1. Copyright © 2009 by Pearson Education Canada 1 - 1 Financial Accounting Theory Purpose: To create an awareness and understanding of the financial reporting environment in a market economy

2. Copyright © 2009 by Pearson Education Canada 1 - 2 1.2 Some Historical Perspective Early development In Italy in 1494 -Double entry bookkeeping In England in 1700’s – The “corporation” Great depression of 1930s Accounting was highly unregulated before this Accounting Information was voluntary but provided SEC created in 1934 started to regulate information In Canada 1975- Canada Business Corporation Acts- formally required adherence to the CICA HB Provincial Securities Exchanges also require it

3. Copyright © 2009 by Pearson Education Canada 1 - 3 Back to the Basics Role of Financial Accounting – to provide users with information that useful in making resource allocation decisions and assessing management stewardship Type of Information that they want –Cash flow predictions –Performance Evaluations –Stewardship

4. Copyright © 2009 by Pearson Education Canada 1 - 4 Back to the Basics Qualitative Characteristics of Financial Information 1. Understandable 2. Comparability 3. Relevant Predictive Value Feedback Value Timely 4. Reliable Representational Faithfulness Verifiable Conservative

5. Copyright © 2009 by Pearson Education Canada 1 - 5 1.6 Role of Information in a Market Economy To improve operation of capital markets –Adverse selection problem To improve operation of managerial labour markets –Moral hazard problem

6. Copyright © 2009 by Pearson Education Canada 1 - 6 1.6 Role of Financial Reporting in a Market Economy Control adverse selection –Convert inside information into outside –Supply useful information to investors Control moral hazard –Control manager shirking –Improve corporate governance

7. Copyright © 2009 by Pearson Education Canada 1 - 7 1.7 The Fundamental Problem Of Financial Accounting Theory The best measure of net income to control adverse selection not the same as the best measure to motivate manager performance –Investors want information about future firm performance Current value accounting? –Good corporate governance requires that managers “work hard” Do historical cost accounting, conservatism better reflect manager effort?

8. Copyright © 2009 by Pearson Education Canada 1 - 8 1.8 Role of Standard Setting Is standard setting needed? –Market forces motivate firms to produce information –But market forces subject to failure Adverse selection Moral hazard –Regulation steps in to try to correct market failures Regulation is costly »Continued

9. Copyright © 2009 by Pearson Education Canada 1 - 9 1.8 Role of Standard Setting (continued) Standard setting mediates between conflicting interests of investors and managers –Investors want lots of useful information –Managers may object to releasing all the information that investors desire

10. Copyright © 2009 by Pearson Education Canada 1 - 10 1.9.5 Ways to Mediate Between Conflicting Interests Due process in standard setting –Representation of diverse constituencies –Super-majority voting –Exposure drafts

11. Copyright © 2009 by Pearson Education Canada 1 - 11 1.9.5 Structure of Standard Setting Bodies IASB –International standards FASB –United States standards AcSB –Canadian standards Securities commissions –Role in enforcing firms to follow standards –May set standards themselves –Much of standard setting is delegated to the “profession”