, CHAPTER 1
THE CANADIAN FINANCIAL REPORTING ENVIRONMENT
CHAPTER STUDY OBJECTIVES
1. Explain how accounting makes it possible to use scarce resources more efficiently.
Accounting provides reliable, relevant, and timely information to managers, investors, and
creditors so that resources are allocated to the most efficient enterprises. Accounting also
provides measurements of efficiency (profitability) and financial soundness.
2. Explain the meaning of “stakeholder” and identify key stakeholders in financial
reporting, explaining what is at stake for each one. Investors, creditors, management,
securities commissions, stock exchanges, analysts, credit rating agencies, auditors, and standard
setters are some of the major stakeholders. Illustration 1-4 explains what is at stake for each one.
3. Identify the objective of financial reporting. The objective of financial reporting is to
communicate information that is useful to key decision makers such as investors and creditors in
making resource allocation decisions (including assessing management stewardship) about the
resources and claims to resources of an entity and how these are changing.
4. Explain how information asymmetry and bias interferes with the objective of financial
reporting. Ideally, all stakeholders should have access to the same information in order to
ensure that good decisions are made in the capital marketplace. (This is known as information
symmetry.) However, this is not the case—there is often information asymmetry. Of necessity,
management has access to more information so that it can run the company. It must also make
sure that it does not give away information that might harm the company, such as in a lawsuit
where disclosure might cause the company to lose. Aside from this, information asymmetry exists
because of management bias whereby management acts in its own self-interest, such as wanting
to maximize management bonuses. This is known as moral hazard in accounting theory.
Information asymmetry causes markets to be less efficient. It may cause stock prices to be
discounted or costs of capital to increase. In addition, it might detract good companies from
raising capital in the particular market where relevant information is not available (referred to as
adverse selection in accounting theory). The efficient markets hypothesis is felt to exist only in a
semi-strong form, meaning that only publicly available information is assimilated into stock prices.
5. Explain the need for accounting standards & identify the major entities that influence
standard setting and financial reporting. The accounting profession has tried to develop a set
of standards that is generally accepted and universally practised. This is known as GAAP
(generally accepted accounting principles). Without this set of standards, each enterprise would
have to develop its own standards, and readers of financial statements would have to become
familiar with every company’s particular accounting and reporting practices. As a result, it would
be almost impossible to prepare statements that could be compared. In addition, accounting
standards help deal with the information asymmetry problem.
The Canadian Accounting Standards Board (AcSB) is the main standard-setting body in Canada
for private companies, pension plans, and not-for-profit entities. Its mandate comes from the
,1 - Test
2 Bank for Intermediate Accounting, Eleventh Canadian Edition
Canada Business Corporations Act and Regulations as well as provincial acts of incorporation.
For public companies, GAAP is International Financial Reporting Standards (IFRS) as
established by the International Accounting Standards Board (IASB). Public companies are
required to follow GAAP in order to access capital markets, which are monitored by provincial
securities commissions. The Financial Accounting Standards Board (FASB) is also important as it
influences IFRS standard setting. Private companies may choose to follow IFRS. Public
companies that list on U.S. stock exchanges may choose to follow U.S. GAAP.
6. Explain the meaning of generally accepted accounting principles (GAAP) & the
significance of professional judgement in applying GAAP. Generally accepted accounting
principles are either principles that have substantial authoritative support, such as the CPA
Canada Handbook, or those arrived at through the use of professional judgement and the
conceptual framework.
Professional judgement plays an important role in Accounting Standards for Private Enterprises
(ASPE) and IFRS since much of GAAP is based on general principles, which need to be
interpreted.
7. Discuss some of the challenges and opportunities for accounting. Some of the
challenges facing accounting are oversight in the capital markets, centrality of ethics, standard
setting in a political environment, principles versus rules-based standard setting, the impact of
technology, and integrated reporting. All of these require the accounting profession to continue to
strive for excellence and to understand how accounting adds value in the capital marketplace.
, The Canadian Financial Reporting Environment 1-3
MULTIPLE CHOICE QUESTIONS
Answer No. Description
d 1. Accounting characteristics
a 2. Nature of financial accounting
c 3. Definition of financial accounting
b 4. Definition of management accounting
d 5. Efficient use of resources
c 6. Capital allocation process
d 7. Importance of accounting information
d 8. Primary exchange mechanism(s) for allocating resources
c 9. Changing financial reporting environment
b 10. Stakeholders in the financial reporting environment
d 11. Preparation of audited financial statements
a 12. Auditor’s responsibility
c 13. Causes of subprime lending crisis
a 14. Management’s primary responsibility with respect to financial statements
c 15. Primary responsibility of security and exchange commissions
b 16. Objectives of financial reporting
b 17. Appropriate objectives of general-purpose financial reporting
b 18. Accrual-basis accounting
c 19. Preparation of biased information
c 20. Existence of information asymmetry
b 21. Efficient markets hypothesis
d 22. Management bias
a 23. Moral hazard
d 24. Conservative accounting
b 25. Reduction of information asymmetry
b 26. Development of GAAP
c 27. Financial reporting before 1900
c 28. Responsibility of the AcSB
a 29. Oversight of AcSB
c 30. Authority over accounting standards in the U.S
d 31. Development of financial reporting standards in Canada
b 32. Adoption of IFRS
d 33. Activities and authority of the Ontario Securities Commission (OSC)
b 34. Use of ASPE
a 35. IASB’s standard setting process
c 36. Primary sources of GAAP under ASPE
c 37. Sources of GAAP
d 38. Exercise of professional judgement
c 39. Rules-based vs. principles-based approach
c 40. Comparison of Canadian GAAP and U.S. GAAP
b 41. SOX
a 42. Advancement of technology on financial reporting
a 43. IASB principles regarding funding
c 44. Rules-based GAAP body of knowledge
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