A Year of Change 

Standards

A Year of Change

A quick review of key changes made to Canadian accounting and assurance standards over the past year

FROM: JAN-FEB 2005 ISSUE | BY STEPHEN SPECTOR

The month of January was named for the Roman god Janus, who was the god of beginnings and endings. Over the centuries, January has become a time to reflect on past events and future plans. In keeping with tradition, here is a condensed "year in review" for accounting and assurance standards.

Accounting Standards

Section 3110: Asset retirement obligations

Effective for fiscal periods beginning on or after January 1, 2004, this section addresses recognition and measurement of liabilities for obligations associated with the retirement of property, plant, and equipment when those obligations result from the acquisition, construction, development, or normal operation of the assets. Typical instances where the standard applies include site restoration costs related to mines, oil or gas wells, or landfills, nuclear plant decommissioning, and removal of plant and equipment from leased property on termination of the lease.

Section 3110 requires that an enterprise recognize any statutory, contractual, or other legal obligation when incurred. Such obligations are to be measured initially at fair value and the resulting costs capitalized into the carrying amount of the related asset. In subsequent periods, the liability is adjusted for the accretion of discount and any changes in the amount or timing of the underlying future cash flows. The asset retirement cost is amortized to income on a systematic and rational basis. Entities are required to disclose key information about the liability.

Section 3870: Stock-based compensation and other stock-based payments

Section 3870 was amended to require that all transactions where goods and services are received in exchange for stock-based compensation are to result in an expense recognized on the income statement. This requirement is effective for fiscal periods beginning on or after January 1, 2004. Share-based transactions must be measured on a fair value basis.

Because Section 3870 was already in place, the revised treatment is to be applied retroactively for awards previously not accounted for at fair value, with or without restatement of prior periods. At the same time, proforma information is required for awards granted from fiscal years beginning on or after January 1, 2002 (or January 1, 2003, for enterprises other than public enterprises, co-operative enterprises, deposit-taking institutions, and life insurance enterprises), and not accounted for under the fair value based method. On the other hand, prospective application is to be followed by an enterprise if the fair value based method had previously been applied for fiscal years beginning before January 1, 2004.

Finally, enterprises other than public enterprises, co-operative enterprises, deposit-taking institutions, and life insurance enterprises are permitted to defer the expense recognition requirements of Section 3870 until fiscal years beginning on or after January 1, 2005.

Assurance Standards

Unlike accounting standards, assurance standards normally do not include an effective date. The presumption is that they are effective for engagements performed subsequent to the release of the relevant Handbook sections. Two exceptions are noted below.

Quality Control Standards

In August 2004, the Handbook was updated to include new standards on quality control at both the firm level and assurance engagement level. These two standards are the first ones to be published in the Handbook that are outside assurance standards, yet they form part of generally accepted auditing standards.

The first, General Standards of Quality Control for Firms Performing Assurance Engagements, provides guidance on quality control policies and procedures to be established by firms performing assurance engagements. It requires that these firms establish a system of quality control to provide reasonable assurance that they comply with professional standards, regulatory and legal requirements, and that reports issued are appropriate in the circumstances. A system of quality control complying with the standard must be in place by December 1, 2005.

The second standard, Section 5030, Quality Control Procedures for Assurance Engagements, provides guidance on the specific quality control procedures to be performed by the assurance team in an assurance engagement. Section 5030 requires that the assurance team implement quality control procedures that are applicable to the individual assurance engagement. It also sets out specific responsibilities for the practitioner concerning the performance of each assurance engagement.

Note that Section 5030 refers to assurance engagements rather than audit engagements, as the ambit of the section is considerably larger than the General Standards of Quality Control for Firms Performing Assurance Engagements. In fact, paragraph 5030.01 specifically directs practitioners to read Section 5030 in conjunction with Section 5025 and recommendations of the Handbook. This section is also effective for assurance engagements concerning financial statements for periods commencing on or after December 1, 2005.

Section 5135: The auditor’s responsibility to consider fraud and error

In March 2002, changes to Handbook Sections 5090 and 5135 were made as a result of the then-Assurance (now the Auditing and Assurance) Standards Board's desire to harmonize Canadian assurance standards with those of the international community.

