Accounting Principles: Part I – Accounting and Audit

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Accounting is the language of the world of finance and taxation.
As with all languages, there are certain rules and conventions that
we follow to make the language universally understandable and
acceptable. We refer to these rules as concepts and principles,
which also provide the foundation for calculations of taxable
income under the Income Tax Act
(“Act”). In this Part, we commence with general
principles. In subsequent Parts, we will examine specific tax rules
of accounting.

When accounting rules become generally accepted by business and
the appropriate authorities, we refer to them an “generally
accepted accounting principles” (GAAPs), which are essentially
the rules within which accountants are supposed to operate. GAAPs
comprise assumptions, principles, standards, rules and conventions
for preparing and presenting financial statements. However, as with
all languages, there can be misinterpretations and distortions,
whether accidental or deliberate. Hence, finance is littered with
accounting scandals.

Professionals rely upon accountants to explain the technical
details of particular principles. For example, in a lawsuit
involving the appropriate accounting treatment of inventory
valuation, lawyers can rely on professional opinions on the
appropriate principles to apply. However, although lawyers do not
require technical expertise, they should be sufficiently familiar
with GAAP and IFRS in drafting domestic and international
contracts.

Sources of GAAPs?

In Canada, the Chartered Professional Accountants of Canada
(CPA Canada), which publishes the CPA Handbook on
accounting, is the leading source of Canadian GAAPs. The Canada
Business Corporations Act
and regulatory statutes recognize
the Handbook as the benchmark of accounting principles for
financial reporting.

Section 1100 of the Handbook describes what constitutes
generally accepted accounting principles (GAAP):

“Generally accepted accounting principles
(GAAP) encompass broad principles and conventions
of general application as well as rules and procedures that
determine accepted accounting practices at a particular time”
[Paragraph 1100.02(b)]

The International Accounting Standards Board (IASB) has other
GAAPs. Canada has adopted international GAAPs as articulated by the
IASB and known as IFRS.

Part I of the Handbook contains the international
financial reporting standards (IFRS) for public enterprises. Since
1 January 2011, public companies must also report using
International Financial Reporting Standards.

A public enterprise is an entity, other than a not-for-profit
organization, that has issued, or is in the process of issuing,
debt or equity instruments that are, or will be, outstanding and
traded in a public market.

Part II discusses accounting standards for private enterprises
(ASPE). Private enterprises have a choice between applying ASPE in
Part II or IFRS in Part I.

Both GAAPs and IFRS refer to broad principles and conventions
that apply generally in accounting. They also refer to specific
rules to determine accounting practices at particular times.
However, GAAPs are not universal and identical. The United States
has its own set of GAAPs.

Canadian GAAPs refer to both IFRS and ASPE. When the
Handbook does not cover a matter, accountants refer to
other sources of information, such as, for example, International
Accounting Standards, Financial Accounting Standards Board (FASB)
pronouncements in the U.S., or academic accounting literature.
Unfortunately, these sources do not always agree on what
constitutes GAAP. The Handbook addresses potential
differences by saying, “the relative importance of these
various sources is a matter of professional judgment in the
circumstances.”

Accounting bodies develop GAAPs by exercising professional
judgment and analyzing the advantages and disadvantages of
alternative methods of accounting and reporting. Since accounting
cannot produce precise answers to every question, GAAPs provide
rules and guidelines that are generally acceptable. Hence, GAAPs
may offer choices between allowable alternatives or may be entirely
silent on the particular point. However, the basic standard of ASPE
is mandatory:

An entity shall apply every primary
source of GAAP that deals with the accounting and reporting in
financial statements of transactions or events encountered by the
entity.” [Paragraph 1100.03 Handbook]

Legal contracts often refer to GAAPs in the preparation of
financial statements. For example, contracts that contain negative
covenants relating to financial status or ratios, such as working
capital or debt/equity ratios, frequently state that the relevant
financial statements must be prepared in accordance with GAAP. In
these circumstances, it is best to specify which GAAP (Canadian,
American, or International) should apply to the particular
contract.

The Audit Opinion

The auditor’s report will refer specifically in its audit
opinion to GAAPs. See, for example, the auditor’s report for
Duggan Inc.”

