12.1: Chapter 2 Solutions
2.1 Information asymmetry simply means that one party to a business transaction has more information than the other party. This problem is demonstrated by the situation where business managers know more about the business's operations than outside parties (e.g., investors and lenders). The information asymmetry problem can take two forms—adverse selection and moral hazard. With adverse selection, a manager may choose to act on inside knowledge of the business in a way that harms outside parties. Insider trading by managers using non-public knowledge may distort market prices of securities and create distrust in investors. Accounting attempts to deal with the problem by providing as much timely information to the market as possible. Moral hazard occurs when a manager shirks or otherwise performs in a substandard fashion, knowing that his or her performance as an agent is not directly observable by the principal (owner). Accounting tries to deal with this problem by providing information to business owners that can help assess management's level of performance. Although the field of accounting does attempt to solve these problems through the provision of high quality information, information asymmetry can never be completely eliminated, so the accounting profession will always seek ways to improve the usefulness of accounting information.
The major disadvantage of maintaining two sets of standards is cost. The burden of standard setters is increased, and these costs will ultimately be passed on to businesses that are required to report. As well, having two sets of standards may create confusion among investors and lenders, as public and private company financial statements may not be directly comparable.
2.3 The conceptual framework is a high-level structure of concepts established by accounting standard setters to help facilitate the consistent and logical formulation of standards, and provide a basis for the use of judgment in resolving accounting issues. This framework is essential to standard setters as they develop new accounting standards in response to changes in the economic environment. The framework gives the standard setters a basis and set of defining principles from which to develop new standards. The framework is also useful to practicing accountants, as it can provide guidance to them when interpreting unusual or new business transactions. The framework gives practicing accountants the tools and support to critically evaluate accounting treatments of specific transactions that may not appear to fit into standard definitions or norms. Without a proper conceptual framework, accounting standards may become inconsistent and ad-hoc, and their application may result in financial statements that are not comparable, resulting in less confidence in capital markets.
2.4 The two fundamental characteristics of good accounting information are relevance and faithful representation. Relevance means that the piece of information has the ability to influence one's decisions. This characteristic exists if the information helps predict future events or confirm predictions made in the past. Some relevant information may have both predictive and confirmatory value, or it may only meet one of these needs. Faithful representation means that the information being presented represents the true economic state or condition of the item being reported on. Faithful representation is achieved if the information is complete, neutral, and free from error. Complete information reports all the factors necessary for the reader to fully understand the underlying nature of the economic event. This may mean that additional narrative disclosures are required as well as the quantitative value. Neutral information is unbiased and does not favour one particular outcome or prediction over another. Freedom from error means that the reported information is correct, but it does not have to be 100% error free. The concept of materiality allows for insignificant errors to still be present in the information, as long as those errors have no influence on a reader's decisions. Although both relevance and faithful representation need to be present for information to be considered useful, accountants face difficulties in achieving maximum levels of both characteristics simultaneously. As a result, trade-offs are often required, which may lead to imperfect information. Accountants are also often faced with a trade-off between costs and benefits. It may be too costly to guarantee 100% accuracy, so a little faithful representation may need to be given up to maintain the relevance of the information. This means that the accountant will need to apply good judgment in balancing the trade-offs in a way that maximizes the usefulness of the information.
- A reduction of both assets and equity
- An exchange of equal value assets
- An exchange of assets of unequal value resulting in income and expense and a resulting increase in equity (assumes goods are sold for an amount greater than cost)
- Recognition of an expense, resulting in a decrease in equity and a liability
- An asset is received and an equal value liability is recognized
- Recognition of an expense, resulting in a decrease in equity and a liability
- An equal increase in an asset and equity
- An equal increase in an asset and a liability
- An exchange of assets of unequal value, resulting in income and an increase in equity
- A recognition of an expense, resulting in a decrease in equity, and a contra-asset
2.7 An item is recognized in the financial statements if it: (a) meets the definition of an element, (b) can result in probable future economic benefits to or from the entity, and (c) can be measured reliably. These criteria can be applied as follows.
- The company has received an asset, but the company has not yet achieved substantial performance of the contract. The contract will be performed as issues of the magazines are delivered. Thus, the appropriate offsetting element to the asset is a liability, as a future obligation is created. As each issue is delivered, the liability is reduced and income can be recognized. The amount can be measured reliably, as the cash has already been received and the price of each magazine issue has already been determined.
- The appropriate element here is the liability that is being created by the lawsuit. Because the lawsuit results from a past event that creates a present obligation to pay an amount in the future, the definition of a liability is met. It also appears that the outflow of economic benefits is probable, based on the lawyer's evaluation. However, if there really is no way to reliably measure the amount, then the liability should not be recognized. However, the lawyers should make a reasonable effort based on prior case law, the facts of the case, and so forth, to see if an amount can be reliably estimated. Even if the amount is not recognized, the lawsuit should still be disclosed in the notes to the financial statements as this information is likely relevant to those reading the financial statement.
