Study Notes For Intermediate Accounting Volume 1, Seventh Canadian Edition
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Intermediate Accounting, 7th edition 1
CHAPTER 1
THE FRAMEWORK FOR FINANCIAL REPORTING
Learning Objectives
After you have studied this chapter, you should:
LO-1 Understand the various accounting standards used by Canadian entities.
LO-2 Understand the objectives of financial reporting.
LO-3 Understand the financial reporting needs of external users of financial
information.
LO-4 Understand the motivations of preparers of financial information.
Lecture Notes
1. ACCOUNTING STANDARDS IN CANADA
Authoritative Source of Canadian Standards
The accounting standard-setting body in Canada is the Accounting Standards Board
(AcSB). The AcSB is part of the Canadian Chartered Professional Accountants of
Canada (CPA Canada). The authority of CPA Canada comes from the corporation
acts of the federal and provincial governments. The GAAP requirement for public
companies is enforceable by the provincial securities commissions. The
commissions are responsible for enforcing the reporting standards for companies
that are traded in their province.
The AcSB had for many decades maintained standards by regular revisions and
additions to the CPA Canada Handbook. Currently the AcSB has a two-pronged
approach for Canadian enterprises:
For public companies or publicly accountable enterprises, International Financial
Reporting Standards (IFRS) is required for financial reporting for all reporting
periods beginning on or after January 1, 2011. All the IFRS standards are included
in the CPA Canada Handbook as Part 1.
Private nonpublicly accountable enterprises have a choice between using full IFRS
or Canadian Accounting Standards for Private Enterprises (ASPE) as prescribed in
the CPA Canada Handbook, Part II. ASPE is somewhat less complex, is based
more on historical-cost accounting, and has far fewer disclosure requirements.
CHAPTER 1
THE FRAMEWORK FOR FINANCIAL REPORTING
Learning Objectives
After you have studied this chapter, you should:
LO-1 Understand the various accounting standards used by Canadian entities.
LO-2 Understand the objectives of financial reporting.
LO-3 Understand the financial reporting needs of external users of financial
information.
LO-4 Understand the motivations of preparers of financial information.
Lecture Notes
1. ACCOUNTING STANDARDS IN CANADA
Authoritative Source of Canadian Standards
The accounting standard-setting body in Canada is the Accounting Standards Board
(AcSB). The AcSB is part of the Canadian Chartered Professional Accountants of
Canada (CPA Canada). The authority of CPA Canada comes from the corporation
acts of the federal and provincial governments. The GAAP requirement for public
companies is enforceable by the provincial securities commissions. The
commissions are responsible for enforcing the reporting standards for companies
that are traded in their province.
The AcSB had for many decades maintained standards by regular revisions and
additions to the CPA Canada Handbook. Currently the AcSB has a two-pronged
approach for Canadian enterprises:
For public companies or publicly accountable enterprises, International Financial
Reporting Standards (IFRS) is required for financial reporting for all reporting
periods beginning on or after January 1, 2011. All the IFRS standards are included
in the CPA Canada Handbook as Part 1.
Private nonpublicly accountable enterprises have a choice between using full IFRS
or Canadian Accounting Standards for Private Enterprises (ASPE) as prescribed in
the CPA Canada Handbook, Part II. ASPE is somewhat less complex, is based
more on historical-cost accounting, and has far fewer disclosure requirements.
Intermediate Accounting, 7th edition 1
CHAPTER 1
THE FRAMEWORK FOR FINANCIAL REPORTING
Learning Objectives
After you have studied this chapter, you should:
LO-1 Understand the various accounting standards used by Canadian entities.
LO-2 Understand the objectives of financial reporting.
LO-3 Understand the financial reporting needs of external users of financial
information.
LO-4 Understand the motivations of preparers of financial information.
Lecture Notes
1. ACCOUNTING STANDARDS IN CANADA
Authoritative Source of Canadian Standards
The accounting standard-setting body in Canada is the Accounting Standards Board
(AcSB). The AcSB is part of the Canadian Chartered Professional Accountants of
Canada (CPA Canada). The authority of CPA Canada comes from the corporation
acts of the federal and provincial governments. The GAAP requirement for public
companies is enforceable by the provincial securities commissions. The
commissions are responsible for enforcing the reporting standards for companies
that are traded in their province.
The AcSB had for many decades maintained standards by regular revisions and
additions to the CPA Canada Handbook. Currently the AcSB has a two-pronged
approach for Canadian enterprises:
For public companies or publicly accountable enterprises, International Financial
Reporting Standards (IFRS) is required for financial reporting for all reporting
periods beginning on or after January 1, 2011. All the IFRS standards are included
in the CPA Canada Handbook as Part 1.
Private nonpublicly accountable enterprises have a choice between using full IFRS
or Canadian Accounting Standards for Private Enterprises (ASPE) as prescribed in
the CPA Canada Handbook, Part II. ASPE is somewhat less complex, is based
more on historical-cost accounting, and has far fewer disclosure requirements.
CHAPTER 1
THE FRAMEWORK FOR FINANCIAL REPORTING
Learning Objectives
After you have studied this chapter, you should:
LO-1 Understand the various accounting standards used by Canadian entities.
LO-2 Understand the objectives of financial reporting.
LO-3 Understand the financial reporting needs of external users of financial
information.
LO-4 Understand the motivations of preparers of financial information.
Lecture Notes
1. ACCOUNTING STANDARDS IN CANADA
Authoritative Source of Canadian Standards
The accounting standard-setting body in Canada is the Accounting Standards Board
(AcSB). The AcSB is part of the Canadian Chartered Professional Accountants of
Canada (CPA Canada). The authority of CPA Canada comes from the corporation
acts of the federal and provincial governments. The GAAP requirement for public
companies is enforceable by the provincial securities commissions. The
commissions are responsible for enforcing the reporting standards for companies
that are traded in their province.
The AcSB had for many decades maintained standards by regular revisions and
additions to the CPA Canada Handbook. Currently the AcSB has a two-pronged
approach for Canadian enterprises:
For public companies or publicly accountable enterprises, International Financial
Reporting Standards (IFRS) is required for financial reporting for all reporting
periods beginning on or after January 1, 2011. All the IFRS standards are included
in the CPA Canada Handbook as Part 1.
