Intermediate Accounting - McGraw-Hill Education … concepts and principles that guide accounting choices. ... • Underlying assumptions (or postulates) are the basic foundation

b a c k n e x th o m e

Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by:Bruce W. MacLean,Bruce W. MacLean,

Faculty of Management,Faculty of Management,

Dalhousie UniversityDalhousie University

Copyright 1998 McGraw-Hill Ryerson Limited, Canada

Intermediate Accounting


Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by:Bruce W. MacLean,Bruce W. MacLean,

Faculty of Management,Faculty of Management,

Dalhousie UniversityDalhousie University


The Environment of Accounting

Chapter2


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Introduction

■ This chapter looks at the financialstatement concepts and principlesthat guide accounting choices.

■ These concepts and principlesunderlie the exercise of professionaljudgement.

■ It is the these sets of principles thatprovide the criteria that distinguishprofessional judgement from theexercise of uninformed opinion orbias.


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Sorting Out Accounting ‘Principles’

•• Underlying assumptionsUnderlying assumptions (or (or postulatespostulates)) are the basicfoundation

•• Measurement methods Measurement methods (or (or measurement conventionsmeasurement conventions))are the various ways in which financial position and theresults of operations can be reported. These are theaccounting choices that management of every organizationmust make.

•• Qualitative criteriaQualitative criteria (or (or qualitative characteristicsqualitative characteristics)) are thecriteria which, in conjunction with the organization’sreporting objectives, are used to evaluate the possiblemeasurement options and choose the most appropriateaccounting policies for the given situation.


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Sorting Out Accounting ‘Principles’

■ To construct financial statements for a particularenterprise, it is necessary:

– to establish the facts of the business and itsoperating and economic environment,

– to determine the objectives of financialreporting

– to develop the statements by using situation-appropriate accounting policies to measurethe elements of the financial statements.

■ This process can be illustrated by the pyramidshown in Exhibit 2-1 in the text (see next slide)

■ The financial statements themselves are the apexof the process; the foundation is the objectives,facts and constraints for the reporting enterprise.


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The AcSB’s Financial StatementConcepts

■ The CICA Handbook contains a section on “FinancialStatement Concepts” (Section 1000). The purposeand scope of this section is described as follows (withemphases added):– The purpose of this Section is to describe the concepts

underlying the development and use of accountingprinciples in general purpose financialstatements. Such financial statementsare designed to meet the commoninformation needs of external usersfor financial information about an entity.[CICA 1000.01]


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Professional Judgement In Accounting

■ In any specific situation, an accountant exercises professionaljudgement about alternative measurement methods, (bothaccounting policiespolicies and accounting estimatesestimates) by taking intoaccount several factors:• the users of the financial statements, and

their specific information needs;

• the motivations of managers;

• the organization’s operations − e.g., thetype of ownership, the sources of financing,the nature of its operating or earnings cycle, etc.;

• its reporting constraints, if any − e.g., auditrequirements, reporting to securities regulators,constraints imposed by foreign owners, etc.;


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Proprietary assumption

■ The proprietary concept: under this approach,an organization’s financialcondition and results of operationsare reported from the point of viewof the ownersowners, or proprietorsproprietors in aneconomic sense

■ The entity concept: under this approach toaccounting, the owners are just one of manyparticipants in the enterprise

■ The fund concept: under this assumption, thebasic accounting function is to trace the flow offunds in the organization.

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Unit of measure assumption

■ Money is the language of accounting– Results of a business's economic activities can be reported in terms of a

standard monetary unit throughout the financial statements.

– The common unit of measure enables dissimilar items to be aggregatedinto a single total. (cost of a ton of coal + amount of an account payable)

– The unit-of-measure assumption implies:• that if it can’t be measured, it can’t be reported.

• if it can’t be reported, it can’t be used for decision-making by external users.

– such as:• the value of customer goodwill,

• the impact of operations on the environment, or

• the value of the intellectual and human capital.


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Nominal dollar capital maintenanceassumption

■ The relative value of a currencyrelative value of a currency can be measured :• in relation to the value of other currencies, or

• in relation to the amount of goods and servicesthat it will buy (its purchasing power).