- An asset is normally created and income recognized when the invoice is issued. The future economic benefit exists, is the result of a past event, and can be measured reliably, based on the terms of the contract. In this case, however, there is some issue regarding the probability of realizing the future economic benefits. A careful analysis of the situation is required to determine if recognition of an asset is appropriate. Only the amount whose collection can be deemed probable should be recognized. Even if the amount is not recognized, the contract should still be disclosed in the supplemental information, as this information is likely relevant to financial statement readers.
- The question of whether this meets the definition of an asset needs to be addressed. Is the goodwill being recorded a "resource controlled by the entity"? Goodwill, by definition, is intangible, but it is not clear what exactly is generating the goodwill in this case. It is difficult to say that this even meets the definition of an asset. If this definitional argument is stretched, it would still be difficult to recognize the element, as it is unlikely to pass the reliable measurement test. An asset based on the current share price is not reliably measured, as share prices are volatile and transitory. No recognition of the asset and corresponding equity amount is warranted in this case.
- This does appear to meet the definition of a liability, as the past event (the drilling) results in a present obligation (the requirement to clean up the site) in the future. This type of liability should normally be recorded at the present value of the expected outflow of resources in 10 years time, as this outflow is probable. The company may have some difficulty measuring the amount, as they have no experience with this type of operation. However, an estimate should be able to be made using engineering estimates, industry data, and so forth. The other item that needs to be estimated is the appropriate discount rate for the present value calculation. Again, the company can use its cost of capital or other appropriate measure for this purpose. This liability and an expense should be recognized, although estimation will be required. Additional details of the method of estimation would also need to be disclosed.
2.8 The four measurement bases are historical cost, current cost, realizable (settlement) value, and present value. Historical cost represents the actual transaction cost of an element. This is normally very reliably measured, but may not be particularly relevant for current decision making purposes. Current cost represents the amount required to replace the current capacity of the particular asset being considered, or the amount of undiscounted cash currently required to settle the liability. This base is considered more relevant than historical cost, as it attempts to use current market information to value the item. However, many items, particularly special purpose assets, do not have active markets and are, thus, not reliably measured by this approach. Realizable value represents the amount that an asset can currently be sold for in an orderly fashion (i.e., not a "fire-sale" price) or the amount required to settle a liability in the normal course of business. Again, this has the advantage of using current market conditions, making it more relevant than historical cost. However, as with current cost, active disposal markets for the asset may not exist. As well, realizable value is criticized as being irrelevant in cases where the company has no intention of disposing of the asset for many years. Present value is, perhaps, the most theoretically justified measurement base. In this case, all assets and liabilities are measured at the present value of the related future cash flows. This measure is highly relevant, as it represents the value in use to the organization. The problem with this approach is that it is difficult to reliably estimate the timing and probability of the future cash flows. As well, determinations need to be made regarding the appropriate discount rate, which may not always have a clear answer.
2.9 Capital maintenance refers to the amount of capital that investors would want to be maintained within the business. This concept is important to investors, as the level of capital maintenance required may influence an investor's choice as to which company to invest in. The measurement of an investor's capital can be defined in terms of financial capital or physical capital.
Financial capital maintenance simply looks at the amount of money in a business, measured by changes in the owners' equity. This can be measured simply by looking at monetary amounts reported in the financial statements. The problem with this approach is that it doesn't take into account purchasing power changes over time. The constant purchasing power model attempts to get around this problem by adjusting capital requirements for inflation by using a broadly based index, such as the Consumer Price Index. The problem with this approach is that the index chosen may not accurately reflect the actual level of inflation experienced by the company. Physical capital maintenance tries to get around this problem by measuring the physical capacity of the business, rather than the financial capacity. The advantage of this approach is that it measures the actual productivity of the business and is not affected by inflation. The disadvantage of this method is that it is not easy or cost-effective to measure the productive capacity of each asset within the business.
Because each capital maintenance model involves trade-offs, the conceptual framework does not draw a conclusion on which approach is the best. Rather, it suggests that end needs of the financial statement users be considered when determining to apply capital maintenance concepts to specific accounting standards.
2.10 Principles-based standards present a series of basic concepts that professional accountants can use to make decisions about the appropriate accounting treatment of individual transactions. Rules-based standards, on the other hand, are more prescriptive and detailed. These standards attempt to create a rule for any situation the accountant may encounter. The main advantage of principles-based systems is their flexibility. They allow the accountant the latitude to apply judgment to deal with new situations or unusual circumstances. This flexibility, however, can also cause problems for the accountant, as there could be pressure to stretch the professional judgment in a way that creates misleading financial statements. As well, the application of judgment in the preparation of financial statement could result in reports that are not comparable, as other accountants may arrive at different conclusions for similar transactions. This suggests that the verifiability characteristic may also be compromised. The main advantage of rules-based approaches is the certainty and comparability offered by detailed rules. Readers can have confidence that similar transactions are reported in similar ways. As well, this may reduce the accountant's professional liability, as long as the rules have been applied correctly. The main disadvantage of the rules-based systems is their inflexibility. Prescription of specific accounting treatments can result in financial engineering, wherein new transactions are designed solely for the purpose of circumventing the rules. This can create misleading financial reports, where the true nature of the transactions is not reflected correctly. As well, overly detailed rules can create a problem of understandability, not only for the readers, but even for the professional accountants themselves. As a practical matter, all systems of accounting regulation contain both broad principles and detailed rules. The challenge for accounting standard setters is to find the right balance of rules and principles.
