LoFisher-Intermediate Accounting, Volume 1, Fifth Edition,5e Kin Lo Solution Manual by Ace Test Banks

LoFisher-Intermediate Accounting, Volume 1, Fifth Edition,5e By Kin Lo

Email: Richard@qwconsultancy.com

Chapter 1 Fundamentals of Financial Accounting Theory I. Problems P1-1. Suggested solution: People need to make decisions under uncertainty, which creates the demand for information to reduce that uncertainty, allowing them to make better decisions. However, if everyone had access to the same information at the same time, no one would be able to supply any information useful to anyone else (since they already have it). Thus, an asymmetric distribution of information is necessary for the supply of information from those who have relatively more of it to those who have relatively less. P1-2. Suggested solution: An IPO is a sale of a part of the entrepreneur’s company to other investors. Inherently, there is uncertainty about the future success of this company and the value of the company’s shares in the future. Potential investors demand information to reduce this uncertainty. If the entrepreneur is able to supply information that reduces the potential investor’s perceptions of uncertainty, she is likely to be able to obtain a higher stock price in the IPO. The entrepreneur has intimate knowledge of her company’s operations, which is likely to be far superior to the information available to potential buyers of the IPO shares—there is information asymmetry between the entrepreneur and potential investors. P1-3. Suggested solution: A borrowing/lending transaction involves an advance of funds from the bank to the company in exchange for promises of future repayment from the company to the bank. There is, of course, uncertainty regarding the ability of the company to repay the bank in the future. The corporation’s management has better information about the company’s prospects in comparison to bank staff. To reduce this information asymmetry, the bank demands information such as audited financial statements. The corporation is willing to supply this information in order to obtain the most favourable borrowing terms (e.g., a low interest rate).

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P1-4. Suggested solution: Hidden action or information? Information about past, present, or future? Associated with the market for “lemons” or insurance deductibles? Mitigation of information asymmetry involves risk sharing or full disclosure? Most closely associated with investment decisions or compliance with contractual terms? Creates demand for provision of relevant or reliable information?

Adverse selection Hidden information Past and present Market for lemons

Moral hazard Hidden action Future Insurance deductibles

Full disclosure

Risk sharing

Investment decisions

Compliance with contractual terms

Relevant information

Reliable information

P1-5. Suggested solution: The managers within companies have an information advantage over outside investors. This adverse selection causes investors to be sceptical of investing in the company, unless management provides information to alleviate that scepticism. If management withholds information, investors will rationally price the company as a “lemon.” To avoid this negative outcome, management’s best response is to voluntarily provide information to investors. P1-6. Suggested solution: Signalling must be costly to be credible because a costless signal can be sent by anyone. A signal that can be sent by anyone has no value because such “cheap talk” does not help differentiate one party from another. Thus, the signal should not believed—it is not credible. Since signalling must be costly to be credible, a company that can credibly communicate information through other more cost-effective means would avoid costly signalling. Therefore, if there are no other cost-effective means to communicate a particular type of information, the company could choose to use costly signalling. For example, to credibly indicate management’s belief in the sustainability of the company’s cash flows, the company can commit to a higher level of dividend payments to shareholders. P1-7. Suggested solution: The separation of ownership and management creates a moral hazard by allowing management to take responsibility for the resources of shareholders, and the shareholders cannot monitor management. Shareholders would like to see high returns on their investment, but this can only be expected if management works hard to create value. Managers incur the cost of hard work, but they do not obtain the benefits of that hard work in the absence of incentive pay. Accounting information helps to alleviate this moral hazard in two ways. Accounting reports provide measures of performance that shareholders can use to evaluate/monitor management. Second, the accounting performance measures can be used as a basis for rewarding management. Incentive pay linking management compensation to value creation helps to align the interests of management with those of shareholders. . 1-2

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P1-8. Suggested solution: Moral hazard arises in a lending context because the bank loses control of funds that it advances to the borrowing enterprise. The bank is justifiably worried that the borrower will misspend the funds and not repay the loan and interest. This scepticism causes banks to be reluctant in lending and to charge high interest rates to cover potential losses from unpaid loans. Accounting information can be valuable in alleviating this moral hazard by allowing the bank to monitor the performance of the borrower using the accounting reports (e.g., is the company profitable, how much assets does it have, how much cash flow is it generating?). Part of the monitoring is in the form of covenants that require the company to comply with various financial ratios computed using accounting reports. By alleviating the extent of moral hazard, accounting information allow banks to be less sceptical of borrowers and thereby lower the interest rates that they charge and increase their lending activity. P1-9. Suggested solution: An agency problem (moral hazard) arises when shareholders hire a manager to run the business for them, as the shareholders cannot directly observe management’s actions in administering the resources entrusted to him. Some would suggest that the shareholders’ motivation for investing is solely to maximize their returns while the employee’s (management) motivation for working is to do as little as possible to earn the agreed upon salary. While this is likely an extreme case it remains that shareholders are normally interested in earning high returns whereas the manager may be reluctant to work hard to create those returns unless there is an incentive to do so. There are various ways to mitigate this problem, including:  Linking the manager’s pay to value creation by paying a bonus for achieving stipulated financial targets such as net income, return on equity, and sales growth.  Granting the manager a partial ownership interest in the company through direct shareholdings or a stock option plan so as to align the manager’s interests with that of the owners.  Using accounting reports to monitor the company’s performance as a proxy (indirect measure) of the manager’s performance. P1-10. Suggested solution: This is a case of adverse selection, because the information is not affected by the actions of the person who has the information—we cannot change time. There is only hidden information, not hidden actions. (Using a fake or borrowed piece of identification is fraudulent and the insurance would be voided.) P1-11. Suggested solution: All three situations are most likely cases of moral hazard as they involve hidden actions, rather than hidden information. An outcome of moral hazard is that parties may take on risks because the negative consequences of those risks will be borne by someone else.

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In situation (a) the mortgage company earns the commission for making the loan, but it is the investors who purchase the pool of mortgages that lose money when the unqualified borrowers default. The hidden action is not verifying the applicants’ income. In situation (b) your friend enjoys his consumer purchases while knowing that he will not have to repay the additional debt when he seeks bankruptcy protection. The hidden action is not telling the credit card companies that he intends to file for bankruptcy at the end of the month. In situation (c) you have little incentive to protect your home as the insurance company bears the risk for loss or damage. The hidden action is not using your alarm system. P1-12. Suggested solution: Adverse selection involves the lack of symmetric information prior to when the contract is signed—hidden information. Moral hazard includes one of the parties deviating from the expected behaviour after the agreement has been made—hidden actions. Situation (a) is an example of adverse selection. You have extensive writing experience, know what the recent and impending changes to the standards are, and thus have an information advantage over CPA Canada as to how long it will take you to complete the project. This permits you to negotiate a higher fee than might otherwise be warranted, by suggesting to CPA Canada that the project will take longer than you envisage during your contract negotiations (hidden information). Situation (b) is potentially an example of moral hazard. You can bill CPA for hours not actually worked. CPA has no way of monitoring your actual hours (hidden actions). Situation (c) is an example of adverse selection. You have an information advantage over that of the new investors, e.g. the undisclosed future costs of repairing the environmental damage (hidden information). P1-13. Suggested solution: Adverse selection involves the lack of symmetric information prior to when the contract is signed—hidden information. Moral hazard includes one of the parties deviating from the expected behaviour after the agreement has been made—hidden actions. Situation (a) is an example of moral hazard. You are not doing the job that you were hired to do to the best of your ability, as you know the cost of your decision (foregone sales and profit for the store) will be borne by the owner of the store, rather than you (hidden actions). Situation (b) is an example of adverse selection. On average, Toronto uses more than twenty times the salt than Vancouver does to de-ice its roads each winter. Road salt is notoriously bad for cars as it can cause rust and salt corrosion in hidden areas like the undercarriage, which reduces the market value of the vehicle (hidden information). Situation (c) is an example of adverse selection. You have an information advantage over the bank, specifically inflated sales figures (hidden information). . 1-4

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P1-14. Suggested solution: Version A of the game involves only uncertainty; the information is symmetrically distributed among all three participants in the game. While there is a demand for information about the value of the drawn card, there is no information for anyone to supply to anyone else. In this scenario (and assuming “risk neutrality”), the rational bids start at $1 and go no higher than $5.50, the latter being the expected value of the card. Bids higher than $5.50 will lose money on average. While the lowest bid of $1 provides you with the most profit, competition from Julia forces you to successively increase your bid, so we expect the equilibrium final bid to be $5.50. Version B of the game involves both uncertainty and information asymmetry. Scott has more information than you and Julia, so he can supply you with information if it is in his best interest to do so. In this game, your best strategy is to bid $1 and to make higher bids only if Scott provides information that indicates the card has a higher value. Since Scott’s income depends on how much you and Julia bid, and his cost equals the value of the card, it is in his interest to provide as much information as possible so that the bids are as high as possible. (Scott’s disclosures about the card must be truthful because they can be verified against the card at the end of the game.) For example, if the card is a seven of hearts, Scott can say any of the following: “the card has hearts,” which is true but not useful; “the card is higher than three,” which is true; “the card is at least six,” which is also true. Since you and Julia increase your bids according to the information that Scott provides, ultimately he is forced to say something that reveals the card’s value of seven. This is the full-disclosure outcome in adverse selection. There is no moral hazard because there is nothing that Scott can do to change the value of the card that was drawn. P1-15. Suggested solution: * * * * *

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This scenario is an example of an agency relationship that gives rise to moral hazard. The taxi driver is an agent of the taxi company. The driver has an information advantage over you (the passengers/visitors) regarding the geography of the city. The driver also has an information advantage over the management and owners of the taxi company regarding the minute-to-minute operations of the taxi. The fare meter is a device to mitigate these two information asymmetries. It is an indirect monitoring device for the taxi company to track how the taxi driver is operating the taxi. It also provides incentives for the driver to take passengers using an efficient route. (Note that the fare increases for both distance travelled and time, so there is more reward when the taxi is moving rather than idling, and more reward when it moves faster.) An assumption we take for granted, but which is nonetheless important, is that the driver’s pay is directly linked to the taxi fare. The meter does not eliminate moral hazard problems. It is only an indirect monitor of driver behaviour and tracks a limited number of items. If the driver is unfriendly or drives recklessly, the meter would not capture that information. The metered fare also does not preclude a driver taking a circuitous route to increase the distance travelled and thus increasing the fare. Many cities require taxi cabs to post

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estimated fares from the airport to popular destinations such as downtown so that taxi drivers do not take advantage of visitors who are not familiar with the city’s geography. Providing a gratuity at the end of the trip is a separate practice that helps to mitigate the moral hazard problem: the passengers serve as the monitors of the driver’s behaviour. For the meter system to be useful, the taxi company and passengers must be confident of its reliability. A meter that can be easily tampered with by the driver will provide misleading information to these users.

P1-16. Suggested solution: a.

This scenario is an example of an agency relationship that gives rise to both moral hazard and adverse selection. i) Uber has an information advantage over riders in that it knows the current supply of drivers and demand of riders—the determinates of surge pricing—whereas riders do not. (Adverse selection) ii) Uber may also have an information advantage over riders, particularly out-of-town visitors, about the time it normally takes drivers to make requested trips at a given day and time. (Adverse selection). iii) Drivers have an information advantage over Uber’s management about why they deviate from recommended routes. (Moral hazard). iv) Drivers have an information advantage over Uber’s management regarding other details of the trip, including how safely they are driving, the level of service provided the clients, and how cordial they are to riders. (Moral hazard).

Uber charges a flat rate for the trip as it knows that many of its customers prefer to know in advance how much the trip will cost them. This gives Uber a competitive advantage over the traditional taxi fare, which is unknown until arrival at the destination. Uber has amassed considerable data on how long a given trip will normally take at a given time on a particular day and can access GPS information on the length of the trip. Thus, the company is usually able to reliably estimate the amount that will be paid to the driver. The company then adds its desired profit margin to the driver’s cost to determine the flat fee quoted to the customer. The company remunerates drivers based on the actual time and distance driven as it promotes safer driving habits than does a flat rate. For example, if drivers are paid a flat fee for a given trip, they are more likely to speed and engage in other unsafe driving habits to shorten the trip’s duration, whereas safer driving enhances the marketplace’s image of Uber and ultimately leads to increased ridership. Moreover, Uber understands that contractors prefer variable compensation as it is more directly linked to driver performance.

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Drivers are agents of Uber. Driver remuneration increases for both distance travelled and time taken, so there is an incentive for drivers to engage in opportunistic behaviour (moral hazard) by taking unnecessary detours and/or adjusting the speed of travel. The Uber app device mitigates moral hazard to some degree. It indirectly monitors the driver’s actual route compared to that suggested by GPS. The app does not eliminate moral hazard problems, though, as it only tracks a limited number of items and does not identify the reason why the driver deviated from the suggested route, e.g. avoiding a traffic jam caused by an accident. Moreover, if the driver is unfriendly or drives recklessly, the app does not capture that information. Passenger feedback via the five-star rating system is another device used by Uber to mitigate moral hazard. This widely used mechanism allows Uber to indirectly monitor drivers’ performance as seen through the passengers’ eyes. Uber’s “charge fixed and pay variable” pricing strategy is effective for the most part given the use of the app and rating system to mitigate moral hazard. Drivers, however, continually trade off their desire to take non-optimal routes to increase their payoff with the penalty of opportunistic behaviour, e.g. sanctions by Uber including deactivation. When surge pricing is in effect, Uber’s strategy is less effective as the relative trade-off tips toward cheating, given the incentive for the drivers to engage in opportunistic behaviour increases while the penalty is unchanged. It should not be surprising then, that empirical studies such as that by Liu et al 1, found that Uber drivers tend to detour more during periods of high surge pricing. P1-17 Suggested solution:       

First note that, without genetic tests, individuals and insurance providers have the same (lack of) information. Insurers are willing to provide coverage to individuals because they can spread the risk over many individuals. They only need to be right on average for the insurance premiums they collect to be sufficient to cover the medical costs when they arise. This is a case of adverse selection (not moral hazard) because genetics cannot be changed; it is just a matter of individuals having an information advantage over the insurance companies. With the advance in genetic testing, individuals will have a better understanding of which medical conditions they are more likely to experience. Under GINA, insurance providers will suspect that individuals will have genetic tests results that are not accessible to the insurance company. Individuals who know that they have a genetic pre-disposition to certain ailments will seek insurance for those conditions, and the insurance company cannot prevent them from doing so under GINA. Other people who do not have these genetic pre-dispositions will find less benefit to obtaining this insurance.

Liu, Meng, Erik Brynjolfsson, and Jason Dowlatabadi, “Do Digital Platforms Reduce Moral Hazard? The Case of Uber and Taxis” (May 19, 2020). Available at https://ssrn.com/abstract=3239763 or http://dx.doi.org/10.2139/ssrn.3239763, accessed August 4, 2020. . 1-7

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Thus, the expected cost of insurance will increase. To cover that increased cost, insurance companies will need to raise insurance premiums. The increased premiums will further reduce the pool of people who will find the insurance beneficial. Hence, the reference to adverse selection spiralling out of control. These premiums will possibly be too high for anyone to afford; people may be better off paying for the cost of treatment when the need arises. Ultimately, insurance companies will need to be rationally sceptical of people seeking insurance, and assume the worse (i.e., assume that they are “lemons”). Now, because insurance companies are not able to pool high and low risk individuals, they could find it unprofitable to insure some medical conditions altogether (i.e., those that are hereditary/genetic) because such a high fraction of the insured will need expensive medical treatment. Given a choice of providing insurance that is unprofitable or not providing that insurance at all, these companies will ultimately decide not to insure certain medical condition. This is what is meant by these conditions being “uninsurable”—people might want to get the insurance, but they can’t buy such insurance.

P1-18. Suggested solution:            

There is a lot of uncertainty regarding the costs and benefits of operating these rental units. The length of time (60 years) is a tremendously long period for making predictions. The new technologies involved in the heating and plumbing adds to the uncertainty. Uncertainty increases risk, and the non-profit societies are averse to risk just like anyone else. The City should try to reduce this risk by some sort of risk-sharing arrangement. Instead, it has made the problem worse by putting all of the risk on the non-profits (the nonprofits suffer the consequences of any losses). And at the same time, the City is not giving the non-profits any rewards for taking on the risk (since surpluses go to the City). The risk-reward trade-off makes no sense. This is a moral hazard problem where the City is the principal and the non-profit operators are the agents. To reduce the moral hazard problem, the City should try to create incentives that align the interests of the non-profits with those of the City. An arrangement in which the principal receives all the benefits, but the agent bears all the risks cannot induce desirable outcomes. The requirement to turn over all surpluses to the city will induce the housing operators to manage their financial reports to minimize any surplus reported. For example, they could take costs that are common to several of their buildings and allocate them into the Olympic village buildings.

P1-19. Suggested solution:    

The fundamental issue is whether equity financing (in addition to debt) is a good idea. The writer does not recognize the importance of moral hazard in his proposal. From the student’s perspective, equity financing reduces the rewards of hard work Conversely, the cost of not working hard is partly borne by investors. . 1-8

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The risks to the student are also reduced. Therefore, the incentives to make money are reduced. The effect is much like that of a tax on income. Debt imposes more risk on students, so students have more incentive to earn money. Equity contracts may lead to misreporting of income during the contract period. Students may engage in pay-deferral arrangements when they start working. Students will tend to self-select the type of financing. o Better students and those willing to work harder will choose the debt contract. o Other less able students will choose the equity contract. o Therefore, the cost of the equity contracts may be very high. Unlike corporations, if the investors do not like how the student is behaving (i.e., not earning money), they cannot fire the management. Again, investors will anticipate this, and demand a high rate of return from the student before investing. Will there be sufficient information available to price the human capital contracts? Equity contracts for different groups of students may offer different rates/returns. o For example, business and medical students vs. others, male/female, different universities o May lead to perception of bias if financial institutions charged different rates to different groups.

P1-20. Suggested solution: Fixed salary: * Does not motivate management; only if the manager’s actions can be observed would a salary be optimal. * Agency theory predicts that the manager will shirk their responsibilities because of selfinterest. * Shirking occurs because there is moral hazard: the owners cannot observe the manager. * Information will be more reliable, but the company would be worth a lot less. * There is a trade-off between reliable information and maximizing firm value. Stock options: * Manager still has incentive to bias information to try to affect stock price. * Option compensation has higher risk than bonuses because stock price is affected by factors outside the manager’s control and not reflective of his/her effort. * Manager needs to be paid more to compensate for the additional risk. * Could lead to more insider trading and more incentive to withhold information from shareholders. * Insider trading is costly to outside investors. P1-21. Suggested solution: * * *

The incentive plan is based on a measure of performance that is not consistent with shareholders’ goals. Shareholders are interested in the stock price and the amount of profit available to them. Incentive plans based on stock price or return on equity would be most appropriate from the shareholders’ perspective. . 1-9

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Changes in ROA and ROE are closely related if leverage remains stable. Using the definition of operating profit margin and ROA, we can infer that turnover = sales / total assets = ROA / op. profit margin = 4.4% / 5.5% = 0.8 (in 2023) vs. 1.23 (2022) and 1.25 (2021). ROA has further declined in 2023 even though profit margin has increased because turnover has declined. The incentive plan prompted management to maximize profit margin while sacrificing turnover. The lower turnover is partly explained by the rise in A/R by roughly half as a proportion of sales. Possibly looser credit policies have been put in place to increase sales without lowering prices. The theory of efficient security markets suggests that QAF’s stock price reflects valuedestroying behaviour. If this were a manufacturer, absorption costing and overproduction could increase profits and reduce inventory turnover. Macroeconomic factors could also be affecting ROA and the stock price.

P1-22. Suggested solution: * * * * * * * * * *

The provision of both auditing and non-audit services creates a conflict of interest for accounting firms. Auditors need to be independent and objective in evaluating companies’ financial statements, but consultants are interested in helping companies become successful. Auditors may compromise their independence to maintain/attract profitable consulting business. Without an independent audit to verify numbers, a firm’s financial statements become unreliable. Investors will become skeptical of reported results, increasing adverse selection. Skeptical investors will pay less for firms’ securities (equity or debt), thereby increasing the cost of capital. The regulation requiring fee disclosure could solve the adverse selection problem: investors will be able to infer from fees paid to what extent audit independence may have been compromised (more non-audit fees = higher risk). As a result, companies that report more non-audit fees will be viewed as “lemons” as it will be difficult to convince investors otherwise, and their cost of capital will rise. Companies will therefore voluntarily reduce the use of accounting firms for non-audit services to lower their cost of capital. Thus, the disclosure regulation could be viewed to be in the public’s best interest. Additional regulation requiring the separation of audit and non-audit divisions would be unnecessary.

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P1-23. Suggested solution: If securities markets are efficient in the semi-strong form, then security prices properly reflect all information that is publicly known about the securities. In such markets, accounting reports are still useful as long they contain information that is not already publicly available. For example, management has private information about the profitability of the company that is not available to the public. The announcement of annual or quarterly earnings by management can provide a significant amount of new information to the securities markets. P1-24. Suggested solution: * * * * * *

The theory of efficient security markets (EMH) applies to commodities as much as to stocks. Investors cannot make superior returns consistently if the markets are efficient. It is probably more difficult to “spot the home-run play” in the commodities market— there are many more buyers and sellers for each commodity (only 20 commodities) than in the stock market. Basic economics tells us that commodity markets, having many buyers and sellers, are nearly perfect. There could be more risk in commodities, explaining the higher returns. Systematic risk could be higher—many commodity prices move together because of weather and the economic cycle. If the brochure provides inside information, you could make superior profits. However, this brochure is widely circulated, and if many others have already bought into this system there is unlikely to be any inside information left.

P1-25. Suggested solution: In response to the friend studying liberal arts: * Opening price reflects expectations before the earnings announcement. * Those expectations incorporate more information than just the previous earnings report. * Non-accounting information led investors to expect earnings to be higher than what was reported. * It is unlikely that MLF’s price is inefficient because its shares are traded so heavily. * The restructuring charges included in the announcement could signal bad news about future operations. * The presence of restructuring charges could also lead to more suspicion about the reliability of earnings before restructuring charges, decreasing confidence in the company. In response to the friend studying finance: * Movement in stock price after the announcement shows that accounting information is useful. If accounting information were not useful, why did the stock price change so much? * Direction of the price change depends on whether the announcement was good news or bad news relative to expectations, not past accounting numbers. . 1-11

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It is also possible that there had been other news releases on that day affecting the price.

P1-26. Suggested solution: a. If you believe in the efficiency of securities markets, then you should predict the following:  The stock price for these two companies should be the same. It does not matter whether the intangible assets are revalued or not.  The theory of efficient markets suggests that all publicly available information is reflected in stock price.  The reporting of intangible assets does not affect future cash flows / future prospects of the companies. Therefore, the future cash flows and risks of the two firms are exactly the same.  Investors are sophisticated enough to “see through” accounting numbers. Investors should be able to undo these different accounting policies. Thus whether the intangible assets are revalued does not make a difference to firm value.  If revaluation provides information not known to investors, it could cause stock price to increase or decrease, depending on whether the reported value is higher or lower than investors’ expectations. b. The concepts of information asymmetry, earnings management, relevance, and faithful representation are applicable to this context as follows:  Insiders have better information about the value of intangibles, which are difficult to value.  The current value of intangible assets could be useful information that would be otherwise unavailable to investors.  The additional information could alleviate uncertainty regarding future cash flows, reducing investors’ perception of risk surrounding the company’s operations. The reduced risk could potentially increase stock price.  Whether the information is useful depends on management’s motivations for providing the information.  If management prepares the figures unbiasedly to aid investors’ decisions, the numbers would provide relevant information.  However, management could bias the information to achieve its own objectives. Since the value of intangible assets is subjective, there is considerable room for manipulation.  The subjectivity and bias in the reported values of intangibles make the information an unfaithful representation of their underlying value.

J. Mini-Cases Case 1: The Aftermath of Enron’s Collapse. Suggested solution: * * *

The Enron scandal has increased investor skepticism of companies’ financial reports. Increased skepticism exacerbates the adverse selection problem as investors suspect that companies’ insiders are withholding bad news. In order to convince investors that they are not withholding information, companies have to disclose even more than before.

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Large companies that attract public attention and political cost (e.g., government regulation and taxes) are particularly susceptible to this problem. The root of Enron’s problem appears to be inappropriate assumptions about the boundaries of the economic entity. Related partnerships held some of Enron’s assets and liabilities but were not consolidated into Enron’s economic entity. The off-balance-sheet financing lowered investors’ perception of the company’s risk. The article claims that it may have been possible for sophisticated investors to identify Enron’s tricks by reading the financial statement footnotes; if so, then the market was not efficient with respect to Enron’s securities. Some analysts had some doubts, but most did not; the consensus was that there weren’t any severe problems. Many analysts have conflicts of interest: to provide accurate forecasts and to generate brokerage business. Reliance on analysts’ “buy” recommendations led many naïve investors to buy the stock. On the other hand, it is likely that not enough about these partnerships was revealed to investors, especially if there are so many of them (“thousands” of partnerships). New accounting standards may be required to prevent such off-balance-sheet financing transactions. The auditors gave clean opinions on Enron’s F/S; did Enron’s accounting comply with GAAP? If so, the auditors are not at fault and new standards are required. Even if GAAP permits the off-balance-sheet treatment of the partnership debts, Enron could have chosen to include them in the financial statements. Management made the decision not to do so; so, ultimately, the blame must be placed on management for choosing such aggressive accounting policies that misled so many investors. It is possible that Enron fraudulently concealed the information from the auditors, in which case it would be difficult to lay blame on Andersen. It is also possible that Andersen compromised its independence by allowing the partnership debts to be left off the balance sheet. Disclosure of fees for audit and non-audit services would allow investors to make up their own minds as to whether the auditors might have a conflict or interest and whether to invest. Investors and analysts need to be skeptical about “murky” disclosure. If the information is so convoluted as to be not understandable, then readers should assume the worst about the company and not buy its securities.

Case 2: The Superstar Who Wears Two Hats. Suggested solution: * * * * *

There is information asymmetry; in particular, Grubman has access to inside information. Inside information may be used to Grubman’s benefit or sold to investors. There is a clear conflict of interest. “Ethical wall procedures” or “Chinese walls” are supposed to prevent use of inside information in stock recommendations, but how do you put a wall inside someone’s head? Thus, the company’s policy is not effective. This is a form of moral hazard—no one can see what Grubman is doing inside his head. . 1-13

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Grubman’s recommendations are likely influenced by his knowledge of impending mergers and acquisitions (M&As). Investors know that Grubman is using insider information and so will want to use his advice. This creates an unlevel playing field for stock analysts. If investors rely on Grubman, then he has the ability to move stock prices with his recommendations. A buy recommendation on a potential target would increase its stock price, making the deal more expensive for the acquirer. Grubman’s compensation is related to how well his employer (Salomon) does, so he has incentives to make a lot of investment-banking deals and to bring in brokerage customers. Grubman’s reports may be biased and less reliable because he needs to maintain good relations with investment-banking clients.

Case 3: In-Substance Defeasance of Long-Term Debt. Suggested solution: Overview This case illustrates many of the ideas in positive accounting theory. It shows the depth to which companies will go to manage earnings by exploiting the flexibility in accounting standards. It also shows that earnings management is not only limited to making accounting choices, but also by arranging real transactions and operations in such a way to as to obtain a particular accounting outcome. The case exposes students to the various parties potentially affected by the firm’s accounting and asks them to apply their judgment to arrive at their own conclusion. The solution to the last question in this case discusses the difficulties faced by standard setters, and the role of accounting research in those decisions. Specific questions a. Exxon was motivated by the gain that could be reported in income as a result of retiring the debt. b.

The gain could be reported on the income statement regardless of whether Exxon chose to directly retire the debt or use the in-substance defeasance structure. Exxon chose the more complex approach to avoid the immediate tax liability on the gain that would arise from directly retiring the debt. Legally, Exxon was still liable for the debt after the insubstance defeasance transaction, so the company had not disposed of the debt for tax purposes. The tax expense of $73 million is a non-cash expense recorded to match the gain reported in the income statement.

For the moment, we can set aside the tax issue discussed in part (b). If income tax were not an issue, then we could simply think of a debt retirement, whether direct or through in-substance defeasance. The debt retirement did not make financial sense. While a gain was recorded as a result of the retirement, no transaction was needed for Exxon to experience the gain economically. The gain on the transaction arose due to significant increases in interest rates (market yields), resulting in large drops in the value of the debt to levels far below . 1-14

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the book value of $515m, which was the amount realized when Exxon issued the bonds. (Recall from introductory economics that bond prices and yields move in opposite directions.) Exxon spent $312m on this transaction, so the value of bonds that Exxon retired would have had an even lower value. First, the company would have incurred significant transaction costs to hire investment bankers to set up the trust and buy the right mix of government bonds to obtain the desired cash flow pattern. For the sake of argument, assume that it is 2% of $312m, or about $6m, leaving $306m for the purchase of government bonds. Second, and more importantly, Exxon purchased U.S. federal government bonds, which are considered the safest bonds available. Since government bonds are safer than Exxon’s bonds, investors demand a lower yield and a higher price for government bonds. For concreteness, if we assume that the long-term debt had an average remaining maturity of 15 years and an average coupon rate of 6.25% (midpoint of 5.8% and 6.7%), then we can infer (using Excel solver) that the yield on the government debt purchased was 12.31%. Assuming a modest premium of 0.50% on Exxon debt, the yield on the bonds Exxon retired would have been 12.81%, double the coupon rate of 6.25%. At this yield, Exxon’s debt would have had a market value of $295m, which is $11m less than the value of the government bonds. To recap, the gain occurred because interest rates increased. Exxon did not have to do anything to earn this gain. Had the company not retired the debt, it would have funds financed at an interest rate of 6.25%, half the rate of any new financing with similar terms. For financial reporting, the gain would gradually show up in the income statement by way of lower interest expense. Put another way, by realizing the gain through the debt retirement, the company reports the gain in that year, but will record higher interest expense in future years due to the higher financing cost. Indeed, the company had plans to issue more debt in 1996. d.

The clear winners in the in-substance defeasance were the investors in Exxon’s debt. Without incurring any cost themselves, their investments were effectively converted from risky corporate bonds to relatively risk-free government bonds, because the payments on the Exxon bonds were now derived from the government bonds. Management probably also gained because the company was able to report higher income, potentially increasing compensation linked to reported income. The losers were Exxon’s shareholders. As the residual owners of the company, they incurred costs in the neighbourhood of $6m + $11m = $17m for no economic benefit. The U.S. government was also a loser because, had the retirement been direct rather than through an in-substance defeasance, Exxon would have paid $73m in extra taxes.

The share price should not increase because the transaction did not create shareholder value. The price could decrease slightly due to the costs incurred in the transaction, although these costs were modest relative to the scale of Exxon’s operations. The price could decrease significantly if shareholders interpret this transaction as a signal that Exxon management is unable to find real value-creating projects and had to resort to this type of earnings management to boost profits.

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Open to student interpretation. If there were no specific accounting standard to the contrary, Exxon’s treatment of the gain on the in-substance defeasance would likely pass scrutiny by the auditors. The end result of the series of transactions is economically the same as a direct repurchase or redemption of the bonds. If a gain would be recorded in the direct transaction, then to reflect economic substance there is a strong case that the insubstance defeasance should be treated the same way.

Without specific guidance on this issue, the application of general principles (particularly economic substance) would permit gain recognition in an in-substance defeasance. However, as discussed above, these transactions are purely cosmetic and do not improve the position of shareholders; indeed, the transactions are costly to shareholders. It would then make sense for accounting standard setters to deter this type of transaction by prohibiting the gain recognition. As it turns out, there was disagreement at the U.S. Financial Accounting Standards Board (FASB). Board staff had recommended allowing firms to recognize gains on in-substance defeasance transactions just as they can for direct repurchases and redemptions. However, the Board rejected staff’s recommendation and prohibited gain recognition on in-substance defeasances. Statement of Financial Accounting Standard No. 125 (FAS 125), issued in June 1996, paragraph 16, indicates:

Case 4: Bremner Health Insurance Company. Suggested solution: a. The information asymmetry present in this case is adverse selection since the consumers have more medical information than BHIC. For BHIC to reduce the information asymmetry, it should require consumers to provide medical documents when buying their insurance coverage with the company. Since BHIC has stated that it will provide coverage regardless of the consumers’ medical state, the information will allow the company to make better decisions for the future financial state of the company. b. Efficient markets assume that all public information will be instantaneously impounded into stock price. In this case, BHIC released information that the market considered as bad news (i.e., earnings per share released were less than analysts’ forecasts), which would decrease share price instantaneously. Furthermore, the disclosure of significant expenses due to terminally ill patients would negatively affect analysts’ future forecasts because it would significantly decrease their confidence in BHICs’ future financial performance. c. If BHIC had released earnings of $1.46/share on its earnings announcement date, we would expect the price of the share to increase because of the good news contained in the earnings announcement.

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d. For publicly traded companies, meeting analysts’ forecasts is very important because it is one of the biggest factors affecting share price. The pressure to meet or beat analysts’ forecasts can compel management to engage in earnings management. Examples of earnings management include: being overly aggressive in revenue recognition, deferring expenses to another period, or not recognizing contingent liabilities. Analysts must be aware of management’s inclination of earnings management when analyzing the financial performance of the company.

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Chapter 2 Conceptual Frameworks for Financial Reporting K. Problems P2-1. Suggested solution: Three reasons for having a conceptual framework for accounting standards include the following: 1. The framework helps to organize the numerous concepts that financial statement preparers and users have found to be important. 2. The framework provides general guidance for standard setters when they deliberate new standards or changes to existing standards. 3. The framework helps financial statement preparers to choose among accounting alternatives when such alternatives exist. P2-2. Suggested solution: a. b. c. d. e.

Statement Conceptual frameworks for financial reporting are purely conceptual and do not relate to the practice of accounting. Conceptual frameworks for financial reporting are a list of concepts that are theoretically desirable. Conceptual frameworks for financial reporting can be understood through the economic lens of supply and demand. Conceptual frameworks for financial reporting describe the demands from financial statement users. The IFRS Conceptual Framework is a mathematical representation of the double-entry bookkeeping system.

True

False

√

√ √ √ √

P2-3. Suggested solution: a. b. c. d. e. f. g. h.

Concept User needs Measurement criteria Assumptions for the preparation of financial statements Objectives of financial reporting Definitions of the elements of financial statements Recognition criteria Constraints Desirable qualitative characteristics . 2-1

Demand

√

Supply

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P2-4. Suggested solution:

a. b. c. d. e. f. g. h.

Concept Understandability Going concern Relevance Benefits vs. costs Verifiability Representational faithfulness Comparability Financial capital maintenance

Qualitative characteristics

√

√ √ √ √

Assumption

Constraint

√ √

√

P2-5. Suggested solution:

a. b. c. d. e. f. g. h.

Concept Current cost Completeness Historical cost Revenue recognition Probable and measurable future flows of resources Neutrality Present value Realizable value

Representational faithfulness

Recognition

√ √ √ √

Measurement

√

√ √

P2-6. Suggested solution: a. b. c. d. e. f. g. h.

Concept Expense Capital maintenance Cost Liability Going concern Income Equity Asset

Element

√

√ √ √ √

Assumption

√

Constraint

√

P2-7. Suggested solution: An asset is a present economic resource, controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. . 2-2

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P2-8. Suggested solution: A liability is a present obligation of the entity to transfer an economic resource as a result of past events. An economic resource is a right that has the potential to produce economic benefits. P2-9. Suggested solution: * * *

Equity is defined as assets net of liabilities. It is not independently defined because the balance sheet and double-entry bookkeeping requires A = L + E. Income involves increases in equity (other than from capital transactions with owners). Since equity is defined in terms of assets and liabilities, income ultimately involves increases in assets or decreases in liabilities. Expenses involve decreases in equity (other than from capital transactions with owners). Since equity is defined in terms of assets and liabilities, expenses ultimately involve decreases in assets or increases in liabilities.

P2-10. Suggested solution: Reasons for the lack of general acceptance of the current cost accounting model include: Cost and benefits constraint: The cost to collect current cost information and to prepare current cost financial statements outweighs the likely benefits. Developing a system to produce current cost information for firms’ assets and liabilities on an ongoing basis is an expensive undertaking. Auditors will also need to develop methods to independently verify the current cost data, which also entails substantial costs. Understandability: Current cost arguably provides better information to users for decision making, in particular regarding the maintenance of physical capital. However, the complexity of the calculations and even the principle of current cost are difficult to understand, such that only the very sophisticated reader will be able to understand the financial statements. This lack of understanding could be so significant as to render the information useless, or at least significantly impair the benefits of having such information. Predictive value: Virtually all prediction models involve extrapolation from past patterns. Historical cost accounting reflects the past and is verifiable, providing a solid base for trend analysis. Articulation: Historical cost accounting produces internally consistent data that are articulated among the financial statements. Current cost accounting information is not necessarily articulated.

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P2-11. Suggested solution: a.

Considering the qualitative characteristics, investments in employees should not be recorded as assets for several reasons. First, the benefits of the training lack verifiability; different people will come up with vastly different estimates of the value of training. Second, the amount would lack representational faithfulness due to the incompleteness and biasedness of the figures. The amounts are likely to be incomplete because there are many different activities that could improve the value of employees and it is not practical to track these activities. Due to the lack of verifiability of the value of employees, the amounts are likely to be biased to serve management’s interests. Considering the elements of financial statement and the recognition, of those elements, there are several reasons for not recording assets for the investment in employees. First, the employees are not under the full control of the company since they can seek employment elsewhere, so they cannot be considered to be assets of the company. Second, since there are outflows of resources associated with employee training, those outflows should be reflected as expenses. Third, even if one argues that investments in employees are assets, they cannot be recognized on the financial statements—the future benefits associated with better trained employees may be probable, but those benefits are not measurable with a sufficient degree of accuracy.

P2-12. Suggested solution: It is true that financial statements are complicated by accounting methods, such as the method of accounting for deferred income taxes, financial instruments, and so on. However, some of these complexities cannot be avoided. The business environment and business transactions are themselves more complex. Since the financial statements try to reflect these business events, it is inevitable that the financial statements will be more complex. Thus, it is not accounting methods per se that make financial statements difficult to understand. Financial statements are not directed at the average person, so they cannot be criticized on the grounds that they are beyond the comprehension of the “average person.” Instead, they are intended for users with a reasonable understanding of financial statements. The question then becomes: should additional explanations be provided for users who have a reasonable understanding of financial information? The answer depends on what type of information the “explanation” will contain. Usefulness of additional information Explanations could be of three types:  They could make information that is now in the financial statements easier to understand by explaining technical accounting terms and concepts used.  They could provide more detail on information that is already contained in the financial statements. For example, certain dollar amounts might be broken down in more detail, or the significance of certain amounts might be spelled out.  They could provide new information not now included in financial statements.

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Additional information for the latter two categories may relate to the past or future. Futureoriented information would obviously be of considerable interest to someone with, say, a cash flow prediction objective. The difficulty, obviously, is that such information is very subjective and could be subject to biases. Auditors would find it difficult to provide any assurance on such future-oriented information. It can be argued that additional information is already being provided in some financial statement packages (i.e., the remainder of the annual report outside of the financial statements). This information can include factual background relating to the year’s results, or it can include subjective projections of the company’s future. There is significant evidence in support of the idea that capital markets are informationally efficient, thereby lessening the need for information that merely clarifies the financial statements or accounting methods used. However, even in efficient markets there will be a role for information that is not currently presented in the financial statements, to the extent that such information is not available elsewhere. The obvious disadvantage is that information disclosed could also be useful to competitors or other interest groups, to the detriment of the reporting company. We should also consider whether providing more information would overload users and whether the incremental benefit is worth the incremental cost of the information. One of the additional costs is the potential delay in the reporting time. Preparers of additional information We should also consider the issue of who prepares this additional information and the implications for its quality. While management is knowledgeable about the company’s events, they can bias the information they provide, particularly with respect to subjective and forwardlooking information that is difficult for auditors to verify. Role of standards Having standards for this additional disclosure will help to promote comparability between companies. However, the risk of attempting to control the provision of additional information via standards is that information may be restricted to that which is historically based, factual, and objective, making it less relevant for purposes such as forecasting and performance evaluation. P2-13. Suggested solution: This question requires the demonstration of understanding of the interrelationships among the concepts of fair presentation, materiality, and users’ needs. The following points could be raised: Fair presentation: Fairness is an abstract concept and, therefore, is open to debate and interpretation. Although it would be impossible to develop a general rule that would apply to all circumstances, fairness has a particular connotation when considered in relation to financial statements. The determination of what constitutes fair presentation in a particular case requires the exercise of professional judgment. Auditors assess whether financial statements present fairly in relation to generally accepted accounting principles (IFRS, CPA Canada Handbook –

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Accounting, or other). Auditors also use judgment to evaluate the selection of accounting policies from among acceptable alternatives. Users of financial statements expect that recommended practices have been followed and that variations from accepted practice have been disclosed. However, auditors also have an obligation to go beyond determining technical compliance to accounting standards; they must ensure that any information required for fair presentation has been disclosed in the financial statements (completeness). It is essential that published financial statements do not lead users to conclusions that preparers and auditors know to be unlikely or incorrect (i.e., not true and fair). Auditors should use judgment not only in the evaluation of individual items, but also in their assessment of the combined effect of these items. Materiality: Materiality is based on the premise that financial statements should contain or disclose information that is relevant to users. An item is material if its omission or misstatement would influence users’ economic decisions. Quantifying materiality is a matter of professional judgment and depends on management and the auditor’s assessment of the firm’s operations, industry, reporting requirements, and most importantly, the users. Users: Financial statements are prepared for users. Accordingly, they should meet the needs of users and be understandable to them. However, there are challenges to defining the users and their needs: Who are the user groups? What kinds of information do they need? What other information do users have access to? How do users’ needs change over time?

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P2-14. Suggested solution:

  



Concepts, principles, and ideas supporting treatment as Asset. The training program has future benefits since employees would be able to operate new high-tech machinery. The training has already occurred. Management has the ability to direct employees to complete assigned tasks with the newly acquired skills, so this satisfies the criterion of control over future benefits. Therefore, all three criteria in the definition of an asset have been satisfied. The amount of $45 million is definitively quantifiable. The future amortization period is also quantifiable as the estimated average remaining service lives of the employees (similar to an estimate used for pension accounting; see Ch. 17). Amortization over future years better matches expenses to revenues that will be recognized in future years. Recognition as an asset provides relevant information to users to determine the potential productivity of employees. Doing so also encourages better management stewardship by investing in employee development. Expense treatment would lead to underinvestment since the expense will negatively affect current profits (and thus management compensation) while the benefits are realized in the future. Investment in employee development increases morale and commitment from employees, increasing productivity and retention.

  



 



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Concepts, principles, and ideas supporting treatment as Expense. The $45 million expenditure fails to meet the definition of an asset (see below). Public Company has no control over the employees since they are free to leave the company. Indeed, the additional training makes the employees more attractive to competitors and other employers, increasing the opportunities for the employees to leave. The 15 years of estimated average remaining service lives of the employees is not reliable given the increased outside opportunities of the employees. While the amount of the expenditure is known to be $45 million, the amount of future benefits is unknown and difficult to estimate. Without a reliable basis of measurement, this fails the recognition criterion. Given the uncertainty of the future benefits, prudence (conservatism) suggests that the costs should be expensed. Information about the program can be disclosed in the notes as this information is relevant to users of the financial statements for assessing management stewardship and the potential productivity of employees. The ability to invest a significant amount on employee development even though the costs must be expensed is a credible signal that Public Company is strong; this signal should help increase stock price and equity-based compensation for management.

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P2-15. Suggested solution: * * * * * * * * * * * *

Does knowledge have future economic benefits? Possibly. Due to past transactions? Yes. Do companies control employees? No, since slavery is not legally permitted. How can intellectual capital be measured? Are the measurements reliable? Estimated values are likely to be unverifiable. There will be severe problems with comparisons between companies. It will be difficult to come up with sensible amortization policies. How should the expenses be matched with future benefits? Provides opportunities for management manipulation (impairs reliability) and increases moral hazard problems. Information is relevant for predicting future cash flows if knowledge results in new products (revenue) or new processes (cost reduction). Information is not relevant because high intellectual capital may not reflect ability to generate future cash flows since employees can leave. Could lead to unintended reactions and behaviour from employees; e.g., “we’re valued less highly than another company’s employees.” Could also lead to high valuations for public and internal relations purposes, to show that the firm highly values employees.

P2-16. Suggested solution:            

Each acquisition on average is $11 million, so they are immaterial. However, materiality should be assessed on a class of transactions, so the acquisitions are material as a group. $8 billion is material relative to the market value of equity ($60b) and earnings ($5b). Materiality is defined with respect to users of the financial statements. The large negative stock price reaction is an indication that information on the acquisitions is material to investors. Information on how Tyco spends its money and what kinds of businesses it is buying is relevant to investors for predicting future cash flows. Summary disclosure of the net cash amount paid may be inadequate for investors; full disclosure of the nature of the acquisitions (e.g., line of business, price paid relative to book value) would be useful for predictions. Full disclosure may be very costly and impractical given the large number of acquisitions; management may have determined that the costs exceed the benefits of disclosure. Management may have selectively concealed information on acquisitions, disclosing information on those that may be viewed favourably and hiding the bad acquisitions. Such concealed information, if it exists, would bias the financial statements and make them unreliable. Unreliable financial statements increase the moral hazard problem by allowing management to cover up its mistakes. Market efficiency suggests that the WSJ article provided new information to investors—the information was not what they had expected.

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

The WSJ’s revelation could indicate to investors that Tyco has been hiding bad news (adverse selection); therefore, they are now more skeptical of Tyco (it is now considered a “lemon”).

P2-17. Suggested solution: * * *

* * * * *

Relevance is the ability to influence users’ economic decisions whereas representational faithfulness is the extent to which the financial information reflects the underlying transactions, resources, and claims of an enterprise. Accountants often need to make trade-offs between relevance and representational faithfulness. A transaction that is measured with greater certainty is representationally more faithful, but that greater certainty may require a delay in the recognition of that transaction, which would reduce its ability to influence decisions (i.e., relevance) because the decision may already have been made by that time. Conversely, recognizing and measuring transactions earlier provides more relevant information, but that information can be representationally less faithful because it is less complete and more likely to contain errors. For example, earlier recognition of a contingent liability for a lawsuit can be more relevant to users, but there is a higher probability and magnitude of error in management’s prediction of the lawsuit’s outcome. A more commonly encountered example is the accrual for bad debts. The accrual provides more relevant information, but the predictions can differ significantly from the actual amount of bad debts, which is only known later when the debtor is unable to pay. The related concepts of timeliness, completeness, and freedom from error are evident in the above discussion. During its 2018 revision, the Board decided that explicitly acknowledging the trade-off between relevance and reliability may help to explain why, in certain cases, that a highly uncertain measurement may still provide useful information to the readers, for example, when a highly uncertain estimate is the only relevant material available.

P2-18. Suggested solution: Pros: * The alternative income number Amazon is using could be more relevant for predicting future cash flows by removing items that are not recurring; e.g., restructuring charges. * Amazon provides full disclosure of the accounting policies that have been used to come up with the alternative income numbers. * Given the full disclosure, sophisticated readers can interpret these numbers and undo Amazon’s policies if they wish. * Information is provided in addition to GAAP income, so at least the GAAP number is reliable as it is audited. * The accounting method is popular in the high-tech industry so the information is comparable to those of similar firms.

