ACCT 351 Chapter 1

Financial Reporting

According to IASB: Provide financial info of a company to existing/potential investors, lenders, and creditors to help decide whether or not to give resources to the company

Financial info must be useful for making decisions, primarily about investment or lending of resources to a business entity, or evaluation of management stewardship

Investor Decisions Based on Financial Reporting

• Buying, selling, or holding equity and debt instruments

• Providing or settling loans and other forms of credit

• Exercising rights to vote on, or influence management’s actions that affect use of company’s economic resources

IASB Characteristics of Financial Reporting

1. Not everyone has the ability to access info from the company, thus, must rely on general-purpose financial statements

2. Management of the company has access to more info than external users

Information Asymmetry

• When one individual has more info than another

• Happens as result of both conditions that IASB says about financial reporting

Types of Information Asymmetry

1. Adverse Selection

2. Moral Hazard

Adverse Selection

• Occurs because employees/managers have more info than the public and investors

• Internal users might be tempted to take advantage of this info

• Investors can lose confidence in the securities market because of this

• Can result in investors paying less for shares

Adverse Selection Mitigation

Making sufficient, high-quality info available to investors in a timely manner can reduce it

Moral Hazard

Managers might use info known to them only to their own benefit

Trade-Offs

• Either predict future investment performance or evaluate management stewardship

• Can happen between different user purposes

• Can happen between a matter of evaluating the cost of producing the info compared with the benefit received

Accounting Standards Board (AcSB)

• Sets accounting standards in Canada

• Independent body whose members are appointed by the Accounting Standards Oversight Council (AcSOC)

• Receives funding, staff, and other resources from CPA Canada

Two Distinct Set of Accounting Standards

• IFRS and ASPE

Publicly Accountable Enterprise

According to the CPA Canada Handbook, is an entity, other than a not-for-profit organization, that:

• Has issued, or in the process of issuing, debt or equity instruments that are, or will be outstanding and traded in a public market (domestic or foreign stock exchange or an OTC market, including local and regional markets); or

• Holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses (banks credit unions, investment dealers, insurance companies, and other businesses that hold assets for clients

International Financial Reporting Standards (IFRS)

• Mainly public companies, but private companies can also use this if they intend to become publicly traded in the future or have some other reporting relationship with a public company

• Created by International Accounting Standards Board (IASB) and adopted by the AcSB

• AcSB actively involved with the IASB in the development of this, and most of this are adopted into the CPA Canada Handbook

• The US has not converged with this yet

Conceptual Framework

According to the CPA Canada Handbook, the purpose of this is to:

• Assist the IASB to develop IFRS Standards that are based on consistent concepts

• Assist preparers to develop consistent accounting policies when no Standard applies to a particular transaction or other event, or when a Standard allows a choice of accounting policy; and

• Assist all parties to understand and interpret the Standards (CPA Canada, 2024)

• A solid set of principles is not only important to standard setters who make principles in response to changes but also to accountants who face these changes

• No section in ASPE identified as _______ but Section 1000 - General Accounting: Financial Statement Concepts has similar elements and principles as the IFRS framework

Fundamental Characteristics of Conceptual Framework

Relevance

Materiality

Faithful representation

Completeness

Neutrality

Prudence

Relevance

The info is “capable of making a difference in the decisions made by users” (CPA Canada, 2024). Is capable if predictive value, confirmatory value, or both

Predictive Value

Info that may be used to make predictions about future events

Confirmatory Value

Info provides some feedback about decisions that were made

Materiality

A piece of info is considered _____ if its omission would affect a user’s decision. Used by internal and auditors in determining the need to adjust for errors identified

Faithful Representation

The financial info presented represents the true economic substance or state of the item being reported. According to the CPA Handbook, in order for info to be __________ it must represent an economic phenomen, must be complete, neutral, and free from error

Completeness

Must have sufficient disclosure for the reader to understand the underlying phenomenon or event. This means that the financial disclosures will require additional explanations that go beyond a mere reporting of the quantitative values

