Intermediate Accounting Volume 1, 7th Edition Solution manual
Concept Review Solutions
CHAPTER 1: THE FRAMEWORK FOR FINANCIAL REPORTING
- A public corporation issues securities (debt or equity) to the public; a private corporation does not. In the Canadian economy, most corporations are privately owned.
2. A private corporation can obtain capital from external investors without registering with provincial securities commissions (i.e., going public) by raising funds privately through institutional investors. A private placement is arranged by direct negotiation between the company seeking capital and one or more suppliers of capital. Private capital suppliers include pension funds, investment funds, private equity investment companies, and major banks.
Equity financing for private companies can also be negotiated in private placements. Securities that are issued in a private placement cannot be publicly traded, and therefore a private company remains outside the jurisdiction of the securities acts and securities regulators.
- A Canadian private enterprise may choose to use IFRS instead of ASPE:
- better access capital – because it is in competition with public companies for capital against companies from the United States, Europe, Asia, South America, etc. who use IFRS.
- the company is a subsidiary of a parent that reports on the basis of IFRS.
- the company may be considering issuing shares to the public in the foreseeable future and wishes to establish a pattern of IFRS compliance in the financial statements that it must submit as part of the company’s prospectus.
- the company’s controlling shareholders may intend to sell the company in the near future. Using IFRS will enhance the financial statements’ credibility to prospective public-company acquirers.
- Financial reporting for public companies is described as general purpose financial reporting.
It is “general purpose” because the potential interest group is large and diverse and is not limited to stakeholders who are able to obtain information directly from the company. A public company’s financial statements must serve the needs of current and prospective shareholders and other suppliers of capital, as well as other potential users. A public company’s financial statements users can be anyone, anywhere. Public-company accounting standards have been developed in order to protect the interests of economic decision-makers who are dependent solely on a company’s financial statements.
- There is a difference between the assessment of current cash flows and the prediction of future cash flows. To assess current cash flows, the user wants to understand the cash inflows and outflows of the enterprise in the current period. Greater emphasis is placed on the cash flow from operating activities. The availability of other sources of financing is also important, as is the disposition of those funds: How much cash is the company generating or raising externally, and what is the company doing with that money?
Cash flow prediction requires extrapolating the current cash flow into future years. Users must make assumptions in order to do this, and accounting can help this process by measuring and/or disclosing the company’s commitments to future cash flows (e.g., forthcoming lease and loan payments).
As all accountants are well aware, a company’s operating cash flow for a year is very different from its earnings for that year. Revenues and expenses arise from cash flows, but differ from the actual cash flows to the extent that accountants engage in the processes of accrual accounting and interperiod allocation in order to estimate earnings.
- High earnings quality means there is a high degree of correlation between reported cash flow from operating activities and net earnings. For example, a company with positive earnings and cash flow from operations is viewed kindly by analysts because it suggests that management is not manipulating earnings through accruals and interperiod allocations.
- While all companies want to reduce their income tax bill, income tax minimization is not an appropriate objective for some companies. The reason is that if the company adopts accounting policies that reduce taxable income, those policies may also reduce reported net income. This might be a problem for managers whose compensation is tied to book income. A lower book income may also lead to a poorer performance evaluation and hence reduced promotion possibilities for managers.
As a result of the impact on reported earnings, income tax minimization is more likely to be an objective for private corporations and, to a lesser extent, for public corporations that have a strong family control block. The owner-managers of these types of corporations have independent sources of information about the company, and their bankers usually are kept closely informed about the activities of the corporation. A tax-minimization objective is in the best interests of bankers and creditors, but they must recognize that reported earnings under a tax minimization objective will look poorer, but the cash flow will actually be better. In contrast, public corporations are likely to place less emphasis on tax minimization because their managers are more concerned about external stakeholder perceptions of the company’s earnings ability.
- A control block exists when a small number of related or affiliated shareholders hold a majority of the voting shares, thereby having the ability to control the corporation.
- Before one accounting policy is selected over another, the financial reporting objectives of a company must be established. That is, the financial reporting objectives of an enterprise must be known in order to ensure that the accounting policies chosen will achieve those objectives (in the face of the multitude of possible accounting treatments available to the accountant).
- A public company must provide financial information to a wide variety of stakeholders with diverse objectives. For example, a public company may focus on the perception of profitability for the purposes of sustaining or improving market confidence in their stock. Therefore, the financial reporting objectives of the public company may be tilted toward income maximization, income smoothing, or stewardship evaluation. In contrast, a private company is not concerned with the informational requirements or perceptions of the general public vis‑à-vis its financial statements, and may be able to focus on objectives such as income tax minimization, cash flow prediction, anal contract compliance (with specific stakeholders such as banks).
- Shareholders’ agreements may influence a company’s financial reporting objectives by stipulating the accounting methods to be used. For example, since there is no public market for the shares of private corporations, the shareholders’ agreement may stipulate that the share prices will be a function of accounting income or accounting asset values. The agreement will also stipulate the accounting policies to be used in determining such values.
- The objectives of financial statement users may conflict with the motivations of managers if the users lack the power to enforce the dominance of their objectives. For example, a manager may wish to maximize income in order to convey the perception of exceptional performance (perhaps for the sake of her annual bonus), while shareholders may prefer cash flow projection statements, or income minimization statements (to minimize tax and therefore improve cash flow for dividends). When the shareholders/users do not have the power to impose their demands on management, management’s objectives in preparing statements will conflict with those of the users.