Private nonpublicly accountable enterprises have a choice between using full IFRS
or Canadian Accounting Standards for Private Enterprises (ASPE) as prescribed in
the CPA Canada Handbook, Part II. ASPE is somewhat less complex, is based
more on historical-cost accounting, and has far fewer disclosure requirements.
Intermediate Accounting, 7th edition 2
IFRS Overview
International Financial Reporting Standards Overview
International standards are developed and issued by the International Accounting
Standards Board (IASB).
Canada accepts IFRS as an adopter, integrating the standards as written by the
IASB without modification into the CPA Canada Handbook.
The authoritative language for IFRS internationally is English although the
standard is translated into many other languages. In Canada, however, there is an
authoritative French version, since the standards must say the same thing in both
English and French.
Accounting Standards for Canadian Publicly-Accountable Enterprises
Publicly accountable enterprise (PAE) is any company that has securities (debt
or equity or both) issued to the public or that is in the process of issuing debt or
equity to the public or a for-profit private enterprise that holds assets in a fiduciary
capacity for a broad group of outsiders as one of its primary businesses.
A fiduciary enterprise is any organization that acts in a trusteeship capacity for
members of the general public. (e.g. a mutual fund, a privately owned bank,
pension funds, credit unions).
Government business enterprises must disclose their financial performance and
thus are PAEs.
Reporting in U.S. GAAP
In order to enhance the acceptability of its shares in the U.S. financial markets, a
Canadian company may choose to follow U.S. GAAP, but it is rare for a Canadian
company to do so.
Legal and Regulatory Requirements
In some special industries such as banks, the normal provisions of IFRSs may be
supplemented by legal conditions such as requirements from Canada’s Bank Act.
Reporting Currency
Canadian companies do not always prepare their financial statements in Canadian
dollars. In general, IFRS requires a company to use another presentation currency
when its financial environment is other than the currency of its home country. The
company should report in its functional currency which is the currency in which
most of a company’s transactions are conducted.
IFRS Overview
International Financial Reporting Standards Overview
International standards are developed and issued by the International Accounting
Standards Board (IASB).
Canada accepts IFRS as an adopter, integrating the standards as written by the
IASB without modification into the CPA Canada Handbook.
The authoritative language for IFRS internationally is English although the
standard is translated into many other languages. In Canada, however, there is an
authoritative French version, since the standards must say the same thing in both
English and French.
Accounting Standards for Canadian Publicly-Accountable Enterprises
Publicly accountable enterprise (PAE) is any company that has securities (debt
or equity or both) issued to the public or that is in the process of issuing debt or
equity to the public or a for-profit private enterprise that holds assets in a fiduciary
capacity for a broad group of outsiders as one of its primary businesses.
A fiduciary enterprise is any organization that acts in a trusteeship capacity for
members of the general public. (e.g. a mutual fund, a privately owned bank,
pension funds, credit unions).
Government business enterprises must disclose their financial performance and
thus are PAEs.
Reporting in U.S. GAAP
In order to enhance the acceptability of its shares in the U.S. financial markets, a
Canadian company may choose to follow U.S. GAAP, but it is rare for a Canadian
company to do so.
Legal and Regulatory Requirements
In some special industries such as banks, the normal provisions of IFRSs may be
supplemented by legal conditions such as requirements from Canada’s Bank Act.
Reporting Currency
Canadian companies do not always prepare their financial statements in Canadian
dollars. In general, IFRS requires a company to use another presentation currency
when its financial environment is other than the currency of its home country. The
company should report in its functional currency which is the currency in which
most of a company’s transactions are conducted.
Intermediate Accounting, 7th edition 3
Accounting Standards for Canadian Private Enterprises
A private enterprise is one that does not issue debt or equity securities to the public
nor is in the process of doing so and also does not hold assets in a fiduciary
capacity. All shares are held privately and not offered for sale on the open market.
Users are limited and generally have access to the information they need, either as
owners and /or managers or as bankers/creditors.
Private companies can use IFRS, ASPE or tailored accounting policies known as a
disclosed basis of accounting. A private company is often referred to
internationally as a SME, which is a small to medium sized enterprise.
Internationally, many countries follow IFRS for SMEs for appropriate private
corporations; Canada chose instead to develop Canadian ASPE. The choice
between following IFRS versus Canadian ASPE is unaffected by a Canadian
private corporation’s size.
Using IFRS
A private company may use IFRS instead of ASPE because it is in competition
with public companies for capital, and wants to be comparable. Despite the
inability to sell shares to the public, private corporations can obtain substantial
capital through private placements. A private placement is arranged by direct
negotiation between the company seeking capital and one or more suppliers of
capital.
Other reasons for private companies to use IFRS:
The company is a subsidiary of a parent that reports on the basis of IFRS.
The company may issue shares to the public in the future and wants to establish
a pattern of IFRS compliance.
The company’s controlling shareholders may intend to sell the company in the
near future and the use of IFRS may enhance credibility.
Using ASPE
The ACSB simplified the pre-existing standards in the CPA Canada Handbook, by
stripping out requirements that are less appropriate for private companies. ASPE is
based more on historical cost and less on fair values, and the disclosure
requirements are less onerous. As a result of the continuing use of the CPA Canada
Handbook instead of IFRS for SMEs, many private companies found little change
in their reports upon adoption of ASPE.
Accounting Standards for Canadian Private Enterprises
A private enterprise is one that does not issue debt or equity securities to the public
nor is in the process of doing so and also does not hold assets in a fiduciary
capacity. All shares are held privately and not offered for sale on the open market.
Users are limited and generally have access to the information they need, either as
owners and /or managers or as bankers/creditors.
Private companies can use IFRS, ASPE or tailored accounting policies known as a
disclosed basis of accounting. A private company is often referred to
internationally as a SME, which is a small to medium sized enterprise.
Internationally, many countries follow IFRS for SMEs for appropriate private
corporations; Canada chose instead to develop Canadian ASPE. The choice
between following IFRS versus Canadian ASPE is unaffected by a Canadian
private corporation’s size.
Using IFRS
A private company may use IFRS instead of ASPE because it is in competition
with public companies for capital, and wants to be comparable. Despite the
inability to sell shares to the public, private corporations can obtain substantial
capital through private placements. A private placement is arranged by direct
negotiation between the company seeking capital and one or more suppliers of
capital.
Other reasons for private companies to use IFRS:
The company is a subsidiary of a parent that reports on the basis of IFRS.
