Study Notes For Intermediate Accounting Volume 1, Seventh Canadian Edition

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Intermediate Accounting,7thedition1CHAPTER 1THEFRAMEWORK FORFINANCIAL REPORTINGLearning ObjectivesAfter you have studied this chapter, you should:LO-1Understand the various accounting standards used by Canadian entities.LO-2Understand the objectives of financial reporting.LO-3Understand the financial reporting needs of external users of financialinformation.LO-4Understand the motivations of preparers of financial information.Lecture Notes1.ACCOUNTING STANDARDS IN CANADAAuthoritative Source of Canadian StandardsThe accounting standard-setting body in Canada is the Accounting Standards Board(AcSB).The AcSB is part of the CanadianCharteredProfessional Accountants ofCanada (CPA Canada).The authority of CPA Canadacomes from the corporationacts of the federal and provincial governments. The GAAP requirement for publiccompanies is enforceable by the provincial securities commissions.Thecommissions are responsible for enforcing the reporting standards for companiesthat are traded in their province.TheAcSB had for many decades maintained standards by regular revisions andadditions to theCPA CanadaHandbook. Currently the AcSB hasa two-prongedapproach for Canadian enterprises:For public companies or publicly accountable enterprises,InternationalFinancialReportingStandards (IFRS)is required for financial reporting for all reportingperiods beginning on or after January 1, 2011. All the IFRS standards are includedin theCPA CanadaHandbook as Part 1.Privatenonpublicly accountable enterpriseshave a choice between using full IFRSor Canadian Accounting Standards for PrivateEnterprises(ASPE) as prescribed inthe CPA CanadaHandbook, Part II. ASPE is somewhat less complex,is basedmore on historical-cost accounting, and has far fewer disclosure requirements.

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Intermediate Accounting,7thedition2IFRSOverviewInternational Financial Reporting Standards OverviewInternational standards are developed and issued by theInternational AccountingStandards Board(IASB).Canada accepts IFRS as an adopter, integrating the standards as written by theIASB without modification into the CPA Canada Handbook.The authoritative language for IFRS internationally is English although thestandard is translated into many other languages.In Canada, however, there is anauthoritative French version, since the standards must say the same thing in bothEnglish and French.Accounting Standards forCanadianPublicly-Accountable EnterprisesPublicly accountableenterprise(PAE)is any company that has securities (debtor equity or both) issued to the public or that is in the process of issuing debt orequity to the public or a for-profit private enterprise that holds assets in a fiduciarycapacity for a broad group of outsiders as one of its primary businesses.Afiduciary enterpriseis any organization that acts in a trusteeship capacity formembers of the general public.(e.g.a mutual fund, a privately owned bank,pension funds, credit unions).Government business enterprises must disclose their financial performance andthus are PAEs.Reporting in U.S. GAAPIn order to enhance the acceptability of its shares in the U.S. financial markets, aCanadian company may choose to follow U.S. GAAP, but it is rare for a Canadiancompany to do so.Legal and Regulatory RequirementsIn some special industries such as banks, the normal provisions of IFRSs may besupplemented by legal conditionssuch as requirements from Canada’s Bank Act.Reporting CurrencyCanadian companies do not always prepare their financial statements in Canadiandollars. In general, IFRS requires a company to use another presentation currencywhen its financial environment is other than the currency of its home country.Thecompany should report in its functional currency which is the currency in whichmost of a company’s transactions are conducted.

