Intermediate Accounting, 10th Edition Test Bank

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CHAPTER 1THE CANADIAN FINANCIAL REPORTING ENVIRONMENTSUMMARY OF QUESTION TYPES BY LEARNING OBJECTIVE ANDLEVEL OF DIFFICULTYItemLOLODItemLOLODItemLOLODItemLOLODMultiple Choice–Conceptual1.1M9.2M17.6M25.7E2.1E10.2H18.6M26.8E3.1E11.3E19.6H27.9M4.1E12.4M20.6M28.9M5.1E13.4H21.6E29.9H6.1M14.4H22.6M30.9E7.2M15.4M23.6E8.2E16.5M24.6MExercises31.1M34.3H37.6H40.9H32.2H35.3M38.6M41.9H33.3E36.4H39.7MNote:E = EasyM = MediumH = Hard

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Test Bank for Intermediate Accounting, Tenth Canadian Edition1-2SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPEItemTypeItemTypeItemTypeItemTypeItemTypeItemTypeLearning Objective 11.MC3.MC5.MC31.Ex2.MC4.MC6.MCLearning Objective 27.MC8.MC9.MC10.MC32.ExLearning Objective 311.MC31.Ex33.Ex34.Ex35.ExLearning Objective 412.MC13.MC14.MC15.MC36.ExLearning Objective 516.MCLearning Objective 617.MC19.MC21.MC23.MC37.Ex18.MC20.MC22.MC24.MC38.ExLearning Objective 725.MC39.ExLearning Objective826.MCLearning Objective927.MC28.MC29.MC30.MC40.Ex41.ExNote:MC = Multiple ChoiceEx =Exercise

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The Canadian Financial Reporting Environment1-3CHAPTER STUDY OBJECTIVES1. Explain how accounting makes it possible to use scarce resources more efficiently.Accounting provides reliable, relevant, and timely information to managers, investors, andcreditors so that resources are allocated to the most efficient enterprises. Accounting alsoprovides measurements of efficiency (profitability) and financial soundness.2.Explain the meaning of “stakeholder” and identify key stakeholders in financialreporting, explaining what is at stake for each one.Investors, creditors, management,securities commissions, stock exchanges, analysts, credit rating agencies, auditors, and standardsetters are some of the major stakeholders. See Illustration 1-3.3.Identify the objective of financial reporting.The objective of financial reporting is tocommunicate information that is useful to key decision makers such as investors and creditors inmaking resource allocation decisions (including assessing management stewardship) about theresources and claims to resources of an entity and how these are changing.4.Explain how information asymmetry and bias interferes with the objective of financialreporting.Ideally, all stakeholders should have access to the same information in order toensure that good decisions are made in the capital marketplace. (This is known as informationsymmetry.) However, this is not the case—there is often information asymmetry. Of necessity,management has access to more information so that it can run the company. It must also makesure that it does not give away information that might harm the company, such as in a lawsuitwhere disclosure might cause the company to lose. Aside from this, information asymmetry existsbecause of management bias whereby management acts in its own self-interest, such as wantingto maximize management bonuses. This is known as moral hazard in accounting theory.Information asymmetry causes markets to be less efficient. It may cause stock prices to bediscounted or costs of capital to increase. In addition, it might detract good companies fromraising capital in the particular market where relevant information is not available (referred to asadverse selection in accounting theory). The efficient markets hypothesis is felt to exist only in asemi-strong form, meaning that only publicly available information is assimilated into stock prices.5.Explain the need for accounting standards.The accounting profession has tried to developa set of standards that is generally accepted and universally practised. This is known as GAAP(generally accepted accounting principles). Without this set of standards, each enterprise wouldhave to develop its own standards, and readers of financial statements would have to becomefamiliar with every company’s particular accounting and reporting practices. As a result, it wouldbe almost impossible to prepare statements that could be compared. In addition, accountingstandards help deal with the information asymmetry problem.6. Identify the major entities that influence the standard-setting process and explain howthey influence financial reporting.The Canadian Accounting Standards Board (AcSB) is themain standard-setting body in Canada for private companies, pension plans, and not-for-profitentities. Its mandate comes from the Canada Business Corporations Act and Regulations as wellas provincial acts of incorporation. For public companies, GAAP is International Financial

