FA Mod1 2013

CMA Ontario Accelerated Program
FINANCIAL ACCOUNTING MODULE 1 Lesson Notes
Financial Accounting Module 1
Table of Contents
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. Financial Statements and the Conceptual Framework The Statement of Cash Flow Revenue Recognition Cash Accounts Receivable Notes Receivable/Payable Inventory Property, Plant and Equipment & Intangible Assets Liabilities Shareholders Equity Employee Benefits Earnings per Share Accounting for Leases Accounting for NonProfit Organizations Financial Statement Analysis 3 83 116 155 163 179 208 235 310 344 379 418 440 475 515
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1.
Financial Statements and the Conceptual Framework
The purpose of this section is to provide a high level review of the accounting cycle, the preparation of financial statements (with the exception of the statement of cash flow) and the conceptual framework. If you are reading this before the course has started, we recommend that you spend as much time as you can working in the Financial Accounting Primer that you received with the course materials. In fact, we would recommend that you only spend time working with the primer until the day the course starts. Chapter 1 of the Financial Accounting Review manual should be read as a preamble to this chapter. It goes over financial accounting basics which are taken for granted in this chapter. A note on which accounting standards you are responsible for: if you are writing the Entrance Examination in June or October 2013, you are responsible for the accounting standards that are published at January 1, 2012. These financial accounting notes present those standards as published at January 1, 2012 even if the implementation date of the standard is beyond the year 2012. When there is a significant time delay between the date the standards are published and the implementation date of the standard, we will provide with an overview of the previous standard.
1.1
The Accounting Cycle
The accounting cycle describes the process whereby individual transactions get compiled to eventually becoming financial statements. The cycle is as follows: 1. Transaction: the company enters into a transaction, for example a sale on credit is made. 2. Transaction analysis: the accountant analyzes the transaction in terms of which account has been impacted upon 3. Journalization: the transaction gets recorded in a source journal. For example, the credit sale would likely get recorded in a sales journal. Other journals are: purchases journal, cash receipts journal, cash disbursements journal, payroll journal and the general journal. Note that this is by no means a comprehensive listing. 4. Posting: the journals get posted to the general ledger. The general ledger shows the details of all transactions in the companys accounts. 5. Trial balance - the trial balance is a listing of all general account balances. 6. Adjusting entries - analysis of the trial balance may require some entries to adjust the accounts before the financial statements are prepared. 7. Financial Statement Preparation. 8. Closing entries - once the financial statements have been prepared, all revenue and expense accounts are cleared out to zero and the residual amount (equal to net income) is closed out to retained earnings.
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Example: Local Stationery Ltd. is a local store providing business supplies, furniture and copy and fax services to local business and individuals. The trial balance as at December 31, 20x5 is as follows: Debit $14,500 74,000 130,000 10,400 1,400 60,000 260,000 90,000 40,000 25,000 2,800 3,600 15,000 150,000 250,000 149,400 $640,300 Credit
Cash Accounts Receivable Allowance for Doubtful Accounts Inventory Note receivable, current Prepaid insurance Land Building Equipment Accumulated depreciation Accounts payable and accrued liabilities Accrued wages payable Accrued income taxes payable Unearned revenue Long-term debt Common stock Retained Earnings
$4,500
$640,300
The following is a schedule of cash receipts and disbursements for the year 20x6: Cash receipts Cash sales Collections on credit sales Deposits received on furniture orders Sale of depreciable assets (note 1) Receipt of note receivable (note 2)
$450,000 620,000 50,000 20,000 10,800 1,150,800
Note 1:
the assets sold had an original cost of $40,000 and accumulated depreciation of $25,000.
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Note 2:
the note was taken out on July 2, 20x5 for $10,000, is due on July 2, 20x6 and bears 8% annual interest.
Cash disbursements Purchase of inventory Wages and salaries Income tax installments paid Operating expenses paid Interest paid on long-term debt Renewal of insurance policy Long-term debt repaid (annual payment due every Dec 31) Dividends paid Purchase of equipment
$650,000 200,000 25,000 150,000 13,500 7,200 15,000 30,000 50,000 $1,140,700
The T-accounts shown on pages 11-12 simulate the general ledger accounts. The following three journal entries will record cash receipts and disbursements: (1) Cash Sales Accounts Receivable Unearned revenues Note Receivable Interest revenue Cash Accumulated depreciation Equipment Gain on sale of depreciable assets $1,130,800 $450,000 620,000 50,000 10,400 400 20,000 25,000 40,000 5,000
(2)
(3)
Inventory Wages and salaries Income tax expense Operating expenses Interest Insurance expense Long-term debt Retained Earnings (dividends) Equipment Cash
650,000 200,000 25,000 150,000 13,500 7,200 15,000 30,000 50,000 1,140,700
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Other information: You find out that $3,600 of accounts receivable were written off as uncollectible this year. (4) Allowance for doubtful accounts Accounts Receivable 3,600 3,600
Accounts receivable at the end of the year total $98,000. After transaction #4, the accounts receivable balance shows a $549,600 credit. This is because we credited the account for collections but did not make an entry to record credit sales. Credit sales are: $549,600 + 98,000 = $647,600. (5) Accounts Receivable Sales 647,600 647,600
Analysis of the accounts receivable indicate that the allowance for doubtful accounts should be $5,700. After transaction # 4, the balance in the allowance for doubtful accounts was a credit of $900. We need to increase this to $5,700 as follows: (6) Bad debt expense Allowance for doubtful accounts 4,800 4,800
An inventory count shows that there is $145,000 of inventory on hand at December 31, 20x6. (7) Cost of goods sold Inventory 635,000 635,000
The company's insurance policy expires on May 31 of every year. On May 31, 20x6, the company renewed it's insurance policy for 2 years. Consequently, the prepaid insurance on December 31, 20x6 should be: $7,200 x 17/24 = $5,100. The current balance in the account is $1,400, thus it needs to be increased by $5,100 - 1,400 = $3,700. (8) Prepaid insurance Insurance expense 3,700 3,700
The annual depreciation on the building and equipment has been calculated to be $20,000. (9) Depreciation expense Accumulated depreciation 20,000 20,000
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Accounts payable and accrued liabilities all relate to the purchase of inventory. The total amount of accounts payable and accrued liabilities as at December 31, 20x6 is $35,000. (10) Cost of goods sold Accounts payable and accrued liabilities 10,000 10,000
Accrued wages payable at December 31, 20x6 is $1,300. (11) Accrued wages payable Wages and salaries 1,500 1,500
The balance in unearned revenues at December 31, 20x6 should be $10,000. (12) Unearned revenues Sales 55,000 55,000
Income taxes are 40% of net income before taxes. Net income before taxes is $122,700. Income tax expense is $122,700 x 40% = $49,080 - 25,000 = (13) Income tax expense Accrued income taxes payable 24,080 24,080
The following two pages posts the above transactions to t-accounts.
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ASSETS Cash 14,500 1,140,700 1,130,800 20,000 24,600 Op (3) Inventory 130,000 635,000 650,000 145,000 Land 60,000 Building 260,000 Prepaid Insurance 1,400 3,700 5,100 Accumulated Depreciation Op 25,000 40,000 20,000 (9) 35,000 Equipment 90,000 40,000 50,000 100,000 (7) Op Note Receivable 10,400 10,400 (1) Accounts Receivable 74,000 620,000 647,600 3,600 98,000
Allowance for Doubtful Accounts
Op (1) (2)
(3)
Op (5)
(1) (4)
(4)
3,600 4,500 4,800 5,700
Op (6)
Op
Op
Op (8)
(2)
Op (3)
(2)
LIABILITIES AND SHAREHOLDERS' EQUITY Accounts Payable and Acc Liab. 25,000 Op 10,000 (10) 35,000 Unearned Revenues (12) 55,000 15,000 50,000 10,000 Common Stock 250,000 Op (3) Retained Earnings 30,000 149,400 Op Long-Term Debt 15,000 150,000 135,000 Accrued Wages Payable 1,500 2,800 Op 1,300 27,680 Accrued Inc Taxes Payable 3,600 Op 24,080 (13)
(11)
Op (1)
(3)
Op
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REVENUES Sales 450,000 647,600 55,000 1,152,600 EXPENSES Cost of Goods Sold 635,000 10,000 645,000 Interest 13,500 Depreciation 20,000 Insurance 7,200 3,700 3,500 Wages and Salaries 200,000 1,500 198,500 Operating Expenses 150,000 Interest Revenue 400 Gain on Disposal of Assets 5,000 (2)
(1) (5) (12)
(1)
(7) (10)
(3)
(11)
(3)
(3)
(9)
(3)
(8)
(3) (13)
Income Taxes 25,000 24,080 49,080
(6)
Bad debt expense 4,800
From the balances in the t-accounts, we can now prepare a full set of financial statements.
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Local Stationery Ltd. Income Statement for the year ended December 31, 20x6 Sales Cost of goods sold Gross margin Selling and general expenses Wages and salaries Depreciation expense Insurance expense Bad debt expense Interest revenue Gain on disposal of assets Interest expense Net income before taxes Income tax expense Net income $1,152,600 645,000 507,600 (150,000) (198,500) (20,000) (3,500) (4,800) 400 5,000 (13,500) 122,700 49,080 $73,620
Local Stationery Ltd. Statement of Changes in Shareholders' Equity for the year ended December 31, 20x6 Common Stock $250,000 Retained Earnings $149,400 73,620 (30,000) $193,020
Balance, December 31, 20x5 Net income Dividends Balance, December 31, 20x6
$250,000
Note: as discussed later in this chapter, although International Financial Reporting Standards (IFRS) require a Statement of Changes in Shareholders' Equity, such a statement is not required for private entities who follow Accounting Standards for Private Enterprises (ASPE). ASPE requires only a statement of changes in retained earnings.
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Local Stationery Ltd. Statement of Financial Position as at December 31, 20x6
ASSETS Noncurrent Land Building Equipment Accumulated depreciation
$ 60,000 260,000 100,000 -35,000 385,000
Current Cash Accounts Receivable (net) Inventory Prepaid insurance
24,600 92,300 145,000 5,100 267,000 $652,000
SHAREHOLDERS' EQUITY AND LIABILTIES Shareholders' equity Common stock Retained Earnings
$250,000 193,020 443,020 120,000
Long-term debt Current liabilities Accounts payable and accrued liabilities Accrued wages payable Accrued income taxes payable Unearned revenues Current portion of long-term debt
35,000 1,300 27,680 10,000 15,000 88,980 $652,000
Note: the above format is the one recommended by International Financial Accounting Reporting Standards (IFRS). A private company following Accounting Standards for Private Enterprises (ASPE) would prepare a balance sheet in with current assets listed first on the asset side and current liabilities, then long-term liabilities followed by shareholders equity on the liabilities and equity side.
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1.2
Financial Statements
Components of Financial Statements IAS 1 states that a complete set of financial statements comprises of the following: (a) a statement of financial position as at the end of the period, (b) a statement of comprehensive income for the period, (c) a statement of changes in equity for the period, (d) a statement of cash flows for the period (e) a set of notes, which provide a summary of the entity's significant accounting policies along with other explanatory information IAS 1 uses different terminology from what was used previously under both IAS's and ASPE, for example a 'statement of financial position' is the equivalent of a 'balance sheet'. Nevertheless, an entity can continue to use financial statement titles other than those used in IAS 1, as long as the titles are not misleading. IAS 1.36 requires that financial statements be presented at least annually. IAS 1.51 states that each financial statement and notes be clearly identified and prominently displayed with the following information: the name of the reporting entity, whether the financial statements are for an individual entity or a group of entities, the date of the end of the reporting period or the period covered by the set of financial statements, the presentation currency, and the level of rounding used in presenting amount.
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The Statement of Financial Position The following is a schematic of a typical Statement of Financial Position: Share Capital Long-term Assets Retained Earnings Long-Term Liabilities
Current Assets
Current Liabilities
A Statement of Financial Position is essentially a listing of all assets of an accounting entity (the left side). The right side of the statement shows how these assets are financed: through external creditor financing (liabilities) or though internal financing, either through direct shareholder financing (share capital) or though growth (retained earnings). Note that the above 'inverted' statement of financial position is not required by IAS 1, so companies can continue to use the traditional balance sheet format, i.e. current assets followed by current liabilities. The inverted format however, is used by all European entities that have adopted IFRS and is used in all examples in IAS 1. Assets are segregated into current and long-term assets. A current asset is defined as follows (IAS 1.66) it is expected to be realized in, or is intended for sale or consumption in, the entitys normal operating cycle it is held primarily for the purpose of being traded it is expected to be realized within 12 months, or it is cash or a cash equivalent. The operating cycle of a business is defined as the amount of time it takes to convert raw materials into a final product and sold. For most businesses this is much less than one year. Some businesses' operating cycle last longer than one year: tree farms, nuclear submarine contractors, scotch whisky distillers, etc For purposes of this course, however, we can generally assume that current assets will be converted into cash or used up in the business within one year.
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The most common current assets are: cash, short-term investments, accounts receivable, inventory and prepaid expenses. Non-current assets are defined by what they are not: they are not current assets. Essentially, they are assets that will convert into cash or be used up in the business over periods of longer than one year or the operating cycle of the business. The most common long-term assets are: long-term investments, land, building, equipment, and intangible assets (goodwill, patents and trademarks). An entity should classify a liability as current when (IAS 1.69): it expects to settle the liability in the entity's normal operating cycle, it holds the liability primarily for the purpose of trading, the liability is due to be settled within twelve months after the reporting period, or the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. The most common current liabilities are: accounts payable, accrued liabilities and the current portion of long-term debt. Non-current liabilities, like non-current assets, are defined by what they are not: they are not current liabilities. Generally non-current liabilities represent those liabilities that are due to be paid in periods exceeding one year or the operating cycle of the business. The most common long-term liabilities are: long-term debt and future income tax liabilities. Shareholders' equity is typically made up of two components: share capital and retained earnings. Share capital represents the amount that shareholders have invested in the corporation directly. There are generally two types of share capital: common shares and preferred shares. Retained earnings represent the sum total of past earnings that have not been distributed to shareholders by way of dividends. IAS 1.54 requires that, as a minimum, the following be disclosed on the face of the statement of financial position: property, plant and equipment investment property intangible assets financial assets investments accounted for using the equity method biological assets (i.e. cattle) inventories trade and other receivables cash and cash equivalents the total of assets classified as held for sale and assets included in disposal groups classified as held for sale trade and other payables
provisions financial liabilities liabilities and assets for current tax (i.e. income taxes payable/receivable) deferred tax liabilities and deferred tax assets liabilities included in disposal groups classified as held for sale noncontrolling interest, presented within equity issued capital and reserves attributable to the parent's equity holders
Current/noncurrent classification - IAS 1.60 requires that current / non-current assets and current / non-current liabilities be disclosed separately except when a presentation based on liquidity would provide information that is reliable and more relevant. If that exception applies, all assets and liabilities should be presented broadly in order of liquidity. Financial institutions, for example, would be more likely to present their statement of financial position on a liquidity basis. IAS 1 acknowledges that the current / non-current classification is useful when an entity supplies goods or services within a clearly identifiable operating cycle (IAS 1.62). The following page provides a illustrative Statement of Financial Position (adapted from IAS 1 - Implementation Guidance).
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XYZ Group Statement of financial position as at December 31, 20x7 (in thousands of currency units) Dec 31, 20x7 ASSETS Non-current assets Property, plant and equipment Goodwill Other intangible assets Investments in associates Available-for-sale financial assets Current assets Inventories Trade receivables Other current assets Cash and cash equivalents Dec 31, 20x6
350,700 80,800 227,470 100,150 142,500 901,620 135,230 91,600 25,650 312,400 564,880 1,466,500
360,020 91,200 227,470 110,770 156,000 945,460 132,500 110,800 12,540 322,900 578,740 1,524,200
EQUITY AND LIABILITIES Equity attributable to owners of the parent Share capital Retained earnings Other components of equity Non-controlling interests Non-current liabilities Long-term borrowings Deferred tax Long-term provisions Current liabilities Trade and other payables Short-term borrowings Current portion of long-term borrowings Current tax payable Short-term provisions Total liabilities
650,000 243,500 10,200 903,700 70,050 973,750 120,000 28,800 28,850 177,650 115,100 150,000 10,000 35,000 5,000 315,100 492,750 1,466,500
600,000 161,700 21,200 782,900 48,600 831,500 160,000 26,040 52,240 238,280 187,620 200,000 20,000 42,000 4,800 454,420 692,700 1,524,200
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The Statement of Comprehensive Income IAS 1 requires firms to present all income and expenses recognized in a period in either (1) a single statement of comprehensive income or (2) in two statements: a statement of income ending with net income/loss and a statement beginning with the net income/loss and displaying components of other comprehensive income. Components of other comprehensive income will in introduced in Module 2 of this course so you will not understand what these mean until we cover the next module. They are illustrated here for purposes of form only. As a minimum, the statement of comprehensive income shall include the following line items (IAS 1.82, 83 and 84): (a) (b) (c) Revenue. Finance costs (interest expense). Share of profits and losses of associates and joint ventures accounted for using the equity method. Tax expense. A single amount comprising the total of(i) the post-tax profit or loss of discontinued operations; and (ii) the post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation. Profit or loss. Each component of other comprehensive income classified by nature. Share of other comprehensive income of associates and joint ventures accounted for using the equity method. Total comprehensive income. Allocations of profit or loss for the period: (i) Profit or loss attributable to minority interest. (ii) Profit or loss attributable to owners of the parent. Allocations of total comprehensive income for the period: (i) Total comprehensive income attributable to minority interest. (ii) Total comprehensive income attributable to owners of the parent.
(d) (e)
(f) (g) (h)
(i) (j)
(k)
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An entity may present items (a) to (f) and (j) above in a separate income statement. The following is a illustration of a statement of comprehensive income in two parts (adapted from IAS 1 - Implementation Guidance): XYZ group Income statement (classification of expenses by nature) for the year ended December 31, 20x7 (in thousands of currency units) 20x7 Revenue Other income Changes in inventories of finished goods and work in progress Work performed by the entity and capitalized Raw material and consumables used Employee benefits expense Depreciation and amortization expense Impairment of property, plant and equipment Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the year from continuing operations Loss for the year from discontinued operations Profit for the year Profit attributable to: Owners of the parent Minority interest Earnings per share (in currency units) Basic and diluted 390,000 20,667 (115,100) 16,000 (96,000) (45,000) (19,000) (4,000) (6,000) (15,000) 35,100 161,667 (40,417) 121,250 121,250 97,000 24,250 121,250 0.46 20x6 355,000 11,300 (107,900) 15,000 (92,000) (43,000) (17,000) (5,500) (18,000) 30,100 128,000 (32,000) 96,000 (30,500) 65,500 52,400 13,100 65,500 0.30
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XYZ group Statement of comprehensive income for the year ended December 31, 20x7 (in thousands of currency units) 20x7 121,250 20x6 65,500
Profit for the year Other comprehensive income: Items that will not be reclassified to profit or loss: Fair value through OCI investments Gains on property revaluation Remeasurements of defined benefit pension plans Share of other comprehensive income of associates Income taxes relating to items that will not be reclassified Items that may be reclassified subsequently to profit or loss: Exchange differences on translating foreign operations Cash flow hedges Income taxes relating to items that may be reclassified
(24,000) 933 (667) 400 5,834 (17,500) 5,334 (667) (1,167) 3,500 (14,000) 107,250 85,800 21,450 107,250
26,667 3,367 1,333 (700) (7,667) 23,000 10,667 (4,000) (1,667) 5,000 28,000 93,500 74,800 18,700 93,500
Other comprehensive income for the year, net of tax Total comprehensive income for the year Total comprehensive income attributable to: Owners of the parent Minority interest
Other comprehensive income has to be classified by nature and grouped into those that will not be reclassified subsequently to profit or loss and those who will be reclassified subsequently to profit or loss when specific conditions are met. As an example, as we will see in the chapter on Property, Plant and Equipment, companies have the option to use a revaluation model that would carry assets on the Statement of Financial Position at their fair values. Assume that we purchase a parcel of land for $50,000 and, a year later, the fair value of the land is assessed at $80,000. If the revaluation model were applied, we would carry the asset at $80,000 with the fair value difference of $30,000 being classified as other comprehensive income. If the asset were subsequently sold for $80,000, then the gain of $30,000 would be precluded from flowing to profit or loss but instead would have to be reclassified within equity, usually to retained earnings. Fair value gains on cash flow hedges, on the other hand would be reclassified to profit and loss. Note that an entity should not present any extraordinary items, either on the face of the income statement or in the notes.
IAS 1.99 requires that expenses be presented in one of two forms on the statement of income: by nature of expense, i.e. depreciation, cost of materials, transport costs, employee benefits, advertising. by function of expense: COGS, selling costs, distribution costs, administrative costs. The choice ultimately depends on which method most fairly presents the elements of the entity's performance and would likely be based on historical and industry factors and the nature of the entity. The nature of expense method will require less analysis and be simpler to use. The income statement presented on the previous page was by nature of expense. The same statement, but presented by function of expense is illustrated below. XYZ group Income statement (classification of expenses by function) for the year ended December 31, 20x7 (in thousands of currency units) 20x7 Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the year from continuing operations Loss for the year from discontinued operations Profit for the year Profit attributable to: Owners of the parent Minority interest Earnings per share (in currency units) Basic and diluted 390,000 (245,000) 145,000 20,667 (9,000) (20,000) (2,100) (8,000) 35,100 161,667 (40,417) 121,250 121,250 97,000 24,250 121,250 0.46 20x6 355,000 (230,000) 125,000 11,300 (8,700) (21,000) (1,200) (7,500) 30,100 128,000 (32,000) 96,000 (30,500) 65,500 52,400 13,100 65,500 0.30
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The Statement of Changes in Equity The statement of changes in equity shows how each component of equity has changed from the beginning of the year to the end of the year. A sample (simplified) statement is as follows: XYZ Company Statement of Changes in Equity For the year ended December 31, 20x6
Preferred Shares Balance, Jan 1, 20x6 Net income Increase in OCI Issue of preferred shares Purchase of common shares Stock Dividend Cash Dividends - Preferred - Common Balance, Dec 31, 20x6 $200,000 Common Shares $100,000 Contributed Surplus $155,000 Retained Earnings $250,000 450,000 Other Comprehensive Income $75,000 5,000 105,000 (14,800) 95,850 (114,700) (95,850) (24,000) (46,860) $533,290
$305,000
$181,050
$40,300
$80,000
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1.3
The Conceptual Framework
A strong theoretical foundation is essential if accounting practice is to keep pace with a changing business environment. Accountants are continuously faced with new situations and business innovations that present accounting and reporting problems. These problems must be dealt with in an organized and consistent manner. The conceptual framework plays a vital role in the development of new standards and in the revision of previously issued standards. According to the International Accounting Standards Board, the purpose of a conceptual framework is as follows: (a) to assist the Board in the development of future IFRSs and in its review of existing IFRSs; (b) to assist the Board in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs; (c) to assist national standard-setting bodies in developing national standards; (d) to assist preparers of financial statements in applying IFRSs and in dealing with topics that have yet to form the subject of an IFRS; (e) to assist auditors in forming an opinion on whether financial statements comply with IFRSs; (f) to assist users of financial statements in interpreting the information contained in financial statements prepared in compliance with IFRSs; and (g) to provide those who are interested in the work of the IASB with information about its approach to the formulation of IFRSs. The Objective of Financial Statements The objectives of financial statements are as follows: to provide information about the financial position, performance and changes in financial position of an entity that is useful to current and potential creditors and shareholders in making economic decisions (although it acknowledged that this is limited by the fact that financial statements primarily portray the financial effects of past events and do not provide non-financial information). This includes: the evaluation of the ability of the entity to generate cash and the timing and certainty of this generation, information about the economic resources controlled by the entity, information about the financial structure of the entity, information about liquidity and solvency of the entity, information about the performance and the variability of performance of the entity, particularly its profitability, and information about changes in the financial position of the entity. to show the results of the stewardship of management, defined as the accountability of management for the resources entrusted to it.
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Underlying Assumptions The conceptual framework considers two underlying assumptions: the accrual basis and the going concern principle. Under the accrual basis, the effects of transactions and other events are recognized when they occur (and not when cash is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. The financial statements are prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Qualitative Characteristics of Financial Statements There are two fundamental qualitative characteristics: 1. Relevance - information is relevant when it influences the economic decisions of users by helping them evaluate past, present or future events (predictive value) or confirming, or correcting, their past evaluations (feedback value or confirmatory role). A secondary characteristic of relevance is materiality - information is considered relevant if it is material. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. 2. Faithful Representation to be useful, financial information must not only represent relevant phenomena, but must represent faithfully that which it either purports to represent or could reasonably be expected to represent. Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. Faithful representation has three characteristics: i. ii. Completeness - the information in financial statements must be complete within the bounds of materiality and cost. Neutrality - financial statements are not neutral if, by the selection or presentation of information, they influence the making of a decision or judgment in order to achieve a predetermined result or outcome. A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users Free from error - means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process.
iii.
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Enhancing Qualitative Characteristics 1. Comparability - implies that accounting information is comparable with previous periods (interperiod comparability or consistency) and comparable to other firms operating in the same industry (interfirm comparability). Consistency implies that accounting principles are applied from period to period in the same manner. Users must be informed of the accounting policies used in the preparation of financial statements. Verifiability - means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Timeliness - Management may need to balance the relative merits of timely reporting and the provision of reliable information. In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the economic decision-making needs of users. Understandability - financial statements must be readily understandable by users. Users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence. Note that this does not preclude the inclusion of complex matters.
2.
3.
4.
The Cost Constraint The basic issue is that the benefits derived from information should exceed the cost of providing it. Costs are mostly imposed on the providers of financial information but are also incurred by users of financial statements to collect needed information that is not provided by the financial statements. In applying the cost constraint in setting new standards, the International Accounting Standards Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. The Elements of Financial Statements An asset is defined as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. The future economic benefits embodied in an asset may flow to the entity in a number of ways. For example, an asset may be: (a) used singly or in combination with other assets in the production of goods or services to be sold by the entity; (b) exchanged for other assets; (c) used to settle a liability; or (d) distributed to the owners of the entity.
A liability is defined as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. The settlement of a present obligation usually involves the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation may occur in a number of ways, for example, by: (a) payment of cash; (b) transfer of other assets; (c) provision of services; (d) replacement of that obligation with another obligation; or (e) conversion of the obligation to equity. An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights. Equity is defined as the residual interest in the assets of the entity after deducting all its liabilities. Income is defined as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. The definition of income encompasses both revenues and gains. Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. Gains represent increases in economic benefits and as such are no different in nature from revenue. Expenses are defined as decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. Expenses that arise in the course of the ordinary activities of the entity include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment. Capital maintenance adjustments - the revaluation or restatement of assets and liabilities gives rise to increases or decreases in equity. While these increases or decreases meet the definition of income and expenses, they are not included in the income statement. Instead these items are included in equity as capital maintenance adjustments or revaluation reserves.
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Measurements of the Elements of Financial Statements There are four basis of measurement under IFRS: Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently. Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. Accounting Standards in Canada
1.4
There are currently four different sets of accounting standards for Canadian entities: 1. If you are a publicly accountable entity, you must follow the accounting standards as prescribed by the International Accounting Standards Board (IASB) - these are the International Financial Reporting Standards (IFRS's). These can be found in Part I of the CICA Handbook. These are to be implemented for yearends starting on or after January 1, 2011. A publicly accountable enterprise is an entity, other than a not-for-profit organization, or a government or other entity in the public sector that has issued, or is in the process of issuing, debt or equity instruments that are, or will be, outstanding and traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); or holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses
Banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks typically meet the second of these criteria. Other entities may also hold assets in a fiduciary capacity for a broad group of outsiders because they hold and manage financial resources entrusted to them by clients, customers or members not involved in the management of the entity. However, if an entity does so for reasons incidental to one of its primary businesses (as, for example, may be the case for some travel or real estate agents, or cooperative enterprises requiring a nominal membership deposit), it is not considered to be publicly accountable. 2. If you are a private enterprise, then you have two choices: you can follow IFRS's or you can follow the accounting standards for private enterprises (ASPE) as prescribed by the CICA's Accounting Standards Board. These can be found in Part II of the CICA Handbook. These were issued in December 31, 2009 and are to be implemented for year-ends starting on or after January 1, 2011. Note that if a private entity chooses to adopt IFRS's it must adopt all of the standards. It is expected that most private entities in Canada will adopt ASPE. Those that adopt IFRS are most likely those entities that are planning to go public or have a parent company who is a public company and is subject to IFRS. A private enterprise is defined as a non-publicly accountable profit-oriented enterprise operating in the private sector that has no debt/equity instruments that are, or will be outstanding and traded in a public market or does not hold assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. 3. If the entity is a non-profit organization, then the accounting standards can be found in Part III of the CICA Handbook. These standard are currently under review and should be issued later in 2010. We will be discussing accounting for nonprofit organizations later in this module and will be referring to the standards currently in place. If the entity is a pension plan, the accounting standards can be found in Part IV of the CICA Handbook. Accounting for pension plans is beyond the scope of this course and will not be discussed.
4.
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1.5
Accounting Standards for Private Enterprises (ASPE)
You are responsible for accounting standards for publicly accountable entities (IFRS's) and accounting standards for private enterprises (ASPE). In these course materials, these will be handled as follows: - the textual material will generally follow international standards, - if the ASPE issue is relatively minor, it will be inserted as a text box within the text materials, - otherwise, ASPE standards that differ from international standards will be in a separate section at the end of each chapter. Assume that all problems in the course materials relate to a publicly accountable entity. If you are expected to apply ASPE's to a particular situation, the question will be very clear that you are dealing with a private entity that follows ASPE (note that private entities can opt to use IFRS). This will apply to exams throughout the Accelerated Program as well. The following are the main ASPE issues relating to this chapter's materials: 1. The Statement of Financial Position is called a Balance Sheet. Current Assets are listed above noncurrent assets. Similarly, on the liabilities and equity side, current liabilities are listed first followed by long-term liabilities and equity. The disclosure requirements are essentially the same as those required by IAS 1. 2. There is no requirement to provide an income statement by function or nature of expense. Management can essentially choose any format for the income statement as long as the following minimum disclosures are provided: revenues, income from investments, showing separately: - income from nonconsolidated subsidiaries and non-proportionately consolidated joint ventures - investments measured using the cost method, - investments measured using the equity method, and - investments measured at fair value government assistance credited directly to income, amortization expense on property, plant and equipment amortization expense on intangible assets asset impairment losses goodwill impairment losses intangible asset impairment losses compensation expense associated with stock based employee compensation foreign exchange gains and losses interest expense interest expense related to capital lease obligations
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revenues, expenses, gains or losses resulting from transactions or events that are not expected to occur frequently over several years, or do not typify normal business activities of the entity, and cost of goods sold.
In addition, the income statement has to distinguish between income/loss before discontinued operations, the results of discontinued operations and net income/loss for the period. There is no other comprehensive income in ASPE. 3. The ASPE conceptual framework is significantly different from the IASB one. The primary reason for the difference relates to the differences in the users of financial statements. In a private entity, the user group is generally limited to much fewer investors and creditors as one would normally see for a publicly accountable entity. And the investors and creditors of a private entity will often have access to additional information about the inner workings of the entity than investors and creditors of publicly accountable entities would have. The following is a summary of the financial statement concepts applicable to private entities in Canada. Financial statements normally include a balance sheet, income statement, statement of retained earnings and cash flow statement. Notes to financial statements and supporting schedules to which the financial statements are cross-referenced are an integral part of such statements. (note that ASPE require a statement of retained earnings whereas IFRS require a Statement of Changes in Shareholders' Equity). Users and their needs The users of financial statements of private enterprises are primarily two broad groups: creditors and shareholders (both present and potential). Consequently, the focus of financial statements is to meet the needs of creditors and shareholders. These two groups are most likely to have the following primary needs: forecast future cash flows: will the company have sufficient future cash flows to meet future interest, principal and dividend payments?, and what is the fallback position: does the company have sufficient assets to satisfy its liabilities? The objective of financial statements is to communicate information that is useful to investors, creditors and other users in making their resource allocation decisions and/or assessing management stewardship. Consequently, financial statements provide information about: (a) an entity's economic resources, obligations and equity; (b) changes in an entity's economic resources, obligations and equity; and (c) the economic performance of the entity.
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Qualitative Characteristics of Accounting Information There are four main qualitative characteristics: 1. Understandability 2. Relevance - Predictive value - Feedback value - Timeliness 3. Reliability - Representational Faithfulness - Verifiability - Neutrality - Conservatism 4. Comparability
A few comments on the differences the materiality principle is also in the ASPE framework as a separate principle outside the qualitative characteristics, the three constraints under the IASB Framework are also included in the ASPE Framework: timeliness is included as a secondary characteristic of relevance balance between benefit and costs and balance between qualitative characteristics are included as separate elements the conservatism concept is not included as part of the IASB Framework. Conservatism means that it is generally preferable that any possible errors be in the direction of understatement of net income. When accountants can choose between two equally acceptable accounting principles, the principle of conservatism implies that the one with the least favourable impact on net income should be the one chosen. The principle of conservatism also leads to the recognition of contingent losses but does not recognize any contingent gains. For example, we must estimate which accounts receivable are likely to become uncollectible in the future and establish an allowance for doubtful accounts. Conservatism is an effort to ensure that the risk or uncertainty inherent in business situations is adequately considered. The definitions of the elements of financial statements (assets, liabilities, equity, revenues, expenses, gains and losses) is fundamentally the same as for the IASB Framework.
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Although the ASPE framework also provides the same four bases of measurement as the IASB Framework, historical cost is recognized as the main basis of measurement. One area where the ASPE framework differs significantly from the IASB framework is that it provides recognition criteria. Recognition is defined as the inclusion of an item in an entity's financial statements (not in the notes, but as a recorded transaction in the statements). The recognition criteria are as follows: the item has an appropriate basis of measurement and a reasonable estimate can be made of the amount involved, and for items involving obtaining or giving up future economic benefits, it is probable that such benefits will be obtained or given up. Items that meet the recognition criteria are accounted for using accrual accounting. The following specific guidance is provided: Revenues are generally recognized when performance is achieved and reasonable assurance regarding measurement and collectibility of the consideration exists. Gains are generally recognized when realized. Expenses and losses are generally recognized when an expenditure or previously recognized asset does not have future economic benefit. Expenses are related to a period on the basis of transactions or events occurring in that period or by allocation. Expenses are recognized in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events. For example, the various components of expense making up the cost of goods sold are recognized at the same time as the income derived from the sale of the goods. However, the application of the matching concept does not allow the recognition of items in the balance sheet that do not meet the definition of assets or liabilities. When economic benefits are expected to arise over several accounting periods and the association with income can only be broadly or indirectly determined, expenses are recognized in the income statement on the basis of systematic and rational allocation procedures. This is often necessary in recognizing the expenses associated with the using up of assets such as property, plant, equipment, patents and trademarks. In such cases, the expense is referred to as depreciation or amortization. These allocation procedures are intended to recognize expenses in the accounting periods in which the economic benefits associated with these items are consumed or expire. An expense is recognized immediately in the income statement when an expenditure produces no future economic benefits or when, and to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition in the balance sheet as an asset. (CICA Handbook, Part II, section 1000.42 to 1000.47)
What the future holds.

When warranted, the end of each chapter will include a short section on proposed changes that are likely to result based on current International Accounting Standard Board (IASB) deliberations and agendas. The source of these changes are currently in the form of either discussion papers or exposure drafts and may or may not be implemented at a future date. It is proposed that three main financial statements (Financial Position, Income and Cash Flow) be reconfigured and each broken down as follows: a business section that would include an operating and investing category, a financing section containing a debt and equity category, an income tax section, and a discontinued operations section. The reconfiguration would be based on the principle of cohesiveness: information has to be presented in the financial statements such that the relationship among items across the financial statements is clear. Note that this project appears to have been delayed and we have no indication of when it will re-appear on the IASBs agenda.
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Financial Statements and the Accounting Cycle Problems with Solutions

Multiple Choice Questions 1. Beach Company paid $3,480 on June 1, 20x8 for a two-year insurance policy and recorded the entire amount as Insurance Expense. The December 31, 20x8 adjusting entry is a. Debit Insurance Expense and credit Prepaid Insurance, $1,015. b. Debit Insurance Expense and credit Prepaid Insurance, $2,465. c. Debit Prepaid Insurance and credit Insurance Expense, $1,015. d. Debit Prepaid Insurance and credit Insurance Expense, $2,465.
2.
Karr Corporation received cash of $7,200 on August 1, 20x8 for one year's rent in advance and recorded the transaction with a credit to Rent Revenue. The December 31, 20x8 adjusting entry is a. Debit Rent Revenue and credit Unearned Rent, $3,000. b. Debit Rent Revenue and credit Unearned Rent, $4,200. c. Debit Unearned Rent and credit Rent Revenue, $3,000. d. Debit Cash and credit Unearned Rent, $4,200.
3.
Baker Corp.'s liability account balances at June 30, 20x2 included a 10 percent note payable in the amount of $1,000,000. The note is dated October 1, 20x0 and is payable in three equal annual payments of $500,000 plus interest. The first interest and principal payment was made on October 1, 20x1. In Baker's June 30, 20x2 balance sheet, what amount should be reported as accrued interest payable for this note? a. $112,500 b. $75,000 c. $37,500 d. $25,000
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4.
Financial information exhibits the characteristic of consistency when a. expenses are reported as charges against revenue in the period in which they are paid. b. accounting entities give accountable events the same accounting treatment from period to period. c. extraordinary gains and losses are not included on the income statement. d. accounting procedures are adopted which give a consistent rate of net income.
5.
Rice Co. was incorporated on January 1, 20x1, with $500,000 from the issuance of stock and borrowed funds of $75,000. During the first year of operations, net income was $25,000. On December 15, Rice paid a $2,000 cash dividend. No additional activities affected owners' equity in 20x1. At December 31, 20x1, Rice's liabilities had increased to $94,000. In Rice's December 31, 20x1, balance sheet, total assets should be reported at a. $598,000 b. $600,000 c. $617,000 d. $692,000
6.
The purpose of recording prepaid expenses that are subsequently disclosed as current assets on the balance sheet is a. to smooth income b. to record payments made on invoices prior to the invoice due date c. to allocate expenditures to the period in which they apply d. to recognize current expenditures that will convert into cash within the next twelve months e. to record payments for services to be received over a period of years
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Problem 1 The following list of accounts and their balances represents the unadjusted trial balance of Guy Ltd. at December 31, 20x4. Dr. $ 188,220 294,000 186,000 7,860 120,000 90,000 372,000 37,200 100,800 16,800 79,800 303,150 630,000 360,000 67,080 570,000 32,400 67,500 32,400 294,000 2,700 52,500 108,000 36,750 $2,029,830 $2,029,830 Additional information 1. Actual advertising costs in Whassup Magazine amounted to $1,000 per month. The company has already paid for advertisements in Whassup Magazine for the first 6 months of 20x5. 2. The company uses straight-line depreciation for its building. The building was purchased and occupied January 1, 20x2 with an estimated life of 20 years. 3. A portion of their building has been converted into a snack bar that has been rented to Snack Shack Corp. since July 1, 20x3 at a rate of $21,600 per year payable each July 1st. Cr.
Cash Accounts Receivable Allowance for Doubtful Accounts Merchandise Inventory Prepaid Insurance Investment in Dude Co. Bonds (10%) Land Building Accumulated Depreciation-Building Equipment Accumulated Depreciation-Equipment Patents Accounts Payable Bonds Payable (20-year; 8%) Common Shares Retained Earnings Sales Rental Income Advertising Expense Supplies Expense Purchases Purchase Discounts Office Salary Expense Sales Salary Expense Interest Expense
$ 10,500
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4. Prepaid insurance contains the premium costs of two policies: Policy Excel, cost of $2,880, one-year term taken out on Sept. 1, 20x3; Policy Access, cost of $5,940, three-year term taken out on April 1,20x4. 5. One of the company's customers declared bankruptcy December 30, 20x4, and it has been definitely established that the $8,100 due from him will never be collected. This fact has not been recorded. In addition, Guy Ltd. estimates that 5% of the Accounts Receivable balance on December 31, 20x4 will become uncollectible. 6. The equipment was purchased January 1, 20x2 with an estimated life of 12 years. The company uses straight-line depreciation. 7. When the company purchased a competing firm on July 1, 20x2 it acquired a patent in the amount of $114,000, which is being amortized over its estimated life. (5 years) 8. On November 1, 20x4 Guy issued 315, $2,000 bonds at par value. Interest payments are made semiannually on April 30 and October 31. The interest expense shown in the trial balance does not relate to the bonds. 9. Office salaries are paid on the first and 16th of each month for the following half month. On December 31, 20x4, $1,800 was given as an advance to an office secretary. The transaction was recorded in Guys books, and the $1,800 was charged to Office Salary Expense. 10. On August 1, 20x4 Guy purchased 60, $2,000, 10% bonds maturing on August 31, 20x9 at par value. Interest payment dates are July 31 and January 31. 11. The inventory on hand at December 31, 20x4 was $222,000 per a physical inventory count. Record the adjustment for inventory in the same entry that records the Cost of Goods Sold for the year. Required (a) (b) (c) Prepare adjusting and correcting entries for December 31, 20x4 using the information given. Prepare an adjusted trial balance as at December 31, 20x4. Prepare year-end financial statements for 20x4. (excluding Statement of Cash Flows)
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Problem 2 Briar Place Construction was founded in January 20x0 by Tom Johnson and Ralph Reinhart and specializes in home remodeling and repairs. Due to high real estate prices in the local area, many residents have been repairing and remodeling their homes rather than moving to larger or newer homes. As a consequence, Briar Place's business during the first year was so successful that Johnson and Reinhart plan to expand their operations. When Johnson approached the local bank for funds to finance the planned expansion, the bank requested audited financial statements prepared on the accrual basis. At the time the company was formed, cash planning was considered important to the successful operation of the business so Reinhart and Johnson requested that their bookkeeping service maintain the company's records on a cash basis. As a result of the bank's request, Reinhart and Johnson hired Mary Anne Logan, an accountant, to convert the cash basis financial statements to accrual basis financial statements. From the company files and from discussions with Reinhart and Johnson, Logan has gathered the following data concerning Briar Place's transactions during 20x0 and the cash basis financial statements. In addition, the company's Statement of Financial Position at January 1, 20x0, is presented below. Summary of Cash Transactions for 20x0 Receipts: Cash sales Collections from customers Proceeds from one-year, 12% note received March 1, 20x0
$116,000 40,000 20,000 $176,000
Disbursements: Payments on account for supplies Wages paid to employees Payments to the utility company Insurance premiums paid Rent paid to landlord Interest paid on September 1, 20x0, 12% note
$40,400 62,000 11,000 9,000 18,000 1,200 $141,600
Uncollected customers' bills totaled $34,900 at December 31, 20x0. On March 1, 20x0, a supplier of Briar Place advanced the company $20,000 on a one-year, 12 percent note payable with semi-annual interest payments to be made on September 1, 20x0, and at maturity on March 1, 20x1. Unpaid bills to suppliers totaled $5,600 at December 31, 20x0.
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Supplies costing $4,000 were on hand at December 31, 20x0. Wages owed to employees at December 31, 20x0, were $2,800. The December utility bill of $975 was unpaid at December 31, 20x0. The insurance premium was paid for a one-year liability and property damage policy effective February 1, 20x0. The rent of $1,500 per month was paid to the landlord on the first of every month. Logan recommends depreciating the company's construction equipment, purchased at the time the company was founded, over its useful life of ten years using straight-line depreciation. The equipment has no estimated residual value. Logan has determined that Briar Place's effective tax rate is 40 percent. No taxes have been paid. Briar Place Construction Statement of Financial Position January 1, 20x0
Assets Cash Supplies inventory Equipment
$ 24,800 12,000 110,000 $146,800
Liabilities and shareholders' equity Purchases payable Common stock
$ 14,000 132,800 $146,800
Required Prepare Briar Place Construction's Income Statement for the year ended December 31, 20x0 and Statement of Financial Position as at December 31, 20x0.
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Problem 3 The unadjusted trial balance for Martina Company is presented for the year ended December 31, 20x5, along with some additional information. Debits Cash Accounts Receivable Allowance for doubtful accounts Inventory Prepaid Expenses Land Building Accumulated Depreciation Equipment Accumulated Depreciation Intangible Assets Accounts Payable Interest Payable Taxes Payable Bonds payable Deferrred income taxes Common Stock Retained Earnings Sales Revenue Cost of Goods Sold Amortization expense Selling expense Administrative expense Income tax expense Interest Expense Dividends $ 104,690 195,550 $ 2,950 289,776 30,376 152,500 445,938 96,812 320,700 117,500 26,960 162,876 20,312 46,000 481,500 21,000 250,000 107,758 3,329,440 2,049,170 85,000 348,300 451,188 46,000 40,000 50,000 $4,636,148 Credits
$4,636,148
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Additional Information Assume that all adjusting and correcting entries have been made except for the following items: 1. A sale on account in the amount of $9,100 and its related cost of goods sold was not recorded as of December 31, 20x5. Martina sells its inventory at a 40% markup on cost and uses a perpetual inventory system. Martina Company estimates bad debts to be equal to 0.25% of sales. On December 28, 20x5, a letter was received from a trustee in bankruptcy informing us that one of our customers has been released from bankruptcy and that we would not be receiving any money on the account owing. The amount owing from this client was $5,000 and is included in the accounts receivable balance at December 31, 20x5. As of December 31, no accrual for electricity expense had been made. An electricity bill for the warehouse for $5,000 was received January 15, 20x6, for electrical consumption from December 13, 20x5, through January 13, 20x6. The bill was paid on February 16, 20x6, and debited to administrative expenses at that time. Martina Company purchased equipment on July 1, 20x5, for $35,000 cash. This amount was debited to selling expenses. The equipment has an estimated useful life of ten years and a residual value of $10,000. The company uses the diminishing balance method of depreciation at a rate of 20%. Insurance was paid on January 31, 20x5, for $5,580 for the time period of January 31, 20x5, through January 31, 20x6. The full amount was debited to administrative expenses at the time it was paid. Sales wages for the time period of December 25, 20x5, through January 7, 20x6, were paid on January 15, 20x6, in the amount of $8,000. Total tax expense for 20x5 should be 34% of income before taxes.
2. 3.
4.
5.
6.
7.
8.
Required a. b. Prepare adjusting and correcting entries for the additional information. Prepare the following financial statements for the year ending December 31, 20x5: i. An income statement. ii. A statement of changes in shareholders' equity. iii. A statement of financial position.
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Problem 4 Heather Company Ltd. closes its books once a year, on December 31, but prepares monthly financial statements by estimating month-end inventories. The company's trial balance on January 31, 20x8 is presented below. HEATHER COMPANY LTD. Trial Balance January 31, 20x8 Cash Accounts Receivable Notes Receivable Allowance for Doubtful Accounts Inventory, Jan. 1, 20x8 Furniture and Fixtures Accumulated Depreciation of Furniture and Fixtures Unexpired Insurance Supplies on Hand Accounts Payable Notes Payable Common Shares Retained Earnings Sales Sales Returns and Allowances Purchases Transportation-in Selling Expenses Administrative Expenses Interest Revenue Interest Expense $ 11,000 23,000 3,000 $ 720 24,000 30,000 7,500 600 1,050 6,000 5,000 20,000 27,005 130,000 1,500 80,000 2,000 11,000 9,000 125 200 $196,350 $196,350
Required (a) Prepare adjusting entries in journal form 1. Estimated bad debts, 0.4% of net sales (sales minus sales returns, allowances, and discounts). 2. Depreciation of furniture and fixtures, 10% of cost per year (straight-line) 3. Insurance expired in January, $80. 4. Supplies used in January, $210. 5. Office salaries accrued, $500. 6. Interest accrued on notes payable, $200. 7. Interest received but unearned on notes receivable, $75. 8. Estimate the January 31 inventory and record the adjusting entry. The average gross profit earned by the company is 30% of net sales. The gross profit rate equals net sales minus cost of goods sold divided by net sales.
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(b)
Prepare a Statement of Financial Position, an income statement, and a statement of changes in Shareholders' Equity. Dividends of $3,000 were declared and paid on the common shares during the month.
Problem 5 Shriver Co. began business as a corporation on December 3, 20x0. The accounting for the business since its inception has been done by Bill Miles. Miles' primary responsibilities are in the purchasing area and his previous experience in accounting was limited. Sam Cray, a qualified accountant, was hired to perform the company's accounting functions in December of 20x2. The first task he was assigned was to review the accounting for the company's first two years and to make any corrections that might be necessary to ensure that the company's 20x1-20x2 financial statements were proper. The preclosing trial balance as of November 30, 20x2, that is presented below includes year-end adjustments that were prepared by Miles. Shriver Co. Preclosing Trial Balance November 30, 20x2 Dr. Cash Accounts receivable Note receivable Inventory Land Furniture and fixtures Unexpired insurance Accounts payable Notes payable Common shares Retained earnings Sales Purchases Purchase returns Selling expenses Administrative expenses Total $ 1,150 9,350 3,000 10,500 8,000 20,000 600 $ 4,950 5,000 27,700 8,950 103,800 78,750 450 12,000 7,500 $150,850 Cr.
$150,850
Cray's review of the accounting records and other records uncovered the following additional information. 1. Cheques totaling $2,350 had been written to vendors and recorded in the November 20x2 cash disbursements journal but were still in the vault on December 7.
2. All receivables from 20x0-20x1 credit sales either had been collected or written off. The estimate for bad debts arising from 20x1-20x2 sales was $2,000, and the following entry was made to recognize this fact. Selling expense Accounts receivable 2,000 2,000
3. The note receivable for $3,000 is from a customer. This three-month note is dated November 1, 20x2, and has an annual interest rate of 18 percent. 4. The physical inventory on November 30, 20x2, includes $9,900 of product on hand and $2,100 of inventory issued to Apex Co. on a consignment basis. 5. The furniture and fixtures were acquired on December 3, 20x0. These capital assets are being depreciated on a straight-line basis over a ten-year life with no residual value. The following adjusting entry was made by Miles in November 20x2 to recognize depreciation. Selling expense Administrative expense Furniture and fixtures The same adjusting entry was made for the 20x0-20x1 fiscal year. 6. The company has one prepaid insurance policy. The policy covers a one-year period and was purchased for $1,200 on June 1, 20x2. 7. The notes payable were issued on November 1, 20x2, with an annual interest rate of 12 percent. The principal and interest are payable on August 1, 20x3. 8. On November 20, 20x2, the Board of Directors declared a cash dividend of $2,500 payable on December 14, 20x2. The dividend is payable to shareholders of record as of December 3, 20x2. 9. The tax return for the 20x1-20x2 fiscal year appears to be properly prepared and shows no tax liability. Required a. b. c. Prepare any adjusting entries. Prepare a Statement of Income for the year ended November 30, 20x2. Prepare a Statement of Financial Position for the Shriver Co. as of November 30, 20x2. 2,000 500 2,500
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Problem 6 Mr. Chicken and Mr. Rib decided to go into business together and start a new restaurant. On June 1, 20x0, Mr. Chicken and Mr. Rib each invested $50,000 cash in exchange for shares in the company. After doing a feasibility study and some preparatory work, they opened the restaurant for business on July 1, 20x0. The following preparatory events took place in getting the new restaurant ready for the grand opening: An ideal location was found in a shopping mall. Mr. Chicken and Mr. Rib signed a lease for $3,000 per month starting July 1, 20x0. Tables and chairs costing $25,000 were purchased on account. These assets were expected to last five years with zero residual value. The assets were delivered to the restaurant on July 1, 20x0. Depreciation is calculated using the straight-line method. As part of the promotion for the grand opening, beer mugs, purchased for $5 cash each, were given away to the first 100 customers. During the month of July, $30,000 worth of food supplies (chicken and ribs) was purchased on account. Salad supplies costing $6,000 were purchased for cash on an "as required" basis. Four cooks and eight waiters were hired. The cooks were paid a monthly salary of $2,000 each and the waiters were paid $1,000 each. The waiters also received gratuities from the customers at an average of $500 per month. Advertising in the newspaper for the grand opening cost $1,500, utilities totaled $1,000 and janitorial services, $1,000. All of these costs were paid in cash.
In a rush to start up the restaurant, Mr. Chicken and Mr. Rib had neglected to hire an accountant. They have approached you to handle their books. Additional information was supplied by the owners: In July, total accounts payable paid were $22,000. On July 15, excess cash of $30,000 was invested in a money market fund as a temporary investment. The return is estimated at 8 percent per year. However, the interest will not be received until the fund is collapsed. As of July 31, the owners had not drawn any money out of the business. It was estimated that each owner deserved a modest amount of $1,250 per month as management fees.
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On July 31, a rough estimate of unsold chicken and rib supplies remaining on hand was $12,700. Cash sales during July were $8,000. Sales to charge account customers, mainly business people in the mall, were $18,000.
The owners would like to find out how much money they have made or lost during the month of July. Required Prepare an income statement for July 20x0, and a Statement of Financial Position as of July 31, 20x0. Show all supporting calculations and state your assumptions, if any.
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Problem 7 You have been given the following trial balances of the Sandmeyer Company. The trial balance as of December 31, 20x0, was taken on a gross basis; that is, the totals of the debits and of the credits in each of the ledger accounts, including any balance from the postclosing trial balance as of June 30, 20x0, rather than the final balance, have been included. You are advised that the company records disbursements for expense items through liability accounts before making payment. The books are not available. The trial balance is out of balance by $270, which is shown as "unlocated difference." You are told that cash in bank of $28,044 has been verified. The Sandmeyer Company Trial Balances ACCOUNT Cash in bank Investments Accounts receivable Merchandise inventory Office furniture and fixtures Accumulated depreciation Notes payable Accounts payable Income taxes payable Common shares Retained earnings Sales Cost of goods sold Salaries expense Other administrative expense Selling expense Uncollectible accounts expense Write-down of obsolete merchandise Gain on sale of investment Loss on sale of fixtures Interest expense Income tax expense Unallocated difference JUNE 30, 20x0 $ 21,849 30,500 47,420 55,542 8,663 $4,967 30,000 15,879 7,350 50,000 55,778 DECEMBER 31, 20x0 $ 275,016 40,712 301,425 208,856 11,164 176 10,000 211,658 5,658 10,000 481 151,914 15,500 21,567 25,348 665 1,025 168 23 850 3,700 270 $1,296,008 $ 246,972 5,000 248,979 153,495 635 5,940 30,000 233,986 11,050 50,000 55,778 254,005
$163,974
$163,974
$1,296,008
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Required Reconstruct the ledger accounts as they probably appear by recording the transactions for the period in journal form and posting to the ledger accounts. You need not prepare financial statements, but you should state where you think the error occurred in the books and give reasons to support your conclusion.
Problem 8 The balances of the following accounts of ABC Travel Ltd. before and after the posting of adjusting entries are: Preliminary Dr. $ 6,112 $ 1,805 175 310 980 Adjusted Cr. Dr. $ 6,112 $ 2,270 165 55 155 980 196 366 3,000 200
Cr.
Cash Commissions receivable Allowance for doubtful accounts Office supplies Prepaid rent Office equipment Accumulated depreciation office equipment Accounts payable Note payable Income taxes payable Salaries payable Interest payable Capital Retained earnings Required -
210
1,000 413
294 366 3,000 200 290 180 1,000 413
Determine what adjusting entries were made and journalize these entries. Provide a narrative to describe the purpose of each entry.
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Problem 9 Below are the account titles of a number of debit and credit accounts as they might appear on the statement of financial position of the Saberhagen Corporation as of October 31, 20x1. DEBITS Cash in bank Land Inventory of operating parts and supplies Inventory of raw materials Patents Cash and Canada Savings Bonds set aside for property additions Investment in subsidiary Accounts receivable Government contracts Regular Instalments, due in 20x1 Instalments, due in 20x2-20x3 CREDITS Accrued payroll Provision for renegotiation of government contracts Notes payable Accrued interest on bonds Accumulated depreciation Accounts payable Accrued interest on notes payable 8% first mortgage bonds to be redeemed in 20x1 out of current assets Share capital, preferred 9 1/2% first mortgage bonds due in 20x8 Required Select the current asset and current liability items from among these debits and credits. If there appear to be certain borderline cases that you are unable to classify without further information, give your reasons for making questionable classifications, if any. Preferred shares dividend, payable 11/1/x1 Allowance for doubtful accounts receivable Provision for federal income taxes Customers' advances (on contracts to be completed in 20x2) Appropriation for possible decline in value of raw materials inventory Premium on bonds redeemable in 20x1 Officers' 20x1 bonus accrued Goodwill Inventory of finished goods Inventory of work in process Deficit Interest accrued on government securities Notes receivable Petty cash fund Government securities Treasury shares Unamortized bond discount
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Problem 10 Mr. Janson, owner of Janson's Retail Hardware, states that he computes income on a cash basis. At the end of each year he takes a physical inventory and computes the cost of all merchandise on hand. To this amount he adds the ending balance of accounts receivable, because he considers this to be a part of inventory on the cash basis. He deducts from this total the ending balance of accounts payable for merchandise to arrive at what he calls inventory (net). The following information has been taken from Mr. Janson's cash-basis income statements for the years indicated: 20x4 Cash received Cost of goods sold Inventory(net), Jan.1 Total purchases Goods available for sale Inventory(net), Dec. 31 Cost of goods sold Gross margin $ 8,000 109,000 117,000 -1,000 116,000 $ 57,000 $ 11,000 100,000 111,000 -8,000 103,000 $ 56,000 $ 3,000 95,000 98,000 -11,000 87,000 $ 63,000 $ 173,000 20x3 $ 159,000 20x2 $ 150,000
Additional information is as follows for the years indicated: 20x4 Cash sales Credit sales Accounts receivable, Dec. 31 Accounts payable for merchandise, Dec. 31 Required 1. 2. Without reference to the specific situation described above, discuss cash-basis and accrual accounting and indicate their conceptual merits. Is the gross margin for Janson's Retail Hardware being computed on a cash basis? Evaluate and explain the approach used with illustrative computations of the cash-basis gross margin for 20x3. Explain why the gross margin for Janson's Retail Hardware shows a decrease while sales and cash receipts are increasing. $151,000 24,000 3,000 33,000 20x3 $147,000 13,000 6,000 19,000 20x2 $141,000 14,000 5,000 12,000
3.
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Problem 11 State whether you agree or disagree with the following and explain why. Consider each statement independently. a) Even though a division of a company is not incorporated separately, it is still a separate entity. b) The financial statements of a company are neutral and free from bias. c) Accounting reports are exact, as they are based on numbers and numbers are exact. d) The historical cost principle allows us to arrive at objective numbers on financial statements.
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SOLUTIONS
Multiple Choice Questions 1. d The amount of prepaid insurance at December 31, 20x8 is: $3,480 / 24 months x 17 months remaining = $2,465 The amount of unearned rent at December 31, 20x8 is: $7,200 / 12 months x 7 months = $4,200 $1,000,000 x 10% x 9/12 = $75,000 Consistency is when the enterprise uses accounting principles that are consistent from one period to the next. $500,000 + 75,000 + 25,000 - 2,000 + (94,000 - 75,000) = $617,000 Payments made for items (such as insurance premiums for the following year) which do not have a benefit until the following year are set up in prepaids and then expensed in the applicable year.
2.
3. 4.
b b
5. 6.
c c
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Problem 1 1. Prepaid Advertising Advertising Expense ($1,000 x 6 months) 2. Depreciation Expense Accumulated Depreciation Building ($372,000 / 20 years) 3. Rental Revenue Unearned Rental Revenue ($21,600 x 6/12) 4. Insurance Expense Prepaid Insurance [($2,880 x 8/12) + ($5,940 / 3 x 9/12)] 5. Allowance for Doubtful Accounts Accounts Receivable Bad Debt Expense Allowance for Doubtful Accounts Allowance for doubtful accounts should be: ($294,000 8,100) x 5% = 14,295 Allowance for doubtful account balance before adjustment is: $10,500 8,100 = $2,400 Bad debt expense= $14,295 2,400 = $11,895 6. Depreciation Expense Accumulated Depreciation Equipment ($100,800 / 12 years) 7. Amortization Expense Patent Patent ($114,000 / 5years) 8. Interest Expense Interest Payable ($630,000 x 0.08 x 2/12) 9. Prepaid Salaries Office Salary Expense 8,400 8,400 6,000 6,000 18,600 18,600
10,800 10,800
3,405 3,405
8,100 8,100 11,895 11,895
22,800 22,800
8,400 8,400
1,800 1,800
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10. Interest Receivable Interest Revenue ($120,000 x 10% x 5/12) 11. Cost of Goods Sold Merchandise Inventory Purchase Discounts Purchases Merchandise Inventory
5,000 5,000
255,300 222,000 2,700 294,000 186,000
(b)
Cash Accounts Receivable Allowance for Doubtful Accounts Interest Receivable Merchandise Inventory Prepaid Advertising Prepaid Insurance Prepaid Salaries Investment in Dude Co. Bonds (10%) Land Building Accumulated Depreciation-Building Equipment Accumulated Depreciation-Equipment Patent Accounts Payable Interest Payable Unearned Rental Income Bonds Payable (20-year; 8%) Common Shares Retained Earnings Sales Cost of Goods Sold Rental Income Interest Income Advertising Expense Supplies Expense Purchases Purchase Discounts Office Salary Expense Sales Salary Expense Bad Debt Expense Insurance Expense Depreciation Expense Amortization Expense Patent Interest Expense Unadjusted Dr. Cr. $ 188,220 294,000 $ 10,500 186,000 7,860 1,800 120,000 90,000 372,000 37,200 100,800 16,800 79,800 303,150 8,400 10,800 630,000 360,000 67,080 570,000 32,400 67,500 32,400 294,000 2,700 52,500 108,000 11,895 3,405 27,000 22,800 8,400
$2,029,830 $585,200 $585,200
Adjustments Dr. Cr. $8,100 11,895 186,000 3,405
$8,100 5,000 222,000 6,000
18,600 8,400 22,800
255,300 10,800 5,000 6,000 294,000 2,700 1,800
Adjusted Trial Balance Dr. Cr. $188,220 285,900 $14,295 5,000 222,000 6,000 4,455 1,800 120,000 90,000 372,000 55,800 100,800 25,200 57,000 303,150 8,400 10,800 630,000 360,000 67,080 570,000 255,300 21,600 5,000 61,500 32,400
36,750
$2,029,830
50,700 108,000 11,895 3,405 27,000 22,800 45,150

$2,071,325 $2,071,325
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(c) Guy Ltd. Income Statement For the year ended December 31, 20x4 Revenues Sales Less Cost of Goods Sold Gross Margin Rental Income Interest Income Total Income Expenses Advertising Expense Supplies Expense Office Salaries Expense Sales Salaries Expense Bad Debt Expense Insurance Expense Depreciation Expense Amortization Expense Interest Expense Total Expenses Net Loss
570,000 (255,300) 314,700 21,600 5,000 341,300 61,500 32,400 50,700 108,000 11,895 3,405 27,000 22,800 45,150 362,850 (21,550)
Guy Ltd. Statement of Changes in Shareholders' Equity For the year ended December 31 20x4 Common Stock $360,000 $360,000 Retained Earnings $67,080 (21,550) $45,530
Balance, Jan 1, 20x4 Net loss Balance, December 31, 20x4
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Guy Ltd. Statement of Financial Position As at December 31 20x4 ASSETS Long-Term Assets Investment in Dude Co. Bonds Land Building Less: Accumulated Depreciation Equipment Less: Accumulated Depreciation Patent $372,000 55,800 100,800 25,200
$120,000 90,000 316,200 75,600 57,000 658,800
Current Assets Cash Accounts Receivable (285,900 - 14,295) Interest Receivable Merchandise Inventory Prepaid Advertising Prepaid Insurance Prepaid Salaries
188,220 271,605 5,000 222,000 6,000 4,455 1,800 699,080 $1,357,880
SHAREHOLDERS EQUITY AND LIABILITIES Shareholders Equity Common Shares Retained Earnings
$360,000 45,530 405,530
Long-Term Liability Bonds Payable Current Liabilities Accounts Payable Interest Payable Unearned Rental Income
630,000
303,150 8,400 10,800 322,350 $1,357,880
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Problem 2
Briar Place Construction Income Statement For the Year Ended December 31, 20x0 Sales ($116,000 Cash Sales + 40,000 Collections on A/R + 34,900 A/R) Supplies Used ($40,400 Paid - 8,400 Decrease in Payable + 8,000 Decrease in Inventory) Wages expense ($62,000 Paid + 2,800 Wages Payable) Utilities expense ($11,000 Paid + 975 Payable) Insurance expense ($9,000 Paid x 11/12) Rent expense Depreciation expense ($110,000 / 10) Interest expense ($1,200 Paid + 800 Payable) Net income before taxes Income tax expense (40%) Net income $190,900 (40,000) (64,800) (11,975) (8,250) (18,000) (11,000) (2,000) 34,875 13,950 $20,925
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Briar Place Construction Statement of Financial Position December 31, 20x0 ASSETS Fixed Assets Equipment Less: Accumulated depreciation
$110,000 11,000
99,000
Current Assets Cash ($24,800 Beginning + 176,000 Cash Receipts - 141,600 Cash Disbursements) Accounts receivable Supplies inventory Prepaid insurance (9,000 Paid - 8,250 Expense)
59,200 34,900 4,000 750 98,850 $197,850
SHAREHOLDERS' EQUITY AND LIABILITIES Shareholders' equity Common stock Retained earnings
$132,800 20,925 153,725
Current Liabilities Accounts payable Note payable Wages payable Utilities payable Interest payable (2,000 Expense - 1,200 Paid) Taxes payable
5,600 20,000 2,800 975 800 13,950 44,125 $197,850
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Problem 3 a. 1. Accounts receivable Sales Cost of goods sold Inventory $9,100 / 1.40 = $6,500 2. Bad debt expense Allowance for doubtful accounts ($3,329,440 + 9,100) x 0.25% Allowance for doubtful accounts Accounts receivable Administrative expense Accounts payable $5,000 x 19/31 Equipment Selling expenses Amortization expense Accumulated amortization $35,000 x 20% x 6. Prepaid expenses Administrative expenses $5,580 / 12 Selling expense Accounts payable $8,000 x 7/14 $9,100 $9,100 6,500 6,500
8,346 8,346
3.
5,000 5,000 3,065 3,065
4.
5.
35,000 35,000 3,500 3,500
465 465
7.
4,000 4,000
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8.
Income tax expense Income tax payable Net income before taxes before adjustment Adjustments Transaction 1 Transaction 1 Transaction 2 Transaction 4 Transaction 5 Transaction 5 Transaction 6 Transaction 7 Net income before taxes adjusted Income tax expense @ 34% Less balance in income tax expense account
81,478 81,478 $355,782 9,100 (6,500) (8,346) (3,065) 35,000 (3,500) 465 (4,000) 374,936 127,478 (46,000) $81,478
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Adjusted Trial Balance Debits Cash Accounts Receivable: $195,550 + 9,100 (1) 5,000 (3) Allowance for doubtful accounts: $2,950 + 8,346 (2) 5,000 (3) Inventory - 289,776 6,500 (1) Prepaid Expenses - 30,376 + 465 (6) Land Building Accumulated Amortization Equipment - 320,700 + 35,000 (5) Accumulated Depreciation - 117,500 + 3,500 (5) Intangible Assets Accounts Payable - 162,876 + 3,065 (4) + 4,000 (7) Interest Payable Taxes Payable: 46,000 + 81,478 (8) Bonds payable Deferred income taxes Common Stock Retained Earnings Sales Revenue 3,329,440 + 9,100 (1) Cost of Goods Sold 2,049,170 + 6,500 (1) Depreciation expense - 85,000 + 3,500 (5) Selling expense - 348,300 35,000 (5) + 4,000 (7) Administrative expense - 451,188 + 3,065 (4) 465 (6) Bad debt expense - $0 + 8,346 (2) Income tax expense - 46,000 + 81,478 (8) Interest Expense Dividends $ 104,690 199,650 $6,296 283,276 30,841 152,500 445,938 96,812 355,700 121,000 26,960 169,941 20,312 127,478 481,500 21,000 250,000 107,758 3,338,540 2,055,670 88,500 317,300 453,788 8,346 127,478 40,000 50,000 $4,740,637 Credits
$4,740,637
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b(i)
Martina Company Income Statement for the year ended December 31, 20x5 Sales Cost of goods sold Gross margin Depreciation expense Selling expense Administration expense Bad debt expense Interest expense Net income before taxes Provision for income taxes Net income $3,338,540 2,055,670 1,282,870 (88,500) (317,300) (453,788) (8,346) (40,000) 374,936 127,478 $247,458
b(ii)
Martina Company Statement of Changes in Shareholders' Equity for the year ended December 31, 20x5 Common Stock $250,000 Retained Earnings $107,758 247,458 (50,000) $305,216
Balance, Jan 1, 20x5 Net income Dividends Balance, December 31, 20x5
$250,000
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b(iii)
Martina Company Statement of Financial Position for the year ended December 31, 20x5 ASSETS Noncurrent Assets Land Building Accumulated depreciation Equipment Accumulated depreciation Intangible assets Current Assets Cash Accounts receivable Inventory Prepaid expenses $445,938 (96,812) 355,700 (121,000)
$152,500 349,126 234,700 26,960 763,286 104,690 193,354 283,276 30,841 612,161 $1,375,447
SHAREHOLDERS EQUITY AND LIABILITIES Shareholders Equity Common Stock Retained Earnings
$250,000 305,216 555,216
Long-term Liabilities Bonds payable Deferred income taxes
481,500 21,000 502,500
Current Liabilities Accounts payable Interest payable Taxes payable
169,941 20,312 127,478 317,731 $1,375,447
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Problem 4
1.
Bad debt expense Allowance for Doubtful Accounts ($130,000 - 1,500) x .4% Depreciation expense Accumulated depreciation $30,000 x 10% / 12 Insurance expense Prepaid insurance Supplies expense Supplies on hand Office Salaries Salaries payable Interest expense Interest payable Interest revenue Unearned Interest Revenue Cost of goods sold (130,000 - 1,500) x 70% Inventory (plug) Purchases Transportation-in
$514 $514
2.
250 250
3.
80 80 210 210 500 500 200 200 75 75 89,950 7,950 80,000 2,000
4.
5.
6.
7.
8.
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Heather Company Ltd. Income Statement for the month ended January 31, 20x8 Sales (net) Cost of goods sold Gross margin Selling expenses Administrative expenses ($9,000 + 500) Depreciation expense Bad debt expense Supplies expense Insurance expense Interest expense Interest income Net income $128,500 89,950 38,550 (11,000) (9,500) (250) (514) (210) (80) (400) 50 $16,646
Heather Company Ltd. Statement of changes in Shareholders' Equity for the month ended January 31, 20x8 Common Shares $20,000 Retained Earnings $30,005 16,646 (3,000) $43,651
Balance, beginning of year Net income Dividends Balance, end of year
$20,000
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Heather Company Ltd. Statement of Financial Position as at January 31, 20x8 ASSETS Noncurrent assets Furniture and fixtures Accumulated Depreciation Current Assets Cash Accounts receivable Note receivable Inventory Supplies on hand Unexpired insurance
$30,000 (7,750) 22,250 11,000 21,766 3,000 16,050 840 520 53,176 $75,426
SHAREHOLDERS' EQUITY & LIABILITIES Shareholders' Equity Common Shares Retained earnings Current liabilities Accounts payable Notes payable Salaries payable Interest payable and unearned interest revenue
20,000 43,651 63,651 $6,000 5,000 500 275 11,775 $75,426
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Problem 5 a. 1. Because the cheques have not yet been mailed out, they cannot be considered to be in circulation at November 30, 20x2. Cash Accounts payable 2. $2,350 $2,350
The entry should have credited allowance for doubtful accounts. The debit to selling expenses is correct (technically it could have been to bad debt expense, but given they are reporting by function of expense, debiting directly to selling expenses is appropriate) Accounts receivable Allowance for doubtful accounts 2,000 2,000
3.
Interest on the note needs to be accrued. Interest receivable Interest revenue $3,000 x 18% x 1/12 45 45
4.
The inventory needs to reflect the $9,900 inventory on hand + the $2,100 of inventory on consignment issued to Apex Co. Cost of goods sold Inventory ($12,000 10,500) Purchase returns Purchases 76,800 1,500 450 78,750
5.
The debits are correct (recall they are using the function of expense format). The credit should have been to accumulated depreciation. The adjustment is for two years of depreciation ($2,500 x 2) Furniture and fixtures Accumulated depreciation 5,000 5,000
6.
They have accounted for this properly: the unexpired insurance account has a balance of $600 which is equal to the portion of the insurance policy that is prepaid. Interest expense/payable needs to be accrued on this note: $5,000 x 12% x 1/12 = $50 Interest expense Interest payable 50 50
CMA Ontario - 2013
7.
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8.
The dividend payable needs to be recorded. Retained earnings Dividend payable 2,500 2,500
b. Shriver Co. Statement of Income for the year ended November 30, 20x2 Sales Cost of goods sold Beginning inventory Purchases net Ending inventory Gross profit Selling expenses Administration expense Interest expense (Entry # 7) Interest earned (Entry # 3) Profit for the year $103,800 $10,500 78,300 (12,000)
76,800 27,000 (12,000) (7,500) (50) 45 $ 7,495
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c. Shriver Co. Statement Of Financial Position As at November 30, 20x2 ASSETS Fixed Assets Land Furniture and fixtures ($20,000 + 5,000 Entry # 5) Accumulated depreciation (Entry # 5)
$ 8,000 25,000 (5,000) 28,000
Current assets Cash ($1,150 + $2,350 Entry # 1) Accounts receivable Note receivable Interest receivable (Entry # 3) Inventory (Entry #4) Prepaid insurance
3,500 9,350 3,000 45 12,000 600 28,495 $56,495
SHAREHOLDERS' EQUITY AND LIABILITIES Shareholders' Equity Common shares Retained earnings ($8,950 Beginning R/E + 7,495 Net Income - 2,500 Dividends Entry # 8)
$27,700 13,945 41,645
Current liabilities: Accounts payable ($4,950 + $2,350 Entry # 1) Notes payable Interest payable (Entry # 7) Dividends payable (Entry # 8)
$ 7,300 5,000 50 2,500 14,850 $56,495
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Problem 6
Journal entries (a) Cash Capital Stock Rent expense Cash Tables and Chairs Accounts payable Depreciation expense (25,000 / 5 / 12) Accumulated depreciation Advertising and promotion Cash Food supplies Accounts payable Food supplies Cash Salaries and wages Cash Advertising and promotion Utilities Janitorial Cash Accounts payable Cash Temporary investment Cash Interest receivable (30,000 x 8% x 0.5/12) Interest revenue $100,000 $100,000 3,000 3,000 25,000 25,000 417 417 500 500 30,000 30,000 6,000 6,000 16,000 16,000 1,500 1,000 1,000 3,500 22,000 22,000 30,000 30,000 100 100
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
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(m) Salaries and wages Salaries and wages payable (n) Cost of food supplies Food Supplies Cash Accounts receivable Sales
2,500 2,500 23,300 23,300 8,000 18,000 26,000
(o)
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ASSETS Cash 100,000 (b) 8,000 (e) (g) (h) (i) (j) (k) 27,000 Food Supplies 30,000 (n) 23,300 6,000 12,700 Tables and Chairs (c) 25,000
(a) (o)
3,000 500 6,000 16,000 3,500 22,000 30,000
(f) (g)
Accumulated Depreciation (d) 417
Accounts Receivable (o) 18,000
Temporary Investments (k) 30,000
(l)
Interest Receivable 100
LIABILITIES AND SHAREHOLDERS' EQUITY Accounts Payable 25,000 (j) 22,000 (c) (f) 30,000 33,000 REVENUES Sales (o) 26,000 Interest Revenue (l) Salaries & Wages Payable (m) 2,500 Capital Stock (a) 100,000
100
EXPENSES Cost of Food Supplies (n) 23,300 Rent 3,000 Salaries and wages (h) 16,000 (m) 2,500 18,500 Janitorial 1,000
(b)
Advertising and Promotion (e) 500 (i) 1,500 2,000 Depreciation Expense (d) 417
(i)
Utilities 1,000
(i)
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Chicken & Rib Income Statement For the Month Ended, July 31, 20x0 Sales Revenue Cost of food supplies Gross Profit Rent expense Salaries and wages expense Advertising and promotion expense Utilities expense Janitorial expense Depreciation expense Interest revenue Net Loss and Deficit, July 31, 20x0 $26,000 23,300 2,700 (3,000) (18,500) (2,000) (1,000) (1,000) (417) 100 $(23,117)
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Chicken & Rib Statement of Financial Position As at July 31, 20x0 Assets Fixed Assets Table and Chairs Less: Accumulated Depreciation
$25,000 417 24,583
Current Assets Cash Temporary Investments Accounts Receivable Interest Receivable Food Supplies
27,000 30,000 18,000 100 12,700 87,800 $112,383
Shareholders' Equity and Liabilities Shareholders' Equity Capital Stock Deficit
100,000 (23,117) 76,883
Current Liabilities Accounts Payable Wages Payable
33,000 2,500 35,500 $112,383
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Problem 7 NOTE: In each entry below, the account with an asterisk has been imputed from the nature of the transaction. a) Investments ($40,712 - $30,500) *Cash To record purchase of investments. *Cash Investments Gain on sale of investment To record sale of investments. *Cash Uncollectible accounts expense Sales Accounts receivable To record collection of accounts receivable, uncollectible accounts expense, and sales returns. Accounts receivable ($301,425 - $47,420) Sales To record sales on account. Cost of goods sold *Inventory . To record cost of goods sold. Writedown of obsolete merchandise *Inventory . To record obsolete merchandise. *Accounts payable Inventory ($153,495 - $151,914 - $1,025) To record purchase returns, perpetual inventory method. Inventory ($208,856 - $55,542) *Accounts payable To record purchases on account. Selling expense *Accounts payable To record selling expenses. 10,212 10,212
b)
5,168 5,000 168
c)
247,833 665 481 248,979
d)
254,005 254,005
e)
151,914 151,914
f)
1,025 1,025
g)
556 556
h)
153,314 153,314
i)
25,348 25,348
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CMA Ontario - 2013
j)
Salaries expense *Accounts payable To record salaries expense. Other administrative expense *Accounts payable Accumulated depreciation To record other administrative expenses, including depreciation. Office furniture and fixtures ($11,164 - $8,663) *Accounts payable To record purchase of furniture. Interest expense *Accounts payable To record interest expense. Accounts payable ($211,658 - $556) *Cash . To record payments on account. *Cash Accumulated depreciation Loss on sale of fixtures Fixtures To record sale of fixtures. Note payable *Cash To record payment on note. Income tax expense Income taxes payable ($11,050 - $7,350) To record income tax expense. Income taxes payable *Cash To record payment of taxes. Retained earnings *Cash To record dividends.
15,500 15,500
k)
21,567 20,594 973
1)
2,501 2,501
m)
850 850
n)
211,102 211,102
o)
436 176 23 635
p)
10,000 10,000
q)
3,700 3,700
r)
5,658 5,658
s)
10,000 10,000
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Bal b) c) o)
Cash* a) 21,849 n) 5,168 p) 247,833 r) 436 s) 275,286
10,212 211,102 10,000 5,658 10,000 246,972
Investments b) 5,000 Bal 30,500 a) 10,212 40,712 Uncollectible Accounts Expense c) 665
Accounts Receivable c) 248,979 Bal 47,420 d) 254,005 301,425 Inventory e) 151,914 55,542 f) 1,025 h) 153,314 g) 556 208,856 153,495
*The total debits to cash exceed the book total by $270; therefore one of the debits is smaller than shown here by the $270 which the books show as "unlocated difference." Office Furniture and Fixtures o) 635 Bal 8,663 l) 2,501 11,164 Note Payable p) 10,000 Bal 30,000
Accumulated Depreciation o) 176 Bal k) 4,967 973 5,940
Loss on Sale of Fixtures o) 23
Income Taxes Payable r) 5,658 Bal 7,350 q) 3,700 11,050 Sales c) 481 d) 254,005
Income Tax Expense q) 3,700
Gain on Sale of Investments b) 168
Cost of Goods Sold e) 151,914
Writedown of Obsolete Merchandise f) 1,025
Selling Expense i) 25,348
j)
Salaries Expense 15,500
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Other Administrative Expense k) 21,567
Interest Expense m) 850 s)
Retained Earnings 10,000 Bal 55,778
Accounts Payable g) 556 n) 211,102 Bal 15,879 h) 153,314 i) 25,348 j) 15,500 k) 20,594 l) 2,501 m) 850 211,658 233,986
Share Capital Bal 50,000
LOCATION OF ERROR: The posting of transactions as they appear to have occurred leaves the cash account with total debits of $275,286 instead of $275,016 and with a balance of $28,314. However, the company's cash balance of $28,044 has been verified. The difference of $270 likely arises from the same error which caused the "unlocated difference" of $270 in the trial balance. The fact that $270 is evenly divisible by nine indicates the possibility of a transposition. Since the $270 discrepancy in the cash account in the solution and the bookkeeper's cash account appears on the debit side of the account the error should be found in one of the entries which included debits to cash. In examining the debits in the cash account we can presume that the opening balance of $21,849 is correct since it was included in the opening trial balance which showed no discrepancies. By looking at entries b and c we see that neither entry contains a figure which could include a transposition error of $270 if we assume that there were no other errors. Entry o, however, contains a credit of $635 to the office furniture & fixtures account. This entry might well be where the $270 transposition error occurred.
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If the $635 credit to office furniture & fixtures had been correct, the entry for the sale would have been: Cash 436 Accumulated depreciation 176 Loss on sale of furniture & fixtures 23 Office furniture & fixtures 635 Since this overstates cash by $270, the amount which was received, and which the bookkeeper posted to the account, must have been $166 ($436 $270). The correct entry would have been: Cash 166 Accumulated depreciation 176 Loss on sale of furniture & fixtures 23 Office furniture & fixtures 365 It appears that the bookkeeper made a transposition error and posted a credit of $635 instead of $365 to office furniture & fixtures.
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Problem 8
1)
Commissions receivable Commissions earned To accrue commissions earned Bad debt expense Allowance for doubtful accounts To record estimated bad debts Office supplies expense Office supplies To record the use of office supplies Rent expense Prepaid rent To recognize the expiration of prepaid rent Depreciation expense Accumulated depreciation - office equipment To record depreciation on office equipment for the period Salary expense Salaries payable To accrue unpaid salaries Interest expense Interest payable To accrue unpaid interest
$465 $465
2)
45 45
3)
120 120
4)
155 155
5)
98 98
6)
290 290
7)
180 180
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Problem 9
ACCOUNT TITLE Cash in bank Inventory of operating parts and supplies
ANALYSIS Current asset if unrestricted Current asset if expected to be used within longer of one year or operating cycle Current asset Current assets if collectible within longer of one year or operating cycle Current asset Current asset process Current asset Same analysis as accounts receivable Current asset Current asset unless expected to be held beyond longer of one year or operating cycle Contra account to current liability only if related bonds appropriately classified as current Current liability Current liability if expected to require use of existing current assets Current liability if expected to be paid with existing current assets or through creation of another current liability Current liability Current liability Current liability
CMA Ontario - 2013
Inventory of raw materials Accounts receivable
Inventory of finished goods Inventory of work in Interest accrued on government securities Notes receivable Petty cash fund Government securities
Unamortized bond discount
Accrued payroll Provision for renegotiation of government contracts Notes payable
Accrued interest on bonds Accounts payable Accrued interest on notes payable

