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LESSON 1Financial reporting and accounting conceptsTexts∙Intermediate Accounting, Volume 1, IFRS Edition, Donald E. Kieso, Jerry J. Weygandt,Terry D. Warfield, John Wiley & Sons.∙IASB FrameworkTopic outline and required reading1.1 The environment ofaccounting (Level 3) ∙Chapter 1, pages 2-7, 9-14, 17-18, Appendix 1A, pages 21-291.2 Financial statement users andobjectives of financialreporting (Level 1) ∙ Chapter 1, pages 7-9, 14-17 ∙Chapter 2, pages 38-431.3 Ethics in accounting(Level 2) ∙Chapter 1, page 17∙Appendix 1-1: ―What is ethics?‖1.4 Qualitative characteristicsand elements of financialstatements (Level 1)∙ Chapter 2, pages 43-48∙1.5 Accounting assumptions,measurement principles andconstraints (Level 1)∙ Chapter 2, pages 48-601.6 Professional judgment infinancial reporting (Level 2)∙No required reading1.7 Accounting informationprocessing system (Level 1)∙No required readingTerminologyFor corporations, there are five financial statements, those being:∙The statement of financial position, previously known as the balance sheet∙The statement of changes in equity, previously known as the statement of retainedearnings∙The statement of cash flows, previously known as the cash flow statement∙The income statement (which may be included in the statement of comprehensiveincome)∙The statement of comprehensive incomeThe descriptors ―balance sheet,‖ ―statement of retained earnings,‖ and ―cash flowstatement‖ are still widely used in practice and may appear in these course notes, reviewquestions, and assignment questions. Notwithstanding this, you should get in the habit ofreferring to the statements by their ―correct names‖ as set out in IAS1 IN11 andelsewhere.IntroductionWelcome to Financial Accounting 2. This lesson serves as a foundation for the entire course.It begins with a review of the environment of accounting and the standard-setting process.Users of financial information are identified, and the way in which financial statementsrespond to users’ needs is explained. Ethics in accoun ting, introduced in FA1, is revisited.The elements of financial statements are explained, including factors that determine inclusionof items in the statements. Accounting assumptions, qualitative characteristics, principles, andimplementation constraints are summarized.Learning objectivesAfter completing this lesson, you should be able to:∙Describe the international accounting standard-setting process. (Level 3)∙Describe the attempts to harmonize accounting standards throughout the world. (Level 3)∙Ide ntify financial statement users and their needs, and describe how users’ needs areusually satisfied. (Level 1)∙Explain the importance of ethical behaviour in financial reporting. (Level 2)∙Evaluate whether accounting practices properly reflect the underlying assumptions andqualitative characteristics of accounting information. (Level 1)∙Evaluate whether the definition of financial statement elements, recognition criteria, andmeasurement principles are properly applied. (Level 1)∙Identify situations when professional judgment must be exercised in accounting. (Level 2)∙Describe the relationships between the seven major types of general ledger accounts.(Level 1)∙Understand the interrelationships between the statement of financial position, statement ofcomprehensive income, statement of changes in equity and the statement of cash flows.(Level 1)TOPIC 1.1The environment of accountingRequired reading Chapter 1, pages 2-7, up to ―Objective of Financial Reporting‖, pages 9-14 from ―Standard-Setting Or ganizations‖, pages 17-18 ―International Convergence‖Appendix 1A, pages 21-29 ―The U.S. Standards-Setting Environment‖LEVEL 3By now, you have already taken at least one course in financial accounting. The objective ofthis course is to explore in more depth the asset side of the statement of financial position .Many of the topics that were introduced in Financial Accounting Fundamentals[FA1] or anequivalent course will be revisited in much more detail. Read pages 2 to 7 in the textbook fora quick overview, and then turn to pages 9 to 14 to learn the standard setting organizations.Accounting is the process of identifying, measuring, recording, and communicating financialinformation about an economic entity to interested user groups. The principal reporting tousers focuses on the results of operations for the entity for a period of time and the entity’sfinancial position at a particular point in time. The entity being accounted for may be of anytype: a profit-oriented business, a not-for-profit organization or a government entity. The keyaspect here is communication. Keep in mind that accountants are in the communicationbusiness; therefore, you must know to whom you are communicating (that is, the users ofaccounting information) and what kind of information the users want. Providing usefulinformation to users is the primary role of accountants.As you progress through this course, be mindful of the diverse user groups and how they willuse the information to make decisions. Continually evaluate accounting practice to determineif it results in useful information. If not, what changes need to be made to our accountingpractices to make the results more useful? In other words, do not simply accept all accountingrules and practices as the absolute truth. Instead, always try to understand the logic behindthese practices. In so doing, you should gain a better understanding of what you are doing andwill achieve better results on the examinations. You may also identify some shortcomings inaccounting practice. This is useful because the first step in solving a problem is recognizingthat a problem exists.Accounting is generally divided into two main branches. Financial accounting is designed toprovide information to external users, such as