Introduction to Accounting Theory & Contemporary Issues

192 Pages·2011·1.44 MB·English

Course Schedule Course Modules Review and Practice Exam Preparation Resources
Introduction to Accounting Theory & Contemporary Issues
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Course purpose
This course has two main goals. The first is to describe and explore various theories that underlie financial
accounting and reporting. The second is to explain and illustrate the relevance of these theories in order to
understand the practice of financial accounting and reporting.
What are some of these underlying theories? You will find that some of these theories are based on economics
and finance. Economics underlies much of financial accounting and reporting. One of the earliest influences of
economics on accounting is the present value model. By discounting future cash flows to a common point in
time, the present value model enables a theoretically correct basis of asset and liability valuation and income
measurement — assets and liabilities are valued at the present value of their future cash receipts and
payments, and income is the change in present value over time. Thus, the present value model provides a
benchmark to guide accounting practice. While it can be difficult to apply in the complex real-world
environment in which accountants operate, there is nevertheless increasing emphasis on the present value
model in financial reporting. Examples include fair value reporting for financial instruments, ceiling tests for
capital assets, and valuation of pension and other employee post-employment benefits.
Portfolio theory and efficient securities market theory are from finance. Portfolio theory is relevant to
accountants because it helps them understand how investors make rational investment decisions and how they
use financial accounting information to make their decisions. Accountants can then prepare financial statements
that are of greatest use to investors.
Efficient securities market theory also has important implications for financial accounting. An efficient securities
market is one in which securities’ prices always properly reflect all available information about securities traded
on that market. Since financial reports supply much (but not all) of the available information about firms,
accountants are now generally aware of the concept of efficient markets. For example, such awareness has led
to the principle of full disclosure, whereby accountants attempt to maximize the information content of financial
statements, including notes to the statements. Often, such full disclosure is not popular with management. Full
disclosure, however, reduces the amount of inside information and the resulting problem of insider trading.
A more recent influence of theory on accounting is that branch of economics called information economics
or the economics of imperfect information. Information economics formally recognizes information
asymmetry between different parties, such as managers and shareholders of large companies. Managers
typically know more about the firm’s prospects than shareholders, which may give managers advantages.
For example, if managers know that future firm prospects are good, they may not work as hard on the
shareholders’ behalf and may take excessive perquisites for themselves instead. They may also be tempted to
profit from their inside information by insider trading, at the expense of investors. These problems complicate
the role of corporate governance in motivating and controlling manager behaviour. For example, a manager
may blame natural disasters for low profits when the actual cause is substandard performance, such as lack of
effort or poor cost control. Shareholders, who cannot observe manager effort, have no way of knowing the real
reasons for the low profits.
Models have been developed in information economics to help us understand and predict the outcome of such
conflict situations. The shareholder-manager interaction just described can be facilitated by making a contract
between these two parties, which will spell out the obligations of each party and specify the compensation for
the manager.
The contractual nature of information economics has major implications for financial accounting and reporting.
One reason is that, directly or indirectly, compensation of top managers depends on reported net income.
Therefore, a precise and sensitive income measure that accurately reflects manager performance is essential.
This role of net income — to assist in motivating managers by providing a reliable measure upon which profit-
sharing contracts can be based — is quite different from its equally important role of providing information to
capital markets. It is not reasonable to expect that a measure of net income that is most useful for contracting
purposes will also be most useful for reporting to investors.
Another reason is that covenants in debt contracts often depend on accounting variables. Since debtholders will
suffer if the firm enters financial distress, they demand conservative accounting, such as lower-of-cost-or-
market and ceiling tests. These provide an early warning system so that debtholders can take steps to protect
their interests before it is too late.
Therefore, financial accounting theory now recognizes two major roles for net income — contracting and
reporting.
Another effect of information economics is that it contains the concept of economic consequences.
