RANDALL TILANDER 19 September, 2007 ADMN 2106 Writing assignment 1-6 (a) The term GAAP means Generally Accepted Accounting Principles. As the term “Generally Accepted” implies, GAAP represents a consensus within the accounting profession as to what is acceptable. GAAP includes a number of specific rules, practices and proceduces as well as a number broader principles and underlying concepts. While the specific rules may be absolutely clear, some of the “broader principles and conventions” may get a little bit fuzzy as they get applied to a quickly changing economy. Page 18 of the text at the top gives a hierarchical list of the various authorities to be used in ascertaining what, specifically, GAAP allows. It starts with the CICA handbook as the primary authority and descends to magazine and journal articles at the bottom end. While most of the GAAP rules seem to come from the accounting profession itself, it should be noted that the rulings of regulators(especially the Securities Regulators) and the courts are also highly relevant. Each of these are interpreted by the Professional Judgement of the accountant who is attempting to apply the rule or principle to the specific statements before him. Within the context of a Prospectus, when an auditor signs off with an unqualified opinion that the statements represent a fair and true representation in accordance with GAAP, the auditor is representing that there are not any significant deviations from standard accounting practices in the preparation of those statements. In practice, investors and Securities Regulators take the auditors’ opinion as an assurance that the Financial Statements represent a Full, True and Plain disclosure of all material financial issues regarding the securities issuer. Investors expect that the rules applied in creating those financial statements do not differ significantly from the rules used in generating the financial statements of comparable firms. As a result of the clarity and the comparability, the investors make their investment decisions. IN this case, it appears that the auditors did not follow GAAP. On the face of it, it appears that the auditors did not make diligent efforts to check that GAAP was being followed. Spot checks of the commodity trading statements should have revealed discrepancies but, apparently, no discrepancies were discovered. (b) How does one determine whether a specific accounting principle has been accepted? If I might paraphrase the question, how do we know that the accounting profession as a whole has determined that a given principle should be applied as a part of GAAP? As page 18 of the text notes, GAAP is a conglomeration of rules and principles drawn from sources as authoritative as the CICA Handbook to sources as ephemeral as the ”commonsense” of a majority of accountants. So, how do we know if a principle has been accepted as a part of GAAP? Firstly, we look at the source of the principle. The CICA handbook lists the sources of GAAP in descending order of significance so that we can know how much weight to apply to the principle. If the principle comes from the CICA Handbook, then it should be taken very seriously; if the principle comes from an Op-Ed piece in the “North Bay Nugget” or an article in the “Journal of Advanced Eccentricity”, well, perhaps the principle should be taken to be less than a rule. And if there is a solid consensus from CICA down the the North Bay Nugget that a given principle is absolutely DAFT, then perhaps we might conclude that the principle is, in no way, a rule. If, on the other hand, one discovers a universal positive consensus concerning an unwritten rule, then perhaps one should consider that the unwritten principle has been generally accepted. (c) If we want to determine whether a principle has substantial authoritative support, what evidence can we use? Firstly, we can see where that principle has been published. If the principle has been published in CICA, then it has substantial authoritative support. If the principle is published in a lesser location, (accounting guidelines, Regulatory Rulings, etc), then the principle has less weight. If it is merely discussed in the kitchenette at KPMG, then it has less authority again. And if it is discussed at the Davedi Club, it has less authority again. Secondly, if I am a junior accountant at an accounting firm, I could ask a few of the more seasoned accountants for their opinions on the principle. Experience counts when it comes to assessing whether the principle has substantial authoritative support or not. Thirdly, as we go through the financial records of clients, we can see what principles have been applied and how. If a principle has substantial authoritative support, then it will be evidenced in those statements. Finally, we can email our professional accounting organization(CA, CGA, CMA) and ask it whether the principle has substantial authoritative support. Keep the email for compliance purposes. WA2-1 Well Roger, let’s begin with the realization that none of us lives in a bubble. Each of us is trying communicate information to stakeholders and other interested parties. If the sender and the receiver of the information are to understand the same things from a set of financial statements, the statements must be communicated in the same language with each term representing the same things to the receiver as to the sender. If I were to send you a message in English and you were to receive it in Swahili, chances are that the content of the message would not be very useful to you. Likewise, when we are attempting to communicate financial information, it helps if each us us understands what is meant by each term. Communicating this same information between sender and receiver becomes easier when both share a common set of assumptions. As accountants mediate between management and stakeholders, they need to assure all parties that each shares the same assumptions as to what each number represents in the financial statements. The easiest way to assure that everyone shares the same assumptions as to what numbers mean is for accountants to establish a set of “concepts and objectives”, principles and rules, which guide the accountants in generating and auditing financial statements. If these principles are prescribed, then the auditor has a checklist which he can use when certifying that those financial statements share the same assumptions as all other financial statements(GAAP). If the governing body of the accounting profession tells all Canadians that, for instance, Liquid Assets are those assets which are expected to be cashed out in the course of the accounting cycle, then all stakeholders in Canadian enterprises will know what the Liquid Assets number represents on the Balance Sheet. This is the value of the Conceptual Framework. It creates a common vocabulary and a common set of assumptions. From the Conceptual Framework, the AcSB has been able to make rules and standards which apply that framework to practical situations. The accounting board attempts to create a coherent set of practices which will increase the comparability between financial entities. Highly comparable financial statements founded upon a set of clear and coherent rules increase public confidence