creditors, shareholders, government, and thepublic. Management accounting is designed to provide information to internal users. Theseinternal users, such as managers and employees of the organization, use the managementaccounting information as a tool in the decision-making processes. For example, managersneed information to decide what prices to charge for products and whether or not to buy orbuild component parts. Since these internal users also have access to all other internalcompany information, they are not completely reliant on this management accountinginformation. Also, since this management accounting information is being used for internalpurposes, it is not required that the information be prepared following any specific guidelinesor standards.There is also what some call a third branch, namely tax accounting, which involves both thepreparation of statutory tax filings and tax planning to minimize the amount of taxes owing.However, it is really a variation on financial accounting since it uses financial accounting datato generate tax accounting statements. We will not address this aspect, except incircumstances where statutory tax-related requirements impact financial accounting.This course focuses on financial accounting — the provision of useful financial informationto external users about a company. These external users are interested in making decisionsabout which companies to invest in, or whether they should or should not lend money to aparticular entity. Because they do not have access to information that would be available to aninternal user, the information about an organization obtained by external users is limited tothe publicly available information that the entity is required to provide. An entity musttherefore ensure that its external financial accounting reports are prepared on a comparableand consistent basis, thereby allowing external users to use this information to makeimportant investment decisions. External users also want to know that the financialaccounting reports of different companies have been prepared using the same set of standards,and that these standards have been applied consistently from one reporting period to the next.Historical backgroundThe first book to formally describe the double-entry a ccounting system was Luca Pacioli’sSumma de Arithmetica, Geometria, Proportioni et Proportionalita written in 1494. At thattime, nearly all accountants worked for banks, merchants, or governments.The role of the accounting profession remained virtually unchanged until the onset of theindustrial revolution. The rapid growth of the size of the business entity and the requirementfor capital resulted in creation of the public accountant. In North America, railroad companieswere the biggest single users of capital, and consequently, railroad finances became a matterof public concern.The first organization of professional public accountants in the world was founded in 1854 asthe Institute of Chartered Accountants in Scotland. The first accounting associationestablished in North America was the Association of Accountants in Montréal in 1880. TheDominion Association of Chartered Accountants was formed in 1902 and was thepredecessor of the Canadian Institute of Chartered Accountants.The Certified General Accountants Association of Canada was founded by John Leslie in1913 as the General Accountants Association. Leslie started the Canadian AccountantsAssociation in 1908 with the object of bringing together bookkeepers and accountants of theCanadian Pacific Railway to study and acquire a greater knowledge of their work. Five yearslater, the General Accountants Association was recognized by the Parliament of Canada.Accounting standard settingAs a result of the need for consistent and comparable external financial reporting, a somewhatstandardized system of financial accounting has developed over the years. This standardizedsystem is referred to as generally accepted accounting principles (or GAAP). GAAP isessentially a set of rules to be followed by entities in the preparation of their external financialstatements. If all entities use the same set of GAAP rules to prepare their financial statements,then the external users should have some confidence that they can make valid comparisons ofthe companies whose financial statements they are examining. If a standardized system doesnot exist, then the external user would not be able to make meaningful comparisons betweenentities based solely on the external financial statements.The process of developing generally accepted accounting principles is known as accountingstandard setting. Where, then, does GAAP come from? Who is responsible for the setting ofGAAP rules that dictate how external financial statements should be prepared? As you mightexpect, many national accounting standard setting bodies adapt GAAP for their own countries.For example, the United Kingdom has the Accounting Standards Board (which reports to anindependent body called the Financial Reporting Council), the United States has the FinancialAccounting Standards Board (FASB), and Canada has the Accounting Standards Board of theCanadian Institute of Chartered Accountants. Since different countries will have differenteconomic, political, or social systems that would influence the choice of a particularaccounting standard, GAAP is somewhat different from country to country. Furthermore,GAAP within a particular country may also provide for alternative accounting treatments ofthe same economic event. This might be the result of competing views within the country asto which are the preferable accounting treatments for specific events. The problem is, itcreates confusion with respect to which is the ―right‖ treatment.Rather than selecting a country-specific set of GAAP, the GAAP established by theInternational Accounting