Case 1-2 [IFRS: The conceptual framework for financial reporting: chapter 3]

(a) Can any alternative to historical cost provide for fair presentation in financial
reports or are the risks too great? Discuss.

When we refer to “present fairly” in the preparation of financial statements, we generally qualify
the statement (as the auditors here have): “in accordance with generally accepted accounting
principles.” That is, fair presentation has a contextual, rather than an absolute, meaning. For
any presentation to be fair to the user, the basis of presentation must be known and understood,
but does not necessarily have to follow any one particular model.

Financial statements may be considered to “present fairly” whether prepared in accordance with
the historical cost convention, replacement cost, general price level adjusted model, or net
realized value. The important issue is that the model employed is known, understood, and
consistently followed.

Arguably, fair value accounting is the model most likely to provide fair presentation, especially
where asset values are volatile, as historical costs become rapidly out of date. For many long-
established companies, historical costs for some assets are significantly out of date and of no
value in support of managerial decisions. In managerial accounting, we have long recognized
that the relevant costs are the current costs. In some European countries, an approach to
financial reporting has developed that adopts more of a managerial approach and seeks to
provide the most relevant information for decision-making. As a result, many companies follow
alternatives to historical cost, generally fair values, in the financial statements.

There are risks, however, that arise from the adoption of alternatives to historical cost. Some of
these are the same risks that arise from the historical cost model in that the recorded amount
may soon be out of date. Prices may go up or down, and even “fair values” of prior periods may
display no relationship to fair values at the present date. Cost is always cost in a particular
context and a cost determined for a particular context or decision may not be valid for a different
context or decision and the user should be aware of this.

The question of objective determination also arises. The reported values in fair value-based
financial statements are not directly supportable by arms’ length transactions. This introduces
the risk of an important (and potentially deliberate) misstatement. This is the principal risk
arising from fair value accounting. It leads many countries to have highly detailed rules for the
preparation, audit, and publication of financial statement asset values under fair values.

(b) Discuss the relative merits of historical cost accounting and fair value accounting.
Consider the question of the achievement of a balance between relevance and reliability
when trying to “present fairly” the financial position of the reporting entity.

Students will provide a wide range of responses to this question; at this stage (unless they have
been provided with supplementary material or have background from other courses) responses
will just scratch the surface. The following note may be helpful:

Historical cost accounting has the advantage that it is verifiable, and therefore tends to be more
reliable and freer from bias than fair value accounting. Historical cost amounts are based on
objective information and are more likely to have the “paper trail” of an actual transaction that
provides support. Historical costs, however, are sunk costs and have limited value in support of
decisions. They are particularly deficient if a long time has passed since the transaction
occurred, or if there have been significant technical developments. These are serious difficulties
which the accounting profession has tried to address through a variety of different mechanisms,
but no other method has become universally acceptable as an answer to the problem and so
historical cost accounting persists, largely because of inertia, and because no better model has
emerged.

Fair value accounting has the advantage of enhanced relevance because the values included
have been determined at the current time, rather than at some uncertain past date. These
amounts may therefore be better for investment decisions than historical costs. However, fair
values may be potentially deficient in that they might not be objectively determined and lack
reliability. At the worst, they could contain bias to support a particular management policy or
decision. In other cases, they could be guesses or otherwise based on invalid information. Also,
the use of fair value in financial statements in no manner makes the financial statements more
“accurate,” although (if the amounts are carefully and objectively determined) there may be
advantages in the fairness of presentation and therefore the relevance of financial statement
amounts.

With respect to income measurement, in a period of inflation, historical cost accounting will
result in an overstatement of income. Income is overstated, as a portion of the reported profits
must be reinvested in the business to maintain the productive capacity and not all profits are
available for distribution. If all profits are distributed, the business will not have the capacity to
replace the items that have been consumed in the process of earning income. Fair value
accounting will alleviate this problem by charging to expense the fair value of all items
consumed. With fair value charged to expense, the income remaining is a true income,
potentially available for distribution without impairment of the productive capacity of the
enterprise.