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Intermediate Accounting,7thedition3Accounting Standards forCanadianPrivate EnterprisesA private enterprise is one that doesnot issue debt or equity securities to the publicnor is in the process of doing soand also does not hold assets in a fiduciarycapacity.All shares are held privately and not offered for sale on the open market.Users are limited and generally have access to the information they need, either asowners and /or managers or as bankers/creditors.Private companies can use IFRS, ASPE or tailored accounting policies known as adisclosed basis of accounting.A private company is often referred tointernationally as aSME, which is a small to medium sized enterprise.Internationally,many countries followIFRS forSMEsfor appropriate privatecorporations; Canada chose instead to developCanadian ASPE.The choicebetween following IFRS versus Canadian ASPE is unaffected by a Canadianprivate corporation’s size.Using IFRSA private company may use IFRS instead of ASPE because it is incompetitionwith public companies for capital, and wants to be comparable. Despite theinability to sell shares to the public, private corporations can obtain substantialcapital through private placements. A private placement is arranged by directnegotiation between the company seeking capital and one or more suppliers ofcapital.Other reasons for private companies to use IFRS:The company is a subsidiary of a parent that reports on the basisof IFRS.The company may issue shares to the public in the future and wants to establisha pattern of IFRS compliance.The company’s controlling shareholders may intend to sell the company in thenear future and the use ofIFRS may enhance credibility.Using ASPEThe ACSB simplified the pre-existing standards in theCPA CanadaHandbook, bystripping out requirements that are less appropriate for private companies. ASPE isbased more on historical costand less on fair values,and the disclosurerequirements are less onerous.As a result ofthecontinuing use of theCPA CanadaHandbook instead of IFRS forSMEs, many private companies found little changein their reportsupon adoption of ASPE.

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Intermediate Accounting,7thedition4Using a Disclosed Basis of AccountingIn practice, private enterprises are not bound by GAAP unless an external user(such as a major lender) requiresthe company to use GAAP.When non-GAAPaccounting policies are used, the company is said to be reporting on a disclosedbasis of accounting (DBA).A company cannot toss out all of GAAP. Deviations from GAAP usuallyare limited to just certain policies (e.g. usingtax basedCCA instead ofaccounting depreciation).Learning Multiple Sets of StandardsCanada is using different accounting standards for public and private enterprises.Although these are two different sets of GAAP, they are very similar and use thesame general principles and practices. Thus, CanadianASPEcan be regardedmainly as simplifying exceptions to IFRS rather than as a substantially differentbody of standards.The Issue of ComparabilityThe point of establishing IFRS is not only to promote multiple exchange listings,but also to greatly improve comparability between companies based in differentcountries. However, international comparisons of financial statements can befraught with hazard because of differences between legal requirements,the politicalenvironment and ways of doing business.2.OBJECTIVES FOR FINANCIAL REPORTINGManagement’s choice of accounting policy and disclosure are constrained by therequirements of IFRS and Canadian ASPE.To exercise judgement, the accountant must have criteria against which tomeasurethesuitability of alternatives. The most fundamental criteria for deciding onpolicies, estimates, and disclosures are the objectives of financial reporting for theorganization.To establish each enterprise’s financialobjectives managementmust consider manyaspects of the company and the users of its financial statements.SeeExhibit 1-1in the text which show the forces that shape a company’s financialreporting objectives (facts, constraints, preparermotivations, user needs and userpower).WATCH!

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Intermediate Accounting,7thedition53.GENERAL PURPOSE FINANCIAL REPORTINGFinancial reporting for public companies is “general purpose” because the potentialinterest group is large and diverse. A publiccompany’s financial statements’userscan be anyone, anywhere. The information needs of investors, lenders and othercreditorstake priority over other groups such as employees and regulatory agenciesfor accounting standard-setting when the IASB is setting accounting standards.4.ENTERPRISE PREPORTING OBJECTIVESIn practice, “general purpose” is too general to guide specific enterprises.Identifying an entity’s specific reporting objectives is the first step for establishingthe criteria by which accounting policies are chosen and accounting estimates aremade.Userscanbe either external users or preparers (managers and accountants).Ethical Issues:Accountants are part of the preparer group because theycarry out the accounting and reporting decisions of management. Anaccountant must be prepared to resist management’s potential pressure todeliberately misstate financial results, even if it leads to dismissal.5.EXTERNAL USER OBJECTIVESAssessing and Predicting CashFlowsCashflow assessment and prediction, especially by investors and creditors,is animportant financial reporting objective.Assessment versus PredictionAnassessment ofcash flowsis done by the financial statement user to understandthe cash inflows and outflows of the enterprise in the current period, normallyemphasizing cash flows from operating activities.Cash flow predictionrequiresextrapolating current cash flow into future years.EarningsQualityIfthere is a high degree of correlation between the operating cash flow per shareand the earnings per share, the company is thought to have a high quality earnings.The perceived quality of earnings is good when the relationship between operatingcash flow and net income is fairly stable.Effect on Financial Reporting ChoicesWhen cash flow assessment and prediction is the primary objective, financialreporting policies are chosen that provide the clearest indication of the cash flowsunderlying reported earnings.WATCH!

