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The Framework of Financial Reporting

What You Really Need to Know

CHAPTER 1: THE ENVIRONMENT OF FINANCIAL REPORTING

This chapter provides a solid framework for understanding the accounting issues you will encounter
throughout the textbook. Chapter 2 expands on this framework through the discussion of additional
criteria used to make accounting choices and professional judgment.

ACCOUNTING STANDARDS IN CANADA (LO1)

The accounting standard-setting body in Canada is the Accounting Standards Board (AcSB). The AcSB
is part of the Canadian Institute of Chartered Accountants (CICA). The authority of the CICA comes
from the corporations acts of the federal and provincial governments. Each corporations act, including
the federal Canadian Business Corporations Act (CBCA), requires auditors to report in accordance with
GAAP, and GAAP is defined in the regulations as being in compliance with CICA requirements. The
AcSB had, for many decades, maintained Canadian standards by regular revisions and additions to the
CICA Handbook.

One by one, other major countries decided to discontinue their own national GAAP and simply adopt
IFRS for public reporting. With the rapid acceptance of IFRS around the world, the AcSB has decided to
follow a two-prong approach for Canadian enterprises:
1. Public companies and other publicly-accountable enterprises must use IFRS (as outlined in
CICA Handbook, Part I) for financial reporting for all reporting periods beginning on or after 1
January 2011.
2. Private non-publicly-accountable enterprises have a choice between two options:
a. full IFRS, just as for public companies; or
b. Canadian accounting standards for private companies (ASPE), as prescribed in the
CICA Handbook, Part II.

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Accounting Standards for Publicly-Accountable Enterprises


A publicly accountable enterprise (PAE) is:
 any company that has securities (either debt or equity, or both) issued to the public or that is in
the process of issuing debt or equity to the public.
 a for profit private enterprise that holds assets in a fiduciary capacity for a board group of
outsides as one of its primary businesses. A fiduciary enterprise is any organization that acts
in a trusteeship capacity for members of the general public, for example: credit unions, mutual
funds, investment funds, pension funds, savings institutions and other deposit-taking
organizations.
 A governmental business enterprise for example: VIA Rail, Canada Post.

Choice of GAAP: Normally, PAE’s in Canada will follow IFRS. However, in cases, where a company’s
shares are heavily traded in the US, a Canadian company may choose to follow US GAAP. The use of
US GAAP is accepted by the Canadian securities commissions. Similarly, the SEC also accepts
financial statements reported under IFRS, without the requirement to reconcile to US GAAP.
As IFRS is the normal reporting requirement for many other international securities exchanges, there is
no conflict for Canadian companies between their reporting in Canada and in these other countries.

Regulatory requirements: For certain industries (e.g. banks, telephone or cable companies), IFRS
may be supplemented by legal or regulatory requirements.
Reporting currency: Under IFRS, a company is to report in its functional currency - which is the
currency that the company predominantly uses for its transactions. For most Canadian companies, this
will be the Canadian dollar. However, some Canadian companies may use the US dollar as its
functional currency since a high proportion of its transactions are conducted in this currency. In this
case, any non-US dollar transactions would be translated into US dollars. A company’s presentation
currency, is the currency used to report the financial statements. In most cases, the presentation and
functional currency will be the same. The presentation currency must be disclosed on the face of the
statements.

Accounting Standards for Private (non publicly-accountable) Enterprises

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The Framework of Financial Reporting

A private enterprise is one that does not issue debt or equity securities to the public nor is in the process of
doing so. Private companies provide information for a limited group of users, including managers,
shareholders, taxation authorities, and lenders and creditors who are presumed to have access to the
information that they need.

In Canada, private companies have three choices:


1. IFRS, the same as public companies;
2. Canadian accounting standards for private enterprises (ASPE), as prescribed in the CICA
Handbook Part II; and
3. Tailored accounting policies, known as a disclosed basis of accounting.

Each option available to a private company has its own advantage and disadvantage. The needs of the
users will determine the accounting framework that is appropriate.

