AFM 291 Chapter 3

Demand for Periodic Reporting and the Need for Accrual Accounting
Accounting: production and transmission of information about an enterprise from those
who have it to those who need it
During Dutch Trading: Accounts will track how much people invested and when the ships
came back after goods were sold distributed the funds to investors based on their share of
investment cash basis
Cash Cycles: transactions that converts cash inflow to cash outflow or vice versa
o Financing Cash Flow: receipt of funding form investors. Use funds to generate profit
which is given to investors
Inflow then outflow
o Investing Cash Flow: use funds to purchase property that has future benefits for the
company and generate cash inflow for the business then disposing the property
Outflow then inflow
o Operating Cash Flow: purchase of inventory, production, sales and delivery of goods
and receipt from customers
Outflow then inflow
Exhibit 3-1: Conceptual Depiction of Cash Cycles pg 72
Without creditable information people did not buy or sell investments while the ship was
on its journey
Dutch East India Company was a corporation with an indefinite life. People did not want to
wait until the dissolution of the company to find out if they made money
With the rise of indefinite life companies people starting selling their investments at some
point before the dissolution of the company and they needed info to help value their
investment so information was provided in intervals
The end of a reporting period such as a year will not correspond with the completion of
transactions

Accrual vs. Cash Accounting

Accrual Accounting: basis of accounting that reflects economical events when they happen
rather than only when cash exchanges occur
Cash Accounting: method of accounting that records only cash exchanges
Cash basis balance sheet has only cash and equity in equal amounts. There are no other
items because all non cash items are accruals
Accruals: accounting entries that record events in a period different from the
corresponding cash flows
Accruals encompasses:
o Events before cash flows
o Events after cash flows
Deferral: accounting entry that reflects events or transactions after the related cash flow
Accrual basis of accounting provides more useful financial info to readers because it permits
companies and their management to communicate their expectations of future outcomes
and it closely reflects underlying events
In history went from a single purpose enterprises with limited life to enterprises that have
indefinite lives creating a demand for periodic reporting
Uncertainty and the Essential Role of Estimates in Accrual Accounting
Accrual accounting involves reporting amounts before the completion of some or all of the
cash cycle so it requires the use of estimates
The use of estimates means that all accrual accounting reports are imprecise
Unbiased Accounting: A conceptual accounting outcomes that would result from taking an
average or consensus from a sample of disinterested accountants
o Unbiased accounting is similar to neutrality
Before IFRS had a concept of true and fair: accountants and auditors have a duty to
evaluate the financial statements as a whole and determine whether those financial
statements present a true and fair presentation of the company. If statements were not true
and fair the accountant must change it so it is
o This concept can override estimates, accounting choices and even accounting
standards if the estimates produce financial statements that are not fair
o There can be no true financial statement
o New conceptual framework does not have true and fair