A further important point is that both the preparer and the user of financial statements should
understand the basis of preparation of the statements, and the strengths and weaknesses of the
approach employed.

(c) Financial statements are now beyond the comprehension of the average person. Many of
the accounting terms and methods of accounting used are simply too complex to
understand just from reading the financial statements. Additional explanations should be
provided with, or in, the financial statements, to help investors understand the financial
statements. Briefly discuss.

It is true that financial statements are complicated by accounting methods, such as the method
of accounting for deferred income taxes, foreign currency translation, and so on. However,
some of these complexities cannot be avoided. The business environment and business
transactions are themselves more complex. Since the financial statements try to reflect these
business events, it is inevitable that the financial statements will be more complex. Thus, it is
not accounting methods per se that make financial statements difficult to understand.

Financial statements are not directed at the average person, so they cannot be criticized on the
grounds that they are beyond the comprehension of the “average person”. Instead, they are
intended for users with a reasonable understanding of financial statements. The question then
becomes should additional explanations be provided for users who have a reasonable
understanding of the financial statements? The answer depends on what type of information
the “explanations” will contain.
Additional explanations might be of three types:

- They could provide more detail on information that is already contained in financial
statements. For example, certain dollar amounts reported in the financial statements might
be broken down into more detail, or the significance of certain amounts might be discussed;
- They could make information that is currently in the financial statements easier to
understand by explaining technical accounting terms and concepts used in the statements;
or
- They could provide entirely new information not included in financial statements that might
help users better understand the significance of the information that appears in the financial
statements.

In all three cases, the information provided might concern the future or the past. It is important
to note that for publicly accountable enterprises, there is already a considerable amount of
supplemental information provided in a company’s MD&A. This document provides
supplementary discussion of financial results and in many cases explanations of accounting
treatments used in a company’s financial statements for the period. Further, it is important to
note that at some point additional information may “overload” the user. Too much information
may achieve the undesired result of making financial statements more difficult to understand.
This must be taken into account when considering supplemental information and explanations.

Problem 1-4
(a)
(i) IFRS1 ASPE2
Development costs @ Dec 31, Yr 2 $135,000 $0
1
$500,000*.30 - ($500,000*.30)/10 = $135,000 – only development costs are capitalized. (IAS
38.57)
2
R&D costs are expensed in Year 1 under ASPE to minimize net income.

(ii) IFRS3 ASPE4

Equipment @ Dec 31, Yr 2 $56,250 $60,000
3
Under IFRS (IAS 36), an asset is impaired at the end of Year 1 if the carrying amount of
$80,000 ($100,000 – $100,000/5 years) exceeds the higher of assets value in use (discounted
cash flows = $75,000 at Dec 31, Yr 1) and its FV less costs to dispose ($72,000). If impaired,
the asset is written down to its value in use. The balance at Dec 31, Yr 2 is therefore
determined using the $75,000 value in use at Dec 31, Yr 1 less one year of depreciation
($75,000/4 = $18,750).
4
Under ASPE, there is no indicator of impairment if the undiscounted cash flows from its use
($85,000) are greater than the carrying amount, $80,000, at Dec 31, Yr 1. The balance under
ASPE at Dec 31, Yr 2 is therefore $100,000 less two years of depreciation ($20,000 per year).
(b)
Net Income Year 2 under IFRS $200,000
Less: additional depreciation under ASPE (20,000 - 18,750) (1,250)
Add: development cost amortization, not recognized under ASPE 15,000
Net Income Year 2 under ASPE $213,750

S/E Dec 31 Year 2 under IFRS $1,800,000

Less: development cost not capitalized under ASPE (135,000)
additional depreciation under ASPE (20,000 - 18,750) (1,250)
Add: impairment on equipment not recognized in Year 1 under ASPE 5,000
S/E @ Dec 31, Year 2 under ASPE $1,668,750

Case 2-2
In this case, students are asked to, in effect, assume the role of a consultant and advise
Cornwall Autobody Inc. (CAI) how it should report its investment representing 33% of the
common shares of Richard’s Specialty Foods Inc. (RSFI).