Standards Board (IASB) will be used. As more firms engage ininternational business, the need arises for accounting standards that are the same, or at leastharmonized, throughout the world. Harmonization does not necessarily mean that thereshould be only one set of GAAP for the world. Rather, it means that standard-setting bodiesaround the world would strive to eliminate differences in standards for the same economicevent. In other words, a similar economic event should be accounted for in the same way,regardless of jurisdiction.There are a number of reasons for this. For example, an international firm wants to raiseequity funds by listing its shares on a number of stock exchanges around the world, possiblyin the countries where it does significant amounts of business. One common listingrequirement for a stock exchange is that the listed company must submit annual financialstatements to the stock exchange, prepared in accordance with that jurisdiction’s gen erallyaccepted accounting principles. If there are significant differences between the accountingprinciples of the entity’s home country and those used in the other jurisdictions in which itwants to be listed, it would be expensive to convert the financial statements prepared usingone set of generally accepted accounting principles to multiple sets of financial statements,each prepared using a different set of generally accepted accounting principles.In addition, since each set of GAAP might be significantly different, there is a risk that economic resources among firms would be misallocated because investors and creditors would be confused by the varying accounting principles being used. During its existence, it has been the goal of the IASB and its predecessor, the IASC, to create a single set of generally accepted accounting principles that would be used by all companies throughout the world and that would be accepted by all of the different regulatory bodies, such as stock exchanges.Many corporations prepare their financial statements using IASB standards. Marks and Spencer Group plc, the UK-based company, referred to International Financial Reporting Standards in its March 29, 2008 financial statements as follows:The financial statements have been prepared in accordance withInternational Financial Reporting Standards (IFRS) as adopted by theEuropean Union and with those parts of the Companies Act 1985 applicableto companies reporting under IFRS. The IFRS, International FinancialReporting Interpretations Committee (IFRIC) and amendments have beenadopted in the financial statements‖However, there are barriers to harmonization. Different countries use financial statements for different purposes. Consider the following examples.∙Governments may use the financial statement figures to assess taxes. Accounting principles in these countries tend to be based on taxation and government policy objectives, which, for example, may be quite different from accrual basis accounting principles.∙In some countries corporate ownership is closely held by individuals, other corporations, governments, or banks. In these countries, there may not be as much disclosure as in other parts of the world because the ownership is not widespread.∙Some stock exchanges and financial regulators have fewer disclosure requirements than others. Companies listed on these exchanges may not be required to prepare financial statements that satisfy the information requirements of all investors.Accounting policies may be designed with particular objectives in mind. For example, Canadian companies are permitted to defer the expensing of certain costs if these costs meet the definition of development costs. This deferral might also be driven by a desire to smooth profit or maximize profit, since less expense will be recorded in any one year than if these costs are not deferred. In the United States, however, such costs must be expensed as incurred. Expensing the costs as incurred supposedly assists in enhancing cash flow predictions. Thus, you can see that policy objectives can result in different treatment of the same ―costs.‖Most companies prepare financial statements using the GAAP of their home country, and the unit of measure will be the local currency of the company. This often makes sense because the majority of the company’s operations, and the majority of the users of its financial statements, are located in the home country. Occasionally, with the increased globalization of business, a company will use another currency as the unit of measure and even a different GAAP from that used in its home country. For example, Nortel Networks Corporation, a Canadian-based telecommunications equipment provider, prepared its statements in U.S. dollars, and followed U.S. GAAP, as indicated in its December 31, 20X1, annual report: The accompanying Consolidated Financial Statements of Nortel NetworksCorporation (―Nortel Networks‖) include all majority owned subsidiariesover which Nortel Networks exercises control and have been prepared inaccordance with accounting principles generally accepted in the UnitedStates of America. Although Nortel Networks is headquartered in theCanada, the accompanying Consolidated Financial Statements are expressedin United States dollars as the greater part of the financial results and netassets of Nortel Networks are denominated in United States dollars.Language can also be a barrier. For example, in some countries, financial statements are onlyavailable in that country’s official language because the loc al stock exchange does not requirepresentation in another language. Listing only in the home country means that investors mustread the statements in the official language or have their own translation done. Companiesthat want to list shares on other exchanges must translate their statements. Nippon YusenKabushiki