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Intermediate Accounting,7thedition6Income Tax Deferralis a common objective for private companies.Financial reporting versus Income Tax ReportingCanada Revenue Agency (CRA) does not require a corporation to use the samereporting principles for tax as for accounting or vice versa.Tax-Book ConformityWhen corporations adopt the same accounting practices for financial reporting asfor tax reporting, this is known as tax-book conformity. There is no requirement todo so in Canada.Tax Deferral versus Tax EvasionThe use of legitimate optionsfor reducinga company’s current taxable income isknown astax deferralortax minimization. In contrast, deliberate misstatement onthe tax return istax evasion, which is fraud.Effect on Financial Reporting ChoicesDelaying recognition of revenue and speeding payment of expenses to the extentpermitted by the Income Tax Actwillminimize taxes. Accounting policies thatreduce taxable income also reduce net income and may or may not be an issue formanagers, depending on if their compensation is tied to book income.Contract ComplianceExternal users often use financial statements as the basis for assessing whether anenterprise has complied with contract provisions (e.g. a debt-to-equity ratio).These provisions are known as covenants. If a company fails to meet them, lendershave the right to call the loan and force immediate payment. Shareholders’agreements in private corporations also usually have provisions that affect thevaluation of shares if a shareholder decides to sell their shares.Effect on Financial Reporting ChoicesRatios in debt agreements and for share valuation in shareholders’ agreements areaffected by accounting policy choices and estimates. Some agreements specifywhat accounting policies must be used for calculating ratios.Stewardshipreporting focuses on showing the financial statement reader just howthe resources entrusted to management’s care were managed, thereforetransparencyof accounting policy and measurement choicesis important.Effect on Financial Reporting ChoicesThe objective of stewardship is reflected in two ways:(1) minimization of interperiod allocations and (2) full disclosure.Performance EvaluationFinancial statement readers often use the statements to evaluate managementperformance.

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Intermediate Accounting,7thedition7Effect on Financial Reporting ChoicesIn order to be useful for performance evaluation, financial statements should reflectthe basis on which management decisions are made. Managers have strongmotivations to select accounting policies that will enhance their apparentperformance.Role of AuditorThe auditor is not a user of the financial statements. Because they are independentfrom the company, they are able to provide an unbiased assessment of the financialstatements and their conformity to GAAP.6.PREPARERMOTIVATIONSPreparer (management) motivations often conflict with external users’ objectivesand may dominate the accounting choice process if external users lack the power toenforce the dominance of their objectives.Earnings ManagementIncomeSmoothingWidelyfluctuating earnings are an indication of business risk,and mangers often don’t want to investors or creditors to perceive the company asbeing risky. Income can be smoothedthrough spreading both revenues and costsover several periods and by edging various accounting estimatesup and downwithin a feasible range.Maximizing EarningsMaximization of net income is one of the most common motivations, particularly inpublic companies where share price is affected by reported earnings.Commonmotivations to maximize earnings:To comply with debt covenants by creditors.To assist in positive management performance evaluations.To preserve or increase management compensation.The “Big Bath”A corporation may elect to maximize a loss in one year as part of a longer-runstrategy to maximize earnings. If there is an operating loss any way, it is anopportunity to load as many losses into that year as possible (“taking abig bath”),and enjoy the benefits of recovery in a subsequent period.Minimizing EarningsManagement may wish to minimize reported earnings to minimize income taxes, toavoid attracting competitors intoa very profitable business, or to avoid negativescrutiny from the public, regulators or employees.