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8% first mortgage bonds Preferred share dividend Allowance for doubtful accounts
Current liability Current liability Contra account to accounts receivable, classified same as related receivables Current liability Current liability Current liability if related bonds are appropriately classified as current liability Current liability
Provision for federal income taxes Customers' advances Premium on bonds redeemable in 20x1
Officers' 20x1 bonus accrued
Problem 10 1. Under cash-basis accounting, net income would be the net cash provided by operations. Revenue would be recognized when cash is received from other than investors and creditors r and expenses would be recognized when cash payments are made for reasons other than financing (including distributions to owners). This approach has very little conceptual merit because it fails to match expenses to revenues so as to satisfactorily measure operating performance during a period. In contrast, accrual accounting focuses on the transactions and events that affect the assets and liabilities of the accounting entity, and attempts to recognize and report those transactions and events in the accounting periods in which they occur. Revenues are recognized when they are earned and expenses are matched against revenues on the basis of: (a) cause and effect, (b) systematic and rational allocation, or (c) immediate recognition. 2. Gross margin for Janson's Retail Hardware is not being calculated on a pure cash basis. Gross margin on a pure cash basis for 20x3 would be: Cash received: $147,000 Cash Sales + 13,000 Credit Sales - 1,000 Increase in AR Cash payments for merchandise: Accounts payable, Jan 1, 20x3 $ 12,000 Purchases during 20x3 100,000 112,000 Less: Accounts payable, Dec 31, 20x3 (19,000)
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$159,000
(93,000)
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Gross margin (net cash inflows)
$66,000
3.
Gross margin shows a decrease because it is being calculated incorrectly. When Mr. Janson adds the ending balance of accounts receivable to the cost of merchandise on hand in his determination of net inventory, he is improperly including the profit margin that is part of the accounts receivable. This results in an overstatement of net inventory at both the beginning and end of the accounting period. The major error in calculating gross margin occurs when Mr. Janson subtracts the accounts payable balance in arriving at the net inventory amounts. The increasing balance of accounts payable each year results in an increasing overstatement of cost of goods sold.
Problem 11 a) A division does not qualify as a separate entity for financial reporting purposes but only for internal control purposes. Financial statements are prepared on a company basis (entity concept). b) Financial statements are neutral in the sense that they reflect certain facts about the company but they are not neutral in the way that these facts are selected and then shown. Financial statements may lack neutrality as many accounting methods may be available and only one is chosen to be used by the accountant. c) Numbers are exact in the sense that they can be added together. But the process generating the numbers is not exact because often it is based on estimates and choices of methods. (Example - depreciation.) d) The historical cost principle allows us to reduce disagreements as to how items should be recorded. Cost is more objective than, for example, market values, but it does not necessarily give us objective numbers as cost is more than just an invoice price in many situations.
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2.
The Statement of Cash Flow
Re-consider the following schematic of the Statement of Financial Position: Share Capital Long-term Assets Retained Earnings Long-Term Liabilities
Current Assets
Current Liabilities
The purpose of the Cash Flow Statement is to report on sources and uses of cash over a period of time as well as the net change in cash and cash equivalents. Reporting information about the cash flows of a firm helps the users of the financial statements to assess both the past performance of the entity in generating and controlling cash resources and the entitys probable future cash inflows, outflows, and net cash flows. The major components of the cash flow statement are the cash flows resulting from the operating, investing, and financing activities of the firm. For the purpose of the cash flow statement, cash is defined as cash and cash equivalents. Cash equivalents include short-term, highly liquid investments that can be readily converted into known amounts of cash. Cash equivalents are shown net of bank overdrafts where overdrafts are part of the cash management strategy of the firm. Investing - all changes in noncurrent assets except those that flow through the income statement (i.e. amortization expense); the latter are considered operating activities. The only possible changes to noncurrent assets are: purchasing noncurrent assets - cash used for investing proceeds on sale of noncurrent assets - cash provided by investing equity income on long-term investments - deducted from net income in the operating section. Financing - all changes in noncurrent liabilities and share capital are financing activities except for those items flowing through the income statement. issue of long-term debt and share capital - cash provided by financing redemption of long-term debt and share capital - cash used by financing dividends paid (not just declared)
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The operating section of the Statement of Cash flow can be prepared using two formats: indirect or direct methods. Although both methods are acceptable under IFRS, IAS 7.19 encourages entities to use the direct method. The direct method provides information which may be useful in estimating future cash flows and which is not available under the indirect method. Cash Flow From Operations - Indirect method: we start with net income and adjust it for non cash items: these are generally of two categories: (1) non cash revenue or expense items and (2) any changes in non-cash working capital items. An indirect cash flow from operations might look like this: Net income Adjust for items not requiring a cash outlay Depreciation Gain on sale of depreciable assets Changes in noncash working capital items Increase in accounts receivable Decrease in inventory Increase in accounts payable Decrease in income taxes payable Cash flow from operations $12,000 2,000 (1,500) (2,500) 500 1,500 (600) $11,400
Cash Flow From Operations - Direct method: as opposed to taking net income and adjusting it, we essentially go through each line on the income statement and convert all items into cash. For example, if the sales were $124,000 for the year and assuming that the accounts receivable increased $2,500, then the cash sales would be calculated as $124,000 2,500 = $121,500. If we continue the example used for the indirect method and we assume that the income statement was as follows: Sales Cost of goods sold Operating expenses (all paid for cash) Depreciation Gain on sale of depreciable assets Net income before taxes Income tax expense Net income $124,000 (75,000) (28,500) (2,000) 1,500 20,000 8,000 $12,000
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The direct approach to determining cash flow from operations would be as follows: Collections from customers ($124,000 Credit Sales 2,500 Increase in Accounts Receivable) Payments to suppliers ($75,000 - 500 Decrease in Inventory 1,500 Increase in Accounts Payable) Payments for operating expenses Payments made for Income taxes ($8,000 Income Tax Expense + 600 Decrease in Income Tax Payable) Cash flow from operations
$121,500 (73,000) (28,500) (8,600) $11,400
Noncash Investing and Financing Activities at times a corporation will enter into noncash transactions. Examples of these could be the purchase of land by issuing new shares as consideration or by taking out a mortgage; issuing a stock dividend or purchasing a company by issuing new shares. Since none of these transactions involve cash, they do not belong on the Statement of Cash flows. Such transactions should be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities. Specific required disclosures regardless of whether the direct or indirect method is used, the following two items need to be disclosed: cash paid on interest, and cash paid on taxes A few more details a Statement of Cash Flows has to be prepared by all entities cash includes cash and cash equivalents which are defined as short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. short term bank loans: bank overdrafts may be included as a component of cash and cash equivalents when the bank balance fluctuates frequently from being positive to overdrawn; otherwise, bank overdrafts and short term demand loans are considered as cash flow from financing. available for sale, held-for-trading and held to maturity investments are considered as part of cash flow from investing regardless of their classification as current or long-term assets. cash flows from dividends received and paid can be classified as either operating, investing or financing cash flows as long as they are reported in a consistent manner.
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Example 1: Karington Ltd. has been manufacturing equipment for making pasta for the past ten years. The company's comparative Statement of Financial Position as at March 31, 20x5, its fiscal year end, is as follows: Karington Ltd. Statement of Financial Position as at March 31, 20x5 ASSETS Long-term Assets Equipment Accumulated depreciation Investment in Kolbe Ltd. Patents 20x5 20x4
1,175,000 (370,125) 176,250 129,250 1,110,375
881,250 (282,000) 141,000 740,250
Current Assets Cash Accounts receivable Inventory Prepaid expenses
$82,250 282,000 458,250 23,500 846,000 $1,956,375
$141,300 312,550 352,500 18,500 824,850 $1,565,100 20x4
LIABILITIES & SHAREHOLDERS' EQUITY Shareholders' Equity Capital stock Retained earnings Long-term Liability Notes Payable Current Liabilities Bank overdraft Accounts payable Salaries payable Income taxes payable Deferred revenues Interest payable Dividends payable
20x5
1,408,100 189,900 1,598,000 105,750
1,233,750 141,000 1,374,750
$ 61,100 105,925 32,900 25,000 10,000 3,600 14,100 252,625 $1,956,375
$ 47,000 59,250 37,600 34,000 8,000 4,500 190,350 $1,565,100
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Karington Ltd. Income Statement for the year ended March 31, 20x5 Sales Cost of goods sold Gross margin Salaries expense Selling and administrative expenses Interest expense Gain on sale of equipment Net income before taxes Income tax expense Net income $1,350,000 830,000 520,000 (220,000) (197,600) (12,400) 15,000 105,000 42,000 $63,000
Additional Information: The investment in Kolbe Ltd. was financed by issuing a 10-year note for $105,750 and providing the remainder in cash. Equipment with an original cost of $50,000 which was 70% depreciated was sold during the year. Depreciation expense in included in selling and administrative expenses Dividends of $14,100 were declared during the year.
Given the above information we can now construct the statement of cash flows as follows.
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Karington Ltd. Statement of Cash Flows for the year ended March 31, 20x5 Cash Flow from Operations Net income Adjust for noncash items Depreciation and amortization Gain on sale of equipment $63,000
1
134,875 (15,000)
Changes in non-cash working capital items: Decrease in Accounts Receivable Increase in Inventory Increase in Prepaid Expenses Increase in Accounts Payable Decrease in Salaries Payable Decrease in Income Taxes Payable Increase in Deferred Revenues Decrease in Interest Payable
30,550 (105,750) (5,000) 46,675 (4,700) (9,000) 2,000 (900) 136,750
Cash Flow from Financing Issue of capital stock ($1,408,100 1,233,750) Cash Flow from Investing Investment in Kolbe Ltd. ($176,250 105,750) Proceeds on sale of equipment ($15,000 Gain + 15,000 NBV of Asset Sold) Purchase of equipment2
174,350
(70,500) 30,000 (343,750) (384,250) (73,150) 94,300 $21,150
Decrease in cash and cash equivalents Cash and cash equivalents*, March 31, 20x4 Cash and cash equivalents, March 31, 20x5 * Cash and cash equivalents include Cash net of the Bank Overdraft.
1
Accumulated depreciation beginning Less accumulated depreciation on asset sold: $50,000 x 70% Less accumulated depreciation, ending Depreciation expense on equipment Add amortization on patent: $141,000 Patent Opening Balance 129,250 Patent Ending Balance
$282,000 (35,000) (370,125) 123,125 11,750 $134,875
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Equipment, end of year Less equipment, beginning of year Net increase Add cost of equipment sold Purchase of equipment
$1,175,000 (881,250) 293,750 50,000 $343,750
If the direct method had been used, the cash flow from operations section would be as follows: Cash collected from customers ($1,350,000 Sales + 30,550 Decrease in A/R + 2,000 Increase in Deferred Revenues) Cash paid to suppliers ($830,000 COGS + 105,750 Increase in Inventory - 46,675 Increase in Accounts Payable) Cash paid to employees ($220,000 Salaries Expense + 4,700 Decrease in Salaries Payable) Cash paid for Selling and Administrative Expenses ($197,600 S&A Expenses + 5,000 Increase in Prepaid Expenses 134,875 Depreciation Expense) Cash paid on interest ($12,400 Interest Expense + 900 Decrease in Interest Payable) Cash paid on taxes ($42,000 Income Tax Expense + 9,000 Decrease in Income Taxes Payable)
$1,382,550 (889,075) (224,700) (67,725) (13,300) (51,000) $136,750
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Example 2 the Statement of Cash Flow for Local Stationery Ltd. (example on page 4) is as follows: Local Stationery Ltd. Statement of Cash Flow for the year ended December 31, 20x6 Cash flow from operations Net income Adjust for items not affecting cash flow Depreciation Gain on disposal of assets Changes in non-cash working capital items Increase in accounts receivable Increase in inventory Decrease in note receivable Increase in prepaid insurance Increase in accounts payable and accrued liabilities Decrease in wages payable Increase in accrued income taxes payable Decrease in unearned revenues
$73,620 20,000 (5,000) (22,800) (15,000) 10,400 (3,700) 10,000 (1,500) 24,080 (5,000) 85,100
Cash flow from investing Purchase of equipment Sale of equipment
(50,000) 20,000 (30,000)
Cash flow from financing Dividends Repayment of long-term debt
(30,000) (15,000) (45,000) 10,100 14,500 $24,600
Increase in cash Cash, beginning of year Cash, end of year
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If the direct method had been used, the cash flow from operations section would be as follows: Cash collected from customers ($1,152,600 Sales - 22,800 Increase in A/R + 10,400 Decrease in Note Receivable - 5,000 Decrease in Deferred Revenues - 4,800 Bad Debt Expense*) Cash paid to suppliers ($645,000 COGS + 15,000 Increase in Inventory - 10,000 Increase in Accounts Payable) Cash paid for Selling and Administrative Expenses Cash paid to employees ($198,500 Wages and Salaries Expense + 1,500 Decrease in Salaries Payable) Cash paid for insurance ($3,500 Insurance Expense + 3,700 Increase in Prepaid Insurance) Cash collected on interest Cash paid on interest Cash paid on taxes ($49,080 Income Tax Expense - 24,080 Increase in Income Taxes Payable)
$1,130,400 (650,000) (150,000) (200,000) (7,200) 400 (13,500) (25,000) $85,100
the concept of how bad debt expense and the change in the allowance for doubtful accounts will be elaborated on when we cover Accounts Receivable.
Accounting Standards for Private Enterprises (ASPE) Although the standards allow for both the direct or indirect methods, the standard does not explicitly state a preference for either method. Recall that IFRS's allow interest expense, interest revenues, dividends paid and dividend revenues to be classified as operating, investing or financing as long as the method chosen is relevant to the users of the financial statements and is applied consistently. ASPE requires that dividends paid be classified as a financing activity, and interest expense, interest and dividend revenues be classified as an operating activity. What the future holds. The IASB is proposing that Cash Flow from Operations be presented using the direct method only. We expect a new standard reflecting this will be issued in 2013.
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Statement of Cash Flows Problems with Solutions

Multiple Choice Questions 1. Lance Corp.s statement of cash flows for the year ended September 30, 20x2, was prepared using the indirect method and included the following: Net income Non-cash adjustments: Depreciation expense Increase in accounts receivable Decrease in inventory Decrease in accounts payable Net cash flows from operating activities $60,000 9,000 (5,000) 40,000 (12,000) $92,000
Lance reported revenues from customers of $75,000 in its 20x2 income statement. What amount of cash did Lance receive from its customers during the year ended September 30, 20x2? a) $80,000 b) $70,000 c) $65,000 d) $55,000
2.
On June 30, 20x4, D Ltd., a manufacturing company, sold a piece of land for its book value of $250,000. D Ltd. Accepted $170,000 cash plus a mortgage in the amount of $80,000 in exchange for the land. How would D Ltd. Report this on its December 31, 20x4, statement of cash flow? a) $250,000 inflow under the investing activities heading. b) $170,000 inflow under the investing activities heading. c) $250,000 inflow under the investing and $80,000 outflow under the financing activities headings. d) $170,000 inflow under the investing and $80,000 outflow under the financing activities headings. e) $250,000 inflow and $80,000 outflow under the investing activities heading.
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3.
Consider the following information for a firms year ended December 31, 20x4: January 1, 20x4 $340,000 14,000 36,000 December 31, 20x4 $385,000 6,000 54,000
Accounts receivable Prepaid Rent Unearned revenues Revenues
1,600,000
Calculate the cash flow from customers for the year ended December 31, 20x4: a) $1,537,000 b) $1,573,000 c) $1,600,000 d) $1,609,000 e) $1,663,000
4.
Net cash flow from operating activities for 20x2 for Graham Corporation was $75,000. The following items are reported on the financial statements for 20x2: Amortization expense Cash dividends paid on common shares Increase in accrued receivables $5,000 3,000 6,000
Based only on the information above, Grahams net income for 20x2 was: a) $64,000 b) $66,000 c) $74,000 d) $76,000 e) None of the above.
5.
The following information is available for Ace Company for 20x2: Disbursements for purchases $500,000 Increase in trade accounts payable 50,000 Decrease in merchandise inventory 20,000 Costs of goods sold for 20x2 was a) $570,000 b) $530,000 c) $470,000 d) $430,000
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6.
On September 1, 20x3, Canary Co. sold used equipment for a cash amount equaling its carrying amount for both book and tax purposes. On September 15, 20x3, Canary replaced the equipment by paying cash and signing a note payable for new equipment. The cash paid for the new equipment exceeded the cash received for the old equipment. How should these equipment transactions be reported in Canarys 2003 statement of cash flows? a) Cash outflow equal to the cash paid less the cash received b) Cash outflow equal to the cash paid and note payable less the cash received c) Cash inflow equal to the cash received and a cash outflow equal to the cash paid and note payable d) Cash inflow equal to the cash received and a cash outflow equal to the cash paid
Questions 7 through 9 are based on the following: Flax Corp. uses the direct method to prepare its statement of cash flows. Flaxs trial balances at December 31, 20x1 and 20x0, are as follows: December 31 20x1 Debits: Cash Accounts receivable Inventory Property, plant, & equipment Cost of goods sold Selling expenses General and administrative expenses Interest expense Income tax expense Credits: Allowance for uncollectible accounts Accumulated depreciation Trade accounts payable Interest payable Income taxes payable Deferred income taxes 8 % callable bonds payable Common stock Additional paid-in capital Retained earnings Sales $44,500 33,000 31,000 100,000 250,000 141,500 137,000 4,300 20,400 $761,700 $1,300 16,500 25,000 5,000 21,000 5,300 45,000 50,000 9,100 44,700 538,800 $761,700
20x0 $41,500 30,000 47,000 95,000 380,000 172,000 151,300 2,600 61,200 $980,600 1,100 15,000 17,500 4,500 27,100 4,600 20,000 40,000 7,500 64,600 778,700 $980,600
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Flax purchased $5,000 in equipment during 20x1. Flax allocated one-third of its depreciation expense to selling expenses and the remainder to general and administrative expenses. What amounts should Flax report in its statement of cash flows for the year ended December 31, 20x1, for the following: 7. Cash collected from customers? a) $541,800 b) $541,600 c) $536,000 d) $535,800
8.
Cash paid for goods to be sold? a) $258,500 b) $257,500 c) $242,500 d) $226,500
9.
Cash paid for interest? a) $4,800 b) $4,300 c) $3,800 d) $1,700
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Problem 1 The income statement and comparative balance sheets of Harold Ltd. are shown below. Harold Ltd. Income Statement for the year ended December 31, 20x2 Sales Cost of goods sold Operating expenses Depreciation expense Interest expense Gain on sale of disposal of property, plant and equipment Income tax expense Net income $ 1,650,000 (1,236,000) (197,000) (120,000) (25,000) 6,000 (27,000) $ 51,000
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Harold Inc. Statement of Financial Position as at December 31, 20x2 20x2 Noncurrent Assets Property, plant and equipment Accumulated depreciation Current assets Cash Accounts receivable Inventory Prepaid expenses $850,000 (426,000) 424,000 145,000 226,000 305,000 14,000 690,000 $1,114,000 Shareholders equity Common shares Retained earnings Long-term debt Current liabilities Accounts payable Salaries payable Interest payable Income taxes payable Dividends payable 20x1 $740,000 (356,000) 384,000 75,000 202,000 336,000 35,000 648,000 $ 1,032,000
$ 450,000 177,000 627,000 213,000 225,000 14,000 12,000 13,000 10,000 274,000 487,000 $1,114,000
$ 400,000 156,000 556,000 219,000 206,000 20,000 10,000 16,000 5,000 257,000 476,000 $ 1,032,000
Additional information During 20x2, property plant and equipment costing $100,000 was sold. Required a. b. Prepare a Statement of Cash Flows for Harold Inc. using the direct method. Prepare the Cash Flow from Operations section using the indirect method.
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Problem 2 The records of Dumbledore Company provided the following data for the accounting year ended December 31, 20x5: Comparative Statements of Financial Position as at December 31 Assets Cash Investment, short term (cash equivalent) Accounts receivable Inventory Prepaid interest Land Machinery Accumulated depreciation Other assets 20x4 $30,000 10,000 56,000 20,000 -60,000 80,000 (20,000) 29,000 $265,000 20x5 $ 75,000 8,000 86,000 30,000 2,000 25,000 90,000 (26,900) 39,000 $328,100
Liabilities and Shareholders Equity Accounts payable Salaries payable Income taxes payable Bonds payable Common shares Preferred shares Retained earnings
39,000 5,000 2,000 70,000 100,000 20,000 29,000 $265,000
54,000 2,000 8,000 55,000 130,000 30,000 49,100 $328,100
Income Statement for the year ended December 31, 20x5 Sales revenue Cost of goods sold Depreciation expense Salaries Interest expense Remaining expenses Gain on sale of land Income tax expense Net income $180,000 (90,000) (6,900) (33,900) (6,000) (4,000) 18,000 (12,100) $ 45,100
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Analysis of selected accounts and transactions: a. b. c. d. e. f. Issued bonds payable for cash, $5,000. Sold land for $53,000 cash; book value, $35,000. Purchased machinery for cash, $10,000. Retired $20,000 bonds payable by issuing common shares; the common shares had a market value of $20,000. Acquired other assets by issuing preferred shares with a market value of $10,000. Statement of retained earnings: Balance, January 1, 20x5 Net income for 20x5 Cash dividends Balance, December 31, 20x5 Required a. b. Prepare the Statement of Cash Flows, indirect method. Prepare the operations section of the Statement of Cash Flows using the direct method of presentation. $29,000 45,100 (25,000) $49,100
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Problem 3 The Statement of Financial Positions of Sunrise Ski Company showed the following: December 31, 20x2 Debits Cash Accounts receivable (net) Inventory Long-term investments Plant and equipment Credits Accumulated depreciation Accounts payable Notes payable-long-term Share capital Retained earnings $ 10,000 18,000 24,000 10,000 104,000 $166,000 $ 14,000 16,000 40,000 60,000 36,000 $166,000 December 31, 20x1 $ 12,000 10,000 20,000 24,000 60,000 $126,000 $ 10,000 12,000 32,000 50,000 22,000 $126,000
The income statement for 20x2 appears below: Sales Cost of sales Expenses, including income taxes, paid in cash Depreciation Loss on disposal of long-term investments Gain on disposal of plant and equipment Net income Additional data concerning changes in the noncurrent accounts: a) Cash dividends paid, $2,000. b) Issue of common shares for cash, $10,000. c) Plant and equipment disposed of during the year cost $6,000. Required a. b. Prepare a statement of cash flows for 20x2. Use the direct method. Calculate Cash flow from operations using the indirect method. $320,000 (200,000) (96,000) (6,000) (4,000) 2,000 $ 16,000
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Problem 4 TGA Corporation, a publicly-held company, develops and sells software application programs. TGA's Statement of Income and Retained Earnings for the year ended December 31. 20x1, and Comparative Statement of Financial Position for 20x0 and 20x1 are presented below. TGA Corporation Statement of Income and Retained Earnings For the Year Ended December 31, 20x1 Sales revenue Cost of goods sold Gross profit Salaries expense Depreciation expense Loss on sale of equipment Interest expense Income before taxes Income tax expense Net income Retained earnings, January 1, 20x1 Dividends Retained earnings , December 31, 20x1 $300,000 120,000 180,000 (50,000) (6,000) (2,500) (2,500) 119,000 48,000 71,000 87,000 (8,000) $150,000
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TGA Corporation Comparative Statement of Financial Position As of December 31, 20x1 and 20x0 Assets Cash Accounts receivable, net Inventory Land Plant and equipment Accumulated depreciation Total assets Dec 31, 20x1 $ 98,500 50,000 70,000 200,000 80,000 (15,500) $483,000 Dec 31, 20x0 $ 86,000 30,000 55,000 200,000 69,500 (13,500) $427,000 Change $ 12,500 20,000 15,000 10,500 (2,000) $ 56,000
Liabilities & Shareholders' Equity Accounts payable Salaries payable Taxes payable 10% convertible bonds payable Common stock Retained earnings Total liabilities & shareholders' equity
$ 15,000 10,000 3,000 305,000 150,000 $483,000
$ 20,000 7,000 13,000 100,000 200,000 87,000 $427,000
$ (5,000) 3,000 (10,000) (100,000) 105,000 63,000 $56,000
Additional Information During the year, additional equipment was acquired by TGA for $20,000 cash. TGA also sold equipment costing $9,500, with a book value of $5,500, for $3,000 cash. On March 30, 20x1, $100,000 of 10% convertible bonds, issued at face value with interest payment dates of June 30 and December 31, were converted into 2,000 shares of TGA Corporation common stock. An additional $5,000 of common stock were issued for cash.
Required Using the direct method, prepare a Statement of Cash Flows for TGA Corporation for the year ended December 31, 20x1.
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Problem 5 Mr. Cumin, the president of Sage Ltd., presented you with the following Statement of Financial Position and asked you to prepare a statement of cash flow. Sage Ltd. Comparative Statement of Financial Position As at June 30, 20x5 20x5 Assets Long-Term Assets Government bonds held for expansion Equipment Accumulated depreciation Leasehold improvements Patents (net)
20x4
97,500 602,550 (270,400) 18,850 18,070 466,570
420,550 (241,800) 18,850 19,500 217,100
Current Assets Cash Accounts receivable Allowance for doubtful accounts Inventories
$ 94,250 164,450 (9,100) 313,950 563,550 $1,030,120
$ 162,500 177,450 (11,050) 313,950 642,850 $859,950
Liabilities and Shareholders' Equity Shareholders' Equity Preferred stock Common stock Retained earnings Long-term Liabilities 12% Bonds payable Current Liabilities Accounts payable Cash dividends payable Current portion of bonds payable
58,500 325,000 274,300 657,800 162,500
65,000 325,000 174,200 564,200 195,000
$ 151,320 26,000 32,500 209,820 $1,030,120
$ 68,250 32,500 100,750 $859,950
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At a meeting with the assistant controller, you learned that legal costs amounting to $1,300 were incurred to defend a patent. A premium paid to retire preferred stock was charged to retained earnings. Equipment with a book value of $39,650 was sold for $31,200. Patent amortization amounted to $2,730. Equipment purchases amounted to $250,900 and net income for the year was $126,750. Dividends in the amount of $26,000 were declared. Required: Prepare a statement of cash flows.
Problem 6 The Statement of Financial Positions for Carlos Ltd. as at December 31, 20x0 and 20x1, and the income statement for the year ended December 31, 20x1 are presented below. CARLOS LTD. Statement of Financial Positions December 31, 20x1 Assets Cash Accounts receivable Inventory Buildings and equipment, net of accumulated amortization Liabilities and shareholders' equity Accounts payable Taxes payable Interest payable Notes payable Common shares Retained earnings $ 20,000 6,000 1,000 53,000 120,000 118,000 $ 318,000 $ 65,000 4,000 2,000 59,000 100,000 20,000 $250,000 20x1 $ 46,000 100,000 90,000 82,000 $ 318,000 20x0 $ 40,000 80,000 50,000 80,000 $ 250,000
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CARLOS LTD. Income Statement year ended December 31, 20x1 Sales Expenses Cost of goods sold Other expenses Depreciation expensebuilding and equipment Interest expense Income tax expense Net income Other Information 1. 2. 3. Equipment costing $ 11,000 was purchased during the year. The company issued 800 shares for $20,000 cash. The note payable matures in 20x3. $ 520,000 $ 300,000 71,000 9,000 7,000 35,000
422,000 $ 98,000
Required a. b. Prepare a cash flow statement for the year ended December 31, 20x1, using the direct method of presenting the cash flows from operations. Prepare the cash flow from operating activities using the indirect approach.
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Solutions
Multiple Choice Questions 1. 2. 3. b b b $75,000 - 5,000 Increase in A/R = $70,000 Only the cash receipt would be shown on the statement of cash flows. $1,600,000 45,000 Increase in A/R + 18,000 Increase in Deferred Revenues = $1,573,000 75,000 + 6,000 5,000 = $76,000
4.
5.
Purchases = $500,000 + 50,000 = $550,000 COGS = $550,000 + 20,000 = $570,000
6. 7. 8.
d c d $538,800 - $2,800 Increase in net receivables = $536,000 Purchases = $250,000 - $16,000 decrease in inventory = $234,000 Cash purchases = $234,000 - 7,500 Increase in trade payables = $226,500 $4,300 Interest expense - $500 Increase in interest payable
9.
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Problem 1 a. Harold Inc. Statement of Cash Flows For the year ended December 31, 20x2 Cash flow from operations Cash collected from customers ($1,650,000 Sales 24,000 Increase in Accounts Receivable) Cash paid to suppliers ($1,236,000 31,000 Decrease in Inventory 19,000 Increase in Accounts Payable) Cash paid for operating expenses ($197,000 21,000 Decrease in Prepaid Expenses + 6,000 Decrease in Salaries Payable) Cash paid for interest ($25,000 2,000 Increase in Interest Expense) Cash paid for income taxes ($27,000 + 3,000 Decrease in Income Taxes Payable)
$1,626,000 (1,186,000) (182,000) (23,000) (30,000) 205,000
Cash flow from investing Purchase of property, plant and equipment (see next page for alternate calculations) $110,000 Increase in PPE + 100,000 Cost of Equipment Sold Proceeds on sale of PPE (see next page for alternate calculations) $50,000 NBV of PPE Sold* + 6,000 Gain on Sale
(210,000)
56,000 (154,000)
Cash flow from financing Issue of common shares Repayment of long-term debt Dividends Paid **
50,000 (6,000) (25,000) 19,000 70,000 75,000 $145,000
Increase in cash Cash, beginning of year Cash, end of year * Accumulated Depreciation on PPE Sold = $120,000 Depreciation Expense - $70,000 Increase in Accumulated Depreciation ** Dividends Declared = $51,000 Net Income - 21,000 Increase in Retained earnings Less Increase in Dividends Payable Dividends paid
$30,000 (5,000) $25,000
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b.
Cash Flow from Operations - Indirect Net Income Adjust for non-cash items Depreciation Gain on sale of disposal of property, plant and equipment Adjust for changes in non-cash working capital items Increase in Accounts Receivable Decrease in Inventory Decrease in Prepaid Expenses Increase in Accounts Payable Decrease in Salaries Payable Increase in Interest Payable Decrease in Income Taxes Payable $51,000 120,000 (6,000) (24,000) 31,000 21,000 19,000 (6,000) 2,000 (3,000) $205,000
Alternate Calculations for purchase and sale of PPE: If you analyze the PPE account, you get the following: Beginning balance $740,000 + additions ???? - disposals $100,000 = ending balance of $850,000 Additions work out to $210,000 If we analyze the Accumulated Depreciation account, we get: Beg balance $356,000 + Depreciation expense $120,000 - Acc Dep on Disposals ????? = Ending balance of $426,000 Accumulated depreciation on PPE sold works out to $50,000 NBV on PPE sold = Cost of $100,000 - Accumulated Depreciation of 50,000 = $50,000 If sold at a gain of $6,000, then proceeds = $56,000
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Problem 2 a. DUMBLEDORE CORPORATION Statement of Cash Flow for the year ended December 31, 20x5 Cash Flow from Operations Net income Adjust for non-cash items: Gain on sale of land Depreciation Adjust for changes in working capital Increase in accounts receivable Increase in inventory Increase in prepaid interest Increase in accounts payable Decrease in salaries payable Increase in taxes payable Cash Flow from Investing Proceeds on sale of land Purchase of machinery
$45,100 (18,000) 6,900 34,000 (30,000) (10,000) (2,000) 15,000 (3,000) 6,000 10,000 53,000 (10,000) 43,000
Cash Flow From Financing Proceeds on the issue of bonds Proceeds in the issue of common shares Cash dividends
5,000 10,000 (25,000) (10,000) 43,000 40,000 $83,000
Net change in cash Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year
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b. Cash Flow from Operations - Direct Cash collected from customers ($180,000 Sales 30,000 Increase in A/R) Cash paid to Suppliers ($90,000 COGS + 10,000 Increase in Inventory 15,000 Increase in Accounts Payable) Cash paid to employees ($33,900 Salary Expense + 3,000 Decrease in Salaries Payable) Cash paid for remaining expenses Cash paid for interest (6,000 Interest Expense + 2,000 Increase in Prepaid Interest) Cash paid for Income taxes (12,100 Income Tax Expense 6,000 Increase in Income Taxes Payable)
$150,000 (85,000) (36,900) (4,000) (8,000) (6,100) 10,000
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Problem 3 a. Sunrise Ski Company Statement Of Cash Flows for the year ended December 31, 20x2 Cash flows from operating activities Cash collections from customers ($320,000 - 8,000 Increase in A/R) Cash paid to suppliers ($200,000 COGS + 4,000 Increase in Inventory - 4,000 Increase in Accounts Payable) Other expenses paid in cash Cash flows from investing activities Proceeds on sale of plant and equipment (Note 1) Sale of long-term investments ($14,000 Decrease in Long-Term Investments - 4,000 Loss on disposal of investments) Purchase of equipment (Note 2) Cash flows from financing activities Issuance of common shares Issue of notes payable Payment of dividends ($16,000 Net Income - 14,000 Increase in R/E)
$312,000 (200,000) (96,000) 16,000 6,000 10,000 (50,000) (34,000) 10,000 8,000 (2,000) 16,000 (2,000) 12,000 $ 10,000
Net decrease in cash Cash, January 1, 20x2 Cash, December 31, 20x2
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Note 1 - Proceeds on sale of plant and equipment Net book value of plant and equipment sold Cost Less Accumulated depreciation $6,000 Depreciation Expense - 4,000 Increase in Accumulated Depreciation Gain on disposal of plant and equipment Proceeds Note 2 - Purchase of equipment Increase in plant and equipment account Add cost of equipment sold Acquisitions during 20x2
$6,000 2,000 4,000 2,000 $ 6,000
$44,000 6,000 $50,000
b. Cash Flow from Operations - Indirect Net income Adjust for non-Cash Items Depreciation Loss on sale of long-term investments Gain on disposal of fixed assets Adjust for changes in non-cash working capital accounts Increase in accounts receivable Increase in inventory Increase in accounts payable $16,000 6,000 4,000 (2,000) (8,000) (4,000) 4,000 $16,000
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Problem 4 TGA Corporation Statement of Cash Flows For the Year Ended December 31, 20x1 Cash flow from operating activities: Cash collected from customers ($300,000 Sales - 20,000 Increase in A/R) Cash paid to suppliers ($120,000 COGS + 15,000 Increase in Inventory + 5,000 Decrease in Accounts Payable) Cash paid to employees ($50,000 Salaries expense - 3,000 Increase in Salaries Payable) Cash paid for interest Cash paid for taxes ($48,000 + 10,000 Decrease in Income Taxes Payable)
$280,000 (140,000) (47,000) (2,500) (58,000) 32,500
Cash flow from investing activities: Proceeds from sale of equipment Purchase of additional equipment
3,000 (20,000) (17,000)
Cash flow from financing activities: Common stock issued for cash Cash dividend paid*
5,000 (8,000) (3,000) 12,500 86,000 $98,500
Net increase in cash Cash balance, December 31, 20x0 Cash balance, December 31, 20x1
* we know that these are paid because there are no dividends payable on the Statement of Financial Position.
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Problem 5 Sage Ltd. Statement of Cash Flows for the year ended June 30, 20x5 Cash provided by operations Net income Add back items not requiring a cash outlay Depreciation Amortization of patent Loss on sale of equipment ($39,650 - 31,200) Decrease in accounts receivable (net) Increase in accounts payable
$126,750 57,850 2,730 8,450 195,780 11,050 83,070 289,900

1
Cash used by investing activities Purchase of government bonds Purchase of equipment Proceeds on sale of equipment Patent defense costs
(97,500) (250,900) 31,200 (1,300) (318,500)
Cash used by financing activities Repayment of bonds Redemption of preferred shares (6,500 + 650 2)
(32,500) (7,150) (39,650) (68,250) 162,500 $ 94,250 $420,550 250,900 (602,550) $ 68,900 $241,800 (29,250) (270,400) $ 57,850
Decrease in cash Cash, beginning of year Cash, end of year

1
Equipment - beginning balance Additions less ending balance = cost of equipment sold Accumulated depreciation - beginning balance less accumulated depreciation on equipment sold: $68,900 - 39,650 less ending balance = depreciation expense
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Retained earnings - Beginning of year Net income Dividends Retained earnings - End of year Premium on retirement of preferred shares
$174,200 126,750 (26,000) (274,300) $ 650
Problem 6 Part (a) CARLOS LTD. Statement of Cash Flow year ended December 31, 20x1 Cash flows from operating activities Cash receipts from customers (520,000 - 20,000 Increase in AR) Cash payments for merchandise (300,000 + 40,000 Increase in Inventory + 45,000 Decrease in Accounts Payable) Cash payment for other expenses Interest payments (7,000 + 1,000 Decrease in Interest Payable) Income tax payments (35,000 - 2,000 Increase in Taxes Payable) Cash flows from investing activities Purchase of equipment (2,000 Increase in Buildings and Equipment + 9,000 Depreciation Expense) Cash flows from financing activities Payments for notes payable (53,000 - 59,000) Proceeds from common shares issued (120,000 - 100,000)
$500,000 (385,000) (71,000) (8,000) (33,000) 3,000
(11,000)
(6,000) 20,000 14,000 6,000 40,000 $ 46,000
Net increase in cash Cash, January 1, 20x1 Cash, December 31, 20x1 Part (b) Cash flows from operating activities Net income Add back depreciation which does not require a cash outlay Changes in working capital items: Increase in accounts receivable Increase in inventory Decrease in accounts payable Increase in taxes payable Decrease in interest payable
$98,000 9,000 (20,000) (40,000) (45,000) 2,000 (1,000) $ 3,000

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3.
Revenue Recognition
Revenue recognition under IFRS is governed by IAS 18 Revenue and IAS 11 Construction Contracts. IAS 18 applies to the following types of revenues: sale of goods, rendering of services, and interest, royalties and dividends. Revenue is measured as the fair value of the consideration received or receivable (IAS 18.9). If the consideration is to be received over time and provides favorable financing terms to the buyer, then the cash flows are discounted and the amount of revenue is calculated based on the discounted value (IAS 18.11). The accounting for these transactions will be discussed in chapter 6 of this Module. Fair value is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction (IAS 39.9). 3.1 Sale of Goods
Revenue from the sale of goods shall be recognized when all the following conditions have been satisfied: (a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; (b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; (c) the amount of revenue can be measured reliably; (d) it is probable that the economic benefits associated with the transaction will flow to the entity; and (e) the costs incurred or to be incurred in respect of the transaction can be measured reliably (note that this item is also referred to as the matching principle). (IAS 18.14) Note that in most cases, i.e. retail sales, the transfer of risks and rewards of ownership will coincide with the transfer of the legal title or the passing of possession to the buyer. In some cases, the timing of transfer of title and transfer of risks and rewards of ownership may not coincide. For example, if the seller holds the legal title to the goods until payment has been made, then you would still recognize revenue on the day the buyer takes possession of the goods since the significant risk and rewards of ownership of the goods has transferred to the buyer.
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If you retain significant risks of ownership, then the transaction is deemed to not be a sale and revenues cannot be recognized. The standard provides the following examples where this could be the case: when the entity retains an obligation for unsatisfactory performance not covered by normal warranty provisions; when the receipt of the revenue from a particular sale is contingent on the derivation of revenue by the buyer from its sale of the goods; when the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the entity; and when the buyer has the right to rescind the purchase for a reason specified in the sales contract and the entity is uncertain about the probability of return. (IAS 18.16) However, if you retain only insignificant risks of ownership, then the transaction is deemed to be a sale and revenue is recognized.
Example: Green Time Landscaping Inc. (GTL), a residential and commercial landscaping contractor, is completing its first year of operations. According to the terms of the bank loan, the audited financial statements must be presented to the bank within 60 days of the company's year-end. The company's year-end is November 30. Jill Grasslands, the controller of GTL, is currently completing the year-end financial statements and is considering alternative methods of recording the annual revenues. The first year of operations was very successful partly due to the high quality of plant materials (i.e., trees, shrubs, etc.) used and the one-year guarantee given to all customers. In addition, the original contract stipulates that GTL must check all plant materials at six months and one year to ensure they are growing as expected. GTL's terms of payment are net 30 days after completion of the initial planting. What factors should Jill Grasslands consider when selecting GTL's revenue recognition policy? What policy should she adopt based on the facts provided? Jill Grassland should consider the following factors when selecting a revenue recognition policy for GTL: 1. Revenue is earned when the vendor has accomplished, or virtually completed, whatever it must do to be entitled to the revenue. GTL, as a landscaping business, must plant trees and shrubs and check that they are growing as expected throughout the following year. The major act of the contract is the planting of the trees and shrubs. The maintenance is considered minimal, but there is some uncertainty regarding the "success" of the plantings until the one year guarantee period has expired. All other significant risks and rewards can be considered to have been transferred to the customer once planting is completed.
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2. The amount of consideration to be received for goods and/or services must be reasonably assured before revenue can be recognized. GTL works on a contract basis with payment terms specified in the contract. It can be assumed that the amount of consideration for the goods and services are also stipulated in the contract. Since most major planting would have been completed by the end of October, the outstanding amounts should be small by the end of November (i.e., at year end). Any estimate required for uncollectible amounts should be made based on a review of outstanding receivables by the reporting deadline. 3. When a "right of return" such as a warranty or guarantee exists, the extent of the goods that can be expected to be returned will influence revenue recognition. Warranties and guarantees entail future costs that should be recognized in the accounts if they can be reasonably estimated. In the case of GTL, a one-year guarantee on the plants is stipulated in the contract with customers. Because this is GTL's first year of operations, there will be no past company experience to draw from in estimating the amount of plants that will have to be replaced during the guarantee period. GTL should look at industry practices in estimating the returns. Considering that GTL uses a high quality of plant, it may be reasonable to assume that returns/ replacements will not be great and that the expense warranty treatment of accounting for warranty (guarantee) costs would be appropriate. Based on the above analysis, it is recommended that all revenue from all contracts that were signed and completed during the year be recognized at year end and that an allowance be made for estimated uncollectible accounts and for estimated cost of replacing plants during the guarantee period.
In the appendix to IAS 18, some additional guidance is provided for some specific transactions such as: Bill and Hold Sales. These occur when the delivery of the goods is delayed at the customer's request but the customer accepts billing and takes title of the goods. Revenue can be recognized as long as the following criteria are met: it is probable that delivery will be made, the item is on hand, identified and ready for deliver to the buyer at the time the sale is recognized, the buyer specifically acknowledges the deferred delivery instructions, and, the usual payment terms apply. Goods subject to Installation and Inspection. Generally, revenue can be recognized when the goods have been installed and inspected, however if the installation is simple in nature or if inspection is performed only for purposes of determining the final contract price, then revenue can be recognized upon the
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buyer's acceptance of delivery. Consignment Sales. A consignment is an arrangement whereby the owner of the product (the consignor) provides the goods to the seller (the consignee) who then sells the goods on behalf of the consignor. The consignee does not purchase the goods, therefore these goods are not inventory of the consignee. Upon the sale, the consignee typically keeps a certain percentage of the sale as a commission and returns the remainder of the proceeds to the consignor. The revenue is recorded by the consignee and consignor only when the goods are sold to the ultimate consumer. Lay away sales. These occur whenever delivery of the product takes place only when the buyer makes the final payment in a series of installments. Generally revenue is recorded when the last payment is made. However, if experience shows that most lay away sales are taken to term, revenue may be recognized when a significant deposit is received so long as the goods are on hand, identified and ready for deliver to the buyer. Orders when payment, or partial payment, is received in advance of delivery. Recognize the cash received as deferred revenues and recognize revenues when the goods are delivered to the buyer. Subscriptions to publications and similar items. If the items involved are of similar value, revenue is recognized on a straight-line basis. If not, revenue is recognized on the basis of the sales value of the items dispatched in relation to the total estimated sales value of all items covered by the subscription. Installment Sales. Installment sales are sales whereby the customer pays the sales consideration in installments over time. The sales price is determined by discounting the cash flows. The mechanics of this process will be discussed in Section 6 of this module - Notes Receivable/Payable. Rendering of Services
3.2
Service revenue is to be recognized on the percentage of completion basis if the following conditions are present: the amount of revenue can be measured reliably; it is probable that the economic benefits associated with the transaction will flow to the entity; the stage of completion of the transaction at the balance sheet date can be measured reliably; and the costs incurred for the transaction and the costs to complete the transaction can be measured reliably. (IAS 18.20) The last two items relate to long-term service contracts. The method referred to is called the percentage of completion method and will be explained in more details later in this
section under 'Construction Contracts'. When the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue shall be recognized only to the extent of the expenses recognized that are recoverable. (IAS 18.26) For example, say you sign a $500,000 three year contract to provide a service to one of your clients. Because you cannot estimate the costs to complete the transaction at the end of the first year, then the outcome of the transaction cannot be estimated reliably. Assuming you incurred $75,000 of costs on this contract, then the amount of revenue you could recognize in the first year is $75,000. As the outcome of the transaction cannot be estimated reliably, no profit can be recognized. If you received $100,000 from your client on this contract in the first year, you would then also record unearned revenues of $25,000 on the Statement of Financial Position. In the appendix to IAS 18, some additional guidance is provided for some specific transactions: Service fees included in the price of the product. If the selling price includes an identifiable amount that relates to servicing the product over a period of time, then that amount should be deferred and amortized over the time of the service contract. Advertising Commissions. Recognize only when the related advertisement appears before the public. Production commissions are recognized in relation to the stage of completion of the project. Insurance Agency Commissions. If no further work is required on behalf of the agent, the commission can be recognized as revenue on the commencement/renewal date of the policy. If further work is required, then the amount is deferred over the period which the work is performed. Franchise Fees supplies of equipment and other tangible assets: recognize revenue when the items are delivered or title passes. supplies of initial and subsequent services: the typical franchise agreement calls for a franchise fee, usually to be paid up front but sometimes paid over a number of years. Over the life of the franchise, the franchisee usually agrees to pay a certain percentage of revenues to the franchisor. For example, a restaurant franchise agreement may ask the franchisee to pay $50,000 up front plus 6% of revenues - 4% royalty and 2% common advertising pool. In exchange for this, the franchisor agrees to support the franchisee on an ongoing basis. The issue is how to recognize the initial franchise fee of $50,000 as revenue. The franchisor
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needs to determine the portion of the franchise fee that relates to continuing service and accrue this portion over the period of time the services are provided. continuing franchise fees - these are recognized as revenues as the services are provided
3.3
Interest, royalties and dividends
The criteria for recognizing interest, royalties and dividends are: it is probable that the economic benefits associated with the transaction will flow to the entity; and the amount of the revenue can be measured reliably. (IAS 18.29) The bases for recognizing revenues are: for interest using the effective interest method, for royalties accrual basis in accordance with the substance of the relevant agreement, and for dividends when the right to receive payment is established (typically when the dividends have been declared). (IAS 18.30) Disclosure Requirements The accounting policies adopted for the recognition of revenue, including the methods adopted to determine the stage of completion of transactions involving the rendering of services have to be disclosed in the notes to the financial statements. (IAS 18.35a) The following revenue items have to be separately disclosed: the sale of goods, the rendering of services, interest, royalties, dividends. (IAS 18.35b)
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3.4
Construction Contracts (IAS 11)
Accounting for construction contracts requires the use of the percentage of completion method. The completed contract method is no longer acceptable. A construction contract is defined as a a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of design, technology and function of their ultimate purpose and use. The standard applies to individual contracts, however if several contracts have been negotiated as a package but separated into separate contracts for legal purposes, then for purposes of applying the standard, these contracts can be combined and viewed as one contract. There are two types of contracts: fixed price and cost plus. The measures of the outcome (i.e. revenue recognition criteria) vary depending whether we are dealing with a fixed price or a cost plus contract. In the case of a fixed price contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied: (a) total contract revenue can be measured reliably; (b) it is probable that the economic benefits associated with the contract will flow to the entity; (c) both the contract costs to complete the contract and the stage of contract completion at the balance sheet date can be measured reliably; and (d) the contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates. (IAS 11.23) In the case of a cost plus contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied: (a) it is probable that the economic benefits associated with the contract will flow to the entity; and (b) the contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably. (IAS 11.24) When the outcome of a construction contract cannot be estimated reliably: (a) revenue shall be recognized only to the extent of contract costs incurred that it is probable will be recoverable; and (b) contract costs shall be recognized as an expense in the period in which they are incurred. (IAS 11.32) During the early stages of a contract it is often the case that the outcome of the contract cannot be estimated reliably. Nevertheless, it may be probable that the entity will recover the contract costs incurred. Therefore, contract revenue is recognized only to the extent of costs incurred that are expected to be recoverable. As the outcome of the contract cannot be estimated reliably, no profit is recognized.
Application of the Percentage of Completion Method actual construction costs incurred are accumulated in a construction-in-progress (an inventory account); accounts receivable is debited and a billings account is credited for progress billings; the billings account is a contra-account to the construction-in-progress account; at year-end, the percentage of completion is determined: % Completion = Total costs incurred to date Total estimated project costs the revenue to be recognized on the contract is the total contract revenue multiplied by the percentage of completion LESS any revenues recognized on the contract in previous years; the costs to be recognized on the contract are equal to the costs incurred to date LESS any costs recognized on the contract in previous years; any profit on the contract is debited to the construction-in-progress account; at the end of the contract, the sum of the debits in the construction-in-progress account should equal to the sum of the credits in the billings account. Both are then removed from the accounts
When it is known that a loss will be incurred, the loss is considered to be a change in accounting estimate and will be accrued in the period the loss becomes known. Example: Assume that the Greenbank Construction Company was contracted to build a roadway for a local municipality. The contract value is $6,000,000 and is expected to be completed within three years. Data related to the contract are summarized as follows (all amounts in '000s) 20x1 $1,560 3,640 1,400 1,200 20x2 $2,340 1,600 3,000 2,500 20x3 $1,700 1,600 1,900
Costs incurred during the year Expected additional costs to complete Billings during the year Cash collections during the year
At the end of year 20x1, the percentage of completion is: Costs incurred to date / Total expected project costs = $1,560 / ($1,560 + $3,640) = $1,560 / 5,200 = 30% The amounts of revenues and expenses that can be recognized on this project in 20x1 are as follows: Revenues: $6,000 x 30% $1,800 Costs 1,560 Profit $240
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Journal entries in 20x1 would be as follows: Construction-in-progress Cash, accounts payable, Accounts Receivable Billings Cash Accounts Receivable Cost of goods sold Construction-in-progress Revenues $1,560 $1,560 1,400 1,400 1,200 1,200 1,560 240 1,800
At the end of year 20x2, the percentage of completion is: Costs incurred to date / Total expected project costs = ($1,560 + 2,340) / ($1,560 + $2,340 + $1,600) = $3,900 / 5,500 = 71% The amounts of revenues and expenses that can be recognized on this project in 20x2 are as follows: Less Amounts Amount to be Previously recognized in Recognized 20x2 Revenues: $6,000 x 71% $4,260 $1,800 $2,460 Cost of goods sold 3,900 1,560 2,340 Profit $360 $240 $120
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At the end of year 20x3, the percentage of completion is obviously 100% since the project is complete. The amounts of revenues and expenses that can be recognized on this project in 20x3 are as follows: Less Amounts Amount to be Previously recognized in Recognized 20x2 Revenues: $6,000 x 100% $6,000 $4,260 $1,740 Cost of goods sold 5,600 3,900 1,700 Profit $400 $360 $40
The following T-accounts summarize the journal entries (entries to cash, accounts payable, etc have been ignored):
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Construction-in-Progress (x1) 1,560 (x1) 240 (x2) 2,340 (x2) 120 (x3) 1,700 (x3) 40 Bal 6,000 Revenue 1,800 2,460 1,740
Billings 1,400 3,000 1,600 6,000
(x1) (x2) (x3) Bal
(x1) (x2) (x3) Bal
Accounts Receivable 1,400 1,200 (x1) 3,000 2,500 (x2) 1,600 1,900 (x3) 400
(x1) (x2) (x3)
(x1) (x2) (x3)
Cost of Goods Sold 1,560 2,340 1,700
A few things to note: at the end of 20x3, the debit in construction-in-progress is equal to the credit in the billings account. These two accounts are then closed out. the $400 accounts receivable represents the billings not yet collected the revenue and cost of goods sold accounts would get closed off to Retained Earnings at the end of each year
Losses on Long-Term Contracts There are two types of losses that can occur on long-term contracts: 1. The contract is profitable, but there is a loss in the current year. This happens when the income recognized in previous periods exceeds the income that should have been recognized to date. Such a loss should get recorded in the current period. The contract as a whole is unprofitable this is called an onerous contract. Such a loss will occur due to an unexpected increase in costs. The entire loss on the contract must be recognized in the year such a loss can be estimated. For example, if in 20x2, we estimated that the additional costs to complete the project would be $2,600, this would imply that an estimated project loss of $500. This loss would have to be absorbed in 20x2. However, we must take into account that a profit was recorded on this contract in 20x1 of $240. In order to show an overall loss on the contract of $500, a loss of $740 ($500 + $240) would have to be recorded in 20x2.
2.
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Onerous Contract example assume that you entered into a $15,000,000, 3 year contract. At the end of the second year of the contract you are provided with the following information: Year 1 $4,900,000 9,100,000 Year 2 $12,800,000 3,200,000
Costs incurred to date Expected costs to complete
At the end of the first year, the % of completion is $4,900 / (4,900 + 9,100) = $4,900 / 14,000 = 35% The contract is expected to be profitable with an expected profit of $15M 14M = $1M and $1,000,000 x 35% = $350,000 of profit will be realized on the contract in the first year. The income statement relative to this contract in year 1 will be as follows: Construction revenues: $15,000,000 x 35% Costs of construction Gross profit on construction contract In the second year, the % of completion is: $12,800 / (12,800 + 3,200) = $12,800 / 16,000 = 80% Because the expected costs to complete the contract exceed the contract revenues by $1,000,000, we are expecting a loss on the contract and have an onerous contract. The loss taken in year 2 will be the $1,000,000 cumulative loss plus the reversal of the profit realized on the contract to the end of year 1 of $350,000 for a total of $1,350,000. The income statement relative to this contract in year 2 will be as follows: Construction revenues: $15,000,000 x (80% - 35%) Costs of construction ($12,800,000 4,900,000) Onerous contract loss Loss on construction contract $6,750,000 7,900,000 200,000 ($1,350,000) $5,250,000 4,900,000 $350,000
The journal entry in to record the above in year 2 would be as follows: Cost of construction Onerous contract loss CIP Account Construction Revenues $7,900,000 200,000 1,350,000 6,750,000
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In year 3, assume the contract is completed at a cost of $3,400,000. Given that the full loss on the contract based on expected costs to complete last year of $3,200,000 was taken to income in year 2, we would expect the loss taken on the contract in year 3 to be $200,000: Construction revenues: $15,000,000 x (100% - 80%) Costs of construction Less reversal of previous year onerous contract loss Loss on construction contract 3.5 $3,400,000 (200,000) 3,200,000 ($200,000) $3,000,000
Revenue Recognition - Accounting Standards for Private Enterprises (ASPE)
The standard states that revenues from the sale of goods and services are to be recognized when specific performance requirements are met provided that ultimate collection is reasonably assured. (CICA Handbook, Part II, 3400.04) Sale of goods - the criteria are essentially the same as for IFRS's: Performance shall be regarded as having been achieved when the following conditions have been fulfilled: (a) the seller of the goods has transferred to the buyer the significant risks and rewards of ownership, in that all significant acts have been completed and the seller retains no continuing managerial involvement in, or effective control of, the goods transferred to a degree usually associated with ownership; and (b) reasonable assurance exists regarding the measurement of the consideration that will be derived from the sale of goods, and the extent to which goods may be returned. (CICA Handbook, Part II, 3400.05) Sale of services - the standard allow for one of two methods: the percentage of completion basis or the completed contract method (recall that the competed contract method is not allowed under IFRS): In the case of rendering of services and long-term contracts, performance shall be determined using either the percentage of completion method or the completed contract method, whichever relates the revenue to the work accomplished. Such performance shall be regarded as having been achieved when reasonable assurance exists regarding the measurement of the consideration that will be derived from rendering the service or performing the long-term contract. (CICA Handbook, Part II, 3400.05) In both cases (goods and services), the standards provide additional guidance as to when performance would be regarded as being achieved
Performance would be regarded as being achieved when all of the following criteria have been met: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have been rendered; and (c) the sellers' price to the buyer is fixed or determinable. This means that the existence of contractual arrangements will be a determining factor when recognizing revenues. Note that contractual arrangement documentation is not necessary under IFRS. Percentage of Completion vs. Completed Contract Method The percentage of completion method is used when performance consists of the execution of more than one act, and revenue would be recognized proportionately by reference to the performance of each act. The completed contract method would only be appropriate when performance consists of a single act or when the enterprise cannot reasonably estimate the extent toward completion. (Recall that under IFRS, if the outcome of the contract cannot be estimated reliably, contract revenue is recognized only to the extent of costs incurred that are expected to be recoverable.) In accounting using the completed contract method, all contract costs are accumulated in the Construction in Progress account until the end of the contract at which time we would debit the Cost of construction account on the income statement and credit the Construction in Progress account on the balance sheet. All client billings would continue to be credited to the Billings account which would remain a contra account to the Construction in Progress account. Example - let's continue with the Greenbank Construction Company example with the exception that the company cannot estimate the extent towards completion. Recall that the contract value was $6,000,000 and is expected to be completed within three years. Data related to the contract are summarized as follows (all amounts in '000s) 20x1 $1,560 1,400 20x2 $2,340 3,000 20x3 $1,700 1,600
Costs incurred during the year Billings during the year
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The journal entries for this contract using the completed contract method would be as follows: 20x1 Construction in Progress Cash, etc Accounts Receivable Billings 20x2 Construction in Progress Cash, etc Accounts Receivable Billings 20x3 Construction in Progress Cash, etc Accounts Receivable Billings Billings Construction Contract Revenues Construction Costs Construction in Progress $1,560 $1,560 1,400 1,400 2,340 2,340 3,000 3,000 1,700 1,700 1,600 1,600 6,000 6,000 5,600 5,600
The net Construction in Progress account that will be reported on the Greenback Construction Company's Balance sheets will be as follows: 20x1 Current Assets Construction in Progress - net ($1,560 - 1,400) Current Liabilities Construction in Progress - net ($1,560 + 2,340 - 1,400 - 3,000)
$160
20x2
$500
Interest, royalty and dividend revenues The recognition of these revenues follow the same rules as those laid out in IAS 18 with one major exception: interest revenue can be accrued using either the effective interest rate method or any other systematic method (i.e. straight line). Recall that IAS 18 requires interest revenues to be accrued using the effective interest method only. Given that the mechanics of the effective interest method is discussed in chapter 6, we will also defer the discussion of the straight line method to that chapter also.
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In June 2010, the IASB, jointly with the FASB, published an Exposure Draft entitled Revenue from Contracts with Customers that would replace both IAS 12 and IAS 18. In 2011, the IASB, due to the overwhelming number of responses to the initial exposure draft, decided to re-issue the exposure draft. The re-exposure draft was issued in November 2011. The comment period ended in March 2012 and it is expected that the new standard will be published in the first half of 2013. The objective of the project is to develop a common, comprehensive, principles based revenue standard that can be applied consistently to complex transactions across a broad range of industries. The core principle is that an entity shall recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The proposal list five key steps for entities to follow in recognizing revenue: Step 1 identify the contract with the customer; Step 2 identify the separate performance obligation in the contract; Step 3 determine the transaction price; Step 4 allocate the transaction price to the separate performance obligations in the contract; and Step 5 recognize revenue when (or as) the entity satisfies each performance obligation. For the great majority of revenue transactions, there will be very little or no difference as to the timing of revenue recognition as compared to the current standards. The following is a summary of the key principles. Step 1 identify the contract with the customer The proposed standard provides a definition of what constitutes a contract, the circumstances when separate contracts can be combined into one and how to deal with contract modifications do they represent a separate contract or are the part of the original contract. A contract is defined as having commercial substance (meaning that the cash flows of the entity are impacted) and must create enforceable rights and obligations between the parties. A contract can be written, oral or implied. Contracts can be combined if they are entered into at or near the same time and meet one of the following criteria: (1) they are negotiated as a package with a single commercial objective, (2) the amount of consideration paid in one contract depends on the price or performance of the other contract or (3) the goods or services in two or more contracts constitute a single performance obligation.
A contract modification comprises of a separate contract when the modifications result in the addition of goods/services that are distinct (see definition in the discussion of Step 2 below) and the amount of additional consideration reflects the stand-alone selling price of the goods/services provided by the contract modification. Otherwise, they are considered to form part of the original contract. Step 2 identify the separate performance obligation in the contract A good/service is accounted for as a separate obligation if it is deemed distinct. A good/service id deemed to be distinct if either of the following criteria are met: (i) the entity regularly sells the good/service separately; or (ii) the customer can benefit from the good/service either on its own or together with resources that are readily available to the customer. A bundled good/service would ne treated as a single performance obligation if both of the following criteria are met (i.e. the individual goods/services in the bundle would not be distinct): (i) the goods or services in the bundle are highly interrelated and transferring them to the customer requires the entity also to provide a significant service of integrating the goods or services into the combined item(s) for which the customer has contracted; and (ii) the bundle of goods or services is significantly modified or customized in order to fulfill the contract. Example a telecom offers the following package to a customer. The customer can purchase a smart phone for $200 if the customer signs a three year contract and purchases a wireless plan costing $50 per month. The total consideration would be $200 + (36 x $50) = $2,000. The telecoms stand-alone prices for these products is $500 for the smart phone and $38 per month for the wireless plan. Because the smart phones are regularly sold separately from the wireless plans, the telecom will identify two separate performance obligation in this contract: one for the sale of the smart phone and another for the wireless plan. Assuming that the time value of money is not significant, the allocated transaction price will be as follows: Stand-alone Sellling price Smart Phone Wireless ($38 x 36) $ 800 1,368 $2,168 % 36.9% 63.1% Allocated Transaction Price $ 738 1,262 $2,000
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The journal entry on the inception of the contract would be as follows: Cash Accounts receivable Revenue Smart Phones $200 538 $738
As monthly payments are received, the following entry would be processed: Cash Accounts receivable ($538 / 36) Revenue Wireless ($1,262 / 36) Step 3 determine the transaction price The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. This would include discounts, rebates and similar items. The transaction price has to be adjusted to reflect the time value of money when this is considered significant to the contract. If the customer provides non-cash consideration, this non-cash consideration is measured at fair value. If fair value cannot be reasonably estimated, the consideration is measured by reference to the stand-alone selling price of the good/service provided. Bad debt expense is to be recognized in a separate line item adjacent to gross revenue on the Statement of Comprehensive Income. Step 4 allocate the transaction price to the separate performance obligations in the contract If each performance obligation has a stand-alone selling price (as in the example above), then the transaction price is allocated to the performance obligations on a pro-rata basis relative to their stand-alone selling price. If stand-alone selling prices are available for some performance obligations, but not for others, then a residual technique may be used. Step 5 recognize revenue when (or as) the entity satisfies each performance obligation An entity satisfies a performance obligation continuously (i.e. transfer over time) is at least one of the following two criteria are met: (i) The entitys performance creates or enhances an asset that the customer controls as the asset is created or enhanced (e.g., the customer controls the work-inprogress). $50 $14.94 35.06
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(ii)
The entitys performance does not create an asset with alternative use to the entity (i.e., the work-in-progress is highly customized and would be difficult to re-sell) and at least one of the following criteria is met: a. The customer simultaneously receives and consumes the benefit as the entity performs each task; b. Another entity would not need to substantially re-perform the work completed to date if that other entity were to fulfill the remaining obligation to the customer - assumes that the other entity would not have access to the work-in-progress, c. The entity has a right to payment for performance completed to date and expects to fulfill the contract as promised. The entity must be entitles to an amount that compensates (costs incurred to date + reasonable profit margin) for the work performed to date.
If one of the above two criteria are met, the entity can recognize revenue on a continuous basis. Progress can be measured using either input or output based measures. Output methods recognize revenue on the basis of direct measurements of the value to the customer of the goods/services transferred to date. The problem with this method is that these measurements may not be directly observable and may be costly to obtain. If this is the case, the entity may have no choice than to use an input based method. Input methods recognize revenue on the basis of efforts or inputs to the satisfaction of a performance obligation relative to the total expected inputs to the satisfaction of that performance obligation. The use of the percentage of completion method is an input method. Note that inputs are not limited to costs incurred, but could be based on other inputs such as labour hours, time lapsed or machine hours. If the performance obligation is not satisfied over time, then it is satisfied at a point in time. This would happen when the customer obtains control of the goods/services.
Other issues related to revenue recognition discussed in the exposure draft: 1. Onerous performance obligations if a contract is expected to result in a loss, the full amount of the loss has to be taken into income in the year the loss is known. Costs of fulfilling or obtaining a contract an asset can be recognized for costs if the following three criteria are met: (i) the costs relate directly to a contract or a specific anticipated contract; (ii) the costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future; and (iii) the costs are expected to be recovered. These costs would include direct labour, direct materials, allocations of costs that relate directly to the contract or to contract activities (contact management and supervision, insurance and depreciation of equipment used in fulfilling the
2.
contract), costs that are explicitly chargeable to the customer under the contract, and any other costs incurred only because the entity entered into the contract (i.e. payments to subcontractors). The following costs are to be expensed: general and administrative costs, cost of wasted materials, labour or other resources that were not reflected in the price of the contract, costs relating to past performance (i.e. costs that relate to previously satisfied performance obligations), and costs that relate to remaining performance obligations but that the entity cannot distinguish from costs that relate to satisfied performance obligations. 3. Warranties if the customer has the option to purchase a warranty separately, the warranty is accounted for as a separate performance obligation and an allocation of revenue would have to be made to the warranty. If the customer does not have the option to purchase the warranty separately, then the entity would account for the warranty on a cost basis.
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Problems with Solutions