“In our opinion, the financial statements present fairly,
in all material respects, the financial position of Duggan Inc. as
at September 30, 20-2 and 20-1, and its financial performance and
its cash flows for the years ended September 20-2 and 20-1 in
accordance with Canadian generally accepted accounting principles
and International Financial Reporting Standards.”

Hierarchy of GAAP Sources

There are various sources for GAAP. At the top of the hierarchy,
however, are the official statements from organizations that the
accounting profession designates as the official body to determine
appropriate accounting treatment for financial transactions. In
Canada, CPA Canada is the official source of GAAP, which are
discussed in its Handbook.

Regulatory Agencies

Canada

Regulatory agencies, such as Securities Commissions, require
financial statements in compliance with GAAPs to be filed and
distributed annually. See, for example, Section 78(1) of the
Ontario Securities Act

Every reporting issuer that is not a
mutual fund and every mutual fund in Ontario shall file annually
within 140 days from the end of its last financial year comparative
financial statements relating separately to,

(a) the period that commenced on the date of incorporation or
organization and ended as of the close of the first financial year
or, if the reporting issuer or mutual fund has completed a
financial year, the last financial year, as the case may be;
and

(b) the period covered by the financial year next preceding the
last financial year, if any,

made up and certified as required by the regulations and in
accordance with generally accepted accounting principles. [R.S.O.
1990, c. S.5, s. 78 (1)]

United States

In the United States, the official body for determining the
appropriate accounting treatment of transactions is the Financial
Accounting Standards Board (FASB), an independent body created to
establish and improve standards for financial accounting and
reporting. It is made up of a cross-section of accountants,
academics, and users of financial statements. In order to enhance
the independence of the board, the seven members of FASB cannot
hold private employment during their tenure of service on the
board.

In the United States, the Securities and Exchange Commission
(SEC) regulates the sale of securities and securities markets.
Therefore, publicly listed companies must file regular financial
statements according to specified criteria with the SEC.

The SEC does not routinely develop accounting principles and,
generally, leaves the development of such principles to the
independent accounting bodies, such as FASB. Nevertheless, the SEC
will, on some occasions, promulgate accounting principles if it is
of the opinion that the accounting profession or bodies are not
acting fast enough on their own.

Role of Management in Selecting GAAPs

Management has a key role in determining the nature, format, and
underlying principles of its financial statements. Indeed, the
Representation Letter that corporate management must submit to its
auditors will usually state in the first paragraph:

We are responsible for the fair presentation in the financial
statements of financial position, results of operations and changes
in financial position in conformity with generally accepted
accounting principles.

To discharge its responsibility, management must select
accounting principles; determine asset life; and decide reporting
policy if there is no existing principle.

The interaction between management and the corporation’s
auditors is delicate and, sometimes, tense. Accounting firms are
first and foremost businesses that value client retention. They
realize, however, that corporations can “opinion shop” if
the audit firm is being difficult in respect of particular items on
the financial statements.

Thus, at the very least, a lawyer who uses financial statements
should have a general understanding of GAAPs and IFRS that the
audit opinion addresses. The Notes to the financial statements will
set out the corporation’s selection of GAAPs and IFRS and their
impact on the financial statements.

Are GAAPs Good for You?

GAAPs and IFRS are rules of content that deal with compiling and
disclosing information in the financial statements. The first item
in the Notes to the financial statements will describe the
principles that the particular enterprise applies in the
preparation of its financial statements. GAAPs and IFRS provide
considered and properly researched principles that accountants can
adhere to and readers can use with reasonable confidence in
understanding financial statements. They also make financial
statements more comparable if the underlying GAAPs are the same for
all statements.

There are, however, some limiting aspects of GAAPs. We have
seen, for example, that conservatism is one of the basic underlying
concepts of accounting, which generally tends to understate income
and understate assets. Although this may be a desirable aspect of
stewardship and fiduciary accounting, conservatism can lead to
lowered valuations, which can mislead investors.

Given the variety of GAAPs that one may apply to measure or
report upon the same situation, we can have many net income
figures, each of which is equally valid and according to GAAPs.
This is an important consideration in drafting legal agreements. In
a sense, consistent application is just as important as the
particular GAAP that one applies in a contract. Thus, in many
situations, cash flow is a much more reliable figure because it
eliminates the need to select between alternative accounting
principles. Ultimately, cash is king!

