COMM 321 Unit 1 Introduction

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COMM 321 Unit 1: Introduction (Chapters 1 & 2) The Canadian Financial Reporting Environment Before studying the various accounting rules and statements, it’s necessary to understand why there is a need for accounting standards, how they are set, and signs that the preparers of financial information may not be following them. By law, any corporation, big or small, must produce a set of financial statements (F/S) for its shareholders as well as the government. For large corporations, the users of F/S can also include banks, equity analysts, credit rating agencies, customers, suppliers, managers, unions, regulators, potential shareholders, tax authorities, etc. All users are relying on the F/S in order to make decisions about the subject corporation. Lenders and investors, whether existing or potential, need to make decisions as to whether they will extend their financial resources (money) to the corporation. Suppliers and customers need to decide whether they will commit their resources to the corporation on an ongoing basis. All are looking to assess how management is performing. This leads to the objective of financial reporting. The objective of financial reporting is to communicate useful information about an entity to key decision makers that allows them to make resource allocation decisions and assess management stewardship. The reality of large corporations is the people or entities with funds at risk (investors and creditors) are not managing the corporation and further, they have investment alternatives. They need to be able to compare the income prospects and economic resources of all alternatives they are evaluating, and to assess the relative risks and returns of each. This creates a need for accounting standards – companies must prepare their F/S using the same principles and rules, thereby allowing users to easily understand their economic situation and compare it to others. Accounting Standards in Canada Standards in Canada must be set by CPA Canada (the organization for Chartered Professional Accountants). This is mandated by the Canadian Business Corporations Act and by the various securities commissions in Canada – both require F/S to be prepared in accordance with Generally Accepted Accounting Principles (GAAP) as set by CPA Canada. All standards can be found in the CPA Canada Handbook, available online (UW students can access it through the library for free). There are two sets of accounting rules or standards that have been mandated by CPA Canada. They are known by the acronyms IFRS and ASPE.  Publicly accountable enterprises and government business enterprises must follow IFRS: International Financial Reporting Standards  Private Companies, pension plans and non-profit enterprises can follow either IFRS or ASPE: Accounting Standards for Private Enterprises 1

Therefore, if a company’s shares are traded publicly (e.g. on the Toronto Stock Exchange), they must follow IFRS. If they are a private company, they can choose either IFRS or ASPE. Both IFRS and ASPE are principles based (vs. strict rules based), allowing for flexibility and the use of professional judgement by the accountant. The IFRS are set by the International Accounting Standards Board (IASB), based in London, England. The ASPE are set by the Accounting Standards Board (AcSB) of CPA Canada, based in Toronto, ON. The U.S. currently follows their own GAAP as set by the Securities and Exchange Commission (SEC), supported by FASB (the U.S. Financial Accounting Standards Board). The SEC has stated it desires to adopt IFRS for US companies but the timetable is unclear – many in the U.S. believe their GAAP is rules based whereas IFRS is principles based. IFRS has been adopted by most countries worldwide – the other major holdouts are China, which has stated it will adopt IFRS but has not set a date, and Japan where IFRS are optional but not required. The process for setting standards is as follows: 1. A need for a standard is identified and put on the agenda of the standard setting body by interested parties; the need is usually created by a new type of business transaction; for example, when the first interest rate swap was entered into by a bank and its customer – a swap is an agreement to exchange one set of cash flows for another – there was no accounting standard in place; as such, neither the bank nor its customer were entirely sure how they should account for the swap. 2. The board conducts its own research and analysis, then publishes an exposure draft for comment. 3. The exposure draft is sent to all interested parties for comments (this will include all major accounting firms as well as the corporations that are currently entering into these new types of transactions). 4. The board receives and evaluates the comments, incorporates them into the standard, possibly issuing a re-exposure draft if necessary. 5. The final standard is issued. 6. Standards are revised if and when necessary using the same approach (the IASB has a mandated 2-year post-implementation review of each standard). When a company enters into a business transaction, the accountants (and auditors) must decide how to account for the transaction in terms of how it should be presented on the F/S. In resolving accounting issues, there is a hierarchy that is followed. In order, it is:  The CPA Canada Handbook (Parts 1-4; Part 1 is IFRS, Part 2 is PE, Part 3 is Non-Profits, Part 4 is pension plans); if the transaction is covered by the CPA Canada Handbook, it must be accounted for in the prescribed manner  AcSB/IASB background information and basis for conclusions; this is an explanation for how the board reached its conclusions; this might provide guidance on how the transaction should be treated  AcSB/IASB implementation guidance  Pronouncements of standard setting bodies in other jurisdictions; for example if there is no Canadian standard but the U.S. has issued a standard, the U.S. standard will most likely be followed  Approved drafts of new standards  Exposure drafts or research studies  Accounting textbooks, journals, studies (many are referenced in CPA Canada Handbook)  Industry practice 2