– currencies of different nations adjust to maintaintheir relative purchasing powers

– In Canada and the United States, accounting isperformed under the assumption that every dollarof revenue and expense has the same value

■■ Three otherThree other alternative approaches to this problem:• nominal dollar capital maintenance (or

maintenance of financial capital);

• constant dollar capital maintenance

• productive capacity capital maintenance


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Qualitative Criteria

■ Relevance

■ Understandability

■ Reliability

■ The Trade-off betweenCost and Benefit

■ Conservatism

■ Objectivity

■ Comparability

■ Other Trade-offs


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Criteria for Assessment of Standardsand of Accountability

Criteria that may be inconflict with those in theother column, or require

"trade-offs"

Criteria thatare compatiblewith those in

both of the firsttwo columns

Constraints that mayapply against any of

the criteria in thefirst three columns

RelevanceComparabilityTimelinessClarityCompleteness orFull Disclosure

ObjectivityVerifiabilityPrecision

Representational faithfulnessFreedom from biasRationalityNonarbitrarinessUniformity

Substance over formMaterialityCost/Benefit effectivenessFlexibilityData availabilityConsistencyConservatism

Criteria that may be inconflict with those in theother column, or require

"trade-offs"

Criteria thatare compatiblewith those in

both of the firsttwo columns

Constraints that mayapply against any of

the criteria in thefirst three columns

RelevanceComparabilityTimelinessClarityCompleteness orFull Disclosure

ObjectivityVerifiabilityPrecision

Representational faithfulnessFreedom from biasRationalityNonarbitrarinessUniformity

Substance over formMaterialityCost/Benefit effectivenessFlexibilityData availabilityConsistencyConservatism


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Understandability

■ Information must beunderstandableunderstandable to be usefulto users in their decision-making

■ Investors and creditors :– reasonable understanding of

business and economic activities,

– some understanding of accounting

– expected to study the informationwith reasonable diligence

– who lack expertise are properly advised.


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Reliability

■ Information is reliable if users candepend on it as a sufficientlyaccurate measure of what it isintended to measure.

■ There are three components toreliability:

– Representational faithfulness(including substance over form)

– Verifiability

– Freedom from bias (or neutrality)


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Comparability

■ Comparability is a characteristic of the relationship betweentwo pieces of information. It enables users to identifysimilarities in and differences between the informationprovided by two sets of financial statements

■ Consistency,– which entails using the same accounting

policies from year to year within a firm

■ Uniformity,– which means that companies with

similar transactions and similarcircumstances use the same accounting treatments.


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Conservatism

■ When uncertainty exists, estimates of aconservative nature attempt to ensure thatassets, revenues and gains are not overstated

■ Conversely, that liabilities, expenses and lossesare not understated.

■ However, conservatism does not encompassthe deliberate understatement of assets,revenues and gains or the deliberateoverstatement of liabilities, expenses andlosses. [CICA 1000.21]


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Other Trade-offs

■ Trade-off between qualitative characteristics,– Reliability may have to be reduced to increase the degree of

relevance, or vice versa.

■ Exercise of professional judgement.

■ Subjectivity in the standard setting process -What is relevant? and What is measurable?

■ The concerns of the auditing profession -Emphasize verifiability.

■ The historical cost measurement convention oftenoverrides the relevance of other highly objectivemeasurements.

Relationship between financial statements

19A Jan. 119B

Dec. 3119B

19CAnnual Accounting Period

BalanceSheet(Begin)

BalanceSheet(Begin)

BalanceSheet(End)

BalanceSheet(End)

Income Statement

Income Statement

Net Income

Statement of Cash Flows

Increase or Decrease in cash

Assets

Liabilities

Owner’s Equity

Assets

Liabilities

Owner’s Equity


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Recognition and Measurement

■ Elements of Financial Statements– AcSB, an element should be included in the

accounts when✜ The item meets the definition of an element.

✜ The item has an appropriate basis of measurement, and areasonable estimate can be made of the amount.

✜ For assets and liabilities, it is probable that the economicbenefits will be received or given up.

■ Measurability is important.– If an item cannot be measured, it cannot be

recognized, even if it has a high probability of beingrealized.


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Balance SheetElements Transaction CharacteristicsAssets are economic resources controlled byan entity as a result of past transactions orevents from which future economic benefitsmay be obtained

To qualify as assets, the resources involvedmust1. Have future economic benefits;2. Be under the entity's current control and3. Result from past transactions

Liabilities are obligations of an entity arisingfrom past transactions or events, the settlementof which will result in the transfer or use ofassets, provision of services, or other yieldingof economic benefits in the future

To qualify as liabilities, obligations must:1. Require future transfer of assets or

economic benefits2. Be an unavoidable current obligation3. Result from past transactions

Owners equity/net assets is the ownershipinterest in the assets of an entity afterdeducting its liabilities. While equity in total isa residual, it includes specific categories ofitems - for example, types of share capital,other contributed capital, and retainedearnings.