Kaisha, a Japanese shipping company, stated the following in its March 31, 20X1,annual report:The accompanying consolidated financial statements are an Englishtranslation of the consolidated financial statements made public for filingwith the Ministry of Finance and the stock exchanges in Japan. The originalconsolidated financial statements, which are prepared in accordance withgenerally accepted accounting principles and practices in Japan, include theaccounts of Nippon Yusen Kabushiki Kaisha (the ―Company‖) and itsconsolidated subsidiaries.In the English translation, certain account reclassifications are made andadditional information is provided in order to present the consolidatedfinancial statements in a format familiar to international readers. The resultsof these reclassifications do not affect the financial position or results ofoperations and cash flows of the consolidated companies as reported in theoriginal consolidated financial statements.Members of professional accounting associations in the industrialized countries have longbeen concerned with having multiple sets of country specific GAAPs as the world becomesmore globalized, for reasons similar to those above. In 1973, the International AccountingStandards Committee (IASC) was formed by representatives from the major accountingstandard setting bodies in ten countries: Australia, Canada, France, Germany, Japan, Mexico,the Netherlands, the United Kingdom and Ireland and the United States. Since that time, theIASC has been producing international accounting standards. Between 1973 and 2000, theBoard of the IASC produced accounting standards called International Accounting Standards(IAS).In 2001, the IASC underwent significant internal restructuring. Under the restructuring, theIASC was dissolved and an independent International Accounting Standards Board (IASB)1emerged, responsible for setting accounting standards to be called International FinancialReporting Standards (IFRS). The Preface to International Financial Reporting Standardsmakes it clear what the objectives of the IASB are:(a)to develop, in the public interest, a single set of high quality,understandable and enforceable global accounting standards thatrequire high quality, transparent and comparable information infinancial statements and other financial reporting to helpparticipants in the various capital markets of the world and otherusers of the information to make economic decisions;(b)to promote the use and rigorous application of those standards; and(c)to work actively with national standard setters to bring aboutconvergence of national accounting standards and IFRSs to highquality solutions.1This Board is a part of an organization called the International Accounting Standards Committee Foundation [IASCF].Before looking at the conceptual framework for financial reporting, the structure of the IASBand the due process followed in setting international financial reporting standards will beexamined. Exhibit 1-1 is an illustration of the structure, reproduced from the IASB website.The IASB is governed by 22 trustees. The trustees form what is known as the InternationalAccounting Standards Committee Foundation [IASCF]. These 22 trustees are selected toachieve specified geographical and organizational representation. Six trustees are from NorthAmerica, six from Europe, six from Asia/Oceania, and the remaining four trustees can befrom any geographical area as long as overall balance is maintained. Organizationally,trustees represent the accounting profession, the academic group, the users of financialreporting, the international organizations of preparers of financial reporting, and otherofficials serving the public interest. The main responsibilities of the trustees are to raise themoney to run the IASB and to appoint the members of the Board, Council, and any otherCommittees that operate to set international accounting standards.EXHIBIT 1-1The organizational structureSource:/About+Us/How+we+are+structured.htm (accessed October2008) Copyright © 2009 International Accounting Standards Committee Foundation. Allrights reserved. No permission granted to reproduce or distribute.Note that Illustration 1-4 in the textbook (page 11) also describes the structure of IASB in aslightly different format from the above exhibit.The principal business of setting accounting standards is carried out by a 14-person Board,with 12 full-time members and two part-time members. The Board members are selected bythe trustees of the IASB. The main criterion for Board membership is technical expertise.Geographical and organizational representation is assured by having at least five members with a background in financial statement preparation, at least three members with a background as users of financial statements, and at least one member whose background is in academic accounting.To get additional input into the accounting standard setting process, the IASCF has created the Standards Advisory Council (SAC). The SAC consists of approximately 30 members, chosen for their expertise in accounting standard setting and representing diverse geographic and organizational constituencies. The SAC advises the IASB on the priorities of their projects and the expected effects of proposed standards on preparers and users of financial statements.The other main body reporting to the IASCF is the International Financial Reporting Interpretations Committee (IFRIC). There are up to 12 members on this committee, representing the accounting profession and preparers and users of financial statements. The role of IFRIC is to publish timely interpretations in areas where convergence of practice is required. Convergence of practice may be required where preparers do not consistently follow the recommendations of an existing standard, or when a new issue