Intermediate Accounting

1. Intermediate Accounting

2. Chapter 1 The Environment of Accounting

3. Generally Accepted Accounting Principles GAAP INTRODUCTION • The purpose of financial accounting is to communicate information to make decisions. • Accountants make financial reporting choicesthat have the potential power to influence someone’s or some group’s behavior. • GAAPis a rather loosely defined set of alternative approaches to measuring and reporting economic activities.

4. Financial statements are the end product of a large number of : • accounting policy decisions • measurement estimates • by management (often with the advice of accountants), many of which are based on expectations about future events. • Accounting involves many subjective choices. Assertions about economic actions and events Footnotes Statement of Changes Income statement Balance Sheet The Difference between Accounting and Bookkeeping • Bookkeeping is a recordingprocess, much of which has been automated through the wide-spread use of computers. • The accountantis responsible for telling the computer what to do (not for the programming) • how to classify and record transactions, • how to disclose those transactions in the financial statements, • how to measure the value of assets and liabilities and of their related revenues and expenses, and • what additional disclosures are appropriate.

5. Demand Complexity Remoteness Consequences CompaniesDirectorsManagement(clients) UsersShareholders Bond holdersBanks Creditors Employees Accounting Information Balance Sheet Income Statement Financial Position Provide(conflict ofinterest) Auditors Assurance User Demand for Reliable Information

6. THE REALM OF FINANCIAL ACCOUNTING • For all organizations, the financial accounting system produces reports both • at a point in time (point statement) balance sheet and • for a period of time (flow statements). • Flow statements vary depending on the type of organization. All types of organization normally prepare three flow statements: • statement of operations • statement of changes in capital • cash flow statement

7. PUBLIC vs. PRIVATE CORPORATIONS • A public corporation is one that issues securities (either debt or equity, or both) to the public that can be traded on the open market, usually through an organized exchange such as the Montreal Exchange or the Toronto Stock Exchange. • Public corporations must be registeredwith the securities commissions in each province in which their securities are traded and must comply with the reporting requirements of the securities commissions. • A private corporation is one that does not issue securities to the public. • Private Placements McCain Foods Ltd., with annual revenues in excess of $4 billion

8. Accounting Implications • Public corporations must be audited and their reporting generallymust conform to generally accepted accounting principles (GAAP). • The business corporations acts (CBCA) and provincial acts usually state that an audit is required for corporations that are above a specified size threshold • Exemptions from the audit requirement are readily available if all the shareholders agree to waive the audit. • Wholly-owned subsidiaries of foreign parents are likely to be audited but not reported publicly.

9. Footnotes Assertions about economic actions and events Statement of Changes Income statement Balance Sheet Other Communications Objective outsider Audit report Obtains and evaluates evidence Independent Auditor A certain degreeof correspondence Knowledge of client’s business observation of physical assets, enquiry of managers, confirmations from outsider’s, inspection of documents ISAC CICA FASB EIC SEC OSC GAAP Overview of FS Auditing

10. Control Blocks • Control block. Canadian public corporations most likely will be controlled by a small number of related or affiliated shareholders who have the majority of the voting shares. • It is common Canadian practice for a public corporation to issue two or more classes of shares: • one with multiple votes and • another with little or no voting rights called restricted shares. • Restricted shares are used as a means of raising public capital without losing the power of the control block. • In Canada, the reporting objectives of the controlling shareholder may well take precedence over those of the public investor. Financial Post’s annual listing of Canada’s 500 largest corporations, known as the FP500 Public companies 50% Public companies with control blocks. >50% “Widely held” public companies. 22% This 22% actually overstates the importance of widely held public companies in Canada, because the list does not include a large number of private companies for which no data is available.