Essentially, this concept asserts that accounting policies do matter. For example, a manager whose
compensation depends on reported net income will be interested in the accounting policies used to calculate
that income. Therefore, changes in accounting policies, such as those laid down by new accounting standards,
can have major consequences, even if those changes have no effects on cash flows. A new accounting policy
that tends to lower reported net income (such as the recording of deferred income taxes, post-employment
benefits, or the successful-efforts method for exploration costs of oil and gas companies) can affect the way
managers run the firm, as can accounting policies that increase net income volatility, such as fair value
accounting. Anticipating a decrease in their compensation or an increase in the volatility of the firm’s reported
net income, managers may change operating and investment strategies to compensate for the effect of the
change in accounting policy. This can influence the market value of the firm’s shares, thereby affecting
shareholder wealth.
The concept of economic consequences has led accountants to pay increased attention to the important and
difficult role of standard-setting bodies, such as the Accounting Standards Board (AcSB) of the Canadian
Institute of Chartered Accountants (CICA, currently responsible for setting standards for private enterprises in
Canada), the Financial Accounting Standards Board (FASB) in the United States, and the International
Accounting Standards Board (IASB). These bodies face the formidable task of determining the economic
consequences of particular accounting policy pronouncements and of trading off the interests of constituencies
who may be affected differently by these pronouncements. In effect, the setting of accounting standards is as
much a political process as an economic one.
The second goal of this course is to explain and illustrate the relevance of the various theories mentioned
previously to financial accounting and reporting. This is accomplished in two main ways. First, the material
alternates between theory and application. For example, Module 2 describes how investors make rational
investment decisions, and then demonstrates how the decision usefulness approach underlies the
pronouncements of the major accounting standard-setting bodies and how it is applied to financial accounting
and reporting. You will better understand and apply these pronouncements when you understand the reasoning
behind them. It is essential to realize that this alternation between theory and practice is designed to motivate
you to consider the theory seriously.
Another approach to illustrating the relevance of the course material is through the review questions and
assignments. A real attempt has been made to design and select material to illustrate the course concepts.
As you know, from 2011, financial reporting for publicly-traded firms in Canada is in accordance with
International Accounting Board (IASB) standards. This course includes coverage of IASB standards, in the
textbook, the modules, the assignments, and review material.
Coverage of certain United States standards is also included where these differ significantly from IASB
standards. Of course, differences are decreasing over time as these two bodies move towards a converged set
of standards.
All of this material is examinable unless specifically marked to the contrary.
In this course, material relating to specific accounting standards is largely (but not completely) at a conceptual
level. Fortunately, at this level, most standards in Canada, the United States, and internationally are broadly
similar, thereby reducing the amount of detail you will have to learn.
Course prerequisites
As an advanced financial accounting course, Accounting Theory & Contemporary Issues draws on knowledge
you have acquired from several other subjects, specifically financial accounting, economics, quantitative
methods, and finance. You can find course descriptions of the prerequisite courses in the CGA-Canada
Syllabus. You can also obtain a copy from your CGA regional office.
In the quantitative area, you should be able to calculate expected utilities, abnormal returns, accretion of
discount, standardized measure income statement and alternative statement, Bayes Theorem and Nash
equilibriums.
Hands-on computer work is not currently required in AT1. Most of the questions are essay type.
Questions that do require computations can be done quickly by hand or by calculator. Of course, you are
welcome to use your knowledge of computer-based problem-solving techniques to solve any of the quantitative
questions.
An understanding of ethical principles and how the accounting profession addresses ethical issues is an
essential part of the CGA program of professional studies. The Ethics Readings Handbook [ERH] has been
developed as a study resource in this area and is provided electronically through the "Reference library" link
under the Resources tab.
In AT1 it is assumed that you have become familiar with Section A of the ERH. This section clarifies important
concepts and terms used throughout the ERH, and is necessary background knowledge for ERH readings
referenced in this and other courses.
