2.8 Chapter Summary

LO 1: Identify the purpose of financial reporting.

The purpose of financial reporting is to provide information that is useful for making decisions about providing resources to the business. The primary user groups are identified as present and potential investors, lenders, and other creditors, although other users will also find financial information useful for their purposes.

LO 2: Describe the problem of information asymmetry, and discuss how this problem can affect the production of financial information.

Information asymmetry simply means there is an imbalance of information between two parties in a business transaction. This imbalance can create problems in two forms: adverse selection and moral hazard. Adverse selection means that one party may try to gain a benefit over the other party by exploiting the information advantage. An example of this behaviour is insider trading. If insider trading is perceived by the market as being a pervasive problem, investors may lose confidence in the market, and security prices will drop. The accounting profession can alleviate this problem by increasing the amount of relevant and reliable information disclosed to the market, thus reducing the information advantage of insiders. Moral hazard occurs when managers shirk their duties because they know their efforts cannot be directly observed. In order to cover up shirking, managers may bias the presentation of financial results. The accounting profession can help alleviate this problem by ensuring financial-reporting standards create disclosures that are useful in evaluating management performance and are not easily manipulated by management.

LO 3: Describe how accounting standards are set in Canada, and identify the key entities that are responsible for setting standards.

Currently, accounting standards are set by the Accounting Standards Board (AcSB). This board applies two sets of standards: International Financial Reporting Standards (IFRS) and Accounting Standards for Private Enterprise (ASPE). IFRS are required for all publicly accountable entities, while private entities have the choice to use ASPE or IFRS. IFRS are developed by the International Accounting Standards Board (IASB) and then adopted by the AcSB. However, the AcSB can remove or alter certain sections of IFRS if it is believed that the accounting treatment does not reflect Canadian practice.

LO 4: Discuss the purpose of the conceptual framework, and identify the key components of the framework.

The conceptual framework provides a solid, theoretical foundation for standard setters when they have to develop new standards to respond to changes in the business environment. It also gives practicing accountants a basis and reference point to use when encountering new or unique business transactions. The key components of the framework describe the purpose of financial reporting, identify the qualitative characteristics of good accounting information and the elements of financial statements, and discuss the criteria for recognizing an item in financial statements, different possible measurement bases, and the framework’s approach to capital maintenance.

LO 5: Describe the qualitative characteristics of accounting information.

The fundamental characteristics of accounting information are relevance (which is com- posed of both predictive and confirmatory characteristics) and faithful representation (which is composed of freedom from error, neutrality, and completeness). Relevance will also be affected by the concepts of materiality and the nature of the item. Enhancing qualitative characteristics are understandability, comparability, verifiability, and timeliness. Trying to meet the requirements of all the characteristics can sometimes result in trade-offs, and this must always be evaluated in the context of costs compared with potential benefits.

LO 6: Identify the elements of financial statements.

The elements of financial statements are assets, liabilities, equity, income, and expenses. The definition of each element contains references to the relationships between events and their time of occurrence, and each definition broadly describes the nature of the element. An underlying assumption in the preparation of financial statements is that the entity will continue as a going concern.

LO 7: Discuss the criteria required for recognizing an element in financial statements.

An element will be recognized in financial statements when it meets the definition of that element and can be measured reliably, and when it is probable that the future economic benefits attached to the element will flow to or from the entity.

LO 8: Identify different measurement bases that could be used, and discuss the strengths and weaknesses of each base.

The conceptual framework identifies four possible measurement bases: historical cost, current cost, realizable value, and present value. Historical cost forms the basis of much of current accounting practice, but other bases are used in circumstances where it is deemed appropriate. Each measurement base has certain advantages and disadvantages, and the choice of measurement base will often result in a trade-off in decision usefulness.

LO 9: Identify the alternative models of capital maintenance that could be applied.

The conceptual framework identifies three possible capital-maintenance models: monetary interpretation, constant purchasing power, and physical capital maintenance. Each model has certain advantages and disadvantages. Current accounting practice is built around the concept of monetary capital maintenance, but the conceptual framework does not identify one model as being preferred over the others.

LO 10: Discuss the relative strengths and weaknesses of rules-based and principles-based accounting systems.

Rules-based systems are seen as providing more detailed guidance to accountants, which could help accountants defend their work if challenged. As well, rules-based systems are thought to provide better comparability, as more consistent presentations will result. However, rules-based systems can also result in financial engineering, where transactions are designed specifically to circumvent the rules. Principles-based systems are seen as more flexible and more adaptive to new or unique circumstances. As well, principles-based systems can result in presentations that better reflect local or industry practices. Principles-based systems are criticized for being too flexible and allowing for too much judgment by the accountant. This could create the potential for management influence on the accountant’s work.

LO 11: Discuss the possible motivations for management bias of financial information.

Management may be tempted to bias or otherwise influence the presentation of financial information because of compensation contracts that are based on financial results. As well, the manager will be concerned about meeting investor or analyst targets, meeting the conditions of loan covenants or other external agreements, achieving certain political or strategic objectives, and demonstrating sound stewardship over the company’s assets. All of these motivations provide a temptation to the manager to influence the results reported in the financial statements.

LO 12: Discuss the need for ethical behaviour by accountants, and identify the key elements of the codes of conduct of the accounting profession.

As accountants control the preparation and presentation of financial information, they play a key role in determining the integrity of the information. Accountants will face pressures from management and other parties who may have an interest in the content and form of financial disclosures. Thus, accountants need to practice their craft with an ethical mindset, but they must also have training in how to deal with ethical issues. All accounting bodies have codes of professional conduct that provide guidance to suggest that accountants always act with integrity, objectivity, and competence. As well, these codes usually specify that accountants should always maintain confidentiality and act in a professional manner. Accountants will often have to apply significant good judgment when dealing with ethical conflicts.

LO 13: Identify the effects on the accounting profession of changes in information technology.

Information technology has the potential to improve the relevance, reliability, timeliness, and comparability of information presented. It can allow accountants and auditors to provide more useful information and to more accurately identify risks. However, accountants also need to be aware that these technologies need to be managed carefully to minimize problems that could negatively affect the quality of information provided.