Xiaofei Song, Saint Mary’s University
xiaofei.song@smu.ca

Dick Chesley. Saint Mary’s University
d.chesley@ns.sympatico.ca

A typical introductory financial accounting class includes two distinctively different types of students: those who will major in accounting or finance and, therefore, take additional financial accounting courses in the future and those who will take no further financial accounting. For the former, the introductory accounting course should provide a solid foundation for their advanced study. For the latter, the introductory accounting course should provide them with enough essentials to become basically “accounting literate”. Given the breadth of the subject and the limited capacity of one course, the key to making introductory financial accounting work for all students is to choose the proper topics and to teach these topics efficiently.   

The objective of this article is to recommend some changes to make introductory financial accounting more relevant and more effective for all students. Our recommendations are based on a review of the current Canadian introductory accounting textbooks. Although these textbooks differ in their emphasis and style, readers would see a high level of consensus in the treatment of issues our recommendations are concerned with.   

Our recommendations are guided by the following considerations. First, as an introduction to an extensive subject, introductory financial accounting should include the topics that are essential to and representative of the subject. Second, university-level introductory financial accounting emphasizes the user’s perspective and its impact on decision making. Thus, introductory financial accounting should strive to be realistic and practical. Third, as a practical subject, financial reporting evolves along with business reality over time. Thus, introductory financial accounting should be up to date. Here are our recommendations.  

Recommendation 1 

Explain why Cost of Goods Sold (CGS), although very important, is not always available and what the alternatives are when it is not. 

For manufacturing and merchandising companies, CGS is the largest and most important expense. Commonly used ratios such as gross margin percentage and inventory turnover require a cost of goods sold number to compute. However, currently, Canadian companies are not required to report CGS separately. According to Financial Reporting in Canada by Byrd, Chen, and Smith (2005) fewer than half of the companies with CGS currently report it separately.   

It is often confusing to students when CGS can’t be found. Current textbooks either give inadequate discussion or are silent on the matter. Our recommendation is that students should be made aware of the practice regarding the CGS disclosure requirement and common practice. In the event that CGS is not available, practical alternatives should be introduced to students. For instance, the combined number of CGS and selling and general administrative expense, which is a typical alternative when a company chooses not to report CGS separately, can be used as an approximation for cost of goods sold. The error in such an approximation is mitigated if companies present their income statement in a consistent format and their selling and administrative expenses are stable.   

According to the AcSB Handbook 1520.03(r), Canadian companies will have to report cost of goods sold separately starting January, 2008. This matter will become less problematic once the new standard is implemented. However, it will remain a practical difficulty for students in the transition period.   

Recommendation 2 

Teach how to estimate the effective income tax rate and how to use the effective tax rate to assess the bottom-line effect of income statement items. 

Income statement analysis typically involves assessing the bottom-line effect of an income statement item, related to either a particular business decision or a specific accounting policy. For instance, in analyzing the trend of net income, analysts typically remove unusual or infrequent items from their analysis. Isolating the effect of an unusual or infrequent item requires the estimate of the tax effect of the item, hence the applicable income tax rate. The simplest way to achieve this is to use the income tax expense and the income before tax reported in the income statement to estimate the effective income tax rate.   

Estimating the effective income tax rate does not require a detailed discussion of income tax, which is beyond the scope of a typical introductory financial accounting course. Most introductory financial textbooks teach income tax as an accrued expense that requires an adjusting entry.  Some also introduce more advanced topics, such as the temporary and permanent differences, statutory and effective tax rates, and current and future income taxes, etc. Regardless of the extent of coverage of income tax, the simple method of estimating effective income tax rate offers a practical but useful technique for analyzing the income statement, especially those of real companies.   

Recommendation 3 

Consistent with common practice, use the term “depreciation” for property, plant and equipment and the term “amortization” for intangible assets. 

“Depreciation” and “amortization” both refer to “a rational and systematic basis for allocating the” cost of a long-term asset “over its estimated life and useful life”. Here is a situation in which a gap exists between what is recommended by the AcSB Handbook and what is commonly practiced by the companies. Section 3061 of the AcSB Handbook, enacted in 2001, recommends the term “amortization” for property, plant, and equipment as well as intangible assets. Prior to that, “depreciation” was used for property, plant and equipment and “amortization” for intangible assets. Most companies did not heed the recommendation of the AcSB Handbook, however, and kept on using both terms: ‘depreciation’ for property, plant and equipment and ‘amortization’ for intangibles.   

The replacement of “depreciation” with “amortization” in the AcSB Handbook is motivated by the belief that “amortization” emphasizes the process of cost allocation while “depreciation” can be associated with physical wear and tear. All Canadian financial accounting textbooks followed suit and replaced the word “depreciation” with “amortization”. In the current textbooks, “depreciation” is either introduced as an old term or a synonym for “amortization” or not mentioned.   

The reason Section 3061 of the AcSB Handbook is ignored cannot be explained by the fact that many Canadian public companies are either cross-listed or subsidiaries of US companies and, thus, influenced by the US GAAP. Non-cross-listed, non-US subsidiary Canadian companies did not change their use of these terms either.   

