Introduction to Accounting Theory & Contemporary Issues

Transcription

1 Course Schedule Course Modules Review and Practice Exam Preparation Resources Introduction to Accounting Theory & Contemporary Issues Print the introduction Course purpose This course has two main goals. The first is to describe and explore various theories that underlie financial accounting and reporting. The second is to explain and illustrate the relevance of these theories in order to understand the practice of financial accounting and reporting. What are some of these underlying theories? You will find that some of these theories are based on economics and finance. Economics underlies much of financial accounting and reporting. One of the earliest influences of economics on accounting is the present value model. By discounting future cash flows to a common point in time, the present value model enables a theoretically correct basis of asset and liability valuation and income measurement assets and liabilities are valued at the present value of their future cash receipts and payments, and income is the change in present value over time. Thus, the present value model provides a benchmark to guide accounting practice. While it can be difficult to apply in the complex real-world environment in which accountants operate, there is nevertheless increasing emphasis on the present value model in financial reporting. Examples include fair value reporting for financial instruments, ceiling tests for capital assets, and valuation of pension and other employee post-employment benefits. Portfolio theory and efficient securities market theory are from finance. Portfolio theory is relevant to accountants because it helps them understand how investors make rational investment decisions and how they use financial accounting information to make their decisions. Accountants can then prepare financial statements that are of greatest use to investors. Efficient securities market theory also has important implications for financial accounting. An efficient securities market is one in which securities prices always properly reflect all available information about securities traded on that market. Since financial reports supply much (but not all) of the available information about firms, accountants are now generally aware of the concept of efficient markets. For example, such awareness has led to the principle of full disclosure, whereby accountants attempt to maximize the information content of financial statements, including notes to the statements. Often, such full disclosure is not popular with management. Full disclosure, however, reduces the amount of inside information and the resulting problem of insider trading. A more recent influence of theory on accounting is that branch of economics called information economics or the economics of imperfect information. Information economics formally recognizes information asymmetry between different parties, such as managers and shareholders of large companies. Managers typically know more about the firm s prospects than shareholders, which may give managers advantages. For example, if managers know that future firm prospects are good, they may not work as hard on the shareholders behalf and may take excessive perquisites for themselves instead. They may also be tempted to profit from their inside information by insider trading, at the expense of investors. These problems complicate the role of corporate governance in motivating and controlling manager behaviour. For example, a manager may blame natural disasters for low profits when the actual cause is substandard performance, such as lack of effort or poor cost control. Shareholders, who cannot observe manager effort, have no way of knowing the real reasons for the low profits. Models have been developed in information economics to help us understand and predict the outcome of such conflict situations. The shareholder-manager interaction just described can be facilitated by making a contract between these two parties, which will spell out the obligations of each party and specify the compensation for the manager. The contractual nature of information economics has major implications for financial accounting and reporting. One reason is that, directly or indirectly, compensation of top managers depends on reported net income. Therefore, a precise and sensitive income measure that accurately reflects manager performance is essential. This role of net income to assist in motivating managers by providing a reliable measure upon which profit-

2 sharing contracts can be based is quite different from its equally important role of providing information to capital markets. It is not reasonable to expect that a measure of net income that is most useful for contracting purposes will also be most useful for reporting to investors. Another reason is that covenants in debt contracts often depend on accounting variables. Since debtholders will suffer if the firm enters financial distress, they demand conservative accounting, such as lower-of-cost-ormarket and ceiling tests. These provide an early warning system so that debtholders can take steps to protect their interests before it is too late. Therefore, financial accounting theory now recognizes two major roles for net income contracting and reporting. Another effect of information economics is that it contains the concept of economic consequences. Essentially, this concept asserts that accounting policies do matter. For example, a manager whose compensation depends on reported net income will be interested in the accounting policies used to calculate that income. Therefore, changes in accounting policies, such as those laid down by new accounting standards, can have major consequences, even if those changes have no effects on cash flows. A new accounting policy that tends to lower reported net income (such as the recording of deferred income taxes, post-employment benefits, or the successful-efforts method for exploration costs of oil and gas companies) can affect the way managers run the firm, as can accounting policies that increase net income volatility, such as fair value accounting. Anticipating a decrease in their compensation or an increase in the volatility of the firm s reported net income, managers may change operating and investment strategies to compensate for the effect of the change in accounting policy. This can influence the market value of the firm s shares, thereby affecting shareholder wealth. The concept of economic consequences has led accountants to pay increased attention to the important and difficult role of standard-setting bodies, such as the Accounting Standards Board (AcSB) of the Canadian Institute of Chartered Accountants (CICA, currently responsible for setting standards for private enterprises in Canada), the Financial Accounting Standards Board (FASB) in the United States, and the International Accounting Standards Board (IASB). These bodies face the formidable task of determining the economic consequences of particular accounting policy pronouncements and of trading off the interests of constituencies who may be affected differently by these pronouncements. In effect, the setting of accounting standards is as much a political process as an economic one. The second goal of this course is to explain and illustrate the relevance of the various theories mentioned previously to financial accounting and reporting. This is accomplished in two main ways. First, the material alternates between theory and application. For example, Module 2 describes how investors make rational investment decisions, and then demonstrates how the decision usefulness approach underlies the pronouncements of the major accounting standard-setting bodies and how it is applied to financial accounting and reporting. You will better understand and apply these pronouncements when you understand the reasoning behind them. It is essential to realize that this alternation between theory and practice is designed to motivate you to consider the theory seriously. Another approach to illustrating the relevance of the course material is through the review questions and assignments. A real attempt has been made to design and select material to illustrate the course concepts. As you know, from 2011, financial reporting for publicly-traded firms in Canada is in accordance with International Accounting Board (IASB) standards. This course includes coverage of IASB standards, in the textbook, the modules, the assignments, and review material. Coverage of certain United States standards is also included where these differ significantly from IASB standards. Of course, differences are decreasing over time as these two bodies move towards a converged set of standards. All of this material is examinable unless specifically marked to the contrary. In this course, material relating to specific accounting standards is largely (but not completely) at a conceptual level. Fortunately, at this level, most standards in Canada, the United States, and internationally are broadly similar, thereby reducing the amount of detail you will have to learn.