arises. Interpretations are also prepared as an interim measure when a new standard under development is not yet complete.The IASB follows due process when considering a new International Financial Reporting Standard or a revision to an existing standard. The most important part of this due process is in the makeup of the IASB. As noted above, the Board has members with technical expertise, representing various geographic and organizational constituents. This diversity, along with the independence of the Board members from external influences — the 12 full-time members are paid employees of the Board —gives legitimacy to the Board’s standard setting process. The actual process followed in developing a new standard would generally involve the following steps:(a)The Board establishes an advisory group to advise on the project. The StandardsAdvisory Council (SAC) would be closely involved in prioritizing projects andgiving advice on the likely impact of proposed standards.(b)If the project is substantive in nature, a Draft Statement of Principles would beproduced for public discussion and input, with a minimum comment period of four to six months. As part of this process, the Board may choose to hold public hearings orconduct field tests to see if the proposals are feasible.(c)After receiving comments and test results based on the Draft Statement of Principles,the Board would prepare and issue an Exposure Draft of the proposed new standard,assuming the results of the previous step had been favourable. The Exposure Draftwould have a minimum comment period of four to six months.(d)Assuming the comments received on the Exposure Draft were favourable, or whenconsensus is reached, the Board would finalize the project and issue a newInternational Financial Reporting Standard.Throughout the standard setting process, liaison between the IASB and the national standard setting bodies would be expected. Where feasible, the national accounting standard setter and the IASB would work together on the same standard, with the goal of having the final standard consistent between the two. As can be seen from the steps involved in the standard setting process, there is ample opportunity for input into the process by all types of interested groups or individuals. Input may be made as a member of the Standards Advisory Council, by responding to the Draft Statement of Principles or Exposure Draft, or by participating in the field tests or public hearings.Approval of a new standard or approval to publish an Exposure Draft requires support fromeight of the fourteen members of the Board. Other decisions, such as the issuing of a DraftStatement of Principles, require only a majority vote by the members of the Board present at ameeting.What influence does the IASB and its International Financial Reporting Standards have onfinancial reporting around the world? Considerable influence is the answer. The InternationalOrganization of Securities Commissions (IOSCO) has been working with the IASB for manyyears on the improvement of IFRS. In 1999, the IASB and IOSCO completed work on a setof core standards which the IOSCO would support being used by companies that want to listin any foreign jurisdiction. In 2000, IOSCO recommended to its members that they allow theuse of IFRS by any multinational issuer.Although the IASB does not have the power to mandate that its accounting standards beadopted by national standard setting bodies or by public stock exchanges, the standard settersin certain countries have decided to adopt IFRS as their own standards. For example,Bangladesh and Egypt are countries that require the use of IFRS for all companies listed ontheir public stock exchanges.In June 2002, the Counci l of the European Union adopted an ―IAS Regulation‖ requiringlisted companies, including banks and insurance companies, to prepare their consolidatedaccounts in accordance with IAS from 2005 onwards. The goal of the Regulation was toeliminate barriers to cross-border trading in securities by ensuring that company accountsthroughout the EU were reliable, transparent, and comparable. The Regulation has the forceof law without requiring transposition into national legislation. In addition, the UnitedKingdom and Australia also adopted IFRSs effective January 1, 2005.Furthermore, in the wake of the US financial failures of 2002, the Financial AccountingStandards Board (which is responsible for setting accounting and reporting standards in theUSA) signed, in October 2002, what became known as the Norwalk Agreement. In it, theFASB and the IASB pledged to eliminate all substantive differences between US andinternational standards over a five-year period. In addition, a short run goal of eliminating―technical‖ differences was to be accomplished by 2005.Finally, in March 2005, the Canadian Accounting Standards Board published a discussionpaper in which it sought input on a proposal to require public companies to comply withIFRSs. In summary, the goal of a single, harmonized set of GAAP, which seemed impossibleto achieve in 1995, was effectively in place in 2005.At this point you may skim through the topic ―International Convergence‖ in the textbook(pages 17 to 18), followed by Appendix 1A (pages 21 to 29) to learn about the U.S. standard-setting environment. You are not responsible to know the U.S. accounting standards for thepurpose of this FA2 course, nor for examination purpose. It is interesting to understand alittle about the financial reporting environment as you may encounter some U.S. corporationsin your future career.Related review and assignment questionsReview Question 1TOPIC 1.2Financial statement users and objectives of financial reportingRequired reading Chapter 1, pages 7-9, pages 14-17, up to ―Ethics in the Environment…‖Chapter 2, pages 38-43, up to ―Second Level: Fundamental Concepts‖。