When working with AT1, you are expected to have acquired basic competence with Microsoft Windows. For
more information on how to work with software in this course, refer to How To/Use Software under the
Resources tab.
Structure and delivery
AT1 comprises 10 modules that can be studied over a 12-week period, one module per week followed by
preparation for the final examination. Each module should take between 15 and 20 hours to complete. The
modules are delivered online and can be saved to your hard drive and also printed.
Course materials
The textbook and reference materials for this course are
William R. Scott, Financial Accounting Theory, Fifth Edition (Toronto, Ontario: Pearson Education
Canada, 2009)
Canadian Institute of Chartered Accountants, CICA Handbook — Accounting, updated to January
2011 release
Ethics Readings Handbook [ERH], Fourth Edition (Vancouver, B.C.: CGA-Canada, 2011)
For a list of the required software for all CGA courses, see Technical Support/System requirements under the
Resources tab.
CICA Handbooks
Whether or not the CICA Handbook is required for your course, you can purchase access to an online
subscription. Be sure to subscribe to the correct Handbook (Accounting, Assurance, or Public Sector). Here are
the CGA courses in which the Handbooks are required:
CICA Handbook — Accounting, required for Financial Accounting: Consolidations & Advanced
Issues [FA4], Accounting Theory & Contemporary Issues [AT1]
CICA Handbook — Assurance, required for External Auditing [AU1], Advanced External Auditing
[AU2]
CICA Handbook — Public Sector Accounting, required for Public Sector Financial Management
[PF1]
The subscriptions expire at the end of the December following the academic year for which they are purchased.
Using the course materials
The module notes and text provide the structure for studying the various course topics. Additional required
readings have been selected to enhance your understanding of the topics.
This course includes a wide selection of learning materials from various sources: textbook, articles, financial
statements, and other materials. You should note:
Articles included as readings for a module: These are to be read and studied at the levels
of competence indicated in the related module notes. They are examinable at the level indicated
and would not be reproduced or provided with the examination paper.
Articles included as part of a review or an assignment question: These are to be read
and studied only for the purposes of answering the specific, related question(s) in that
assignment. You are not responsible for the content of such articles for examination purposes.
Articles included as part of an examination question: An examination question may
include, as part of its data, an article, statement, or similar source material. If this material is
part of the module notes (a reading), then it would not be provided on the examination. Any
other article will be attached to the examination paper.
Comparison of commonly used terms — IFRS and pre-IFRS CICA Handbook
The Accounting Standards Board prepares the CICA Handbook and the International Accounting Standards
Board prepares IFRSs. Understandably, while the terminology used by these two bodies is similar in many
aspects, it does vary somewhat. A list of some of the more common differences follows. As these terms may
be used interchangeably in the CGA course materials, you need to be familiar with both versions.
IFRS CICA
at fair value through profit and loss held for trading
closing rate, closing exchange rate current rate, current exchange rate
deferred income tax future income tax
depreciation amortization
foreign currency transactions integrated foreign operation
foreign operation self-sustaining foreign operation
ordinary shares common shares
reserves accumulated other comprehensive income
statement of changes in equity statement of retained earnings
statement of financial position balance sheet
statement of profit and loss income statement
through profit or loss on the income statement
CICA IFRS
accumulated other comprehensive income reserves
amortization depreciation
balance sheet statement of financial position
common shares ordinary shares
current rate, current exchange rate closing rate, closing exchange rate
future income tax deferred income tax
held for trading at fair value through profit and loss
integrated foreign operation foreign currency transactions
income statement statement of profit and loss
on the income statement through profit or loss
self-sustaining foreign operation foreign operation
statement of retained earnings statement of changes in equity
Recommended study approach
The recommended study approach is to begin each module with the overview. The text frequently includes
such overviews. Use the introductions to begin thinking about the material, and skim through the text and
module notes. Then, review the text and related module note material in detail. The module notes are
designed to be studied after the text readings have been completed. Some reference materials are meant to
complement the module notes and should be read when indicated in the topic. A glossary is also provided,
which summarizes important terms used throughout the course. For each term, cross-references are
provided to one or more topics where the term is defined and described in either the module notes or the
required readings.