Management Bias Any user of financial statements knows that the F/S have been prepared by management of the issuing corporation. It must be acknowledged that management are not neutral parties. In other words, users need to be aware of management bias. Preparers of the financial information are not neutral and may be presenting it in a manner that may overemphasize the positive and/or underemphasize the negative. Management compensation may be based on net income or by the value of the company’s shares. Further, there exists pressure on management to meet analyst expectations. There may also be a need to comply with certain contracts (most loan agreements have minimum financial ratios that must be met or the debt is in default) or with certain regulatory minimums if the company operates in a regulated environment (if the company fails to meet the minimums the regulator can replace management). Hence management may be distorting the F/S. Warning signs that the F/S might be misstated or that fraud could be present include any of the following:  Worsening economy making it harder for the company to maintain growth and profitability targets  Worsening industry results – in many frauds, the entire industry was suffering but the company committing fraud continued to report increased profits  Worsening company results (although this is difficult to assess outside of the company)  Unrealistic budgets or the forecasts released to the public appear aggressive; managers missing budgets are often fired  Management compensation tied to financial statistics, such as operating income, net income, etc. thus creating a real incentive to inflate these statistics  Management compensation linked to stock price , or the compensation from stock options dwarfs all other compensation, thus creating an incentive to continually report results the market will view as favourable  Existence of analyst targets (for EPS), particularly when the company is followed by several analysts; missing targets usually causes stock price to drop significantly, creating pressure on management  Existence of contractual financial ratios in loan agreements, particularly if the company appears close to missing the required ratio; e.g. must maintain interest coverage ratio of 4:1 or higher and the company reports its coverage ratio at 4.1:1; since missing the ratio means the loan is in default (which in turn could lead to bankruptcy), the true ratio could be less than 4:1  Existence of regulatory minimum financial hurdles or a requirement to pass stress tests; typically the regulator has the power to take over the company if these are missed The Role of Auditors To offset the risk associated with management bias, the F/S of all public companies must be audited. Further, most banks dealing with private companies require their F/S to be audited too. An audit is an examination of a company’s books and records by an independent body, to ensure the F/S present fairly the underlying transactions. An external audit is conducted by an independent accounting firm – the 4 largest are Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – who sign and attach their audit report to the company’s F/S. The report expresses their opinion as to whether the F/S are presented fairly and in accordance with GAAP (i.e. IFRS for public companies). An auditing firm that fails to uncover material fraud or misstatements in the 3

F/S can, and has been , successfully sued for damages suffered by investors and creditors who relied on those F/S and the auditor’s report. Agency problem When it comes to the operation of businesses, an odd phenomenon occurs as the organization grows – the entities with the money at risk (bankers, bondholders, investors) are not the entities running the business day to day. All big corporations utilize agents – these are people who act for the entities with the money at risk. Examples include management, auditors, credit analysts, equity analysts, consultants, etc. The agency problem is the fact that sometimes agents will act in their own best interest rather than in the best interests of the shareholders or lenders. Examples of agent abuses that have occurred historically include:  Management concealing poor performance by altering financial statements  CEOs and CFOs intimidating junior staff to produce higher income numbers even when not warranted, through accounting misstatements  CEOs selecting close personal friends to sit on their board of directors  Senior executives giving themselves incentive compensation in life-changing dollar amounts (i.e. 8 and 9 figures) and tied to stock prices  Senior executives buying or selling their own company’s stock prior to good or bad news releases  Credit analysts rating companies higher than warranted in order to maintain fee revenues  Auditors approving financial statements they knew were wrong in order to maintain fee revenue, or in some cases, to maintain consulting revenue that dwarfed audit fees  Security analysts maintaining “buy” or “strong buy” ratings in order to win lucrative investment banking business In 2001/02, several large American multinationals went bankrupt, generating huge investor losses as well as job and pension losses. In many of these cases, F/S had been distorted to fraudulently conceal the underlying problems in the business. (Some of these frauds are topics for the COMM 321 group project.) Auditors, equity analysts and credit rating analysts had all failed to warn of any problems, even in as little as 3 weeks prior to the company going bankrupt. In response, the U.S. government passed the Sarbanes Oxley Act (2002). This act significantly changed the accounting, auditing and securities industries in the U.S, and was copied by many international jurisdictions, including Canada. The changes included:  Stronger independence rules for auditors, audit committees and securities analysts; for example, auditors could no longer accept consulting engagements from their audit customers  F/S must be signed and certified by CEO and CFO; prior to the act, only the auditors signed the F/S  Stronger jail sentences for executives who knowingly commit fraud and/or misrepresent their F/S; jail sentences handed out under the Act have been as high as 25 years  Protection for whistle blowers – these are people who spot illegal activity and report it  SEC given power over accounting and auditing industries through the Public Company Oversight Board (including power over accounting and auditing standards); previously this had been the sole domain of the U.S. accounting profession  Stronger reporting requirements for senior executive stock transactions ; executives now required to publicly report any stock purchases or sales 4