3 Course prerequisites As an advanced financial accounting course, Accounting Theory & Contemporary Issues draws on knowledge you have acquired from several other subjects, specifically financial accounting, economics, quantitative methods, and finance. You can find course descriptions of the prerequisite courses in the CGA-Canada Syllabus. You can also obtain a copy from your CGA regional office. In the quantitative area, you should be able to calculate expected utilities, abnormal returns, accretion of discount, standardized measure income statement and alternative statement, Bayes Theorem and Nash equilibriums. Hands-on computer work is not currently required in AT1. Most of the questions are essay type. Questions that do require computations can be done quickly by hand or by calculator. Of course, you are welcome to use your knowledge of computer-based problem-solving techniques to solve any of the quantitative questions. An understanding of ethical principles and how the accounting profession addresses ethical issues is an essential part of the CGA program of professional studies. The Ethics Readings Handbook [ERH] has been developed as a study resource in this area and is provided electronically through the "Reference library" link under the Resources tab. In AT1 it is assumed that you have become familiar with Section A of the ERH. This section clarifies important concepts and terms used throughout the ERH, and is necessary background knowledge for ERH readings referenced in this and other courses. When working with AT1, you are expected to have acquired basic competence with Microsoft Windows. For more information on how to work with software in this course, refer to How To/Use Software under the Resources tab. Structure and delivery AT1 comprises 10 modules that can be studied over a 12-week period, one module per week followed by preparation for the final examination. Each module should take between 15 and 20 hours to complete. The modules are delivered online and can be saved to your hard drive and also printed. Course materials The textbook and reference materials for this course are William R. Scott, Financial Accounting Theory, Fifth Edition (Toronto, Ontario: Pearson Education Canada, 2009) Canadian Institute of Chartered Accountants, CICA Handbook Accounting, updated to January 2011 release Ethics Readings Handbook [ERH], Fourth Edition (Vancouver, B.C.: CGA-Canada, 2011) For a list of the required software for all CGA courses, see Technical Support/System requirements under the Resources tab. CICA Handbooks Whether or not the CICA Handbook is required for your course, you can purchase access to an online subscription. Be sure to subscribe to the correct Handbook (Accounting, Assurance, or Public Sector). Here are the CGA courses in which the Handbooks are required: CICA Handbook Accounting, required for Financial Accounting: Consolidations & Advanced Issues [FA4], Accounting Theory & Contemporary Issues [AT1] CICA Handbook Assurance, required for External Auditing [AU1], Advanced External Auditing [AU2]

4 CICA Handbook Public Sector Accounting, required for Public Sector Financial Management [PF1] The subscriptions expire at the end of the December following the academic year for which they are purchased. Using the course materials The module notes and text provide the structure for studying the various course topics. Additional required readings have been selected to enhance your understanding of the topics. This course includes a wide selection of learning materials from various sources: textbook, articles, financial statements, and other materials. You should note: Articles included as readings for a module: These are to be read and studied at the levels of competence indicated in the related module notes. They are examinable at the level indicated and would not be reproduced or provided with the examination paper. Articles included as part of a review or an assignment question: These are to be read and studied only for the purposes of answering the specific, related question(s) in that assignment. You are not responsible for the content of such articles for examination purposes. Articles included as part of an examination question: An examination question may include, as part of its data, an article, statement, or similar source material. If this material is part of the module notes (a reading), then it would not be provided on the examination. Any other article will be attached to the examination paper. Comparison of commonly used terms IFRS and pre-ifrs CICA Handbook The Accounting Standards Board prepares the CICA Handbook and the International Accounting Standards Board prepares IFRSs. Understandably, while the terminology used by these two bodies is similar in many aspects, it does vary somewhat. A list of some of the more common differences follows. As these terms may be used interchangeably in the CGA course materials, you need to be familiar with both versions. IFRS at fair value through profit and loss closing rate, closing exchange rate deferred income tax depreciation foreign currency transactions foreign operation ordinary shares reserves statement of changes in equity statement of financial position statement of profit and loss through profit or loss CICA held for trading current rate, current exchange rate future income tax amortization integrated foreign operation self-sustaining foreign operation common shares accumulated other comprehensive income statement of retained earnings balance sheet income statement on the income statement CICA accumulated other comprehensive income amortization balance sheet common shares current rate, current exchange rate future income tax held for trading integrated foreign operation income statement IFRS reserves depreciation statement of financial position ordinary shares closing rate, closing exchange rate deferred income tax at fair value through profit and loss foreign currency transactions statement of profit and loss

