ACC 414 Week 1 Session Notes - Overview of key points

Canadian Financial Reporting Environment: Chapter 1 All LOs except 6 and 9 Conceptual Framework: Chapter 2 All LOs except 7 Text = Keiso Tenth edition Also see PowerPoint slides on text website for chapter summaries Note: Each week I plan to give a short lecture just covering what I find to be the most important ideas and concepts in that weeks material. This will allow most of our class time to be spent going through cases and problems. The PowerPoints that come with the text are quite good for a summary of the text chapters, and can be viewed as part of your own chapter preparation. Environment of Accounting
Accounting involves those who have information supplying it to those who need it ...that is, there is information asymmetry in the economy and it creates a demand for accounting information. The objective of financial statements is to meet this demand by providing information about an entitys: financial position (the state of the company at a point in time) performance and changes in financial position (how well it has done over a period of time) that is useful to a wide range of users in making economic decisions. Objective of financial reporting: What? Communicate information about an entity, its economic resources and claims on them, and changes in its economic resources and claims on them Why? Support users/ decision makers information needs For whom? Investors and creditors (assumed to be reasonably knowledgeable & diligent) are the main users GAAP focusses on, but many other stakeholders could be affected The overall purpose of financial reporting is to meet users/ decision makers information needs for: Capital resource allocation (by predicting nature, timing, amounts of future cash flows) Management stewardship/performance evaluation Contracting As a result, accounting outcomes (e.g. Net Income measurement) matter, i.e. they have economic consequences therefore people have incentives to try to influence accounting outcomes so the consequences will be favourable to them.

Financial statement preparers and users often have different perspectives, and incentives (in ACC 414 we are learning mostly from a preparer perspective...)

Accounting versus bookkeeping Accounting is a professional activity - consequences, incentives lead to choices of how to do accounting that require advanced study, understanding and sensitivity to what is proper and ethical in different circumstances

Bookkeeping is a clerical activity - only requires following instructions, 1

not thinking about consequences of choices, but it does require sensitivity to potential for fraud and unethical implications of accounting information.

Generally Accepted Accounting Standards, GAAP - is a moving target Information needs evolve with business and society changes, so accounting is always evolving. Fot example: In Canada we now have multiple sets of GAAP to meet expanding needs of global companies. For business entities there are IFRS (International Financial Reporting Standards) or ASPE (Accounting Standards for Private Entities). Since 2011 Publicly Accountable entities must use IFRS. (In ACC 414 we need to consider both sets of principles that apply for business enterprises) Fair value measurement a relatively new principle within GAAP in response to needs for more current information, also increases problems of measurement uncertainty Demand now emerging for information on a companys accountability for sustainability (economic, social and environmental, a triple bottom line) - how can accounting meet this demand? Can this be measured? The current GAAPs for Canada are available through the CICA Standards and Guidance Collection (follow RU library links on the Course Outline and take a look at how they are set up). GAAP - Principle-based versus rules-based standards? All standards involve a mix of principles and specific rules or bright-line requirements, or recommendations, but this balance can differ along a continuum. E.g., consider ASPE, IFRS, US GAAP, Russian GAAP [ref: http://www.iasplus.com/en/jurisdictions/europe/country79 ].....

Conceptual framework aka Accounting Theory

What ? Fundamental principles that underlie accounting standards (e.g., GAAP, or other Financial Reporting Frameworks), accounting practice, and accounting choices. Concepts are abstract, hard to understand and apply, but unavoidable .... ....accounting information ultimately comes from peoples decisions about how to portray subjective ideas... a business cant speak - the accountants have to speak for it Why? Provides a plan for how accountants can supply the information that meets the demand. While very abstract, the concepts are essential for making, and justifying, accounting choices to result in fairly presented financial information (i.e., information that accurate, complete and unbiased accounting information, etc.) Accounting standard setters such as IASB inlcude a conceptual framework that is relevant to all their individual accounting standards. IASB is currently involved in a longterm project to revamp its Framework (see www.iasb.org -> Work plan for IFRSs for an overview)

How?