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Intermediate Accounting,7thedition8Minimum Compliancerefers to the motivation of managers to reveal the leastamount of information that is possible while still complying with GAAP,whichreduces the cost of producing the statements. Managers may wish to maintainconfidentiality about their business activities in order to keep competitors in thedark.Expanded DisclosureThe motivation for expanded disclosure may simply be to indicate that thecompany and its management are “good citizens”that have nothing to hide.7.CONFLICTING OBJECTIVESOnce a company’s objectives have been identified, they then must be prioritized asoften they are conflicting.Accounting requires theconstant exercise ofprofessional judgement anda clear ethical orientationto deal with the impact ofconflicting objectives.8.REQUIRED FINANCIAL STATEMENTSUnder IFRS a complete set of financial statements consist of:1.Statement of financial position2.Statement of comprehensive income (including statement of profit or loss andstatement ofothercomprehensive income)3.Statement of changes in equity4.Statement of cash flows5.Disclosure notes:A set of notes comprising a summary of significantaccounting policies and other explanatory informationUnder IFRS, financial statement titles are variable based on relevance to the usersso variations in the statement titles are acceptable.Canadian Accounting Standards for Private Enterprises (ASPE) haveasomewhatsimpler set of financial statements:1.Balance sheet2.Income statement3.Statement of changes in retained earnings4.Statement of cash flows5.Disclosure notes

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Intermediate Accounting, 7thedition1CHAPTER2Accounting JudgementsLearning Objectives:After you have studied this chapter, you should:1Understand the conceptsinvolved in constructing financial statements.2Explain the role of ethical professional judgementin accounting.3Apply the universal and entity specific assumptions underlying thefoundation of GAAP.4Apply the fundamental and enhancing qualities and pervasiveconstraints of financial reporting.5Describe the measurement methods available within GAAP.6Discuss the criteria for recognizing business events and transactions inthe financial records.7Describe the measurement methods used in the accounting standardsfor private enterprises.Lecture NotesAccounting is often a matter of making choices among possible alternatives. This chapterdiscusses the financial statement concepts and principles that guide standard setters andthat accountantsuse to make those choices. These concepts and principles are the basisfor professional judgement. Chapters 6 to 11 illustrate how those concepts and principlesare applied to specific accounting issues.1.CATEGORIES OF ACCOUNTING CONCEPTSThe generally accepted body of accounting principles consists of three different types ofconcepts. The types of concepts are:1.Underlying assumptions,whichformthe basic foundation forwhichaccounting measurement rests.The accounting principle of continuity (goingconcern) is an underlying assumption.

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Intermediate Accounting, 7thedition22.Qualitative criteria,which in conjunction with the organization’s reportingobjectives, facts and constraints, are used to evaluate thepossiblemeasurement optionsand select the most appropriatemeasurementmethodsfor a given situation.Theprinciples of comparability and understandabilityare examples of qualitative criteria.3.Measurement methods, which arethe various ways in which financialposition and the results of operations can be reported.These methodsarehow transactions and events are measured and reported.The accountingprinciples of fair value and realizable value areexamples of measurementmethods, and are both based on the underlying continuity assumption.Limitations of the ConceptsThere are limitations to the use ofaccounting concepts. They focus on generalitiesbecause they determine policies for a wide application and on producinggeneral purposefinancial statements.Therefore, there are exceptions to theapplicabilityof the conceptsand conclusions.Structure ofAccountingPolicy ChoiceIn constructing the financial statements for an enterprise, you must determine theobjectivesof the financial reporting,make sure the underlying assumptions are valid,measure the elements of financial statements for thesituation that satisfy the qualitativecriteria and finally prepare the financial statements. This process is illustrated in Exhibit2-1 ofthetextbook and follows this order of consideration:1.Underlying assumptions2.Qualitative criteria3.Accounting choicesa.Financial statement elementsb.Recognition and realizationc.Measurement methodsIn selecting accounting policies, an accountant must first evaluate the facts inthesituationincluding reporting constraints. If the facts allow a choice, thenthe usersand objectives are considered in selecting the appropriate accounting policy.Decisions cannot be made strictly according to which policy is best for the usersand objectives while ignoring the facts in the situation.WATCH!