5 on the income statement self-sustaining foreign operation statement of retained earnings through profit or loss foreign operation statement of changes in equity Recommended study approach The recommended study approach is to begin each module with the overview. The text frequently includes such overviews. Use the introductions to begin thinking about the material, and skim through the text and module notes. Then, review the text and related module note material in detail. The module notes are designed to be studied after the text readings have been completed. Some reference materials are meant to complement the module notes and should be read when indicated in the topic. A glossary is also provided, which summarizes important terms used throughout the course. For each term, cross-references are provided to one or more topics where the term is defined and described in either the module notes or the required readings. The review questions are taken mainly from the text. They are designed to further enhance your understanding of the text and module notes and will often assist you in approaching the assignments. Work through the questions and review their accompanying suggested solutions once you have finished the text and module note material. Try to answer the review questions for yourself before looking at the suggested answer at the end of the review material for that module. To fully understand the course concepts, you should consider the various theories set forth in the text and module notes and the applications described. Failure to understand course concepts is perhaps the main reason for poor performance on examinations. Course assessments The assessments in this course consist of the following: Five quizzes, one each in Modules 2, 4, 6, 8, and 10. These are in the form of multiple-choice questions that you complete online and submit for marking. For instructions on accessing and submitting quizzes, see your AT1 Assignment/Quiz submission area. Assignment 1 (due at the end of week 5 see Course Schedule), Assignment 2 (due at the end of week 7), and Assignment 3 (due at the end of week 9). You prepare each assignment response in Word and submit it to your marker using an electronic drop box. Course examination: As with other foundation level CGA courses, the final examination is three hours long. Your final course mark will be the combined quiz/assignment mark and examination mark (30 for the quiz/assignment mark and 70 for the examination). The five quizzes will be worth a combined maximum score of 10 (each quiz has a maximum score of 2). Assignment 1 and Assignment 3 will be worth a maximum score of 5 each. Assignment 2 will be worth a maximum score of 10. Your final examination will be graded out of 100, and your raw examination mark will be scaled into a mark out of 70. Your quiz/assignment mark (with a maximum score of 30) will then be added to the scaled examination mark. Several resources are available to help you prepare for the final examination: two practice examinations, which show you the general form of the final examination, including the types of questions you can expect examination reviews, in the form of recorded lectures, available approximately two weeks before the course examination an examination blueprint, which outlines the primary content areas covered on the examination, the related learning objectives, the proportion of marks assigned, and the weighting for different types of questions

6 To access these resources, see the Exam Preparation tab in the course navigation. Important reminder: For CGA-Canada's policy regarding original work on assignments and discussions, check out the Academic integrity policy in your AT1 Assignment /Quiz Submission area. Boldfaced terms Icons and boldfaced terms have been incorporated throughout the module notes to help you through the course materials. Words in bold type: When it is particularly important that you learn the meaning of a term (a key word or phrase), that term will appear in bold at the first instance, such as ideal conditions in Topic 1.1. Copyright Accounting Theory & Contemporary Issues Fourth Edition Author: William R. Scott, University of Waterloo Curriculum Developer: Rita Leung and Alison Howard Curriculum Editors: Chris Van Cauwenbergh and Patryce Kidd Product Coordinator: Shuhan Lee This course is produced in Canada by: Certified General Accountants Association of Canada North Fraser Way Burnaby, British Columbia Canada V5J 5K7 CGA-Canada, 2011 All rights reserved. These materials or parts thereof may not be reproduced or used in any manner without the prior written permission of the Certified General Accountants Association of Canada. Every reasonable effort has been made to obtain permissions for all articles and data used in this edition. If errors or omissions have occurred, they will be corrected in future editions, provided written notification has been received by the publisher. Both the curriculum and content of this course have been reviewed by the School of Commerce of Laurentian University, and have been found to meet acceptable standards.

7 Course Schedule Course Modules Review and Practice Exam Preparation Resources Module 1: Accounting under ideal conditions Texts William R. Scott, Financial Accounting Theory, Fifth Edition (Toronto, Ontario: Pearson Education Canada, 2009) Canadian Institute of Chartered Accountants, CICA Handbook Accounting, updated to January 2011 release. Ethics Readings Handbook [ERH], Fourth Edition (Vancouver, BC: CGA-Canada, 2011) Note: For all modules, complete required readings before designated topics, unless instructed otherwise. Overview Required reading Chapter 1; Chapter 2 Overview, Section 2.1, page 24 Because this is an accounting theory course, it will be different from most courses you have taken to date. Some of the concepts raised, such as the matching principle, will be familiar to you, while others will be new and challenging. Read Chapter 1 of the text, which provides a "roadmap" of how this course will unfold, including descriptions of the standard setting processes in Canada, the United States, and internationally. The essence of the course is to explain the tremendous importance of financial accounting in our economy. You have no doubt heard of financial reporting disasters such as Enron and WorldCom. Both companies were forced into bankruptcy after massive accounting frauds were revealed. The collapse of investor confidence in financial reporting that followed was a major contributing factor to the economic recession of the early 2000s. More recently, the collapse of the market for asset-backed securities and its repercussions leading to worldwide recession contains serious accounting implications for fair value accounting and consolidation policy. Topic 1.2 describes these recent developments in greater detail. The course aims to give you a good balance of theoretical and conceptual topics with practical and real world information to enable you to understand how such unfortunate events can occur, how they can affect real business activity, and how accountants can reduce the likelihood of them happening again. After this introduction and overview, Module 1 looks at the present value model. This model is highly relevant to financial statement users as it reports on the cash flows and profitability of the firm. The module will also explain ideal conditions, a rather conceptual but essential element in understanding the relevance and reliability of financial information. You will be introduced to a standard reserve recognition accounting (RRA) that uses present value accounting in far-from-ideal conditions. It is interesting to note management s concerns with RRA. The module will then revisit historical cost accounting and explain the tradeoffs between reliability and relevance that the two accounting methods historical cost and present value represent. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Topics

8 1.1 Due process 1.2 Recent developments relevant to financial accounting 1.3 Present value accounting 1.4 Present value model under certainty 1.5 Present value model under uncertainty 1.6 Reserve recognition accounting 1.7 Historical cost accounting revisited 1.8 Conclusion Learning objectives Module summary Explain the concept of due process and understand how the structure of accounting standard setting bodies attains due process. (Level 2) Review recent development relevant to financial accounting. (Level 2) Define the concept of ideal conditions and outline the necessary assumptions that underlie the definition. (Level 1) Explain and illustrate the following concepts: (Level 1) states of nature probabilities of states of nature (objective and subjective) expected value of an asset or liability abnormal earnings risk Use the present value model, under conditions of certainty and uncertainty, to prepare an articulated set of financial statements for a simple firm. (Level 1) Critically evaluate reserve recognition accounting as an application of the present value model. (Level 1) Explain why relevance and reliability of accounting information have to be traded off. (Level 1) Evaluate historical cost-based accounting in terms of relevance and reliability, revenue recognition, recognition lag, and matching. (Level 1) Print this module