Neutrality

The info is not biased and does not favour one particular outcome or prediction over another

Prudence

The exercise of caution when making judgement under conditions of uncertainty (CPA Canada, 2024). Does not allow for overstatement of assets or income, or understatement of liabilities or expenses

Enhancing Characteristics of Conceptual Framework

Comparability

Verifiability

Timeliness

Understandability

Comparability

• Allows readers to compare results between entities or results from the same entity from one year vs another year

• Important because investors want to make decisions on which company’s shares to purchase over another, or to divest a previously owned share

• A key component of this is consistency, which is the use of the same method to account for the same items

Verifiability

• Suggests that two or more independent and knowledgeable observers could come to the same conclusion about the reported amount of a particular financial statement item

• They don’t have to be in complete agreement, could be for example they agree that the amount of something fall under a certain range but could disagree on which end of the range is more probable

• But the info is still ______ since they both agree on the range

Timeliness

• Info needs to be current to be useful, people need to know the economic condition of the business at the present moment

• But past info is still useful for tracking trends and evaluating management stewardship

Understandability

• This is a characteristic that the accounting profession has been accused of disregarding

• It is assumed that readers of financial statement should have a reasonable understanding of business issues and basic accounting terminology

• But many business transactions are complex and different, and the accountant faces a challenge in crafting the disclosures in a way that everyone can read them

Elements of Financial Statements

Assets

Liabilities

Equity

Income

Expenses

Assets

• Something a business owns

• A present economic resource controlled by the entity as a result of past events (CPA Handbook)

• An economic resource is a right that can produce economic benefits

• Economic benefits are expected to be received at some point in the future as a result of holding this resource

• The “right” suggests other types of relationships, such as the right to use a patented process or the right to receive a favourable amount under a derivative contract

• Can be either tangible or intangible

Liabilities

• A present obligation of the entity to transfer an economic resource as a result of past events (CPA Handbook)

• Legal obligation

• Can exist in the form of a contract

• Can result from common business practice, even if there is no legally enforceable amount

Equity

• The owners’ residual interest in the business, representing the remaining amount of assets available after all liabilities have been settled

• Subdivided into various categories on the balance sheet

• These classifications are related to legal requirements regarding ownership interest

• Categories include share capital (common and preferred shares), retained earnings, and accumulated other comprehensive income (IFRS only)

• Other types can arise based on certain types of transactions such as contributed surplus, appropriated retained earnings, and other reserves that may be allowed under local law

• The purpose of these subcategories is to give readers enough info to understand how and when the owners may be able to receive a distribution of their interests

• The company’s reported equity does not represent its value

• Prices that shares trade at in the stock market represent the market cumulative decisions of investors

Income

• Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims (CPA Handbook)

• Balance sheet approach: considers any measure of performance, such as profit, to be simply a representation of the change in balance sheet amounts

• Can include revenues and gains

• Revenues arise in the course of the normal activities of a business, and gains arise from either the disposal of noncurrent assets (realized gains) or the revaluation of noncurrent assets (unrealized gains)

• Unrealized gains on certain types of assets are usually included in other comprehensive income

Expenses

• Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims

• Can include those that are incurred in the regular operation of the business and those that result from losses, and can also be realized or unrealized and the definition is the same as for gains

Recognition

• Occurs when items in financial statements meet the definition of a financial statement element (CPA Canada)

• But sometimes, even if the item meets the requirements, it still is not recognized because doing so would not provide useful info

• The Framework acknowledges relevance and faithful representation when referencing usefulness

• Also, possible that if the costs of recognition outweigh the benefits to users of the financial statements, the item will not be recognized

• These rare cases of non-recognition of financial statement elements highlight the complex nature of some accounting measurements and emphasize the importance of the accountant’s careful use of professional judgement and ethical decision making

• If an item is not eligible for recognition, it may still be necessary to disclose details in the notes to the financial statements