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Intermediate Accounting, 7thedition32.ETHICAL PROFESSIONAL JUDGEMENT–PART 1The process of making choices in accounting is the process of exercisingprofessionaljudgement.An accountant exercises professional judgementto be fair to all stakeholders.Judgement is used in many aspects of accounting that are not specifically dealt with in theaccounting standards.This is doneby taking into account several factors:•The usersof financial statements and their specific information needs;• The motivations of managers;• Thenature of theorganization’s operations; and•The organization’sreporting constraints.Accounting policy choices and estimates must be made taking these factors in to account.3.UNDERLYING ASSUMPTIONSUnderlying assumptions provide the foundation of GAAP for for-profit enterprises, butonly the going-concern assumption is discussed specifically in the IFRS conceptualframework.There are six basic assumptions affect the recording, measuring, and reportingof accounting information.These are divided into 2 general categories (1) universalassumptions and (2) entity-specific assumptions.Universal assumptions:1.Time-period.2.Separate entity.3.Unit of measure.Entity-specific assumptions(depend on an individual entity’s reporting circumstances):1.Proprietary.2.Continuity.3.Stable currency.GAAP changes in response to changes in the environment but the underlying assumptionsare assumed to be constant. If any of these assumptions are not valid, thenGAAP is notappropriate.Universal AssumptionsThetime-period assumptionrecognizes that information needs to be provided to users fora time period less than the enterprise’s life spanand states that it is feasible to provideuseful information in shorter periods while the enterprise is in operation.The standard reporting period is one year; however, some companiesuse a calendar year-end that coincides with the low point in business activity over a 12-month period.Othercompanies report summarized information on an interim basis (quarterly for public

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Intermediate Accounting, 7thedition4companies, monthly for internal purposes).Although the reporting period varies, one yearis the standard.Theseparate entity assumptionconsiders an accounting unit or identifiable businessenterprise as separate and apart from its owners and from other entities.This concept does not necessarily correspond with legal and tax status of an entity.A corporation is an entity that is legally distinct. Partnerships and proprietorships are notlegally distinct but the separate entity assumption still applies; for accounting purposes theyare considered separate from their owners. All accounting records and reports aredeveloped from the point of view of a single entity with the assumptionthat an individual’stransactions are distinguishable from those of the business.Theunit-of-measure assumptionrefers to the results of the business’s economic activities.The assumption is that these can be reported in terms of a single standardmonetary unitand, further, that everything of relevance can be measured using the dollar as the unit ofmeasure. Thus, something that can’t be measured can’t be reported. Therefore, informationthat may be relevant to decision makers may not be reported,such as:• The value of in-house intellectual capital.• The impact of the company’s operations.• The value of customer goodwill and “human capital” (i.e.employees).Entity-Specific AssumptionsTheproprietaryconceptconsiders that the results of an enterprise’s operations should bereported from thepoint of viewof the owners. This concept is applied to all types ofbusiness enterprises and has nothing to do with the form of the enterprise (i.e.,proprietorship, partnership, or corporation).This concept follows the accounting equationwith assets discharging liabilities and residual wealth to the owners.Thecontinuity assumptionis also known as thegoing-concern assumption.Theassumption is that the enterprise will continue operating for the foreseeable future and notbe liquidated.It assumes that the business will continue long enoughto recover the assetsand repayits outstanding liabilities.This assumption provides the conceptual basis formeasuring and classifying assets and liabilitiesin current and non-current classifications.There are two instances where this assumption is not valid-alimited life venture, and abusiness in financial difficulty that is expected to be shut down. If this assumption is indoubt because of financial difficulty, the historical costs of assets are not relevant andliquidation accounting is appropriate.