Quality of Earnings and Earnings Management

Some believe earnings quality should be measure by comparing actual reported profits to
what true earnings would be
Finance professionals evaluate quality of earnings in different ways:
o Since a measure of true earnings does not exist, we cannot evaluate earnings quality
relative to true earnings
o Using cash flow to evaluate the quality of earnings implies that cash flow is a better
measure of performance, but cash flow is an inferior measure of performance
compared to accrual basis earnings
Quality of Earnings: how closely reported earnings correspond to earnings that would be
reported in the absence of management basis
o i.e. company reported $500 in cash flow and $800 in earnings. $300 (800-500)
represents the accrual difference in cash flow and earnings. The $300 of accruals
can be separated in 2 components:
unbiased accruals that reflect economic conditions and accounting
standards in the application of professional judgment and considering
professional ethics
excessive accruals that result from contractual incentives for the
firm/management and any unethical managerial opportunism to over or
under accrue
o i.e. if company had $200 in unbiased accrual, they will have $100 in excessive
accruals. Therefore unbiased earnings = cash flows + unbiased earnings = $500 +
$200 = $700
lower excessive accruals means higher quality earnings
we can only observe total accruals
to distinguish between excessive and unbiased accruals, users need to make
conjectures/estimations about the incentives faced by management that would lead them to
make more or less excessive accruals
Periodicity, Cut-Off and Subsequent Events
accrual accounting exists precisely because users desire to know what events and
transactions occurred in a particular period of time
Periodicity
o Typical reporting period of any entity: 12 months
o An annual period does not have to match the calendar year
o Many businesses choose a year end that coincides with a time of lower activity
o Some enterprises will have reporting periods that are close to but not exactly 12
months
i.e. retailers have reporting period of 52 weeks and 53 weeks once every
several years because doing so provides more comparable info year to year
due to sales being higher on some day of the week then others
Cut-off
o Point in time at which one reporting periods ends and the next one begins
o In accrual accounting some cash cycles are not complete so it is necessary to have
rules stating which events will be reflecting in the reporting period and what will
not be recorded
o Should consider the timing of information because it is not reasonable to wait for
the most updated info with no uncertainty because it goes against the idea of
periodic reporting
o Subsequent event periods (events after reporting period): period between the
cutoff date and the date when the company authorizes it financial statements
o confusion if an event is a subsequent event and not part of the reporting period
We Recognize transaction and events occurring with the reporting period
(up to the cut off date) but the measurement of those transactions can use
the best info available whether that info is form the reporting period or the
subsequent events period
o If inventory becomes obsolete prior to cut off date then the obsolesce should be
recognized even if the info about the technological change becomes available in the
subsequent events period
o If technological change occurs during the subsequent events period then there will
be no impact on the amounts recognized
If the effect is material then information about the technological change
should be in the notes to the financial statements
o A company can use the information in the subsequent period to estimate the
amount to record in the allowance for doubtful accounts
o If a truck was an accident after the cut of period the reported value of the truck will
not include the effect of the accident but if the amount was material it should be
included in the notes

Accounting Changes: Errors, Changes in Accounting Policy, and Changes in Estimates

Correction of Errors
Error: when company reports an incorrect amount given the information available at the
time
Not an error: A forecast of the useful of equipment that turns to wrong is not an error as
long as the forecast was made in good faith based on info provided.
Error: monument though the useful life was 5 years then uses 10% straight line deprecation
 Correction of an Error: accounting change made necessary by the discovery of an
incorrect amount given info available at the time the amount was recorded
Retrospective Adjustment (retroactive adjustment): applying an accounting change to
all periods affected in the past, present and future.
o Retrospective adjustment with restatement shows and compares figures on the
same basis as the current period figures
o Retrospective adjustment without restatement reflects accounting change impact on
past periods in current period
o Restore statements to what they should have been given the info available at their
prior date

Changes in accounting policy

An accounting change made at the discretion of management
i.e. change from FIFO to weighted average
for accounting policy changes there must be retrospective adjustments with restatement
which increases comparability of financial statement (consistency over time)
switching from weighted average to FIFO increases current income so users need to have
prior statement to make meaningful comparisons
having retrospective adjustments with restatement reduces the temptation to change
accounting policies to manage earnings because the effect of the change applies to current
and prior years
In US GAAP it is retrospective adjustments without restatement so comparative financial
statements are not adjusted and the current income statement records the effect as
cumulative effect of accounting change
Change in depreciation method used can be an accounting policy change or a change in
accounting estimate)
Example of change in depreciation used pg 82

Change in Accounting Estimates

i.e. percentage of bad debts, number of use life for equipment
estimates should be based on information provided at the time but new information can
suggest an alternative estimate
Prospective Adjustment: applying an accounting change to the current and future reporting
periods without change to past financial statements
Change in estimate: accounting change made necessary by the arrival of new information
A change from declining balance method to straight line can be justified as a change in
estimate if the straight line method more closely resembled the pattern of usage or value
derived from the equipment
Type of accounting change Treatment under IFRS and ASPE
Correction of errors Retrospective with restatement
Changes in accounting policy Retrospective with restatement
Changes in estimates Prospective

Summary t 3-10 Summary of types of accounting changes and corresponding treatments

Can distinguish between the accounting change by answering 2 questions:
o Is the accounting change due to new information or just management choice?
If it is just management choice it would be a change in accounting policy
 o If a change due to info information when was the information known or when
should have been know?
Known or should have been known in a prior period error that should be
corrected
Info couldnt have been known until the current period change in estimate

The Structure of Financial Reports and their Relationships

Cash flow statement: cash balance from beginning to end
Statement of comprehensive income reports on performance
Balance sheet accumulates all the accruals

