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Chapter 1-6

MGT220H5 Chapter Notes - Chapter 1-6: Earnings Before Interest And Taxes, Cash Flow Statement, Measurement Uncertainty

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Kathy Falk

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Chapter 1 The Canadian Financial Reporting Environment:
Accounting has been changing drastically because:
oFailures like Enron, World Com and Arthur Anderson
oCapital market failures including subprime lending crisis and bank failures
oNear bankruptcies of several countries
oGlobalization of capital and other markets
oIncreasing use of more sophisticated technology
oIncreasing access to information
Accounting is:
oIdentification, measurement and communication of financial information about
economic entities to interested persons
Financial accounting reporting): process that culminates in the preparation of financial reports
that cover all of the enterprises business activities and that are used by both internal and
external parties , users of these financial reports include investors, creditors and others
Managerial accounting: process of identifying, measuring, analyzing and communicating
financial information to internal decision makers
Accounting and Capital Allocation:
oBecause resources are limited, people try to conserve them and use them effectively
and identify and encourage those who can make efficient use of them, through an
efficient use of resources, standard of living increases
oAccounting profession measures company’s performance accurately and fairly on a
timely basis
oThe accounting information provided by accounting enables investors and creditors to
compare the income and assets of companies and this assess the relative risks and
returns of different investment opportunities
oCapital allocation: based on assessments, investors, and creditors can then channel their
resources (that is, invest in these companies or lend them money)
Important for a healthy economy
Unreliable irrelevant information leads to poor capital allocation
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Stakeholders: parties who have something at risk in the financial reporting environment , such
as they salary, job, investment or reputation
oUsers: anyone who prepares, relies on, reviews, audits or monitors financial information
GAAP: generally accepted accounting principles
Subprime mortgages normal securitization of mortgage assets
o1) lender lends money to customer to buy homes
o2) lender sells pool of mortgage assets from the above loans to a separate entity (often
referred to as a special purpose entity or SPE)
o3) SPE sells units or shares in the pool of mortgages to investors
Good for borrowers because it makes funds more accessible
Good for lenders because they are able to get their cash out of the mortgage
It is good for SPE’s as they can earn interest on the pool of assets
Good for investors as they can earn return on their investment
oSubprime lending went wrong because:
Brokers lent money aggressively in hopes of higher profits to borrowers who
may not have been credit worthy
Many loans were adjustable-rate notes which meant initially interest rates were
low (often below subprime lending rate) then rates reset themselves according
to loan agreement often significantly higher  which resulted in people not
being able to payoff loan
Many investors in the SPE did not understand the risks they were taking which
was risky
Many people lost homes, driving house prices down amount of mortgages
were higher than value of home
Lessons learned:
Capital participants act in their own self interest to potential harm of
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Amount and nature of risk is not always properly communicated to
Investors do not always understand what they are investing in
oObjective financial reporting: provide financial reporting 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 referred to as
decision-usefulness approach to financial reporting)
General purpose financial statements: provide financial reporting information to
a wide variety of users
Entity perspective: companies are viewed as separate distinct from their owners
Investors are interested in assessing companies ability to generate net cash
inflows and managements ability to protect and enhance the capital providers
oInformation asymmetry: being careful with what info to disclose (ex. Lawsuit)
1) capital markets such as stick exchange are not necessarily fully
efficient, not all info is incorporate  insider information
2) human behavior  some companies act in ways that will maximize
their own well-being at the cost of other capital market participants ex.
A company may wish to only how positive information to maximize their
Efficient markets hypothesis: proposes that market prices reflect all information
about a company
Adverse selection: where information asymmetry exists, the capital market
place may attract the wrong type of company; that is those companys that have
the most to gain from not disclosing information. Those that fully disclose
information may chose not to enter the capital marketplace knowing that share
prices may be discounted due to the known existence of information asymmetry
Moral hazard: “no one is watching” management bias
Aggressive accounting: downplay negative and focus on positive overstated
assets and/or net income, understated stuff
Conservative accounting: opposite of aggressive
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