both in financial statements and the accounting profession. If the general public has confidence in financial statements, it will continue to invest and spend. If the general public has confidence in accountants, then you and I Roger will continue to be employed(and that’s probably a good thing). Occasionally, the ruling bodies of the accounting world will make new rules or modify old ones. The world is changing and we must change with it. Amendments to the Conceptual Framework enable the accounting profession to keep up with a changing world. If, for instance, the securities industry is going to come up with exotic new varieties of derivatives, then the accounting profession has to modify its way of measuring these so that future financial statements will continue to deliver accurate financial statements in a manner which all stakeholders can understand. Amendment is not a weakness but a sign of flexility and strength. WA2-3 (a) So, why would costs be expensed at the time of sale? The principle is that we should try, as far as is humanly possible, to match Expenses to Revenues. Okay, so that’s the principle; why should we apply this principle? What’s the benefit to expensing costs at the time of sale? To answer this, why don’t we ask what would happen if we simply expensed costs as they occurred? Let’s say, for instance, our Insurance Broker were willing to give us a huge discount for prepaying our business insurance five years into the future. And so, we prepurchase the insurance. If we were to expense these costs as they occur, the five years of insurance premiums would hit the Income Statement in the first year with no further Insurance being expensed in any of the following four years. So what happens to our Income Statement. Five years of Insurance Premiums hit the Income Statement at once. Thanks to the insurance premium, expenses are much higher in year one; Profits are significantly lower as a result of the impact of the prepaid Insurance Expense. The CEO of the company prepares an urgent action plan to cut costs. Layoffs follow; belts get tightened. The CFO gets fired. In year two, there is no Insurance expense and so, Profits soar; extra-ordinary dividends get declared; the CEO would consider rehiring the CFO were it not for the fact that the CFO cheats at golf. In years three, four and five, the extra-ordinary dividends continue. In year six, the insurance gets renewed for another five years, there is another balloon expense and the cycle repeats itself. If, on the other hand, we were to expense costs at the time of product sale, expenses and profits make much more sense. There are fewer balloon expenses, far less variation in Net Income and far more predicability as to future Expenses and Profits. By attributing costs at the time of sale, we can more readily see the contribution of that cost to the overall profitability of our enterprise. When we can predict the future, we can make investment plans and grow our business. (b) I don’t quite understand the question and so, let me rephrase the question. What is the rationale for treating as cost as an expense rather than assigning the cost to an asset? In brief, we treat an operating cost as an expense because it is used to generate Revenue but seldom has any significant effect upon the Capital Asset. Let’s go to an example. Let’s say that I have a transportation business built around a a 20 year old Ford Econoline van(Since Traven Reed is a Ford afficionado, I’m going to pick on Ford). Every so often, I have to put a quart of oil worth $5.00 into the van. The purchase(and use) of the oil doesn’t change the capital value of the van. The Econoline was worth $50 before the oil went in; $50 after . The Econoline wasn’t worth $55.00 as a result of that quart of oil; neither was it worth $45. The capital value of that van remained constant.(Leaving the principle of historical cost of capital assets to one side for the purposes of this example) On the other hand, that $5.00 quart of oil(and water from Lourdes in the radiator) kept my Ford running throughout another workday. Without that van, I wouldn’t have been able to make any deliveries; thanks to that quart of oil, I was able to make $50.00 in deliveries. Because that quart of oil enabled me to make revenues for my delivery company, doesn’t it make sense for me to charge the cost of the oil against the Revenue which I was able to earn as a result of having a working vehicle? Of course, the transmission fell out of my van at the beginning of the next workday but the next workday is irrelevant to our discussion. c) I can see two instances where it would be appropriate to treat a cost as an asset. It would make sense to treat costs as an asset if those costs are attributable to a long-term project whose Revenues are in the future and are reasonably uncertain as to magnitude. If I were to capitalize those costs, I would essentially be saving these costs until such a time as I had Revenues in my hand against which I could expense them. When the Revenues come, I would remove the Expenses from the Assets and expense it through the Income Statement. By expensing those costs in the future, I would then be able to match the costs against the Revenues in order to produce a reasonably accurate version as to the profitability of the project. Please note that if there are progress payments for this project or if the eventual payment were absolutely certain, it would probably be appropriate to spread the Revenues and Expenses throughout the duration of the project. Attributing Revenues and Expenses to each accounting period would entirely remove the illusion that all economic activity from the project occurs in the final year. Spreading Revenues and Expenses out would produce smoother Revenues and Profits and more understandable Financial Statements. I might also treat a cost as an asset if I were to prepay an expense. If the period for which I prepay extends into a future accounting period, then I would want to make the unused portion of that cost into an Asset so that I could expense that cost in the future periods during which I use the costed item. The example illustrated in WA2-3(a) whereby I prepaid 5 years of insurance presents a perfect example of a prepaid expense. If I were to account for that insurance properly, I would expense only the first year’s premium; I would leave the next four years of insurance premiums in a “Prepaid Expenses” account until such time as the insurance protection was expended. d) One might treat a cost as a loss if it were part of a company’s peripheral or incidental activities or from other cost activities which are not associated with expenses or distributions to the equity owners. The clearest example of peripheral or incidental activities would be the stock trading losses suffered by Japanese zaitech practitioners. During the 80s, the Japanese stock market was so buoyant and interest rates were so low that industrial companies borrowed on the debenture markets so that they could speculate on the equity markets. As equity markets soared, these companies reaped extra-ordinary gains. When equity markets crashed, the zaitech practitioners suffered their costs as losses because their primary business continued to be manufacturing.