A private company may decide to adopt IFRS for the following reasons:
 Allows for easier comparison with public companies, especially when competing for capital
globally. Private companies may raise capital with private placements which are negotiated
directly with the supplier of the capital such as pension funds, private equity investment
companies, investment funds and major banks. These private placements may be debt or
equity.
 The company is a subsidiary of a parent that reports on the basis of IFRS.
 The company may be considering issuing shares to the public in the foreseeable future and wishes
to establish a pattern of IFRS compliance in the financial statements that it must submit as part of the
company’s prospectus.
 The company’s controlling shareholders may intend to sell the company in the near future. Using
IFRS will enhance the financial statements’ credibility to prospective public-company acquirors.

ASPE may be adopted because


 ASPE is more simplified, founded less on fair values and more on historical cost, and with less onerous
disclosure requirements.

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 ASPE was similar to pre-changeover GAAP in Canada, and so there were few changes required on
adoption of ASPE. This allowed private companies to maintain the continuity of their cost-effective
financial reporting framework.

If external users do not require ASPE or IFRS to be used, then the private enterprise may decide on a
disclosed basis of accounting. As such, some private companies deviate from the standards in one or more
respects. The deviation is usually in order to make the statements more useful for specific users or to
coincide with the income tax treatment of specific items. For example, a company may prepare statements to
satisfy contractual requirements, such as compliance with the requirements of a major bank loan. Be
cautious! We are not suggesting that a company can toss out all of GAAP.

Comparability
The point of adopting IFRS is to improve comparability across different countries. Unfortunately,
comparisons are still not that simple. The financial reporting of any company is strongly affected by its
national environment. There are differences between countries regarding legal requirements, economic
environment, political environment, regulation, and ways of doing business. International comparisons of
financial statements are fraught with hazard because of these differences.

In the United States and Canada, the principal focus of general purpose statements is on residual
earnings for the shareholder. Other countries may place greater emphasis on other stakeholder groups
or have different cultural practices. Other differences may arise due to:
• Many countries base income tax on reported earnings; taxable income is equal to accounting
income. Income tax minimization therefore becomes a dominant financial reporting objective.

• Corporations in Sweden are expected to provide information about social responsibility and
environmental protection in their annual reports.

• German financial reporting places a strong emphasis on creditor protection. The tendency is to
understate earnings and to provide for income reserves that have no correspondence in IFRS or
Canadian ASPE.

• Many countries emphasize employee protection. Information on employee compensation and


benefits must be disclosed in considerable detail, in contrast to Canadian and U.S. practice where

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detailed information about employee compensation and benefits is rarely (if ever) in the financial
statements—usually only broad totals are provided.

• Companies that follow Muslim practice do not enter into lending relationships. Instead, banks and
other sources of financing enter into equity-based arrangements. Therefore, amounts that would be
reported as interest expense in Canada will be dividends in those companies.

 In Japan, since the “parent” holds only a small percentage of other companies in the group and
does not have control, consolidated statements of large Japanese conglomerates do not include
most of these related companies.

FINANCIAL ACCOUNTING REPORTING OBJECTIVES (LO2)

In preparing financial statements, decisions must be made with respect to:


1) accounting policies;
2) accounting estimates; and,
3) disclosure.

The purpose of financial statement is to communicate information to help users make decisions.
Decisions include those that have a direct economic impact and evaluative decisions.

Direct Economic Impact – to shareholder or Evaluative – may not have immediate


to entity, or both economic impact, but affect the users’
perceptions
• Reported earnings may be used as the • Lenders evaluate cash flow potential.
basis for bonuses. • Income tax authorities evaluate financial
• Accounting methods may increase or statements to see how compatible they are to
decrease tax liability. owners; reporting.
 Reported levels of accounts receivable • Employees evaluate an employer’s ability to
and inventories may affect the levels of pay higher compensation.
financing • Shareholders assess management’s ability
• Various reported numbers in the financial to conduct the affairs of the enterprise.

