Intermediate Accounting 13th Canadian Edition, Volume 1 PDF

Intermediate Accounting 13th Canadian Edition, Volume 1 Kieso Weygandt Warfield Wiecek McConomy Chapter 2 Conceptual Framework Underlying Financial Reporting This slide deck contains animations. Please disable animations i...

Intermediate Accounting 13th Canadian Edition, Volume 1 Kieso Weygandt Warfield Wiecek McConomy Chapter 2 Conceptual Framework Underlying Financial Reporting This slide deck contains animations. Please disable animations if they cause issues with your device. Copyright ©2022 John Wiley & Sons, Canada, Ltd. Chapter 2: Conceptual Framework Underlying Financial Reporting After studying this chapter, you should be able to: 1. Indicate the usefulness and describe the main components of a conceptual framework for financial reporting. 2. Identify the qualitative characteristics of accounting information. 3. Define the basic elements of financial statements. 4. Describe the foundational principles of accounting. 5. Explain the factors that contribute to choice and/or bias in financial reporting decisions. Copyright ©2022 John Wiley & Sons, 2 6. Discuss current trends in Ltd. Canada, standard setting for the Rationale for a Conceptual Framework Coherent system of interrelated objectives and fundamentals that are the foundation for consistent standards A conceptual framework is needed to o Create standards based on established concepts o Increase users’ understanding of and confidence in financial reporting o Enhance comparability of different companies’ financial statements o Solve new and emerging practical problems more quickly LO 1 Copyright ©2022 John Wiley & Sons, 3 Canada, Ltd. Development of the Conceptual Framework New framework issued by IASB; effective Jan 1, 2020 Not considered accounting standards; does not override ASPE or IFRS LO 1 Copyright ©2022 John Wiley & Sons, 4 Canada, Ltd. Information Asymmetry Revisited Investors and creditors need information for sound resource allocation decisions— available through the financial statements When various stakeholders do not have the same information, some may make suboptimal decisions Problems may arise because of adverse selection and moral hazard Conceptual framework based on sound principles helps to address information asymmetry Strong control and governance systems and LO 1 environmentsCopyright are critical ©2022 John Wiley & Sons, Canada, Ltd. 5 Objective of Financial Reporting The objective of financial reporting is to communicate information that is: o useful to investors, creditors, and other users o Useful in making decisions about how to allocate resources Information should be about financial position, changes in financial position, performance and management stewardship General-purpose financial statements should provide the most useful information possible to different kinds of users subject to cost/benefit considerations LO 1 Copyright ©2022 John Wiley & Sons, 6 Canada, Ltd. Qualitative Characteristics of Useful Information Determining the amount and types of information to present requires choosing alternatives that provide the most useful information (decision usefulness) The second level of the conceptual framework has identified characteristics that distinguish more useful information from the less useful Relevance and representational faithfulness are fundamental qualities L O 2 that make accounting Copyright ©2022 John information Wiley & Sons, useful 7 Canada, Ltd. Relevance To be relevant, information must be capable of making a difference in a decision o Has predictive value—helps users make predictions about past, present and future events o Has feedback/confirmatory value—helps users confirm or correct previous expectations o Is material—how important the information is; would it make a difference to the LO 2 decision-maker? Copyright ©2022 John Wiley & Sons, 8 Canada, Ltd. Making Materiality Judgements Identify information that might make a difference to primary users when making decisions Assess materiality using qualitative and quantitative factors Present the information in an organized way—clear and concise Review statements to ensure all material information is included; presented appropriately LO 2 Copyright ©2022 John Wiley & Sons, 9 Canada, Ltd. Auditing Standards on Materiality Quantitative benchmarks (CAS 320.A8) o 5% of pre-tax income from continuing operations for manufacturers o 1% of revenues for NFP entities o Impact on sensitive numbers in the financial statements Qualitative factors: illegal acts, inadequate or inappropriate descriptions of accounting policy Reasonableness and practicality with internal accounting decisions (e.g., level of detail required) LO 2 