Concepts Overview - Piece by Piece PREPARER PERSPECTIVE

Environment of business
............... . Economy...Society....Politics....Laws...etc. . ....................

ENTITY Reporting Entity Organizational unit defined by the resources, activities and events under its control (e.g., may be a legal entity - incorporated )

RECOGNITION What information is being demanded? Lets try to include everything that would be relevant to users...

MEASUREMENT If we include it, how many $$$ should we show? It should be a fair representation of the economic value to be useful...

FULL DISCLOSURE Weve made a lot of judgment calls so far! Is this what users need? Lets give lots of extrta information to make sure we give a fair picture to users. We need to justify what we included, amounts we used, what we didnt include but might be relevant....

QUALITY ! ? ? Have we really come up to what users need? Lets consider some key quality characteristics to assess it: $ Relevance (does it give feedback about what happened, help predict whats going to happen?) $ Representational faithfulness (is it complete, accurate, unbiased?) $ Other quality factors (is it consistent/comparable, verifiable, timely and understandable?

COST < BENEFIT ? Okay, this is getting expensive! Do we really need ALL this information ? Is it material (i.e. big and important enough to even matter to users?) If it doesnt matter, I guess we can leave it out and lower the costs of producing information.

FINANCIAL STATEMENTS Now we are ready to build some great, fair financial statements, but is there any conventional format to follow? The key building blocks are these elements: assets, liabilities, revenues, expenses, gains, and losses. The key structures are: balance sheet, income statement, cash flow statement, changes in equity statement, and notes

USER PERSPECTIVE Information asymmetry FAIRLY PRESENTED FINANCIAL STATEMENTS

How do I know this information is what I need, and not misleading? After all, it was prepared by someone else who might have incentives to bias the information to make things look better that they really are... How do I know if I should trust this information when making a big financial decision? (see Illustration 2-5 in LO5 of Ch2 of the text)

$$$$$$$$$$$$$$$$$$$$$$$$$$$ To sum up, the most important point to remember about todays topics is this: To meet the users demand for fair useful financial information, accountants need to supply information that reflects .... SUBSTANCE over FORM

$$$$$$$$$$$$$$$$$$$$$$$$$$$

$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$ In Class Discussion Questions WA 1-1 (Time 15-20 minutes) Purposeto provide the student with an opportunity to evaluate the viewpoint of removing mandatory accounting standards and allowing each company to voluntarily disclose the information it desired. Text Solution It is not appropriate to abandon mandatory accounting standards and allow each company to voluntarily disclose the type of information it considers important. Without a coherent body of accounting theory and standards, each accountant or enterprise would have to develop its own theory structure and set of practices, and readers of financial statements would have to familiarize themselves with every company's own accounting and reporting practices. As a result, it would be almost impossible to prepare statements that could be compared and there would be a tremendous waste of resources in both preparation and in analysis. Further, GAAP has been set by standard setters to help with the preparation of financial statements and to help reduce management bias. A single set of general-purpose financial statements is prepared to meet the majority of users needs. In addition, voluntary disclosure may not be an efficient way of disseminating information. Some companies will be likely to disclose less information if given the discretion. Thus, companies can reduce the cost of assembling and disseminating information. However, an investor wishing additional information has to pay to receive the desired additional information. Different investors may be interested in different types of information. Since the company may not be equipped to provide the requested information, it would have to spend additional resources to fulfill such needs; or the company may refuse to supply such information if it is too costly to do so. As a result, investors may not get the desired information or they may have to pay a significant amount of money for it. Furthermore, redundancy in gathering and distributing information occurs when different investors ask for the same information at different points of time. To the society as a whole, this would not be an efficient way of utilizing resources. Note that a contrary argument to companies providing less disclosure is set out in the competitive disclosure hypothesis which suggests that companies in competition for scarce capital resources will actively increase their disclosure to reduce their perceived risk and therefore reduce their cost of capital and increase their access to investors.