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statements may trigger a default on loan • Security analysts evaluate public


requirements, known as covenants. companies’ performance and issue
• In partnerships, cooperatives and mutual recommendations
insurance companies, the reported numbers to buy, hold, or sell shares.
affect the financial rewards of the partners, • Regulators evaluate rate-regulated entities
members and policyholders. to see if earnings are reasonable.

To establish each enterprise’s financial objectives, management must consider many aspects of the
company and the users of its financial statements. Exhibit 1-1 illustrates the forces that shape a
company’s financial reporting objectives:

General-purpose financial statements

Financial reporting for public companies is described as general purpose financial reporting.
It is “general purpose” because the potential interest group is large and diverse and is not limited to
stakeholders who are able to obtain information directly from the company.

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Because of the wide-ranging users and uses of publicly-issued financial statements, accounting
standard-setters phrase their objectives in a very broad fashion. The IASB states that the objective of
financial statements is to provide useful information that can be used by “existing potential investment,
lenders and other creditors” in their decisions”.

Control block: when control is given to a small group of shareholders. At times, a public corporation
may be controlled by a small number of shareholders who hold the majority of the voting shares (i.e. a
control block). When there is a control block, a company’s financial reporting is unlikely to be dominated
by a concern for the public shareholder. Instead, the reporting objectives of the controlling shareholder
may well take precedence over those of the public investor.

Restricted shares: when a class of shares has limited (or not) voting power. Restricted shares allow
companies to raise capital from the public without reducing the power of the controlling shareholders.

In practice, “general purpose” is too general to be an effective guide for a specific enterprise.
Accountants and managers must identify the appropriate reporting objectives for their own enterprise.
Identifying an entity’s specific reporting objectives is the first step for establishing the criteria by which
accounting policies are chosen and accounting estimates are made.

“Users” can be grouped into two categories—(1) external users and (2) preparers:
• External users include all non-management users of the financial statements, such as investors,
creditors, and employees.
• Preparers consist of the managers who make and carry out decisions in the three areas of accounting
policy, estimates, and disclosure, as well as the accountants who participate in those decisions and
incorporate them into the accounts.

Ethical Responsibility - Accountants are part of the preparer group because accountants carry out the
accounting and reporting decisions of management. A professional accountant, whether internal or

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external (i.e., an auditor) must be prepared to resist management’s pressure to deliberately misstate
financial results.

EXTERNAL USER OBJECTIVE (LO3)

The five most common financial reporting objectives are (This list is by no means comprehensive
because entity-specific objectives often arise.):

Reporting Objective Financial Statement Impact


1. Cash flow assessment A company that selects this as its primary objective
Assessing and predicting cash flow will (1) reduce its interperiod allocations as far as is
from GAAP financial statements permitted by GAAP (i.e. expense development costs
involves taking the current cash flow and increase the threshold for capitalizing costs; and
and extrapolating it into the future. (2) provide full disclosure of cash flow commitments
This is a key objective for creditors in the notes.
(and bankers), who typically want to
determine whether a company will When cash flow assessment and prediction is the
have enough cash to pay its debts primary objective, policies are chosen that provide
(and the interest and principal on its the clearest indication of the cash flows underlying
loans). Users place emphasis on reported earnings.
cash flow from operating activities to
assess the entity’s ability to generate
cash; as well as other sources of
external financing.
Assessment (current cash flows) vs.
Predictions (future cash flows)
Affected by accrual accounting and
interperiod allocations.
Earnings quality – correlation
between EPS and cash flow per

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share.

2. Income tax deferral A company that selects this as its primary objective
Income tax minimization (through will attempt to delay the recognition of revenue and
legitimate options) is a common speed up the recognition of expenses.
objective of private companies. As such, the reported earnings for the company will
Financial reporting vs. income tax look poorer, but the cash flow will look better.
reporting. Additionally, it may lower management
The general aim of the Income Tax compensation for managers whose bonus is tied to
Act is to collect tax revenue. Taxation net income.
principles tend to emphasize cash
flows because those flows normally As such, this objective is more likely to be
can be measured quite clearly – emphasized by private corporations and to a lesser
generally steer clear of interperiod extent by public corporations with strong control
allocations and subjective estimates. blocks (who focus on the perceptions of external
stakeholders about the company’s earnings ability).