Copyright ©2022 John Wiley & Sons, 10 Exercising good judgement and professional Canada, Ltd. Dynamic Materiality With sustainability reporting, each company has a materiality signature Signature evolves with changes in business and industries, and societal views and norms Considers environmental, social and governance (ESG) matters as well as financial information Differs from financial reporting materiality: o Broader set of stakeholders o Broader set of stakeholder considerations and information needs (includes ESG issues) o A longer-term time frame LO 2 Copyright ©2022 John Wiley & Sons, 11 Canada, Ltd. Concept of Dynamic Materiality LO 2 Copyright ©2022 John Wiley & Sons, 12 Canada, Ltd. Representational Faithfulness Economic substance over legal form Transparency—represents economic reality Completeness—include all information needed to portray underlying events and transactions (e.g., level of detailed included) Neutrality—information does not favour one set of interested parties over another; supported by the concept of conservatism/prudence o Economic consequences argument: neutrality in standard setting Freedom from error—reliability; arises from good information systems and strong internal controls LO 2 Copyright ©2022 John Wiley & Sons, 13 Canada, Ltd. Application of Fundamental Qualitative Characteristics To ensure information has relevance and representational faithfulness, follow three steps: 1. Identify the economic event or transaction 2. Identify the type of information that would be relevant and can be faithfully represented 3. Assess whether the information is available (cost/benefit) and can be faithfully represented LO 2 Copyright ©2022 John Wiley & Sons, 14 Canada, Ltd. Enhancing Qualitative Characteristics Comparability: information is measured and reported in a similar way—company to company and year to year (e.g., same accounting policies) Verifiability: knowledgeable, independent users achieve similar results Timeliness: information is available in sufficient time to influence decisions Understandability: information must be of sufficient quality and clarity (onus on the preparer) so reasonably informed users (onus on the user) can see its significance LO 2 Copyright ©2022 John Wiley & Sons, 15 Canada, Ltd. Trade-offs of Useful Information Both relevance and representational faithfulness must be present to ensure decision-relevant information Not always possible to have all enhancing qualities, Trade-offs are necessary (e.g., adopting a new accounting policy to provide better information but lose year to year comparability [consistency]) The cost-benefit relationship must be considered LO 2 Copyright ©2022 John Wiley & Sons, 16 Canada, Ltd. Cost-Benefit Relationship The cost of providing information is weighed against the benefits of providing it Costs are not always evident or measurable: such as costs involving collecting and processing, distributing, auditing, litigation and analysis Benefits are enjoyed by both preparers and users but are more difficult to quantify Separate standards (ASPE) developed for less complex organizations based on cost- L O 2 benefit considerations Copyright ©2022 John Wiley & Sons, 17 Canada, Ltd. Elements of Financial Statements Basic elements of financial statements most directly related to measuring performance and financial status: Assets The basic elements of financial statements are Liabilities defined so users have a Equity common understanding of the main items Revenues/Income presented on the Expenses financial statements. Gains/Losses LO 3 Copyright ©2022 John Wiley & Sons, 18 Canada, Ltd. Assets Assets have three essential characteristics: 1. They represent a present economic resource—a right to use an asset that produces economic benefit or that has the potential to produce economic benefits 2. Entity has control over that resource— entity’s ability to decide how to use the asset and receive economic benefits (through legal ownership or a contractual orThe conceptual other right) framework defines the asset as the right as opposed 3. Resource results from a past transaction or to the physical asset. LO 3 event Copyright ©2022 John Wiley & Sons, 19 Canada, Ltd. Liabilities Liabilities have three essential characteristics: 1. They represent a present duty or responsibility—and there is no practical ability to avoid them 2. Entity is obligated to transfer an economic resource 3. Obligation results from a past transaction or event Both financial and non-financial liabilities Types of liability obligations: LO 3 o ContractualCopyright or statutory ©2022 John Wiley requirements & Sons, 20 Canada, Ltd. Equity A residual interest in an entity that remains after deducting liabilities