Foundational Principles Flashcards
1.4: Describe the foundational principles of accounting
What is the conceptual framework’s third level, and what does it implement?
Foundational principles, implement the basic objectives of the first level
What do the concepts of foundational principles help explain?
Which, when, and how financial elements and events should be recognized, measured, and presented/disclosed by the accounting system
What do the foundational principles act as a guideline for?
Developing rational responses to controversial financial reporting issues
How have foundational principles changed over time?
Evolved over time, and the specific accounting standards issued by standard setters are based on these concepts in a fundamental way
When is it important to decide at which level these concepts will be applied? What is this calle?
Recognizing and measuring rights (assets) and obligations (liabilities). This is called the unit of account
What is the unit of account?
The level at which an asset such as property, plant, and equipment is recognized (that is, the extent to which separate components are measured and recorded).
Describe how unit of account is recognized for a building in accounting.
Owner building has right to use, right to pledge, and right to sell. Rights grouped together and recognized as one asset: property, plant, and equipment. The building is therefore the unit of account
What determines the unit of account?
The accounting standard itself
How is the accounting standard itself determines the unit of account. Give an example with depreciation applied to an asset like an airplane.
When depreciating an asset like an airplane, the total cost is divided into its component parts, and each component is depreciated separately.
An airplane would have numerous components, including the engine, body, and cabin interior equipment
What is an example of a unit of account for an airplane?
The airplane itself serves as a unit of account for recognition purposes, while its individual components are used for measurement purposes during depreciation.
Do accounting standards allow for different units of account for recognition and measurement?
Yes, it is acceptable to use one unit of account for recognition purposes and another for measurement purposes (such as depreciation).
How are the components of an airplane treated in terms of depreciation?
The components of an airplane, such as the engine, body, and cabin interior equipment, are depreciated separately from the whole aircraft.
What rights does the owner of a building have according to the content?
The owner of a building has the right to use, pledge, and sell the property.
What do the basic foundational principles underlying the financial accounting structure also include?
Assumptions and conventions
Why have the basic foundational principles become grouped together?
Because it is often difficult to put a label onto them and accounting practices vary
The label of the basic foundational principles isn’t important rather…?
It is the substance of the concept and how it provides a solid foundation for accounting standard setting that is important
What are the 10 Foundational Principles and Assumptions?
- Economic entity assumption
- Control
- Revenue recognition and realization principles
- Matching principle
- Periodicity assumption
- Monetary unit assumption
- Going concern assumption
- Historical cost principle
- Fair value principle and value in use
- Full disclosure principle
The 10 foundational principles and assumptions are under what 3 groupings?
- Recognition/derecognition
- Measurement
- Presentation and disclosure
What are the 4 principles/assumptions under recognition/derecognition?
- Economic entity assumption
- Control
- Revenue recognition and realization principles
- Matching principle
What are the 4 principles/assumptions under measurement?
- Periodicity assumption
- Monetary unit assumption
- Going concern assumption
- Historical cost principle
- Fair value principle and value in use
What is the principle/assumption under presentation and disclosure?
- Full disclosure principle
What is recognition?
The process of recording a transaction in a company’s statement of financial position or income statement.
At what 2 levels do recognition decisions occur?
- Macro level
- Micro level
What recognition decisions occur at a macro level?
Deciding whether to consolidate investments in other entities.
What recognition decisions occur at a micro level?
Deciding whether and when to include specific items (e.g., assets, liabilities, revenues, expenses, gains, and losses) in financial statements.
What are executory contracts?
Agreements between two or more parties under which neither party has yet performed their obligations.
Can you provide an example of an executory contract?
A contract to buy inventory from a supplier where neither the goods have been shipped nor payment has been made.
Are executory contracts typically recognized in financial statements? Why or why not?
Most are not recognized because neither party has performed under the contract (e.g., purchase orders for inventory).
What is an example of recognition.
Executory contracts
What does the conceptual framework provide for recognition?
General recognition and measurement criteria.
What may be used to justify whether something should be reflected in the financial statements or not in the absence of specific guidance under IFRS and ASPE?
Underlying principles
Historically, when have elements of financial statements been recognized?
When they:
- Meet the definition of an element (e.g., a liability).
- Are probable.
- Are reliably measurable.
How does ASPE handle recognition criteria?
