Accounting Standards and Fair Value Analysis
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Questions and Answers

What is the main difference between fair value and value in use?

  • Fair value is determined by historical cost, while value in use is determined by market transactions.
  • Fair value focuses on market conditions, while value in use considers expected cash flows. (correct)
  • Fair value is always higher than value in use in all cases.
  • Fair value represents an entry price, while value in use represents an exit price.

    • Under which condition is fair value equal to historical cost?

  • At the time of sale of the asset.
  • At acquisition of the asset. (correct)
  • When the asset is fully depreciated.
  • During a market downturn.

    • Why do standard setters encourage the use of fair value?

  • It is simpler and easier to calculate than historical cost.
  • It eliminates the need for regular re-evaluation.
  • It reflects the current cash equivalent value, making it more relevant for financial instruments. (correct)
  • It provides a less volatile measure compared to historical cost.

    • What does fair value, according to IFRS, represent?

    <p>The price received to sell an asset or paid to transfer a liability.</p> Signup and view all the answers

    Which of the following statements is true regarding fair value measurements?

    <p>Fair value measurements provide more relevant information than historical cost in many cases.</p> Signup and view all the answers

    What is a consequence of adverse selection in capital markets?

    <p>Attraction of poor investments</p> Signup and view all the answers

    Which accounting approach emphasizes positive results while minimizing negative ones?

    <p>Aggressive accounting</p> Signup and view all the answers

    What can be a reason for management to engage in aggressive accounting?

    <p>To meet analyst expectations</p> Signup and view all the answers

    Which entity is responsible for setting accounting standards for Canadian private companies?

    <p>Canadian Accounting Standards Board</p> Signup and view all the answers

    What is moral hazard in the context of information asymmetry?

    <p>Risk of parties acting in self-interest</p> Signup and view all the answers

    Which of the following describes conservative accounting?

    <p>Focusing on negatives while downplaying positives</p> Signup and view all the answers

    Which board sets the accounting standards for U.S. entities?

    <p>Financial Accounting Standards Board</p> Signup and view all the answers

    What percentage of pre-tax income from continuing operations is typically considered a quantitative materiality benchmark for for-profit entities?

    <p>5%</p> Signup and view all the answers

    Which of the following is NOT one of the enhancing characteristics of useful information?

    <p>Profitability</p> Signup and view all the answers

    What is the first essential characteristic of an asset?

    <p>It represents a present economic resource.</p> Signup and view all the answers

    Which qualitative factor impacts materiality related to compliance and regulations?

    <p>Illegal acts</p> Signup and view all the answers

    What is the correct definition of a liability?

    <p>A present obligation that is unavoidable.</p> Signup and view all the answers

    Which enhancing characteristic ensures that information is available in time to influence decision-makers?

    <p>Timeliness</p> Signup and view all the answers

    How is comparability achieved in financial information?

    <p>By measuring and reporting in a similar way.</p> Signup and view all the answers

    Which of the following best describes verifiability?

    <p>Independent users find similar results.</p> Signup and view all the answers

    Which of the following is an element of financial statements?

    <p>Equity</p> Signup and view all the answers

    What does the going concern assumption imply about a business?

    <p>The business will continue to operate for the foreseeable future.</p> Signup and view all the answers

    Under which condition should liquidation accounting be applied?

    <p>When the business's future operations are uncertain.</p> Signup and view all the answers

    What is the primary measurement basis under the historical cost principle?

    <p>Cash or cash equivalents exchanged at the time of transaction.</p> Signup and view all the answers

    What is required when remeasuring an asset under the historical cost principle?

    <p>Assessment of market trends for fair value estimation.</p> Signup and view all the answers

    Which assumption is NOT part of the historical cost principle?

    <p>Results from a unilateral acquisition.</p> Signup and view all the answers

    What defines a gain under both ASPE and IFRS?

    <p>Increases in equity from incidental transactions</p> Signup and view all the answers

    How are losses defined in both ASPE and IFRS?

    <p>Decreases in equity from incidental transactions</p> Signup and view all the answers

    Why might the historical cost lose predictive value over time?

    <p>No subsequent external exchanges may occur.</p> Signup and view all the answers

    Which of the following constitutes a gain for a real estate company?