from assets Also known as net worth In business, equity is the ownership interest and is normally o Common and preferred shares o Retained earnings o Accumulated other comprehensive income (IFRS) LO 3 Copyright ©2022 John Wiley & Sons, 21 Canada, Ltd. Elements of Financial Statements: Other Eleme ASPE IFR S nt Revenu Revenue is defined as increases in Income is defined as increases es/ economic resources, which result in assets or decreases in Income from ordinary operations. liabilities, that result in increases to equity, other than those relating to contributions from shareholders. Expens Decreases in economic resources No distinction between es that result from ordinary revenue- ordinary revenue-generating generating activities. activities and losses. Focuses on decreases in assets or increases in liabilities, that result in decreases in equity. Gains/ Increases/decreases in equity from Revenues and gains are Losses an entity’s peripheral or incidental grouped together under transactions except Income (they are not revenues/expenses and owner’s separately defined), and LO 3 activity. expenses and losses are Copyright ©2022 John Wiley & Sons, 22 Canada, Ltd. grouped together under Items Included in Financial Statements: IFR S ASPE Statement of financial performance Income statement Or Statement of profit and loss and statement of other comprehensive OCI does not exist income* Statement of financial position Balance sheet Statement of changes in Statement of retained shareholders’ equity earnings Statement of cash flows Cash flow statement Other comprehensive income (O C I) includes all changes in * equity except for net income and owner’s investments and distributions. Comprehensive income includes net income and other comprehensive income. LO 3 Copyright ©2022 John Wiley & Sons, 23 Canada, Ltd. Foundational Principles Implement the basic objectives of the first level of the conceptual framework Concepts and constraints that help explain o which, when, and how financial elements and events should be recognized/derecognized, measured, and presented/disclosed Includes assumptions and conventions Guidelines for developing rational responses to controversial financial reporting issues Must decide at which level it’s applied—define the unit of account LO 4 Copyright ©2022 John Wiley & Sons, 24 Canada, Ltd. Summary of Foundational Principles Recognition/ Presentation/ Derecognition Measurement Disclosure 1. Economic entity 5. Periodicity 10. Full disclosure assumption assumption principle 2. Control 6. Monetary unit assumption 3. Revenue recognition and 7. Going concern realization principles assumption 4. Matching principle 8. Historical cost principle 9. Fair value principle and value in use LO 4 Copyright ©2022 John Wiley & Sons, 25 Canada, Ltd. Recognition/Derecognition Part 1 Recognition is the act of including something on the statement of financial position or income statement Under ASPE, elements of financial statements are recognized when they o Meet the definition of an element o Are probable o Are reliably measurable Under IFRS, the element must o Meet the definition of an element o Provide relevant information that faithfully represents the underlying transaction or event LO 4 Copyright ©2022 John Wiley & Sons, 26 Canada, Ltd. Recognition/Derecognition Part 2 IFRS encompasses the principle of usefulness when determining recognition Information is not considered useful if there is significant uncertainty as to existence or measurement— so probability and measurability criteria are not included as separate IFRS recognition criteria Derecognition is the act of taking something off the statement of financial position or income statement o For assets: when control is given up o For liabilities: when the obligation is LO 4 extinguished Copyright ©2022 John Wiley & Sons, Canada, Ltd. 27 1. Economic Entity Assumption Also called entity concept Means an economic activity can be identified with a particular unit of accountability, e.g., a company, a division, an individual An economic entity is not always a legal entity Legal entities can be merged into an economic entity for financial reporting purposes (consolidated financial statements) Defining factor for an economic entity is “Who has control?” LO 4 Copyright ©2022 John Wiley & Sons, 28 Canada, Ltd. 2. Control Control is an important concept when determining asset recognition ASPE IFRS Control is the continuing power to Investor has control over an determine strategic decisions investee when it has: without the cooperation of others. 1. power over the investee 2. rights to returns from its In some situations, the focus is on involvement with the whether the other entity is investor “demonstrably distinct” from the 3. ability to affect the amount other company. Criteria consist of of the investors’ returns. 