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Test Bank for Intermediate Accounting, Tenth Canadian Edition1-4Reporting Standards (IFRS) as established by the International Accounting Standards Board(IASB). Public companies are required to follow GAAP in order to access capital markets, whichare monitored by provincial securities commissions. The Financial Accounting Standards Board(FASB) is also important as it influences IFRS standard setting. Private companies may chooseto follow IFRS. Public companies that list on U.S. stock exchanges may choose to follow U.S.GAAP.7.Explain the meaning of generally accepted accounting principles (GAAP).Generallyaccepted accounting principles are either principles that have substantial authoritative support,such as theCICA Handbook, or those arrived at through the use of professional judgement andthe conceptual framework.8.Explain the significance of professional judgement in applying GAAP.Professionaljudgement plays an important role in Accounting Standards for Private Enterprises (ASPE) andIFRS since much of GAAP is based on general principles, which need to be interpreted.9.Discuss some of the challenges and opportunities for accounting.Some of thechallenges facing accounting are oversight in the capital markets, centrality of ethics, standardsetting in a political environment, principles versus rules-based standard setting, the impact oftechnology, and integrated reporting. All of these require the accounting profession to continue tostrive for excellence and to understand how accounting adds value in the capital marketplace.

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The Canadian Financial Reporting Environment1-5MULTIPLE CHOICE—ConceptualAnswerNo.Descriptiond1.Accounting characteristicsa2.Nature of financial accountingc3.Definition of financial accountingb4.Definition of management accountingd5.Efficient use of resourcesc6.Capital allocation processb7.Stakeholders in the financial reporting environmentd8.Preparation of audited financial statementsa9.Auditor’s responsibilityc10.Causes of subprime lending crisisb11.Objectives of financial reportingc12.Preparation of biased informationc13.Existence of information asymmetryb14.Efficient markets hypothesisd15.Management biasb16.Reduction of information asymmetryc17.Responsibility of the AcSBa18.Oversight of AcSBc19.Authority over accounting standards in the U.Sd20.Development of financial reporting standards in Canadab21.Adoption of IFRSd22.Activities and authority of the OSCb23.Use of ASPEa24.IASB’s standard setting processc25.Primary sources of GAAP under ASPEd26.Exercise of professional judgementb27.SOXc28.Rules-based vs. principles-based approachc29.Changing financial reporting environmenta30.Advancement of technology on financial reportingEXERCISESItemDescription1-31Effective capital allocation1-32Stakeholders in the financial reporting environment1-33Objectives of financial reporting1-34Entity vs. proprietary perspective1-35User needs1-36Information asymmetry1-37Role of securities commissions and stock exchanges1-38Standard setting1-39Source of GAAP1-40SOX and standard setting1-41Challenges facing financial reporting

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Test Bank for Intermediate Accounting, Tenth Canadian Edition1-6MULTIPLE CHOICE—Conceptual1. The essential characteristic(s) of accounting is (are)a) communication of financial information to interested internal parties only.b) communication of economic information to external parties.c) identification and measurement of financial information only.d) identification, measurement, and communication of financial information.2. Financial accounting is concerned with the process that culminates ina) the preparation of financial reports.b) specialized reports for inventory management and control.c) specialized reports for income tax calculation and recognition.d) reports on changes in stock prices and future estimates of market position.3. Financial accounting can be broadly defined as the area of accounting that prepares financialstatements to be useda) by parties internal to the business enterprise only.b) by investors only.c) by parties both internal and external to the business enterprise.d) primarily by external users and Canada Revenue Agency.4. Management accounting can be broadly defined as the area of accounting that communicatesfinancial informationa) to investors only.b) to parties internal to the business enterprise only.c) to parties both internal and external to the business enterprise.d) primarily to external users and Canada Revenue Agency.5. Whether a business is successful and thrives is determined bya) free enterprise or competition.b) competition and markets only.c) markets and competition only.d) markets, competition and free enterprise.6. Which of the following is correct?a) Reported accounting numbers do not affect the transfer of resources.b) Credit rating agencies use accounting information to assess their assets.c) Efficient capital markets promote productivity and encourage innovation.d) Efficient capital markets promote productivity but do not encourage innovation.7. Stakeholders who help in the efficient allocation of resources includea) investors and creditors.b) financial analysts and regulators.c) creditors and auditors.