11. WHAT IS GAAP? GAAP • Generally accepted accounting principles (GAAP) represent the body of accounting practices that has been built up over a long period of time through use. • Pronouncements by designated authoritative bodies that must be followed in all applicable cases • Accounting practices developed by respected bodies and industries or that have evolved over time Practices Pronouncements

12. WHAT IS GAAP?CICA Handbook • examples • pensions, leases, income taxes • R&D costs; capital assets; long-term investments • disclosure in the balance sheet, income statement and the cash flow statement • business combinations; foreign operations • interim statements; segmented reporting; earnings per share • Areas covered • liabilities • categories of assets • financial statement format and presentation • problem areas that are important mainly for large corporations • a few disclosures that are required for public companies only

13. WHAT IS GAAP?Other Areas - Sources of GAAP • Past accounting practice • Accounting GuidelinesAcSB’s Steering Committee • Abstracts of the Emerging Issues Committee (EIC) • Research publications of Canadian professional accounting bodies • Pronouncements by U.S.A.’s Financial Accounting Standards Board or by the International Accounting Standards Committee. • Textbooks and Other publications

14. WHAT IS GAAP?CICA Handbook - not Included • Revenue and expense recognition • Accounting practices in the specialized industries (In Canada - A majority of the economic activity of the country) • Real property development, • Financial services (e.g., insurance, banking, and investment dealers and funds), • Resource companies (forest products, mining, oil and gas), and agriculture.

15. Task Forces AcSB - Accounting Standards Board Nominationsone each CCFA Financial Analysts CAAA Academics FEAC Financial Executives CGAAC CGA SMAC CMA CICA 8 members + 2 non-voting Appoints AcSB members Accounting Standards Board StandardsAdvisory Board Emerging Issues Committee

16. The Accounting Standard Setting Process in Canada • Write project proposal • Appoints task force • Develop issues paper • Create statement of principles • Review with associates • Develop exposure draft • Develop re-exposure draft • Make revisions • Obtain AcSB approval • CICA Handbook Section • Accounting Guidelines

17. Consensus Groups AcSB Individuals • a broad accounting issue is identified • AcSB forms a task force • AcSB prepares a statement of principles • AcSB prepares an exposure draft • AcSB decision; issues a standard • Professional accounting organizations • Provincial Securities Commissions • Industry Groups • Other professional organizations • Public Accounting firms • Financial Analysts • Academics • Lawyers • Business Leaders • Other Interested Parties

18. Click to Link to Internet Site FASB Financial Accounting Standards Board (FASB) • Two type of pronouncements • Statements of Financial Accounting Concepts (SFACs) • Statements of Financial Accounting Standards (SFASs) • Due process procedures followed • Conduct research where appropriate Financial Accounting Foundation 7 full-time, independent voting members 30 full time staff

19. Virtues of the AcSB procedure: • It is a slow process, allows time for alternative accounting and reporting treatments to be tested in practice before the field of ‘acceptable’ practices is narrowed; • It prevents the proverbial ‘knee-jerk’ reaction to issues that turn out to be temporary and of limited concern; • The members of the AcSB are all engaged in their regular full-time employment elsewhere, so that they maintain an outside perspective; and • The AcSB requires a two-thirds vote for approval of new recommendations, which helps to ensure that the recommendations have a reasonably wide base of support.

20. OTHER ORGANIZATIONS • Canadian Institute of Chartered Accountants (CICA) • CA Magazine, Financial Accounting in Canada,CICA Research Studies, Statements of Auditing Standards,Statements of Accounting Standards • Certified General Accountants’ Association of Canada (CGAAC) CGA Magazine, GAAP Guide • Society of Management Accountants (SMA) • Research Studies, Cost and Management • Securities and Exchange Commission (SEC) • Ontario Securities Commission (OSC) • Revenue Canada • Internal Revenue Service (IRS)

21. OTHER ORGANIZATIONS • Academic Associations • Canadian Academic Accounting Association (CAAA) • American Accounting Association (AAA) • Executive Associations • Canadian Council of Financial Analysts (CCFA) • Financial Executives Association of Canada (FEAC) • American Institute of Certified Public Accountants (AICPA) • Governmental Accounting Standards Board (GASB) • Institute of Management Accountants (IMA)

22. ETHICS • To be useful, accounting information must be objective and reliable. • Management may be under pressure to report desired results and ignore or bend existing rules. • As professionals, we must be aware of these pressures and sensitive to the need to make appropriate decisions.

