Welcome to Class

CCFC 511
Financial Accounting I
 Introduction

• Robert Matarasso, CPA

– Bachelor of Commerce, McGill University
– Graduate Certificate in Professional Accounting, McGill
University
– In-depth Tax Course, CPA Canada
– CPA (Quebec)
– Senior Manager @ EY, Private Client Services
– Email: Robert.Matarasso@mcgill.ca
• Guest Lecturer – Dr. Preetika Joshi, CPA
• Teaching Assistants
– Lead TA – Chloe Luo
– Peizy Tan, Julia Maturo
 Course Overview
• Course Evaluation
– In Class Tests (50%)
– Final Exam (40%)
– Participation (10%)
• Highlights of Course Content
– Fundamentals of Accounting Theory
– Conceptual Framework
– Accounting Cycle & Accrual Accounting
– Revenue Recognition
– Asset Recognition and Measurement
 https://www.mcgill.ca/desautels/programs/gcpa

• To be a CPA, you would need to finish the undergraduate major and

complete the CFE Exam
– McGill offers the prestigious GCPA Program
– Understand the prerequisite and structure of the program
– There are also other out of province options
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 So Let’s Start the Class!
• Rules of Engagement:
– Participation is highly encouraged
– Questions are welcome
– Professionalism is appreciated so don’t be late!
– Accounting & financial reporting may be
stereotyped as boring, but I will try to make it as
interesting as possible with real life and
hypothetical examples, and you need to come to
class prepared & with a good mood
 Chapter 1

Fundamentals of
Financial Accounting Theory

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 LEARNING OBJECTIVES

• The demand and supply of accounting information

• The concepts of information asymmetry, adverse
selection, and moral hazard in accounting,
management, and related situations.
• The qualitative characteristics of accounting
information that help to alleviate adverse selection
and moral hazard
• The introduction to earnings management
• How accounting information interacts with
securities markets.
 THE DEMAND AND SUPPLY OF
ACCOUNTING INFORMATION
• Accounting = the production and
transmission of information about an
enterprise
• Information: Evidence that can potentially
affect an individual’s decisions
• External parties’ decision-making needs
create demand
• Fundamental to accounting is communicating
information from those who have it to those
who need it
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Importance of Financial Accounting
• Financial Accounting:
– Serves the important function of generating
financial information
– Financial accounting provides historical
information to users
– Financial reporting is used by both internal and
external users
– External users include such decision makers as
investors, creditors, unions, and government
agencies
– Internal users include managers, employee and
owners 1-12
Generally Accepted Accounting Principles

• Preparation of accounting information may lead to

reports that show the enterprise in its best light
• Motives include:
– to reflect positive management stewardship (job,
compensation)
– meet financial analysts’ expectations, resulting in a
positive reaction in the capital markets
• What safeguards are in place to protect financial users
from management bias?
– Standards setting
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Generally Accepted Accounting Principles

• Standards are developed to aid preparers and users of

accounting information
• They allow the preparers to present fairly the
operations of the company
• They also allow users to better understand the
information
• Standards are not rules, regulations, or laws, they are
principles that guide financial reporting:
– Generally Accepted Accounting Principles

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Generally Accepted Accounting Principles

• For public companies (reporting under IFRS), GAAP

includes:
– IFRS
– International Accounting Standards (IAS)
– Interpretations (IFRIC or SIC)
– If above sources do not specifically apply, other sources
may be considered:
• Pronouncements of other standard-setting bodies
• Other accounting literature
• Accepted industry practices

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 Professional Judgement and Ethics
• There cannot be a rule for every situation
• The standards in IFRS are based primarily on
principles rather than specific rules
• Therefore, must use professional judgement
• Ethical dilemmas are common in accounting and
other areas of business
• It is not always easy to do the right thing or make
the right decision under information asymmetry
Example: If your boss asks whether you are busy, would you ever tell the truth if you are not?