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Cons: * The alternative numbers are less reliable because management has discretion over how “pro forma operating profit” and “pro forma net profit” are defined. * The alternative numbers are biased because they “inevitably make the numbers look a lot better”—only expenses and losses (and not gains) are being excluded. * Lower reliability increases moral hazard; management can present good results even if things don’t turn out to be so good. * Measuring income excluding certain costs provides management with the incentive to classify costs into those categories. * The income numbers could mislead naïve investors who interpret them as if they are GAAP income numbers. * Could also mislead investors if there is inadequate disclosure of how the non-GAAP income number is derived. * Comparability of non-GAAP numbers is lower because different firms could define their income measures differently. * Consistency is also lower because Amazon can change the income definitions from year to year. The non-GAAP numbers are not based on standards and are not auditable, lowering their quality (reliability, comparability, consistency). P2-19. Suggested solution: Graduates: * They have a tendency to favour the school they attended. * This increases the prestige of their degree, which is better for their careers. * They will be biased. * BUT, all graduates face the same incentives, so they are all biased. * If bias is constant, it does not affect the results. * However, responses from some schools may be more biased than others (e.g., if a school lobbies its students to answer the survey positively). * Students at schools with a stronger emphasis on ethics may answer the surveys with less bias, and such schools would be unjustifiably harmed in the rankings. Recruiters: * Not as much incentive to be biased toward a particular school. * Could be biased toward the schools from which they graduated (MBA or other degree). * Could be biased in favour of the schools from which they hire the most in order to justify their past hiring decisions. (This is related to an effect called confirmation bias in psychology.) * Again, the bias incentive affects everyone. * Recruiters can only rank schools they recruit from; many smaller schools would be ranked lowly by this exclusion. * Geography affects where firms recruit. Only very large global firms would recruit from a diverse range of locations.

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* *

Schools with long histories and large programs (e.g., Harvard, with 900 full-time MBAs per year) will have more grads who are recruiters, so there may be more bias toward these schools. Past reputation of schools can bias recruiters’ rankings.

General comments: * Consistent rankings year to year suggests that the rankings are reliable—not just noise. * Large swings in rankings could reflect events causing extreme bias in a particular school that year (e.g., deliberate efforts to have students bias their surveys). * Response rates are fairly high for surveys. * Samples are large enough so that errors cancel out. P2-20. Suggested solution: * * * * * * * *

* * *

The value of an audit derives from the credibility (representation faithfulness) added to the financial reports. That credibility relies on the independence of those doing the audit from those being audited. Reduced independence will jeopardize the representational faithfulness of financial reports. The reduction in independence does not even have to be real; if users of financial reports perceive the auditors to lack independence, then they will think twice about trusting the audit report and financial statements. The growth in the consulting side of the Big Four firms could lead to a reduction in independence if their audit clients are also their consulting clients. That is, trying to earn high consulting fees could lead the firms to make audit judgements in favour of companies’ management who hired them. In other words, the dual relationship creates a conflict of interest, a type of moral hazard, because users of audit reports cannot observe how the auditors conduct the audit. However, the article excerpts do not indicate whether and to what extent the firms provide audit and consulting services to the same clients; if the audit is for Company A but the consulting is for Company B, then we should not expect an impairment of independence. On the other hand, if and when the firms are dominated by their consulting side, as was projected to happen at Deloitte by 2017, then the firms’ overall culture can be affected. Dominance of consulting can lead to an attitude/culture that is too entrepreneurial where growth in revenue and the number clients is more important than providing a quality audit. The demise of audit firm Arthur Andersen in the early 2000s was partly attributed to the growth in the firm’s consulting arm and the effects that had on its culture and independence.

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P2-21. Suggested solution: * * * * * * * * *

In the age of the Internet, there is high demand for up-to-date information. Policy makers, businesses, consumers, and unions are some of the potential users of this information. This information is more timely than official statistics, making it more useful and increasing its ability to influence decision. However, the information is based on incomplete data. The index assumes that items tracked (those sold on the Internet) are representative of aggregate consumer purchases. The index lacks neutrality because the non-representative sample could lead to biases in the price index, although the bias may not be intentional as in the case earnings management in financial reporting. Certain items are bought and sold more frequently on the Internet than other. For example, electronics and computers are often sold online, and it is widely known that the prices of these products decline rapidly with technological advances. This decline is not representative of most other products. Biased information could lead users to make wrong decisions.

P2-22. Suggested solution: Since the R-word index provides an alternative to Gross Domestic Product (GDP) as a gauge of economic activity, it is useful to evaluate the merits of the R-word index relative to GDP. In this light, the R-word index has both good and bad attributes: * This index is more valuable or useful because it is more timely than official GDP figures. * The R-word index aggregates information from only two sources (Financial Times and Wall Street Journal), so it is incomplete--the index may not reflect broader sentiments about the economy. * On the other hand, there are many different writers who contribute to these newspapers, so the index is actually aggregating information from many different sources. * In general, information that is aggregated over many different people/sources is more accurate. (This is the foundation of the theory of efficient securities markets.) * Aggregation helps because it pools common beliefs while minimizing the effect of idiosyncratic beliefs held by some individuals. * Counting “recession” can be a problem in terms of representational faithfulness: both affirmative and negative uses of the term (“we are going into a recession” or “we will not go into a recession”) are counted the same way. * Likewise, an article may discuss historical instances of recession, or recession in a small foreign country, both of which have little bearing on recession in the U.S. (the focus of the article and the R-word index). * In terms of macroeconomics, the immediate availability of the index on a continuous basis has a significant drawback: publication and use of the index may lead to a selffulfilling prophecy. * If some writers become pessimistic about the economy and so use “recession” more frequently, the R-word index will increase immediately, and people who see an increase in this index will become more worried about the economy and spend less, causing a . 2-12

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* *

decrease in economic activity, which then affects other people writing about the economy. It may only take a few writers to start this vicious cycle. To avoid this cycle, it may be better to not have this index continuously calculated, but released only periodically and with some delay just like the publication of GDP figures.

P2-23. Suggested solution: Similarities: * Both the IFRS Conceptual Framework and a constitution set the foundation for more specific standards / laws. That is, the specific standards and laws are built on the general principles by the Framework or constitution. * Neither the IFRS Conceptual Framework nor a constitution provides standards / laws that have sufficient detail to define specific practices. * Specific laws that are inconsistent with a constitution can be ruled to be illegal (unconstitutional) by a court of law, and citizens governed by the laws can go against a law that is unconstitutional. Likewise, IFRS (in IAS 1 paragraph 19) permits an enterprise to depart from a specific accounting standard if following that standard would conflict with the objective set out in the IFRS Conceptual Framework, that objective being the provision of information useful to investors, lenders, and other creditors. P2-24. Suggested solution: a. The historical cost model will result in the most representationally faithful balance sheet because the cost paid is neutral as it is not subjective. The cost of the land is also verifiable. Different parties looking at the documentation supporting the purchase price should all agree on the cost of the land. The fair value of the land is subjective though and involves estimates. Different parties are likely to use differing assumptions to determine the value of the land and such will end up with different estimates of the asset’s value. b. The revaluation (fair value) model will result in the most relevant balance sheet as the fair value of the land is more likely to influence users’ economic decisions. For example, if LKC need to raise cash, it is more interested in how much it could sell it for today, rather than how much it paid for it. Similarly, if LKC wanted to borrow money and pledge the land as security, the lender is not that interested in how much the land cost. Rather, it is interested in how much the proposed security for the loan is worth today. c. The historical cost model will result in its reported comprehensive income more closely portraying that of its core kennel operations. The reason for this is that under the historical cost model the $200,000 unrealized increase in the fair value of the land is not reported in comprehensive income. If LKC adopted the revaluation (fair value) model, comprehensive income would include the $200,000 increase in the value of the land, which is independent of the kennel operations.

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P2-25. Suggested solution: Balance sheet HC CC Asset A $100,000 $104,000 2023 Owners’ $100,000 $104,000 equity Cash $120,000 $120,000 2024 Owners’ $120,000 $120,000 equity

Income statement FV HC CC FV $118,000 0 $ 4,000 $18,000 $118,000 Income $ $120,000 $120,000 Income $20,000 $16,000

$ 2,000

P2-26. Suggested solution: a. Machine B’s historical cost on January 1, 2024 was $176,000. Historical cost = cost – accumulated depreciation; depreciation per year = (cost – residual value) / useful life = ($215,000 - $20,000) / 5 = $195,000 / 5 = $39,000; years depreciated = one  accumulated depreciation = $39,000; historical cost = $215,000 - $39,000 = $176,000. b. Machine B’s fair value on January 1, 2024 was $105,103. Using a BAII PLUS financial calculator: 4 N, 5 I/Y, 25,000 PMT, 20,000 FV CPT PV  PV = −105,103 (rounded). N = 4 as the machine has been used for one year meaning that four years of use are remaining. FV = 20,000 as the fair value measurement basis excludes exit costs. c. Machine B’s value-in-use on January 1, 2024 was $101,812. Using a BAII PLUS financial calculator: 4 N, 5 I/Y, 25,000 PMT, 16,000 FV; CPT PV  PV = −101,812 (rounded). N = 4 as the machine has been used for one year meaning that four years are left. FV = $20,000 - $4,000 = $16,000 as the value in use measurement basis deducts the present value of the estimated $4,000 exit cost (auctioneer commission). d. Machine B’s current cost on January 1, 2024 was $108,000 ($95,000 + $13,000). P2-27. Suggested solution: Arguments for reintroducing prudence: * Conservatism contributes to reliable information; information that is more reliable is more useful for evaluating managers’ performance. * Management, which prepares the financial statements, has a tendency to be optimistic; applying conservatism helps to counteract that optimism. * Conservatism also increases reliability by demanding a higher degree of verifiability for gains (than for losses) when there is uncertainty. * Conservatism does not allow deliberate understatement, so there is no undue pessimistic bias in the financial statement numbers. Arguments for continuing to exclude prudence: * Conservatism involves a pessimistic bias and reduces neutrality of information. * Less neutral information is less reliable and consequently less useful. * Conservatism information is not representationally faithful, again reducing the reliability of financial reports. * Excluding conservatism would allow write-ups (as well as write-downs), which is information that is relevant for valuation. . 2-14

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* *

Different managers/accountants will apply a different amount of conservatism, making it difficult for users to know how much conservatism is embedded in the reported numbers. Users are better able to apply their own standard of conservatism given their own risk tolerance.

P2-28. Suggested solution: * * * * * *

First it is necessary to make an assumption that genetically modified (GM) food is perceived to be bad, so that consumers will pay more for good (non-GM) food. If there is no difference to the consumer, then there is no demand for information/labelling. Manufacturers know whether the food is GM or not, and consumers know that they know. Consumers will assume unlabelled food to be GM products, which are inferior, so they are willing to pay less for these. So non-GM foods will be labelled to be distinguished from GM foods. This is an application of adverse selection and disclosure principle. The role for standard setting is not clear. Market forces should lead to labelling of nonGM products, which imposes costs on traditional non-GM producers. Standards to require labelling GM products would shift the cost to those products and away from the non-GM products. There are possible litigation costs for not labelling (for example, due to allergic reactions).

P2-29. Suggested solution: a. Paragraphs 5.1 – 5.25 of The Conceptual Framework for Financial Reporting of Part I of the CPA Canada Handbook – Accounting establish the requirements for the recognition of the elements of financial statements. b. The substance of the recognition process can be summarized as follows:  Recognition involves including items on the balance sheet or income statement that meets the definition of an element (e.g. an asset) and satisfies the criteria for recognition (paragraph 5.6).  An element should be recognized if the future inflows or outflows of resources are probable (paragraph 5.14) and can be reliably measured (paragraph 5.18).  Items that otherwise meet the criteria of an element are only recognized if they are material (paragraph 5.9). P2-30. Suggested solution: a. Paragraphs 6.1 – 6.395 of The Conceptual Framework for Financial Reporting of Part I of the CPA Canada Handbook – Accounting establish the requirements for measuring the elements of financial statements. b. Measurement is the quantification of the amounts to be reported on the financial statements using one or more bases of measurement summarizes the substance of paragraph 6.1.

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c. The most common measurement bases are historical cost and current value with current value measurement bases including: fair value; value in use for assets and fulfilment value for liabilities; and current cost (paragraphs 6.4 and 6.11). P2-31. Suggested solution: a.

c. d.

In addition to accounting, the collection also includes standards and guidance for - assurance - public sector accounting - management’s discussion and analysis, and - several other areas. The five definitions identify the five types of entities to which Parts I to V of the Accounting Handbook apply. For example, the first definition (publicly accountable enterprise) identifies the types of entities that would fall under the scope of Part I (IFRS). The second definition (private enterprise) identifies the types of entities that would fall under the scope of Part II (ASPE). Paragraphs 1.1 to 1.23 discuss the objectives of financial statements. Paragraphs 2.5 to 2.22 discuss the fundamental qualitative characteristics. Paragraphs 2.23 to 2.38 discuss the enhancing qualitative characteristics. The standards are as follows: - IAS 1 Presentation of Financial Statements - IAS 2 Inventories - IAS 16 Property, Plant and Equipment - IFRS 6 Exploration for and Evaluation of Mineral Resources - IFRS 15 – revenue for contracts with customers There is no logical ordering of the IFRS/IAS. The standards are numbered chronologically according to when the particular standard was first issued. There are no meaningful differences between IFRS and IAS other than the fact that IAS preceded IFRS; new standards will be labelled IFRS ##.

P2-32. Suggested solution: a. b.

Paragraphs 15 to 21 discuss the qualitative characteristics of financial statements. Paragraphs 36 to 47 discuss recognition criteria. The standards are as follows: - 1100 – Generally Accepted Accounting Principles - 1400 – General Standards of Financial Statement Presentation - 1521 – Balance Sheet - 3031 – Inventories - 3061 – Property, Plant and Equipment - 3400 – Revenue The ASPE section numbers are distinguished between “General accounting” (Sections 1000 to 1800) and “Specific items” (Sections 3000 to 3870). Within each of these two broad categories, related items are grouped together. For example, standards for the income statement, balance sheet, and cash flow statement are placed together as Sections

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1520, 1521, and 1540, respectively). Likewise, share capital, equity, and reserves are together in Sections 3240, 3251, and 3260. Paragraph 1100.02 defines primary sources of GAAP as Sections 1400-3870 of ASPE including their appendices, and Accounting Guidelines including their appendices, with the former having higher authority than the latter. Paragraph 1100.03 indicates that “an entity shall apply every primary source of GAAP that deals with the accounting and reporting in financial statements of transactions or events encountered by the entity.” Entities may consult other sources of GAAP should the primary sources not deal with a particular circumstance. A search for “inventories” results in numerous hits. The numbers of instances are summarized on the left side in the table of contents. The right side shows excerpts of the documents that contain the search term.

P2-33. Suggested solution: For uniformity: * Increases comparability of financial reports for companies in different countries. * Decreases costs to users; they don’t need to learn many different GAAPs. * Investors need to be less sophisticated to understand financial statements of companies from different countries, thereby decreasing information asymmetry, increasing the size of the pool of potential investors. * Increased geographical diversification of investments reduces risk and lowers the cost of capital. * Resources can be focused on developing and refining one set of standards, resulting in a superior set of standards. Against uniformity: * Uniform standards do not imply uniform application; differing circumstances in each country lead to different interpretations of standards and different reporting outcomes. * Global accounting standards result in conflict with local laws and regulations. * Uniformity does not respect diversity of cultures, history, and legal structures. * Uniformity hinders innovation by eliminating competition. * Flaws in standards have potentially catastrophic effects around the world. * Increases systemic risk since most of the world is covered by the same set of standards. P2-34. Suggested solution: *

The CPA Canada Handbook – Accounting provides guidance in general circumstances to service the largest numbers of situations and users. Although these standards provide definitive guidance under certain circumstances, it is impossible to deal specifically with all possible situations. Therefore, standards are general in order not to restrict the exercise of professional judgment. Where there is no authoritative guidance, accountants rely on their professional training and judgment to fairly present the economic reality of the situation. In such cases, they can consider basic concepts and principles from the conceptual frameworks as well as the

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spirit and intent of the related standards. They can also consider current prevailing practice in the profession. Leaving application open to judgment, however, in the presence of client pressure, may result in general acceptance of a minimal amount and quality of reporting. The eventual outcome may be a lack of comparability of financial statements. With no standards at all, these problems would be even more acute.

Points favouring the existence of standards: * In a complex world, standards are a means of transmitting wisdom and avoiding unintentional error due to ignorance. They present the “aggregate wisdom” of the accounting profession on complex issues. * Many standards arose because market and other mechanisms failed to prevent the occurrence of serious errors or misinterpretations. * The fact that certain legal requirements, such as the Canada Business Corporations Act, refer to GAAP in the CPA Canada Handbook – Accounting as authoritative practice indicates that the standards are filling a need. * GAAP are so important to our financial reporting system that the codification of best practices is legally and administratively essential. * Proactively setting standards may be a more efficient way of creating a body of GAAP than the development of case law after specific reporting failures. * Compliance with a documented set of standards can provide a better defence against legal liability. * In some instances, prevailing practice may not be well thought out conceptually. Adopting standards can result in new practices that are conceptually more sound. * Standards instil confidence in the fairness and reliability of financial statements to users. Points against the existence of standards: * Many people believe that there is a free market for information. If the market were unrestricted by standards, information would be available to the extent that it was demanded. * Capital market research suggests that accounting numbers prepared in accordance with many standards do not assist the operation of the market. * Users’ information needs are diverse and not well understood, so it may be presumptuous of the accounting profession to design information standards for these users. * Standards interfere with management’s freedom to report to shareholders in the way it believes is in the best interest of the company (i.e., to best alleviate adverse selection). * Some standards encourage uneconomic decisions merely to improve the appearance of financial statements. * Compliance with more stringent reporting standards is expensive for companies. * Standard setting is expensive for the accounting profession. * The existence of standards reduces the exercise of professional judgment by constraining their choices and eliminating options that, in accountants’ judgment, may be the most appropriate for the circumstance. * General standards have a tendency to evolve into narrow, restrictive rules. * Given the complexity of the economic reality that financial statements attempt to portray, no set of standards can be theoretically correct nor deal appropriately with all situations. . 2-18

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L. Mini-Cases Case 1: West Pacific’s Mortgage-Backed Securities. Suggested solution: Issue Supporting WP Supporting OSC #1 Mortgages receivable can be removed Receivables cannot be removed because because they are no longer assets. they are assets to WP. * WP no longer controls the mortgages. * WP retains risks and rewards of * WP does not retain future benefits mortgages. from the mortgages. * 0.6% fee is a future benefit to WP. * WP maintains control of mortgages since it manages the collection of mortgage payments. Asset cannot be removed if corresponding liability remains on books. * WP’s guarantee of timely payment to investors is an unavoidable obligation. #2 PV of 0.6% fee can be recognized when Revenue should be recognized as the MBS is sold because earnings process is earnings process is completed, which is largely complete at that time; most of the over the duration of the mortgage work required has been completed. contracts. CMHC guarantee ensures that future There is uncertainty in the amount and payments will be received, so the future timing of future payments, so revenue benefits are probable and measurable with should be delayed until the time when reasonable accuracy. payment is received. #3

The short amount of time that the mortgages are held suggests that cost is a good reflection of value at year-end. Any differences between cost and market value at year-end are likely to be immaterial. The costs of revaluation are high and likely to exceed any benefits.

Since WP regularly sells these mortgages, they are short-term investments or inventory; therefore, they should be revalued to reflect market prices (especially declines).

Case 2: Financial Reporting, Fraud, and Accounting Theory. Suggested solution: * * * * *

The fraud demonstrates that significant information asymmetry existed between insiders and outside investors in this case. Insiders used their information advantage to divert funds from the company/shareholders. Having lost significant amounts, investors lost trust in the company. Skeptical investors would have demanded a high cost of capital to invest in the technology. The high cost of capital prevented further development of this technology until this century.

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As a consequence, the history of public transportation was changed forever, probably for the worse. * Battery technology would probably have developed more rapidly had these electric buses been commercially viable. * This article illustrates that information asymmetry and the lack of trust can destroy markets and substantially alter the allocation of resources in the economy. * Better standards and regulations could have prevented the frauds. * Better disclosure of related party transactions would have alerted investors to be suspect of the company. * Better disclosure requirements would have made it more difficult for insiders to perpetrate the fraud. * Having an independent audit would also have made the fraud more difficult. * Independent audits also alleviate skepticism from investors about the veracity of the company’s financial reports. * The article also illustrates the importance of aligning the interests of owners and managers. A compensation system that better rewards managers for the company’s success would have provided them with more incentive to make the company successful instead of siphoning money using the fraudulent scheme. Case 3: More Disclosure Equals More Pain? Suggested solution: a. * * * * * * b. * * * * *

“Real” earnings are more reliably measured. “Real” earnings are subject to a set of standards of measurement (i.e., GAAP), whereas “pro forma” earnings could be defined in ways that best suit management. “Pro forma” earnings lead to confusion among investors. “Real” earnings could be less relevant if they poorly predict future earnings and cash flows. “Real” earnings could lack comparability with past results if they contain one-time items. “Pro forma” earnings could lack comparability because management can change the definition from year to year. Stock options involve an economic sacrifice from the shareholders and should be expensed. They should be expensed in the period they are granted because they are a form of compensation to pay employees for services (benefits) received. This matches expenses to economic benefits. Some or most of the benefit to the company is realized subsequent to the grant date in the form of employee motivation, so matching can be used to argue that the expense should be recorded later. These future benefits suggest that the value of these options should be recorded as an asset. The value of stock options is difficult to measure, so the criteria for recognition in the financial statements are arguably not satisfied. . 2-20

Chapter 2: Conceptual Frameworks for Financial Reporting

c. * * * * d. * * * * *

Whether to consolidate depends on whether the company has control over the assets of the SPEs and whether it is obligated to satisfy the liabilities of the SPEs (i.e., are the definitions of assets and liabilities satisfied?). If the company is responsible for the SPEs’ debts, that would argue for consolidation. The entity concept in the conceptual framework suggests that SPEs should be consolidated if the company exercises control, enjoys substantial benefits, and faces most of the risk of SPEs. Shareholders need to know the full extent of the company’s activities to properly estimate future cash flows and risks in order to make informed investment decisions. If one believes markets are fairly efficient, these comments don’t make sense, especially because the author believes that most of the information is already available. More information would not lead to dramatic downward price adjustments if investors form expectations rationally. Based on adverse selection, the lack of information would actually depress stock prices, so more information would dispel some uncertainty and lift stock prices. Less information asymmetry would encourage more investors to trade equities (instead of some other securities), thus increasing demand and liquidity in the market. Additional debts reported on balance sheets may affect contracts that companies have (particularly debt contracts), increasing costs to the company; therefore, shareholder value may decrease.

Case 4: Wicon Waste. Suggested solution: To: From: Date: Subject:

Partner CA September 18, 2025 Wicon Waste Engagement

Overview The Wicon Waste engagement has considerable risk associated with it. In reviewing the file, I noted a number of events that raise concerns about the integrity of WWF’s management. These events include: * management’s refusal to notify the bank of its error in converting foreign funds and the inclusion of the amount of the error in income; * the change in the accounting estimate of the useful lives of assets, which has the effect of increasing income; * the patent infringement suit; and No single one of these circumstances provides compelling evidence of questionable management integrity. Changing accounting estimates is commonplace and often justifiable. There has been no conviction on the patent infringement suit and nuisance lawsuits are not unusual. Collectively however, these events give a hint that management may lack integrity, which could result in biased financial statements. We must bear this risk of bias in mind in evaluating individual issues

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and the financial statements as a whole. The following will discuss the more specific issues individually. A. Bank error The treatment of the bank error results in income being increased by $9,997,500 ($10,000,000 – GNF 20,000,000 / GNF 8,000/CAD), an amount that is material. This misstatement of income could influence the decisions of potential buyers and bond-rating agencies. Clearly, including the amount in income is not correct accounting and unethical. The money does not belong to WWF, and the bank will ask for repayment once they discover the error. The amount of the error should be set up as a liability, not included as revenue. Of course, the liability may never be paid if the bank does not notice the error. There is a small chance that the bank does not notice the error; in that case the money would legally become WWF’s after a number of years (due to the statute of limitations), but for now treatment as income is not acceptable. B. Patent infringement award The award against WWF made by the court in the patent infringement case is unusual. Aggrieved parties normally receive a straightforward payment as compensation. The payment is usually treated as an expense for accounting purposes. In this case, however, WWF is receiving something that may or may not have value, so the accounting is more complex. Various accounting approaches could reasonably be used. First, since the purchase is a court-imposed penalty, the $18 million share purchase could be considered to be an $18 million fine and shares to have been acquired at zero cost. This approach would be unattractive to WWF since it would have a significant effect on the income statement at a time when it is very concerned about the bottom line (because of the potential sale of the shares and the alert placed on WWF’s credit rating). An alternative approach would be to record the shares as an asset on the balance sheet at $18 million. This approach would be attractive to WWF’s management because the income statement would be unaffected. To determine whether WWF is receiving an asset because of the court decision, the first step would be to determine whether the shares meet the definition of an asset. According to the IFRS Conceptual Framework, paragraph 4.4, “An asset is 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 shares will be controlled by WWF and are the result of a past event (the court ruling), however whether or not there will be any future benefits depends on the performance of Waste Systems. If WWF is likely to derive a future benefit from the shares, then the definition of an asset has been met. The next question to be resolved is how much the asset is worth. If the shares are to be recorded on the balance sheet at $18 million, they need to have a value of $18 million to arm’s length parties (i.e., fair value). If the fair value is less than $18 million, then the amount in excess of the fair value should be expensed since that amount represents a penalty. Since Waste Systems Integrated Limited is a private company, it could be difficult to arrive at a reasonable estimate of its fair market value. I strongly suggest that WWF obtain an independent valuation of Waste . 2-22

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Systems so that we have authoritative support for the company’s value. Such support is especially important in view of WWF management’s concern about the income-statement figures at the present time. That Waste Systems had been in financial difficulty is an indication that its market value is low. C. Waste-disposal sites WWF has significantly lengthened the estimated lives of its waste disposal sites and decreased the estimated cost of sealing and cleaning up the sites. The change has a significant effect on income, which is important because the owners are considering selling their shares. Wastedisposal sites represent 64% of WWF’s assets and 41% of operating expenses. The disposal sites will be an important consideration for prospective purchasers, and they may rely on the financial statements. Thus, we must exercise great care in this highly risky part of the audit. Compounding the problem is the fact that WWF changed consulting engineers this year and the new engineers, Cajanza Consulting Engineers (Cajanza), recommended the changes. It is not clear why WWF changed engineers for this purpose, but a possible reason is to obtain more favourable estimates to improve the company’s financial reports. It is difficult to understand how the costs of sealing and cleaning up sites can decrease at a time when environmental regulation is increasing, so the reduction in estimated costs requires additional attention. WWF uses three different methods for determining amortization expense. We should examine whether using three methods is justifiable. To enhance comparability, the IFRS Conceptual Framework requires consistent treatment of transactions and items that are similar. It is therefore possible that using these different methods is not acceptable unless different circumstances justify the different methods. Therefore, the company should identify the rationale for each amortization policy and if it is unable to do so, then one consistent accounting policy should be chosen. Given the circumstances and the incentives for management to increase earnings, additional audit steps should be taken to satisfy ourselves that the estimated lives and clean-up costs are reasonable. One approach would be for us to engage an engineering firm to assess the lives and clean-up costs of the sites. D. Locating and negotiating costs WWF amortizes the costs of locating new waste-disposal sites and negotiating agreements with municipalities, this approach is not reasonable. Under IFRS, the cost associated with negotiating a contract would be considered transaction costs and would be expensed as incurred. According to IAS 16.19 “Examples of costs that are not costs of an item of property, plant and equipment are…administration and other general overhead costs.” The company will need to make this adjustment in the current year.

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E. Overall conclusion The above discussion identifies several issues that have a material impact on WWF’s financial statements. We should consider whether our audit report should be qualified if management does not agree to adjust the statements for material errors and misstatements discussed in this memo. The effects of the bank error and the treatment of the waste disposal sites raise the possibility that the financial statements may be materially misstated. Management seems to have taken steps that have had the effect of increasing net income and the assets on the balance sheet. In the extreme case, we should consider whether we should resign from the engagement altogether because of the questionable integrity of management. Among other integrity concerns, the company’s handling of the bank error and changes in accounting estimates, apparently to window-dress the financial statements, should make us question whether we want to be associated with this client. Case 5: Douglas Décor Company. Suggested Solution: a. The management at PDI would need reliable financial information to assess the financial performance of the company. In particular, they would need to look at cash flows, earnings as well as the capital structure of DDC when analyzing the financial statements. Cash flow information is important for PDI to evaluate the cash flow trend and cash generating ability of DDC. Earnings are also important because they indicate whether revenue of the company can adequately cover expenses. Furthermore, the examination of earnings can also help PDI management to assess the overall financial performance of the company and to compare the performance of DDC with industry peers. Finally, as PDI is the potential buyer who would acquire the company, the management would also care about the financial position of DDC (i.e., components of assets, liabilities and equity). The accounting records provided by DDC did not fulfill those needs. Since there were no accounting statements produced over the years of operations, PDI was unable to reliably measure the financial performance of DDC. In this situation, it would be very difficult for PDI to generate reliable estimates of the value of the DDC business. Furthermore, DDC has been accounting for the company on a cash basis, which may omit useful accrual information. b. Based on the cost versus benefit constraint, it could be argued that producing sophisticated financial statements for a small private company such as DDC would incur greater costs than benefits. However, considering Doug and Dez want to sell the company, they should be aware of the needs of potential buyers, and prepare a proper set of financial statements accordingly in the more recent years. c. The IFRS Conceptual Framework enumerates six qualitative characteristics, categorized as either fundamental or enhancing characteristics. While the fundamental qualitative characteristics describe whether information is useful for decision-making (relevance and representational faithfulness), the enhancing qualitative characteristics affect the information’s degree of usefulness (understandability, comparability, verifiability, and timeliness). For example, understandability is important for the users of the financial statements to understand the information presented in DDC’s financial records. Relevance . 2-24

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is important because of its ability to influence users’ economic decision. Representational faithfulness is important because it signifies that the financial statements faithfully represent the economic reality. Comparability is important to allow users to compare the financial position of DDC with other similar companies in the industry. d. Considering DDC would have produced their financial statements under ASPE and PDI is a publicly traded company, PDI would have to re-evaluate many of the items on the balance sheet and account for them using IFRS.

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Chapter 3 Accrual Accounting O. Problems P3-1. Suggested solution:

a. b. c. d. e. f. g.

Factor Improved technological capability (computers, Internet) A diffuse investor base comprising many people Increased pace of business transactions Invention of the printing press Establishment of regulators such as the Ontario Securities Commission Creation of indefinite-life entities such as corporations Establishment of professional accounting organizations

Not a Significant significant contributor contributor √ √ √ √ √ √ √

P3-2. Suggested solution: Not a Significant significant contributor contributor √

Factor a. Establishment of accounting standard setters such as the International Accounting Standards Board b. Invention of the double-entry system of bookkeeping √ c. Creation of indefinite-life entities such as corporations √ d. Development of credit cards and other substitutes for cash √ e. Preparation of periodic financial reports √ f. Incomplete transactions at reporting dates √ g. The going-concern assumption √ h. Accounting standards such as IFRS require accrual √* accounting i. Financial reports using accrual accounting are simpler to √ understand compared with those prepared using cash accounting *For (h), accounting standards arguably are a contributing factor. However, accounting standards regarding the use of accrual accounting are only formalizations of practices that derive from the demand for accrual accounting. Indeed, we observe the use of accrual accounting for entities that do not need to follow IFRS or other formal accounting standards.

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P3-3. Suggested solution: The easy answer is that regulations (accounting standards, stock exchange requirements, etc.) require companies to do so. However, this answer does not address the question of why regulations have this requirement. Both business and regulations respond to market demands. Investors and creditors of publicly accountable enterprises are numerous and have needs for information at different times for their investing and lending decisions. It would be impractical for enterprises to provide financial statements according to when each of these investors/creditors requires the information. Therefore, companies provide the information on fixed schedules annually or quarterly. P3-4. Suggested solution: * * *

Investors require information that will help them estimate the value of their investments and to evaluate the performance of management. Investors need timely information to make these decisions, and periodic reports provide such information. When there are many investors, the timing of when each will find the information most useful can vary, and therefore it is impractical to produce reports at different times for different investors. As a result, a fix time period such as a year or three months is a practical response to the demand for financial information.

P3-5. Suggested solution: Accrual accounting numbers can be a better predictor of future cash flows because they smooth out and reallocate cash flows to periods that better reflect the long-term average cash flow of the enterprise. For example, an equipment purchase results in a large cash outflow but benefits the company over many years, so allocating the cost of purchase over those years makes each year more representative of the cash flow expected in a typical year. P3-6. Suggested solution: * * * * * *

While it is true that the calculation of net present value (NPV) involves discounting cash flows, this does not imply that accrual accounting numbers are not useful. It is important to recognize that capital budgeting and other applications of NPV always involve the future, and the future is always uncertain. The difficult part of an NPV exercise is not the computation of discounted values, but forecasting future cash flows accurately. Accounting numbers can help forecast those future cash flows because accrual accounting reflects the results of both complete and incomplete transactions. Accrual accounting numbers also smooth out irregularities in cash flows such as large purchases of property, plant, and equipment that produce benefits over many years. Thus, while accruals are not cash flows, they provide information that is useful for the prediction of future cash flows.

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P3-7. Suggested solution: a.

When PPE are acquired, the business and finance assumption is that these assets will be used for a number of years to directly or indirectly generate earnings. PPE will create productive capacity that will allow the firm to operate in the future and produce revenues or reduce costs, with the overall consequence of increasing net income and net cash flows. As PPE are held for use, not for resale, they can be recorded on the balance sheet at their depreciated net book value. The goal of recording PPE in this manner is to match the recognition of the cost of the asset to expense with the period when the benefit of the asset is realized. As PPE are expected to last for several years for the future service potential of the asset to be realized, it is essential that the firm continue to exist into the foreseeable future (i.e., continue to be a going concern) for this allocation process to resolve itself. Restated, if a piece of PPE is to be depreciated over a 10-year useful life, we are assuming that the firm will continue to operate for those 10 years for the depreciation allocation process to fully expense the cost of the asset.

If the going-concern assumption is no longer valid (and the firm is going into bankruptcy), then assets should be valued at their exit value. This usually will be their net realizable value, which will likely result in a major reduction in the carrying value of the asset on the balance sheet and a large loss recorded on the income statement.

Depreciation expense for 2023 and 2024 = $900,000 per year ($10,000,000 – 1,000,000)/10). The depreciation for 2024 should not be the same because the firm will not continue to operate, so the asset should be valued at its net realizable value. The value of the machine on the balance sheet on December 31, 2024: $5,500,000. The downward adjustment to the carrying value of the machine in 2024: $2,700,000 (= 10,000,000 – 2 × 900,000 – 5,500,000). Technically, as will be seen in Chapter 10, this amount is in addition to the normal amount of depreciation that would have been recorded if the going concern assumption were valid (i.e., $900,000). This $2,700,000 is an additional expense or loss due to the need to write down the machine to its net realizable value.

Prepaid rent should be reported as an asset at the unexpired value of the rent of $100,000 if the company were a going concern. If the company were not a going concern, it should value this amount at its net realizable value—the amount it could recover if it were to ask for a refund from the landlord—which is likely to be $0. If the premises could be sub-leased to another tenant, then the prepaid rent could be reported at the value obtainable from the sub-lease.

When a company goes into bankruptcy, inventories should be valued at net realizable value, such as the amount that would be received if it were sold in an auction. Such forced liquidation would likely be less than the FIFO or average-cost values.

. 3-3

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-8. Suggested solution: Tyler Inc. Income Statement For the year ended December 31

2024

2025

Income earned in 2024 / 2025: Reported in 2023 on a cash basis Reported in 2024 on a cash basis Reported in 2025 on a cash basis To be reported in 2026 on a cash basis Sales revenue on an accrual basis

$ 40,000 425,000 110,000 0 $575,000

Expenses incurred related to sales made in 2024 / 2025: Reported in 2023 on a cash basis Reported in 2024 on a cash basis Reported in 2025 on a cash basis To be reported in 2026 on a cash basis Expenses on an accrual basis

$ 20,000 275,000 80,000 0 $375,000

Sales revenue on an accrual basis Expenses on an accrual basis Net income before income taxes on an accrual basis

$575,000 375,000 $200,000

$670,000 420,000 $250,000

0 50,000 475,000 145,000 $670,000 0 40,000 325,000 55,000 $420,000

P3-9. Suggested solution: a. b.

Item Accounts receivable Inventories

Equipment

d. e. f.

Warranty liability Sales revenue Revenue from long-term contract

Cost of goods sold

Estimates required Customer default rate; speed of collection Costs of items sold/held; prices of inventory items; Possible obsolescence or shrinkage Useful lives; pattern of benefits obtained; residual values at end of useful lives; possible impairment and revaluation Rate of defect; cost to repair or to replace product Customer default rate; speed of collection Profitability of contract; degree of progress fulfilling contract Costs of each item sold/held; possible inventory shrinkage

P3-10. Suggested solution: *

Estimates are an essential part of financial reporting because cash cycles are incomplete when we prepare these reports.

. 3-4

Chapter 3: Accrual Accounting

* * * *

Incomplete cash cycles require the forecasts of what will happen in the remainder of each cash cycle. The future is always uncertain, so estimates (forecasts) of future events are always necessary. For example, reporting the balance of accounts receivable requires an estimate of the most likely amount that will be collected in the future. Since such estimates concern future events rather than past transactions, they cannot be verified, but only evaluated for reasonability. If management has incentives to increase or decrease receivables or income, then the estimate for the collectible amount can be biased upwards or downwards.

P3-11. Suggested solution: a.

Quality of earnings refers to how closely reported earnings correspond to earnings that would be reported in the absence of management bias.

The practice of assessing earnings quality by comparing earnings and cash flows has some merit but is imperfect. The difference between earnings and cash flows generally can be referred to as accruals. These accruals reflect economic circumstances, accounting standards, professional judgment, ethics (the unbiased portion), as well as management bias resulting from contractual incentives and managerial opportunism. To the extent accruals reflect management bias, comparing earnings and cash flows helps to uncover that bias. On the other hand, management bias comprises only one component of the accruals; the other component is an unbiased reflection of economic circumstances. The fundamental idea/assumption underlying accrual accounting is that accrual numbers are more useful/meaningful compared to cash basis accounting. Using the difference between accrual numbers and cash flows to assess the quality of earnings in effect says that cash flows are more useful, and accruals made by accountants/management confuse the picture rather than make the numbers more meaningful. If this were true, only the cash flow statement is meaningful, while the balance sheet and income statement would be useless. However, this is inconsistent with the observed demand for information in the balance sheet and income statement.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-12. Suggested solution: a. ($ 000’s) Cash flow statement Operations Inflow from sale of goods Outflow for operating costs Cash flow from operations Cash flow from investing activities Cash flow from financing activities Net cash flow for the year Cash at beginning of year Cash at end of year

Year 2

Year 3

Year 4

4-year Total

$ 5 (3) 2 (15) 20 7 0 $ 7

$ 5 (2) 3 0 0 3 7 $10

$10 (1) 9 0 0 9 10 $19

$10 (1) 9 7 0 16 19 $35

$30 (7) 23 (8) 20 35 0 $35

Year 1

Year 2

Year 3

Year 4

4-year Total

$5.0 (1.0) (0.5) 0.0 0.0 3.5 0.0 $3.5

$5.0 (1.0) (0.5) (4.5) (1.0) (2.0) 3.5 $1.5

$10.0 (2.0) (1.0) 0.0 0.0 7.0 1.5 $ 8.5

$10.0 (2.0) (1.0) (0.5) 0.0 6.5 8.5 $15.0

$30 (6) (3) (5) (1) 15 0 $15

Balance sheet Cash Prepaid expenses Ships at cost Less: accumulated depreciation Total assets

$7.0 2.0 15.0 (0.5) 23.5

$10.0 2.0 10.0 (0.5) 21.5

$19.0 1.0 10.0 (1.5) $28.5

$35 0 0 0 $35

Contributed capital Retained earnings Total equity

$20.0 3.5 $23.5

$20.0 1.5 $21.5

$20.0 8.5 $28.5

$20 15 $35

($ millions) Statement of income and retained earnings Revenue ($5m/arrival) Operating expenses ($1m/arrival) Depreciation ($0.5m/arrival) Loss on ships Write-off of prepaid expenses Net income (loss) Retained earnings at beginning of year Retained earnings at end of year

Year 1

We observe that the total cash flows for operating activities ($23 million) and investing activities (–$8 million) combine to result in $15 million, which equals the amount of net income of $15 million over the four years. In addition, just prior to dissolution of the company, we observe that the amount of cash equals the balance in owners’ equity, at $35 million. Of this amount, $15 million is return on capital (i.e., retained earnings), while $20 million is return of capital supplied by the investors. . 3-6

Chapter 3: Accrual Accounting

P3-13. Suggested solution: a.

Annual net income with accounting policy set 1 2023 2024 Sales $3,000,000 $3,500,000 Operating expenses (2,100,000) (2,500,000) Warranty expense (9% of sales, (270,000) (315,000) except 2026) Bad debt expense (5% of sales, (150,000) (175,000) except 2026) Depreciation expense (straight line) (250,000) (250,000) Gain on disposal 0 0 Net income 230,000 260,000 Annual net income with accounting policy set 2 2023 Sales $3,000,000 Operating expenses (2,100,000) Warranty expense (10% of sales, except 2026) Bad debt expense or recovery (ADA at 40% of gross A/R—see below) Depreciation expense (50% declining balance) Gain on disposal Net income (loss)

2025 $4,000,000 (2,700,000) (360,000)

2026 $500,000 (350,000) (170,000)

(200,000)

(75,000)

(250,000) 0 490,000

(250,000) 400,000 55,000

2024 $3,500,000 (2,500,000)

2025 $4,000,000 (2,700,000)

2026 $500,000 (350,000)

(300,000)

(350,000)

(400,000)

(65,000)

(220,000)

(355,000)

(200,000)

(175,000)

(500,000)

(250,000)

(125,000)

(62,500)

337,500 535,000

(120,000)

. 3-7

45,000

575,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Derivation of bad debt expense (BDE) for each year:

2023 Jan 1 balance 2023 Credit sales Collections Write-offs

Accounts receivable 0 3,000 2,600 100

2023 Dec 31 balance 2024 Credit sales Collections Write-offs

300 3,500

2024 Dec 31 balance 2025 Credit sales Collections Write-offs

875 4,000

2025 Dec 31 balance 2026 Credit sales Collections Write-offs

875 500

2026 Dec 31 balance

Annual net cash flows: Collections Cash operating expenses Warranty expense paid Purchase of capital asset Proceeds on disposal of capital asset Net cash flow

Allowance for doubtful accounts (ADA)

100 ×40% =

2,800 125

125 ×40% =

3,800 200

200 ×40% =

1,200 175 ×40% =

175 175

220 120

BDE (plug) Required balance

355 350

BDE (plug) Required balance

200 350

BDE (plug) Required balance

2023 2024 2025 2026 $2,600,000 $2,800,000 $3,800,000 $1,200,000 (2,100,000) (2,500,000) (2,700,000) (350,000) (250,000) (275,000) (410,000) (180,000) (1,000,000) 0 0 0 400,000 $ (750,000) $ 25,000 $ 690,000 $1,070,000

Sum of income over four years using accounting policy set 1: $1,035,000 Sum of income over four years using accounting policy set 2: $1,035,000 Sum of net cash flows over four years: $1,035,000 These sums show that, from a company’s beginning to its end (cradle to grave), the sum of net income and cash flows must be equal.

The differences in net incomes for the two scenarios is the result of using different methods of accruing (or allocating, calculating) warranty, bad debt, and depreciation expense.

. 3-8

Chapter 3: Accrual Accounting

The net income for 2026 is significantly higher using accounting policy set 2 than set 1 $535,000 versus $55,000). This is due to the fact that the first set of accounting policies recorded much lower expenses in the earlier years, which means in later years and when the firm was wound up, this understatement of expenses must be reversed such that the total of all the years for any type of expense is the same. For example, total bad debt expense must equal the actual accounts written off (of $600,000), total warranty expense must equal warranties paid (of $1,115,000), and the sum of depreciation expense and gain on disposal together must equal the difference between the cost of the computer and final proceeds on disposal (of $600,000).

P3-14. Suggested solution: a.

Net Income B would likely result in the highest share price as it shows a continuous pattern of improving/growing earnings. Users are likely to extrapolate this growth pattern into the future as earnings growth is an important component in the valuation of a share, with higher growth expectation resulting in higher share prices. Net Income C would likely have the lowest share price as there is a declining pattern of earnings. Net Income D might be the lowest, as the high variability of earnings (volatility) would suggest that the firm is very risky and predicting net income will be highly uncertain. Higher degrees of risk should result in lower share prices.

Net Income B would likely give you the highest aggregate bonus, as each year’s earnings are growing and the growth rate is increasing from 14% (3/22) in 2024 to 18% (6/34) in 2027. Clearly, you appear to be doing something right! If bonuses were based on earnings, the absolute and relative growth in net income would have direct bearing on your bonus as president.

As sole owner and chief executive officer, I am less concerned with what others think about my company’s performance and more interested in its true economic performance. Whereas Net Income A is the least interesting sequence, it likely captures the true condition of the company—it shows that the firm is stable, neither growing nor declining in profitability for the past five years. I may not like this summary, but it is likely the most faithful representation of the company’s underlying condition. As owner/manager I would also be interested in reducing or delaying the income taxes I pay. Net Income B would likely do that, but it presents a distorted view of the company’s achievement that may cause lower-level managers to make the wrong decisions.

Accounting does not change what actually occurs, but it does change what people may believe occurred. In particular, accounting does not change cash flows (except income tax and bonus payments), but different accrual policies will change reported net income. The way financial accounting derives net income will influence what people think happened in the past and present and therefore influence what users believe the future will be. This is because users of financial statements use past and present achievement to predict future achievements.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-15. Suggested solution: Pros of GAAP accrual accounting in government: * Information becomes more relevant to users (taxpayers) for evaluating the use of tax dollars. * Provides better information on financial position—more complete reporting of assets and liabilities. * Budget balance not adversely affected by large capital investments. * Increases government’s willingness to invest in projects that have long-term benefits, such as infrastructure. * Decreases incentives to sell assets just to get cash flow even if it is a bad deal. * Therefore, accrual number will better measure performance than will cash surplus/deficit. * Politicians are agents of the citizens in that taxpayers have entrusted the money to them. * Having a better performance measure reduces agency problems (politicians being the agents managing taxpayers’ money). Cons: * Accrual accounting uses more judgments. * Politicians will have more latitude to affect reported numbers. * Therefore, the numbers will be less reliable. * Accrual numbers may be more difficult to understand for the average citizen. * It will be more difficult to evaluate the government’s performance if the numbers are more subjectively determined. * Skeptics claim that some government spending programs (e.g., “make-work” projects) do not have much future benefit and therefore would not qualify as assets. P3-16. Suggested solution: * * * * * * * * * *

The NHS data lack neutrality; they are biased. Non-response rates are predictably higher among those at the very high and low ends of the income spectrum, so extreme income figures are not reported. Therefore, the NHS is biased to show less income inequality. The data is also incomplete since it omits many households. The summary statistics are not free from error since they are based on bad data. The statistics do not show what they purport to show (i.e., not representationally faithful). The data from the NHS is not comparable to that collected under the previous census. Political costs and benefits could explain the government’s use of the voluntary NHS instead of the mandatory long-form census. The government could use the data to justify cutting programs aimed at reducing income inequality. Biased statistics are of low quality (just like biased earnings have low quality). It appears that the conservative government was using the NHS in place of the long-form census to manage perceptions, just like how management manipulates earnings to try to fool outsiders. Citizens should be sceptical of this data as well as the character of the government leadership, just as we should be sceptical of executives who manage earnings.