9 Course Schedule Course Modules Review and Practice Exam Preparation Resources 1.1 Due process Required reading LEVEL 2 Chapter 1 Chapter 1 lays out the organization of the course and explains many important course concepts. A careful reading of this chapter will help you to see the course as a whole, and will assist in your understanding of the material in later modules. This course contains many references to accounting standards. To fully understand these standards, you need to appreciate that they are designed so as to trade off the conflicting interests of constituencies affected by these standards usually investors and managers. Standard setting bodies make these tradeoffs through due process. That is, standards are set in consultation with major constituencies. Devices to achieve due process include representation of major constituencies on the standard setting boards, super-majority voting, exposure drafts, and public meetings. Be sure you are aware of these various ways to achieve due process. This will be particularly helpful when you reach the topics of game theory and agency theory (Modules 7 and 8), and the political aspects of standard setting (Module 10).

10 Course Schedule Course Modules Review and Practice Exam Preparation Resources 1.2 Recent developments relevant to financial accounting LEVEL 2 Section 1.2 of the text describes highlights of the development of financial reporting up to and including the Enron and WorldCom scandals, leading to the introduction of the Sarbanes-Oxley Act in the United States. However, you are no doubt aware of the meltdown of the markets for asset-backed securities in 2007, which led to the subsequent collapse of stock markets and the threat of worldwide recession. These developments took place as the 5th edition of the text was being written. Consequently, they are not included in Section 1.2. This topic outlines these developments and some of their implications for accountants. Although the following descriptions of these developments are quite detailed, the key objectives are to illustrate that financial reporting must be transparent so that investors can properly value assets and liabilities; that off-balance sheet activities should be fully reported in order to discourage management from excessive risk-taking; and that there is a risk that fair value accounting could understate value-in-use when markets collapse. New standards for consolidation Following the Enron fraud described in the text, standard setting bodies moved to tighten up standards for consolidation, since Enron s failure to consolidate its Special Purpose Entities (SPEs) was at the heart of its misreporting. In the United States, Financial Accounting Standards Board Interpretation No. 46 (FIN 46) (2003) expanded requirements for consolidation of SPEs (called variable interest entities (VIEs) by FIN 46). Consolidation under IASB standards is governed by Standing Interpretations Committee Interpretation 12, (SIC 12) Consolidation-Special Purpose Entities (1999). It was felt that by forcing VIE consolidation, thus bringing their assets and liabilities onto their sponsors balance sheets, the financial reporting for financial institutions, particularly with respect to their overall liquidity and capital adequacy, would be improved. However, despite this tightening up of consolidation standards, the use of SPEs did not decline, particularly by financial institutions, where they were frequently called structured investment vehicles (SIVs). These vehicles were often created by banks, mortgage companies, and other financial institutions to securitize their holdings of mortgages, credit card balances, auto loans, and other financial assets. That is, the institution would transfer large pools of these assets to the SIVs it sponsors. The SIV would pool them into asset backed securities (ABSs), that is, into tranches of similar credit quality. Thus, a particular ABS would be a tranche of, say, residential mortgages (mortgage backed securities (MBSs)) of high quality, another ABS would be of lower quality, etc. down to sub-prime mortgages of lowest quality. These various ABS tranches would then be resold to investors or, particularly for the lowest quality tranche, retained by the SIV and its sponsor. As mortgagors made payments, cash flowed to the SIV and on to the tranche holders, after deduction of various fees. Holders of higher quality (i.e., lower risk) tranches received a lower return than holders of lower quality tranches. Prior to selling ABSs, they could be further repackaged and sold as collateralized debt obligations (CDOs), which also consisted of tranches of similar quality mortgages or other financial assets. The difference was that holders of ABSs had an interest in the underlying assets, whereas CDO holders had an interest only in the cash flows generated by those assets. Also, unlike ABSs, CDOs tended to be arranged and sold privately, and often consisted of riskier mortgages. When it is not necessary to distinguish them, we will refer to these securities collectively as ABSs. ABSs were highly popular with investors, since they offered higher returns than, say, bonds, and were viewed as safe because of the diversification of credit risk created by the large underlying pools of mortgages or other financial assets that backed them up. They also enabled investors to invest in tranches of the particular risk and return that they desired. As an alternative to selling the ABSs it acquired, SIVs could hold them. To pay the sponsor for ABSs transferred