 Management and auditors must report on internal controls ; internal controls are the controls a company puts in place to ensure fraudulent transactions do not take place; the most common control is ensuring that an employee who has access to an asset does not have access to the accounting records that report on movement of that asset (e.g. the accounts receivable clerk would not have access to customer cheques arriving; warehouse staff would not have access to inventory records, etc.) The changes appear to be working. The number and size of frauds committed since the passage of the bill have declined. Further, before the act, it was relatively common for a University of Waterloo CPA co-op student to encounter fraud on several, if not every, work term. Today, many co-op students graduate without ever encountering fraud. Conceptual Framework for Financial Reporting In order to ensure accounting standards remain useful and consistent, standards setters use a conceptual framework to provide a guide for all standards and for the use of professional judgment by all accountants. The framework is presented pictorially in the textbook on page 2-31. The starting point is the users’ needs. This leads to the objective of financial reporting which as mentioned, is to provide useful information about the entity to existing and potential investors, creditors and other stakeholders to assist in making their resource allocation decisions and to assess the effectiveness of management stewardship. Other elements to the framework are: the qualitative characteristics of useful information, the elements of financial statements and the foundational principles of accounting. Qualitative Characteristics of useful financial information: 1. Fundamental Characteristics: a. Relevance - capable of making a difference; has predictive or confirmatory value b. Faithful Representation - complete, neutral and free from error 2. Enhancing Characteristics: a. Comparability - allows users to identify similarities and differences between entities; includes consistency b. Verifiability - different observers will reach same value c. Timeliness - to make their decisions d. Understandability – clear and concise to users; note that the standard for users is those who have reasonable business knowledge 3. Constraints: a. Materiality (if omitting it could influence decisions, it’s material); calculations indicative of materiality include 5% of pre-tax income, 1% or 2% of sales, 5% of assets b. Cost (cost of obtaining information must not be greater than benefit of providing it) Elements of Financial Statements: 1. Assets – owned by the company with the potential to provide future economic benefits 2. Liabilities – owed by the company, representing an obligation to transfer economic resources 3. Equity – the residual interest, representing assets less liabilities 4. Revenues – increases in economic resources resulting from an entity’s ordinary activities 5

5. Expenses – decreases in resources resulting from an entity’s revenue generating activities 6. Gains and Losses – increases or decreases in equity from peripheral or incidental transactions Foundational Principles of Accounting: These are the principles that determine how most transactions are to be measured, recorded and presented in the F/S. They include the following. 1. Economic entity – it’s possible to identify an economic entity with distinct activities; present most meaningful entity (usually the consolidated group rather than the legal entity) 2. Control – F/S should include all legal entities under common control 3. Revenue recognition – record revenues when earned (regardless of when cash is received) * 4. Matching – record expenses in same period as the related revenue * 5. Periodicity – financial information must be reported periodically so it is assumed that an entity’s economic activities can be divided into artificial time periods 6. Monetary unit – money is the common denominator of economic activity and is appropriate for accounting measurement (ignore CPI) 7. Going concern – the reporting entity will continue to operate for the foreseeable future (note that liquidation values are usually drastically different from F/S values) 8. Historical cost – transactions initially recorded at historical cost (since this is readily measurable at a point in time, represents an arms-length exchange with an independent 3 rd party) 9. Fair value – may be more useful than historical cost for certain assets and liabilities in certain industries; where used, the F/S should present the fair value as the value it can be sold at on the reporting date 10. Full disclosure – anything that is relevant should be disclosed in the financial statements * Note that Revenue Recognition and Matching govern when Income Statement transactions are to be recorded. Public Company Annual Report Every public company issues an annual report, usually a few months after its year-end. Note however that the financial results are usually released to the press 3-4 weeks after year-end. Although there is no standard requirement, the typical annual report for a Canadian public company often exceeds 100 pages comprised as follows:  Financial highlights for the year combined with a statement from the CEO (2-3 pages)  MD&A (Management Discussion and Analysis) – management’s detailed explanation for the financial results and ratios (40-50 pages)  Management and Auditor Reports – standard wording is the norm (4-6 pages)  Financial Statements (4 pages)  Notes to the Financial Statements – provides more detail on each line in the F/S (40-50 pages)  Info on Management and Directors (2-4 pages) If you’re curious, there is an example of a set of F/S at the back of your text (Volume 1). Alternatively, the F/S for Apple Inc. are readily available online and fairly easy for a student to read. The auditors report (and their audit) covers only the financial statements and accompanying notes . However, CPA Canada has provided guidance for the MD&A in which they suggest preparers view the company through 6

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