1. whether the entity can be unilaterally dissolved by the Control is assessed through company exposure to the risks and 2. whether others have more than rewards of the entity—not just 10% ownership. ownership of shares. LO 4 Copyright ©2022 John Wiley & Sons, 29 Canada, Ltd. 3. Revenue Recognition Principle (ASapproach--revenue Income statement PE) is recognized when o Risks and rewards have passed and/or the earnings process is substantially complete— significant acts have been performed and there is no continuing involvement o The revenue is measurable o The revenue is collectible (realized or realizable) LO 4 Copyright ©2022 John Wiley & Sons, 30 Canada, Ltd. 3. Revenue Recognition Principle (IF Balance sheet R S) approach—transaction occurs when entity enters the contract o Follows a five-step approach 1. Identify the contract with the customer 2. Identify the performance obligations 3. Determine the transaction price 4. Allocate the price to each performance obligation 5. Recognize revenue when each performance obligation is satisfied LO 4 Copyright ©2022 John Wiley & Sons, 31 Canada, Ltd. 3. Revenue Realization Principle Revenues are realized when products, merchandise or other assets are exchanged for cash Revenues are realizable if the assets received or held can be readily converted into cash or claims to cash Assets are readily convertible if they can be sold or interchanged in an active market o at a price that is readily determinable and o there is no significant additional cost LO 4 Copyright ©2022 John Wiley & Sons, 32 Canada, Ltd. 4. Matching Principle Cause and effect relationship between money spent to earn revenues and the revenues themselves The effort (expenditure) is matched to the accomplishments (revenues) o Product costs are held in inventory until the costs (cost of goods sold) are recorded at the same time as the revenue (sale) o PPE costs, which benefit future periods, are matched to future revenues through depreciation o However, period costs are recognized immediately even if some of the benefits are realized in the future—expenditures that do not meet the definition of an asset are expensed LO 4 Copyright ©2022 John Wiley & Sons, 33 Canada, Ltd. Measurement Uncertainty Because of accrual accounting, measuring many elements of financial statements requires the use of estimates Estimates give rise to uncertainty— uncertainty affects faithful representation Measurement uncertainty: when a value cannot be objectively measured due to o Existence uncertainty: difficulty in determining whether an asset or liability exists or not o Outcome uncertainty: difficulty in determining future outflows and inflows LO 4 Copyright ©2022 John Wiley & Sons, 34 Canada, Ltd. Measurement Basis Measurement basis must provide relevant information that faithfully represents the transaction or event Common choices: historical cost (including amortized cost); and current cost (fair value, value in use or fulfilment value) Key for accountants when choosing a basis: o Determine an acceptable level of uncertainty o Use measurement tools that deal with uncertainty o Disclose enough information to signal the uncertainty LO 4 Underlying assumptions: Canada, Ltd. periodicity, unit of Copyright ©2022 John Wiley & Sons, 35 5. Periodicity Assumption Economic activity of an entity can be divided into artificial time periods for reporting purposes Most common: one month, one quarter, and one year For shorter time periods, more difficult to determine proper net income (i.e. more likely errors occur due to more estimates) With technology and AI, investors use more online, real-time financial information to ensure relevant information—continuous reporting LO 4 Copyright ©2022 John Wiley & Sons, 36 Canada, Ltd. 6. Monetary Unit Assumption Money is the common unit of measure of economic transactions Use of a monetary unit is relevant, simple and understandable, universally available, and useful In Canada and the United States, the dollar is assumed to remain relatively stable in value (effects of inflation/ deflation are ignored i.e. price-level change is ignored) Monetary unit is relevant as long as it is assumed that quantitative data are useful in communicating economic information LO 4 Copyright ©2022 John Wiley & Sons, 37 Canada, Ltd. 7. Going Concern Assumption Assumption that a business enterprise will continue to operate in the foreseeable future There is an expectation of continuing long enough to meet objectives and commitments Management must look out at least 12 months from balance sheet date If liquidation of the