ASPE maintains the historical criteria:
- An entity must assess if the element meets the definition
- Determine if it is probable that an inflow or outflow of resources will occur
- Confirm the element is reliably measurable
What significant change does the new IFRS conceptual framework introduce for recognition?
Now require:
- Meeting the definition of the element.
- Providing users with relevant information that faithfully represents the underlying transaction or event.
How does the new IFRS framework differ from historical recognition criteria?
No additional special recognition criteria. Principle is to recognize an element in the financial statements if the information is useful (and therefore has the fundamental qualities associated with useful information)
What is existence uncertainty?
Uncertainty as to whether an element exists or not (for instance, a liability).
What is derecognition?
The process of removing an item from a company’s statement of financial position or income statement.
Does IFRS include probability or measurability as recognition criteria?
No, these criteria are not explicitly required under IFRS.
How does significant uncertainty affect recognition under IFRS?
Information may not be useful if:
- There is significant existence uncertainty (e.g., whether a liability exists).
- There is low probability of occurrence.
- Measurement of the element is uncertain.
What is existence uncertainty under IFRS? Give an example.
It refers to uncertainty about whether something (e.g., a liability) exists.
Example: A lawsuit where it is unclear if the company is at fault.
Why might a lawsuit not be recognized as a liability under IFRS initially?
If fault is unclear (existence uncertainty), information about the lawsuit may not be relevant or faithfully represent the situation. Even if fault is established, it might similarly be difficult to measure the expected damages to be paid (measurement uncertainty)
When might representational faithfulness not be met?
When insufficient or biased information is available, preventing users from understanding the transaction or event.
How can biased information be addressed?
Engaging neutral experts (e.g., lawyers for both sides) to provide more objective information.
When does derecognition occur for assets and liabilities?
Assets: When control is relinquished.
Liabilities: When the obligation is extinguished.
What is the economic entity assumption?
An assumption that a company’s business activity can be kept separate and distinct from its owners and any other business units. Economic activity can therefore be identified with a particular degree of accountability.
Why is the economic entity assumption important for accounting?
It provides a basis for determining what to include or recognize in financial statements and what to exclude.
What factors often influence a company’s organizational structure?
Tax considerations and legal factors.
What are the two additional types of organizational structures that are used by professionals in Canada?
- Professional corporations
- Limited liability partnerships (LLPs)
What are the 2 main reasons the additional types of organizational structures have evolved in Canada?
- for tax planning, and
- to limit liability of the partners for negligence by other partners.
What does LLP legislation state about a partner’s liability?
A partner is not personally liable for the debts, obligations, or liabilities of the LLP resulting from another partner’s negligent acts or those under another partner’s direct supervision.
Does LLP legislation limit the liability of the firm as a whole?
No, the firm’s assets and insurance protection remain at risk.
Are partners in an LLP accountable for their own actions?
Yes, partners remain personally liable for their own actions and for those they directly supervise and control.
How does the liability of a partner in an LLP differ regarding the actions of other partners?
Partners are not held personally liable for the actions of other partners.
What are the advantages of professional corporations?
They may provide greater flexibility for tax planning.
How are legal entities treated for tax and legal purposes in incorporated companies?
The legal entity is the relevant unit.
Tax returns are filed, and taxes are paid based on the taxable income of each corporation.
Lawsuits are generally filed against the corporation as it is a separate legal entity.
How does GAAP differ from legal entity treatment when preparing financial statements?
GAAP uses a broader definition, consolidating parent companies and subsidiaries into one set of financial statements for meaningful information.
What is the perspective used for preparing consolidated financial statements under GAAP?
The perspective of the economic entity, grouping together assets, liabilities, and other elements under the parent company’s control
Why are consolidated financial statements prepared?
To recognize and group assets, liabilities, and other financial elements under the control of the parent company into a single set of statements.
Several separate corporations may therefore be grouped together to produce the consolidated financial statements
Historically, how has control been defined in financial reporting?
Control has been anchored in owning more than 50% of the voting common shares of another entity.
How has the concept of control in financial reporting been changing?
The definition of control has evolved to reflect changes in business practices.
Why is control an important concept in financial reporting?
It is crucial in determining whether something meets the definition of an asset.
What are the three criteria for an investor to have control over an investee under IFRS 10?
- power over the investee;
- exposure, or rights, to variable returns from its involvement with the investee; and
- the ability to use its power over the investee to affect the amount of the investors’ returns.
How does IFRS 10 broaden the concept of control?
