐profit  entities   • Basic  premises  underlie  the  process  of  establishing  financial  accounting  standards:   1. AcSB  should  respond  to  needs/viewpoints  of  the  entire  economic  community   2. Operates  in  full  public  view  through  a  due  process  system  that  gives  interested  persons  enough   opportunity  to  make  their  views  known  
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