CA 1-1 POPOVICH Overview: Reported net income a key focus for management represents a reporting bias. Controller (Paula) is concerned about doing the right thing not just doing what is required under GAAP. Role players: Popov and VP-Finance (and Auditor, Investor)

Analysis and Recommendation: GAAP constrained companies must adopt new standards as prescribed in the CICA Handbook (publicly accountable entities follow IFRS which is included as Part I to the CICA Handbook and private entities follow private entity GAAP which is Part II to the CICA Handbook) . Normally the AcSB gives companies some lead time so that they may ensure that they have all the appropriate

information needed to present the information. Thus they are not required to change to a new standard until GAAP requires it (the date is written into each standard). The issue is whether to adopt a change earlier even though not required or later when required. Adopt new standard as required Adopt new standard earlier than required GAAP requirements are met. Need additional time to ensure that the company has all the information needed to prepare the financial statements under the new standard i.e. to ensure reliable. Other. Provides greater comparability between years earlier if adopted earlier. - If this is the better presentation, why not share it with users as soon as possible. - Consideration of the impact on net income should not be a motivator for making the financial reporting decision (unbiased). - Other. In conclusion, earlier adoption of the standard is always encouraged and should be attempted where the costs of doing so do not exceed the benefits. -

EXERCISE 2-2 (15-20 minutes) (a) 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. (b) 1. 2. 3. Asset the contract represents a present economic resource to which the entity has a right that is legally enforceable; the amount is uncertain: the fact that future recordings are necessary will factor into the valuation or measurement of the asset. Asset consignment inventory belongs to the FastMart until it is sold to the final customer. Liability this contract represents an unconditional requirement and an obligation that is presently enforceable, subject to the sale of the recordings. Gains, Losses. Liabilities. Revenues, (also possible would be Gains). Equity represents the balance of the ownership interest, but not an increase. Equity (decrease). Assets. Expenses. Revenues. Equity. Revenues. Equity (decrease).

EXERCISE 2-4 (20-25 minutes) 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Monetary unit Full disclosure Capitalized and depreciated Going concern Fair value Historical cost Full disclosure Revenue recognition and realization Full disclosure Full disclosure Economic entity

12. 13. 14. 15.

Periodicity Matching/fair value Historical cost Matching

EXERCISE 2-5 (25-30 minutes) (a) A conceptual framework is useful for standard setters since having an established body of concepts and objectives allows them to issue additional useful and consistent standards. This results in a coherent set of standards and rules that are built upon the same foundation, and an understanding of the underlying concepts helps the preparer and the auditor ensure consistent and meaningful application of the principles. Such a framework also increases the financial statement users understanding of and provides confidence in financial reporting, and also enhances comparability of different companies financial statements. (b) Foundational principle or characteristic violated: 1. Periodicity; relevance (predictive and feedback value) 2. Historical cost; representational faithfulness (neutral, completeness) 3. Historical cost; verifiability 4. Historical cost or matching; comparability 5. Revenue recognition and realization; representational faithfulness 6. Full disclosure; understandability; representational faithfulness 7. Economic entity; free from error 8. Control; comparability; representational faithfulness 9. Matching; free from error 10. Full disclosure and representational faithfulness (neutrality) Problem 2-5 (Time 30-35 minutes)