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The Canadian Financial Reporting Environment1-7d) management and auditors.8. Audited financial statements are prepared bya) auditors.b) financial analysts.c) Canada Revenue Agency.d) management.9. The auditor’sprimaryresponsibility is toa) review financial statements and discuss them with management.b) prepare financial statements.c) report to Canada Revenue Agency.d) report to standard setters.10. The widely publicized subprime lending crisis was NOT caused bya) capital market participants who acted in their own self-interest.b) a lack of transparency.c) the practice of securitizing assets.d) a lack of investor understanding of the investment's true risk.11. Objectives of financial reporting do NOT includea) providing information that is useful to users in making resource allocation decisions.b) providing information about the liquidation value of an enterprise.c) providing information about an entity’s economic resources, obligations, and equity/netassets.d) providing information about changes in an entity’s economic resources, obligations, andequity/net assets.12. The preparation by some companies of biased information is sometimes referred to asa) conservative financial reporting.b) full disclosure of all material facts.c) aggressive financial reporting.d) stewardship.13. Where information asymmetry exists, the capital market may attract the wrong kind ofcompany. This is known asa) moral hazard.b) conservative accounting.c) adverse selection.d) an inefficient marketplace.14. The “efficient markets hypothesis” proposes thata) market prices reflect information known only to internal stakeholders.b) market prices reflect all information about a company.c) market prices reflect information known only to external stakeholders.

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Test Bank for Intermediate Accounting, Tenth Canadian Edition1-8d) information asymmetry is required.15. Which of the following does NOT describe a cause of management bias?a) the need to comply with contracts, such as debt covenantsb) the desire to meet financial analysts’ expectationsc) the tendency to downplay negative eventsd) the desire for all stakeholders to have access to all information16. The problem of information asymmetry can be reduced bya) aggressive accounting.b) accounting standards.c) adverse selection.d) only focusing on positive events.17. As of 2011, the responsibilities of the Accounting Standards Board (AcSB) in Canada relate tosetting standards fora) publicly accountable entities only.b) both publicly accountable entities and private enterprises.c) private enterprises, not-for-profit entities and pension plans.d) not-for-profit entities and pension plans only.18. In Canada, the body that has the responsibility of overseeing the Accounting Standards Board(AcSB) is thea) Accounting Standards Oversight Council (AcSOC).b) International Accounting Standards Board (IASB).c) Canadian Institute of Chartered Accountants (CICA).d) Financial Accounting Standards Board (FASB).19. In the United States, the body that has the final authority over accounting standards is thea) Financial Accounting Standards Board (FASB).b) International Accounting Standards Board (IASB).c) Securities Exchange Commission (SEC).d) Accounting Standards Oversight Council (AcSOC).20. In Canada, the body which is NOT instrumental in the development of financial reportingstandards is thea) Accounting Standards Board (AcSB).b) Financial Accounting Standards Board (FASB).c) International Accounting Standards Board (IASB).d) American Institute of Certified Public Accountants.21. The adoption of International Financial Reporting Standards in Canada is an example ofa) the impact of technology on user's needs.b) the impact of globalization on capital markets.c) ethical behaviour.

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The Canadian Financial Reporting Environment1-9d) the desire of most private companies to expand internationally.22. Which of the following statements does NOT describe the activities and authority of theOntario Securities Commission (OSC)?a) The OSC reviews and monitors the financial statements of companies whose shares arelisted on the Toronto Stock Exchangeb) The OSC issues its own disclosure requirements for listed companies.c) The OSC has the ability to fine or delist companies.d) The OSC issues financial accounting standards for Canadian companies.23. Which of the following does NOTsupport the use of Accounting Standards for PrivateEnterprises (ASPE)?a) Private enterprises usually have less complex business models.b) Private enterprises that are “going public.”c) Private enterprises usually have fewer users.d) Private enterprises’ financial statement users tend to have first-hand information.24. Which of the following does NOT describe a step in the IASB’s standard setting process?a) appointing trustees to the IFRS Foundationb) development of an Exposure Draftc) provision of strategic advice by the IFRS Advisory Councild) public consultation25. Under ASPE, the primary sources of GAAP includea) accounting textbooks and journals.b) International Financial Reporting Standards.c) the CICA Handbook and appendices.d) research studies.26. The exercise of professional judgement does NOT involvea) the use of knowledge gained through education.b) the application of knowledge gained through experience.c) the use of ethical decision making.d) aggressive accounting.27. The Sarbanes-Oxley Act (SOX) was NOT enacted toa) help prevent fraud and poor financial reporting practices.b) ensure the act was applied internationally.c) enable the SEC to increase its policing efforts.d) introduce new independence rules for auditors.28. In a rules-based approach (such as U.S. GAAP), compared to a principles-based approach(such as Canadian GAAP),a) the body of knowledge is smaller.b) the importance of communicating the best information to users is emphasized.