Multiple Choice Questions 1. Gow Constructors, Inc. has consistently used the percentage-of-completion method of recognizing income. In 20x5, Gow started work on an $18,000,000 construction contract that will be completed in 20x7. The following information was taken from Gow's 20x5 accounting records: Progress billings $6,600,000 Costs incurred 5,400,000 Collections 4,200,000 Estimated costs to complete 10,800,000 What amount of gross profit should Gow have recognized in 20x5 on this contract? a) $1,400,000 b) $1,200,000 c) $ 900,000 d) $ 600,000
2.
Carson Construction Co. uses the percentage-of-completion method. In 20x2, Carson began work on a contract for $1,650,000 and it was completed in 20x3. Data on the costs are: Year Ended December 31 20x2 20x3 Costs incurred $585,000 $420,000 Estimated costs to complete 390,000 For the years 20x2 and 20x3, Carson should recognize gross profit of 20x2 $ $387,000 $405,000 $405,000 20x3 $645,000 $258,000 $240,000 $645,000
a) b) c) d)
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3.
The Gerard Construction Company entered into a long-term construction contract on January 2, 20x3 for a total contract price of $20,000,000. Project data for the first three years of the project are as follows: 20x3 $3,300,000 14,700,000 20x4 $7,800,000 11,700,000 20x5 $14,600,000 6,900,000
Costs incurred to date Estimated costs to complete
What amount of gain / loss will be recognized on this contract for the year ended December 31, 20x5? a) $818,605 Gain b) $0 c) $1,300,000 Loss d) $1,500,000 Loss e) $1,700,000 Loss
4.
An independent automobile dealer acts as an agent for an automobile manufacturer on a non-consignment basis. The automobile manufacturer should normally recognize revenue when a) an order for an automobile is received from the dealer. b) an automobile comes off the assembly line. c) an automobile is shipped to the dealer. d) an automobile is picked up by the consumer from the dealer. e) payment is received from the dealer.
5.
Bella Construction Co. uses the percentage-of-completion method. In 20x1, Bella began work on a contract for $2,200,000; it was completed in 20x2. The following cost data pertain to this contract: Year ended December 31 20x1 20x2 $780,000 $560,000 520,000 --
Costs incurred during the year Estimated costs to complete at the of year
The amount of gross profit to be recognized on the income statement for the year ended December 31, 20x2 is a) $320,000 b) $344,000 c) $360,000 d) $860,000
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Problem 1 Newcastle Health and Racquet Club (NHRC), which operates eight clubs in the Calgary metropolitan area, offers one-year memberships. The members may use any of the eight facilities but must reserve racquetball court time and pay a separate fee before using the court. As an incentive to new customers, NHRC advertised that any customers not satisfied for any reason could receive a refund of the remaining portion of unused membership fees. Membership fees are due at the beginning of the individual membership period; however, customers are given the option of financing the membership fee over the membership period at a 15 percent interest rate. Some customers have expressed a desire to take only the regularly scheduled aerobic classes without paying for a full membership. During the current fiscal year, NHRC began selling coupon books for aerobic classes only to accommodate these customers. Each book is dated and contains 50 coupons that may be redeemed for any regularly scheduled aerobic class over a one-year period. After the one-year period, unused coupons are no longer valid. During 20x0, NHRC expanded into the health equipment market by purchasing a local company that manufactures rowing machines and cross-country ski machines. These machines are used in NHRC's facilities and are sold through the clubs and mail order catalogs. Customers must make a 20 percent down payment when placing an equipment order; delivery is 60-90 days after order placement. The machines are sold with a twoyear unconditional guarantee. Based on past experience, NHRC expects the costs to repair machines under guarantee to be 4 percent of sales. NHRC is in the process of preparing financial statements as of May 31, 20x6, the end of its fiscal year. James Hogan, corporate controller, expressed concern over the company's performance for the year and decided to review the preliminary financial statements prepared by Barbara Sullens, NHRC's assistant controller. After reviewing the statements, Hogan proposed that the following changes be reflected in the May 31, 20x6, published financial statements. Membership revenue should be recognized when the membership fee is collected. Revenue from the coupon books should be recognized when the books are sold. Down payments on equipment purchases and expenses associated with the guarantee on the rowing and cross-country machines should be recognized when paid.
Sullens indicated to Hogan that the proposed changes are not in accordance with generally accepted accounting principles, but Hogan insisted that the changes be made. Sullens believes that Hogan wants to manipulate income to forestall any potential financial problems and increase his year-end bonus. At this point, Sullens is unsure what action to take.
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Required A. 1. Describe when Newcastle Health and Racquet Club (NHRC) should recognize revenue from membership fees, court rentals, and coupon book sales. 2. Describe how NHRC should account for the down payments on equipment sales, explaining when this revenue should be recognized. 3. Indicate when NHRC should recognize the expense associated with the guarantee of the rowing and cross-country machines. B. Discuss why James Hogan's insistence that the financial statement changes be made is unethical. C. Identify all of the specific steps Barbara Sullens should take to resolve the situation described above.
Problem 2 On April 1, 20x0, Butler, Inc., entered into a cost-plus-fixed-fee contract to construct an electric generator for Dalton Corporation. At the contract date, Butler estimated that it would take two years to complete the project, at a cost of $2 million. The fixed fee stipulated in the contract is $300,000. Butler appropriately accounts for this contract under the percentage-of completion method. During 20x0 Butler incurred costs of $700,000 related to the project, and the estimated cost at December 31, 20x0, to complete the contract is $1.4 million. Dalton was billed $500,000 under the contract and remitted $300,000 to Butler. Required 1. Prepare a schedule to compute the amount of gross profit to be recognized by Butler under the contract for the year ended December 31, 20x0. Show supporting computations in good form. Prepare Butler's journal entries for the above data.
2.
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Problem 3 The Rushmore Company obtained a construction contract to build a highway. It was estimated at the beginning of the contract that it would take 3 years to complete the project at an expected cost of $50 million. The contract price was $60 million. The project actually took 4 years to complete. The following information describes the status of the job at the close of production each year:
Actual Costs Incurred Estimated Costs to Complete Collections on Contract Billings on Contract 20x1 $12,000,000 38,000,000 12,000,000 13,000,000 20x2 $18,160,000 27,840,000 13,500,000 15,500,000 20x3 $14,840,000 10,555,555 15,000,000 17,000,000 20x4 $10,000,000 15,000,000 14,500,000 20x5 $4,500,000 -
Required (a) Using the percentage-of-completion method, calculate the estimated gross profit (loss) to be recognized in the years 20x1 to 20x4. (b) Prepare all journal entries for the years 20x1 to 20x5 relative to this contract. (c) Repeat item (b) assuming that Rushmore is a private entity following ASPE and has determined that the completed contract method of accounting should be used because this project consists of a single act. Assume that the loss on the project was not anticipated until 20x4. (d) Refer to part (c). What would the journal entries be in 20x3 and 20x4 had the company estimated at the end of 20x3 that the estimated costs to complete the project would have been $18,000,000. Assume that the actual costs incurred in 20x4 were $17,000,000. Problem 4 On February 1, 20x1, Dandan Inc. obtained a contract to build an athletic stadium. The stadium was to be built at a total cost of $5.4 million and was scheduled for completion by September 1, 20x4. Contract price was $6.6 million. Below are the data pertaining to the construction period. 20x1 $1,782,000 3,618,000 1,200,000 1,000,000 20x2 $3,850,000 2,650,000 3,100,000 2,800,000 20x3 $6,300,000 900,000 5,000,000 4,500,000
Costs to date Estimated costs to complete Progress billings to date Cash collected to date
Required (a) Using the percentage-of-completion method, calculate the estimated gross profit recognized in the years 20x1 to 20x3. (b) Prepare all journal entries for the years 20x1 to 20x3 relative to this contract. (c) Prepare a partial Statement of Financial Position for December 31, 20x2, showing the balances in the receivable and inventory accounts.
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Problem 5 The board of directors of Jaworski Construction Company is meeting to choose between the completed-contract method and the percentage-of-completion method of accounting for long-term contracts in the company's financial statements. You have been engaged to assist Jaworski's controller in the preparation of a presentation to be given at the board meeting. The controller provides you with the following information: a) Jaworski commenced doing business on January 1, 20x2. b) Construction activities for the year ended December 31, 20x2, were as follows: TOTAL CONTRACT PRICE $ 520,000 670,000 475,000 200,000 460,000 $2,325,000 BILLINGS THROUGH 12/31/x2 $ 350,000 210,000 475,000 70,000 400,000 $1,505,000 CASH COLLECTIONS THROUGH 12/31/x2 $310,000 210,000 395,000 50,000 400,000 $1,365,000
PROJECT A B C D E
PROJECT A B C D E
CONTRACT COSTS INCURRED THROUGH 12/31/x2 $ 424,000 126,000 315,000 112,750 370,000 $1,347,750
ESTIMATED ADDITIONAL COSTS TO COMPLETE CONTRACTS $106,000 504,000 -092,250 30,000 $732,250
c) Each contract is with a different customer. d) Any work remaining to be done on the contracts is expected to be completed in 20x3. Required (a) Prepare a schedule by project, computing the amount of income (or loss) before selling, general, and administrative expenses for the year ended December 31, 20x2, which would be reported under ... i. The completed-contract method. ii. The percentage-of-completion method (based on estimated costs).
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(b)
For each numbered space on the statement of financial position below, supply the correct balance (indicating DR or CR as appropriate). Assume that the percentage of completion method is used. Disregard income taxes. Jaworski Construction Company Statement of Financial Position as at December 31, 20x2
Assets Cash Accounts (contracts) receivable Costs and estimated earnings in excess of billings on uncompleted contracts Tangible capital assets, net Other assets
$xx 1 2 xx xx $xx
Liabilities and shareholders' equity Accounts payable and accrued liabilities Billings in excess of costs and estimated earnings on uncompleted contracts Notes payable Common shares Retained earnings
$xx 3 xx xx xx $xx
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SOLUTIONS
Multiple Choice Questions 1. d Costs incurred Estimated costs to complete Estimated total project costs Percentage complete $5,400,000 / 16,200,000 Total project revenue Estimated total project costs Estimated total project gross profit Amount to recognize in 20x5 - 33 1/3% 2. c $ 5,400,000 10,800,000 $16,200,000 33 1/3% $18,000,000 16,200,000 1,800,000 $ 600,000
20x2 % of completion: $585,000 / (585,000 + 390,000) = 60% Gross profit to be recognized to the end of 20x2 (including the 20x1 profit): ($1,650,000 585,000 390,000) x 60% = $405,000 20x3: Total profit = $1,650,000 585,000 420,000 = $645,000 Gross profit to be recognized in 20x3: $645,000 405,000 = $240,000 Gross profit recognized to the end of 20x4: % completion = 7,800 / 19,500 = 40% $500,000 x 40% = $200,000 Expected contract loss at end of 20x5 = $1,500,000 Loss to be recognized in 20x5 - $1,500,000 + 200,000 = $1,700,000
3.
4. 5.
c a 2001 % Completion = 780 / (780 + 520) = 780 / 1,300 = 60% Gross profit recognized in 2001 = 2,200 1,300 = 900 x 60% = $540 Gross profit recognized in 2002 = $2,200 1,340 540 = $320
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Problem 1 A. 1. NHRC should recognize revenue on the following bases. The membership fees, which are paid in advance and sold with a money-back guarantee, should be recognized as revenue over the life of the membership. Each month, NHRC earns one-twelfth of the revenue. This results in a liability for the unearned and potentially refundable portion of the fee. For those membership fees that are financed, interest is recognized as time passes at the rate of 15 percent per annum. Court rental fees should be recorded as revenue as the members use the courts. Revenue from the sale of coupon books should be recorded when the coupons are redeemed, i.e., when members attend aerobics classes. At year-end, an adjustment should be made to recognize the revenue from the unused coupons that have expired.
2. Since NHRC has not provided any service when the down payment for equipment is received, the down payment should be treated as a current liability until delivery of the equipment is made. 3. Since NHRC expects to incur costs under the guarantee and these costs can be estimated, an amount equal to 4 percent of the total revenue should be accrued in the accounting period in which the sale is recorded. B. By insisting that the financial statement changes be made, James Hogan has violated the following ethical standards: Competence Hogan has an obligation (1) to perform his professional duties in accordance with relevant technical standards and (2) to prepare complete and clear reports after appropriate analyses of relevant and reliable information. Hogan's proposed changes to the financial statements are not in accordance with generally accepted accounting principles and, therefore, will not result in clear reports based on reliable information.
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Confidentiality Hogan has an obligation to refrain from using or appearing to use confidential information acquired in the course of his work for unethical personal advantage. If Hogan is proposing the accounting changes to increase his year-end bonus, as Sullens believes, he has misused confidential information. Integrity By insisting on making the adjustments to the financial statements to cover up unfavorable information and increase his bonus, Hogan has (1) failed to avoid a conflict of interest, (2) prejudiced his ability to carry out his duties ethically, (3) subverted the attainment of the organization's legitimate and ethical objectives, (4) failed to communicate unfavorable as well as favorable information, and (5) engaged in an activity that discredits his profession. Objectivity Hogan's proposals do not communicate information fairly and objectively nor will they disclose all relevant information that could reasonably be expected to influence an intended user's understanding of the financial statements.
C. Barbara Sullens may wish to speak to Hogan again regarding the GAAP violations to ensure that she understands his position. In order to resolve the situation, Sullens should follow the policies established by NHRC for the resolution of ethical conflicts. If the company does not have such a policy or the policy does not resolve the conflict, Sullens should consider the following course of action: Since her immediate supervisor is involved in the situation, Sullens should take the issue to the next higher managerial level. Sullens need not inform Hogan of this step because of his involvement. If there is no resolution, Sullens should continue to present the problem to successively higher levels of internal review, i.e., audit committee, Board of Directors. Sullens should have a confidential discussion of her options with an objective advisor to obtain a clearer understanding of possible courses of action. After exhausting all levels of internal review without resolution, Sullens may have no other recourse than to resign her position. Upon doing so, she should submit an informative memorandum to an appropriate representative of the organization. Sullens should not communicate with individuals outside of the organization about this situation unless legally prescribed to do so.
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Problem 2 1. Estimated contract cost at completion ($700,000 + $1,400,000) Fixed fee Total contract price Total estimated cost Gross profit Percentage-of-completion ($700,000 / $2,100,000) Gross profit to be recognized ($300,000 x 33-1/3%) 2. Construction-in-progress Miscellaneous credits To record costs incurred. Accounts receivable Billings on contract To record billings. Cash Accounts receivable To record collections. Construction-in-progress Costs of construction revenue Construction revenue 700,000 700,000 $ 2,100,000 300,000 $ 2,400,000 (2,100,000) $ 300,000 33-1/3% $ 100,000
500,000 500,000
300,000 300,000
100,000 700,000 800,000
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Problem 3 (a) 20x1 % of completion = $12,000,000 / (12,000,000 + 38,000,000) = 24% Expected total contract profit = $60,000,000 - 50,000,000 = $10,000,000 Profit recognized in 20x1 = $10,000,000 x 24% = $2,400,000 % of completion = $30,160,000 / (30,160,000 + 27,840,000) = $30,160,000 / 58,000,000 = 52% Expected total contract profit = $60,000,000 - 58,000,000 = $2,000,000 Cumulative profit to be recognized to end of 20x2 = $2,000,000 x 52% = $1,040,000 Loss to be recognized in 20x2 = $1,040,000 - 2,400,000 Cumulative Profit to end of 20x2 = ($1,360,000) % of completion = $45,000,000 / (45,000,000 + 10,555,555) = $45,000,000 / 55,555,555 = 81% Expected total contract profit = $60,000,000 - 55,555,555 = $4,444,445 Cumulative profit to be recognized to end of 20x3 = $4,444,445 x 81% = $3,600,000 Profit to be recognized in 20x3 = $3,600,000 - 1,040,000 Cumulative Profit to end of 20x2 = $2,560,000 % of completion = 100% Actual total contract profit = $60,000,000 - 55,000,000 = $5,000,000 Profit to be recognized in 20x4 = $5,000,000 - 3,600,000 Cumulative Profit to end of 20x3 = $1,400,000 Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable Cost of construction Construction in Process Revenue $12,000,000 $12,000,000 13,000,000 13,000,000 12,000,000 12,000,000 12,000,000 2,400,000 14,400,000
20x2
20x3
20x4
(b)
20x1
Revenue = $60,000,000 x 24% = $14,400,000 Cost of construction = $50,000,000 x 24% = 12,000,000
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20x2
Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable Cost of construction Construction in Process Revenue Revenue = $60,000,000 x 52% = $31,200,000 - 14,400,000 Recognized in 20x1 = $16,800,000 Cost of construction = $58,000,000 x 52% = $30,160,000- 12,000,000 Recognized in 20x1 = $18,160,000
18,160,000 18,160,000 15,500,000 15,500,000 13,500,000 13,500,000 18,160,000 1,360,000 16,800,000
20x3
Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable Cost of construction Construction in Process Revenue
14,840,000 14,840,000 17,000,000 17,000,000 15,000,000 15,000,0000 14,840,000 2,560,000 17,400,000
Revenue = $60,000,000 x 81% = $48,600,000 - 14,400,000 Recognized in 20x1 - 16,800,000 Recognized in 20x2 = $17,400,000 Cost of construction = $55,555,555 x 81% = $45,000,000 - 12,000,000 Recognized in 20x1 - 18,160,000 Recognized in 20x2 = $14,840,000
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20x4
Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable Cost of construction Construction in Process Revenue
10,000,000 10,000,000 14,500,000 14,500,000 15,000,000 15,000,0000 10,000,000 1,400,000 11,400,000
Revenue = $60,000,000 - 14,400,000 Recognized in 20x1 - 16,800,000 Recognized in 20x2 - 17,400,000 Recognized in 20x3 = $11,400,000 Cost of construction = $55,000,000 - 12,000,000 Recognized in 20x1 - 18,160,000 Recognized in 20x2 - 14,840,000 Recognized in 20x2 = $10,000,000 20x5 Cash Accounts Receivable Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable 20x2 Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable 4,500,000 4,500,000 $12,000,000 $12,000,000 13,000,000 13,000,000 12,000,000 12,000,000 18,160,000 18,160,000 15,500,000 15,500,000 13,500,000 13,500,000
(c)
20x1
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20x3
Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable
14,840,000 14,840,000 17,000,000 17,000,000 15,000,000 15,000,0000 10,000,000 10,000,000 14,500,000 14,500,000 15,000,000 15,000,0000 55,000,000 55,000,000 60,000,000 60,000,000
20x4
Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable Cost of construction Construction in Process Billings Revenue
(d)
20x3
The first three entries to CIP, A/R, Billings and Cash are the same as in part (c) and will not be repeated. Contract loss (income statement) Construction in progress 3,000,000 3,000,0000 17,000,000 17,000,000
20x4
Construction in progress Cash, Accounts Payable,
The J/E for A/R and Billings and collections are the same as in part (c). Cost of construction Construction in Process Billings Revenue 59,000,000 59,000,000 60,000,000 60,000,000
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Problem 4 (a) 20x1: % of completion: 1,782 / (1,782 + 3,618) = 33% Gross profit to recognize: $6,600 - 5,400 = 1,200 x 33% = $396 20x2: % of completion: 3,850 / (3,850 + 2,650) = 59% Gross profit to recognize to date: $6,600 - 6,500 = 100 x 59% = $59 Loss to recognize in 20x2: $396 - 59 = $337 20x3: Expected contract loss of $600 Loss to recognize in 20x3: $59 + 600 = $659 % of completion = $6,300 / (6,300 + 900) = 87.5% (b) 20x1 Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable Cost of construction Construction in Process Revenue $1,782,000 $1,782,000 1,200,000 1,200,000 1,000,000 1,000,000 1,782,000 396,000 2,178,000
Revenue = $6,600,000 x 33% = $2,178,000 Cost of construction = $5,400,000 x 33% = 1,782,000 20x2 Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable Cost of construction Construction in Process Revenue 2,068,000 2,068,000 1,900,000 1,900,000 1,800,000 1,800,000 2,053,000 337,000 1,716,000
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Revenue = $6,600,000 x 59% = 3,894,000 - 2,178,000 Recognized in 20x1 = 1,716,000 Cost of construction = $6,500,000 x 59% = 3,835,000 - 1,782,000 Recognized in 20x1 = 2,053,000 20x3 Construction in Process Cash, Accounts Payable, Accounts Receivable Billings Cash Accounts Receivable Cost of construction Construction in Process Revenue 2,450,000 2,450,000 1,900,000 1,900,000 1,700,000 1,700,000 2,540,000 659,000 1,881,000
Revenue = $6,600,000 x 87.5% = 5,775,000 - 2,178,000 Recognized in 20x1 - 1,716,000 Recognized in 20x2 = $1,881,000 Cost of construction = $1,881,000 + 659,000 Loss to be recognized in 20x2 = $2,540,000
(c)
Dandan Inc. Partial Statement of Financial Position As at December 31, 20x2 20x1 Current Assets Construction in progress Costs to date Profits/loss Less billings 20x2 20x3
$1,782,000 396,000 -1,200,000 $ 978,000 $200,000
$3,850,000 59,000 -3,100,000 $ 809,000 $300,000
$6,300,000 -600,000 -5,000,000 $ 700,000 $500,000
Accounts receivable
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Problem 5
(a)
(i)
Completed Contract Project A C D Totals
Revenue to be Reported $475,000 475,000 Revenue to be Reported (Schedule 1) $416,000 134,000 475,000 110,000 425,500 $1,560,500
Costs Incurred $315,000 315,000
Provision for Loss $10,000 5,000 15,000
Income (Loss) to be Reported $(10,000) * 160,000 (5,000) ** 145,000
(ii) Project A B C D E
Costs Incurred $424,000 126,000 315,000 112,750 370,000 $1,347,750
Income (Loss) to be Reported $(10,000) * 8,000 160,000 (5,000) ** 55,500 $208,500
*$520,000 - $530,000. **$200,000 - $205,000. Schedule 1 Project A $424,000 $530,000 $126,000 $630,000 $315,000 $315,000 $112,750 $205,000 $370,000 $400,000 x $520,000 = $416,000
x $670,000 =
134,000
x $475,000 =
475,000
x $200,000 =
110,000
x $460,000 =
425,500 $1,560,500
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(b)
1 - total billings of $1,505,000 less cash collections of $1,365,000 = $140,000 2 - $127,250 - see Schedule 2 3 - $76,000 - see Schedule 2
Schedule 2 Costs and Estimated Earnings or Losses $414,000 134,000 107,750 425,500 $1,081,250 Costs and Estimated Earnings in Excess of Billings $ 64,000 $76,000 37,750 25,500 $127,250
Project A B D E
Related Billings $350,000 210,000 70,000 400,000 $1,030,000
Billings in Excess Estimated Earnings
$76,000
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4.
4.1
Cash
Petty Cash
Most companies have a petty cash account for small-dollar purchases and transactions. Imprest petty cash funds provide a means of paying for small expenditures and purchases evidenced by vouchers or receipts. The size of the fund is limited to relatively small amounts in relation to the size of the organization. The amount is determined by how often the fund is to be replenished, the estimated number of transactions per period, and the average expenditure. The fund is established with a fixed sum and periodically replenished based upon an approved request by the person responsible for administering the fund. The request to bring the fund back to its authorized cash balance is supported by signed vouchers or receipts, which provide control. As an example, assume that Rizzo Industries establishes a petty cash fund for $200 on October 1, 20x8, and makes the following disbursements out of the fund during October: Supplies Postage stamps Delivery charges $ 40 29 100 $169
The journal entries to establish the fund and, subsequently, to replenish it are as follows: Oct 1, 20x8 Petty Cash Cash Supplies expense Postage expense Delivery expense Cash $200 $200 40 29 100 169
Oct 31, 20x8
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4.2
Bank Statement Reconciliation
Each month a bank statement is typically sent to depositors of demand accounts. Upon its receipt, a bank reconciliation of the differences (if any) between the cash balance as shown by the bank and the cash balance reflected on the books of the organization should be made. For most organizations the Cash account has more activity than any other account, making the reconciliation process extremely important, since it helps maintain control of cash. The proper method of reconciliation is to bring both balances up to date, reflecting the correct cash amount, a point at which the book balance and bank balance should be the same. This method highlights the adjustments required to bring the book balance to the true cash position at the date of reconciliation. The book balance also could be reconciled to the bank balance or the bank to the books. Neither of these procedures, however, will provide the correct cash balance at the financial statement date. The following example illustrates a bank reconciliation in which both the bank balance and the book balance are brought to the true cash-available position. To adjust the bank balance, any cheques outstanding are deducted and deposits in transit added. Any errors made by the bank also must be corrected. The most frequent adjustments to the book balance are for bank service charges, interest earned on the account, errors made in the books, and cheques returned by the bank as nonsufficient funds (NSF) checks. These are customer cheques deposited in an account that have been returned to the depositor's bank because they failed to clear the customer's bank. Note that any correction to the book balance requires an adjusting entry to correct the Cash account. Any adjustments to the bank balance will be made by the bank and do not require adjusting entries on the company books. Example : You have been asked to calculate the balance in the Cash account of Tender Footsies Ltd. as at December 31, 20x4, and have been supplied with the following data: A bank statement dated January 31, 20x5, was found with an opening balance on January 1, 20x5, of $12,000 and a closing balance of $15,598. The canceled cheques returned totaled $18,227: $1,888 were dated November 20x5; $13,429, December 20x5; and $2,910, January 20x5. All cheques issued prior to January 20x5 had been cashed by the end of January 20x5. Deposits totaled $32,940 and included: a 30-day promissory note due January 15, 20x5, for $200 plus $26 of interest; a deposit dated December 31, 20x4, for $1,080 relating to accounts collected on that day; and a $500 credit to correct a bank error which occurred in December 20x4. The bank statement also showed one debit, dated January 2, 20x5, for $11,115 which represented the last payment of a bank loan including $115 of interest, and another debit for $8 which represented January's bank charges. None of these amounts had yet been entered in the books of Tender Footsies.
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The bank reconciliation as at December 31, 20x4 would be as follows: Cash in bank, December 31, 20x4 Less outstanding cheques: November December Add outstanding deposit Add bank error Cash per books, December 31, 20x4 $12,000 $ 1,888 13,429
-15,317 1,080 500 $ -1,737
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Multiple Choice Questions 1. In preparing its August 31, 20x5, bank reconciliation, Apex Corp. has available the following information: Balance per bank statement, Aug 31, 20x5 Deposit in transit, Aug 31, 20x5 Return of customer's check for insufficient funds, Aug 31, 20x5 Outstanding cheques, Aug 31, 20x5 Bank service charges for August At August 31, 1995, Apex's correct cash balance is a) $18,550 b) $17,950 c) $17,850 d) $17,550 $18,050 3,250 600 2,750 100
2.
Mork, Ltd. had the following bank reconciliation at July 31, 20x6: Balance per bank statement, July 31, 20x6 Add: Deposit in Transit Less: Outstanding cheques Balance per books, July 31, 20x6 Data per bank for the month of August 20x6 was as follows: Deposits Disbursements $37,200 10,300 (12,600) $34,900
$47,700 49,700
All reconciling items at July 31, 20x6 cleared the bank in August. Outstanding cheques at August 31, 20x6 totalled $5,000. There were no deposits in transit at August 31, 20x6. What is the cash balance per books at August 31, 20x6? a) $30,200 b) $32,900 c) $35,200 d) $40,500
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Problem 1 In comparing the monthly bank statement for J.B. Enterprises with the cash ledger, the following items were found to reconcile the difference: 1) Bank service charge of $8. 2) Cheque #0178 written in payment to a supplier for $175 was inadvertently recorded in the ledger at $157. 3) Three cheques written in the month had not yet cleared the bank. The total amount was $448. 4) The deposit made on the last day of the month for $2,650 was not included on the bank statement. 5) The bank collected a note for $980 which included $80 interest for J.B. Enterprises. 6) A cheque written by J.B. Holdings, a sister company, had been charged against this bank account in the amount of $320. 7) A customer cheque was returned N.S.F. with the bank statement. The cheque had been made out for $28. There was a $5 fee charged by the bank for this. Required a) Prepare a journal entry to record each of the reconciling items where necessary in J.B.'s books. Also indicate where no entry is required. b) If the cash ledger had an unadjusted ending balance of $6,161, what was the ending balance per the bank statement? c) Briefly explain why it is necessary to do a bank reconciliation upon receipt of the bank statement.
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Problem 2 The following information for the month of December 20x6, with respect to cash activities, was gathered by Tressa Ltd.s bookkeeper. Cash balance per books, December 1 Cash received during December Cash payments made during December Cash balance per bank statement, December 31 Cheques outstanding, December 31 Bank service charges for December Deposits in transit at December 31 Cheque issued by Sparg Ltd. deducted from Tressas account in error by the bank A $1,200 cheque received from a customer on December 13 in payment of an account receivable was incorrectly recorded as Required a. b. Prepare the December 20x6 bank reconciliation for Tressa. Prepare any adjusting journal entries that would result from the December 20x6 bank reconciliation. $ 3,700 77,000 77,548 6,300 5,300 52 1,700 580 1,020
Problem 3 The bank statement of Wills Golf Shop indicated a balance of $15,670 at May 31, 20x3. The bank balance did not include a deposit of $4,300 made by Will on May 31. Total outstanding cheques as at May 31 totalled $7,650. In addition, the bank statement revealed the following: i) ii) iii) the bank statement included a cheque in the amount of $500 written out by another local business Jim the Undertaker, service charges of $25 were charged by the bank, cheque # 345 was recorded on the books in the amount of $4,546 was actually written out for $4,456. This cheque was for golf supplies. The correct amount of the invoice was $4,456. a deposit made on May 26 included a cheque from a customer that was returned marked Insufficient Funds. The amount of the cheque was for $630. The bank charged a $10 fee for handling this returned cheque.
iv)
The May 31, 20x3 general ledger balance in the cash account was $13,395. Required Prepare a bank reconciliation as at May 31 for Wills Golf Shop and any adjusting entries required.
SOLUTIONS
Multiple Choice Questions 1. a Balance per statement Add deposit in transit Less Outstanding cheques Balance per books $18,050 3,250 (2,750) $18,550
2.
$34,900 + (47,700 - 10,300) - (49,700 - 12,600 + 5,000) = $30,200
Problem 1 a) 1.
Other expenses Cash Accounts payable Cash No entry required. These cheques have already been recorded. No entry required. This deposit has already been recorded. Cash Note receivable Interest revenue No entry required. Notify bank of error. Accounts receivable Cash
$8 $8 18 18
2.
3. 4. 5.
980 900 80
6. 7.
33 33
b.
Adjusted cash balance = $6,161 - 8 - 18 + 980 - 33 = $7,082 Balance per bank = $7,082 + 448 Outstanding Cheques - 2,650 Outstanding deposits - 320 Bank error = $4,560 The bank reconciliation must be done for control purposes. Any errors made by the bank or the entity should be detected by this process. It also serves to identify any unrecorded transactions regarding cash. When these are identified, the records of the entity can be updated to the correct cash balance.
c.
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Problem 2 a. Cash balance per books, Dec 1 Add cash received during December Less cash payments made during December Cash balance per books, Dec 31, before adjustments Less bank service charges Add error in recording cheque ($1,200 - $1,020) Adjusted cash balance per books, Dec 31 Cash balance per bank, December 31 Add Sparg cheque deducted in error Add deposits in transit Less outstanding cheques Cash balance per books b. Cash Accounts receivable Bank service charges Cash $180 $180 52 52 $3,700 77,000 (77,548) 3,152 (52) 180 $3,280 $6,300 580 1,700 (5,300) $3,280
Problem 3 Adjusting Journal Entries Bank service charges Cash Cash Golf supplies $4,546 4,456 Accounts receivable ($630 + 10) Cash Revised bank balance = $13,395 25 + 90 640 = $12,820 Bank Reconciliation Balance per bank Add: Bank error Deposits in transit Less: Outstanding cheques Balance per books $25 $25 90 90
640 640
$15,670 500 4,300 (7,650) $12,820
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5.
Accounts Receivable
Accounts receivable arises whenever sales are made on account and our credit policy allows customers a certain amount of time before payment is due. The recognition of accounts receivable on the Statement of Financial Position derives from the revenue recognition criteria developed in chapter 3. Once the revenue recognition criteria are applied and it is deemed that we can record the revenue, the offsetting entry is typically to accounts receivable. Consequently, the only accounting issue dealt with in this section is that of the valuation of accounts receivable - specifically, how to calculate the allowance for doubtful accounts and bad debt expense. Accounting standards requires that accounts receivable be recorded at the lower of cost or market. In the case of accounts receivable, we define market to be net realizable value of the receivables (Accounts Receivable less the Allowance for Doubtful Accounts). There are two general theoretical approaches to the recording of bad debts: the direct write-off approach and the allowance method. The direct write-off approach writes off accounts receivable to bad debts when the probability of collecting an account becomes low. There are two problems with this method: (1) it does not meet the lower of cost or market criteria for the recording of accounts receivable in that receivables would be recorded at their gross amount on the Statement of Financial Position and (2) it does not meet the matching principle since accounts could get written off years after the sale was recorded. Consequently, the direct write-off method is not acceptable. The allowance method is in accordance with accounting standards and is the method we will use and elaborate on. There are two distinct ways to apply the allowance method: the Statement of Financial Position approach and the Income Statement approach.
5.1
Statement of Financial Position Approach
The Statement of Financial Position approach involves the estimation of the allowance for doubtful accounts. The allowance for doubtful accounts can be generally estimated in one of three ways: 1. by a review of individual accounts, 2. as a percentage of accounts receivable, 3. by aging the accounts receivable and taking a percentage for each category of receivables as potentially doubtful.
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During the year, any account that has been deemed uncollectible is written off against the allowance for doubtful accounts: Allowance for doubtful accounts Accounts receivable XXX XXX
Any recoveries of accounts previously written off are first recovered by reversing the above entry and then collected: Accounts receivable Allowance for doubtful accounts Cash Accounts receivable XXX XXX XXX XXX
At period-end, the balance in the allowance for doubtful accounts is estimated. A journal entry is written to bring the balance in the account up (or down) to what the desired ending balance should be. The offsetting debit or credit to the journal entry goes to bad debt expense. To summarize: under this approach, we estimate the allowance for doubtful accounts directly and treat the bad debt expense account as a residual (i.e. the bad debt expense amount is not directly calculated). 5.2 Income Statement Approach
The income statement approach estimates the bad debt expense directly and uses the allowance for doubtful accounts as a residual. This method is typically used by companies that offer revolving credit to their customers (VISA, American Express) and therefore cannot properly age their accounts receivable. They will normally estimate bad debts as a percentage of credit sales and credit the amount to the allowance for doubtful accounts. The transactions to record the write-off and recovery of accounts is the same as for the Statement of Financial Position approach. Example 1: All of Tender Footsies sales are on credit. Sales for 20x4 totaled $934,800. Included in the 20x4 sales were $10,000, representing the cost of goods which were sent on consignment during the year. None of these goods had been sold by the end of 20x4. The allowance for doubtful accounts had a balance of $4,540 on December 31, 20x3. During 20x4, Tender Footsies wrote off $14,690 as uncollectible, but collected $3,300 which it had previously written off. The company follows the practice of allowing 2% of net sales as uncollectible. Sales returns for 20x4 were $3,670.
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The Allowance for doubtful accounts at December 31, 20x4 is as follows: Balance, December 31, 20x3 Accounts written off as uncollectible Collection of account previously written off Bad debt expense for the year: ($934,800 -10,000 - 3,670) x 2% Balance, December 31, 20x4 $4,540 (14,690) 3,300 18,423 $11,573
Example 2: As an employee of Dunlop Company, you are provided with the following information: Account Balances as at December 31 Accounts receivable Allowance for doubtful accounts $659,600 Dr. 13,000 Cr.
Sales on credit for the year amounted to $2,500,000. An aging schedule shows the following totals: Number of Days Past Due Total Balance $659,600 Current $325,000 1-30 $177,000 30-60 $72,000 61-90 $65,000 Over 90 $20,600
It is estimated that the following percentage of accounts receivable balances wil1 be uncollectible: Percentage Estimated Uncollectible 2% 4 12 25 50
Number of Days Past Due Current 1-30 31-60 61-90 Over 90
It is assessed that 3 percent of all credit sales during the year will be uncollectible.
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Required: a. (1) Assuming that Dunlop Company uses the aging analysis method, determine the balance required in the Allowance for Doubtful Accounts. Prepare a journal entry to adjust the balance in the Allowance for Doubtful Accounts.
(2)
b.
Assuming that Dunlop Company uses the percentage-of-credit-sales method instead of the aging method, calculate the required addition to the Allowance for Doubtful Accounts as of December 31 and prepare the required entry. Prepare the journal entry to write off the account of Titus Kanbee, who owes the company $1,200.
c.
SOLUTION Part (a) Current: $325,000 x 2% 1-30: $177,000 x 4% 31-60: $72,000 x 12% 61-90: $65,000 x 25% Over 90: $20,600 x 50% $6,500 7,080 8,640 16,250 10,300 $48,770 $35,770 $35,770
Bad Debt Expense ($48,770 13,000) Allowance for Doubtful Accounts
Part (b) Bad debt expense = $2,500,000 x 3% = $75,000 Bad Debt Expense Allowance for Doubtful Accounts $75,000 $75,000
Part (c) Allowance for Doubtful Accounts Accounts Receivable $1,200 $1,200
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Problem 1 Mr. N. Eedy, president of Scotland Corporation, approached Mr. P. L. Enty, manager of Old Halifax Bank, for a loan. After reviewing the December 31, 20x0, financial statements of Scotland Corporation, Mr. P. L. Enty asked for more information since a few things bothered him: (a) Scotland Corporation has its accounts with Old Halifax Bank and the balances of these accounts total the amount reported as cash on the Statement of Financial Position. (b) The accounts receivable balance appears large compared to the previous year. Mr. P. L. Enty requested a copy of the bank reconciliation and an aging schedule of the accounts receivable prior to making a decision as to whether or not the loan should be granted. The bank reconciliation has not been prepared. The total balances in the bank accounts were reported as cash. However, Mr. N. Eedy provided the following data: i) ii) iii) iv) v) vi) Total balances in bank accounts Outstanding cheques Outstanding deposits Bank charges for December Adjusted cash balance per the November 30, 20x0, bank reconciliation The bank had collected a loan receivable for Scotland Corporation and deposited it in December An NSF cheque had been debited to the account by the bank There was an error in the books of Scotland Corporation. A receipt of cash had been credited rather than debited to the cash account $14,349.18 $24,327.16 $3,619.22 $57.02 $2,027.03
$2,000.00 $150.00
vii) viii)
$290.00
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Mr. N. Eedy provided you with the following aging schedule of accounts receivable: Aged Accounts Receivable Days Outstanding December 31, 20x0 Total AB Ltd. CD Ltd. EF Ltd. GH Ltd. IJ Ltd. Others $14,360 22,000 6,900 14,900 2,050 10,600 $70,810 0-30 $12,200 19,360 3,600 4,900 2,350 $42,410 31-60 61-90 $ 2,160 $2,640 $ 1,800 7,500 4,700 $14,000 1,500 2,000 2,050 2,500 $10,210 500 1,050 $4,190 Over 90
Mr. Eedy apologized for the fact that the control account for accounts receivable on the Statement of Financial Position shows $75,500. He assured you that his customers are large well-known companies and that they are good credit risks. Required Mr. P. L. Enty approaches you, as the assistant bank manager, and asks you to determine whether or not the bank should loan $50,000 to Scotland Corporation for a period of 90 days. Include in your reply the current cash balance, your opinion of the accounts receivable and your opinion of Scotland Corporation as a whole.
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Problem 2 The following are transactions affecting accounts receivable for the Jurdi Company during the year ended December 31, 20x5: Total Sales (all credit) Cash collected on account (note that one half of customers took advantage of the trade discount 2/10, net 30) Accounts receivable written off Credit issued to customers for sales returns and allowances Recoveries of accounts receivable written off as uncollectible in prior periods (not include in cash collected above) $620,000
589,050 5,450 14,500
3,400
The following balances were taken from the Balance Sheet dated December 31, 20x4: Accounts receivable Allowance for doubtful accounts $96,400 9,700
The Jurdi Company estimated bad debts to be equal to 0.5% of credit sales net of sales returns and allowances. Required Calculate the Accounts Receivable and Allowance for Doubtful Accounts balance as at December 31, 20x5.
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Problem 3 The Webster Company uses the aging method to estimate the allowance for doubtful accounts. The following schedule of accounts receivable was prepared as at December 31, 20x6: Age 0-30 days 31-60 days 61-90 days 91-120 days Over 120 Days Balance $674,000 186,000 65,400 19,500 7,800 $952,700 % uncollectible 0.5% 1.2% 10% 50% 75%
The balance in the allowance for doubtful accounts at the beginning of the year was $31,150 (cr). The following transactions were recorded during the year: Accounts receivable written off Recoveries of accounts receivable written off as uncollectible in prior periods Required Calculate the bad debt expense for the year 20x6. 34,500
2,300
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Problem 4 The following information pertains to Bedford Company's accounts receivable for the year ended December 31, 20x2: Accounts receivable at January 1 Credit sales for 20x2 Allowance for doubtful accounts at January 1 Collections from 20x2 credit sales Accounts written off August 31 Previously written off accounts received September 20 $ 900,000 5,800,000 55,000 4,900,000 70,000 6,000
An aging analysis estimates uncollectible receivables at December 31, 20x2, to be $80,000. Required: a. b. c. Prepare all relevant journal entries. What is the accounts receivable balance at December 31? What effect did the accounts written off at August 31 have on the net realizable value of accounts receivable?
Problem 5 Any company that has a policy of extending credit when making sales must expect a portion of these sales to become uncollectible. As a result, the company must recognize bad debt expense either as a direct write-off or as an allowance. Required a) Describe the difference between the direct write-off method and the allowance method of recognizing bad debts. b) Are these methods in accordance with GAAP? Discuss the reasons, if any, why one of the above methods would be preferable to the other.
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Problem 6 During the audit of accounts receivable, your client asks why the current year's income statement reports bad debt expense when some accounts may become uncollectible next year. He then said that he had read that financial statements should be based on verifiable, objective evidence, and that it seemed to him to be much more objective to wait until individual accounts receivable were actually determined to be uncollectible before recording them as expenses. Required 1. Discuss the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts. 2. Describe the percentage-of-sales method and the aging method of estimating bad debts. Explain how well each method accomplishes the objectives of the allowance method of accounting for bad debts. 3. Of what merit is your client's contention that the allowance method lacks the objectivity of the direct writeoff method? Discuss in terms of accounting's measurement function.
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SOLUTIONS
Problem 1 Cash Balance Bank Balance Less outstanding cheques Add outstanding deposits Book Balance - Overdraft $14,349.18 (24,327.16) 3,619.22 $(6,358.76)
Other items: Bank charges, loan collection, NSF cheque, book error are already adjusted by using the bank balance. Accounts Receivable The control account does not equal the subledger total. This is an indication of unrecorded sales or errors. Some customers may not be as good of a credit risk as the president believes. GH, for example, and others owe amounts three months past due. Since many accounts are past due, it is an indication that the credit department may not be aggressive enough in its collection policies (or credit applications are not screened). CD, as an example, owes amounts currently in addition to some old amounts. This is an indication of errors or problems in the credit area. Overall, an adjustment for doubtful accounts appears necessary to properly value the accounts receivable. Scotland Corporation The system of internal control does not appear to be functioning properly. There is no bank reconciliation and the control account does not balance to the accounts receivable subledger. The net realizable value of the accounts receivable is much less than $70,810 and there is a bank overdraft on the books of Scotland Corporation. Should the Bank Loan the $50,000? Yes/No. Depends on arguments above.
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Problem 2 Accounts Receivable Balance, January 1, 20x5 Sales Collections ($297,500* x 2) Accounts written off Credits issued to customers Balance, December 31, 20x5 * Let X = one half of sales before cash discount X + 0.98X = $589,050 1.98X = $589,050 X = $297,500 Allowance for doubtful accounts Balance, January 1, 20x5 Accounts written off Account recoveries Bad debt expense: ($620,000 14,500 Sales Returns and Allowances) x 0.5% Balance, December 31, 20x5
$ 96,400 620,000 (595,000) (5,450) (14,500) $101,450
$9,700 (5,450) 3,400 3,027 $10,677
Problem 3 Allowance for doubtful accounts, December 31, 20x6: $674,000 x 0.5% 186,000 x 1.2% 65,400 x 10% 19,500 x 50% 7,800 x 75%
$3,370 2,232 6,540 9,750 5,850 $27,742 $31,150 (34,500) 2,300 1,050 dr. 27,742 cr. $28,792 dr.
Allowance for doubtful accounts, January 1, 20x6 Accounts written off Account recoveries Balance before adjustment for bad debt expense Allowance for doubtful accounts, December 31, 20x6 Bad debt expense
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Problem 4 Part (a) Accounts Receivable Sales Cash Accounts receivable Allowance for doubtful accounts Accounts receivable Accounts receivable Allowance for doubtful accounts Cash Accounts receivable Bad debt expense Allowance for doubtful accounts $5,800,000 $5,800,000 4,900,000 4,900,000 70,000 70,000 6,000 6,000 6,000 6,000 89,000 89,000
Part (b)
900,000 Opening Balance + 5,800,000 Credit Sales - 4,900,000 Collections - 70,000 Write-Offs + 6,000 Recovery - 6,000 Collection on Recovery = $1,730,000 No effect (decreased both the accounts receivable and the allowance)
Part (c)
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Problem 5 a) Direct write-off: i) identify an uncollectible account ii) remove it from the accounts receivable iii) recognize bad debt expense Allowance method: i) estimate bad debts expense by either % of sales or aging of accounts receivable at the end of a period ii) adjust the allowance for doubtful accounts iii) record the bad debt expense iv) when an uncollectible is identified, write it off against the allowance for doubtful accounts In the direct write-off method, the net accounts receivable are reduced when an account is written off; but in the allowance method, the net accounts receivable do not change. In the allowance method, the expense is recognized in the same period as the sales; but in the direct write-off method the expense may be recognized in a different period. b) Allowance method: matches sales in the period with possible bad debts achieves proper carrying value of the accounts receivable (because of the allowance for doubtful accounts) Direct write-off: Write-off and thus bad debt expense occurs in the period in which an account becomes uncollectible and this is not necessarily the same period in which the sale was recorded; therefore the expense and revenue may not be matched. The allowance method is in accordance with GAAP but the direct write-off method may also be if the bad debt expense is not material.
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Problem 6 1. The theoretical superiority of the allowance method over the direct write-off method of accounting for bad debts is twofold. First, because revenue is recognized at the point of sale on the assumption that the resulting receivables are valid liquid assets merely awaiting collection, periodic income will be overstated to the extent of any receivables that eventually become uncollectible. Second, accounts receivable on the Statement of Financial Position should be stated at their estimated net realizable value. The allowance method accomplishes this objective by deducting from gross receivables the allowance for doubtful accounts. 2. THE PERCENTAGE OF SALES METHOD: Under this method bad debt expense is debited and the allowance for uncollectible accounts is credited with a percentage of the current year's credit or total sales. The rate is determined by reference to the relationship between prior years' credit or total sales and actual bad debts arising therefrom. The percentage of sales method of providing for estimated uncollectible receivables is intended to record bad debt expense in the period in which the corresponding sales are recorded. Cumulatively significant errors in the experience rate may result in either an excessive or inadequate balance in the allowance account, however, this method may not accurately report accounts receivable at their estimated net realizable value. This result can be prevented by periodically reviewing and, if necessary, adjusting the balance in the allowance account. The materiality of any such adjustment would govern its treatment for reporting purposes. THE AGING METHOD: Under this method each year's debit to the expense account and credit to the valuation account is determined by an evaluation of the collectibility of open accounts receivable at the close of the year. An analysis of the accounts according to their due dates is the usual procedure. For each of the age categories established in the analysis, average percentage rates may be developed on the basis of past experience and applied to the accounts in the respective age categories. This method may also utilize individual analysis for some accounts, especially those that are considerably past due, in arriving at estimated uncollectible receivables. On the basis of the foregoing analysis the balance in the valuation account is then adjusted to the amount estimated to be uncollectible. This method of providing for uncollectible accounts is quite accurate for purposes of reporting accounts receivable at their estimated net realizable value in the Statement of Financial Position. From the standpoint of the income statement, however, the aging method may not match accurately bad debt expenses with the sales which caused them because the charge to bad debt expense is not based on sales.
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3. A major part of accounting is the measurement of financial data. Changes in value should be recognized as soon as they are measurable in objective terms in order that accounting may provide useful information on a periodic basis. Accountants have had to develop a philosophy regarding an acceptable degree of uncertainty in order to make their work useful. The accountant's term "objectivity" does not imply certainty. Estimates can be objective, though by definition they are not certain. To be considered objective, they must be based on evidence that is reliable and subject to verification by another competent investigator. This kind of criterion permits the preparation of meaningful periodic financial statements through such conventions as the sales method of revenue recognition and the allowance method of accounting for bad debts. The very existence of accounts receivable is based on the decision that a credit sale is an objective indication that revenue should be recognized. The alternative is to wait until the debt is paid in cash. If revenue is to be recognized and an asset recorded at the time of a credit sale, the need for fairness in the statements requires that both expenses and the asset should be adjusted for the estimated amounts of the asset that experience, which is subject to verification by competent investigators, indicates will not be collected.
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6.
Notes Receivable / Payable
A note receivable is usually created in one of the following two ways: a customer with a current account receivable re-negotiates the terms of repayment by agreeing to pay the balance by a specified date. When this happens, the account balance should be removed from accounts receivable and set up as a note receivable: Dr. Notes Receivable Cr. Accounts Receivable XXX XXX
a credit sale is made and the terms of repayment exceed the usual normal credit terms. For example, a furniture company makes a sale and agrees to delay the payment for 18 months. Such a receivable would be classified as a note receivable.
Whether a note receivable is classified as a current or long-term asset depends on the terms of the note receivable. If at the Statement of Financial Position date if the note, or a portion of the note is due within the next 12 months, then it is classified as current. Otherwise, it is classified as long-term. Notes receivable are usually interest bearing. If the amount of interest charged is equal to or above the imputed interest rate (defined on the next page), the note gets recorded at its face value and the interest gets recorded as it accrues. Example 1: On January 2, 20x0 you sell equipment to one of your customers. The value of the sale is $10,000 and you agree to take back a note receivable for two years. Interest of 10% (equal to the imputed interest rate) is charged on the note and is payable on December 31 of each year. The note is repayable on December 31, 20x1. Given that the interest rate on the note is equal to market interest rates, the note would get recorded as follows: Jan 1, 20x0 Note Receivable Sales $10,000 $10,000
The following journal entries will record the remaining transactions: Dec 31, 20x0 Cash Interest Revenue Cash Note Receivable Interest Revenue $1,000 $1,000 $11,000 $10,000 1,000
Dec 31, 20x1
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The complication arises when the interest rate on the note receivable is less than the imputed interest rate. In this case, the note receivable gets recorded at the sum of the discounted cash flows to be received on the note receivable. The cash flows are discounted at the imputed rate of interest. The imputed rate of interest is the more clearly determinable of the following two rates: (a) the prevailing rate for a similar instrument of an issuer with a similar credit rating, or (b) a rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods or services. (IAS 18.11) Note that when establishing an imputed rate of interest for a note receivable, the imputed interest rate in part (a) above is based on the credit rating of your customer. For a note payable, it would be based on your own credit rating. Example 2: Assume that in example 1, the seller of equipment agrees to only charge 4% interest on the note. The discounted value of the note is calculated as follows: N 2 I/Y 10 PV X= 8,959 PMT 400 FV 10000
Enter Compute
The note would get recorded as follows: Jan 1, 20x0 Note Receivable Sales $8,959 $8,959
On December 31, 20x0, the interest revenue on the note will be equal to the carrying value of the note times the market rate of interest: $8,959 x 10% = $896. The difference between the interest revenue of $896 and the interest of $400 received increases the carrying value of the note: Dec 31, 20x0 Cash Note receivable Interest Revenue $400 496 $896
On December 31, 20x1, the interest revenue on the note will be equal to the carrying value of the note times the market rate of interest: ($8,959 +$ 496) = $9,455 x 10% = $945. The difference between the interest revenue of $945 and the interest of $400 received increases the carrying value of the note: Dec 31, 20x1 Cash Note Receivable Interest Revenue $400 545 $945
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Note that the carrying value of the note is now: $9,455 + $545 = $10,000. The journal entry to record the receipt of the principal amount of the note is as follows: Dec 31, 20x1 Cash Note Receivable $10,000 $10,000
To summarize, whenever you have a note receivable (or payable) whose interest rate is less than the market interest rate, you first determine the cash flows that are expected from the note receivable and then discount these cash flows at the market rate of interest. Note that the methodology used to calculate the interest revenue and the related increase in the note receivable on the above example is called the effective interest method. This method is required by IFRS. Example 3: assuming the same information as for Example 2, but assume instead that the best measure of the imputed interest rate is based on the cash price of the equipment sold of $9,200. The note would get recorded as follows: Jan 1, 20x0 Note Receivable Sales $9,200 $9,200
In order to calculate the interest revenue, we need to determine the imputed interest rate: N 2 I/Y I/Y = 8.518% PV -9,200 PMT 400 FV 10000
Enter Compute
On December 31, 20x0, the interest revenue on the note will be equal to the carrying value of the note times the market rate of interest: $9,200 x 8.518% = $784. The difference between the interest revenue of $784 and the interest of $400 received increases the carrying value of the note: Dec 31, 20x0 Cash Note receivable Interest Revenue $400 384 $784
On December 31, 20x1, the interest revenue on the note will be equal to the carrying value of the note times the market rate of interest: ($9,200 +$384) = $9,584 x 8.518% = $816. The difference between the interest revenue of $816 and the interest of $400 received increases the carrying value of the note:
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Dec 31, 20x1
Cash Note Receivable Interest Revenue
$400 416 $816
Note that the carrying value of the note is now: $9,584 + $416 = $10,000. The journal entry to record the receipt of the principal amount of the note is as follows: Dec 31, 20x1 Cash Note Receivable $10,000 $10,000
Accounting Standards for Private Enterprises (ASPE) As discussed in chapter 3, private enterprises following ASPE have two choices with regards to the accrual of interest expense/revenues on discounted notes. They can opt to use the effective interest rate method or any other method of systematic allocation of the discount which will typically be the straight line method. No specific guidance is given on how the imputed rate is determined, so we will use the same approach as for IFRS. Example 4: In December 31, 20x3 you sell equipment to a customer. The terms of payment require that the face value of the note of $200,000 is payable on December 31, 20x7. You estimate that an appropriate discount rate for this note is 8%. You are a private enterprise and are following ASPE. You account for discounts on notes using the straight line method. The present value of the note is: N 4 I/Y 8% PV PV = $147,006 PMT FV 200,000
Enter Compute
The journal entries for the duration of the term of the note would be as follows: Dec 31, 20x3 Note Receivable Sales Note Receivable Interest Revenue Discount on note = $200,000 - 147,006 = $52,994 / 4 = $13,248 $147,006 $147,006 13,248 13,248
Dec 31, 20x4
The journal entries for 20x5 - 20x7 will be the same. After the 4th entry at the end of 20x7, the balance of the note receivable account will be $200,000.
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Appendix Using your Financial Calculator The format for solutions using a financial calculator used throughout this module and other Accelerated Program modules is as follows: N 5 I/Y 6 PV X PMT FV 1000
Enter Compute
In the above example, we are trying the calculate the present value of $1,000 to be received in 5 years from now at an interest rate of 6%. If you are using the Texas Instruments BA II Plus, you need to do the following: set the calculator to accept one payment per year as follows: 1 2ND N You only need to do this once. clear the Time Value of Money memory as follows: 2ND FV You should do this every time you do a time value of money calculation. enter the numbers above in the TVM memory registers to solve, press CPT and the TVM register you are attempting to solve for, in this case PV the answer provided is -747.26. This means that if you were to invest $747.26 today (money out of pocket and therefore the negative sign) and invest it for 5 years at 6% compounded annually, the amount would grow to $1,000. If you are using the Hewlett Packard 10BII, you need to do the following: set the calculator to accept one payment per year as follows: 1 then Orange Button then PMT You only need to do this once. clear the Time Value of Money memory as follows: Orange Button C ALL You should do this every time you do a time value of money calculation. enter the numbers above in the TVM memory registers to solve, press the TVM register you are attempting to solve for, in this case PV the answer provided is -747.26. This means that if you were to invest $747.26 today (money out of pocket and therefore the negative sign) and invest it for 5 years at 6% compounded annually, the amount would grow to $1,000.
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Unless otherwise indicated, assume that the effective interest rate method is used.
Problem 1 Present Value Exercises a. b. c. You just came into some money - $50,000 and want to invest it for 12 years at 6%. How much will you have in 12 years? You plan to deposit $5,000 in your RRSP each year for the next 30 years. The first payment will be in one year from now. How much will accumulate if i=7%? Continuation of part (b). It is now 30 years later and you have $472,303.93 in your RRSP account. You expect to live another 30 years - how much can you withdraw each year? Assume that the interest rate is still 7%. Continuation of part (b). It is now 30 years later, you are wondering what the purchasing power of $38,061.28 is compared to 30 years ago. You find out that the average inflation rate for the past 30 years was 2.5%. You need to purchase a vehicle costing $70,000. The dealership is offering you 4.9% on a 5 year loan. What is your annual loan payment? Continuation of part (e). You purchased the car and have just made your 3rd loan payment. What is the balance of your loan?
d.
e. f.
Problem 2 The Low Quality Furniture Company allows you to purchase $5,000 of furniture on the following terms: i. 0% down, no interest for 2 years, full $5,000 to be repaid in 2 years ii. 50% down, no interest for 3 years, balance of $2,500 to be repaid in 3 years iii. 0% down, no interest for 5 years, required annual repayments of $1,000 at the end of each year for 5 years iv. 0% down, annual interest repayments of 5% for 4 years, balance payable at the end of 4 years v. 0% down, annual payments of $1,200 per year for 5 years. vi. Assume now that the Low Quality Furniture Company is subject to ASPE and has opted to amortize discounts on the straight-line method. Redo (i) on this basis. Assuming an imputed rate of 8%, and assuming that each of the above situation is independent, prepare all journal entries made by the store for each of the situations for all years in question.
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Problem 3 The Bertolo Corporation sold equipment with a list price of $50,000 to Chan Ltd. on the following terms: $5,000 payable on December 31, 20x1 (the day the equipment was delivered) and four payments of $11,250 payable on December 31 of each year starting on December 31, 20x2. The cash price of the equipment is $43,106. Required Prepare all journal entries for the Bertolo Corporation for the years ended December 31, 20x1 through to December 31, 20x3.
Problem 4 On December 31, 20x2, Kyle Corporation sold for $30,000 an old machine having an original cost of $50,000 and a book value of $12,000. The terms of the sale were as follows: a) $10,000 down payment. b) $10,000 payable on December 31 for each of the next two years. The agreement of sale made no mention of interest; however, 10 percent would be a fair rate for this type of transaction. Required 1. Prepare the entry to record the sale on December 31, 20x2. 2. Prepare the entry to record the receipt of $10,000 on December 31, 20x3 and on December 31, 20x4.
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Problem 5 Linden, Inc., had the following long-term receivable account balances at December 31, 20x2: Note receivable from sale of division Note receivable from officer $1,500,000 400,000
Transactions during 20x3 and other information relating to Linden's long-term receivables were as follows: a) The $1.5 million note receivable is dated May 1, 20x2, bears interest at 9 percent, and represents the balance of the consideration received from the sale of Linden's electronics division to Pitt Company. Principal payments of $500,000 plus appropriate interest are due on May 1, 20x3, 20x4, and 20x5. The first principal and interest payment was made on May 1, 20x3. Collection of the note instalments is reasonably assured. b) The $400,000 note receivable is dated December 31, 20x0, bears interest at 8 percent, and is due on December 31, 20x5. The note is due from Robert Finley, president of Linden, Inc., and is collateralized by 10,000 of Linden's common shares. Interest is payable annually on December 31 and all interest payments were paid on their due dates through December 31, 20x3. The quoted market price of Linden's common shares was $45 per share on December 31, 20x3. c) On April 1, 20x3, Linden sold a patent to Bell Company in exchange for a $100,000 noninterest-bearing note due on April 1, 20x5. There was no established exchange price for the patent, and the note had no ready market. The prevailing rate of interest for a note of this type at April 1, 20x3, was 15 percent. The patent had a carrying value of $40,000 at January 1, 20x3, and the amortization for the year ended December 31, 20x3, would have been $8,000. The collection of the note receivable from Bell is reasonably assured. d) On July 1, 20x3, Linden sold a parcel of land to Carr Company for $200,000 under an instalment sale contract. Carr made a $60,000 cash down payment on July 1, 20x3, and signed a four-year, 16 percent note for the $140,000 balance. The equal annual payments of principal and interest on the note will be $50,000 payable on July 1, 20x4, through July 1, 20x7. The land could have been sold at an established cash price of $200,000. The cost of the land to Linden was $150,000. Circumstances are such that the collection of the instalments on the note is reasonably assured. Required 1. Prepare the long-term receivables section of Linden's Statement of Financial Position at December 31, 20x3.
2. Prepare a schedule showing the current portion of the long-term receivables and accrued interest receivable that would appear in Linden's Statement of Financial Position at December 31, 20x3. 3. Prepare a schedule showing interest revenue from the long-term receivables and gains recognized on sale of assets that would appear on Linden's income statement for the year ended December 31, 20x3. Problem 6 On January 2, 20x1, the Harry Company acquired a truck with a list price of $500,000. The Harry Company's incremental borrowing rate is 8% (imputed rate). Assume that the truck manufacturer is offering Harry the following terms (each situation is independent). For each of the terms, prepare the journal entries for the life of the note. Assume a December 31 year end. a) Harry Company has to make equal annual payments of principal and interest over five years. Payments are due on December 31 of every year. The interest rate charged is 10%. Harry Company pays the $500,000 in three years. No interest is charged on the note. Harry Company pays the $500,000 in three years. Interest of 3% is charged on the note payable on December 31 of every year. Harry Company pays $100,000 on the principal at the end of every year. No interest is charged. Harry Company pays $100,000 on the principal at the end of every year. Interest of 4% is charged on the balance. Harry Company has to make equal annual payments of principal and interest over five years. The interest rate charged is 4%.
b) c) d) e) f)
Problem 7 Business transactions often involve the exchange of property, goods, or services for notes or similar instruments that may stipulate no interest rate or an interest rate that varies from prevailing rates. Required 1. When a note is received in exchange for property, goods, or services, what value should be placed on the note if it bears interest at a reasonable rate and is issued in a bargained transaction? If it bears no interest or is not issued in a bargained transaction? Explain. 2. If the recorded value of a note differs from the face value, how should the difference be accounted for? How should this difference be presented in the financial statements? Explain.
Problem 8 On April 1, 20x3 the Apex Company sold used equipment for proceeds of $500,000 to the Johnson Company. The terms of payment are as follows: $50,000 on April 1, 20x3 $100,000 on April 1, 20x4 $150,000 on April 1, 20x5, and $200,000 on April 1, 20x6.
Interest of 2% is payable each April 1st based on the loan balance outstanding over the previous year (i.e. interest of $450,000 x 2% = $9,000 is payable on April 1, 20x4). The equipment was acquired by the Apex Company on January 1, 20x0 for $700,000, had an estimated useful life of 10 years and a salvage value of $50,000. The Apex Company uses the diminishing balance method of depreciation at a rate of 20% and has a December 31 year end. The Apex Companys incremental borrowing rate is 8%. Depreciation expense is recorded at the end of the year only. Required Prepare all journal entries relative to this transaction for the years 20x3 to 20x6.
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SOLUTIONS
Problem 1 a. b. c. d. e. f. N = 12, I = 6, PV = 50000, Solve for FV = 100,609.82 N = 30, I = 7, PMT = 5000, Solve for FV = 472,303.93 N = 30, I = 7, PV = 472303.93, Solve for PMT = 38,061.28 N = 30, I = 2.5, FV = 38061.28, Solve for PV = 18,145.44 N = 5, I = 4.9, PV = 70000, Solve for PMT = 16,123.57 N = 2, I = 4.9, PMT = 16123.57, Solve for PV = 30,022.87
Problem 2 Part (i) PV of note: N 2 I/Y 8 PV X= 4,287 PMT FV 5000
Enter Compute
Initial
Note receivable Sales Note Receivable Interest revenue (4,287 x 8%) Note Receivable Interest Revenue (4,287 + 343) x 8% Cash Note receivable
$4,287 $4,287 343 343 370 370 5,000 5,000
End Yr 1
End Yr 2
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Part (ii) PV of note: N 3 I/Y 8 PV X= 1,985 PMT FV 2500
Enter Compute
Initial
Note receivable Cash Sales Note Receivable Interest revenue (1,985 x 8%) Note Receivable Interest Revenue (1,985 + 159) x 8% Note Receivable Interest Revenue (1,985 + 159 + 172) x 8% Cash Note receivable
$1,985 2,500 $4,485 159 159 172 172 185 185 2,500 2,500
End Yr 1
End Yr 2
End Yr 3
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Part (iii) PV of note: N 5 I/Y 8 PV X= 3,993 PMT 1000 FV
Enter Compute
Initial
Note receivable Sales Cash Note Receivable Interest revenue (3,993 x 8%) Cash Note Receivable Interest revenue (3,993 - 681) = 3,312 x 8% Cash Note Receivable Interest revenue (3,312 - 735) = 2,577 x 8% Cash Note Receivable Interest revenue (2,577 - 794) = 1,783 x 8% Cash Note Receivable Interest revenue (1,783 - 857) = 926 x 8%
$3,993 $3,993 1,000 681 319 1,000 735 265 1,000 794 206 1,000 857 143 1,000 926 74
End Yr 1
End Yr 2
End Yr 3
End Yr 4
End Yr 5
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Part (iv) PV of note: N 4 I/Y 8 PV X= 4,503 PMT 250 FV 5000
Enter Compute
Initial
Note receivable Sales Cash Note Receivable Interest revenue (4,503 x 8%) Cash Note Receivable Interest revenue (4,503 + 110) = 4,613 x 8% Cash Note Receivable Interest revenue (4,613 + 119) = 4,732 x 8% Cash Note Receivable Interest revenue (4,732 + 129) = 4,861 x 8% Cash Note Receivable
$4,503 $4,503 250 110 360 250 119 369 250 129 379 250 139 389 5,000 5,000
End Yr 1
End Yr 2
End Yr 3
End Yr 4
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Part (v) PV of note: N 5 I/Y 8 PV X= 4,791 PMT 1200 FV
Enter Compute
Initial
Note receivable Sales Cash Note Receivable Interest revenue (4,791 x 8%) Cash Note Receivable Interest revenue (4,791 - 817) = 3,974 x 8% Cash Note Receivable Interest revenue (3,974 - 882) = 3,092 x 8% Cash Note Receivable Interest revenue (3,092 - 953) = 2,139 x 8% Cash Note Receivable Interest revenue (2,139 - 1,029) = 1,110 x 8%
$4,791 $4,791 1,200 817 383 1,200 882 318 1,200 953 247 1,200 1,029 171 1,200 1,111 89
End Yr 1
End Yr 2
End Yr 3
End Yr 4
End Yr 5
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Part (vi) PV of note: N 2 I/Y 8 PV X= 4,287 PMT FV 5000
Enter Compute
Initial
Note receivable Sales Note Receivable Interest revenue ($5,000 - 4,287) / 2 Note Receivable Interest Revenue Cash Note receivable
$4,287 $4,287 356 356 357 357 5,000 5,000
End Yr 1
End Yr 2
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Problem 3 The first step is to determine the imputed interest rate. Note that the PV amount is equal to the cash price of $43,106 less the initial deposit of $5,000. N 4 I/Y X = 7% PV -38,106 PMT 11,250 FV
Enter Compute
Dec 31, 20x1
Note receivable Cash Sales Cash Note receivable Interest revenue ($38,106 x 7%) Cash Note receivable Interest revenue ($38,106 - 8,583) x 7%
$38,106 5,000 $43,106 11,250 8,583 2,667 11,250 9,184 2,067
Dec 31, 20x2
Dec 31, 20x3
Problem 4 1. Cash Note receivable* Accumulated depreciation ($50,000 - $12,000) Machine Gain on sale of machine * N=2, i=10, PMT=10000, solve for PV = 17,355 2. Dec 31, 20x3 Cash Interest revenue ($17,355 x 10%) Note receivable Cash Interest revenue ($17,355 - 8,264) x 10% Note receivable 10,000 1,736 8,264 10,000 909 9,091 $10,000 17,355 38,000 $50,000 15,355
Dec 31, 20x4
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Problem 5 1. Long-term receivables: 9% note receivable from sale of division, due in annual installments of $500,000 to May 1, 20x5, less current portion 8% note receivable from officer, due December 31, 20x5, collateralized by 10,000 shares of Linden, Inc., common shares with a fair market value of $450,000 Non-interest-bearing note from sale of patent, net of 15% imputed interest, due April 1, 20x5 Installment contract receivable, due in annual installments of $50,000 to July 1, 20x7, less current installment Total long-term receivables .
$ 500,000 (1)
400,000 84,121 (2) 112,400 (3) $1,096,521
2. Current portion of long-term receivables: Note receivable from sale of division Installment contract receivable Total current portion of long-term receivables Accrued interest receivable: Note receivable from sale of division Installment contract receivable Total accrued interest receivable 3. Interest income: Note receivable from sale of division Note receivable from sale of patent Note receivable from officer Installment contract receivable from sale of land Total interest income Gains on sale of assets: Patent Land Total gains on sale of assets Total interest income and gains
$ 500,000 (1) 27,600 (3) $527,600 $ 60,000 (4) 11,200 (5) $ 71,200
$ 105,000 8,507 32,000 11,200 $ 156,707
(6) (2) (7) (5)
$ 37,614 (8) 50,000 (9) $ 87,614 $ 244,319
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Explanations of amounts: (1) Long-term portion of 9% note receivable at Dec 31, 20x3: Face value Less installment received, May 1, 20x3 Balance, December 31, 20x3 Less installment due May 31, 20x4 (current portion) Long-term portion, December 31, 20x3 Non-interest bearing note, net of imputed interest at December 31, 20x3: Discounted value of note: N = 2, I = 15, FV = 100000, solve for PV: Add: Interest earned to December 31, 20x3 $75,615 x 15% x 9/12 Balance, December 31, 20x3 Long-term portion of installment contract receivable at December 31, 20x3 Contract selling price, July 1, 20x3 Less: Down payment, July 1, 20x3 Balance December 31, 20x3 Less: Installment due, July 1, 20x4 [$50,000 - ($140,000 x 16%)] Long-term portion, December 31, 20x3 Accrued interest--note receivable, sale of division, at December 31, 20x3: Interest accrued from May 1, 20x3 to Dec 31, 20x3: $1,000,000 x 9% x 8/12 Accrued interest--installment contract at Dec 31, 20x3: Interest accrued from July 1, 20x3 to Dec 31, 20x3 $140,000 x 16% x 1/2 Interest income--note receivable, sale of division, Interest earned from Jan 1, 20x3 to Apr 30, 20x3 $1,500,000 x 9% x 4/12 Interest earned from May 1, 20x3 to Dec 31, 20x3 (#4 above) Interest income Interest income--note receivable from officer: 400,000 x 8%
$1,500,000 (500,000) $1,000,000 (500,000) $ 500,000
(2)
$75,614 8,507 $ 84,121
(3)
$ 200,000 (60,000) $ 140,000 (27,600) $ 112,400
(4)
$ 60,000
(5)
$ 11,200
(6)
$ 45,000 60,000 $ 105,000
(7)
$ 32,000
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(8)
Gain on sale of patent: Selling price (part 2) Less: Cost of patent (net): Carrying value Jan 1, 20x3 Less: Amortization Jan 1, 20x3 to Apr 1, 20x3 $8,000 x 1/4
$ 75,614 $40,000 (2,000) (38,000) $ 37,614
(9)
Gain on sale of land: Selling price Less cost
$ 200,000 (150,000) $ 50,000
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Problem 6
a)
Annual payment: N = 5, I = 10, PV = 500000, solve for PMT = $131,899 Since the rate implied in the note is higher than the company's incremental borrowing rate, we do not discount the cash flows of the note at the incremental borrowing rate. Jan 2, 20x1 Equipment Note payable Interest expense ($500,000 x 10%) Note payable Cash Interest expense ($418,101* x 10%) Note payable Cash * $500,000 - 81,899 Interest expense ($328,012* x 10%) Note payable Cash * $418,101 - 90,089 Interest expense ($228,914* x 10%) Note payable Cash * $328,012 - 99,098 Interest expense ($119,906* x 10%) Note payable Cash * $228,914 109,008 ** difference due to rounding $500,000 $500,000
Dec 31, 20x1
50,000 81,899 131,899
Dec 31, 20x2
41,810 90,089 131,899
Dec 31, 20x3
32,801 99,098 131,899
Dec 31, 20x4
22,891 109,008 131,899
Dec 31, 20x5
11,993** 119,906 131,899
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b)
PV of note: N = 3, I = 8, FV = 500000, Solve for PV = $396,916 Jan 2, 20x1 Equipment Note payable Interest expense ($396,916 x 8%) Note payable Interest expense ($396,916 + 31,753) = $428,669 x 8% Note payable Interest expense ($428,669 + 34,294) x 8% Note payable Note payable Cash $396,916 $396,916
Dec 31, 20x1
31,753 31,753
Dec 31, 20x2
34,294 34,294
Dec 31, 20x3
37,037 37,037 500,000 500,000
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c)
PV of note : N = 3, I = 8, PMT = 15000, FV = 500000, Solve for PV = $435,573 Jan 2, 20x1 Equipment Note payable Interest expense ($435,573 x 8%) Cash Note payable Interest expense ($435,573 + 19,846) = $455,419 x 8% Cash Note payable Interest expense ($455,419 + 21,434) = $476,853 x 8% Cash Note payable Note payable Cash $435,573 $435,573
Dec 31, 20x1
34,846 15,000 19,846
Dec 31, 20x2
36,434 15,000 21,434
Dec 31, 20x3
38,147* 15,000 23,147 500,000 500,000
* rounded to balance
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d)
PV of note: N = 5, I = 8, PMT = 100000, Solve for PV = $399,271 Jan 2, 20x1 Equipment Note payable Interest expense ($399,271 x 8%) Note payable Cash Interest expense ($399,271 - 68,058) = $331,213 x 8% Note payable Cash Interest expense ($331,213 - 73,503) = 257,710 x 8% Note payable Cash Interest expense ($257,710 - 79,383) = $178,327 x 8% Note payable Cash Interest expense ($178,327 - 85,734) = $92,593 x 8% Note payable Cash $399,271 $399,271
Dec 31, 20x1
31,942 68,058 100,000
Dec 31, 20x2
26,497 73,503 100,000
Dec 31, 20x3
20,617 79,383 100,000
Dec 31, 20x4
14,266 85,734 100,000
Dec 31, 20x5
7,407 92,593 100,000
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e)
Interest in 20x1 = $500,000 x 4% = $20,000 20x2 = $400,000 x 4% = $16,000 20x3 = $300,000 x 4% = $12,000 20x4 = $200,000 x 4% = $8,000 20x5 = $100,000 x 4% = $4,000 PV of note: 20x1: N = 1, I = 8, FV = 20,000, Solve for PV = 20x2: N = 2, I = 8, FV = 16,000, Solve for PV = 20x3: N = 3, I = 8, FV = 12,000, Solve for PV = 20x4: N = 4, I = 8, FV = 8,000, Solve for PV = 20x5: N = 5, I = 8, FV = 4,000, Solve for PV = Principal annuity: N = 5, I = 8, PMT = 100,000, Solve for PV =
$18,518.52 13,717.42 9,525.99 5,880.24 2,722.33 399,271.00 $449,636.00
Jan 2, 20x1
Equipment Note payable Interest expense ($449,636 x 8%) Note payable Cash Interest expense ($449,636 - 84,029) = $365,607 x 8% Note payable Cash Interest expense ($365,607 - 86,751) = $278,856 x 8% Note payable Cash Interest expense ($278,856 - 89,692) = $189,164 x 8% Note payable Cash Interest expense ($189,164 - 92,867) = $96,297 x 8% Note payable Cash
$449,636 $449,636 35,971 84,029 120,000
Dec 31, 20x1
Dec 31, 20x2
29,249 86,751 116,000
Dec 31, 20x3
22,308 89,692 112,000
Dec 31, 20x4
15,133 92,867 108,000
Dec 31, 20x5
7,703 96,297 104,000
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f)
Annual payment: N = 5, I = 4, PV = 500000, Solve for PMT = $112,314 PV of note: N = 5, I = 8, PMT = 112314, Solve for PV = $448,437 Jan 2, 20x1 Equipment Note payable Interest expense ($448,437 x 8%) Note payable Cash Interest expense ($448,437 76,439) = $371,998 x 8% Note payable Cash Interest expense ($371,998 82,554) = $289,444 x 8% Note payable Cash Interest expense ($289,444 89,158) = $200,286 x 8% Note payable Cash Interest expense ($200,286 96,291) = $103,995 x 8% Note payable Cash $448,437 $448,437
Dec 31, 20x1
35,875 76,439 112,314
Dec 31, 20x2
29,760 82,554 112,314
Dec 31, 20x3
23,156 89,158 112,314
Dec 31, 20x4
16,023 96,291 112,314
Dec 31, 20x5
8,319 103,995 112,314
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Problem 7 1. A note received in exchange for property, goods, or services should be recorded at its present value, which is presumably the value of the property exchanged. In the case of a note bearing interest at a reasonable rate and issued in an arm's-length transaction, the face value of the note should be used, as explained below. A note received for property, goods, or services represents two elements, which may or may not be stipulated in the note: (a) the principal amount, equivalent to the cash exchange price of the property, goods, or services as established between the seller and the buyer and (b) an interest factor to compensate the seller over the life of the note for the use of funds he would have received in a cash transaction at the time of the exchange. Notes so exchanged are accordingly valued and accounted for at the present value of the consideration exchanged between the contracting parties at the date of the transaction in a manner similar to that followed for a cash transaction. When a note is exchanged for property, goods, or services in a bargained transaction entered into at arm's length, there is a presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the seller for the use of the related funds. In these circumstances the note's present value is identical with its face value. Furthermore, where the rate of interest is reasonable and separately stated, the face value of the note is equal to the bargained exchange price for the property. When a note bears no interest (or has a stated interest rate that differs sharply from the prevailing rate and/or is not issued in an arm's-length transaction), the present value must be determined through consideration of the economic substance of the transaction. The note and the sales price of the property, goods, or services exchanged for the note should be recorded at the fair value of the property, goods, or services or at an amount that reasonably approximates the present value of the note, whichever is the more clearly determinable. That amount may or may not be the same as the face amount; any resulting discount or premium should be accounted for as an element of interest over the life of the note. In the absence of established exchange prices for the related property, goods, or services or evidence of the market value of the note, the present value of a note that stipulates no interest (or a rate of interest that differs sharply from the prevailing rate) should be determined by discounting all future payments on the note, using an imputed (implicit) rate of interest. 2. If the recorded value of a note differs from its face value, the difference is amortized as interest over the life of the note in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. This method is the "effective interest" method.
Problem 8 The first step is to calculate the cash flows that will be generated by this note. April 1, 20x3 - $50,000 April 1, 20x4 - $100,000 + $9,000 of interest = $109,000 April 1, 20x5 - $150,000 + $7,000($350,000 x 2%) of interest = $157,000 April 1, 20x6 - $200,000 + $4,000($200,000 x 2%) of interest = $204,000 The next step is to discount these cash flows at April 1, 20x3 at the incremental borrowing rate of 8%: Present Value $ 50,000 100,926 134,602 161,942 $447,470
Cash Flow of April 1, 20x3 April 1, 20x4 April 1, 20x5 April 1, 20x6
N = 1, I = 8, FV = $109,000 N = 2, I = 8, FV = $157,000 N = 3, I = 8, FV = $204,000
The net book value of the equipment sold at December 31, 20x2 is: $700,000 x 0.803 = $358,400 Depreciation for the period Jan 1, 20x3 to April 1, 20x3 = $358,400 x 20% x 3/12 = $17,920 Net book value of the equipment on April 1, 20x3 = $358,400 17,920 = $340,480 Journal Entries Apr 1, 20x3 Depreciation expense Accumulated Depreciation Cash Note receivable Accumulated depreciation Equipment Gain on sale of equipment Dec 31, 20x3 Interest receivable Interest revenue $397,470 x 8% x 9/12 $17,920 $17,920 50,000 397,470 359,520 700,000 106,990 23,848 23,848
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Apr 1, 20x4
Cash Interest receivable Interest revenue ($397,470 x 8% x 3/12) Note receivable Interest receivable Interest revenue ($397,470 - 77,203) = 320,267 x 8% x 9/12 Cash Interest receivable Interest revenue ($320,267 x 8% x 3/12) Note receivable Interest receivable Interest revenue ($320,267 - 131,379) = 188,888 x 8% x 9/12 Cash Interest receivable Interest revenue ($188,888 x 8% x 3/12)* Note receivable
* difference due to rounding
109,000 23,848 7,949 77,203 19,216 19,216
Dec 31, 20x4
Apr 1, 20x5
157,000 19,216 6,405 131,379 11,333 11,333
Dec 31, 20x5
Apr 1, 20x6
204,000 11,333 3,779 188,888
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7.
Inventory
Inventory is defined as assets (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. (IAS 2.6) 7.1 Cost of Inventories
The cost of inventories is measured at the lower of cost and net realizable value (IAS 2.9). Cost is defined as all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition (IAS 2.10). Costs of purchase would include the purchase price, import duties, transport, handling and any other costs directly attributable to the purchase of inventory. Any trade discounts or rebates should be deducted against the cost of inventory. Costs of conversion refer to a manufacturing environment and will be explored in detail in Segment 2 (on Management Accounting) of this program. The following are the requirements for the financial reporting of any work-in-process or finished goods manufactured inventories: the allocation of fixed production overhead to inventory should be based on normal capacity, normal capacity is defined as the production expected to be achieved over a number of periods under normal circumstances; unallocated overhead is recognized as an expense in the period in which it is incurred; and variable overhead is allocated to inventory on the basis of the actual use of production facilities. Goods in transit - following the general rule that title to the merchandise is evidence of ownership, any goods in transit belong to whomever has title or legal ownership. When merchandise is in transit between buyer and seller, title or legal ownership is dependent on the shipping terms between the buyer and seller. If the goods are shipped F.O.B. shipping point, title passes to the buyer at the time the goods are loaded on the common carrier. The buyer assumes the responsibilities of ownership, including freight charges, insurance, and risk of loss or damage, and includes the merchandise in inventory. When the terms of the sale are F.O.B. destination, title transfers to the buyer at the time the goods are off-loaded to the buyer from the common carrier. In this case, the seller assumes responsibility for the freight charge, insurance, and risk of loss, and includes the merchandise as part of inventory until the buyer takes possession.
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Perpetual vs. periodic inventory systems - A periodic inventory system records all merchandise purchases in a purchases account and determines the inventory quantity and value periodically (usually at the time of preparation of the financial statements) by actual physical count. This system makes no attempt to maintain a current balance in the inventory account. In contrast, a perpetual inventory system does maintain a current balance in the inventory account. Increases to the inventory account occur with each new purchase, while decreases are made with each sale. Compared to the periodic system, the perpetual system requires more record keeping, but it affords greater control over the inventory. A periodic inventory system requires the use of several temporary accounts: Purchases all inventory purchases are recorded in this account Purchase returns and allowance any returns of merchandise to the supplier or any credits provided by the supplier for non-returned merchandise are credited to this account Purchase discounts any purchase discounts taken on terms of payment (i.e. 2/10, n30) are credited to this account. Transportation-in any freight costs paid for the acquisition of inventory are debited to this account. At year-end, the inventory is counted, all of these accounts are closed off and cost of goods sold is recorded. Example assume that a company using a periodic system has the following account balances: Dr. $ 655,000 3,540,000 Cr.
Inventory (beginning of year) Purchases Purchase returns and allowances Purchase discounts Transportation-in
$46,300 5,800 67,500
The year-end inventory count establishes the total cost of inventory at $768,000. The journal entry to record cost of goods sold would be as follows: Cost of goods sold Inventory Purchase returns and allowances Purchase discounts Purchases Transportation-in $3,442,400 113,000 46,300 5,800 $3,540,000 67,500
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In the above entry, cost of goods sold was calculated as a plug figure to balance the journal entry. If you were to calculate cost of goods sold directly you would get the same amount: Inventory, beginning of year Purchases Purchases Transportation-in Purchase returns and allowances Purchase discounts Less inventory, end of year $655,000 $3,540,000 67,500 (46,300) (5,800)
3,555,400 (768,000) $3,442,400
7.2
Inventory Valuation Methods
When inventory items are of high value and can be identified individually (for example, by way of serial numbers), the specific identification method of inventory valuation has to used. This method is quite simple and assigns the invoice price to each inventory item. Note that specific identification is not appropriate when there are large numbers of inventory items that are ordinarily interchangeable. When the specific identification method is not used, then the cost of inventory is to be assigned using one of two cost flow methods: FIFO or Weighted Average. IAS 2 requires that the same method be used for all inventories having a similar nature and use. For inventories with a different nature or use, different cost formulas can be used (IAS2.25). Note that LIFO is no longer considered an acceptable method. FIFO (First-in, First-out) The FIFO method assumes that older goods get sold first. FIFO assigns the more recent purchase price to the Statement of Financial Position inventory account; the older costs go to the COGS account. It is convenient to use and produces an inventory asset value close to current cost. Weighted Average The weighted average method of inventory is based on the assumption that all costs can be aggregated and that the cost to be assigned to any particular unit should be the weighted average of the costs of the units held during the accounting period. The weighted average method assumes no particular flow of goods. Weighted average assigns the available cost equally to the inventory asset and to cost of goods sold expense. It is used for inventories that are a mixture of recent and older purchases and that are not particularly perishable.
Example: The Madison Company had the following inventory transactions for the month of June 20x2: Date Opening Balance June 2 June 5 June 12 June 15 June 20 Number of Units 1,000 2,000 -1,400 1,500 -2,800 1,000 Total Purchase cost $11,000 23,000 18,000 12,300 Balance (Units) 1,000 3,000 1,600 3,100 300 1,300
Cost of goods available for sale Opening Inventory Purchases: June 2 June 12 June 20
$11,000 $23,000 18,000 12,300
53,300 $64,300
Calculations of cost of goods sold and final inventory values under all four methods of accounting for inventory are as follows. FIFO Periodic Ending inventory = 1,000 units from the June 20 purchase @ $12.30 Plus 300 units from the June 12 purchase @ $12.00 = $12,300 + 3,600 = $15,900 Cost of goods sold = $64,300 15,900 = $48,400
Weighted Average Periodic Weighted average cost per unit = Cost of goods available for sale number of units available for sale = $64,300 5,500 = $11.69 Ending inventory = 1,300 units x $11.69 = $15,197 Cost of goods sold = $64,300 15,197 = $49,103
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FIFO - Perpetual The ending inventory and Cost of Goods Sold for FIFO Perpetual are identical as for FIFO Periodic. The following table is for illustration purposes only. Number of Total Purchase Date Units cost Opening Balance 1,000 $11,000 June 2 2,000 23,000 June 5 -1,000 -400 June 12 1,500 18,000 June 15 -1,600 -1,200 June 20 1,000 12,300 Cost of goods sold = $64,300 15,900 = $48,400 Unit Cost $11.00 11.50 11.00 11.50 12.00 11.50 12.00 12.30 Balance ($) $11,000 34,000 23,000 18,400 36,400 18,000 3,600 15,900
Moving Weighted Average Perpetual Total Purchase cost $11,000 23,000 18,000 12,300
Number of Balance in Date Units Units Opening Balance 1,000 1,000 June 2 2,000 3,000 June 5 -1,400 1,600 June 12 1,500 3,100 June 15 -2,800 300 June 20 1,000 1,300 Cost of goods sold = $64,300 15,797 = $48,503
Average Cost $11.0000 11.3333 11.3333 11.6558 11.6558 12.1515
Balance ($) $11,000 34,000 18,133 36,133 3,497 15,797
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7.3
Application of the Lower of Cost or Market Method
Market is defined as net realizable value. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. The lower of cost or market rule is applied to inventory on an item by item basis (IAS 2.29). Note that net realizable value is not the same as fair value. The standard allows for the reversal of a write-down in a subsequent period if the net realizable value of the inventory increases, but not above the original cost (IAS 2.34). Grouping of items is allowed under the following condition: items that cannot be practically evaluated separately from other items in the product line, i.e. inventory relating to the same product line having similar purposes and used which are produced in and marketed in the same geographical area. For example, you sell an item that you source from three different suppliers. All items are identical and your customers do not know the difference between the items. Your inventory costing system treats these three items in inventory separately, but for purposes of calculating net realizable value, you can group the three items together. Example: Assume that a company has 5 items of inventory whose cost and net realizable value at year-end are as follows: Original Cost $30,000 56,000 12,000 32,000 4,000 Net Realizable Value $36,000 55,000 14,000 45,000 2,500
Item A B C D E
Inventory items B and E need to be written down to net realizable value as follows: Periodic Inventory System: the values assigned to the ending inventory for items B and E are $55,000 and $2,500. Perpetual Inventory System: the following journal entry will be recorded: Cost of goods sold (or an Inventory loss account) Inventory $2,500 $2,500
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7.4
Estimating Inventories
Estimating Inventories there are two approaches to estimate the values of ending inventory: the gross profit and retail method. The gross profit method uses historical estimates of gross profit as a percentage of sales to estimate cost of goods sold. Once cost of goods sold has been estimated, we can estimate the value of ending inventory. The gross-profit method is useful in situations where a physical inventory is not practical, such as a fire loss or a suspected theft loss. The gross-profit method is not acceptable for financial reporting purposes (except during interim reporting periods), because it provides only an estimate of the inventory. A physical count must be taken for annual financial reporting purposes. Example: you are given the following information for the first quarter ending March 31, 20x4: Beginning inventory Purchases Transportation-in Purchase returns and allowances Sales Historical gross profit margin $80,000 1,020,000 35,000 18,000 1,500,000 30%
The estimated cost of goods sold is $1,500,000 x (1 - 0.30) = $1,050,000 The cost of goods available for sale is: Beginning inventory + Purchases + Transportation-in - Purchase returns and allowances $ 80,000 1,020,000 35,000 (18,000) $1,117,000
The estimate of ending inventory is $1,117,000 - 1,050,000 = $67,000. Two major assumptions underlie the gross-profit method: (1) the rate of gross profit is constant from one period to the next, and (2) the sales mix of products is constant from one period to the next. The historical records of the company provide the information necessary to use the gross profit method. The rate of gross profit is based on the weighted average of the gross profit rates of all the individual products. This assumes that the gross profit rates of the individual products are constant from one period to the next and that the mix of products sold is constant from one year to the next. Finally, the gross profit method assumes that if any changes in the gross profit rates or the product mix sold did occur, the changes would offset each other with no resulting differences in the composite gross profit rate. If any of these assumptions is violated, the gross profit method gives a faulty estimate of the inventory value.
The retail inventory method is commonplace in the retail industry. As purchased merchandise is received, it is displayed immediately for sale at the retail price. Most retail concerns follow a consistent, observable pattern of markup on the cost of the merchandise, thereby allowing the use of the retail method to estimate the cost of the ending inventory. The records required for the retail method include beginning inventory, purchases at cost and retail, total sales, and any changes in selling price resulting from additional markups and markdowns. A cost-to-retail ratio is calculated from these data and then applied to the ending inventory at retail to estimate the ending inventory at cost. Note that for financial reporting purposes, the gross profit method can only be used for interim reporting. It cannot be used to estimate the ending inventory at the end of a company's fiscal year. The retail method, however, can be used to estimate the ending inventory at the end of a company's fiscal year.
Disclosure Requirements The following information must be disclosed with regards to inventories (IAS 2.36): the accounting policies adopted in measuring inventories, including the cost formula used; the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity; the carrying amount of inventories carried at fair value less costs to sell; the amount of inventories recognized as an expense during the period; the amount of any write-down of inventories recognized as an expense in the period; the amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period; the circumstances of events that led to the reversal of a write-down of inventories; and the carrying amount of inventories pledged as security for liabilities.
Accounting Standards for Private Enterprises There are no significant differences between IFRS and ASPE with regards to accounting for inventories.
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Multiple Choice Questions The Following Data Apply to Items 1-3 Addison Hardware began the month of November with 150 large brass switchplates on hand at a cost of $4.00 each. These switchplates sell for $7.00 each. The following schedule presents the sales and purchases of this item during the month of November. Purchases Date of Received 200 200 250
Transaction November 5 November 7 November 9 November 11 November 17 November 22 November 29 1.
Quantity Unit Cost $4.20
Units Sold 100 150
4.40 220 4.80 100
If Addison uses FIFO inventory pricing, the value of the inventory on November 30 would be a) $936. b) $1,012. c) $1,046. d) $1,076. e) $1,104.
2.
If Addison uses perpetual moving average inventory pricing, the sale of 220 items on November 17 would be recorded at a unit cost of a) $4.00. b) $4.16. c) $4.20. d) $4.32. e) $4.40.
3.
If Addison uses weighted average inventory pricing (periodic), the gross profit for November would be a) $1,046. b) $1,482. c) $1,516. d) $1,548. e) $1,574.
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4.
Miller, Ltd. estimates the cost of its physical inventory at March 31 for use in an interim financial statement. The rate of markup on cost is 25%. The following account balances are available: Inventory, March 1 Purchases Purchase returns Sales during March $220,000 172,000 8,000 350,000
The estimate of the cost of inventory at March 31 would be a) $34,000 b) $104,000 c) $121,500 d) $78,000
Problem 1 So Slow Ltd.s record of transactions for the month of April was as follows: Purchases 600 @ $6.20 1,500 @ 6.00 800 @ 6.40 1,400 @ 10.00 600 @ 11.00 1,200 @ 6.50 700 @ 6.60 1,200 @ 11.00 900 @ 12.00 500 @ 6.79 Sales 500 @ $10.00
April 1 April 3 April 4 April 8 April 9 April 11 April 13 April 21 April 23 April 27 April 29 Required 1. 2.
Assuming that the periodic system is used, compute the inventory at April 30 using (1) FIFO and (2) weighted-average cost. Assuming that the perpetual system is used, compute the inventory at April 30 using (1) FIFO and (2) weighted-average cost.
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Problem 2 High Tech Manufacturing Company uses a special alloy called Moly in its manufacturing process. In 20x0, the beginning inventory and the purchases of Moly during the year were as follows: kg Price/kg January 1 Inventory 300 $11.50 April 12 Purchase 400 12.00 July 7 Purchase 240 11.70 November 2 Purchase 320 12.30 At December 31, 20x0, a physical inventory count showed that 360 kg of Moly were still in inventory. Required a) Determine the dollar value of the December 31, 20x0, inventory using: i) FIFO ii) Weighted Average Costs. b) Which inventory valuation method will produce the highest net income for 20x0? Explain.
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Problem 3 Manning Company Ltd. purchases and sells one product. Information regarding this product for the first period of operations was as follows: Quantity Purchased 2,000 1,500 1,800 5,300 Acquisition Cost $24,000 21,000 27,000 $72,000
Unit Cost $12 14 15
The Manning Company uses a periodic inventory system. Sales for the period were 5,000 units at $20 per unit. Assume that all sales took place at the end of the period at which time the replacement cost of the product was $16.50 per unit. Required Compute the cost of goods sold expense and the ending inventory balance under the FIFO assumption.
Problem 4 You are a member of the internal audit team performing the year end examination of the inventory of Pilfer Limited, as of December 31, 20x0, and are confronted with the following situations: 1. On December 30, Pilfer had completed and packed a special order for delivery to Steel Ltd. Pilfer had invoiced Steel on December 30, and had excluded the items in this special order from its December 31 inventory count. However, because of the unavailability of a courier during the holiday season, Pilfer did not ship the order until January 3, 20x1. The order had a cost of $600, and a selling price to Steel of $900. Steel accepted and processed the invoice on December 30. 2. During your observation, you noted several cartons being unloaded on January 2. These had been shipped FOB shipping point on December 20, and the invoice for $350 had been received and recorded at that time. 3. You noted that invoices totalling $450 from your customs broker for his fees relative to incoming merchandise had been charged to "Brokerage expense". One third of the current year's purchases were still in inventory at December 31. 4. It was noted that purchases later in the year were at generally much lower prices than those earlier in the year. Pilfer uses the weighted-average method of inventory
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valuation, which provided a recorded value of $32,000 for inventory; market value for inventory was $30,000 at December 31. Required a) As a member of the internal audit team, make a recommendation to your team leader as to what action should be taken, as a result of the above information. You should fully justify your recommended treatment in terms of normal accounting practice and accounting principles as they relate to these situations. b) Prepare the necessary journal entries to correct or update the books of the Pilfer Company as at December 31, with respect to the four situations.
Problem 5 Port Debit Marina buys and sells new and used sailboats. At the end of the 20x0 season, a B&B 27 built in 1979 was purchased for $20,000 and placed in inventory. The boat was white with blue trim. At the beginning of the 20x1 season, the marina purchased another B&B 27, also built in 1979, for $24,000 and placed it in inventory. This boat was white but had green trim. During the 20x1 season, 1979 B&B 27s are selling for $28,000. The white and blue boat and the white and green boat are identical boats in similar condition except for the trim colors. These colors are equally popular with sailors. The marina uses the specific identification method to value inventory because boats are usually different. The accountant for the marina is concerned about this. He wants to change the method from specific identification to another "fairer" method to value inventory of similar boats. He is considering FIFO or weighted average but feels that the weighted-average method will be better to achieve his purpose, which is to make gross profit the same for either B&B 27. There are only three working days left in April, 20x1, and this month's sales have been slow. The manager of Port Debit Marina wants to report as high a profit as possible for April, 20x1. He receives a bonus based on income before income taxes. Because of this, he wants the salesmen to concentrate on selling the white and blue sailboat rather than the white and green one. It is expected that one B&B 27 will be sold before the month is over. Required Discuss the accountant's concerns and the manager's point of view. Is it to the advantage of Port Debit Marina to use the weighted-average method to value inventory? Discuss.
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Problem 6 Sapphire Company lost the previous month's records. The current month's records show the following: Transportation-In Purchase Returns and Allowances Ending Inventory Purchases Cost of Goods Sold Required i) ii) Calculate the current month's beginning inventory. If the inventory at the end of the current year is overstated and the error is not caught during the following year, what is the effect on income for both years? Briefly explain. $ 1,800 2,100 32,300 75,900 72,500
Problem 7 The Simpson Company supplies you with the following information: Freight-in Freight-out (selling expense) Gross sales Merchandise inventory, Jan 1, 20x2 Merchandise inventory, Dec 31, 20x2 Purchases Office supplies used Purchase discounts Purchase returns and allowances Sales returns and allowances Supplies inventory, Dec 31, 20x2 Required Calculate the cost of goods sold for Simpson Company. Make entries to (1) record cost of goods sold and (2) close all temporary accounts to cost of goods sold. Simpson uses a periodic inventory system. $ 3,000 2,000 100,000 12,000 14,000 72,000 7,000 4,000 6,000 10,000 5,000
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Problem 8 The Wicks Company was formed on January 1, 20x2. The following information is available from Wicks' inventory records: UNIT COST $ 9.00 9.50 10.50 11.00 11.50
Beginning inventory, 1/1/x2 Purchases 1/5/x2 1/25/x2 2/16/x2 3/26/x2
UNITS 800 1,500 1,200 600 800
A physical inventory on March 31, 20x2, shows 1,600 units on hand. Required: Prepare schedules to calculate the ending inventory at March 31, 20x2, under each of the following inventory methods (assume a periodic inventory system): 1. FIFO. 2. Weighted average.
Problem 9 D Ltd.'s December 31, 20x2, Statement of Financial Position reported inventory of $55,000. There were 10,000 units of inventory on hand at December 31, 20x2. During 20x3, D Ltd. engaged in the following inventory transactions: Jan. 31 Feb. 20 Mar. 30 June 29 Aug. 4 Oct. 15 bought sold sold bought sold bought 6,000 4,000 2,000 6,000 12,000 9,000 units for units for units for units for units for units for $ 27,000 32,000 16,500 28,800 102,000 36,000
Calculate D Ltd.'s reported gross profit from the above inventory transactions assuming that D Ltd. uses: a) FIFO - Periodic b) Weighted Average - Periodic d) FIFO - Perpetual d) Moving Weighted Average - Perpetual
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Problem 10 The Windsor Company has the following inventory transactions for item #A203 for the month of August: Date August Units 1,000 200 600 400 800 500 800 Unit Cost $12.00 12.20
1 5 8 10 13 17 21
Balance Purchase Sale Sale Purchase Sale Purchase
12.60 13.00
Calculate Windors ending inventory from the above inventory transactions assuming that Windsor uses: a. FIFO - Periodic b. Weighted Average - Periodic c. FIFO - Perpetual d. Moving Weighted Average Perpetual
Problem 11 The Schmitt Corporation carries four items in inventory. The following data are available at December 31, 20x5: Units A301 A302 A303 A304 Required Calculate the value of inventory and the journal entry (if any) to adjust the ending inventory value. 2,500 1,500 4,500 2,400 Cost $11.00 12.00 5.00 14.00 Replacement Cost $10.50 12.00 4.00 15.00 Estimated Selling Price $12.00 18.50 8.40 15.00 Selling Cost $1.80 1.60 1.90 2.40 Normal Profit $4.00 2.50 1.00 3.50
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Problem 12 A fire destroyed the inventory of the Udit Company on October 16, 20x3. Data for the 20x2 fiscal year and for the year to data on 20x3 is as follows: Year ended December 31, 20x2 $5,000,000 840,000 4,300,000 850,000 Period ended October 16, 20x3 $3,600,000 850,000 2,800,000 ????
Sales Beginning inventory Purchases Ending inventory Required
Estimate the cost of the inventory destroyed on October 16, 20x3.
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SOLUTIONS
Multiple Choice Questions 1. 2. e d 230 x $4.80 = 1,104 50 200 250 -150 100 200 300 @ @ @ @ @ @ 4.00 4.20 4.16 4.16 4.16 4.40 4.32 200 840 1,040 -624 416 880 1,296
3.
Cost of goods available for sale = (150 x 4.00) + (200 x 4.20) + (200 x 4.40) + (250 x 4.80) = $3,520 Unit cost = $3,520 / 800 = $4.40 Gross Profit = 570 units sold x (7.00 - 4.40) = $1,482
4.
Gross profit % = 25 / 125 = 20% Cost of goods sold = $350,000 x 80% = $280,000 Ending inventory = $220,000 + 172,000 8,000 280,000 = $104,000
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Problem 1 a. (1) FIFO 500 x 6.79 200 x 6.60 $3,395 1,320 $4,715
(2)
Sum of purchases = (600 x 6.20) + (1,500 x 6.00) + (800 x 6.40) + (1,200 x 6.50) + (700 x 6.60) + (500 x 6.79) = $33,655 Average cost = 33,655 5,300 = $6.35 Inventory = $6.35 x 700 units = $4,445
b.
(1)
FIFO Change in Units 600 -500 1,500 800 -100 -1,300 -200 -400 1,200 700 -400 -800 -400 -500 500 Unit Cost 6.20 6.20 6.00 6.40 6.20 6.00 6.00 6.40 6.50 6.60 6.40 6.50 6.50 6.60 6.79 Change In Cost 3,720 -3,100 9,000 5,120 -620 -7,800 -1,200 -2,560 7,800 4,626 -2,560 -5,200 -2,600 -3,300 3,395 Inventory Balance 3,720 620 9,620 14,740 14,120 6,320 2,560 10,360 14,980 7,220 1,320 4,715
Date Apr 1 Apr 3 Apr 4 Apr 8 Apr 9 Apr 11 Apr 13 Apr 21 Apr 23 Apr 27 Apr 29
Balance 600 100 1,600 2,400 2,300 1,000 800 400 1,600 2,300 1,900 1,100 700 200 700
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(2)
Moving Average Change in Units 600 -500 1,500 800 -1,400 -600 1,200 700 -1,200 -900 500 Unit Cost 6.20000 6.20000 6.01250 6.14167 6.14167 6.14167 6.41063 6.46826 6.46826 6.46826 6.69857 Change In Cost 3,720 -3,100 9,000 5,120 -8,598 -3,685 7,800 4,620 -7,762 -5,821 3,395 Inventory Balance 3,720 620 9,620 14,740 6,142 2,457 10,257 14,877 7,115 1,294 4,689
Date Apr 1 Apr 3 Apr 4 Apr 8 Apr 9 Apr 11 Apr 13 Apr 21 Apr 23 Apr 27 Apr 29
Balance 600 100 1,600 2,400 1,000 400 1,600 2,300 1,100 200 700
Problem 2 a) i)
FIFO Ending Inventory 320 kg at 12.30 = 40 kg at 11.70 = 360 kg
$3,936 468 $4,404
ii)
Weighted Average Cost Ending Inventory kg 300 400 240 320 1,260 Cost/kg $11.50 12.00 11.70 12.30
January 1 April 12 July 7 November 2
Inventory Purchase Purchase Purchase
x x x x
= = = =
$3,450 4,800 2,808 3,936 $14,994
$14,994/1,260 kg = $11.90/kg Ending Inventory: 360 kg x $11.90/kg = $4,284 b) Net Income = revenue - cost of goods sold FIFO produces the highest ending inventory value which results in a lower cost of goods sold and, therefore, the highest net income.
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Problem 3 a) FIFO: cost of goods sold
= (2,000 x $12) + (1,500 x $14) + (1,500 x $15) = $67,500
Ending inventory = 300 x $15 = $4,500
Problem 4 1) This is a bill and hold sale - the item was invoiced and the client accepted the late delivery. The item is properly excluded from the inventory count, as it is a special order item that has been completed and segregated from inventory. The essential criteria of completion of the earnings process appears complete, so that revenue may be recognized. The terms of the sale are FOB shipping point, so risk transferred to Pilfer on December 20, and these items should be included in the ending inventory count. The purchase and related liability are correctly recorded in the year just ended. The brokerage fees should be included as a part of the cost of inventory, they are directly attributable to the acquisition of merchandise. They are included as a result of the cost principle, which specifies that inventories be valued at the "net laid-down cost." An appropriate portion should be charged to the cost of goods sold. 4) The company should recognize the decline in value as a charge against income in the period just ended. No entry required. No entry required, but these items should be included in the inventory count.
2)
3) as
b)
1) 2)
3) Inventory Cost of goods sold Brokerage expense 4) Unrealized loss on decline in market value of
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$150 300 $450
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inventory Inventory $2,000
Problem 5 Accountant's proposal Specific identification may indicate different costs for similar items. This portrays reality since the items' costs vary. The method selected to determine costs should be the one which results in the fairest matching of costs against revenues. However, changing methods frequently inhibits comparability. When specific identification is possible it has to be used unless the products are interchangeable. In the case of sailboats, these normally would not be interchangeable. Therefore, the use of the specific identification method should be used. Weighted-average method can only be used if the items are all identical. Aside from the color of the trim, this is the case for these boats. FIFO assumes that goods are sold on a FIFO basis, which is not the case for boats. Manager's point of view Since his objectives are to maximize profit (i.e., his bonus), the manager's logic cannot be faulted under the existing accounting scheme. He would want to use specific identification if the white and blue sailboat is sold and weighted average if the white and green sailboat is sold. Is it to the advantage of Port Debit to use the weighted-average method? Port Debit Marina is a going concern and therefore we must not only consider the profits to be reported today but also those to be reported in the future. Under the current system, when the marina sells the white and blue boat it will report $8,000 profit. When the white and green boat is sold it will generate $4,000 profit. Based on specific identification, the profit to be reported first will depend on which boat is sold first. There is no difference to the cash flows whichever inventory method is used (except that the manager's bonus is higher this year and lower next). Average cost would smooth out income. The desirability of this should be examined.
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The decision of which method to use should be based on sound accounting principles and not on the manager's potential bonus. From a control (and matching) point of view, Port Debit is probably better off with specific identification.
Problem 6 i) Purchases - Purchase Returns & Allowances + Transportation-In Cost of Gross Purchases Cost of Goods Sold + Ending Inventory Cost of Goods Available for Sale - Cost of Gross Purchases Beginning Inventory 75,900 (2,100) 1,800 75,600 72,500 32,300 104,800 75,600 29,200
ii)
To overstate income this year and understate income next year.
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Problem 7 Cost of goods sold (a residual) Inventory Purchase discounts Purchase returns and allowances Purchases Freight in 63,000 2,000 4,000 6,000 72,000 3,000
Problem 8 1. FIFO: Ending inventory by physical count = 1,600 units Purchased March 26 800 units @ $11.50 per unit = Purchased February 16 600 units @ $11.00 per unit = Purchased January 25 200 units @ $10.50 per unit = FIFO ending inventory 1,600 units = 2. WEIGHTED AVERAGE: Inventory, January 1 800 units Purchase, January 5 1,500 units Purchase, January 25 1,200 units Purchase, February 16 600 units Purchase, March 26 800 units 4,900 units =
$ 9,200 6,600 2,100 $17,900
@ $ 9.00 per unit = @ $ 9.50 per unit = @ $10.50 per unit = @ $11.00 per unit = @ $11.50 per unit = =
$ 7,200 14,250 12,600 6,600 9,200 $49,850
Total cost of goods available Total units of goods available Weighted average ending inventory
49,850 = $10.173 4,900 = 1,600 units @ $10.173 per unit = $16,277
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Problem 9 a) Ending inventory = 13,000 units 9,000 x $4.00 4,000 x $4.80
$36,000 19,200 $55,200 $150,500 55,000 91,800 -55,200
Sales (32,000 + 16,500 + 102,000) COS Opening inventory Purchases (27,000 + 28,800 + 36,000) Ending inventory Gross margin b) Average cost = Cost of goods available for sale Units available for sale = ($55,000 + 91,800) (10,000 + 6,000 + 6,000 + 9,000) = $146,800 31,000 = $4.735484 Ending inventory = 13,000 units x $4.735484 Sales (32,000 + 16,500 + 102,000) COS Opening inventory Purchases (27,000 + 28,800 + 36,000) Ending inventory Gross margin c) d) Same as for periodic system. Date Jan 1 Jan 31 Feb 20 Mar 30 Jun 29 Aug 4 Oct 15 Purchases 6,000 4,000 2,000 6,000 12,000 9,000 Sales Balance 10,000 16,000 12,000 10,000 16,000 4,000 13,000
91,600 $58,900
$61,560 $150,500 55,000 91,800 -61,560
85,240 $65,260
Cost 55,000 82,000 61,500 51,250 80,050 20,013 56,013
Cost/Unit 5.5000 5.1250 5.1250 5.1250 5.0031 5.0031 4.3087 $150,500
Sales (32,000 + 16,500 + 102,000) COS Opening inventory Purchases (27,000 + 28,800 + 36,000) Ending inventory Gross margin
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55,000 91,800 -56,013
90,787 $59,713
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Problem 10 a. Ending inventory in units = 1,300 units (800 units x $13.00) + (500 units x $12.60) = $16,700 b. Cost of goods available for sale = (1,000 x $12.00) + (200 x $12.20) + (800 x $12.60) + (800 x $13.00) = $12,000 + 2,440 + 10,080 + 10,400 = $34,920 Units available for sale = 1,000 + 200 + 800 + 800 = 2,800 Average cost = $34,920 / 2,800 = $12.471 Cost of ending inventory = 1,300 units x $12.471 = $16,212 c. Date August 1 August 5 August 8 August 10 August 13 August 17 August 21 d. Date August 1 August 5 August 8 August 10 August 13 August 17 August 21 * Change in Units 200 -600 -400 800 -200 -300 800 Change in Units 200 -600 -400 800 -500 800 Unit Cost 12.00 12.20 12.00 12.00 12.60 12.20 12.60 13.00 Unit Cost* 12.00 12.03333 12.03333 12.03333 12.48700 12.48700 12.80308 Change In Cost 2,440 -7,200 -4,800 10,080 -2,440 -3,780 10,400 Change In Cost 2,440 -7,220 -4,813 10,080 6,243 10,400 Inventory Balance 12,000 14,440 7,240 2,440 12,520 10,080 6,300 16,700 Inventory Balance 12,000 14,440 7,220 2,407 12,487 6,244 16,644
Balance 1,000 1,200 600 200 1,000 800 500 1,300
Balance 1,000 1,200 600 200 1,000 500 1,300
the unit cost is recalculated each time a purchase is made, for example, the unit cost on August 5 is calculated by taking the inventory balance of $14,440 and dividing it by the unit balance of 1,200.
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Problem 11 Market is defined as Net Realizable Value = estimated selling price less selling costs. Units 2,500 1,500 4,500 2,400 Unit Cost $11.00 12.00 5.00 14.00 Total Cost $27,500 18,000 22,500 33,600 Unit NRV $10.20 16.90 6.50 12.60 $2,000 $2,000 3,360 3,360 Total NRV $25,500 25,350 29,250 30,240
A301 A302 A303 A304
Unrealized loss on inventory Inventory (Unit A301) Unrealized loss on inventory Inventory (Unit A304)
Problem 12 Cost of goods sold in 20x2 = $840,000 + 4,300,000 850,000 = $4,290,000 Cost of goods sold as a % of sale in 20x2 = $4,290,000 / 5,000,000 = 85.8% Estimated cost of goods sold in 20x3 = $3,600,000 x 85.8% = $3,088,800 Estimated ending inventory => $850,000 + 2,800,000 EI = $3,088,800 = $3,650,000 3,088,800 = $561,200
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8.
Property, Plant and Equipment and Intangible Assets
Given the large size of this chapter, the ASPE/IFRS differences will be discussed in each section within a text box. 8.1 Property, Plant and Equipment - General Recognition Principle
Property, plant and equipment are defined as tangible items that: (a) are held for use in the production or supply of goods and services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period. (IAS16.6) The general recognition principle applies to (i) the initial recognition of an asset, (ii) when parts of that asset are replaced, and (iii) when costs are incurred relative to that asset during its useful life. The standard does not distinguish between costs capitalized at acquisition and costs capitalized post-acquisition. It specifies that the cost of an item of property, plant and equipment shall be recognized as an asset if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the entity, and (b) the cost of the item can be measured reliably. (IAS 16.7) ASPE's definition of property, plant and equipment is fundamentally the same and extend to include assets held for the development, construction, maintenance or repair of other property, plant and equipment. While IFRS apply the same general recognition principle to both the initial acquisition of an asset as well as future costs incurred on the asset, ASPE provides a somewhat different rationale for capitalization for future costs. These are called betterments and are capitalized only when they increase the service potential of an asset. This occurs when: there is an increase in the previously assessed physical output or service capacity, operating costs are lower, the life or extended useful life is extended, or the quality of the output is improved. Assets acquired for safety or environmental reasons should be capitalized as property, plant and equipment even though these do not meet the strict general recognition principle. This is because these expenditures have to be incurred in order for the productive assets to generate future benefits. (IAS 16.11) Capital assets should be recorded at cost. Cost should be interpreted fairly broadly and is meant to include all costs incurred in order to put the asset to productive use. For example, this would include, in addition to the cost of acquiring the asset, freight, installation costs, and testing of equipment.
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There are three components of the initial cost of an asset: (1) the purchase price the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire the asset. If the asset is acquired in exchange for a note payable, the asset is recorded at the present value of the note. Purchases of groups of assets are allocated to the assets based on their relative fair market values. For example, say we purchase a building that comprises several pieces of equipment for $1,000,000. If we obtain separate market values for the land, building and equipment, we would break down the cost as follows: Separate Market Value Land Building Equipment $200,000 900,000 300,000
% 14.3% 64.3% 21.4%
Allocation of Cost $143,000 643,000 214,000 $1,000,000
$1,400,000 100.0%
(2) directly attributable costs these are defined as costs necessary to bring the asset to the location and condition necessary for it to be capable of operating in the manner intended by management (IAS 16.20). Examples of directly attributable costs (IAS 16.17): costs of employee benefits arising from the construction or acquisition of the item of property, plant and equipment costs of site preparation initial delivery and handling costs installation and assembly costs costs of testing whether the asset is functioning properly professional fees Note the use of the words necessary which implies that in order to be capitalized, that these costs could not have been avoided. An additional cost that can be capitalized are borrowing costs. This is discussed further in this section. The following costs are specifically excluded (IAS 16.19 and 16.20): costs of opening a new facility, such as an open house. These costs are incurred after the asset is capable of being used. costs of introducing a new product or service, including costs of advertising and promotional activities. administrative and other general overhead costs. costs incurred while waiting for the asset to be used, but subsequent to the asset being capable of being used. operating losses incurred in the initial stages of operating the asset.
(3) the initial estimate of the cost of dismantling, removal or restoration this refers to costs of dismantling, removing or restoring an asset, also known as decommissioning costs (or asset retirement obligations). These costs are typically at the end of the useful life of the asset. The present value of these costs are added to the cost of the asset and depreciated over the useful life of the asset. The resulting asset retirement obligation is shown as a long-term liability. Interest accrued on the asset retirement obligation over the life of the asset is expensed as a finance cost on the income statement. Note that decommissioning costs do not necessarily have to be a legal obligation, they can also result from a constructive obligation. This will be discussed further when the topic of provisions is discussed in the Liabilities chapter. Example: an oil refinery is purchased on December 31, 20x1 at a cost of $50 million cash (allocated $10 million to land and $40 million to the refinery itself). The company has a legal/constructive obligation to dismantle the site at the end of its 30 year useful life. The best estimate of this cost is $10 million. Assuming a discount rate of 5%1, the present value of the asset retirement obligation is $2,313,774: N 30 I/Y 5 PV X= 2,313,774 PMT FV 10,000,000
Enter Compute
The journal entry to record the purchase of the oil refinery would be as follows: Dec 31, 20x1 Land Refinery Cash Asset Retirement Obligation $10,000,000 42,313,774 $50,000,000 2,313,774
Assuming the refinery has no residual value and that the company uses the straight line method of depreciation, the journal entry to record depreciation expense at December 31, 20x2 would be as follows: Dec 31, 20x2 Depreciation expense Accumulated Depreciation $42,313,774 / 30 years $1,410,459 $1,410,459
1 The discount rate is a firm specific credit risk adjusted rate.
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The interest accrued on the asset retirement obligation would be recorded as follows: Dec 31, 20x2 Interest expense Asset Retirement Obligation $2,313,774 x 5% $115,689 $115,689
At December 31, 20x3, the following entries would be recorded: Dec 31, 20x3 Depreciation expense Accumulated Depreciation $42,313,774 / 30 years Interest expense Asset Retirement Obligation ($2,313,774 + 115,689) x 5% $1,410,459 $1,410,459
121,473 121,473
Assume now that, in 20x14, the estimate of the asset retirement obligation at the end of the useful life of the refinery will be $15 million. We first calculate the present value of the new estimate as at January 1, 20x14: N 18 I/Y 5 PV X= 6,232,810 PMT FV 15,000,000
Enter Compute
The book value of the asset retirement obligation as at December 31, 20x13 is: N 18 I/Y 5 PV X= 4,155,207 PMT FV 10,000,000
Enter Compute
The following entry would be recorded in 20x14 to increase the asset retirement obligation: 20x14 Refinery Asset retirement obligation $6,232,810 - 4,155,207 $2,077,603 $2,077,603
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The net book value of the refinery at December 31, 20x13 is: $42,313,774 x 18/30 = 25,388,264. The journal entries to record depreciation expense on the refinery and interest expense on the asset retirement obligation at December 31, 20x14 are as follows: Dec 31, 20x14 Depreciation expense Accumulated Depreciation ($25,388,264 + 2,077,603) / 18 years Interest expense Asset Retirement Obligation $6,232,810 x 5% $1,525,882 $1,525,882
311,641 311,641
Note that the increase in the carrying value of the refinery is subject to the general recognition principle in that it is probable that future economic benefits associated with the item will flow to the entity (IFRIC 1.5). ASPE differences in the accounting for asset retirement obligations are as follows: they are only set up for legal or contractual obligations (as opposed to IFRS which also sets up an asset retirement obligation when there is a constructive liability discussed in the Liabilities section). the amount recognized as an asset retirement obligation is the best estimate of the expenditure required to settle the present obligation at the balance sheet date (note that this is sharply different than the requirement under IFRS where the amount is equal to the discounted value of the expected future outlay). Note that there is nothing preventing an entity from estimating the retirement obligation by discounting the cash flows as was done above, but they also have the option of simply estimating the obligation as the best estimate of how much it would cost to settle the obligation at the balance sheet date. If discounting is used, the cash flows are discounted at the risk free rate (i.e. no credit risk adjustment is considered when establishing the discount rate as is done for IFRS). the increase in the liability from one period to the next is calculated as follows: we first apply the risk-free rate to the opening balance. This amount gets charged to the income statement as Accretion expense (not as interest expense as per IFRS). Accretion expense becomes part of operating expenses for the period. Any increase in the liability to bring it up (or down) to the amount required at the balance sheet date also increases (decreases) the related asset.
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8.2
Component Approach
The standard requires a component approach to asset recognition i.e. significant parts of an asset have to be recorded in separate accounts and depreciated separately. These are generally parts that have a significant cost in relation to the total cost of the asset. For example, an asset costing $100,000 may be made up of two distinct parts Part A which has a useful life of 10 years and Part B which has a useful life of 5 years. On the date of acquisition, the cost of the asset would have to be split between the two parts and the two parts would have to be depreciated separately. (IAS 16.9) Note that the decision to breakdown an asset into components is based on managerial judgment and materiality. Example - on December 31, 20x1 a truck is purchased at a cost of $250,000. The components of the truck are as follows: Cost $150,000 90,000 10,000 Useful Life 20 years 10 years 5 years
Truck Body Engine Tires
Each of the three components would be recorded and depreciated separately. The component approach is also required under ASPE. 8.3 Depreciation
There are generally speaking, three methods used to depreciate capital assets: units of production, straight-line and the diminishing balance method. The residual value of an asset is defined as the estimated amount that could be currently obtained from disposal of the asset, after deducting the estimated costs of disposal, on the assumption that the asset were already of the age and condition expected at the end of its useful life (IAS 16.6). Depreciation starts when an asset is available for use.
1.
Units of Production
Units of production method is used when the asset use (mileage, machine hours) can be measured. For example, if a machine has a useful life of 200,000 machine hours and it is possible (and economically feasible) to measure these machine hours, then the units of production method of depreciation may be used.
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Assume that the original cost of the asset was $150,000 and has a residual value of $20,000. We would then depreciate $130,000 ($150,000 20,000) over the 200,000 machine hours: $130,000 200,000 = $0.65 per machine hour. If, in the first year, we used 24,000 machine hours, then the depreciation charge would be: 24,000 x $0.65 = $15,600. This method is not often used. The probable reason is that it requires that each piece of equipment be metered and measured. 2. Straight-line method
The straight-line method depreciates assets evenly over time. The depreciation expense is the same year after year. Continuing with the same example, if we assume that the useful life of the asset is 5 years, then the annual depreciation would be: $130,000 5 years = $26,000. 3. Diminishing Balance method
This method provides depreciation charges be higher in the first year and dropping off afterwards. Example: you purchase a piece of equipment costing $200,000 with a $20,000 residual value and you decide to depreciate it at the rate of 20%, the following would be the depreciation charges over the life of the asset:
Year 1 2 3 4 5 6 7 8 9 10 11
Net Book Value Beginning $200,000 160,000 128,000 102,400 81,920 65,536 52,428 41,942 33,554 26,843 21,474
Depreciation $40,000 32,000 25,600 20,480 16,384 13,108 10,586 8,388 6,711 5,369 1,474
Net Book Value Ending $160,000 128,000 102,400 81,920 65,536 52,428 41,942 33,554 26,843 21,474 20,000
Note that the depreciation expense in a given year is equal to the Net Book Value of the asset times the depreciation rate. Also, the asset is depreciated down to its residual value and no more. In the 11th year, the calculated depreciation would have been: $21,474 x 20% = 4,295. But this would have brought the net book value of the asset below its
residual value. Therefore, the amount of depreciation taken in the 11th year was equal to $1,474 which is just enough to bring the book value down to $20,000. If you are required to determine the net book value of an asset at the end of the nth year, you can do so by using the following formula: Net Book Value at end of nth year = Original cost x (1- depreciation rate)n For example, the net book value at the end of the 10th year is: $200,000 (1 - .20)10 = $200,000(.8)10 = $21,474 Choice of Depreciation Methods The choice of depreciation method is driven by the patterns in which the asset's future economic benefits are expected to be consumed by the entity (IAS 16.60) and has little to do with the economic depreciation of the asset itself. A common misconception is that if an asset depreciates at a greater amount in the early years of its useful life, then the diminishing balance method must be used. The choice depreciation method is based on the expected revenue stream to be generated by the asset itself: if an asset is expected to generate revenues evenly over the assets useful life, then the straight line method should be used, if the asset is expected to generate higher revenues in the early years of the assets useful life, then the diminishing balance method should be used, and if the asset is expected to generate revenues based in the assets use, then the units of production method should be used. Both the depreciation method used and the residual values of assets have to be assessed on an annual basis. ASPE Differences the residual value of an asset is defined as the estimated net realizable value of an item at the end of its useful life annual amortization charge is defined as the greater of (a) the cost less salvage value over the life of the asset, and (b) the cost less residual value over the useful life of the asset. Salvage value is defined as the estimated net realizable value of an asset at the end of its life and is normally negligible. the standards uses the term 'amortization' although it makes it clear that the word 'depreciation' can also be used.
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ASPE Differences - Cont'd the only direction given as to the method of depreciation taken is that the method of amortization recognized in a rational and systematic manner appropriate to the nature of the asset. The requirement is that the method reflects service as a function of usage and includes the straight-line method and increasing charge or decreasing charge methods.
8.4
Self-Constructed Assets and Borrowing Costs
A self-constructed asset is one where the company uses its own equipment and labour to produce the asset. The cost of the self-constructed asset should include all direct out-of pocket costs and should also include appropriate cost allocations of joint costs consumed by the construction of the asset. For example, if a construction company decides to pave its company headquarters parking lot, it will put depreciable assets to use (trucks, paving equipment). It would make sense that a reasonable amount of depreciation on this equipment be capitalized to the cost of the parking lot. Note that the general recognition criteria applies to self-constructed assets, i.e., the costs can be capitalized if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the entity, and (b) the cost of the item can be measured reliably. The capitalization of borrowing costs is covered by IAS 23. The standard defines a qualifying asset as an asset that necessarily takes a substantial amount of time to get ready for its intended use or sale (IAS 23.5). This includes intangible assets and inventory, but excludes inventories that are routinely manufactured or otherwise produced in large quantities or on a repetitive basis. Examples of these would include items that take some time to manufacture but that are sold as standard items such as residential housing, subway cars, aircraft, etc (IAS 23.4). Borrowing costs are defined as interest on short-term and long-term debt and includes any amortization of discounts and premiums and finance charges on leases. The capitalization rate is defined as the annual borrowing costs divided by the weighted average debt that generated borrowing costs. The capitalization rate is applied to the weighted average expenditures made on qualifying assets. The resulting amount is the amount of borrowing costs to be capitalized to the asset. Note that the borrowing costs capitalized can be on borrowings made for the direct purpose of financing the selfconstructed asset and/or can be on the firm's general borrowings. If the proceeds of an asset-specific loan are invested to generate investment income, the proceeds of the investment income reduce the borrowing costs capitalized. Commencement of capitalization occurs when the earliest of all of the following three conditions are met: (a) expenditures for the asset are being incurred; (b) borrowing costs are being incurred; and
(c) activities that are necessary to prepare the asset for its intended use or sale are in progress. (IAS 23.17) Cessation of capitalization occurs when substantially all the activities necessary to prepare the qualifying asset for its intended use of sale are complete. (IAS 23.22) Note that the capitalization of borrowing costs is mandatory. Example: On March 1, 20x3, a company begins the construction of an asset. Construction ended on October 31, 20x3. The company's year end coincides with the calendar year. The following costs were incurred in the construction of the asset: Mar 1, 20x3 May 1, 20x3 June 1, 20x3 July 15, 20x3 Sep 1, 20x3 Oct 1, 20x3 $180,000 120,000 60,000 150,000 240,000 150,000
The company's borrowings are as follows: a $200,000, 7% one year note dated January 1, 20x3. This note relates specifically to the self-constructed asset. bonds payable in the amount of $5,000,000. The annual interest on these bonds is 8.5%. other long-term debt in the amount of $2,000,000 bearing interest at 6%. First, we calculate the average investment in the project: Costs Proportion of time Incurred to October 31, 20x3 $180,000 120,000 60,000 150,000 240,000 150,000 8/12 6/12 5/12 3.5/12 2/12 1/12 Average Investment $120,000 60,000 25,000 43,750 40,000 12,500 $301,250 Borrowing costs on specific borrowings are charged first to the asset, then we will allocate general borrowings based on the weighted average borrowing rate of 7.8%: 8.5% x ($5,000,000 / 7,000,000) + 6% x (2,000,000 / 7,000,000) = 7.8%
Date Mar 1, 20x3 May 1, 20x3 June 1, 20x3 July 15, 20x3 Sep 1, 20x3 Oct 1, 20x3
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Borrowing costs to be capitalized: Asset specific note: $200,000 x 7% General borrowings: ($301,250 - 200,000) x 7.8% $14,000 7,898 $21,898
Disclosure requirements - the entity must disclose (1) the amount of borrowing costs capitalized and (2) the capitalization rate used to determine the amount if borrowing costs eligible for capitalization. ASPE Differences - capitalization of borrowing costs is not mandatory. If an entity opts to capitalize borrowing costs, the methodology used above would still apply. Disclosure of borrowing costs capitalized has to be disclosed in the notes to the financial statements.
8.5
The Revaluation Model
Companies can choose between two models for accounting for property, plant and equipment: the cost model and the revaluation model. The revaluation model measures the carrying amount of the assets at their fair value which is defined as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arms length transaction. In most cases this would be equal to the market value of the asset. However, when there is no active market for the assets in question, the use of surrogate measures such as depreciated replacement cost or use of market indices can be used. The standard is silent on the nature of the frequency of revaluations. The only guideline provided is that revaluations should be done in sufficient regularity such that the carrying amount of the asset does not materially differ from fair value. The frequency of revaluation should ultimately depend on the nature of the assets. If the assets are subject to rapid obsolescence, then revaluations should occur more frequently. The revaluation model is applied to individual assets but a company cannot choose to revalue only one asset in a class of assets (i.e. land, buildings, machinery, etc), the whole class of assets must be subject to the revaluation model. For each asset class, management can choose between the cost and revaluation model as long as these are applied consistently for all components in the class. For example, it is possible to use the revaluation model for land and buildings and the cost model for all other classes of assets. The best way to describe the application of the revaluation model is by way of example.
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Assume that Company X is formed on January 1, 20x1. The following assets are purchased on this date: Land Building $500,000 1,500,000
Useful life = 40 years Residual value = $300,000
Company X chooses to apply the revaluation model. Because the market for real estate is relatively stable, the company chooses to revalue the assets every three years, i.e. the first revaluation will be made in January 20x4, the second in January 20x7 For years 20x1 20x3, the building will be depreciated at the rate of $30,000 per year. The net book value of the building on January 1, 20x4 will be: $1,500,000 (30,000 x 3 years) = $1,410,000 January 20x4 revaluation - The appraisals of the land and building in January 20x4 are $600,000 for land and $1,460,000 for the building. The increase in the value of land will be as follows: Land Revaluation Surplus (OCI) $100,000 $100,000
The Revaluation Surplus account will be part of Other Comprehensive Income, which in turn, is part of Shareholders Equity. For the building, two approaches can be used: 1. proportional approach - restate proportionately with the change in the gross carrying amount of the asset so that the carrying amount of the asset after revaluation equals its revalued amount, or 2. gross carrying amount approach - eliminate the accumulated depreciation balance against the gross carrying amount of the asset and the net amount is then restated to the fair value of the asset. (IAS 16.35) We will only be discussing the second approach. If you are interested in the application of the proportional approach, you can find the solution in the appendix to this section.
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Under the Gross Carrying Amount method, we first eliminate the accumulated depreciation of the building against the building account, and then increase the carrying amount of the building: Accumulated Depreciation Building Building Revaluation Surplus (OCI) The depreciation expense for 20x4 through to 20x6 will be: ($1,460,000 300,000) / 37 = $31,351 January 20x7 revaluation - The appraisals of the land and building in January 20x7 are $540,000 for land and $1,300,000 for the building. The decrease in value of land will offset the previous revaluation surplus on land of $100,000 reducing it to $40,000: Revaluation Surplus (OCI) Land $60,000 $60,000 $90,000 $90,000 50,000 50,000
The net book value of the building is $1,460,000 ($31,351 x 3) = $1,365,947. We need to decrease the carrying value of the building by $65,947 which exceeds the revaluation surplus on the building of $50,000. In this situation, we would first apply the decrease in value to the balance in the revaluation surplus and any excess would be an expense that would flow to the income statement. Under the Gross Carrying Amount Method, the journal entries would be as follows: Accumulated Depreciation ($31,351 x 3) Building Revaluation Surplus (OCI) Loss on asset revaluation (I/S) Building $94,053 $94,053 50,000 15,947 65,947
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Note that the new carrying value of the building under the Gross Carrying Amount Method would be: Carrying amount, net January 1, 20x4 Less accumulated depreciation from 20x4 to 20x6: $31,351 x 3 years Less revaluation reduction in January 20x6 Gross value of building on January 1, 20x6 The depreciation expense for the years 20x6 through 20x8 will be: ($1,300,000 300,000) / 34 years remaining = $29,412 $1,460,000 (94,053) (65,947) $1,300,000
To summarize the accounting treatment for revaluations: when the revaluation results in an increase in carrying values, we credit the Revaluation Surplus Account. This account is part of Other Comprehensive Income in Shareholders Equity. This was the case for the 20x4 revaluation in our example. What was not illustrated was the situation where an increase in carrying value occurs, but this asset incurred a decrease in the past that was expensed to the income statement. In this case, the increase is first credited to income to the extent of previous accumulated losses and then to the revaluation surplus. The credit to income is reduced by the following: Accumulated depreciation taken on the asset Less the accumulated depreciation on the asset assuming the historical cost model was used. when the revaluation results in a decrease in carrying values, we debit the Revaluation Surplus to the extent that we have a balance relating to the asset. If the decrease in revaluation surplus is not enough to cover the decrease in value, any excess is charged as an expense to the income statement. This was the case for the 20x7 revaluation.
Note that if a class of assets has more than one asset, then each asset will generate its own revaluation surplus accounts and gains/losses incurred on one asset cannot be used to offset gains and losses on other assets. For example, if a company has two parcels of land, each subject the revaluation model. Each parcel was purchased at the beginning of the year for $1,000,000 each. At the end of the year, the first parcel of land is worth $1,200,0000 and the other is worth $700,000. We will create a revaluation surplus for the first parcel of $200,000 and take a loss on the income statement of $300,000 on the other.
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Disposition of the Revaluation Surplus Account There are two ways to dispose of the Revaluation Surplus Account: 1. when an asset is derecognized, any Revaluation Surplus relative to that asset should also be disposed of through Retained Earnings, and 2. the standard also allows the option of transferring amounts from the Revaluation Surplus directly to Retained Earnings throughout the assets useful life as it is being depreciated. The amount of surplus transferred would be equal to the difference between depreciation based on the original cost, and the depreciation based on the revalued amount. The revaluation model is not allowed under ASPE. Appendix Proportional Approach Using the Proportional Method, we first recalculate the original cost and the accumulated depreciation on the building by multiplying each by the revalued amount divided by the current net book value of the assets, 1,460 / 1,410: Carrying amount before revaluation $1,500,000 1,460 / 1,410 (90,000) 1,460 / 1,410 $1,410,000 Carrying amount after revaluation $1,553,191 (93,191) $1,460,000
Building Accumulated Depreciation
The journal entry to record the revaluation of the building under the proportional method will be: Building Accumulated Depreciation Revaluation Surplus (OCI) $53,191 $3,191 50,000
Using the proportional approach, the analysis would be as follows: Carrying amount before revaluation $1,553,191 (187,244) $1,365,947
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Building Accumulated Depreciation
1,300,000 / 1,365,947 1,300,000 / 1,365,947
Carrying amount after revaluation $1,478,204 (178,204) $1,300,000