11 to it, the SIVs typically borrowed money. Thus, SIVs were highly levered. Since the ABSs generated higher returns than the cost of borrowed funds, the SIV became a money machine. Of course, this strategy was risky. Despite the inherent diversification of ABSs, credit losses could still occur. Consequently, some form of credit enhancement of ABSs was necessary if the SIV was to be able to borrow at a low interest rate. One common way to accomplish this was for the sponsor to agree to buy back the SIV s asset-backed securities should they become impaired. Also, SIVs could hedge their risk by purchasing credit default swaps (CDSs). These were derivative financial instruments that would reimburse the SIV for all or part of credit losses on its ABSs. To obtain this protection, the CDS purchaser paid a fee (called the spread) to the CDS issuer. The belief that credit losses on the underlying ABSs were protected increased the confidence of lenders that their loans to the SIV were low risk. Note that if an SIV was consolidated into the financial statements of its sponsor, the high SIV leverage would show up on the consolidated balance sheet. Now, sponsors will be penalized by the market if their leverage gets too high, even given the apparent safety of ABSs, since investors react negatively to increased risk. This is particularly so for financial institutions, many of which are subject to capital adequacy regulations. Consequently, like Enron, firms that sponsored SIVs had an incentive to avoid consolidation of their SIVs into their own financial statements. Then, leverage could be further exploited by remaining off-balance sheet. This motivation would be reduced to the extent that the market looked through the lack of consolidation and valued the sponsor and its VIEs as one entity. Landsman, Peasnell, and Shakespeare (2008) report evidence that the market did do this. Even so, avoiding consolidation would be of crucial importance to financial institutions facing capital adequacy regulations, since these are based on financial statements. As described above, standard setters had moved to tighten up the rules for consolidation. Crash of mortgage backed securities (MBSs) Nevertheless, sponsors were able to avoid consolidation, by creating expected loss notes (ELNs). These were securities sold by sponsors to outside parties under which the purchasers committed to absorb a majority of a VIE s expected losses and receive a majority of expected net returns. Thus, the holder of the ELN became the primary beneficiary under FIN 46, and consolidation would be with the financial statements of the ELN holder, not with the sponsor. Freed from consolidation, the sponsor could then exploit VIE leverage as much as it wanted. Presumably, the balance of net returns would go to the sponsor. In addition, sponsors received fees for various services rendered to VIEs. Beginning in 2007, this whole structure came crashing down, however. It had become increasingly apparent that because of lax lending practices to stoke the demand for more and more MBSs to feed leverage profits, many of the mortgages underlying MBSs were unlikely to be repaid. As a result, a major advantage of ABSs from an investor s perspective (diversification of credit risk across many similar assets) turned out to be their greatest weakness: asset-backed securities lacked transparency. This was particularly so for CDOs, which tended not to be publicly traded. As concern about mortgage defaults increased, investors were unable to (or neglected to) determine how many mortgages associated with a specific ABS were likely to go bad. The rational reaction to the difficulty of valuing specific ABSs is to not buy any of them. Thus, in July 2007, financial media reported that two mutual funds of Bear Stearns (at the time, a large U.S. investment bank) were suffering severe losses on their large holdings of ABSs. This was followed, in August 2007, with a suspension by BNP Paribas, a large France-based bank, of subscriptions to and redemptions of several of its funds, on grounds that the market values of its holdings of ABSs were impossible to determine. Other U.S. and European financial institutions reported similar problems. In effect, the market for these securities collapsed. Loss of confidence due to counterparty risk There was another major contributing factor to the market collapse, however. Above, we mentioned that SIVs could purchase CDSs to reimburse any losses suffered on their ABSs. If so, why did investors lose confidence? The answer lies in counterparty risk. As mentioned, many SIVs purchased CDSs to reduce the credit risk of their ABSs. However, as concern about mortgage defaults grew, concern also grew that CDS issuers (i.e., counterparties) would not be able to meet their obligations. Counterparty risk was greatly enhanced, however, due to a significant feature of CDSs it was not necessary for the purchaser of a CDS to own the underlying assets secured by that CDS. Anyone could buy a CDS that protected against losses on specific reference ABSs. Such a CDS would protect an investor who did not own

12 that ABS but wanted to hedge against the possibility of, say, a downturn in the economy. If the economy deteriorated, the value of the ABS would likely decline as well. A CDS that pays off if an ABS declines in value would thus increase in value. CDSs also were a vehicle for speculators, since any event that lowered the value of ABSs would raise the value of CDSs written on those securities. The demand for CDSs became very high, and their issuance quickly spread from insurance companies to other financial institutions, attracted by the spread that they generated. Indeed, CDSs were often packaged into synthetic CDOs, that is, tranches of CDSs, for sale to investors. As a result, the face value of CDSs written on specific asset-backed securities could be many times their value. Also, like CDOs, CDSs and synthetic CDOs were not traded on an organized exchange, where regulations would be in place to protect the integrity of trade transactions. Instead, they were bought and sold privately, making it difficult to know how many CDSs were outstanding against specific ABSs. A major contributing factor to the ABS market collapse was that CDSs did not protect ABSs in the eyes of investors, due to counterparty risk. SIVs faced several problems simultaneously. They were unable to roll over maturing debt: No one would buy it due to the collapse of their underlying security, their holdings of ABSs themselves were difficult or impossible to sell, and the ability of CDS issuers to reimburse losses was doubtful. In the face of this collapse of liquidity and severe counterparty risk, SIVs faced either insolvency or the necessity for their sponsors to buy back their impaired assets. For example, the Financial Times (November 19, 2008) reported that Citigroup returned the last $17.4 billion of assets of its sponsored SIVs to its balance sheet, recording a writedown of $1.1 billion in the process. Buybacks led to recession These buybacks had severe consequences, however. Paying for them lowered sponsors liquidity, and required writedowns of the toxic assets thus acquired. These writedowns were in addition to writedowns of CDSs, and of asset-backed securities held directly by the sponsors. Further writedowns were frequently required as the fair value of these assets continued to deteriorate. Many sponsors were rescued by governments, raised additional capital at distressed prices, or failed outright, resulting in a major contraction of the financial system. The resulting reduction in market liquidity spread to the real economy, leading to worldwide recession. Failure to control risk While blame for the initial collapse of the market for ABSs is usually laid at the feet of lax mortgage lending practices, the lack of transparency of complex financial instruments created by the finance and investment communities was also to blame. Of greater significance for accountants, however, was sponsors failure to adequately control the risks of excessive leverage in the quest for leverage profits. Risk-taking was encouraged since, as described above, financial accounting standards allowed sponsor firms to avoid SIV consolidation, thereby encouraging them to take on large amounts of off-balance sheet leverage. Arguably, accountants and auditors who allowed this avoidance were meeting the letter of FIN 46 while avoiding its intent. Losses reported under fair value accounting Another result of the meltdown was severe criticism of fair value accounting, particularly by financial institutions. They claimed that the requirement to write down the carrying values of financial instruments made matters worse, by creating huge losses that threatened their capital adequacy ratios and eroded investor confidence. Writedowns were further criticized because inactive markets often meant that fair values had to be estimated by other means. For example, fair value of asset-backed securities could be estimated from the spreads charged by CDS issuers. Since these spreads became very high as underlying ABS values fell, the resulting estimates, which reflected lack of liquidity in the market, were less than the value-in-use that the institutions felt they would eventually realize if they held these assets to maturity. Historical cost accounting, or at least allowing institutions to put their own valuations on these assets, it was claimed, would eliminate these excess writedowns. Accounting standard setters largely held their ground in the face of these criticisms. However, faced with threats that governments would step in to override fair value accounting, they did relax some requirements. In October 2008, the IASB and FASB issued similar guidance on how to determine fair value when markets are inactive. The guidance was that when market values did not exist and could not be reliably inferred from values of similar items, firms could determine fair value by using their own assumptions of future cash flows from the