    <p>Profit from selling a building</p> Signup and view all the answers

    What does the term 'arm's-length party' refer to in the context of historical cost?

    <p>A party with no significant relationship to the transacting parties.</p> Signup and view all the answers

    What trend is indicated in the approach towards asset measurement?

    <p>Shift from historical cost to mixed valuation models primarily utilizing fair value.</p> Signup and view all the answers

    What is not considered when defining gains under ASPE and IFRS?

    <p>Revenue-generating activities</p> Signup and view all the answers

    How are asset values stated under liquidation accounting?

    <p>At net realizable value, considering costs of disposal.</p> Signup and view all the answers

    In a real estate context, expenses related to selling buildings are classified as what?

    <p>Incidental losses</p> Signup and view all the answers

    What distinguishes gains from regular revenues for a real estate company?

    <p>Gains result from incidental transactions rather than regular activities</p> Signup and view all the answers

    Which of the following best describes the historical cost principle?

    <p>Measurement based on the amount paid at acquisition with potential for adjustments.</p> Signup and view all the answers

    Which of the following best describes the treatment of losses under IFRS?

    <p>Losses are defined as decreases in equity stemming from incidental transactions</p> Signup and view all the answers

    When do gains occur for a company that primarily rents out properties?

    <p>When the company sells a property at a profit</p> Signup and view all the answers

    What might a real estate company record as a loss?

    <p>Loss from selling properties below purchase price</p> Signup and view all the answers

    Which statement accurately reflects the difference between losses and expenses?

    <p>Losses are from incidental transactions, while expenses are regular costs</p> Signup and view all the answers

    Study Notes

    Chapter 1: The Canadian Financial Reporting Environment

    • This chapter covers the Canadian financial reporting environment.
    • Contact information for the instructor Harjot Mehmi is provided
    • Office hours are listed.
    • In-class questions from CA1.2 and textbook brief exercises are available on D2L.
    • Solutions to other textbook questions can be obtained during office hours.

    Characteristics of Accounting

    • Accounting measures and communicates financial information about economic entities
    • Two broad classifications: financial accounting and managerial accounting.

    Financial Accounting

    • Includes preparation of financial statements.
    • Relevant to internal and external users (e.g., management, employees, investors, creditors).

    Managerial Accounting

    • Communicates financial information in diverse formats (e.g., cost-benefit analyses, sales forecasts).
    • Used by management for planning, evaluating, and controlling operations.
    • Relevant to internal decision-makers.

    Basic Financial Statements

    • Communicate financial information to external users.
    • Major financial statements include:
      • Statement of financial position (balance sheet)
      • Statement of income/comprehensive income (income statement)
      • Statement of cash flows
      • Statement of changes in equity (IFRS) or statement of retained earnings (ASPE)
        • Note disclosures (e.g. supplementary schedules, management forecasts, news releases, descriptions of social or environmental impact)

    What is at Stake for Each Stakeholder?

    • Stakeholders' concerns in the financial reporting environment:
      • Investors/creditors: Investment/loan, reputation, job, bonus, access to capital markets.
      • Management: Reputation, effective capital markets, profits
      • Securities, commissions, and stock exchanges: Reputation, effective capital markets
      • Analysts and credit rating agencies: Reputation, profits, reporting companies are their clients.
      • Auditors: Reputation, profits, reporting companies are their clients
      • Standard setters: Reputation
      • Tax authorities: Reputation, tax revenue
      • Others: Various

    Objective of Financial Reporting

    • To provide financial information about the reporting entity that is useful to current and potential decision-makers
    • Entity perspective: Companies are distinct from owners; reporting for shareholders and other users
    • Investors focus on assessing: company ability to generate net cash inflows, management ability to protect and grow capital providers' investments

    Information Asymmetry

    • Ideally, all stakeholders have equal access to relevant information (information symmetry).
    • Information asymmetry: Managers have more information than other stakeholders.
    • Companies weigh cost-benefit of information sharing:
      • Benefit: attracting more investors, lower capital costs
      • Cost: loss of proprietary information, impacting profits
    • Perfect information symmetry does not exist.

    Information Asymmetry

    • Reasons for asymmetry:
      • Capital markets do not reflect all available information.
      • Individuals may act selfishly, e.g., management withholding negative information.
    • Two types of information asymmetry problems
      • Adverse selection: the market may attract companies with poor investments.
      • Moral hazard: parties with concealed information may act in their own self-interest, e.g., inflate personal bonus.