Accountant #1 suggests that the cost method is appropriate because it is just a loan. This might
have some validity because Richard’s friend Connelly certainly seems to have come to her
rescue. However, Connelly’s company did buy shares, and there is no evidence that they can or
will be redeemed by RSFI at some future date. An investment in shares is not a loan, which
would have to be reported as some sort of receivable. While knowledge of the business or the
ability to manage it such as might be seen in the exchange of management personnel or
technology, might be indicators that significant influence exists and can be asserted, the
absence of knowledge of the business and ability to manage do not necessarily mean that there
cannot be significant influence. They are not requirements for the use of an alternative such as
the cost method. [IAS 28]

Accountant #2 feels that the equity method is the one to use simply because the ownership
percentage is over 20%. This number is a quantitative guideline only and whether an investment
provides the investee with significant influence over the investee or not depends on facts other
than the ownership percentage. For significant influence, the ability to influence the strategic
operating and investing policies must be present. Representation on the board of directors
would be evidence of such ability. There is no evidence of board membership. [IAS 28]

Accountant # 3 also suggests the equity method saying that 33% ownership gives them the
ability to exert significant influence. Whether they exert it or not doesn’t matter. This part is
correct; you do not have to exert it. However, owning 33% does not necessarily mean that you
possess this ability. Ms. Richard was the sole shareholder of RSFI before CAI’s investment, and
we have no knowledge that she has relinquished some of this control to Connelly in return for
his bail out. [IAS 28]

The circumstances would seem to rule out the three possibilities presented by the accountants.
The investment should be reported at fair value. The only choice (and it is a choice) is whether
to report the unrealized gains in net income or other comprehensive income. More information
is needed to determine whether CAI has other similar investments and what its preference is
with respect to the reporting of this type of investment. [IFRS 9]

Problem 2-6
Part (a) Equity method

(i) Investment in Saltspring 285,000

Cash 285,000
To record 30% investment in Saltspring

Cash (30% x 110,000) 33,000

Investment in Saltspring 33,000
Dividends received

Investment in Saltspring (30% x 306,000) 91,800

Equity method loss – discontinued operations (30% x 33,000) 9,900
Equity method income (30% x 339,000) 101,700
To record 30% of Saltspring’ s profit and discontinued operations

(ii) Investment cost Jan. 1, Year 6 $285,000

Dividends received (33,000)
Share of income 91,800
Investment account Dec. 31, Year 6 $343,800
(iii)
Pender Corp
Statement of Operations
Year ended December 31, Year 6

Sales $990,000
Equity method income 101,700
1,091,700
Operating expenses (110,000)
Income before income tax 981,700
Income tax expense (352,000)
Net income before discontinued operations 629,700
Disc. Operations – Equity method loss (9,900)
Profit $619,800

Part (b) Cost method

(i) Investment in Saltspring 285,000

Cash 285,000
To record 30% investment in Saltspring

Cash 33,000
Dividend income 33,000
Dividends received

(ii) Investment account balance December 31, Year 6 $285,000

(iii)
Pender Corp
Statement of Operations
Year ended December 31, Year 6
Sales $990,000
Dividend income 33,000
1,023,000
Operating expenses (110,000)
Income before income tax 913,000
Income tax expense (352,000)
Profit $561,000

Part (c)

Pender would want to use the equity method if its bias were to show the highest return on
investment since the equity method considers the full increase in value of the investee (i.e.
recognizes proportion of income earned for the year) whereas the cost method only recognizes
income to the extent of dividends received.

Cost method return on investment = $33,000/ $285,000 = 11.58%

Equity method return on investment = ($101,700 - $9,900)/ $285,000 = 32.21%