13 assets/liabilities, discounted at a risk-adjusted interest rate (that is, value-in-use). Presumably, this would overcome management criticisms that fair value writedowns were excessive. Also, the IASB relaxed somewhat the extent of its fair value requirements, by allowing certain financial instruments to be reclassified from full fair value to less volatile valuation bases, in a manner consistent with existing FASB standards. These changes are described more fully in Topic 5.5. In sum, three points relevant to accountants stand out from the events just described. First, financial reporting must be transparent, so that investors can properly value assets and liabilities. Second, fair value accounting, being based on market value or estimates thereof, may understate value-in-use when markets collapse due to a severe decline in investor confidence. This leads to management objections. Finally, off-balance sheet activities should be fully reported; otherwise, they can encourage excessive risk taking by management.

14 Course Schedule Course Modules Review and Practice Exam Preparation Resources 1.3 Present value accounting Required reading LEVEL 1 Reread Chapter 1, Section 1.9.1, page 16 (Level 1) This module approaches the presentation of accounting information from a basic and idealistic situation called ideal conditions. Section of the text briefly describes accounting under ideal conditions. Note the following points in particular: Under ideal conditions, accounting is done on the basis of present values of future cash flows, which is a basic and idealistic way of accounting. Nevertheless, it provides a benchmark against which actual accounting practice can be evaluated. Specifically, without the theoretical guidance provided by accounting under ideal conditions, we have no way of judging whether an actual accounting practice, such as historical cost accounting, is "good" or "bad." With the theory s guidance, however, we can state that the closer an accounting practice comes to present value (without sacrificing too much reliability), the better. The text (page 4) introduces the term current value accounting. This is a general term used to refer to departures from historical cost designed to increase relevance of financial information. One such departure is present value accounting (also called value-in-use), as just mentioned. The other departure is fair value accounting (also called exit value or opportunity cost). Fair value is the amount the firm could sell an asset for or the cost to dispose of a liability, that is, market value. An implication of valuing assets and liabilities at opportunity cost is that management s success is then evaluated by its ability to generate more profits from retaining assets and liabilities and using them in the business than by taking the opportunity of selling them. Under ideal conditions, present value and market value are equal. This module concentrates on present value accounting, since this is the fundamental basis on which market values are determined. However, when ideal conditions do not hold, the present value of an asset or liability may differ from its market value. Furthermore, no market value exists for many assets and liabilities, such as specialized assets (for example, oil and gas reserves, power dams, and steamships), intangibles, and illiquid asset and debt securities, which is a situation called incomplete markets.

15 Course Schedule Course Modules Review and Practice Exam Preparation 1.4 Present value model under certainty Required reading LEVEL 1 Chapter 2, Sections 2.1 and 2.2, pages (Level 1) Example 2.1 of the text illustrates the present value accounting model under certainty, also known as ideal conditions under certainty. Be sure you understand the mechanics of the example. Notice that the format of the balance sheet is identical to conventional financial statements prepared under historical cost accounting. What is different is that valuation of all assets and liabilities is now the basis of discounted present value. The income statement is much simpler than under historical cost accounting. It contains only accretion of discount, that is, interest on opening net assets. To understand accretion of discount, note the reference in the text to interest on a bank savings account. If you have $1 in your account at the beginning of the year and the account pays 3%, you will have $1.03 at year end. The 3 cents is your income for the year, that is, accretion of discount. The term arises because as time passes, the balance in your account grows (that is, it accretes) at the interest rate you receive. It is instructive to also think of Example 2.1 in terms of revenue recognition. As you are aware, the usual point in the operating cycle at which revenue is recognized is the point of sale. In present value accounting under ideal conditions, the present value of all future revenues net of costs is recognized when productive capacity is acquired (for example, plant and equipment is valued at the present value of its future net cash receipts at date of acquisition). Then, income for the year is simply the accretion of discount on the opening present value. That is, under ideal conditions, it is not necessary to wait until the realization of revenue is probable, since, by definition, all future revenues are reliably known. While the text addresses this in terms of asset valuation, it is useful to also evaluate the pros and cons of present value accounting in terms of revenue recognition. In effect, asset valuation and revenue recognition are two sides of the same coin. Notice that Example 2.1 includes only the first year of P.V. Ltd. s operations. In years beyond the first, there will be opening cash-on-hand. Any such cash will be invested at the given interest rate. (It would not be rational for the firm to let cash sit idle when it can be invested for a riskless return.) Then, accretion of discount in subsequent years must be based on total assets including opening cash. Self-test Question 1 illustrates this point. Note that even if the firm pays out all of its profits as dividends, there will be cash-on-hand equal to accumulated amortization. This illustrates the point learned in introductory accounting courses that amortization retains assets in the business. The concept of dividend irrelevancy is mentioned on page 26 of the text. The basic idea is that when there is only one interest rate in the economy, investors do not care about the firm s dividend policy. If the firm retains profits, it will earn a return at the given interest rate on earnings retained in the business. If it pays a dividend, investors can invest it to earn the same return. The investor s wealth is the same either way. If investors wish to consume their shares of firm profits rather than invest them, they can simply spend any dividends, or, if the firm does not pay dividends, borrow with the retained profits as security. Again, they are equally well off whether the firm pays dividends or not. To help you understand the process of preparing an income statement and balance sheet using present value accounting, first set up your steps. As an example, the steps for preparing the balance sheet at the top of page 26 of the text are shown in Exhibit 1-1, which follows. Exhibit 1-1 Steps for preparing a balance sheet at end of year 1