3. Contract compliance. A company may select accounting policies with the


With some companies there may be objective of contract compliance or enhancement.
external users that have stipulated To minimize manipulation, debt agreements may
maintenance tests or covenants specify the accounting policies to be followed when
(e.g., a maximum debt-to-equity the covenant is calculated.
ratio; maximum percentage of
dividend payout; minimum times-
interest-earned ratio; and minimum
level of shareholders’ equity). Also,
shareholders’ agreements may
include provisions that affect the
value of the shares in the event that
a shareholder decides to buy or sell

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its shares

4.Stewardship Full disclosure and transparent reporting


Steward – person who is responsible Financial reporting should not be complicated by a
for managing on behalf of someone large number of allocations that obscure the
else Stewardship reporting, therefore, operating results for the year. Minimize interperiod
focuses on showing the financial allocations and have full disclosure.
statement reader just how the
resources entrusted to management’s
care were managed.

5. Performance evaluation Statements should reflect the basis on which


External and internal users may use management decisions were made. This objective
the financial statements to evaluate may conflict with the objective of assessing and
management performance. predicting cash flows. Managers have strong
motivations to select accounting policies that will
show improved performance. See further below

Role of the Auditor


The auditor is not a user of the financial statements. They are an independent from the company and
they provide an opinion on the financial statements if they are “fair” and if they conform to GAAP.

PREPARER MOTIVATIONS FOR FINANCIAL REPORTING (LO4)

When selecting accounting policies within the constraints of GAAP, accountants must first evaluate the
facts. Only when GAAP allows a choice based on the facts can policies be chosen that meet users' or

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management's objectives. Accounting policies cannot be selected strictly on the basis of what is best for
users and/or managers-the facts must first allow a choice.

Users' objectives and management objectives often are in conflict. Accountants must use professional
judgment when determining which accounting policies are fair and appropriate. Conflicting objectives
must be prioritized.

The most common management motivations are:

Earnings Management
Reasons for income Smoothing include:
 Managers often like to show a smooth record of earnings, free of peaks and valleys.
Fluctuating earnings may signify risk to investors or creditors. Strong motivation to
show a smooth upward trend in earnings, year after year.
 Methods include: spreading revenues/costs over several periods; edging estimated
up or down.

Reasons for maximizing income include the following:


 to comply with debt covenants;
 to positively influence user’s judgements on performance evaluations;
 increase compensation to management;
There is no evidence to indicate that shareholders are able to see through complex
earnings maximizations over the long run.

Reasons for income minimization:


 Income minimization may be motivated by the desire to minimize income taxes.
 Companies may maximize a loss in one year in order to minimize future losses. This
is referred to as taking a “big bath”.
 Other possible reasons are to avoid public embarrassment by reporting 'excessive'
earnings, discourage competition, hostile takeover bids, the scrutiny of regulators,

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and/or large wage claims.

Minimum compliance

Desire of managers to provide as little information as necessary while adhering to the


guidelines set out in the CICA Handbook. This ensures confidentiality is maintained about
the business in order to keep competitors in the dark.

Doing so reduces accounting and auditing costs. It may result in a cost in terms of
reduced share prices. Minimum compliance may be appropriate in private companies
where users can obtain additional information as required.

Expanded disclosure

Refers to those times when management voluntarily discloses additional information.

This is the opposite of minimum disclosure.

Disclosure may be expanded for the sake of "good citizenship"; to comply with foreign
accounting standards; or to attract capital investment.
Examples of additional disclosure are: value of current contracts for a service company;
order backlog for a manufacturer; environmental protection initiatives.

Conflicting Objectives: Once a company’s objectives have been identified, they then must be
prioritized: Which one is the most important, which one is second most important, and so forth. Only
then can accounting choices of policy, estimates, and disclosures be made.

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In the real world, accounting requires constant exercise of judgement. Despite the apparent “precision”
of the numbers in financial statements, accounting reports are always approximations of the underlying
economic phenomena.

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