. 3-10

Chapter 3: Accrual Accounting

P3-17. Suggested solution: a. Paragraph 3 of IAS 10 in Part I of the CPA Canada Handbook – Accounting defines events after the reporting period as: “…those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. Two types of events can be identified: (a) those that provide evidence of conditions that existed at the end of the reporting period (adjusting events after the reporting period); and (b) those that are indicative of conditions that arose after the reporting period (non-adjusting events after the reporting period).” b. In accordance with paragraph 8, an entity must adjust the amounts recognized in its financial statements to reflect adjusting subsequent events. c. In accordance with paragraph 10, an entity does not adjust the amounts recognized in its financial statements to reflect non-adjusting subsequent events. Rather, in accordance with paragraph 21, for material amounts the entity must disclose the nature and the estimated financial effect of each category of event. If the financial effect cannot be estimated the entity must disclose this. P3-18. Suggested solution: The bankruptcy of Kingston Pen Ltd. occurred on February 14, 2024 due to continuing financial difficulties, suggesting that the company was already in financial difficulty on December 31, 2023, the year-end of Bellevue Company. Therefore, the information about the bankruptcy collected in the subsequent events period should be used in the measurement of the value of accounts receivable at the year-end. The $55,000 receivable should be written off. News about the closing of Trenton Homes became available on February 22, 2024, during the subsequent events period. However, this information should not be used to measure the value of accounts receivable as at December 31, 2023 because the cause of the company’s closing was an unpredictable natural disaster (an ice dam). There is no indication that Trenton Homes would be unable to pay Bellevue as at December 31, 2023. The key difference in the treatment of the two receivables is whether the information obtained in the subsequent events period reflects events and conditions prior to the year-end. As at December 31, 2023, Kingston Pen was most likely already in financial difficulty, whereas Trenton Homes was financially healthy.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-19. Suggested solution:

Item a. Inventory – bottled water

June 30, 2023 balance sheet amount after adjustment (if any) $75,000 (decrease of $25,000)

Explanation Information obtained in the subsequent events period relates to a contamination event prior to year-end, so the decline in inventory value should be recognized.

b. Equipment $80,000 – truck (no change)

Accident occurred after the year-end, so decline in value should not be reflected in the financial statements for June 30, 2023.

c. Investment $55,000 – RBC (no change) shares

In an efficient market, the change in value after the yearend reflects information and events occurring after the year-end. The decline in value after June 30, 2023 is not relevant to the measurement of value as at June 30, 2023. A variety of different reasons could explain the change in cash balance after the year-end. The $3,000 balance on September 30 is not an indication that the cash balance is overstated at the year-end of June 30, 2023.

d. Cash

$67,000 (no change)

P3-20. Suggested solution: a.

This is a non-adjusting event as the liability did not exist at year-end. The amount of the dividend declared should be disclosed in the notes to the financial statements in accordance with paragraph 137 of IAS 1, Presentation of Financial Statements.

An adjustment is required as the event pertains to conditions prevailing at the balance sheet date. This is required as this new information relates to the measurement of an obligation not previously recognized at the year-end.

This is a non-adjusting event as it is indicative of a condition that arose after year-end. Details of the share issuance should be disclosed.

An adjustment is required as the event pertains to conditions prevailing at the balance sheet date. While not part of the question, it appears that the company made an error and that the adjustment will likely require that the company’s 2023 financial statements be restated in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

An adjustment is required as the event pertains to conditions prevailing at the balance sheet date. This is required as the information provided in events (a) – (d) changes estimates used at the year-end for calculating bonus expense. . 3-12

Chapter 3: Accrual Accounting

P3-21. Suggested solution: a.

No adjustment is required as the fire does not change any estimates or assumptions used in valuing year-end amounts. This event should be disclosed in the notes to the financial statements and the amount of the loss quantified; but not recorded, only described in the notes. Mention should be made of the effect of the fire on the following year’s earnings. Disclosure is required as all the relevant information is known and the event is significant to the future operations of the company.

An adjustment is required as the market price is lower than cost, and inventory should be valued at the lower of cost and market. The drop in market price is relevant to the measurement of inventories at year-end because it reflects conditions at that point in time. No additional disclosure; this is just an unfortunate but unusual operating occurrence.

New competition requires neither recognition nor disclosure. The event does not relate to conditions at or prior to the year-end for recognition. The event is neither specific nor unusual in nature to warrant disclosure.

Due to the new technology, you should review the assumptions for useful life, salvage value, and depreciation methods and change the assumptions that are no longer appropriate based on this new information. The depreciation expense for the current year should reflect these new estimates. This is required as this information clarifies estimates used at the year-end for calculating depreciation expense.

For the bankruptcy of a client, recognize the reduction in the carrying value of the accounts receivable by 70% and make the necessary adjustment. This is required as this new information relates to the measurement of receivables recognized at the year-end.

No adjustment and no disclosure; labour strikes are just an unfortunate aspect of normal business operations. However, if the strike threatens the survival of the company it should be disclosed, as this would put into question the validity of the going-concern assumption.

P3-22. Suggested solution: a. This is a non-adjusting event as it is indicative of a condition that arose after year-end. The event should be disclosed, though as it is a material event that can reasonably be expected to influence decisions that the primary users of financial statements make on the basis of those financial statements. IAS 10 paragraphs 21 and 22 refer. While the first interest payment on the bond on June 1, 2024 represents six months interest from December 1, 2023 – June 1, 2024, it is not necessary to adjust the 2023 financial statements for this reason. As discussed in Chapter 12: i) borrowing costs must be allocated over the borrowing period. Gretta Corp. did not owe money on the bonds in 2023 so it would not be appropriate to record interest expense on the bonds in that year; and ii) by convention, when bonds are sold between interest payment dates, the purchaser pays the seller the agreed upon purchase price plus the interest that has accrued since the last payment . 3-13

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

date. As the interest paid on the bonds pertaining to December 2023 would have been recovered by Gretta Corp. from the purchaser, the company’s net cost of borrowing in 2023 is $0. b. An adjustment to the financial statements is required. We have gained additional information during the subsequent events period that allows us to more accurately measure a condition that existed at year-end (the amount of wages earned by its employees in 2023 and that must be expensed in that period). c. An adjustment to the financial statements is required. We have gained additional information during the subsequent events period that allows us to more accurately measure a condition that existed at year-end (the amount to be paid out under the lawsuit that must be expensed). d. Disclosure is appropriate. An adjustment to the financial statements may be required. While the explosion took place after the year-end, it remains that this may be an adjusting event as paragraph 14 of IAS 10 provides that “An entity shall not prepare its financial statements on a going concern basis if management determines after the reporting period either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so.” You are not given sufficient information to make this determination in this instance, as the question only raises the possibility that the company may not be able to continue to operate as a going concern, rather than concluding that it cannot. Moreover, scenario e. suggests that the company is in the process of restructuring its operations to address the production issue. If company management and the auditors conclude that the company cannot continue to operate as a going concern then the asset values would have revisited and adjusted as appropriate to reflect the fact that the entity is no longer a going concern. Note though, that while both IAS 1.25 and IAS 10.14 both suggest that “When an entity does not prepare financial statements on a going concern basis, it shall disclose that fact, together with the basis on which it prepared the financial statements and the reason why the entity is not regarded as a going concern”, that neither standard provides any guidance on how the financial statements should be prepared. If management and the auditors determine that the going concern assumption is still appropriate no adjustment is required as the explosion does not change any estimates or assumptions used in valuing year-end amounts. This event should still be disclosed in the notes, however, as the event will significantly impact on the future operations of the company. Mention should be made of the effect of the explosion on the following year’s earnings. e. This is a non-adjusting event as it is indicative of a condition that arose after year-end. The event should be disclosed, though as it is a material event that can reasonably be expected to influence decisions that the primary users of financial statements make on the basis of those financial statements. IAS 10 paragraphs 21 and 22 refer.

. 3-14

Chapter 3: Accrual Accounting

P3-23. Suggested solution: Fiscal year Journal entries or explanation a. July 31, Dr. Inventories – raw materials 325,000 2023 Cr. Accounts payable 325,000 2024 Dr. Accounts payable 325,000 Cr. Cash 325,000 b. July 31, Dr. Inventories – finished goods 875,000 2023 Cr. Inventories – raw materials 325,000 Cr. Wages and accounts payable 550,000 2024 Dr. Accounts receivable 1,230,000 Cr. Sales revenue 1,230,000 Dr. Costs of goods sold 875,000 Cr. Inventories – finished goods 875,000 c. July 31, The discovery of the contamination occurred in the subsequent events period, 2023 and the information relates to products processed prior to the cut-off date of July 31, 2023. Therefore, the effect of the contamination should have been included in the financial statements of July 31, 2023. The lamb inventory should have been written down from $875,000 down to zero. Even if the extent of contamination was not certain, note disclosure would be required at a minimum. d. July 31, As noted in part c, since the effect of the contamination should have been 2023 recorded in fiscal year ended July 31, 2023. The fact that it was not so recorded is an error (the information about contamination was known or should have been known to management). The error needs to be corrected retrospectively. Dr. Opening retained earnings 1,500,000 Cr. Inventories (to write-down inv. produced Jul 28 – 31) 875,000 Cr. Accrued liability (for recall costs other than inventory write-down) 625,000 P3-24. Suggested solution: a.

Fiscal year Journal entries or explanation 2024 Dr. Inventories – work in process 240,000 Cr. Cash Cr. Wages payable

b. 2024

2024

Dr. Accounts receivable Dr. Cash Cr. Sales revenue Dr. Costs of goods sold Cr. Inventories – finished goods Dr. Bad debts expense Cr. Allowance for doubtful accounts

. 3-15

150,000 1,700,000 950,000 2,800

225,000 15,000

1,850,000 950,000 2,800

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

2024

The discovery of the defect occurred in the subsequent events period, but the cause of the defect originated in the fall of 2023, prior to the cut-off date of February 28, 2024. Therefore, the reduction in inventory value should have been reflected on the Feb. 28, 2024 financial statements. Dr. Loss on write-down of inventory $50,000 Cr. Inventories – work in process 50,000 d. Feb. 28, The event causing the vines to die occurred prior to the cut-off date. Had the 2025 fiscal information about the dead vines been available during the subsequent events year period, the vines would have been written off for the year ended Feb. 28, (correction 2024. However, the information did not become available until after the to 2024 financial statements were issued. One could argue that this is an error and fiscal should be corrected retrospectively if management could or should have year). known about the dead vines. In this case, the error correction entry is: Dr. Opening retained earnings 80,000 Cr. Biological assets 80,000 or Feb. 28, Equally, one could argue that management could not have known about the 2025 fiscal dead vines until the spring growing season. In this case, the journal entry year. would be: Dr. Loss on vines from root damage 80,000 Cr. Biological assets 80,000

P3-25. Suggested solution: a.

Derivation of net income for the two sets of accounting policies: Accounting policy set A 2023 2024 Sales $11,000,000 $12,000,000 Cost of goods sold (FIFO) (3,000,000) (3,200,000) Bad debts expense (6% of sales) (660,000) (720,000) Warranty expense (4% of sales) (440,000) (480,000) Depreciation expense (1,000,000) (1,000,000) Other operating expenses (3,000,000) (3,300,000) Net income $2,900,000 $3,300,000

. 3-16

2025 $12,800,000 (3,500,000) (768,000) (512,000) (1,000,000) (3,900,000) $3,120,000

Chapter 3: Accrual Accounting

Accounting policy set B

2023

2024

2025

Sales

$11,000,000

$12,000,000

$12,800,000

Cost of goods sold (average cost)

(3,200,000)

(3,300,000)

(3,200,000)

Bad debt expense (allowance at 10% of gross A/R – see below)

(740,000)

(735,000)

(673,000)

Warranty expense (aged analysis)

(450,000)

(490,000)

(492,000)

Depreciation expense

(1,000,000)

Other operating expenses

(3,000,000)

(3,300,000)

(3,900,000)

Net income

$2,610,000

$3,175,000

$3,535,000

Derivation of bad debt expense (BDE) for Accounting policy set B ($000’s): Allowance for Accounts doubtful accounts receivable (ADA) 2023 Jan 1 balance 2023 Credit sales Collections Write-offs 2023 Dec 31 balance 2024 Credit sales Collections Write-offs 2024 Dec 31 balance 2025 Credit sales Collections Write-offs 2025 Dec 31 balance

0 11,000 9,000 600 1,400 12,000

600 ×10% =

10,500 650 2,250 12,800

BDE (plug)

140

Required balance

735

BDE (plug)

225

Required balance

673

BDE (plug)

Required balance

650 ×10% =

13,270 800 980

740

800 ×10% =

. 3-17

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

By coincidence, cumulative net income for the three years is the same for both situations ($9,320,000). As a result, retained earnings will be equivalent between the two methods.

Cumulative operating cash flows for the three years: Total collections – purchases – warranties paid – other operating expenses: $9,108,000. This amount is the same for both sets of policies because the balance sheet accounts for the affected accounts are the same at the end of 2025. If the relevant balance sheet accounts are the same, all timing differences between different accrual/allocation methods have cancelled out. (This problem was designed to show identical total net income for the three years.)

Net incomes are different between methods for each of the three years due to the timing of when certain amounts were expensed. As the cumulative net incomes for the three years happen to be the same, it is just a matter of when the warranty and bad debt expenses were accrued. As accruals try to estimate actual expenditures or events that occur later, the aggregate effects over multiple periods eventually net or wash out. Accrual or allocation methods are ways of estimating amounts that will only be clarified later when confirming events occur (warranty actually paid) or fail to occur (account receivable actually written off due to non-payment). Accruals are essential as accounting seeks to implement the matching principle, whereby expenses are matched with revenues recognized to determine net income for a period.

P3-26. Suggested solution: a. b. c.

Type of accounting change Change in estimate Change in accounting policy Correction of an error

Accounting treatment Prospective Retrospective with restatement Retrospective with restatement

P3-27. Suggested solution:

a. b. c.

Type of accounting change Change in estimate Change in accounting policy Correction of an error

Accounting change due to management choice? No Yes No

. 3-18

Information known (or should have been known) in prior period? No n/a Yes

Chapter 3: Accrual Accounting

P3-28. Suggested solution:

a. b.

c. d.

e. f.

Situation Furniture maker bad debts Manufacturer credit losses

Type of change Change in estimate Change in estimate

Parking service Change in bad debts accounting policy Shipbuilder Change in revenue estimate recognition

Electronics retailer warranties Clothing company inventory

Change in estimate Change in accounting policy or correction of error

Treatment Prospective

Discussion (not part of required) Due to new information

Prospective

Due to new information (that credit losses are becoming material). Could also be a change in accounting policy and treat retrospectively to maintain comparability from year to year. Retrospective with Not due to new information, but just restatement of a choice by management prior periods Prospective This is a change in circumstance, which is a change in estimate. It is due to new information. This is a change in accounting that reflects a change in business policy, not a change in accounting policy. Prospective Due to new information (enactment of new law) Retrospective but likely unable to restate prior periods

Not due to new information. Retrospective treatment would be ideal, but information on net realizable values for prior years is unlikely to be obtainable.

P3-29. Suggested solution: A change in accounting policy is a change that is due to management choice rather than the arrival of new information. Accounting standards require such changes in policy choice to be reflected retrospectively such that the financial statements in different periods are prepared with the same accounting policies. This requirement enhances the comparability (consistency) or financial statements from one period to another. In contrast, changes in estimates reflect new information, and the arrival of new information is not a choice made by management. Fundamentally, accrual accounting requires making estimates using available information, and we accept that these estimates will be imperfect due to uncertainty. Consequently, new information leads us to update these estimates going forward but do not result in changes to estimates made in the past.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-30. Suggested solution: For prospective treatment * If accounting policy alternatives are available because different alternatives best suit different circumstances, then such policy changes should be considered to result from changed circumstances. * Changing circumstances cannot be predicted with accuracy, so retrospective treatment would inappropriately assume a certain amount of clairvoyance (the ability to see the future). * Retrospective treatment is not representationally faithful for the prior periods because the new accounting policy was not the alternative chosen in those prior periods. * Retrospective treatment allows management to change past reported numbers, which erodes readers’ confidence in the representational faithfulness of financial statements. * Retrospective treatment allows management to spread out the effect of accounting policy changes rather than show the full effect in the year of change, potentially increasing chances for earnings management.

For retrospective treatment (GAAP) * Ensures comparability (consistency) among reporting periods. * Comparable financial statements allow for better predictions about the future. * Retrospective treatment provides more relevant information because the impact of the accounting change on several periods is not artificially included in one reporting period. * Retrospective treatment prevents management from making accounting policy changes that temporarily and superficially improve the appearance of current-year results due to one-time changes in accounting policy. * Reduction in earnings management opportunities increases earnings quality and users’ confidence in financial reports.

P3-31. Suggested solution:

a. b. c.

Type of accounting change Change in estimate Correction of error Change in accounting policy

Effects in year prior to change Treatment Prospective Retrospective Retrospective

Assets or liabilities — ↑$8,000 asset ↓$3,000 assets

Equity —

Income —

↑$8,000

↓$3,000

. 3-20

Effects in year of change Assets or liabilities Equity Income ↓$5,000 ↓$5,000 ↓$5,000 assets no effect no effect ↓$8,000 ↓$7,000 assets

↓$7,000

↓$4,000

Chapter 3: Accrual Accounting

P3-32. Suggested solution: Effect of accounting change on June 30, 2024 financial statements (indicate both direction and amount) Assets Liabilities Equity Income

Type of accounting change

Treatment

Correction of error.

Retrospective

–

↑8,000

↓8,000

Change in accounting policy

Retrospective

↓35,000

–

↓35,000

↓15,000

Change in estimate

Prospective

↑100,000

–

↑100,000

P3-33. Suggested solution: a.

Each of the six issues should be addressed as follows:

Long-Term Contracts: This is a clear change in accounting policy where the new policy is deemed to be more appropriate, so it should be retrospectively applied.

ii.

Accounts Receivable: This is not an error, but rather a change in estimate due to new information. As the bankruptcy occurred after the subsequent-events period (i.e., after completion of the audit), no adjustment to the 2023 financial statements is permitted.

iii.

Machine Depreciation: This is a change in estimate of the useful life of the machine. This new information should be applied prospectively to the depreciation charges for 2024 and subsequent periods. The depreciation expense for 2023 should remain and reduce the carrying value of the machine accordingly for 2024. The remaining useful life of the machine should be changed from 9 to 14 years (15 years total – 1 year elapsed) as at January 1, 2024.

iv.

Building Depreciation: The new depreciation method should be treated prospectively as the new method is judged to be a more appropriate reflection of the consumption of benefits than the prior method.

Inventories: This is an error correction as lower of cost and net realizable value should have been used in 2023. The 2023 income statement should be adjusted accordingly. The 2024 inventory should be valued using the allowance for 2024.

vi.

Warranties: This is an error as warranties should be accrued and matched with the revenue recognized in that period. The 2023 and 2024 income statements should reflect the warranty accrual and related change in expense.

. 3-21

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

The amended statements of comprehensive income:

Long-term contract income Other income (loss) Bad debt expense Depreciation expense—machine Depreciation expense—building Inventory write-down Warranty expense Income before taxes Income taxes (at 30%)

2023 as originally presented $3,000,000 (800,000) (400,000) (500,000) (300,000) 0 (200,000) 800,000 (240,000)

2023 as amended (answer) $4,200,000 (800,000) (400,000) (500,000) (300,000) (200,000) (350,000) 4 1,650,000 (495,000)

2024 as originally presented $4,000,000 (900,000) (500,000) (500,000) (270,000) 0 (320,000) 1,510,000 (453,000)

2024 as amended (answer) $3,700,000 (900,000) (500,000) (321,429) 1 (142,105) 2 (100,000) 3 (445,000) 5 1,291,466 (387,440)

Net income

$560,000

$1,155,000

$1,057,000

$904,026

(5,000,000 – 500,000) / (15 – 1) = 321,429 (3,000,000 – 300,000) / (20 – 1) = 142,105 3 (300,000 – 200,000) = 100,000 4 200,000 + 150,000 = 350,000 5 320,000 – 150,000 + 275,000 = 445,000 2

P3-34. Suggested solution:

a. b. c. d. e. f. g. h.

Criteria The asset is expected to be sold in the entity’s normal operating cycle. The asset is traded in an active market. The asset is expected to be realized within 12 months after the balance sheet date. The asset is held primarily for the purpose of being traded. The asset is expected to be consumed in the entity’s normal operating cycle. The asset is an item of inventory. The asset is cash or cash equivalent. The asset is a receivable from another company.

. 3-22

Relevant for classification as current? (Yes/No) Yes No Yes Yes Yes No Yes No

Chapter 3: Accrual Accounting

P3-35. Suggested solution:

a. b. c. d. e. f. g.

Criteria The liability is expected to be settled in the entity’s normal operating cycle. The liability requires settlement in cash. The liability is expected to be realized within 12 months after the balance sheet date. The liability is held primarily for the purpose of being traded. The entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the balance sheet date. The liability is a line of credit owing to a financial institution. The liability is unavoidable.

Relevant for classification as current? (Yes/No) Yes No Yes Yes Yes No No

P3-36. Suggested solution: a. b.

Item Investments at fair value through profit or loss Provision for warranties

j. k. l.

Reported where? Current assets; non-current assets Current liabilities; non-current liabilities Equity Non-current assets; non-current liabilities Equity Current assets Current liabilities Non-current assets Current liabilities; non-current liabilities Current assets Non-current assets Equity

c. d.

Retained earnings Deferred income tax

e. f. g. h. i.

Common shares Accounts receivables Income taxes payable Investments in associates Lease liabilities

Current assets Non-current assets Current liabilities Current liabilities; non-current liabilities Non-current assets (contra account)

Cash on deposit Property, plant, and equipment Reserves (accumulated other comprehensive income) m. Inventory n. Patent o. Accounts payable p. Bank loans Accumulated depreciation, property, plant and equipment

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-37. Suggested solution:

a. b. c. d. e. f. g. h. i.

Required? (Yes/No) Yes Yes No No Yes No Yes Yes Yes

Line item Revenue Profit or loss (net income) Cost of goods sold General and administrative expenses Comprehensive income Labour costs Income tax expense Other comprehensive income Finance costs (interest expense)

P3-38. Suggested solution: a. b. c. d. e. f. g. h. i. j.

Type of operating expense Cost of goods sold Delivery Employee wages and benefits Administration Building depreciation Utilities (electricity, heating, etc.) Marketing and advertising Sales commissions Raw materials consumed Insurance

Nature

√ √ √ √ √

Function

√ √ √

√ √

“Nature” refers to the source of the expense, whereas “function” refers to the use. For example, employees are the source of wage costs, so employee wages are according to nature. Some of these wages go toward the production of goods that are later sold, so cost of goods sold is according to use.

. 3-24

Chapter 3: Accrual Accounting

P3-39. Suggested solution:

Current assets Cash Accounts receivable Inventory Stationery Prepaid rent Total current assets Non-current assets Long-term loan receivable Equipment Less: accumulated depreciation Total non-current assets

Total assets Computation of retained earnings: Sales revenue Cost of goods sold Advertising expense Depreciation expense Income tax expense Interest expense Rent expense Stationery expense Wages expense Net income Less dividends Retained earnings, Jan. 1 Retained earnings, Dec. 31

Wan Industries Limited Balance Sheet As at December 31, 2023 Current liabilities 334,000 Accounts payable 95,000 Interest payable 51,000 Wages payable 5,000 Unearned revenue 25,000 Current portion of LT debt 510,000 Total current liabilities Non-current liabilities Long-term loan payable Total liabilities

300,000 500,000 (50,000) 750,000 Shareholders’ equity Common stock Retained earnings (see below) Total shareholders’ equity 1,260,000

800,000 (410,000) (16,000) (12,000) (35,000) (41,000) (75,000) (14,000) (91,000) 106,000 (21,000) 385,000 470,000

. 3-25

Total liabilities and equity

142,000 10,000 15,000 23,000 40,000 230,000 360,000 590,000 200,000 470,000 670,000 1,260,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-40. Suggested solution: Company A $500

Company B $800

Company C $1,500

Company D $2,500

Company E $4,000

Liabilities Common Stock Retained Earnings Liabilities + Equity

350 20 130 $500

425 175 200 $800

1,100 125 275 $1,500

1,800 100 600 $2,500

2,800 500 700 $4,000

Opening Retained Earnings + Net Income (Loss) – Dividends Closing Retained Earnings

$100 70 (40) 130

$140 70 (10) 200

$200 160 (85) $275

$500 160 (60) $600

$750 (40) (10) $700

Assets

P3-41. Suggested solution: a.

Since the information was found in the subsequent events period, and it pertains to the 2024 fiscal year, the amounts for 2024 should be adjusted as follows: Assets (A/R) +$100,000 Revenues +$100,000 Liabilities No effect Expenses No effect Equity (R/E) +$100,000

b. * * *

2023: Accounts payable understated $350,000 2024: No effect; A/P balance is correct at the end of 2024. No journal entry required to adjust A/P. Although not expected for this question, a more complete answer would also consider the income statement effect. The delayed recording of the goods purchased understates the purchase account in 2023, which understates COGS. The effect reverses in 2024 with an overstatement in COGS in that year. To adjust for this: Dr. Opening R/E (for 2023 COGS) 350,000 Cr. COGS (2024) 350,000

Articulation errors: R/E(2023) + NI – Div = 2,630k + 1,554k – 1,750k = $2,434k ≠ R/E(2024) = $2,510k Dec. 31, 2023 cash on the cash flow statement does not equal the cash on the balance sheet.

. 3-26

Chapter 3: Accrual Accounting

P3-42. Suggested solution: a. 2024 2025

Assets No effect –$35,000

Liabilities No effect No effect

Equity No effect –$35,000

Income No effect –$35,000

Assets Liabilities Equity Income 2024 –$50,000 No effect –$50,000 No effect 2025 –$50,000 No effect –$50,000 No effect c. Substantive errors: * Current and long-term liabilities need to be separated. * Net income ($380,000) and dividends (-$450,000) do not articulate with the change in retained earnings (-$120,000). P3-43. Suggested solution: a.

* * * *

* *

Asset valuation is a process of determining the amount of benefit to carry forward to future periods. Therefore, uncertainty is inherent in the process. The balance sheet embodies the most fundamental elements of the financial statements, from which the elements of the income statement derive. Asset valuation involves capital maintenance concepts that enter into the computation of income. Examples: – Historical cost implies revenue recognition and expense matching on a transactional basis (i.e., only when transactions occur). – Making general price-level adjustments also implies revenue and expense recognition on a transactional basis, but with adjustments for overall price level changes. – Using current values to measure the value of assets disregards transactional data in favour of prevailing market price data. – Stating assets at their present value implies revenue recognition as time elapses, not at the dates of transactions. Revenue involves increases in economic benefits during an accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants, and arising from ordinary activities. Thus, recognition of revenue impacts the balance sheet by way of increments to assets, decrements to liabilities. Examples: – Recognizing revenue on a transactional basis only results in balance sheet amounts that do not reflect changes in prices and market values.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

The uncertainty of future benefits associated with research activities has resulted in the rejection of recording research costs as an asset, which also implies recognition of an expense. This expense does not match the revenues that could be generated in the future from the research efforts.

P3-44. Suggested solution: B/S – balance sheet / statement of financial position I/S – income statement / statement of profit or loss OCI – statement of other comprehensive income SCE – statement of changes in equity

a. b.

Economic event Issue (sell) common shares Purchase a machine

Pay salaries when due

d. e.

Pay accounts payable Use electricity during the year

Unrealized gain at period end on investment at fair value through profit or loss Unrealized loss at period end on investment at fair value through other comprehensive income Dividends declared on common shares Cumulative effect of change in accounting policy Write off of bad debt previously provided for Repurchase common shares; consideration paid was greater than the average cost of the shares Accrue interest expense

g. h. i. j. k. l.

m. Unrealized gain at period end on land purchased during the year that is subsequently valued using the revaluation model

. 3-28

Financial statement(s) affected B/S; SCE B/S; I/S (depreciation); SCE (retained earnings) I/S; B/S (retained earnings); SCE (retained earnings) B/S I/S; B/S (retained earnings); SCE (retained earnings) B/S; I/S; SCE B/S; OCI; SCE B/S; SCE B/S; SCE B/S B/S; SCE B/S; I/S; SCE (retained earnings) B/S; OCI; SCE

Chapter 3: Accrual Accounting

P3-45. Suggested solution:

Cash A/R (net) Inventory Prepaid insurance Equip. (net) License (net) Total assets

Meika’s Veterinarian Corp. Balance Sheet As at December 31, 2023

Unadjust $10,000 62,000

Adjust (2,000)

Adjusted $10,000 60,000

35,000 1,200

(1,500) (600)

33,500 600

A/P Payroll taxes pay Notes payable Long-term debt

Unadjust $35,000 6,000

Adjust

22,000 60,000

1,500

74,000

(8,000)

66,000

Common shares

10,000

12,000

(4,000)

8,000

61,200

(18,600)

42,600

$194,200

(16,100)

$178,100

Retained earnings Total liabilities and equity

$194,200

(16,100)

$178,100

1,000

Adjusted $35,000 7,000 23,500 60,000 10,000

P3-46. Suggested solution: a. The income statement with subtotal and operating expenses listed by nature is as follows: Axo Inc. Income Statement For the year ended December 31, 2023 Sales $ 9,224,000 Raw material used (1,670,000) Salaries and wages (5,210,000) Depreciation (1,475,000) Income before interest and taxes 869,000 Interest expense (355,000) Income before income taxes 514,000 Income tax expense (154,200) Income from continuing operations 359,800 Income from discontinued operations, net of tax 17,500 Net income $ 377,300 

The $25,000 income from discontinued operation must be presented net of related tax of $7,500.

b. The statement of changes in equity is as follows

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Axo Inc. Statement of Changes in Equity For the year ended December 31, 2023 Common Retained shares earnings Balance, January 1, 2023 $500,000 $ 817,000 Net income -377,300 Shares issued $200,000 -Dividends declared -(300,000) Balance, December 31, 2023 $700,000 $ 894,300

Total $1,317,000 377,300 200,000 (300,000) $1,594,300

P3-47. Suggested solution: a. The income statement with subtotal and operating expenses listed by function is as follows: Meika Inc. Income Statement For the year ended December 31, 2023 Sales $ 3,661,000 Cost of goods sold (2,775,000) Gross profit 886,000 Marketing and advertising expenses (642,000) Income before income taxes 244,000 Income tax expense (73,200) Income from continuing operations 170,800 Loss from discontinued operations (net of $32,100 income taxes) (74,900) Net income $ 95,900   

The income tax expense of $73,200 equals 30% of pre-tax income of $244,000. The loss from discontinued operation must be presented net of tax. Pre-tax loss of $107,000 × 30% = $32,100 of income tax. Items of expense based on the nature of the expense have been excluded; the amounts for depreciation, employee wages and benefits, and utilities are already included in the expenses listed by function.

. 3-30

Chapter 3: Accrual Accounting

b. The statement of changes in equity is as follows Meika Inc. Statement of Changes in Equity For the year ended December 31, 2023 Common Retained shares earnings Balance, January 1, 2023, as originally reported $1,600,000 $ 443,000 Effect of change in accounting policy (-$62,000 net of income tax of $18,600) -(43,400) Balance, January 1, 2023, restated 1,600,000 399,600 Net income -95,900 Dividends declared -(150,000) Shares issued 400,000 -Balance, December 31, 2023 $2,000,000 $ 345,500

Total $2,043,000 (43,400) 1,999,600 95,900 (150,000 400,000 $2,345,500

P3-48. Suggested solution: a. The income statement with subtotal and operating expenses listed by nature is as follows: Kalico Kats Statement of Comprehensive Income For the year ended December 31, 2023 Sales $ 15,344,000 Raw material used (4,670,000) Salaries and wages (7,210,000) Depreciation – equipment (580,000) Depreciation – plant (500,000) Utilities expense (876,000) Income before interest and taxes 1,508,000 Interest expense (165,000) Income before income taxes 1,343,000 Income tax expense (537,200) Income from continuing operations 805,800 Income from discontinued operations, net of tax (300,000) Net income 505,800 Other comprehensive income – gain on land revaluation 3,000,000 Total comprehensive income $3,505,800 

The $500,000 loss from discontinued operation must be presented net of related tax of $200,000.

. 3-31

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

b. The statement of changes in equity is as follows Kalico Kats Statement of Changes in Equity For the year ended December 31, 2023 AOCI on Common land Retained shares revaluation earnings Total Balance, Jan. 1 $10,000,000 $ 0 $1,834,000 $11,834,000 Net income 505,800 505,800 OCI – gain on land revaluation 3,000,000 3,000,000 Issuance of common shares 5,000,000 5,000,000 Dividends declared ( 500,000) (500,000) Balance, Dec. 31 $15,000,000 $3,000,000 $1,839,800 $19,839,800 P3-49. Suggested solution: a. The statement of changes in equity is as follows Davidson Company Statement of Changes in Equity For the year ended December 31, 2023 AOCI on Preferred Common FVOCI Retained shares shares investments earnings Balance, Jan. 1 $10,000,000 $20,000,000 $ 0 $7,212,000 Net income 838,000 OCI 140,000 Dividends declared (400,000) Balance, Dec. 31 $10,000,000 $20,000,000 $140,000 $7,650,000

. 3-32

Total $37,212,000 838,000 140,000 (400,000) $37,790,000

Chapter 3: Accrual Accounting

b. The balance sheet using the current / non-current presentation is as follows: Davidson Company Balance Sheet As at December 31, 2023 Current assets Cash $ 457,000 Accounts receivable 3,035,000 Inventories 820,000 Total current assets 4,312,000 Non-current assets Investments at fair value through other comprehensive income 1,640,000 Property, plant, and equipment – net 61,570,000 Intangible assets 1,750,000 Total non-current assets 64,960,000 Total assets $69,272,000 Current liabilities Accounts payable Income tax payable Current portion of long-term debt Total current liabilities Non-current liabilities Long-term debt Total liabilities Equity Preferred shares Common shares Accumulated other comprehensive income on FVOCI investments Retained earnings Total equity Total liabilities and equity 

1,357,000 125,000 6,000,000 7,482,000 24,000,000 31,482,000 10,000,000 20,000,000 140,000 7,650,000 37,790,000 $69,272,000

Property, plant, and equipment is the total of equipment, plant, and land accounts net of their accumulated depreciation: $5,520,000 + $50,000,000 + $12,000,000 – 3,450,000 − $2,500,000 = $61,570,000.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-50. Suggested solution:

Current assets Cash Accounts receivable Prepaid expenses

Zo-bear Corp. Balance Sheet As at December 31, 2023

Non-current assets Investments at fair value through other comprehensive income Equipment – net Total non-current assets Total assets Current liabilities Accounts payable Unearned revenue

$ 22,000 150,000 45,000 217,000 110,000 60,000 170,000 $387,000 $ 65,000 18,000 83,000

Non-current liabilities Bonds payable, due January 1, 2029 Total liabilities Equity Common shares Accumulated other comprehensive income on FVOCI investments Retained earnings Total equity Total liabilities and equity Zo-bear Corp. Statement of Changes in Equity For the year ended December 31, 2023 Common AOCI on FVOCI Retained shares investments earnings Balance, Jan. 1 $40,000 $ 0 $ 50,000 Correction of error 0 0 (22,000) Balance, Jan. 1, as restated 40,000 0 28,000 Gain on investments at FVOCI 20,000 Net income 27,000 Balance, Dec. 31 $40,000 $20,000 $ 55,000

. 3-34

189,000 272,000 40,000 20,000 55,000 115,000 $387,000

Total $90,000 (22,000) 68,000 20,000 27,000 $115,000

Chapter 3: Accrual Accounting

P3-51. Suggested solution: The following are the substantive errors contained in the summary financial statements. * The Statement of Cash flow ($0 net change in cash) does not articulate with the change in cash on the Statement of Financial Position ($70 decline). * Net income ($940) and dividends (-$80) do not articulate with the change in retained earnings (+$1460) * Long-term debt should not be part of equity. * Assets should be separated between current and non-current components. * A statement of changes in equity is required. P3-52. Suggested solution: The following are some of the articulation and reasonability tests that could be used. This is not an exhaustive list. First Articulation Test: Do the retained earnings add up? If one takes opening retained earnings plus net income less dividends, will the result equal closing retained earnings? Second Articulation Test: Is the cash position correct? If a statement of cash flows has been prepared, does it reconcile the change in cash? If there is no statement of cash flows, does the cash position seem reasonable given the investment and financing activities of the company? Third Articulation Test: Does the depreciation expense on the income statement agree with the change in accumulated depreciation on the balance sheet? (Note that this articulation test works if there are no planned disposals of property, plant, and equipment in the forecast period. First Reasonableness Test: Does the change in total assets support the change in revenue? If revenues grow significantly, does the balance sheet expand in approximately the same percentage? Second Reasonableness Test: Are the return on equity and return on assets reasonable percentages? Returns on equity or assets of more than 20% are suspicious if there is competition that prevents enormous returns. Third Reasonableness Test: Do the balances of inventory and accounts receivable appear reasonable given the changes in revenue and cost of goods sold? Are the accounts receivable and inventory turnover ratios reasonable given the seasonality of the industry? Fourth Reasonableness Test: If there were major investments in new property, plant, and equipment, do the changes in financing (long-term debt and share balances) appear reasonable?

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P3-53. Suggested solution: a.

The corrected balance sheet is as follows: Maple Company Balance Sheet As at December 31, 2023 Current assets Cash Accounts receivable Inventory (note 1) Non-current assets Cars – net (note 2) Equipment – net (note 3) Land held for future development Total non-current assets Total assets

4,000 145,000 595,000 744,000

92,750 102,000 228,000 422,750 $1,166,750

Current liabilities Accounts payable Credit balances in accounts receivable Interest payable (note 4) Bank loan payable Current portion of loan due to shareholder Total current liabilities Non-current liabilities Loan due to shareholder Total liabilities Equity Common shares (40,000 shares authorized and issue) Retained earnings (deficit) Total equity Total liabilities and equity

$ 119,000 55,000 4,500 320,000 50,000 548,500 250,000 798,500 400,000 (31,750) 368,250 $1,166,750

Notes: 1. Inventory includes car parts ($65,000) and cars intended for resale ($530,000), for a total of $595,000 2. Car used by executives, at cost: $105,000. Accumulated depreciation for a half year, straight-line over 3 years: [$105,000 – ($105,000 × 30%)] / 3 × ½ = $12,250. Net: $105,000 - $12,250 = $92,750.

. 3-36

Chapter 3: Accrual Accounting

3. Equipment cost $170,000. Accumulated depreciation for one year, declining balance at double the straight-line rate with 5-year useful life: $170,000 × 40% = $68,000. Net: $170,000 - $68,000 = $102,000. 4. Interest payable = $300,000 ×6% × 3/12 = $4,500. b.

The incident should not be recognized but should be disclosed in the 2023 financial statements. Since the fire occurred after the 2023 year-end (i.e., after cut-off), the inventory value at December 31, 2023 would not be adjusted. However, the first loss should be disclosed in the notes to the 2023 financial statements. Since the loss caused significant changes to assets or liabilities in 2024, users would want to be informed of this loss as part of the 2023 financial statements, rather than waiting to be informed in the 2024 financial statements.

P3-54. Suggested solution: a. b.

The comparative years is shown as at the end of December 29, 2018 because Canadian Tire is primarily a retailer, and for such companies, they report on 52-week, 364-day cycles rather than 12-month cycles. (Every few years, the company will report 53 weeks.) The reporting of subtotals for current assets and current liabilities is generally required byIFRS. There are two relevant paragraphs in IAS 1: 55 and 60. Paragraph 60 requires entities to present current assets separately from non-current assets, and likewise current liabilities separately from long-term liabilities. This paragraph does not say anything about subtotals. However, paragraph 55 states, “An entity shall present … headings and subtotals in the statement of financial position when such presentation is relevant to an understanding of the entity’s financial position.” Given that paragraph 60 requires current items to be separated from non-current items, it would seem that in most cases, subtotals should be presented.

P3-55. Suggested solution: a.

Canadian Tire shows operating expenses according to their nature in Note 29 (“Cost of Producing Revenue”) and Note 30 (“Selling, general and administrative expenses”). The largest operating expense by nature is, not surprisingly for a retailer, inventory cost of sales at $9,116.8 million followed by personnel expenses at $1,375.0 million.

The income statement shows operating expenses by function (“Cost of producing revenue” and “Selling, general and administrative expenses”).

The company presents or discloses operating expenses both by their nature and function because the company chose to present the expenses by function in the income statement, and when it does so, IAS 1 requires the company to also disclose operating expense by their nature. Had the company presented operating expense by nature in the income statement, then it would not have needed to disclose the expenses by function (although it could still choose to do so).

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P. Mini-Cases Case 1: Effects of Different Accrual Policies. Suggested solution: To: Executive Committee From: Vice-President Finance and Chief Financial Officer Re: Accounting policies for depreciation and bad debt expense Food Processing must make some critical and strategic choices as to the long-term orientation of its accounting policies for depreciation and bad debt expenses. The policies selected must be logical, practical, consistently applied, permitted by IFRS, and faithfully/fairly represent the company’s achievements over the longer run as we cannot change them at will or regularly. It should also be noted upfront that there is no such thing as “correct net income.” Financial accounting uses accrual accounting, whereby the consequences of transactions and events often must be allocated or assigned to several fiscal periods with no method of splitting up these amounts being absolutely correct or undisputedly better than some other possibilities. For example, depreciation expense is the apportioning of the cost of plant and equipment to expense over a series of years. Different depreciation methods will record different depreciation expenses each year but the total expensed cannot exceed the cost of the depreciated asset. The same is true for bad debt expense. In the long run, the total bad debt expense must equal the amount of accounts receivable actually written off. If more bad debts are expensed earlier on, in later periods less would be charged to expense. So net income is set within a range of possible estimates, and in the longer run the total income recorded using any set of accounting policies must be the same. In selecting the orientation of these policies, we should be mindful of the objectives of the shareholders to take the company public in four years. The accounting policies will influence the perceptions of new investors as to the success and future prospects of Food Processing, and in turn impact on the value they assign to the company in four years. While accounting policies do not change reality and what really occurred, the policies will affect what external parties believe the future earnings and cash flows will be. Finally, accounting policies will change net income from period to period; they change cash flows only to the extent income taxes are affected. As Canadian tax rules have their own methods for calculating depreciation and bad debt expenses, our policies should not change the amount of income taxes paid. Broadly described, I suggested three orientations to accounting policies noted: “conservative,” “neutral,” and “liberal.” In the short run (first two or three years), the “conservative” approach would result in the lowest income and the “liberal” methods the highest earnings. This would be because under conservative allocation methods higher amounts would be expensed. For example, in the earlier years depreciation expense would be materially larger than if liberal methods of calculating depreciation were used. However, as the total amount to be expensed for depreciation or bad debts cannot exceed the actual cost of the asset or the actual accounts receivable written off, any excess or deficiency in the amounts charged to income would be reversed. If depreciation expense was high in the earlier years, the amount expensed would decrease in later years, and the same for bad debts.

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Chapter 3: Accrual Accounting

Note also that the larger the relative amount expensed, the smaller the income in that year. A conservative approach to accounting policies would lower net income in the first few years, but as the amounts charged to expense decreased, this would increase the rate of growth of net income in the medium term and longer term. The opposite would be the effect if liberal policies were used. In the early years, expenses would be relatively less but would increase in subsequent periods, resulting in a lower overall growth rate for net income later on. As the owners have a plan to seek new investors in four years, a legitimate objective in selecting accounting policies is to consider how our choice today will influence the perceptions of these new investors in four years. A series of improving and growing earnings will reasonably bias the price of Food Processing upward when the firm is ready for new investors, so I recommend using the more conservative allocation policies from the start. Further, as Food Processing is starting and the owners are also part of management, there is no separation of ownership from management. In such a case, it would be prudent for the shareholders to start by getting a cautious estimate of income and later, with the benefit of hindsight, learn that a higher amount of income could be justified. This is preferable to learning the reverse lesson and being disappointed later. Being conservative at the start would be both a wise business and accounting strategy. I have not considered in detail the “neutral” allocation approach as it would neither harm nor advance the owners’ medium-term plans of inviting new investors to Food Processing. Being neutral, while a compromise, fails to address the impossibility of deriving a “correct” net income and is at best a half measure. Case 2: Grosco’s Redeemable Preferred Shares. Suggested solution: * * *

To address this question, it is important to clearly understand when events took place. It is also necessary to quantify as much as possible because the bond covenant ratios are clearly important. While the amount of information provided is limited, there is enough to make accurate quantitative assessments of compliance with the covenants. The following chart displays the quantitative information given regarding the ratios.

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* * * * *

The superficial examination of the facts suggests that Grosco has no substantive issues relating to the covenants and the related debt. That is, at December 31, 2021, the company’s debt-to-equity ratio was below both thresholds, at 2.4:1. This conclusion does not consider the accounting treatment of the retractable preferred shares and information in the subsequent events period. Management has treated the preferred shares as equity, as implied by the drop in the debtto-equity ratio on the date of issuance. However, we need to consider whether they should instead be considered a liability. The preferred shares would be a liability if they arose from a past transaction, if they entail the sacrifice of future resources, and if they are a present obligation (meaning that Grosco does not have the discretion to avoid the outflow of resources). It is the last criterion that is contentious. Shares confer to the holder the benefit of dividends, but dividends are always at the discretion of the company’s board of directors. The cumulative aspect of these preferred shares does not alter this assessment. Therefore, the dividends, by themselves, suggest that this is equity, as shares usually are. For the equity or liability determination, we also need to consider the retractable feature of the preferred shares. These preferred shareholders have the right to retract the shares beginning May 1, 2022, one year after issuance, which is less than one month away (currently being sometime in April 2022). We have to consider the likelihood that the shareholders will retract the shares. Why would they retract? At first blush, it does not seem likely that they will, since these shareholders decided to invest less than a year ago.

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Chapter 3: Accrual Accounting

It needs to be recognized that the primary benefit of the shares is the promised stream of quarterly dividends. Three payments have been made and the fourth is due by the end of April 2022. However, the preliminary first-quarter financial statements show a debt-toequity ratio of 2.8:1, which violates Covenant A, barring the company from paying dividends. It is important to note a subtle point: For the purpose of the year-end financial statements, the March 31, 2022 debt-to-equity ratio is information from the subsequent-events period, and it is relevant only to the extent that it provides information concerning Grosco’s state of affairs at the year-end. So what does the 2.8:1 debt-to-equity ratio on March 31, 2022 say about conditions on December 31, 2021? It provides information about the appropriate classification of the preferred shares as equity or liability. The inability to pay dividends significantly increases the likelihood that preferred shareholders will retract their shares. What would happen if this likelihood is assessed to be sufficiently high, such that the preferred shares are classified as a liability on December 31, 2021? It is tempting at this point to just say that the debt-to-equity ratio will go up, but by an unknown amount since we do not have the dollar amounts involved. However, we can actually be quite specific about what would happen, using the little information we have been given: – First, pick any arbitrary amount for equity on April 30, 2021. Suppose it is $100 million. – Then, using the ratios given, we can infer the other amounts. – Denoting E = equity, D = debt, and Pfd = retractable preferred shares, the following chart identifies the calculations. As shown in the chart below, we can infer that, if the retractable preferred shares were to be classified as a liability, then the December 31, 2021, debt-to-equity ratio would be 3.2:1. If this were the case, Grosco would violate both Covenants A and B. Not only would the company not be able to pay dividends, but it also would need to repay the bond principal (whatever amount that may be). This outcome would require the debt to be reclassified as a current liability. In addition, this outcome brings into doubt the assumption that Grosco is a going concern. So, as the auditor, what do you do? This is a difficult situation, to say the least. Option 1: Agree with management’s determination that the preferred shares should be classified as equity. Option 2: Reclassify the preferred shares as a liability. Option 3: Delay the completion of the audit to obtain addition information regarding the company’s financial condition and to see whether preferred shareholders retract their shares. None of these options are without drawbacks, as each will have severe implications for bondholders, common shareholders, preferred shareholders, and management, with consequent risk of litigation. The decision is left as an open question that requires the application of professional judgment. Note: This case is designed for the purpose of illustrating the issues surrounding timing, uncertainty, incomplete information, and subsequent events. Partly reflecting the thorny issues raised in this case, current accounting standards (e.g., IAS 32) require retractable preferred shares (such as those involved in this case) to be classified as liabilities.

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Standards relating to financial liabilities is beyond the level of preparation expected of students at this level, so discussion of specific standards has been intentionally omitted.

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Chapter 3: Accrual Accounting

Case 3: Sleep King Manufacturing Company. Suggested Solution: a.

Though the auditor might query all the above-mentioned issues, the issue of the biggest concern should be the premature recognition of revenue with the December 28th shipment. While SKMC management may be able to justify other issues, the premature recognition of revenue was clearly a violation of accrual accounting principles. The terms of sale were FOB destination, meaning revenue should only be recorded once the mattresses were delivered to the destination of the client on January 2nd, 2024. The decision of SKMC to recognize revenue related to this shipment showed that management did not respect periodicity and cut-off. The company operated in a 12-month period and the cut-off date for revenues was December 31, 2023. The auditor would probably demand SKMC management to undo the recognition of the $20,000 in its 2024 financial statements.