    Management Bias

    • Two types of management bias:
      • Aggressive accounting: downplaying negative aspects (e.g., overstating assets, understating liabilities).
      • Conservative accounting: downplaying positive details (e.g., understating assets, overstating liabilities)
    • Reasons for management bias
      • Managers aim for enhanced perceived performance
      • Compensation tied to financial statements
      • Meeting analyst expectations, lower capital costs, market access
      • Meeting debt covenants
    • Bias in financial reporting impacts information usefulness.

    Entities Responsible for GAAP

    • Accounting standards help reduce information asymmetry
    • Standard setters and their jurisdictions
      • AcSB: Canadian Accounting Standards Board (Canadian private companies, not-for-profit entities)
      • IASB: International Accounting Standards Board (public companies, IFRS option for not-for-profit entities/private companies)
        • FASB: U.S. Financial Accounting Standards Board (U.S. entities, US GAAP option for Canadian public companies listed in U.S.)
      • Security Commissions: not responsible for GAAP but require additional disclosures (public companies)

    CA1.2 – Ethics Case

    • This case is to be discussed in class.

    Chapter 2: Conceptual Framework Underlying Financial Reporting

    • The chapter focuses on the conceptual framework for financial reporting
    • Weeks/office hours are given for the chapter.

    In-Class Questions

    • Textbook brief exercises and in-class questions E2.4, E2.14, E2.15, E2.16, E2.17 are present in D2L
    • Solutions will be shared through course material.

    Development of the Conceptual Framework

    • New framework issued by IASB, effective Jan 1, 2020
    • Objective of financial reporting: communicating information to stakeholders such as investors, creditors, and other users.

    Fundamental Characteristics of Useful Information

    • Faithful representation: complete, neutral, free from error, including all relevant details and unbiased perspective.
      • Complete: all relevant details
      • Neutral: unbiased representation -Free from error: reliable representation
    • Relevance: capable of influencing decisions,
      • Predictive value: helps users predict past, present, and future events (e.g., separating income from continuing operations from discontinued operations for future predictions).
      • Feedback/confirmatory value: confirms or corrects expectations (e.g., evaluating investment value)
      • Materiality: influence on decision-making

    Materiality

    • Importance of information concerning a company's financial operations or activities
    • Quantitative materiality:
      • Thresholds: 5% of pre-tax income from continuing operations (for-profit entities), 1% of revenues (not-for-profit entities)
    • Qualitative materiality: illegal activities, noncompliance, inadequate descriptions of accounting policies.

    Enhancing Characteristics of Useful Information

    • Four enhancing characteristics:
      • Comparability: consistent measurement and reporting approaches between companies.
      • Verifiability: independent parties can reach similar results.
      • Timeliness: information must be available in time to influence decisions.
      • Understandability: information with sufficient quality and clarity for user comprehension

    Elements of Financial Statements

    • Elements of financial statements:
      • Assets
      • Liabilities
      • Equity
      • Revenues/Income
      • Expenses
      • Gains and Losses

    1. Assets

    • Asset characteristics: present economic resource, controlled by the entity, and resulting from a past event.
    • Conceptual framework defines asset as a right, not strictly the physical asset

    2. Liabilities

    • Liability characteristics: present obligation, transfer of economic resources, and result from a past event
    • Types of liabilities: contractual, statutory, constructive, and equitable obligations.

    3. Equity

    • Also known as net worth, the residual interest after deducting liabilities.
    • Primarily consists of: common shares, preferred shares, retained earnings, and accumulated other comprehensive income (under IFRS).

    4. Revenues/Income

    • ASPE (Revenue): Increases in economic resources from ordinary operations
    • IFRS (Income): Increases in assets or decreases in liabilities, increasing equity
    • Example: Real estate company's rental income

    5. Expenses

    • ASPE: Decreases in economic resources from ordinary operations
    • IFRS: Decreases in assets or increases in liabilities, which results in decreases in equity
    • Example: Real estate company's heating and property taxes

    6. Gains and Losses

    • ASPE: Increases/decreases in equity. Peripheral/incidental transactions excluding revenue/expense and owner's activity
    • IFRS: Same definition as income and gains, relating to asset increases/decreases, and liability changes.
    • Example: Real estate gains from asset sale.