The review questions are taken mainly from the text. They are designed to further enhance your understanding
of the text and module notes and will often assist you in approaching the assignments. Work through the
questions and review their accompanying suggested solutions once you have finished the text and module note
material. Try to answer the review questions for yourself before looking at the suggested answer at the end of
the review material for that module.
To fully understand the course concepts, you should consider the various theories set forth in the text and
module notes and the applications described. Failure to understand course concepts is perhaps the main reason
for poor performance on examinations.
Course assessments
The assessments in this course consist of the following:
Five quizzes, one each in Modules 2, 4, 6, 8, and 10. These are in the form of multiple-choice
questions that you complete online and submit for marking. For instructions on accessing and
submitting quizzes, see your AT1 Assignment/Quiz submission area.
Assignment 1 (due at the end of week 5 – see Course Schedule), Assignment 2 (due at the end
of week 7), and Assignment 3 (due at the end of week 9). You prepare each assignment
response in Word and submit it to your marker using an electronic drop box.
Course examination: As with other foundation level CGA courses, the final examination is
three hours long.
Your final course mark will be the combined quiz/assignment mark and examination mark (30 for the
quiz/assignment mark and 70 for the examination). The five quizzes will be worth a combined maximum score
of 10 (each quiz has a maximum score of 2). Assignment 1 and Assignment 3 will be worth a maximum score
of 5 each. Assignment 2 will be worth a maximum score of 10. Your final examination will be graded out of
100, and your raw examination mark will be scaled into a mark out of 70. Your quiz/assignment mark (with a
maximum score of 30) will then be added to the scaled examination mark.
Several resources are available to help you prepare for the final examination:
two practice examinations, which show you the general form of the final examination, including
the types of questions you can expect
examination reviews, in the form of recorded lectures, available approximately two weeks before
the course examination
an examination blueprint, which outlines the primary content areas covered on the examination,
the related learning objectives, the proportion of marks assigned, and the weighting for different
types of questions
To access these resources, see the Exam Preparation tab in the course navigation.
Important reminder:
For CGA-Canada's policy regarding original work on assignments and discussions, check out the Academic
integrity policy in your AT1 Assignment /Quiz Submission area.
Boldfaced terms
Icons and boldfaced terms have been incorporated throughout the module notes to help you through the
course materials.
Words in bold type: When it is particularly important that you learn the meaning of a term (a key word or
phrase), that term will appear in bold at the first instance, such as ideal conditions in Topic 1.1.
Copyright
Accounting Theory & Contemporary Issues
Fourth Edition
Author: William R. Scott, University of Waterloo
Curriculum Developer: Rita Leung and Alison Howard
Curriculum Editors: Chris Van Cauwenbergh and Patryce Kidd
Product Coordinator: Shuhan Lee
This course is produced in Canada by:
Certified General Accountants Association of Canada
100 – 4200 North Fraser Way
Burnaby, British Columbia
Canada V5J 5K7
© CGA-Canada, 2011
All rights reserved. These materials or parts thereof may not be reproduced or used in any manner without the
prior written permission of the Certified General Accountants Association of Canada.
Every reasonable effort has been made to obtain permissions for all articles and data used in this edition. If
errors or omissions have occurred, they will be corrected in future editions, provided written notification has
been received by the publisher.
Both the curriculum and content of this course have been reviewed by the School of Commerce of
Laurentian University, and have been found to meet acceptable standards.
Course Schedule Course Modules Review and Practice Exam Preparation Resources
Module 1: Accounting under ideal conditions
Texts
William R. Scott, Financial Accounting Theory, Fifth Edition (Toronto, Ontario: Pearson Education
Canada, 2009)
Canadian Institute of Chartered Accountants, CICA Handbook – Accounting, updated to January
2011 release.