The company may issue shares to the public in the future and wants to establish
a pattern of IFRS compliance.
The company’s controlling shareholders may intend to sell the company in the
near future and the use of IFRS may enhance credibility.
Using ASPE
The ACSB simplified the pre-existing standards in the CPA Canada Handbook, by
stripping out requirements that are less appropriate for private companies. ASPE is
based more on historical cost and less on fair values, and the disclosure
requirements are less onerous. As a result of the continuing use of the CPA Canada
Handbook instead of IFRS for SMEs, many private companies found little change
in their reports upon adoption of ASPE.
Intermediate Accounting, 7th edition 4
Using a Disclosed Basis of Accounting
In practice, private enterprises are not bound by GAAP unless an external user
(such as a major lender) requires the company to use GAAP. When non-GAAP
accounting policies are used, the company is said to be reporting on a disclosed
basis of accounting (DBA).
A company cannot toss out all of GAAP. Deviations from GAAP usually
are limited to just certain policies (e.g. using tax based CCA instead of
accounting depreciation).
Learning Multiple Sets of Standards
Canada is using different accounting standards for public and private enterprises.
Although these are two different sets of GAAP, they are very similar and use the
same general principles and practices. Thus, Canadian ASPE can be regarded
mainly as simplifying exceptions to IFRS rather than as a substantially different
body of standards.
The Issue of Comparability
The point of establishing IFRS is not only to promote multiple exchange listings,
but also to greatly improve comparability between companies based in different
countries. However, international comparisons of financial statements can be
fraught with hazard because of differences between legal requirements, the political
environment and ways of doing business.
2. OBJECTIVES FOR FINANCIAL REPORTING
Management’s choice of accounting policy and disclosure are constrained by the
requirements of IFRS and Canadian ASPE.
To exercise judgement, the accountant must have criteria against which to measure
the suitability of alternatives. The most fundamental criteria for deciding on
policies, estimates, and disclosures are the objectives of financial reporting for the
organization.
To establish each enterprise’s financial objectives management must consider many
aspects of the company and the users of its financial statements.
See Exhibit 1-1 in the text which show the forces that shape a company’s financial
reporting objectives (facts, constraints, preparer motivations, user needs and user
power).
WATCH!
Using a Disclosed Basis of Accounting
In practice, private enterprises are not bound by GAAP unless an external user
(such as a major lender) requires the company to use GAAP. When non-GAAP
accounting policies are used, the company is said to be reporting on a disclosed
basis of accounting (DBA).
A company cannot toss out all of GAAP. Deviations from GAAP usually
are limited to just certain policies (e.g. using tax based CCA instead of
accounting depreciation).
Learning Multiple Sets of Standards
Canada is using different accounting standards for public and private enterprises.
Although these are two different sets of GAAP, they are very similar and use the
same general principles and practices. Thus, Canadian ASPE can be regarded
mainly as simplifying exceptions to IFRS rather than as a substantially different
body of standards.
The Issue of Comparability
The point of establishing IFRS is not only to promote multiple exchange listings,
but also to greatly improve comparability between companies based in different
countries. However, international comparisons of financial statements can be
fraught with hazard because of differences between legal requirements, the political
environment and ways of doing business.
2. OBJECTIVES FOR FINANCIAL REPORTING
Management’s choice of accounting policy and disclosure are constrained by the
requirements of IFRS and Canadian ASPE.
To exercise judgement, the accountant must have criteria against which to measure
the suitability of alternatives. The most fundamental criteria for deciding on
policies, estimates, and disclosures are the objectives of financial reporting for the
organization.
To establish each enterprise’s financial objectives management must consider many
aspects of the company and the users of its financial statements.
See Exhibit 1-1 in the text which show the forces that shape a company’s financial
reporting objectives (facts, constraints, preparer motivations, user needs and user
power).
WATCH!
Intermediate Accounting, 7th edition 5
3. GENERAL PURPOSE FINANCIAL REPORTING
Financial reporting for public companies is “general purpose” because the potential
interest group is large and diverse. A public company’s financial statements’ users
can be anyone, anywhere. The information needs of investors, lenders and other
creditors take priority over other groups such as employees and regulatory agencies
for accounting standard-setting when the IASB is setting accounting standards.
4. ENTERPRISE PREPORTING OBJECTIVES
In practice, “general purpose” is too general to guide specific enterprises.
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 either external users or preparers (managers and accountants).
Ethical Issues: Accountants are part of the preparer group because they
carry out the accounting and reporting decisions of management. An
accountant must be prepared to resist management’s potential pressure to
deliberately misstate financial results, even if it leads to dismissal.
5. EXTERNAL USER OBJECTIVES
Assessing and Predicting Cash Flows
Cash flow assessment and prediction, especially by investors and creditors, is an
important financial reporting objective.
Assessment versus Prediction
An assessment of cash flows is done by the financial statement user to understand
the cash inflows and outflows of the enterprise in the current period, normally
emphasizing cash flows from operating activities. Cash flow prediction requires
extrapolating current cash flow into future years.
Earnings Quality
If there is a high degree of correlation between the operating cash flow per share
and the earnings per share, the company is thought to have a high quality earnings.
The perceived quality of earnings is good when the relationship between operating
cash flow and net income is fairly stable.
Effect on Financial Reporting Choices
When cash flow assessment and prediction is the primary objective, financial
reporting policies are chosen that provide the clearest indication of the cash flows
underlying reported earnings.
WATCH!
3. GENERAL PURPOSE FINANCIAL REPORTING
Financial reporting for public companies is “general purpose” because the potential
interest group is large and diverse. A public company’s financial statements’ users
can be anyone, anywhere. The information needs of investors, lenders and other
creditors take priority over other groups such as employees and regulatory agencies
for accounting standard-setting when the IASB is setting accounting standards.
4. ENTERPRISE PREPORTING OBJECTIVES
In practice, “general purpose” is too general to guide specific enterprises.
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 either external users or preparers (managers and accountants).
Ethical Issues: Accountants are part of the preparer group because they
carry out the accounting and reporting decisions of management. An
accountant must be prepared to resist management’s potential pressure to
deliberately misstate financial results, even if it leads to dismissal.
5. EXTERNAL USER OBJECTIVES
Assessing and Predicting Cash Flows
Cash flow assessment and prediction, especially by investors and creditors, is an
important financial reporting objective.