16 1. Determine cash $ Determine current net present value of future cash flows $150 /1.10 = $ Calculate shareholders' equity Opening value + net income dividends (if any) $ = $ Arrive at total assets and shareholders equity $ When all the items are set out for each statement, you can then construct your financial statements. Finally, while the interest rate in Example 2.1 of the text is referred to as the risk-free interest rate in the economy, this rate can also be interpreted as the firm s cost of capital. In effect, under ideal conditions, all firms costs of capital are equal, and equal to the investment and borrowing rates used by investors. Of course, under realistic conditions, firms that prepare present value estimates may use their own costs of capital, which will typically differ from interest rates faced by investors.

17 Course Schedule Course Modules Review and Practice Exam Preparation Resources 1.5 Present value model under uncertainty Required reading LEVEL 1 Chapter 2, Section 2.3, pages (Level 1) This topic proceeds to the present value model under uncertainty. The major change in moving from certainty to uncertainty is that the cash flows may differ depending upon the states of nature, and each possible cash flow is expected with a known probability. Be sure you understand the mechanics of text Example 2.2 (page 29), which illustrates the present value model under uncertainty. In many ways, present value accounting under uncertainty is a simple extension of accounting under certainty. Example 2.2 introduces several new concepts that are frequently drawn on throughout the course: States of nature. States of nature are possible future events that will affect the outcome of a decision. In Example 2.2, the states of nature are "economy is bad" and "economy is good." The decision outcome this affects is whether the firm will use its asset (operate as a business) for the next two years or sell it. Example 2.2 assumes the firm will continue to operate. However, under ideal conditions the firm can always sell its net assets at their expected present values. For example, if the firm sells out at the end of period 1 it will not face the prospect of the low state in period 2 (nor will it enjoy the prospect of the high state). Several other types of decisions that are also affected by states of nature will be illustrated in subsequent modules. For now, the important point to realize is that, under ideal conditions, the set of states of nature comprise an exhaustive list of events affecting the decision at hand that may happen in the future. Of course, at the time a decision under uncertainty is taken we do not know which state will happen. Nevertheless, whatever state does actually happen must be a member of the set of states. Probabilities of states of nature. Under ideal conditions, these probabilities are known, similar to the probability of obtaining heads or tails when tossing a coin that you know is fair. These are called objective probabilities. This is the case in Example 2.2, where the probability of "economy is good" is known to be 0.5. However, the example also introduces the concept of subjective probabilities, where the probabilities are not known but must be assessed by the firm or decision maker. (What is the probability of a head if you are not sure that the coin you are about to flip is fair?) Subjective probabilities are more formally introduced in Module 2. For now, the main points to realize are the difference between the two probability concepts and that ideal conditions of uncertainty assume objective probabilities. Expected value of an asset or liability. This concept should be familiar to you from earlier courses. Be sure you are able to make expected value calculations. The mechanics of the calculations are the same regardless of whether probabilities are objective or subjective. However, the accuracy of the calculation may be much lower in the latter case. Abnormal earnings. These are the difference between the expected value of earnings and their actual realization. This is the main difference between income statements prepared under ideal conditions of certainty and uncertainty. Note that expected earnings (that is, accretion of discount) are the same in both Examples 2.1 and 2.2. Since, as a practical matter, almost every firm operates under uncertainty, abnormal earnings are an important concept that will come up again when you study investor reaction to firms reported earnings in Modules 3 to 6. For example, investors seem to respond strongly to unexpected earnings. You have probably seen the major effect on share price when a firm reports earnings higher or lower than the market had expected. The Income Statements illustrated in Example 2.2 (see pages 31 and 33) show how

18 reported earnings consist of an expected and an unexpected component. Risk. Most firms operate under considerable risk. As you will see in Module 5, accountants have been giving increased attention to reporting on risk. Example 2.2 provides a conceptual basis for thinking about and understanding the nature of risk under ideal conditions. Risk is the knowledge that one of several different possible state realizations will occur, but it is not known for sure which one it will be. When ideal conditions do not hold, additional risks appear. For example, there may be realizations of states of nature during the year that were not anticipated at the beginning of the year. The present value model has one additional feature that is conceptually important to note. With respect to revenue recognition, all future revenues are recognized (that is, their expected values are capitalized into the carrying value of assets such as plant and equipment) as at the financial statement date. This is similar to the case of ideal conditions under certainty. The only difference is that under uncertainty, that is, in uncertain situations, expected revenues are recognized and capitalized.