Quality of earnings is defined as how closely reported earnings correspond to earnings that would be reported in the absence of management bias. In this case, the auditor might very be aware of the presence of management bias. First, there was strong motivation of earnings management in SKMC management, because management bonus is directly tied to net income. Second, there was the issue of premature revenue recognition. Third, there were three significant changes of estimates in the current year and they all resulted in increase in net income. Though it might be hard to say that these new estimates were all biased, auditor might be skeptical of all estimates that resulted in increase in net income in the current year. As a result, one may conclude earnings quality is low for SKMC.

In accrual accounting, many estimates are used to account for company’s transactions. In a sense, there is a trade-off between relevance and reliability. Estimates are essential because they allow management to provide financial information to users that is timely and relevant. However, financial statement users may be concerned about the reliability of these estimates. It is usually not an easy task for auditor to assess whether estimates provided by management are reasonable (i.e., they are true and fair). When there is an extensive use of estimates in the financial statements, the benefit of providing relevant information might be outweighed by the concerns about the reliability of these estimates.

The financial statement least affected by estimates would be the cash flow statement. This is because the cash flow statement shows the company’s financial position based on cash flows from operating, financing and investing activities. The statement is less subject to the impact of accrual accounting and thus it is less affected by accounting estimates.

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Chapter 4 Revenue Recognition N. Problems P4-1. Suggested solution: An enterprise creates value at many different points or periods of time. Conceptually, revenue and associated costs, or income, should be recorded whenever the enterprise creates or adds value. The discovery of a process or product, manufacturing, distribution, product display, sales, delivery, credit provision, warranties are all value-adding activities, so revenue/income could be recognized at all of these points or periods of time. P4-2. Suggested solution: * * * *

* *

It is true that there is significant evidence supporting the efficiency of security prices, such that those prices reflect information available to market participants. Information about a mineral discovery is indeed relevant to the value of a mining company, so stock price should respond to such information. However, accounting’s role is not to simply reflect the information that is already contained in security prices. Rather, accounting reports should be a source of information for various purposes, one of them being the valuation of securities. The market price for the company’s securities is the result of buying and selling by many traders who are interpreting information without bias. Allowing companies to record revenue when they make a mineral discovery (or for similar types of events) gives a great deal of latitude for making estimates about the value of the discovery, and such estimates could be severely biased. While the mineral discovery may be verifiable by geological engineers to some extent, numerous estimates are required to translate that discovery to a dollar figure in terms of future revenue or income. Revenue recognition criteria try to balance the demands for relevant information and the reliability of the recorded revenue, taking into consideration the uncertainty of events, the motives of management, and the availability of other sources of information.

P4-3. Suggested solution: * * * *

The cash basis of revenue recognition would be more reliable since cash receipts are readily verifiable. However, doing so usually delays the recognition of revenue, reducing its timeliness and relevance to users. Cash basis information is generally less useful for making predictions about the future, as it can fluctuate due to random events affecting the timing of payment. While more reliable, the cash basis does not eliminate judgment and overstatements. Many transactions involve payments in advance of the delivery of goods or provision of services. . 4-1

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* *

Restricting revenue recognition to the cash basis can have real consequences on business activities. For instance, a company would be less willing to sell products on credit; the supply of credit is essential to the health of the economy. Revenue recognition criteria try to balance the reliability of reported revenue with the demand for relevant information.

P4-4. Suggested solution: a.

* ABC’s investment satisfies the definition of an asset, but it fails the recognition criteria because the future economic benefits of the R&D are highly uncertain. Therefore, the investment should be expensed. * XYZ can recognize the $500 million equity investments as assets because the value of the shares can be readily determined from quoted prices on stock exchanges. * Success: While the discovery of the vaccine will likely lead to significant future cash flows in the form of sales of vaccines, those revenues cannot be recognized until the sales occur. * Failure: There are no revenues or income to recognize in this instance. In addition, since the R&D costs had been expensed, there are no assets to write off when the R&D is unsuccessful. * Success: XYZ would record income for the increase in the value of its investment and correspondingly write up the value of the asset. * Failure: XYZ would record a loss for the decrease in value of its investment and write off the asset. * This approach relies on the efficiency of security markets providing reliable evidence of the value of the vaccine.

d. ABC

XYZ

Vaccine success

Revenue = 0

Gain = $1,950 million

Vaccine failure

Revenue = 0

Loss = $50 million

* The differences in accounting between ABC and XYZ are due to the recognition criteria, particularly in regard to whether there is reasonable certainty in the amounts to be recognized. * ABC must defer the recognition of revenue until the actual sale of the malaria vaccine (if any) while XYZ could indirectly recognize its share of future revenues (net of costs) that the biotechnology company is expected to earn from the vaccine via the increase in its stock price. . 4-2

Chapter 4: Revenue Recognition

P4-5. Suggested solution: Activity Sale of products Post-sale services (multiple deliverable contracts) Sales with repurchase commitments or right of return Lease agreements Financial services

Method of revenue recognition Upon transfer of the risks and rewards of ownership. Deferred and recognized as revenue over the period of contract according to the pattern of expected costs. Revenue is either recognized proportionally or the difference between the sales and repurchase price is recognized in instalments over the term of the contract depending on the nature of the agreement. For vehicles sold to the dealership that are expected to be repurchased in a subsequent period as part of leasing operations, revenues are deferred until the vehicle has been sold Revenues from operating leases are recognized on a straight-line over rental period. Revenues from finance leases are recognized at the lease commencement date. Interest income using effective interest method.

P4-6. Suggested solution: The five steps in the revenue recognition process and the purpose of each are listed below: 1. Identify the contract. The purpose of this step is to identify the contract that will be accounted for. The contract can be written or oral providing that it meets the commercial substance test and it is probable that the consideration will be collectible. The contract must also meet the requirements with respect to identification of the respective parties’ rights and obligations and payment terms. 2. Identify the performance obligation. The purpose of this step is to determine whether there is more than one performance obligation and the nature of each obligation. 3. Determine the transaction price. The purpose of this step is to determine the amount that ultimately needs to be accounted for. This is normally a fairly straight-forward exercise; however, complications can arise if: the consideration received is a non-cash asset; there is a significant financing component; there is consideration payable to the customer; and/or the amount of consideration to be received is not fixed at the outset. 4. Allocate the transaction price to the performance obligations. The purpose of this step is to determine how much revenue should be recognized for the completion of each part of a contract that includes multiple performance obligations. 5. Recognize income in accordance with performance. The purpose of this step is to ensure that revenue is recognized when the enterprise transfers control of the good or service to the

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customer. For contracts that include multiple performance obligations, an appropriate amount of revenue is recognized upon the completion of each obligation. P4-7. Suggested solution:

a. b.

d. e. f. g. h. i. j.

Situation A vendor sells tomatoes at a farmers’ market. A department store sells and delivers a washing machine with a three-year warranty against manufacturing defects. An electronics store sells a television set with a 14-day “lowest price” guarantee. (That is, if the customer finds a lower price on the same product offered by the company or a competitor, the company will refund the difference to the customer.) A bus manufacturer signs a contract to supply 280 buses over five years for the Toronto transit system. A university receives students’ course registrations. An insurance company issues a one-year insurance policy on a car. A company deposits funds into a two-year term deposit that earns 4% per year. A company takes a five-year loan bearing interest at 8% per year. A company purchases computers for its accounting department. A company purchases manufacturing equipment that is expected to produce 50,000 widgets. A company incurs delivery costs on January 3 for a shipment of products sold five days earlier (before the year-end).

Method of recognition At point of sale At point of sale At point of sale

According to degree of completion According to degree of completion Over time Over time Over time Over time According to units of production At point of sale (before year-end)

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Brief explanation Sale of goods: risk and rewards transferred. Sale of goods: significant risk and rewards transferred; assurance-type warranty is not a separate performance obligation. Sale of goods: significant risk and rewards transferred; remaining indemnity risk is small and estimable.

Provision of services on long-term contract involving the transfer of a series of similar products. Provision of services. Revenue earned as courses progress. Provision of services. Revenue earned as time elapses. Provision of services: a deposit provides funds to the bank to use for lending. Matching with the benefits received from using funds. Matching with the benefits received over time. Matching with the benefits of production and subsequent sales. Matching delivery costs with the related sales.

Chapter 4: Revenue Recognition

P4-8. Suggested solution: Revenue recognition criteria not met An apartment owner receives a deposit of $1,200 Service: It is not probable that the equal to one month’s rent. economic benefits (the value of the deposit) will flow to the entity. An insurance company receives annual premiums for Service: Revenue should be fire insurance on June 25 for coverage beginning July recognized according to the stage 1. of completion; the coverage period has not yet begun. A city transit authority issues 200,000 monthly Good: The transit authority has passes at $80 each for sale at various retailers. not transferred to the buyer the Retailers act as consignees for these passes. risks and rewards of ownership. Service: See next item. A city transit authority sells 50,000 monthly passes at Service: Revenue should be $80 each to transit riders at its own retail recognized according to the stage offices/stores. of completion. The period for which the passes are valid has not elapsed. A provincial lottery corporation delivers 10 million Good: The lottery corporation has scratch-and-win cards to retailers. The cards retail for not transferred to the buyer the $2 and generate a commission of $0.20 per card for risks and rewards of ownership. the retailer. The retailer can return unsold cards to the lottery corporation. Circumstance

P4-9. Suggested solution: a. This transaction includes a significant financing component, consideration payable to the customer, and variable consideration. The transaction price is $200,000 (cash) + $924,556 (PV note) − $29,000 (consideration payable to customer) + $30,000 (variable consideration) = $1,125,556 as determined below.  

The present value of the $1,000,000 interest free note is $1,000,000 / 1.042 = $924,556. The consideration payable to the customer (the $50,000 maximum discount on a future purchase) is valued at either the expected value or the most likely amount of the consideration payable, whichever is more appropriate in the circumstances. While professional judgement must be exercised to determine this, given the wide-range of probabilities here, the expected value approach appears to be the more appropriate method to estimate the consideration payable to the customer.

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Probability

30% 40% 30% 100%

Amount

$0 $20,000 − $50,000 >$50,000

Expected Value

$0 *$14,000 **$15,000 $29,000

* ($20,000 + $50,000)/2 = $35,000 midpoint of range; $35,000 × 40% = $14,000 ** If the sales price of the machine purchased is > $50,000, the discount is limited to $50,000. 

The transaction price includes variable consideration when it is highly probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. Given that the $30,000 delivery bonus will either be earned or it won’t, the most likely amount is more suited to the circumstances. As Reenie Inc. has an established record of earning delivery bonuses and is highly confident that it will earn this bonus as well, the variable consideration should be included in the transaction price. From a practical perspective, as revenue will not be recorded until delivery, whether the delivery bonus is earned or not, would be known with certainty when the sale is recorded. Determining the amount of variable consideration for inclusion in the transaction price becomes more of an issue when accounting for long-term contracts, or when accounting for contracts when the amount of variable consideration actually earned, will not be known until after revenue is initially recognized.

b. Dr. Cash ($200,000 + $30,000) Dr. Note receivable (from PV calculation) Cr. Consideration payable to customers (from expected value calculation) Cr. Sales revenue ($230,000 + $924,556 − $29,000)

230,000 924,556

Dr. Cost of goods sold (given) Cr. Inventory

750,000

29,000 1,125,556 750,000

P4-10. Suggested solution: a. This transaction includes a significant financing component, consideration payable to the customer, and variable consideration. The transaction price is $500,000 cash down payment + $1,128,143 (PV note) − $50,000 (consideration payable to customer – parts inventory purchase) − $22,500 (consideration payable to customer – discount on future purchases) + $1,500,000 cash (variable consideration) = $3,055,643 as determined below:

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Chapter 4: Revenue Recognition

 

The present value of the $1,200,000 interest free note determined using a BAII Plus: 24 N, .5 I/Y, 50000 PMT, 0 FV, CPT PV  PV = −1,128,143; 6% annual interest rate / 12 months = 0.5% I/Y. There are two components of the consideration payable to the customer: the parts inventory that DRMC has agreed to purchase from Liberty and the discount on future purchases that DRMC has agreed to provide Liberty. Purchase of parts inventory from Liberty As per paragraph 71 of IFRS 15, providing that fair value of the goods or service purchased is greater than or equal to the contract price, the purchase of distinct goods or services from the customer (in this case the parts inventory) is accounted for in the same way that DRMC accounts for purchases from other suppliers. If, though, the contract price exceeds the fair value of the goods or services purchased, as is the case here, the excess is deducted from the transaction price. $300,000 contract price for parts − $250,000 fair value for parts = $50,000 deduction from the transaction price for the equipment. Discount on future purchases by Liberty The discount on future purchases is valued at either the expected value or the most likely amount of the consideration payable, whichever is more appropriate in the circumstances. In scenario 1, management believes that the appropriate method is the most likely amount approach. The most likely amount is estimated to be $0 − $1,500,000 with all points within the range equally likely and a 45% probability of occurrence. The consideration is thus valued a $750,000 (midpoint of the range) × 3% (contract discount) = $22,500.



The transaction price includes variable consideration when it is highly probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. In scenario 1, there is a high degree of uncertainty as to when the machine will actually be delivered. It is thus appropriate to allocate the $1,500,000 stipulated minimum in the contract to the transaction price, as there is a significant risk of reversal of amounts in excess of this. From a practical perspective, as revenue will not be recorded until delivery, there would not be any question as to the amount of cash actually due on delivery (the variable consideration). This is illustrated in part b as the cash due on delivery is $1,900,000 versus the $1,500,000 forecast, as DRMC delivered the machine during September. Determining the amount of variable consideration for inclusion in the transaction price becomes more of an issue when accounting for long-term contracts, or when accounting for contracts when the amount of variable consideration actually earned, will not be known until after revenue is initially recognized.

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b. Dr. Unearned revenue (Cash received when contract signed) Dr. Cash (Given) Dr. Note receivable (PV of note) Cr. Consideration payable to customer – purchase of parts inventory from Liberty Cr. Consideration payable to customers – discount on future sales to Liberty Cr. Sales revenue ($500,000 + $1,900,000 + $1,128,143 − $50,000 − $22,500)

500,000 1,900,000 1,128,143

Dr. Cost of goods sold (given) Cr. Inventory

2,200,000

50,000 22,500 3,455,643

2,200,000

c. This transaction includes a significant financing component, consideration payable to the customer, and variable consideration. The transaction price is $500,000 cash down payment + $1,094,457 (PV note) − $113,875 (consideration payable to customer – discount on future purchases) + $2,000,000 cash (variable consideration) = $3,480,582 as determined below:  

The present value of the $1,200,000 interest free note determined using a BAII Plus: 24 N, .75 I/Y, 50000 PMT, 0 FV, CPT PV  PV = −1,094,457; 9% annual interest rate / 12 months = 0.75% I/Y. There two components of the consideration payable to the customer that must be considered are the parts inventory that DRMC has agreed to purchase from Liberty, and the discount on future purchases that DRMC has agreed to provide Liberty. As the price to be paid for the parts inventory to be purchased from Liberty equals the fair value of the assets to be acquired, no adjustment to the transaction price is required. The discount on future purchases is valued at either the expected value or the most likely amount of the consideration payable, whichever is more appropriate in the circumstances. In scenario 2, management believes this to be the expected value approach. The consideration payable to the customer is thus $113,875 as calculated below: Aggregate transaction price Up to $1,500,000 $1,500,001 − $3,000,000 $3,000,001 − $$5,000,000 Over $5,000,000

Midpoint $ 750,000 2,250,000 4,000,000 ?

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Discount granted Probability 3% 45% 5% 7% 8%

30% 25% 0%

Expected value $ 10,125 33,750 70,000 0 $113,875

Chapter 4: Revenue Recognition



In scenario 2, there is a low degree of uncertainty that the machine will be delivered by August 31. It is thus appropriate to allocate the $2,000,000 variable consideration to be received for achieving this delivery date to the transaction price. As mentioned in part a) of the question, from a practical perspective, as revenue will not be recorded until delivery of the machine, there will not be any question as to the amount of cash that is actually due on delivery.

d. Dr. Unearned revenue (Cash received when contract signed) Dr. Cash (Given) Dr. Note receivable (PV note) Cr. Consideration payable to customers – discount on future sales to Liberty Cr. Sales revenue ($500,000 + $2,000,000 + $1,094,457 − $113,875)

500,000 2,000,000 1,094,457

Dr. Cost of goods sold (given) Cr. Inventory

2,200,000

113,875 3,480,582 2,200,000

P4-11. Suggested solution: The loyalty program creates two performance obligations whereby each sale is a combination of the delivery of one large cup of coffee immediately, and 1/7th of the free large cup of coffee for a loyalty customer. Using the stand-alone selling price method, the proceeds from 7 sales need to be allocated over 8 transactions, since the 8th one is “free.” Dr. Cash (140,000 × $4.00) Cr. Sales revenue ($560,000) × 7/8) Cr. Deferred revenue ($560,000 - $490,000)

560,000

Dr. Deferred revenue (15,000 × $4.00 × 7/8) Cr. Sales revenue

52,500

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P4-12. Suggested solution: Dr. Account receivable (200,000 units × $6.00/unit) 1,200,000 Cr. Sales revenue ($1,200,000 − $117,000) 1,083,000 Cr. Consideration payable to customers (30% × 300,000 coupons × 117,000 $1.30/coupon) Dr. Cost of goods sold (200,000 units × $2.50/unit) Cr. Inventory

500,000

Dr. Consideration payable to customers (from above) Cr. Sales revenue ($117,000 − $110,500) Cr. Accounts payable

117,000

500,000 6,500 110,500

P4-13. Suggested solution: a. The loyalty program creates two performance obligations whereby each sale is a combination of the delivery of one cup of coffee immediately, and 1/9th of the tenth cup of coffee for a loyalty customer. Using the stand-alone selling price method and assuming that each customer consumes the same product each time, then the proceeds from 9 sales need to allocated over 10 transactions, since the 10th one is “free.” Dr. Cash (100,000 × $1.50 / sm cup) Dr. Cash (250,000 × $1.80 / md cup) Dr. Cash (320,000 × $2.00 / lg cup) Cr. Revenue ($150,000 + $450,000 + 640,000) × 9/10 Cr. Deferred revenue ($1,240,000 – $1,116,000)

150,000 450,000 640,000

1,116,000 124,000

b. Using the residual value method and assuming all customers redeem for a large size, the journal entries would be as follows: Dr. Cash (100,000 × $1.50 / sm cup) Dr. Cash (250,000 × $1.80 / md cup) Dr. Cash (320,000 × $2.00 / lg cup) Cr. Deferred revenue (670,000 cups × 1/10 × $2.00 / lg cup) Cr. Revenue ($1,240,000 – $134,000)

150,000 450,000 640,000

134,000 1,106,000

c. In this scenario, the residual value method would be more appropriate because it uses only one fair value for a large cup of coffee. In contrast, if the relative stand-alone selling price method were to be used, the amount of deferred revenue would differ depending on whether the sale involved a small, medium, or large cup of coffee, even though the three different . 4-10

Chapter 4: Revenue Recognition

deferred revenue amounts relates to the same product to be delivered in the future. While there is nothing specific in the standards to prohibit this outcome, it is certainly unsatisfying. To see the different amounts of deferred revenue, compute the revenue amounts using the relative stand-alone price method (using the nominal prices as their fair values since other customers not on the loyalty program do pay these prices):

Small cup sales 100,000 sm cups @ $1.50 10,000 lg cups @ $2.00 Total

Component fair value as Component percentage fair value of total

× Actual sale price

= Allocation

150,000

88.24%

$150,000

$132,353

20,000

11.76%

$150,000

17,647

170,000

100.00% × Actual sale price

= Allocation

250,000 md cups @ $1.80

450,000

90%

$450,000

$405,000

25,000 lg cups @ $2.00

50,000

10%

$450,000

45,000

Total

500,000

100%

Large cup sales

Component fair value as Component percentage fair value of total

Amount per free large cup $1.80

$450,000

× Actual sale price

= Allocation

320,000 lg cups @ $2.00

640,000

90.91%

$640,000

$581,818

32,000 lg cups @ $2.00

64,000

9.09%

$640,000

58,182

Total

704,000

100.00%

. 4-11

$1.76

$150,000

Component fair value as Component percentage fair value of total

Medium cup sales

Amount per free large cup

$640,000

Amount per free large cup $1.82

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P4-14. Suggested solution: a.

DR Accounts receivables (10,000 × $350) CR Sales revenue ($3,500,000 - $300,000) CR Consideration payable to customers (10,000 × 60% × $50) DR Cost of goods sold (10,000 × $180) CR Inventory DR Consideration payable to customers (from above) CR Sales revenue ($300,000 - $25,000) CR Cash (10,000 × 55% × $50)

3,500,000

1,800,000 300,000

3,200,000 300,000 1,800,000 25,000 275,000

P4-15. Suggested solution: a.

Expected discount = 0.5% × $30,000 = $1,500 Revenue = nominal price – volume discount = $30,000 – $1,500 = $28,500.

The purchase volume in the first ten months of $1.65 million suggests that the annual purchase volume will be $1.65m × 12/10 = $1.98 million if the trend is maintained for the final two months of the year. However, given that this amount is only $20,000 short of the threshold for the next higher level of discount, Foothills Grocers is incentivized to make additional purchases from GD to reach $2 million in purchases. Doing so will entitle Foothills Grocer to the 1.0% discount rate, which is an additional 0.5% in discount for all its purchases for the year. This benefit is 0.5% × $2 million = $10,000. This additional discount works out to 50% of the additional $20,000 purchase made to obtain the discount. Given this large incremental benefit, it is very likely that Foothills Grocer will increase its purchases to reach the $2 million threshold. As long as the purchased goods are non-perishable, there is little additional cost for Foothills Grocer to do this. Consequently, GD should anticipate that Foothills Grocer will reach the $2 million threshold and adjust revenues to reflect a 1% volume discount rate rather than a 0.5% rate.

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Chapter 4: Revenue Recognition

P4-16. Suggested solution:

Months elapsed SubscriptionSubscriptions by end of months earned in received December the year January 4,600 11 50,600 February 4,000 10 40,000 March 4,500 9 40,500 April 5,200 8 41,600 May 6,000 7 42,000 June 5,300 6 31,800 July 4,700 5 23,500 August 4,400 4 17,600 September 7,200 3 21,600 October 4,000 2 8,000 November 4,200 1 4,200 December 9,500 0 Total 63,600 321,400 Number of months per year 12 Subscription years Price per subscription per year Revenue earned in the year

$ $

26,783.33 99 2,651,550

P4-17. Suggested solution:

Zoom 1 Car: immediate recognition Warranty: defer and amortize Total

Component fair value

Component fair value as percentage of total

× Actual sale price

= Allocation

14,000

90.32%

$15,000

$13,548

1,500

9.68%

$15,000

1,452

15,500

100.00%

. 4-13

$15,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Zoom 2 Car: immediate recognition Warranty: defer and amortize Total

Component fair value

Component fair value as percentage of total

× Actual sale price

= Allocation

15,000

88.24%

$18,000

$15,882

2,000

11.76%

$18,000

2,118

17,000

100.00%

$18,000

P4-18. Suggested solution: a. Sale price

– Fair value of more reliably measured component (car)

= Residual value (warranty)

Zoom 1

$15,000

$14,000

$1,000

Zoom 2

18,000

15,000

3,000

Sale price

– Fair value of more reliably measured component (warranty)

= Residual value (car)

Zoom 1

$15,000

$1,500

$13,500

Zoom 2

18,000

2,000

16,000

P4-19. Suggested solution: a. The sale price should be allocated using the stand-alone selling prices. Therefore, the amount of revenue that should be recorded is computed as follows:

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Chapter 4: Revenue Recognition

Stand-alone selling price

Stand-alone selling price as percentage of total

× Actual sale price

= Allocation

Car

45,000

90%

$45,900

$41,310

Basic service package Increment for premium service package

3,000

$45,900

2,754

2,000

$45,900

1,836

Total

50,000

100%

$45,900

The basic service package is for two years, so its value should be allocated over Year 1 and Year 2 ($2,754 / 2 = $1,377). Likewise, the increment for the premium package should be allocated over Years 3 and 4 ($1,836 / 2 = $918). The revenue for each time period would be as follows.

Car Basic service package Increment for premium service package Total

Upon delivery

Year 1

Year 2

Year 3

Year 4

$41,310

1,377

918

$41,310

$1,377

$918

b. In this case, the sale price should be allocated using the relative stand-alone selling prices. The answer here is similar to that in part (a) except that the revenue for Years 1 to 4 will differ because the two service components have been combined.

Stand-alone selling price

Stand-alone selling price as percentage of total

× Actual sale price

= Allocation

Car

45,000

90%

$45,900

$41,310

Premium service pkg

5,000

10%

$45,900

4,590

Total

50,000

100%

. 4-15

$45,900

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Car

Upon delivery

Year 1

Year 2

Year 3

Year 4

$41,310

Premium service pkg Total

$1,147.50

$41,310

$1,147.50

c. The assumed facts here suggest that the stand-alone selling prices of the service packages are more reliably determined while the stand-alone selling price of the car varies considerably. Therefore, the residual value method seems more appropriate than the relative stand-alone price method.

Total sale price

$45,900

– Basic service package

– 1,500

– Increment for premium service package

– 1,800

Residual = amount allocated to car

$42,600

P4-20. Suggested solution:

Option A

Component of performance obligation

Amount

Phone

$600

Upon sale

Phone

$600

Upon contract signing and delivery of JPhone

Cellular service

$1,040

Timing (i.e., when)

Service revenue over 24 months = $200 + $60 × 24 − $600 = $1,040; or $43.33/mth)*

*Note that $600 is the fair value of the JPhone given the additional external evidence, so the revenue for the phone is readily identifiable. There is not independent information on the fair value of cellular services, so the residual method needs to be applied to determine the revenue for cellular services. P4-21. Suggested solution: a. The phone packages involve multiple performance obligations, so it is important to separate the two streams of revenue: sale of the phone and cellular services. However, the nominal prices for the two components are not necessarily indicative of the value of the components. . 4-16

Chapter 4: Revenue Recognition

For example, the phone is provided for “free” under Option A, but costs $400 under option B and $600 under option C. Option C is the only option with a single deliverable, so the $600 can serve as the stand-alone selling price for the Raspberry 300. For this option, $600 can be recognized as revenue upon delivery of the phone. Option A has total revenue of $1,800 over the 36 months of the contract ($50 × 36 = $1,800). Of that amount, $600 can be allocated to the phone, while the remaining $1,200 should be allocated to the service contract, resulting in $33.33 per month ($1,200 / 36). Likewise, Option B has total revenue of $1,000 over 12 months ($50 × 12 + $400 = $1,000). Allocating $600 to the phone, the remaining $400 should be recognized over 12 months of the contract, or $33.33 per month. b. To ensure the validity of the approach just described, it is important to ascertain whether the $600 price for the phone under Option C is indeed its fair value. If a significant number of customers do choose Option C, then those market transactions supports $600 as the fair value. If no one, or if very few customers choose Option C, then that brings into doubt that $600 is the fair value of the phone. The more general point is that prices quoted by the reporting entity may not be truly reflective of fair value. Consider the possibility for earnings management if all such quoted prices were accepted as fair values. In the case of the Raspberry 300, if the company artificially set a high price for Option C, say, $1,000, then accepting $1,000 as the value of the phone would allow the company to record $1,000 immediately in revenue (and less later) if customers chose Options A or B. However, any rational customer will not accept this price because Option B has the same cost ($400 initially plus $50/month × 12 months = $1,000) but provides both the phone and one year of service. P4-22. Suggested solution: The different sources of revenue for REYC warrant different treatment due to their differing characteristics. The following discusses each in turn. Initiation fee of $50,000 This fee is charged only once upon a member joining and is non-refundable. Therefore, an argument can be made that the full amount can be recognized in revenue when received. That is, the criteria for the recognition of service revenue under IFRS 15 paragraph 9 have been satisfied: (a)

A contract has been signed or orally agreed to.

(b)

The contract requires that the yacght club provide access to the member to the yacht clubs facilities and services, provided that the member remains in good standing.

(c)

The member must pay a $50,000 non-refundable initiation fee.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

(d)

The timing and amount of the yacht club’s cash flow will change as it will received $50,000 immediately that it would not otherwise receive.

(e)

The collectability and the amount of the consideration is certain as it must be paid before membership is granted and it is non-refundable.

On the other hand, recognizing the full $50,000 in revenue can be premature. When members join, they expect and have rights to certain services as long as they remain members in good standing. Therefore, it can be argued that REYC has obligations to provide services in the future. From this perspective, criteria (c) noted above has not been satisfied because the transactions is only partially complete, if at all, at the time of membership initiation. Furthermore, the club is operated on a break-even basis, implying that the proceeds from the initiation fees would be used to cover capital and operating costs (e.g., for the clubhouse, outstations); otherwise, the club would generate large surpluses from the initiation fees. This argument suggests that REYC should record the initiation fee as deferred revenue. Under this approach, the revenue would be recognized over the expected life of memberships, which is around 25 years. On balance, it appears that the deferral approach for initiation fees is more appropriate to reflect the services that the club is expected to provide to new members over many future years. Annual membership fee of $10,000 On the surface, the treatment of the annual membership fee would seem to be straightforward because the fees are paid annually for services received in the same period. Therefore, the full $10,000 should be recognized in revenue in each year. However, the membership fee entails multiple deliverables. One deliverable is the $2,400 credit toward restaurant meals, and the second are the use of the facilities (clubhouse, outstation). The fair value of the latter (access to facilities) is difficult to estimate. Therefore, it would be appropriate to use a residual value approach where the fair value of the meals would be deducted from the membership fee to obtain the residual for the value of the facilities access. The $2,400 amount of the restaurant credit could be a reasonable indication of the value of the meals that will be delivered, leaving $7,600 for the value of the facilities access. On the other hand, there is evidence that the club restaurant charges prices that are 25% below market. Therefore, an argument can be made to attribute a stand-alone selling price of $3,200 (= $2,400 / (1 – 0.25)) to the restaurant credit, leaving $6,800 as the residual value for facilities access. While the latter approach is conceptually better, it is not recommended because it would create a complex billing system in the club restaurant where meals consumed as part of the $2,400 credit would be grossed up by 1/3 (e.g., a $24 meal would be recorded as $32) while other meals paid out-of-pocket would be recorded at face value. The combination of the two types of revenue would hinder the management of the restaurant as some meals will have much higher margins than other meals. Ultimately, all $10,000 of the annual membership fee including the $2,400 of restaurant credit will be recognized in income in the year since the credits cannot be carried over from year to year. Thus, there is little to be gained by allocating any amount other than $2,400 to the restaurant meals—financial statement readers (the membership) are better served by seeing . 4-18

Chapter 4: Revenue Recognition

the performance of the club restaurant based on actual prices paid for meals rather than imputed prices. Other revenue sources REYC should record revenue from moorage in the period in which the moorage services are consumed. Likewise, the club should record revenue from courses when the courses are delivered to participants. As mentioned above, restaurant revenue should be recorded at the actual prices charged rather than at market rates. P4-23. Suggested solution: The sale of the tablet with the assurance-type warranty represents a contract with a single performance obligation. As such the entire transaction price will be recognized at time of sale and an assurance warranty obligation established. The sale of the tablet with the sales-type warranty represents a contract with two performance obligations. The transaction price must be allocated to the two obligations based upon their relative stand-alone sales prices. Revenue pertaining to the sale of the tablet (including the assurance-type warranty) will be recognized at time of sale and an assurance warranty obligation established. Revenue pertaining to the sale of the sales type warranty will be deferred until performance is achieved. a.

DR Cash (100 × $500) CR Sales revenue DR Cost of goods sold (100 × $300) CR Inventory DR Warranty expense (100 × $25) CR Provision for assurance warranty costs

50,000 30,000 2,500

DR Cash (150 × $600) 90,000 CR Sales revenue (150 × $480*) 72,000 CR Unearned sales revenue – service warranty 18,000 (150 × 120*) DR Cost of goods sold (150 × $300) 45,000 CR Inventory 45,000 DR Warranty expense (150 × $25) 3,750 CR Provision for assurance warranty costs 3,750 *The transaction price of $600 must be allocated to the two performance obligations based on their relative stand-alone sales prices of $500 and $125. $500/$625 × $600 = $480; $125/$625 × $600 = $120. c.

DR Provision for assurance warranty expense claims CR Labour expense ($2,000 × 50%) CR Parts inventory ($2,000 × 50%)

. 4-19

2,000

1,000 1,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

DR Service warranty costs 2,100 CR Labour expense ($2,100 × 50%) 1,050 CR Parts inventory ($2,100 × 50%) 1,050 DR Unearned sales revenue – service warranty* 7,200 CR Sales revenue – service warranty 7,200 *Revenue to be recognized is determined based on the cost-based input measure. Total expected costs = # of tablets × cost per tablet = 150 × $35 = $5,250. Cumulative performance to date = costs expensed to date / total expected costs = $2,100 / $5,250 = 40%. Revenue to recognize for the year = unearned revenue originally recognized × cumulative percentage earned – unearned revenue previously recognized = $18,000 × 40% – $0 = $7,200. P4-24. Suggested solution: June 30

Dr. Inventory Cr. Cash

400

August 15

Dr. Cash ($50,000 × 80% - $500) Dr. Advertising expense Cr. Sales revenue

39,500 500

Dr. Costs of goods sold ($40,000 × 80% + $400) Cr. Inventory

32,400

400

40,000 32,400

Note: The shipment of inventory on consignment and the return of unsold merchandise by the consignee is not journalized as the significant risks and rewards of ownership have not been transferred. Rather, Amanda Corp. would track the amount and location of inventory out on consignment in a subsidiary record. P4-25. Suggested solution: 42,000 copies × $2/copy = $84,000 P4-26. Suggested solution: These magazines are consignment sales and need to be accounted for as such. Copies distributed during 2024 Less: Copies distributed during 2024 and returned in 2024 (830,000 – 35,000) Less: Copies distributed during 2024 and returned in 2025 Copies distributed and sold during 2024 Price per copy (Retail price of $4 less 50%)

. 4-20

1,950,000 (795,000) (32,000) 1,123,000 × $2 $2,246,000

Chapter 4: Revenue Recognition

P4-27. Suggested solution: Installment sales involve higher uncertainty regarding the amount that will be collected from customers. In other words, the amount of future benefits (cash flows) to be received is more uncertain than for typical transactions involving the sale of goods. P4-28. Suggested solution: July 2023

Dr. Installment receivable Cr. Inventory (60% × $7.2m) Cr. Deferred gross profit (40% × $7.2m)

7,200,000

4,320,000 2,880,000

P4-29. Suggested solution: Note that the gross margin is $7,500 / $30,000 = 25%. Jan 2023

Dr. Installment accounts receivable Cr. Inventory Cr. Deferred gross profit

30,000

May 2023 Sep 2023 Jan 2024

Dr. Deferred gross profit ($10,000 × 25%) Dr. Cost of goods sold ($10,000 × 75%) Cr. Sales revenue ($30,000 × 1/3)

2,500 7,500

Dr. Cash Cr. Installment accounts receivable

10,000

22,500 7,500

10,000 10,000

P4-30. Suggested solution: May

Dr. Installment accounts receivable Cr. Inventory ($90,000 × 60%) Cr. Deferred gross profit ($90,000 × 40%)

90,000

Aug, Sep Oct, Nov

Dr. Deferred gross profit ($36,000 × 1/4) Dr. Cost of goods sold ($54,000 × 1/4) Cr. Sales revenue ($90,000 × 1/4) Dr. Cash Cr. Installment accounts receivable

9,000 13,500

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22,500

54,000 36,000

22,500 22.500

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P4-31. Suggested solution: a.

First, note that all installment sales made from January to June would have been fully collected by December 31. Therefore, the amount that remains outstanding can be computed to be $530,000, as follows:

Month January February March April May June July August September October November December

Installment sales $ 80,000 70,000 90,000 100,000 90,000 100,000 120,000 x 110,000 x 100,000 x 90,000 x 130,000 x 150,000 x

No. of payment o/s at year-end 0 0 0 0 0 0 1 2 3 4 4 4

$ 1,230,000

/ / / / / /

Total number of payments

Amount o/s at year-end

4 4 4 4 4 4 Installment accounts receivable

= $ 30,000 = 55,000 = 75,000 = 90,000 130,000 = = 150,000

Gross margin

$ 530,000 40% $ 212,000

The amount of deferred gross profit is $212,000, as shown in the table for part (a). This amount is 40% of the installment accounts receivable.

The amount of sales recognized in the year equals the amount of installment sales made in the year less the amount remaining in receivables at year-end. Thus, the amount is $1,230,000 – $530,000 = $700,000.

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Chapter 4: Revenue Recognition

P4-32. Suggested solution: Path Pavers must use the percentage of completion method, with the amount of trail resurfaced as an indicator of the percentage complete. (Dollar amounts in millions)

2023

2024

2025

2026

2027

Total

Distance completed in the year Cumulative kilometres completed

8 km 8 km

12 km 20 km

12 km 32 km

12 km 44 km

6 km 50 km

50 km

16% $25 $ 4 0 $ 4

40% $25 $10 4 $ 6

64% $25 $16 10 $ 6

88% $25 $22 16 $ 6

100% $25 $25 22 $ 3

$25

(Dollar amounts in millions)

2023

2024

2025

2026

2027

Total

Distance completed in the year Percentage completed (50 km total) Contract price Revenue for the year

8 km 12 km 12 km 12 km 6 km 50 km 16% 24% 24% 24% 12% 100% $25 $25 $25 $25 $25 $25 $ 4 $ 6 $ 6 $ 6 $ 3 $25

Cumulative % completed Contract price Cumulative revenue Less: revenue previously recognized Revenue for the year Alternative solution:

It is important to note that this alternative is quicker but that it will only work in situations where the original estimates are completely accurate and not later revised (i.e., there is certainty). Thus, it is not recommended for general application. P4-33. Suggested solution: Gross profit recognized in 2023: Estimated Gross profit Cost incurred to date × − gross profit previously recognized Estimated total cost 2,000,000 =( × 2,000,000) − 0 8,000,000 = 25% × 2,000,000 = 500,000

Gross profit =

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Gross profit recognized in 2024: Gross profit =

Estimated Gross profit Cost incurred to date × − gross profit previously recognized Estimated total cost

5,500,000 × 1,200,000) − 500,000 8,800,000 = (62.5% × 1,200,000) − 500,000 = 250,000 =(

P4-34. Suggested solution: Since the company is unable to estimate total cost, the company should use the cost recovery method. In this method, revenue each year prior to completion equals costs incurred. In the final year, revenue equals the amount that remains to be recognized. Revenue (= cost of sales) Cost of sales Gross profit

2023 2m 2m 0

2024 3.5 m 3.5 m 0.0

2025 4.5 m 3.5 m 1.0 m

Total 10 m 9m 1m

P4-35. Suggested solution: * *

For cost-plus contracts, SNC-Lavalin records revenue as costs are incurred. For fixed-price contracts, the company uses the percentage of completion method. The percentage completed is determined using the cost-to-cost approach.

P4-36. Suggested solution: *

Airbus SE identifies the various performance obligations of the contract and allocates the transaction price to these performance obligations. Revenue from the sale of commercial aircraft is recognized when the aircraft is delivered. Revenue from the sale of military aircraft, space systems and services are recognized over time using the percentage of completion method. The percentage completed is determined using the cost-to-cost approach.

* *

P4-37. Suggested solution: a.

* * *

Total cost = 800 % complete = 320 / 800 = 40% Revenue = 40% × 960m – 144m = $240m

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Chapter 4: Revenue Recognition

2024 * Total cost = 108 + 792 = 900 * % complete = 108 / 900 = 12% * Revenue to date = 12% × 960m = $115.2m 2025 * Revenue = 40% × 960m – 115.2m = $268.8m

P4-38. Suggested solution: a.

To apply the percentage of completion method, we must use the cost-to-cost approach since no other estimate of the stage of completion is available. 2023 A $ 80,000 B = Sum of A 80,000 C 158,000 D = B+C 238,000 E = B/D 33.61% F = E × 300,000 $100,840 G = Prior F 0 H=F–G 100,840 A 80,000 J=H–A 20,840

2024 $120,000 200,000 39,000 239,000 83.68% $251,046 100,840 150,206 120,000 30,206

2025 $ 50,000 250,000 0 250,000 100% $300,000 251,046 48,954 50,000 (1,046)

Receivables beginning balance Billings during year Collections during year Receivables ending balance

0 65,000 (60,000) 5,000

5,000 130,000 (128,000) 7,000

7,000 105,000 (112,000) 0

CIP inventory beginning balance Cost incurred during year Gross profit (loss) recognized Contract completion CIP inventory ending balance

0 80,000 20,840 n/a 100,840

100,840 120,000 30,206 n/a 251,046

251,046 50,000 (1,046) (300,000) 0

Cost incurred during year Cost incurred to date Additional costs to complete Total estimated costs % complete Cumulative revenue Less: revenue previously recorded Revenue – current year Expenses Gross profit (loss)

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Cash 80,000

Year 2023 Incur costs Bill client

Accts Receivable

CIP Inventory 80,000

Billings on CIP

65,000

Receive cash

60,000

Revenue or expense 65,000

60,000

Rev & exp recog

20,840

Balance

20,000

2024 Incur costs

5,000

100,840

120,000

Bill client

80,000 100,840 65,000

120,000 130,000

Receive cash

128,000

130,000 128,000

Rev & exp recog

30,206

Balance

12,000

2025 Incur costs

7,000

120,000 150,206

251,046

50,000

Bill client

195,000

112,000

105,000 112,000

Rev & exp recog

1,046

Balance

50,000

30,206

50,000 105,000

Receive cash

*20,840

50,000

300,000

Close project

300,000 300,000

Balance

48,954

1,046

300,000

Total income over three years

50,000

* Revenue and expenses are temporary accounts, which are closed at the end of each period, so balances do not carry forward. P4-39. Suggested solution: $ millions

2023 $13.500 (12.000) – $ 1.500

Revenue Cost of sales [not required] Expected loss [not required] Gross profit (loss)

2024 $14.625 (18.000) ( 1.125) $( 4.500)

Computations: Revenue = %complete × total revenue – revenue previously recognized 2023 Rev = (12 / 40) × 45 = 30% × 45 = $13.500m 2024 Rev = (30 / 48) × 45 − 13.5 = 62.5% × 45 – 13.5 = $14.625m Gross profit = %complete × total gross profit – gross profit previously recognized 2023: GP = (12 / 40) × (45 – 40) = 30% × 5 = $1.5m 2024: GP = 100% × (45 – 48) – 1 = −3 − 1.5 = −$4.5m

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Chapter 4: Revenue Recognition

P4-40. Suggested solution: Revenue − COGS − Expected loss (recovery) = Gross profit (loss)

Year 1 10,000 12,000 8,000 (10,000)

Year 2 20,000 18,000 (8,000) 10,000

Year 3 20,000 25,000 0 (5,000)

Total 50,000 55,000 0 (5,000)

P4-41. Suggested solution: 2023 65,000 1,000

2024 65,000 6,000

2025 65,000 500

2026 65,000 1,500

66,000

71,000

65,500

66,500

Costs incurred to date Estimated cost to complete Estimated total cost

15,000 47,000 62,000

30,000 42,000 72,000

50,000 11,000 61,000

63,000 0 63,000

Estimated gross profit (loss)

4,000

(1,000)

4,500

3,500

% complete

24.19%

41.67%

81.97%

100%

968 0 968

(1,000) 968 (1,968)

3,689 (1,000) 4,689

3,500 3,689 (189)

Original contract price Price adjustment [50% × (est. cost – 60m)] Adjusted contract price

Cumulative profit (loss) Less: profit (loss) previously recognized Current year gross profit (loss)

Total

3,500

P4-42. Suggested solution: Cost incurred to date Additional costs to complete Total estimated costs % complete Cumulative revenue Less: revenue previously recorded Revenue – current year Expenses Expected loss accrual (reversal) Gross profit (loss)

2023 B 150,000 C 1,350,000 D=B+C 1,500,000 E=B/D 10% 190,000 F = E × 1,900,000 G = Prior F 0 H=F–G 190,000 J = B – prior B 150,000 See Note 1 0 See Note 2 40,000

. 4-27

2024 1,200,000 800,000 2,000,000 60% 1,140,000 190,000 950,000 1,050,000 40,000 (140,000)

2025 2,100,000 0 2,100,000 100% 1,900,000 1,140,000 760,000 900,000 (40,000) (100,000)

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Note 1: These figures may be computed directly or as plug figures after determining the gross profit. The direct computation for 2024 is: expected loss accrual = percentage uncompleted × total expected loss – previous accruals = 40% × 100,000 – 0 = 40,000. For 2024, expected loss accrual = 0% × 200,000 – 40,000 = –40,000. Note 2: Because the expected total cost exceeds the contract price in 2024, the gross profit (loss) in the year must reflect all of the loss, and reverse any prior profit recorded. Thus, the gross profit (loss) = 100% × –100,000 – 40,000 = –140,000. Similarly, in 2025 the computation is gross profit = 100% × –200,000 – –100,000 = –100,000. P4-43. Suggested solution: Under the completed contract method, no revenue would be recognized until the contract is completed. However, it is still necessary to recognize any expected losses so that the financial statements are not overstated. Therefore, the amounts for revenue and profit/loss should be: 2023 0 0

Revenue – current year Expenses Gross profit (loss) before Less: Expected loss accrual (reversal) Gross profit (loss)

0 0

2024 0 0 0 100,000 (100,000)

2025 1,900,000 2,100,000 (200,000) (100,000) (100,000)

P4-44. Suggested solution: The question only asks for the gross profit or loss, so we can simply apply these formulas. Normal circumstance (year 2023, 2025, and 2026): Note: the following equation is the bottom part of Exhibit 4-17. Gross profit (loss ) =

Gross profit Cast incurred to date Estimated × − Estimated total cast gross profit previously recognized

When there is an expected loss on the contract (year 2024): Note: the following equation is Exhibit 4-24. Gross profit (loss ) = 100% ×

Estimated Gross profit (loss ) − gross profit previously recognized

2023 gross profit (loss) = 1,000,000/3,500,000 × 2,000,000 – 0 = 571,429.

. 4-28

Chapter 4: Revenue Recognition

2024 gross profit (loss) = 100% × -500,000 – 571,429 = –1,071,429 Cumulative profit (loss) recognized = 571,429 + –1,071,429 = –500,000 2025 gross profit (loss) = 3,000,000/5,000,000 × 500,000 – –500,000 = 800,000 Cumulative profit (loss) recognized = –500,000 + 800,000 = 300,000 2026 gross profit (loss) = 100% × 1,500,000 – 300,000 = 1,200,000 Cumulative profit recognized = 300,000 + 1,200,000 = 1,500,000 P4-45. Suggested solution: For the completed contract method, no profit is recognized until the end of the contract. However, any expected losses are recognized in their entirety in the year anticipated. The gross profits (losses) for the four years are shown in the following table. It is important to note that the loss is not reversed in 2025 when the project becomes profitable again—all profits are deferred to the date of contract completion. Year Gross profit (loss)

2023 0

2024 (500,000)

2025 0

2026 2,000,000

Total 1,500,000

P4-46. Suggested solution: a. GP = % complete × estimated total GP – GP previously recognized 2023: GP = (42 / 75) × (80 – 75) – 0 = 56% × 5 = $2.8m 2024: GP = 100% × (80 – 84) – 2.8 = −4 − 2.8 = −$6.8m 2025: GP = 100% × (80 – 81) – -4 = -1 – -4 = $3.0m –$1.0m b. Revenue = % complete × estimated total revenue – revenue previously recognized 2023 Rev = (42 / 75) × 80 = 56% × 80 = $44.8m 2024 Rev = (63 / 84) × 80 − 44.8 = 75% × 80 – 44.8 = $15.2m

. 4-29

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

c. Costs incurred

Dr. CIP Cr. Cash, A/P

Billings

Dr. A/R Cr. Billings on construction

Collections Dr. Cash Cr. A/R

Revenue Dr. COGS and Cr. CIP (reversal of 2023’s profit) expense Cr. Revenue (see part b) recognition Cr. Provision for onerous contract* Dr. Expected loss on construction contract Cr. Provision for onerous contact*

21 20 19 2.8 15.2 3.0

* $80 contract revenue - $84 expected loss (2024) = $4 expected loss (2024). Provision for loss = $3 + $1 = $4 P4-47. Suggested solution: a. GP = % complete × estimated total GP – GP previously recognized Year 1: GP = (3,500 / 10,000) × (12,000 – 10,000) – 0 = 35% × 2,000 = $700k Year 2: GP = 100% × (12,000 – 13,000) – 700 = −1,000 − 700 = −$1,700k Year 3: GP = 100% × (12,000 – 12,000) – –1,000 = $1,000k b. Revenue = % complete × estimated total revenue – revenue previously recognized = (10,000 / 13,000) × 12,000 − 4,200 = $5,031k c. (in $ thousands) Costs incurred Dr. CIP Cr. Cash, A/P

6,500

Billings Dr. A/R Cr. Billings on construction

4,000

. 4-30

6,500

4,000

Chapter 4: Revenue Recognition

Collections Dr. Cash Cr. A/R Revenue and expense recognition Dr. COGS Cr. CIP (Reversal of Year 1’s profit) Cr. Revenue Cr. Provision for onerous contract* Dr. Expected loss on LT contract Cr. Provision for onerous contract*

4,200 6,500

231

4,200 700 5,031 769 231

* $12,000 contract revenue - $13,000 expected costs (Y2) = $1,000 expected loss (Y2). Provision for loss = $769 + $231 = $1,000 d.