Assessment versus Prediction
An assessment of cash flows is done by the financial statement user to understand
the cash inflows and outflows of the enterprise in the current period, normally
emphasizing cash flows from operating activities. Cash flow prediction requires
extrapolating current cash flow into future years.
Earnings Quality
If there is a high degree of correlation between the operating cash flow per share
and the earnings per share, the company is thought to have a high quality earnings.
The perceived quality of earnings is good when the relationship between operating
cash flow and net income is fairly stable.
Effect on Financial Reporting Choices
When cash flow assessment and prediction is the primary objective, financial
reporting policies are chosen that provide the clearest indication of the cash flows
underlying reported earnings.
WATCH!
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Intermediate Accounting, 7th edition 6
Income Tax Deferral is a common objective for private companies.
Financial reporting versus Income Tax Reporting
Canada Revenue Agency (CRA) does not require a corporation to use the same
reporting principles for tax as for accounting or vice versa.
Tax-Book Conformity
When corporations adopt the same accounting practices for financial reporting as
for tax reporting, this is known as tax-book conformity. There is no requirement to
do so in Canada.
Tax Deferral versus Tax Evasion
The use of legitimate options for reducing a company’s current taxable income is
known as tax deferral or tax minimization. In contrast, deliberate misstatement on
the tax return is tax evasion, which is fraud.
Effect on Financial Reporting Choices
Delaying recognition of revenue and speeding payment of expenses to the extent
permitted by the Income Tax Act will minimize taxes. Accounting policies that
reduce taxable income also reduce net income and may or may not be an issue for
managers, depending on if their compensation is tied to book income.
Contract Compliance
External users often use financial statements as the basis for assessing whether an
enterprise has complied with contract provisions (e.g. a debt-to-equity ratio).
These provisions are known as covenants. If a company fails to meet them, lenders
have the right to call the loan and force immediate payment. Shareholders’
agreements in private corporations also usually have provisions that affect the
valuation of shares if a shareholder decides to sell their shares.
Effect on Financial Reporting Choices
Ratios in debt agreements and for share valuation in shareholders’ agreements are
affected by accounting policy choices and estimates. Some agreements specify
what accounting policies must be used for calculating ratios.
Stewardship reporting focuses on showing the financial statement reader just how
the resources entrusted to management’s care were managed, therefore
transparency of accounting policy and measurement choices is important.
Effect on Financial Reporting Choices
The objective of stewardship is reflected in two ways:
(1) minimization of interperiod allocations and (2) full disclosure.
Performance Evaluation
Financial statement readers often use the statements to evaluate management
performance.
Income Tax Deferral is a common objective for private companies.
Financial reporting versus Income Tax Reporting
Canada Revenue Agency (CRA) does not require a corporation to use the same
reporting principles for tax as for accounting or vice versa.
Tax-Book Conformity
When corporations adopt the same accounting practices for financial reporting as
for tax reporting, this is known as tax-book conformity. There is no requirement to
do so in Canada.
Tax Deferral versus Tax Evasion
The use of legitimate options for reducing a company’s current taxable income is
known as tax deferral or tax minimization. In contrast, deliberate misstatement on
the tax return is tax evasion, which is fraud.
Effect on Financial Reporting Choices
Delaying recognition of revenue and speeding payment of expenses to the extent
permitted by the Income Tax Act will minimize taxes. Accounting policies that
reduce taxable income also reduce net income and may or may not be an issue for
managers, depending on if their compensation is tied to book income.
Contract Compliance
External users often use financial statements as the basis for assessing whether an
enterprise has complied with contract provisions (e.g. a debt-to-equity ratio).
These provisions are known as covenants. If a company fails to meet them, lenders
have the right to call the loan and force immediate payment. Shareholders’
agreements in private corporations also usually have provisions that affect the
valuation of shares if a shareholder decides to sell their shares.
Effect on Financial Reporting Choices
Ratios in debt agreements and for share valuation in shareholders’ agreements are
affected by accounting policy choices and estimates. Some agreements specify
what accounting policies must be used for calculating ratios.
Stewardship reporting focuses on showing the financial statement reader just how
the resources entrusted to management’s care were managed, therefore
transparency of accounting policy and measurement choices is important.
Effect on Financial Reporting Choices
The objective of stewardship is reflected in two ways:
(1) minimization of interperiod allocations and (2) full disclosure.
Performance Evaluation
Financial statement readers often use the statements to evaluate management
performance.
Loading page 7...
Intermediate Accounting, 7th edition 7
Effect on Financial Reporting Choices
In order to be useful for performance evaluation, financial statements should reflect
the basis on which management decisions are made. Managers have strong
motivations to select accounting policies that will enhance their apparent
performance.
Role of Auditor
The auditor is not a user of the financial statements. Because they are independent
from the company, they are able to provide an unbiased assessment of the financial
statements and their conformity to GAAP.
6. PREPARER MOTIVATIONS
Preparer (management) motivations often conflict with external users’ objectives
and may dominate the accounting choice process if external users lack the power to
enforce the dominance of their objectives.
Earnings Management
Income Smoothing Widely fluctuating earnings are an indication of business risk,
and mangers often don’t want to investors or creditors to perceive the company as
being risky. Income can be smoothed through spreading both revenues and costs
over several periods and by edging various accounting estimates up and down
within a feasible range.
Maximizing Earnings
Maximization of net income is one of the most common motivations, particularly in
public companies where share price is affected by reported earnings. Common
motivations to maximize earnings:
To comply with debt covenants by creditors.
To assist in positive management performance evaluations.
To preserve or increase management compensation.
The “Big Bath”
A corporation may elect to maximize a loss in one year as part of a longer-run
strategy to maximize earnings. If there is an operating loss any way, it is an
opportunity to load as many losses into that year as possible (“taking a big bath”),
and enjoy the benefits of recovery in a subsequent period.
Minimizing Earnings
Management may wish to minimize reported earnings to minimize income taxes, to
avoid attracting competitors into a very profitable business, or to avoid negative
scrutiny from the public, regulators or employees.
Effect on Financial Reporting Choices
In order to be useful for performance evaluation, financial statements should reflect
the basis on which management decisions are made. Managers have strong
motivations to select accounting policies that will enhance their apparent
performance.
Role of Auditor
The auditor is not a user of the financial statements. Because they are independent
from the company, they are able to provide an unbiased assessment of the financial
statements and their conformity to GAAP.