The dollar amounts reported represent theresidual interest in the assets after deductingthe liabilities. In addition, the equity elementis used to report capital transactions

Elements Transaction CharacteristicsAssets are economic resources controlled byan entity as a result of past transactions orevents from which future economic benefitsmay be obtained

To qualify as assets, the resources involvedmust1. Have future economic benefits;2. Be under the entity's current control and3. Result from past transactions

Liabilities are obligations of an entity arisingfrom past transactions or events, the settlementof which will result in the transfer or use ofassets, provision of services, or other yieldingof economic benefits in the future

To qualify as liabilities, obligations must:1. Require future transfer of assets or

economic benefits2. Be an unavoidable current obligation3. Result from past transactions

Owners equity/net assets is the ownershipinterest in the assets of an entity afterdeducting its liabilities. While equity in total isa residual, it includes specific categories ofitems - for example, types of share capital,other contributed capital, and retainedearnings.

The dollar amounts reported represent theresidual interest in the assets after deductingthe liabilities. In addition, the equity elementis used to report capital transactions

Source: CICA Handbook , “FinancialStatement Concepts”, Section 1000.


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Example: suppose that a company signs athree-year contract to hire a specialconsultant; the contract is non-cancelable.

■ Should the company recognize a liability?

■ The conditions for recognition do seem to be satisfied:✈ the contract will require a cash outflow over the next three years;

✈ there is a present obligation that is unavoidable; and

✈ the transaction has already occurred.

■ However, such a contract is not recognized in businessaccounting because the consultant has not yet rendered theservices for which she was hired.

■ A commitment, even if irrevocable, does not normally result inrecognition of a liability or asset.

■ Therefore, the commitment would be viewed as an executorycontract − a contract wherein neither party has yet fulfilled therequirements of the contract − and would not be recognized.


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Recognition, Realization, and Accrual

■ Recognition is the process of measuring andincluding an item in the financial statements.

– The item is given a titleand a numerical value.

– Recognition applies toall financial statement elements inall accounting entities.

■ Disclosure– (in the notes to the financial statements) is

not recognition; when a financial statementelement is recognized, it is reported on the

face of the financial statements.


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■ Realization– is the process of converting an assetasset,

liability, or commitment into a cash flowcash flow.

– A receivable is said to be realized whenit is collected;

– Revenues are realized when received;

– Expenses and liabilities are realizedwhen the cash payment occurs.

■ Once realization has occurred, recognitionmust occur because there has been a cashflow impact that cannot be ignored in the accounts.


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■ When we recognize the effects of transactions and eventsprior to their realization, we are using the accrualconcept.

– we recognize assetsassets when we have theright to receive their benefits, and

– we recognize liabilitiesliabilities when we takeon the obligation to deliver cash (orother assets) or services in the future.

■ Accrual does not refer to the subsequenttransfer of amounts from the balancesheet to the income statement, whichis a secondary form of recognition


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Measurement Conventions

■ Measurement is the process of determining the amount atwhich an item is recognized in the financial statements.

■ Measurement methods encompass not only the process ofattaching a number to a construct but also the process ofincome measurement

■ The process of income measurement involves not only theinitial measurement, but also the disposition of thatmeasurement as it moves through the financial statements.– Historical Cost Convention

– Revenue Recognition Convention

– Matching Convention

– Full Disclosure


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Historical Cost Convention

■ The historical cost convention specifies that theactual acquisition cost be used for initial accountingrecognition purposes.

■ The cost principle assumes that assets are acquiredin business transactions conducted at arm's length

■ If an asset is acquired via some means other thancash, the cost of the asset is based on the value of theconsideration given.

■ Consideration is whatever the buyer gives the seller.

■ The cost principle provides guidance primarily at theinitial acquisition date


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Revenue Recognition Convention

■ The revenue recognition convention requires therecognition and reporting of revenues when all three ofthe recognition criteria − definition, measurability andprobability – are met

■ Traditionally, four conditions have to be met to satisfythe revenue recognition convention:

✜ All significant acts required of the seller have beenperformed.

✜ Consideration is measurable.

✜ Collection is reasonably assured.

✜ The risks and rewards of ownership have passed to thebuyer.


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Matching Convention

■ Matching - all expenses incurred in earning revenue shouldbe recognized in the same period that the revenue isrecognized. For example:• If revenue is carried over (deferred) for recognition in a future

period, any related expenses should also be carried over ordeferred, since they are incurred in earning that revenue.