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Test Bank for Intermediate Accounting, Tenth Canadian Edition1-10c) since it is more prescriptive, it may be easier to defend how to account for a particularitem.d) companies frequently do not interpret the rules literally.29. Which of the following is/are major factors in the rapidly changing financial reportingenvironment in Canada?a) increased demand for accountants and the impact of technologyb) globalization and the unethical actions of accountantsc) the growing number of institutional investors who want more information regardingenvironmental and social issuesd) increased use of the Internet30. Which of the following is likely to be an advantage of the advancement of technology onfinancial reporting?a) Users of financial information will have access to more information.b) The quality and reliability of the information may be compromised.c) Equal and fair access may be at issue.d) Internet reporting will increase costs.

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The Canadian Financial Reporting Environment1-11MULTIPLE CHOICE ANSWERS—ConceptualItemAns.ItemAns.ItemAns.ItemAns.ItemAns.ItemItem1.d6.c11.b16.b21.b26.d2.a7.b12.c17.c22.d27.b3.c8.d13.c18.a23.b28.c4.b9.a14.b19.c24.a29.c5.d10.c15.d20.d25.c30.a

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Test Bank for Intermediate Accounting, Tenth Canadian Edition1-12EXERCISESEx. 1-31Effective capital allocationExplain the advantages of an effective capital allocation process.Solution 1-31An effective capital allocation process encourages innovation, promotes productivity, andprovides a platform for buying and selling securities and obtaining and granting credit.Ex. 1-32Stakeholders in the financial reporting environmentBriefly describe the much-publicized subprime lending crisis in the United States, and identify thestakeholders and how they were affected.Solution 1-32At the centre of this issue were securitized mortgage assets that were sold to investors. Theseassets were based on mortgages that had been extended to high-risk borrowers who could nolonger afford their mortgage payments once interest rates rose. This led to a flooding of thehousing market as borrowers walked away from their houses (and debt). The primarystakeholders were the lenders, borrowers and investors. Lenders (acting in their own self-interest)sold these investments to investors who may not have fully understood the high-risk nature oftheir investment. Borrowers lost their homes they could no longer afford, and investors sufferedlarge losses due to the defaulted loans.Ex. 1-33Objectives of financial reportingWhat are the objectives of financial reporting by business enterprises?Solution 1-33The objectives of financial reporting are to provide information1.that is useful to investors, members, contributors, creditors and other users in making theirresource allocation decisions and/or assessing management stewardship.2.to help users in evaluating an entity’s economic resources, obligations and equity/net assetsand the changes to these items.3.to help users evaluate the economic performance of an entity.Ex. 1-34Entity vs. proprietary perspectiveExplain the difference between the entity perspective and the proprietary perspective.Solution 1-34The entity perspective views companies as separate and distinct from their owners. e.g.,corporate assets are viewed as assets of the company and not of a specific creditor orshareholder. Investors and creditors have liability or equity claims. On the other hand, theproprietary perspective holds that financial reporting should focus only on the needs of theshareholders, and is not considered appropriate. The entity perspective is adopted as part of theobjective of general purpose financial reporting.Ex. 1-35User Needs

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The Canadian Financial Reporting Environment1-13Explain why providing information to users is a challenging task.Solution 1-35First, users have very different knowledge levels. Some users have accounting designations orhave worked in the finance industry for several years. Others have limited knowledge of how theinformation is gathered and reported. Second, users have very different needs. Some users areinstitutional investors who hold a large percentage of equity shareholdings and generally devotesignificant resources to managing their investment portfolios. Others are credit managers atbanks or credit unions who deal mainly with small business or personal loans. Still others arelabour negotiators whose knowledge of financial reporting is limited to periodic reviews offinancial information for the purpose of negotiations.Ex. 1-36Information asymmetryIn markets where information asymmetry exists, there can be adverse selection and moralhazard. Explain what these terms mean.Solution 1-36Adverse selection refers tohidden knowledge, where the capital marketplace may attract thewrong type of company, such as companies who have the most to gain from not disclosinginformation. Given this situation, companies who do fully disclose all information may choose notto enter the marketplace if they are aware of the presence of adverse selection.Moral hazardrefers tohidden actions, and occurs as a result of human nature. People orcompanies may shirk their responsibilities if they think they can get away with it, e.g., not disclosenegative information since they know it may be detrimental to their share price. This is a form ofmanagement bias.Ex. 1-37Role of Securities Commissions and Stock ExchangesExplain the role of securities commissions and stock exchanges in financial reporting.Solution 1-37The securities commissions and stock exchanges monitor the financial statements of companieswhose shares are publicly traded to ensure that they provide full and plain disclosure of materialinformation, and to ensure that the companies may continue to list shares on the stockexchanges. Securities commissions oversee and monitor the capital marketplace.Ex. 1-38Standard settingExplain the relationship between Canadian GAAP and International Financial ReportingStandards (IFRS).Solution 1-38Since the decision to adopt IFRS was made, Canadian GAAP has been continuously adjusted(converged) to mirror IFRS. Even prior to that convergence, both standards were principles based(rather than rules-based).Ex. 1-39Sources of GAAPInternational Financial Reporting Standards (IFRS) are the primary source of GAAP for publicenterprises in Canada. They are, however, insufficient to address all of the accounting issues