6. PREPARER MOTIVATIONS
Preparer (management) motivations often conflict with external users’ objectives
and may dominate the accounting choice process if external users lack the power to
enforce the dominance of their objectives.
Earnings Management
Income Smoothing Widely fluctuating earnings are an indication of business risk,
and mangers often don’t want to investors or creditors to perceive the company as
being risky. Income can be smoothed through spreading both revenues and costs
over several periods and by edging various accounting estimates up and down
within a feasible range.
Maximizing Earnings
Maximization of net income is one of the most common motivations, particularly in
public companies where share price is affected by reported earnings. Common
motivations to maximize earnings:
To comply with debt covenants by creditors.
To assist in positive management performance evaluations.
To preserve or increase management compensation.
The “Big Bath”
A corporation may elect to maximize a loss in one year as part of a longer-run
strategy to maximize earnings. If there is an operating loss any way, it is an
opportunity to load as many losses into that year as possible (“taking a big bath”),
and enjoy the benefits of recovery in a subsequent period.
Minimizing Earnings
Management may wish to minimize reported earnings to minimize income taxes, to
avoid attracting competitors into a very profitable business, or to avoid negative
scrutiny from the public, regulators or employees.
Loading page 8...
Intermediate Accounting, 7th edition 8
Minimum Compliance refers to the motivation of managers to reveal the least
amount of information that is possible while still complying with GAAP, which
reduces the cost of producing the statements. Managers may wish to maintain
confidentiality about their business activities in order to keep competitors in the
dark.
Expanded Disclosure
The motivation for expanded disclosure may simply be to indicate that the
company and its management are “good citizens” that have nothing to hide.
7. CONFLICTING OBJECTIVES
Once a company’s objectives have been identified, they then must be prioritized as
often they are conflicting. Accounting requires the constant exercise of
professional judgement and a clear ethical orientation to deal with the impact of
conflicting objectives.
8. REQUIRED FINANCIAL STATEMENTS
Under IFRS a complete set of financial statements consist of:
1. Statement of financial position
2. Statement of comprehensive income (including statement of profit or loss and
statement of other comprehensive income)
3. Statement of changes in equity
4. Statement of cash flows
5. Disclosure notes: A set of notes comprising a summary of significant
accounting policies and other explanatory information
Under IFRS, financial statement titles are variable based on relevance to the users
so variations in the statement titles are acceptable.
Canadian Accounting Standards for Private Enterprises (ASPE) have a somewhat
simpler set of financial statements:
1. Balance sheet
2. Income statement
3. Statement of changes in retained earnings
4. Statement of cash flows
5. Disclosure notes
Minimum Compliance refers to the motivation of managers to reveal the least
amount of information that is possible while still complying with GAAP, which
reduces the cost of producing the statements. Managers may wish to maintain
confidentiality about their business activities in order to keep competitors in the
dark.
Expanded Disclosure
The motivation for expanded disclosure may simply be to indicate that the
company and its management are “good citizens” that have nothing to hide.
7. CONFLICTING OBJECTIVES
Once a company’s objectives have been identified, they then must be prioritized as
often they are conflicting. Accounting requires the constant exercise of
professional judgement and a clear ethical orientation to deal with the impact of
conflicting objectives.
8. REQUIRED FINANCIAL STATEMENTS
Under IFRS a complete set of financial statements consist of:
1. Statement of financial position
2. Statement of comprehensive income (including statement of profit or loss and
statement of other comprehensive income)
3. Statement of changes in equity
4. Statement of cash flows
5. Disclosure notes: A set of notes comprising a summary of significant
accounting policies and other explanatory information
Under IFRS, financial statement titles are variable based on relevance to the users
so variations in the statement titles are acceptable.
Canadian Accounting Standards for Private Enterprises (ASPE) have a somewhat
simpler set of financial statements:
1. Balance sheet
2. Income statement
3. Statement of changes in retained earnings
4. Statement of cash flows
5. Disclosure notes
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Intermediate Accounting, 7th edition 1
CHAPTER 2
Accounting Judgements
Learning Objectives:
After you have studied this chapter, you should:
1 Understand the concepts involved in constructing financial statements.
2 Explain the role of ethical professional judgement in accounting.
3 Apply the universal and entity specific assumptions underlying the
foundation of GAAP.
4 Apply the fundamental and enhancing qualities and pervasive
constraints of financial reporting.
5 Describe the measurement methods available within GAAP.
6 Discuss the criteria for recognizing business events and transactions in
the financial records.
7 Describe the measurement methods used in the accounting standards
for private enterprises.
Lecture Notes
Accounting is often a matter of making choices among possible alternatives. This chapter
discusses the financial statement concepts and principles that guide standard setters and
that accountants use to make those choices. These concepts and principles are the basis
for professional judgement. Chapters 6 to 11 illustrate how those concepts and principles
are applied to specific accounting issues.
1. CATEGORIES OF ACCOUNTING CONCEPTS
The generally accepted body of accounting principles consists of three different types of
concepts. The types of concepts are:
1. Underlying assumptions, which form the basic foundation for which
accounting measurement rests. The accounting principle of continuity (going
concern) is an underlying assumption.
CHAPTER 2
Accounting Judgements
Learning Objectives:
After you have studied this chapter, you should:
1 Understand the concepts involved in constructing financial statements.
2 Explain the role of ethical professional judgement in accounting.
3 Apply the universal and entity specific assumptions underlying the
foundation of GAAP.
4 Apply the fundamental and enhancing qualities and pervasive
constraints of financial reporting.
5 Describe the measurement methods available within GAAP.
6 Discuss the criteria for recognizing business events and transactions in
the financial records.
7 Describe the measurement methods used in the accounting standards
for private enterprises.
Lecture Notes
Accounting is often a matter of making choices among possible alternatives. This chapter
discusses the financial statement concepts and principles that guide standard setters and
that accountants use to make those choices. These concepts and principles are the basis
for professional judgement. Chapters 6 to 11 illustrate how those concepts and principles
are applied to specific accounting issues.
1. CATEGORIES OF ACCOUNTING CONCEPTS
The generally accepted body of accounting principles consists of three different types of
concepts. The types of concepts are:
1. Underlying assumptions, which form the basic foundation for which
accounting measurement rests. The accounting principle of continuity (going
concern) is an underlying assumption.