For Accounting, firms may not always want to present the truthful information to investors if it has
not been doing well

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UNCERTAINTY AND INFORMATION
ASYMMETRIES
• A condition in which some people have
more information than others
– Once again, it could be problematic because
it gives opportunity for individuals to lie
• Two types:
adverse selection and moral hazard

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 Adverse Selection

• Example – buying a used car

• Seller has more information than
you
– Lemon problem!
• Seller will cheap talk –
unverifiable disclosures that the car
is in good condition
• Seller needs costly signalling –
providing guarantee or warranties
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 Moral Hazard
• Example – driving a used car with
full insurance
• One party to a contract cannot
observe some actions relating to
the fulfillment of the contractual
terms by the other
– Moral hazard is costly
• Driver does not exhibit good
behavior
• Insurance needs costly signalling –
providing deductible or sharing
damage 1 - 16
Definitions of Adverse Selection
and Moral Hazard

• For adverse selection: one party to a contract has

an information advantage over another party
– “hidden information”
• For moral hazard: one party to a contract cannot
observe some actions relating to the fulfillment of
the contractual terms by the other party
– “hidden actions”

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Adverse Selection & Moral Hazard
in Accounting

• Adverse Selection:
– Selling shares in the stock market
– CEO can claim the company is good, and
there are a lot of businesses and
resources, yet this is cheap talk!
– Solution: Costly signaling by
independent auditor
• What problem remains?
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Real Life Example: Sino-Forest
• Listed on TSX, the firm claims to be one of the
leading forest plantation operators in China
– 757,000 hectares of trees under management
– Market cap: $5 billion in 2010
• Fraud discovered in 2011
– Muddy Waters Research discovered assets were
fraudulently inflated
– This is the case of famous “phantom trees”
– Shares fell by 82%
– CEO and auditor EY paid $117 million penalty
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 Adverse Selection & Moral Hazard
in Accounting

• Moral Hazard:
– Agency problem within a company
– Separation of ownership and
management: the owners cannot
effectively monitor the managers
– Solutions: Incentive pay, employee stock
purchase and stock options
• What problem remains?

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 Real Life Example:
Wells-Fargo
• One of the biggest banks in the U.S.
– CEO John Stumpf’s pay was $200 million, of
which $165 million was incentive pay
– Resulted in aggressive sale practices and increase
in stock price
• Illegal conduct since 2011 discovered in 2016
– Creating customer accounts and charging fees
without consent
– Shares fell through 2016
– California government cut off business relations as
a penalty
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 Real Life Example:
The Financial Crisis of 2008

• Critical role in the financial crisis

• Mortgage companies issue bad
mortgages
• Banks packaged bad mortgages:
mortgage-backed securities (MBS)
• MBS sold to investors who insure
with credit default swap (CDS)
• Passing on risk: result – bankers and
investors became careless
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QUALITATIVE CHARACTERISTICS OF
ACCOUNTING INFORMATION

• Investors demand relevant information

• Investors demand reliable information
• However, more relevant information could
be more reliable
– Trade-offs must be made

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 EARNINGS MANAGEMENT

• Standards allow for choices in accounting

policies and estimates
– One size does not fit all
• Given the adverse selection and moral
hazard problems
– Management may want to cheat!
• What can happen?
– Earnings management

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Motivations for Managing Earnings
Upward
• Pay more for the firm’s shares
• Access more funds or borrow at a lower interest
rate
• Meet its contractual obligations such as debt
covenants
• Meet regulatory requirements, such as capital
requirements for banks
• Provide a stronger bargaining position in merger
negotiations
• Obtain higher compensation for managers
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Motivations for Managing Earnings
Downward
• Reduce additional taxes or regulations
• Increase the likelihood of receiving government
subsidies and trade protection Think about asking your parents for money!
• Take a “big bath” in a bad year resulting in:
– Higher future growth/performance improvement
– Higher future compensation and stock price
increase
• Improve the firm’s bargaining position relative to
employee unions

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 ACCOUNTING AND SECURITIES
MARKETS
• Accounting and finance are always important for
each other!
• Securities markets take accounting information
– Efficient market: price of securities reflect all
information publicly known
• Securities markets provide accounting information
– Firms hold investments that trade in the securities market
– Markets provide information for valuing investments
recorded in financial statements

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