Project completion Dr. Billings on construction Cr. CIP

12,000

P4-48. Suggested solution: a.

Revenue 2023 Rev 2024 Rev 2025 Rev

= %complete × total revenue – revenue previously recognized = (4 / 32) × 40 = 12.5% × 40 = $ 5m = (24 / 48) × 40 − 5 = 50.0% × 40 – 5 = $15m = (34 / 40) × 40 − 20 = 85.0% × 40 – 20 = $14m

2023: GP = (4 / 32) × (40 – 32) = 12.5% × 8 2024: GP = 100% × (40 – 48) – 1 = −8 − 1 2025: GP = (34 / 40) × (40 – 40) – -8 = 0 – -8

. 4-31

= = =

$1.0m −$9.0m (given) $8.0m $0.0m

12,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

c. Costs incurred

Dr. CIP Cr. Cash, A/P

Billings

Dr. A/R ($31 – $20) Cr. Billings on construction

Collections Dr. Cash ($29 – $17) Cr. A/R

Revenue Dr. COGS and Dr. Provision for onerous contract* expense Cr. Revenue (see part a) recognition Cr. Expected loss recovery on construction contract**

10 8

10 11 12

14 4

*$40 million contract revenue - $4 + $20 actual costs and $24 million expected costs (2024) = $8 million expected loss (2024). Loss is reversed in 2025 as the contract is expected to break even. ** $10 + $8 - $14 = $4 In 2025 the contract was forecasted to break even ($4 cost $2023 + $20 cost 2024; + $10 cost 2025 + $6 remaining expected costs = $40); $40 revenue - $40 costs = $0 profit or loss; in 2024 a loss of $9 was recognized on the contract, bringing the cumulative loss to $8 ($1 profit in 2023 - $9 loss 2024) which now has to be reversed. ($14 revenue + ? loss recovery - $10 COGS = $8 reversal of cumulative 2024 loss; ? = $8 + $10 - $14 = $4. Essentially, in 2025 we are recognizing $4 profit in the normal manner based on percentage of completion ($14 revenue - $10 COGS) and we need to credit the expected loss revenue account for the difference between this amount and the cumulative loss previously recognized ($8 cumulative loss 2024 - $4 profit 2025 = $4 expected recovery of loss in 2025.) P4-49. Suggested solution: a.

(in $ thousands) Cost incurred to date Estimated cost to complete Estimated total cost Contract price Estimated gross profit % complete Gross profit to date Gross profit previously recognized Current gross profit

Notes A B C=A+B D D–C E=A/C F=D×E G

Year 1 13,000 37,000 50,000 60,000 10,000 26% 2,600 0

Year 2 40,000 18,000 58,000 60,000 2,000 68.97% 1,380 2,600

Year 3 54,000 0 54,000 60,000 6,000 100% 6,000 1,380

Total

F–G

2,600

–1,220

4,620

$ 6,000

. 4-32

Chapter 4: Revenue Recognition

(in $ thousands) Costs incurred Dr. CIP Cr. Cash, A/P

27,000

Billings Dr. A/R Cr. Billings on construction in progress

25,000

Collections Dr. Cash Cr. A/R

20,000

Revenue (income) recognition Dr. COGS Cr. Revenue [40/58 × 60,000 – 26%×60,000] Cr. CIP c.

Dr. Billings on construction in progress Cr. CIP

27,000

60,000

27,000

25,000

20,000

25,780 1,220

60,000

d. * * *

If the cost to complete is $22 million, estimated total cost would be $62 million, resulting in a projected loss. The entire projected loss must be recognized immediately, and any prior profits reversed. Profit (loss) to be recorded = 100% × –2,000,000 – 2,600,000 = –$4,600,000.

P4-50. Suggested solution: a.

i. * * * * *

Estimated total gross profit = 20% × $1.9 billion = $380m Estimated total cost = (1 – 20%) × $1.9 billion = $1,520m 2023 Gross profit = % complete × estimated GP – GP previously recognized 2023 Gross profit = 228m / 1,520m × 380m – 0 2023 Gross profit = 57m

ii. Dr. COGS Dr. CIP Cr. Revenue (15% × 1,900m)

228m 57m

. 4-33

285m

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

ii.

Est. total costs:

2023 to 2025 $ 684m 2026 380m Beyond 2026 912m Total $1,976m > $1,900m contract price Since a loss is projected, record 100% of loss. 2026 gross profit (loss) = 100% × estimated GP – GP previously recognized = 100% × –76m − 76m = –$152m (GP previously recognized = $760m – $684m = $76m) % complete = (684m + 380m) / 1,976m = 1,064m / 1,976m = 53.85% (rounded) Dr. COGS 380.000m Dr. Expected loss 35.074m Cr. Provision for loss on onerous contract (46.15% × -76m) 35.074m Cr. CIP (53.85% × -76m − 76m) 116.926m Cr. Revenue (53.85% × 1900m − 760m) 263.074m (The provision for loss and reduction in CIP equals 35.074m + 116.926m = 152m)

P4-51. Suggested solution: a.

(in $ millions)

Year 1 480 2,520 3,000 16% 3,600 576 0 576

Year 2 1,250 1,875 3,125 40% 3,600 1,440 576 864

Year 3 2,660 1,140 3,800 70% 3,600 2,520 1,440 1,080

Year 4 3,750 0 3,750 100% 3,600 3,600 2,520 1,080

Cumulative expense Expense previously recognized Current-year expense without loss Additional expense for expected loss* Total expense for the year

480 0 480 0

1,250 480 770 0

2,660 1,250 1,410 60

3,750 2,720 1,030 0

3,690 60

480

770

1,470

1,030

3,750

Current-year gross profit (loss)

(390)

( 150)

Costs incurred to date Estimated cost to complete Estimated total cost % complete Contract price Cumulative revenue Less: revenue previously recognized Current-year revenue

Total

3,600

Additional expense for expected loss = % uncompleted × projected total loss = 30% × $200 = $60. . 4-34

Chapter 4: Revenue Recognition

(in $ millions) Costs incurred Dr. CIP Cr. Cash, A/P

480

Billings Dr. A/R Cr. Billings on construction in progress

500

Collections Dr. Cash Cr. A/R

450

Revenue and expense recognition Dr. COGS Dr. CIP Cr. Revenue

480 96

Dr. Billings on construction in progress Cr. CIP

3,600

480

500

450

576

3,600

Costs incurred to date Estimated cost to complete Estimated total cost % complete Contract price Cumulative revenue Less: revenue previously recognized Current-year revenue

480 2,520 3,000 16% 3,600 576 0 576

2 1,250 1,875 3,125 40% 3,600 1,440 576 864

Cumulative expense Expense previously recognized Current-year expense without loss Additional expense for expected loss Total expense for the year

480 0 480 0

1,250 480 770 0

2,660 1,250 1,410 0

3,750 2,660 1,090 0

3,750 0

480

770

1,410

1,090

3,750

Current-year gross profit (loss) Gross profit (loss) from part (a)

96 96

94 94

(190) (390)

(150) 50

( 150) ( 150)

. 4-35

3 2,660 940 3,600 73.9% 3,600 2,660 1,440 1,220

4 3,750 0 3,750 100% 3,600 3,600 2,660 940

Total

3,600

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Underestimating the cost to complete by $200 million would reduce the Year 3 loss by $200 million, while the Year 4 gross profit of $50 million would go down by $200 million to result in a $150 million loss. Over the four years, the loss is $150 million regardless of the estimates used in the first three years. P4-52. Suggested solution: The errors include the following: * The percentage complete is solely based on hours to date/budget hours. The denominator needs to be updated to reflect the best estimate, as at December 31, 2023, of the total hours required to complete the contract. * After including the updated estimates of total hours, the company needs to determine if any of the contracts are expected to have a loss. – The table shows Contract Epsilon as more than 100% complete, meaning that actual hours exceed budget hours. However, the amount of time elapsed is 6 months out of 12 months for the contract, so it is likely that the actual progress is closer to 50%, meaning that this contract is likely to produce a loss. – Given the 30% margin (average cost is $70 while contract rate is $100 per hour), it is also likely that projects Alpha and Chi will produce losses. * The completion dates for projects Phi and Eta have already passed (2023/10/06 and 2023/11/25). Presence in this table suggests these projects are supposedly still in progress. The actual hours are also substantially below budget (21.3% and 42.9% of budget). The company has also not sent any invoices to the client. Together, these facts suggest that the company was not able to fulfill the terms of the contract. If this is true, then these contracts need to be written off (i.e., revenue reversed and inventory written off). * The accrued revenue in the table represents the amount of revenue in excess of amount billed to the client. Since it is shown together with accounts receivable on the balance sheet, receivables are overstated. For long-term contracts, the only amount that should be shown in accounts receivable should be the amount of billings (less any collections). Revenue indirectly affects the balance sheet through the adjustment of work-in-progress for the gross profit on the contract. For example, Dr. Cost of sales Dr. Work-in-progress Cr. Revenue

70,000 30,000

100,000

P4-53. Suggested solution: a.

In addition to general revenue recognition policies, Thomson Reuters describes five other revenue recognition policies in Note 1 of the financial statements: (i) recurring revenues; (ii) transaction revenues; (iii) print revenues; (iv) multiple performance obligations; and (v) sales involving third parties. . 4-36

Chapter 4: Revenue Recognition

For multiple performance obligations, the company uses the relative fair value method for allocating revenue to the different components. The portion of the note relating to multiple component arrangements indicates, “The transaction price is allocated to the separate performance obligations based on the relative standalone selling price,” For multiple performance obligations, the company identifies two critical judgments: (i) whether there are separately identifiable components; (ii) how to allocate the price to the components. To resolve the first issue, the company considers whether it regularly sells a good or service separately, or whether the goods or services are highly interrelated. For the second issue, the company applies the relative fair value method using evidence of fair value from components when they are sold separately (i.e., stand-alone selling prices). Given that it typically has more than one selling price for individual products and services, the company determines the standalone price by taking into consideration marker and other factors. This disclosure is contained in the section of Note 2 on “Critical judgments in applying accounting policies.”

P4-54. Suggested solution: a.

Canadian Tire’s accounting policies are described in Note 3. The policies relating to revenue are: as follows: (i) Sale of goods – recognize revenue when goods are delivered, less an estimate for sales and warranty returns. (ii) Customer loyalty program – defer a portion of revenue until customer redeems loyalty award. (iii) Interest income on loans receivable – recognize income using the effective interest rate method. (iv) Services rendered – recognize according to terms in contract (usually when service is provided or over the contractual period). (v) Reinsurance revenue – recognized over the life of the insurance contract on a prorata basis (vi) Royalties and license fees – recognized as revenue when “earned in accordance with the substance of the relevant agreement, which is generally based on percentage of occurred sales” (vii) Rental income – recognized as revenue evenly over the lease term.

Note 28 of the financial statements tabulates the revenue recognized on five of the seven categories noted in part (a).

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

28. Revenue (C$ in millions)

2019 $12,708.30 1,123.40 55.40 195.00 452.30 $14,534.40

Sale of goods Interest income on loans receivable Royalties and licence fees Services rendered Rental income

2018 $12,303.00 1,037.60 57.10 204.60 456.40 $14,058.70

Note 18. includes the amount of deferred revenue on gift cards and customer loyalty programs. While not explicitly stated, it also include the amounts related to premiums received on insurance and service rendered revenue that remain unearned at year-end (i.e., the portion of revenue that had not been earned) as this is the only deferred revenue liability reported on the balance sheet. 18. Trade and Other Payables Trade and other payables include the following: (C$ in millions)

2019

2018

Trade payables and accrued liabilities Derivatives (Note 33)

$2,087.0 28.3

$2,034.4 21.4

Total financial liabilities

2,115.3

2,055.8

Deferred revenue

222.8

216.2

Insurance reserve

8.6

14.4

145.7

138.6

$2,492.4

$2,425.0

Other

Deferred revenue consists mainly of unearned revenue relating to gift cards and customer loyalty program rewards. Deferred revenue will be recognized as revenue as the customer utilizes gift cards and loyalty rewards are redeemed. The majority of deferred revenue is expected to be redeemed within one year from issuance. $198.3 million included in deferred revenue at the beginning of the period was recognized as revenue in 2019 (2018 – $194.4 million).

. 4-38

Chapter 4: Revenue Recognition

Other consists primarily of the short-term portion of share based payment transactions and sales taxes payable. The credit range period on trade payables is one to 180 days (2018 – one to 270 days). Revenue from all sources grew by 3.4% (from $14,059m to $14,534m). In percentage terms, revenue from interest income on loans receivable was the highest growth area, increasing by 8.3% from $1,038m to $1,123m. In dollar terms the sale of goods was the largest source of growth increasing $405m from $12,303m to $12,708m. Revenue from i) royalties, ii) services rendered, and iii) rental income, all of which are relatively small contributors to Canadian Tire’s total revenue all declined from that evident in 2018. P4-55. Suggested solution: a.

Bombardier uses the cost-to-cost approach to estimate the percentage of completion. When the company anticipates a loss on a contract, it recognizes the entire loss in the period when it identifies the loss. Note 2 on pages 143-144 contains this information.

Revenue recognition Long-term contracts – Revenues from long-term contracts related to designing, engineering or manufacturing specifically designed products (including rail vehicles, vehicles overhaul and signalling contracts) and service contracts are generally recognized over time. The measure of progress toward complete satisfaction of the performance obligation is generally determined by comparing the actual costs incurred to the total costs anticipated for the entire contract, excluding costs that are not representative of the measure of performance. The contract transaction price is adjusted for change orders, claims, performance incentives and other contract terms that provide for the adjustment of prices to the extent they represent enforceable rights for the Corporation. Variable considerations such as assumptions for price escalation clauses, performance incentives and claims are only included in the transaction price to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. Customer options are only included in the transaction price of the contract when they become legally enforceable as a result of the customer exercising its right to purchase the additional goods or services. If a contract review indicates the expected costs to fulfill the contract exceed the expected economic benefits expected to be received under it, the entire expected loss on the contract is recognized as an onerous contract provision with the corresponding expense recorded in cost of sales. The expected benefits to be received are generally limited to the revenues from the associated contract. b. c.

From Notes 17 and 18 below, we can see that Bombardier had a contract asset balance of $2,485m, a contract liability balance of $7,156m, and inventories of $4,599m as at December 31, 2019. Bombardier’s inventory position, net of monies received in advance from its customers was a deficit of $72 million as at December 31, 2019 ($2,485m contract asset + $4,599m inventories - $7,156m contract liabilities = $72m deficit). . 4-39

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

17. CONTRACT BALANCES Contract assets were as follows, as at: Long-term contracts Production contracts Cost incurred and recorded margins Less: advances and progress billings

31-Dec 19

31-Dec-18

01-Jan-18

$9,930

$8,882

$8,306

(7,983) 1,947

(6,707) 2,175

(6,171) 2,135

674

506

367

(136) 538 $2,485

(64) 442 $2,617

(42) 325 $2,460

31-Dec 19 $4,018

31-Dec-18 $3,075

01-Jan-18 $2,120

2,286

2,124

1,981

852 7,156 5,739 1,417 $7,156

996 6,195 4,262 1,933 $6,195

991 5,092 3,820 1,272 $5,092

Service contracts Cost incurred and recorded margins Less: advances and progress billings

Contract liabilities were as follows, as at: Advances on aerospace programs Advances and progress billings in excess of longterm contract cost incurred and recorded margin Other deferred revenues Of which current Of which non-current

18. INVENTORIES Inventories were as follows, as at: Aerospace programs Finished products(1) Other

31-Dec-19 $3,990 468 141 $4,599

(1)

31-Dec-18 $3,546 733 123 $4,402

01-Jan-18 $2,472 749 208 $3,429

Finished products include $58 million of new aircraft not associated with a firm order and pre-owned aircraft as at December 31, 2019 ($53 million as at December 31, 2018 and $93 million as at January 1, 2018).

. 4-40

Chapter 4: Revenue Recognition

O. Mini-Cases Case 1: Revenue Recognition at Telecom Firms. Suggested solution: * *

Global Crossing was under pressure to maintain the confidence of lenders who have advanced them $7 billion and equity investors who have valued the company at $40 billion. Also not stated in the facts, there were probably also explicit debt covenants.

Provision of fibre capacity: * Does the “sale” of fibre-optic capacity satisfy the criteria for revenue recognition? * Global Crossing’s treatment is consistent with the sale of a good. Assuming that payment was reasonably assured, the risks and rewards of ownership of the fibre capacity (not the cable itself) had been transferred to the buyer. * An alternative treatment is to consider these transactions as long-term contracts for the provision of services. While there may have been advance payments, the period of service had not elapsed. If considered a service, revenue should have been recognized over the term of the contract. (In fact, there were no payments—see note at end of this solution.) * Treatment as the provision of services would be more consistent with the company’s revenue recognition policy for other sources of revenue. Global Crossing charges other companies as they send data through the company’s cables on a pay-as-you-go basis and records revenue at that time. * It is also not clear what costs, if any, have been matched to the revenue recorded. Purchases of fibre capacity: * Global Crossing’s treatment relies on the future benefits to be provided by the purchased fibre capacity. * It is questionable whether Global Crossing has use of the additional capacity given that it is also selling capacity at the same time. Possibly, the capacity could be needed where there are bottlenecks. Conclusion: * Taken in isolation, there are possibly reasonable arguments for Global Crossing’s accounting treatments. * However, the nature of the transactions and the way they were recorded—asymmetrically for sales and purchases of fibre capacity—indicate that this is not a simple matter of applying judgment to instances where there are a range of alternatives. Rather, it suggested a deliberate decision to inflate profits. The practice is not appropriate and highly unethical. * The fact that other companies also engaged in similar practices suggests a concerted effort to collude and mislead financial statement users. This fact illustrates the perils of following industry practice. * This case highlights the necessity to look at a company’s operations holistically rather than in a piecemeal fashion.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Note: A fact deliberately left out of the case is that much of the transfer of fibre-optic capacity was conducted in reciprocal swaps (e.g., Global Crossing transferred capacity to Qwest at the same time that Qwest transferred similar capacity back to Global Crossing). Omission of this fact is to make the case more open-ended, allowing for more thorough discussion of issues. Case 2: Modern Electronics’ Product Service Plans. Suggested solution: To: CFO From: Controller Subject: Impact of Product Service Plan on accounting for products sold The accounting issues relating to the Product Service Plan (PSP, or the Plan) principally concern the satisfaction of performance obligations, which is a key determinant of whether revenue recognition criteria have been satisfied. In International Financial Reporting Standards (IFRS), paragraphs 31, 35, and 38 of IFRS 15 contains the following guidance: Satisfaction of performance obligations 31 An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e., an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. Performance obligations satisfied over time 35 An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met: (a) the customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs (see paragraphs B3–B4); (b) the entity's performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced (see paragraph B5); or (c) the entity's performance does not create an asset with an alternative use to the entity (see paragraph 36) and the entity has an enforceable right to payment for performance completed to date (see paragraph 37). Performance obligations satisfied at a point in time 38 If a performance obligation is not satisfied over time in accordance with paragraphs 35–37, an entity satisfies the performance obligation at a point in time. To determine the point in time at which a customer obtains control of a promised asset and the entity satisfies a performance obligation, the entity shall consider the requirements for control in paragraphs 31–34. … While our sale of products clearly satisfies the performance obligations at a point in time by transferring the control of the asset (products) to the customer, the provision of the PSP possibly results in our company bearing a sufficient level of indemnity risk relating to the product during the Plan’s coverage period such that our performance is satisfied over the period of the service plans.

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Chapter 4: Revenue Recognition

Adding to the complication is the proposal to offer the PSP, or some portion of it, for free as part of the product purchase. These transactions, if the proposal goes ahead, would more closely tie the indemnity risk to the product and make it more difficult to separate the sale of the product from the service provided by the PSP (see below). Deferring revenue recognition until the expiration of the Plan would be the prudent/conservative accounting policy. Another similar alternative is to defer and recognize revenue over the period covered by the PSP. However, following either of these two alternatives would create two separate revenue recognition policies: revenue deferral for products sold with PSPs, and revenue recognition at point of sale for products sold without PSPs (which is the policy that the vast majority of companies follow for the sale of goods and which complies with the revenue recognition criteria of IFRS). Furthermore, having these two revenue recognition policies can lead to dysfunctional managerial actions. Assuming that the PSPs are profitable, we do not want to discourage sales of these Plans. However, requiring deferral of revenue for products sold with PSPs means that store managers would have incentives to sell products without PSPs, as the revenue for those products would be recognized in full immediately. A more reasonable approach would be to treat the PSP as a service separate from the product that the Plan covers. Doing so allows a single, consistent revenue recognition policy for products sold with and without PSPs. This approach is justified by the fact that the Plan is a service in substance the same as an insurance policy, and it is separable from the product just as auto insurance is separable from the purchase of a car. Indeed, our PSPs are reinsured with American Bankers Insurance Company of Florida. Indeed, paragraph 22 of IFRS 15 requires the separate identification of distinct performance obligations: 22 At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: (a) a good or service (or a bundle of goods or services) that is distinct; or (b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (see paragraph 23). Given that the Plan covers multiple years, we should recognize revenue over the period of coverage. For simplicity, a straight-line method may be adequate. However, the nature of product breakdowns is that they tend to occur more frequently later rather than sooner. In addition, we have recourse to the manufacturer in instances where the product becomes defective during the manufacturer’s warranty period. Thus, we should recognize revenue on the PSPs in a fashion that is lower initially and higher later on to reflect the stage of completion of the service provided. We should conduct more analysis of service records to determine the appropriate percentage of revenue we can recognize.

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In conclusion, I believe that it is most reasonable to separate the service revenue for the Product Service Plan from the sale of goods revenue. Doing so complies with IFRS, provides consistent accounting treatment for different types of sales, and does not create perverse operational incentives. Case 3: Penguins in Paradise. Suggested solution: To: From: Subject:

File David Financial Accounting Issues for Penguins in Paradise (PIP)

Overview—users, needs, and objectives Many users will be relying on the financial statements. Most significantly, equity investors will be relying on the financial statements to calculate their participation payment. They will want accounting policies that maximize net income. In addition, they will want to ensure that PIP’s operations, particularly its costs, are being efficiently controlled. The bank will also be relying on the financial statements to ensure that the operations are under control. They will likely want to see statements that maximize revenue since part of the interest payment on the loan varies with gross revenue. The client and promoter, Darth Garbinsky, will be relying on the financial statements to calculate his participation payment. Like all the other investors, he will want net income to be high in order to maximize his own income. In the assessment of acceptable accounting policies, we should bear in mind that, in this instance, accounting policies have a direct impact on PIP’s cash flows. That is, high reported income results in higher cash outflows. However, in the first stages of the life of the play, expenses will likely exceed revenues. Early recognition of expenses will not impact payments in the early (loss) years but will increase future net income and the participation payments, which are based on operating profits. Due to the uncertainty regarding the future success of Penguins in Paradise, we should err on the side of caution and recommend conservative/prudent accounting policies that have the least risk of overstating assets and income. Royalty rights Accounting for the royalty rights payments to PIP is very important because of the impact this amount will have on the participation payments to investors. We must first determine whether the amount paid to PIP for the royalty rights is an income item or a capital item. A royalty payment is very similar to a dividend. The investors will receive a royalty (or participation) payment that is based on their initial contribution. The payment that they receive could also be considered a return of their investment. Both of these facts imply that the payments to PIP by the investors are on account of capital.

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On the other hand, in order for the investors to earn a royalty, the critical event that must take place is the production of the play. The cost of producing the play is the cost of earning the income. In addition, the original contributions will not be refunded to the investors. If the amount paid to PIP by the investors is considered to be on account of income, we must determine the period in which the amount should be recognized. The critical event here is the signing of the contract. Also, no future services have to be provided. These facts suggest that the amount should be recognized as income immediately. However, if net income is earned and a royalty payment is made by PIP, it will be based on future net income. Expenses will be incurred in the future, and therefore the amount paid to PIP by investors should be matched to the period in which the expense is incurred. In addition, by recognizing the investors’ payments to PIP as income in future periods we would obtain a better matching of expenses since the production is in a future period. I recommend that the investor payments to PIP be treated as income and recognized in future years. “True operating expenses” To help avoid interpretation problems in the future, the term “true operating expenses” must be defined. The definition will help clarify what types of costs should be expenses in a particular period. Sale of reservation rights The timing of recognition of the fees earned from selling reservation rights must be determined. The amount relates to the future performance of the play, that being next year. Therefore, there is a case for future recognition. On the other hand, arguments favouring recognition this year include the fact that the reservation rights have been sold, and that the amount is non-refundable. In addition, the amount paid cannot be applied against future ticket prices and no future services are to be rendered. To be conservative, I recommend recognizing this revenue source next year, when the performances are given. Sale of movie rights The payment received for the sale of the movie rights can be taken into income in the current year because there is no direct connection to future services or events. Alternatively, the amount that was paid is based on the success of the play, and should be taken into income in future periods. From this perspective, at a minimum, the payment should be disclosed as an unusual item because it will not occur again. Government grant We must determine whether the government grant is attributable to income or capital. The treatment of this amount will affect the royalty program. If the amount is taken into income immediately, the participation payments will increase.

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If the amount is offset against an asset that will be depreciated, then the participation payments derived from the grant will be paid over time. If the grant is tied to hiring Canadians to perform in the play, then the amount should be credited against related labour expenses. If the grant has to be spent on costumes and sets made in Canada, then the amount should be netted against the related assets. In order to decide how this amount should be recognized, we must determine what the 50% content rule pertains to—against what purchases should it be offset? We must also determine the length of time that the rules apply in case the amount has to be repaid at a later date. Bank loan The 5% fixed interest should be expensed. However, there is some uncertainty regarding how to record the payment to the bank that is based on the play’s success. For the current year, we could accrue for an amount based on expected future profits. Alternatively, we could record the expense in a future period when PIP recognizes the revenue that generates the royalty. Given the difficulty in estimating future revenue, I recommend not recognizing interest expense for the 1% royalty in the current year. Start-up costs We need to determine whether start-up costs fit the definition of “true operating expense.” If not, then the royalty payment to investors will not be based on net income for financial statement reporting purposes. As these expenses have been incurred in the start-up phase of operations, the amounts can be recognized in either the current year or deferred to future years. Arguments can be made for either treatment. There is no certainty that the play will succeed, so to be conservative the amount should be expensed in the current period. On the other hand, the amounts do relate to production in future years, and in order to match expenses with revenues, the amounts should be expensed in future periods.

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Case 4: Plex-Fame Corporation. Suggested solution: Overview As a public corporation, the company’s financial statements will be used by stakeholders for a variety of purposes, including the evaluation of the company and its management. As a result, the managers have incentives to increase or smooth earnings to influence the share price or to present a favourable impression of themselves. In addition, the company is expanding rapidly and therefore may need to raise capital. By using accounting choices to increase earnings or otherwise improve the appearance of the financial statements, management may be attempting to reduce the cost of financing by lowering the cost of debt or increasing the selling price of shares. While the company may have a competing objective of minimizing taxes, to the extent that the financial accounting policies apply to tax filings it is likely that management would choose accounting policies that increase income. Since PFC is publicly traded, the company must comply with IFRS. Penalty payment PFC received a $2 million payment from a contractor who built a theatre complex for PFC in Montreal. The payment was for completing the project late. If my assumption about PFC’s bias toward choosing income-increasing accounting policies is correct, management will want to record the penalty as revenue. Arguments could be made for treating the penalty payment either as income or as a reduction in the capital cost of the complex on the balance sheet. If PFC incurred additional costs because of the delay in opening the new complex, then the penalty should be used to offset the costs, which may have been expensed or deferred. If the related costs had been expensed when incurred, then the penalty payment should be recognized in income to offset those expenses. In contrast, if the related costs were considered pre-opening costs and had been capitalized, then the penalty payment should be used to reduce those capitalized assets. Thus, if the penalty payment is compensation for lost revenue or profit, then an argument could be made for treating the penalty as income, in which case we need to consider whether separate disclosure is warranted given that the payment is non-recurring. Financial statement users would find separate disclosure informative because the portion of revenue and income that is nonrecurring has different valuation implications. “Rue St. Jacques” Ticket proceeds: The most appropriate treatment for recognizing revenue for “Rue St. Jacques” is when the show is performed. The show is service provided by PFC, and the company should recognize revenue according to the provision of services (i.e., staging the performances). At present, there is no assurance that the production will be completed, or that any shows for which tickets have been sold will take place. For example, the show could be closed down before it begins its run or even after it begins to run. In that case, it will be necessary to refund the purchase price of tickets to buyers.

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PFC would likely prefer to recognize revenue earlier, upon the sale of the tickets, in order to increase income and lower the cost of financing. If revenue were to be recognized at this early stage, it would be necessary to match costs against the revenue. However, there would be considerable uncertainty about those costs. Pre-production costs are not fully known, and the actual cost of putting on the performances, including wages, advertising, overhead, and so on, cannot be known with reasonable certainty. Interest on ticket proceeds: PFC earns a significant amount of interest by holding the money paid in advance by ticket purchasers. The interest revenue could be treated as income or deferred revenue. Again, management’s preference will be to recognize the interest revenue immediately. This position can be justified on the basis that any ticket refunds involve only the ticket price, not any accrued interest. On the other hand, interest may have been factored into the advance subscription price that is discounted relative to ticket prices in the future. If this is the case, then treating the interest as deferred revenue makes more sense. Pre-production costs: PFC has incurred significant costs in advance of the opening of “Rue St. Jacques.” We must determine whether these costs should be capitalized and amortized, or expensed as incurred. In principle, capitalization as an asset and amortization over the life of the show is reasonable as long as the show is expected to generate adequate revenue to cover costs. However, it is difficult to determine whether a theatre production will be successful. The long run of the show in Paris and advance ticket sales suggest that the show will be a success. However, the situation could easily take a turn for the worse if the actual show receives poor reviews from critics. If PFC chooses to capitalize the pre-production costs, they must be amortized over a reasonable period of time. One method is to use a cost-recovery method, where costs would be matched against revenue dollar for dollar until the pre-production costs are covered. A second alternative is to amortize the costs over the estimated life of the show. Under the capitalization alternative, we must also ensure that only costs pertaining to “Rue St. Jacques” are capitalized. Management might try to include costs related to other activities (e.g., a less successful show) among the costs for “Rue St. Jacques.” Ongoing production costs after the show opens should be expensed as incurred, which matches the recognition of ticket revenues. Sale of theatres PFC began selling theatres recently where economic conditions justified the sale of a particular theatre. This year, a significant part of net income was generated through the sale of theatres. PFC has included the proceeds from these sales as revenue on the income statement (as opposed to treating them as gains or losses on disposition) because it considers such as an ongoing part of its operations. However, the sales could also be considered incidental to ongoing operations, in which case the gains and losses would not be included in revenues. Including the proceeds from the sale of theatres is consistent with management’s objective of making the financial statements more attractive for going to the capital markets, to the extent that revenues could be increased (although net income would be unaffected). . 4-48

Chapter 4: Revenue Recognition

If the sales can be considered a part of ongoing operations, we should consider whether there should be separate disclosure of revenue from theatre sales. Burying this revenue with revenues from other sources makes it more difficult for users to predict future revenues. We should also consider whether the sale of theatres constitutes discontinued operations, which would require separate disclosure. With the available information, it does not seem appropriate to consider these theatre sales as discontinued operations, as PFC is not ceasing to operate movie theatres completely. If theatre sales are considered part of ongoing operations, then theatres that are available for sale should be classified as inventory rather than property, plant, and equipment. Case 5: Happy Valley Homes. Suggested solution: a. Memo to: From: Subject:

Partner CA Happy Valley Homes Ltd. (HVHL)

As requested, I have prepared a draft report to Tom Mullins on the issues raised during your meeting with him. Draft Report on Happy Valley Homes Ltd. In order to recommend accounting policies for your new business, we must first identify the likely users of HVHL’s financial statements and their information needs and objectives. This will provide a basis for choosing among accounting policy alternatives. You, Tom, have explicitly requested that the accounting policies be simple and not too costly. You will be concerned about presenting a good financial position to attract investors. The other users of HVHL’s financial statements are as follows: * * *

The bank will be concerned about liquidity and the ability of HVHL to repay its debt. The bank would prefer information that focuses on cash flow and the valuation of its security. Investors will require some form of current value information to evaluate HVHL’s performance. The Canada Revenue Agency requires historical cost information to assess income taxes.

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Need for current-value information The bank and the investors are concerned with liquidity and performance evaluation. For this purpose, some form of current-value information would be most useful. Current-value information, sometimes called “fair value,” is more relevant to HVHL’s users since the objective of the business is to realize gains from holding houses over a long period of time. The houses should be valued at some form of market value, so that users could determine unrealized holding gains and losses and thereby evaluate management’s decision-making ability. This information would be costly, and the values determined would be very subjective since there will be much uncertainty about the date on which HVHL will eventually gain title to the property and the market prices at that time. Although current-value information is costly, the users’ need for this type of information outweighs the costs, and HVHL must provide this information to attract and retain investors. There are several different methods of calculating current-value information. HVHL could obtain independent appraisals of each of the houses as at the financial statement dates. This process would be costly but would provide the most accurate information since the appraisals would consider such aspects as the state of repair of the property, and so on. The cost could be reduced by having appraisals performed on a rotational basis only. That is, HVHL could have a few homes appraised each year so that all homes are appraised at least once over, say, a five-year period. An alternative method is to value the properties based on the present value of future cash flows. This method would not be practical for HVHL, as no hard estimate of the timing and amount of future cash flows would be available. I recommend that market appraisals be performed on a rotational basis to determine the current value of the homes to reduce the cost of revaluation. Accounting policies Asset valuation We must first determine the nature of the asset before deciding upon the appropriate accounting and reporting treatment for the properties. The homes could be considered as any of the following assets: * inventory, since they are held specifically for resale; * capital assets, since they will be held for a long period of time and they produce income through capital appreciation; * prepaid expenses, since Tom does not have legal title to the property until the death of the senior citizens; or * an equity instrument, since they represent an “interest” in real property. The classification of the homes as short-term or long-term assets must also be considered, because the date of eventual sale of the homes is uncertain.

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I recommend that the homes be recorded as long-term assets, “Interest in Homes,” since management intends to keep the homes for several years. Detailed note disclosure will be required to explain the unique nature of the “reverse mortgages.” Revenue recognition HVHL's operations of purchasing “reverse mortgages” in houses will result in two types of revenue being recognized over the life of each property venture. Discount HVHL pays less than the market value of the home since it receives a “reverse mortgage” only, and not legal title to the home. The difference between the market value of the home at the time of purchase and the purchase price of the home is the discount. This discount can be compared to rent or interest earned over the holding period of the home. Alternatives are available for recognizing the discount as income: a. The discount could be recognized as income at the time that the “reverse mortgage” agreement is signed. This would be very aggressive treatment since it would result in the home being valued at its fair market value, even though HVHL holds only an interest in the home. b. The discount could be taken into income over the expected remaining life of the senior citizen (i.e., the holding period of the house). The expected life of the senior citizen would be calculated using actuarial methods and assumptions about life spans. c. The discount could be recognized as revenue at the time of death of the last inhabitant of the home. This would be conservative since no revenue would be recognized until legal title to the home had passed to HVHL. I recommend that the discount be taken into income over the expected remaining life of the senior citizen because revenue is earned over this period. Thus, its revenue-generating activity is being performed as the home is held over time. The revenue can be measured (difference between market value and purchase price), and collectability is assured since HVHL gains title to the home at the death of the last inhabitant. This method of recognizing the discount revenue meets your objective of providing financial statements that are relevant to HVHL's unique business and that will attract investors. Capital appreciation or depreciation Capital appreciation or depreciation arises from the increase or decrease in market value of the home from the date that the “reverse mortgage” is purchased to the date that the home is sold. This type of revenue could be recognized at the following times: 1.

Capital appreciation could be estimated at the date that the “reverse mortgage” is purchased and taken into income over the expected remaining life of the senior citizen. However, this would involve much uncertainty and estimation of future market value and life spans. Another similar alternative is to recognize actual capital appreciation or depreciation annually. This would entail an annual appraisal for each home. The change in the market value of the home between financial statement dates would be recorded as revenue for the period. This method could result in significant fluctuations in income and . 4-51

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asset values between years, depending on the volatility of the real estate market. It would also be costly to obtain annual appraisals. However, relevant information about HVHL's operations would be provided. 2.

Capital appreciation could be recognized when the last inhabitant dies. This method would be more conservative than the first alternative since revenue would not be recognized until a market value at the time that HVHL obtains legal title could be determined.

Capital appreciation could be recognized when HVHL finally sells the home. This would be the most conservative option. No uncertainty exists regarding life spans or market values between the date of death and the date that the home is resold. This method would be appropriate only if the actual selling of the home is a significant act in the revenueearning process.

I recommend that the capital appreciation be recognized when the last survivor of the home dies. This is the point at which HVHL obtains legal title to the home, and the decision to hold the home is a separate management decision that should be reported separately in the financial statements. Thus, the capital appreciation between the time that the “reverse mortgage” is purchased and the death of the last survivor will be recorded at the time of death. Any depreciation in the market value of the homes should be recorded in the period that it occurs so that assets are not overstated. The subsequent appreciation or depreciation arising between the time of death and the eventual resale of the home would be reported when the home is sold, as a gain or loss on holding the home subsequent to obtaining legal title. This revenue recognition policy meets your objective of being simple and inexpensive, and it provides relevant information to the users. Accounting for expenses The major expenses that HVHL will incur are bank interest and legal fees. These expenses could be capitalized as part of the cost of the homes, as they could be considered necessary to get the home in a saleable condition. Capitalization also provides a better matching of costs with the capital appreciation revenue that is not recorded until legal title is obtained. Alternatively, the interest costs could be expensed as incurred since the cost of the home should not depend on the method of financing selected (i.e., debt versus equity). I recommend that the legal fees be capitalized since they must be incurred to obtain the “reverse mortgage” in the home. However, the bank interest should be expensed for the reason stated above. The costs incurred in producing and distributing the proposed offering document will be substantial. These costs should be excluded from the determination of income and should be reported as a reduction in shareholders’ equity.

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Both adverse selection and moral hazard have important implications for the proposed business. Adverse selection will result in a pool of seniors that are potentially much less profitable than would be expected from a random sample from the population. Moral hazard will result in homes that may be less valuable than anticipated.

To understand why these two information asymmetries are so important for this business, it is essential to understand the nature of the “reverse mortgages.” A bank that offers a conventional mortgage to homeowners is a creditor: in exchange for loaning the homeowner a fixed sum of money, the bank has a fixed claim on the home and other assets of the borrowers. In contrast, HVHL’s reverse mortgage is an equity claim: in exchange for paying the seniors a fixed sum, HVHL obtains the uncertain value of the home at some uncertain future date. If the real estate markets in which HVHL intends to operate are reasonably active, there will be little information asymmetry between the seniors and HVHL. However, the seniors will always have an information advantage regarding their own life expectancy given that they have private knowledge about their own health, the healthiness of their current and past lifestyles, past illnesses, and their families’ history of diseases. Given this information advantage, rational seniors will choose between a conventional or reverse mortgage based on their personal circumstances. Specifically, seniors who are in relatively good health and expect long life expectancies will choose the reverse mortgage because they receive the cash up front and have no need to repay any amount until their death, which they expect to be far into the future. Other seniors who are in relatively poor health and have short life expectancies will choose a conventional mortgage because they expect fewer payments on the mortgage over the remainder of their lives. Thus, the adverse selection will result in HVHL attracting seniors who will tend to live the longest, not those who will die relatively soon and who are most profitable from HVHL’s perspective. (In a way, this is a macabre business.) HVHL must anticipate the adverse selection and pay a correspondingly lower amount for the reverse mortgage, which of course will reduce the attractiveness of the product to seniors. The realization that conventional and reverse mortgages are debt and equity contracts, respectively, suggests that moral hazard will be a concern, just as it is for firms that issue debt or equity. When homeowners obtain a mortgage, they retain the equity in the home and therefore they are self-interested in maintaining the value of their home. When they obtain a reverse mortgage, they have sold the entire equity interest in the home, since all proceeds upon the senior’s death go to HVHL. Consequently, seniors who have reverse mortgages do not have an interest in maintaining the value of the home. c.

The discussion in part (b) highlights what should be expected to happen if senior citizens act rationally and choose the financial product that is in their best interest. However, HVHL’s business plan involves a segment of the population that is particularly vulnerable. While many seniors are physically and mentally fit, there are many who are more frail and not fully capable of making financial decisions rationally. Would it be ethical for HVHL to sell reverse mortgages to such seniors when it is unclear whether it is in the interest of the seniors? HVHL’s business becomes more successful if it is able to attract seniors who will die relatively soon, so is it a good business practice to target the

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seniors who are the most frail? What regulations might be appropriate to prevent abuses by companies such as HVHL? Case 6: Revenue Recognition in Governments. Suggested solution: * * * * * * *

* * * * * * * *

The public needs financial reports to evaluate the government’s performance. To meet the needs of the public, government accounting should provide an unbiased or conservative representation of government performance. The government needs financial reports for planning purposes. To meet the government’s needs, accounting should facilitate long-term planning and provide appropriate incentives to manage public funds. B.C.’s policy could be used to manage public expectations about the government’s ability to spend on social services over the long term. B.C.’s policy to recognize revenue over several years is consistent with accrual accounting. That is, record revenue as the earnings process is completed. Doing so avoids “windfall” surpluses that trigger overspending by the government. Doing so also allows for better long-term management of public funds. Such a policy would provide more relevant information as it gives a fairer depiction of the government’s financial performance to the public because future revenues are more predictable. Alberta and Saskatchewan’s policy of recognizing revenue all at once is closer to cash accounting. Cash accounting tends to produce reliable numbers. However, the amounts tend to be “lumpy,” making it difficult to predict the future. Such a policy is not conducive to long-term planning. Ebner does not appear to understand the basic principles of accrual accounting. If he did understand accrual accounting, then he has presented a biased view against the B.C. government by alleging secrecy or a cover-up. Following accrual accounting is not being secretive; rather, it is being prudent. The title of the article is inappropriately sensational.

Epilogue On February 20, 2009, less than three months after the publication of the article, Alberta projected a $1 billion deficit for the year ending March 2009, when only six months ago the province had forecast an $8.5 billion surplus. Alberta’s April 2009 budget for the fiscal year ending March 2010 projected a deficit of $4.7 billion. The dramatic reversal in fortunes resulted from plunging commodity prices as the world sank into a deep recession. Meanwhile, B.C. continued to project a surplus for the year ending March 2009 and a deficit of only $495 million for the next fiscal year.

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Case 7: Patricia Leather Company. Suggested Solution: a. Alternative 1: Revenue would be recognized once the consignee sells the goods to customers because risks and rewards have been transferred to customers. At that point, PLC retains no continuing managerial involvement, the amount can be measured reliably and the economic benefits would flow to PLC when the consignees remit payment to PLC. However, PLC would not be able to recognize any sales when merchandises are shipped to the consignee stores. Alternative 2: Revenue would be recognized on sales but recognition of profit is delayed until payment is received. This is because although the product has been transferred to the customer at the point of sale, there are still many risks, namely credit risks, associated with the possibility of customers not being able to pay back. Alternative 3: Revenue would be recognized once the franchisee has signed the franchise documents for the initial franchise fee, however some of the revenue must be deferred until future obligations of the franchisor is fulfilled. Deferred revenue would then be recognized over the period of the contract. Furthermore, ongoing franchise revenue would be recognized annually. b. Alternative 1: The main concern with this alternative would be that net income could be lower as we would lose sales from the retail stores currently purchasing the products. These stores would now act as our agent to try to sell our products for us, charging us a commission. A minor concern would be that whether PLC had a sophisticated inventory tracking system to account for the inventory on consignment. Furthermore, we must also consider that if too many stores were selling the products, it would undermine the sales at our retail boutique. Alternative 2: The main concern here would be the issue of collectability. There might be uncertainty with the collectability of the installment account receivables, as credit risks of customers become a bigger concern when they now have longer period to pay. Since we cannot be completely certain whether the clients will be able to pay the full amount, we might also need to be conservative when accounting for these sales, delaying the recognition of gross profits until payment is received. Alternative 3: The main concern here would be the costs associated with becoming a franchisor and whether investors would be willing to become franchisees. Considering the business had a mere net income of $80,000 this year, it is hard to imagine PLC could afford to establish franchises in the same city without undermining sales in its own store. As the franchisor, PLC would also need to incur expenses to exercise adequate oversight on its franchisees. c. In this situation, it is more likely PLC would go for alternative 2. Simply put, extending credit to existing or potential customers was probably the easiest alterative that PLC could adopt in this situation to boost sales. Alternative 3 of starting a franchise was probably unrealistic given the size and business life cycle stage of PLC. Alternative 1 was implementable, but it is uncertain how much additional sales PLC could make on consignment given that PLC has already been selling its products to other retailers. . 4-55

Chapter 5 Cash and Receivables S. Problems P5-1. Suggested solution: To report an investment as a cash equivalent, it must be (i) readily convertible to known amounts of cash (convertibility), (ii) have insignificant risks of changes in value (substantially risk-free), and (iii), it must be held to meet short-term cash commitments (intent). P5-2. Suggested solution: Publicly traded shares cannot be included in cash and cash equivalents because the value of shares can fluctuate a lot over short periods of time whereas cash has a definite value. Therefore, they are not similar enough to cash to be considered equivalent to cash. P5-3. Suggested solution: A $50,000 GIC maturing in two years cannot be included in cash and cash equivalents because it cannot be readily converted into cash to satisfy obligations that come due. Therefore, the GIC is not sufficiently similar to cash to be considered equivalent to cash. P5-4. Suggested solution: Note: explanations of convertibility and risk are not required but provided here to show reasons for the recommended classification.

a. b. c. d. e.

Chequing account in Canadian dollars. Investment in a mutual fund that invests in common shares. Investment in long-term government bonds. Term deposit maturing 120 days after the year-end. Cash in a sinking fund account for a future redemption of bonds payable.

. 5-1

Cash and Readily cash convertible equivalents to cash? Yes Yes

Risk of change in cash value? Low

Yes

High

No No

Yes No

Moderate Low

None

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P5-5. Suggested solution: Note: explanations of convertibility and risk are not required but provided here to show reasons for the recommended classification.

a. b. c. d. e.

Negative balance in a chequing account.‡ Investment in Treasury bills maturing 60 days after the year-end. 100 ounces of gold. Chequing account in U.S. dollars. Investment in U.S. government Treasury bills maturing 60 days after the year-end.