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Intermediate Accounting, 7th edition 2
2. Qualitative criteria, which in conjunction with the organization’s reporting
objectives, facts and constraints, are used to evaluate the possible
measurement options and select the most appropriate measurement methods
for a given situation. The principles of comparability and understandability
are examples of qualitative criteria.
3. Measurement methods, which are the various ways in which financial
position and the results of operations can be reported. These methods are
how transactions and events are measured and reported. The accounting
principles of fair value and realizable value are examples of measurement
methods, and are both based on the underlying continuity assumption.
Limitations of the Concepts
There are limitations to the use of accounting concepts. They focus on generalities
because they determine policies for a wide application and on producing general purpose
financial statements. Therefore, there are exceptions to the applicability of the concepts
and conclusions.
Structure of Accounting Policy Choice
In constructing the financial statements for an enterprise, you must determine the
objectives of the financial reporting, make sure the underlying assumptions are valid,
measure the elements of financial statements for the situation that satisfy the qualitative
criteria and finally prepare the financial statements. This process is illustrated in Exhibit
2-1 of the textbook and follows this order of consideration:
1. Underlying assumptions
2. Qualitative criteria
3. Accounting choices
a. Financial statement elements
b. Recognition and realization
c. Measurement methods
In selecting accounting policies, an accountant must first evaluate the facts in the
situation including reporting constraints. If the facts allow a choice, then the users
and objectives are considered in selecting the appropriate accounting policy.
Decisions cannot be made strictly according to which policy is best for the users
and objectives while ignoring the facts in the situation.
WATCH!
2. Qualitative criteria, which in conjunction with the organization’s reporting
objectives, facts and constraints, are used to evaluate the possible
measurement options and select the most appropriate measurement methods
for a given situation. The principles of comparability and understandability
are examples of qualitative criteria.
3. Measurement methods, which are the various ways in which financial
position and the results of operations can be reported. These methods are
how transactions and events are measured and reported. The accounting
principles of fair value and realizable value are examples of measurement
methods, and are both based on the underlying continuity assumption.
Limitations of the Concepts
There are limitations to the use of accounting concepts. They focus on generalities
because they determine policies for a wide application and on producing general purpose
financial statements. Therefore, there are exceptions to the applicability of the concepts
and conclusions.
Structure of Accounting Policy Choice
In constructing the financial statements for an enterprise, you must determine the
objectives of the financial reporting, make sure the underlying assumptions are valid,
measure the elements of financial statements for the situation that satisfy the qualitative
criteria and finally prepare the financial statements. This process is illustrated in Exhibit
2-1 of the textbook and follows this order of consideration:
1. Underlying assumptions
2. Qualitative criteria
3. Accounting choices
a. Financial statement elements
b. Recognition and realization
c. Measurement methods
In selecting accounting policies, an accountant must first evaluate the facts in the
situation including reporting constraints. If the facts allow a choice, then the users
and objectives are considered in selecting the appropriate accounting policy.
Decisions cannot be made strictly according to which policy is best for the users
and objectives while ignoring the facts in the situation.
WATCH!
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Intermediate Accounting, 7th edition 3
2. ETHICAL PROFESSIONAL JUDGEMENT – PART 1
The process of making choices in accounting is the process of exercising professional
judgement. An accountant exercises professional judgement to be fair to all stakeholders.
Judgement is used in many aspects of accounting that are not specifically dealt with in the
accounting standards. This is done by taking into account several factors:
• The users of financial statements and their specific information needs;
• The motivations of managers;
• The nature of the organization’s operations; and
• The organization’s reporting constraints.
Accounting policy choices and estimates must be made taking these factors in to account.
3. UNDERLYING ASSUMPTIONS
Underlying assumptions provide the foundation of GAAP for for-profit enterprises, but
only the going-concern assumption is discussed specifically in the IFRS conceptual
framework. There are six basic assumptions affect the recording, measuring, and reporting
of accounting information. These are divided into 2 general categories (1) universal
assumptions and (2) entity-specific assumptions.
Universal assumptions:
1. Time-period.
2. Separate entity.
3. Unit of measure.
Entity-specific assumptions (depend on an individual entity’s reporting circumstances):
1. Proprietary.
2. Continuity.
3. Stable currency.
GAAP changes in response to changes in the environment but the underlying assumptions
are assumed to be constant. If any of these assumptions are not valid, then GAAP is not
appropriate.
Universal Assumptions
The time-period assumption recognizes that information needs to be provided to users for
a time period less than the enterprise’s life span and states that it is feasible to provide
useful information in shorter periods while the enterprise is in operation.
The standard reporting period is one year; however, some companies use a calendar year-
end that coincides with the low point in business activity over a 12-month period. Other
companies report summarized information on an interim basis (quarterly for public
2. ETHICAL PROFESSIONAL JUDGEMENT – PART 1
The process of making choices in accounting is the process of exercising professional
judgement. An accountant exercises professional judgement to be fair to all stakeholders.
Judgement is used in many aspects of accounting that are not specifically dealt with in the
accounting standards. This is done by taking into account several factors:
• The users of financial statements and their specific information needs;
• The motivations of managers;
• The nature of the organization’s operations; and
• The organization’s reporting constraints.
Accounting policy choices and estimates must be made taking these factors in to account.
3. UNDERLYING ASSUMPTIONS
Underlying assumptions provide the foundation of GAAP for for-profit enterprises, but
only the going-concern assumption is discussed specifically in the IFRS conceptual
framework. There are six basic assumptions affect the recording, measuring, and reporting
of accounting information. These are divided into 2 general categories (1) universal
assumptions and (2) entity-specific assumptions.
Universal assumptions:
1. Time-period.
2. Separate entity.
3. Unit of measure.
Entity-specific assumptions (depend on an individual entity’s reporting circumstances):
1. Proprietary.
2. Continuity.
3. Stable currency.
GAAP changes in response to changes in the environment but the underlying assumptions
are assumed to be constant. If any of these assumptions are not valid, then GAAP is not
appropriate.
Universal Assumptions
The time-period assumption recognizes that information needs to be provided to users for
a time period less than the enterprise’s life span and states that it is feasible to provide
useful information in shorter periods while the enterprise is in operation.
The standard reporting period is one year; however, some companies use a calendar year-
end that coincides with the low point in business activity over a 12-month period. Other
companies report summarized information on an interim basis (quarterly for public
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Intermediate Accounting, 7th edition 4
companies, monthly for internal purposes). Although the reporting period varies, one year
is the standard.
