Chapter 5
Knowledge Check – Page 239
 Do all corporations have to follow GAAP? Explain.
Not all corporations have to follow GAAP. Federal and provincial corporations
acts and the provincial securities acts require that the financial statements comply
with GAAP. This suggests that all corporations in Canada must comply with
GAAP. However, this is not the case. Public companies must follow GAAP. For
private entities the situation is less clear. If a private company is audited the
financial statements will likely comply with GAAP. However, while the
corporations acts apply to private corporations and require them to provide
audited financial statements to their shareholders, the shareholders are entitled to
waive this requirement if they unanimously agree. Private corporations might
prepare GAAP statements if they are required as part of a borrowing agreement
with a bank.
Partnerships and proprietorships are not covered by any constraints that require
them to follow GAAP.
 What organization is responsible for setting accounting standards (GAAP) in
Canada? What are its strategic plans for GAAP over the next few years?
The Accounting Standards Board (ASB) of the Canadian Institute of Chartered
Accountants (CICA) is responsible for setting the accounting standards that are
included in the CICA Handbook.
In 2005 the CICA released a strategic plan that proposes that for Canadian public
companies International Financial Reporting Standards (IFRS) will be Canadian
GAAP. IFRS are produced by the International Accounting Standards Board and
are used in many countries around the world as the basis for preparing financial
statements. This means that for most Canadian public companies Canadian GAAP
will be replaced with IFRS. Canadian public companies that trade in the US will
be allowed to use US GAAP. The strategic plan also proposes that for private
companies with significant external stakeholders (such as bankers), a new set of
accounting standards will be established that would be designed to meet the needs
of these private business entities. For private entities whose financial statements
are not used for external reporting purposes the strategic plan proposes removing
GAAP as a constraint altogether. In addition GAAP for not-for-profit
organizations are expected to converge with the international standards. The
CICA intends to have its plan implemented by 2011.
 Identify and briefly explain the four basic assumptions that underlie GAAP.
Unit of Measure: The unit-of-measure assumption states that the economic
activity of an entity can be effectively stated in terms of a single unit of measure.
The unit of measure that is almost always used is money, and in Canada the
monetary unit used is usually the Canadian dollar
Entity: The financial statements of an entity should only provide information
about that entity. Transactions and economic events that do not pertain to that
entity should be excluded.
Going Concern: A going concern is an entity that will be continuing its operations
for the foreseeable future. GAAP assumes that, absent evidence to the contrary,
an entity operates as a going concern. This means that an entity is expected to
complete its current plans, use its existing assets, and meet its obligations in the
normal course of business.
Periodic Reporting: The periodic-reporting assumption states that meaningful
financial information about an entity can be provided for periods of time that are
shorter than the life of an entity.
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 What is comparability and why is it important according to GAAP?
Comparability means that stakeholders should be able to compare the accounting
information provided by different entities and compare the information of a
particular entity from period to period. Comparability is important because
accounting numbers are very difficult to evaluate in absolute terms. It is necessary
to have benchmarks or bases of comparison to make sense of the numbers.
 Identify and briefly explain the characteristics that, according to the CICA
Handbook and GAAP, make accounting information relevant.
The CICA Handbook describes three characteristics that contribute to the
relevance of information:
Predictive value: Many decisions that stakeholders make involve predicting the
future. Financial statement information should help stakeholders predict future
earnings and cash flows.
Feedback value: When users make predictions, they require information that
allows them to evaluate their predictions and to revise, update, correct, and adjust
them. GAAP-based accounting is reasonably well suited for providing feedback
because it presents the results of what happened. Stakeholders are then able to
compare the actual results with their predictions.
Timeliness: For information to be useful for decision making it must be available
to stakeholders in time to influence their decisions.
 Identify and briefly explain the characteristics that, according to the CICA
Handbook and GAAP, make accounting information reliable.
The CICA Handbook identifies the following components of reliability:
Verifiability: Information is verifiable if independent and knowledgeable
observers can come up with the same results for the measurement of an attribute.
Representational faithfulness: Representational faithfulness refers to the
association between underlying information being represented and the
representation of that information. Financial statements are a representation of the
underlying economic activity of an entity. If the statements are to be
representationally faithful, then they must capture the economic activity of an
entity.
Neutrality or freedom from bias: Information is neutral or free from bias if it is
not presented in a way that is designed to bias or manipulate users’ decisions.
Knowledge Check – Page 251
 What is matching? Why does matching make it necessary to estimate future
costs in some situations?
Matching is the process of associating costs (based on the historical costs) with
the revenue the costs help earn so that income can be determined. Matching gives
rise to the need to estimate expenses because some expenditures are not made
until after the revenue is recognized but these must be accrued at the time the
revenue is recognized.
 What is conservatism? Why does conservative accounting in the present
sometimes lead to non-conservative results in the future?
Conservatism requires that measurements in financial statements should be made
to ensure that assets, revenues, and net income are not overstated and that
liabilities and expenses are not understated. Conservative accounting in the
present sometimes lead to non-conservative results in the future because
accounting is a zero-sum game. By, for example, making a more conservative
estimate of expenses today (meaning a higher estimate), there will be fewer
expenses to be made in the future. Total expenses over the life of the entity will
be the same, but the timing of recognition is affected.
 Why does the existence of non-arm’s length or related party transactions make
it possible that the reporting entity’s financial statements will be difficult to
interpret?
When transactions take place between related parties it can’t be assumed that the
transaction amount is the fair market value. An implicit assumption about GAAP
financial statement is that transactions and economic events take place at arm’s
length and are recorded at fair market value. If this assumption is not followed
financial statements will be difficult to interpret because it will not be possible to
tell if the financial statements are representative of economic activity recorded at
fair value.