Purpose to provide the student with an opportunity to review again the basic principles, assumptions and constraints illustrated in the chapter. The student is asked to agree or disagree with each of these situations. 1. The change appears acceptable. Comparability is affected in this situation, although its violation may not be material. The revenue recognition principle requires that the risks and reward transfer to the purchaser in order for the sale to be recognized. While the shipping terms have been changed, further investigation should be undertaken to ensure that customer business practices are aligned with this changed policy; for example, if the company will continue to replace items lost or damaged in transit, the risks have not passed irrespective of the change in shipping terms (further discussed in Chapter 6). In addition, the rationale for any change in policy should be understood. For example, is this more comparable with industry practice? This should also not be a temporary change else representation faithfulness at risk (neutrality and free from bias could be violated). 2. Agree. Depreciation is a means of cost allocation on a systematic charge against revenues. As it is based on best estimates, the useful life should be revised when economic or business events dictate that an asset will remain useful for a longer period. While comparability is impaired, changes in estimates are accounted for prospectively. Restatement would not provide decision useful information. All estimates and judgements used to prepare the financial information should be free from bias, error or omission. 3. Agree. The full disclosure principle recognizes that reasonable condensation and summarization of the details of a corporation's operations and financial position are essential to readability and comprehension. Thus, in determining full disclosure the accountant makes decisions on the basis of whether omission will cause a misleading inference by the reader of the financial statements. Only the total amount of cash is generally presented on a balance sheet, unless some special circumstance is involved such as a possible restriction on the use of the cash. In most cases, however, the company's presentation would be considered appropriate and in accordance with the full disclosure principle.

Showing the additional detail on the balance sheet would not be relevant to the reader. 4. Disagree. The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. If we were to select sales value, for example, we would have an extremely difficult time in attempting to establish an appraisal value for the given item without selling it (i.e. verifiability violated). It should further be noted that the revenue recognition principle provides the answer to when revenue should be recognized. In this case, the revenue was not earned because the transfer of risks and rewards (i.e. "sale of the land") had not occurred. In addition the development costs of subdividing the land should be included in inventory cost of the lots and appear on the balance sheet, and not as expenses of the period. These costs are associated with the land (economic resource) not an expense associated with the revenue producing activities for the year. 5. From the facts it is difficult to determine whether to agree or disagree with the president. Comparability requires that accounting entities give accountable events the same accounting treatment from period to period for a given business enterprise. The choice of accounting policy should not be made based on the impact on net income but rather on the method that provides the most relevant information (i.e. neutrality and free from bias could be violated). It might be useful for users if Sophia reports on a moving average basis. 6. Disagree. While there is an economic burden as a result of the new legislation, this is not a present obligation since the new law cannot be enforced until 2015. A liability does not exist in fiscal 2010. 7. Disagree. The voluntary recall establishes an unconditional economic burden for Sophia. This is a present obligation that is legally enforceable based on Sophias recall announcement. A liability should be provided at the time the recall is made.

Problem 2-6

(Time 15-20 minutes)

Purpose to provide the student with the opportunity to examine a series of transactions that involve financial engineering and to determine where on the continuum of choices in accounting decision-making the transactions fall. 1. This transaction is a bona fide business transaction that is structured to minimize the impact on debt covenants. By modifying the payment terms (and with the creditors agreement, the company president will move the payable into long-term debt and improve the companys current ratio. 2. This is an aggressive interpretation of GAAP. Capital assets should be tested regularly for impairment and written down when their cost will not be recovered. The timing of the write-down to coincide with lower levels of net income indicates that the controller may be trying to show improved financial results in future years. The controller is taking advantage of current poor financial results to write down the capital assets, thereby improving future years results when those write-downs would have been claimed. 3. This is an example of a bona fide business transaction with no bias. Companies should select the inventory cost assumption that best approximates the cost flow. As well, under GAAP, this change in accounting policy would be accounted for retrospectively hence full disclosure would sufficiently inform the users. 4. Under IFRS, companies must capitalize interest on self-constructed assets; under private entity GAAP, companies have an accounting policy choice. Since the policy is applied to only one property, this indicates that the policy may have been set with key financial ratios in mind. As such, this would mean that the sole purpose is to make the financial statements look better. 5. This is an example of a business transaction entered into for the sole purpose of making the financial statements show revenue on merchandise that is not sold to independent third parties.

6. This represents an error in the application of GAAP. Under the economic entity and control principles, Maher Company does not have control over the investee and as such it is not part of Mahers economic activities and would not be consolidated.

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