We do not recommend automatically siding with the practice whenever there is a divergence between common practice and the standards; however, in this case, we think the rationale for term changes is less compelling. In addition, Canadian public companies will soon be reporting under the International Financial Reporting Standards, and IFRS uses “depreciation” for property, plant, and equipment. Canadian public companies may be required to use “depreciation” again soon.   

Recommendation 4 

Stop teaching notes receivable. 

Most textbooks teach notes receivable as something similar to accounts receivable which arise from sales on credit. However, notes receivable have become very rare in real financial statements. Those that do show up occasionally usually do not result from sales on credit. Rather, they are primarily employee loans. Since the accounting of notes receivable is the mirror image of that of notes payable, and most textbooks include a detailed discussion on notes payable, including both is redundant.   

The disappearance of notes receivable reflects changes in the credit markets. Notes receivable traditionally are used to formalize the receivables that result from credit sales for the purpose of selling or factoring. However, the widespread use of credit cards, the increased availability of financing, and the practice of selling, factoring, and securitizing accounts receivables directly have made notes receivable from credit sales obsolete.   

In addition, the discussion of notes receivable requires the time value of money, which is often placed in later chapters of a textbook. Excluding notes receivable will allow a textbook to flow better because the discussion will then be in sequence.   

Recommendation 5 

Use mortgages or leases, rather than bonds, as primary examples of long-term debt. 

Bonds are commonly used as an example of long-term debt to explain two things essential to the accounting of long-term debts: (1) long-term debts are valued at the present value of the future payments, and (2) interest expenses on long-term debts are determined by the effective interest method. In reality, however, bonds are not the only type of long-term debts. Others include mortgages, capital leases, credit lines, credit lines, and notes.   

We have several reasons for recommending using mortgages or leases, rather than bonds, as the primary examples of long-term debts. First, bonds are far less common as long-term debt in real financial statements, compared with other types of long-term debts. Second, since bonds are rare, students are unfamiliar with the bond mechanism and bond-related jargon. On the other hand, mortgage and lease arrangements are more common in everyday life, so the concepts related to them are easier for students to understand. Third, bonds are unnecessarily complicated as an example to explain the present value and the effective interest method. The confusion partly arises from the dual concepts involved in the bonds: stated interest rate and effective interest rate; face amount and liability balance; cash interest payment and interest expense.  The unnecessary complexity of bonds distracts students from learning the essentials of present value valuation and the effective interest method.   

Mortgages and leases, on the other hand, are more familiar concepts, less complicated, and more commonly seen in real financial statements. Also, they are sufficient in demonstrating how long-term debts should be valued at their present value and how interest expense can be determined using the effective interest method. There is an essential difference between mortgages and leases, i.e., mortgage payments usually are made at the end of each period while lease payments are usually at the beginning of each period. Thus, the former are ordinary annuities and latter are annuities due.  

Recommendation 6 

Teach the legality of dividends in accordance with the Canada Business Corporations Act. 

Dividends are the earnings returned to the shareholders by a corporation. The legality of dividends concerns when and how much dividends can be declared and paid. Most current textbooks use “sufficient retained earnings” and “enough cash” as the necessary conditions for a dividend. However, according to the Canada Business Corporations Act, a “corporation shall not declare or pay a dividend if there are reasonable grounds for believing that (a) the corporation is or would after payment be unable to pay its liabilities as they become due; or (b) the realizable value of the corporation’s assets would thereby be less than the aggregate of its liabilities and stated capital.”  

There is a fundamental difference between using the book valued-based “retained earnings” and “cash and cash equivalent” versus using the market value-based ability to meet the obligations to determine the legality of a dividend. Given the historical cost principle and accounting conservatism constraint, market value-based measures would mean less restrictive dividend criteria.   

In reality, book-value based dividends policy is consistent with the practice in some of the states in U.S. It is not a Canadian practice. If the legality of dividends is discussed it should reflect Canadian regulation and practice accurately.   

Recommendation 7 

Teach the correct shipping terms. 

Two shipping terms are typically discussed in most textbooks: FOB (Free On Board) shipping point and FOB destination point. The origin of these shipping terms is the official Terms of Sales defined in the International Chambers of Commerce Terms of Trade. However, according to these official terms, the acronym FOB should not be used with the destination point. Instead, the term that indicates that the goods should be delivered and insured at the seller’s expense until they reach the buyer is Cost, Insurance and Freight (CIF) plus the point of destination.  

The rules of the International Chamber of Commerce Terms of Trade are intended for international ocean freight but are frequently used domestically for other forms of transportation such as air freight. It is true the both FOB shipping point and FOB destination point are sometimes used in Canada. Teaching them in accounting textbooks as if they were the universally accepted terms, however, contributes to a continuing misuse.  

Most changes recommended in this article are minor. Some require replacing the existing terms with the recommended ones; others require removing or adding a short section. The most extensive revisions are required for substituting bonds with mortgages or leases as primary examples of long-term debts. These changes should not affect the overall scope of an introductory financial accounting class. However, by eliminating or simplifying certain topics and tightening the connection between the textbook coverage and real practice on others, students will be better equipped for either pursuing more advanced study or applying this knowledge in the real world.