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The journal entry would be as follows: Accumulated Depreciation ($187,244- 178,204) Revaluation Surplus (OCI) Loss on asset revaluation (I/S) Building ($1,553,191 1,478,204) 8.6 Derecognition of Assets
$9,040 50,000 15,947 $74,987
When an asset is disposed of, the proceeds on disposal are compared to the net book value of the asset. If the proceeds on disposal exceed the net book value of the asset, then we record a gain on disposal. If the proceeds on disposal are less than the net book value of the asset, we record a loss on disposal. The carrying amount of an item of property, plant and equipment shall be derecognized: (a) on disposal; or (b) when no future economic benefits are expected from its use or disposal. (IAS 16.67) For example, an asset with an original cost of $140,000 was purchased on January 2, 20x1 and is depreciated using the diminishing balance method at the rate of 30% per year. On December 31, 20x6, the asset is sold for proceeds of $35,000. The net book value of the asset on December 31, 20x6 is: $140,000 x .76 = $16,471. The gain on sale of the depreciable asset is $35,000 16,471 = $18,529. The journal entry to record the disposal of asset is: Cash Accumulated depreciation ($140,000 16,471) Asset Gain on sale of asset $35,000 123,529 $140,000 18,529
Note that when assets are traded in, the market value of the asset traded in becomes the proceeds on disposal and not the trade-in value. The reason for this is that the trade-in value often reflects a discount on the purchase price of the new asset purchased, which should be recorded as such.
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Example 2 - recall the example used when discussing the component approach: on December 31, 20x1 a truck is purchased at a cost of $250,000. The components of the truck are as follows: Cost $150,000 90,000 10,000 Useful Life 20 years 10 years 5 years
Truck Body Engine Tires
Assume that on July 1, 20x10 the engine is replaced at a cost of $120,000. We would first have to derecognize the old engine: Net book value of old engine: $90,000 x 1.5 years remaining /10 years useful life = $13,500 The journal entry to record the derecognition of the old engine would be: Accumulated depreciation ($90,000 13,500) Loss on derecognition of engine Engine We would then record the acquisition of the new engine: Engine Cash ASPE Differences - none $120,000 $120,000 $76,500 13,500 $90,000
8.7
Exchanges of Assets
Nonmonetary asset exchanges are exchanges of one productive asset for another. The cost of the asset received is measured at fair market value unless: the exchange transaction lacks commercial substance, or the fair value of neither the asset received nor the asset given up is reliably measurable. If the asset received is not measured at fair value, its cost is measured at the carrying amount of the asset given up (IAS 16.24). The fair value of the asset given up is used to measure the cost of the asset received unless the fair value of the asset received is more clearly evident (IAS 16.26). The determination of commercial substance is based on the extent to which the entity's future cash flows are expected to change as a result of the transaction. An exchange transaction has commercial substance if:
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the configuration (risk, timing and amount) of the cash flows of the asset received differs from the configuration of the cash flows of the asset transferred; or the entity-specific value of the portion of the entity's operations affected by the transaction changes as a result of the exchange;
AND the difference in the above two items is significant relative to the fair value of the assets exchanged. Example - a hotel chain exchanges Hotel A for Hotel B from another hotel chain they receive $100,000 cash as a result of the transaction to account for the fair value differential between the two hotels. The carrying and fair values of both hotels is as follows: Carrying Value $1,200,000 900,000 Fair Value $1,500,000 1,400,000
Hotel A Hotel B
Assuming no commercial substance, the journal entry to record this transaction is: Property, plant and Equipment - Hotel B* Cash Property, plant and Equipment - Hotel A $1,100,000 100,000 $1,200,000
* carrying value of $1,200,000 less cash received of $100,000 Assuming commercial substance, the journal entry to record this transaction is: Property, plant and Equipment - Hotel B** Cash Property, plant and Equipment - Hotel A Gain on sale of property, plant and equipment $1,400,000 100,000 $1,200,000 300,000
** fair value of Hotel A of $1,500,000 less cash received of $100,000 Had there been no cash exchanged on this transaction, the journal entry to record this transaction would be: Property, plant and Equipment - Hotel B Property, plant and Equipment - Hotel A Gain on sale of property, plant and equipment $1,500,000 $1,200,000 300,000
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The journal entries from the perspective of the original owner of Hotel B would be as follows: Assuming no commercial substance: Property, plant and Equipment - Hotel A ($900,000 Carrying Value + $100,000 Cash Paid) Cash Property, plant and Equipment - Hotel B Assuming commercial substance: Property, plant and Equipment Hotel A ($1,400,000 Fair Value + $100,000 Cash Paid) Cash Property, plant and Equipment - Hotel B Gain on sale of property, plant and equipment
$1,000,000 100,000 $900,000
$1,500,000 100,000 900,000 500,000
Had there been no cash exchanged on this transaction, the journal entry to record this transaction would be: Property, plant and Equipment Hotel A Property, plant and Equipment - Hotel B Gain on sale of property, plant and equipment $1,400,000 900,000 500,000
ASPE Differences the measurement of the asset received is a the more readily measurable of the fair value of the asset given up and the fair value of the asset received.
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8.8
Impairment of Assets
Because IFRS is moving from a historical cost model to a fair value model of accounting, there must be a control mechanism to prevent overvaluations of assets. The impairment test performs this function. It applies to all assets2, regardless of how these are classified, although in practice they apply mostly to property, plant and equipment and intangible assets. The purpose of the test is to ensure that assets are not carried at an amount that is greater than their recoverable amount. The recoverable amount is defined as the greater of: (i) the fair market value of the assets less costs to sell (FV), or (ii) their value in use (VIU) this is defined as the present value of cash flows expected from the future use and sale of the assets at the end of their useful lives. Because the principle is the higher of the two, management may have to calculate both. However, if one exceeds the carrying amount, then the other does not have to be calculated. One of the key concepts behind the impairment of asset test is that of the Cash Generating Unit (CGU). A CGU is defined as the smallest identifiable group of assets that together have cash inflows that are largely independent of the cash flows of another asset, i.e. the part of a business that generates income and which is largely dependent of other parts of a business. At a minimum, a company has as many CGUs as they have operating segments for the purposes of segment reporting. For example, Rogers Communications Incs 2007 Annual Report3 shows that the company operates in three segments: wireless, cable and media. At a minimum, Rogers would have three CGUs. However if one of the segments is made up of smaller identifiable businesses, then it could potentially be broken down into separate CGUs. Examples of typical CGU's are single retail stores and factories. Note that a CGU can be a single asset. Value-in-use starts with an approved cash flow forecast for the CGU. This forecast has to be reasonable, supportable, reflect an expected outcome and should not exceed a period of 5 years. A terminal value is also calculated representing the value of the CGU at the end of the 5 years. These cash flows are then discounted at an appropriate risk-adjusted discount rate to obtain their value-in-use. Fair value of an asset is defined as the value that an external market participant would place on the asset Impairment tests do not have to be done on an annual basis, rather they only need to be done if there is some indication that impairment has occurred. However, some assets have to be tested for impairment annually (IAS 36.10):
2 With the exception of inventories, assets arising from construction contracts, deferred tax assets, assets
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intangible assets with indefinite useful lives, intangible assets not yet available for use, and goodwill acquired in a business combination (the specific requirements for the impairment test for goodwill will be discussed in Module 2 of the Accelerated Program).
The reason for requiring annual impairment tests for the above is due to the fact that their values may be more uncertain than other assets. In addition, these assets are not amortized on a regular basis. The standards provide indicators of impairment and are classified as external and internal sources (IAS 36.12): External indicators: indicators that the market value of the assets has decreased significant changes in the external environment the firm operates in changes in market interest rates comparison of the market capitalization of the firm with the carrying value of its assets Internal indicators: obsolescence or physical damage to the assets change in use of the assets changes in the economic performance of the assets If an impairment loss is required, this loss must be allocated to the assets within the CGU on a pro-rata basis. The standard allows for a subsequent reversal of any impairment losses (with the exception of goodwill) (IAS 36.123). ASPE Differences the impairment test can be done at the asset level or by grouping assets into an asset group (note that the ASPE definition of an asset group is essentially the same as that for a Cash Generating Unit). an impairment loss is recognized when the carrying amount of an asset is not recoverable and exceeds its fair value. The adjusted carrying amount becomes the new cost basis. impairment losses cannot be reversed if the fair value of the asset subsequently increases. fair value is defined as the sum of the undiscounted cash flows, including a terminal value, expected to be generated by the asset or asset group. as with IFRS, the assets have to be tested for recoverability if events or changes in circumstances indicate that the carrying value of assets may not be recoverable. The indicators of impairment are essentially the same as those under IFRS however, there is no requirement to do an annual search for indicators of impairment.
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the impairment test for intangible assets not subject to amortization only needs to be done when indicators of impairment are present (as opposed to annually under IFRS).
8.9
Assets held for Sale
Noncurrent assets held for sale need to be disclosed as such on the statement of financial position, i.e. they need to be disclosed separately from other capital assets. To qualify as held for sale, the following two criteria must be met: they must be available for immediate sale in their existing condition and the sale must be highly probable (meaning there is an active plan to sell and the price is reasonable); and the sale will occur within a year from the date the assets are classified as held for sale A discontinued operations is defined as a subset of assets held for sale or disposed of during the year and: represents a separate major line of business or geographical area of operations, is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations, or is a subsidiary acquired exclusively with a view to resale On the date an asset, disposal group or discontinued operation is classified as held for sale, they are measured at the lower of carrying costs and fair market less costs to sell. If the selling costs exceed one year, they must be discounted. Any losses on measurement are classified as an impairment loss. If, at a subsequent balance sheet date, the remeasurement of fair market value indicates a recovery, then such recovery can be recorded as a gain, but only to the extent of previous losses. Assets held for sale are not depreciated. Assets that meet the held for sale criteria are classified as current assets. Discontinued operations are presented as a single amount comprising: the post-tax profit or loss from discontinued operations, and the post-tax gain or loss recognized on the measurement to fair value less costs to sell on the disposal of the assets or disposal group constituting the discontinued operations This single amount needs to broken down further in the notes into the revenue, expenses and pre-tax profit of the discontinued operations; the gain or loss recognized on the measurement to fair value less costs to sell or on the disposal of the assets separately for each of the two items above, the related income tax expense.
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ASPE Differences the definition of a discontinued operation is much less restrictive. It includes: operating segments - defined as a component of an entity that engages in business activities from which it may earn revenues and incur expenses, whose operating results are regularly reviewed by the enterprises chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance and for which discrete financial information is available, reporting units - one level down from an operating segment whose performance is reviewed by a lower level of management, a subsidiary, or an asset group (as defined in the Impairment of Assets section). assets that meet the held for sale criteria do not get reclassified, i.e. if the asset was initially classified as a long-term asset, its classification remains as a longterm asset.
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8.10
Disclosure Requirements - Property, Plant and Equipment
For each class of property, plant and equipment, the following have to be disclosed: the measurement bases used for determining the gross carrying amount; the depreciation methods used; the useful lives or the depreciation rates used; the gross carrying amount and the accumulated depreciation at the beginning and end of the period; and a reconciliation of the carrying amount at the beginning and end of the period showing: additions; assets classified as held for sale or included as held for sale and other disposals; acquisitions through business combinations; increases or decreased resulting from revaluations and from impairment losses recognized or reversed in other comprehensive income; impairment losses recognized or reversed on the income statement; depreciation expense recognized during the period; and any other changes. (IAS 16.73) If items of property, plant and equipment are stated at revalued amounts, the following have to be disclosed: the effective date of the revaluation; whether an independent valuer was involved; the methods and significant assumptions applied in estimating fair values; the extent to which the fair values were determined directly bu reference to observable prices in an active market or recent market transactions on arm's length terms or were estimated using other valuation techniques; for each class of property, plant and equipment, the carrying amount that would have been recognized had the assets been carried under the cost model; and the revaluation surplus, indicating the change for the period and any restrictions on the distribution of the balance to shareholders.
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8.11
Intangible Assets
IAS 38 defines an intangible asset as an identifiable non-monetary asset without physical substance. Intangible assets can be distinguished between those that are identifiable and non-identifiable. Identifiable intangible assets are those whose existence can be clearly identified such as patents, copyrights and franchises. Non-identifiable intangible assets exist but cannot be associated with a particular asset. Goodwill is the best example of a non-identifiable intangible asset. A distinction can also be made between purchased and internally developed intangible assets. To be considered identifiable, an intangible asset must meet one of the following two criteria: the intangible asset is separable, i.e. is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations (IAS 38.12) The same recognition criteria applies for intangible assets as for any other asset; the cost of an intangible asset can be recognized as an asset if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the entity, and (b) the cost of the item can be measured reliably. (IAS 38.9) The accounting for intangible assets is based on whether or not the intangible asset has a useful life. Amortization of intangible assets: intangible assets with a finite useful life should be amortized over the lessor of their useful lives or legal life (IAS 38.97) intangible assets with an indefinite life are subject to an annual impairment test (IAS 38.109) Examples of intangible assets: 1. 2. 3. Patents: a legal right to the exclusive use of a process, design, product or plan and the right to permit others to use it under license, generally for 17 years. Trademark: a distinctive word or symbol. These have an unlimited life. Copyright: right to publish materials such as books, CDs, tapes, and computer programs. Life: person's life plus 50 years for an individual or 75 years for a company. Franchise: the right to operate under the name of the franchisor. Goodwill. The definition of this term and the accounting thereof is described in Lesson 9. Generally goodwill has an unlimited life.
4. 5.
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Internally developed intangible assets Internally developed intangible assets such as research and development are accounted for as follows: research expenditures are written off to the income statement whereas development costs are to be capitalized if they meet the following six criteria: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale. (b) its intention to complete the intangible asset and use or sell it. (c) its ability to use or sell the intangible asset. (d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset. (e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset. (f) its ability to measure reliably the expenditure attributable to the intangible asset during its development. (IAS 38.57) Research is defined as 'original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding'. Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devises, products, processes, systems or services before the start of commercial production or use. (IAS 38.8) Revaluation Model It is possible to use the revaluation model for intangibles but only for those intangibles whose value can be determined in an active market. The accounting for revaluation of intangible assets is the same as for property, plant and equipment. Disclosure Requirements - Intangible Assets The following must be disclosed for each class of intangible assets, distinguishing between internally generated intangible assets and other intangible assets: whether the useful lives are indefinite or finite, and if finite, the useful lives, the amortization rates and methods used; the gross carrying amount and any accumulated amortization at the beginning and end of period; the line item(s) of the statement of comprehensive income in which any amortization of intangible assets is included; and a reconciliation of the carrying amount at the beginning and end of the period showing: additions, indicating separately those form internal development, those acquired separately and those acquired through business combinations; assets classified as held for sale or included as held for sale and other disposals;
increases or decreased resulting from revaluations and from impairment losses recognized or reversed in other comprehensive income; impairment losses recognized or reversed on the income statement; amortization expense recognized during the period; and any other changes. (IAS 16.73)
Note that because the standard requires the disclosure of accumulated amortization on intangible assets separately from the cost of intangible assets, then clearly there has to be an accumulated amortization account set up for intangibles.
ASPE Difference - entities have the option of either expensing or capitalizing internally developed intangible assets. If they choose to capitalize them, the same criteria apply. Amortization can reduce the intangible asset account directly or an accumulated amortization can be set up.
8.12
Depletion and Accounting for Natural Resources
When a mine has been developed, an oil well proved or a parcel of land purchased for clearing, the cost of the asset should be charged against accounting periods in a manner that matches the cost against the revenue reported. The usual procedure is as follows: 1. an estimate is made of the total amount of resources that can be economically recovered. 2. the capitalized cost is then written off as a function of the resources taken out. The amount of expense is called depletion. Note that this method is essentially a variation of the units of production method.
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8.13
Property, Plant and Equipment Comprehensive Examples
Example 1: Tender Footsies owned the land they were on and the building they were in, along with much machinery and equipment used both in the factory and in the office. The land had cost $14,000, the building $89,000 and the machinery and equipment $143,000. Since the company had been in operation for forty-five years, everything was fully depreciated. But since all the assets had been well maintained, they could be used for many years to come. Tender Footsies acquired two new assets in 20x4. The first was an adjacent piece of land, which was used to construct a warehouse; the other was a new state-of-the-art packaging machine for the shipping department. The land cost $115,000 and came with an old building which had to be demolished. The materials obtained from the demolition were sold as scrap for $2,300. The following additional costs were incurred and paid: Legal fees Land transfer tax Cost of company hired to demolish the old building Cost of company hired to dig the hole for the foundation Cost of constructing the warehouse Cost of changing the locks after master key was stolen Cost of moving the goods to the new warehouse on July 1, 20x4 $4,100 1,450 2,770 14,940 361,700 210 1,390
The warehouse was to last 50 years and has a residual value of $2,640. The company used the straight-line method of depreciation for the building. The packaging machine was purchased on October 1, 20x4, at a cost of $24,000 plus delivery of $800. The company had to build a special base to hold the machine which cost $700. The machine could package 50,000 boxes over its life span. It was used to package 100 boxes in 20x4 in its three months of use. It had no estimated residual value. The company uses the units of production method for depreciating the packaging machine. Management believes that the cost of the warehouse cannot be broken down into further components.
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Cost of new warehouse: Land Land cost Legal fees Land transfer tax Proceeds on sale of scrap materials Cost to demolish old building Warehouse Cost of foundation Construction cost
$115,000 4,100 1,450 (2,300) 2,770 $121,020 $ 14,940 361,700 $376,640
Note: the cost of changing the locks and moving the goods should not be capitalized, but rather, be expensed since they do not add value to the warehouse. Depreciation expense for the year Depreciation base ($376,640 - 2,640) Years Annual depreciation expense 20x4 Depreciation expense (1/2) Cost of packaging machine Cost of machine Delivery cost Cost of special base
$374,000 50 7,480 $ 3,740
$24,000 800 700 $25,500 $ 51
Depreciation expense - $25,500 x 100/50,000
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Example 2: Wilson Ltd. started a business on July 1, 20x3 and has a June 30 year end. The following information was available on June 30, 20x5: on July 1, 20x3, a new office complex complete with new office equipment was purchased for $400,000. A municipal tax bill showed an assessed value of $100,000 for the land and $150,000 for the building. The fair market values of the land and building at that time were estimated to be $175,000 and $200,000 respectively. A quote from an office equipment store for equipment similar to that bought on July 1, 20x3, showed a price of $125,000. The residual value of the building was estimated to be $25,000 while that of the equipment was $7,000. Management believes that the cost of the building cannot be broken down into further components. also on July 1, 20x3, three identical display trucks were purchased for a total of $75,000. The trucks have a residual value of $5,000 each. on December 31, 20x4, Wilson Ltd. traded one of the display trucks plus $9,000 cash for a new truck. The new truck's residual value was estimated to be $2,000. The trade-in allowance was $15,000. The old truck could have been sold for $12,000. on March 31, 20x5, office equipment was sold for $1,000. The cost of this equipment had been properly recorded on July 1, 20x3, at $5,000. At that time, the expected residual value was $ 500 . also on March 31, 20x5, new office equipment was purchased for $24,000. This equipment has a residual value of $1,500 .
The following expenditures associated with the purchase of the new office equipment were charged to expense: Installation fees Freight-in Purchase discount Repairs to machine for damage during installation Wages during testing Testing supplies $ 730 1,050 650 380 490 150
the company depreciates all of its assets using the 10% diminishing balance method
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Land - July 1, 20x3, lump-sum acquisition (Note 1) Building - July 1, 20x3, lump-sum acquisition (Note 1) Office Equipment July 1, 20x3, lump-sum acquisition (Note 1) Sale - March 31, 20x5 Purchase - March 31, 20x5 Cost Installation fee Freight-in Purchase discount Wages - testing Testing supplies
$140,000 $160,000
$100,000 (5,000) $24,000 730 1,050 (650) 490 150
25,770 $120,770
Trucks Purchase - July 1, 20x3 Sale of truck - December 31, 20x4 Purchase of truck - December 31, 20x4 (9,000 + 12,000) $75,000 (25,000) 21,000 $71,000
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Depreciation expense / Accumulated Depreciation Office Building Y/E June 30, 20x4 Depreciation (Note 2) Y/E June 30, 20x5 Disposals (Note 3) Depreciation (Note 4) $16,000
Equip. $10,000
Trucks $7,500
Total $33,500
14,400 $30,400
(838) 9,532 $18,694
(3,625) 6,675 $10,550
(4,463) 30,607 $59,644
Loss or gain on disposal Equipment: Proceeds Net book value Cost Accumulated Depreciation Loss on disposal
$1,000 $5,000 (838) 4,162 $(3,162)
Truck: Proceeds (FMV) Net book value Cost Accumulated Depreciation Loss on disposal Notes (1) Allocation of cost between properties Total fair market value: Land Building Equipment $12,000 $25,000 (3,625)
21,375 $(9,375)
$175,000 200,000 125,000 $500,000
35% 40% 25% 100%
Allocation of total cost Land: $400,000 x 35% Building: $400,000 x 40% Equipment: $400,000 x 25%
$140,000 160,000 100,000 $400,000