It assesses control not only through ownership of common shares but also through exposure to the risks and rewards of the entity.
How does IFRS 10 relate to the IFRS conceptual framework’s definition of control?
IFRS 10 specifically deals with consolidation and overrides the more general definition of control in the conceptual framework.
How does ASPE define control?
Control is the continuing power to determine strategic decisions without the cooperation of others.
Are ASPE standards similar to IFRS for companies owning voting common shares in another company?
Yes, they are mostly similar in these cases.
How does ASPE differ from IFRS for control in certain situations, such as sales of financial instruments?
ASPE focuses on whether the other entity is “demonstrably distinct” from the company.
What factors are assessed under ASPE to determine if an entity is demonstrably distinct?
- Whether the entity in question can be unilaterally dissolved by the company
- Whether others have more than a 10% ownership interest
What is the purpose of having a high-level view of the economic entity in financial reporting?
To understand which entities are included as part of the economic entity, such as special purpose entities.
How does the inclusion of entities impact financial reporting under ASPE?
It influences consolidation and the accounting for derecognition of financial instruments when assets are transferred.
What are special purpose entities (SPEs)?
Separate legal entities, such as limited partnerships or corporations, created for specific purposes like holding leases, pension funds, investments, or creating investment opportunities for investors.
Are SPEs part of the economic entity for consolidated financial reporting purposes?
It depends on the specific circumstances and accounting standards. Under revised standards, SPEs that were previously excluded may now be included if they meet consolidation criteria.
What was the role of SPEs in the Enron scandal?
Enron created many SPEs, did not consolidate them, and sold assets to these entities, often at a profit.
Enron’s failure to consolidate the SPEs understated liabilities and overstated income in its financial statements.
Why should Enron have consolidated its SPEs?
Enron was exposed to the risks of ownership, meaning the liabilities and losses of the SPEs were effectively those of Enron.
How have accounting standards for SPEs changed?
Revised standards may require SPEs that were previously excluded to be consolidated, while others may now be excluded due to updated detailed guidance.
What is another name for SPEs?
Variable interest entities or structured entities.
What is the revenue recognition principle?
The accounting principle that sets guidelines as to when revenue should be reported.
What are performance obligations?
An obligation that arises when a company promises to deliver something or provide a service in the future.
What does being “realized (revenue)” mean?
Revenue from products (goods or services), merchandise, or other assets that is received in cash.
What is realizable (revenue)?
Revenue from products (goods or services), merchandise, or other assets that is received in cash.
What principle governs revenue recognition?
The revenue recognition principle
Historically what 3 conditions are met under the revenue recognition principle when a revenue has generally been recognized?
- risks and rewards have passed and/or the earnings process is substantially complete (significant acts have been performed and there is no continuing involvement);
- the revenue is measurable; and
- the revenue is collectible (realized or realizable).
How does ASPE approach revenue recognition?
ASPE follows an income statement approach, focusing on the earnings process.
What significant change occurred under IFRS 15 for revenue recognition?
IFRS 15 uses a five-step, balance sheet approach to recognize revenue:
1. Identify the contract with the customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to each performance obligation.
5. Recognize revenue when each performance obligation is satisfied.
What is the new IFRS approach and how does it recognize revenues?
Balance sheet approach, which recognizes that a transaction has occurred when the entity enters into a contract. The entity has rights and performance obligations under the contract
How does IFRS 15 differ from ASPE in its approach?
IFRS 15 takes a balance sheet approach, focusing on rights and obligations under the contract, while ASPE emphasizes the earnings process.
When are collectible revenues recognized?
When performance obligations are settled (when control over goods or services passes to the customer). There is a presumption that the contract is measurable
When are revenues considered realized or realizable?
Revenues are realized when goods or services are exchanged for cash.
Revenues are realizable if assets received can be readily converted into cash or claims to cash.
What makes an asset readily convertible into cash?
It can be sold or interchanged in an active market at readily determinable prices with no significant additional costs.
What is matching?
The accounting principle that dictates that efforts (expenses) be matched with accomplishments (revenues) whenever reasonable and practicable.
What is the matching principle in accounting?
It matches effort (expenditures) with accomplishment (revenues) to reflect the cause-and-effect relationship between the money spent to generate revenues and the revenues themselves.
How does accounting allocate the costs of long-lived assets?
Costs are allocated over all accounting periods during which the asset contributes to revenue generation, using a rational and systematic allocation policy.