company is assumed to be likely, use liquidation accounting (at net realizable value) Measuring financial statement elements at historical cost would have limited usefulness if liquidation were assumed to be likely LO 4 Copyright ©2022 John Wiley & Sons, 38 Canada, Ltd. 8. Historical Cost Principle (Part 1) are measured at the amount Transactions of cash (or equivalents) paid or received, or the fair value of the initial transaction Three basic assumptions of historical cost o Represents a value at a point in time o Results from a reciprocal exchange (i.e. a two-way exchange) o Exchange includes an outside arm’s-length party Sometimes the historical cost principle cannot be applied in determining a value LO 4 Copyright ©2022 John Wiley & Sons, 39 Canada, Ltd. 8. Historical Cost Principle (Part Times 2) when historical cost cannot be used … o Nonmonetary or barter transactions (no cash or monetary consideration) o Nonmonetary, non-reciprocal transaction (no exchange) o Related party transactions In these types of situations, an attempt may be made to estimate the fair value Principle also applies to financial instruments when issued in exchange for assets or services; the price becomes the “cost” of the instrument LO 4 Copyright ©2022 John Wiley & Sons, 40 Canada, Ltd. 8. Historical Cost Principle (Part 3)historical cost usually equals fair Initially, value Over time, this value may lose its predictive value Calls for subsequent remeasurement o Can be based on different measurement values, but that means measurement uncertainty o With no external exchange, value may be subjective Trend is toward using a mixed valuation L O 4 model: primarily historical Copyright ©2022 cost moving to John Wiley & Sons, 41 Canada, Ltd. 9. Fair Value Principle At acquisition, historical cost = fair value Subsequently, with market and economical conditions changing, the values diverge Fair value (current value, market-based) measures provide more relevant information than historical cost for some assets and liabilities Fair value reflects the current cash equivalent Fair-value option—to encourage using fair value o There is an option to use fair value for most financial instruments (non-strategic investments) LO 4 Financial instruments are Copyright ©2022 John measured Wiley & Sons, at fair 42 Canada, Ltd. Fair Value Principle (IFRS) IFRS defines fair value as “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” An exit price and a market-based measure Explicitly allowed for some non-financial assets (investment properties, PPE) Required for some assets (biological) LO 4 Copyright ©2022 John Wiley & Sons, 43 Canada, Ltd. Fair Value Principle (ASPE) ASPE defines fair value as “amount of consideration that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act.” Definition under ASPE o Does not refer to an orderly market (as does IFRS) o Does not stipulate the price as an exit price Does not refer to non-financial assets or P PE, but acknowledges use for certain L O 4 industries (e.g., agriculture, Copyright mining) ©2022 John Wiley & Sons, 44 Canada, Ltd. Market-Based versus Entity- Specific Value Fair value is a market-based measure as opposed to an entity-specific value Market-based value o How market participants would value the item in question o More objective and must be applied under IFRS for fair value situations Entity-specific value (value in use) o Present value of the future cash flows expected from the asset o More relevant for operating assets but is LO 4 subjective Copyright ©2022 John Wiley & Sons, 45 Canada, Ltd. Fair Value versus Value in Use Value in use is an entity-specific value (perspective of the entity) Defined as the present value of the future cash flows expected from use of the asset LO 4 Copyright ©2022 John Wiley & Sons, 46 Canada, Ltd. 10. Full Disclosure Principle Only principle associated with presentation and disclosure General practice of providing information that is important enough to influence an informed user’s judgement and decisions Recognizes a series of judgemental trade-offs o Detailed enough to disclose matters that make a difference to users? o Condensed enough to make the information understandable? Avoid information overload LO 4 Copyright ©2022 John Wiley & Sons, 47 Canada, Ltd. Presentation and Disclosure Information about an entity is presented in three places o Main body of financial statements—formalized structured way of communicating financial information o Notes to the financial statements—amplify or explain items presented in the main body of the statements o Supplementary documents including the Management Discussion and Analysis (MD&A) Report—includes details or amounts that present a different