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(2) Depreciation expense for the year ended June 30, 20x4: Building: $160,000 x 10% Equipment: $100,000 x 10% Trucks: $75,000 x 10% (3) Accumulated Depreciation on disposals for the year ended June 30, 20x5: Equipment July 1, x3 - June 30, x4: $5,000 x 10% July 1, x4 - March 31, x5: $4,500 x 10% x 9/12
$16,000 10,000 7,500
$ 500 338 $ 838
Truck July 1, x3 - June 30, x4: $25,000 x 10% July 1, x4 - Dec 31, x4: 22,500 x 10% x 6/12 $2,500 1,125 $3,625
(4) Depreciation expense for the year ended June 30, 20x5: Building: $160,000 - 16,000 = 144,000 x 10% Equipment: July 1, x4 - Jun 30, x5: $95,000 - 9,500 = 85,500 x 10% July 1, x4- Mar 31, x5 (on equipment sold) Mar 31, x5 - June 30, x5 (on new equipment): $25,770 x 10% x 3/12
$14,400
$ 8,550 338 644 $ 9,532
Trucks July 1, x4 - Jun 30, x5: $50,000 - 5,000 = 45,000 x 10% July 1, x4 - Dec 31, x4 (on truck sold) Dec 31, x4 - June 30, x5 (on new truck): $21,000 x 10% x 6/12
$ 4,500 1,125 1,050 $ 6,675
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Multiple Choice Questions 1. During 20x4, Yvo Corp. installed a production assembly line to manufacture furniture. In 20x5, Yvo purchased a new machine and rearranged the assembly line to install this machine. The rearrangement did not increase the estimated useful life of the assembly line, but it did result in significantly more efficient production. The following expenditures were incurred in connection with this project: Machine $75,000 Labor to install machine 14,000 Parts added in rearranging the assembly line to provide future benefits 40,000 Labor and overhead to rearrange the assembly line 18,000 What amount of the above expenditures should be capitalized in 20x5? a. $147,000 b. $107,000 c. $ 89,000 d. $ 75,000
2.
Zahn Corp.'s comparative balance sheet at December 31, 20x5 and 20x4, reported accumulated depreciation balances of $800,000 and $600,000 respectively. Property with a cost of $50,000 and a carrying amount of $40,000 was the only property sold in 20x5. Depreciation charged to operations in 20x5 was a. $190,000 b. $200,000 c. $210,000 d. $220,000
3.
Weston Company purchased a tooling machine on January 3, 20x1 for $600,000. The machine was being amortized on the straight-line method over an estimated useful life of ten years, with no residual value. At the beginning of 20x8, the company paid $150,000 to overhaul the machine. As a result of this improvement, the company estimated that the useful life of the machine would be extended an additional five years (15 years total). What should be the amortization expense recorded for the machine in 20x8? a) $41,250 b) $50,000 c) $60,000 d) $66,000
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4.
A company installed an assembly line costing $50,000 in 20x1. In 20x6, the company invested $100,000 to automate the line. The automation increased the market value and productive capacity of the assembly line but did not affect its useful life. Proper accounting for the cost of the automation should be to a) report it as an expense in 20x6. b) debit the accumulated depreciation account by $100,000. c) allocate it between the fixed asset and accumulated depreciation accounts. d) debit the fixed asset account by $100,000. e) none of the above.
5.
Assume you are employed as the chief accountant for DrawPro Inc., a computer software company. The company was developing a new software program called Graphics Tool. At the end of the year, the director of research estimated that $1 million was spent during the year for the Graphics Tool program. He asked you to reduce his expenses by capitalizing $1 million as research and development costs. Prior to capitalizing the research and development costs, which of the following questions would NOT be considered in ensuring that your statements would be in accordance with generally accepted accounting principles? a) Has the future market for Graphics Tool been clearly defined? b) Is the Graphics Tool program technology feasible? c) Are the costs related to research activities or development activities? d) Does management have the desire to launch the Graphics Tool program upon completion? e) All of the above questions would be considered.
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Problem 1 Purchase of Land & Building / Depreciation The Flour Co. Ltd. wanted to build a new factory in Montreal. In June, 20x0, the company purchased a block of land as a factory site for $190,000. Two small office buildings were standing on the site. The buildings had a market value of $50,000 (included in the purchase price of $190,000). The company paid $12,500 to demolish the old buildings. The bricks from the old buildings were salvaged and sold for $1,400. Legal fees of $475 were paid for a land title search. Property taxes in arrears of $1,500 were paid by Flour Co. Ltd.. Payment of $20,000 was made to an engineering firm for drawing factory building plans. A construction contractor agreed to build the factory on a fixed-fee basis. The contractor's fixed fee charge for construction was $390,000. Special lighting was added to the building for $10,000. The factory building was completed on October 31, 20x0. The Flour Company's year end is December 31. Required a. b. Calculate the cost of the land and building. Assuming the factory building (and special lighting) has a 10 year life, compute the depreciation expense for both 20x0 and 20x1 on each of the following bases: i) straight-line ii) diminishing balance at 20%
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Problem 2 Accounts Receivable / Depreciation / Derecognition Vesley Air Freight is a small freight forwarder operating out of Baltimore and serving the Chesapeake Bay area. The company is in the process of preparing annual financial statements for the fiscal year ended May 31, 20x1. Neal Kaiser, assistant controller, has gathered the following data concerning accounts receivable and depreciable assets. At May 31, 20x1, Vesley's Accounts Receivable were $525,000, and the Allowance for Doubtful Accounts had a balance of $1,400. Kaiser prepared an aging report accounts receivable at May 31, 20x1, and the schedule below summarizes the relevant information from that aging report. Age Under 30 days 31 - 90 days 91 150 days Over 150 days Amount $420,000 31,000 26,000 48,000 Probability of Collection 97% 85 80 70
To update its fleet, Vesley purchased three Colt airplanes and two Parker airplanes during January 20x0 for $2,930,000. The airplanes were put into service and were available for use on June 1, 20x0. The details concerning cost, residual value, and the expected life of each of the airplanes are given below. Vesley has decided to depreciate the airplanes using the straight-line method of depreciation. On May 27, 20x1, one of the Colt airplanes (the N05110), costing $610,500, was damaged beyond repair when it caught fire during a refueling accident. The insurance proceeds amounted to $420,000. On May 30, 20x1, the company purchased another Colt airplane for $593,200. Identification Number N16313 N70224 N42326 N05110 N62199 Total Residual Value $ 94,050 55,600 55,950 60,900 60,800 $327,300 Expected Life 9 years 11 11 12 13
Airplane Colt Parker Parker Colt Colt
Cost $ 576,000 563,800 562,500 610,500 617,200 $2,930,000
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Required A. 1. 2. Calculate the proper balance in the Allowance for Doubtful Accounts using the percentage-of-receivable approach. Prepare the entry to adjust the Allowance for Doubtful Accounts as of May 31, 20x1. Prepare the journal entries to record the depreciation expense as at May 31, 20x1. Record the retirement of the Colt Airplane on May 27, 20x1 and the purchase of the new plane.
B.
1. 2.
Problem 3 Bundle Purchase of Assets The Verdini Company made a lump-sum purchase of three pieces of machinery for $120,000. At the time of acquisition, Verdini paid $5,000 to determine the appraised value of the machinery. The appraisal disclosed the following values: Machine 1 Machine 2 Machine 3 Required Calculate the amount that Verdini should record in the accounts for each machine. $70,000 52,000 23,000
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Problem 4 Component Approach & Depreciation The Jurasni Company acquired a building on December 31, 20x1 at a total cost of $1,500,000. The contractor provided the following breakdown of the major components of the building: Residual Value $100,000 0 25,000 0
Component Structure & frame Heating & AC System Elevators (2) Roof
Cost $1,000,000 200,000 225,000 75,000
Useful Life 40 years 15 years 20 years 25 years
The company depreciates the structure & frame and roof using the straight line method. The heating & AC system and elevators are depreciated using the diminishing balance method at a rate of 15% and 10% respectively. Required a. b. Calculate the depreciation expense on the building's components for the year 20x2 and 20x3. On June 30, 20x15 one of the two elevators is replaced at a cost of $150,000. The useful life of the new elevator is expected to be 20 years with a $20,000 residual value. The parts of the old elevator are sold for $10,000. i. Prepare the journal entries to record these transactions. ii. Calculate the depreciation expense on the elevators for the year 20x15. On January 2, 20x23, the roof is replaced at a cost of $120,000. The useful life of the new roof is 25 years. Prepare the journal entries for these transactions.
c.
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Problem 5 - Borrowing Costs On January 1, 20x4, the Britton Corporation started the construction of a self-constructed asset. Construction of the asset was completed on August 31, 20x4 and was put in productive use on that date. The following is a schedule of direct costs incurred in the construction of the asset: January 1, 20x4 February 1, 20x4 April 1, 20x4 May 15, 20x4 July 1, 20x4 Aug 1, 20x4 $ 30,000 50,000 75,000 40,000 60,000 45,000 $300,000
The company's borrowings are as follows: a $100,000, 6.5% one year note dated January 1, 20x4. This note relates specifically to the self-constructed asset. The note was repaid on August 31, 20x4. bonds payable in the amount of $10,000,000. The annual interest on these bonds is 7.5%. a bank loan payable in the amount of $15,000,000 bearing interest at 5%. Required Calculate the cost of the asset at August 31, 20x4.
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Problem 6 Discontinued Operations The following is the income statement for the Jen-Ward Company for the year ended December 31, 20x7: Sales Cost of goods sold Gross margin Operating expenses Net income before taxes Income taxes (@ 40%) Net income $9,500,000 6,000,000 3,500,000 2,000,000 1,500,000 600,000 $900,000
During December 20x7, the companys board of directors passed a resolution to dispose of one of the companys three divisions. This division had revenues of $2,500,000, cost of goods sold of $1,500,000 and operating expenses of $800,000. These amounts are included in the above income statement. The carrying value of the net assets of the division (net of current liabilities) was $6,900,000. The fair market value of the net assets is estimated to be $6,200,000 and the costs to sell the division are expected to be equal to 5% of the fair value of the net assets. None of these have been taken into account in preparing the above income statement Required Prepare an income statement for the Jen-Ward Company for the year ended December 31, 20x7.
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Problem 7 Capitalization vs. Expense The controller for Murdock, Inc., has asked a member of the staff to review the repair and maintenance expense account to determine if all of the charges are appropriate. The staff member has reviewed this account and has identified the following ten transactions for further scrutiny. All of these transactions are considered material in amount. DATE a) b) 1/3/x2 3/7/x2 4/12/x2 4/20/x2 5/12/x2 5/18/x2 6/19/x2 7/3/x2 9/14/x2 10/18/x2 AMOUNT DESCRIPTION
d) e) f) g) h) i) j)
$10,000 Service contract on office equipment. 10,000 Initial design fee for proposed extension of office building. 18,500 New condenser for central air-conditioning unit located on the roof of office building. 7,000 Purchase of two executive chairs and desks. 40,850 Purchase of storm and screen windows and installation of same on all office windows. 38,450 Sealing of roof leaks over entire production plant. 28,740 Replacement of large door to production area. 11,740 Installation of automatic door-opening system on the above door to speed opening. 38,500 Purchase of overhead crane for the Assembly Department to speed up production, 11,000 Replacement of broken gear on machine in the Machining Department.
Required For each of the ten transactions identified by the controller's staff member, indicate whether the transaction is properly charged to the repair and maintenance expense account, and if not, indicate the appropriate account to which the transaction should be charged. Explain your reasoning in each case.
Problem 8 Depreciation Methods Pinewood Corporation sells and erects shell houses-frame structures that are completely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work necessary to make the houses livable. Pinewood buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing, doors, windows, and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Pinewood buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of from $3,000 to $7,000, including the cost of the unassembled
packages. The chief element of cost of the display houses is the unassembled packages, since erection is a short, low-cost operation. Old sample models are torn down or altered into new models every three to seven years. Sample display houses have little residual value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package. Required Would it be preferable to depreciate the cost of display houses on the basis of (a) the passage of time or (b) the number of shell houses sold? Explain.
Problem 9 Revaluation Model On December 31, 20x5, Harwale Corporation had the following property, plant and equipment on its balance sheet: Accumulated Depreciation $300,000 180,000 Net Carrying Value $600,000 270,000
Cost Buildings Equipment $900,000 450,000
Harwale uses the revaluation model for its buildings and equipment and applies revaluations using the gross carrying amount method. The revaluation surplus account has a balance of $60,000 for the buildings and $0 for the equipment. The equipment revaluation resulted in a charge to income of $20,000 in the year ended December 31, 20x2 the last time the company revalued its assets. An independent appraiser assessed the fair value of the buildings to be $700,000 and the fair value of the equipment to be $300,000. Required Prepare the journal entries at December 31, 20x5 to reflect the revaluation of the buildings and equipment.
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Problem 10 Revaluation Model The JZ Company acquired a building on January 2, 20x1 at a cost of $600,000. The expected useful life of the building is 30 years with a residual value of $120,000. JZ uses the revaluation model and applies revaluations using the gross carrying amount method. The buildings appraisals are as follows: December 31, 20x1 December 31, 20x2 December 31, 20x3 The building was sold on January 2, 20x4 for $560,000. Required Prepare the journal entries for the years 20x1-20x4. $596,000 560,000 565,000
Problem 11 Revaluation Model The Jerome Property Corporations capital asset policy is to use the revaluation model for land and buildings and the historical cost model for equipment. The latest revaluation occurred on December 31, 20x2. Jerome uses the Gross Carrying Amount method when applying the revaluation model. Selected balance sheet data relating to the most current fiscal year ending December 31, 20x2 is as follows: Long-Term Assets Land Buildings Equipment Less accumulated depreciation
$1,200,000 5,600,000 900,000 (300,000) 600,000 $7,400,000
Shareholders Equity Revaluation Surplus Land Revaluation Surplus Buildings
$400,000 300,000
The buildings have a remaining useful life of 25 years. The equipment has a total useful life of 10 years. The straight line method is used. Residual values are assumed to be zero. The assets are revalued every two years. The appraisal results for the years ended December 31, 20x4 and 20x6 are as follows: Dec 31, 20x4 $1,000,000 4,600,000 Dec 31, 20x6 $1,500,000 4,500,000
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Land Buildings
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There were no additions or disposals to the land, building and equipment accounts for the years 20x3 to 20x6. Required Prepare all journal entries for the years 20x3 to 20x6 for the Land, and Buildings accounts.
Problem 12 Miscellaneous Issues On December 31, 20x1, certain accounts included in the capital assets section of the Townsand Company's Statement of Financial Position had the following balances: Land Buildings Leasehold improvements Machinery and equipment During 20x2 the following transactions occurred: a) Land site number 621 was acquired for $1 million. In addition, Townsand paid a $60,000 commission to a real estate agent. Costs of $15,000 were incurred to clear the land. During the course of clearing the land, timber and gravel were recovered and sold for $5,000. b) A second tract of land (site number 622) with a building was acquired for $300,000. The closing statement indicated that the land's value was $200,000 and the building's value was $100,000. Shortly after acquisition, the building was demolished at a cost of $30,000. A new building was constructed for $150,000 plus the following costs: Excavation fees Architectural design fees Building permit fee Imputed interest on funds used during construction $11,000 8,000 1,000 6,000 $500,000 900,000 400,000 500,000
The building was completed and occupied on September 30, 20x2. c) A third tract of land (site number 623) was acquired for $600,000 and was put on the market for resale. d) Extensive work was done to a building occupied by Townsand under a lease agreement that expires on December 31, 20x8. The total cost of the work was $125,000, which consisted of the following:
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Work Done Ceilings painted Electrical work Extension to current work area constructed Total
Cost $10,000 35,000 80,000 $125,000
Estimated Useful Life (years) 1 10 30
The lessor paid one-half of the costs incurred in connection with the extension to the current working area. e) During December 20x2 costs of $65,000 were incurred to improve leased office space. The related lease will terminate on December 31, 20x4, and is not expected to be renewed. f) A group of new machines was purchased under a royalty agreement that provides for payment of royalties based on units of production for the machines. The invoice price of the machines was $75,000, freight costs were $2,000, unloading charges were $1,500, and royalty payments for 20x2 were $13,000. Required Prepare a detailed analysis of the changes in each of the following Statement of Financial Position accounts for 20x2: 1. Land. 2. Buildings. 3. Leasehold improvements. 4. Machinery and equipment. Disregard the related accumulated depreciation accounts.
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Problem 13 Intangible Assets Illini Technologies designs and manufactures aircraft parts and subsystems for several large airplane manufacturers, and the company is known for its strong research and development. Occasionally, Illini assigns patent rights to other companies and has also acquired patent rights from outside companies. The transactions listed below occurred during the current fiscal year ending December 31, 20x0. Illini has a policy of amortizing patent costs using the straight-line method, calculated to the nearest month. (1) On March 1, 20x0, Illini acquired a patent from Lucas Industries covering a new landing gear system for small, high performance jet aircraft. Lucas accepted a $75,000, 6% note due September 1, 20x0, in exchange for the patent. On September 1, 20x0, Illini paid Lucas $77,250, the maturity value of the note. Illini believes that the patent will be technologically obsolete in six years. (2) On July 1, 20x0, Illini received notification that a recent application for a patent was granted. Over the past three years, the company's Research and Development Department has expensed $1.2 million on this project, including $485,000 spent during 20x0. The attorney's and filing fees for this patent totaled $104,800. Illini's engineers estimate that this patent has a useful life of ten years. (3) In August 20x0, Illini was notified that an application for a patent covering a bonding process was denied. Illini's Research and Development Department expensed $460,000 on this project. The attorney's and filing fees spent on this patent application totaled $34,950. (4) During the first quarter of 20x0, Illini reevaluated the useful life of several patents. The engineering staff determined that three patents had no future value. The book value of these patents at the beginning of January 20x0 was $171,255. The engineering staff recommended that the useful life of another patent be reduced from four to two years. The book value of this patent at the beginning of January 20x0 was $40,700. (5) During 20x0, Illini was successful as a plaintiff in a patent infringement suit. Legal costs incurred in this suit totaled $431,000. Of this amount, $380,000 had been expensed in prior years. The remaining $51,000 represents legal costs of this case incurred during 20x0. (6) During January 20x0, Illini granted a license to Savey Company to manufacture a gear reduction unit for light aircraft engines. The manufacturing process is covered by one of Illini's patents. The licensing agreement calls for Savey to pay Illini a fee for each unit produced. Savey reported $103,260 as due under this agreement for the fiscal year ending December 31, 20x0.
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Required A. Describe how each of the six transactions would be presented on Illini Technologies' financial statements at December 31, 20x0, identifying the appropriate dollar amount where applicable. Footnote disclosure requirements should be ignored. B. Describe the factors that should be considered when determining the useful life of a patent.
Problem 14 Depreciation Company A and Company B are independent companies in a similar line of business. They have each just purchased identical pick-up trucks for company use. Company A purchased its truck for $13,000 cash. Company B paid $9,000 cash and traded in a truck which it had bought three years ago for $8,500. The older truck had been depreciated on a 30% diminishing balance basis. This truck could have been sold for $4,500 had it not been traded in. Both trucks were listed with the dealer at a selling price of $14,500. Required a) Will the estimated lives of both trucks be the same for the purposes of computing depreciation? What information must be considered by the companies in estimating the useful lives of their trucks for depreciation purposes? b) Should the companies use the same depreciation methods? Explain. c) What is the acquisition cost of Company B's new truck? Explain. d) Prepare the journal entry to record the purchase of the truck by Company B.
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Problem 15 Land and Building acquisition The Morash Company Ltd. purchased a commercial lot for $100,000. An old building on the site was demolished at a cost of $8,000. Building stone from this old building was sold for $1,500. Legal fees of $1,300 were incurred in connection with this acquisition, and, in addition, land survey fees of $600 were paid in order to obtain preliminary approval for the financing of the new construction. An engineering firm prepared factory plans at a cost of $25,000. The contract price for the new building was $950,000. During the construction, which lasted four months, a Morash foreman with an annual salary of $24,000 acted exclusively as the liaison between the Morash Company and the contractor, in order to supervise construction. Insurance premiums paid for the new premises during construction totalled $600. Required Determine the amount that should be debited to each of the land and building accounts for this project. Show all calculations, and label the components of each of the asset accounts.
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Problem 16 Land and Building acquisition During 20x6, the Alfaro Corporation purchased land with an existing building at a cost of $860,000. The land was valued at $780,000 with the difference allocated to the building. Alfaro demolished the existing building and began construction of a new office building for its own use. The following represent costs incurred during the construction of the building: architects fees of $130,000 interest of $130,000 on construction financing taken on March 1, 20x6 and repaid on October 31, 20x6. cost of $40,000 to demolish the existing building proceeds on sale of materials from existing building = $8,000 costs to move from current building to new one = $106,000 payment of $15,000 of delinquent property taxes when the existing land and building were purchased land survey fees of $6,000 cost to build new building = $1,200,000 liability insurance during construction = $5,000
The land and building were purchased on March 1, 20x6. Construction of the new building started on April 1, 20x6 and was completed on October 31, 20x6 and was available for use at that time. Required a) b) Calculate the cost of the land and building. Assume that the company moved into the new building on December 1, 20x6 and that the straight line method of depreciation is used. Calculate the depreciation expense on the building for the year ended December 31, 20x6. Assume a useful life of 50 years and a residual value of $200,000.
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Problem 17 Depreciation Expense Lavoie Company's records show the following property acquisitions and disposals during the first two years of operations: Acquisition Cost of Property $50,000 20,000 Estimated Useful Life (years) 10 10 Disposals Year of Acquisition 20x5
Year 20x5 20x6
Amount
Cost - $7,000 Proceeds - $4,000
The Lavoie Companys capital asset policy is to depreciate assets for one-half year in the year of acquisition and in its year of disposal. Required 1. Compute depreciation expense for 20x5 and for 20x6 and the balances of the property and related accumulated depreciation accounts at the end of each year under the following depreciation methods. Show computations and round to the nearest dollar. a. Straight-line method. b. Diminishing balance method at a rate of 20%. Prepare the journal entry to record the disposal of property in 20x6 under the straight-line method.
2.
Problem 18 Depreciation Expense The Linnay Company purchased a machine costing $500,000 on January 2, 20x1. The expected useful life of the machine is 8 years and the residual value is expected to be $100,000. The company uses the diminishing balance method of depreciation. The rate used for machines is 25%. The Linnay Company has a December 31 year end. Required Calculate the depreciation on the equipment in the year 20x6.
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Problem 19 Asset Retirement Obligation The Jobim Corporation purchased the rights to mine a site at a cost of $65,000,000. Legislation requires Jobim to decommission the site once mining operations are over in 30 years. The mine became operational on December 31, 20x0. Required (a) Assume that Jobim is a publicly accountable company. They estimate the cost to decommission the site will be $50,000,000. Assuming a discount rate of 7%, prepare all journal entries relating to the mine asset and its asset retirement obligation for the years December 31, 20x0 to December 31, 20x2. Using the same data as above, assume that during 20x12, the estimate to decommission the site rises to $60,000,000. Calculate the depreciation and interest expense for the year 20x12. What will the carrying value of the mining asset and the asset retirement obligation be at December 31, 20x12? Using the same data as in (b), assume that during the year 20x28, the estimate to decommission the site is now $15,000,000. Prepare the journal entries relating to the mine asset and its asset retirement obligation for the year December 31, 20x28. Assume now that the Jobim Corporation is a private entity that has adopted ASPE. The company estimates that the cost to decommission the refinery on the following dates is as follows: December 31, 20x0 December 31, 20x1 December 31, 20x2 $14,000,000 20,000,000 18,000,000
(b)
(c)
(d)
Prepare all journal entries related to the refinery for the years 20x0 - 20x2. The risk free rate is 4%.
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Problem 20 Exchanges of assets Cranshaw Limited exchanged an asset with Dexter Corporation. Details of the asset exchange are as follows: Cranshaw Ltd. $1,400,000 700,000 900,000 Dexter Corp. $1,750,000 650,000 800,000 100,000
Original Cost Accumulated Depreciation Fair value Cash paid Required (a) (b) (c)
Assume that this transaction has commercial substance, prepare the journal entries on the books of the Cranshaw and Dexter to record the exchange. Redo part (a) on the assumption that no cash was exchanged. Assume that this transaction lacks commercial substance, prepare the journal entries on the books of the Cranshaw and Dexter to record the exchange.
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SOLUTIONS
Multiple Choice Questions 1. 2. a c All amounts provide future benefits and should therefore be capitalized. Accumulated depreciation, December 31, 20x4 Accumulated depreciation on property sold: $50,000 - 40,000 Accumulated depreciation, December 31, 20x5 Depreciation expense, 20x5 NBV at beginning of 20x8: $600,000 /10 x 3 = $180,000 NBV with improvement = $180,000 + 150,000 = $330,000 Amortization = $330,000 / 8 = $41,250 The cost of an item of property, plant and equipment as an asset if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the entity, and (b) the cost of the item can be measured reliably All of the items meet the recognition principle and should be capitalized. Development costs (but not research costs) can be capitalized if certain criteria are met. All choices need to be met in order to capitalize internally generated intangible assets. $600,000 -10,000 -800,000 $210,000
3.
4.
5.
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Problem 1 a. Purchase price of land Cost to demolish existing buildings Salvage Land title search Property taxes in arrears Factory building plans Construction costs Special lighting Land $190,000 12,500 (1,400) 475 1,500 $20,000 390,000 10,000 $420,000 20x1 Building
$203,075 b. Depreciation of Building: i) Straight-line 420,000 / 10 x 2/12 = 7,000 420,000 x 20% x 2/12 = 14,000 20x0
420,000 / 10 = 42,000 406,000 x 20% = 81,200
ii) Diminishing Balance
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Problem 2 A. 1. The proper balance in Vesley Air Freight's Allowance for Doubtful Accounts using the percentage-of-receivable approach is $36,850 as calculated below. Vesley Air Freight Allowance for Doubtful Accounts Age Under 30 days 31-90 days 91-150 days Over 150 days Percentage Amount Uncollectible $420,000 .03 31,000 26,000 48,000 .15 .20 .30 Required Balance in Allowance $12,600 4,650 5,200 14,400 $36,850
Required balance in Allowance
2. The entry to adjust Allowance for Doubtful Accounts as of May 31, 20x1, is as follows. Bad Debt Expense $35,450 Allowance for Doubtful Accounts $35,450 To adjust the Allowance for Doubtful Accounts as of May 31, 20x1, in accordance with calculations below. Balance required in Allowance Less current balance Amount of adjustment B. 1. Residual Value $ 94,050 55,600 55, 950 60,900 60,800 Depreciable Cost $481,950 508,200 506,550 549,600 556,400 Expected Life 9 yrs. 11 11 12 13 Annual Depreciation $ 53,550 46,200 46,050 45,800 42,800 $234,400 $36,850 1,400 $35,450
Airplane Colt Parker Parker Colt Colt
Cost $ 576,000 563,800 562,500 610,500 617,200
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Depreciation Expense $234,400 Accumulated Depreciation $234,400 To record the depreciation expense for the fiscal year ended May 31, 20x1, for Vesley Air Freight. 2. Cash $420,000 Accumulated Depreciation 45,800 Loss on disposal of fixed assets 144,700 Fixed Assets Airplanes To record retirement of damaged airplane, as of May 20x1. Fixed Assets - Airplanes $593,200 Cash To record the acquisition of a new airplane as of May 20x1.
$610,500
$593,200
Problem 3 Appraisal Values $70,000 52,000 23,000 $145,000 Allocation of % Purchase Price 48.27% 60,345 35.86% 44,828 15.87% 19,827 $125,000
Machine 1 Machine 2 Machine 3
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Problem 4 a. 20x2 Structure & Frame - ($1,000,000 - 100,000) / 40 years Heating & AC System - $200,000 x 15% Elevators: $225,000 x 10% Roof: $75,000 / 25 years
$22,500 30,000 22,500 3,000 $78,000
20x3 Structure & Frame - ($1,000,000 - 100,000) / 40 years Heating & AC System - ($200,000 - 30,000) x 15% Elevators: ($225,000 - 22,500) x 10% Roof: $75,000 / 25 years
$22,500 25,500 20,250 3,000 $71,250
b.
i.
Cost of elevator = $225,000 / 2 = $112,500 Net book value of elevator at December 31, 20x14: $112,500 x (1 - 0.10)13 = $28,596 Net book value of elevator at June 30, 20x15: $28,596 - (28,596 x 10% x ) = $27,166 Cash Accumulated depreciation ($112,500 - 27,166) Loss on derecognition of asset Elevator Elevator Cash $10,000 85,334 17,166 $112,500 150,000 150,000
ii.
Depreciation expense to June 30, 20x15 on elevator derecognized: $28,596 x 10% x Depreciation expense from July 1 to Dec 31, 20x15: $150,000 x 10% x Depreciation expense on other elevator: $112,500 x (1 - 0.10)13 x 10%
$1,430 7,500 2,860 $11,790
c.
Net book value of original roof as at Dec 31, 20x22: $75,000 / 25 x 4 years remaining = $12,000 Loss on derecognition of asset Accumulated depreciation ($75,000 - 12,000) Roof $12,000 63,000 $75,000
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Roof Cash
120,000 120,000
Problem 5 The average investment in the project: Costs Incurred $30,000 50,000 75,000 40,000 60,000 45,000 Proportion of time to Aug 31, 20x4 8/12 7/12 5/12 3.5/12 2/12 1/12 Average Investment $20,000 29,167 31,250 11,667 10,000 3,750 $105,834 Borrowing costs on specific borrowings are charged first to the asset, then we will allocate general borrowings based on the weighted average borrowing rate of 6%: 7.5% x ($10,000,000 / 25,000,000) + 5% x (15,000,000 / 25,000,000) = 6% Borrowing costs to be capitalized: Asset specific note: $100,000 x 8/12 = 66,667 x 6.5% General borrowings: ($105,834 - 66,667) x 6%
Date January 1, 20x4 February 1, 20x4 April 1, 20x4 May 15, 20x4 July 1, 20x4 August 1, 20x4
$4,333 2,350 $6,683
The total cost of the asset will be: $300,000 + 6,683 = $306,683
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Problem 6
Jen-Ward Company Statement of Income For the year ended December 31, 20x7 Sales ($9,500,000 - 2,500,000) Cost of goods sold ($6,000,000 1,500,000) Gross margin Operating expenses ($2,000,000 800,000) Net income before taxes Income taxes (40%) Net income before discontinued operations Net loss from discontinued operations (note) Net income $7,000,000 4,500,000 2,500,000 1,200,000 1,300,000 520,000 780,000 486,000 $294,000
Discontinued operations Income from operations: $2,500,000 1,500,000 800,000 Writedown to market value: $6,900,000 (6,200,000 x 0.95)
$200,000 (1,010,000) 810,000 x 0.6 ($486,000)
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Problem 7 a) If the service contract does not extend beyond the current period, it is properly included in repair and maintenance expense. If the service contract does extend beyond the current period, then the portion of the contract price related to future periods should be recorded as a prepaid expense and amortized to repair and maintenance expense over the periods benefited. In either case, the cost of the service contract should not be added to the cost of the assets to which the contracts apply, because the contracts do not enhance the future service potential of the assets. b) The design fee should not be recorded as repair and maintenance expense. The fee is a capital expenditure which should be recorded as a part of the cost of the building addition. It is a necessary expenditure to provide future benefits from the building addition. c) The cost of the new condenser should be capitalized and depreciated over its useful life. The old condenser should be derecognized. d) The cost of the furniture should not be recorded as repair and maintenance expense. The desks and chairs have future service potential. Therefore, the cost is a capital expenditure and should be recorded as an asset, furniture and fixtures, and depreciated over the useful life of the furniture. e) The cost of the storms and screens should not be recorded as repair and maintenance expense. The implication from the problem wording is that there were no storms and screens prior to this expenditure. Thus, the storms and screens constitute an improvement to the office building. Future service potential has been added to the building. The capital expenditure should be recorded as a part of the cost of the office building and depreciated over the remaining life of the building. f) The cost of sealing the roof leaks is properly recorded as repair and maintenance expense. It is a revenue expenditure because it does not enhance the service potential of the plant. The expenditure merely enables the entity to obtain the originally anticipated service potential of the plant. g) The cost of the new door should be capitalized and depreciated over its useful life. The old door should be derecognized. h) The installation of the automatic door opening system constitutes an improvement, because it enhances the efficiency of the plant, thereby providing future service potential. Assuming the door opener will last beyond the current period, the cost should be capitalized and depreciated over its useful life. i) The cost of the overhead crane should not be recorded as repair and maintenance expense. The crane enhances the service potential of the plant and therefore
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constitutes a capital expenditure. The cost should be capitalized and depreciated over the useful life of the crane. j) The cost of the new gear should be capitalized and depreciated over its useful life. The old gear should be derecognized.
Problem 8 If all of the shell houses are to be sold at the same price, it may be appropriate to depreciate the costs of the display houses on the basis of the number of shell houses sold. This method would be similar to the units-of-production method of depreciation and would result in proper matching of costs with revenues. The success of this method is dependent upon accurate estimates of the number and selling price of shell houses to be sold. Depreciation based upon the passage of time may be preferable when the life of the models can be estimated with a great deal more accuracy than can the number of units which will be sold. If unit sales and selling prices are uniform over the life of the display house, a satisfactory matching of costs and revenues may be achieved using this straightline procedure.
Problem 9 Accumulated Depreciation Buildings Buildings Building Revaluation Surplus (OCI) Accumulated Depreciation Equipment Equipment Equipment Revaluation Gain (I/S) Revaluation Surplus (OCI) 100,000 100,000 180,000 180,000 30,000 20,000 10,000 $300,000 $300,000
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Problem 10 Jan 2, 20x1 Building Cash Depreciation expense Accumulated depreciation ($600,000 120,000) / 30 Accumulated depreciation Building Building Revaluation Surplus (OCI) Note: book value of building becomes $596,000 Dec 31, 20x2 Depreciation expense Accumulated depreciation ($596,000 120,000) / 29 Accumulated depreciation Building Book value of building becomes: $596,000 16,414 = $579,586 Revaluation surplus (OCI) Revaluation loss (I/S) Building This will bring the book value of the building to: $579,586 19,586 = $560,000 (its appraisal value) $600,000 $600,000 16,000 16,000
Dec 31, 20x1
16,000 16,000 12,000 12,000
16,414 16,414
16,414 16,414
12,000 7,586 19,586
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Dec 31, 20x3
Depreciation expense Accumulated depreciation ($560,000 120,000) / 28 Accumulated depreciation Building Book value of building becomes: $560,000 15,714 = $544,286 Building Revaluation Gain (I/S) Revaluation Surplus (OCI)
15,714 15,714
15,714 15,714
20,714 7,586 13,128 5,000 5,000 560,000 560,000 8,128 8,128
Jan 2, 20x4
Revaluation Surplus (OCI) Building Cash Building Revaluation Surplus (OCI) Retained Earnings
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Problem 11 (a) Land Revaluation Surplus - Land Land Land Revaluation Surplus Land $200,000 $200,000 500,000 500,000
Dec 31, 20x4
Dec 31, 20x5
Buildings Dec 31, 20x3 Depreciation expense Accumulated depreciation $5,600,000 / 25 Depreciation expense Accumulated depreciation Accumulated depreciation Buildings Revaluation Surplus Buildings Revaluation Loss (I/S) Buildings Dec 31, 20x5 Depreciation expense Accumulated depreciation $4,600,000 / 23 Depreciation expense Accumulated depreciation Accumulated depreciation Buildings Buildings Revaluation gain (I/S) Revaluation surplus Buildings 224,000 224,000
Dec 31, 20x4
224,000 224,000 448,000 448,000 300,000 252,000 552,000 200,000 200,000
Dec 31, 20x6
200,000 200,000 400,000 400,000 300,000 252,000 48,000
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Problem 12 1. LAND Beginning balance Add: Site number 621 $1,000,000 Real estate commission (621) 60,000 Clearing costs (621) 15,000 Site number (622) 300,000 Demolition (622) 30,000 Deduct: Residual (621) Ending balance a The cost of Site 623 is included as Land held for sale because it is held for re-sale. BUILDINGS Beginning balance Add: Construction costs (site 622) Excavation fees (622) Architectural fees (622) Building permit (622) Interest (622) Ending balance
$500,000
1,405,000a (5,000) $1,900,000
2.
$ 900,000 $150,000 11,000 8,000 1,000 6,000
176,000 $1,076,000
3.
LEASEHOLD IMPROVEMENTS Beginning balance $400,000 Add: Electrical work (leased building) $35,000 Extension to leased building ($80,000 x 50%) 40,000 Improvements to leased offices 65,000 140,000c Ending balance $540,000 c The cost of painting the ceilings is a normal maintenance expenditure and thus must be expensed as incurred. MACHINERY AND EQUIPMENT Beginning balance $500,000 Add: Cost of new machines $75,000 Freight on new machines 2,000 Handling charges, new machines 1,500 78,500d Ending balance $578,500 d The royalty payments are not costs associated with getting the machines ready to use. They must be expensed as incurred.
4.
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Problem 13 A. The six transactions should be presented on Illini Technologies' December 31, 20x0, financial statements in the following manner. (1) The patent for the landing gear system should appear on Illini's Statement of Financial Position at cost less ten months of amortization. Cost Amortization ($75,000 / 6) x 10/12 Book value $75,000 10,417 $64,583
The Income Statement presentation for this patent should include $10,417 of amortization expense and $2,250 of interest expense ($75,000 x .06 x 6/12). (2) This patent should appear on the Statement of Financial Position at cost less six months of amortization. Cost Amortization ($104,800 / 10) x 6/12 Book value $104,800 5,240 $99,560
The Income Statement presentation for this patent should include $5,240 of amortization expense. All research and development costs should be expensed in the year in which they occur unless the criteria for capitalization of development costs have been met. (3) There should be no patent costs reflected on the company's Statement of Financial Position as the patent application was denied. The filing fees of $34,950 should be expensed on the current Income Statement. The three patents determined to have no future value should no longer appear on the company's Statement of Financial Position. The Income Statement should include the write-off of $171,255 for these patents. The patent account on the Statement of Financial Position should include $20,350 ($40,700 / 2) for the patent with the revised useful life. Patent amortization on the Income Statement should include $20,350 for this patent. (5) Since the lawsuit was successful, the legal fees of $51,000 should be capitalized and included on Illini's Statement of Financial Position. In general, the total costs expended to establish the validity of a patent can be capitalized; however, the previously expensed $380,000 should not be capitalized. The expensing was not
(4)
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the result of an error but was a properly recorded estimate at the time, and changes in estimates must be accounted for prospectively. (6) The $103,260 reported by Savey Company should be reported as revenue on Illini's Income Statement and as License Fees Receivable on the company's Statement of Financial Position.
B. Factors that should be considered when determining the useful life of a patent include the following. Consideration should be given to factors that may cause a patent to become economically ineffective, e.g., obsolescence due to changing technology. The maximum life of a patent cannot exceed its legal life of 17 years.
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Problem 14 a) The estimated lives of the trucks need not be the same for depreciation purposes. The depreciation process is one of allocating the cost of the asset to the periods of its use. The useful life to each company will depend upon the planned intensity of use, maintenance policy, and the retirement policy. There is no reason to believe that each company would be identical with respect to these considerations. b) The methods by which each company chooses to allocate the cost of the assets might also be different. The allocation over the useful life should be reasonable and orderly. Depreciation seeks to measure realistically the expiration of the asset; i.e., the pattern of services consumed during the period. The problem is that this is not observable. Therefore, firms are free to select from among the methods allowed. Each will select what it feels is most appropriate for reporting purposes, and these need not be the same. c) The asset should be recorded at the cash and/or cash equivalent given up to acquire it according to the cost principle. In this instance, cost will be cash plus the fair market value of the truck traded in. Cost = $9,000 + $4,500 = $13,500 d) Automotive equipment Accumulated depreciation Automotive equipment Cash Gain on trade of equipment $13,500.00 5,584.50 $8,500.00 9,000.00 1,584.50
Problem 15 Land $100,000 8,000 (1,500) 1,300 600 Building
Purchase of lot Demolition Sale of building stone Legal fees Land survey fees Factory plans Contract price Foreman's salary ($24,000 x 4/12) Insurance
$108,400
$ 25,000 950,000 8,000 600 $983,600
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Problem 16 a) Cost of land with existing building Architect fees Interest on construction financing Cost to demolish the old building Proceeds on sale of materials Payment of delinquent taxes Land survey fees Cost of new building Liability insurance during construction Land $860,000 $130,000 130,000 40,000 (8,000) 15,000 6,000 1,200,000 5,000 $1,465,000 Building
$913,000 The moving costs would be expensed. b) ($1,465,000 200,000) / 50 x 2/12
$4,216
Note that depreciation starts when the asset is available for use. In this case depreciation starts on October 31, 20x6.
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Problem 17 1. a. 20x5: $50,000 /10 x 20x6: 20x5 Acquisitions: $43,000 / 10 $7,000 / 10 x 20x6 Acquisitions: $20,000 / 10 x $2,500 $4,300 350 1,000 $5,650 $5,000 $7,740 630 2,000 $10,370
b.
20x5: $50,000 x 20% x 20x6: 20x5 Acquisitions: $38,700* x 20% $6,300* x 20% x 1/2 20x6 Acquisitions: $20,000 x 20% x 1/2
Ending balance on $43,000 of assets acquired in 20x5 = $43,000 x .9 = $38,700 (i.e. the depreciation in the first year is 10%, the ending net book value of the asset is the acquisition cost times one minus the depreciation rate) ** $7,000 x .9 = $6,300 2. Cash Accumulated depreciation: $350 x 2 Loss on disposal of equipment Equipment $4,000 700 2,300 $7,000
Problem 18 Net book value of equipment at January 1, 20x6 = $500,000 x (1 - .25)5 = $118,652 Depreciation in 20x6 = lesser of: $118,652 x 25% = $29,663 $118,652 100,000 Salvage Value = $18,652 => $18,652
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Problem 19 (a) Present value of asset retirement obligation: N = 30, I = 7, FV = $50,000,000 CPT PV = $6,568,356 Carrying value of mine site = $65,000,000 + 6,568,356 = $71,568,356 Dec 31, 20x0 Mine Asset Cash Asset Retirement Obligation (ARO) Interest expense ARO $6,568,356 x 7% Depreciation expense Accumulated depreciation $71,568,356 / 30 Dec 31, 20x2 Interest expense ARO ($6,568,356 + 459,785) x 7% Depreciation expense Accumulated depreciation (b) $71,568,356 $65,000,000 6,568,356 459,785 459,785
Dec 31, 20x1
2,385,612 2,385,612
491,970 491,970
2,385,612 2,385,612
Present value of increase in the asset retirement obligation at Jan 1, 20x12 N = 19, I = 7, FV = $60,000,000 - 50,000,000 = 10,000,000 CPT PV = $2,765,083 PV of the asset retirement obligation at Jan 1, 20x12 (revised estimate) N = 19, I = 7, FV = $60,000,000 CPT PV = $16,590,500 Carrying value of mine asset at Dec 31, 20x11: $71,568,356 x 19/30 = $45,326,625 Carrying value of mine asset at Jan 1, 20x12 = $45,326,625 + 2,765,083 = $48,091,708 Interest expense for 20x12 = $16,590,500 x 7% = $1,161,335 Depreciation expense for 20x12 = $48,091,708 / 19 = $2,531,143
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Mine asset carrying value, Dec 31, 20x12: $48,091,708 - 2,531,143 = $45,560,565 Asset retirement obligation, Dec 31, 20x12 $16,950,500 + 1,161,335 = $17,751,835 (c) PV of the asset retirement obligation at Jan 1, 20x28 (revised estimate) N = 3, I = 7, FV = $15,000,000 CPT PV = $12,244,468 PV of the asset retirement obligation at Jan 1, 20x28 (original estimate) N = 3, I = 7, FV = $60,000,000 CPT PV = $48,977,872 Decrease in ARO = $48,977,872 12,244,468 = $36,733,404 Carrying value of mine asset at Dec 31, 20x27 $2,531,143 Annual Depreciation x 3 years remaining = $7,593,429 Jan 1, 20x28 ARO Mine Asset Gain on reduction of ARO (P&L) Interest expense ARO $12,244,468 x 7% Mine Asset Cash Asset Retirement Obligation (ARO) Accretion expense ARO $14,000,000 x 4% Depreciation expense Acc. Depreciation $79,000,000 / 30 Mine Asset ARO $20,000,000 (14,000,000 + 560,000) $36,733,404 $7,593,429 29,139,975 857,113 857,113
Dec 31, 208
(d)
Dec 31, 20x0
$79,000,000 $65,000,000 14,000,000 560,000 560,000
Dec 31, 20x1
2,633,333 2,633,333
5,440,000 5,440,000
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Dec 31, 20x2
Accretion expense ARO $20,000,000 x 4% Depreciation expense Acc. Depreciation ($79,000,000 + 5,400,000 2,633,333) / 29 ARO Mine Asset $18,000,000 (20,000,000 + 800,000)
800,000 800,000
2,820,920 2,820,920
2,800,000 2,800,000
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Problem 20 (a) Cranshaw Asset new* Acc. Depreciation old Cash Asset old Gain on asset exchange * $900,000 FV of outgoing asset 100,000 cash received Asset new** Acc. Depreciation old Loss on asset exchange Cash Asset old ** $800,000 FV of outgoing asset + 100,000 cash paid Asset new Acc. Depreciation old Asset old Gain on asset exchange Asset new Acc. Depreciation old Loss on asset exchange Asset old Asset new Acc. Depreciation old Cash Asset old Asset new Acc. Depreciation old Cash Asset old $800,000 700,000 100,000 $1,400,000 200,000
Dexter
900,000 650,000 300,000 100,000 1,750,000
(b)
Cranshaw
900,000 700,000 1,400,000 200,000 800,000 650,000 300,000 1,750,000 600,000 700,000 100,000 1,400,000 1,200,000 650,000 100,000 1,750,000
Dexter
(c)
Cranshaw
Dexter
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9.
Liabilities
A liability is defined as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits (IAS 37.10). 9.1 Current Liabilities
An entity should classify a liability as current when (IAS 1.69): it expects to settle the liability in the entity's normal operating cycle, it holds the liability primarily for the purpose of trading, the liability is due to be settled within twelve months after the reporting period, or the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. The ASPE definition of a current liability is as follows: current liabilities shall include amounts payable within one year from the date of the balance sheet or within the normal operating cycle, when that is longer than a year. Accounts Payable and Accrued Liabilities Accounts payable are those debts to suppliers that arise from the normal purchasing activities of the company. Accrued liabilities are typically not legally payable at the financial statement date but will become payable later. For example, if the electrical utility takes meter readings on the 15th of every month, an estimate of electricity usage to the end of the fiscal period will usually be made. Other types of current liabilities include: provisions, notes payable (the accounting thereof is similar to notes receivable), customer deposits, income taxes payable, vacation/sick pay payable, and current portion of long-term debt.
9.2
Provisions
A provision is to be recognized as a liability when all of the following three criteria are met: the entity has a present obligation (legal or constructive) as a result of a past event; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and a reliable estimate can be made of the amount of the obligation (IAS 37.14).
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If all of the above criteria are not met, then no recognition can take place. Provisions differ from other liabilities such accounts payables and accrued liabilities because there is uncertainty about the timing or amount of the future expenditure. Consequently, provisions should be reported separately from accounts payable and accrued liabilities (IAS 37.11). A past event is deemed to give rise to a present obligation ie, taking account of all available evidence, it is more likely than not that a present obligation exists at the end of the reporting period (IAS 37.15). A legal obligation is an obligation that derives from: a contract, legislation, or other operation of law (IAS 37.10). A constructive obligation is an obligation that derives from an entity's actions where: by an established pattern of past practice, published policies of a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities (IAS 37.10). Examples of constructive obligations: the entity announces that they will provide an additional one year warranty beyond the three year contractual warranty; the right to return merchandise, although not legally required, is published as a policy on the firm's website; and the entity publishes its environmental policy with goes beyond what is legally required of them. A provision is measured as the best estimate of the expenditure required to settle the present obligation at the end of the reporting period (IAS 37.36). If the range of outcomes is discrete, i.e. if the provision involves several estimates, the obligation is estimated by calculating the expected value. If the range of outcomes is continuous, and each point in that range is as likely as any other, the mid-point of the range is used (IAS 37.39). Example4: an entity in the oil industry causes contamination and operates in a country where there is no environmental legislation. However, the entity has a widely published environmental policy in which it undertakes to clean up all contamination that it causes and has a record of honouring this published policy. The estimates for the costs of cleaning up this contamination along with the associated probabilities are as follows:
4 this is an adaptation of Example 2B of Appendix C of IAS 37.
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Cost $400,000 500,000 600,000 700,000 800,000
Probability 0.10 0.30 0.45 0.09 0.06
This is a provision because: the entity has a constructive obligation to decontaminate the land; and the outflow of resources is probable The provision would be recorded at its expected value of $571,000. ($400,000 x 10%) + ($500,000 x 30%) + ($600,000 x 45%) + ($700,000 x 9%) + ($800,000 x 6%) = $571,000 If the range of possible outcomes ranges from $400,000 to $800,000 as a continuous range (i.e. no estimate is better than the other), then we would accrue the mid-point, or $600,000. Of course, this assumes that the provision would need to be settled in the near future. If the expenditures resulting from this provision are expected to be incurred in several years from now and that the effect of time value of money is material, then the amount has to be discounted (IAS 37.45). The discount rate to be used is the pre-tax rate that reflects current market assessments of the time value of money and risks specific to the liability (IAS 37.47). Example: assume the same facts as in the previous example and that it is expected that these expenditures will be incurred in 15 years. At a discount rate of 6%, the present value of the provision is N 15 I/Y 6 PV X= $238,258 PMT FV 571,000
Enter Compute
If the difference between the undiscounted amount of $571,000 and the discounted amount of $238,258 is material, then we have to accrue the discounted amount. The provision would then be treated as decommissioning cost. A provision can only be used for expenditures for which the provision was originally recognized (IAS 37.61). A example of a provision is the warranty liabillity.
Warranty Liabilities An expense warranty is an undertaking by a vendor to maintain and repair a product or service. For example, a new car is usually sold with a warranty that contains some distance limits. According to the revenue recognition criteria, the cost of the warranty should be charged to the period in which the profit on the sale is recognized. Usually much of the warranty work is done in accounting periods following the sale. Thus, the estimated cost of the warranty is recorded in the year of sale through the following journal entry: Dr. Warranty expense Cr. Warranty Liability When warranty work is actually done, it is charged against this liability account: Dr. Warranty Liability Cr. Cash, Accounts Payable Example: Company X provides a 3 year warranty on all of the products it sells. Sales for the current year were $3,000,000 and it is estimated that the warranty expense is equal to 5% of sales. The warranty liability at the beginning of the year was $165,000 and actual costs incurred to service warranties during the year amounted to $130,000. The journal entry to record warranty expense is: Warranty expense ($3,000,000 x 5%) Warranty Liability The journal entry to record actual warranty costs incurred is: Warranty Liability Cash 130,000 130,000 $150,000 $150,000
The warranty liability at the end of the year will be $165,000 Opening Balance + 150,000 Warranty Expense 130,000 Warranty Costs Incurred = $185,000.
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Contingent Liabilities and Contingent Assets A contingent liability is defined as: a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one of more uncertain future events not wholly within the control of the entity; or a present obligation that arises from past events but is not recognized because: it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability (IAS 37.10). Contingent liabilities are not recognized (IAS 37.27). Unless the possibility of any outflow in settlement is remote, an entity shall disclose for each class of contingent liability a brief description of the nature of the contingent liability and, where practicable, an estimate of the financial effect; an indication of the uncertainties relating to the amount or timing of any outflow; and the possibility of any reimbursement. Appendix A of the standard provides the following table which outlines the key differences between provisions and contingent liabilities: There is a present obligation that probably requires an outflow of resources. A provision is recognized. Disclosures are required for the provision. There is a possible obligation or a present obligation that may, but probably will not, require an outflow of resources. No provision is recognized. Disclosures are required for the contingent liability. There is a possible obligation or a present obligation where the likelihood of an outflow of resources is remote. No provision is recognized. No disclosure is required.
Contingent Assets A contingent asset arises from an unplanned or other unexpected event that gives rise to the possibility of an inflow of economic benefit to the entity. For example, a claim that an entity is pursuing through the legal system, where the outcome is uncertain. Contingent assets cannot be recognized since this may result in the recognition of income that may never be realized (IAS 37.31 and 37.33). If an inflow of economic benefit is probable, contingent assets must be disclosed in the notes to the financial statements (IAS 37.34).
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ASPE - what IFRS refers to as provisions and contingencies are grouped and called contingent liabilities under ASPE. The criteria are fundamentally the same: if a liability meets the criteria for a provision under IFRS, then it is called a contingent liability that is recorded. If the liability meets the definition of a contingent liability as per IFRS, then it is also called a contingent liability under ASPE and is disclosed. Also, if you have a range of possible outcomes of a contingent liability that is to be recorded, ASPE requires you to record the lower of the range and disclose the remaining exposure.
9.3
Customer Incentive Programs
Deferred revenues arises when a company offers its customers redeemable coupons, frequent flyer points or any program whereby the customer can receive something of value in the future based on current purchases. Like warranties, the matching principle requires that the reduction of revenues in a given year be properly matched to the revenues that were recognized when the primary sale was made (IFRIC 13).
Example for every dollar of revenue, you give your customers one coupon. They can then redeem 10,000 coupons to receive a gizmo that is valued at $50. You estimate that only 60% of coupons will be redeemed. Your sales for the year amount to $5,600,000, the opening balance in the deferred revenue account relative to this incentive program was $15,000 and 4,800,000 coupons were redeemed. The journal entry to record the premium expense is: Revenues ($5,600,000 / 10,000 x $50 x 60%) Deferred Revenues Incentive Program The journal entry to record actual premium costs incurred is: Deferred Revenues Incentive Program (4,800,000 / 10,000 x $50) Revenues $16,800 $16,800
24,000 24,000
If we assume that the cost of each gizmo is $20, the following journal entry would also have to be recorded: Cost of good sold (480 gizmos sold x $20) Inventory 9,600 9,600
The Deferred Revenues - Premiums at the end of the year will be $15,000 Opening Balance + 16,800 Premium Expense 24,000 Premium Rewards Incurred = $7,800.
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Disclosure Requirements - Provisions For each class of provision, the following has to be disclosed: the carrying amount at the beginning and end of the period; additional provisions made in the period, including increases to existing provisions; amounts used (i.e. incurred and charged against the provision) during the period; unused amounts reversed during the period; the increase during the period on the discounted amount arising from the passage of time and the effect of any change in the discount rate; a brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits; an indication of the uncertainties about the amount and timing of those outflows; and the amount of the any expected reimbursement, stating the amount of any asset that has been recognized for that expected reimbursement (IAS 37.84:85). ASPE - provisions are considered as part of contingent liabilities under ASPE. See discussion after the contingent liability section of this chapter.
9.4
Sales Warranties
In addition to providing warranties that come with products, some entities often sell extended warranties. The accounting for the expense warranty (the one that comes with the product) was explained above. The accounting for the sales warranty is accounted for as rendering of services, i.e. using the percentage of completion method as follows: on date of sale, the sale warranty is recorded as unearned revenue: dr. Cash Cr. Unearned sales warranty revenue as the sales warranty period progresses, the sales warranty is earned (as per the percentage of completion of the contract). dr. Unearned sales warranty revenue cr. Sales warranty revenue Percentage of completion at the end of each period is measured as follows: Costs incurred to date / Total estimated contract costs as expenses are incurred under the sales warranty, they are simply charged to expense:
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dr. Sales warranty expense cr. Cash or Accounts Payable Example assume that you sell a product that comes with a one year warranty. In addition, you provide your customers an optional two year extended warranty. The product sells for $1,000, you estimate that the warranty costs will equal to 2% of sales on average. The extended warranty costs the customer $120. The journal entries to record the sale of product and extended warranty on January 2, 20x2 are as follows. Assume a calendar year end and that the product is returned for repairs on September 15, 20x2 at a cost of $30, February 28, 20x3 at a cost of $36 and on July 23, 20x4 at a cost of $160. At December 31, 20x3, you estimate that it will cost you an additional $54 to service the warranty in 20x3. Jan 2, 20x2 Cash ($1,000 + 120) Sales Unearned sales warranty revenues Warranty expense ($1,000 x 2%) Warranty liability Sep 15, 20x2 Warranty liability Cash Sales warranty expense Cash $1,120 $1,000 120 20 20 30 30 36 36
Feb 28, 20x3
At December 31, the % of completion of the contract is: $36 / (36 + 54) = $36/90 = 40%. Total revenues to realize in 20x3 = $120 x 40% = $48. Dec 31, 20x3 Unearned sales warranty revenues Sales warranty revenues Sales warranty expense Cash Unearned sales warranty revenues Sales warranty revenues 48 48 160 160 72 72
Jul 23, 20x4
Dec 31, 20x4
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9.5
Accounting for Bonds Payable
A bond is a legal document giving evidence of a contractual obligation by a company, starting at a time referred to as the inception date, to (i) (ii) redeem the bond for a stated amount (the face amount or par value) at some stated time in the future called the maturity date and make periodic interest payments during the term of the bond.
These interest payments are normally stated as a percentage of the face amount, and this percentage is termed the coupon rate (or stated rate). The length of time between the inception and maturity dates is known as the term of the bond. Bonds may be secured by the pledge of specific assets of the company, such as land and buildings, in which case they are referred to as mortgage bonds. If there is no pledge of specific assets but rather a general charge against all assets, the bonds are referred to as debentures. The legal terms of the bond are very important because the sums borrowed are often very large (e.g., $25 million). Moreover, as any given issue is often widely held, renegotiation of the terms is usually expensive and difficult. The terms of the bond issue are set out in a trust indenture, which is a legal agreement between the issuing company and a trust company acting on behalf of the bondholders. The trust company is referred to as the bond trustee. It is the bond trustee's duty to see that the issuing company lives up to the terms of the trust indenture and to take whatever steps are necessary to protect the bondholders (ie., seize the assets given as security for the bond issue). Here is an example of a straightforward bond issue. On July 1, 20x1, Gamma Corporation issued bonds with a face value of $500,000 and a coupon rate of 10%. The bonds pay interest semi-annually on January 1 and July 1 and are due in five years. If the bonds were sold for their face amount, they would be selling at par value; if less than their face amount, they would be selling at a discount; and if more than their face value, they would be selling at a premium. Assume that the going market interest rate for similar bonds on July 1, 20x1 is 8%. Because the Gamma bonds pay a higher amount of interest, investors will be willing to pay more for these bonds and will purchase them at a premium. The bonds will sell for the discounted value of the bond's cash flow. The cash flows are discounted at the market rate of interest. Note also that because the interest is paid semi-annually, that we are dealing with semi-annual amortization. The value of the bond issue will be as follows: N 10 I/Y 4 PV X= 540,554 PMT 25000 FV 500000
Enter Compute
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The journal entry to record the issuance of these bonds is as follows: July 1, 20x1 Cash Bonds payable $540,554 $540,554
On January 1, 20x2, the first interest payment is made to bondholders of $25,000 ($500,000 x 10% x 1/2). However, because the firm is effectively paying 8% interest on these bonds (the market rate), the interest expense will be lower than $25,000. The difference will be handled through the amortization of the premium on bonds payable ($540,554 Proceeds 500,000 Face Value = $40,554). This premium will be amortized and reduce the balance of the bonds payable to $500,000 by the end of the bond term. The method used to account for the amortization of the discount or premium on bonds is called the effective interest method. The journal entry to record the interest payments is as follows: Jan 1, 20x2 Bonds payable Interest expense (540,554 x 4%) Cash $3,378 21,622 25,000
Note that the amount of interest expense is calculated directly and that the amount of the premium on bonds payable is imputed as Cash - Interest expense. The interest expense is calculated as the carrying value of the bond times the market rate of interest. The journal entry to record the interest payment of July 1, 20x2 would be as follows: Jul 1, 20x2 Bonds Interest expense (540,554 - 3,378) x 4% Cash $3,513 21,487 25,000
If we now assume that the going rate of interest at the time of issue is 14%, then the bonds would sell at a discount since investors want to be compensated for the fact that the bonds are paying a coupon rate of only 10%. The value of each $1,000 bond will be as follows: N 10 I/Y 7 PV X= 429,764 PMT 25000 FV 500000
Enter Compute
The journal entry to record the issuance of the bonds would be as follows: July 1, 20x1 Cash Bonds payable $429,764 $429,764
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The journal entry to record the first interest payment if the straight-line method of amortization is used is as follows: Jan 1, 20x2 Interest expense Bonds payable ($70,236 10) Cash $32,024 7,024 25,000
Note that the interest expense is higher because the firm is effectively paying 14% interest even though they are paying coupon payments of 10% of the face value. The journal entry to record the first two interest payments if the effective interest method of amortization is used is as follows: Jan 1, 20x2 Interest expense (429,764 x 7%) Bonds payable Cash Interest expense (429,764 + 5,083) x 7% Bonds payable Cash $30,083 5,083 25,000 $30,439 5,439 25,000
Jul 1, 20x2
Accounting for bonds can be summarized as follows: 1. On date of issue, we calculate the present value of the bonds by discounting the coupon payments and face value at the yield to maturity (market interest rate). If the resulting amount is less than the face value of the bonds, then the bonds have issued at a discount. If the resulting amount is higher than the face value of the bonds, then the bonds have issued at a premium. The journal entry to record the bond issue is as follows: Cash Bonds Payable 2. XXX XXX
On coupon payment dates, we record the interest expense using the effective interest method. The interest expense is equal to the book value of the bonds payable times the yield to maturity. Since bonds pay coupons semi-annually, the yield to maturity rate must be divided by two. The difference between the interest expense and the coupon paid is equal to the amortization of the bond premium or discount and gets recorded directly to the Bonds Payable Account. If the bonds were issued at a discount, the journal entry would be as follows: Interest expense Bonds Payable Cash XXX XXX XXX
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If the bonds were issued at a premium, the journal entry would be as follows: Interest expense Bonds Payable Cash 3. XXX XXX XXX
If the coupon payment date does not coincide with the companys year-end, then interest on the bond issue must be accrued at year end. The accrued interest = book value of bonds payable x YTM x prorata for time since last coupon payment date The journal entry would be as follows (note that this journal entry would be reversed at the beginning of the next period): Interest expense Interest Payable XXX XXX
4.
If the bonds are redeemed before the maturity date of the bonds, we must first calculate the book value of the bonds and then remove these from the books. Any difference between the cash paid to retire the bonds and the book value of the bonds retired gets debited/credited to loss/gain on redemption of bonds payable. If the bonds are retired at a loss, the journal entry would be as follows: Bonds Payable Loss on retirement of Bonds Payable Cash XXX XXX XXX
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Example: In order to finance a major expansion program, Aughey Ltd. issued bonds dated May 31, 20x5, with a face amount of $3,000,000 and a coupon rate of 10%. Interest is payable on November 30 and May 31. The bonds were issued to yield 12% and mature in twelve years. Aughey Ltd. uses the effective interest rate method. Assume that the company retires $900,000 face amount of the bonds on September 30, 20x8, at 97 plus accrued interest. The fiscal year end of Aughey Ltd. is December 31. The proceeds received on the bond issue will equal to: N 24 I/Y 6 PV PMT 150000 FV 3000000
X= 2,623,489 The journal entry to record the bond issue on July 2, 20x5 will be: Jul 2, 20x5 Cash Bonds payable $2,648,489 2,648,489
Enter Compute
The journal entries for 20x5 to May 31, 20x6 and the journal entry to record the retirement of the bonds on September 30, 20x8 will be: Nov 30, 20x5 Interest expense ($2,623,489 x 6%) Bonds payable Cash Interest expense Interest payable ($2,623,489 + 7,409) x 6% x 1/6 = $2,630,898 x 6% x 1/6 Interest payable Interest expense Interest expense ($2,630,898 x 6%) Bonds payable Cash $157,409 7,409 150,000 26,309 26,309
Dec 31, 20x5
Jan 1, 20x6
26,309 26,309 157,854 7,854 150,000
May 31, 20x6
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In order to prepare the journal entry for the bond redemption on September 30, 20x8, we need to calculate the book value of the bonds payable at May 31, 20x8 (the most recent interest payment date). Book value of bonds payable = the present value of the remaining cash flows at the original yield to maturity N 18 I/Y 6 PV X= 2,675,172 PMT 150000 FV 3000000
Enter Compute
The first thing we need to do is accrue interest expense on these bonds to September 30, 20x8: Sep 30, 20x8 Interest expense ($2,675,172 x 6% x 4/6) Bonds payable Interest payable ($150,000 x 4/6) 107,007 7,007 100,000
This brings the book value of the bonds payable at: $2,675,172 + 7,007 = $2,682,179 We will have to pay the bondholders 4 months coupon: $900,000 x 5% x 4/6 = $30,000 Sep 30, 20x8 Interest payable Cash 30,000 30,000
The entry to record the redemption of the bonds payable is: Sep 30, 20x8 Bonds payable ($2,682,179 x 900/3,000) Loss on redemption of bonds payable Cash ($900,000 x .97) 804,654 68,346 873,000
Bond Issue Costs Any direct costs incurred to issue bonds, i.e. underwriting, legal and accounting fees reduce the bond proceeds.
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ASPE - entities have the option to account for discounts and premiums either using the effective interest method (as outlined above) or any other systematic method (i.e. straight-line method). Example - an entity issues 6%, $20,000,000 face value bonds on December 31, 20x4. The bonds are due in 10 years, pay coupon payments on June 30 and December 31 of every year and were issued to yield 5.5%. Total cash proceeds received on the bond issue amounted to $ 20,761,363 (check it yourself using your financial calculator). The journal entries for 20x4-20x5 are as follows: Dec 31, 20x4 Cash Bonds Payable $20,761,363 $20,761,363
Jun 30, 20x5
Interest expense 561,932 Bonds payable* 38,068 Cash * premium of $761,363 / 20 periods = $38,068 Interest expense Bonds payable Cash 561,932 38,068
600,000
Dec 31, 20x4
600,000
Note that the interest expense is equal to the coupon payments adjusted for the amortization of the premium/discount.
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9.6
Events after the reporting period
Events after the reporting period are events arising between the end of the reporting period and the date the financial statements are authorized to be issued. There are two types of subsequent events: adjusting events after the reporting period - those which provide further evidence of conditions which existed at the financial statement date - these will result in an adjustment to the financial statements, and non-adjusting events after the reporting period - those which are indicative of conditions which arose subsequent to the financial statement date that do not provide further evidence of conditions which existed at the financial statement date - if material, these have to be disclosed in the notes to the financial statements (IAS 10.3) Examples of adjusting events after the reporting period: institution of bankruptcy proceedings against a debtor - you may have to revise the allowance for doubtful accounts; a long-term investment in which you hold a significant influence announces its worst annual results since inception - you may have to determine whether a writedown is required; a court case confirms the existence of a previously recorded provision or a previously disclosed contingent liability. Examples of non-adjusting events after the reporting period: an event such as a fire or flood which results in a loss; purchase of a business; commencement of litigation where the cause of action arose subsequent to the date of the financial statements; changes in foreign currency exchange rates; the issue of capital stock or long term debt. Financial statements should be adjusted when events occurring between the date of the financial statements and the date the financial statements are authorized to be issued since these provide additional evidence relating to conditions that existed at the date of the financial statements (IAS 10.8). Disclosure Requirements If non-adjusting events after the reporting period are material, non-disclosure could influence the economic decisions that users make on the basis of the financial statements. Accordingly, an entity shall disclose the following for each material category of nonadjusting event after the reporting period: the nature of the event, and an estimate of its financial effect, or a statement that such an estimate cannot be made (IAS 10.21).

Multiple Choice Questions 1. Robb Company requires advance payments with special orders from customers or machinery constructed to their specifications. Information for 20x5 is as follows: Customer advances - balance December 31, 20x4 Advances received with orders in 20x5 Advances applied to orders shipped in 20x5 Advances applicable to orders cancelled in 20x5 $295,000 460,000 410,000 125,000
At December 31, 20x5, what amount should Robb report as a current liability for customer deposits? a. $0. b. $220,000. c. $345,000. d. $370,000. 2. Cobb Company sells appliance service contracts to repair appliances for a two year period. Cobb's past experience is that, of the total amount spent for repairs on service contracts, 40% is incurred evenly (per month) during the first contract year and 60%, evenly during the second contract year. Receipts from service contract sales for the two years ended December 31, 20x5, are $500,000 in 20x4 and $600,000 in 20x5. Receipts from contracts are credited to unearned service contract revenue. Assume that all contract sales are made evenly (per month) the during the year. What amount should Cobb report as unearned service contract revenue at December 31, 20x5? a. $360,000. b. $470,000. c. $480,000. d. $630,000.
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3.
Farr Company sells its products in expensive, reusable containers. The customer is charged a deposit for each container delivered and receives a refund for each container returned within two years after the year of delivery. Farr accounts for the cash received for containers not returned within the time limit as a sale at the deposit amount when the time limit expires. Information for 20x5 is as follows: Containers held by customers at December 31, 20x4, from deliveries in: 20x3 20x4 $ 75,000 215,000 $290,000 $390,000
Containers delivered in 20x5 Containers returned in 20x5, from deliveries in: 20x3 20x4 20x5
$ 45,000 (Eligible for refund) 125,000 143,000 $313,000
What amount should Farr report as a liability for returnable containers at December 31, 20x5? a. $247,000. b. $322,000. c. $337,000. d. $367,000.
4.
Bonds due in 5 years were sold at $104,158 on January 1 to yield an effective interest rate of 7% compounded semiannually. Face value of the bonds is $100,000 and the annual coupon rate is 8%. Cash interest is paid semiannually. What is the interest expense for the first 6-month period using the effective interest method? a. $3,500. b. $3,646. c. $3,584. d. $4,166. e. $4,416.
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5.
The 10% bonds payable of Issac Company had a net carrying amount of $760,000 on January 2, 20x3. The bonds, which had a face value of $800,000, were issued at a discount to yield 12%. The amortization of the bond discount was recorded under the effective interest method. Interest was paid on January 1 and July 1 of each year. On July 2, 20x3, several years before their maturity, Issac retired the bonds at 102. The interest payment on July 1, 20x3 was made as scheduled. What is the loss that Issac should record on the early retirement of the bonds on July 2, 20x3? Ignore taxes. a) $16,000 b) $50,400 c) $44,800 d) $56,000
6.
Which of the following situations would NOT require disclosure in the notes to the financial statements of Company A? a) Company A is being sued by an employee for wrongful dismissal and is unsure as to whether it will lose. If Company A does lose, the most likely loss will be $400,000, a material amount. No amount has been accrued. b) Company A changed its inventory valuation method from FIFO to average cost. c) There is a high probability that a lawsuit launched by Company A against a competitor for breach of copyright will be successful, resulting in significant proceeds. d) Company A is being sued by a former customer for $40,000 relating to some deficient work. Company A is sure that it will lose and has therefore accrued a liability of $40,000. e) Company A recently determined that it under-remitted payroll taxes in a previous fiscal year. Although the under-remittance has been accrued, Company A is unsure as to whether the maximum amount of $100,000 of penalties will be charged.
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7.
On November 5, 20x1, a Dunn Corp. truck was in an accident with an auto driven by Bell. Dunn received notice on January 12, 20x2, of a lawsuit for $700,000 damages for personal injuries suffered by Bell. Dunn Corp.'s counsel believes it is probable that Bell will be awarded an estimated amount in the range between $200,000 and $450,000, and that $300,000 is a better estimate of potential liability than any other amount. Dunn's accounting year ends on December 31, and the 20x1 financial statements were issued on March 2, 20x2. What amount of provision should Dunn accrue at December 31, 20x1? a) $0 b) $200,000 c) $300,000 d) $450,000
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Problem 1 Early in 20x0, Draeger Incorporated decided to retool its automotive engine plant to produce a newly designed 24-valve, six-cylinder automotive engine. This engine is capable of attaining a high gas mileage rating with low emissions. The advance notices in several national automotive magazines were very favorable. In order to finance the retooling, Draeger issued $200 million of 8% registered debentures due in ten years June 30. Interest is payable semi-annually on December 31 and June 30. As a result of the favorable notices in the automotive magazines, the noncallable bonds were sold to yield 7%. The issue was sold through underwriters on July 1, 20x0. The company's fiscal year ends December 31. Required a. Prepare the journal entries for Draeger Incorporated to record the issuance of the bonds on July 1, 20x0. b. Prepare the journal entries for Draeger Incorporated to reflect the bond issuance on the financial statements dated December 31,20x0.
Problem 2 Alpha Corporation sold $400,000 of 8% (payable semi-annually on June 30 and December 31), three-year bonds. The bonds were dated and sold on January 1, 20x2, at an effective interest rate of 10%. The accounting period for the company ends on 31 December. Required 1. 2. 3. 4. 5. 6. Compute the price of the bonds. Prepare a debt amortization schedule for the life of the bonds (use the effective interest method and round to the nearest dollar). Prepare entries for Alpha through December 31, 20x2. Show how Alpha would report the bonds on its Statement of Financial Position at December 31, 20x2. What would be reported on the income statement for the year ended December 31, 20x2? Repeat items # 2-3 on the assumption that Alpha Corporation is a private entity subject to ASPE and has opted to account for bond discounts/premiums using the straight-line method.
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Problem 3 On April 1, 20x0, Hanson Industries Ltd. issued ten year bonds with a face value of $5,000,000. The proceeds of the issue were $5,159,133. The bonds have a stated interest rate of 10%, payable semi-annually at October 1 and April 1. Hanson Industries has a December 31 year end. Required a) Prepare all of the journal entries necessary from April 1, 20x0 to April 1, 20x1. b) Assume that one-half of the bonds were retired on April 1, 20x4 at 102. Prepare the journal entry to record the retirement of the bonds.
Problem 4 On January 1 20x0, the Nolan Trust Ltd. issued for $519,641 five-year, 12% bonds that have a maturity value of $500,000 and pay interest semi-annually on June 30 and December 31 of each year. The yield to maturity on that date was 10.96%. A call price of 105 exists on these bonds. Required a) What does the issue price of the bonds tell you about the market interest rate on January 1, 20x0? Explain your answer. b) If the bonds are called by Nolan Trust Ltd. at any time during their life, would you expect a gain or a loss to be realized upon the early retirement? Explain your answer. c) What is the interest expense as reported on the income statement for the year ended December 31, 20x0? Show your calculations. d) Present the liability for these bonds as it would be reported on the Statement of Financial Position as at December 31, 20x0.
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Problem 5 Maston Company is a manufacturer of toys. During the year, the following situations arose: Situation 1: A safety hazard related to one of Maston's toy products was discovered. It is considered likely that liabilities have been incurred. A reasonable estimate of the amount of loss can be made on the basis of past experience. Situation 2: One of Maston's small warehouses is located on the bank of a river and can no longer be insured against flood losses. No flood losses have occurred since the date when the insurance became unavailable. Required 1. How should Maston report the safety hazard? Why? 2. How should Maston report the uninsurable flood risk? Why?
Problem 6 The following two independent sets of facts relate to the possible accrual of a loss contingency or its possible disclosure by other means. Situation 1: A company offers a one-year warranty for the product that it manufactures. A history of warranty claims has been compiled and the likely amount of claims related to sales for a given period can be determined. Situation 2: A company has adopted a policy of recording self-insurance for any possible losses resulting from injury to others by its vehicles. The premium for an insurance policy for the same risk from an independent insurance company would have an annual cost of $2,000. During the period covered by the financial statements, there were no accidents involving the company's vehicles which resulted in injury to others. Required For each of the two independent sets of facts above, discuss the accrual or type of disclosure necessary (if any) and the reason why such disclosure is appropriate.
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Problem 7 In May 20x2 the Dennon Company became involved in litigation. As a result, it is likely that Dennon will have to pay $1.3 million. In July 20x2 a competitor commenced a suit against Dennon alleging violation of antitrust laws and seeking damages of $2.2 million. Dennon denies the allegations, and the likelihood that Dennon will have to pay any damages is remote. In September 20x2 Blane County brought action against Dennon for $1.8 million for polluting Bass Lake. It is possible that the county's suit will be successful, but the amount of damages Dennon will have to pay is not reasonably determinable. Required 1. What amount, if any, should be accrued in 20x2? 2. Draft the disclosures, if any, that should appear in Dennon Company's 20x2 financial statements as the result of the litigation in 20x2.
Problem 8 On January 1, 20x4, H. Ltd. issued 10% bonds, maturing in ten years, with a face value of $200,000 at a price to yield 8% compounded semi-annually. The bonds pay interest semi-annually. H. Ltd. uses the effective interest rate method to account for bond discounts and premiums. What amount of bond interest expense will H. Ltd. report on its fiscal year ended December 31, 20x4, financial statements?
Problem 9 The Canadian Chocolate Company (CCC) is a manufacturer of chocolate candy products. Earlier this year, one of CCC's subsidiaries was the victim of an extortion attempt. The extortionists demanded $24 million from the company. When CCC refused to comply, the extortionists carried out the threat to poison "Treat" bars in three large cities, apparently chosen at random. As a result, six people died and 12 others became seriously ill. The company responded by removing every "Treat" bar from the shelves of all retailers and destroying the stock. The company also introduced a tamper-proof wrapper for new stock and hired a public relations firm to undertake a special campaign to rebuild consumer confidence in the bar. All costs were transferred to the head office to allow for one consolidated insurance claim. The company has estimated that the total cost resulting from the poisoning is about $25 million: $2 million for the new wrapping machinery, $8 million for the products destroyed, $2 million for the public relations firm, and $14 million for profits lost through reduced product sales. CCC does not want to include the insurance settlement in income in the current year but wants to defer and amortize the amount over
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a five-year term (on the same basis as the costs of machinery and equipment are depreciated). Legal proceedings have been commenced against CCC and its subsidiaries by the estates of the deceased parties and by those who became ill. They are suing for $450 million. Required How should CCC reflect the above facts in the current year-end financial statements? Provide calculations where possible.
Problem 10 Foster Music Emporium carries a wide variety of musical instruments, sound reproduction equipment, recorded music, and sheet music. As a sales promotion technique, Foster uses warranties to attract customers. Musical instruments and sound equipment are sold with a one year warranty for replacement of parts and labour. The estimated warranty cost, based on experience, is 1.5 percent of sales. Sales for these items were $5.4 million in 20x2. Foster uses the accrual method to account for the warranty costs for financial reporting purposes. The balance in the account related to warranties on January 1, 20x2, was as shown below. Estimated liability from warranties $63,000
Replacement parts and labour for warranty work totalled $80,000 during 20x2. Required Foster Music Emporium is preparing its financial statements for the year ended December 31, 20x2. Determine the amount that will be shown on the 20x2 financial statements for the following: a) Warranty expense. b) Estimated liability from warranties.
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SOLUTIONS
Multiple Choice Questions 1. 2 b d The outstanding contracts at Dec 31, 20x5: 20x4: $500,000 x 60% x 1/2 = $150,000 20x5: $600,000 x 40% x 1/2 = $120,000 600,000 x 60% = $360,000 Total = $630,000 $290,000 + 390,000 - 313,000 - 30,000 = $337,000 The interest expense for the first 6 months that the bonds are outstanding is calculated as (7% x $104,158) x .5 = $3,646. Book value of bonds on July 2, 20x3 = $760,000 + [(760,000 x 6%) (800,000 x 5%)] $760,000 + (45,600 40,000) $765,600 Cost to retire bond issue = $800,000 x 1.02 = $816,000 Loss on retirement = $816,000 765,600 = $50,400 No disclosure is necessary since no further exposure exists in addition to the amount accrued. Choices a), b), c) and e) all describe situations where disclosure in the notes would be required. A provision should be accrued if it is probable that a liability has been incurred at the balance sheet date and the amount of the loss is reasonably estimable. This loss must be accrued because it meets both criteria. Notice that even though the lawsuit was not initiated until 1/12/x2, the liability was incurred on 11/5/x1 when the accident occurred. When some amount within an estimated range is a better estimate than any other amount in the range, that amount is accrued. Therefore, a loss of $300,000 should be accrued.
3. 4.
c b
5.
6.
7.
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Problem 1 a. The journal entries to record Draeger Incorporated's issuance of bonds and payment of related costs at July 1, 20x0 are presented below. The proceeds on the bond issue: N 20 I/Y 3.5 PV X= 214,212,403 PMT 8000000 FV 200000000
Enter Compute
Cash Bonds payable To record bond issuance at July 1, 20x0.
$214,212,403 $214,212,403
b.
The journal entries to record Draeger Incorporated's bond issuance on the financial statements dated December 31, 20x0 are presented below. Interest expense ($214,212,403 x 3.5%) $7,497,434 Bonds payable 502,566 Cash To record interest and premium at December 31, 20x0.
$8,000,000
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Problem 2 1. Enter Compute N 6 I/Y 5 PV X= $379,697 Discount Amortization 18,985 19,134 19,290 19,455 19,628 19,811* 2,985 3,134 3,290 3,455 3,628 3,811 PMT 16000 FV 400000
2. Time 0 1 2 3 4 5 6 Date Jan 1, x2 Jun 30, x2 Dec 31, x2 Jun 30, x3 Dec 31, x3 Jun 30, x4 Dec 31, x4 Interest
Balance $379,697 382,682 385,816 389,106 392,561 396,189 400,000
* rounded to balance 3. Jan 1, x2 Cash Bonds Payable Interest expense Bonds payable Cash Interest expense Bonds payable Cash 379,697 379,697 18,985 2,985 16,000 19,134 3,134 16,000 $385,816 $38,119 Discount Amortization 3,384 3,384 3,384 3,384 3,384 3,383*
Jun 30, x2
Dec 31, x2
4. 5. 6.
Bonds payable Interest expense (18,985 + 19,134) 2. Time 0 1 2 3 4 5 6 Date Jan 1, x2 Jun 30, x2 Dec 31, x2 Jun 30, x3 Dec 31, x3 Jun 30, x4 Dec 31, x4 Interest 19,384 19,384 19,384 19,384 19,384 19,383
Balance $379,697 383,081 386,465 389,849 393,233 396,617 400,000
* rounded to balance.
3.
Jan 1, x2
Cash Bonds Payable Interest expense Bonds payable Cash Interest expense Bonds payable Cash
379,697 379,697 19,384 3,384 16,000 19,384 3,384 16,000
Jun 30, x2
Dec 31, x2
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Problem 3 a) First, we have to calculate the YTM on the bonds: N 20 I/Y 4.75% Cash Bonds payable Interest expense ($5,159,133 x 4.75%) Bonds payable Cash Interest expense ($5,159,133 - 4,941) x 4.75% x 3/6 Interest payable Interest expense Bonds payable Interest payable Cash $5,159,133 $5,159,133 PV 5,159,133 PMT -250,000 FV -5,000,000
Enter Compute Apr 1, 20x0
Oct 1, 20x0
$245,059 4,941 250,000
Dec 31, 20x0
122,412 122,412 122,412 5,176 122,412 250,000
Apr 1, 20x1
b) Book value of bonds payable at April 1, 20x4: N 12 I/Y 4.75 PV 5,112,369 PMT 250,000 FV 5,000,000
Enter Compute
Bonds payable ($5,112,369 x 50%) Gain on retirement of bonds Cash ($2,500,000 x 1.02)
$2,556,185 $ 6,185 2,550,000
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Problem 4 a) Since the bonds were issued at a premium (i.e., the proceeds exceeded the face value), this indicates that the market interest rate at January 1, 20x0 must be less than the 12% offered by the bond issue. Otherwise, investors would not be willing to pay more than the face value for this investment. b) If the bonds are called by Nolan Trust Ltd., the company will have to pay the call price of 105. The bonds were issued at 104 ($520,000 / $500,000) . The four percent premium will be amortized over the life of the bonds. The bonds at face value plus the unamortized premium represent the carrying value of the bonds. At any time the call price would exceed the carrying value of the bonds in this case; therefore, there would be a loss on retirement realized by Nolan Trust Ltd. c) 1st half of the year: $519,641 x 5.48% 2nd half of the year: $519,641 - (30,000 Coupon Pmt - 28,476 Interest Exp - 1st Half) x 5.48% = $518,117 x 5.48% d) Bonds payable [$518,117 - (30,000 Coupon Pmt - 28,393 Interest Exp - 2nd Half)] $28,476
28,393 $56,869 $516,510
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Problem 5 1. Maston should report the estimated loss from the safety hazard as an expense in the income statement and a provision in the Statement of Financial Position because both of the following conditions were met: the entity has a present obligation (legal or constructive) as a result of a past event; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and a reliable estimate can be made of the amount of the obligation (IAS 37.14). 2. Maston should not report the estimated loss from the uninsurable flood risk as an expense in the income statement or as provision in the Statement of Financial Position because no losses have occurred since the warehouse has 'been uninsured. Furthermore, disclosure of the uninsurable risk in the notes to the financial statements is not required because no losses have occurred since the warehouse has been uninsured. Disclosure in the notes to the financial statements is, however, desirable to alert the reader to the exposure created by the lack of insurance.
Problem 6 SITUATION 1. When a company sells a product subject to a warranty, it is likely that there will be expenses incurred in future accounting periods relating to revenues recognized in the current period. As such, a liability has been incurred to honour the warranty at the same date as the recognition of the revenue and a provision should be taken for the warranty liability. Based on prior experience or technical analysis, the occurrence of warranty claims can be reasonably estimated and a likely dollar estimate of the liability can be made. SITUATION 2. The fact that a company chooses to self-insure the contingency of injury to others caused by its vehicles is not basis enough to accrue a provision that has not occurred at the date of the financial statements. An accrual or "reserve" cannot be made for the amount of insurance premium that would have been paid had a policy been obtained to insure the company against this particular risk. A provision may only be accrued if prior to the date of the financial statements a specific event has occurred that will impair an asset or create a liability and an amount related to that specific occurrence can be reasonably estimated. The fact that the company is self-insuring this risk should be disclosed by means of a note to alert the financial statement reader to the exposure created by the lack of insurance.
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Problem 7 1. An amount of $1,300,000 should be accrued as a provision on the first lawsuit since: Dennon has a present obligation as a result of a past event; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and a reliable estimate can be made of the amount of the obligation. The $2.2 million dollar lawsuit does not qualify as a contingent liability since the likelihood of paying damages is remote. No disclosure is necessary. The $1.8 million dollar lawsuit qualifies as a contingent liability since it is possible for the lawsuit to be successful. Disclosure of the contingency is required. 2. NOTE - LOSS CONTINGENCY: In September of 20x2, Blane County filed suit against Dennon Company for polluting Bass Lake. Blane County is requesting $1,800,000 from Dennon. It is likely that Blane County will be successful, but the amount of damages Dennon will have to pay is not reasonably determinable.
Problem 8 Issue Price N 20 I/Y 4 PV X= $227,181 PMT 10000 FV 200000
Enter Compute
Bond Interest: Period 1 = $227,181 x 4% = Period 2 = [$227,181 - ($10,000 - $9,087)] x 4% = $226,268 x 4% =
$ 9,087 9,051 $18,138
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Problem 9 The net book value of the equipment taken out of service, the cost of the destroyed products, and the public relations cost do not represent future benefits so they should not be capitalized and amortized over time. CCC should recognize them as an expense on the Statement of Income. CCC should accrue a provision with respect to the lawsuits if a loss is likely and if an amount can be reasonably estimated. If not, then the company needs to assess if the outcome of the lawsuit is possible and if so, then the lawsuit is a contingent liability and the details of the litigation should be disclosed by way of note.
Problem 10 a) Sales of musical instruments and sound equipment Estimated warranty cost Warranty expense for 20x2 Estimated liability from warranties--January 1, 20x2 20x2 Warranty expense (Requirement a) Actual warranty costs during 20x2 Estimated liability from warranties--December 31,20x2 $5,400,000 x .015 $81,000 $63,000 81,000 $144,000 (80,000) $64,000
b)
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10.
10.1
Shareholders Equity
Components of Shareholders Equity
Historically, companies had common shareholders, or those entitled to elect the board of directors, and preferred shareholders, who were entitled to receive a dividend of a stated minimum amount before any dividends were paid to common shareholders. The voting rights of preferred shareholders were usually minimal or nil unless they failed to receive a dividend, at which time their voting rights increased according to the terms under which the shares were issued. In effect, the preferred shareholders had to play a more passive role, but their dividend and rights on the winding-up of the company were better protected. This simple distinction between common and preferred shareholders has been blurred over time, as companies have developed classes of common shareholders with differing rights between them. The Canada Business Corporations Act (CBCA) now makes no distinction between common and preferred shares, but allows for different classes whose rights, privileges, restrictions, and conditions must be set out in the articles of incorporation of the company. However, at least one of the classes of shares must contain (i) the right to vote at all meetings of that class of shareholder and (ii) the right to dividends and distribution of assets when the company is wound up. These are the traditional rights of common shareholders. Thus, in effect the act requires that at least one class of shares must have the minimum attributes of common shares. For convenience we will refer to this class of shares as common shares. Apart from disclosure requirements (which were discussed in Chapter 1 of this Module), Share Based Payments and Stock Option Grants to Employees (discussed later in this chapter), there are no IFRS's dealing with accounting for shareholders' equity items. Therefore, the discussion in this section are based on pre-IFRS Canadian GAAP and ASPE requirements. A typical shareholders' equity section of a statement of financial position could look as follows: No Name Company Ltd. Partial Statement of Financial Position As at December 31, 20x6 Shareholders' Equity Common Shares, 1,000,000 shares issued and outstanding Preferred Shares, $5, cumulative, 250,000 shares issued and outstanding Contributed Surplus Retained Earnings Accumulated Other Comprehensive Income
$26,000,000 12,000,000 3,000,000 9,500,000 (750,000) $49,750,000