19 Course Schedule Course Modules Review and Practice Exam Preparation Resources 1.6 Reserve recognition accounting Required reading LEVEL 1 Chapter 2, Section 2.4, pages (Level 1) Note: You may wonder why American standards are sometimes used for illustrative purposes rather than Canadian or international standards. Also, why are the standards and articles in some cases quite dated? The objective is to illustrate the concepts with the most developed illustration, whether it be Canadian, American, or international. Since the three sets of standards are very similar in concept, any one of them can usually serve the purpose acceptably. However, in some cases the standards differ. For example, at present the FASB pensions standard is more advanced towards current value accounting than international standards. For such cases, we will discuss the more advanced standard, with less attention to the others. The purpose is always to select the standard that best illustrates course concepts. With respect to dating, the objective is to explain or illustrate the concept with an appropriate release whether it be an earlier or more recent release. An article or standard that is quite old in time can still be highly relevant to current practice. With respect to reserve recognition accounting, Canada does have its own standard (described below). However, we will see that most large Canadian oil and gas companies report under the United States standard. This topic gives you some exposure to the mechanics of reserve recognition accounting (RRA), which reports expected present value of proved oil and gas reserves as supplementary information. It is interesting that, even though RRA is an American accounting standard, it shows up in the financial statements of a major Canadian corporation (here, Suncor Energy, Inc.). One reason is that shares of many Canadian corporations, such as Suncor, are traded in the United States. U.S. investors, and the SEC in the United States, will expect RRA information. Another reason is that some large Canadian oil and gas companies are subsidiaries of U.S. parents. Because of increasing integration of world economies, it is becoming more important for Canadian accountants to be aware of financial reporting practices in other countries. Under ideal conditions, the future cash flows of the firm are known, the interest rate in the economy is known with certainty, and present value and market values are equal, as mentioned earlier. These conditions never exist in the real world. The main purpose of this topic is to illustrate some of the difficulties that arise when accountants attempt to apply the present value model under non-ideal conditions. A study of RRA helps us to understand the problems that arise as accounting moves more towards the reporting of current values. A major problem involves the reliability of the estimates. Reliability remains a concern for RRA despite attempts in SFAS 69 to reduce the problem. Specifically, SFAS 69 mandates a 10% interest rate, applies only to proved reserves, and requires that future receipts from oil and gas be priced at year-end levels rather than the more "ideal" prices expected to be in effect when the oil and gas is actually sold. Another problem faced by RRA is how to overcome management objections, as illustrated by the text s quotation from Suncor s management on page 38. While management s concerns are expressed in terms of low reliability, another problem from management perspective is that present value accounting produces relatively (that is, relative to historical cost) volatile asset values and earnings. Management often feels that this volatility produces financial statements that do not properly reflect its performance. We postpone consideration of this concern to Module 6 and subsequent modules. With respect to reliability, the serious consequences of unreliable RRA information are illustrated by the case of Royal Dutch/Shell, outlined in the vignette on text page 41. While this company is European, not Canadian, it

20 too reported in accordance with SFAS 69. Canadian oil and gas firms should take note of Shell's experience. In this regard, Canadian securities regulators have now introduced their own RRA standard, namely National Instrument of the Canadian Securities Administrators (CSA), a forum of 13 Canadian provincial and territorial securities commissions. This standard goes beyond SFAS 69 in several ways: The definition of proved reserves is tightened up. Under NI , these are reserves with at least a 90% probability of recovery. The SFAS 69 definition requires only "reasonable certainty" of recovery. Probable reserves must also be reported. These are additional reserves such that there is a greater than 50% probability that the sum of proved plus probable will be recovered. Two present value estimates of future cash flows from reserves are required based on yearend prices and costs (as in SFAS 69) and on forecasted prices and costs. Discounting is required at several different discount rates, ranging from 0% to 20%. SFAS 69 requires only 10%. The use of different discount rates reflects the perceived risk of receipts. Clearly, the Canadian requirements go beyond SFAS 69. Nevertheless, the same problems of reliability that the text outlines for SFAS 69 remain. It should be noted that Canadian firms can apply for exemption from NI if they report under SFAS 69. Most large Canadian oil and gas companies have secured this exemption. Consequently, despite the Canadian standard, RRA as per SFAS 69 remains as an important disclosure standard in Canada. For example, Suncor Energy, Inc. states in its 2006 Annual Report (page 035, not reproduced in textbook): We are a Canadian issuer subject to Canadian reporting requirements, including rules in connection with the reporting of our reserves. However, we have received an exemption from Canadian securities administrators permitting us to report our reserves in accordance with U.S. disclosure requirements. This exemption allows the Company to substitute United States Securities and Exchange Commission ("SEC") requirements for certain disclosures required under NI Revenue recognition Read the discussion of revenue recognition and asset valuation on pages of the text with particular care. Note that the revenue recognition criteria of RRA are somewhat different from those of ideal conditions, where all future revenue is recognized as at the financial statement date. Under RRA, revenue is recognized, in effect, when reserves are proved. While this is somewhat later in the operating cycle than under ideal conditions (which could be when exploration rights are acquired), it is still substantially earlier than the conventional sale basis of revenue recognition. An understanding of the question of revenue recognition enables you to economize on the amount of material you have to understand. This is because asset valuation and revenue recognition are two sides of the same coin. The text discussion is primarily in terms of asset valuation (the debit side of the coin), concentrating on the problems of estimating the value of proved reserves. However, the discussion on pages is also in terms of the timing of revenue recognition from oil and gas (the credit side). Note that early revenue recognition, as in RRA, is relevant (early recognition helps investors evaluate the firm s future cash receipts from oil and gas) but less reliable (less precise and more subject to possible manager bias). Exactly the same tradeoff between relevance and reliability is present as in the problem of asset valuation greater relevance can be attained only by sacrificing reliability, and vice versa. Many "real world" accounting problems are cast in terms of revenue recognition rather than asset valuation. Indeed, when firms get into trouble over their financial reporting, the most common cause is their revenue recognition practices. Question 22, on pages of the text, illustrates this point. (Read the question only. The solution is not required for this illustration.) Lucent restated its earnings for 2000 to reverse $679 million of revenue that had been included in its earnings for that year. Note that instead of asking if Lucent should recognize revenue when product is shipped to distribution partners, the problem could equivalently be expressed as whether Lucent s accounts receivable from distribution partners should be valued at selling price (that is, the price charged by Lucent to its distribution partners) or at cost (that is, the cost to Lucent of producing the products and services sold to distribution partners). (This latter treatment, in effect, regards the