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Test Bank for Intermediate Accounting, Tenth Canadian Edition1-14facing accountants. Explain why this is so and outline some other sources of GAAP thataccountants use.Solution 1-39Although IFRS outline the specific accounting treatment for a multitude of items, for some itemsthe guidelines are very general. Also, the business environment is complex and constantlychanging and, therefore, some items may not be discussed at all. Thus, accountants must useIFRS in conjunction with other sources like professional judgement, pronouncements of otherstandard-setting bodies, accounting literature, and accepted industry practices.Ex. 1-40SOX and standard settingAfter several highly-publicized accounting scandals in the U.S. such as Enron, Sunbeam andWorldCom, all of whom, coincidentally, were clients of the now basically defunct publicaccounting firm of Arthur Andersen, the U.S. regulators enacted the Sarbanes-Oxley Act (SOX).Pressure was put on Canada to follow a similar course. Explain what Canada has done to makepublic companies more accountable.Solution 1-40First, the Canadian Public Accountability Board (CPAB) was created to supervise accountingissues similar to those addressed by SOX. These included establishing auditing, quality controland independence standards and rules.The Canadian Securities Administrators (CSA) has issued guidelines/rules that require (amongother things)1.company management to take responsibility for the appropriateness and fairness of thefinancial statements2.public enterprises to have independent audit committees3.management to report on the effectiveness of their internal controls3.public accounting firms to be subject to CPAB4.greater disclosures, such as ratings from rating agencies, legal proceedings, payments tostock promoters, details about corporate directors.Ex. 1-41Challenges Facing Financial ReportingIn North America, the financial reporting environment is changing at a very rapid pace. Brieflydescribe four challenges facing the accounting profession today.Solution 1-411.Oversight in the capital marketplace. The Sarbanes-Oxley Act (SOX) instituted the PublicCompany Accounting Oversight Board (PCAOB), stronger independence rules for auditors,reporting on the effectiveness of the financial reporting internal control system, anddisclosure of a code of ethics for senior financial officers.Canada has followed suit and developed the Canadian Public Accountability Board (CPAB).As well, the Canadian Securities Administrators (CSA) requires company management totake responsibility for the appropriateness and fairness of the financial statements, publiccompanies to have independent audit committees, and public accounting firms to be subjectto the CPAB. The CSA also requires much greater disclosures. The overall impact of thesefinancial reforms has been to put more emphasis on government regulation and less on self-regulation.

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The Canadian Financial Reporting Environment1-152.Centrality of ethics. Accountants are central in making the capital marketplace efficient andeffective. However, ethical dilemmas are common, often precipitated by management bias. Itis not always easy to “do the right thing.” Pressure to bend the rules, play the game or “justignore it” are often there. There is no consensus (yet) among accounting professionals as towhat a comprehensive ethical system is, and so it is up to the individual accountant tomaintain a high standard of ethics at all times.3.Standard setting in a political environment. Since standard setting is part of the real world,accounting standards often arise from political action. The stakeholders who lobby thehardest may unduly influence new or revised accounting standards. This is not surprisingsince many accounting standards have economic consequences. Thus standard setters suchas the IASB must consider the needs of all stakeholders when creating or changingstandards. The challenge is to find a balance between letting stakeholders have a say whilenot bowing to undue political pressure.4.Principles vs. rules. Rules-based, prescriptive systems (such as U.S. GAAP or the Canadianincome tax system) have a significantly larger body of knowledge than a principles-basedapproach such as IFRS and ASPE. However, there is a tendency to interpret the rulesliterally with a rules-based approach, possibly because it may be easier to defend theaccounting for a particular item. A disadvantage of the rules-based approach is that it maynot always communicate the best information to the user. The principles-based approachesare based on professional judgement, resulting in carefully reasoned application of theprinciple to the business facts. Since the body of knowledge is smaller with principles-basedapproaches, the standard setters must ensure it rests on a cohesive set of principles andconceptual framework, which is sufficiently flexible, and sufficiently detailed to provide goodguidance.Other challenges are the impact of technology and integrated reporting.

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