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Common Shares Common shares typically have the following features: they provide the right to vote at annual meetings, upon liquidation of the company, any cash remaining after all obligations have been settled revert back to common shareholders, and they are a perpetuity, meaning they never become due. The corporation is under no obligation to provide a financial return to common shareholders, that is, any dividend declarations are at the sole discretion of the companys board of directors. Dividends become a liability of the corporation only when the board of directors declares them. Note that the IFRS standards refer to common shares as 'ordinary shares'. This is because some countries do not use common share terminology. These lesson notes will refer to these shares as common shares. Preferred Shares Preferred shares have the following characteristics: they are generally non-voting shares, they carry a stated dividend per share, like common shares, they are a perpetuity, and they have preference on liquidation. Like common shares, the corporation is under no obligation to provide a financial return to preferred shareholders, that is, any dividend declarations are at the sole discretion of the companys board of directors. Dividends become a liability of the corporation only when the board of directors declares them. However, in most cases preferred shares are cumulative. This means that if dividends are missed, any preferred dividends in arrears must be paid before any dividends can be paid to common shareholders. Example Assume the shareholders' equity as outlined on the previous page. The preferred share dividends were last paid on December 31, 20x3. It is now December 1, 20x6 and management wants to pay a dividend of $8 per common shares. First, the preferred dividends in arrears for 20x4 and 20x5 will have to be paid: 250,000 shares x $5.00 x 2 years = $2,500,000 Next, the preferred dividends for the year 20x6 must be paid: 250,000 shares x $5.00 x 1 year = $1,250,000 Finally, the dividend to common shareholders can be paid: 1,000,000 shares x $8 = $8,000,000 The total dividend to be declared will be: $2,500,000 + 1,250,000 + 8,000,000 = $11,750,000
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Contributed Surplus Contributed Surplus arises when shares are repurchased at an amount less than the average amount of cash that was raised when they were issued (see the Issuance, Reacquisition and Retirement of Shares section of this chapter); and when a share based payment plan is put in place (discussed later in this chapter), and when subscribed shares are defaulted. Retained Earnings Retained earnings represents the accumulated earnings of the corporation net of any dividends paid. Any premiums paid on retirement of shares are also charged to retained earnings. The statement of retained earnings is as follows: Retained earnings, beginning of year Premium on redemption of shares Net income (loss) for the year Dividends Retained earnings, end of year Accumulated Other Comprehensive Income At its fundamental level, accumulated other comprehensive income consists of unrealized gains or losses that do not flow to profit or loss but get placed in accumulated other comprehensive income until realized, at which time they flow from accumulated other comprehensive income to either profit or loss or directly to retained earnings. These include: actuarial gains and losses on a defined pension plan (discussed in Chapter 11 of this Module); unrealized gains or losses on investments in investments in Fair Value through Other Comprehensive Income (FVTOCI) investments (discussed in Chapter 1 of Module 2); unrealized gains or losses on cash flow hedges (discussed in Chapter 6 and 8 of Module 2); unrealized gains and losses on the translation of the financial statements of foreign subsidiaries when the functional currency is the Canadian dollar (discussed in Chapter 7 of Module 2), and revaluation surpluses arising from the use of the Revaluation model (discussed in Chapter 9 of this Module. There is no other comprehensive income in ASPE. $ XXX -XXX XXX -XXX $ XXX
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The following types of differences between classes of shares be disclosed: 1. Dividend preferences: It is common for some classes of shares to have a predetermined annual dividend (i.e. $1.50 per share) that must be paid before any dividends can be paid on the common shares or any other class of shares ranking lower in preference. While there is no legal requirement that any dividend should be paid until the directors actually declare it, the provision that it be paid in preference to common shareholders' dividends would normally put pressure on the directors to declare a preferred dividend. In addition, the dividend may be made cumulative, so that any arrears in preferred dividends must be paid before any dividends can be paid on common shares. Redemption, call, and retraction privileges: certain classes of shares may be issued on the condition that they can be redeemed at the option of either the shareholder or the company (depending on the terms of issue). If redeemable at the option of the shareholder, they are often called redeemable shares5. If redeemable at the option of the company, they are usually referred to as retractable preferred shares or callable preferred shares. Voting privileges: The voting privileges set out in the articles of incorporation may eliminate or restrict the right of certain classes of shares to vote to elect directors, thus keeping the bulk of the power to influence company affairs in the hands of the common shareholders. However, in certain circumstances, the shares with restricted voting rights may have these restrictions changed to increase their voting power. Typically, this happens when dividends have not been paid on these shares for a period of time, such as two years. Conversion privileges: The articles of incorporation may provide that holders of a particular class of share have the privilege of converting their shares into shares of another class. Typically, this would be the right to convert shares with a fixed annual dividend into common shares or to convert voting (but non-marketable) shares into non-voting (but marketable) shares
2.
3.
4.
In some circumstances, retractable preferred shares which are redeemable at the option of the shareholders could be classified as financial liabilities. This will be discussed in more depth in Chapter 8 of Module 2. CMA Ontario - 2013
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10.2
Issuance, Reacquisition and Retirement of Shares
Issuance of Shares A company may issue shares for cash or non-cash consideration. When issuing shares for cash consideration, the journal entry to reflect the issuance of shares is quite simple: Dr. Cash Cr. Common Stock (or Preferred Stock) When shares are issued for non-cash consideration, the fair value of the asset(s) or service acquired in exchange for the shares must be determined. The assets/services are recorded at their fair market value of the goods or services received at the date they are received with the corresponding entry to common stock. If the fair value of the goods or services cannot be determined, then the value shall be determined by reference to the fair value of the equity instruments granted. (IFRS 2.10) Dr. Asset(s) or Expense (service) Cr. Common Stock (or Preferred Stock) Under ASPE, the value ascribed to the shares issued is the most clearly determinable of the assets/serviced received or the fair value of the shares issued.
Issue Costs Corporations generally contract with underwriters who sell or issue stock to investors. A percentage of the proceeds from issuing stock is normally retained as a fee by the underwriters. Other costs associated with a stock issue include legal fees, registration fees with the Securities Commission, accounting fees and printing costs. These direct costs of issuing stock are deducted from the proceeds of the stock issuance and the net proceeds are credited to the Capital Stock account. Indirect costs such as management time spent on the stock issue are expensed. Issuance of Shares by way of Subscription At times, companies may conduct a share issue on a subscription basis. Generally, this is done when a small company goes public for the first time or when shares are offered to employees. For example, a company issues, on a subscription basis, 1,000,000 shares of its stock at $30 per share. The terms of the contract require that a down payment of 20% be made at the time the contract is signed with the balance payable in 90 days. On the date the contracts are signed, the following entries will be made: Share Subscriptions Receivable (1,000,000 x $30) Common Stock Subscribed
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Cash (1,000,000 x $6) Share Subscriptions Receivable
6,000,000 6,000,000
The Common Shares Subscribed account will become part of Shareholders' Equity. The Share Subscriptions Receivable account can be disclosed in one of two ways: as a current asset or as a reduction of shareholders' equity. I believe it is best shown as a reduction of shareholders' equity because current assets are generally used for operating purposes, which share subscriptions receivable are not. On the date the final payment is received, the following entries are made - the first entry records the final receipt of cash; the second entry records the issuance of common stock. Cash (1,000,000 x $24) Share Subscriptions Receivable Common Stock Subscribed Common Stock 24,000,000 24,000,000 30,000,000 30,000,000
The above entries assume that 100% of the final payments were received. Generally, some subscribers will default on their final payment. How we account for defaults depends on whether the down payment is refundable. If we assume that 95% of the shares are fully paid and that the down payment is fully refundable, then the journal entries would be as follows: Cash (950,000 x $24) Share Subscriptions Receivable Common Shares Subscribed (50,000 x $30) Share Subscriptions Receivable (50,000 x $24) Cash (50,000 x $6) Common Stock Subscribed (950,000 x $30) Common Stock 22,800,000 22,800,000 1,500,000 1,200,000 300,000 28,500,000 28,500,000
If the down payment is not refundable, then we would credit Contributed Surplus instead of Cash in the second entry above.
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Reacquisition and Retirement of Shares When a company reacquires its own shares, it has to cancel them and effectively retire the shares. The journal entry will comprise of the following: a debit to common shares in an amount equal to the number of shares retired times the average book value per common share, and a credit to cash in the amount of the net cost to retire the shares. A debit or credit will be required to balance the entry: if a credit is required, then the we credit Contributed Surplus, if a debit is required, then we first debit Contributed Surplus to the extent it was created by a similar transaction in the past, if there is not enough Contributed Surplus, then we debit the remaining amount directly to Retained Earnings. For example, assume that a company has 1,000,000 common shares issued with a book value of $2,750,000 on January 1, 20x2. On March 16, 20x2 the company issues an additional 200,000 shares for a total of $750,000. On June 22, 20x2, the company repurchases 50,000 of these shares at a price of $2.80, the journal entry to record the repurchase of the shares would be as follows: Common shares (50,000 x $2.9167) Contributed Surplus Cash (50,000 x $2.80) $145,835 $5,835 140,000
* Average book value per share = ($2,750,000 + 750,000) / (1,000,000 + 200,000) = $2.9167 If, on August 31, 20x2, the company repurchased 30,000 shares at a price of $3.30, the journal entry would be as follows: Common shares (30,000 x $2.9167) Contributed Surplus Retained earnings Cash (30,000 x $3.30) $87,501 5,835 5,664 99,000
10.3
Accounting for Stock Splits and Stock Dividends
A stock dividend is a dividend paid in any class of shares of the company's own shares to holders of the same class of shares. Usually it is paid to common shareholders in common shares. The shareholders' proportionate share in the equity of the company has not changed after the dividend. They are essentially in the same position as before - they simply have more share certificates to represent the same interest in the company. Nevertheless, it is common to capitalize a portion of the retained earnings which is thought to represent the value of the new shares that have been issued, thus reducing the retained earnings available for cash dividends.
The Canada Business Corporations Act requires that shares must be issued for their fair market value. Thus the issue of such shares would increase the stated capital and decrease the retained earnings correspondingly. Darren Inc declared a stock dividend of ten common share for each 100 common shares held (10% stock dividend). There were 400,000 shares outstanding before the declaration of the dividend, and their market value at the time the dividend was declared was $15 each. The entry at the time the dividend was declared would be as follows: Retained Earnings (40,000 x $15) Common Stock $600,000 $600,000
Note that we are implicitly assuming that the share price of $15 is the share price after the stock dividend is announced. Since a stock dividend does not increase the value of the firm, the share price will go down once a stock dividend is announced. For example, if the $15 was the share price before the stock dividend was announced, then the share price after the stock dividend would be equal to the value of the firm's equity divided by the number of shares outstanding after the stock dividend: Value of the firm's equity = 400,000 shares x $15 = $6,000,000 Share price after the stock dividend = $6,000,000 440,000 shares = $13.64 If this was the case, we would have capitalized the retained earnings at a share price of $13.64 and not $15.00. A stock dividend should be distinguished from a stock split, which is an increase in the number of existing shares outstanding. A share split is often used to decrease the price at which the company's shares are traded on the stock market, often with the intention of increasing their appeal to a wider group of small investors. Under a stock split there is no increase in the common shares dollar amount in shareholders equity of the firm, only an increase in the number of shares outstanding. No journal entries are required to record a stock split.
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10.4
Share Based Payments (IFRS2)
A share based payment is defined as an agreement between the entity and another party (including an employee) that entitles the other party to receive (a) cash or other assets of the entity for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity, or (b) equity instruments (including shares or share options) of the entity, provided the specified vesting conditions, if any, are met. For example, a share based payment occurs when an entity issues shares in exchange for an asset. The value of the transaction is based on the fair value of the asset or service received unless it is not determinable, in which case the value of the shares given up are used. IFRS2 provides one exception to this general rule: when a share based payment is made in exchange for services provided by employees, then the valuation of the share based payment is based on the value of the equity instrument. There are two types of share based payments: equity settled and cash settled: An equity settled share based payment is defined as a share-based payment transaction in which the entity (a) receives goods or services as consideration for its own equity instruments (including shares or share options), or (b) receives goods or services but has no obligation to settle the transaction with the supplier. A cash settled share based payment transaction is defined as a share-based payment transaction in which the entity acquires goods or services by incurring a liability to transfer cash or other assets to the supplier of those goods or services for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity.
Equity settled Share Based Payments When a company provides stock options to executives and employees as part of their compensation package, we must measure and accrue the compensation expense arising out of the stock option grant. In order to do so, we need to know three things: 1. The market value of the stock options on the date of grant. This can be calculated by using an accepted stock option pricing model such as the Black-Scholes or the binomial option pricing models. The vesting period for which it is expected the executives will provide services. This is usually the period in which the options cannot be exercised. For example, if stock options are issued on January 1, 20x3 and are exercisable anytime after
2.
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January 1, 20x6, then the vesting period is the period Jan 1, 20x3 to Dec 31, 20x5. 3. An estimate as to what percentage of the stock options will vest.
The market value of the stock options are accrued over the vesting period as follows: dr. Compensation Expense cr. Contributed Surplus - Unexpired Stock Options If the vesting period exceeds the current year, then the total market value of the options on the date of grant is accrued over the vesting period. At the end of each of the year of the vesting period, the compensation expense is calculated as follows: Total cumulative value of the stock options earned to the end of the period times the estimated percentage of stock options that will vest. Less the cumulative compensation expense recorded on this stock option plan to as of the end of the previous fiscal period. For example, assuming the options are granted on January 1, 20x3, the vesting period is 20x3-20x5, the total market value of the options is $300,000, and in 20x3 management estimates that 85% of the options will vest, then the compensation expense for 20x3 would be: $300,000 x 1/3 x 85% = $85,000. At the end of 20x4, assume that management revises their estimate and believes that 90% of the options will vest, then the compensation expense for 20x4 would be: Cumulative value of the stock options earned for the period 20x3 - 20x4: $300,000 x 2/3 x 90% Less cumulative compensation expense to the end of 20x3 Compensation expense - 20x4
$180,000 85,000 $ 95,000
If, by the end of 20x5, 92% of the stock options actually vested, then the compensation expense for 20x5 would be calculated as follows: Cumulative value of the stock options earned for the period 20x3 - 20x5: $300,000 x 100% x 92% Less cumulative compensation expense to the end of 20x4: $85,000 + 95,000 Compensation expense - 20x5
$276,000 180,000 $ 96,000
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After the vesting period, but during the exercise period, one of two events will occur with regards to the options: 1. They will be exercised, in which case we record the issuance of the stock as follows: dr. dr. Cash Contributed Surplus - Unexpired Stock Options cr. Common Stock
The credit to common stock is simply the sum of the cash received on the exercise of the options plus the prorata amount of contributed surplus created by these stock options. Note that the market value of the shares on the date of exercise has absolutely no impact on the above entry. 2. The options will expire due to the holders of the options letting the options expire. The journal entry to record expired stock options is as follows: dr. Contributed Surplus - Unexpired Stock Options cr. Contributed Surplus - Expired Stock Options
Example: on January 2, 20x2 the Solomons Company issued 140,000 stock options to their executive team and senior managers. The market price of the company's stock on January 2, 20x2 was $16. The exercise or strike price of the options was also $16. The employment contract stated that the executives had to provide services to Solomons Company for the period January 1, 20x2 to December 31, 20x4. The stock options were exercisable in the fiscal year ended December 31, 20x5. The Black-Scholes model puts the market value at $2.25 per option. At the end of 20x2, management estimates that 95% of the stock options will vest. At the end of 20x3, this estimate was revised to 90%. At December 31, 20x4 the actual number of options that vested amounted to 120,000. During 20x5, 90,000 of the options were exercised when the stock price was $28 per share. The remaining 30,000 options expired at December 31, 20x5. The total value of the options on the date of grant is: 140,000 x $2.25 = $315,000. Dec 31, 20x2 Compensation expense ($315,000 x 1/3 x 95%) Contributed Surplus Unexpired Stock Options
$99,750 $99,750
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The compensation expense for the 20x3 is calculated as follows: Cumulative value of the stock options earned for the period 20x2 - 20x3: $315,000 x 2/3 x 90% Less cumulative compensation expense to the end of 20x2 Compensation expense - 20x3
$189,000 99,750 $ 89,250
Dec 31, 20x3
Compensation expense Contributed Surplus Unexpired Stock Options
89,250 89,250
The compensation expense for the 20x4 is calculated as follows: Cumulative value of the stock options earned for the period 20x2 - 20x4: 120,000 options vested x $2.25 Less cumulative compensation expense to the end of 20x3: $99,750 + 89,250 Compensation expense - 20x4 Dec 31, 20x4 Compensation expense Contributed Surplus Unexpired Stock Options
$270,000 189,000 $ 81,000 81,000 81,000
In 20x5, we record the conversion of 90,000 options. Note that the stock market price at that date is not relevant to this transaction. 20x5 Cash (90,000 x $16) Contributed Surplus Unexpired Stock Options (90,000 x $2.25) Common stock 1,440,000
202,500 1,642500
Finally, on December 31, 20x5 we record the expiration of the remaining 30,000 stock options: Dec 31, 20x5 Contributed Surplus Unexpired Stock Options Contributed Surplus 30,000 x $2.25
67,500 67,500
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Cash settled Share Based Payments The fundamental difference between an equity settled share based payment and a cash settled one is that in an equity settled plan, the obligation to pay accumulates in shareholders equity whereas the obligation to pay under a cash settled share based payment plan accumulates as a liability. Under an equity settled plan, the fair value of the plan is calculated on the date of grant and is never subsequently adjusted. Under a cash settled plan, the liability has to be revalued at the end of each year (recall that a liability is defined as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits). Therefore, an estimate of the value of the plan must be made at the end of each year the plan is in operation. Compensation expense in a given year will therefore be made up of two components: (1) the amount that accrues because part of the vesting period has expired and (2) the amount required to revalue the liability at year-end. The type of cash settled share based payment plan we will examine are share appreciation rights (SARs). These are provided to employees and, once vested, they are settled by paying the employees in cash. The formula for the cash payment is based on the share price at the time the SARs are exercised. Example: on January 2, 20x1, an entity grants 50 cash share appreciation rights (SARs) to each of its 1,200 employees, on condition that the employees remain in its employ for the next three years. During 20x1, 60 employees leave. The entity estimates that a further 150 will leave during years 20x2 - 20x3. During 20x2, 90 employees leave and the entity estimates that a further 100 will leave during 20x3. During 20x3, 80 employees leave. At the end of 20x3, 320 employees exercise their SARs, another 450 employees exercise their SARs at the end of 20x4 and the remaining 200 employees exercise their SARs at the end of 20x5. The entity estimates the fair value of the SARs at the end of each year in which a liability exists as shown below. At the end of year 3, all SARs held by the remaining employees vest. The intrinsic values of the SARs at the date of exercise (which equal cash paid out) at the end of years 20x3, 20x4 and 20x5 are also shown below. Fair value $18.50 20.60 22.40 19.60 Intrinsic value
Year 20x1 20x2 20x3 20x4 20x5
$23.50 20.50 18.20
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The compensation expense for 20x1 will be equal to the total number of employees the company estimates will ultimately exercise their SARs multiplied by the number of SARs given to each employee (50) multiplied by fair value of each SAR at the end of 20x1 multiplied by the portion of time the vesting period has expired: 1,200 60 Left in 20x1 150 Expected to Leave = 990 x 50 x $18.50 x 1/3 = $305,250 20x1 Compensation Expense SAR Liability $305,250 $305,250
In 20x2, we calculate the cumulative compensation expense to the end of 20x2: 1,200 60 Depart in 20x1 90 Depart in 20x2 100 Expected to Leave = 950 x 50 x $20.60 x 2/3 = $652,333 The 20x2 compensation expense will be equal to the cumulative amount to the end of 20x2 less the 20x1 compensation expense: $652,333 305,250 = 347,083 20x2 Compensation Expense SAR Liability $347,083 $347,083
At the end of 20x3, the vesting period is over. Also, some of the SARs were exercised on the last day of the year. The journal entry to record the exercise of the SARs is: 20x3 SAR Liability (320 x 50 x $23.50) Cash $376,000 $376,000
The balance in he SAR liability account is now: $305,250 20x1 Compensation Expense + 347,083 20x2 Compensation Expense 376,000 20x3 Cash Out = $276,333 There are 650 (1,200 60 Depart in 20x1 90 Depart in 20x2 80 Depart in 20x3 320 Cash out in 20x3) employees who have yet to cash out at the end of 20x3. The balance in the SAR Liability account at December 31, 20x3 should be: 650 x 50 x $22.40 = $728,000 The compensation expense for 20x3 will be equal to whatever is required to bring the current balance in the account of $276,333 to the required re-measured balance of $728,000:
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20x3
Compensation Expense SAR Liability
$451,667 $451,667
In 20x4, 450 employees cash out at $20.50. The required balance in the SAR Liability account at year end will be: 650 450 = 200 Employees Remaining x 50 x 19.60 = $196,000 SAR Liability balance, December 31, 20x3 SARs cashed out in 20x4: 450 x 50 x $20.50 SAR Liability balance before year end re-measurement Required ending balance = 20x4 Compensation expense The journal entries in 20x4 are: 20x4 SAR Liability Cash SAR Liability Compensation expense 461,250 461,250 70,750 70,750 $728,000 (461,250) 266,750 196,000 $70,750
In 20x5, the last year of the exercise period, the remaining 200 employees cash out at $18.20: 20x5 SAR Liability (200 x 50 x $18.20) Cash 182,000 182,000
There remains a credit of $14,000 ($196,000 20x2 Ending Balance 182,000 Cash Out). The SAR account is cleared out by a credit to compensation expense: 20x5 SAR Liability Compensation expense 14,000 14,000
ASPE Differences the ASPE requirements for both equity settled or cash settled share based payment plans are fundamentally the same. There are differences that go beyond the scope of this course.
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Multiple Choice Questions
1.
How would the declaration of a 15 % stock dividend by a corporation affect each of the following? Total Retained earnings Shareholders' equity a. b. c. d. No effect No effect Decrease Decrease No effect Decrease No effect Decrease
Use the following information for questions 2-3: Gott Co. was organized on January 1, 20x2, with 300,000 no par value common shares authorized. During 20x2, Gott had the following shares transactions: Jan 4 Mar 8 May 17 Jul 6 Aug 27 2. Issued 120,000 shares at $10 per share. Issued 40,000 shares at $11 per share. Purchased 15,000 shares at $12 per share and cancelled them. Issued 30,000 shares at $13 per share. Issued 10,000 shares at $14 per share.
The total amount in the share capital account at December 31, 20x2 is a) $2,170,000 b) $2,016,250 c) $2,007,250 d) $1,990,000
3.
The total amount of contributed surplus at December 31, 20x2 is a) $-0b) $26,250 c) $153,750 d) $180,000
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4.
Renn Corporation was organized on January 1, 20x2, with an authorization of 400,000 no par value common shares. During 20x2, the corporation had the following capital transactions: January 5 April 6 June 8 July 28 December 31 issued 150,000 shares @ $10 per share issued 50,000 shares @ $12 per share issued 50,000 shares @ $14 per share purchased 20,000 shares @ $11 per share and cancelled them issued 20,000 shares @ $18 per share
What is the total amount of contributed surplus as of December 31, 20x2? a) $0 b) $4,000 c) $20,000 d) $220,000
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Problem 1 The following is the Shareholders' Equity section of Parsely Industry Ltd.'s Statement of Financial Position at its fiscal year end, September 30. 20x1 Common Shares, 1,000 shares outstanding at end of 20x0 Preferred Shares Contributed Surplus Retained Earnings Total Shareholders' Equity $ 105,880 10,000 5,040 199,500 $320,420 20x0 $105,000 10,000 177,300 $292,300
The company's net income for 20x1 was $30,300. On January 2, 20x1, Parsely Industry Ltd. re-acquired and cancelled 120 of its common shares at $63 per share. Required Prepare journal entries to record all the transactions affecting shareholders' equity during the 20x1 fiscal year.
Problem 2 The shareholders' equity section of Parsley Ltd. at September 30, 20x0, was as follows: Common stock, 40,000 shares issued and outstanding Retained earnings Total shareholders' equity Additional Information: On October 1, 20x0, the company issued 4,000 shares for $135,000 cash Parsley Ltd. reacquired and cancelled 3,000 of its own shares for $24 per share on October 31, 20x0. On November 15, 20x0, the company announced a 2:1 stock split. The stock split was carried out on November 30, 20x0. A cash dividend of $2.50 per share was declared on December 31, 20x0, to shareholders of record on this date. The dividend was to be paid out on February 1, 20x1. $800,000 480,000 $1,280,000
Required -a) b) Prepare a journal entry to record the reacquisition and cancellation of the corporation's own stock. Prepare a journal entry to record the cash dividend.
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Problem 3 At the beginning of 20x2, the shareholders' equity section of Barnes Incorporated was as follows: $5 cumulative preferred shares, authorized 15,000 shares, issued and outstanding 5,000 shares Common shares, 175,000 shares issued and outstanding Retained earnings
$500,000 700,000 1,000,000 $2,200,000
The preferred shares did not receive dividends in either 20x1 or 20x0. They are redeemable at $105. The company is subject to a 50% tax rate. The following affected shareholders' equity during 20x2: 1) The company purchased a building in exchange for 5,000 preferred shares. The preferred shares were trading at $115. The fair value of the building on the date of purchase was $600,000. 2) Paid dividends of $1 per share to common shareholders. 3) Net income for the year was $750,000. Required Prepare all the necessary journal entries for the above transactions.
Problem 4 The J-Mo Corporation offered 1,000,000 common shares at $70 on a subscription basis on June 30, 20x5. The terms of the contract stipulated that a downpayment equal to 35% of the subscription price had to be made when the subscription contract was signed. The balance was due on September 30, 20x5. By July 5, 20x5 all of the shares were subscribed. Required 1. 2. Record the all transactions assuming that the subscribers all paid the final payment on the shares and that all of the shares were issued. Record all of the transactions on the assumption that 90% of subscribers paid the final balance and that the contract requires the company to reimburse the deposits on un-issued shares.
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3.
Record all of the transactions on the assumption that 90% of subscribers paid the final balance and that the contract does not require the company to reimburse the deposits on un-issued shares.
Problem 5 The Shlee Company was formed on July 1, 20x0. It was authorized to issue 200,000 shares and 50,000, $.60, and cumulative and nonparticipating preferred shares. Shlee Company's fiscal year ends June 30. The following information relates to the shareholders' equity accounts of Shlee Company: COMMON SHARES Before the 20x2-20x3 fiscal year, Shlee Company had 105,000 outstanding common shares issued as follows: a) 95,000 shares were issued for cash on July 1, 20x0, at $20 per share. b) On July 24, 20x0, 5,000 shares were exchanged for a plot of land that cost the seller $70,000 in 19x4 and had an estimated fair market value of $102,000 on July 24, 20x0. c) 5,000 shares were issued on March 1, 20x2; the shares had been subscribed for $32 per share of October 31, 20x1. d) During the 20x2-20x3 fiscal year, the following common share transactions took place: October 1, 20x2 Subscriptions were received for 10,000 shares at $40 per share. Cash of $80,000 was received in full payment for 2,000 shares and stock certificates were issued. The remaining subscriptions for 8,000 shares were to be paid in full by 9/30/x3, at which time the certificates were to be issued. November 30, 20x2 Shlee purchased and cancelled 2,000 of its own shares on the open market at $38 per share. PREFERRED SHARES e) Shlee issued 30,000 preferred shares at $15 per share on July 1, 20x1.
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CASH DIVIDENDS f) Shlee has followed a schedule of declaring cash dividends in December and June, with payment being made to shareholders of record in the following month. The cash dividends that have been declared through June 30, 20x3, are shown below.
Declaration Date January 15, 20x1 June 15, 20x2 December 15, 20x2
Common Shares (per share) $0.10 0.10 -
Preferred Shares (per share) $0.30 0.30
No cash dividends were declared in June 20x3 because of Shlee's liquidity problems. RETAINED EARNINGS g) As of June 30, 20x2, Shlee's retained earnings account had a balance of $370,000. For the fiscal year ended June 30, 20x3, Shlee reported net income of $20,000. Required Prepare the shareholders' equity section of the Statement of Financial Position, including appropriate notes, for Shlee Company as of June 30, 20x3.
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Problem 6 Howard Corporation is a publicly owned company whose shares are traded on the TSE. At December 31, 20x4, Howard had unlimited shares of common shares authorized, of which 15,000,000 shares were issued. The shareholders' equity accounts at December 31, 20x4, had the following balances: Common shares (15,000,000 shares) Retained earnings During 20x5, Howard had the following transactions: a. b. c. d. e. On February 1, a distribution of 2,000,000 common shares was completed. The shares were sold for $18 per share. On February 15, Howard issued, at $110 per share, 100,000 of no-par value, $8, cumulative preferred shares. On March 1, Howard reacquired and retired 20,000 common shares for $14.50 per share. On March 15, Howard reacquired and retired 10,000 common shares for $20 per share. On March 31, Howard declared a semi-annual cash dividend on common shares of $0.10 per share, payable on April 30, 20x5, to shareholders of record on April 10, 20x5. (Record the dividend declaration and payment.) On April 15, 18,000 common shares were reacquired and retired for $17.50 per share. On September 30, Howard declared a semi-annual cash dividend on common shares of $0.10 per share and the yearly dividend on preferred shares, both payable on October 30, 20x5, to shareholders of record on October 10, 20x5. (Record the dividend declaration and payment.) $230,000,000 50,000,000
f. g.
Required: Prepare journal entries to record the various transactions. Round per share amounts to two decimal places.
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Problem 7 On January 3, 20x4 the Bailey Company granted 200,000 stock options to its executives. The exercise price of the options is $25 and was equal to the stock price on that date. An option pricing model puts the total value of these stock options at $125,000. The options are exercisable during the fiscal period ending December 31, 20x6 on the condition that the executives are still in the employ of Bailey Company as of December 31, 20x5. The Bailey Company estimates that 80% of the stock options will vest at December 31, 20x4. The actual number of options that vested on December 31, 20x5 was 175,000. During the year 20x6, 160,000 options were exercised and the remaining 15,000 options expired. Required Prepare the journal entries for the years 20x4 through to 20x6
Problem 8 50 executives are given a stock option grant of 1,000 options each on January 2, 20x4. The vesting period is 4 years and the market value of each option is estimated to be $20. It is estimated that 75% of the options will vest. At the end of 20x5 (the second year), management estimates that 80% of the executives will vest their stock options. This estimate still holds for the year ended December 31, 20x6. At the end of 20x7, there are 41 executives still in the employ of the company (i.e. a total of 9 executives left the company between 20x4 and 20x7). Required Calculate compensation expense for the years 20x4 - 20x7.
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Problem 9 At December 31, 20x1, the shareholders' equity of the Page Golf Club Company totaled $3,707,500. The balances of various accounts at that date were as follows: $4 preferred shares (10,000 shares authorized, 5,000 shares issued) Common shares (100,000 shares authorized, 50,000 shares issued) Retained earnings The following transactions occurred during 20x2: MARCH 20 APRIL 1 JUNE 15 The regular semi-annual preferred dividend was declared, payable April 1. Payment of previously declared dividend. The regular semi-annual common dividend of 40 cents per share was declared, payable July 10. Payment of the previously declared dividend. Regular semi-annual preferred dividend was declared, payable October 1. Payment of previously declared dividend. The regular semi-annual dividend of 40 cents per common share was declared payable January 10. In addition, a 10 percent stock dividend (5,000 shares) was declared to common shareholders of record as of December 20, to be issued January 20. The market price of the shares was $20 per share (which is the amount that should be transferred from retained earnings to contributed capital). $ 507,500 750,000 2,450,000
JULY 10 SEP 20 OCT 1 DEC 15
Required 1. Prepare all journal entries necessary to reflect the above transactions during 20x2. 2. Prepare a statement of shareholders' equity at December 31, 20x2, assuming net income for 20x2 amounted to $165,000. 3. Prepare a statement of changes in shareholders' equity for the year ended December 31, 20x2.
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Problem 10 On January 2, 20x1, an entity grants 100 cash share appreciation rights (SARS) to each of its 2,000 employees, on condition that the employees remain in its employ for the next three years. During 20x1, 90 employees leave and the entity estimates that a further 200 will leave during years 20x2-20x3. During 20x2, 75 employees leave and the entity estimates that another 110 employees will leave in 20x3. In 20x3, 135 employees leave and 600 employees exercise their SARs, another 475 employees exercise their SARs at the end of 20x4 and the remaining employees exercise their SARs at the end of 20x5. The entity estimates the fair value of the SARs at the end of each year in which a liability exists as shown below. At the end of 20x3, all SARs held by the remaining employees vest. The intrinsic values of the SARs at the date of exercise (which equal cash paid out) at the end of years 20x3, 20x4 and 20x5 are also shown below. Fair value $12.45 13.70 18.60 15.75 Intrinsic value
Year 20x1 20x2 20x3 20x4 20x5 Required
$20.00 18.00 12.00
Calculate compensation expense for the years 20x1 to 20x5.
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SOLUTIONS
Multiple Choice Questions 1. 2. c b (120,000 x 10) + (40,000 x 11) 15,000 x $10.25 (1,640,000 / 160,000) (30,000 x $13) + (10,000 x $14) $1,640,000 -153,750 530,000 $2,016,250
3.
15,000 x (12.00 10.25) = $26,250 debit to retained earnings, No Contributed Surplus. Book value per share = [(150,000 x $10) + (50,000 x $12) + (50,000 x $14)] 250,000 = $11.20 Increase in contributed surplus = 20,000 shares x ($11.20 11.00) = $4,000
4.
Problem 1 Common Shares ($105,000 / 1,000) x 120 Cash (120 x $63) Contributed Surplus Retained Earnings1 Dividends Payable Cash Common Shares2 1. 2. $12,600 7,560 5,040 8,100 8,100 13,480 13,480
$30,300 Net Income 22,200 Increase in retained earnings = $8,100 $105,880 - $105,000 = $880 net Increase in common Stock + 12,600 Common Stock repurchases = $13,480.
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Problem 2 a) Common Stock (3,000 x $21.25) Retained Earnings Cash (3,000 x 21.25) Book value per share = ($800,000 + 135,000) / (40,000 + 4,000) = $935,000 / 44,000 = $21.25 b) Retained Earnings (41,000 x 2 x $2.50) Dividends payable $205,000 $205,000 $63,750 8,250 $72,000
Problem 3 Building Preferred Shares Retained Earnings (note) Cash 600,000 600,000 275,000 275,000
Calculation of total dividend declaration Dividends Preferred Arrears: (5,000 x 5) x 2 Current year: 10,000 x 5 Common (175,000 x $1)
$50,000 50,000 175,000 $275,000
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Problem 4 1. Jul 5, 20x5 Share subscriptions receivable Common shares subscribed 1,000,000 shares x $70 Cash ($70,000,000 x 35%) Share subscriptions receivable Sep 30, 20x5 Cash ($70,000,000 x 65%) Share subscriptions receivable Common shares subscribed Common shares 2. July 5, 20x5 Sep 30, 20x5 Same as in part (1). Cash ($70,000,000 x 90% x 65%) Share subscriptions receivable Common stock subscribed Cash ($24,500,000 x 10%) Subscription receivable Common stock subscribed Common Stock 3. 40,950,000 40,950,000 7,000,000 2,450,000 4,550,000 63,000,000 63,000,000 $70,000,000 $70,000,000
24,500,000 24,500,000 45,500,000 45,500,000 70,000,000 70,000,000
All entries are the same with one exception. In the second journal entry in part (2), we would credit Contributed Surplus and not Cash.
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Problem 5 Shlee Company SHAREHOLDERS' EQUITY JUNE 30, 20x3 Share capital: $.60 Preferred shares, no par, cumulative and nonparticipating, 50,000 shares authorized, 30,000 shares issued and outstandingNote A Common shares, no par, 200,000 shares authorized, 105,000 shares issued and outstanding Common shares subscribed, 8,000 shares Total common shares issued and subscribed Retained earningsb Total shareholders' equity
$ 450,000 $ 2,200,100a 320,000 2,520,100 346,900 $3,317,000
NOTE A: Shlee Company is in arrears on the preferred shares in the amount of $9,000.
a
Outstanding prior to current year (105,000) Subscribed shares fully paid (2,000 x $40) Shares cancelled [($2,242,000 / 107,000) x 2,000)
$ 2,162,000 80,000 (41,900) $ 2,200,100
Beginning Net Income Preferred dividend ($.30 x 30,000) Common share retirement in excess of carrying value ($76,000 - $41,900)
$ 370,000 20,000 (9,000) (34,100) $346,900
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Problem 6
Feb 1
Cash Common Shares Cash Preferred shares Common shares (20,000 x 15.65*) Contributed Surplus (20,000 x 1.15) Cash (20,000 x 14.50) * 266,000,000 / 17,000,000 = $15.65 Common shares (10,000 x 15.65) Contributed Surplus Retained earnings Cash (10,000 x 20) Retained earnings (16,970,000 x .10) Dividends Payable Dividends Payable Cash Common shares (18,000 x 15.65) Retained earnings Cash (18,000 x $17.50) Retained Earnings * Dividends payable * (16,952,000 x .1) + (100,000 x 8) Dividends payable Cash
$36,000,000 $36,000,000 11,000,000 11,000,000 313,000 23,000 290,000
Feb 15
Mar 1
Mar 15
156,500 23,000 20,500 200,000 1,697,000 1,697,000 1,697,000 1,697,000 281,700 33,300 315,000 2,495,200 2,495,200
Mar 31
Apr 30
Apr 15
Sep 30
Oct 30
2,495,200 2,495,200
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Problem 7 Dec 31, 20x4 Compensation expense ($125,000 x 1/2 x 80%) Contributed Surplus Unexpired Stock Options
$50,000 $50,000
The compensation expense for the 20x5 is calculated as follows: Cumulative value of the stock options earned for the period 20x4 - 20x5: $125,000 x 100% x 175,000 / 200,000 Less cumulative compensation expense to the end of 20x4 Compensation expense - 20x5
$109,375 50,000 $ 59,375
Dec 31, 20x5
Compensation expense Contributed Surplus Unexpired Stock Options Cash (160,000 x $25) Contributed Surplus Unexpired Stock Options ($109,375 x 160,000 / 175,000) Common stock Contributed Surplus Unexpired Stock Options Contributed Surplus
59,375 59,375 4,000,000
20x6
100,000 4,100,000
Dec 31, 20x5
9,375 9,375
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Problem 8 20x4 20x5 50,000 options x $20 x 75% x Cumulative compensation expense to end of 20x5: 50,000 options x $20 x 80% x 2/4 Less 20x4 compensation expense $187,500
$400,000 187,500 $212,500
20x6
Cumulative compensation expense to end of 20x6: 50,000 options x $20 x 80% x 3/4 Less cumulative compensation expense to end of 20x5: $187,500 + 212,500
$600,000 400,000 $200,000
20x7
Total cumulative compensation expense to the end of 20x7: 1,000 shares x 41 executives x $20 Less cumulative compensation expense to end of 20x6: $187,500 + 212,500 + 200,000
$820,000 600,000 $220,000
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Problem 9 1. March 20
Retained earnings (or dividends--preferred) Dividends payable (5,000 x $4 x 1/2) Dividends payable Cash Retained earnings (or dividends--common) Dividends payable ($.40 x 50,000 shares) Dividends payable Cash Retained earnings (or dividends--preferred) Dividends payable (5,000 x $4 x 1/2) Dividends payable Cash Retained earnings (or dividends--common) Dividends payable ($.40 x 50,000 shares) Retained earnings ($20 x 5,000 shares) Stock dividends distributable ($20x 5,000)
10,000 10,000
April 1
10,000 10,000 20,000 20,000
June 15
July 10
20,000 20,000 10,000 10,000
Sept. 20
Oct. 1
10,000 10,000 20,000 20,000
Dec. 15
100,000 100,000
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2. Page Golf Club Company Statement of Shareholders' Equity as at December 31, 20x2 Preferred shares Common shares Common share dividend distributable Total contributed capital Retained earnings $ 507,500 750,000 100,000 1,357,500 2,455,000 $3,812,500
3. Page Golf Club Company Statement of Changes in Shareholders' Equity for the year ended December 31, 20x2
Common Share Dividend Distrib. $ -
Preferred Shares Balance, January 1, 20x2 Net income for the year ended December 31, 20x2 Cash dividends declared and paid Stock dividend declared Balance, December 31, 20x2 $507,500
Common Shares $750,000
Retained Earnings $2,450,000 165,000 (60,000) (100,000) $2,455,000
Total $3,707,500 165,000 (60,000) $3,812,500
100,000 $507,500 $750,000 $100,000
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Problem 10
SARs Liability 20x1 Compensation Expense: (2,000 90 - 200) = 1,710 1,710 x 100 x $12.45 x 1/3 20x2 Compensation Expense 20x2 Ending Balance = (2,000 90 75 110) = 1,725 x 100 x $13.70 x 2/3
709,650 865,850 1,575,500
20x3 Cash Out: 600 x 100 x $20
1,200,000 1,670,500 2,046,000
20x3 Expense 20x3 Ending Balance = (2,000 90 75 135 - 600) 1,100 x 100 x $18.60
20x4 Cash Out: 475 x 100 x $18.00 20x4 Compensation Expense
855,000 206,625
984,375
20x4 Ending Balance = 1,100 - 475 = 625 625 x 100 x $15.75
20x5 Cash Out: 625 x 100 x $12.00 20x5 Compensation Expense
750,000 234,375 -020x5 Ending Balance
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11.
Employee Benefits
IAS19 Employee Benefits defines employee benefits as all forms of consideration given by an entity in exchange for service rendered by employees or for the termination of employment (IAS19.8). Employee benefits are classified into four distinct categories: 1. Short-term employee benefits such as wages, salaries and social security contributions, paid annual and sick leave, profit-sharing and bonuses and nonmonetary benefits such as medical care, housing, cars, subsidized goods or services; Post-employment benefits such as retirement benefits and other postemployment benefits such as post-employment life insurance and medical care; Other long-term employee benefits such as long-term paid absences (sabbatical leave), other long-term service benefits and long-term disability benefits; and Termination benefits.
2.
3.
4.
11.1
Short-Term Employee Benefits
Short-term employee benefits are defined as employee benefits expected to be settled wholly within twelve months after the end of the annual reporting period (IAS19.8). The amount expensed is the undiscounted amount expected to be paid to settle the obligation. Note that one of the key differentiating factors between short-term and long-term employee benefits is discounting: long-term employee benefits are discounted, shortterm employee benefits are not. Paid Absences Paid absences fall into two categories accumulating and non-accumulating. Accumulating paid absences are those that carry forward and can be used in future periods. The obligation at the end of the reporting period needs to take into account (i) the amount, i.e. rate of pay, at which the obligation is expected to be settled and (ii) the proportion of paid absences that are expected to be taken. For non-accumulating paid absences, the expense is incurred when the absence occurs. Example: an entity provides its employees with 8 sick days per year. A given years sick days accumulate but must be used by the end of the following year. When sick days are used, the current year sick days are first drawn down before the previous years accumulated amounts are used, (i.e. if an employee carries over three sick days into year 2 from year 1 and takes seven sick days in year 2, then the three sick days that have accumulated at the end of year 1 expire at the end of year 2 and only one sick day will carry over to year 3.)
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Assume that the entity employs 130 employees and that that the average rate of pay in year 1 is $150 per day. A total of 210 sick days have accumulated to the end of year 1 and management estimates that 80 of these will expire at the end of year 2. If the projected rate of pay in year 2 is expected to be $160, then the provision for sick days at the end of year 1 should be equal to (210 80) x $160 = $20,800. Profit Sharing and Bonus Plans In order to record an expense/provision for profit sharing and bonuses payable, you must meet the definition of a provision, i.e. you have a present legal or constructive obligation to make a payment as a result of past events and a realiable estimate of the obligation can be made. A reliable estimate of the obligation can be made when one of the following criteria are met: (i) the formal terms of the plan contain a formula for determining the amount of the benefit, (ii) the entity determined the amount to be paid before the financial statements are authorized for issue, or (iii) past practice gives clear evidence of the entitys constructive obligation. (IAS 19.22) Any amounts accrued/paid on account of profit sharing are treated as an expense as they result from employee service and are not considered a transaction between the entity and its owners.
11.2
Post Employment Benefits (IFRS)
A pension plan is any arrangement (contractual or otherwise) by which a program is established to provide retirement income to employees. There are two basic types of pension plans. The first type is a defined benefit pension plan. This type specifies either the benefits to be received by employees after retirement or the method for determining those benefits. Benefits are typically determined by reference to the number of years of service and by the employee's earnings during those years of service. For example, the standard benefit formula used by public service pension plans is as follows: 2% x the average five best years of salary x number of years of service to a maximum of 35 years. An employee with 32 years of service whose average five best years of salary is $120,000 would be eligible for a pension equal to $120,000 x 2% x 32 = $76,800. The second type is a defined contribution pension plan. This is one in which the employer's contributions are fixed, usually as a percentage of compensation, and allocated to specific individuals. Pension benefits are a direct function of accumulated
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contributions of the employer, employee, and earnings from investing those contributions. For the accountant, a defined contribution pension plan presents few problems. The pension plan agreement provides a formula to be used in determining the employer's contributions. Since these contributions represent the employer's only obligation to the plan, there are usually no issues in determining the employer's annual cost the pension expense is usually equal to the contributions made to the employees pension plan by the employer. Defined benefit pension plans are considerably more complex. The future benefits to be obtained by retirees under the pension plan are influenced by such things as the future rates of return, mortality rates, early retirements/termination of employment prior to retirement and future salary levels. Calculations of the plan's cost are based on actuarial estimates. When creating a pension plan, the employer must examine the level of economic risk that the firm will assume. For a defined contribution pension plan, the employer contributes the amount that was determined in the pension plan agreement. This is the employer's only obligation. In other words, the employer assumes no risk for the accumulation of the pension plan funds. It is the employee who assumes this risk as well as the risk of what the prevailing economic conditions will be like at the time of retirement (as this affects the amounts to be paid out as benefits). The reverse is true for a defined benefit pension plan. The employer assumes the risk for the benefits that are paid out to employees and these are not known with certainty until paid. As stated previously, a number of things influence the total amount to be paid out as benefits and these are all based on estimates. Therefore, there is risk inherent with this type of plan. Also, the employer assumes the risk of the accumulation of the fund's assets and its investments. It is the employer who must make up any shortfall caused by a deficiency in the expected returns of the fund's investments. Defined Benefit Pension Plans The single employee pension plan This example assumes that the entity has a defined benefit pension plan in place for one employee only. This is so we can break it down into manageable components. The purpose of the exercise is to understand how a defined benefit pension plan works and to understand the concept of what the current service cost and defined benefit obligation are. Imagine you were just hired by an entity with a defined benefit pension plan. For every year of service, you will receive a pension (in the form of an annuity from the time of retirement to the time of death) equal to 2% of the average of your five best years of salary to a maximum of 70%. You just turned 30 and are planning on retiring at the age of 65. Your current annual salary is $80,000.
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The First Year At the end of the first year, your employer (with the help of the actuary) will have to estimate the following: what your average five best years of salary will be meaning they will have to project your salary in 30-35 years from now, how long you are expected to live mortality tables will provide this information, and at what rate to discount the standard stipulates that we should discount using the yield on high quality corporate bonds. Assume that the answers to the above are: average five best years of salary is projected to be $200,000 you are expected to live to age 79, or 14 years in retirement high quality corporate bonds yield is currently 5% After one year of service, you will have earned a pension annuity for 14 years equal to $200,000 x 2% = $4,000. The present value at age 65 of this annuity is: N = 14 I = 5% CPT PV = $39,595 PMT = 4,000
The present value at the end of your first year of employment would be: N = 34 I = 5% PV = $7,537 FV = $39,595
The $7,537 represents the current service cost resulting in you providing one year of service to your employer. Note that the above amounts would be calculated by the actuary and provided to management. In the first year, this amount would be expensed: Pension expense service cost Pension liability $7,537 $7,537
Assume further that your employer transferred $7,000 to the pension plan at the end of the year: Pension liability Cash 7,000 7,000
At the end of Year 1, the balance in the pension liability account is equal to $7,537 7,000 = $537 cr.
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The Second and Third Year The actuary typically revalues a pension plan every 2-3 years or so. In the intervening years, all the entity does is rollover the amounts using the original estimates. In the second year, you have earned an additional $4,000 annuity during your retirement years. The present value of this annuity at the end of year 2 is: N = 33 I = 5% PV = $7,914 FV = $39,595
At the end of year 3, the present value of the additional $4,000 annuity is: N = 32 I = 5% PV = $8,310 FV = $39,595
The $7,914 and $8,310 represent the current service cost for Year 2 and 3 respectively. Additional information: Year 2 Contributions to pension plan by employer Actual return on pension plan assets $6,500 600 Year 3 $10,000 400
The entity will keep track of two balances: the defined benefit obligation and the pension plan assets. The defined benefit obligation is essentially the accumulation of current service cost and accrued interest. It would be calculated as follows: Year 2 Defined benefit obligation - beginning of year Accrued interest (5%) Current service cost Defined benefit obligation - end of year $ 7,537 377 7,914 $15,828 Year 3 $15,828 791 8,310 $24,929
At the end of year 3, you have accumulated three years of service, or a total annuity of $4,000 x 3 = $12,000 during retirement. The present value at the end of year 3 of this amount is: N = 14 I = 5% CPT PV = $118,784 PMT = 12,000
N = 32 I = 5% FV = $118,784 PV = 24,929. which is equal to the ending balance of the defined benefit
obligation at the end of Year 3. The pension plan assets would be calculated as follows: Year 2 Pension plan assets - beginning of year Accrued interest (5%) Contributions Remeasurement Pension plan assets - end of year $7,000 350 6,500 250 $14,100 Year 3 $14,100 705 10,000 (305) $24,500
Note that the total return on the plan assets has been broken down into two components: 1. the accrued interest which is equal to the discount rate used (the market yield on high quality corporate bonds), and 2. the remeasurement which is equal to the difference between the actual return on the pension plan assets and the accrued interest. The accrued interest the remeasurement will always equal the actual return. We break it out this way because each of these two amounts will be accounted for separately: the accrued interest on the plan assets will offset the accrued interest on the defined benefit obligation and will be classified with finance costs in profit and loss whereas the remeasurement will be classified as other comprehensive income. The rationale for this is that remeasurements are expected to net out to zero over time (or close to zero). This is based on the assumption that long-term actual returns will equal the remeasurements. The journal entries for year 2 will be as follows: Pension expense service cost Pension liability Net interest cost on pension plan Pension liability $377 Accrued Interest on DBO 350 Expected Return on Plan Assets Pension liability Cash Pension Liability Other Comprehensive Income Remeasurements $7,914 $7,914 27 27
6,500 6,500 250 250
At the end of Year 2, the balance in the pension liability account will be equal to: $537 cr. Balance Beginning of Year + 7,914 Pension Expense Service Cost + 27 Net Interest Cost 6,500 Contributions - 250 Remeasurements = $1,728 cr.
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The difference between the defined benefit obligation and the pension plan assets at the end of year 2 is equal to $15,828 14,100 = $1,728. This amount is formally referred to as the net defined benefit liability of the pension plan. It can also be referred to as the funded status of the pension plan. It is not a coincidence that these two amounts are the same. The net defined benefit liability of the pension plan will appear on the statement of financial position as a liability when the pension plan is underfunded and as an asset when the pension plan is overfunded. Before you continue, attempt to prepare the Year 3 journal entries on your own. The journal entries for year 3 will be as follows: Pension expense service cost Pension liability Net interest cost on pension plan Pension liability $791 Accrued Interest on DBO 705 Expected Return on Plan Assets Pension liability Cash Other Comprehensive Income Remeasurements Pension Liability $8,310 $8,310 86 86
10,000 10,000 305 305
At the end of Year 2, the balance in the pension liability (asset) account will be equal to: $1,728 cr. Balance Beginning of Year + 8,310 Pension Expense Service Cost + 86 Net Interest Cost 10,000 Contributions + 305 Remeasurements = $429 cr. The net defined benefit liability at the end of year 3 is $24,929 24,500 = $429.
Defined Benefits Pension Plans the Aggregate Picture The formal definitions for the terminology introduced above (and a few more) are as follows (IAS 19.8): Defined contribution plans are post-employment benefit plans under which an entity pays fixed contributions into a separate entity (a fund) and will have no legal or constructive obligations to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods.
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Defined benefit plans are post-employment benefit plans other than defined contribution plans. The net defined liability (asset) is the pension plan deficit or surplus and is equal to the present value of the defined benefit obligation less the fair value of plan assets. This is also known as the funded status of the pension plan. The net defined liability or asset is shown in long-term liabilities (assets) on the statement of financial position. For purposes of this course, we will call the financial statement account holding the balance of the net defined liability (asset) the pension account. If the balance in the pension account is a credit, it is classified as a liability. If the balance is a debit, it is classified as an asset. The present value of a defined benefit obligation is the present value, without deducting any plan assets, of expected future payments required to settle the obligation resulting from employee service in the current and prior periods. Service cost comprises: (a) current service cost, which is the increase in the present value of the defined benefit obligation resulting from employee service in the current period; (b) past service cost, which is the change in the present value of the defined benefit obligation for employee service in prior periods, resulting from a plan amendment (the introduction or withdrawal of, or changes to, a defined benefit plan) or a curtailment (a significant reduction by the entity in the number of employees covered by the plan); and (c) any gain or loss on settlement. Remeasurements of the net defined benefit liability (asset) comprise: (a) actuarial gains and losses (see below); and (b) the return on plan assets net of any accrued interest on the plan assets. Actuarial gains and losses are changes in the present value of the defined benefit obligation resulting from: (a) experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred); and (b) the effects of changes in actuarial assumptions.
In our simple one person pension plan example, the defined benefit obligation was calculated as follows: Defined benefit obligation, beginning of year Accrued interest Current service cost Defined benefit obligation, end of year $XXX XXX XXX $XXX
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In addition to the above, there are three elements that could account for the change in the defined benefit obligation in a given year: (1) Benefits paid to retirees. Most active pension plans will have retired employees who are drawing down their pension benefits. The benefits paid reduce both the defined benefit obligation and the pension plan assets. Actuarial gains and losses. The actuary is required to perform a clean-slate actuarial revaluation periodically. The timing of these revaluations vary depending on the nature of the plan and regulatory requirements but is generally every two to three years. IAS 19.58 requires that the plan revaluation be done with sufficient regularity so that there are no material differences. When the actuary revalues a defined benefit plan, certain assumptions made in the last revaluation may no longer hold, i.e. the discount rate used may have changed, employees are expected to live longer, expected future salary assumptions have changed, etc.. Actuarial revaluations will therefore cause the defined benefit obligation to increase or decrease. This change in the defined benefit obligation is called an actuarial gain or loss and becomes part of the remeasurements that are recorded in Other Comprehensive Income. Plan Amendments these are relatively rare and occur only when the pension plan formula is initiated, amended or curtailed. A plan amendment will cause the defined benefit obligation to change, usually by a substantial amount. Plan amendments become part of the service cost expense.
(2)
(3)
As mentioned earlier, the discount rate to use for both the defined benefit obligation and the pension plan assets is by reference to market yields at the end of the reporting period on high quality corporate bonds. If there is no deep market for such bonds, the market yield on government bonds can be used. The defined benefit obligation calculation becomes: Defined benefit obligation, beginning of year Accrued interest Current service cost Benefits paid Actuarial gain or loss Plan amendment Defined benefit obligation, end of year The pension plan asset calculation: Pension plan assets, beginning of year Accrued interest Contributions made to pension plan Benefits paid
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$XXX XXX XXX (XXX) XXX XXX $XXX
$XXX XXX XXX (XXX)

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Remeasurement Defined benefit obligation, end of year The defined benefit cost is made up of three different amounts: (1) (2) (3)
XXX $XXX
Service cost (current service cost and past service costs following a plan amendment) in profit or loss; Net interest (accrued interest on the defined benefit obligation net of the accrued interest on the plan assets) in profit and loss; and Remeasurements (actuarial gains or losses and remeasurements on plan assets) in other comprehensive income.
Example You are provided with the following data for the Tarrant Company pension plan. The company has a fiscal year coinciding with the calendar year. Balances as at January 1, 20x5: Defined benefit obligation Plan Assets Pension account Accumulated Other Comprehensive Income Remeasurements Data for the year ended December 31, 20x5: Current service cost Benefits paid to retirees Actual return on plan assets Contributions made to pension plan
$26,000,000 19,500,000 6,500,000 cr. 2,900,000 dr.
$3,000,000 1,800,000 2,200,000 4,000,000
The market yield on high quality corporate bonds is 7%. The actuary revalued the defined benefit obligation at December 31, 20x5 and calculated the balance to be $30,400,000. The defined benefit obligation and pension plan assets at the end of the year are calculated as follows: Defined benefit obligation Balance, beginning of year Accrued interest @ 7% Current service cost Benefits paid to retirees Actuarial loss Balance, end of year
$26,000,000 1,820,000 3,000,000 (1,800,000) 1,380,000 $30,400,000
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Plan assets Balance, beginning of year Accrued interest @ 7% Contributions Benefits paid to retirees Remeasurement: $2,200,000 1,365,000 Balance, end of year
$19,500,000 1,365,000 4,000,000 (1,800,000) 835,000 $23,900,000
The net defined liability at year-end is equal to $30,400,000 23,900,000 = $6,500,000 The journal entries for 20x5 will be as follows: Pension expense service cost Pension account 3,000,000 3,000,000
Net interest cost on pension plan 455,000 Pension account $1,820,000 Accrued Interest on DBO 1,365,000 Expected Return on Plan Assets Pension account Cash Other Comprehensive Income Remeasurements Pension account 1,380,000 Actuarial Loss 835,000 Remeasurement on Plan Assets The balance in the pension account at year end is as follows: Balance, beginning of year Pension expense service cost Net interest cost on pension Contributions to pension plan Remeasurements Balance, end of year = the net defined liability 4,000,000
455,000
4,000,000 545,000 545,000
$6,500,000 cr. 3,000,000 cr. 455,000cr. 4,000,000 dr. 545,000 cr. $6,500,000 cr.
Lets carry on for one more year assume the following information for the year 20x6: Current service cost Benefits paid to retirees Actual return on plan assets Contributions made to pension plan $3,600,000 2,000,000 1,200,000 10,000,000
The discount rate remains steady at 7%. In addition to the above, the company made a change to the pension plan formula on January 2, 20x6 which caused the defined benefit obligation to increase by $4,000,000 at that time. All employees participating in the
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pension plan were given retroactive service. The actuary has not revalued the defined benefit obligation in 20x6. The defined benefit obligation and pension plan assets at the end of the year are calculated as follows: Defined benefit obligation Balance, beginning of year Plan amendment Jan 2, 20x6 Accrued interest: $34,400,000 x 7% Current service cost Benefits paid to retirees Balance, end of year Plan assets Balance, beginning of year Accrued interest @ 7% Contributions Benefits paid to retirees Remeasurement: $1,673,000 1,200,000 Balance, end of year
$30,400,000 4,000,000 2,408,000 3,600,000 (2,000,000) $38,408,000
$23,900,000 1,673,000 10,000,000 (2,000,000) (473,000) $33,100,000
The net defined liability at year-end is equal to $38,408,000 33,100,000 = $5,308,000 The journal entries for 20x6 will be as follows: Pension expense service cost Pension account $3,600,000 Current Service Cost + 4,000,000 Past Service Cost 7,600,000 7,600,000
Net interest cost on pension plan 735,000 Pension account $2,408,000 Accrued Interest on DBO 1,673,000 Expected Return on Plan Assets Pension account Cash Other Comprehensive Income Remeasurements Pension account (experience loss) 10,000,000
735,000
10,000,000 473,000 473,000
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The balance in the pension account at year end is as follows: Balance, beginning of year Pension expense service costs Net interest cost on pension Contributions to pension plan Remeasurements Balance, end of year net defined liability $6,500,000 cr. 7,600,000 cr. 735,000 cr. 10,000,000 dr. 473,000 cr. $5,308,000
11.3
Other Long-Term Employee Benefits
Other long-term employee benefits are defined by what they are not: all employee benefits other than short-term employee benefits, post-employment benefits and termination benefits. They are not expected to be settled wholly before twelve months after the end of the fiscal period. The recognition and measurement of other long-term employee benefits follow much of the same approach as for defined benefit plans in that the present value of the obligation is shown on the statement of financial position as a liability, the increase in the obligation between the beginning and end of the year is broken out between a service component and an interest component and are disclosed separately on the statement of comprehensive income in the calculation of profit or loss for the period, and the interest rate used to discount the obligation is based on high-quality corporate bonds. There are no items that would flow to other comprehensive income for other long-term employee benefits (i.e. there are no equivalents to remeasurements). Any remeasurement would flow to profit and loss. Example: an entity offers its employees a six month sabbatical at the full rate of pay for every ten years of consecutive service. This example considers only the accounting for the sabbatical plan for one employee. The employee has just completed the first year of service and the employees current salary is $150,000. Management expects that the employees salary in year 11 would be $220,000. Assuming that the yield on high quality corporate bonds is 5%, at the end of the first year, an expense (service cost) and corresponding liability in the amount of $7,091 would be recorded: N = 9 I = 5 FV = $220,000/2 = $110,000 x 1/10 = $11,000 CPT PV = $7,091
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Assuming that the estimates remain the same, the roll forward of the liability from in year 2 would be as follows: Balance, beginning of year Accrued interest @ 5% Service cost for the year* Balance, end of year * N = 8, I =5, FV = $11,000 CPT PV = $7,445 The balance at the end of the year is the present value of the accumulated service cost: N=8 I=5 FV = $22,000 CPT PV = $14,890 $7,091 354 7,445 $14,890
The service cost of $7,445 would be classified with operating expenses. The accrued interest of $354 would be classified as a finance cost.
11.4
Termination Benefits
Termination benefits result from either an entitys decision to terminate the employment or an employees decision to accept an entitys offer of benefits in exchange for termination of employment. A liability and expense is recorded at the earliest of the following dates: (i) when the entity can no longer withdraw the offer of those benefits, and (ii) when the entity recognizes costs for a restructuring (per IAS 37 Provisions, Contingent Liabilities and Contingent Assets) and the restructuring involves the payment of termination benefits. (IAS 19.165) The standard provides specific guidance on when to determine when the entity can no longer withdraw the offer of termination benefits. (IAS 19.166 and 19.167) Example: an entity is planning on closing one of its retail stores in 8 months. Once the store is closed, all employees of the store will be terminated. In order to entice the employees to stay until the store closes, the entity provides them with the following offer: if they stay until the store closes, they will each receive $40,000. If they leave before the store closes, they will receive $15,000. The termination benefit consists of only the $15,000 and the incremental $25,000, paid if an employee stays until the end, is considered to be short-term employee benefits since they relate to an exchange of service.
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11.5
Post Employment Benefits ASPE Immediate Recognition Option
The ASPE standard (section 3461) provides entities with two options with regards to accounting for defined benefit pension plans: 1. The immediate recognition approach which writes off all changes to the pension obligation and plan assets (except for benefits paid to retirees and contribution to plan assets) to expense, and 2. The defer and amortize approach which allows actuarial gains and losses, experience gains and losses and past service costs resulting from plan amendments to be deferred to future periods. This section will examine the immediate recognition approach and the defer and amortize approach will be examined in the section 11.6. We assume that you are familiar with section 11.2 and will focus mostly on the differences between the IFRS approach and the ASPE immediate recognition approaches: the defined benefit obligation is called the accrued benefit obligation. the accrued benefit obligation is based on an actuarial valuation report prepared for funding purposes (note that the actuarial valuation report prepared for purposes of calculating the DBO under IFRS is one for accounting purposes. These tend to be generally more complex and detailed and will generally lead to higher valuations than actuarial reports for funding purposes). The standard requires that such a report be prepared at least every three years (3561.031). in years where the ending balance of the accrued benefit obligation has been provided by an actuary, the pension expense for the year is calculated as follows: Current Service Cost any remeasurements of the accrued benefit obligation - actual return on pension plan assets There is no requirement to break out the pension costs into a service and interest component. in years where an actuarial valuation report is unavailable, the accrued benefit obligation is calculated on a roll forward basis as follows: Accrued benefit obligation, beginning of year + Accrued interest + Current service cost
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The pension expense would be equal to: Current Service Cost + accrued interest on the accrued benefit obligation - actual return on pension plan assets The rate of return to be used to accrue interest on the accrued benefit obligation in a roll-forward period is to be determined by reference to: (a) market interest rates on high-quality debt instruments with cash flows that match the timing and amount of expected benefit payments; or (b) the interest rate inherent in the amount at which the accrued benefit obligation could be settled. (3461.063) Example - You are provided with the following data for the ASPE Company pension plan. The company has a fiscal year coinciding with the calendar year. Balances as at January 1, 20x5: Accrued benefit obligation Plan Assets Pension account balance Data for the year ended December 31, 20x5: Current service cost Benefits paid to retirees Actual return on plan assets Contributions made to pension plan
$19,000,000 16,700,000 2,300,000 cr.
$2,200,000 1,400,000 1,600,000 2,500,000
The actuary provided an actuarial valuation report for funding purposes at December 31, 20x5 and calculated the balance of the accrued benefit obligation to be $21,200,000. The accrued benefit obligation and pension plan assets at the end of 20x5 are calculated as follows: Accrued benefit obligation Balance, beginning of year Current service cost Benefits paid to retirees Re-measurement Balance, end of year
$19,000,000 2,200,000 (1,400,000) 1,400,000 $21,200,000
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Plan assets Balance, beginning of year Actual return Contributions Benefits paid to retirees Balance, end of year The pension expense for the year would be calculated as follows: Current service cost Re-measurement on accrued benefit obligation Actual return on plan assets
$16,700,000 1,600,000 2,500,000 (1,400,000) $19,400,000
$2,200,000 1,400,000 (1,600,000) $2,000,000
The journal entry for 20x5 is: Pension expense Pension account Cash $2,000,000 500,000 $2,500,000
The pension account balance at the end of the year will be equal to: $2,300,000 cr. Beginning 500,000 = $1,800,000 cr. The difference between the accrued benefit obligation and the plan assets is: $21,200,000 19,400,000 = $1,800,000 The year 20x6 will be a roll-forward year as there is no actuarial valuation report available at December 31, 20x6. Data for the year ended December 31, 20x6: Current service cost Benefits paid to retirees Actual return on plan assets Contributions made to pension plan
$2,400,000 1,500,000 2,100,000 3,000,000
The discount rate to be used in 20x6 is 6%. The defined benefit obligation and pension plan assets at the end of 20x6 are calculated as follows: Accrued benefit obligation Balance, beginning of year Accrued interest @ 6% Current service cost Benefits paid to retirees Balance, end of year
$21,200,000 1,272,000 2,400,000 (1,500,000) $23,372,000
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Plan assets Balance, beginning of year Actual return Contributions Benefits paid to retirees Balance, end of year The pension expense for the year would be calculated as follows: Current service cost Accrued interest on accrued benefit obligation Actual return on plan assets
$19,400,000 2,100,000 3,000,000 (1,500,000) $23,000,000
$2,400,000 1,272,000 (2,100,000) $1,572,000
The journal entry for 20x6 is: Pension expense Pension account Cash $1,572,000 1,428,000 $3,000,000
The pension account balance at the end of the year will be equal to: $1,800,000 cr. Beginning 1,428,000 = $372,000 cr. The difference between the accrued benefit obligation and the plan assets is: $23,372,000 23,000,000 = $372,000
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Problems with Solution