Overview of Financial Statement Presentation and Interrelationships

Financial statements are the end product of the accounting process made to meet the
information needs of users
Objective of Financial Statements: provide useful information for investment and lending
decisions
IFRS asserts financial reports help users; make decisions by providing 2 main types of
information
o 1) Information on the entitys resources and claims against those resources
What it has and what it owes to lenders and equity investors
o 2) Information on changes in the entitys resources and claims
IFRS considers 3 categories of information about changes in resources and claims
o Financial performance according to accrual accounting
o Financial performance according to cash flow
o Changes in the entitys resources and claims that are not due to financial
performance
Types of information and related statement
o Resource and claims -> balance sheet
o Performance on accrual basis -> statement of comprehensive income
o Performance on cash basis -> cash flow statement
o Changes in resources and claims not due to performance -> statement of changes in
equity
Exhibit 3-12 pg 82: Financial statements, relationships and the scope of IFRS
The balance sheet (records assets, liabilities and equity at a point in time) is in the middle
and the other 3 statements track the flows of items on the balance sheet
o The balance sheet is the center of the financial statements because we use double
entry accounting
Cash flow statement: different activities that explain the change in cash
Statement of equity: changes in equity, differentiating comprehensive income/loss from
other changes in equity
Statement of comprehensive income: detail on income generated
Financial notes provide additional disclosure
Articulation: connection of financial statements with each other
o The amount recorded on the comprehensive income statement connects with the
balance sheet through equity accounts
There can be a lot of accounts so financial statements should be grouped together in a
logical fashion
Balance Sheet (statement of financial position)
Shows financial position (the amount and composition of assets and the composition of
claims on those assets) of entity at a point in time
Double entry accounting: total assets equal total financial claims
Entities should have separate current (short term) and non current (long term) items
Can order based on liquidity
Assets:
o Asset gives rise to future inflows of economic benefits, arose from past transactions
and is under the control of the enterprise
o To be recorded must meet the definition of an asset and criteria for recognition and
measurement
The future economic benefit must be probable and must be able to
reasonable measure it
o Asset Categories:
Cash and cash equivalents
Trade and other receivables
Investments accounts for using the equity method
Financial assets other than those in 1,2,3
Inventory
Biological assets
PPE
Investment property
Intangible assets
Receivables for current tax
Deferred tax assets
o ^these categories can be split further if need. i.e. PPE into land, building and
equipment if different measurement bases (historical cost/current value) are used
o Current asset if

a) and c) together means the asset will be realized (sold or used) within a
year or during the operating cycle, whichever is longer
Liabilities
o Present obligation arising from past transactions that entail future outflows of
economic resources
o If future outflow is probable and reasonably measureable, the enterprise recognizes
the liability on the balance sheet
o IFRS requires at a minimum the following categories of liabilities
Trade and other payables
Provisions (warranty liability, pension benefits, restricting costs)
 Financial liabilities other than the above
Liability for taxes payable
Liability for deferred taxes
o Classification of current liability under IAS 1:

D) debt with a short nominal maturity that is rolled over from one period to
another (line of credit)
Equity
o Residual amount of total assets total liabilities
o Components of equity:
Contributed Capital
Retained Earnings
Reserves
Non controlling interest
o Reserves can arise from the revaluation of land

Statement of changes in Equity

Shows reason for changes in total equity
Components of equity;
o Contributed Capital: funds provided by owners, net of any repayments to the
owners or repurchases of shares
o Retained Earnings: cumulative profits (or loses) recognized through the stamen of
compressive income less dividends
o Reserves: accumulated from events/transactions increasing equity that are not
transitions with owners and which have not flowed through profits or loss
i.e. accumulated other comprehensive income (AOCI)
5 classes of transactions that explain the changes on the statement:
o Profit or loss income and expenses as recognized on the income statement shown
in retained earnings
o Other comprehensive income (OCI) shown in Accumulated other comprehensive
income
o Dividends shown in retained earnings
o Capital Transactions: transactions with owners such as share issuances or
repurchases shown in contributed capital or sometimes retained earnings
o Effects of changes in accounting policy and correction of errors shown in
contributed capital or retained earnings
Other comprehensive Income (OCI)
o Includes changes in value that have not been realized by a transaction
o Depending on the type of OCI, some will immediately impact retained earnings
while others will be parked in a reserve within equity until a future date when they
are recognized through net income and retained earnings
 o Recycling: latter process of recognizing amounts through OCI, accumulating that
OCI in reserves and later recognizing those amounts through net income and
retained earnings
i.e. purchased an investment for $25,000 and it increases in value to
$27,000. On the balance sheet it is recorded as $25,000 and the $2000 is
kept in accumulated other comprehensive income. When you sell the
investment the selling price is $28,000 so $2000 is recycled and $1000
comes for additional increase in value from $27,000 to $28,000. So the
$2000 is recognized twice: first through OCI and then through net income
o OCI that is not recycled impacts retained earnings immediately
Can have several types of contributed capital when there is more than one class of shares
Each type of OCI needs to be tracked as a separate component of reserves