The separate entity assumption considers an accounting unit or identifiable business
enterprise as separate and apart from its owners and from other entities.
This concept does not necessarily correspond with legal and tax status of an entity.
A corporation is an entity that is legally distinct. Partnerships and proprietorships are not
legally distinct but the separate entity assumption still applies; for accounting purposes they
are considered separate from their owners. All accounting records and reports are
developed from the point of view of a single entity with the assumption that an individual’s
transactions are distinguishable from those of the business.
The unit-of-measure assumption refers to the results of the business’s economic activities.
The assumption is that these can be reported in terms of a single standard monetary unit
and, further, that everything of relevance can be measured using the dollar as the unit of
measure. Thus, something that can’t be measured can’t be reported. Therefore, information
that may be relevant to decision makers may not be reported, such as:
• The value of in-house intellectual capital.
• The impact of the company’s operations.
• The value of customer goodwill and “human capital” (i.e. employees).
Entity-Specific Assumptions
The proprietary concept considers that the results of an enterprise’s operations should be
reported from the point of view of the owners. This concept is applied to all types of
business enterprises and has nothing to do with the form of the enterprise (i.e.,
proprietorship, partnership, or corporation). This concept follows the accounting equation
with assets discharging liabilities and residual wealth to the owners.
The continuity assumption is also known as the going-concern assumption. The
assumption is that the enterprise will continue operating for the foreseeable future and not
be liquidated. It assumes that the business will continue long enough to recover the assets
and repay its outstanding liabilities. This assumption provides the conceptual basis for
measuring and classifying assets and liabilities in current and non-current classifications.
There are two instances where this assumption is not valid - a limited life venture, and a
business in financial difficulty that is expected to be shut down. If this assumption is in
doubt because of financial difficulty, the historical costs of assets are not relevant and
liquidation accounting is appropriate.
companies, monthly for internal purposes). Although the reporting period varies, one year
is the standard.
The separate entity assumption considers an accounting unit or identifiable business
enterprise as separate and apart from its owners and from other entities.
This concept does not necessarily correspond with legal and tax status of an entity.
A corporation is an entity that is legally distinct. Partnerships and proprietorships are not
legally distinct but the separate entity assumption still applies; for accounting purposes they
are considered separate from their owners. All accounting records and reports are
developed from the point of view of a single entity with the assumption that an individual’s
transactions are distinguishable from those of the business.
The unit-of-measure assumption refers to the results of the business’s economic activities.
The assumption is that these can be reported in terms of a single standard monetary unit
and, further, that everything of relevance can be measured using the dollar as the unit of
measure. Thus, something that can’t be measured can’t be reported. Therefore, information
that may be relevant to decision makers may not be reported, such as:
• The value of in-house intellectual capital.
• The impact of the company’s operations.
• The value of customer goodwill and “human capital” (i.e. employees).
Entity-Specific Assumptions
The proprietary concept considers that the results of an enterprise’s operations should be
reported from the point of view of the owners. This concept is applied to all types of
business enterprises and has nothing to do with the form of the enterprise (i.e.,
proprietorship, partnership, or corporation). This concept follows the accounting equation
with assets discharging liabilities and residual wealth to the owners.
The continuity assumption is also known as the going-concern assumption. The
assumption is that the enterprise will continue operating for the foreseeable future and not
be liquidated. It assumes that the business will continue long enough to recover the assets
and repay its outstanding liabilities. This assumption provides the conceptual basis for
measuring and classifying assets and liabilities in current and non-current classifications.
There are two instances where this assumption is not valid - a limited life venture, and a
business in financial difficulty that is expected to be shut down. If this assumption is in
doubt because of financial difficulty, the historical costs of assets are not relevant and
liquidation accounting is appropriate.
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Intermediate Accounting, 7th edition 5
A common problem is the misuse of the term going concern. A company that is
considered to be a going concern is expected to continue in operation. If there is a
going concern issue or going concern problem, then this assumption is no longer
valid. An example would be where the company is undergoing financial
restructuring.
The stable currency assumption assumes constant purchasing power and that the value of
the dollar does not change significantly from year to year. The reason for this assumption
is that inflation in most developed countries has been relatively modest. It also assumes the
dollar is constant in relation to the value of other currencies (its exchange rate).
Two other concepts are related to the stable currency assumption. The concept of capital
maintenance explains that to keep operating successfully, an entity must preserve its
capital investment. This assumption also includes the use of a nominal dollar, which is not
adjusted for inflation. The nominal dollar assumption is still dominant universally, due to
the reliance on historical cost methods in the measurement of assets. As we move more to
fair value accounting, alternative perspectives are gaining strength.
Alternative Capital Maintenance Approaches
Financial capital maintenance is measured in nominal monetary units or in units of
constant purchasing power.
Constant dollar capital maintenance says that not all dollars are created equally.
Therefore, if prices are rising then the enterprise needs to keep more nominal dollars
invested in capital to stay even.
Physical capital maintenance concept recognizes that the prices of different goods and
services change at different rates. The key is the company needs to maintain the same level
of productive capacity in its assets. This is the perspective that supports the use of fair-
value reporting.
4. QUALITATIVE CRITERIA
Qualitative criteria are criteria that, in conjunction with the organization’s reporting
objectives, are used to evaluate possible measurement options and to choose the most
appropriate accounting policies. The qualitative criteria are summarized in a table on the
next page.
WATCH!
A common problem is the misuse of the term going concern. A company that is
considered to be a going concern is expected to continue in operation. If there is a
going concern issue or going concern problem, then this assumption is no longer
valid. An example would be where the company is undergoing financial
restructuring.
The stable currency assumption assumes constant purchasing power and that the value of
the dollar does not change significantly from year to year. The reason for this assumption
is that inflation in most developed countries has been relatively modest. It also assumes the
dollar is constant in relation to the value of other currencies (its exchange rate).
Two other concepts are related to the stable currency assumption. The concept of capital
maintenance explains that to keep operating successfully, an entity must preserve its
capital investment. This assumption also includes the use of a nominal dollar, which is not
adjusted for inflation. The nominal dollar assumption is still dominant universally, due to
the reliance on historical cost methods in the measurement of assets. As we move more to
fair value accounting, alternative perspectives are gaining strength.