Multiple Choice Questions 1. Defined contribution plans and defined benefit plans are two common types of pension plans. Choose the correct statement concerning these plans. a. The required annual contribution to the plan is determined by formula or contract in a defined contribution plan. b. Both plans provide the same retirement benefits. c. The retirement benefit is usually determinable well before retirement in a defined contribution plan. d. In both types of plans, pension expense is generally the amount funded during the year.
2.
The following information for Gamez Enterprises, a publicly accountable entity, is given below: Plan assets (at fair value), Dec 31, 20x7 Defined Pension Obligation, Dec 31, 20x7 Current service cost for 20x8 Contributions to plan assets during 20x8 Actual return on plan assets Yield on high quality long-term corporate bonds $2,476,000 2,760,000 360,000 324,000 115,000 6%
What is the amount that Gamez Enterprises should report as Pension Liability on its Statement of Financial Position as of December 31, 20x8? a. $296,480 b. $330,060 c. $343,520 d. $370,600
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The following information relates to questions 3-4: On January 1, 20x8, Moore Co., a publicly accountable entity, had the following balances: Defined benefit obligation Fair value of plan assets $2,800,000 2,500,000
The current yield on high quality corporate bonds is 10%. Other data related to the pension plan for 20x8 are as follows. Current service cost Contribution to plan assets Benefits paid Actual return on plan assets 3. The balance of the defined benefit obligation at December 31, 20x8 is a. $3,048,000 b. $3,060,000 c. $3,085,000 d. $3,090,000 The fair value of plan assets at December 31, 20x8 is a. $2,354,000. b. $2,526,000. c. $2,706,000. d. $2,856,000. $160,000 180,000 150,000 176,000
4.
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Problem 1 IFRS & ASPE (continuation of in-class problem) This problem is a continuation of the Do-Re-Mi problem taken up in class. It assumes you have completed the in-class problem. Assume the following additional data: 20x4 Current service cost Actual return on plan assets Annual funding payments to trustee Benefits paid to retirees Changes in actuarial assumptions establishes a December 31 benefit obligation of (relevant for parts a) and c) only) $120,000 120,000 45,000 20x5 $134,000 10,000 300,000 65,000 20x6 $165,000 50,000 600,000 90,000
$1,400,000
$1,900,000
For each of the following parts, calculate the end of year balance for the defined (accrued) benefit obligation, the plan assets and the pension liability (asset). Calculate the pension cost/expense for the year and the prepare a reconciliation of the funded status at the end of the year. Required a) Recognition of actuarial gains and losses in other comprehensive income (IFRS). Assume that the yield on high quality corporate bonds is 5%. On January 2, 20x5, the company amended the pension plan formula this caused an increase in the defined benefit obligation of $252,000. Immediate recognition approach option under ASPE. Assume further that the changes in actuarial assumptions establishes an ABO at December 31, 20x4 of $1,100,000 and at December 31, 20x6 of $1,450,000. The discount rate to be used for the accrued benefit obligation in roll-forward years is 6%. On January 2, 20x5, the company amended the pension plan formula this caused an increase in the accrued benefit obligation of $200,000.
b)
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Problem 2 - IFRS The Chisnall Corporation Ltd., a publicly accountable entity, began a pension fund in the year 20x3, effective January 1, 20x4. Terms of the pension plan follow: employees will receive partial credit for past service. The defined benefit obligation, valued by the actuary, is $216,000 as of January 1, 20x4. past service cost will be funded over 15 years. The initial payment, on January1, 20x4 is $20,000. After that, another $20,000 will be added every year to the December 31 current service funding amount, including the December 31, 20x4 payment. The amount of past service funding will be reviewed every five years to ensure its adequacy. the current service cost will be fully funded each December 31, plus or minus any actuarial losses or gains on the defined benefit obligation. Remeasurements on the pension plan assets will not affect plan funding in the short-run, as they are expected to offset over time. the yield on high quality long-term corporate bonds is 6%
Data for 20x4 and 20x5 Current service cost Funding amount, January 1, 20x4 Funding amount, December 31 Actual return on fund assets Increase in the defined benefit obligation at yearend due to an actuarial revaluation Required: Calculate the end of year balance for the defined benefit obligation, the plan assets and the pension liability (asset) for 20x4 and 20x5. Calculate the pension cost/expense for the years 20x4 and 20x5 and prepare a reconciliation of the funded status at the end of each year. 20x4 $51,000 20,000 ?? 1,000 20x5 $57,000 ?? 6,800 16,000
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Problem 3 - IFRS Bufflehead Ltd., a publicly accountable entity, has a defined benefit pension plan which was instituted on January 1, 20x0. The current data as at December 31, 20x1 are as follows: Yield on high quality long-term corporate bonds Yield on long-term government bonds Defined benefit obligation, January 1, 20x1 Pension plan assets at fair value, January 1, 20x1 Current service cost 20x1 Contributions to pension fund by Bufflehead Ltd. in 20x1 Pension benefits paid to retirees during 20x1 Pension plan assets at fair value, December 31, 20x1 Defined benefit obligation, December 31, 20x1 (per actuarial estimate) 6% 4% $658,000 245,000 148,000 95,000 174,000 261,000 710,000
Assume all payments to and from the plan are made at the end of the year. Required Show the calculations for the year end balances for the defined benefit obligation, the plan assets and the pension liability (asset) for 20x1. Calculate the pension cost/expense for the year 20x1 and prepare a reconciliation of the funded status at the end of each year.
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Problem 4 - IFRS The Harold Corporation operates a defined benefit plan for its employees. Data relative to the plan for the year 20x8 are as follows: Data relative to balances at January 1, 20x8: Defined benefit obligation Plan assets Current service cost Benefits paid to employees Contributions to pension plan assets January 2, 20x8 July 2, 20x8 December 31, 20x8 Actual return on pension assets Yield on high-quality long-term corporate bonds
$6,600,000 8,900,000 360,000 270,000 100,000 200,000 70,000 310,000 5%
The actuary estimates that the defined benefit obligation as at December 31, 20x8 is $7,500,000. Harold made a change to the defined benefit formula on January 2, 20x8. This change cause the defined benefit obligation to increase by $500,000. Required Calculate the end of year balances for the defined benefit obligation, the plan assets and the pension liability (asset) for 20x8. Calculate the pension cost/expense for the year 20x8 and prepare a reconciliation of the funded status at the end of the year.
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Problem 5 ASPE (Immediate Recognition) The Seger Corporation Ltd began a pension fund in the year 20x3, effective January 1, 20x4. Terms of the pension plan follow: employees will receive partial credit for past service. The accrued benefit obligation, valued by the actuary, is $216,000 as of January 1, 20x4. the discount rate to be used in roll forward years is 6% the company uses the immediate recognition approach Data for 20x4 and 20x5 Current service cost Funding amount, January 1, 20x4 Funding amount, December 31 Actual return on fund assets Increase in accrued benefit obligation at year-end due to an actuarial revaluation Required: Calculate the end of year balances for the accrued benefit obligation, the plan assets and the pension liability (asset) for 20x4 and 20x5. Prepare journal entries to record pension expense and funding for 20x4 and 20x5. Also prepare a reconciliation of funding status to the pension account as it would appear on the balance sheet. 20x4 $51,000 20,000 60,000 1,000 20x5 $57,000 90,000 6,800 16,000
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Problem 6 ASPE (Immediate Recognition) Grantham Ltd. has a noncontributory pension plan which was instituted on January 1, 20x0. The current data as at December 31, 20x1 are as follows: Accrued benefit obligation, January 1, 20x1 Pension plan assets at fair value, January 1, 20x1 Current service cost 20x1 Contributions to pension fund by Grantham Ltd. in 20x1 Pension benefits paid to retirees during 20x1 Pension plan assets at fair value, December 31, 20x1 Accrued benefit obligation, December 31, 20x1 (per actuarial estimate) Discount rate for the Accrued Benefit Obligation to be used in roll-forward years $520,000 285,000 165,000 160,000 174,000 242,000 600,000 7%
Assume all payments to and from the plan are made at the end of the year. Grantham Ltd. is a private company that has adopted ASPE and has opted to use the immediate recognition approach in accounting for its defined benefit plan. Required Show the calculations for the year end balances for the accrued benefit obligation, the plan assets and the pension liability (asset) for 20x1. Prepare journal entries to record pension expense and funding for 20x1. Also prepare a reconciliation of funding status to the pension account as it would appear on the balance sheet.
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Problem 7 ASPE (Immediate Recognition) The Cash Corporation operates a defined benefit plan for its employees. Data relative to the plan for the year 20x8 are as follows: Data relative to balances at January 1, 20x8: Accrued benefit obligation Plan assets Current service cost Benefits paid to employees Contributions to pension assets January 2, 20x8 July 2, 20x8 December 31, 20x8 Actual return on pension assets Discount rate used for Accrued benefit obligation in roll-forward periods The actuary estimates that the accrued benefit obligation as at December 31, 20x8 is $8,900,000. Required Reconcile the opening balances of the Accrued benefit obligation and Plan assets to their ending balances. Calculate pension expense for the year 20x8 and reconcile the funded status at December 31, 20x8. Assume that the Cash Corporation is a private company and uses the immediate recognition approach.
$ 8,600,000 10,700,000 160,000 120,000 100,000 100,000 100,000 550,000
6%
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Solutions
Multiple Choice Questions 1. 2. a d Pension liability, beginning of year Pension cost service component Pension cost net interest component $284,000 x 6% Contributions Remeasurement Plan Assets ($2,476,000 x 6%) 115,000 Pension liability, end of year DBO, beginning balance Accrued interest @ 10% Current service cost Benefits paid Pension Obligation, ending balance Plan assets, beginning of year Contributions Benefits paid Actual return $284,000 cr. 360,000 cr. 17,040 cr. 324,000 dr. 33,560 cr. $370,600 cr. $2,800,000 280,000 160,000 -150,000 $3,090,000 $2,500,000 180,000 -150,000 176,000 $2,706,000
3.
4.
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Problem 1 Part (a) 20x4 Defined benefit obligation Balance, beginning of year Plan amendment Accrued interest @ 5% Current service cost Benefits paid to retirees Actuarial loss (gain) $1,008,000 50,400 120,000 (45,000) 266,600 $1,400,000 20x5 $1,400,000 252,000 82,600 134,000 (65,000) $1,803,600 20x6 $1,803,600 90,180 165,000 (90,000) (68,780) $1,900,000
Pension Plan Assets Balance, beginning of year Accrued interest @ 5% Contributions Benefits paid to retirees Remeasurement
$458,000 22,900 (45,000) 97,100 $533,000
$533,000 26,650 300,000 (65,000) (16,650) $778,000
$778,000 38,900 600,000 (90,000) 11,100 $1,338,000
Journal entries 20x4 Pension expense service cost Pension account Net interest on pension plan Pension account $50,400 DBO 22,900 Plan Assets OCI Remeasurements Pension account $266,600 Actuarial Loss 97,100 Remeasurement 20x5 Pension expense service cost Pension account 134,000 CSC + 252,000 Plan Amendment Net interest on pension plan Pension account $82,600 DBO 26,650 Plan Assets Pension account Cash
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120,000 120,000 27,500 27,500
169,500 169,500
386,000 386,000
55,950 55,950
300,000 300,000
CMA Ontario - 2013
OCI Remeasurements Pension account 20x6 Pension expense service cost Pension account Net interest on pension plan Pension account $90,180 DBO 38,900 Plan Assets Pension account Cash Pension account OCI Remeasurements 68,780 Actuarial Gain + 11,100 Remeasurement
16,650 16,650 165,000 165,000 51,280 51,280
600,000 600,000 79,880 78,880
Balance in Pension Account 20x4 $550,000 cr. 120,000 cr. 27,500 cr. 169,500 cr. $867,000 cr. 20x5 $867,000 cr. 386,000 cr. 55,950 cr. 300,000 dr. 16,650 cr. $1,025,600 cr. 20x6 $1,025,600 cr. 165,000 cr. 51,280 cr. 600,000 dr. 79,880 dr. $562,000 cr.
Beginning balance Pension expense service cost Net interest on pension plan Contributions Remeasurements Ending Balance = Funded Status
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Part (b) 20x4 Defined benefit obligation Balance, beginning of year Plan amendment Accrued interest @ 6% Current service cost Benefits paid to retirees Remeasurement $858,000 120,000 (45,000) 167,000 $1,100,000 20x5 $1,100,000 200,000 78,000 134,000 (65,000) $1,447,000 20x6 $1,447,000 165,000 (90,000) (72,000) $1,450,000
Pension Plan Assets Balance, beginning of year Actual return Contributions Benefits paid to retirees
$458,000 120,000 (45,000) $533,000
$533,000 10,000 300,000 (65,000) $778,000
$778,000 50,000 600,000 (90,000) $1,338,000
Pension expense Current service cost Accrued interest/remeasurement on ABO Actual return on plan assets Plan amendment
$120,000 167,000 (120,000) $167,000
$134,000 78,000 (10,000) 200,000 $402,000
$165,000 (72,000) (50,000) $43,000
Journal Entries 20x4 Pension Expense Pension Account Balance in pension account = $400,000 cr. + 167,000 cr. = $567,000 cr. Pension Expense Pension Account Cash Balance in pension account = $567,000 cr. + 102,000 cr. = $669,000 cr. Pension Expense Pension Account Cash Balance in pension account = $669,000 cr. + 557,000 dr. = $112,000 cr. $167,000 $167,000
20x2
402,000 102,000 300,000
20x3
43,000 557,000 600,000
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Problem 2 20x4 Defined benefit obligation Balance, beginning of year Plan amendment, Jan 1, 20x4 Accrued interest @ 6% Current service cost Actuarial loss -0$216,000 12,960 51,000 $279,960 Pension Plan Assets Balance, beginning of year Funding Jan 1 Accrued interest @ 6% Funding Dec 31: 20,000 + 51,000 $20,000 + 57,000 + 16,000 Remeasurement 20x5 $279,960 16,798 57,000 16,000 $369,758
-020,000 1,200 71,000 (200) $92,000
$92,000 5,520 93,000 1,280 $191,800
Journal entries 20x4 Pension expense service cost Pension account $216,000 Plan Amendment + 51,000 CSC Net interest on pension plan Pension account $12,960 DBO 1,200 Plan Assets Pension account Cash OCI Remeasurements Pension account 20x5 Pension expense service cost Pension account Net interest on pension plan Pension account $16,798 DBO 5,520 Plan Assets Pension account Cash 267,000 267,000
11,760 11,760
91,000 91,000 200 200 57,000 57,000 11,278 11,278
93,000 93,000
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OCI Remeasurements Pension account 16,000 Actuarial Loss 1,280 Remeasurement on Plan Assets Pension Account -
14,720 14,720
Beginning balance Pension expense service cost Net interest on pension plan Contributions Remeasurements Ending Balance = Funded Status
20x4 -0$267,000 cr. 11,760 cr. 91,000 dr. 200 cr. $187,960 cr.
20x5 $187,960 cr. 57,000 cr. 11,278 cr. 93,000 dr. 14,720 cr. $177,958 cr.
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Problem 3
Defined benefit obligation Balance, beginning of year Accrued interest @ 6% Current service cost Benefits paid Actuarial loss
$658,000 39,480 148,000 (174,000) 38,520 $710,000
Pension Plan Assets Balance, beginning of year Accrued interest @ 6% Contributions Benefits paid Remeasurement
$245,000 14,700 95,000 (174,000) 80,300 $261,000
Journal entries Pension expense service cost Pension account Net interest on pension plan Pension account $39,480 DBO 14,700 Plan Assets Pension account Cash Pension account OCI Remeasurements $80,300 Remeasurement Plan Assets 38,520 Actuarial Loss Pension Account Beginning balance: $658,000 245,000 Pension expense service cost Net interest on pension plan Contributions Remeasurements Ending Balance = Funded Status $148,000 $148,000 24,780 24,780
95,000 95,000 41,780 41,780
$413,000 cr. 148,000 cr. 24,780 cr. 95,000 dr. 41,780 dr. $449,000 cr.
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Problem 4
Defined benefit obligation Balance, beginning of year Plan amendment Accrued interest: (6,600,000 + 500,000) @ 5% Current service cost Benefits paid Actuarial gain
$6,600,000 500,000 355,000 360,000 (270,000) (45,000) $7,500,000
Pension Plan Assets Balance, beginning of year Contributions Jan 2 - July 2 Accrued interest: On opening balance & Jan 2 contribution: $9,000,000 x 5% On July 2 contribution: 200,000 x 5% x Contributions year end Benefits paid Remeasurement : $310,000 Actual Return 455,000 Accrued Interest
$8,900,000 100,000 200,000
450,000 5,000 70,000 (270,000) (145,000) $9,310,000
Journal entries Pension expense service cost Pension account $500,000 Plan Amendment + 360,000 Current Service Cost Pension account Net interest on pension plan $355,000 DBO 455,000 Plan Assets Pension account Cash OCI Remeasurements Pension account $145,000 Remeasurement Plan Assets - 45,000 Actuarial Gain $860,000 $860,000
100,000 100,000
370,000 370,000 100,000 100,000
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Pension Account Beginning balance: $8,900,000 6,600,000 Pension expense service cost Net interest on pension plan Contributions Remeasurements Ending Balance = Funded Status
$2,300,000 dr. 860,000 cr. 100,000 dr. 370,000 dr. 100,000 cr. $1,810,000 dr.
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Problem 5 20x4 Accrued benefit obligation Balance, beginning of year Plan amendment Accrued interest @ 6% Current service cost Remeasurement -0$216,000 12,960 51,000 $279,960 Pension Plan Assets Balance, beginning of year Actual return Contributions 20x5 $279,960 57,000 16,000 $352,960
-01,000 80,000 $81,000
$81,000 6,800 90,000 $177,800
Pension expense Current service cost Accrued interest/remeasurement on ABO Actual return on plan assets Plan amendment
$51,000 12,960 (1,000) 216,000 $278,960
$57,000 16,000 (6,800) $66,200
Journal Entries 20x4 Pension Expense Cash Pension Account Pension Expense Pension Account Cash Balance in pension account = $198,960 cr. + 23,800 dr. = $175,160 cr. $278,960 $80,000 198,960 66,200 23,800 90,000
20x2
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Problem 6 Accrued benefit obligation Balance, beginning of year Current service cost Benefits paid Remeasurement
$520,000 165,000 (174,000) 89,000 $600,000
Pension Plan Assets Balance, beginning of year Contributions Benefits paid Remeasurement
$285,000 160,000 (174,000) (29,000) $242,000
Pension expense Current service cost Remeasurement on ABO Remeasurement on plan assets
$165,000 89,000 29,000 $283,000
Journal Entries Pension Expense Pension Account Cash Balance in pension account: Beginning of year: $520,000 285,000 Increase in 20x1 Balance, end of 20x1 = Funded Status $283,000 $123,000 160,000
$235,000 123,000 $358,000
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Problem 7 Accrued benefit obligation Balance, beginning of year Current service cost Benefits paid Remeasurement
$8,600,000 160,000 (120,000) 260,000 $8,900,000
Pension Plan Assets Balance, beginning of year Actual return Contributions Benefits paid
$10,700,000 550,000 300,000 (120,000) $11,430,000
Pension benefit Current service cost Remeasurement on ABO Actual return on plan assets
$160,000 260,000 (550,000) ($130,000)
Journal Entries Pension Account Pension Benefit Cash Balance in pension account: Beginning of year: $10,700,000 8,600,000 Increase in 20x8 Balance, end of 20x8 = Funded Status $430,000 $130,000 300,000
$2,100,000 dr. 430,000 dr. $2,530,000 dr.
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12.
Earnings Per Share
Earnings per share data have to be disclosed by entities (i) whose shares are traded in a public market, or (ii) that files, or is in the process of filing, its financial statements with a securities commission or other regulatory organization for the purpose of issuing shares in a public market (IAS 33.2). Two earnings per share numbers have to be disclosed: basic earnings per share and diluted earnings per share. This chapter discuses the details on how to calculate each of these EPS numbers. If income from continuing operations is calculated, then earning per share numbers have to be presented for both profit and loss attributed to common shareholders and on profit or loss from continuing operations attributable to those common shareholders (IAS 33.9).
12.1
Basic Earnings Per Share
Basic earnings per share is calculated as follows: Net income available to common shareholders Weighted average number of common shares outstanding during the period The numerator of the computation is equal to net income less dividends declared on noncumulative preferred shares and annual dividend entitlements on cumulative preferred shares, whether or not declared (IAS 33.14). The denominator of the computation is an amount representing the weighted average number of common shares outstanding during the period. Note that common shares issued, during the year or after the year-end but prior to the issuance of the annual report, in connection with a common stock dividend or stock split are considered to have been issued at the beginning of the accounting period (or at the time of issue, in the case of common stock issued during the year). Stock dividends and stock splits do not change the proportionate ownership of the shareholders. However, shareholders will be assessing the value of their investment in terms of the number of shares currently owned. To avoid misleading shareholders into thinking their investment is worth more than it really is, the stock dividends and stock splits are considered outstanding for the entire period (IAS 33.26). If a stock split and stock dividend is declared during the year, this is applied retrospectively to previous fiscal years. For example, if a 2:1 split is declared in the year ended December 31, 20x4, then the EPS for previous years are recalculated on the assumption that the stock split done at that time.
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Example 1: The long-term liabilities and stockholders' equity section of Thompson Ltd. at January 1, 20x3, was as follows: Long-Term Liabilities 8% convertible bonds, each $1,000 bond convertible into 50 common shares, interest payable June 30 and December 31 Shareholders' Equity 4% non-cumulative series A preferred shares, $100 par value, outstanding 20,000 shares 5% cumulative convertible series B preferred shares, $100 par value, convertible into 2 common shares, outstanding 50,000 shares Common Stock - 400,000 shares outstanding Retained Earnings $2,000,000 5,000,000 6,000,000 3,000,000 16,000,000 $20,000,000 At January 1, 20x3, there were stock options outstanding enabling the option holders to acquire 100,000 common shares at $60 per share. Information for the year ended December 31, 20x3: 1) Net income was $2,410,0000. 2) On July 1, all the 8% convertible bonds were converted. The company had no interest obligation on these bonds in the month of July. 3) Dividends were declared and paid on the A and B preferred shares respectively. 4) The company is subject to a 40% tax rate. 5) The average share price during the year 20x3 was $80. We start by determining net income available to common shareholders: Net income Less: preferred dividend entitlements A - 20,000 x 4 B - 50,000 x 5 Net income available to common shareholders Weighted average number of common shares outstanding: Shares outstanding at January 1 Half-Year Conversion of bonds on July 1: 200,000* x 6/12 = * (4,000,000/ 1,000 x 50) Basic E.P.S = $2,080,000 / 500,000 = $4.16 $4,000,000
$2,410,000 (80,000) (250,000) $2,080,000
400,000 100,000 500,000
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12.2
Diluted earnings per share
Companies with complex capital structures have various securities outstanding which can potentially be converted into common shares at the option of the holder. These securities include convertible debt, convertible preferred shares, common share warrants and stock options. The exercise of any of these securities would reduce the ownership percentage of the existing common shareholders. Diluted earnings per share indicates what basic earnings per share would have been if the potentially dilutive securities outstanding at any time during the year had been converted at the later of the beginning of the year or the date of issue of the convertible security. The objective is to report the most pessimistic earnings per share figure so it is necessary to rank the potentially dilutive items (IAS 33.41). The steps in the calculation of diluted earnings per share are (IAS 33.44): (1) Individually analyze each outstanding convertible security to determine its impact on basic earnings per share. The denominator in the analysis is the additional common shares due to the conversion of the particular item. The numerator is the additional amount of after-tax income available assuming the item was converted. This additional income is generally one of the following two items: (a) the amount of dividends applicable to convertible preferred shares for the period. (b) the amount of interest expensed for the period, net of income taxes, on convertible debt. (2) Compare the individual earnings per share figures with basic EPS to determine which items are dilutive (decrease earnings per share), and which are anti-dilutive (increase earnings per share). The anti-dilutive securities are excluded from the calculation, as we are trying to determine the lowest possible earnings per share figure assuming all convertible items were converted. (3) Rank the dilutive items from most dilutive to least dilutive. (4) Individually add the dilutive items to the basic EPS beginning with the most dilutive. Calculate the new earnings per share figure after each dilutive item is added. Continue to add dilutive items as long as the earnings per share figure decreases. The lowest earnings per share figure is the fully-dilutive earnings per share. Impact on conversion of warrants and options: the exercise of options and warrants is assumed at the beginning of the period and common shares are assumed to be used. The proceeds from the exercise are then assumed to be used to purchase common shares at the average market price for the period. The difference between the number of shares assumed issued and the number of shares assumed purchased are included in the denominator of the fully diluted earnings per share computation (IAS 33.45). Stock options that are in the money (i.e. when the exercise price is lower than the average market price of the stock) are always dilutive. If they are out of the money (i.e. when the
exercise price is higher than the average market price of the stock), then they would be antidilutive and would not be included in the diluted EPS calculations. For example, a company has 20,000 options outstanding exercisable at $67.50 per share. The average market price per common share during the year was $90. The assumed exercise of these options would generate $67.50 x 20,000 = $1,350,000 which is an amount sufficient to acquire 15,000 shares ($1,350,000 / $90). Thus, 5,000 incremental shares (20,000 15,000) are added to the denominator in computing fully diluted earnings per shares
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Example 2: Refer to the Thompson Ltd. data in Example 1. We first analyze the dilutive effect of each convertible item: a) Convertible bonds - impact on EPS had the bonds been converted on January 1 instead of July 1: Impact on numerator: $4,000,000 x 8% x 6/12 x 0.6 = $96,000 Impact on denominator: 4,000 bonds x 50 shares x 6/12 = 100,000 Incremental impact: $96,000 / 100,000 = $0.96 => Dilutive since it is lower than Basic EPS of $4.16 b) Convertible B preferred shares Impact on numerator: $5,000,000 x .05 = $250,000 Impact on denominator: 50,000 x 2 = 100,000 Incremental impact: $250,000 / 100,000 = $2.50 => Dilutive since it is lower than Basic EPS of $4.16 c) Stock options Proceeds on assumed conversion = 100,000 x $60 $6,000,000 These could be used to purchase $6,000,000 / $80 = 75,000 shares Increase in denominator = 100,000 75,000 = 25,000 shares The order of entry into the diluted EPS calculation is as follows: 1 - Stock options 2 - Convertible Bonds 3 - Convertible Preferred Shares Income Basic EPS Stock options 2,080,000 2,080,000 Convertible bonds 96,000 2,176,000 Preferred shares Diluted EPS 250,000 2,426,000 Shares 500,000 25,000 525,000 100,000 625,000 100,000 725,000 $3.35 3.48 $3.96 EPS $4.16
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Example 3 Assume the following information for the Skyview Inc.: Skyview has income available to common shareholders of $10,000,000 for the year 20x6 (i.e. preferred dividends were already deducted in arriving at this amount) 2,000,000 weighted average common shares were outstanding for the year 20x6 the average market price of common shares was $75 during the year 20x6 Skyview has the following potential convertible instruments outstanding during the year: options to purchase 100,000 common shares at $60 each 800,000 convertible preferred shares entitled to a cumulative dividend of $8 per share. Each preferred share is convertible into two common shares. 5% convertible debentures with a principal amount of $100,000,000 (issued at par). Each $1,000 debenture is convertible into 20 common shares. the tax rate was 40% for 20x6 Determination of earnings per incremental share: Increase in number of common shares 20,000 1,600,000 2,000,000 Earnings per incremental share $4.00 1.50
Options (1) Convertible preferred shares (2) 5% convertible debentures (3)
Increase in Income $6,400,000 3,000,000
(1) 100,000 options x $60 = $6,000,000 / $75 = 80,000; 100,000 80,000 = 20,000 (2) Income: 800,000 shares x $8 = $6,400,000; shares = 800,000 x 2 (3) Income: $100,000,000 x 5% x .6 = $3,000,000 Shares: $100,000,000 / 1000 x 20 = 2,000,000 Order of entry: options first; convertible debentures second and preferred shares last. Computation of diluted earnings per share: Income $10,000,000 10,000,000 3,000,000 13,000,000 6,400,000 $19,400,000 Shares 2,000,000 20,000 2,020,000 2,000,000 4,020,000 1,600,000 5,620,000 EPS $5.00 4.95 3.23 $3.45
As reported Options 5% convertible debentures Convertible preferred shares
Diluted earnings per share is therefore $3.23 since the convertible preferred shares are anti-dilutive.
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Example 4 - Net Loss Situation The Loser Corporation's net loss for the year ending December 31, 20x4 was $1,500,000. The weighted average number of shares for the year was calculated as 1,000,000. The company has convertible, cumulative preferred shares outstanding. There are 100,000 shares outstanding with an annual dividend rate per share of $2.00. The conversion ratio is 2 common shares for one preferred share. The company also has $10,000,000 of 6% convertible bonds outstanding. The conversion ratio is 20 common shares for each $1,000 bond. The companys tax rate is 35%. The basic EPS would be calculated as follows: [($1,500,000) - 200,000] / 1,000,000 = (1,700,000) / 1,000,000 = ($1.70) Note that the inclusion of the preferred shares in the diluted EPS calculations would cause EPS to be equal to: ($1,500,000) / 1,200,000 = ($1.25). Because this causes the loss per share to decrease, the preferred shares are antidilutive. The inclusion of the bonds would cause EPS to become: ($1,500,000) + 390,000 / (1,000,000 + 200,000) = ($1,110,000) / 1,300,000 = ($0.85) Again antidutive. The point of this example is that when the company is in a loss situation, the inclusion or ordinarily dilutive convertible instruments will cause the loss per share to reduce and become antidilutive. Therefore, whenever a company is in a loss situation, the basic EPS will always equal the dilutive EPS. Additional Considerations whenever discontinued operations are reported on the Statement of Profit and Loss, both basic and diluted EPS numbers must be disclosed for the profit or loss from continuing operations, profit or loss from discontinued operations and profit or loss for the period. For example: Basic Earnings per share On profit from continuing operations On loss from discontinued operations
$12.56 (1.15) $11.41
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Diluted Earnings per share On profit from continuing operations On loss from discontinued operations
$11.42 (1.15) $10.27
if there has been a stock split, a change in accounting policy or a correction of an error which resulted in the restatement of prior year financial statements, the earnings per share amounts need to be restated.
Note that EPS disclosures are not required under ASPE.
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Multiple Choice Questions 1. Poe Co. had 300,000 shares of common stock issued and outstanding at December 31, 20x4. On January 1, 20x5, Poe issued 200,000 shares of nonconvertible preferred stock. During 20x5, Poe declared and paid $75,000 cash dividends on the common stock and $60,000 on the preferred stock. Net income for the year ended December 31, 20x5, was $330,000. What should be Poe's 20x5 earnings per common share? a. $1.10 b. $0.90 c. $0.85 d. $0.65
2.
Timp, Inc. had the following common stock balances and transactions during 20x5: January 1, x5 February 1, x5 March 1, x5 July 1, x5 Dec 31, x5 Common stock outstanding 2:1 stock split Issued common stock Issued common stock Common stock outstanding 30,000 30,000 9,000 8,000 77,000
What was Timp's 20x5 weighted average shares outstanding? a. 60,000 b. 69,000 c. 71,500 d. 80,000
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3.
On June 30, 20x4, Lomond, Inc. issued twenty, $10,000, 7% bonds at par. Each bond was convertible into 200 shares of common stock. On January 1, 20x5, 10,000 shares of common stock were outstanding. The bondholders converted all the bonds on July 1, 20x5. The following amounts were reported in Lomond's income statement for the year ended December 31, 20x5: Revenues Operating expenses Interest on bonds Income before income tax Income tax at 30% Net income $977,000 920,000 7,000 50,000 15,000 $ 35,000
What amount should Lomond report as its 20x5 basic earnings per share? a. $2.50 b. $2.86 c. $2.92 d. $3.50
4.
Dextar Corporation had 300,000 common shares outstanding at December 31, 20x1. On April 1, 20x2 an additional 120,000 common shares were issued. On June 1, 20x2 a 10% stock dividend was declared. In addition, it had 90,000 stock options outstanding, which had been granted to certain executives, and which gave them the right to purchase Dextar's shares at an option price of $37 per share. The average market price of Dextar's common shares for 20x2 was $50. What is the number of shares that should be used in calculating diluted earnings per share for the year ended December 31, 20x2? a) 420,000 b) 449,000 c) 466,600 d) 454,740
5.
On January 2, 20x2, Starr Co. issued at par $10,000 of 6% bonds convertible in total into 1,000 of Starr's common shares. No bonds were converted during 20x2. Throughout 20x2, Starr had 1,000 shares of common shares outstanding. Starr's 20x2 net income was $6,000. Starr's income tax rate is 30%. No potentially dilutive securities other than the convertible bonds were outstanding during 20x2. Starr's diluted earnings per share for 20x2 would be (rounded to the nearest penny) a) $3.00. b) $3.21 c) $3.30 d) $6.42
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Problem 1 The December 31, 20x2 Statement of Financial Position of Davis Company included the following items: 4,000 9% convertible bonds outstanding. The 20-year bonds mature December 31, 20x5. Each $1,000 bond is convertible into 30 common shares. 270,000 convertible, cumulative, preferred shares. These preferred shares have an annual dividend of $2.00 per share and each preferred share can be exchanged for 3 common shares. 1,500,000 common shares issued and outstanding. 125,000 Series 1 share options outstanding with an exercise price of $45. 100,000 Series 2 share options outstanding with an exercise price of $60. During 20x2, the following occurred: Net income was $4,000,000. On June 1, 20x2, Davis issued 150,000 new common shares for cash The dividends on the preferred shares were paid on June 30, 20x2. A $0.25 per share dividend was paid to common shareholders (date of record was April 15) on April 30, 20x2. The tax rate for the year was 40%. The market value of the common shares averaged $50 for the year. Required a) Compute basic and diluted earnings per common share for 20x2. Show your calculations. b) Assume that on Nov 30, 20x2, Davis issued a 2:1 stock split to common shareholders. Calculate the weighted average number of common shares for purposes of calculation of basic earnings per share.
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Problem 2 The following data is available for the Culum Company for its 20x4 fiscal year. Net income for the year ended December 31, 20x4 amounted to $1,650,000. the Culum company had 1,500,000 common shares outstanding at January 1, 20x4. The following share issues took place: March 31 100,000 shares @ $15.67 per share November 1 200,000 shares @ $17.60 per share On May 18, the company completed a 2:1 stock split. the Company has $1,000,000 of convertible, cumulative preferred shares outstanding. These shares pay a dividend of 6%. The last time a preferred share dividend was paid was on December 31, 20x1. Each $1,000 par value preferred share converts into 120 common shares the company also has $3,000,000 of convertible bonds outstanding. These bonds were issued at par when the market interest rates were 7%. The bonds pay interest semi-annually. Each $1,000 bond is convertible into 50 common shares. there are 60,000 stock options outstanding that expire on July 16, 20x8. The holder of the stock options can purchase a share of stock for $7.50. the average market price of the shares for 20x4 was $16.00. the tax rate is 40%. the conversion ratios above are before the effects of the stock split. All conversion ratios are adjusted for any stock split, i.e. the conversion ratio for the preferred shares would become each $1,000 par value preferred share converts into 240 common shares.
Required Compute the basic and diluted earnings per share.
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Problem 3 Marion Tess, controller, at Norris Pharmaceutical Industries, a public company, is currently preparing the calculation for basic and fully diluted earnings per share and the related disclosure for Norris' external financial statements. Below is selected financial information for the fiscal year ended June 30, 20x2.
Norris Pharmaceutical Industries Selected Statement of Financial Position Information June 30, 20x2 Long-term debt Notes payable, 10% 7% convertible bonds payable 10% bonds payable Total long-term debt Shareholders' equity Preferred stock, 8.5% cumulative, $50 par value, 100,000 shares authorized, 25,000 shares issued and outstanding Common stock, $1 par, 10,000,000 shares authorized. 1,000,000 shares issued and outstanding Additional paid-in capital Retained earnings Total shareholders' equity The following transactions have also occurred at Norris. Options were granted in 20x0 to purchase 100,000 shares at $15 per share. Although no options were exercised during 20x2, the average price per common share during fiscal year 20x2 was $20 per share, while the market price on June 30, 20x2, was $25 per common share. Each bond was issued at face value. The 7% convertible debenture will convert into common stock at 50 shares per $1,000 bond. They are exercisable after five years. The 8.5% preferred stock was issued in 20x0. There are no preferred dividends in arrears; however, preferred dividends were not declared in fiscal year 20x2.
$ 1,000,000 5,000,000 6,000,000 $12,000,000
$ 1,250,000
1,000,000 4,000,000 6,000,000 $12,250,000
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The 1,000,000 shares of common stock were outstanding for the entire 20x2 fiscal year. Net income for fiscal year 20x2 was $1,500,000, and the average income tax rate is 40%.
Required a. For the fiscal year ended June 30, 20x2, calculate Norris Pharmaceutical Industries' 1. basic earnings per share. 2. diluted earnings per share. b. Describe the appropriate disclosure required for earnings per share for Norris Pharmaceutical Industries for the fiscal year ended June 30, 20x2.
Problem 4 Perfume Inc. had the following securities outstanding at January 1, 20x8: Preferred shares, $6.00, no par value, cumulative convertible shares; authorized 500,000 shares; outstanding 200,000 shares Common shares, no par value; authorized 2,000,000 shares; outstanding 1,050,000 shares
$ 15,000,000
$ 10,500,000
The preferred shares are convertible into common shares on a one-for-one basis and pay dividends February 28 and August 31. During 20x8, Perfume reported net income of $14,400,000 and had the following transactions: June 30 September 30 450,000 common shares (market value $5,400,000) were issued to acquire a competitor. 90,000 common shares were purchased for $13.00 each and retired.
The tax rate for 20x8 was 40% and the pretax internal rate of return was 12%. Required a. b. Compute basic earnings per share for 20x8. Compute diluted earnings per share for 20x8.
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Problem 5 Ruby Company was incorporated on January 1, 20x0, with the following authorized capital structure: 100,000 non-cumulative no par value preferred shares, which pay a $6 dividend, and 1,000,000 no par value common shares. In January 20x0, 500,000 common shares were sold for $1 per share, and 10,000 noncumulative preferred shares were sold for $90 each. On September 30, 20x1, an additional 200,000 common shares were issued at $1 each. Net income after taxes for 20x0 and 20x1 was $75,000 and $88,000 respectively. No dividends were declared. Required a) b) Calculate the earnings per share for 20x0 and 20x1. Calculate the earnings per share assuming the preferred shares are cumulative.
Problem 6 Spray, Inc., had 4 million common shares outstanding on December 31, 20x1. An additional 1 million common shares were issued on April 1, 20x2, and 500,000 more shares were issued on July 1, 20x2. On October 1, 20x2, Spray issued 10,000, $1,000 face value, 7 percent convertible bonds. Each bond is convertible into 40 common shares. No bonds were converted into common shares in 20x2. Required What is the number of shares to be used in calculating basic EPS and diluted EPS, respectively? Assume that the convertible bonds are dilutive.
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Problem 7 Davis, Inc., earned $700,000 after taxes in 20x2. Davis began 20x2 with 200,000 common shares outstanding. On May 1, 30,000 new shares were issued and on October 31, 10,000 shares were acquired as treasury shares. On December 1 Davis split its common shares 2 for 1. In addition to common shares, Davis had 50,000 $100 par, 8 percent cumulative nonconvertible preferred shares outstanding during all of 20x2. Required Calculate Davis' EPS for 20x2. Provide a schedule showing determination of the weighted average number of common shares used in the EPS calculation.
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SOLUTIONS
1. 2.
b c
($330,000 60,000) / 300,000 = $0.90 Opening balance Feb 1 Stock Split Mar 1 Issue - 9,000 x 10/12 Jul 1 Issue - 8,000 x 6/12 30,000 30,000 7,500 4,000 $71,500
3.
Weighted average number of common shares: Outstanding at beginning of year July 1 conversion: 200 x 20 x 6/12
10,000 2,000 12,000 $2.92
Basic earnings per share = $35,000 / 12,000 4. d Free shares = 90,000 (90,000 x 37 / 50) = 23,400 x 1.1 = 25,740 Weighted average number of CS = Opening balance April 1 issue: 120,000 x 9/12 June 1 stock dividend: 390,000 x 10%
300,000 90,000 39,000 429,000
Increase in denominator = 429,000 + 25,740 = 454,740 5. b Basic EPS = $6,000 / 1,000 = $6.00 Increase in numerator $10,000 x 6% x .7 = $420 Increase in denominator = 1,000 Incremental impact = $420/1,000 = $0.42 => Dilutive Diluted-EPS = ($6,000 + 420) / (1,000 + 1,000) = $3.21
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Problem 1 a) Weighted Average # of Common Shares Common Shares outstanding at beginning of year 1,500,000 150,000 June 1 Issue: 150,000 x 7/12
1,350,000 87,500 1,437,500
Basic EPS = ($4,000,000 540,000) / 1,437,500 = $2.41 Effect of Dilution: Convertible bonds: Increase in numerator: $4,000,000 x 9% x .6 = $216,000 Increase in denominator: 4,000 x 30 = 120,000 Incremental impact = $216,000 / 120,000 = $1.80 Preferred Shares: $540,000 / 810,000 = $0.67 Series 1 share options: Free shares = 125,000 - 125,000 x $45 / 50 = 125,000 112,500 = 12,500 Series 2 share options are out of the money and therefore antidilutive. Numerator Denominator $3,460,000 1,437,500 12,500 $3,460,000 1,450,000 540,000 810,000 $4,000,000 2,260,000 EPS $2.41 2.39 $1.77
Basic EPS Series 1 share options Preferred shares Diluted EPS
Convertible bonds are not included since they would have an antidilutive effect. b) Common Shares outstanding at beginning of year (1,500,000 / 2) 150,000 June 1 Issue: 150,000 x 7/12 Nov 30 2:1 stock split
600,000 87,500 687,500 x2 1,375,000
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Problem 2
Basic EPS Calculations Weighted average number of common shares Shares outstanding at beginning of year March 31 issue: 100,000 x 9/12 May 18 stock split November 1 issue: 200,000 x 2/12
1,500,000 75,000 1,575,000 x2 3,150,000 33,333 3,183,333
Basic EPS = (1,650,000 60,000) / 3,183,333 = 1,590,000 / 3,183,333 = 0.50 Diluted EPS Calculations Impact of preferred shares: 60,000 / (1,000,000 / 1,000 x 120 x 2) = 60,000 / 240,000 = $0.25 Impact of convertible bonds: = ($3,000,000 x 7% x .6) / (3,000,000 / 1,000 x 50 x 2) = $126,000 / 300,000 = $0.42 Impact of options: [60,000 (60,000 x $7.50 / 16)] x 2 = (60,000 28,125) x 2 = 63,750 Order of entry: options, preferred shares, bonds Numerator Basic EPS Options Preferred shares Convertible bonds Diluted EPS $1,590,000 1,590,000 60,000 1,650,000 126,000 $1,776,000 Denominator 3,183,333 63,750 3,247,083 240,000 3,487,083 300,000 3,787,083 EPS $0.50 0.49 0.47 $0.47
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Problem 3 a. Basic EPS = $1,500,000 - 106,2501 / 1,000,000 = $1,393,750 / 1,000,000 = $1.39

1
25,000 shares x $50 x 8.5%
Fully Diluted EPS: Incremental impact of the exercise of options: Number of shares assumed purchased: 100,000 x $15 = $1,500,000 / $20 = 75,000 Increase in shares (free shares): 100,000 75,000 = 25,000 Incremental impact of the exercise of bonds: Increase in income = $5,000,000 x 7% x .6 = $210,000 Increase in shares = $5,000,000/1,000 x 50 = 250,000 Incremental impact = $0.84 Numerator Denominator $1,393,750 1,000,000 25,000 $1,393,750 1,025,000 210,000 250,000 1,603,750 1,275,000 EPS $1.39 $1.36 $1.26
Basic EPS Options Convertible Bonds
b.
Norris Pharmaceutical Industries should disclose both basic earnings per share and fully diluted earnings per share on the face of the income Statement for all periods presented.
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Problem 4 a. Weighted average number of common shares Shares outstanding at the beginning of the year June 30 Issue: 450,000 x 1/2 September 30 retirement: 90,000 x 3/12
1,050,000 225,000 -22,500 1,252,500 $10.54 $9.91
Basic EPS = (14,400,000 - 1,200,000) 1,252,500 b. Diluted EPS: 14,400,000 (1,252,500 + 200,000)
Problem 5 a) Weighted Average number of common shares Balance, beginning of year Issue: 200,000 x 3/12 20x1 500,000 50,000 550,000 20x0 500,000 500,000 $0.15 $0.16 $0.03 $0.05
Basic EPS: $75,000 / 500,000 $88,000 / 550,000 b) Basic EPS: ($75,000 - 60,000) / 500,000 ($88,000 - 60,000) / 550,000
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Problem 6 Weighted Average Number of Shares - Basic EPS: Balance, beginning of year April 1, 20x2: 1,000,000 x 9/12 July 1, 20x2: 500,000 x 6/12
4,000,000 750,000 250,000 5,000,000
Weighted Average Number of Shares Diluted EPS: Basic EPS Weighted Average number of shares Add: shares assumed on conversion (400,000 x 3/12) Number of shares to be used for fully diluted EPS 5,000,000 100,000 5,100,000
Problem 7 Weighted Average Number of Shares - Basic EPS: Balance, beginning of year May 1, 20x2: 30,000 x 8/12 October 31, 20x2: 10,000 x 2/12 December 1 Stock Split: (200,000 + 20,000 - 1,667) x 2
200,000 20,000 -1,667 218,333 436,666
Basic EPS = [$700,000 - (50,000 x $100 x 8%)] / 436,666 = $0.69
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13.
Accounting for Leases
A lease is a contract between a lessor, the owner of the property involved, and the lessee, the person or entity wishing to use that property in exchange for a certain number of cash payments. Prior to 1979, accounting for leases was based simply on the legal form of the transaction. The existence of a leasing agreement ensured that a leasing transaction would be regarded as a non-capital transaction (i.e. the asset and the lease liability were kept off the Statement of Financial Position), regardless of whether in substance, the arrangement amounted to an outright sale of the asset by the lessor and purchase of the asset by the lessee. This helped to make leasing a popular alternative to outright purchase. If a company chose to lease a piece of equipment, its debt-to-equity ratio would generally be lower than if the asset was purchased on credit. Starting in 1979, the accounting for leases became a function of the economic substance of the transaction rather than the form. In essence, it stated that when a leasing arrangement results in a transfer to the lessee of virtually all of the risks and benefits associated with ownership of the asset then the arrangement should be treated as a capital transaction - the sale of an asset by the lessor and the purchase of an asset by the lessee. A finance lease is defined as a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. (IAS 17.4) An operating lease is defined as a lease other than a finance lease (IAS 17.4). 13.1 Classification of leases
IAS 17.10 provides the following guidance when classifying a lease. The following situations, individually or in combination, would normally lead to a lease being classified as a finance lease: (a) the lease transfers ownership of the asset to the lessee by the end of the lease term; (b) the lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised (often referred to as a bargain purchase option); (c) the lease term is for the major part of the economic life of the asset even if title is not transferred; (d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and (e) the leased assets are of such a specialized nature that only the lessee can use them without major modification.
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Clearly, if situations (a) or (b) were to occur, the lease would be considered a finance lease since title to the asset is expected to pass. Under previous Canadian GAAP, the numerical criteria for item (c) was that if the lease term was 75% or more of the economic life of the asset, then the lease was deemed to be a finance lease. The numerical criteria for item (d) was that if the present value of the minimum lease payments was 90% of more of the fair value of the asset, then the lease was deemed to be a finance lease. Although, these numerical criteria do not apply under IFRS, they will likely be used as guidelines for some time to come. The minimum lease payments are equal to the payments over the lease term that the lessee is or can be required to make (excludes contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor6) together with: any amounts guaranteed by the lessee such as a guaranteed residual value, or a bargain purchase option. IAS 17.12 makes it clear that if there are other features that the lease does not transfer substantially all risks and rewards incidental to ownership, the lease can be classified as an operating lease. Ultimately, the classification of a lease as a finance lease is subject to managerial judgment. At the commencement of the lease term, the lessee recognizes finance leases as assets and liabilities in the statement of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. The discount rate to be used is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee's incremental borrowing rate shall be used. (IAS 17.20).
Depreciation Expense on Leased Assets If there will be a transfer of ownership either directly of through a bargain purchase option, then the asset is depreciated over its useful life . If the asset reverts back to the lessor, then the asset is depreciated over the lease term. Executory Costs Some lease agreements require the lessee to reimburse the lessor for expenses incurred by the lessor. These are typically for insurance and/or maintenance. These costs are called executor costs. They are typically added on the lease payments, but for accounting purposes are accounted for separately from the financing portion of the leas payments. Executory costs are expensed on an accrual basis.
6 These are referred to as executory costs.
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Accounting for bargain purchase options and residual values With a bargain purchase option (BPO), the lessee obtains legal title to the leased asset at the end of the lease term and has use of the asset for its entire economic life. Both the lessee and the lessor include the BPO as part of the minimum lease payments (MLP). Guaranteed and unguaranteed residual value can only exist when the leased property returns to the lessor at the end of the lease term. The lessee would completely disregard the unguaranteed residual value (URV) in his/her MLP and depreciation computations. The lessor on the other hand, would treat the URV as part of the calculation of the lease payment. The lessor is in effect charging less than he would otherwise because he/she is expecting the leased property to be of some additional value after the lease term has expired. Both the lessee and lessor would regard any guaranteed residual value (GRV) as part of the MLP because, at the end of the lease term the lessee would expect the leased property to have a value equal to the GRV, he/she would depreciate on that basis. An amount equal to the GRV should still be in his/her leased property and liability accounts at the end of the lease term. The lessor would have an outstanding receivable in the amount of the GRV until the lessee discharged his/her liability. The following example will include coverage of bargain purchase options and guaranteed and unguaranteed residual values. Example 1A: Sampson Ltd. leases equipment to Bowie Ltd. on January 1, 20x0, for five years. The following information pertains to the lease agreement: Sampson Ltd. paid $43,438 to acquire the equipment on January 1, 20x0. Rental payments are $10,000 annually for five years; the first payment is due in January 1, 20x0, subsequent payments are due on December 31 of each year (i.e. the second payment is due on December 31, 20x0). A purchase option to buy the asset for $3,000 exists at the end of the fifth year. The fair value of the leased equipment is $43,438. Estimated economic life of the equipment is eight years. Sampson Ltd. pays executory costs related to the leased property. A fair estimate of such costs included in the annual rental payments is $400 annually. Bowie Ltd.'s incremental borrowing rate is 6%. The interest rate implicit in the lease, known to the lessee, is 8%. the residual value of the equipment at the end of five years is $8,000; residual value at the end of eight years is $1,000. Bowie Ltd. depreciates similar equipment on the straight-line basis. Bowie Ltd. has a calendar year-end.
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Classification of lease contract by Bowie Ltd.: Criteria 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. 2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title is not transferred. At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. The leased assets are of such a specialized nature that only the lessee can use them without major modification. Assessment No
Yes. Bowie Ltd. can acquire the equipment for $3,000 at the end of the lease term when its estimated fair market value is $8,000.
3.
No. The lease term of 5 years is about 63% of the equipment' s economic life of 8 years. Yes - the present value of the minimum lease payments is equal to 100% of the fair value of the asset. See schedule below. Unknown.
4.
5.
The present value of annual lease payments and bargain purchase option set your financial calculator to assume that the cash flows occur at the beginning of the year (BGN mode). Once you have completed the calculation, set it back to normal mode. [BGN] Enter Compute N 5 I/Y 8 PV X= $43,438 PMT 9600 FV 3000
Conclusion: due to the existence of the bargain purchase option, this is a finance lease.
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The interest expense and liability reduction schedule is as follows: Principal Reduction $9,600 6,893 7,444 8,040 8,683 2,778
Date Jan 2, 20x0 Jan 2, 20x0 Dec 31, 20x0 Dec 31, 20x1 Dec 31, 20x2 Dec 31, 20x3 Dec 31, 20x4
Payment $9,600 9,600 9,600 9,600 9,600 3,000
Interest 2,707 2,156 1,560 917 222
Balance $43,438 33,838 26,945 19,501 11,461 2,778 0
Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows: Jan 1, 20x0 Equipment under finance lease Obligation under finance lease Executory costs Obligation under finance lease Cash Dec 31, 20x0 Prepaid executory costs Interest expense Obligation under finance lease Cash Depreciation expense Accumulated depreciation ($43,438 - 1,000) / 8 Jan 1, 20x1 Executory Costs Prepaid Executory Costs Prepaid executory costs Interest expense Obligation under finance lease Cash Depreciation expense Accumulated depreciation ($43,438 - 1,000) / 8 $43,438 $43,438 400 9,600 10,000 400 2,707 6,893 10,000 5,305 5,305
400 400 400 2,156 7,444 10,000 5,305 5,305
Dec 31, 20x1
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The December 31, 20x4, journal entries follow: Interest expense Obligation under finance lease Cash Equipment Equipment under finance lease 222 2,778 3,000 43,438 43,438
Example 1B - Assume the same facts as in Example 1A, with the following exception: there is no option to purchase the asset at the end of the 5th year. The equipment reverts back to the lessor at the end of the 5th year. The lessee guarantees the residual value of the asset ($8,000). Annual lease payments are $9,211 (including the $400 executory costs). Classification of lease contract by Bowie Ltd.: Criteria 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. 2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title is not transferred. At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. The leased assets are of such a specialized nature that only the lessee can use them without major modification. Assessment No
No.
3.
No. The lease term of 5 years is about 63% of the equipment' s economic life of 8 years. Yes - the present value of the minimum lease payments is equal to 100% of the fair value of the asset. See schedule below. Unknown.
4.
5.
The present value of annual lease payments and guaranteed residual value set your financial calculator to assume that the cash flows occur at the beginning of the year (BGN mode). Once you have completed the calculation, set it back to normal mode.
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[BGN] Enter Compute
N 5
I/Y 8
PV X= $43,438
PMT 8,811
FV 8,000
Conclusion: due to the existence of the guaranteed residual value, this is a finance lease. The interest expense and liability reduction schedule is as follows: Principal Date Payment Interest Reduction Jan 2, 20x0 Jan 2, 20x0 $8,811 $8,811 Dec 31, 20x0 8,811 2,770 6,041 Dec 31, 20x1 8,811 2,287 6,524 Dec 31, 20x2 8,811 1,765 7,046 Dec 31, 20x3 8,811 1,201 7,610 Dec 31, 20x4 594 Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows: Jan 1, 20x0 Equipment under finance lease Obligation under finance lease Executory costs Obligation under finance lease Cash Dec 31, 20x0 Prepaid executory costs Interest expense Obligation under finance lease Cash Depreciation expense Accumulated depreciation ($43,438 - 8,000) / 5 Jan 1, 20x1 Executory Costs Prepaid Executory Costs Prepaid executory costs Interest expense Obligation under finance lease Cash Depreciation expense Accumulated depreciation
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Balance $43,438 34,627 28,586 22,062 15,016 7,406 8,000
$43,438 $43,438 400 8,811 9,211 400 2,770 6,041 9,211 7,088 7,088
400 400 400 2,287 6,524 9,211 7,088 7,088

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Dec 31, 20x1
The December 31, 20x4, journal entries follow: Interest expense Obligation under finance lease Accumulated depreciation Obligation under finance lease Equipment under finance lease 594 594 35,438 8,000 43,438
If the appraisal value of the equipment works out to less than $8,000, then the lessee will have to make up the difference. This difference will simply be expensed at the time it is known. The differences between example 1A (Bargain Purchase Option) and example 1B (guaranteed residual value) can be summarized as follows: in example 1B, the asset reverts back to the lessor at the end of the lease term, the guaranteed residual value is included as part of the minimum lease payments, the asset is depreciated over 5 years down to its residual value of $8,000 at the end of the lease term, just before the asset reverts to the lessor, the lessee has an net asset balance of $8,000 and an obligation under capital lease of $8,000. These net out against the other when the asset is removed from the books.
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Example 1C - Assume the same facts as in Example 1A, with the following exception: there is no option to purchase the asset at the end of the 5th year. The equipment reverts back to the lessor at the end of the 5th year. The lessee does not guarantee the residual value of the asset ($8,000). Annual lease payments are $9,211 (including the $400 executory costs). Classification of lease contract by Bowie Ltd.: Criteria 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. 2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title is not transferred. At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. Assessment No
No.
3.
No. The lease term of 5 years is about 63% of the equipment' s economic life of 8 years. Yes - the present value of the minimum lease payments is equal to 87% of the fair value of the asset. See schedule below.
4.
5.
The leased assets are of such a specialized nature that only the lessee can use them without major modification.
Unknown.
The present value of annual lease payments and bargain purchase option set your financial calculator to assume that the cash flows occur at the beginning of the year (BGN mode). Once you have completed the calculation, set it back to normal mode. [BGN] Enter Compute N 5 I/Y 8 PV X= $37,994 PMT 8,811 FV
Conclusion: the most likely conclusion would be that this lease is an operating lease, given that the lease term is 63% of the economic life and that the present value of the minimum lease payments is equal to 87% of the fair value of the asset. The classification of this lease would be based on managerial judgment and may consider other factors.
Two solutions will be presented: the first assuming that the lease classification is a finance lease and the second on the assumption that it is an operating lease. Finance Lease Assumption Per IAS 17.20, the lease would be recorded as an asset and liability of $37,994. The interest expense and liability reduction schedule is as follows: Principal Reduction $8,811 6,476 6,994 7,554 8,158
Date Jan 2, 20x0 Jan 2, 20x0 Dec 31, 20x0 Dec 31, 20x1 Dec 31, 20x2 Dec 31, 20x3
Payment $8,811 8,811 8,811 8,811 8,811
Interest 2,335 1,817 1,257 653
Balance $37,994 29,183 22,707 15,712 8,158 0
Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows: Jan 1, 20x0 Equipment under finance lease Obligation under finance lease Executory costs Obligation under finance lease Cash $37,994 $37,994 400 8,811 9,211
Dec 31, 20x0
Prepaid executory costs Interest expense Obligation under finance lease Cash Depreciation expense Accumulated depreciation $37,994 / 5
400 2,335 6,476 9,211 7,599 7,599
Jan 1, 20x1
Executory Costs Prepaid Executory Costs Prepaid executory costs Interest expense Obligation under finance lease Cash
400 400 400 1,817 6,994 9,211
Dec 31, 20x1
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Depreciation expense Accumulated depreciation
7,599 7,599
The differences between example 1B (guaranteed residual value) and 1C (unguaranteed residual value) can be summarized as follows: the unguaranteed residual value is included as part of the minimum lease payments, the lessor will likely include the residual value as part of the calculation of the lease payment, the asset is depreciated over 5 years down to zero.
Operating Lease Assumption Jan 1, 20x0 Prepaid lease payment Cash Lease expense Prepaid lease payment Prepaid lease payment Cash Lease expense Prepaid lease payment 9,211 9,211 9,211 9,211 9,211 9,211 9,211 9,211
Dec 31, 20x0
Jan 1, 20x1
Dec 31, 20x1
13.2
Leases of Land and Buildings
A characteristic of land is that it normally has an indefinite economic life. If title is not expected to pass to the lessee by the end of the lease term, the lessee normally does not receive substantially all of the risks and rewards incidental to ownership, in which case the lease of land will be an operating lease (IAS 17.14). An exception to this is if the value of the land relative to the total value of the lease is immaterial, in which case the land can be combined with the value of the building (IAS 17.17). This means that a lease for both land and building would have to be considered separately for purpose of lease classification. The minimum lease payments would be allocated to land and building elements based on the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception of the lease. If the lease payments cannot be allocated reliably between these two elements, the entire lease is classified as a finance lease. (IAS 17.16)
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13.3
Lessor Accounting
The criteria for determining whether or not a lease is a finance lease are the same as those used by the lessee. Fundamentally, lessor accounting is a mirror image of lessee accounting, in that: the lessor recognizes a receivable at an amount equal to the net investment in the lease (IAS 17.36); and the lessor recognizes finance income based on a pattern reflecting a constant periodic rate of return on the lessor's net investment in the finance lease (IAS 17.39). Note that, unlike previous Canadian GAAP, IAS 17 does not distinguish between a sales-type and direct financing lease for lessor accounting. The lessor will calculate the lease payments as follows: they will want to recover the initial cost or fair value of the asset being leased, and they will consider the bargain purchase option, the guaranteed or unguaranteed residual values as a future cash inflow. Example - the fair value of the asset leased is $400,000. The lease term is 6 years and there is a bargain purchase option to purchase the asset at the end of the lease term of $20,000. Assuming that the first payment is due at the signing of the lease agreement and that the lessor requires a 7% return, the lease payment will be $75,815.33: [BGN] N=6 I/Y = 7% Compute PMT = $75,815.33 PV = -400,000 FV = 20,000
13.4
Sale and Leaseback transactions
A sale and leaseback transaction involves the sale of property with the seller concurrently leasing the same property back from the lessor. The same criteria outlined above are used to determine whether the lease is classified as an operating or finance lease. One feature of sale and leaseback transactions is that the lessee may show a gain or loss on sale of the property to the lessor. If the sale and leaseback transaction results in a finance lease, any gain or loss on the transaction shall be deferred and amortized over the lease term (IAS 17.59). If the sale and leaseback transaction results in an operating lease, and it is clear that the transaction is established at fair value, any gain or loss shall be recognized immediately. If the sales price is below fair value, any gain or loss are recognized immediately except that, if the loss is compensated for by future lease payments at below market price, it shall be deferred and amortized in proportion to the lease payments over the period for
which the asset is expected to be used. If the sales price is above fair value, the excess over fair value shall be deferred and amortized over the period for which the asset is expected to be used. (IAS 17.61)
ASPE differences minor terminology difference - what IFRS calls a finance lease, ASPE calls a capital lease if one of the criteria is met, then the lease is classified as capital leases: The lease contains a clause that automatically transfers ownership of the asset to the lessee the lease contains a bargain purchase option, the lease term is for the major part of the economic life of the asset even if title is not transferred (if the lease term is greater than or equal to 75% of the asset's economic life, this criteria is deemed to be met), or at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset (if the present value of lease payments is greater than or equal to 90% of the fair value of the asset, then this criteria is deemed to be met) the discount rate used to calculate the present value of the minimum lease payments is the lesser of the lessee's incremental borrowing rate or the rate implicit in the lease (if known) the standards differentiate between sales-type leases and direct financing leases (from the lessor's perspective). A sales-type lease is one where the lessor is selling an asset at a profit and is recognizing profit on sale in addition to interest income over the lease term. A direct financing lease is one where the lessor acquires the asset for use by the lessee and only recognizes interest income over the lease term.

The IASB issued an exposure draft in 2010 and after further deliberation have decided to issue a revised exposure draft. The revised exposure draft is expected to be published in the 4th quarter of 2012. It is not known when the final standard will be published. The following discussion is based on board deliberations to date (up to July 2012). The IASB is proposing a right-of-use model for leases. A lease contract is one which the right to control an asset (for a period of time) is transferred to the lessee. The lessee contains the right to use the asset and an obligation to pay for that right. They are proposing two classification models:
1 - The lessee acquires more than an insignificant portion of the leased asset. This category therefore would include assets that are retained by the lessee at the end of the lease term, i.e. include an automatic transfer of ownership or include a bargain purchase option. They would also include those assets whose value is significantly depleted by the lessee before they are returned to the lessor. By definition real estate leases would be excluded from this category. This category would normally include all leases classified as finance leases under the current standard. The accounting for leased assets under this model would be the same as the accounting for finance leases under the current standard. 2 The lessee does not acquire more than an insignificant portion of the leased asset. This category would include real estate leases and any other lease in excess of 12 months that does not fall in the first category. Essentially, this category would include operating leases per the current standard. The accounting for leased assets under this model would be as follows: a lease obligation and a corresponding leased asset is set up on the Statement of Financial position at the present value of the minimum lease payments based on the most likely total lease term (renewals would only be included if there is an economic advantage to renew). the total lease expense would be equal to the amount of the lease payment made the lease obligation would be reduced each time a lease payment is made and would be equal to the assumed reduction on payment of principal the lease asset would be reduced by the same about as above. Example on December 31, 20x4, an entity enters into a real estate lease. The most likely lease term is 10 years and the lease payment is $25,000/year with the first payment due on December 31, 20x4. The discount rate is 8%. The present value of the minimum lease payments is: [BGN] N = 10 I=8 PMT = 25,000
PV = $181,172 The journal entries for 20x4-20x6 from the lessees perspective are as follows:
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Dec 31, 20x4
Right to use asset Lease obligation Lease obligation Cash
$181,172 $181,172 25,000 25,000
Dec 31, 20x5
Lease expense ($181,172 25,000) x 8% Lease obligation Cash Lease expense Right to use asset
12,494 12,506 25,000 12,506 12,506
Dec 31, 20x6
Lease expense ($156,172 12,506) x 8% Lease obligation Cash Lease expense Right to use asset
11,493 13,507 25,000 13,507 13,507
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Multiple Choice Questions 1. On December 30, 20x1, Rafferty Corp. leased equipment under a finance lease. Annual lease payments of $20,000 are due December 31 for 10 years. The equipment's useful life is 10 years, and the interest rate implicit in the lease is 10%. The finance lease obligation was recorded on December 30, 20x1, at $135,000, and the first lease payment was made on that date. What amount should Rafferty include in current liabilities for this capital lease in its December 31, 20x1, balance sheet? a. $ 6,500 b. $ 8,500 c. $11,500 d. $20,000
2.
On December 29, 20x1, Action Corp. signed a 7-year capital lease for an airplane to transport its sports team around the country. The airplane's fair value was $841,500. Action made the first annual lease payment of $153,000 on December 29, 20x1. Action's incremental borrowing rate was 12 %, and the interest rate implicit in the lease, which was known by Action, was 9%. What amount should Action report as capital lease liability in its December 31, 20x1, balance sheet? a. $841,500 b. $780,300 c. $688,500 d. $627,300
3.
Hammer Company leased equipment from the King Company on July 1, 20x8, for an eight-year period expiring June 30, 20x16. Equal annual payments under the lease are $400,000 and are due on July 1 of each year. The first payment was made on July 1, 20x8. The rate of interest contemplated by Hammer and King is 8%. The cash selling price of the equipment is $2,482,500 and the cost of the equipment on King's accounting records was $2.2 million. Assuming that the lease is appropriately recorded as a sale for accounting purposes by King, what is the amount of profit on the sale and the interest income that King would record for the year ended December 31, 20x8? a. $0 and $0. b. $0 and $83,300. c. $282,500 and $83,300. d. $282,500 and $99,300.
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Problem 1 JKL Company manufactures and distributes heavy equipment. One of its popular lathes costs $67,500 to make and sells for $100,000. On January 1, 20x8, MNO agrees to lease a lathe for 4 years from JKL. The lathe is expected to have a useful life of 6 years and no residual value at that time. However, it is expected to have a residual value of $9,000 at the end of the lease at which time MNO has the option to purchase it for $3,000. The first payment is due on January 1, 20x8. The rate implicit in the lease, known to MNO, is 12% while MNO's incremental borrowing rate is 14%. Required a. b. c. Compute the lease payment. Prepare all 20x8 journal entries for MNO. Prepare all January 1, 20x8, journal entries for JKL.
Problem 2 The McGrath Corporation entered into a 5 year lease agreement for equipment on December 31, 20x3. Data relative to this transaction is as follows: Fair value of equipment Economic life of equipment Residual value at end of economic life $250,000 10 years 20,000
For each of the independent situations below, prepare all journal entries relative to this lease for the year 20x4 and 20x5. (a) The rate implicit in the lease is 8%. The lease agreement includes an option to purchase the equipment at the end of the lease term for $10,000. The fair value of the equipment at the end of the lease term is estimated to be $60,000. The rate implicit in the lease is 8%. The lease agreement requires McGrath to return the equipment at the end of the lease term and to guarantee the residual value of $60,000. The rate implicit in the lease is 8%. The lease agreement requires McGrath to return the equipment at the end of the lease term. The residual value of $60,000 was considered in calculating the lease payments by the lessor but is unguaranteed. The rate implicit in the lease is not known, nor is the fair value of the equipment. The lease term is for 8 years. McGraths incremental borrowing rate is 7% and the annual lease payment is $42,000.
(b)
(c)
(d)
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Problem 3 On January 3, 20x5, Thermotech Inc. leased a specialized piece of diagnostic equipment to Eastview Medical Clinic. Details are as follows: Cost to manufacture to Thermotech Normal sales price Lease term Economic Life Residual value at the end of the lease term Residual value at end of useful life Lease payment (1st payment payable January 3, 20x5) Purchase option (exercisable at end of year 8) Incremental borrowing rate of Eastview Rate implicit in the lease $ 80,000 $100,000 8 years 10 years $20,000 $ 500 $16,881 $ 2,000 12% 10%
Assume that Thermotech has reasonable assurance that Eastview will make the remaining lease payments. All costs of operating the leased equipment are borne by Eastview. Assume that subsequent payments are due on December 31st of every year. Required. Prepare the journal entries and disclosure for Thermotech Inc. and Eastview Medical Clinic for 20x5 and 20x6. Assume that both companies have a December 31 year-end.
Problem 4 The Johnson Company leased equipment from the Ike Company on October 1, 20x2. For accounting purposes the lease is appropriately recorded as a finance lease. The lease is for an eight-year period that expires September 30, 20x10. Equal annual payments under the lease are $600,000 and are due on October 1 of each year. The first payment was made on October 1, 20x2. The cost of the equipment on Ike's accounting records was $3 million. The equipment has an estimated useful life of eight years with no residual value expected. Johnson uses straight-line depreciation. The implicit rate of interest in the lease is 10 percent. Required 1. What expense should Johnson record for the year ended December 31, 20x2? 2. What income or loss before income taxes should Ike record for the year ended December 31, 20x2?
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Problem 5 At the beginning of 20x2, Agudelo entered into a 20-year, non-cancellable, long-term lease agreement for a truck terminal that had been constructed on Agudelos land. The terminal has a useful life of 40 years, and Agudelo can acquire title to the facility at the end of the lease term by paying the lessor $1. The annual lease payments over the lease term, payable at the beginning of the year, are as follows: First 10 years Second 10 years $1,000,000 per year 300,000 per year
Agudelo also must make annual payments to the lessor of $75,000 for property taxes and $125,000 for insurance. The implicit rate in the lease (known to Agudelo) was 6%. On January 1, 20x2, Agudelo made the first payment of $1.2 million to the lessor. Required a. b. Discuss how Agudelo should classify the truck terminal lease. Prepare all necessary entries for Agudelo for the year 20x2.
Problem 6 On December 31, 20x3, Cooray Inc. sold a building with a net book value of $1,800,000 to Gardner Industries for $1,757,346. Cooray immediately entered into a leasing agreement whereby Cooray would lease the building back for an annual payment of $260,000. The term of the lease is 10 years, the expected remaining useful life of the building. The first annual lease payment is to be made immediately, and future payments will be made on December 31 of each succeeding year. Gardners implicit interest rate is 10%. The building has a residual value of $0 and the Cooray Company amortizes its buildings using the straight-line method. Required 1. 2. Prepare the journal entries that should be made by Cooray on December 31, 20x3, relating to this sale and leaseback transaction. Prepare the journal entries that should be made by Cooray for the year ended December 31, 20x4, relating to this sale and leaseback transaction.
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Problem 7 On November 1, 20x0, the president of Pepper Ltd. summoned you, the controller, to an emergency meeting of the officers of the company. President: I'm sorry I had to call this meeting on short notice but we have a problem. The bank has turned down our loan request for $600,000. Is that the $600,000 for my equipment? Yes. I thought that might happen, so I took the liberty of contacting White Star Leasing. They are prepared to offer us the same equipment on a lease basis for seven years, the same period that we had requested for the bank loan. Why did the bank turn us down? I don't really know. We were willing to pay 14% and that's high. We don't need the bank loan. White Star's lease will carry only a 10% interest rate and the bottom line is we won't have to show anything concerning the lease on our financial statements. I would want to see all calculations and explanations supporting your statement. I'm sure the lease would have to appear on the Statement of Financial Position. What will this lease cost? The annual payments will be $98,595, due on January 1st of each year. Who will own the equipment at the end of the lease term? White Star retains ownership. Can we add an option-to-purchase clause? I asked that, but White Star said it's not their policy. Who cares anyway? I know the equipment is supposed to have a useful life of ten years, but I don't think it will be in any great shape after seven. You said that the installments start January 1, 20x1. When does the lease term begin?
CMA Ontario - 2013
V.P. Production: President: V.P. Production:
Treasurer: President: V.P. Production:
President:
Treasurer: V.P. Production:
Treasurer: V.P. Production: President: V.P. Production:
Treasurer:
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V.P. Production: Treasurer:
That same day. I don't understand why the leasing company can charge us only 10% when the bank won't give us the loan at 14%. Before we adjourn today, there is one other thing to consider. In terms of the effects on our income statement and Statement of Financial Position, would the lease or the bank loan be better?
President:
The following day the president presented you with a copy of the minutes of the meeting and asked you to write a report addressing the questions and concerns raised at the meeting. Required As the controller of Pepper Ltd., write the report to the president.
Problem 8 Aaron, Inc., was incorporated in 20x1 to operate as a computer software service firm with a fiscal year ending August 31. Aaron's primary product is a sophisticated on-line inventory control system; its customers pay a fixed fee plus a charge for using the system. Aaron has leased a large, BIG-I computer system from the manufacturer. The lease calls for an annual rental payment of $700,000 for the 12 year lease term. The estimated useful life of the computer is 15 years. The computer is installed on August 31, 20x2. Each scheduled annual payment includes $120,000 for full-service maintenance on the computer to be performed by the manufacturer. All rentals are payable on August 31 of each year beginning with August 31, 20x2. The lease is noncancellable for its 12-year term, and it is secured only by the manufacturer's chattel lien on the BIG-1 system. On any anniversary date of the lease after August 20x7, Aaron can purchase the BIG-1 system from the manufacturer at the then current fair market value of the computer. This lease is to be accounted for as a finance lease by Aaron, and it will be depreciated by the straight-line method with no expected residual value. Borrowed funds for this type of transaction would cost Aaron 10 percent per year. Required a. b. Why is the lease a finance lease to Aaron? Prepare all entries Aaron should have made in its accounting records from August 31, 20x2 and August 31, 20x3.
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Solutions
Multiple Choice Questions 1. b Lease payment, Dec 31, 20x2 Interest: ($135,000 - 20,000) x 10% Principal reduction = current portion $841,500 - 153,000 Profit: $2,482,500 - 2,200,000 Interest: ($2,482,500 - 400,000) x 8% x 1/2 $20,000 11,500 $8,500 $688,500 $282,500 83,300
2. 3.
c c
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Problem 1 a. Calculation of lease payments [BGN] Enter Compute N 4 I/Y 12 PV -100000 PMT X= $28,835 FV 3000
b.
Lease is a finance lease due to the presence of bargain purchase option. Jan 1, x8 Asset under finance lease Lease liability (100,000 - 28,836) Cash Interest expense (71,165 x 12%) Interest payable Depreciation expense Accumulated Depreciation (100,000 6) Lease receivable Cash Revenue Cost of sales Inventory Dec 31, x8 Interest receivable Interest revenue $100,000 $71,165 28,835 8,540 8,540 16,667 16,667
Dec 31, x8
Dec 31, x8
c.
Jan 1, x8
$71,165 28,835 $100,000 67,500 67,500 8,540 8,540
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Problem 2
(a)
This is a finance lease due to the presence of the bargain purchase option. It is assumed that the lessee will exercise the bargain purchase option and keep the asset for its economic life. Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -10,000 Solve for PMT = $56,398 Dec 31, 20x3 Equipment under Finance Lease Cash Lease Obligation Interest expense ($193,602 x 8%) Lease obligation Cash Depreciation expense Accumulated depreciation ($250,000 20,000) / 10 Dec 31, 20x5 Interest expense ($193,602 40,910) x 8% Lease obligation Cash Depreciation expense Accumulated depreciation $250,000 $56,398 193,602 15,488 40,910 56,398 23,000 23,000
Dec 31, 20x4
12,215 44,183 56,398 23,000 23,000
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(b)
This is a finance lease since the existence of the guaranteed residual value makes the present value of the minimum lease payments equal the fair value of the equipment. Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -60,000 Solve for PMT = $48,506 Dec 31, 20x3 Equipment under Finance Lease Cash Lease Obligation Interest expense ($201,494 x 8%) Lease obligation Cash Depreciation expense Accumulated depreciation ($250,000 60,000) / 5 Dec 31, 20x5 Interest expense ($201,494 32,386) x 8% Lease obligation Cash Depreciation expense Accumulated depreciation $250,000 $48,506 201,494 16,120 32,386 48,506 38,000 38,000
Dec 31, 20x4
13,529 34,977 48,506 38,000 38,000
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(c)
Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -60,000 Solve for PMT = $48,506 Present value of lease payments: N = 5, I = 8, PMT = 48,506 Solve for PV = 209,164 PV as a % of the fair value of equipment = $209,164 / 250,000 = 84% Lease term as a % of economic life = 5/10 = 50% This lease should be classified as an operating lease since it does not transfer the rights, rewards and risks of ownership to McGrath.
Dec 31, 20x3
Prepaid rent Cash Rent expense Cash Rent expense Cash
$48,506 $48,506 48,506 48,506 48,506 48,506
Dec 31, 20x4
Dec 31, 20x5
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(d)
PV of minimum lease payments: [BGN] N = 8, I = 7, PMT = 42,000 Solve for PV = $268,350 This one is a little trickier. The lease term is 80% of the economic life of the asset which is an indicator of a finance lease, however we cannot compare the present value of the minimum lease payments to the fair value of the equipment since the latter is unknown. It would be up to managerial judgment to determine whether the present value of the minimum lease payments covers a substantial portion of the fair value of the equipment. The fact that the lease term covers 80% of the economic life of the asset is significant and therefore, we will classify this lease as a finance lease. Dec 31, 20x3 Equipment under Finance Lease Cash Lease Obligation Interest expense ($226,350 x 7%) Lease obligation Cash Depreciation expense Accumulated depreciation $268,350 / 8 Dec 31, 20x5 Interest expense ($226,350 26,156) x 7% Lease obligation Cash Depreciation expense Accumulated depreciation $268,350 $42,000 226,350 15,844 26,156 42,000 33,544 33,544
Dec 31, 20x4
14,014 27,986 42,000 33,544 33,544
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Problem 3 Lease Classification Criteria 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title is not transferred. At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. Assessment No
2.
Yes. Purchase option is $2,000 when equipment is estimated to have a residual value of $20,000
3.
Yes. The lease term is about 80% of the equipment' s economic life.
4.
Yes. The present value of the minimum lease payments is equal to 100% of the fair value of the property. See schedule below.
5.
Unknown.
[BGN] Enter Compute
N 8
I/Y 10
PV X= $99,998
PMT 16881
FV 2000
Therefore, lease is a finance lease from the lessee's point of view
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Journal Entries - Lessee Jan 1, 20x5 Asset Under Finance Lease Cash Finance Lease Obligation Interest Expense (83,119 x 10%) Finance Lease Obligation Cash Depreciation expense Accumulated depreciation (100,000 - 500 ) 10 years Dec 31, 20x6 Interest Expense (83,119 - 8,569) x 10% Finance Lease Obligation Cash Depreciation entry same as for 20x5 $100,000 $16,881 83,119 8,312 8,569 16,881 9,950 9,950
Dec 31, 20x5
7,455 9,426 16,881
Journal Entries - Lessor Jan 1, 20x5 Lease receivable Cash Sales Cost of goods sold Finished Goods Inventory Dec 31, 20x5 Cash Lease Receivable Interest Revenue Cash Lease Receivable Interest Revenue $83,119 16,881 $100,000 80,000 80,000 16,881 8,569 8,312 16,881 9,426 7,455
Dec 31, 20x6
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Problem 4 1. Depreciation [$3,521,040 (Schedule 1) / 8 x 3/12] Interest expense (Schedule 2) $110,033 73,026 $183,059
2.
Profit on sale: Sales price (Schedule 1) Cost of equipment Finance income (Schedule 2)
$3,521,051 (3,000,000) $521,051 73,026 $594,077
Schedule 1 [BGN] Enter Compute N 8 I/Y 10 PV X= $3,521,051 PMT 600000 FV
Schedule 2 Calculation of Interest Purchase price of equipment Payment made on October 1, 20x2 Interest rate Interest expense (October 1, 20x2 to October 1, 20x3) Interest expense applicable to 20x2 (3/12 months) $3,521,051 (600,000) $2,921,051 x 10% $292,105 x 25% $73,026
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Problem 5
a. 1.
Criteria The lease transfers ownership of the asset to the lessee by the end of the lease term. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title is not transferred.
Assessment No
2.
Yes.
3.
No. The lease term is only 50% of the equipment' s economic life.
4.
At the inception of the lease the present value Unknown since we do not know of the minimum lease payments amounts to at the FMV of the property least substantially all of the fair value of the leased asset.
5.
Unknown.
Lease is a finance lease due to the bargain purchase option. b. PV of the first 10 years of payments: [BGN] Enter Compute N 10 I/Y 6 PV X= $7,801,692 PMT 1000000 FV
PV of the last 10 years of payments (remember to take your calculator off the BEGIN mode: N 10 I/Y 6 PV X= $2,208,026 PMT 300000 FV
Enter Compute
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This is a present value at t=9, so we need to bring it back to t=0: N 9 I/Y 6 PV X= $1,306,927 PMT FV 2208026
Enter Compute
Total PV of minimum lease payments: $7,801,692 + 1,306,927 = $9,108,619 Jan 1, x2 Terminal under finance lease Lease liability Lease liability Property taxes (or prepaid) Insurance (or prepaid) Cash $9,108,619 $9,108,619 1,000,000 75,000 125,000 $1,200,000 486,517 486,517
Jan 1, x2
Dec 31, x2 Interest expense Interest payable (9,108,619 1,000,000) x 6% = 486,518 Dec 31, x2 Depreciation expense Accumulated depreciation $9,108,619 / 40 years
227,715 227,715
Problem 6 1. Dec 31, 20x3 Building under Finance Lease Deferred loss on sale-leaseback Building Cash ($1,757,346 260,000) Lease obligation 2. Dec 31, 20x4 Interest expense ($1,497,346 x 10%) Lease obligation Cash Depreciation expense Accumulated depreciation $1,757,346 / 10 Depreciation expense Deferred loss on sale-leaseback $42,654 / 10
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$1,757,346 42,654 $1,800,000 1,497,346 1,497,346 149,735 110,265 260,000 175,735 175,735
4,265 4,265
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Problem 7 Report to the President Date: From: Regarding: November 2, 20x0 CMA Student, Controller Issues raised at the meeting of November 1, 20x0
Whether or not the lease must be shown on the Statement of Financial Position depends on the kind of lease it is deemed to be. A lease must be capitalized based on managerial judgment based on the following criteria; otherwise, it may be accounted for as an operating lease. Criteria 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. 2. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title is not transferred. At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. Assessment No
No.
3.
No. The lease term of 7 years is equal to 70% of the equipment' s economic life of 10 years. Yes - the present value of the minimum lease payments is equal to 88% of the fair value of the asset. See schedule below.
4.
5.
Unknown.
Enter Compute
N 7
I/Y 10
PV X= $528,002
PMT 98595
FV
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The lease is therefore an operating lease and requires only the following journal entry annually: Lease rental expense Cash $98,595 $98,595
Since the lease is not a finance lease, neither the assets nor the liabilities of Pepper Ltd. are affected. It should be noted that had the company been able to secure the bank loan to buy the equipment, both long-term assets and liabilities would increase by $600,000. This would place the company in a more leveraged financial position than it is in at the moment which will have a detrimental effect on the company's ability to incur additional debt financing. Pepper Ltd. received the relatively low 10% rate of interest from White Star because the financing terms of the lease may have been sufficient to provide an adequate profit to the lessor. From an earnings point of view, the following shows that the lease option would be the more favorable of the two options discussed:
Operating Lease Expected before interest and lease installment (assumed) Depreciation expense ($600,000/10) Interest expense ($600,000 x .14) Lease rental cost Earnings before taxes Conclusion $4,680,000
Bank Loan $4,680,000 (60,000) (84,000) $4,536,000
( 98,595) $4,581405
The above shows that Pepper Ltd. need not be concerned that the bank turned down its loan request. The lease option would afford a cleaner Statement of Financial Position presentation notwithstanding the fact that a long-term liability exists, assuming that the lease is an irrevocable one. In addition, the lease option would help to improve the company's cash flow situation.
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Problem 8 a. 1. Criteria The lease transfers ownership of the asset to the lessee by the end of the lease term. The lessee has the option to purchase the asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title is not transferred. Assessment No
2.
No.
3.
Yes. The lease term is about 80% of the equipment' s economic life.
4.
At the inception of the lease the present value Unknown since we do not know of the minimum lease payments amounts to at the FMV of the property. least substantially all of the fair value of the leased asset.
5.
Unknown.
Lease is a finance lease since the lease term is 80% of the equipment's economic life. b. [BGN] N = 12, I = 10, PMT = $700,000 -120,000 = $580,000 PV = $4,347,135 Aug 31, x2 Computer under finance lease Prepaid maintenance Cash Lease obligation Maintenance expense Interest expense ($3,767,135 x 10%) Lease obligation Cash Depreciation expense ($4,347,135 / 12) Accumulated depreciation
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$4,347,135 120,000 $700,000 3,767,135 120,000 376,714 203,286 700,000 362,261 362,261
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Aug 31, x3
14.
Accounting for Non-Profit Organizations
The material in this chapter is based on current CICA handbook pronouncements in Part IV of the CICA Handbook.
14.1
Differences and similarities of not-for-profit organizations with business enterprises.
The following table summarizes the major differences: Factors Ownership Business Enterprises Private or share ownership that is transferable. Not-for-Profit Enterprises No specific individual ownership and therefore no transferable ownership interests. Usually some form of service function. In many not-for-profit organizations, the objectives are specific and tend to make the organizations less flexible than businesses. Usually the board is elected by members. In cases where there is a large amount of government financing, a certain percentage of the board may be appointed by the specific government. If an organization has a closed membership, the board can basically elect itself and is selfperpetuating. The make-up of the board impacts on user needs and therefore the type of financial reporting required. Fees, grants, donations.
Organization Objectives
Profit Maximization (an over simplification)
Board of Directors
Elected by shareholders.
Major Source of Funds
Equity and debt. In an ongoing sense, the organization funds itself.
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Cost Control and General Expenditures
The profit motive provides a measurement of the effectiveness of cost controls.
Since there is no bottom line, and the provision of some specific service will probably seem to require more funds than are available, cost control and expenditure control are very serious issues in accounting for not-for-profit organizations. The analysis of what is needed and how efficiently and effectively funds are used is extremely subjective. Not-for-profit organizations may have a number of restrictions on sources of funds and therefore need to account for various funds individually.
Need to segregate funds
Not generally an issue. Usually this can be done by management discretion. Certain government grants may require funds to be used for specific purposes; therefore, these funds need to be tracked separately.
A brief summary of the above table can be stated in two words: profit and nonprofit. The profit objective has led to widely held transferable ownership. It makes the operations of the organization flexible in that resources can be moved from one industry to another as long as the move has profit potential. Profit, the basic measurement of success, has a built-in incentive to make expenditures that will generate revenue and has, relatively speaking, automatic cost control. Nonprofit organizations are usually set up for specific purposes and, although ownership cannot be transferred, members tend to perpetuate the organization because of their interest in the specific purpose - e.g., Church, Art Gallery, etc. Except for fee-for-service organizations, revenues are not generated by resource expenditures - expenditures are limited by revenues and measurement of success, or what is optimal, tends to be difficult. Because sources of funds often have restrictions, accounting records need to be segregated by type of fund. Both business and not-for-profit organizations should be run effectively and efficiently. Both have goals or objectives; both wish to be productive in the sense of achieving these goals with a minimum of input. The measurement issue involved is a relatively easy one for business organizations - net income is the success indicator. Measuring the success of not-for-profit organizations has varying degrees of difficulty depending on the nature of the organization. Fee-for-service organizations are very similar to business organizations. Service organizations which depend almost exclusively on grants and donations are on the opposite end of the continuum.
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14.2
Objectives of financial reporting
The basic objective of financial reporting for both business and not-for-profit organizations is to provide information that is useful for decision making. Who are the users of these statements? The following table lists some of the users for business and not-for-profit organizations, and from the list, it is apparent that there is a strong overlap in users and the types of information they would require. The types of information are: a) b) c) performance evaluation stewardship cash flow predictions Business Users managers shareholders creditors employees investors in general governments general public Not-for-Profit Users managers members/directors creditors employees donors governments general public
The relative importance of each type of information would depend on the nature of the organization. Not-for-profit organizations have tended to stress the stewardship function because members/donors are concerned with how the money has been spent and because it involves relatively easier measurements. However, this may not provide the most useful information. Given similar user groups, the same principles of relevance, materiality, etc. should apply to reporting of business and not-for-profit organizations. The following table summarizes how financial statements relate to required information for both business and not-for-profit organizations.
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Type of Information Performance Evaluation
Business Organizations
Not-for-Profit Organizations
Income statements; profit Statements don't really measure can be compared to other this; they can show a deficit or firms in the same industry. surplus but generating income dollars is not the primary function. Income statement, Statement of Financial Position, etc. Statements can show if the organization stayed within budget and can report on the use and segregation of funds. Basically, this is seen by many users and preparers as the primary function of statements for the not-for-profit organizations and explains the lack of allocations. Statements can indicate the sources of funds and the organization's expenditures, but external factors which predict future sources and liquidity are of major importance.
Stewardship
Cash Flow
Statements and external assessments.
14.3
Non-profit Organizations defined
A non-profit organization is defined as an entity, normally without transferable ownership interests, organized and operated exclusively for social, educational, professional, religious, health, charitable or any other not-for-profit purpose. A nonprofit's members and contributors do not receive any financial return directly from the organization. Therefore, there are three essential characteristics to a non-profit organization: no transferable ownership interest, they are operated exclusively for non-profit purposes, and resource providers do not stand to benefit because of their status as resource providers. This definition is important, because the accounting requirements for non-profit organizations will not apply if the organization has not met all of the criteria.
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The statements normally required for financial reporting are: Statement of Financial Position (in the for-profit world: Statement of Financial Position) Statement of Operations (in the for-profit world: income statement) Statement of Cash Flows Statement of Changes in Net Assets (in the for-profit world: statement of changes in Retained Earnings) All revenues and expenditures should be shown at their gross amounts. For example, a charitable organization that conducts a weekly bingo often pays out all prizes and expenses of running the bingo out of receipts and deposits and discloses the remainder as net bingo revenues. Such an organization would have to disclose the gross bingo receipts and related expenses. The notes to the financial statements have to provide a clear and concise description of the non-profit's purpose, its intended community of service, its status under income tax legislation and its legal form.
14.4
Fund Accounting
In a simple not-for-profit organization, there might be a single service function and a single source of funds. Accounting for such an organization would be fairly straightforward. The organization would simply keep track of a single set of expenditures to relate to its source of funds. However, many not-for-profit organizations have various sources and uses of funds which require separate tracking because of restrictions - donors specify uses, or there are legal requirements; or simply because specific funds are raised for specific purposes and stewardship requires tracking these particular sources and uses. A brief review of common types of funds and their purposes follows: Operating funds - sources and uses of funds to conduct the organization's day-today functions. Self-sustaining funds - sources and uses of a revenue-generating activity in an organization such as the sale of prints in an art gallery. Special funds - sources and uses of funds for a special project or event such as a benefit concert given by a local symphony or a survey carried on by a health service organization to assess local needs. Trust funds - accounting for funds held for other organizations or groups; the benefit does not go to the holding organization itself, but is a service provided to others.
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Endowed funds - these funds are provided mainly so that only the investment income from them is available to the organization. Such funds may be established to provide scholarships or operating funds to a museum. Capital funds - as the name implies, these funds are segregated for asset purchase or improvement. Each type of fund requires its own record keeping and its own statements. This results in some rather complex accounting statements, but serves to meet the stewardship requirements of nonprofit organizations. It should be noted that a Statement of Financial Position must be prepared for each segregated fund. Many of the items contained on the fund Statement of Financial Position are similar to those found on a Statement of Financial Position for a business enterprise. The major difference between not-for-profit Statement of Financial Positions and the business enterprise Statement of Financial Position is in the equity section. The equity section of a nonprofit business Statement of Financial Position is called Net assets and must disclose the following: 1) restricted balances - those which cannot be expended because of legal or contractual conditions. 2) unappropriated - the amounts available for future operations. If fund accounting is used, a brief description of the purpose of each fund reported should be provided in the notes to the financial statements.
14.5
Accounting for Contributions
There are three types of contributions: restricted contributions: these are subject to externally imposed stipulations specifying the purpose for which they must be used. The organization has a responsibility to the external contributor to use these resources in a specific way. The reporting of contributions depends on which of the two methods of accounting for contributions the organization uses (discussed below). Note that contributions can be implicitly deemed restricted, This would be the case if (i) the organization is unable to spend a contribution received in a current period, (ii) it is clear from the purpose for which the contributions was solicited by the organization or, (iii) the contributor is aware of the purposes for which the contribution will be used and would have recourse if the contributed resources were not used in the way specified. endowment contributions: these are a special type of restricted contribution. The assets endowed are usually held as investments and cannot be used by the organization. Only the income generated by the investments can be used. Again, the reporting of contributions depends on which of the two methods of accounting for contributions the organization uses.
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unrestricted contributions: these contributions were received with 'no strings attached'. The organization is free to use these funds as they see fit. Unrestricted contributions are recognized as revenue immediately, regardless of which method the organization uses to account for contributions.
The two methods of accounting referred to above are (1) the deferral method and (2) the restricted fund method. - if the organization uses fund accounting to show restrictions, then it should use the restricted fund method, - if the organization uses fund accounting to show activities, then it should use the deferral method - if the organization does not use fund accounting, then it should use the deferral method. An organization using fund accounting to show restrictions would normally have a general fund and one or more restricted funds - each restricted fund showing the receipt of restricted funds as revenues and the related allowable expenses. For example, assume the Canadian Heart Institute, a national clinic for people with severe heart problems, operates two programs: the regular clinical program where doctors treat patients and a research program. Sources of funding are as follows: unrestricted government contributions for the treatment program unrestricted government contributions for the research program restricted contributions received from various sources for the research program endowment funds If the Canadian Heart Institute does not use fund accounting, then it must follow the deferral method of accounting for these contributions. If the Canadian Heart Institute uses fund accounting, then the choice of method to account for contributions will depend on how funds are structured. If funds are structured according to activities: Clinic Fund, Research Fund and Endowment Fund, then it would still use the deferral method. Note that the Research Fund receives both restricted and unrestricted contributions, consequently the restricted fund method does not apply to the Research Fund. If the Institute's funds were organized on the basis of restrictions: a general fund where all clinical work and research funded by unrestricted funds, a research fund showing only restricted revenues and related expenditures, and an endowment fund. In this case, the restricted fund method would apply.
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The following schematic summarizes the above discussion: Fund Accounting Currently Used?
Yes
No
Objective of Fund Accounting?
Show Restrictions
Show Activities
Restricted Fund Method
Deferral Method
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Deferral Method The majority of non-profit organizations will likely adopt the deferral method. The following describes the accounting treatment of different types of contributions under the deferral method: Type of Contribution Endowment Contributions Accounting Treatment Direct increases in net assets. The contribution by-passes the statement of operations and essentially increases assets (investments - restricted) and increases net assets - restricted. This is the non-profit equivalent of deferred revenues. These contributions are set up as deferred contributions when received. As expenditures are made against these funds, an equivalent amount of revenue is recognized in the statement of operations. These are deferred and amortized on the same basis as the amortization of the related capital asset. For example, if we receive a $100,000 contribution for the purchase of a building which will get amortized over 40 years, then the contribution will also get deferred and amortized over 40 years. The net effect is that the amortization of the contribution offsets the related amortization expense. If the contribution is received for an asset that does not amortize, then it is recorded as a direct increase in net assets. Any restricted contributions for expenses in the current period and unrestricted contributions should be recognized in the current period. Disclosure requirements are as follows: deferred contributions should be presented in the liabilities section of the Statement of Financial Position the nature and amount of changes in deferred contribution balances should be disclosed (likely as a note to the financial statements)
Restricted Contributions for expenses of future periods
Restricted Contributions for the purchase of capital assets
Restricted Fund Method Generally, all revenues reported in a restricted fund should be externally restricted. An external restriction is one imposed by the funder. All unrestricted funds should be reported in the General Fund.
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Endowment contributions should be recognized as revenue of the endowment fund in the current period. Note that any revenues generated by the endowment fund are recorded as revenues of the general fund since these are usually unrestricted. If revenues are restricted for a specific purpose, they should be recorded as revenues of the appropriate restricted fund. Restricted contributions are recorded as revenues of the period in the related restricted fund. However, restricted contributions for which no corresponding restricted fund is presented should be recognized in the general fund in accordance with the deferral method. 14.6 Contributions Receivable
Not-for-profit organizations which rely on donations as a source of revenues often receive pledges from donators. The United Way is such an organization. Their fund raising campaign is in the fall of each year and serves to finance the following calendar year. Most of the donation revenue received by the United Way is by means of payroll deductions. Employees will pledge a certain amount to be deducted from their pay cheques in the upcoming year; for example, you might pledge to give $20 every pay. If you get paid every two weeks, such a pledge amounts to $520. When preparing its financial statements at December 31, the United Way will include these pledges as pledges receivable on their Statement of Financial Position. However, pledges have one important difference with ordinary accounts receivable. Pledges are not legally enforceable. Therefore, if you decide to not fulfill your promise, the not-for-profit organization to which you made the pledge has no recourse against you. The reason for this lies in contract law: for a claim to be legally enforceable, good consideration must have occurred. In this case, there has been no good consideration since there has been no exchange between the parties. Is it possible to record an asset we do not own? The answer is yes. If you refer to the definition of an asset you will note that an asset is defined as economic resources controlled by an entity. Thus, it is not necessary to have legal ownership of an asset. Another example of this are capital leases where the ownership of the asset lies with the lessor. Consequently, a contribution receivable should be recognized as an asset when it meets the following criteria: the amount can be reasonably estimated, and ultimate collection is reasonably assured. Note that these are simply the same revenue recognition criteria that apply to any organization. Also, as for any organization, an allowance for uncollectible contributions should be set up.
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The amount recognized as assets and the amount recognized as revenues need to be disclosed. 14.7 Capital Assets
In the past, there were three principal accounting methods allowed: 1. 2. 3. Expense immediately Capitalize and depreciate Capitalize but do not depreciate.
Expensing immediately was the most common method used; the main reason for its popularity relates to the nature of the revenue used to acquire the assets. Not-for-profit organizations often receive capital grants which are given for the purpose of purchasing specific assets - the capital grant is shown in income with the corresponding asset shown as an expense. If the organization were to capitalize and depreciate the asset, then recognition of the revenue in the period of acquisition without the offsetting expenditure would make it appear that the organization has a substantial surplus and, in future periods, the depreciation would put the organization in an operating deficit position. Sometimes capital grants are given only for major assets (buildings) while smaller acquisitions (furniture & fixtures) must be financed through the operating grants - in that case, different accounting policies might be used for the two types of assets due to the differing relationship to revenues. For example, you could capitalize and depreciate those capital items financed as part of normal ongoing operations and expense those capital items financed through capital grants. There are two side effects of expensing capital assets. First, the Statement of Financial Position does not disclose the existence of, or investment in, capital assets, and second, future operations bear no part of the cost of the capital assets. The first problem is often solved by creating a capital fund whereby capital assets are shown on the Statement of Financial Position and an offsetting amount called the capital fund balance is shown on the liabilities and surplus side of the Statement of Financial Position. Capitalization without depreciation is only appropriate when the assets do not decline in value or in usefulness; i.e. collections of art galleries and museums. Only not-for-profit organizations whose average gross revenues for the last two years are under $500,000 have the above options available to them. All others must depreciate assets over their useful lives. If an organization prevails itself of the requirement to depreciate assets, it must disclose the following: (i) the policy followed in accounting for capital assets, (ii) information about the major categories of capital assets not recorded, including a description of the assets and, (iii) if capital assets are expensed when acquired, the amount expensed in the current period.
Organizations following the recommendations for capital assets (i.e. whose accounting policy is to depreciate capital assets) whose revenues subsequently fall below $500,000 have to continue depreciating the assets.
14.8
Donated Goods & Services and Capital Assets
The issue can be summarized as follows. Not-for-profit organizations often receive goods and services. Should these goods and services received be recognized in the financial statements of the not-for-profit organization? A simple example will put this issue to light. Assume a not-for-profit organization has an audit done for free. The substance of the transaction is that the auditors are donating their time (which has value) to the organization. One way to do this would be for the not-for-profit organization to pay for this service and then have the auditor remit a donation to the organization of the same amount. Such a transaction would have the effect of increasing donation revenues and audit expense by the same amount. However, when the audit is done for free, there is no exchange of cheques and the transaction may never make it to the financial statements. The basic issue, however, is that there is absolutely no difference between the two transactions. Therefore, why should the accounting for these transactions be different. The recognition criteria set out by the CICA handbook becomes one of (1) whether or not a value can be put on these goods or services and (2) whether or not the organization would otherwise have to pay for these goods or services. In all cases, criteria 1 must be met if these transactions are to be recorded in the financial records. In the case of donated fixed assets, if criteria 1 is met, then the asset must be recorded. In the case of donated materials and services (non capital), the organization may choose to record these, so long as criteria 2 is met. Donated property, plant and equipment should be recorded at fair value when fair value can be reasonably estimated. The nature and amount of donated property, plant and equipment received in the period and recorded in the financial statements should be disclosed. An organization may choose to record the value of donated materials and services, but should do so only when a fair value can be reasonably estimated and when the materials and services are normally purchased by the organization and would be paid for if not donated. When donated materials and services are recorded, fair value should be used as the basis of measurement. The policy followed in accounting for donated materials and services should be disclosed.
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The nature and amount of donated materials and services received in the period and recorded in the financial statements should be disclosed.7 When donated goods or services are assigned a value and recorded by the organization, the credit to revenues offsets the debit to expenditures and there is no impact in the net operating results - however, the absolute values of the revenues and expenses are affected, and it is possible that management performance could be evaluated differently.
14.9
Encumbrance System
An encumbrance system results from the need to control expenditures and/or keep track of financial commitments. Basically, it is a built-in device to record transactions at the decision/commitment stage rather than when an actual transaction occurs. In a business organization, you would record the purchase of inventory when the goods are in your possession, not when ordered. In an encumbrance system, an entry is made at the time of the order. The result of such a system is that the records clearly show what funds are available - or encumbered. Given the fact that nonprofit organizations have limited sources of funds, the system provides a cost control function.
14.10 Collections held by NonProfit Organizations Collections are defined as works of art, historical treasures or similar assets that are (i) held for public exhibition, education or research, (ii) protected, cared for and preserved and, (iii) subject to an organizational policy that requires any proceeds from their sale to be used to acquire other items to be added to the collection or for the direct care of the existing collection. If all the above three criteria are met, then collections are excluded from the definition of capital assets and do not have to be depreciated. The organization can choose to either capitalize or expense the cost of collections as they are acquired. If the organization opts for this exemption, the following must be disclosed: a description of the collection, the accounting policies followed with respect to the collection, details of any significant changes to the collection for the period, the amount of expenditures on collections items in the period, and the proceeds of any sales collection items in the period and how the proceeds were used.
7 CICA Handbook, 4230.04 to .08
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14.11 Reporting Controlled and Related Entities Some non-profit organizations have close ties and relationships with other non-profit organizations. For example, most hospitals and universities operate a foundation. The foundation may share the same name as the main institution, but operates as a separate organization and often has a completely separate board of directors. In the for profit world, the main organization would own shares of the other organization making the control or significant influence relationship easier to determine. But nonprofit organizations do not issue shares. Therefore, we must look for other indicators. The standards on Accounting for Non-Profit organizations have requirements for three different types of relationships: 1. Control which is defined as the continuing power to determine the strategic, operating, investing and financing policies without the cooperation of others. Control is presumed to exist if the reporting entity has the right to appoint the majority of the entitys board of directors. If this is not the case, then the following factors, taken together or individually, can establish control: a significant economic interest, provisions in the other organizations by-laws or charter that cannot be changed without the reporting organizations consent and that limit the other organization to activities that provide future economic benefits to the reporting organization, or the other organizations purpose is integrated with that of the reporting organization so that the two organizations have common or complementary objectives. If control is established, then the reporting organization has two options: consolidate the financial statements of the other organization with its own, or provide disclosure about the relationship between the two organizations. If the disclose option is taken, the following information about the controlled organization must be disclosed: total assets, liabilities and net assets, revenues, expenses and cash flows in the major categories, details of any restrictions on the resources of the controlled organization and, significant differences in accounting policies. If the organization has control over a large number of individually immaterial organizations (i.e. local branches of a national nonprofit organization), these may be excluded from consolidation/disclosure provided that the reporting organization discloses the reasons why the controlled organizations have neither been consolidated nor included in the disclosure requirements
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2.
Significant influence which is defined as the ability to affect the strategic, operating, investing and financing policies of the entity. The following have to be disclosed: a description of the relationship with the significantly influenced organization, and a clear and concise description of the significantly influenced organization's purpose, its intended community of service, its status under income tax legislation and its legal form; and the nature and extent of any economic interest that the reporting organization has in the significantly influenced organization. Economic interest exists if the other organization holds resources that must be used to produce revenues or provide services to the reporting organization, or if the reporting organization is responsible for the liabilities of the other corporation. Note that economic interest can be an indicator of either control or significant influence but may exist without control or significant influence. The only disclosure requirement is that the nature and extend of the economic interest must be disclosed.
3.
14.12 Disclosure of Allocated Expenses When allocations of fundraising and general support expenses have been made to other functions, the accounting policy disclosure should explain: the policies adopted for the allocation of expenses among functions, the nature of the expenses being allocated, and the basis on which such allocations have been made The amounts allocated from each of the two functions (fundraising and general support) and the amounts and the functions to which have been allocated, should be disclosed
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1.
George Rogers takes a 6-month leave of absence from his job to work full-time for an NPO. George's employer continues paying his salary. Rogers fills the position of finance director because the incumbent is on paid sick leave during this period. This position normally pays $38,000 per year. How should Roger's contribution be recorded (assuming that the NPO chooses to record the contribution)? a) As revenue of $19,000 and expense of $19,000 b) As revenue of $19,000 c) As deferred revenue of $19,000 d) No entry should be recorded
2.
In 20x9, Mercy Clinic, a not-for-profit health care facility, received an unrestricted bequest of common stock with a fair market value of $50,000 in accordance with the will of a deceased benefactor. The testator had paid $20,000 for the stock in 20x0. The clinic should record the bequest as a) Unrestricted revenue of $20,000 b) Unrestricted revenue of $50,000 c) Endowment revenue of $50,000 d) Deferred revenue of $50,000
3.
The Smythe family lost its possessions in a fire. On December 23, 20x4, an anonymous benefactor sent money to the Aylmer Benevolent Society, an NPO, to purchase furniture for the Smythe family. During January 20x5, Aylmer purchased this furniture for the Smythe family. How should Aylmer report the receipt of this money in its 20x4 financial statements? Assume the deferred method is used. a) b) c) d) As an unrestricted contribution As a restricted contribution As a deferred contribution As a liability
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The following information applies to questions 4 and 5 although each question should be considered independently. First Harvest (FH) collects food for distribution to people in need. During November 1998, its first month of operations, the organization collected a substantial amount of food and also $26,000 in cash from a very wealthy donor. The donor specified that the money was to be used to pay down a loan that the organization had with the local bank. The loan had been taken out to buy land, on which the organization plans to build a warehouse facility. A warehouse is needed since, although the organization does not plan to keep a lot of food in stock, sorting and distribution facilities are crucial. FH has also received $100,000, which according to the donor is to be deposited, with any income earned to be used as FH sees fit. 4. In which of the following ways should the food donation and the $26,000 be reflected in the financial statements. Assume that fair market values are available and that FH uses the deferral method and does not maintain separate funds. Food donations Deferred revenues Deferred revenues Revenues Revenues $26, 000 cash donation Deferred revenues Increase in net assets Increase in net assets Deferred revenues
a) b) c) d)
5.
In which of the following ways should the $100,000 contribution be accounted for under the following revenue recognition methods? Deferral method Direct increase in net assets Direct increase in net assets Revenue Revenue Restricted fund method Revenue of the endowment fund Revenue of the general fund Revenue of the endowment fund Revenue of the general fund
a) b) c) d)
6.
Home Care Services Inc. (HCS), an NPO, has a roster of volunteers who visit sick and elderly people to provide companionship. These volunteers do not provide any other services. HCS staff estimate that these services have a fair value of $6.00 per hour. If these services were not contributed on a volunteer basis, HCS would not pay for them. How should HCS account for these contributed services? a) Do not recognize these donated services in the financial statements. b) Recognize contributed services as revenue, and record salaries expense for only the number of hours for which time sheets were kept. c) Recognize these donated services as contributed services revenue and as salaries expense. d) Recognize these donated services as salaries expense and as increase in the unrestricted fund balance.
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7.
Jubilee Home Care is a not-for-profit organization. It uses the deferral method of accounting for contributions. Which of the following contributions should be reported as deferred revenue? a) Restricted contributions for expenses of one or more future periods b) Restricted contributions for the purchase of capital assets that will not be amortized c) Restricted contributions for setting up an endowment fund d) Unrestricted contributions
8.
On January 1, 20x2, NP, a not-for-profit organization, received a $650,000 contribution from a wealthy benefactor. The contribution was to be used to build a subsidized housing complex on vacant land that NP had owned for several years. Construction was to begin in the summer of 20x3. Any interest earned on the $650,000 was to be used for the same purchase. NP uses restricted fund accounting, and it has established a separate fund for the housing complex. How should the contribution and related earned interest be treated under GAAP? a) In 20x2, the contribution should be shown as a deferred contribution in the restricted fund, and earned interest should be recognized as revenue. b) In 20x2, both the contribution and earned interest should be shown as deferred revenue in the restricted fund. c) In 20x2, both the contribution and earned interest should be immediately recognized as revenue in the restricted fund. d) The amount of contribution recognized as revenue should be equal to any eligible expenses incurred (such as maintenance expense or amortization). Therefore, revenue recognition will commence in 20x3.
9.
Durali Festival Corp. (DFC) is a not-for-profit organization with annual revenues of $350,000. Which of the following policies VIOLATES generally accepted accounting principles? a) DFC expenses capital assets when acquired. This policy is fully disclosed in DFCs notes. b) DFC uses the restricted fund method for contributions to its restricted funds and it accounts for restricted contributions to the general fund in accordance with the deferral method. c) Membership revenues are recognized on an accrual basis. d) DFC recognizes both a revenue and expense equal to the fair value of services donated by a local singer who performs at the festival. The singer would be hired for a fee if he did not donate his time. e) All transfers between funds are reported in the statement of operations as revenue of the receiving fund and as an expense of the fund being transferred from.
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10.
A not-for-profit seniors home is preparing its year-end financial statements. Which of the following should be included in the current assets section of the balance sheet? a) A bank savings account with a balance of $52,000 representing a restricted capital fund for an expansion project to take place in two years. b) A $20,000 grant application for a project that has been completed. There is a 20% likelihood of the grant application being accepted; however, at the time of preparing the financial statements, no word on the grants status has been received. c) Inventory totalling $80,000 representing gift items held on consignment. When the items are sold, the seniors home receives 20% of the revenue to aid in the expansion of one of the wings of the building. d) Cash held in trust in a bank account for the residents of the seniors home. e) None of the above.
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Problem 1 City Youth Services (CYS) is a not-for-profit organization established to provide counselling and other services to children under the age of 18. It concentrates on troubled teenagers who are typically referred to CYS by the courts, police, and hospitals. In years past, the majority of the operating budget of CYS has been funded by the Provincial Government; increasingly, however, CYS is turning to private donors for support. Two years ago, CYS engaged in a major funding drive in order to raise funds for a group home for troubled teenagers. The drive was a success; $110,000 was raised during 20x0 and a mortgage of $90,000 was negotiated so that CYS was able to purchase a house for $200,000 in January 20x1. Since then, CYS continued its fund raising activities and was able to raise $125,000 in donations in 20x1. The funds raised annually for the group home are used to employ several in-house social workers on an hourly basis and pay the operating expenses of the home. CYS has continued to operate in separate rented premises and employs 12 social workers to provide counselling. Increasingly, time spent by the regular social workers has involved overload group home work that cannot be handled by in-house social workers. As a result of the increase in group home related work, and the resulting increase in the payroll costs of regular CYS social workers, CYS is currently running a deficit in its operating fund. Fund raising for the counselling activities, which is separate from fund raising for the group home, has been insufficient to offset the operating deficit. A major fund raising drive to secure donations for CYS and the group home is planned for 20x2. Twenty volunteers from the community have assisted the social workers in the group home and in the regular counselling services. Two of these volunteers have also assisted with clerical duties in the office. You are Mary Jones, CMA, a friend of the Executive Director of CYS, James Smith. You attend a meeting of the Board of Directors of CYS, where Smith says the following: "As you know, Mary, our needs for private donations are greater than ever, especially with government funding freezes. The trouble with private donations is that we are competing with so many other worthwhile causes. Some of the people we approach for donations have complained about a lack of information regarding where we spent past donations, our current financial position, and our effectiveness in achieving the purposes for which we receive money. Accordingly, we have decided to provide all donors in 20x2 with a copy of our 20x1 annual report. Since you are an accounting expert, perhaps you could advise us on ways in which we might improve our annual report to enhance the information value for donors." He then gave you the statement of operations and the Statement of Financial Position of CYS (see attached).
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Required: As Mary Jones, comment on ways in which the reporting of CYS might be improved to enhance the informational value for donors.
City Youth Services Statement of Operations For the year ended December 31, 20x1 Operating Fund Revenues: Donations to City Youth Services Program funding from Provincial Government Investment income Expenses: Staff salaries Payroll - social workers Office expenses Excess of expenses over revenues Net Assets (deficit) - January 1 - December 31 Capital Fund Revenues: Donations to Group Home Expenses: Payroll - social workers Operating expenses Home purchase Mortgage payments Excess of expenses over revenues Capital fund balance (deficit) - January 1 - December 31
$104,500 300,000 500 405,000 70,000 300,000 50,000 420,000 (15,000) (7,000) $(22,000)
$125,000 50,000 30,000 200,000 10,000 290,000 (165,000) 110,000 $(55,000)
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City Youth Services Statement of Financial Position As at December 31, 20x1 Assets Cash Donor pledges $ 6,000 10,000 $16,000
Liabilities Accounts payable Mortgage
$ 3,000 90,000 93,000
Net Assets Operating fund Capital fund
(22,000) (55,000) $16,000
Additional Information: 1. Included in office expenses in the Operating Fund are outlays of $6,000 for two typewriters, a personal computer, and a used photocopier. CYS charges capital expenditures to the current period. 2. CYS maintains one bank account into which it deposits donations for both CYS and the group home.
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Problem 2 Lark Opera Company (LOC) was formed and registered as a charity under the Provincial Charities Act. The original idea to form the association was from Marcia Braun. She has been LOC's artistic director and general manager, as well as a board member, since LOC's inception. Marcia owns and operates a singing school that trains students for the opera. Ninety percent of the performers in LOC's productions are her students and the others are professional performers. LOC is recognized in the artistic community for the high quality of its productions. The City of Lark has a population of 550,000 and is a suburb of the metropolis of Oriole which is the location of the well established National Opera. The City of Lark has many opera fans who patronize the National Opera. As a registered charity, LOC has several sources of funds, as follows: Grants from the City of Lark Bingo Donations Box office ticket sales Advertising.
For every LOC production, the City of Lark grants an amount equal to revenue from ticket sales. Before every major production, the city advances funds based on projected ticket sales. Once the production is finished, the funding amount is to be adjusted to equal actual revenue from ticket sales. ED Corporation (EDC), the major donor to LOC, makes donations for specific opera productions. Recently, EDC has expressed concern that it has not seen any financial statements and is questioning the possible use of its donations for activities not related to the specified opera productions. LOC has a volunteer board of eight directors. All are members of the local arts community with little business experience. The banking and accounting functions for LOC are performed by various members of the board. Marcia Braun and Vince George, the treasurer, are authorized to sign cheques against LOC's main operating bank account. Only one of their signatures is required on a cheque. A separate bank account is maintained by another board member, Lou Smith, for LOC's fund raising bingo operations. Under the Provincial Charities Act, audited financial statements must be prepared annually. The last audited statements available are for 20x4. During 20x5 and 20x6, LOC has put on four productions and the financial impact of these productions is unclear. The last auditor moved to Europe and the board has not yet appointed a new auditor.
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Once the board approves a new production, a rough estimate of revenue from ticket sales is made and submitted to the City of Lark, which uses the information to determine its advance funding. The advance funds received from the city are deposited to the main operating bank account and are not segregated for the production. Further, no budget is drawn up, nor is a forecast of expenses made. Cash is drawn out of the main operating account as and when needed during the production. As the artistic director, Marcia Braun has total control of who is hired to provide the various services required to produce the opera (i.e., choreographer, vocal trainer, orchestra, etc.). She also negotiates the terms of payment to these people. As the general manager, Marcia Braun developed a system of segregated duties that she felt would ensure internal control. Financial information (i.e., invoices, cheques and bank statements) is placed in the hands of different people. All invoices are sent to Vince George who approves and pays them, and then keeps them in a file in his home. Payments to performers are usually made by Marcia Braun. Anne Warne, another member of the board, makes all deposits to the main operating account and the bankbook is in her care. The bank sends the canceled cheques together with bank statements to Anne Warne. Since 20x5, LOC has run a bingo as a major source of funds. Lou Smith, a board member, runs all aspects of the bingo, including all banking. His only help is casual labor needed on bingo nights. These workers are paid cash from the bingo revenues before deposits are made to the bingo bank account. Each month, Lou transfers money from the bingo bank account to LOC's main operating bank account. In the past, other board members have offered to help Lou, but he has rejected all such offers. The city recently indicated that no further funds will be granted in the future unless audited financial statements are made available and the future viability of LOC is demonstrated. In June 20x7, at the request of the board, the city appointed Ren Laberge, CMA, from the municipality's program review division to help LOC's board of directors produce financial statements in accordance with generally accepted accounting principles and conduct an assessment of the viability of LOC. After an initial review, Ren Laberge made the following observations: 1. There appear to be no accounting records for the bingo operations. Except for answering a few questions over the phone, Lou Smith was unavailable to meet with Rene and unable to provide any records. At times, payments have been made with no supporting invoices and some duplicate payments have been made. Attendance at LOC's productions has been dropping despite good reviews of the productions. An initial survey of opera lovers in the City of Lark indicated that 95% of them patronized the National Opera's productions in Oriole, but only 25% of them patronized LOC's productions. Fifty percent of those surveyed were not
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2.
3.
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even aware of the existence of LOC. Of those who attended productions by both, most commented that LOC's ticket prices averaged one-quarter the ticket prices of the National Opera Company's productions. 4. A detailed review of the financial account balances prepared by the treasurer for 20x5 and 20x6 (see Exhibit 1) revealed a number of additional observations (see Exhibit 2).
A special board meeting has been called to review Rene Laberge's report. Required: As Ren Laberge, prepare the requested report for Lark Opera Company's board of directors. The report should include a comparative statement of financial position and statement of operations for 20x5 and 20x6, as well as recommendations regarding nonfinancial and management control issues. Exhibit 1 Lark Opera Company Balance of Accounts As at December 31 20x6 20x5
Accounts payable $ 53,100 Accounts receivable $ 2,000 Advertising expense 4,000 Advertising revenue 3,000 Bank overdraft 16,000 Bingo revenue (net) 63,000 Computer equipment 2,500 Donations revenue 27,000 Grants from the city 25,000 Interest expense 2,600 Marcia Braun's salary 48,000 Net assets (liabilities) - beginning balance 50,000 Office expense 10,000 Prepaids 0 Production costs 76,500 Suspense 5,000 Ticket sales 13,500 Totals $200,600 $200,600
$ 38,200 $0 6,000 4,000 12,000 59,000 0 30,000 25,000 2,400 48,000 39,000 12,000 200 75,600 0 15,000 $183,200 $183,200
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Exhibit 2 Additional Observations Made by Rene Laberge 1. Since its inception, LOC has run fund-raising campaigns for which pledges are usually recorded only when the cash is received. In the 20x6 fund-raising campaign, $6,500 of pledges were made. Of these pledges, $3,000 have been received to date and recorded as donations. Past experience has shown that about 75% of the remaining pledges will be received, but this has not been recognized in the accounting records. LOC purchased a computer in January 20x6 for Marcia Braun's use in planning opera productions. The cost of the computer has been capitalized, but no depreciation has been recorded. The computer is expected to have a five-year useful life. In 20x5, a $5,400 payment was made to a professional singer for a production held in 20x5. The National Opera had made this particular singer available to LOC for the production and a payment for this singer had already been made to the National Opera. These payments were both recorded as production costs in 20x5. No attempt has been made to recover this overpayment or adjust the accounting records. Grants from the city have not been adjusted to match actual ticket sales. In 20x6, a donation of props and costumes for the latest production was received from a private donor. A tax receipt of $5,000 was issued for this donation and $5,000 was recorded as donations revenue. Since there was no invoice submitted by the donor, no expense was recorded. Instead, a suspense asset account was debited for $5,000. The donations revenue recorded for 20x6 includes a $9,000 donation from EDC. According to EDC, this donation was to be used specifically for a production planned for 20x8. Bingo revenues represent the amounts that Lou Smith transfers monthly to LOC's general operating bank account. These monthly transfers are made after the casual workers hired to help at the bingos are paid in cash. Lou has not been able to provide a reconciliation of the bingo account, but has confirmed that the amounts reported in the bingo revenue account for 20x5 and 20x6 were the actual amounts transferred to LOC's operating bank account. He also confirmed that there were no outstanding accounts payable for the bingo operation at the end of the two years. The bank confirmed that the December 31 bank balances in the bingo account were $4,000 for 20x5 and $8,500 for 20x6. Included in the 20x6 production costs is a $17,000 advance paid to performers who will appear in a 20x7 opera production.
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2.
3.
4. 5.
6.
7.
8.
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SOLUTIONS
Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. a b c c a a a c e According to section 4400.17 of the CICA Handbook, transfers between funds do not result in increases or decreases in the economic resources of the organization as a whole and therefore are reported in the statement of changes in net assets rather than in the statement of operations. Choices a), b), c) and d) all are in accordance with generally accepted accounting principles. Choice a) is a restricted fund that can only be used for a specific project to take place in two years; therefore, it is not liquid. The project costs in choice b) must be expensed in the year because the grant is not guaranteed and cannot be recorded as a receivable. For choice c), the seniors home does not have ownership of the gift items; therefore, they cannot be recorded as assets. For choice d), the account is held in trust and is therefore not accessible to the seniors home. Therefore, choice e) is the correct answer.
10.
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Problem 1 MEMORANDUM TO: FROM: SUBJECT: James Smith Executive Director of CYS Mary Jones Reporting of City Youth Services
There are several groups of potential users of the annual report of CYS, but you have asked me to comment on how the reporting might be improved to enhance the information value for donors. The following issues will be discussed with respect to donors specifically. Program Effectiveness Donors are especially interested in seeing what their donations will accomplish. A brochure, or notes to the financial statements, should include a description of the objectives of CYS, the number of children who have been counselled or helped in other ways, the number of social workers and volunteers, and a description of the services that they typically perform, a description of the home purchased, the number of children in the home and their average length of stay, what happens to them after they leave the home, etc. Financial Statements The financial statements, including notes, should provide information to enable donors to assess the stewardship of management. The current statement of operations and the statement of financial position (balance sheet) of CYS may be misleading. The following discussion and suggestions may enhance the information value. Notes to the Financial Statements The notes to the financial statements should provide a clear description of the not-forprofit organization's purpose, the community it intends to serve, its status under income tax legislation, and its legal form. Net Assets "Net Assets" is the terminology in the emerging not-for-profit accounting literature that replaces the term "surplus" in describing a not-for-profit organization's equity on its statement of financial position. Net assets should be presented for each fund. Net assets that represent investments in capital assets are not available for general use by the not-for-profit organization and should be distinguished on the statement of financial position. For this reason, the use of a "Net assets invested in capital assets" account is recommended.
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Revenue Recognition There are two alternative methods for accounting for contributions under GAAP for notfor-profit organizations: the deferral method and the restricted fund method. The restricted fund method is a specialized type of fund accounting that presents details of financial statement elements by fund. Restricted contributions (those contributions that are "earmarked" by the contributors for a specific purpose) would be recorded as revenue in the corresponding restricted fund in the period that they were received or receivable. The deferral method relates restricted contributions to the expenses that they are intended to finance. Restricted revenue that pertains to expenses of future periods is deferred and recognized as revenue in the period in which the related expenses are incurred. The deferral method can be used with either a fund accounting or "corporate" style of financial statement presentation. Statement of Cash Flow A statement of cash flow should be presented along with the statement of financial position, the statement of revenue and expenditures, and the statement of changes in net assets. Fund Accounting It should be noted that fund accounting involves an accounting segregation of funds and not necessarily a physical segregation of funds. From the perspective of internal control and to aid the board in understanding fund accounting, it may be appropriate to have separate bank accounts for the operating fund and the group home fund. City Youth Services should provide a brief description in the notes to the financial statements as to the purpose of each fund. The statement of financial position should indicate if any of the assets are restricted. The statement of operations should present a total that includes all funds reported. In other words, total revenues, expenditures, and the total excess or deficiency for the period should be reported in the statement of operations (i.e., the statement of revenue and expenditures). This assumes that the deferral method is the appropriate method of accounting for contributions received by CYS. Segregation of Funds At present, there is a lack of clear segregation between the operating fund and the capital fund. Some of the social worker payroll costs charged to the operating fund should have been charged to the capital fund, since the costs relate to group home activities and are the major reason why the operating fund is showing a deficit. All of the financial activities related to running the group home should be segregated in the statement of operations so that donors to either CYS or the group home can get a clear picture of money spent on group home activities. This segregation will likely show that revenues are covering expenses for the regular operations of CYS. The segregation of funds would
be facilitated by the use of separate bank accounts. Service charges and interest revenue or deductions would then be allocated accurately. The name of the capital fund should be changed to the group home fund to better reflect its use. A separate capital fund could be set up for future projects. Donor Pledges A pledge is a non-enforceable promise to contribute cash or some other asset or economic benefit to a not-for-profit organization. Because of the nature of pledges, it is likely that less than 100% of the pledges will ultimately be collected. In order for CYS to recognize pledges as revenue in the current year's financial statement, CYS needs to demonstrate that the pledges can be reasonably estimated and that their ultimate collection is reasonably assured. Alternatively, contributions would not be recognized until they were collected. Donated Services The service of the volunteers could be credited to revenue offset by a debit to expenses. This would only be appropriate where the services provided are used in the course of CYS's operations and would otherwise have been purchased. However, because of the difficulty of estimating the value, I would recommend simply describing the donated services in the annual report. Comparative Statements Comparative information for 20x0 should be provided to enhance the assessment of trends and also to emphasize the success of the fund raising drive for the group home. Budgets The donors would likely be interested in seeing a comparison of actual revenues and expenses to those budgeted for the year, along with the budget for next year. It should not be necessary to use budgetary accounts or an encumbrance system, however. It would be best to keep the accounting system as uncomplicated as possible, especially because volunteers are required in the office. Capital Assets The expensing of the home has produced a large deficit in the capital fund. This treatment does not charge any of the cost to future periods that will benefit from the expenditure. Also, the investment is not shown on the CYS statement of financial position. GAAP recommends that not-for-profit organizations with annual gross revenues of $500,000 or greater should capitalize and amortize capital assets. Average revenues of City Youth Services appear to exceed $500,000; therefore, CYS should capitalize its purchases of both the home and the office equipment and amortize these assets over their useful lives. This amortization must be recognized as an expense in City Youth Services' statement of operations. The choice of fund to which the amortization expense is charged would be based on providing the most meaningful information to the user. Showing it as an expense of the operating fund emphasizes that
it is a cost of delivery. Showing it as an expense of the capital fund or group home fund presents all revenues and expenses associated with the group home in a single fund. Mortgage Payments If the mortgage payments included a repayment of principal, then the mortgage liability on the statement of financial position should be reduced. In accounting for the mortgage payments, CYS should expense the interest portion and debit the principal repayment directly to the mortgage liability. Conclusion The above recommendations should assist you to provide the most useful information to prospective donors. If you have any questions, please do not hesitate to call me.
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Problem 2
A. Financial Statements
1. Pledges receivable GAAP allows pledges to be shown on the balance sheet as pledges receivable provided that (i) reasonable assurance of collection exists and (ii) the amount can be reasonably estimated LOC has enough past history to estimate collectibility recommend that pledges receivable be recorded at their net realizable value of: $3,500 x 75% = $2,626 dr. Pledged receivable cr. Donation revenues the amount of pledges recorded as revenue will have to be disclosed in the notes to the financial statements
2.
Computer Equipment GAAP requires that NPOs whose average revenues are in excess of $500,000 capitalize and depreciate capital assets. Those NPOs whose average revenues are less than $500,000 have three options: I. capitalize and depreciate ii. expense in the year of purchase, or iii. capitalize and do not depreciate. given the small size of this organization, I would recommend that they expense the computer equipment - no accounting adjustment required
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3.
Duplicate Payment the duplicate payment should be treated as a recoverable amount however, if the National Opera forces LOC to recover the payment from the singer, collectibility may prove to be a problem - consideration should be then given to the need to set up an allowance against this amount dr. Accounts receivable cr. Production costs (20x5) $5,400 $5,400
4.
Donation of Props and Costumes assuming the props and costumes are good for one production only, then we are dealing with donated materials and services (as opposed to a capital item) GAAP allows NPOs the option of recording donated materials and services if two criteria are met: (i) a monetary value can be ascribed to the donated goods or services, and (ii) the donated goods or services would have been purchased if not donated the two criteria are met in this case. Therefore, I recommend that the value of the donated props and costumes be recorded since it would show the true cost of producing the specific opera dr. Production costs cr. Suspense account $5,000 $5,000
5.
Matching of City grant against ticket sales 20x5: $25,000 - 15,000 = $10,000 due to city 20x6: $25,000 - 13,500 = $11,500 due to city dr. Grants from the City (20x5) dr. Grants from the City (20x6) cr. Payable to City $10,000 $11,500 $21,500
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6.
Donation revenue from EDC the $9,000 donation should be removed from current revenues and set up as a deferred contribution since it relates to a future production dr. Donations revenues cr. Deferred Contributions $9,000 $9,000
7.
Bingo Revenues GAAP requires that such revenues be reported using the gross method. That is, the gross revenues must be reported separately from the expenses. given that no accounting records were kept, we will be unable to do this year. However, it is recommended that starting this year, detailed records be kept of revenues and expenditures the Bingo revenues need to be adjusted for the changes in the bingo bank account and the bingo bank account needs to be brought on LACs Statement of Financial Position: dr. Cash cr. Bingo revenues (20x5) cr. Bingo revenues (20x6) 8,500 4,000 4,500
8.
Prepaid Production costs the $17,000 should be set up as a prepaid Production Cost since the payment relates to a future period
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Revised Financial Statements:
Lark Opera Company Statement of Operations for the year ended December 31, 20x6 20x6 Revenues Ticket sales Grant from City Donations (27,000 + 2,625 Pledges - 9,000 Deferred Contribution from EDC) Bingo - net (63,000 + 4,500 | 59,000 + 4,000) Advertising $13,500 13,500 20,625 67,500 3,000 118,125 20x5 $15,000 15,000 30,000 63,000 4,000 127,000
Expenses Advertising Computer equipment Interest Salary Office Production costs (76,500 - 17,000 Prepaid Production Costs + 5,000 Donation of Props and Costumes) (75,600 - 5,400 Duplicate Payment)
4,000 2,500 2,600 48,000 10,000
6,000 2,400 48,000 12,000
64,500 131,600 (13,475) (50,600) $(64,075)
70,200 138,600 (11,600) (39,000) $(50,600)
Excess of revenues over expenses Net Assets - beginning Net Assets - end
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Lark Opera Company Statement of Financial Position as at December 31, 20x6 20x6 ASSETS Current Cash Accounts receivable (2,000 + 2,625 + 5,400) Prepaid production costs 20x5
$8,500 10,025 17,000 $35,525
$4,000 5,400 200 $9,600
LIABILITIES AND NET ASSETS Current Bank overdraft Due to city Accounts payable Deferred contribution
$16,000 21,500 53,100 9,000 99,600 (64,075) $35,525
$12,000 10,000 38,200 0 60,200 (50,600) $9,600
Net Assets
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B.
Internal Controls
most of the problems of LOC rise from the fact that the internal controls implemented by Marcia Braun were not working as anticipated. For example, there is no indication that bank reconciliations were done after Anne Warne collected the bank statements. Both Marcia Braun and Vince George, who approve payments and write cheques, have authority to sign the cheques they prepare without the other's approval. This and the fact that payments were made without supporting backup caused duplicate payments to be made. a contributing factor to LOC's problems was the fact that financial information was not being prepared for the board of directors on a timely basis. No financial statements have been prepared since 20x4; therefore, it is assumed that no financial information has been presented to the board in two years. it is difficult to have any separation of duties because of the shortage of people but, as a start, the following can be done: 1. Ideally, whoever writes and prepares the cheques should not have signing authority. At least there should be a requirement that each cheque be signed by two officers of LOC who have cheque signing authority. 2. All payments should be supported by approved supporting invoices. 3. All bank statements, deposit books and invoices should be in one centralized place. 4. Bank reconciliations should be done every month, independent of those handling the banking. 5. Budgeted financial statements, using accrual accounting, should be produced and given to the board regularly (e.g., quarterly). 6. An auditor should be appointed immediately. 7. The bingo operation should be considered part of LOC's operation. Details of the bingo operation's expenses and revenues should be accounted for in LOC's books.
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C. Budgeting
in a nonprofit organization like LOC where profit is not the bottom line and funds are allocated, budgets are important as a control mechanism to ensure that the expenses do not exceed revenues and cash resources are available as needed. Allocations should also be made in the context of the organization's goals and objectives. as well, the city has made it clear that no further funds will be granted to LOC unless audited financial statements are made available and future viability is demonstrated. This will require the implementation of a budgeting process as follows: 1. Prepare quarterly and annual cash flow budgets. 2. Prepare a budget for each production based on realistic estimates of projected revenues from ticket sales, advertising, grants and donations. 3. Ensure that the production budgets are reviewed and approved by the board prior to submission to the city for review. 4. Monitor actual revenues, expenses and cash flows against the budgets and prepare variance reports to be circulated to the board on a timely basis.
D. Business Involvement
the current board's appointment of Marcia Braun as both artistic director and general manager has allowed her to use LOC as a platform to give her students public exposure which could be construed as a conflict of interest. As well, Marcia's position as a director may conflict with her role as general manager. the board has approved a large salary for Marcia Braun (i.e., almost 50% of total revenues) which could be viewed as inappropriate for a board member. LOC's board of directors, though strong in artistic background, lacks business involvement which may account for its poor marketing efforts, its failure to attract more corporate donors and its failure to run the affairs of LOC in a fiscally prudent manner. it is recommended that leaders in the business community of Lark be invited to sit on the board and that an accountant (able to prepare appropriate financial information and manage the funds) be appointed as the treasurer. The combination of business acumen with artistic talent is essential.
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E.
Management of Bingo Operations