Ethics Readings Handbook [ERH], Fourth Edition (Vancouver, BC: CGA-Canada, 2011)
Note:
For all modules, complete required readings before designated topics, unless instructed otherwise.
Overview
Required reading
Chapter 1; Chapter 2 Overview, Section 2.1, page 24
Because this is an accounting theory course, it will be different from most courses you have taken to date.
Some of the concepts raised, such as the matching principle, will be familiar to you, while others will be new
and challenging. Read Chapter 1 of the text, which provides a "roadmap" of how this course will unfold,
including descriptions of the standard setting processes in Canada, the United States, and internationally.
The essence of the course is to explain the tremendous importance of financial accounting in our economy.
You have no doubt heard of financial reporting disasters such as Enron and WorldCom. Both companies were
forced into bankruptcy after massive accounting frauds were revealed. The collapse of investor confidence in
financial reporting that followed was a major contributing factor to the economic recession of the early 2000s.
More recently, the collapse of the market for asset-backed securities and its repercussions leading to worldwide
recession contains serious accounting implications for fair value accounting and consolidation policy. Topic 1.2
describes these recent developments in greater detail. The course aims to give you a good balance of
theoretical and conceptual topics with practical and real world information to enable you to understand how
such unfortunate events can occur, how they can affect real business activity, and how accountants can reduce
the likelihood of them happening again.
After this introduction and overview, Module 1 looks at the present value model. This model is highly relevant
to financial statement users as it reports on the cash flows and profitability of the firm. The module will also
explain ideal conditions, a rather conceptual but essential element in understanding the relevance and reliability
of financial information. You will be introduced to a standard — reserve recognition accounting (RRA) — that
uses present value accounting in far-from-ideal conditions. It is interesting to note management’s concerns with
RRA. The module will then revisit historical cost accounting and explain the tradeoffs between reliability and
relevance that the two accounting methods — historical cost and present value — represent.
Test your knowledge
Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.
Topics
1.1 Due process
1.2 Recent developments relevant to financial accounting
1.3 Present value accounting
1.4 Present value model under certainty
1.5 Present value model under uncertainty
1.6 Reserve recognition accounting
1.7 Historical cost accounting revisited
1.8 Conclusion
Learning objectives
Explain the concept of due process and understand how the structure of accounting standard
setting bodies attains due process. (Level 2)
Review recent development relevant to financial accounting. (Level 2)
Define the concept of ideal conditions and outline the necessary assumptions that underlie the
definition. (Level 1)
Explain and illustrate the following concepts: (Level 1)
states of nature
probabilities of states of nature (objective and subjective)
expected value of an asset or liability
abnormal earnings
risk
Use the present value model, under conditions of certainty and uncertainty, to prepare an
articulated set of financial statements for a simple firm. (Level 1)
Critically evaluate reserve recognition accounting as an application of the present value model.
(Level 1)
Explain why relevance and reliability of accounting information have to be traded off. (Level 1)
Evaluate historical cost-based accounting in terms of relevance and reliability, revenue
recognition, recognition lag, and matching. (Level 1)
Module summary
Print this module
Course Schedule Course Modules Review and Practice Exam Preparation Resources
1.1 Due process
Required reading
Chapter 1
LEVEL 2
Chapter 1 lays out the organization of the course and explains many important course concepts. A careful
reading of this chapter will help you to see the course as a whole, and will assist in your understanding of the
material in later modules.
This course contains many references to accounting standards. To fully understand these standards, you need
to appreciate that they are designed so as to trade off the conflicting interests of constituencies affected by
these standards — usually investors and managers. Standard setting bodies make these tradeoffs through due
process. That is, standards are set in consultation with major constituencies. Devices to achieve due process
include representation of major constituencies on the standard setting boards, super-majority voting, exposure
drafts, and public meetings. Be sure you are aware of these various ways to achieve due process. This will be
particularly helpful when you reach the topics of game theory and agency theory (Modules 7 and 8), and the
political aspects of standard setting (Module 10).