23. Revenue CanadaAgency of the federal government • Interpret and enforce the nation’s federal tax laws • Procedures and reporting requirements • To collect money and, • To attain specific social or economic objectives • Taxation principles: • Emphasize cash flows - usually are measurable quite clearly • Exception reporting - Expenses Per Books (defer-and-amortize approach) vs Tax Deductions (Capital Cost Allowance) • Different Year Ends • Book-tax conformity causes GAAP to be influenced

24. Harmonization - YES! Harmonization - No! • Simplify life for the large number of U.S. subsidiaries • Canadian-owned corporations (raise capital in USA) - would not report under two different sets of accounting standards. • Securities commissions could share the regulatory burden • International audit firms could transfer staff • The Canadian accounting profession is smaller and more closely knit, and the ethical control mechanism is stronger • U.S. has a proportionately larger mercantile (i.e., retailing and wholesaling) industry and a far larger manufacturing segment. (Canada - Resources and services based) • U.S. has a large portion of economicactivity carried on by public corporations • Debt financing is much higher in Canadian business practice Influence of Accounting Standards of Other Countries • Profound impact through two forms of accounting imperialism • Political influence - families of accounting standards. • Capital flows - close economic ties • Harmonize Canadian accounting with that of the U.S • AcSB’s decide whether or not to adopt U.S. accounting standards. • Few Canadian companies are registered public companies in the US • SEC and the Ontario Securities Commission (OSC) - cross-registered corporations in each jurisdiction may file their financial statements in the host country using home-country GAAP

25. International Accounting Standards • The International Accounting Standards Committee (IASC) was established in 1973. The IASC consists of representatives from professional accountancy bodies (i.e., auditors) from a wide number of countries (107 bodies from 81 countries, in 1993), but is governed by a much smaller group. • The objective of the IASC is to promote the world-wide harmonization of accounting principles. IASC has been dominated by the Anglo-Saxon approach to accounting • There is little evidence to suggest that such harmonization is needed in order to facilitate the international movement of capital. • Restatement of GAAP is often not effective: Japanese financial statements restated according to U.S. GAAP may be comparable to U.S. financial statements in form, but not in substance

26. Tailored Accounting Policies • When non-GAAP accounting policies are used, the company is said to be using tailored accounting policies (TAP) and to be reporting on a disclosed basis of accounting (DBA). The CICA Handbook recommends that: • A clear and concise description of the significant accounting policies of the enterprise should be included as an integral part of the financial statements. [CICA 1505.04] • In 1996, the CICA’s Auditing Standards Board (AuSB) began deliberations on recommendations to clarify the role of the auditor in engagements for companies in which TAP are used.

27. Objectives Of Financial Reporting Preparers (firms) • Communicate information for the decision purposes to one or more groups or types of users. • Financial statements often have direct economic impacts for either the enterprise or its stakeholders, or both. • profit-sharing, income tax liability, financing provided by a bank, permitted return in regulated industries, covenants, financial rewards • Many of the decisions that users must make are evaluative decisions that may not haveimmediate economic impacts PublishedFinancialStatements Auditors Users Otherinformationsources

28. Objectives Of Financial Reporting • Assessing Predicting Cash Flows • Income Tax Minimization • Contract Compliance • Stewardship • Performance evaluation

29. Assessing Predicting Cash Flows • The consequences of adopting cash flow prediction as a primary reporting objective include the following: • Accounting policies are chosen that tend to reduce inter-period allocations. • Full disclosure of future cash flowcommitments is given in the notes • When cash flow assessment and prediction is the primary objective, financial reporting policies are chosen that provide the clearest indication of the cash flows underlying reported earnings.

