1 © 2007 by Nelson, a division of Thomson Canada Limited. CHAPTER 5: Standards and Principles...

1 © 2007 by Nelson, a division of Thomson Canada Limited.

CHAPTER 5:CHAPTER 5:

Standards and Standards and Principles Principles

Surrounding the Surrounding the Financial StatementsFinancial Statements


Main topics in Chapter 5:

What the main accounting principles are and how they affect the usefulness of financial accounting information;

The development of Canadian and international accounting standards;

The rest of the annual report beyond the four financial statements studied in Chapters 2-4;

The external auditor’s report; and Several surrounding topics: professions, professional ethics,

capital markets, and contracts.

CHAPTER 5Standards and Principles Surrounding the Financial Statements

Decision Criteria

Usefulness

Cost-benefit

Tax Effects

Particular Circumstances

Internal Control

Preparation Steps

Recording

Adjustment

Presentation


Disclosure

GAAPIncome measurement

Balance sheet valuationFairness


Verifiability

Accounting Entity

Decision CriteriaDecision CriteriaThese criteria refer to serving the needs of shareholders, managers,

creditors, and others who use accounting information.

Usefulness: Accounting information fundamentally should be useful in numerous ways (e.g. relevance, materiality).

Cost-benefit: Accounting information’s usefulness should be balanced against its costs (e.g. lawsuits, competition).

Tax effects: Income and other taxes are significant considerations and accounting information is used in assessing many taxes.

Internal control: Like tax, internal control decisions lie behind accounting decisions.

Particular circumstances: Every entity has its own unique circumstances (industry, financial/legal situation, etc.).

Generally Accepted Accounting PrinciplesGenerally Accepted Accounting PrinciplesThese principles form the conceptual structure of financial accounting,

and have been developed over many years.

Income measurement: Revenue recognition and the matching of revenues and expenses are fundamental.

Balance sheet valuation: Valuing assets, liabilities, and equity is just as fundamental as measuring income.

Fairness: Financial accounting information should depict the enterprise fairly.

Verifiability: Documentation and evidence should be available so that accounting information can be verified.

Particular circumstances: The above principles must be interpreted according to the entity’s circumstances.

Preparation StepsPreparation StepsAccounting involves a series of procedures for producing the

information users get. These procedures are usually done in the order below. Recording: When the business and economic events are

turned into accounting data using the double-entry system. Adjustment: Recorded data is changed or augmented to

comply with additional information or to comply with the 2 groups above.

Presentation: The recorded and adjusted data are organized and formatted to produce the financial statements.

Disclosure: The accountant must decide how to supplement the numbers with notes and other narrative.

Particular circumstances: As in the other 2 groups of ideas, each entity’s circumstances affect what is actually done.


Some Scenarios for Using Financial Accounting Some Scenarios for Using Financial Accounting InformationInformation

1. The board has to evaluate how the CEO is doing in managing the company.

2. A financial analyst has to decide whether to recommend the company’s shares.

3. A bank lending officer has to review the company’s borrowing status.

4. A supplier has to decide whether to sign a contract with the company.


Applying the Principles to a CompanyApplying the Principles to a Company

1. The financial statements should not be deliberately misleading. The auditors state their opinion that the financial statements “present fairly” the company’s financial position and results. (Fairness criterion)

2. Users are unlikely to be concerned about insignificant errors in the information as long as the important elements are represented fairly. (Materiality criterion)

3. GAAP represent the quality standard against which the financial statements are held. The auditors state their opinion that the statements have been prepared “in accordance with GAAP”.



4. The financial statements should report the economic substance of events happening to the company. (Reliability criterion)

5. Under uncertainty, assets, revenues, and income should not be overstated while liabilities, expenses, and losses should not be understated. (Conservatism criterion)

6. Extensive disclosure beyond the numbers is helpful for financial analysts to interpret the numbers. The financial statements include a large number of notes and account descriptions intended to make them clearer for the reader.



7. Most users of the financial statements want to be able to compare the company validly to other companies. (Comparability criterion)

8. The users of the financial statements will want to study the trend in financial performance and position over time. For this reason, keeping the same accounting methods over time is important. (Consistency criterion)

Tradeoffs Among Accounting PrinciplesTradeoffs Among Accounting Principles

• Conservatism is often argued to interfere with fairness.

• Under unusual circumstances, conforming rigorously to GAAP may distort the portrayal of a particular company.

• A company may choose accounting methods that are not quite optimal, for comparability with other companies.

• If new standards are developed, following GAAP will mean inconsistency with previous methods.