Accounting Standards

The two key accounting standards–setting bodies in the
world are the International Accounting Standards Board (IASB) and
the Financial Accounting Standards Board (FASB) of the United
States. The two bodies do not have identical standards. Indeed,
they differ quite significantly in some areas such as “fair
value” accounting.

Broadly speaking, fair value accounting standards value a
firm’s assets and liabilities based upon market value rather
than historical cost. The difference is particularly important in
the valuation of financial instruments, property, plant, and
equipment on the balance sheet.

Canada adopted International Financial Reporting Standards
(IFRS) for public companies in 2011 even though our economy is more
closely linked to the United States, which primarily uses FASB
pronouncements.

Framework of IFRS

IFRS refers to the body of authoritative literature of the
International Accounting Standards Board (IASB) designed
principally for use by profit-oriented entities. The IFRS
Foundation oversees the IASB. The IASB developed a Conceptual
Framework
for the development of IFRS and for guidance to
accountants in preparing public enterprise financial
statements.

The objective of the IASB is to narrow the differences among
accounting standards, procedures, and regulations that apply in the
preparation of financial statements in different countries.
Harmonization facilitates economic decision making and
international comparisons of companies. Reporting entities must
comply with all of the standards and interpretations (including
disclosure requirements) and make a positive statement of explicit
and unreserved compliance in the audit opinion.

The framework recognizes that the overall objective of
general-purpose financial reporting is to provide financial
information about the reporting entity that is useful to existing
and potential investors, lenders and other creditors in making
decisions about providing resources to the entity. General purpose
financial reports are not designed to show the value of a reporting
entity. However, they provide useful information to help existing
and potential investors, lenders, financial analysts, and other
creditors to estimate the value of the reporting entity.

Financial statements prepared according to IFRS will
involve:

Accounting policy choices;

Professional judgment in making estimates;

Fair value measures in the financial statements; and

Disclosures in the Notes.

The overall objective of IFRS is fair presentation in the
financial statements. In this aspect, there is no underlying
difference in principle between IFRS and Canadian GAAPs. However,
absent specific prohibition, IFRS admits deviation and provides for
a “true and fair” override if complying with IFRS would
produce misleading information. In contrast, there is no such
concept of a true and fair view override in Canadian GAAPs.

Financial reports are based on estimates, judgments, and models
rather than exact depictions. The Conceptual Framework of IFRS
establishes the concepts that underline those estimates, judgments,
and models. The fundamental qualitative characteristics of useful
financial information are relevance and faithful
representation.

Financial statements, per se, are not predictions or
forecasts. However, relevant and faithful representation of
material financial information are the foundation for making
predictions and forecasts by investors, management, and financial
analysts. Thus, accounting is a stepping stone to financial
valuation.

Faithful representation does not imply perfect accuracy in all
respects, but the information should be relevant and faithfully
represented. Financial information in reports should be material.
Materiality means that omission or misstatement of the information
could influence decisions that users make based on the information
about a specific reporting entity.

Materiality is an entity-specific aspect of relevance based on
the nature or magnitude, or both, of the items to which the
information relates in the context of its financial report. The
IASB does not specify a uniform quantitative threshold for
materiality. Whether an item is material or not is a matter of
professional judgment in the circumstances of the entity’s
financial information.

Both IFRS and Canadian GAAPs rely on a conceptual framework of
accounting standards, which preparers of financial statements can
refer to in the absence of specific guidance. IFRS states that it
does not apply to items that are “immaterial.” Although
Canadian GAAP does not contain a similar explicit statement, that,
in practice, is how accountants apply GAAP.

Who Is Affected by IFRS?

The underlining objective of the IFRSs is to produce global
accounting standards that are transparent and provide comparable
information on financial statements. By having a single set of
global standards, public corporations can eliminate multiple GAAP
reconciliations between countries.

Both IFRS and Canadian GAAPs are comprehensive sets of
principles-based standards that have a similar form and structure
and share similar basic concepts of income recognition and
measurement principles. However, IFRS requires more professional
judgment and a greater volume of disclosures.

Canadian GAAPs are simpler to apply and, therefore, less costly.
They also have fewer disclosure requirements than IFRS. However,
Canada adopted IFRS for “publicly accountable
enterprises” (PAE), which include “profit-oriented”
enterprises with publicly issued securities and enterprises that
hold assets in a fiduciary capacity for a broad group of outsiders.
PAE also includes government business enterprises, such as the
Ontario Securities Commission.