Cash and Readily cash convertible equivalents to cash? Yes Yes

Risk of change in cash value? None

Yes

Low

No Yes/No

Yes Yes

High* Depends†

Yes/No

Yes

Depends†

‡

Assumes that the bank overdraft is a normal result of the entity’s cash management activities to minimize cash holdings. * Currencies such as the Canadian dollar are not currently backed by gold deposits at central banks. However, during some periods in history currencies had a fixed exchange rate relative to an ounce of gold. When there is such a fixed relationship, gold can be considered a cash equivalent. † Whether U.S. dollar and U.S. Treasury bills should be included in cash and cash equivalents depends on the volatility of the CAD/USD exchange rate. P5-6. Suggested solution: In support of classifying this refundable airline ticket as a cash equivalent are the facts that (i) it is readily convertible into cash by cancelling the trip and (ii) there is little risk of a change in cash value, other than the bankruptcy of the airline. However, another consideration that is not specific to cash is the general issue of management intent. People do not generally “park” cash by buying refundable airline tickets and then converting them back to cash later. The ticket purchase can be presumed to be for the purpose of the flight purchased rather than as a temporary investment of cash. Thus, the ticket is not a cash equivalent, but a prepaid expense. This situation illustrates the importance of professional judgment. One cannot simply apply the two criteria for cash equivalents without considering the broader context of the business transaction (management intent).

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Chapter 5: Cash and Receivables

P5-7. Suggested solution: The company’s investment in cryptocurrencies should not be included in cash and cash equivalents because they don’t satisfy both criteria required of cash and cash equivalents. While the cryptocurrencies may be readily available to settle debts, their value is too volatile to satisfy the criterion of having little risk of changes in value. While the rapid increases in historical prices are a boon to anyone who held these cryptocurrencies prior to the price increases, these price changes (whether upwards or downwards) indicate that they are too risky to be consider cash or equivalent to cash. P5-8. Suggested solution: Jay Company Cash reconciliation October

Balance per books $6,000 Bank service charges (100) Corrected cash balance ($5,900) The outstanding cheque and outstanding deposit are already reflected on Jay’s books, so those items do not appear on the reconciliation. P5-9. Suggested solution: a.

Liberty Inc. Cash reconciliation June

Balance per bank statement Cheque #118 incorrectly recorded by bank at $51,200 Cheque #118 correct amount Corrected cash balance b.

($38,300) 51,200 (15,200) ($ 2,300)

The overdraft balance of $2,300 should be included in assets as an offset against cash and cash equivalents, not as a separate liability. Should the overall balance of cash and cash equivalents be negative, the amount would be reported as a current liability.

P5-10. Suggested solution:

Balance per bank statement Outstanding cheques Outstanding deposits Corrected cash balance

Gidget Corp. Cash reconciliation July

. 5-3

$12,500 (8,500) 1,800 $5,800

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-11. Suggested solution:

Balance per Bank Statement, May 31 Add: Deposit in-transit

Barb Lee Inc. Cash reconciliation May

$11,003.74 899.14 11,902.88

Less: Outstanding cheques #124 #126 #129 Corrected bank balance, May 31

$2,041.25 951.56 1,000.00

Balance per General Ledger, May 31 Less: NSF cheque Service charges ($32.00 + $29.00) Corrected cash balance, May 31

$ 313.00 61.00

b. Dr. Accounts receivable Cr. Cash ($313.00 + $32.00) OR Dr. Accounts receivable Dr. Bank service charges Cr. Cash ($313.00 + $32.00)

345.00

Dr. Bank service charges Cr. Cash

29.00

313.00 32.00

(3,992.81) $ 7,910.07 $ 8,284.07 (374.00) $ 7,910.07 345.00

345.00 29.00

P5-12. Suggested solution:

Chris Hacker Ltd. Bank Reconciliation September 30 Balance per Bank Statement, September 30 Add: Bank error Less: Outstanding cheques #222 #223 #225 Corrected bank balance, September 30

$6,626.87 800.00 7,426.87 $ 456.23 1,450.00 122.19

Balance per General Ledger, September 30 Less: NSF cheque Service charges ($28.00 + $14.00) Corrected cash balance, September 30

$ 245.00 42.00

. 5-4

(2,028.42) $5,398.45 $5,685.45 (287.00) $5,398.45

Chapter 5: Cash and Receivables

b. Dr. Accounts receivable Cr. Cash ($245.00 + $28.00) OR Dr. Accounts receivable Dr. Bank service charges Cr. Cash ($245.00 + $28.00)

273.00

Dr. Bank service charges Cr. Cash

14.00

245.00 28.00

273.00

273.00 14.00

P5-13. Suggested solution: a.

Segregation of duties is intended to ensure that a person in a position to misappropriate assets like cash is not in a position to cover up the theft.

The existing cash-handling procedures are not sufficiently segregated (they are not segregated at all). The accountant both handles the cash and prepares the cash reconciliation. To mitigate the risk of embezzlement, GL should assign someone other than the accountant to prepare cash reconciliations.

P5-14. Suggested solution: While the use of cameras is an important component of a casino’s security system, it is probably not the most basic level of security. Indeed, the end of the passage notes that it was subsequent to 1988 when cameras were first used in casinos, but casinos have been in operation for much longer. Clearly, other low-tech security measures are more fundamental. The simplest security measure is the use of gambling chips or tokens to represent money. These chips and tokens have no value outside of the casino, which eliminates the risk of theft of these items by staff and customers. This is a simple example of segregation of duties to separate those who handle the cash from those who have an opportunity to misappropriate it. [The following discussion is not required as some students may not have experience at a casino.] The exchange of cash for chips and tokens takes place in a secure manner, either at a secure cash desk or at the gambling table. In the latter case, the table staff (the dealer) places cash receipts in a lock box attached to the table, and they have no ability to withdraw cash from the box. Furthermore, issuances of chips at the table need to be authorized by the “pit boss.” P5-15. Suggested solution: The event has two significant and distinct sources of cash transactions: admissions and beverages. Each has different cash-control requirements. The risks in admissions are twofold: some guests may gain admission without payment, and some admission fees may be misappropriated.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

* *

To mitigate the first risk of uncollected admission fees, the entrance should be monitored by two volunteers if possible. Having two volunteers reduces the chance of admitting guests (friends) without tickets. We should use pre-printed tickets that are serially numbered. If tickets are sold in advance by club members, record the serial numbers for the tickets assigned to each person. At the end of the advance ticket sales period, each club member is responsible for the return of unsold tickets and proceeds, which must reconcile with the number of tickets issued. For example, a member who is assigned 10 tickets and who sells 7 of them must return 3 unsold tickets plus $70. Likewise, on the night of the event, there needs to be a record of the tickets assigned to the person who sells tickets at the door, and a reconciliation with ticket sales and unsold tickets at the end of the night. The person assigned to sell tickets at the door should not also collect the tickets.

The sale of beverages creates a risk of cash misappropriation at the point of sale. * Because there is no cash register to ensure completeness of the sales record—which then would allow for a reconciliation with cash—alternate procedures are required. * We should use pre-printed, serially numbered coupons, with differently coloured coupons for beverages of differing price. * A volunteer would sell these drink coupons. At the end of the night, we will reconcile the cash received with the number of coupons sold. * The volunteer(s) serving the beverages would collect the coupons. * There will still be a risk of beverages being served for free, and this risk will be difficult to reduce at reasonable cost especially if beverages are not served in closed containers (i.e., in cans and bottles). P5-16. Suggested solution: An expenditure is an outlay of cash or incurrence of a liability that could result in an expense or an asset being recorded for accounting purposes. The expenditure results in an asset if it satisfies the definition and recognition criteria for an asset; otherwise, the amount must be expensed. Previously recorded assets turn into expenses as the benefits from the assets are used up. For example, a payment to purchase a machine would result in an asset (property, plant, and equipment) because the machine is expected to generate future benefits, it results from a past transaction, it is under the control of the enterprise, and its future benefits are reasonably estimable. As the equipment is used, depreciation expense is recorded. P5-17. Suggested solution: Issue invoice for $6,500

Gross method Dr. Accounts receivable Cr. Sales revenue

6,500

. 5-6

Net method Dr. Accounts receivable 6,500 Cr. Sales revenue

6,435

Chapter 5: Cash and Receivables

P5-18. Suggested solution: Issue invoice August 5

Gross method Dr. Accounts receivable Cr. Sales revenue

Receive payment August 14

Dr. Cash Dr. Cash discount [I/S] Cr. Accounts receivable

300k 294k 6k

Net method Dr. Accounts receivable 300k Cr. Sales revenue Dr. Cash

294k

300k Cr. Accounts receivable

294k

P5-19. Suggested solution: Gross method Issue invoice Dr. Accounts receivable December 10 Cr. Sales revenue Receive payment January 20

5,000

Dr. Cash

5,000

Cr. Accounts receivable

Net method Dr. Accounts receivable 5,000 Cr. Sales revenue

4,850

Dr. Cash 5,000 Cr. Interest or other revenue 150 5,000 Cr. Accounts receivable 4,850

P5-20. Suggested solution: * * *

Poor matching: In the direct write-off method, revenue is recorded in one period while the associated bad debts expense is recorded in a subsequent period. Direct write-off results in an A/R balance that overstates net realizable value. Note: this question has nothing to do with the A/R sub-ledger. The use of a contra account for bad debts allows for the reconciliation of the sub-ledger with the A/R balance on the general ledger, but a sub-ledger is used regardless of the method of accounting for bad debts.

P5-21. Suggested solution: ADA write-offs

44,000

60,000 6,000 50,000 72,000

Beginning balance Recoveries Bad debts expense Balance from aging analysis

5,000

Beginning balance

1,500 3,500

1.5% × 100,000 Balance in ADA

P5-22. Suggested solution: ADA write-offs

3,000

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-23. Suggested solution: ADA write-offs

39,850

26,000 5,000 130,000 121,150

Beginning balance Recoveries (opposite of write-offs) 4% × 3,250,000 Balance in ADA

P5-24. Suggested solution: Bad debt expense totalled $ 137,080 as shown below: Days outstanding 0 – 30 31 – 75 Amount 345,000 133,000 % not collectible 2% 6% Estimated amount uncollectible 6,900 7,980 Note: Entries to ADA during the year do not affect the final answer because their effects are reflected in the $12,000 balance

76 – 120 175,000 12% 21,000

120 + 136,000 20% 27,200

ADA

BDE

62,000 

74,000 balance before adjustments 12,000

Total 789,000 — 63,080

62,000

75,080  75,080 63,080 137,080

P5-25. Suggested solution: a. Bad debts expense totaled $37,059 as detailed below Days outstanding 0 – 30 31 – 60 61 – 90 Amount $722,000 $214,000 $89,000 % not collectible 1% 3% 6% Estimated amount uncollectible 7,220 6,420 5,340 Note: Entries to ADA during the year do not affect the final answer because their effects are reflected in the $14,521 balance balance before adjustments

The journal entry for bad debts expense is: Dr. Bad debts expense Cr. Allowance for doubtful accounts

. 5-8

91 + $42,000 30% 12,600

ADA ? 20,000  16,379 14,521 17,059  31,580

Total $1,067,000 — 31,580 BDE

20,000 17,059 37,059

17,059

Chapter 5: Cash and Receivables

P5-26. Suggested solution: a. The bad debts expense for 2023 is $6,300, as shown below in the T-account for ADA. Days outstanding Balance in A/R, Dec. 31, 2023 % of A/R estimated to be uncollectible Estimated uncollectible Dec. 31, 2023

Current 30–60 61–90 Over 90 Total 400,000 150,000 40,000 10,000 0.5% 1% 2% 5% 2,000 1,500 800 500 4,800

Balance in A/R, Dec. 31, 2024 % of A/R estimated to be uncollectible Estimated uncollectible Dec. 31, 2024

440,000 0.5% 2,200

ADA 5,000 write-off 6,500 6,300 BDE 4,800 write-off 7,400 8,000 BDE 5,400

160,000 1% 1,600

30,000 2% 600

20,000 5% 1,000

5,400

Dec. 31, 2023 balance from calculations above Dec. 31, 2024 balance from calculations above

b. The journal entry for bad debts expense for 2023 is: Dr. Bad debts expense Cr. Allowance for doubtful accounts

6,300

c. The accounts receivables written off in 2024 is $7,400, as calculated in the ADA T-account from part a. P5-27. Suggested solution: This problem is best solved using T-accounts for receivables and the allowance for doubtful accounts (ADA). Note that the facts provide the net accounts receivable, so the gross amount needs to be computed by summing the net amount and the allowance for doubtful accounts. $755k + $15k Credit sales Write-offs Cash collected Bad debts expense $649k + $13k 

Accounts receivable (gross) 770,000 3,210,000 19,000 3,299,000 662,000

. 5-9

ADA 15,000 

19,000 17,000 13,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-28. Suggested solution: This problem is best solved using T-accounts for receivables and the allowance for doubtful accounts (ADA). Accounts receivable (gross) ADA Given 335,000 5,000 Credit sales 2,200,000  Write-offs 8,000 8,000 Cash collected on A/R 2,178,000 Bad debts expense 9,000 Given 349,000 6,000 Cash sales = total sales – credit sales = $2,450,000 - $2,200,000 = $250,000 Total cash collected from customers = cash collected on A/R + cash sales = $2,178,000 + $250,000 = $2,428,000 P5-29. Suggested solution: This problem is best solved using T-accounts for receivables and the allowance for doubtful accounts (ADA). Accounts receivable (gross) ADA Given 120,000 17,000 Credit sales 7,200,000  Write-offs 42,000 42,000 Cash collected on A/R 7,153,000 BDE estimate using % sales 36,000 BDE adjustment at Y/E 5,000 Given 125,000 16,000 Cash sales = total sales – credit sales = $7,670,000 - $7,200,000 = $470,000 Total cash collected from customers = cash collected on A/R + cash sales = $7,153,000 + $470,000 = $7,623,000 Percentage-of-sales rate = BDE / credit sales = $36,000 / $7,200,000 = 0.005 = 0.5% P5-30. Suggested solution: a) $20,000,000 sales × 0.50% = $100,000. The summary journal entry for bad debts expense for the eleven months ending November 30 is: Dr. Bad debts expense 100,000 Cr. Allowance for doubtful accounts 100,000 b) The summary journal entry to record the writing off of bad debt during the year is: Dr. Allowance for doubtful accounts Cr. Accounts receivable

72,000

. 5-10

72,000

Chapter 5: Cash and Receivables

c) The summary journal entry to record the recovery of bad debts previously written off is: Dr. Accounts receivable 16,000 Cr. Allowance for doubtful accounts 16,000 Dr. Cash 16,000 Cr. Accounts receivable 16,000 d) To record the journal entry to record the bad debt estimate at December 31, we must first estimate the ADA required and compare that to the current ADA as set out below. Days outstanding Amount % not collectible Estimated amount uncollectible

0 – 15 $1,200,000 1.0% $12,000

write-offs Bad debts expense (recovery) for year-end

16 – 45 $365,000 2.0% $7,300

ADA 60,000 72,000 16,000 100,000 59,200 44,800

46 – 75 $45,000 10.0% $4,500

76 + $30,000 70.0% $21,000

Total $1,640,000 — $44,800

Beginning balance Recoveries Bad debt expense first eleven months Required balance from aging analysis

The journal entry to record the bad debts estimate at December 31 is: Dr. Allowance for doubtful accounts Cr. Bad debts expense (recovery)

59,200

e) Mega’s current method of estimating bad debt expense at 0.5% of sales, overstates its bad debt expense during the year, and should be downwardly adjusted. In this respect, if the 0.5% of sales during the year were a reasonable proxy, we would expect that the bad debt expense recognized in December would be roughly 0.5% of sales as well. This was not the case, however, as Mega reported a recovery of $59,200 in December versus the $15,000 ($3,000,000 × 0.5%) that would have been provided for under its sale proxy. Mega’s $23,000,000 in sales for the year, versus bad debt expense for the year of $40,800 ($100,000 - $59,200) suggests that an interim provision of, say 0.25%* of sales would be more than adequate. *$40,800 / $23,000,000 = 0.18%

. 5-11

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-31. Suggested solution: a) $2,000,000 sales × 90% credit sales = $1,800,000 credit sales; $1,800,000× 1% allowance = $18,000. The journal entry for bad debts expense for the quarter ending March 31 is: Dr. Bad debts expense 18,000 Cr. Allowance for doubtful accounts 18,000 b) The summary journal entry to record the writing off of bad debt during the year is: Dr. Allowance for doubtful accounts 158,000 Cr. Accounts receivable 158,000 c) The summary journal entry to record the recovery of bad debts previously written off is: Dr. Accounts receivable 11,000 Cr. Allowance for doubtful accounts 11,000 Dr. Cash 11,000 Cr. Accounts receivable 11,000 d) To record the journal entry to record the bad debt estimate at December 31, we must first estimate the ADA required and compare that to the current ADA as set out below. Days outstanding Amount % not collectible Estimated amount uncollectible

write-offs

0 – 30 $2,000,000 1% $20,000

31 – 60 $700,000 2% $14,000

ADA 150,000 158,000 11,000 72,000 59,000 134,000

61 – 90 $300,000 20% $60,000

91 + $50,000 80% $40,000

Total $3,050,000 — $134,000

Beginning balance Recoveries Bad debt expense first three quarters* Bad debts expense for year-end Required balance from aging analysis

* Total sales for 9 months ($2,000,000 + $2,500,000 + $3,500,000) = $8,000,000; $8,000,000 × 90% sales on credit terms = $7,200,000 credit sales; $7,200,000 × 1% ADA = $72,000. The journal entry to record the bad debts estimate at December 31 is: Dr. Bad debts expense Cr. Allowance for doubtful accounts

59,000

e) Rainbow’s current method of estimating bad debt expense at 1% of credit sales, understates its bad debt expense during the year and should be upwardly adjusted. In this respect, if the 1% of credit sales during the year were a reasonable proxy, we would expect that the bad debt expense recognized in the fourth quarter would be roughly 1% of credit sales as well.

. 5-12

Chapter 5: Cash and Receivables

This was not the case, however, as Rainbow expensed $59,000 in the fourth quarter versus the $16,200* that would have been provided for under its credit sale proxy. * $1,800,000 sales × 90% = $1,620,000 credit sales ×1% ADA = $16,200. Rainbow’s credit sales for the year totalled $8,820,000* versus bad debt expense for the year of $131,000** suggests that an interim provision of, say 1.5% of credit sales*** would be more reasonable. *$2,000,000 + $2,500,000 + $3,500,000 + $1,800,000 = $9,800,000; $9,800,000 × 90% = $8,820,000 **$72,000 + $59,000 = $131,000 ***$131,000 / $8,820,000 = 1.49% P5-32. Suggested solution: Upon transfer Dr. Cash of receivables Dr. Interest expense Cr. Accounts receivable

720,000 80,000

800,000

P5-33. Suggested solution: Upon transfer Dr. Cash of receivables Dr. Due from factor Cr. Short-term debt—asset-backed financing Completion of collection

Dr. Allowance for doubtful accounts Cr. Due from factor Cr. Cash Dr. Short-term debt—asset-backed financing Dr. Interest expense Cr. Accounts receivable

. 5-13

14,000,000 500,000

900,000

14,500,000 500,000

14,500,000

500,000 400,000

15,000,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-34. Suggested solution: Upon transfer Dr. Cash ($500,000 × 95%) of receivables Dr. Due from factor ($500,000 × 2% for holdback) Cr. Short-term debt—asset-backed financing Completion of collection

Dr. Cash Dr. Allowance for doubtful accounts ($500,000 – $496,000) Cr. Due from factor Dr. Short-term debt—asset-backed financing Dr. Interest expense Cr. Accounts receivable

475,000 10,000

485,000

6,000 4,000 10,000 485,000 15,000

500,000

P5-35. Suggested solution: Upon transfer of receivables

Dr. Cash ($45,000,000 × 97%) Dr. Due from factor ($45,000,000 × 1% holdback) Cr. Short-term debt—asset-backed financing

Completion of collection

Dr. Cash Dr. Allowance for doubtful accounts ($45,000,000 – $44,800,000) Cr. Due from factor Dr. Short-term debt—asset-backed financing Dr. Interest expense Cr. Accounts receivable

43,650,000 450,000

44,100,000

250,000 200,000 450,000 44,100,000 900,000

45,000,000

P5-36. Suggested solution: a. The securitization transaction transfers the risks and rewards of ownership from Sparwood to the investors in the mortgage-backed securities because it is the investors who bear the cost of non-payment. Consequently, the transactions should be recorded as a sale. b. Dr. Cash Dr. Interest expense Cr. Mortgages receivable

19.5 m 0.5m

. 5-14

20m

Chapter 5: Cash and Receivables

P5-37. Suggested solution: Alternative 1 (% of sales method): First compute the amount of BDE required for the year, at 0.75% of credit sales of $650,000, which amounts to $4,875. Since $4,500 of BDE had already been recorded for the year, the remainder to be recorded is $375. This $375 is the amount by which the ADA accounting is increased (i.e., credited). Balance, Jan. 1 write-offs

2,500

ADA 3,000 4,500 375

BDE



5,375

4,500 375

BDE at 0.75% of 650,000 credit sales

4,875

Alternative 2 (aging method): First compute the amount of ADA. Of the $120,000 balance of accounts receivable, management expects 80% to incur a 2% loss and the remaining 20% to incur a 10% loss. Thus, the balance in ADA should be $120,000 × (80% × 2% + 20% × 10%) = $4,320. Combined with other information relating to the ADA account, we can determine the amount of adjustment required to the ADA account to be $680 debit and a corresponding credit to BDE. Balance, Jan. 1 write-offs 120,000 × (80% × 2% + 20% ×10%) 

2,500 680

ADA 3,000

BDE

4,500

4,320

3,820

680

P5-38. Suggested solution: a. Amounts used are in $millions. Dec. 31, 2023 Dr. Bad debts expense Cr. Allowance for doubtful accounts Calculation:

ADA 2.25 Beginning balance write-offs 12.50 9.45 Interim BDE (1% x 945) 3.30 Year-end BDE 2.50 Ending balance

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3.3

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

When A/R factored

Dr. Cash Dr. Due from factor (holdback) Cr. Short-term debt – asset-backed financing

47 2

Six months later

Dr. Cash Dr. Allowance for doubtful accounts Cr. Due from factor (holdback) Dr. Short-term debt – asset-backed financing Dr. Interest expense Cr. Accounts receivable

1.5 0.5

49 1

P5-39. Suggested solution: a. To determine BDE, first determine the amount ADA using and aging schedule. Days outstanding from invoice date 0–30 days 31–90 days > 90 days Balance outstanding $7,100,000 $1,800,000 $375,000 Estimated default rate 0.5% 2% 10% Estimated bad debts $35,500 $36,000 $37,500

Total $9,275,000 — $109,000

The desired ending balance of ADA is thus $109,000. Combining this and other information relating to ADA, we can determine the amount of BDE. ADA 120,000 write-off 70,000 3,000 recovery 56,000 = BDE 109,000 (from aging) b.

Dr. Bad debts expense Cr. Allowance for doubtful accounts

56,000

Dr. Allowance for doubtful accounts Cr. Accounts receivable

70,000

Dr. Cash Dr. Interest expense Cr. Accounts receivable

1,900,000 100,000

. 5-16

56,000

70,000

2,000,000

Chapter 5: Cash and Receivables

Dr. Cash Dr. Due from factor (2% × $2,000,000) Cr. Short-term debt—asset-backed financing

1,930,000 40,000

1,970,000

P5-40. Suggested solution: a. When A/R factored Final payment

Dr. Cash Dr. Due from factor Cr. Short-term debt—asset-backed financing

550,000 20,000

Dr. Cash Dr. Allowance for doubtful accounts ($600,000 – $585,000) Cr. Due from factor

5,000 15,000

Dr. Short-term debt—asset-backed financing Dr. Interest expense Cr. Accounts receivable

570,000 30,000

570,000

20,000

b. To determine BDE, first determine the amount ADA using and aging schedule. Days outstanding from invoice date 0–30 days 31–90 days > 90 days Balance outstanding, Dec. 31 $600,000 $170,000 $80,000 Estimated default rate 1% 2% 5% Estimated bad debts $6,000 $3,400 $4,000

600,000 Total $850,000 — $13,400

The desired ending balance of ADA is thus $13,400. Combining this and other information relating to ADA, we can determine the amount of BDE. Take care to include the effect of the factoring transaction. ADA 25,000 Write-off 50,000 Factored accounts not collectible 15,000 53,400 = BDE 13,400 (from aging) c.

Dr. Bad debts expense Cr. Allowance for doubtful accounts

53,400

Dr. Allowance for doubtful accounts Cr. Accounts receivable

50,000

. 5-17

53,400

50,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-41. Suggested solution: Completing the aging schedule results in the amount of $10,800, which is the required ending balance of ADA. Days outstanding from invoice date 0–30 days 31–90 > 90 days Total Balance outstanding, Dec. 31 $700,000 $180,000 $37,000 $917,000 Estimated default rate 0.5% 2% 10% — Estimated amount of doubtful accounts $3,500 $3,600 $3,700 $10,800 As shown in the T-account below, the correct bad debts expense is $5,800, so the expense is overstated by $5,000: ADA 12,000 write-off 7,000 5,800 BDE 10,800 The journal entry required to correct the accounts is as follows: Dr. Allowance for doubtful accounts Cr. Bad debts expense

5,000

P5-42. Suggested solution: a. ADA 5,000 write-off 3,500 2,500 BDE 4,000 The journal entry to record the bad debts expense is as follows: Dr. Bad debts expense Cr. Allowance for doubtful accounts

2,500

b. All of the relevant accounts (A/R, ADA, BDE) are correctly stated. Corrected ADA (what the account should have looked like) 5,000 write-off 3,500 write-off 1,500 This is the amount of BDE that should have been recorded, which is the same as the 4,000 BDE BDE that was recorded ($2,500 from part a and $1,500 in the erroneous entry given in this part.) 4,000 . 5-18

Chapter 5: Cash and Receivables

c. The journal entry to record the sale of all receivables for $110,000 is as follows: Dr. Cash 110,000 Dr. Allowance for doubtful accounts 4,000 Dr. Interest expense or loss on sale of accounts receivable 6,000 Cr. Accounts receivable 120,000 P5-43. Suggested solution: a. The balance of the allowance for doubtful accounts is determined as follows: ADA 0 Opening balance Write-offs 35,000 69,000 BDE for 2023 34,000 Dec. 31, 2023 Write-offs 160,000 132,000 BDE for 2024 6,000 Dec. 31, 2024 b. Write-off entry: Dr. Allowance for doubtful accounts Cr. Accounts receivable

160,000

Adjusting entry: Dr. Retained earnings (to adjust for BDE not recorded in 2023) Cr. Allowance for doubtful accounts Dr. Bad debts expense (for 2024 BDE) Cr. Allowance for doubtful accounts

34,000 132,000

160,000

34,000 132,000

P5-44. Suggested solution: The time value of money is significant in this instance, because the receivable is due over an extended period of time. The receivable comprises four payment of $1,000 each at annual intervals one year after the date of sale. Therefore, the account receivable is: Account receivable = $1,000 × PVFA(6%, 4) = $1,000 ×3.4651 = $3,465 Or using a BAII PLUS financial calculator: 4 N, 6 I/Y, 1,000 PMT, CPT PV = –3,465 (rounded) Dr. Cash Dr. Note receivable Cr. Sales ($1,000 + $3,465)

1,000 3,465

Dr. Cost of goods sold (given) Cr. Inventory

3,000

The amount of revenue is $1,000 more than the receivable, so it is $4,465.

5-19

4,465 3,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-45. Suggested solution: a. To determine BDE, first determine the amount ADA using and aging schedule. Days outstanding from invoice date 0–30 days 31–90 days > 90 days Balance outstanding, Dec. 31, 2023 $320,000 $80,000 $30,000 Estimated default rate 1% 2% 4% Estimated allowance for doubtful $3,200 $1,600 $1,200 accounts

Total $430,000 — $6,000

The desired ending balance of ADA is thus $6,000. Combining this and other information relating to ADA, we can determine the amount of BDE. ADA 20,000 Write-off 75,000 8,000 = Recovery 53,000 = BDE 6,000 (from aging) b. The journal entry for the factoring without recourse is as follows. Dr. Cash Dr. Interest expense Cr. Accounts receivable

186,000 14,000

200,000

c. To record the journal entry for the sale, it is necessary to compute the value of the transactions. The only information available relates to the promissory note; there is not information on the fair value of the sale. The present value of the note is computed as follows: PV of coupons = $10,500 × PVFA(10%,3) = $10,500 × 2.4869 PV of principal = $150,000 / 1.103 PV of note Or using a BAII PLUS financial calculator: 3 N, 10 I/Y, 10,500 PMT, 150,000 FV, CPT PV = –138,809 (rounded)

$ 26,112 112,697 $138,809

Then the journal entry for the sales made in exchange for the promissory note is as follows: Dr. Note receivable 138,809 Cr. Sales revenue 138,809 d. Since the company made the sale and received the promissory note at the beginning of the year, the amount of interest is for the full year, so it is $138,809 × 10% = $13,881.

. 5-20

Chapter 5: Cash and Receivables

P5-46. Suggested solution: a. The desired ending balance of ADA is $350,000. Combining this and other information relating to ADA, we can determine the amount of BDE. ADA 320,000 Given write-off 250,000 12,000 Recovery 268,000 BDE 350,000 Given The journal entry to record the bad debts expense is as follows: Dr. Bad debts expense Cr. Allowance for doubtful accounts b.

268,000

Dr. Cash Dr. Interest expense Cr. Accounts receivable

440,000 60,000

Dr. Cash Dr. Due from factor (holdback) Cr. Short-term debt—asset-backed financing

750,000 30,000

Dr. Restructured loan receivable ($421,478.40 / 1.122) Dr. Loss on loan restructuring Cr. Loan receivable ($300,000 × 1.123)

. 5-21

336,000 85,478.40

268,000

500,000

780,000

421,478.40

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-47. Suggested solution: a. 01/01/2023 To record the sale of the preferred shares Dr. Note receivable (given) Cr. Preferred shares

89,000

12/31/2023 To record the accrual of interest Dr. Note receivable Cr. Interest revenue ($89,000 × 6%)

5,340

12/31/2024 To record the accrual of interest Dr. Note receivable Cr. Interest revenue (($89,000 + $5,340) × 6%)

5,660

01/01/2025 To record the derecognition of the note receivable Dr. Note receivable Cr. Cash

100,000

89,000

5,340

5,660

100,000

b. $100,000 − $89,000 = $11,000 discount to be amortized; $11,000 / 2 = $5,500 amortization per year 01/01/2023 To record the sale of the preferred shares Dr. Note receivable (given) 89,000 Cr. Preferred shares 89,000 12/31/2023 To record the accrual of interest Dr. Note receivable Cr. Interest revenue (from above)

5,500

12/31/2024 To record the accrual of interest Dr. Note receivable Cr. Interest revenue

5,500

01/01/2025 To record the derecognition of the note receivable Dr. Note receivable Cr. Cash

100,000

5,500

100,000

P5-48. Suggested solution: To record the journal entry for the sale, it is necessary to compute the value of the transaction. The only information available relates to the promissory note; there is not information on the fair value of the sale. The present value of the note is computed as follows:

. 5-22

Chapter 5: Cash and Receivables

PV of Note = $5,000 × PVFA(0.5%, 48) = $5,000 ×42.5803 = $212,902 Or using a BAII PLUS financial calculator: 48 N, 0.5 I/Y, 5,000 PMT, CPT PV→PV = –212,902 (rounded) a. To record the sale of the data management system Dr. Note receivable Cr. Sales revenue Dr. Cost of goods sold Cr. Inventory

212,902 170,000

b. To record the accrual of interest on January 31 Dr. Note receivable Cr. Interest revenue ($212,902 × 0.5%)

1,065

c. To record the receipt of the loan payment on February 1 Dr. Cash Cr. Note receivable

5,000

d. To record the accrual of interest on February 28 Dr. Note receivable Cr. Interest revenue (($212,902 + $1,065 – $5,000) × 0.5%)

1,045

212,902 170,000

1,065

5,000

1,045

P5-49. Suggested solution: To record the journal entry for the sale, it is necessary to compute the value of the transaction. The only information available relates to the promissory note; there is not information on the fair value of the sale. The present value of the note is computed as follows: PV of Note = $5,000 × PVFA(0.5%, 48) = $5,000 ×42.5803 = $212,902 Or using a BAII PLUS financial calculator: 48 N, 0.5 I/Y, 5,000 PMT, CPT PV→PV = – 212,902 (rounded) Discount to be amortized = $240,000 - $212,902 = $27,098; $27,098 / 48 = $565 (rounded) discount to be amortized per month

. 5-23

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

a. To record the sale of the data management system Dr. Note receivable Cr. Sales revenue Dr. Cost of goods sold Cr. Inventory

212,902 170,000

b. To record the accrual of interest on January 31 Dr. Note receivable (from preliminary calculations) Cr. Interest revenue

565

c. To record the receipt of the loan payment on February 1 Dr. Cash (given) Cr. Note receivable

5,000

d. To record the accrual of interest on February 28 Dr. Note receivable (from preliminary calculations) Cr. Interest revenue

565

212,902 170,000

565

5,000

565

P5-50. Suggested solution: To record the journal entry for the sale, it is necessary to compute the value of the transaction. The only information available relates to the promissory note; there is not information on the fair value of the sale. The present value of the note is computed as follows: PV of coupons

= $8,734 × PVFA(7%,5) = $8,734 × 4.1002

Or using a BAII PLUS financial calculator: 5 N, 7 I/Y, 8,734 PMT, CPT PV→PV = –35,811 (rounded)

. 5-24

$35,811

Chapter 5: Cash and Receivables

To record the sale of inventory on January 1, 2023 Dr. Cash Dr. Note receivable Cr. Sales revenue Dr. Cost of goods sold Cr. Inventory

6,000 35,811 32,000

To record the accrual of interest on December 31, 2023 Dr. Note receivable Cr. Interest revenue ($35,811 × 7%)

2,507

To record the receipt of the loan payment on January 1, 2024 Dr. Cash Cr. Note receivable

8,734

To record the accrual of interest on December 31, 2024 Dr. Note receivable Cr. Interest revenue (($35,811 + $2,507 – $8,734) × 7%)

2,071

41,811 32,000

2,507

8,734

2,071

P5-51. Suggested solution: Issuance of promiss. note

Dr. Note receivable Cr. Cash

5,000,000

Interest accrual – Yr 1

Dr. Note receivable Cr. Interest income ($5,000,000 × 10%)

500,000

Interest accrual – Yr 2

Dr. Note receivable Cr. Interest income (($5,000,000 + $500,000) × 10%)

550,000

Loan restructuring

Dr. Restructured note receivable ($7,000,000 / 1.103) Dr. Loss on note restructuring Cr. Note receivable ($5,000,000 + $500,000 +$ 550,000)

5,259,204

. 5-25

790,796

5,000,000 500,000 550,000

6,050,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P5-52. Suggested solution: 2023 Dr. Note receivable (or interest receivable) Cr. Interest income (50,000 × 12%)

6,000

2024 Dr. Restructured note receivable (56,000 / 1.122) Dr. Loss on restructuring of note receivable Cr. Note receivable

44,643 11,357

Dr. Restructured note receivable (or interest receivable) Cr. Interest income (44,643 × 12%) Note: Balance of restructured note receivable on Dec. 31, 2024 is 44,643 + 5,357 = 50,000. This amount is also equal to 56,000 / 1.12 = 50,000.

6,000

56,000

5,357

P5-53. Suggested solution: a. In Note 1—Accounting Policies, CNRL states the following in part (C) for Cash and Cash Equivalents: “Cash comprises cash on hand and demand deposits. Other investments (term deposits and certificates of deposit) with an original term to maturity at purchase of three months or less are reported as cash equivalents in the consolidated balance sheets.” b. The gross amount of trade receivables was $1,238 million as disclosed in Note 7 showing the composition of $1,235 million in “Accounts receivable and accrued revenues,” which was reported on the face of the balance sheet. There were $3 million in the allowance for doubtful accounts, leaving a net receivable of $1,235 million ($1,238 – $3).

c. The small amount for the allowance for doubtful accounts ($3 million or 0.24% of gross receivables) could be reasonable under the circumstances. The company is in the business of exploration, development, production, and marketing of natural gas, oil, and natural gas liquids (see Note 1 of the financial statements). Thus, the company’s customers are regulated utilities, oil refineries, and other petroleum companies. These entities inherently have low credit risk. This conclusion is confirmed by Note 25(c), which says, “A substantial portion of the Company’s accounts receivable are with customers and working interest owners in the oil . 5-26

Chapter 5: Cash and Receivables

and gas industry and are subject to normal industry credit risk. As at December 31, 2019, approximately 95 percent of Encana’s accounts receivable … were with investment grade counterparties.” d. Note 11 indicates $81 million in “Long-term receivable” within “Other Assets.” P5-54. Suggested solution: a. At the end of 2019, Air Canada had $2,090 million in cash and cash equivalents (see balance sheet). Note 18 on financial instruments explains the composition of this amount in cash and cash equivalents: Therefore, the amount of cash is $2,090 million − $381 million = $1,709 million. b. The company had restricted cash of $157 million in current assets, which is shown on the balance sheet. Note 2(P) explains the source of this restricted cash:

Thus, the restricted cash arises because Air Canada, as a commercial airline, receives payment for flight tickets before customers take their flights. Government regulations require some portion of these amounts to be set aside, presumably so that the company can reimburse customers should the company be unable to honour the commitment to provide flight services as promised in the ticket. c. The company reported $926 million in net accounts receivable on the balance sheet. As for the gross amount of accounts receivable, there is insufficient information to determine that amount. The company disclosed neither that figure nor the amount in the allowance for doubtful accounts. According to the “Credit Risk” disclosure within Note 18, these accounts receivable “are generally the result of sales of tickets to individuals, often through the use of major credit cards, through geographically dispersed travel agents, corporate outlets, or other airlines.” One might infer that the credit risk associated with these receivables are extremely low and that the allowance for doubtful accounts is close to zero or immaterial. P5-55. Suggested solution: a. The amount of cash and cash equivalents shown on the balance sheet is $205.5 million. Unusually, this amount includes $18.2 million of “restricted cash and cash equivalents” as shown in Note 7:

. 5-27

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Strictly speaking, restricted cash should not be included with cash and cash equivalents, which are presumed to be unrestricted. Possibly this presentation was permitted because $10.5 million is an immaterial amount to warrant separate presentation on the balance sheet. b. The company recorded $796.8 million in “allowance for impairment on loan receivable” as shown in Note 9:

Note that the details in the three middle columns are not necessary to understand and to answer this question. The company did not provide a corresponding allowance for “Trade and other receivables,” in Note 8, which presumably means that the amount is immaterial c. Note 9 indicates that the company had $6,416.6 million in loans receivable, of which $5,813.8 million was classified as current. (These amounts are net of the allowance for credit losses indicated in part b above). It is reasonable that most of the loans receivable are current

. 5-28

Chapter 5: Cash and Receivables

because most of the loans derive from credit card loans, which comprise $5,794.1 million of the total.

. 5-29

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

T. Mini-Cases Case 1: MGM Mirage. Suggested solution: [Catch: new solution to come Feb 2022] a. The amount of the allowance for doubtful accounts (ADA), at $100m, is a very high amount relative to accounts receivable (A/R), at $403m. Furthermore, the casino portion of ADA is 37.7% of casino receivables. These percentages are higher than in recent years: 28.9% in 2007 and 33.5% in 2006 (see table below). Considering the financial crisis and the recessionary economic conditions, the increase in the ADA percentage appears warranted. The amount of ADA also appears to be sufficient if we consider the median age of casino receivables. That age has increased from 28 days to 36, which is similar to the increase in ADA percentage (from 28.9% to 37.7%). We can also use the income statement numbers and look at bad debts expense relative to casino revenues. While we do not have numbers that are not strictly comparable—the bad debts expense includes all activities while the revenue is for casino operations only—the comparison is still informative because most bad debts arise from casinos and table play in particular. Looking at it this way, bad debts expense is 7.4% of casino table revenue in 2008 compared with 2.7% in 2007 and 3.8% in 2006. Thus, it appears that management has factored in a large effect of the recession on the collectability of accounts. A third way to evaluate the appropriateness of the valuation of accounts receivable is to look at the bad debts expense relative to write-offs. Write-offs did increase significantly, going from $37m in 2007 to $66m in 2008. These amounts suggest that credit quality has indeed deteriorated, and a higher bad debts expense or ADA is required. Although we are less concerned about non-casino receivables, we should nonetheless review this portion. As the figures in the table below show, the amount of non-casino ADA has also increased from 2007 (3.9% to 5.0%) Given the negative economic conditions, this increase appears to be reasonable. (Non-bold items are repeated from facts; bolded figures are computations.) Casino accounts receivable Allowance for doubtful casino accounts receivable Casino ADA as % of casino A/R

2008 $ 244m $ 92m 37.7%

2007 $ 266m $ 77m 28.9%

2006 $ 248m $ 83m 33.5%

Median age of casino accounts receivable

36 days

28 days

46 days

Casino revenues—Tables Bad debts expense Write-offs net of recoveries Allowance for doubtful accounts receivable Bad debts expense as a % of casino table revenue

$1,079m $ 80m $ 66m $ 100m 7.4%

$1,228m $ 33m $ 37m $ 86m 2.7%

$1,251m $ 48m $ 35m $ 90m 3.8%

. 5-30

Chapter 5: Cash and Receivables

Total A/R – casino and non-casino Non-casino A/R Non-casino ADA Non-casino ADA as % of non-casino A/R

$ 403m $ 159m $ 8m 5.0%

$ 499m $ 233m $ 9m 3.9%

$ 453m $ 205m $ 7m 3.4%

b. In comparison to other types of businesses, MGM Mirage’s bad debts are extraordinarily high, which does suggest that their credit policy needs to be considered carefully. The company’s disclosures describe significant risks of uncollectability, particularly for markers issued to foreign clients and possible instability in foreign countries that would put at risk the ability of clients to repay their debts. To MGM Mirage, these are likely acceptable risks. Casino revenues depend on there being players. Casinos rely on the “house” taking a percentage on average in poker, blackjack, roulette, and so on, so the higher the volume of play, the more the casino expects to earn. While certainly players who will be able to repay their debts are preferred, the presence of players who may ultimately not be able to repay their debts is also a necessary component of the gaming environment. Part of the excitement of gambling is winning in the presence of other players, and winning against other players. c. While ethical considerations are probably not the highest of priority for casino management, ethics is nonetheless important. In the pursuit of profit, casinos will issue markers to players who may not have the ability to repay the debt without taking drastic steps such as selling their home or business. A counterargument can be made that people make conscious choices to engage in gambling and it is not the duty of the casino to turn customers away. However, there is substantial scientific evidence that suggests gambling can be an addiction and ethical business practice should consider limiting the patronage of certain gamblers, including putting reasonable limits on the issuance of markers and refusing entry to problem (addicted) gamblers.

. 5-31

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Case 2: West Pacific’s Mortgage Receivables. Suggested solution: Issue Arguments supporting WP 1 Mortgages receivable can be removed because they are no longer assets: * WP no longer controls the mortgages * WP does not retain future benefits from the mortgages

Arguments supporting OSC Receivables cannot be removed because they are assets to WP: * WP retains risks and rewards of mortgages * 0.6% fee is a future benefit to WP * WP maintains control of mortgages since it manages the collection of mortgage payments Removing an asset also implies derecognition of the corresponding liability, but that liability has not been extinguished. * WP’s guarantee of timely payment to investors is an unavoidable obligation. Revenue should be recognized as earnings process is completed, which is over the duration of the mortgage contracts.

PV of 0.6% fee can be recognized when MBS is sold because earnings process is largely complete at that time; most of the work required has been completed. CMHC guarantee ensures that future payments will be received, so the future benefits are probable and measurable with reasonable accuracy. The short amount of time that the mortgages are held suggests that cost is a good reflection of value at year-end. Any differences between cost and market value at year-end are likely to be immaterial. The costs of revaluation are high and likely to exceed any benefits.

. 5-32

There is uncertainty in the amount and timing of future payments, so revenue should be delayed until the time when payment is received. Since WP regularly sells these mortgages, they are short-term investments or inventory; therefore, they should be revalued to reflect market prices (especially declines).

Chapter 5: Cash and Receivables

Case 3: Kanata Motor Company. Suggested solution: To: Tom Delorian, Chief Executive Officer From: Kate Moffat, VP Finance Re: Proposal to offer credit protection to customers This proposal has some merits in terms of stimulating sales during tough economic times. While I’m not in a position to comment on the magnitude of the sales increase we can expect, I do agree with Willy that we will see a significant uptick in sales if the proposal goes ahead, as it is quite an attractive value proposition from the customer’s perspective. Despite the positive impact on sales, there are several risks that we should be concerned about and manage if possible. All of these risks centre on the ability of the customer to return the car in the event of job loss. The first risk is inherent in the type of clientele that we would attract with this offer. There will be a type of self-selection, called adverse selection, in which those customers who face the highest risk of job loss will find our offer most beneficial. This means that we cannot use statistics on unemployment and job losses of the general population to extrapolate to the group of customers we will attract. We should be mindful that we need to be more conservative while making such estimates. Indeed, we may attract some unscrupulous customers who have some foreknowledge of their future job situations taking advantage of our offer. They could buy a new vehicle from us, use it over the short term, and return it to us later, all the while knowing that he/she was going to be jobless temporarily while changing jobs, for example. The second risk is in the commission plan that we have in place. Our sales people, as typical, receive a percentage of the sale price of each vehicle. As long as they can make a sale, they will receive a commission. However, the commission incentivizes our sales people to oversell, in the sense that they do not have any incentive to screen out bad customers who have a high probability of returning the vehicle due to job loss. Before implementing this proposal, we should consider changing the commission structure to reflect not sales, but cash received since the latter includes the effect of credit problems. Normally, the bad credit risk would be appropriately managed by the credit department. However, with this offer, our credit department may be unable to screen the customers sufficiently well. This is because the credit assessment is based on credit history, which cannot reflect what will happen in the future. Customers are eligible to return their vehicle if they lose their jobs in the future and that future event cannot be captured by historical credit information. This is the third risk. Together, we can think of the second and third risks as control risks—the risks that our sales and credit personnel do not mitigate the inherent risk that high-risk customers will avail themselves of this offer.

. 5-33

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Finally, there is a risk that our financial reporting would be negatively affected. This proposal has the potential to affect both our revenues and accounts receivable. Our sales numbers would likely go up under this offer if we maintain the same accounting policies and estimates as we have in the past. For a business such as ours, we would normally recognize revenue at the point of sale because that is the point at which there is a transfer of risks and rewards to the customer. However, with this credit protection, the customer has the right of return if he/she loses his/her job, and when that happens, we need to cancel the loan receivable. This means that we retain some of the risk of ownership, and this risk is reasonably substantial given the current economic conditions. The risk of product returns and loan forgiveness does not preclude the recognition of revenue and accounts receivable at the point of sale as long as we can provide a reasonably accurate estimate of future returns (or loans to be forgiven) and accrue for such costs in the period of the sale. In this instance, however, we do not have a history upon which to make these estimates, so it may not be possible to satisfy the measurability criterion. This is especially important given that we are already in the final quarter of the year, so there will be little time to gain experience to assess the reasonability of any estimates. If we are unable to provide a reasonable estimate of returns, then we will have to delay the recognition of revenue on credit sales until a point in time when the risk of return is sufficiently low. Revenue recognition for cash sales would not be affected since this proposal applies only to sales with financing. To conclude, I believe that the proposal will have some positive impact on sales. However, we should carefully consider the risks of the plan, especially the risk to our ability to recognize revenues and accounts receivable given that our shareholders are concerned about this year’s performance. Case 4: Barkwood Winery. Suggested Solution: a. There are serious internal control problems related to the situation. While it is true that Edmond has a small business and the opportunities available to segregate duties may be severely limited as he can only afford to hire one full-time person to manage the tasting room, it seems that he is not imposing any kind of internal control to cash as well as to inventory management. In a small enterprise, direct supervision by owners is extremely important. In this situation, Edmond did not seem to have exercised adequate supervision to his employees. Since the full-time employee was the only person handling the sales as well as keeping track of inventory, there could be possible employee theft to both cash and inventory. What made the matters worse was that there was no reconciliation between cash, the sales record and inventory by the owner when the full-time employee passed over the cash register to the owner before the weekend, hence any possible fraud by the full-time employee would go unnoticed. There was also no restriction to access of the cash register from the part-time employee. Since the tasting room had so far been predominantly a cash business and there was no record of cash receipts from tasting fees, the risks associated with cash embezzlement were significant.