Section 5135 incorporated guidance from International Standard on Auditing (ISA) 240, The Auditor's Responsibility to Consider Fraud and Error in an Audit of Financial Statements, with just minimum changes to ISA 240 in order to conform to Canadian standards. Similarly, Section 5090 was amended to reflect changes to ISA 200, Objective and General Principles Governing an Audit of Financial Statements — changes that had been made so that ISA 200 conformed to ISA 240.

When Section 5135 and ISA 240 were issued in 2002, conforming amendments were made to Section 5090. However, unlike ISA 200,Section 5090 retained the assumption of management's good faith. Further, as 2002 drew to a close, the magnitude of the corporate failures in the United States created an atmosphere where the old approach was just not good enough anymore — and so we had a cascading impact. The U.S. standards, which had been at the core of the revised international standards changed, and so Canada had to change its standards again.

The 2004 version of Section 5135 dropped the reference to an assumption of management's good faith. In other words, management may be acting in good faith, but auditors can no longer make that assumption. Why not? The notion of management's good faith is incompatible with the requirement to conduct procedures to address the possibility of management override of internal controls. This approach is also reflected in a presumption that there is a risk of fraud in revenue recognition. Accordingly, auditors have to perform further procedures if risk is present and document the reasons when revenue recognition is not recognized as a risk.

Other changes to Section 5135 include a requirement:

• for members of the engagement team to discuss the susceptibility of an enterprise's financial statements to material misstatement due to fraud or error, and a requirement for the engagement partner to consider which matters are to be communicated to members of the engagement team not involved in the discussion;
• to design and perform certain mandatory procedures to address the risk of management override of internal controls, including examining journal entries, reviewing accounting estimates for bias and evaluating the business rationale for significant unusual transactions; and
• to incorporate an element of unpredictability in the selection of the nature, extent, and timing of the audit procedures performed in response to assessed risks of material misstatement due to fraud.

Section 5306: Auditing fair value measurements and disclosures

Section 5306 is based on International Standard on Auditing 545, which has the same title as Section 5306, with limited changes to fit the material within the context of the Handbook and to be consistent with the American Institute of Certified Public Accountants Statement on Auditing Standards no. 101, which also has the same title as Section 5306. As a result, an auditor complying with Section 5306 will also be in compliance with ISA 545 and SAS 101.

The section establishes standards and provides guidance on auditing the measurement, presentation, and disclosure of material assets, liabilities, and specific components of equity disclosed at fair value in financial statements. It is particularly appropriate for financial statements reporting financial instruments, stock options, and/or pension obligations. In order to comply with the section, an auditor will have to:

• understand the process for determining fair values;
• evaluate the appropriateness of fair value measurements and
• disclosures;
• test fair value measurements and disclosures;
• evaluate fair value disclosures;
• evaluate the result of audit procedures; and
• obtain a representation from management.

Section 5600 deals with the limited circumstances in which non-GAAP financial statements are prepared in accordance with regulatory, legislative, or contractual requirements. When non-GAAP financial statements are prepared in accordance with Section 5600, the auditor reports in accordance with that section.

When an auditor undertakes an engagement under Section 5600, it differs from a "traditional" audit engagement. Before accepting the engagement, the auditor must obtain an understanding of the specified user(s) of the financial statements and the purpose(s) for which they will use them, and the basis of accounting used. Prior to commencing the engagement, the auditor would confirm this understanding in writing, preferably in an engagement letter, after assessing whether the basis of accounting used in the financial statements is suitable for the engagement. The auditor would inform the entity that because the financial statements have been prepared on a non-GAAP basis, they are not intended for distribution to anyone other than the specified user(s).

The engagement cannot relate to a hypothetical set of circumstances. For example, the auditor cannot accept an engagement to report under Section 5600 on financial statements that have been prepared for the purpose of meeting a precondition to entering into a contract that does not yet exist.

Section 7600: Reports on the application of accounting principles

Section 7600 was revised so that the Canadian standard was consistent with the American Institute of Certified Public Accountants Statement on Auditing Standards no. 50, Reports on the Application of Accounting Principles. Section 7600 now prohibits the issuance of a report on a hypothetical transaction and requiring reports issued on specified transactions to contain a paragraph restricting the use of the report to specified parties.

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Stephen Spector, MA, FCGA, owns Spector and Associates and teaches Financial and Managerial Accounting at Simon Fraser University. He also serves on CGA-BC’s board of governors. E-mail shspector@shaw.ca.