Standards
More Change Ahead
This year is shaping up to be a watershed year for standards. Practitioners can look forward to significant changes in a number of key areas.
FROM: MAR-APR 2005 ISSUE | BY STEPHEN SPECTOR
The audit risk model has been the basis for audit planning for most of the past 20 years. However, the fallout from the U.S. corporate failures in 2002 highlighted this model's weaknesses. In May 2004, the Auditing and Assurance Standards Board (AASB) issued an exposure draft on proposed changes to the model.
To properly perform an audit, the auditor must have extensive knowledge about the nature of the client's business and industry to determine whether or not financial reporting assertions are valid. The auditor must understand the business risks faced by the client, as well as the risks affecting the processing and recording of transactions. The auditor needs to know the client's business strategy and how the client plans to respond to changes in the business environment.
As for a new audit risk model, final standards have yet to be issued; however, changes are expected to take place in the third quarter of 2005. (See the May-June 2003 and September-October 2004 issues of CGA Magazinefor background.) A number of assurance sections will need to be changed to assist practitioners in meeting the increased demands of the new model. Accordingly, the following Handbook sections are expected to change in 2005:
- Authority of Auditing and Assurance Standards and other Guidance will develop a hierarchy for standards based on the AICPA Statement on Auditing Standards No. 95, Generally Accepted Auditing Standards.
- Audit Documentation will be revised to keep pace with the revisions to the audit risk model. The goal is to harmonize Section 5145 with International Standard on Auditing 230, Audit Documentation(ISA 230), and AICPA Statement on Auditing Standard 96, Audit Documentation(SAS 96).
- Management Representations is to be a new section requiring the practitioner to obtain written representations from management as part of the evidence obtained to support the conclusion in his or her report providing assurance on financial statements. The standards will incorporate the basic principles and essential procedures included in International Standard on Auditing 580, Management Representations(ISA 580), of the IAASB, and in Statement of Auditing Standards No. 85, Management Representations, of the AICPA.
- Planning will revise Handbook Section 5150, Planning and Supervision, harmonizing it with International Standard on Auditing 300, Planning an Audit of Financial Statements(ISA 300), which was revised and issued by the IAASB in July 2004. The revisions to Section 5150 will also conform to the amendments arising from the audit risk model project.
- Terms of the Engagement will result in the creation of a new Handbook section to establish standards and provide guidance on agreeing with the client the terms of the engagement relating to the audit of financial statements. In addition, Section 8200, Public Accountant's Review of Financial Statements, will be revised to incorporate guidance on agreeing the terms of the engagement relating to the review of financial statements.
Financial Instruments
More than fifteen years after research first began on financial instruments, Canadian standard-setters plan to bring the project to a close, at least for the next few years. In 1996, stage one saw the introduction of HandbookSection 3860 dealing with disclosure issues. Although the initial plan was to address disclosure and measurement issues, the measurement side of the project was postponed until a consensus could be reached among world standard-setters.
In March 2003, three exposure drafts were issued dealing with the above-noted topics. These standards will result in significant changes in accounting for derivatives and equity investments. For example, under the proposed standards all derivatives and most equity investments, such as common shares, will have to be recognized and measured at fair value. (See the September-October 2003 issue of CGA Magazine for background information.)
In July 2004, re-exposure drafts on the first two topics were issued, while Section 1530 entitled Comprehensive Income, was approved (it will not be effective until fiscal periods beginning on or after October 1, 2006). The final standards in the package are expected to be issued mid-2005 to be effective for fiscal periods beginning on or after October 1, 2006.
Accounting Changes
In the first quarter of 2005, the AcSB expects to release amendments to Section 1506; the goal is to amend the section in accordance with equivalent amendments to U.S. GAAP and international accounting standards. Under the revised section, a change in accounting policy could be made only when it is required by a primary source of GAAP, or results in a reliable and more relevant presentation in the financial statements. Furthermore, unless the primary source of GAAP contains specific transitional provisions, a change in accounting policy would have to be applied retroactively.
Non-monetary Exchanges
In the first quarter of 2005, the AcSB expects to release amendments to Section 3830. The revisions will harmonize Section 3830 with the FASB's revisions to APB 29 Exchanges of Productive Assets and the IASB's revisions to IAS 16, Property, Plant and Equipment. The revisions are intended to be effective for transactions initiated on or after the first of the month following issue. Application date is similar to that in place in the United States (transactions initiated on or after December 15, 2004) and countries following international standards (transactions initiated on or after January 1, 2005).
The key change is that all non-monetary transactions will be measured at fair value unless:
- the transaction lacks commercial substance;
- the transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange;
- neither the fair value of the assets or services received nor the fair value of the assets or services given up can be reliably measured; or
- the transaction is a non-monetary, non-reciprocal transfer to owners that represents a spin-off or other form of restructuring or liquidation.
Gone is the need to determine whether an exchange results in the culmination of the earnings process. Likewise, determining whether the assets exchanged are similar productive assets will no longer be necessary. The focus is now on "commercial substance." Commercial substance is deemed to exist when a transaction causes an identifiable and measurable change in the economic circumstances of an entity. Further, because the commercial substance tests require assessment of all cash flows, the 10 per cent cash "boot" has been eliminated.
Two tests determine whether commercial substance is present:
- Comparing the configuration of the asset-specific or service-specific cash flows before and after the transaction.
- Comparing entity-specific values.
Commercial substance exists when either the difference in cash flow configuration or entity-specific value is significant relative to the fair value of the assets exchanged. Cash flow configuration looks at the risk, timing, and amounts of the cash flows directly associated with the assets or services exchanged. A transaction will have commercial significance if there is a significant difference in any of these elements relative to the fair values of the assets exchanged. The test is a straight comparison — no PV calculations needed.
Implementation will require amendments in other Handbook sections to remove references to the culmination of the earnings process or the exchange of similar assets, as well as amendments to Section 3055, Interest in Joint Ventures:
- when the venturers are unrelated, transfers will be measured at fair value since there is a significant change in cash flow configuration;
- when the venturers are related, transfers are deemed related party transactions.
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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.