Alternative Capital Maintenance Approaches
Financial capital maintenance is measured in nominal monetary units or in units of
constant purchasing power.
Constant dollar capital maintenance says that not all dollars are created equally.
Therefore, if prices are rising then the enterprise needs to keep more nominal dollars
invested in capital to stay even.
Physical capital maintenance concept recognizes that the prices of different goods and
services change at different rates. The key is the company needs to maintain the same level
of productive capacity in its assets. This is the perspective that supports the use of fair-
value reporting.
4. QUALITATIVE CRITERIA
Qualitative criteria are criteria that, in conjunction with the organization’s reporting
objectives, are used to evaluate possible measurement options and to choose the most
appropriate accounting policies. The qualitative criteria are summarized in a table on the
next page.
WATCH!
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Intermediate Accounting, 6th edition 15
CRITERIA COMPONENTS DESCRIPTION
FUNDAMENTAL QUALITIES (both qualitative characteristics must be present to represent an economic event and cannot be traded of)
1.Relevance Capacity of accounting information to make a difference to the external decision-makers who
use financial reports. Theoretically, relevance is the most important qualitative characteristic.
Predictive value
Confirmatory or
Feedback value
Accounting information should be helpful to external decision makers by increasing their
ability to make decisions about the outcome of future events (predictive value).
Accounting information should be helpful to external decision makers who are confirming or
adjusting past predictions.
2.Faithful
representation
The information is a sufficiently accurate measure of what it is intended to measure.
Although currently not a specific component of faithful representation, substance over form,
represents the economic rather than legal impact of a transaction, is included as an element of
faithfully portraying a transaction. Faithful representation is closely related to reliability.
Completeness Information must give a faithful picture of the economic events or financial elements.
The information must not mislead or deceive.
Neutrality Financial reports are neutral if they do not influence a user’s decisions. It is also known as
free from bias.
Freedom from
material error
If the statements are free from bias, overstatements and understatements must not exist.
Faithful representation does not imply “accuracy” in that it is completely free from error, but
rather free from material error.
ENHANCING QUALITIES
(the order of these qualities is not a hierarchy, as these characteristics are traded off as needed in support of the fundamental qualities)
3. Comparability Enables users to identify similarities and differences between two sets of financial statements.
Consistency Entails using the same accounting policies from period to period within the firm. If
consistency is carried too far, it adversely affects relevance, so a change of policy is permitted
if applied appropriately.
Uniformity Companies with similar transactions and similar circumstances use the same accounting
treatments.
4.Verifiability The accounting measure is a reasonable measure of the economic event, without material
error or bias; and
CRITERIA COMPONENTS DESCRIPTION
FUNDAMENTAL QUALITIES (both qualitative characteristics must be present to represent an economic event and cannot be traded of)
1.Relevance Capacity of accounting information to make a difference to the external decision-makers who
use financial reports. Theoretically, relevance is the most important qualitative characteristic.
Predictive value
Confirmatory or
Feedback value
Accounting information should be helpful to external decision makers by increasing their
ability to make decisions about the outcome of future events (predictive value).
Accounting information should be helpful to external decision makers who are confirming or
adjusting past predictions.
2.Faithful
representation
The information is a sufficiently accurate measure of what it is intended to measure.
Although currently not a specific component of faithful representation, substance over form,
represents the economic rather than legal impact of a transaction, is included as an element of
faithfully portraying a transaction. Faithful representation is closely related to reliability.
Completeness Information must give a faithful picture of the economic events or financial elements.
The information must not mislead or deceive.
Neutrality Financial reports are neutral if they do not influence a user’s decisions. It is also known as
free from bias.
Freedom from
material error
If the statements are free from bias, overstatements and understatements must not exist.
Faithful representation does not imply “accuracy” in that it is completely free from error, but
rather free from material error.
ENHANCING QUALITIES
(the order of these qualities is not a hierarchy, as these characteristics are traded off as needed in support of the fundamental qualities)
3. Comparability Enables users to identify similarities and differences between two sets of financial statements.
Consistency Entails using the same accounting policies from period to period within the firm. If
consistency is carried too far, it adversely affects relevance, so a change of policy is permitted
if applied appropriately.
Uniformity Companies with similar transactions and similar circumstances use the same accounting
treatments.
4.Verifiability The accounting measure is a reasonable measure of the economic event, without material
error or bias; and
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Intermediate Accounting, 6th edition 16
CRITERIA COMPONENTS DESCRIPTION
If knowledgeable and independent observers using the same measurement methods can
measure an economic event and arrive at generally the same result, the measurement is
verifiable.
5.Timeliness Accounting information should be reported soon enough for it to be useful for decision
making (within economic context). Lack of timeliness reduces relevance.
6.Understandability Based on the assumption that investors and creditors have a reasonable understanding of
business and economic activities—and of accounting. Information must be understandable to
be useful.
PERVASIVE CONSTRAINTS
7. Materiality Materiality is used to describe the significance of an item. Information is material if its
omission or misstatement would be likely to change or impact the user’s decision. Materiality
is related to both relevance and faithful representation.
8.Cost/benefit tradeoff Any accounting measurement or disclosure should result in greater benefits to the users than
its cost to prepare and present. Benefits should exceed costs.
It is for this reason the AcSB provides for a somewhat simpler version of GAAP called
Accounting Standards for Private Enterprises (ASPE) which enables private companies to
follow simpler accounting policies in some areas.
CRITERIA COMPONENTS DESCRIPTION
If knowledgeable and independent observers using the same measurement methods can
measure an economic event and arrive at generally the same result, the measurement is
verifiable.
5.Timeliness Accounting information should be reported soon enough for it to be useful for decision
making (within economic context). Lack of timeliness reduces relevance.
6.Understandability Based on the assumption that investors and creditors have a reasonable understanding of
business and economic activities—and of accounting. Information must be understandable to
be useful.
PERVASIVE CONSTRAINTS
7. Materiality Materiality is used to describe the significance of an item. Information is material if its
omission or misstatement would be likely to change or impact the user’s decision. Materiality
is related to both relevance and faithful representation.
8.Cost/benefit tradeoff Any accounting measurement or disclosure should result in greater benefits to the users than
its cost to prepare and present. Benefits should exceed costs.
It is for this reason the AcSB provides for a somewhat simpler version of GAAP called
Accounting Standards for Private Enterprises (ASPE) which enables private companies to
follow simpler accounting policies in some areas.
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