• If revenue is recognized in the current period but there areexpenditures yet to be incurred in future periods, the expensesare recognized and a liability is created (e.g., the estimatedprovision for warranty costs).

• If costs are incurred to enhance the general revenue-generatingability of the company in future periods and the future benefitsare measurable, the costs are capitalized and amortized.


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Full Disclosure

■ Full disclosure means that the financial statementsshould report all relevantrelevant information bearing on theeconomic affairs of a business enterprise.

■ A useful guide to deciding what to disclose is as follows:– Disclose items not in the regular or

normal activities of the business.

– Disclose items reflecting changesin expectations.

– Disclose that which a statute orcontract requires to be disclosed.

– Disclose new activities or majorchanges in old ones.


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Making Choices In Accounting: TheExercise Of Professional Judgement

■ Professional judgement permeates the work of aprofessional accountant, and it involves an ability to buildaccounting measurements that take into account:

• the objectivesobjectives of financial reporting in each particular situation,

• the factsfacts of the business environment and operations, and

• the organization’s reporting constraintsconstraints (if any).

■■ Choices ofChoices of accounting accounting policiespolicies, accounting accounting estimatesestimates, andaccounting accounting measurement methodsmeasurement methods are then based on testsof the validity of the underlying assumptions, followed byan evaluation of the various possible measurementmethods with reference to the qualitative characteristics.


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SUMMARY OF KEY POINTS

" Accounting “principles” consist of three different set of concepts: (1)underlying assumptions, (2) measurement methods, and (3) qualitativecriteria.

# Underlying assumptions include the basic postulates which makeaccounting measurements possible (such as the separate entity assumption,the unit of measure concept, and the time period assumption), but they alsoinclude underlying measurement assumptions that usually, but not always,are true in a given reporting situation. These measurement assumptionsinclude the going concern assumption, the proprietary assumption, and thenominal dollar capital maintenance concept.

$ Qualitative criteria are the criteria which are used in conjunction with anenterprise’s financial reporting objectives to determine the most appropriate

measurement methods to use in that particular reporting situation.


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■ The most important qualitative criterion is that of relevance; relevanceshould be determined with reference to the users of the financialstatements and the resultant financial reporting objectives.

■ Some qualitative criteria conflict with each other. For example, themost relevant measurement in a particular situation may not besufficiently objective to permit its use.

■ Objectivity is a general concept that has several components, includingmeasurability, verifiability, freedom from bias, and reliability.

■ The role of conservatism in accounting is to ensure that theuncertainties and risks inherent in measuring the effects of any givenbusiness situation are given adequate consideration. Conservatismshould not be used as a justification for overstating liabilities orunderstating assets.


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■ Measurement methods are the various ways that the results of transactionsand events can be reported in the financial statements. There is a group ofwidely-used measurement methods that can be called measurementconventions, but they are not universally applicable. Measurementconventions include historical cost, the revenue recognition convention,matching, and full disclosure.

■ The elements of financial statements are the seven types of accounts thatappear on the balance sheet and income statement: assets, liabilities,owners’ equity, revenues, expenses, gains, and losses.

■ Initial accounting recognition occurs when the effects or results of atransaction or event are first measured and assigned to an account orelement. Subsequent recognition occurs when an amount previouslyrecognized is transferred from one element to another, such as byrecognizing an expense that previously had been recognized as an asset.


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■ Recognition of an asset or liability requires that threetime references be present: a future benefit or sacrificeand a present right or obligation, arising from a pasttransaction or event.

■ Realization occurs when a cash flow occurs. Realizationoften occurs after recognition, but can never occur prior torecognition because the cash flow forces recognition if ithas not occurred previously.

■ The accrual concept relates to the recognition ofreceivables when the right to receive cash arises,and to the recognition of liabilities when the obligation is created. Accrual does not refer to subsequentsecondary recognition through interperiod allocations.


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■ Accounting is full of choices. This series of related decisions is what

constitutes professional judgement in accounting. The choice processincludes these elements:

– (1) financial statements are constructed from(2) the financial statement elements that havebeen recognized (3) using measurement methodsthat (4) optimize the qualitative characteristics andthat (5) are based on the appropriate underlyingassumptions which reflect the organization’s(6) reporting constraints and (7) the facts of itsbusiness and environment, and that provideinformation that (8) best satisfies the objectivesof financial reporting in any given situation.

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Intermediate Accounting - McGraw-Hill Education … concepts and principles that guide accounting choices. ... • Underlying assumptions (or postulates) are the basic foundation