Course Schedule Course Modules Review and Practice Exam Preparation Resources
1.2 Recent developments relevant to financial accounting
LEVEL 2
Section 1.2 of the text describes highlights of the development of financial reporting up to and including the
Enron and WorldCom scandals, leading to the introduction of the Sarbanes-Oxley Act in the United States.
However, you are no doubt aware of the meltdown of the markets for asset-backed securities in 2007, which
led to the subsequent collapse of stock markets and the threat of worldwide recession. These developments
took place as the 5th edition of the text was being written. Consequently, they are not included in Section 1.2.
This topic outlines these developments and some of their implications for accountants.
Although the following descriptions of these developments are quite detailed, the key objectives are to
illustrate that financial reporting must be transparent so that investors can properly value assets and liabilities;
that off-balance sheet activities should be fully reported in order to discourage management from excessive
risk-taking; and that there is a risk that fair value accounting could understate value-in-use when markets
collapse.
New standards for consolidation
Following the Enron fraud described in the text, standard setting bodies moved to tighten up standards for
consolidation, since Enron’s failure to consolidate its Special Purpose Entities (SPEs) was at the heart of its
misreporting. In the United States, Financial Accounting Standards Board Interpretation No. 46 (FIN 46) (2003)
expanded requirements for consolidation of SPEs (called variable interest entities (VIEs) by FIN 46).
Consolidation under IASB standards is governed by Standing Interpretations Committee Interpretation 12, (SIC
12) “Consolidation-Special Purpose Entities” (1999). It was felt that by forcing VIE consolidation, thus bringing
their assets and liabilities onto their sponsors’ balance sheets, the financial reporting for financial institutions,
particularly with respect to their overall liquidity and capital adequacy, would be improved.
However, despite this tightening up of consolidation standards, the use of SPEs did not decline, particularly by
financial institutions, where they were frequently called structured investment vehicles (SIVs). These
vehicles were often created by banks, mortgage companies, and other financial institutions to securitize their
holdings of mortgages, credit card balances, auto loans, and other financial assets. That is, the institution
would transfer large pools of these assets to the SIVs it sponsors. The SIV would pool them into asset
backed securities (ABSs), that is, into tranches of similar credit quality. Thus, a particular ABS would be a
tranche of, say, residential mortgages (mortgage backed securities (MBSs)) of high quality, another ABS
would be of lower quality, etc. down to “sub-prime” mortgages of lowest quality. These various ABS tranches
would then be resold to investors or, particularly for the lowest quality tranche, retained by the SIV and its
sponsor. As mortgagors made payments, cash flowed to the SIV and on to the tranche holders, after deduction
of various fees. Holders of higher quality (i.e., lower risk) tranches received a lower return than holders of
lower quality tranches.
Prior to selling ABSs, they could be further repackaged and sold as collateralized debt obligations (CDOs),
which also consisted of tranches of similar quality mortgages or other financial assets. The difference was that
holders of ABSs had an interest in the underlying assets, whereas CDO holders had an interest only in the cash
flows generated by those assets. Also, unlike ABSs, CDOs tended to be arranged and sold privately, and often
consisted of riskier mortgages.
When it is not necessary to distinguish them, we will refer to these securities collectively as ABSs.
ABSs were highly popular with investors, since they offered higher returns than, say, bonds, and were viewed
as safe because of the diversification of credit risk created by the large underlying pools of mortgages or other
financial assets that backed them up. They also enabled investors to invest in tranches of the particular risk
and return that they desired.
As an alternative to selling the ABSs it acquired, SIVs could hold them. To pay the sponsor for ABSs transferred