    Financial Statements

    • ASPE and IFRS financial statement representations

    Foundational Principles

    • Help achieve objectives of financial reporting.
    • Explain how to recognize, measure, and present financial elements and events
    • Recognition/Derecognition, Measurement, Presentation/disclosure.
    • Recognition/derecognition principles: Economic entity, control, revenue recognition, matching
    • Measurement principles: Periodicity, monetary unit, going concern, historical cost, fair value
    • Disclosure principles: Full disclosure

    1. Economic Entity Assumption

    • Economic activity can be identified with a specific unit, whether individuals, companies or divisions.
    • Legal and economic entities may not always be the same.
    • Consolidating financial statements of different legal entities provides more comprehensive information

    2. Control

    • Control is the power to determine strategic decisions without others' cooperation
    • ASPE and IFRS perspective on control

    3. Revenue Recognition Principle (ASPE)

    • Revenue is recognized when risks and rewards have transferred, substantially complete, measurable, and collectible.
    • Realization: exchanging goods/services for cash
    • Realizability: converting assets to cash

    3. Revenue Recognition Principle (IFRS)

    • Follows a 5-step approach (IFRS 15) for recognizing revenue.
      • Identifying the contract with the customer
      • Identifying performance obligations.
      • Determining the transaction price.
      • Allocating the price to each performance obligation.
      • Recognizing revenue when each performance obligation is fulfilled.

    4. Matching Principle

    • Matching expenses with revenues.
    • Example: Product costs are matched to revenues (Cost of Good Sold).
    • PPE costs are matched to future revenues through depreciation

    5. Periodicity Assumption

    • Dividing economic activity into artificial time periods (e.g., monthly, quarterly, yearly) for reporting net income.
    • Shorter periods are less reliable than longer periods (more estimations)

    6. Monetary Unit Assumption

    • Economic activity measured in a stable monetary unit (e.g., Canadian dollar), ignoring inflation and deflation .
    • Quantitative data used to make economic decisions.

    7. Going Concern Assumption

    • Businesses expected to continue operations for the foreseeable future (at least 12 months)
    • Liquidation accounting if likely liquidation.
    • Reporting assets at net realizable value = selling price - costs of disposal

    8. Historical Cost Principle

    • Measures transactions and balances at the price acquired originally or equivalent.
    • Transaction values at the time they occurred
    • Three fundamental assumptions
      • Value at a point in time
      • Reciprocating Exchange
      • Arm's length party

    8. Historical Cost Principle

    • Initially, historical cost generally equals current fair value.
    • Loss of predictive power of historical cost over time
    • Measurement uncertainty if remeasurement is based on different metrics (fair value, etc.)
    • Trend towards a mixed valuation model (historical cost and fair value)

    9. Fair Value Principle

    • Measuring transactions and balances at their current market values.
    • IFRS and ASPE perspectives on fair value.
    • Fair value is more relevant in financial instruments.
    • Fair valuation useful for some non-financial assets (e.g., investments, properties, PPPs), and some biological assets

    9. Fair Value Principle

    • Historical cost = fair value at acquisition.
    • Fair value diverges (over time)
    • Current/market-based (fair value) more applicable for assets and liabilities.

    9. Fair Value Principle

    • Standard setters encourage use of fair value, especially in financial instruments (reflects current cash equivalents)
    • Some standards allow fair value for non-financial assets, like investments or PPE; other standards mandate it for specific items, like biological assets

    Market-Based vs. Entity-Specific Value

    • Market-based value: Measured by market participants—more objective and essential in IFRS fair value cases
    • Entity-specific value (value in use): Measured by the entity's future cash flow—more relevant to operational assets, but more subjective.

    10. Full Disclosure Principle

    • Providing detailed enough information to affect user decisions.
    • Trade-offs between detail/conciseness, and comprehensibility.
    • To avoid information overload.

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    Description

    This quiz explores key concepts in accounting, including fair value, value in use, and the implications of accounting standards. It covers the roles of standards setters and issues like moral hazard and aggressive accounting practices. Test your understanding of these fundamental topics in financial reporting.

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