• There are different viewpoints about revenues and expenses being matched. Some feel that if they are not matched, it is still appropriate as long as the problem and information to adjust properly are disclosed.

The Relevance-Reliability TradeoffThe Relevance-Reliability Tradeoff

HIGH

LOW

NowWait

Relevance Reliab

ility

Market RegulatorsMarket Regulators

The Ontario Securities Commission (OSC) is the most important regulator of capital markets in Canada and therefore has a great influence on the accounting used by corporations whose shares are traded on stock exchanges (especially the Toronto Stock Exchange (TSX) which is Canada’s largest). The exchanges in the United States (especially the NYSE and NASDAQ) also have a large impact on Canadian accounting.

There is no national securities commission in Canada, but the national Securities and Exchange Commission (SEC) of the United States plays a major role in influencing Canadian accounting, sometimes as influential as Canadian regulators.

Capital market regulators pay close and increasing attention to financial accounting.

Accounting Standard SettersAccounting Standard Setters The CICA Handbook is the main source of financial accounting

standards in Canada. The Handbook contains recommendations intended to produce fair financial accounting.

The Financial Accounting Standards Board (FASB) is the main source of financial accounting standards in the U.S. The U.S. SEC generally supports the FASB’s pronouncements as the financial accounting standards for the United States, which gives the FASB great influence in accounting throughout much of the world, including Canada.

There is much activity at the international level, such as the International Federation of Accountants (IFAC), and the International Accounting Standards Committee (IASC). IASC standards have so far been less binding than the national standards (e.g. CICA and FASB), but there is great interest in harmonizing standards.


• Make reporting managers’ performance clearer;

• Make for easier comparison with other companies;

• Reduce accounting costs (save time and resources in not having to invent all the accounting methods);

• Increase the company’s credibility to important users;

• Help to evaluate the conceptual and numerical effects of accounting choices and business decisions.

Managers are Interested in Accounting StandardsManagers are Interested in Accounting Standards

On the positive side, standards:


Managers are Interested in Accounting StandardsManagers are Interested in Accounting Standards

• Standards may specify general methods that do not work well for specific companies or situations;

• Not all managers may wish to be measured clearly or have their company compared to others;

• Some complex standards may be costly to follow;

• Changes caused by new standards may cause difficulty for existing financial and business arrangements.

On the negative side:


Accounting OrganizationsAccounting Organizations

Canadian Institute of Chartered Accountants

CGA- Canada

Society of Management Accountants of Canada

American Institute of Certified Public Accountants

Financial Accounting Standards Board (U.S.)

Institute of Chartered Accountants in England and Wales

International Accounting Standards Board

A G C

Past Future?

A- Authoritative, written standards (CICA Handbook, FASB, etc.)G- GAAP (authoritative standards and additional accepted practices)

C- Complex world economy, to which accounting tries to respond

The Growth of Accounting Standards and Principles

Present

A CG


Non-business OrganizationsNon-business Organizations

Two common non-business organizations are governments and not-for-profit organizations, whose accounting must adapt to

their legal, organizational, and financial peculiarities.Key points to note:

Government financial statements do not contain an owners’ equity section (instead it is usually called “fund balance”), and they do not have an “income statement.” This is because a government’s goal is not to measure income.

Even though there are no owners, financial accounting for not-for-profit organizations is becoming more business-like.


Financial StatementsFinancial Statements

1. Balance sheet

2. Income Statement

3. Statement of retained earnings

4. Cash flow statement

5. Notes to the financial statements

6. Auditor’s report Accompanies the financial statements

Components of the Annual ReportComponents of the Annual Report

1. Summary data on the company’s performance for the year;

2. A letter to the shareholders from the company’s CEO, who is usually the president or chairperson of the board of directors;

3. Information about the company’s history, plans, products, etc.;

4. A description of the economic, financial, and other factors behind the company’s business;

5. The short section explaining the financial statements and the general internal control of the business;

6. The set of financial statements, with extensive notes, and the auditor’s report;

7. Various details about the company’s legal status, names of its directors, and other important information.

Notes and Other Supplementary InformationNotes and Other Supplementary Information1. Normally Required and Covered by the Auditor’s Report

a. A description of the company’s significant accounting policies

b. Backup details on any statement figures needing explanation

c. Information on some things not included in the figures

d. Analysis of revenues and contributions to income of any significant product-line or “segments” of the company

2. Also Fairly Standard, Especially for Larger Companies

a. Comparative income and balance sheet figures going back five or ten years

b. An explanation of the different responsibilities of management and the external auditor

Notes and Other Supplementary InformationNotes and Other Supplementary Information

c. The “management discussion and analysis” of the decisions and results for the year

3. Still Largely Voluntary

a. Graphs and other pictorial supplements

b. Details of employment contracts, product specifications, business policies and objectives, donations, and other details

c. Lists of subsidiary and associated companies, senior managers, office addresses, and the home Web page

d. Reports on pollution control, excellent employees, customer relations, HR management, and other socially sensitive issues

Adding AssuranceThe external auditor provides assurance about the fairness of the

financial statements. Assurance refers to adding credibility to the financial statements by doing an expert examination of them.