Statement of comprehensive Income

Measure of the return on capital so it provides a measure of performance
Good to distinguish between operating activity results from financial results because the
effect of financial leverage (use of debt to acquire other assets) significantly affects
performance and risk
Tax costs are only partially under the control of management, so such costs should be
separately identified
Company has limited influence over decisions at associated companies so income/loss from
such associated should be a separate item as well
IAS 1 requires reporting at a minimum, items relating to each of the 5 components of equity
plus 2 summary measures of performances: a subtotal of profit/loss and total compressive
income
Can represent accounts in a single statement of comprehensive income or to break up info
into 2 parts: income statement that includes items 1-5 and statement of compressive
income that includes items 5-7
o Items:
1) revenue
Operating Expenses
^ IAS does not require it but the requirement to show profit/loss implies
an amount for operating expense
2) Finance Costs
3) Share of Profit/loss associates
4) Tax Expense
5)Profit or loss (net income)
6) Other Comprehensive income
7) Total Comprehensive Income
Classify expenses according to:
o Nature: the source of the expenses (deprecation for equipment, labour costs from
employees, cots of raw materials or other means of production)
o Function: use to which the expenses has been put (cost of sales, distribution,
administration)
o Information on the nature of an expense is mandatory, but information about their
function is optional so much provide info on the nature of expenses
 Must disclose the earnings per share either on the face of the statement of comprehensive
income or in the notes
Statement of Cash Flows
Shows the change in financial position of an entity in terms of the most liquid assets
available, cash and cash equivalents
Cash and cash equivalents: short term, highly liquid investments that are readily
convertible to known amounts of cash and that are subject to an insignificant risk of
changes in value
Has 3 sections corresponding to the 3 cash cycles: operating, investing and financing
activities
Direct Method: shows amounts attributable to each activity
Indirect Method: uses profit/loss form income statement as a starting point and then
itemizes adjustments to arrive at operating cash flows

Note Disclosures
An important and integral part of the statements
Some of the general requirements of disclosure:
o A statement of compliance with IFRSa reporting entity must provide an
unreserved statement as to whether it complies with IFRS in its entirety
o A summary of significant accounting policies, including the bases of measurement
used in preparing the financial statements
o Disclosures required by specific standards in IFRS
o Disclosures relevant to understanding the items reported on the face of the four
financial statements
IAS 1 requires cross referencing of items on the financial statements and the related note
disclosures (not required in US standards)

Discontinued Operations and other non current assets held for sale
Once management has decided to dispose a group of assets and related liabilities, they no
longer satisfy the assumption of going concern
IFRS requires separate reporting for discontinued operations and other non current assets
held for sale (current assets held for sale like inventory is not included)
Should segregate discontinued operations using separate line items and disclosures

Comparative Figures
To help users discern trends for a particular company, IAS 1 requires the presentation of
comparative information for the relevant prior period
For comparison items to be meaningful items need to be measured and reported on the
same basis over time
Even something small as splitting one line item as 2 line items in the current year the
company needs to ensure that they present comparative figures for past periods on the
same basis

Canadian Tire Example pg 101 some observations

financial statements begin with a declaration of managements responsibility for the
financial statements. While companies hire auditors to verify their books and records, it is
not the responsibility of auditors to prepare the financial statements.
 All statements say consolidated because these financial statements present information not
only for the legal entity of Canadian Tire Corporation, but also for all of the subsidiaries that
are owned by the company.
Notes: significant accounting policies used to create statements, judgment and estimates
management has made, additional details about things on the statements

Difference between IFRS and ASPE