perspective Full disclosure is not a substitute for proper LO 4 accounting Copyright ©2022 John Wiley & Sons, Canada, Ltd. 48 Notes to the Financial Statements Additional information needed to complete the picture of performance and position Information does not have to be quantifiable; could include o Descriptions of policies and methods o Explanations of uncertainties and contingencies o Details too voluminous to include in the statements According to guidance from I FRS conceptual framework for effective communication o Entity-specific over general information LO 4 Copyright ©2022 John Wiley & Sons, 49 o Duplication inhibits usefulness Canada, Ltd. of information Management Discussion and Analysis Six disclosure principles for the MD&A o Provide a view through management’s eyes o Supplement and complement information in the financial statements o Provide fair, complete, and balanced information that is material to decision-makers o Outline key trends, risks, and uncertainties that may affect the company in the future o Explain management’s plan for long- and short-term goals o Be understandable, relevant, comparable, verifiable, timely LO 4 Copyright ©2022 John Wiley & Sons, 50 Canada, Ltd. Management Discussion and Analysis cont. Provides management’s explanation of financial information and a discussion of its significance Includes forward-looking information Five key elements included to give users greater insight into the business o Core businesses o Objectives and strategies o Capability to deliver results o Results and outlook o Key performance measures and indicators LO 4 Copyright ©2022 John Wiley & Sons, 51 Canada, Ltd. Expanded Conceptual Framework LO 4 Copyright ©2022 John Wiley & Sons, 52 Canada, Ltd. Financial Reporting Issues IFRS and ASPE are principles-based The reporting system will not always work properly because: o It means selecting and interpreting accounting principles, and rules relying on the application of professional judgment o Accounting is influenced by its environment o Individuals may act out of self-interest—either consciously or unconsciously LO 5 Copyright ©2022 John Wiley & Sons, 53 Canada, Ltd. Principles-Based Approach IFRS and ASPE are based on similar foundational principles and concepts Theoretically, decisions should be consistent if coming from the same foundation—grounded in the conceptual framework However, absence of detailed rules allows G AAP to be flexible—but this leads to lack of comparability Neutrality is of greatest importance In the absence of primary sources of G AAP, use professional judgement and apply the conceptual framework LO 5 Copyright ©2022 John Wiley & Sons, 54 Canada, Ltd. Financial Engineering Creating complex legal arrangements and financial instruments so the resulting accounting meets the desired objective within GAAP Structured financing—creating instruments so the financial reporting objectives are within GAAP Can be dangerous since it often results in biased information Has moved from being an accepted practice and commodity to a potentially fraudulent activity LO 5 Copyright ©2022 John Wiley & Sons, 55 Canada, Ltd.  Fraudulent Financial Reporting Often fraudulent reporting results from pressures on individuals or the company Economic pressures and budget pressures may result in “propping up” revenues or deferring expenses to avoid negative impacts on financial reporting To lessen the chances of fraudulent reporting, companies should put in place controls and a solid governance structure that may include vigilant, knowledgeable top management; an independent audit committee; an internal audit function; and strong internal control systems LO 5 Copyright ©2022 John Wiley & Sons, 56 Canada, Ltd. IFRS/ASPE Comparison IFRS and ASPE are fundamentally similar as they are both principles-based Some differences have been noted in the chapter, such as o Less stringent standards under A SPE o Naming conventions for financial statements o Definitions for the elements o Criteria for revenue recognition o Definition of control o Definition of fair value LO 6 Copyright ©2022 John Wiley & Sons, 57 Canada, Ltd. Looking Ahead IFRS Foundation Technology Initiative— looking at how big data, artificial intelligence, and automation are affecting accounting, including o the standard-setting process o consumption of financial information AcSB—has a current project on financial statement concepts IASB-–Primary Financial Statements project o Exposure Draft: General Presentation and LO 6 Disclosure Copyright ©2022 John Wiley & Sons, 58 Canada, Ltd. Copyright Copyright © 2022 John Wiley & Sons, Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright ©2022 John Wiley & Sons, 59 Canada, Ltd.