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Intermediate Accounting, 7thedition5A common problem is the misuse of the termgoing concern. A company that isconsidered to be a going concern is expected to continue in operation. If there is agoing concern issue or going concern problem, then this assumption is no longervalid. An example would be where the company is undergoing financialrestructuring.Thestable currency assumptionassumes constant purchasing power and that the value ofthe dollardoes not change significantly from year to year. The reason for thisassumptionis that inflation inmost developed countries has been relatively modest. It also assumes thedollaris constant in relation to the value of other currencies (its exchange rate).Two other concepts are related to thestablecurrency assumption. The concept ofcapitalmaintenanceexplainsthatto keep operating successfully,an entity must preserve itscapital investment.This assumptionalsoincludes the use of anominal dollar, which is notadjusted for inflation.The nominal dollar assumption is still dominant universally, due tothe reliance on historical cost methods in the measurement of assets. As we move more tofair value accounting, alternative perspectives are gaining strength.AlternativeCapital Maintenance ApproachesFinancial capital maintenanceis measuredin nominal monetary units or in units ofconstant purchasing power.Constant dollar capital maintenancesays that not all dollars are created equally.Therefore, if prices are rising then the enterprise needs to keep more nominal dollarsinvested in capital to stay even.Physical capital maintenance conceptrecognizes that the prices of different goods andservices change at different rates. The key is the company needs to maintain the same levelof productive capacity in its assets.This is the perspective that supports the use of fair-value reporting.4.QUALITATIVE CRITERIAQualitative criteria are criteria that, in conjunction with the organization’s reportingobjectives, are used to evaluate possible measurement options and to choose the mostappropriate accounting policies. The qualitative criteria are summarized in a table on thenextpage.WATCH!

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Intermediate Accounting,6thedition15CRITERIACOMPONENTSDESCRIPTIONFUNDAMENTALQUALITIES(both qualitative characteristics must be present to represent an economic event and cannot be traded of)1.RelevanceCapacity of accounting information to make a difference to the external decision-makers whouse financial reports.Theoretically,relevance isthe most importantqualitative characteristic.Predictive valueConfirmatory orFeedback valueAccounting information should be helpful to external decision makers by increasing theirability to make decisions about theoutcome of future events (predictive value).Accounting information should be helpful to external decision makers who are confirming oradjusting past predictions.2.FaithfulrepresentationThe information is a sufficientlyaccuratemeasure of what it is intended to measure.Although currently not a specific component of faithful representation, substance over form,represents the economic rather than legal impact of a transaction, is included as an element offaithfully portraying a transaction.Faithful representation is closely related to reliability.CompletenessInformation must give a faithful picture of theeconomic events or financial elements.The information must not mislead or deceive.NeutralityFinancial reports are neutral if they do not influence a user’s decisions.It is also known asfree from bias.Freedom frommaterial errorIf the statements are free from bias,overstatements and understatements must not exist.Faithful representation does not imply “accuracy” in that it is completely free from error, butrather free from material error.ENHANCING QUALITIES(the orderof these qualitiesis not a hierarchy, as these characteristics are traded off as neededin support of the fundamental qualities)3.ComparabilityEnables users to identify similarities and differences between two sets of financial statements.ConsistencyEntails using the sameaccounting policies from period to period within the firm.Ifconsistency is carried too far, it adversely affects relevance, so a change of policy is permittedif applied appropriately.UniformityCompanies with similar transactions and similar circumstances use the same accountingtreatments.4.VerifiabilityThe accounting measure is a reasonable measure of the economic event, without materialerror or bias; and

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Intermediate Accounting,6thedition16CRITERIACOMPONENTSDESCRIPTIONIfknowledgeable and independent observersusing the same measurement methodscanmeasure an economic event and arrive at generally the same result, the measurement isverifiable.5.TimelinessAccounting information should be reported soon enough for it to be useful for decisionmaking(within economic context). Lack of timeliness reduces relevance.6.UnderstandabilityBased on theassumption that investors and creditors have a reasonable understanding ofbusiness and economic activities—and of accounting. Information must be understandable tobe useful.PERVASIVE CONSTRAINTS7.MaterialityMateriality is used to describe thesignificance of an item. Information is material if itsomission or misstatement would be likely tochange or impact theuser’sdecision.Materialityis related to both relevance and faithful representation.8.Cost/benefit tradeoffAny accounting measurement or disclosure should result in greater benefits to the users thanits cost to prepare and present. Benefits should exceed costs.It is for this reason the AcSB provides fora somewhat simpler version of GAAP calledAccountingStandards forPrivateEnterprises (ASPE)whichenables private companies tofollow simpler accounting policies in some areas.

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