Accounting Standards and Fair Value Analysis

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.

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.