There are four types of auditor’s opinions:

1. Clean - a routine statement supporting the statements, indicating that the auditor does not believe there are problems or special circumstances.

2. Qualified - indicates that the auditor has some concern(s) about the statements.

3. Denied – in extreme cases where the auditor believes severe problems prevent an opinion.

4. Adverse (not fair)- in extreme cases where there are severe misstatements.

The Standard Audit ReportThe external auditor’s report has

three standard paragraphs for its findings (four in the U.S.)

1. Identifies the company and the set of statements and their date and states that they are the responsibility of management and that the auditors’ responsibility is to express an opinion on them.

2. Outlines what the auditors did to enable them to express an opinion, stating in particular that they followed generally accepted auditing standards (GAAS).

3. States what the auditors’ opinion is concerning the fairness of the statements and whether they adhere to GAAP.

4. (U.S) Comments on any accounting changes.


Some Auditing IssuesSome Auditing Issues

Independence- having no financial or other interest that would influence one’s decisions. External auditors are expected to be independent of the enterprises they audit.

Objectivity- The notion that the information in financial statements must be as free from bias as possible, in order that all user groups can have confidence in them.

Professional ethics- Codes of conduct to guide professionals in applying their judgment.

Audit committee- A committee of a corporation’s Board of directors, usually composed largely or entirely of directors not having management positions, which reviews the company’s accounting statements and communicates directly with the external auditor.


Capital Market ComponentsCapital Market Components

Stock markets facilitate the exchange of shares by investors. Today, there are many exchanges including ones in New York, Tokyo, London, Paris, and Toronto. Other capital markets include “over-the-counter” markets.

There are various types of securities available on these exchanges including shares, bonds, and rights (or “options”).

Once securities are offered to the market(s), the companies issuing the shares have no direct control of who owns the securities. The securities are then purchased and sold between individual investors.

Daily stock prices are reported by several different “market watchers” such as the the National Post and the Globe and Mail.

Security Trading and Security Prices-Capital markets work about the same as any other markets. People trade what they own for something else of value.

-Securities’ prices are set by supply and demand forces.

Return and Risk-The return from holding a security is part current cash flow (dividends or interest) and part price change.

-Systematic risk: the risk that relates to or correlates with variation in the overall market.

-Unsystematic risk: the risk specific to the individual security.

Diversification-A portfolio of investments has less unsystematic risk than individual securities.

Capital Markets ContinuedCapital Markets Continued


Market Informational Efficiency

-Efficiency of information use means that markets respond so quickly to information that, once it becomes public, its effects are immediately reflected in prices through the trading of securities. The efficient market hypothesis is the basis of much of modern finance theory and related accounting research.

-Insiders may have access to information more quickly than others. These insiders can buy or sell securities before other investors learn about such information. This is the basis of the frowned-on act of “insider trading”. Immediate disclosure of information helps to keep capital markets fair.

Capital Markets ContinuedCapital Markets Continued

Contracts and Other Accounting InformationContracts and Other Accounting Information

• Financial accounting has many roles besides providing information to capital markets.

• In a contract, people agree to do things on each other’s behalf and to be compensated for doing so properly.

• Contracts can either be formal (such as legally binding indentures providing protection to bondholders), or informal (handshake between partners).

• Opposite parties in a contract generally will not have the same interests (e.g. principal and agent likely differ in objectives).

• If the agent is to provide effort on behalf of the principal, it would be natural for the agent to work less than the principal wishes.


Contracts and Other Accounting InformationContracts and Other Accounting Information

• A contract about managerial compensation is agreed upon after careful negotiations between owners and managers (the owners are the principal, represented by the board of directors, and top management are the agents, working on behalf of the owners).

• Auditors evaluate the managers’ accounting information on behalf of the owners.

1 © 2007 by Nelson, a division of Thomson Canada Limited. CHAPTER 5: Standards and Principles...

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