30. Income Tax Minimization • A very common objective, particularly for private companies, is that of income tax minimization. • Since there is a time value of money, why pay taxes this year if they can be delayed until next year? • It will adopt accounting policies that tend to • delay the recognition of revenue to the extent permitted by the Income Tax Act, particularly for long earnings cycles, and • speed up the payment of expenses that can legitimately be deducted for tax purposes.

31. Contract Compliance • Financial statements often are the basis that external users use for assessing whether an enterprise has complied with contract provisions. • The most common type of financial statement contracting is for debt, particularly with bank loans and with issues of bonds (both publicly issued and privately placed). • Accounting policy choices and accounting estimates can have a significant effect on the ratios used in debt agreements and for share valuation in shareholders’ agreements.

32. Stewardship • A question commonly asked by business investors, by taxpayers, and by donors to charitable organizations is: • “What did they do with my money?” • A stewardis a person who is responsible for managing an enterprise on behalf of someone else • The stewardship objective is most clearly dominant in reporting for non-profit organizations, where donors and members need to see how managers used the resources at their disposal for the period.

33. Performance evaluation • Financial statement readers often use the statements to evaluate management performance. • The common use of bonus schemes based on reported earnings as means of compensating senior executives • Managers are fully aware of the performance evaluation objective of financial statements, • Therefore, managers have strong motivations to select accounting policies that will enhance their apparent performance.

34. Management Motivations • Income Maximization or Minimization • Income Smoothing • Minimum Compliance • Expanded Disclosure

35. Income Maximization or Minimization • The maximization of net income is one of the commonest motivations of managers. This motivation stems from three powerful concerns: • to make it easier to comply with debt covenants, • to positively influence users’ judgements in evaluating the performance of management • to enhance managers’ compensation, in the many corporations wherein management compensation is tied either to net income or to stock price performance, or both.

36. Income Maximization or Minimization • In addition to the possible objective of minimizing income taxes, management may strive to reduce earnings for any of the following reasons: • to avoid public embarrassment by reducing a high level of reported earnings; • to avoid attracting competitorsinto a very lucrative business; • to discourage hostile take-over bids; • to avoid the scrutiny of regulators or politicians; or • to discourage large wage claims

37. ? Income Smoothing • Canadian managers do seem to be fond of showing a smooth record of earnings, free of disturbing peaks and valleys. • Widely fluctuating earnings are an indication of risk, and managers often do not want investors or creditors to perceive the company as being risky. • Income can be smoothed by taking advantage of the many opportunities available (within GAAP) for spreading both revenues and costs over several periods. • Accounting estimates provide a great opportunity for income smoothing

38. Minimum Compliance • Minimum compliance refers to the motivation of managers to reveal the least amount of information that is possible within the recommendations of the CICA Handbook and still receive a clean audit opinion (assuming that a clean opinion is needed in the circumstances). • Minimum compliance may be a motivation for managers in a public company because management does not wish to give outsiders any more information about the company than is absolutely necessary. • Minimum compliance is usually equated with minimum cost of providing accounting information.

39. Expanded Disclosure • The opposite to minimum compliance may be called expanded disclosure. • Management may wish to disclose a great deal of information that they are not required to disclose under GAAP. • The motivation for expanded disclosure may be simply to indicate that the company and its management are ‘good citizens’ who have nothing to hide and wish to provide the most informative financial statements possible. • Sometimes, expanded disclosure is motivated by the expected concerns of specific stakeholders.

40. Objectives vs. Motivations • Users’ objectives and managers’ motivations often conflict. • Being aware of users’ objectives, it isnot uncommon for managers to attempt to put the best picture on the corporation’s operations and financial position. • The resolution of this conflict depends on general concepts of fair presentation and often presents an ethical dilemma for management, for the company’s accountants, and for auditors (if any). • Prioritizing conflicting objectives is part of the exercise of professional judgement that is discussed further in Chapter 2.

41. WOW!