Measurement Bases

• Historical cost

• Current value, which includes

  • Fair Value

  • Value in use/fulfillment value, and

• Current Cost

Historical Cost

• Items are recorded at the actual moment of cash paid or received at the time of the original transaction

• This concept has stuck in accounting because of its relative reliability and verifiability

• Also criticized because it loses relevance

Current Value

• Elements being reported at amounts that reflect current conditions at the measurement date

• This measurement base tries to achieve greater relevance by using current info, but may not be possible to represent this info faithfully when active markets for the item do not exist

Fair Value

• The price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date (CPA Handbook)

• Can be easily determined when active markets exist

• However, if there is no market, the FV may still be estimated using a discounted cash flow technique

Value in Use

• A discounted cash flow technique

• Different from FV in that it uses entity specific assumptions rather than market assumptions

• Entity projects future CF based on the specific way it uses the asset in question

Current Cost

• The cost to acquire an equivalent asset at the measurement date

• Will include any transaction costs to acquire the asset and will take into consideration the age and condition of the asset

• Represents an entry value, where FV and Value in Use represent exit values

Capital Maintenance

• Attempts to define the level of capital or operating capability that investors would want to maintain in a business

• Financial and Physical

Financial Capital Maintenance

• Measured simply by the changes in equity reported on the company’s balance sheet

• Changes can be measured either in terms of money invested or in terms of purchasing power

• The monetary interpretation is consistent with the approach used in historical cost accounting, where wealth is measured in nominal units

• Short-term relevance: simple and reasonable for short periods

• Long-term relevance: less meaningful due to inflation

• Constant Purchasing Power Model

Constant Purchasing Power Model

• Adjusts equity for inflation using an index like the Consumer Price Index

• Challenge: Broad-based indices may not reflect a company’s actual inflation experience

Physical Capital Maintenance

• Measured by maintaining the same level of outputs year after year

• Rationale: underpins the current cost measurement base

• Challenges:

  • Broad and flexible, allowing for interpretation

• Advantages

  • Easier defense of accounting treatments

  • Greater comparability

• Disadvantages

  • Can lead to financial engineering

  • May focus more on the form than substance of transactions

Motivations for Management Bias

• Ethical Dilemmas and Pressures

• Management Influence on Financial Reporting

• Role of the Accountant

Ethical Dilemmas and Pressures

• Information imbalance

• Misleading use of information imbalance damages confidence in capital markets

• Accountant’s role

• Under pressure to withhold or distort information to benefit certain vested interests

• Complexity and Judgement

• Accountant must not share privileged client information with other parties and must not use that information for own personal gain

Ethics of Information Technology

• Automation and Advanced Functions

• Cloud Computing and Mobile Devices

• Big Data Applications

• XBRL (eXtensible Business Reporting Language)

• Computer Assisted Audit Tools and Techniques

• Blockchain Technology

• Data Analytics and Robotic Process Automation

• Generative AI

Automation and Advanced Functions

• Routine bookkeeping tasks automated

• Advanced functions like data mining and strategic analysis developed

Cloud Computing and Mobile Devices

• Provide instant access to information, enhancing timeliness

Big Data Applications

• Improve relevance by targeting specific user needs

XBRL (eXtensible Business Reporting Language)

• Standardizes financial statement delivery, improving comparability

Computer Assisted Audit Tools and Techniques

• Allow auditors to identify key audit risks and analyze larger samples, enhancing reliability and efficiency

Blockchain Technology

• Potential for instant transaction verification and unalterable, transparent records

• May shift auditor’s role to continuous auditing and smart contract verification

Data Analytics and Robotic Process Automation

• Transform accountant’s role

• Data analytics adds value through descriptive, diagnostic, predictive, and prescriptive functions

• Collaboration with data scientists and use of data visualization techniques

Generative AI

• Enhances efficiency, accuracy, analysis, and communication

• Generate journal entries, analyze patterns, draft communications, detect errors, etc

• Responds to queries mimicking human writing