. 5-34

Chapter 5: Cash and Receivables

b. Internal control would probably be stronger on the weekend due to direct supervision of owner. However, it is not without its weaknesses, as the owner should have restricted cash access from the part-time employee. c. While common wisdom suggests that cash has the greatest risk of being misappropriated, it is hard to say whether the employees would be more likely to embezzle cash or inventory given the internal control weaknesses in both cash and inventory in this situation. The fact that the owner and the employees all shared the same cash register without any reconciliation at the end of each day would give opportunity to employees for misappropriating cash going unnoticed. On the other hand, as there was no inventory count until the end of the month, employees could easily steal inventory (i.e., wine) from the cellar. The story titled “ethics and honesty in relation to cash and non-cash items” in text has taught us that people are more likely to lie when it comes to non-cash items. The particular wine tasting business gives additional concerns as well to wine misappropriation. As the size of wine pour varies by server, it might be more difficult to obtain a norm of the costs of goods sold in this business. Thus, it might give more opportunities to the employee for misappropriation of inventory.

. 5-35

Chapter 6 Inventories P. Problems P6-1. Suggested solution: Potential benefit True / False A perpetual system is less costly than a periodic system. F A perpetual system produces information that is more useful for inventory manT agement. A perpetual system helps to estimate expected amounts of inventory at year-end. T A perpetual system allows a company to avoid conducting costly inventory counts. F A perpetual system is required by IFRS and ASPE. F A perpetual system helps to determine the amount of shrinkage. T P6-2. Suggested solution: Feasible to track inventory continuously

Benefit of continuous inventory tracking

a. Supermarket

Yes

High—helps to determine the amount of spoilage and theft, and when to reorder.

b. Ice cream store

No—each unit of inventory cannot be tracked due to the inconsistent sizes of servings

Low—low risk of theft or overconsumption by staff

c. Car dealership

d. Electronics store

P6-3. Suggested solution:

Yes

High—helps to identify models that sell better or worse for future purchases High—helps to determine the amount of theft or damage and to identify products that sell better or worse for future purchases

. 6-1

Costs of tracking inventory continuously Medium—with barcode scanning technology, continuous tracking is reasonably affordable.

Recommendation

Perpetual

n/a

Periodic

Low—items are high value and easy to track

Perpetual

Low—items are medium to high value and easy to track

Perpetual

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

a. A department store—Perpetual. A department store has a wide range of products that need to be tracked to identify products that sell well versus others that do not. Theft is also a significant concern, so information about the amount of shrinkage is valuable. b. A furniture manufacturer—Periodic. Making furniture requires many different components (wood, nails, screws, fabric) that have low value (although the finished product may have high value). Trying to track how much of these raw materials are being used for the manufacture of each item has little benefit but high cost in slowing down the production process. c. A restaurant—Periodic. It is not possible to track all the ingredients that go into the preparation of meals served by the restaurant. Even if it were possible, there would be little benefit to the information in terms of supply management. d. A post office—Perpetual. Postage stamps are essentially pieces of paper that store value, so they are similar to paper money. It is important for the post office to maintain tight control over this inventory, so a perpetual system would be beneficial. P6-4. Suggested solution: a. b. c. d. e. f. g. h. i. j

Item Invoice cost of purchased inventory. Non-refundable tariffs on imported inventory. Cost of shelves and racks at retail store. Cost of shipping from distributor to warehouse. Transportation from warehouse to retail store. Cost to courier products to VIP customers. Rent for warehouse. Rent for retail store. Wages of staff at retail store. Salary of purchasing manager.

Product √ √ √ √ √ √

Period √ √ √ √

P6-5. Suggested solution:

a. b. c. d. e. f. g. h. i. j.

Item Raw materials. Salary for production line supervisor. Salary for sales manager. Pension benefits for assembly line workers. Electricity used in production plant. Production accountant (who tracks costs and variances). Cost of shipping to company’s warehouse prior to sale. Heating cost for production plant during operating hours. Heating cost for production plant during off-hours. Depreciation on production plant.

. 6-2

Include in inventories √ √ √ √ √ √ √ √

Expensed √

√

Chapter 6: Inventories

P6-6. Suggested solution: a.

Dr. Inventory (purchase price) Dr. HST recoverable* ($1,700,000 × 10%) Cr. Cash ($1,700,000 + $170,000)

1,700,000 170,000

Dr. Inventory (freight in) Cr. Cash

30,000

1,870,000 30,000

*The HST paid on the purchase is recoverable by Zoe and accordingly will not be included in the cost of inventory to be allocated. b. Costs to be allocated ($1,700,000 + $30,000) = $1,730,000 # Sales Total Factor price 2-person spa 200 $5,000 $1,000,000 1,000 / 2,515 × 1,730,000 4-person spa 140 6,000 840,000 840 / 2,515 × 1,730,000 6-person spa 90 7,500 675,000 675 / 2,515 × 1,730,000 $2,515,000

Allocated $ 687,873 577,813 464,314 $1,730,000

P6-7. Suggested solution: a.

Dr. Z1 inventory Cr. Cash

100,000

Dr. Z2 Inventory Cr. Cash

7,000

Dr. Interest expense Cr. Cash

100,000

Dr. Interest expense Cr. Cash

7,000

100,000 7,000 1,00,000 7,000

c. Under both IFRS and ASPE, Zamphir could elect to either capitalize or expense the $100,000 interest costs on the Z1, as while the jets take a substantial time to get ready, they are manufactured in large quantities on a repetitive basis. If Zamphir reported its financial results in accordance with IFRS, the $7,000 interest costs on the Z2 must be capitalized and included in product costs, as per the solution to part a. The reason for this is that the jet will take a substantial time to get ready for sale and is not manufactured in large quantities on a repetitive basis.

. 6-3

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-8. Suggested solution: a. The two conceptual principles that MRC must consider in determining whether it should accrue a receivable for a possible volume rebates are: i) does the receivable meet the definition of an asset; and ii) does it meet the recognition criteria. Recall that the Framework defines an asset as a present economic resource controlled by the entity as a result of past events where an economic resource is a right that has the potential to produce economic benefits. The recognition concept normally requires that accounting elements be recognized in the financial statements when the inflow of resources is probable, and the amounts are reasonably measurable. b. In this scenario the potential rebate meets the recognition criteria for an asset as the inflow of resources is probable (MRC has purchased sufficient quantities to earn the rebate for five years in a row), and reasonably measurable ($0.10 per unit). Accordingly, for the each of the first 100,000 units purchased from YLI during the year, MRC should debit inventory $2.40 and accrue a $0.10 rebate receivable. c. In this scenario the potential rebate does not meet the recognition criteria for an asset. While the amount is reasonably measurable ($0.10 per unit), there is some uncertainty as to whether the 100,000-unit threshold will be achieved. As such MRC should debit inventory $2.50 for the first 100,000 units purchased from YLI. If MRC subsequently meets the threshold during the year, the $10,000 rebate should be credited to cost of goods sold. P6-9. Suggested solution: To answer this question, we need to consider a number of factors, including: i. whether costs like freight-in and duty meet the definition of an asset; ii. if so, is it appropriate to recognize an asset on our balance sheet; and, iii. if recognized, what amount should we value the asset at? Dealing with the first point, IFRS’s Conceptual Framework for Financial Reporting (The Framework) defines as asset as, a present economic resource, controlled by the entity, as a result of past events, where an economic resource is a right, that has the potential to produce economic benefits. Do duty and freight-in meet the three tests embodied in this definition, specifically: present economic resource; controlled by the entity; and the potential economic benefits? If we look at the question narrowly, we might not think that the $2 paid for duty and freight to get the asset to its present location and condition, meets the definition of an asset. There is little question that the past event criterion has been met, as the item was shipped and cleared customs in the past. The control aspect is debatable, however. Yes, we paid the duty and shipping costs, but how is it possible for an entity to control things like duty paid? Also, how do these items represent a present economic resource? Its not like we can take the duty paid and go sell it as a stand-alone item to someone else. If we take a broader view of the situation, though, we will recognize that while we may not control the duty or the shipping, that we do control the asset that was shipped and that duty was paid on. Continuing on with this thought, we should recognize that these items, when packaged with the book, have potential value to prospective purchasers. The additional value arises, because . 6-4

Chapter 6: Inventories

potential purchasers are likely willing to pay more for a locally available, duty paid, book, than one that they have to source internationally, and for which they would ultimately be responsible for paying the duty and shipping costs. When looked at in this manner, the broader view supports the view that shipping and duty costs meet the definition of an asset. The second point can be addressed by referring to The Framework’s recognition criteria, which suggests that an asset is recognized in the financial statements, when the inflow of resources is probable, and the amounts are reasonably measurable. If you are a bookseller, the probability test will normally be met, as you are in the business of selling books. You will receive cash (an economic resource), when you sell the book to a customer. Moreover, the amounts are reasonably measurable as we know how much we paid for the book and how much we paid for the shipping and duty. The third point is governed by IAS 2, the Inventory standard, which provides that the cost of inventory includes all costs required to bring it to its present location and condition. In this instance this amounted to $12 ($10 for the book + $2 for the shipping and duty = $12 in inventory). In summary, we debit inventory for $12, because: the costs comprising this amount all meet the definition of an asset; the downstream inflow of resources is probable and the costs were measurable; and, the amount recognized in inventory consists only of the costs required to bring the asset to its present location and condition. P6-10. Suggested solution: a. To compute cost of goods sold and ending inventory, first compute the cost of goods available for sale (COGAS). Since this is the first year of operations, COGAS equals the current year’s production costs. (Later years would also need to include the cost of beginning inventory.) Product costs Opening raw materials Raw materials purchases Raw materials inventory, December 31 Raw materials used in production Plant supplies Direct labour Production manager’s salary Utilities expense ($40,000 × 85% for manufacturing facility) Property taxes ($8,000 × 70% for manufacturing facility) Depreciation – manufacturing facility Depreciation – equipment Total production cost = COGAS a. Cost of goods sold ($353,600 COGAS × 85% sold) b. Ending finished goods inventory ($353,600 COGAS × 15% remaining)

. 6-5

Amount $ 20,000 140,000 (30,000) 130,000 13,000 60,000 75,000 34,000 5,600 22,000 14,000 353,600 300,560 $53,040

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-11. Suggested solution: a. To compute cost of goods sold and ending inventory, first compute the cost of goods available for sale (COGAS). Since this is the first year of operations, COGAS equals the current year’s production costs. (Later years would also need to include the cost of beginning inventory.) Product costs Amount Raw materials purchases $123,500 Raw materials inventory, ending balance (14,600) Raw materials used in production 108,900 Miscellaneous plant supplies 12,400 Direct labour 62,000 Supervisory salaries, production manager 65,000 Utilities expense (9/10 for plant) 18,000 Property taxes (4/5 of $5,000 for plant building) 4,000 Amortization, plant equipment 10,000 Total production cost = COGAS 280,300 Cost of goods sold (80% of COGAS) 224,240 Ending finished goods inventory (20% of COGAS) $ 56,060 b. Using the amounts for COGS and ending inventory from (a), and the other information given, the income statement that results would be as follows: Inventive Controls Income Statement For the year ended December 31, 2023 Sales $527,000 Cost of goods sold 224,240 Gross profit 302,760 Sales commissions 75,000 General administration expenses 38,800 Executive salaries 100,000 Utilities expense (1/10 related to the office) 2,000 Property taxes (1/5 for office building) 1,000 Amortization, office building 8,000 Income before tax $ 77,960

. 6-6

Chapter 6: Inventories

P6-12. Suggested solution: Potential reason for requirement to capitalize under IFRS and ASPE: The fixed overhead is relatively constant, which contributes to stable values of earnings and inventories. Fixed overhead contributes to the production of goods that have future benefits. Capitalizing fixed overhead into inventories helps to match costs to revenues. Capitalizing fixed overhead into inventories helps to smooth earnings. Fixed overhead costs are reliable and verifiable. Capitalizing fixed overhead is consistent with the going-concern assumption. Fixed overhead costs are measurable and are usually material.

Yes / No N Y Y N N Y N

P6-13. Suggested solution: The correct answer is (b). When actual production exceeds normal, the fixed overhead rate is reduced so as not to over allocate fixed overhead to inventory. The total overhead cost of $10,000 is allocated over 1,250 units of actual production, resulting in $8/unit. P6-14. Suggested solution: The correct answer is (a). When actual production is significantly below normal, the fixed overhead rate is not increased, but remains at $20/unit. For 500 units produced, the amount of fixed overhead capitalized in inventory is 500 units × $20/unit = $10,000. The remaining fixed overhead ($10,000) would be directly expensed. P6-15. Suggested solution: Production level 120,000 units 110,000 units 100,000 units 98,000 units 90,000 units 80,000 units 0 units

Amount capitalized into inventories $500,000 500,000 500,000 500,000 450,000 400,000 0

Amount directly expensed $ 0 0 0 0 50,000 100,000 500,000

. 6-7

Explanation At or above normal production level. Capitalize all fixed overhead. Per unit fixed overhead rate would be adjusted. Within range (+/–5%) of normal production. Significantly below normal production. Capitalize at $5/unit and expense remainder.

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-16. Suggested solution: Fixed overProduction head allocation Total fixed level rate = overhead 50,000 units $ 80.00 $4,000,000

# units for fixed overhead alloca÷ tion 50,000 units

46,000 units

86.96

$4,000,000

46,000 units

42,000 units

95.24

$4,000,000

42,000 units

40,000 units

100.00

$4,000,000

40,000 units

39,000 units

102.56

$4,000,000

39,000 units

30,000 units

100.00

$4,000,000

40,000 units

0 units

100.00

$4,000,000

40,000 units

Explanation When production is at or above normal level, fixed overhead rate should be adjusted downward using actual production volume so as not to over-capitalize overhead. Within normal range (+/– 10%) of normal production level. Significantly below normal production. Use normal production level to allocate costs so that cost per unit is not overstated.

P6-17. Suggested solution: a. This question indicates that the actual production volume approximated normal levels, so all material production variances should be adjusted through inventories (rather than expensed). Inventory Item Standard cost Variance amount Raw materials $ 210,000 $15,000 U $ 225,000 Production wages 670,000 20,000 F 650,000 Variable production overhead 180,000 3,000 F 177,000 Fixed production overhead 350,000 50,000 U 400,000 Total production cost $1,410,000 $42,000 U $1,452,000 b. If actual volume exceeded normal, the fixed cost per unit would need to be lowered so that total fixed cost absorbed by production equals total fixed costs. If actual volume is significantly lower than normal, the unallocated fixed cost would be expensed. P6-18. Suggested solution: The standard rate for fixed overhead has been determined based on a normal production level of 750 batches. Since the actual production volume of 900 batches exceeded this level, the fixed overhead rate needs to be recomputed (i.e., reduced) so as not to over allocate fixed overhead. Total fixed overhead, which comprises depreciation on storage silos, is $300/batch × 750 batches = $225,000. . 6-8

Chapter 6: Inventories

Cost of goods sold is then computed as follows: Variable costs Fixed production costs Total production cost to include in inventories Add: Opening inventory (raw materials) Cost of goods available for sale Less: Ending inventory (raw materials) Cost of goods sold

Cost per batch $2,200 $ 250 $2,450

# batches 900 900 900

Amount $1,980,000 225,000 $2,205,000 1,200,000 3,405,000 (900,000) $2,505,000

P6-19. Suggested solution: Total fixed overhead equals 500 units × $20,000/unit = $10,000,000. Cost per unit # units Variable costs $70,000 320 Fixed production costs $20,000 320 Total production cost to include in invento$90,000 ries Fixed overhead Fixed overhead allocated (see above) Unallocated fixed overhead to be expensed

$20,000

Sales Cost of sales From opening inventory From current year production Unallocated fixed overhead ($10,000,000 – $6,400,000) Gross profit

500

Amount $22,400,000 6,400,000 $28,800,000 $10,000,000 6,400,000 $ 3,600,000 $42,000,000

$90,000

40 240

(3,600,000) (21,600,000) (3,600,000) $13,200,000

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-20. Suggested solution: a. Using normal production volume of 20,000 units of each production line, the total fixed cost of $5 million equals $125/unit. If the two product lines were treated separately, the following amounts would result: Economy line Cost per unit # units Amount Variable costs $300 16,000 $4,800,000 Fixed production costs $125 16,000 2,000,000 Total production costs $425 $6,800,000 Fixed overhead Fixed overhead allocated (see above) Unallocated fixed overhead to be expensed Cost of sales From opening inventory From current-year production Unallocated fixed overhead (see above) Total cost of sales—Economy line Deluxe line Variable costs Fixed production costs Total production costs Cost of sales From opening inventory From current-year production Cost of goods sold—Deluxe line

$125

20,000

$2,500,000 2,000,000 $ 500,000

$425 $425

4,000 11,000

$1,700,000 4,675,000 500,000

$458.33 Cost per unit $400 $104.17 $504.17

15,000 # batches 24,000 24,000 24,000

$6,875,000 Amount $9,600,000 2,500,000 $12,100,000

$525.00 504.17 507.50

4,000 21,000 25,000

$ 2,100,000 10,587,500 $12,687,500

Thus, the cost of goods sold for Variety Appliances = $6,875,000 + 12, 687,500 = $19,562,500. b. If both production lines were considered together, the below-normal production of the Economy line would be offset by the above-normal production of the Deluxe line. That is, production of both lines taken as a whole approximated normal production levels. The following amounts would result. Economy line Cost per unit # units Amount Variable costs $300 16,000 $4,800,000 Fixed production costs $125 16,000 2,000,000 Total production costs $425 $6,800,000 Cost of sales From opening inventory From current-year production

$425 $425 . 6-10

4,000 11,000

$1,700,000 4,675,000

Chapter 6: Inventories

Total cost of sales—Economy line Deluxe line Variable costs Fixed production costs Total production costs

$425 Cost per unit $400 $125 $525

15,000 # batches 24,000 24,000

$6,375,000 Amount $9,600,000 3,000,000 $12,600,000

$525.00 525.00 525.00

4,000 21,000 25,000

$ 2,100,000 11,025,000 $13,125,000

Cost of sales From opening inventory From current-year production Cost of goods sold—Deluxe line

Total cost of goods sold for both lines combined = $6,375,000 + 13,125,000 = $19,500,000. This amount is $62,500 lower than that obtained in part (a) because there was a cost reduction resulting from not having to expense $500,000 of unallocated overhead on the Economy line, partially offset by a $20.83 higher fixed overhead rate on the Deluxe line that resulted in $20.83/unit × 21,000 units = $437,500 of additional fixed overhead expensed through COGS. c. Either approach (a) or (b) is acceptable, and professional judgment is necessary. One could argue that the two product lines are distinct and therefore the overhead allocation needs to be made separately. For Variety Appliances, the production process suggests that the two product lines are manufactured through the same production process, so there is an argument to treat them both together for the purpose of allocating fixed overhead. Doing so has the advantage that a change in product mix will not result in unallocated overhead in one product while there is a need to reduce overhead rates for another product line to prevent overallocation. P6-21. Suggested solution: a. Beginning balance Production Units sold Ending balance Production cost Cost per mbf

Inventory quantity 2024 1,540 mbf 3,230 mbf 2,820 mbf 1,950 mbf

Given Solve Given Given

= 90,000/mbf × 3,230 mbf + $120,000,000 = $410,700,000 = $410,700,000 / 3,230 mbf = $127,152/mbf

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Units 1,540 mbf 3,230 mbf 4,770 mbf

Opening inventory Current-period production Goods available for sale Weighted-average cost per unit Cost of goods sold Ending inventory c. 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 =

(2,820 mbf) 1,950 mbf

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼

× Unit cost $127.152/mbf

= Total cost $216,000,000 410,700,000 $626,700,000

131.384/mbf 131.384/mbf ($370,501,887) 131.384/mbf $256,198,113

$370,501,877 ($216,000,000 + $256,198,113)/2 = 1.569 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡

d. The inventory turnover ratio indicates how fast the inventory is being sold; that is, how many times the inventory is sold in a period. e. With a single product, there is sufficient information here to compute an inventory turnover ratio based on physical quantities rather than dollar value. (When there are multiple products, this computation would not be possible.) 𝑃𝑃ℎ𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 =

𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠

𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢

$2820 𝑚𝑚𝑚𝑚𝑚𝑚 (1540 𝑚𝑚𝑚𝑚𝑚𝑚 + 1950 𝑚𝑚𝑚𝑚𝑚𝑚)/2 = 1.616 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡

f. Cost of goods sold using variable costing is computed as follows: Variable costing COGS = units sold × variable cost/unit = 2,820 mbf × $90,000/mbf = $253,800,000 P6-22. Suggested solution: Ending inventory = 2,500 units × $11/unit = $27,500. COGS = COGAS – ending inventory = $132,000 – $27,500 = $104,500. Alternative solution: Compute COGS first, then ending inventory. COGS = $25,000 + $36,000 +$27,000 + (1,500 units × $11/unit) = $25,000 + $36,000 + $27,000 + $16,500 = $104,500. Ending inventory = COGAS – COGS = $132,000 – $104,500 = $27,500. .

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Chapter 6: Inventories

P6-23. Suggested solution: a. WAC = COGAS / # units available for sale = $132,000 / 11,000 = $12.00. b. Number of units sold = 11,000 – 2,500 = 8,500. COGS = 8,500 units × $12 / unit = $102,000. Ending inventory = 2,500 units × $12 / unit = $30,000. P6-24. Suggested solution: Compute ending inventory value first, then COGS. Beginning inventory, January 1 Purchase, January 7 Purchase, January 22 Goods available for sale Ending inventory, January 31 Goods sold

# units 300 200 400 900 (200) 700

Cost per unit $200 $210 $205 $205

Total cost $ 60,000 42,000 82,000 184,000 41,000 $143,000

Alternative solution: Compute COGS first, then ending inventory.

Beginning inventory, January 1 Purchase, January 7 Purchase, January 22 Goods available for sale Goods sold Ending inventory, January 31

Cost per unit $200 $210 $205

# units 300 200 400 900 (700) 200

$205

. 6-13

Total cost $60,000 42,000 82,000 184,000 143,000 $41,000

Units to include in COGS 300 200 200

Total $ $60,000 42,000 41,000

700

143,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-25. Suggested solution:

Beginning inventory, January 1 Purchase, January 4 Purchase, January 25 Sales, month of January Purchase, February 14 Sales, month of February Purchases, March 7 Purchases, March 21 Sales, month of March Cost of goods available for sale Ending inventory

# units 3,000 5,000 6,000 (12,000) 8,000 (7,000) 4,000 5,000 (11,000) 1,000

Cost per unit $5.00 5.10 5.15

Total cost $ 15,000 25,500 30,900

5.00

40,000

4.95 5.10

19,800 25,500 $156,700

Cost of ending inventory = 1,000 units × $5.10/unit (latest purchase) = $5,100. COGS = COGAS – ending inventory = $156,700 – $5,100 = $151,600. P6-26. Suggested solution:

Beginning inventory, January 1 Purchase, January 4 Purchase, January 25 Goods available for sale Weighted-average cost Sales, month of January Ending inventory, January 31 Purchase, February 14 Goods available for sale Weighted-average cost Sales, month of February Ending inventory, February 28

Cost per unit $5.00 5.10 5.15

# units 3,000 5,000 6,000 14,000

5.10 5.10 5.10

(12,000) 2,000 8,000 10,000

5.00 5.02 5.02 5.02

(7,000) 3,000

Purchases, March 7 4,000 4.95 Purchases, March 21 5,000 5.10 Goods available for sale 12,000 Weighted-average cost 5.03 Sales, month of March (11,000) 5.03 Ending inventory, March 31 1,000 5.03 COGS = $61,200 + $35,140 + $55,330 = $151,670. Cost of ending inventory = 1,000 units × $5.03/unit = $5,030. . 6-14

Total cost $15,000 25,500 30,900 $71,400 (61,200) $10,200 40,000 $50,200 (35,140) 15,060 19,800 25,500 60,360 (55,330) $ 5,030

Chapter 6: Inventories

P6-27. Suggested solution: Cost per unit $5.00 5.10 5.15

Beginning inventory, January 1 Purchase, January 4 Purchase, January 25 Goods available for sale Sales, month of January Ending inventory, January 31

# units 3,000 5,000 6,000 14,000 (12,000) 2,000

Purchase, February 14 Goods available for sale Sales, month of February Ending inventory, February 28

8,000 10,000 (7,000) 3,000

5.00

Purchases, March 7 Purchases, March 21 Goods available for sale Sales, month of March Ending inventory, March 31

4,000 5,000 12,000 (11,000) 1,000

4.95 5.10

COGS, January COGS, February COGS, March Total COGS, January – March

5.00

Total cost $15,000 25,500 30,900 $71,400 61,400* $10,000 40,000 $50,000 $35,000* $15,000 19,800 25,500 $60,300 55,300* $ 5,000 $ 61,400 35,000 55,300 $151,700

*Calculation of COGS: COGS (January) = $30,900 + $25,500 + 1,000 units × $5.00/unit= $61,400. Or = COGAS – Ending inventory = $71,400 – $10,000 = $61,400. COGS (February) =7,000 units × $5.00/unit (from Feb. 14 purchase) = $35,000. Or = COGAS – Ending inventory = $50,000 – $50,000 = $35,000. COGS (March) = $25,500 + $19,800 + 2,000 units × $5.00/unit= $61,400. Or = COGAS – Ending inventory = $60,300 – $5,000 = $55,300. P6-28. Suggested solution To answer this question, we need to calculate the ending inventory using each of the three methods and find the amount that matches the reported amount of $67,200. FIFO LIFO Weighted average Ending inventory units 320 320 320 Per unit cost × 508,000 / 2400 × $80,000 / 400 × 588,000 / 2800 Ending inventory value = $67,733 = $64,000 = $67,200 The amount obtained using the weighted-average calculation matches the reported inventory value, so we conclude that the company uses the weighted-average cost flow assumption.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-29. Suggested solution: a. The lower of cost and net realizable value method does not apply matching. Rather, it is a method to value the ending inventory and the amount of expense that would result does not necessarily match the revenue recognized in the period. b. The highest income corresponds to the lowest cost of goods sold. Since 2023 is the first year of operations, the lowest cost of goods sold occurs when the ending inventory is the highest. Thus, the answer is the FIFO method. Although not required, numerical proof is as follows: Avg. cost FIFO LOCNRV Spec. ID Opening inventory $ 0 $ 0 $ 0 $ 0 + Purchases 750,000 750,000 750,000 750,000 − Ending inventory (366,000) (370,000) (346,000) (362,000) = Cost of goods sold $384,000 $380,000 $404,000 $388,000 c. The cost of goods sold for the second year under FIFO would be $832,000, calculated as follows: FIFO Opening inventory $370,000 + Purchases 800,000 − Ending inventory (338,000) = Cost of goods sold $832,000 P6-30. Suggested solution: The best answer is (d): the last-in, first-out (LIFO) periodic system will tend to have the lowest year-end inventory value. When the purchase price is rising, the oldest inventory costs tend to be the lowest (on a per unit basis). The LIFO system expenses the newest costs to cost of goods sold (COGS) and retains the oldest costs as inventory, which would be the lowest costs. The first-in, first-out (FIFO) method has the opposite effect, expensing the oldest costs to COGS and retaining in inventory the newest costs, which tend to be the highest. The perpetual system for FIFO produces the same result as the periodic system. The specific identification method would produce results similar to FIFO if the flow of goods is similar to the flow of costs (i.e., oldest units are sold first). It is unlikely for a firm that uses the specific identification method to retains the oldest products in inventory. The weighted average cost method produces results in-between LIFO and FIFO so this method will not produce the lowest inventory values.

. 6-16

Chapter 6: Inventories

P6-31. Suggested solution: a. The FIFO ending inventory, under both the periodic and perpetual inventory systems would be $120,000, calculated as follows: Units × Unit cost = Total cost Ending inventory from purchase #2 3,000 $28 $ 84,000 Ending inventory from purchase #1 1,000 $36 36,000 Total (# units given) 4,000 $120,000 b. The periodic weighted-average cost of goods sold would be $174,667, calculated as follows: Units × Unit cost = Total cost Opening inventory 3,600 $40 $144,000 Purchase #1 2,400 $36 86,400 Purchase #2 3,000 $28 84,000 Total 9,000 $314,400 Weighted-average cost per unit $34.9333 ($314,400 / 9,000) Cost of goods sold 5,000 $34.9333 $174,667 c. The perpetual weighted-average ending inventory would be $136,960, calculated as follows: Units × Unit cost = Total cost Opening inventory 3,600 $40 $144,000 Purchase #1 2,400 $36 86,400 Sub-total 6,000 230,400 Weighted-average cost per unit $38.40 Cost of sale #1 (1,500) $38.40 (57,600) Purchase #2 3,000 $28 84,000 Subtotal 7,500 $256,800 Weighted-average cost per unit $34.24 Cost of sale #2 3,500 $34.24 (119,840) Ending inventory 4,000 $34.24 $136,960 P6-32. Suggested solution: First, calculate cost of goods available for sale (COGAS), which is the same for all three cost flow assumptions. Units × Unit cost = Total cost Opening inventory 3,000 $8.00 $24,000 Purchase #1 2,000 $7.65 15,300 Purchase #2 4,000 $7.50 30,000 Total available for sale 9,000 $69,300

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

a. Weighted average, periodic

Units 9,000

Total available for sale Weighted-average cost per unit (COGAS / # units available for sale) Ending inventory Cost of goods sold

× Unit cost

Total cost $69,300

$7.70 5,000 4,000

$7.70 $7.70

$38,500 $30,800

b. FIFO, perpetual [Note: perpetual and periodic systems yield the same results under FIFO.] Units × Unit cost Total cost Ending inventory from purchase #2 4,000 $7.50 $ 30,000 Ending inventory from purchase #1 1,000 $7.65 7,650 Total ending inventory 5,000 $37,650 Cost of goods sold (COGAS—end inv.) $31,650 c. Weighted average, perpetual

Units 3,000 2,000 5,000

Opening inventory Purchase #1 Subtotal Weighted-average cost per unit Sale #1 Purchase #2 Subtotal Weighted-average cost per unit Sale #2 Ending inventory Cost of goods sold (COGAS—end inv.)

(1,500) 4,000 7,500 (2,500) 5,000

× Unit cost $8.00 $7.65 $7.86 $7.86 $7.50 $7.668 $7.668 $7.668

= Total cost $24,000 15,300 39,300 (11,790) 30,000 57,510 (19,170) $38,340 $30,960

P6-33. Suggested solution: First, calculate cost of goods available for sale (COGAS), which is the same for all three cost flow assumptions. Units × Unit cost = Total cost Opening inventory 10,000 $16.00 $ 160,000 Purchase #1 5,000 17.50 87,500 Purchase #2 4,000 17.25 69,000 Purchase #3 6,000 16.75 100,500 Total available for sale 25,000 $417,000

. 6-18

Chapter 6: Inventories

a. FIFO, periodic [Note: under FIFO, perpetual and periodic systems will produce the same results.] Units × Unit cost Total cost Ending inventory from purchase #3 500 $16.75 $8,375 Total ending inventory 500 $8,375 Cost of goods available for sale Less: Ending inventory Cost of goods sold b. Weighted average, periodic Total available for sale Weighted-average cost per unit (COGAS / # units available for sale) Ending inventory

$417,000 (8,375) $408,625

Units 25,000

× Unit cost $16.68

500

$16.68

Cost of goods available for sale Less: Ending inventory Cost of goods sold c. Weighted average, perpetual Opening inventory Purchase #1 Subtotal Weighted-average cost per unit Sale #1 Purchase #2 Subtotal Weighted-average cost per unit Sale #2 Purchase #3 Subtotal Weighted-average cost per unit Sale #3 Ending inventory (rounded)

Total cost $417,000 $8,340 $417,000 (8,340) $408,660

Units 10,000 5,000 15,000 (500) 4,000 18,500 (11,000) 6,000 13,500 (13,000) 500

Cost of goods available for sale Less: Ending inventory Cost of goods sold

× Unit cost $16.0000 17.5000 16.5000 16.5000 17.2500 16.6622 16.6622 16.7500 16.7012 16.7012 16.7012

= Total cost $160,000 87,500 247,500 (8,250) 69,000 308,250 (183,284) 100,500 225,466 (217,116) $ 8,350 $417,000 (8,350) $408,650

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-34. Suggested solution: a.i. P#1

To record the purchase of the inventory Dr. Inventory* Cr. Accounts payable

P#2

Dr. Inventory* Cr. Accounts payable

69,000

P#3

Dr. Inventory* Cr. Accounts payable

100,500

a.ii. S#1

To record the sale of the inventory Dr. Cash (500 × $24.00) Cr. Sales Dr. Cost of goods sold* Cr. Inventory

S#2

S#3

87,500

12,000 8,250

Dr. Cash (11,000 × $26.00) Cr. Sales Dr. Cost of goods sold* Cr. Inventory

286,000

Dr. Cash (13,000 × $25.50) Cr. Sales Dr. Cost of goods sold* Cr. Inventory

331,500

183,284

217,116

a.iii. To record payment of the trade payables account I#1 Dr. Accounts payable* Cr. Cash ($87,500 - $1,750) Cr. Purchase discounts ($87,500 × 2%)

87,500

I#2

Dr. Accounts payable* Cr. Cash

69,000

I#3

Dr. Accounts payable* Cr. Cash

100,500

87,500 69,000 100,500

12,000 8,250 286,000 183,284 331,500 217,116

85,750 1,750 69,000 100,500

*See the solution to P6-33 To determine how these amounts were calculated b. $629,500 ($12,000 + $286,000 + $331,500) would be reported as a cash inflow from the sale of inventory. $255,250 ($85,750 + $69,000 + $100,500) would be reported as a cash outflow from the purchase of inventory on GFF’s Statement of Cash Flows.

. 6-20

Chapter 6: Inventories

P6-35. Suggested solution: Mark-up = 50% on cost  retail price = 150% of cost  cost = 2/3 of retail price. Cost of goods sold = $330,000 × 2/3 = $220,000. Ending inventory = BI + P – COGS = $160,000 + $200,000 – $220,000 = $140,000. P6-36. Suggested solution: Estimated gross profit (30% × ($150,000 – $8,000))

$42,600

Beginning inventory Purchases (net) COGAS Estimated COGS = net sales – estimated gross profit ($150,000 – $8,000 – $42,600) Estimate ending inventory = COGAS – COGS

$90,000 80,000 170,000 99,400 $70,600

P6-37. Suggested solution: Regular products: retail price = cost × 200%  cost = 50% of retail price. Discounted products: retail price = cost × 200% × (1 – 30%)  cost = retail price / (200% × 70%) = 71.4% of retail price. P6-38. Suggested solution:

Product category Regular Discounted Total

Mark-down Retail price Mark-up (% of regu- per dollar (% on cost) lar price) of cost 100% — 2.00 100% 35% 1.30

Estimated Cost as % cost of retail Retail value (cost % × price of inventory retail value) 50% $2,860,000 $1,430,000 76.92% 520,000 400,000 $3,380,000 $1,830,000

COGS = Beginning inventory + Purchases – Ending inventory = $1,790,000 + $13,700,000 – $1,830,000 = $13,660,000

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-39. Suggested solution: Preliminary calculations: $4,500,000 × 70% = $3,150,000; $4,500,000 × 10% = $450,000; $4,500,000 × 20% = $900,000. Product category A B C Total

Mark-up (% on cost) 80% 80% 80%

Mark-up (% of regular price) — 15% —

Markdown (% of regular price) — — 30%

Retail price per dollar of cost 1.80 2.07 1.26

Cost as % of retail price 55.56% 48.31% 79.37%

Estimated cost Retail value (cost % × of inventory retail value) $3,150,000 $1,750,140 450,000 217,395 900,000 714,330 $4,500,000 $2,681,865

COGS = Beginning inventory + Purchases – Ending inventory = $2,200,000 + $13,400,000 $2,681,865 = $12,918,135. Gross profit = sales – COGS = $21,500,000 - $12,918,135 = $8,581,865 P6-40. Suggested solution: a. No. FG NRV exceeds FG cost, so RM does not need to be examined. b. No. FG NRV is below FG cost, so RM needs to be examined. RM replacement cost exceeds RM cost so no write down. c. Yes. FG NRV is below cost, so need to examine RM for write-down. RM replacement cost is below RM actual cost so write-down is required. d. No. FG NRV exceeds FG cost, so RM does not need to be examined. WIP NRV being below WIP cost is irrelevant. P6-41. Suggested solution:

Product A B C D E Total

# Units 200 100 300 200 300

Cost per unit $ 40 150 60 100 65

Selling costs (10% of price) $8 $12 $10 $10 $7

Selling price $ 80 120 100 100 70

. 6-22

Net realizable value (price – selling cost) $ 72 108 90 90 63

Writedown per unit required (cost – NRV) or 0 $ 0 42 0 10 2

Total writedown for product $ 0 4,200 0 2,000 600 $6,800

Chapter 6: Inventories

P6-42. Suggested solution:

$200 —

Writedown? (Yes / No) No No

— $45

$220 —

No No

$100 $50

— $50

$80 —

Yes No

$100 $50

— $45

$80 —

Yes Yes

Inventory item Finished good A Raw material A

Cost per unit $100 $50

Replacement cost — $50

Finished good B Raw material B

$100 $50

Finished good C Raw material C Finished good D Raw material D

Net realizable value

For B, even though the raw materials replacement cost is below cost in the books, the finished product has NRV exceeding cost, so neither the finished product nor the raw material needs to be written down. P6-43. Suggested solution: a. The finished product’s NRV < cost. Therefore, it needs to be written down by $20 per unit on 300 units, for a total of $6,000. The raw materials need to be evaluated together, not individually, because they are both required to produce the finished product. Total reCost per Replaceplacement WriteInventory item # Units unit ment cost Total cost cost down Raw material A 200 $ 20 $ 25 $4,000 $5,000 Raw material B 100 50 45 5,000 4,500 nil Total $9,000 $9,500 b. If the replacement cost of raw material A were to be $21 per unit, the answer would change even though $21 is higher than cost. This is because the raw materials need to be evaluated together as they are jointly used in production. The amount of write-down is determined as follows: Total reCost per Replaceplacement WriteInventory item # Units unit ment cost Total cost cost down Raw material A 200 $ 20 $ 21 $4,000 $4,200 Raw material B 100 50 45 5,000 4,500 $300 Total $9,000 $8,700 . 6-23

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-44. Suggested solution: Alphas Finished goods: NRV ($425) < cost ($450), so Alphas need to be written down. Raw materials need to be evaluated for impairment. Betas Finished goods: NRV ($600) > cost ($520), so Betas are not impaired. Raw materials do not need to be evaluated for impairment because the final product is not impaired. The inventory write-down computations for Alphas and its raw materials are as follows. Note that the three types of raw materials need to be considered together because they are all required to produce Alphas. Total reCost per Replaceplacement WriteInventory item # Units unit ment cost Total cost cost down Raw material A 50 $ 30 $ 20 $1,500 $1,000 Raw material B 100 10 11 1,000 1,100 Raw material C 80 50 40 4,000 3,200 $1,200 Total $6,500 $5,300 P6-45. Suggested solution: a. The costs related to production should be included in the inventory account (work-in-process). Non-product (period) costs should be expensed. Storage and interest costs are period costs; all other costs are product costs. The journal entry to correct the error is as follows: Debit Credit Dr. Inventory (WIP) 175,000 Dr. Storage expense 4,000 Dr. Interest expense 3,000 Cr. Production expense 182,000 b. Assuming the periodic FIFO method, the cost of goods sold and ending inventory are computed as follows: # pairs Cost per pair Total Opening inventory 5,000 $2.40 $ 12,000 Production during year 70,000 $2.50 175,000 Cost of goods available for sale 75,000 $187,000 Cost of goods sold—from opening inv. Cost of goods sold—from production Cost of goods sold—total Ending inventory

5,000 64,000 69,000 6,000

. 6-24

$2.40 $2.50 $2.50

$ 12,000 160,000 $172,000 $ 15,000

Chapter 6: Inventories

c. Assuming the periodic weighted average cost method, the cost of goods sold and ending inventory are computed as follows: # pairs Cost per pair Total Cost of goods available for sale (see (b)) 75,000 $187,000 Weighted average cost $2.4933 (COGAS/units available for sale) Cost of goods sold 69,000 $2.4933 $172,040 Ending inventory 6,000 $2.4933 $ 14,960 P6-46. Suggested solution: a. The puppy inventory needs to be written down to the lower of cost and market. “Market” should be net realizable value, or $100 each. The replacement cost of $40 each is not relevant. Since the purchases had been recorded at $150 each, the inventory value needs to be written down by $50 per puppy. Dr. Loss on write-down of inventory (or cost of sales) 4,500 Cr. Inventories (90 puppies × $50 / puppy) 4,500 b. Inventory, December 31, 2023: overstated by $4,500 Cost of goods sold, year 2023: understated by $4,500 Cost of goods sold, year 2024: overstated by $4,500 P6-47. Suggested solution: 2023 income a. Inventory count error b. Invoice recorded too late c. Incorrect inclusion of consignment goods in inventory

overstated $20,000 overstated $25,000 correct

2024 income understated $20,000 understated $25,000

2024 end R/E

overstated $40,000

correct correct

P6-48. Suggested solution: a. Dr. Retained earnings (re: cost of goods sold for 2024) Cr. Cost of goods sold

20,000

b. Dr. Retained earnings (re: cost of goods sold for 2024) Cr. Cost of goods sold*

25,000

20,000 25,000

c. Dr. Cost of goods sold 40,000 Cr. Inventory 40,000 * This amount may be recorded in purchases if the purchases account has not yet been closed for the year. . 6-25

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-49. Suggested solution: Year 1 Scenario a. b. c. d.

Year 2

Inventory Income $25,000 overstated $25,000 overstated 8,000 overstated 8,000 overstated correct 15,000 overstated correct correct

Inventory correct correct correct correct

Income $25,000 understated 8,000 understated 15,000 understated correct

a. Use the cost of goods sold equation: COGS = BI + P – EI. Ending inventory in Year 1 is overstated by $25,000, so COGS is understated and income overstated. Beginning inventory in Year 2 is overstated, so COGS is overstated and income understated in Year 2. b. Reasoning similar to (a). c. Ending inventory is correct according to year-end count. Since purchase was not recorded, COGS = BI + P – EI is understated, so income is overstated in Year 1. Recording the purchase incorrectly in Year 2 overstated COGS and understated income in Year 2. P6-50. Suggested solution: a. WA cost per unit = COGAS / units available = $540,000 / 250 units = $2,160/unit Ending inventory = 90 units × $2,160/unit = $194,400 COGS = 160 units × $2,160/unit = $345,600 Or COGS = COGAS – ending inv = $540,000 - $194,400 = $345,600 b.

Direction (overstated or understated) understated

Amount ($) $10,000

2023 Ending retained earnings

overstated

$10,000

2024 Cost of goods sold

overstated

$10,000

2024 Ending retained earnings

correct

2023 Cost of goods sold

Production vol- Total variable Per unit cost of production for finanume costs Fixed costs cial reporting purposes 250 units $300,000 $200,000 $2,000 200 units $240,000 $200,000 $2,200 100 units $120,000 $200,000 $2,200* *Per unit fixed cost is not increased due to abnormally low production volume.

. 6-26

Chapter 6: Inventories

P6-51. Suggested solution: a. The inventory account included $800,000 too much cost. The $300,000 salary of the company president and the $500,000 cost of advertising and promotion are not part of the production process, so they cannot be included in inventories. The corrected amount should be $13,580,000 – $800,000 = $12,780,000. b. To determine the ending value of inventory and cost of goods sold, first determine the perunit cost of the bikes manufactured in the year. Correcting for the error in part (a), total cost is $12,780,000. Production was 50,000 bikes, so cost per bike is $12,780,000 / 50,000 = $255.60. Beginning inventory 6,000 bikes × $250 / bike $ 1,500,000 Cost of goods manufactured 12,780,000 Cost of goods available for sale $14,280,000 Ending inventory 4,000 bikes × $255.60 / bike – 1,022,400 Cost of goods sold $13,257,600 c. If the error in inventory costing has not been corrected as per part (a), the inventory would be overstated by $64,000, computed as follows: Uncorrected cost per unit produced $13,580,000 / 50,000 bikes $271.60 / bike Uncorrected ending inventory 4,000 bikes × $271,60 $1,086,400 Corrected inventory From part (b) 1,022,400 $ 64,000 In this particular scenario, this amount can also be computed more directly using the $800,000 of overstatement: $800,000 / 50,000 units of production = $16 / unit $16 / unit × 4,000 units of ending inventory = $64,000 Note that this computation works in this case because the company uses FIFO and the ending inventory costs all derive from production during the year. If the number of units in ending inventory exceeds the number of units in beginning inventory, then this computation would be incorrect. d. The correcting journal entry is as follows. Note that the effect of the error needs to be allocated between units sold and units remaining in inventory. Dr. Salary and wages expense 300,000 Dr. Advertising and promotion expense 500,000 Cr. Inventory (from part c, $16 / bike × 4,000 units) 64,000 Cr. Cost of goods sold ($16 / bike × 46,000 units) 736,000 e. If the company had used the weighted-average cost method, the ending inventory and COGS would be as follows: Cost of goods available for sale (from part a) $14,280,000 Units available for sale 56,000 bikes Weighted-average cost per unit $255 / bike Ending inventory 4,000 bikes × $255 / bike $1,020,000 Cost of goods sold $14,280,000 – $1,020,000 $13,260,000 . 6-27

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P6-52. Suggested solution: It is important to note that a change from FIFO to weighted-average cost would be a change in accounting policy. Such changes must be reflected retrospectively, the same as would be for an accounting error. Recognizing this fact, we begin with re-computing figures for 2023 and carrying through the changes to the current year 2024. (Note that the information indicates that prices were stable prior to 2023, so FIFO and WA cost numbers would not be materially different.) BeginUnits Units COGS or ning Purchases avail. sold or cost of Units inven- or trans- COGA for progoods in in- Ending tory fers in* S sale WA cost cessed processed ventory inventory Column A B C D E F G H I Calculation A+B C/D E×F E×H 2023 $ $ $ # $ # $ # $ Glass 2,500 53,500 1,377 40.67 1,302 52,950 75 3,050 56,000 Aluminum 1,600 33,500 35,100 1,377 25.49 1,302 33,188 75 1,912 WIP 4,600 312,338 316,93 1,325 239.20 1,300 310,958 25 5,980 8 Fin. goods 24,200 310,958 335,15 1,421 235.86 1,301 306,855 120 28,303 8 2024 Glass Aluminum WIP

$ 3,050 1,912 5,980

Fin. goods

28,303

$ $ # 74,700 77,750 1,310 50,700 52,612 1,310 340,491 346,47 1,275 1 342,395 370,69 1,380 8

$ 59.35 40.16 271.74

# 1,250 1,250 1,260

$ 74,189 50,202 342,395

60 60 15

$ 3,561 2,410 4,076

268.62

1,230

330,405

150

40,293

* Note that transfers into WIP and finished goods need to be adjusted for changes in cost in earlier stages of inventory: WIP transfer in (@WA cost) = WIP transfer in (@ FIFO) + change in cost of raw materials processed 2023 WIP transfer in (@WA cost) = $311,800 + (52,950 – 52,600) + (33,188 – 33,000) = $312,338 2024 WIP transfer in (@WA cost) = $339,100 + (74,189 – 73,200) + (50,202 – 49,800) = $340,491

. 6-28

Chapter 6: Inventories

With this information in hand, we can restate the financial statements. 2024 2023 Original Revised Original Revised FIFO WA Cost Change FIFO WA Cost Change Cash $ 8,900 $ 8,900 $ 0 $ 7,600 $ 7,600 $ 0 Accounts receivable 42,600 42,600 0 40,900 40,900 0 Inventories: raw materials 7,900 5,971 -1,929 5,500 4,962 -538 Inventories: work-in-process 5,100 4,076 -1,024 6,200 5,980 -220 Inventories: finished goods 48,400 40,293 -8,107 29,400 28,303 -1,097 Other assets 320,000 320,000 0 310,000 310,000 0 Total assets $432,900 $421,888 -11,060 $399,600 $397,745 -1,855 Total liabilities $113,800 $113,800 0 $137,900 $137,900 0 Contributed capital 5,000 5,000 0 5,000 5,000 0 Retained earnings 314,100 302,288 -11,060 256,700 254,845 -1,855 Total liabilities and equity $432,900 $421,888 -11,060 $399,600 $397,745 -1,855 Sales Cost of goods sold Gross margin Operating expenses Net income

$561,000 $561,000 321,200 330,405 $239,800 $230,596 182,600 182,600 $ 57,200 $ 47,996

$ 0 $529,000 $529,000 +9,205 305,000 306,855 -9,205 $224,000 $222,145 0 178,300 178,300 -9,205 $ 45,700 $ 43,845

$ 0 +1,855 -1,855 0 -1,855

The cumulative effect on income over the two years is -$1,855 – $9,205 = -$11,060, which is the amount by which retained earnings decreases. As the owner of Oculus speculated, using the weighted-average cost method would reduce income by just over 10% of the income over the two years ($11,060 / ($45,700 +$ 57,200)). P6-53. Suggested solution: a. b. c. d.