2.11 Managers may attempt to influence the outcome of financial reporting for a number of reasons. Managers may have bonus or other compensation schemes that are directly tied to reported results. Managers are rational in attempting to influence their own compensation, as they understand that compensation earned now is more valuable than compensation that is deferred to future periods. Even if the manager's compensation is not directly tied to financial results, the manager may still have an incentive to make the company's results look as good as possible, as this would enhance the manager's reputation and future employment prospects. Managers will also feel pressure from shareholders to maintain a certain level of financial performance, as public securities markets can be very punitive to a company's share price when earnings targets are not reached. Shareholders do not like to see the price of the share fall drastically. On the other hand, shareholders also want to have a realistic assessment of the company's earning potential. These conflicting goals may create a complicated dynamic for the manager's behaviour in crafting the financial statements. Managers are also influenced by the conditions of certain contracts, such as loan agreements. Loan covenants may require the maintenance of certain financial ratios, which clearly puts pressure on managers to influence the financial reports in a certain fashion. Managers may also feel pressure to keep earnings low where there are political consequences of being too profitable. This may occur when a company has disproportionate power over the market, or where there is a public interest in the operations of the business. The company does not want to demonstrate earnings that are too high, as it risks attracting additional taxation, penalties, or other actions that may restrict future business.
The pressures that managers feel to influence financial results will eventually find their way to the accountant, as the accountant is ultimately responsible for creating the financial statements. Whether the accountant is internal or external to the business, his or her work must be performed ethically and professionally. The accountant must always act with integrity and objectivity, and must avoid being influenced by the pressures that may be exerted by managers or other parties. The accountant must demonstrate professional competence and must keep client information confidential. The accountant should not engage in any work that falls outside of the scope of that accountant's professional capabilities. As well, the accountant must not engage in any behaviour that discredits the profession. Although it is easy to describe the accountant's professional responsibilities, it is not always easy to put these concepts into practice. The accountant needs to be aware of the pressures faced in the reporting environment, and may need to seek outside advice when faced with ethical or professional problems. Ultimately, the accountant is a key player in establishing the overall credibility of financial reporting, and financial markets rely on this credibility to function in an efficient manner.
2.12 The vice-president finance's comments hint at a threat to my objectivity as financial controller. The potential reward of the vice-president finance position should not influence how I perform my professional duties. The specific issues identified by the vice-president finance can be addressed as follows.
- This lawsuit appears to meet the definition of a liability, as it is a present obligation that results from a past transaction and will require a future outflow of economic resources. As well, it appears to have satisfied the recognition criteria, as the payment is probable and the amount can be estimated. This amount should be accrued this year, although prior years' financial statements do not need to be adjusted. Further consultation with the lawyers is required to determine the most reasonable amount to accrue within the range provided. Also, IFRS and ASPE use different approaches to accounting for provisions based on a range of values.
- A change in accounting policy should be disclosed in the notes to the financial statements. However, the change should also be accounted for in a retrospective fashion, where prior years' results are restated to show the effect of the change on those years. This retrospective treatment may result in a change in the effect on the current year's income. This treatment is necessary to maintain comparability with prior years' results.
- Prepayments from customers appear to meet the definition of a liability, as they represent a present obligation to deliver future resources to the customers (in this case, products to be manufactured). The recognition criteria also appear to have been met, so these amounts should be disclosed as liabilities. It is generally not appropriate to net assets and liabilities together, as this distorts the underlying nature of the individual financial statement elements.
- It is unlikely that this even meets the definition of an asset, as it cannot be said that we control the resource. Although we pay the research and development director's salary and likely have proprietary rights to his inventions, we cannot really say that the resource, his knowledge, is controlled by the company. Even if we stretch the definition of an asset here to include this knowledge, it still doesn't meet the recognition criteria, as there is no demonstration that the future flow of economic resources is either probable or measurable.
- The vice-president finance is indicating that year-end accounting adjustments need to be considered for their effects on the debt-to-equity ratio. All of the accounting treatments proposed by the vice-president finance would improve this ratio. However, all of the proposed accounting treatments are likely unsupportable under the conceptual framework. It appears that the vice-president finance's objectivity may have been impaired by his requirement to prevent a debt covenant violation. It is likely that the vice-president finance's proposed accounting treatments will be challenged by the company's external auditors, which may create delays and other problems in issuing the financial statements. This could also cause problems with the bank. In performing my duties as the financial controller, I need to be aware of the threats to my objectivity. Although there is no evidence of any ethical conflict yet, I will need to perform my duties with integrity. If my actions do result in a conflict with the vice-president finance, I will need to carefully consider my actions. I may need to seek outside advice from my professional association and others, if necessary. Ultimately, I must ensure that I do not prepare financial statements that are false or misleading in any way.