there is concern when any one individual manages a function of LOC separately from other operations. This is the case with Lou Smith who manages the bingo operations on his own and without reporting to the board in detail. He does not make any reports on the bingo operations, has not made himself available to meet with me, and has refused any offers of help from other board members. It also appears that there are no accounting records for the bingo operations and that casual labor payments are made in cash, therefore, there is likely no audit trail to follow. This lack of accountability presents an opportunity for Lou and/or his workers to pocket cash raised at the bingo (i.e., high risk of fraud). The gross revenue and the expenses from the bingo operations should be recorded in LOC's accounts. As well, records should be kept to track the payments to the bingo workers so that T4 slips can be issued to them at the end of the year. without Lou's input, it is impossible for me to assess the management of these operations. It is important for all board members to realize that the board requires some regular reports on the bingo operations and that co-operation with other board members and management requests will result in better service. an improved system in internal control will also serve to protect LOC and all its directors against potential loss of assets.
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F.
Marketing and Pricing

LOC has concentrated on its artistic merit but has failed to effectively promote its productions. Despite good reviews and the fact that the ticket prices for LOC's productions are only one quarter the prices for the National Opera Company's productions, sales of tickets to LOC's productions have been decreasing. A survey of opera lovers in the City of Lark has revealed that 50% of them are not even aware of LOC's existence. If LOC is to survive, it should increase its efforts on marketing its productions and at least make the opera lovers in the city of Lark aware of its existence. it is recommended that ticket prices for its productions should be increased (by say 200%) and some of the extra revenues generated should be invested in an aggressive marketing campaign targeted at the opera lovers in the cities of Lark and Oriole. Assuming such a campaign results in doubling ticket sales, LOC could generate approximately $13,500 x 2 x 200% = $54,000 more in revenue. If $20,000 of that amount is required for the marketing campaign, the net effect will be an increase in revenues over expenses of over $34,000 which would wipe out the deficit experienced in both 20x5 and 20x6 and substantially reduce the net liabilities. LOC has a good product. The key to its success is an effective marketing strategy. This must be made a top priority. LOC should also explore ways of taking advantage of the presence of the National Opera to generate some synergistic spin-offs.
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15.
Financial Statement Analysis
The broad purpose of financial statement analysis is to enable a user to make predictions about the firm that will assist his/her decision making. Published financial statements are the sources of information generally available to users. The nature of the analysis of financial statement information is primarily in the form of ratios. Before getting into the specifics of financial statement analysis, it seems worthwhile to inquire into the exact nature of the information a particular user needs in order to make his/her decision. As an example, consider the situation where an investor is trying to decide whether or not to sell his/her shares in a company. Alternatively, an analogous situation is one in which a prospective investor is trying to decide whether or not to buy shares in a particular company. Specifically, what information does this investor need? The corporate finance literature is replete with stock valuation models. There is a common element, however, to all of these models. Essentially, the value of a share of common stock is considered to be the present value of all future dividends expected to be received on the share. This includes the final liquidating dividend. If we accept this basic premise, then the investor would like to estimate the future cash dividends that he/she will receive if he/she invests in the company's shares. In order to predict the company's future dividend policy, the investor must predict those things that affect dividend policy. The following are the variables that affect a firm's future dividend policy: 1. Net cash flows from future operations. 2. Expected non-operating cash flows; i.e., from activities considered incidental to the firm's main function. 3. Future cash flows from changes in the levels of investments made by shareholders and creditors. 4. The amount of cash expected to be invested in the firm's long lived assets as well as in working capital. 5. The amount of future cash flow to service debt requirements; i.e., interest payments, repayment of principal, sinking fund provisions, etc. 6. The amount of future cash flow from random events such as windfall gain or casualties. 7. The firm's future policy regarding the holding of cash balances (for precautionary and liquidity reasons) in excess of those required to maintain the expected level of operations. 8. Management's attitude toward future cash dividend policy.
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Each of these eight variables that affect future dividend policy is in turn affected by others, which the investor would like to predict. However, published financial statements are historical in nature and do not provide the information we have just outlined. Nonetheless, historical information can be used to make projections and is sometimes extremely useful in this respect. The limitations of using historical information must, of course, be recognized. 15.1 1. Financial Analysis Techniques Horizontal (trend), Vertical and Percentage (common size) analysis
Horizontal analysis expresses financial data in terms of a single designated base period, or as compared to an amount of the preceding period. For example, the historical financial performance data for a company for the years 20x3 to 20x6 (all data is in millions of dollars) 20x3 Revenue Expenses Net income before taxes Income taxes Net income $7,975 7,369 606 200 $406 20x4 $8,509 7,882 627 207 $420 20x5 $11,500 10,673 827 273 $554 20x6 $13,619 12,546 1,073 354 $719
Horizontal analysis of the data as a percentage of the year 20x3 amounts: 20x3 Revenue Expenses Net income before taxes Income taxes Net income 100% 100% 100% 100% 100% 20x4 107% 107% 103% 104% 103% 20x5 144% 145% 136% 137% 136% 20x6 171% 170% 177% 177% 177%
Horizontal analysis of the data as a percentage of the previous year's amounts: 20x3 Revenue Expenses Net income before taxes Income taxes Net income 100% 100% 100% 100% 100% 20x4 107% 107% 103% 104% 103% 20x5 135% 135% 132% 132% 132% 20x6 118% 118% 130% 130% 130%
Vertical Analysis (also referred to as common size financial statements), presents all the data in a financial statement as a percentage of a single line item. Generally, when
performing vertical analysis on a balance sheet, all numbers are expressed as a percentage of total assets; on the income statement as a percentage of sales. Vertical analysis of the above data is as follows: 20x3 Revenue Expenses Net income before taxes Income taxes Net income 100% 92% 8% 3% 5% 20x4 100% 93% 7% 2% 5% 20x5 100% 93% 7% 2% 5% 20x6 100% 92% 8% 3% 5%
2.
Ratio Analysis
Ratio analysis is performed in order to evaluate the firm's liquidity, solvency, profitability and asset management: liquidity: assessment of the firm's ability to meet current liabilities as they come due, solvency: ability of the firm to pay both current and long-term debt, profitability: evaluation of manager's abilities in generating returns to capital providers, asset management (or activity ratios): how well are the firm's assets managed. Note that the list of ratios below are the ones that would be tested on the Entrance Exam as well as the Accelerated Program. It is not an all-encompassing list of financial ratios but outlines the ratios and respective calculations that are expected knowledge for CMA candidates. Liquidity Analysis - the following ratios are typically used in assessing the liquidity of a firm: Current Ratio Quick Ratio (Acid-Test Ratio) Current Assets Current Liabilities (Cash + Accounts Receivable + Temporary Investments) / Current Liabilities Alternatively: (Current Assets Inventory Prepaid Expenses) / Current Liabilities The current ratio tells us how much current assets there are relative to current liabilities. The quick ratio tells us how much liquid current assets there are relative to current liabilities. Caution must be applied when using the current ratio. Assume that two companies have a current ratio of 1.5. One cannot draw a conclusion that these companies face a similar
liquidity situation. Upon further investigation you find out that the companies have the following current asset structure: Company A Current Assets Cash Temporary Investments Accounts Receivable Inventory $1,000 34,000 100,000 $135,000 $90,000 Company B $5,000 20,000 60,000 50,000 $135,000 $90,000
Current Liabilities
Clearly Company B is more liquid than Company A - it has significantly less inventory relative to Company A. The Quick Ratio for the two companies is much more conclusive: Company A: (1,000 + 34,000) 90,000 = .39 Company B: (5,000 + 20,000 + 60,000) 90,000 = .94 All things being equal, the quick ratio is a much better measure of liquidity. Many people rely on 'rules of thumb' to assess the quality of a liquidity ratio. The most often quoted rule of thumb for the current ratio is 2.0 and for the quick ratio, 1.0. All rules of thumb, by definition are incorrect and must be used with caution. The rule of thumb for the quick ratio is much firmer than that for the current ratio.
Solvency Analysis - the following ratios are typically used in assessing the solvency of a firm: Debt-to-Equity Ratio Times Interest Earned Total Liabilities / Shareholders' Equity
Income before Interest and Taxes / Interest expense
The debt-to-equity ratio must be compared (1) to the firms historical data (interperiod) and/or (2) to other companies operating in the same industry or industry averages (interfirm). As the Financial Management module will show, it is wrong to say that the lower the debt-to-equity ratio, the better off the firm is. All firms have a theoretical optimal debt-to-equity ratio they should be aiming for. Firms whose debt-to-equity ratio is optimal will maximize the value of the firm and minimize their weighted average cost of capital. The problem is that the finance literature does not provide us with a mechanism to establish this optimal debt-to equity ratio. We tend to use the industry average as a surrogate for the optimal debt-to-equity ratio. Take the following two firms:
Debt-to-equity Ratio
Company A 0
Company B 2.5
Industry Average 3.0
Although, Company A is clearly more solvent than Company B, one could argue that Company B is better off than Company A since its weighted average cost of capital should be lower. The times interest earned ratio is a good judge of a firms solvency. A firm with a times interest earned ratio of 2.0 is generating operating income that is only twice as high as interest charges. Such a firms exposure to fluctuations in interest rates is high.
Profitability Analysis the following ratios are typically used in assessing the profitability of a firm: Return on Sales Return on Assets Return on Equity Gross margin % Price Earnings Ratio Net Income / Sales Net Income / Average total assets Net Income / Average shareholders equity Gross Margin / Sales Share Price / Earnings per share
Also note that we are using averages in the denominators. This is the theoretically correct way to calculate the ratios. Whenever you divide an income statement number into a balance sheet number (or vice-versa), the balance sheet number must always be an average. However, there are times where this may be either impossible or impractical to do. In situations where you only have one year of data, it is impossible. When you have two years of data, you can calculate the ratios for one year only and you do not have any comparatives. In these situations, one can assume that the year-end balances are good surrogates for the average and simply use the year end balances. Note that multiple choice exams will always assume you use averages.
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Asset Management Ratios (activity ratios) the following ratios are typically used in assessing the solvency of a firm: Inventory turnover Days Sales in Accounts Receivable Total asset turnover Accounts payable turnover Cost of goods sold Average Inventory Average Accounts Receivable (Net Credit Sales 365)
Sales Average total assets
Purchases / Average Accounts Payab;e
The inventory turnover measures the number of times the inventory rolls over within a year. The days sales in accounts receivable tells us what the average number of days our accounts receivable have been outstanding. The total asset turnover tells us how many sales dollars are generated by each dollar of asset invested. The accounts payable turnover tells us how often a company pays off its accounts payable in a given period. At times, in an examination setting, you will be presented with a company's financial statements and the industry average accounts receivable and inventory turnover ratios. Given these, it is possible to perform some comparative analysis and, more importantly, determine how much cash could be generated by the company if it were able to reduce its accounts receivable and inventory balances. (More often than not, the question mentions that the company is cash strapped.) Example 1 - Assume the following balances taken from the Harlow Company's December 31, 20x5, financial statements: 20x5 $2,450,000 3,545,000 $9,500,000 6,650,000 20x4 $1,975,000 3,345,000 $9,200,000 5,980,000
Accounts receivable - net Inventory Sales (all on credit) Cost of goods sold Industry averages Days Sales in Accounts Receivable Inventory turnover
61 days 3.5
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The Harlow Company's ratios are as follows: Days sales in accounts receivable = Average accounts receivable / Sales 365 = [($2,450,000 + 1,975,000) / 2)] / ($9,500,000/365) = 85 days Inventory turnover = Cost of goods sold / Average Inventory = $6,650,000 / [($3,545,000 + 3,345,000) / 2)] = 1.93 Clearly, there is room for improvement. The company has the potential to generate a one-time cash saving by reducing their accounts receivable and inventory balances to a level where the turnover ratios are in line with the industry average. The amount of cash inflow from such a reduction is calculated as follows: Current average accounts receivable balance Accounts receivable balance if days sales in accounts receivable was 61 days: $9,500,000 / 365 x 61 Current average inventory balance Inventory balance if turnover was 3.5 $6,650,000 / 3.5 Total potential one time cash inflow from reduction $2,212,500
1,587,671 $3,445,000 1,900,000
$ 624,829
1,545,000 $2,169,829
It is not enough to perform the above calculations since this reduction will not happen by itself. It is very important to provide management with means to reduce the accounts receivable and inventory balance. Measures to reduce accounts receivable include: offering discounts for early payment, charging interest on overdue accounts, sending late payment notices with follow-up phone calls, and turning accounts over to a collection agency. Measures to reduce inventory include: dispose of obsolete inventories, improve production throughput, stop production for a short period of time, and consider implementing a just-in-time purchasing and production system. Note that when performing financial statement analysis on examinations, it is usually not necessary to calculate all of the ratios shown above. All you really need to do is calculate enough ratios per category to feel comfortable in drawing a conclusion. For example, the
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calculation of the quick ratio of 0.11 is usually enough to indicate that the company has a liquidity problem.
15.2
Limitations of Financial Statement Analysis
Changes in ratios can only be interpreted by understanding the underlying economic events. For example a sudden increase in the current ratio may simply be due to the fact that a short-term bank loan was converted to a long-term loan. Ratios may change as a result of non-economic events that affect the financial statements e.g., change in accounting method or estimate Comparisons of a companys ratios with another companys or with industry averages involve certain restrictive assumptions: that all companies being compared are: structurally similar use the same (or similar) accounting principles experience a common set of external influences
15.3
Comprehensive Example
On the following pages, you will find the financial statements for Sample Company Inc. for the year ended December 31, 20x5. Ratios for the year 20x4 will be calculated only if we do not need to average out asset balances. Liquidity Analysis: 20x5 Current Ratio Quick Ratio (Acid-Test Ratio) 14,791.1 7,974.7 = 1.85 (1,664.0 + 7,765.6) 7,974.7 = 1.18 20x4 12,155.0 7,791.8 = 1.56 (1,738.7 + 5,840.1) 7,791.8 = 0.97
I would draw two conclusions on Sample Company's liquidity situation: (1) it is improving and (2) the quick ratio implies that the company is liquid.
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Solvency Analysis: 20x5 Debt-to-Equity Ratio 13,422.3 3,611.8 = 3.72 20x4 10,789.4 3,488.5 = 3.09 (826.9 + 114.3) 114.3 = 8.23
Times Interest Earned (1,072.9 + 94.9) 94.9 = 12.3
Based solely on the times interest earned ratio, Sample Company appears to be solvent. The debt-to-equity ratio tells us that solvency is decreasing. Whether or not the company is better or worse off depends on how the debt-to-equity ratio of 3.71 compares with industry averages.
Profitability Analysis 20x5 Return on Sales Return on Assets 718.8 13,618.5 = 5.3% 718.8 [(17,034.1 + 14,277.9) / 2)] = 718.8 / 15,656.0 = 4.6% 718.8 [(3,611.8 + 3,488.5) / 2] =718.8 / 3,550.15 = 20.3% 20x4 554.0 11,500.1 = 4.8% n/a
Return on Equity
n/a
One can conclude that profitability is increasing. The assessment of how profitable they are would depend on how they compare to competitor ratios. The 20x4 ratios cannot be calculated for the return on assets and return on equity because the 20x3 ending asset and shareholders equity balance is not known We cannot compute the gross margin % nor the price earnings ratio because we are not provided with the cost of sales or the market price of the stock.
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Asset Management (Activity Ratios) 20x5 Inventory turnover Days Sales in Accounts Receivable 20x4
Cannot be calculated since cost of goods sold is not provided. [(7,765.6 + 5,840.1) / 2] (13,618.5 365) = 6,802.85 / 37.311 = 182 days 13,618.5 [(17,034.1 + 14,277.9) / 2)] = 13,618.5 / 15,656 = .87 n/a
Total asset turnover
n/a
The days sales in accounts receivable is typically compared to the credit terms. In this case, the amount is likely low because much of their contracts are long-term in nature and require substantial deposits before work is even started. The days sales in accounts receivable appears to be deteriorating, but this is inconclusive given the nature of the business. The total asset turnover indicates that each dollar of asset generates $0.87 in sales. To properly assess the company's asset management, we would need to compare the ratios with industry averages and historical company data.
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Sample Company Inc. Consolidated Statement of Financial Positions As at December 31, 20x5 and 20x4 (millions of dollars) 20x5 Assets Cash and cash equivalents Accounts receivable Inventories Fixed assets Other assets $1,664.0 7,765.6 5,361.5 14,791.1 1,898.7 344.3 $17,034.1 Liabilities Short-term borrowings Accounts payable and accrued liabilities Advances and progress billings in excess of related costs Long-term debt Other liabilities 20x4 $1,738.7 5,840.1 4,576.2 12,155.0 1,842.7 280.2 $14,277.9
$2,002.7 3,335.2 2,636.8 7,974.7 4,795.0 652.6 13,422.3 3,611.8 $17,034.1
$2,363.5 3,099.7 2,328.6 7,791.8 2,575.9 421.7 10,789.4 3,488.5 $14,277.9
Shareholders equity
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Sample Company Inc. Consolidated Statement of Shareholders Equity For the years ended December 31, 20x5 and 20x4 (millions of dollars)
20x5 Amount $300.0 20x4 Amount $300.0
Number Share capital Preferred shares - Series 2 Common Shares Class A Shares (multiple voting) Balance at beginning of year Converted to Class B Balance at end of year Class B Subordinate Voting Shares Balance at beginning of year Issued under the share option plans Issued to employees for cash Converted from Class A Balance at end of year Balance at end of year common shares Total share capital Retained Earnings Balance at beginning of year Net income Dividends: Preferred shares Common shares Redemption of convertible notes Other Balance at end of year Convertible notes equity component Deferred translation adjustment Total shareholders equity 12,000,000
Number 12,000,000
176,707,676 (910,612) 175,797,064 506,465,319 5,635,420 593 910,612 513,011,944 688,809,008
49.1 (0.5) 48.6 796.4 16.8 0.5 813.7 862.3 1,162.3 1,900.4 718.8 (16.5) (152.3) (51.5) (6.4) 2,392.5 57.0 $3,611.8
177,265,658 (557,982) 176,707,676 501,652,790 1,871,250 2,383,297 557,982 506,465,319 683,172,995
49.3 (0.2) 49.1 746.9 7.4 41.9 0.2 796.4 845.5 1,145.5 1,491.0 554.0 (16.5) (117.3) (10.8) 1,900.4 180.5 262.1 $3,488.5
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Sample Company Inc. Consolidated Statement of Income For the years ended December 31, 20x5 and 20x4 (millions of dollars, except per share amounts) 20x5 $13,618.5 12,220.4 227.5 94.9 (48.3) 12,494.5 1,124.0 51.1 1,072.9 354.1 $718.8 $1.02 $1.00 684,492,101 20x4 $11,500.1 10,398.8 232.6 114.3 (72.5) 10,673.2 826.9 826.9 272.9 $554.0 $0.77 $0.76 680,385,027
Revenues Expenses Cost of sales and operating expenses Depreciation and amortization Interest expense Interest income Income before unusual items and income taxes Unusual items, net Income before income taxes Income taxes Net Income Earnings per share: Basic Fully diluted Average number of common shares outstanding during the year
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Sample Company Inc. Consolidated Statement of Cash Flows For the years ended January 31, 20x5 and 20x4 (millions of dollars) 20x5 Operating activities Net income Non-cash items: Depreciation and amortization Provision for credit losses Deferred income taxes Unusual items, net Net changes in non-cash balances related to operations Cash flows from operating activities Investing activities Additions to fixed assets Net investment in asset-based financing items Disposal of businesses Other Cash flows from investing activities Financing activities Net variation in short-term borrowings Proceeds from issuance of long-term debt Repayment of long-term debt Redemption of convertible notes Issuance of shares, net of related costs Dividends paid Cash flows from financing activities Effect of exchange rate changes on cash and cash equivalents Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year $718.8 227.5 31.7 240.9 51.1 (389.3) 880.7 (419.5) (2,251.4) 145.6 (27.7) (2,553.0) (284.0) 2,464.5 (133.1) (243.2) 16.8 (168.8) 1,652.2 (54.6) (74.7) 1,738.7 $1,664.0 20x4 $554.0 232.6 (12.9) 146.0 1,074.6 1,994.3 (364.2) (2,145.0) (2.8) (2,512.0) 141.4 1,056.6 (165.0) 49.3 (133.8) 948.5 80.2 511.0 1,227.7 $1,738.7
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Appendix - CMA Entrance Exam - Ratio List

Liquidity Analysis Current Ratio Quick Ratio (Acid-Test Ratio) Current Assets Current Liabilities (Cash + Accounts Receivable + Short-Term Investments) Current Liabilities Alternatively: (Current Assets Inventory Prepaid Expenses) Current Liabilities Solvency Analysis Debt-to-Equity Ratio Times Interest Earned Profitability Analysis Return on Sales (profit margin) Return on Assets Gross margin % Return on Equity
Total liabilities Shareholders Equity Income before Interest and Taxes Interest expense
Net income Sales
Net income Average total assets Gross margin / Sales Net Income less preferred dividends* Average common shareholders equity * preferred dividends declared on noncumulative preferred shares plus the annual preferred dividend on cumulative preferred shares
Price Earnings
Share price earnings per share
Activity Analysis (Asset management ratios) Inventory turnover Cost of goods sold Average Inventory (when cost of goods sold is not known, use sales) Days Sales in Accounts Receivable Accounts Payable Turnover Total asset turnover Average Accounts Receivable (Net Credit Sales 365) Purchases / Average Accounts Payable Sales Average total assets
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Multiple Choice Questions The Following Data Apply to Items 1-5 Selected data from Ostrander Corporation's financial statements for the years indicated are presented below in thousands. December 31 20x1 20x0 Cash $32 $28 Marketable securities 169 172 Accounts receivable (net) 210 204 Merchandise inventory 440 420 Tangible fixed assets 480 440 Total assets 1,397 1,320 Current liabilities 370 368 Total liabilities 790 750 Common stock outstanding 226 210 Retained earnings 381 360
20x1 Operations Net sales Cost of goods sold Interest expense Income tax Gain on disposal of a segment (net of tax) Net income $4,175 2,880 50 120 210 385
1.
The quick ratio for Ostrander Corporation in 20x1 is a) 1.73 b) 1.87 c) 1.11 d) 0.54 e) 2.30
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2.
Merchandise inventory turnover for Ostrander Corporation in 20x1 is a) 6.54 times b) 6.69 times c) 6.85 times d) 9.70 times e) 9.94 times
3.
The days sales in Accounts Receivable for Ostrander Corporation in 20x1 is a) 18.10 days b) 26.61 days c) 17.83 days d) 18.36 days e) 26.23 days
4.
Times interest earned for Ostrander Corporation for 20x1 is a) 4.50 times b) 7.70 times c) 3.50 times d) 6.90 times e) 5.90 times
5.
The total debt to equity ratio for Ostrander Corporation in 20x1 is a) 3.49 b) 1.85 c) 2.07 d) 1.30 e) 0.69
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Problem 1 - Financial Statement Analysis Two-Rivers Inc. (TRI) manufactures a variety of consumer products. The company's founders have run the company for thirty years and are now interested in retiring. Consequently, they are seeking a purchaser who will continue its operations, and a group of investors, RayWalsh Inc., is looking into the acquisition of TRI. To evaluate its financial stability and operating efficiency, TRI was requested to provide the latest financial statements and selected financial ratios. Summary information provided by TRI is presented below and in the next column. TRI Statement of Income For the Year Ended November 30, 20x2 (in thousands) Sales (net) Interest income Total revenue Costs and expenses Cost of goods sold Selling and administrative expense Depreciation and amortization expense Interest expense Total costs and expenses Income before taxes Income taxes Net income Selected Financial Ratios TRI 20x0 1.62 .63 8.50 12.1 % 1.02 1.83 3.21 Current Industry Average 1.63 .68 8.45 13.0% 1.03 1.84 3.18 $30,500 500 31,000 17,600 3,550 1,890 900 23,940 7,060 2,900 $4,160
Current ratio Quick ratio Times interest earned Return on sales Total debt to equity Total asset turnover Inventory turnover
20x1 1.61 .64 8.55 13.2% .86 1.84 3.17
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TRI Statement of Financial Position As of November 30 (in thousands) 20x2 Cash Marketable securities (at cost) Accounts receivable (net) Inventory Total current assets Property, plant, & equipment (net) Total assets $400 500 3,200 5,800 9,900 7,100 17,000 20x1 $500 200 2,900 5,400 9,000 7,000 16,000
Accounts payable Income taxes payable Accrued expenses Total current liabilities Long-term debt Total liabilities Common stock ($1 par value) Paid-in capital in excess of par Retained earnings Total shareholders' equity Total liabilities and shareholders' equity
$ 3,700 900 1,700 6,300 2,000 8,300 2,700 1,000 5,000 8,700 $17,000
$ 3,400 800 1,400 5,600 1,800 7,400 2,700 1,000 4,900 8,600 $16,000
Required A. Calculate a new set of ratios for the fiscal year 20x2 for TRI based on the financial statements presented. B. Explain the analytical use of each of the seven ratios presented, describing what the investors can learn about TRI's financial stability and operating efficiency. C. Identify two limitations of ratio analysis.
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Problem 2 - Financial Statement Analysis The following partial information has been extracted from the financial statements of Toss Away Ltd., a recycling plant: 20x6 Current assets Current liabilities Cash and temporary investments Net accounts receivable Net income Sales Cost of goods sold Interest expense Amortization expense Income tax rate $800,000 450,000 400,000 250,000 300,000 2,200,000 1,350,000 100,000 150,000 40% 20x5 $750,000 430,000 380,000 175,000 220,000 1,895,000 1,130,000 105,000 145,000 40%
The following industry averages have been obtained: Average collection period Gross margin Times interest earned 70 days 34% 10 times
Calculate and interpret each of the following ratios for 20x6 for Toss Away Ltd.: i) ii) iii) iv) v) current ratio quick ratio (acid test) accounts receivable turnover gross margin times interest earned.
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Problem 3 - Financial Statement Analysis Arnold, Inc., manufactures and sells portable radios. Condensed comparative income statements for 20x1 and 20x2 are as follows: Arnold, Inc. Comparative Income Statements 20x2 Sales Sales returns Beginning inventories Cost of manufactured radios Ending inventories Cost of goods sold Selling expenses Administrative expenses Income before tax Required 1. Prepare a horizontal percentage analysis using 20x1 as the base year. Round each figure to the nearest percentage point. 2. Prepare a vertical percentage analysis for both 20x1 and 20x2, using sales as the basis for comparison. Round each figure to the nearest percentage point. 3. Arnold is concerned with its 20x2 profit. On the basis of your analysis in parts 1 and 2, identify those financial statement items that appear to be problem areas for Arnold. Give reasons for your choices. $486,100 (20,400) 131,250 291,600 (160,400) 262,450 107,500 48,600 47,150 20x1 $305,200 (6,100) 110,100 143,700 (131,250) 122,550 91,500 45,750 39,300
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Problem 4 - Financial Statement Analysis The following selected financial data are taken from the financial statements of Jackson Corporation: 12/31/x2 Cash Accounts receivable (net) Merchandise inventory Short-term marketable securities Land and buildings (net) Mortgage payable (noncurrent) Accounts payable (trade) Short-term notes payable $ 20,000 50,000 90,000 30,000 340,000 270,000 70,000 20,000 12/31/x1 $ 80,000 150,000 150,000 10,000 360,000 280,000 110,000 40,000
YEAR ENDED 12/31/x2 12/31/x1 Cash sales Credit sales Cost of goods sold Required Calculate Jackson Corporation's 20x2: 1. 2. 3. 4. Quick ratio. Receivable turnover. Merchandise inventory turnover. Current ratio. $1,800,000 600,000 1,200,000 $1,600,000 800,000 1,400,000
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Problem 5 - Financial Statement Analysis The December 31, 20x2, balance sheet of Cook, Inc., is presented below. These are the only accounts in Cook's balance sheet. Amounts indicated by a question mark (?) can be calculated from the additional information given. Assets Cash Accounts receivable(net) Inventory Tangible capital assets (net)
$ 24,000 ? ? 281,600 $432,000
Liabilities and shareholders' equity Accounts payable (trade) Income taxes payable (current) Long-term debt Common shares Retained earnings Additional information Current ratio (at year-end) Total liabilities divided by total shareholders' equity Inventory turnover based on sales and ending inventory Inventory turnover based on cost of goods sold and ending inventory Gross margin,20x2 Required 1. What was Cook's December 31, 20x2, balance in accounts payable? 2. What was Cook's December 31, 20x2, balance in retained earnings? 3. What was Cook's December 31, 20x2, balance in the inventory account?
$? 25,000 ? 300,000 ? ? 1.6:1 .8 15 times 11 times $315,000
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Problem 6 - Financial Statement Analysis The Rayon Company is listed on the Toronto Stock Exchange. The market value of its common shares was quoted at $18 per share on both December 31, 20x2, and December 31, 20x1. Rayon's balance sheets as of December 31, 20x2, and December 31, 20x1, and statements of income and retained earnings for the years then ended are presented below: Statement of Financial Positions 12/31/x2 12/31/x1 ($ in 000s) Assets Current assets Cash Marketable securities, at cost that approximates market Accounts receivable, net of allowance for doubtful accounts Inventories at lower of cost or market Prepaid expenses Total current assets Tangible capital assets, net of accumulated depreciation Other assets Total assets Liabilities and shareholders' equity Current liabilities Notes payable Accounts payable and accrued expenses Income taxes payable Payments due within one year on long-term debt Total current liabilities Long-term debt Deferred taxes Other liabilities Total liabilities Shareholders' equity Common shares, no-par value: authorized, 20,000,000 shares; issued and outstanding, 10,000,000 shares Retained earnings Total shareholders' equity Total liabilities and shareholders' equity
$ 3,800 $ 3,600 13,000 11,000 105,000 95,000 134,000 154,000 2,500 2,400 $258,300 $266,000 311,000 308,000 29,000 34,000 $598,300 $608,000
$5,000 $ 15,000 62,500 74,500 1,000 1,000 6,500 7,500 $ 75,000 $ 98,000 177,300 180,000 74,000 67,000 9,000 8,000 $335,300 $353,000
$121,000 $121,000 142,000 134,000 $263,000 $255,000 $598,300 $608,000
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Net sales Costs and expenses Cost of goods sold Selling, general, and administrative expenses Depreciation expense Interest expense Other expenses, net Total costs and expenses Income before income taxes Income taxes Net income Retained earnings at beginning of period, as previously reported Adjustment required for correction of error Retained earnings at beginning of period, as restated Dividends on common shares Retained earnings at end of period Additional facts are as follows:
Statements of Income and Retained Earnings YEAR ENDED 12/31/x2 $600,000 $400,000 64,000 80,000 2,000 17,000 (563,000) $37,000 (16,800) $20,200 $141,000 (7,000) 134,000 (12,200) $142,000
12/31/x1 $500,000 $325,000 58,500 75,000 1,500 6,000 (466,000) $34,000 (15,800) $18,200 $132,000 (6,000) 126,000 (10,200) $134,000
a) Selling, general, and administrative expenses for 20x2 included an usual but infrequently occurring loss of $10 million. b) Adjustment required for correction of error was a result of a change from an accounting principle that is not generally accepted to one that is generally accepted. c) Rayon Company has a simple capital structure and has disclosed earnings per common share for net income in the notes to the financial statements. Required 1. Describe the general significance of the following financial analysis tools: a) Quick (acid-test) ratio. b) Inventory turnover. c) Return on shareholders' equity. Perform a financial statement analysis of Rayon Company.
2.
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SOLUTIONS
Multiple Choice Questions 1. 2. 3. 4. c b a d (32 + 169 + 210) / 370 = 1.11 2,880 / [(440 + 420) 2] = 6.69x [(210 + 204) 2] / (4,175 365) = 18.1 EBIT = 385 - 210 + 120 + 50 = 345 EBIT / I = 345 / 50 = 6.9x 790 / (226 + 381) = 1.30
5.
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Problem 1 A. The calculation of selected financial ratios for TRI for the fiscal year 20x2 is as follows. Current ratio = Current Assets / Current Liabilities = $9,900 / $6,300 = 1.57 Quick ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities = ($400 + 500 + 3,200) / 6,300 = 0.65 Times interest earned = Income before interest and taxes / Interest expense = ($7,060 + 900) / 900 = 8.8 Return on sales = Operating income / Sales = $4,160 / 30,500 = 13.6% Total debt to equity = Total debt / Total Shareholders' Equity = $8,300 / 8,700 = 0.95 Total asset turnover = Sales / Average total assets = $30,500 / 16,500 = 1.85 Inventory turnover = Cost of goods sold / Average inventory = 17,600 / 5,600 = 3.14
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B. The analytical use of each of the seven ratios presented above and what investors can learn about TRI's financial stability and operating efficiency are presented below. Current ratio Measures the ability to meet short-term obligations using short-term assets. TRI's current ratio has declined over the last three years from 1.62 to 1.57. This declining trend, coupled with the fact that it is below the industry average, is not yet a major concern; however, the company should be watched in the future as the ratio assumes that non-cash current assets (particularly inventory) can be quickly converted to cash at/or close to book value.
Quick ratio Measures the ability to meet short-term debt using the most liquid assets. TRI has improved its liquidity ratio over the last three years: however, it is still below industry average. Furthermore, a liquidity ratio below 1 indicates that TRI may have difficulty meeting its short-term obligations if inventory does not turn over fast enough.
Times interest earned Measures the ability to meet interest commitments from current earnings. The higher the ratio, the more safety for long-term creditors. TRI's ratio has been improving over the last three years and is above the industry average. This provides an indication that TRI has been paying down or refinancing debt and/or increasing sales and profits which indicates long-term stability.
Return on Sales Measures the net income generated by each dollar of sales. It provides some indication of the ability to absorb cost increases or sales declines. TRI's profit margin has been improving and is currently above the industry average indicating a trend towards marginal operating efficiency. Furthermore, it improves the ability to absorb soft economic periods, pay down debt, or take on additional debt for expansion.
Total debt to equity Measures how well protected creditors are in case of possible insolvency. Measures the degree of leverage and whether or not the entity will be able to obtain additional financing through borrowing. TRI's ratio has deteriorated slightly in 20x2 but has been below the industry average over the last three years. This indicates that TRI should be able to raise additional financing through debt and still remain below the industry average which indicates there is long-term stability.
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Total asset turnover Measures the efficiency of resource use, i.e., the ability to generate sales through the use of assets. TRI's ratio has been steadily improving and is above the industry average, indicating good use of assets and ability to generate sales.
Inventory turnover Measures how quickly inventory is sold, as well as, how effectively investment in inventory is used. It also provides a basis for determining if obsolete inventory is present or pricing problems exist. TRI's ratio has been steadily declining and is below the industry average. This slower than average situation may indicate a decline in operating efficiency, hidden obsolete inventory, or overpriced stock items.
C. Limitations of ratio analysis include difficulty making comparisons among firms in the industry due to accounting differences. Different accounting methods may cause different results in straight line depreciation versus accelerated methods, LIFO versus FIFO, etc. the fact that no one ratio is conclusive.
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Problem 2 i) Current ratio = current assets/current liabilities = $800,000/$450,000 = 1.78 The current ratio is one of the ratios that are useful in determining the liquidity of a company. That is, it helps determine the company's short-term debt-paying ability. To properly interpret this ratio, it should be compared with a benchmark, such as the industry standard, or compared with the ratio for the past few years. Without this information, we can only compare it with the general rule of thumb that a current ratio of 2 or more is satisfactory. Based on this, it appears that Toss Away Ltd.'s ability to pay short-term debt is below a satisfactory level. ii) Quick ratio = (cash + temporary investments + accounts receivable) /current liabilities = ($400,000 + $250,000)/$450,000 = 1.44 The quick ratio is another ratio that is useful in determining the liquidity of a company. It eliminates slow-moving inventories from the current ratio formula. Again, this ratio should be compared with an industry standard or with past years. A general rule of thumb is that a quick ratio of 1 or more is satisfactory. Based on this, Toss Away Ltd. has a very favorable quick ratio. Because inventories of the company represent only a small proportion of current assets (i.e., 18.75% in 20x6), it can be concluded that the company has satisfactory ability to pay shortterm debt. iii) Accounts receivable turnover= sales/average accounts receivable = $2,200,000/[($250,000 + $175,000)/2] = 10.35 times Another way of evaluating liquidity is to determine how quickly certain assets, such as receivables, can be turned into cash. Such ratios, called activity ratios, provide information related to how efficiently the company utilizes its assets. The receivables turnover provides some information on the quality of the receivables and how successful the company is in collecting its outstanding receivables. The higher this turnover, the more credence the current ratio and quick ratio have in the financial analysis. The industry average collection period of 70 days may be converted to the accounts receivable turnover (i.e., 365/70 days = 5.21 times). Toss Away Ltd.'s accounts receivable turnover of 10.35 is significantly higher than the industry average of 5.21 times which indicates that Toss Away Ltd. is converting its receivables to cash more quickly than the industry average. However, to properly assess receivables turnover, we need to compare it to the desired turnover implied in the company's credit terms. For example, if it extends 30 days credit, Toss Away Ltd. would expect a receivables turnover of 12 times.
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iv)
Gross margin = (sales - cost of goods sold)/sales = ($2,200,000-$1,350,000)/$2,200,000 = $850,000/$2,200,000 = 38.6%. When compared with trends or industry norms, this ratio provides information about a company's profitability. Toss Away Ltd. has a favorable gross margin of 38 6% which is 4.6% above the 34% industry average.
v)
Times interest earned = income before taxes and interest charges/interest charges = [($300,000 / .6) + $100,000]/$100,000 = $600,000/$100,000 = 6 times. This is considered one of the coverage ratios. The coverage ratios help in predicting the long-run solvency of a company and are of interest primarily to long-term debtors who need some indication of the measure of protection available to them. The times interest earned ratio stresses the importance of a company covering all interest charges. Toss Away Ltd.'s times interest earned ratio of 6 indicates that its profits are sufficient to cover interest, but is below the industry average of 10 times. This, together with a higher than industry average gross margin could signify that the company has higher interest charges (i.e., more debt) than the industry average.
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Problem 3 1.
Sales Sales returns Beginning inventories Cost of manufactured radios Ending inventories Cost of goods sold Selling expenses Administrative expenses Income before tax
20x2 AMOUNTS AS A PERCENTAGE OF 20x1 AMOUNTS 159% 334% 119% 203% 122% 214% 117% 106% 120%
2. 20x2 Dollars Percentage $ 486,100 100% (20,400) 4% 131,250 27% 291,600 60% (160,400) 33% 262,450 54% 107,500 22% 48,600 10% 47,150 10% 20x1 Dollars Percentage $ 305,200 100% (6,100) 2% 110,100 36% 143,700 47% (131,250) 43% 122,550 40% 91,500 30% 45,750 15% 39,300 13%
Sales Sales returns Beginning inventories Cost of manufactured radios Ending inventories Cost of goods sold Selling expenses Administrative expenses Income before tax
3. The problem areas for Arnold appear to be: a) Sales returns, which increased from 2% to 4%. Sales returns in 20x2 are 334% of the 20x1 amount. b) Cost of manufactured radios, which increased from 47% to 60%. Cost of manufactured radios in 20x2 is 203% of the 20x1 amount. c) Cost of goods sold, which increased from 40% to 54%. The 20x2 amount is 214% of the 20x1 amount, primarily because of the increase in cost of manufactured radios. Arnold should take a hard look at why its manufacturing costs and sales returns increased in 20x2.
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Problem 4 1. Quick ratio Cash + Short-term Mkt.Sec. + Net short-term receivables = Current liabilities = $20,000 + $30,000 + $50,000 $70,000 + $20,000 $100,000 $90,000 1.11
2. Receivable turnover Net credit sales = Average Receivables = $600,000 ($50,000 + $150,000) / 2 $600,000 $100,000 6
3. Merchandise inventory turnover Cost of goods sold = Average inventory = $1,200,000 ($90,000 + $150,000) / 2 $1,200,000 $120,000 10.0 times
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4. Current ratio = Current Assets Current Liabilities $20,000 + $50,000 + $90,000 + $30,000 $90,000 $190,000 $90,000 2.11
Problem 5 1. Current Ratio Current Assets = Current Liabilities 1.6 = $432,000 - $281,600 Accounts payable + $25,000
(Accounts payable + $25,000) x 1.6 = $150,400 Accounts payable + $25,000 = $94,000 Accounts payable 2. Total liabilities Total shareholders' equity $432,000 ($300,000 + X) $300,000 + X $132,000 X 1.8X X Retained earnings = .8 = $69,000
= = = = =
.8 $240,000 + .8X $(108,000) ($60,000) $(60,000)
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3. Sales Inventory Sales = = 15 15 x Inventory Cost of goods sold Inventory Cost of goods sold = = 11 11 x Inventory
Gross margin = $315,000 = $315,000 = Inventory =
Sales - Cost of goods sold (15 x Inventory) - (11 x Inventory) 4 x Inventory $78,750
Problem 6 1. The three financial analysis tools listed are ratios. Ratio analysis is used as an aid in interpreting the relationships between various financial data. a) The quick (acid-test) ratio attempts to measure the ability of the firm to pay its current liabilities as they come due. It is a test similar to, although stricter than, the current ratio in that less liquid current assets (such as inventory and prepaid expenses) are omitted from the numerator. The ratio is concerned with the relationship between near-cash items and current liabilities. b) Inventory turnover attempts to measure how quickly inventory is sold. It can also aid in isolating problem areas such as obsolete inventory and pricing errors. This ratio is concerned with the relationship between cost of goods sold and inventories. c) Return on shareholders' equity attempts to measure the adequacy of net income in relation to shareholders' investment. It is the percentage return earned on funds invested by owners. 2. Liquidity Analysis 20x2 Current Ratio Quick Ratio (Acid-Test Ratio) 258,300 75,000 = 3.44 (3,800 + 105,000 + 13,000) 75,000 = 1.62 20x1 266,000 98,000 = 2.71 (3,600 + 95,000 + 11,000) 98,000 = 1.12
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Solvency Analysis 20x2 Debt-to-Equity Ratio 335,300 263,000 = 1.27 20x1 353,000 255,000 = 1.38 (34,000 + 1,500) 1,500 = 23.67
Times Interest Earned (37,000 + 10,000 + 2,000 ) 2,000 = 24.5 Profitability Analysis 20x2 Return on Sales Return on Assets 20,200 600,000 = 3.4% 20,200 [(598,300 + 608,000) / 2] = 20,200 / 603,150 = 3.4% 20,200 [(263,000 + 255,000) / 2] = 20,200 / 259,000 = 7.8% 200,000 / 600,000 = 33.3%
20x1 18,200 500,000 = 3.6% n/a
Return on Equity
n/a
Gross Margin %
175,000 / 500,000 = 35%
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Activity Analysis 20x2 400,000 / [(134,000 + 154,000) / 2] = 400,000 / 144,000 = 2.8 times [(105,000 + 95,000) / 2] (600,000 365) = 100,000 / 1,643.84 = 60.83 days 600,000 [(598,300 + 608,000) / 2] = 600,000 / 603,150 = 0.99 times Purchases = $400,000 20,000 Increase in Inventory = $380,000 $380,000 / [(62,500 + 74,500) / 2] = 380,000 / 68,500 = 5.5 times 20x1 n/a
Inventory turnover
Days Sales in Accounts Receivable
n/a
Total asset turnover
n/a
Accounts Payable Turnover
n/a
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CMA Ontario Accelerated Program

FINANCIAL ACCOUNTING MODULE 1 Lesson Notes

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

Financial Statements and the Conceptual Framework

The Accounting Cycle

CMA Ontario - 2013

Financial Accounting Module 1

$450,000 620,000 50,000 20,000 10,800 1,150,800

CMA Ontario - 2013

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

The following two pages posts the above transactions to t-accounts.

CMA Ontario - 2013

Financial Accounting Module 1

3,600 4,500 4,800 5,700

CMA Ontario - 2013

Financial Accounting Module 1

(1) (5) (12)

Income Taxes 25,000 24,080 49,080

Bad debt expense 4,800

CMA Ontario - 2013

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

Local Stationery Ltd. Statement of Financial Position as at December 31, 20x6

ASSETS Noncurrent Land Building Equipment Accumulated depreciation

$ 60,000 260,000 100,000 -35,000 385,000

Current Cash Accounts Receivable (net) Inventory Prepaid insurance

24,600 92,300 145,000 5,100 267,000 $652,000

$250,000 193,020 443,020 120,000

35,000 1,300 27,680 10,000 15,000 88,980 $652,000

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

(f) (g) (h)

CMA Ontario - 2013

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

The Conceptual Framework

CMA Ontario - 2013

Financial Accounting Module 1

CMA Ontario - 2013

Financial Accounting Module 1

Financial Accounting Module 1

CMA Ontario - 2013