Not-for-profits are not required to adopt IFRS.

Part I of the Handbook deals with IFRS. Entities that
prepare their financial statements in accordance with the part must
state in their audit opinion that they have been prepared in
accordance with IFRS. Such entities may also state that its
financial statements are in accordance with Canadian GAAPs.

IFRS and Canadian GAAPs require that management account for
financial transactions based upon their substance, rather than
their legal form. Thus, accountants should recognize transactions
with shareholders in their capacity as shareholders directly in the
equity portion of the financial statements rather than through the
income statement.

However, there are differences between IFRS and Canadian GAAP.
Generally, there are fewer bright lines and rules in IFRS. Hence,
there are more accounting policy choices and fewer interpretative
matters. In particular, there are substantial differences in
valuation and disclosure of impaired assets and
securitizations.

IFRS and US GAAP

In Canada, IFRS affects large multinational public companies and
small private corporations differently. The big four Canadian
accounting firms and their multinational corporate clients like
IFRS because it simplifies transnational accounting and makes it
easier for them to raise corporate capital in international
markets. On the other hand, IFRS is more complex and expensive to
administer and, therefore, not particularly attractive to smaller
companies that operate only in Canada.

The United States Securities and Exchange Commission continues
to study the implications for US companies. It appears, however,
that the United States will not adopt a full-blown changeover to
IFRS because of the cost and burden of any such change. Instead,
the United States may, like Canada, adopt a compromised
“endorsement” model that would gradually incorporate IFRS
into the US system of rules, while maintaining the United
States’ authority to modify or reject any international rules
if it saw fit.

Fair Value Measurement

Most items are disclosed in the financial statements based on
their historical costs. In some circumstances (such as,
inventories), historical cost may be reduced to reflect a loss if
fair market value is less than cost ([International Accounting
Standard (IAS) 2]. In other cases, such as property, plant, and
equipment, an entity may reduce or increase amounts to reflect
their fair value (IAS 16).

IFRS 13 defines fair value and has a framework for measuring and
disclosing it in the financials.

Fair value is the price that an entity would receive if it sold
an asset or paid to transfer a liability in an orderly transaction
between market participants as at the measurement date. Thus, fair
value is a market-based measurement, not an entity-specific
measurement. When measuring fair value, an entity uses the
assumptions that market participants would use to price the asset
or liability under current market conditions. As such, the
entity’s intention to hold the asset is not relevant when
measuring fair value. The measure is what the buyer will pay for
the benefit that it expects to generate from the use (or sale) of
the assets, regardless of the entity’s actual intentions.

An entity measuring fair value must determine:

  • The particular asset or liability that is to be measured;
  • For a non-financial asset, the highest and best use of the
    asset and whether it will be used in combination with other assets
    or on a stand-alone basis;
  • The market in which the orderly transaction would take place
    for the asset or liability; and
  • The appropriate valuation technique to use.

To increase consistency and comparability in the fair value
measurements, IFRS 13 establishes a fair value hierarchy that
categorizes the inputs used in valuation techniques.

  • Level 1 inputs are quoted prices in active markets for
    identical assets or liabilities that the entity can access at the
    mea­surement date.
  • Level 2 inputs are inputs (other than quoted prices included
    within Level 1) that are observable for the asset or liability,
    either directly or indirectly.
  • Level 3 inputs are non-observable inputs for the asset or
    liability. Such inputs must reflect the assumption that market
    participants will use when pricing the asset or liability,
    including assumptions about risk.

In order to measure fair value, management must identify the
characteristics of an asset or liability that market participants
will take into account when pricing that asset or liability. They
must also determine whether a principal market for an asset or
liability exists and whether the entity has access to that market.
In the absence of a principal market, it will be necessary to
identify the most advantageous market for the asset or liability,
which is likely to be that which maximizes the amount that would be
received to sell the asset or minimize the amount that would be
paid to transfer the liability.

For non-financial assets, management must determine the highest
and best use of the asset from the perspective of market
participants. This is so even if the entity intends to use the
asset for a different purpose. Management must exercise judgment in
determining the appropriate valuation technique to measure fair
value.

The rationale of the input disclosures is to provide users with
information so they may assess the valuation techniques and inputs
used to develop fair value measurements, their effect on profit or
loss or on other comprehensive income for the period.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.


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