The company only has finished goods, which makes sense for a retailer. Inventory cost includes purchase cost plus inbound shipping costs. The company uses the weighted-average cost flow assumption. Net realizable value is the estimated normal selling price less estimated selling expenses.

Note 3 on Significant Accounting Policies (page 93) contains the above information.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

e. Days of inventory = merchandise inventory / cost of sales × 365 = $1997.5 m / 8863.8 m × 365 days = 82.3 days. Merchandise inventory is obtained from the balance sheet while cost of sales is from Note 28. In 2017, this figure is $1769.8 m / 8,398.9 m × 365 days = 76.9 days. The increase in days of inventory is mostly a result of the acquisition of Teodin Holdco AS, which owns and operates the Helly Hansen brands: the purchase was completed on July 3, 2018 (Note 1 and Note 36 of the financial statements on pages 80 and 140), so the 2018 financial statements include only about 6 months of Helly Hansen sales and cost of sales, but all of the FGL inventories at December 29, 2018. Note35 also shows that Helly Hansen had $169.0 million of inventories on the date of purchase. While the company does not disclose the cost of sales for Helly Hansen, it does indicate that Helly Hansen contributed $347.6 million of revenue from July 3 to December 29, 2018. To make the ratio comparable between the two years, one of two adjustments can be made: (i) remove an estimated amount of inventory and cost of sales related to Helly Hansen, or (ii) increase the cost of sales by extrapolating FGL sales and cost of sales to a full year. P6-54. Suggested solution: a. The balance sheet shows inventories at $4,599 million. Note 18 on page 181 shows three components comprising this amount, being: Aerospace programs ($3,990m), finished products ($468m), and “other” of $141m.

. 6-30

Chapter 6: Inventories

b. To determine the cost of inventories and cost of sales for aircraft, the company uses the “unit cost method” (see excerpt below). This term is not standard terminology and is not defined / explained elsewhere in the annual report. In context of aircraft (high value item), it is likely to mean the specific identification method (i.e., the cost specifically identified with each unit). This method is in contrast to the moving average method used for spare parts.

P6-55. Suggested solution: a. Note 13 on page 104 indicates that inventories on hand at December 31, 2019 totalled $2,056million of which $1,981 million was classified as current with the remaining $75 million classified as long term. The four components comprising this amount were: supplies ($721m), raw materials ($271m), work-in-process ($491m), and finished products ($573m).

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

b. Note 13 indicates that long-term inventory consisted of ore stockpiles and other in-process materials that the company does not expect to be processed within one year. The segregation between current and long-term portions reflects the expected time until such inventories will be processed. The long-term portion of the inventory was included in the “Financial and other assets” category on the balance sheet (see Note 14on page 105.)

c. As per the inventory section of Note 3 on pages 86-86, the company includes “all direct costs incurred in production, including direct labour and materials, freight, depreciation and amortization, and directly attributable overhead costs. Production stripping costs that are not capitalized are included in the cost of inventories as incurred. Depreciation and amortization of capitalized production stripping costs are included in the cost of inventory.”

d. Teck Resources Limited uses the weighted average cost flow assumption as identified in Note 3 above. .

6-32

Chapter 6: Inventories

Q. Mini-Cases Case 1: Rocky Dilemma. Suggested solution: a. First note that this is the first year of operations, so the cost of goods available for sale (COGAS) is equal to purchases (19,000 units with cost of $249,600). There are 4,000 units in ending inventory. We can either first calculate the cost of ending inventory, or the cost of goods sold. The following shows the former method. FIFO ending inventory = 3,200 units × $16/unit + 800 units × $13/unit = $51,200 + $10,400 = $61,600. Weighted-average cost per unit = $249,600 / 19,000 units = $13.13684/unit. Weighted-average ending inventory = 4,000 units × $13.13684/unit = $52,547. Specific ID ending inventory = 3,500 units × $11/unit + 500 units × $13/unit = 38,500 + 6,500 = $45,000. FIFO $249,600 61,600 $188,000

Cost of goods available for sale Ending inventory Cost of goods sold

Weighted average $249,600 52,547 $197,053

Specific ID $249,600 45,000 $204,600

b. Using the given information and the results from part (a), we can calculate the relevant ratios. Weighted avFIFO erage Specific ID Current assets, excluding inventory $ 10,000 $ 10,000 $ 10,000 Ending inventory 61,600 52,547 45,000 Current assets 71,600 62,547 55,000 Non-current assets 107,000 107,000 107,000 Total assets $178,600 $169,547 $162,000 Current liabilities Long-term bank loan Total liabilities

$ 32,600 50,000 $ 82,600

Sales Cost of goods sold Expenses, other than cost of goods sold Net income before bonuses

$284,000 (188,000) (40,000) $ 56,000

$284,000 (197,053) (40,000) $ 46,947

$284,000 (204,600) (40,000) $ 39,400

71,600 32,600

62,547 32,600

55,000 32,600

Ratio calculations: Current assets Current liabilities . 6-33

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Current ratio (2 to 1 preferred)

2.196

1.919

1.687

Total liabilities Total assets Total debt to total assets (<50% required)

82,600 178,600 46.2%

82,600 169,547 48.7%

82,600 162,000 51.0%

Net income before bonuses Ending total assets Return on ending total assets (prefer <25%)

56,000 178,600 31.4%

46,947 169,547 27.7%

39,400 162,000 24.3%

RDL’s choice of cost flow assumption has economic (cash flow) consequences because the choice affects ratios that determine (implicit and explicit) contractual outcomes. The FIFO method results in the highest current ratio and lowest debt-to-assets ratio, which are preferable. However, this method would result in a bonus payment of $6,000 since ROA is 6.4% above the threshold of 25%. The weighted average method meets the debt-to-assets ratio requirement of <50%. It also reduces the bonus payment (relative to FIFO) to $2,000. However, the current ratio falls below 2, so future purchases will cost more. In the past year, purchases were almost $250,000. If this amount is representative of purchases this coming year, a 10% increase in cost would amount to $25,000. The specific identification method results in no bonus payment because ROA is below 25%. However, the current ratio is below 2, and the debt-to-assets ratio is above 50%. The latter is particularly problematic since the bank could put the company into bankruptcy. My recommendation is to use the FIFO method because it minimizes the cost of the different contracts. Bankruptcy is of course a very undesirable outcome and the 10% increase in cost of purchases would be substantial; these two costs greatly outweigh the additional $6,000 of bonuses for the general manager.

. 6-34

Chapter 6: Inventories

Case 2: Eastern Pacific Lumber. Suggested solution: The controller indicated that cost of goods sold per unit declined by 2.4%, which, on the surface, is a good sign. This 2.4% is obtained as follows: 2024 cost of goods sold Less: export tariffs 2024 COGS excluding tariffs 2023 cost of goods sold Less: export tariffs 2023 COGS excluding tariffs

# Units

Total cost Cost/unit $ 176,642,000 $ (17,700,000) 600,000 $ 158,942,000 264.90 $ $ 500,000 $

164,203,000 (28,500,000) 135,703,000

271.41 -2.40%

Decrease in COGS per unit

While COGS per unit has decreased, it is not conclusive evidence that production costs have decreased, because cost of goods sold is based on absorption costing and this method of costing can have anomalous results due to the inclusion of fixed costs. In fact, we can show that variable costs have actually increased from 2023 to 2024. To show this, we need to determine the production volume for the two years. The following inventory continuity schedule reconciles inventory on the balance sheet with production and sales information. Calculated figures are in bold, while unbolded figures have been given. Dec. 31, 2022 Inventory + 2023 production - 2023 sales Dec. 31, 2023 inventory + 2024 production - 2024 sales = Dec. 31, 2024 inventory

# Units Total cost Cost/unit 46,053,000 $ 270.26 170,404 $ 136,700,000 272.00 502,574 271.41 (500,000) (135,703,000) 172,978 47,050,000 272.00 262.00 705,580 184,862,000 (600,000) (158,942,000) 264.90 278,511 72,970,000 262.00

Using the production figures of 502,574 Mbf and 705,580 Mbf, we can determine the variable costs per unit. While fixed costs per unit are not meaningful, they are also shown in the following table to demonstrate the source of the decline in total cost per unit.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

2023 Production costs - Fixed costs

Variable costs 2024 Production costs - Fixed costs Variable costs

Costs 136,700,000 (34,000,000)

# Units Cost/unit 502,574 $ 272.00 502,574 (67.65)

102,700,000

502,574

204.35

184,862,000 (34,000,000)

705,580 $ 705,580

262.00 (48.19)

150,862,000

705,580

213.81

Thus, variable costs per unit actually increased by $9.46. The decline in per unit production costs is entirely due to the decrease in fixed costs per unit, which is due to the higher production volume. By definition, fixed costs do not increase with production volume; by increasing production, a fixed amount of cost is being spread over more units. The production volume of more than 700,000 Mbf appears to be excessive given that sales in 2024 was only 600,000 Mbf. This has contributed to the inventory balance ballooning from $47 million to almost $73 million. This ties up valuable capital and increases storage costs. The excessive production could be due to the incentive plan the company has in place. The production manager receives $20,000 for each dollar that production costs fall below $280/Mbf. By increasing production volume (without regard to the amount being sold), the production manager maximizes his bonus. Furthermore, the chief operating officer receives a bonus based on net income; lower cost per unit will benefit him as well, although he may become concerned with the high level of inventory and the cost that entails. There may be good reason for stockpiling the inventory that I am not aware of, such as in anticipation of a big order to be filled soon after year-end. In any case, the board of directors should consider revising the incentive plan for the production manager so that he is rewarded based on variable costs, which he controls and is not subject to manipulation using production volume. The board might also consider revising the incentive plan for the chief operating officer, but that change is not as compelling. The COO’s responsibilities are more global and net income is arguably a good enough measure.

. 6-36

Chapter 6: Inventories

Case 3: Mountain Mines Lubrication. Suggested solution: To: Partner From: CA Re: Mountain Mine Lubrication Engagement Overview This engagement poses a number of risks for our firm. MML is a new review client, and the bank will be relying on the financial statements in deciding whether to extend a new line of credit to MML. These facts, combined with the fact that MML has liquidity problems that call into question whether it is a going concern, make the risk of the engagement quite high. MML has implemented a new method of revenue and expense recognition this year for some of its clients. The change appears to have been implemented incorrectly, with the result that the 2024 financial statements are misstated. The new method has implications for the amounts reported on the financial statements for inventory, cost of goods sold, and net income. Inventory is of particular concern because it is a material item. Misstatement of financial statements For three of its customers MML recognizes revenue on the basis of hours of machine use. The mining machines of these customers have been equipped with meters that measure that number of hours that a machine operates. Each week the customers advise MML of the meter readings, and MML bills the customer based on the number of hours of use. Revenue is recognized based on the meter readings. However, the cost of the lubricant is fully expensed when MML is notified that a new tub of lubricant has been poured into the machine. As a result, it could be argued that a portion of the cost of the lubricant is being recognized before the revenue is recognized. The result is that cost of goods sold is overstated and inventory understated because too much lubricant is expensed at the time a machine is filled. MML should expense only that portion of the cost of the lubricant that has been used since that is the basis of revenue recognition. If 20% of a tub of lubricant has been billed to the customer, only 20% of the cost should be expensed. Given the new billing arrangement that MML now uses for three of its customers, recognizing revenue when lubricant is used is reasonable, although it is also possible to make an argument for recognizing the revenue when the lubricant is poured into the machine. The critical event for revenue recognition is actual usage of the machine. Alternatively, the new method can be viewed simply as a billing arrangement. Once lubricant is put into a machine, it probably cannot be returned to MML and the customer will ultimately have to pay for it. Under this approach revenue recognition can be advanced to the point when the lubricant is put into a machine. In my opinion, both approaches are acceptable. Deferring revenue and expense recognition to when the lubricant is actually used is a more conservative approach. Either method would correct the error.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

The effect on the revenue and expenses can be seen from the effect on the gross margins: Slip Coat Gross margin per unit Gross margin per the income statement

Calculation

Gross Margin

Maximum Guard Calculation

Gross Margin

(16.00 – 13.50) / 16.00

15.6% (22.50 – 18.25) / 22.50

18.9%

$18,067 / $136,000

13.3% $31,892 / $200,250

15.9%

As the table shows, the gross margin per unit is greater than the gross margin per the income statement. They should be the same. The error occurs because the method MML uses expenses the cost of lubricant before all the related revenue is recognized, thereby increasing the cost of sales and decreasing the gross margin. Because this billing method is new this year, last year’s financial statements will not have any errors as a result of this method. To calculate the amount of the error, we must determine the amount of lubricant that was most recently put into machines that has been used up. This calculation is done using the number of hours a machine has been used since the last top-up. The calculation is: Amount of lubricant × × cost per kilogram put in machine 1 Proportion of tub used is calculated on the basis of 28 days.

proportion of tub used1

The cost of the remaining amount of lubricant is the amount by which inventory is understated and cost of sales is overstated. The exact amounts are:

Scorched Earth Slip Coat Maximum Guard Moon Crater Slip Coat Maximum Guard Big Scar Slip Coat Maximum Guard

Cost of lubricant put into machine

% used

Amount used

$675.00 912.50

21.4% 21.4%

$145.00 195.50

$ 530 717

675.00 912.50

64.2% 64.2%

433.00 585.50

242 327

2,700.00 5,475.00

10.7%

289.00

10.7%

586.00

2,411 4,889

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Remaining amount

Chapter 6: Inventories

The cost of the amount remaining in the machines, $9,116, is the amount by which inventory is understated and cost of sales is overstated. These errors are large, and they result in the financial statements being materially misstated. The gross margin per the income statement and per unit can be made the same by adjusting inventory and cost of sales. The adjustment will increase net income and, as a result, the amount of tax that must be paid. The amount of extra tax that MML will have to pay using the effective tax rate on the income statement of 27.7% is $2,525. Given MML’s liquidity problem, this extra demand on cash flows exacerbates the situation. It is likely that MML will want to do whatever it can to conserve cash by minimizing taxes, and this may be the motivation behind the “error.” Adjustment of the error is straightforward since MML already has estimates of the hourly usage rates of lubricant. However, we must review the method used for determining the usage rate to ensure it is reasonable. If MML has used very crude rules of thumb to estimate usage, the above calculations may be significantly in error. Constant usage rates have been used across all customers, and usage rates may vary depending on the equipment and conditions. It must be made clear to MML that if the error is not corrected, we will not be able to give negative assurance on the financial statements. There are a number of minor questions that need to be addressed so that we can have confidence in the amount of revenue and expense that is recognized. First, is it possible for a customer to buy lubricant from another supplier? If lubricant is purchased from another supplier, how does this affect MML? Second, can the meters be tampered with or incorrect information conveyed to MML? If they can be tampered with, does MML have policies in place to detect whether the meters have been tampered with or if usage is otherwise under reported. Potential theft of lubricant There are inconsistencies in the information provided about the consumption of lubricant at Scorched Earth Mine that may be the result of problems ranging from equipment breakdown to the theft of MML’s product. The mine seems to be using large amounts of lubricant, as evidenced by the fact it is running low on lubricant even though it received a large shipment in the spring. Yet Ms. Verhan has advised us that Scorched Earth’s meter reading was low, indicating that the equipment is operating well below capacity. On the other hand, Mr. Mulholland told us that the mine was working at capacity recently. We do not have enough information to explain the inconsistency, but there are many possible explanations that need to be investigated so that we can rule out explanations that have an impact on reporting. Mr. Mulholland’s information may simply be incorrect, which would explain the low meter readings but not the high usage of lubricant, unless the machines at the mine are very inefficient. Scorched Earth may be using lubricant from other suppliers and only reporting usage of MML’s lubricant. Another possibility is that the meter is broken and Scorched Earth has not noticed. However, given that Scorched Earth is in financial trouble, we cannot easily rule out the possibility of theft. We need to notify Mr. Mulholland immediately of our concerns so that he can take his own steps to investigate. We should advise MML to consider not making further shipments to Scorched Earth until payment is assured. . 6-39

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Cash crunch Despite having higher net income in 2024 than in 2023, MML has a serious liquidity problem. Inventory, plant, property and equipment, and accounts receivable have each increased significantly over last year—inventory by almost 50%, plant, property and equipment by 29% and receivables by almost 18%. These increases have been financed by suppliers through accounts payable and by a sizable bank overdraft. MML’s current ratio has fallen from 2.66 in 2023 to 1.25 in 2024 and it has no cash reserves on hand. Unless MML is able to generate a significant amount of cash, it may be unable to pay its shortterm obligations. Mr. Mulholland appears to be aware of the problem because he is attempting to obtain a new line of credit from the bank. However, MML’s financial position is not strong, and there is some doubt as to whether it can continue as a going concern. MML may be able to increase the amount of bank financing it obtains by correcting the inventory misstatement because the correction will increase inventory and thereby increase the amount of collateral available to the bank. Most of MML’s current assets are inventory. It is not clear why there has been such a large build-up of inventory. However, MML must be concerned about how long it will take for the inventory to be converted to cash and whether it can be sold quickly to raise cash if needed. Compounding any problems with selling inventory quickly is the fact that most of it is at mine sites that are far from any major commercial centre. The implication is that it will be time consuming and costly to recover and sell the inventory at these distant mine sites. However, despite the fact that the inventory is at customer locations, it does belong to MML so if a customer does not pay, MML is entitled to get its inventory back. Since the inventory belongs to MML, it should be insured even if held at distant mine sites to protect MML’s investment in the inventory. The inventory at the mine sites also poses an environmental risk: any damage caused by leakage or spillage may be MML’s responsibility. While this is not an engagement issue at this time based on the information available to us, we should advise the client to take steps to ensure that these potential environmental problems do not occur. One final point on the inventory: Two of the mines have very large quantities of inventory on site. Assuming that lubricant in a machine lasts about four weeks, there is a 40-month supply at Moon Crater and 17.5-month supply at Big Scar. While there is nothing inherently wrong with having that much inventory at the mine sites, it does seem an inefficient use of resources, especially when cash is so tight. However, transportation costs may justify this approach. It is also not clear how collectable MML’s receivables are, given that one of its customers is in financial trouble and another may have troubles (given the possibility that it may be stealing lubricant from MML). I do not know at this point whether MML has made an allowance for uncollectible accounts in its 2024 income statement. If no allowance has been made, the amount of receivables may be overstated. There are some steps that MML can take to improve its liquidity position in addition to obtaining additional bank financing. It should try to refinance the $60,000 current portion of its long-term debt. That alone would relieve a lot of the pressure on MML. It might also seek out new longterm financing, either debt or equity, to finance its growth. In 2024 it financed its acquisitions of . 6-40

Chapter 6: Inventories

plant, property and equipment through current liabilities. It is usually appropriate to finance long-lived assets with long-term liabilities. Case 4: James Television Inc. Suggested Solution: a. Under ASPE, absorption costing has to be used for manufactured goods for external financial reporting. The difference between absorption costing and variable costing is that absorption costing includes the cost of fixed inventory overhead as product costs while variable costing expenses fixed overhead costs in the period they are incurred. If all units are sold in the current period, absorption and variable costing methods should result in the same level of expenses. However, given that this is a new product and the company is unlikely to sell all of its 20 units, absorption costing would result in lower inventory expenses. In this case, one should note it is also debatable whether the company is manufacturing these products through Global Manufacturing Inc., or it is simply buying these products from the other company. If it is the latter, then the goods should be accounted for as purchased goods. b. A perpetual inventory system is one that constantly keeps track of additions to and sales of inventory while a periodic inventory system does not keep track of inventory and COGS. In this case, considering the high price of each unit of inventory and its low sales volume, it is beneficial for the company to account for its inventory using the perpetual inventory system. FIFO is a cost flow assumption that uses the oldest costs in the computation of cost of sales. Considering the price of inventory is rising due to currency appreciation of the Yen, FIFO would result in higher ending inventory on the balance sheet, and COGS is relatively lower when older inventory items are assumed to be sold first. If the company has an objective to increase net income, then FIFO is the preferred costing method. c. As price of buying the televisions from the Japanese manufacturers is increasing, it might be a good idea to consider a new line of products. Provided that retail prices of televisions remain rigid in Canada, currency appreciation of the Yen would reduce the profit margin of the company. The downside of ordering the lower-cost televisions, however, would be the uncertainty associated with selling these lower-cost products with little brand recognition, and the possibility of this new line of products undercutting the sales of the higher-end televisions. From a financial standpoint, if the company manages to sell all its products, it would have sold more televisions than before and would be able to record higher revenue. But it is hard to determine if retailers are willing to buy the lower-cost televisions from the company, so the risk of inventory obsolescence and the chance of inventory write-down are higher.

. 6-41

Chapter 7 Financial Assets M. Problems P7-1. Suggested solution: a. b. c. d. e.

Cash Account receivable Investment in property, plant, and equipment Investment in a derivative Investment in bonds

Financial asset? Yes Yes No—operating asset Yes Yes

P7-2. Suggested solution: a. b. c. d. e.

Financial asset? No—operating asset No—operating asset Yes Yes No—financial liability

Prepaid expense Inventory Investment in shares of another entity Investment in a joint venture Bond issued by the reporting entity

P7-3. Suggested solution: a. A financial asset results from a contract with a counterparty that gives the holder rights to future benefits in the form of cash flows. For example, a loan is a financial asset to a bank and a financial obligation of the borrower; the bank is entitled to receive future cash payments from the borrower. A real asset does not have a counterparty. b. Cash does not strictly have this characteristic. The holder of cash has a contract with the central bank that issued the cash, but the only right that cash gives to its holder is ... more cash (i.e., you can trade in old bills for new bills). During some periods in the past, currency represented a certain amount of gold, a real commodity. Modern currency is not backed by any real assets; it is fiat money—money issued at the discretion of government. Cash has future benefits only to the extent that people attribute value to it.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-4. Suggested solution: The following are the financial assets involved in the scenario. Exceptions are noted as necessary. Company X’s investment in Zed. Company Y’s investment in Zed. Bank’s investment in the mortgage issued to Zed. Contractors’ accounts receivable from Zed. An investor’s hotel room is NOT a financial asset, but a real asset that generates revenues. The 60% share of revenue is generated by the room that the investor owns, and is not a claim against the hotel operator, Zed. In other words, an investor owns his room while Zed is just an agent who manages his/her property for a fee. P7-5. Suggested solution: An investor buying into Alpha’s hotel has a financial asset in the form of a 55% claim on 1/100th of the hotel’s revenue, or a fixed $200,000 at the time of sale. The investment is not in a hotel room per se, because the investor does not have a right to sell his/her room at current market value (whatever that may be). In other words, the investor does not own a real asset because he/she does have the risks and rewards of ownership of a hotel room. The investor has a purely financial claim on future cash flows. The uncertainty of those future cash flows does not invalidate this as a financial asset; many equity investments have similar characteristics. In contrast to P7-4, Alpha rather than the investors is the owner of the hotel rooms. P7-6. Suggested solution: Accounting classification FVPL

Type of financial instrument Equity Debt Derivatives

FVOCI

Debt

Amortized cost

Debt

Associate Joint venture

Equity Equity

Joint operations

Equity

Subsidiary

Equity

. 7-2

Business model To realize changes in value To sell and to collect contractual cash flows To collect contractual cash flows Significant influence Joint control of net assets Joint control of assets and joint obligation for liabilities Control

Chapter 7: Financial Assets

P7-7. Suggested solution: a. Atlantic Company buys 5,000 common shares of a publicly traded company that has 200 million shares outstanding. b. Beetleweed buys $20,000 in bonds maturing in five years. c. A bank lends $400,000 to a person to purchase a home. d. An exporter enters into a currency swap (a derivative contract) in order to secure the Canadian dollar price of a sale. e. Elite Cars buys 800,000 shares in Selective Autos. f. Fanciful Gifts buys 3,000 preferred shares in another company. These shares have no voting rights.

Financial asset categories FVPL FVPL FVOCI Amortized cost FVPL FVOCI Amortized cost FVPL Subsidiary Joint operations Joint venture Associate FVPL FVPL

P7-8. Suggested solution: a. Atlantic Company buys 5,000 common shares of a publicly traded company that has 200 million shares outstanding. b. Beetleweed buys $20,000 in bonds maturing in five years. c. A bank lends $400,000 to a person to purchase a home. d. An exporter enters into a currency swap (a derivative contract) in order to secure the Canadian dollar price of a sale. e. Elite Cars buys 800,000 shares in Selective Autos. f. Fanciful Gifts buys 3,000 preferred shares in another company. These shares have no voting rights.

. 7-3

Financial asset categories Portfolio equity investment. Debt investment Debt investment Derivatives Subsidiary Joint venture Associate Portfolio equity investment Portfolio equity investment

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-9. Suggested solution:

a. Investment in 500 shares of Bank of Montreal. Management believes the shares are currently underpriced. b. Investment in bonds maturing in two years. Management made the purchase to park idle cash until after two years, when it will make a major capital expenditure. c. Investment in 800,000 shares of Calisto Corp., a public company with 2 million shares outstanding. d. Purchase of 800 shares of Dupree Donuts, a private company with 1,000 shares outstanding. e. Purchase of 1,000 shares of Epic Adventures, a public company with 10 million shares outstanding. f. Investment in 60% of the outstanding shares of Fruitloops Fountains. An agreement with the company’s founder specifies that he retains the right to make all operating decision for Fruitloops. g. St. George Company buys 15% of the outstanding shares of Gigantic Gargoyles. After the purchase, St. George appoints its chief executive office to the board of directors of Gigantic Gargoyles. h. Investment in bonds maturing in 30 years.

Financial asset category relevant for financial reporting purposes FVPL

Amortized cost

Associate Subsidiary FVPL Associate (Ownership > 50% but no control.) Associate (Ownership < 20% but have significant influence.) FVOCI (Likely to be held to collect cash flows or sold given length of time.)

P7-10. Suggested solution:

. 7-4

Financial asset category relevant for financial reporting purposes Portfolio equity investment

Debt investment

Chapter 7: Financial Assets

c. Investment in 800,000 shares of Calisto Corp., a public company with 2 million shares outstanding. d. Purchase of 800 shares of Dupree Donuts, a private company with 1,000 shares outstanding. e. Purchase of 1,000 shares of Epic Adventures, a public company with 10 million shares outstanding. f. Investment in 60% of the outstanding shares of Fruitloops Fountains. An agreement with the company’s founder specifies that he retains the right to make all operating decision for Fruitloops. g. St. George Company buys 15% of the outstanding shares of Gigantic Gargoyles. After the purchase, St. George appoints its chief executive office to the board of directors of Gigantic Gargoyles. h. Investment in bonds maturing in 30 years.

Associate Subsidiary Portfolio equity investment Associate (Ownership > 50% but no control.) Associate (Ownership < 20% but have significant influence.) Debt investment

P7-11. Suggested solution: a.

Amortized cost—This is a debt instrument, so it is potentially FVPL, FVOCI, or amortized cost. A term deposit is not tradable, which excludes the first two categories. In addition, the nature of a term deposit indicates that the investor (Foxtrot) intends to hold the investment to maturity and collect the deposit with interest at that time. b. FVPL—A call option is a derivative and all derivatives must be classified as FVPL. c. Associate or FVPL—The 25% ownership creates a presumption of significant influence and categorization as an affiliate; there is no specific information to refute this presumption. However, the purchase was made in anticipation of resale over the short term, making a classification as FVPL also acceptable. d. FVPL—This is a portfolio investment and it is in equity securities, so it must be classified as FVPL. P7-12. Suggested solution: a. Debt investment—A term deposit is a debt instrument. b. Derivative—A call option is a derivative. c. Associate or equity portfolio investment—The 25% ownership creates a presumption of significant influence and categorization as an affiliate; there is no specific information to refute this presumption. However, the purchase was made in anticipation of resale over the short term, making a classification as a portfolio equity investment. d. Portfolio equity investment—This is a portfolio investment and it is in equity securities.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-13. Suggested solution: Strategic investments provide the investor with the opportunity to direct or to influence the strategic direction of the investee. This ability is valuable because it reduces the potential moral hazard between the investor and the company’s management. In addition, an investment with control, joint control, or significant influence implies that the investor has access to valuable inside information about the investee not available to portfolio investors. The reduction in both types of information asymmetry (moral hazard and adverse selection) for strategic investments implies that such investments should not be valued using market prices or other estimates of fair value. P7-14. Suggested solution: a. Dr. Investment in financial assets at FVPL (100,000 × $5.00) 500,000 Dr. Investment transaction costs 10,000 Cr. Cash ($500,000 + $10,000) 510,000 In the absence of an election to present the changes in fair value through OCI, they must be classified as FVPL. The asset is recorded at fair value and the transaction costs are expensed. b. Dr. Investment in financial assets with FVOCI election 130,000 Cr. Cash (5,000 × $25.00 + $5,000) 130,000 The asset is classified at FVOCI in accordance with the irrevocable election. The transaction fee is capitalized (added to the cost of the asset). c.

Dr. Investment in financial assets at amortized cost 2,443,859 Cr. Cash ($2,393,859 + $50,000) 2,443,859 As the investment meets ICI’s investment objectives of holding the asset for the purpose of collecting the contractual cash flows and as the expected cash inflows are solely payments of principal and interest on the principal amount outstanding, it is appropriate to classify the investment at amortized cost. The transaction fee is capitalized (added to the cost of the asset). P7-15. Suggested solution: a.

July 1, 2023 – Interest on Zoe bonds Dr. Cash ($2,500,000 × 3.5% / 2) Dr. Investment in financial assets at amortized cost ($48,877 - $43,750) Cr. Investment revenue - interest ($2,443,859 × 2.0%) December 31, 2023 – Accrual of interest on Zoe bonds Dr. Interest receivable ($2,500,000 × 3.5% / 2) Dr. Investment in financial assets at amortized cost ($48,980 - $43,750) Cr. Investment revenue ($2,448,986* × 2.0%) *$2,443,859 + $5,127 = $2,448,986 . 7-6

43,750 5,127 48,877 43,750 5,230 48,980

Chapter 7: Financial Assets

b. September 30, 2023 – Dividends on Bleay cumulative preferred shares Dr. Cash 3,750 Cr. Investment revenue – dividends c.

December 31, 2023 – Dividends on Norman ordinary shares Dr. Cash Cr. Investment revenue - dividends

2,000

d. December 31, 2023 – Holding loss on Norman ordinary shares Dr. Holding loss on investments at FVPL 10,000 Cr. Investment on financial assets at FVPL (100,000 × $4.90 - $500,000) e.

3,750

2,000

10,000

December 31, 2023 – Holding gain on Bleay cumulative preferred shares Dr. Investment in financial assets with FVOCI election 1,250 Cr. OCI - Holding gain on investments at FVOCI (5,000 × $26.25 - $130,000)

1,250

December 31, 2023 – Zoe bonds There is no need to adjust this investment to fair value (unless impaired) as it is subsequently measured at amortized cost.

P7-16. Suggested solution: a. Shares without an irrevocable election. b. Bonds classified as FVOCI. c. Bonds held to collect contractual cash flows. d. Investment in an associate. e. A derivative on foreign currency. f. A subsidiary. g. Bonds held to collect contractual cash flows and sold for profit h. Investment in a joint venture. *OCI = other comprehensive income

Measurement basis Fair value, with changes through income Fair value, with changes through OCI* Amortized cost Equity method Fair value, with changes through income Consolidation Fair value, with changes through OCI* Equity method

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-17. Suggested solution: a. There are three reasons. First, the two sets of investments differ in the amount of influence the reporting entity (the investor) has in the investee. When the investor has control, joint control, or significant influence in the operations of the investee, consolidation, proportionate consolidation, and the equity method are appropriate because these methods produce results as if the investor directly invested in the assets and liabilities of the investee. When this level of influence does not exist, the investor does not have direct decision-making authority over the assets and liabilities of the investee; rather, the investor’s main decision is to buy, hold, or sell the security, so the fair value of the investment is more relevant information than the value of the investee’s individual assets and liabilities. Second, fair values are not the most relevant amounts for investments in subsidiaries, joint ventures, and associates because such investors are privy to information not available to the general public (i.e., they have inside information). In addition, such investments are not likely to be sold on a piecemeal basis, but more likely in all-or-nothing transactions that will have prices that are transaction-specific and significantly different from any available market prices. Third, the amount of information available to the investor differs. When the investor has control, joint control, or significant influence, it is able to obtain substantially more information about the internal operations of the investee, relative to other investors who do not have these levels of influence. Application of consolidation, proportionate consolidation, and the equity method require such inside information; therefore, methods similar to these are not feasible for portfolio investors. b. Amortized cost rather than fair value is more appropriate for debt investments that are held with the objective of collecting contractual cash flows because fair values during the holding period are relevant only for sales of the investment, which is not expected to occur. In contrast, fair values are relevant for debt investments held in business models with the objective (in whole or in part) of selling the investment for profit, because the fair values will influence whether management decides to sell the securities. P7-18. Suggested solution: a. The best answer is (iv). The criterion for using the equity method is significant influence. While having at least 20% of the voting shares (answer i) creates a presumption of significant influence, it is the significant influence that results in the equity method. b. Arch should report its 35% share of Cascadia’s income of $75,000 = $26,250. P7-19. Suggested solution: a. Income = 40% × $3,000,000 = $1,200,000 b. Investment carrying value = opening carrying value + 40% of income – 40% of dividends = $25,500,000 + $1,200,000 – $400,000 = $26,300,000 . 7-8

Chapter 7: Financial Assets

P7-20. Suggested solution: a. 2023

2024

Journal entries Dr. Investment in associate (Moonbeam) Cr. Cash (given)

270,000

Dr. Investment in associate (Moonbeam) Cr. Investment income ($300,000 × 30%)

90,000

Dr. Cash ($50,000 × 30%) Cr. Investment in associate (Moonbeam)

15,000

Dr. Investment loss ($80,000 × 30%) Cr. Investment in associate (Moonbeam)

24,000

Dr. Cash ($30,000 × 30%) Cr. Investment in associate (Moonbeam)

9,000

270,000 90,000 15,000

24,000 9,000

The market value of the investment is irrelevant as the investment is not adjusted to fair value when the equity method is used, although the investee’s income is adjusted to reflect impairment losses, if any. A full discussion of this latter aspect is beyond the scope of this text. b.

Investment in associate (Moonbeam) 270,000 90,000 15,000 24,000 9,000 312,000

P7-21. Suggested solution: a. Douglas should report the BMO shares at fair value of $69/share × 1,000 shares = $69,000. b. Douglas should report income of $6,800. Total for Per share 1,000 shares Dividend income $2.80 $2,800 Unrealized gain ($69 – $65) 4.00 4,000 Total $6.80 $6,800

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

c. Zero. The investment is classified as FVPL, so gains and losses flow through income and there is no OCI. P7-22. Suggested solution: a. Douglas should report the BMO shares at fair value of $69/share = $69,000. b. Douglas should report income of $2.80/share × 1,000 shares = $2,800. c. OCI = unrealized gain = ($69 – $65)/share × 1,000 shares = $4,000. P7-23. Suggested solution: a. Ganges should report the bonds at amortized cost, which equals cost because the bond was purchased at par. Cost = $5,000. b. Ganges should report income of $200, which is 4% × $5,000. c. Zero. There is no OCI for investments carried at amortized cost. P7-24. Suggested solution: a. b. c. d. e.

Ganges should report the bonds at fair value of $4,900. Ganges should report income of $200, which is 4% × $5,000. OCI for 2023 = fair value – carrying value = $4,900 – $5,000 = –$100. OCI for 2024 = fair value – carrying value = $4,700 – $4,900 = – $200. Accumulated OCI at end of 2024 = –$100 – $200 = –$300.

P7-25. Suggested solution:

Balance sheet Investment in Tango shares Statement of comprehensive income Dividend income Other income - Unrealized gain - Income from associate Sub-total (= effect on net income) Other comprehensive income Total (= effect on comprehensive income)

Fair value through OCI election

FVPL

Associate

$720,000

$610,000*

$ 40,000

— — $ 40,000 120,000 $ 160,000

120,000 — $ 160,000 — $ 160,000

— 50,000† $ 50,000 — $ 50,000

* Cost + income from associate – dividends received = $600,000 + $50,000 – $40,000 = $610,000. † Income from associate = 20% × $250,000 = $50,000. . 7-10

—

Chapter 7: Financial Assets

P7-26. Suggested solution: January 1, 2023 – Purchase date Dr. Investment in Tango shares (40,000 shares × $15) Cr. Cash

600,000

July 31, 2023 – $1 per share dividend received from Tango Dr. Cash (40,000 shares × $1/share) Cr. Investment in Tango shares

40,000

December 31, 2023 – Recording share of Tango’s income Dr. Investment in Tango shares Cr. Income from associate (20% × $250,000)

50,000

600,000

40,000

50,000

P7-27. Suggested solution: a. Accounting classification

Clues for classification

b. Cost (unknown) Add equity income Less dividends received Add (subtract) unrealized gain (loss) on change in fair value Balance sheet value reported

Investment A

Investment B

Investment C

Associate

Equity with irrevocable election to measure at fair value through OCI

FVPL

Dividend received not reported as income.

Dividends received reported as dividend income; unrealized gain in cumulative OCI.

Dividends received reported as dividend income; no OCI.

$114,500 7,000 (1,500)

$60,000 — —

$85,000 — —

—

3,000

(5,000)*

$120,000 $63,000 $80,000 * The total income on this investment is –$1,000, which includes $4,000 of dividend income. Therefore, there was a loss due to decrease in fair value of $5,000.

. 7-11

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-28. Suggested solution:

Investment a. 20,000 shares of MasterTrade

b. 6,000 units in mutual fund c. 25% of Unique Tools

Financial asset category FVPL

Balance sheet Fair value = 20,000 shares × $46/share = $920,000.

FVPL

Fair value = 6,000 units × $21 = $126,000.

Associate

Equity method: investment value increased by income and decreased by dividends of associate = $3,000,000 + 25% × $800,000 – 25% × $160,000 = $3,000,000 + $200,000 – $40,000 = $3,160,000

Statement of comprehensive income Change in fair value through income = 20,000 shares × ($46 – $42)/share = $80,000. Dividends received recorded as income = 20,000 shares × $0.50/share = $10,000 Change in fair value through income = 6,000 units × ($21 – $22)/unit = –$6,000. Proportionate share of Unique Tools’ income = 25% × $800,000 = $200,000.

P7-29. Suggested solution:

Investment a. 20,000 shares of MasterTrade

b. 6,000 units in mutual fund c. 25% of Unique Tools

Financial asset category Portfolio equity investment

Portfolio equity investment Associate

Balance sheet Fair value = 20,000 shares × $46/share = $920,000.

Fair value = 6,000 units × $21 = $126,000. Equity method: investment value increased by income and decreased by dividends of associate = $3,000,000 + 25% × $800,000 – 25% × $160,000 = $3,000,000 + $200,000 – $40,000 = $3,160,000

. 7-12

Income statement Change in fair value through income = 20,000 shares × ($46 – $42)/share = $80,000. Dividends received recorded as income = 20,000 shares × $0.50/share = $10,000 Change in fair value through income = 6,000 units × ($21 – $22)/unit = –$6,000. Proportionate share of Unique Tools’ income = 25% × $800,000 = $200,000.

Chapter 7: Financial Assets

P7-30. Suggested solution: a. Investment in 20,000 shares of MasterTrade. Purchase date Dr. FVPL Investment in MasterTrade (20,000 shares @ $42) Cr. Cash

840,000 840,000

During year Dr. Cash Cr. Dividend income

10,000

December 31 Dr. FVPL Investment in MasterTrade Cr. Unrealized gain on shares of MasterTrade

80,000

b. Investment in 6,000 units of mutual fund. Purchase date Dr. FVPL Investment in mutual fund (6,000 units @ $22) Cr. Cash December 31 Dr. Unrealized loss on units of mutual fund Cr. FVPL Investment in mutual fund c. Investment in 25% of Unique Tools. Purchase date Dr. Investment in associate – Unique Tools Cr. Cash

132,000

6,000

3,200,000

During year – upon receipt of dividends Dr. Cash Cr. Investment in Associate – Unique Tools

40,000

December 31 Dr. Investment in associate – Unique Tools Cr. Equity income from associate – Unique Tools

200,000

. 7-13

10,000

80,000

132,000

6,000

3,200,000

40,000

200,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-31. Suggested solution: With election 2023 2024 Balance sheet

$1,030,000

Amount through profit or loss - Dividend income - Gain or loss

50,000

Other comprehensive income

30,000

Without election 2023 2024 —

$1,030,000

—

50,000 30,000

15,000

—

2026 —

15,000

P7-32. Suggested solution: 15,000 shares of Pinetree classified as FVPL Balance sheet Financial asset: FVPL investment Equity: AOCI on Pinetree shares Retained earnings

2023

2024

2025

$72,000 n/a 7,500

$63,000 n/a 1,500

$78,000 n/a 21,000

0 27,000

Statement of comprehensive income Dividend income 1,500 3,000 Gain or loss (realized or unrealized) 6,000 (9,000) Other comprehensive income n/a n/a *OCI = other comprehensive income; AOCI = accumulated OCI.

4,500 15,000 n/a

$6,000 n/a

P7-33. Suggested solution: 15,000 shares of Pinetree with election to record fair value changes through OCI* Balance sheet Financial asset: AFS investment Equity: AOCI on Pinetree shares* Retained earnings

2023

2024

2025

2026 —

$72,000 6,000 1,500

$63,000 (3,000) 4,500

$78,000 12,000 9,000

27,000

Statement of comprehensive income Dividend income 1,500 3,000 Gain or loss — — Other comprehensive income 6,000 (9,000) *OCI = other comprehensive income; AOCI = accumulated OCI.

4,500 — 15,000

0 6,000

When an enterprise elects to record changes in the fair value of equity investments through OCI, there is no recycling of OCI into income upon disposition of the investment. The AOCI is closed to retained earnings when the investment is derecognized.

. 7-14

Chapter 7: Financial Assets

P7-34. Suggested solution: a. Recorded as FVPL When received

Dr. Cash (1,000 sh × $2.14/sh) Cr. Dividend income

2,140

Nov 2

Dr. Cash (1,000 sh × $55/sh) Cr. FVPL investment (1,000 sh × $50/sh) Cr. Gain on FVPL investment

55,000

2,140 50,000 5,000

b. With irrevocable election to record changes in value through OCI When received

Dr. Cash (1,000 sh × $2.14/sh) Cr. Dividend income

2,140

Nov 2

Dr. Cash (1,000 sh × $55/sh) Cr. Equity investment with OCI election (1,000 sh × $50/sh) Cr. OCI – gain (loss) on equity investment with OCI election (1,000 sh × ($55/sh-$50/sh))

55,000

2,140 50,000 5,000

P7-35. Suggested solution: 3,000 shares of Oaktree classified as FVPL Balance sheet Financial asset Equity: AOCI on Oaktree shares* Retained earnings due to gains or losses Retained earnings from dividend income Statement of comprehensive income Dividend income Gains (losses) recognized through income Gains (losses) recognized through OCI

2023

2024

$102,000 n/a 9,000

$87,000 n/a (6,000)

3,000

6,000

9,000

$ 3,000 9,000

$ 3,000 (15,000)

$ 3,000 21,000

n/a

. 7-15

2025 $

Total

— n/a 15,000

$ 9,000 15,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

3,000 shares of Oaktree with election to record fair value changes through OCI* Balance sheet Financial asset Equity: AOCI on Oaktree shares* Retained earnings due to gains or losses Retained earnings from dividend income

2023

2024

$102,000 9,000 —

$87,000 (6,000) —

3,000

6,000

Statement of comprehensive income Dividend income $ 3,000 $ 3,000 Gains (losses) recognized through — — income Fair value changes recognized through 9,000 (15,000) OCI * OCI = other comprehensive income; AOCI = accumulated OCI

2025 $

Total

— — 15,000 9,000

$ 3,000 —

$ 9,000

21,000

15,000

Since all the shares were purchased and sold at the same time for the same price, the only difference is in the initial classification. The total amount of retained earnings for the three years combined is the same for both investments, totalling $9,000 + $15,000 = $24,000. Using FVPL, realized and unrealized gains and losses flow through net income to reach retained earnings. With the irrevocable election, realized and unrealized gains and losses flow through OCI and is not recycled into net income; the AOCI is closed directly into retained earnings when the company sells the shares. P7-36. Suggested solution: a. Amortized cost investment in government bonds. January 1 Dr. Investment in government bonds Cr. Cash December 31 Dr. Interest receivable ($200,000 × 3%) Cr. Interest revenue (227,156 × 2%) Cr. Investment in government bonds (There is no entry for the change in fair value as bonds are carried at amortized cost.)

. 7-16

227,156

6,000

227,156

4,543 1,457

Chapter 7: Financial Assets

b. FVPL investment in shares of Stork. July 1 Dr. Investment in shares of Stork Cr. Cash

200,000

December 31 Dr. Dividends receivable Cr. Dividend revenue Dr. Investment in shares of Stork Cr. Unrealized gain on FVPL investment c. Investment with significant influence. July 1 Dr. Investment in Pigeon Cr. Cash

12,000 24,000

1,500,000

December 31 Dr. Investment in Pigeon Cr. Investment income (30% × 400,000) Dr. Cash Cr. Investment in Pigeon (30% × 220,000) (There is no entry for the change in fair value as the equity method is used for investment under significant influence.)

120,000 66,000

200,000

12,000 24,000

1,500,000

120,000 66,000

P7-37. Suggested solution: a. This is a discount bond because the coupon rate is lower than the market rate. b. Value of $100,000 × PVF(6%, 10) = $100,000 × 0.5584 principal Value of coupons $5,000 × PVFA(6%, 10) = $5,000 × 7.3601 Total Using a Texas Instruments BAII Plus: N = 10; I/Y = 6%; FV = $100,000; PMT = $5,000 ($100,000 × 5%) 10 N, 6 I/Y, 100000 FV, 5000 PMT, CPT PV PV = -92,640 (rounded)

. 7-17

$55,840 36,800 $92,640

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-38. Suggested solution: a. This is a premium bond because the coupon rate exceeds the market rate. b. Value of principal $10,000 × PVF(3%, 20) = $10,000 × 0.5537 Value of coupons $350 × PVFA(3%, 20) = $350 × 14.8775 Total

$ 5,537 5,207 $10,744

Using a Texas Instruments BAII Plus: N = 20 (10 × 2); I/Y = 3% (6% / 2); FV = $10,000; PMT = $350 ($10,000 × 7% × 6/12); 20 N, 3 I/Y, 10000 FV, 350 PMT, CPT PV PV = -10,744 (rounded) P7-39. Suggested solution:

P7-40. Suggested solution: Since the $10,000 bond was purchased for $10,890, the premium is $890. Using the straight-line method, the amortization per year is $890 / 5 years = $178 / year. The interest income = coupon payment – amortization = $600 - $178 = $422 / year.

Year 1 2 3 4 5

Opening Amortized Cost $10,890 10,712 10,534 10,356 10,178

Interest Income $422 422 422 422 422

Coupon Payment $600 $600 $600 $600 $600

. 7-18

Ending Amortized Cost $10,712 10,534 10,356 10,178 10,000

Chapter 7: Financial Assets

P7-41. Suggested solution:

Period 1 2 3 4 5 6 7 8 9 10

Opening amortized + Interest income - Coupon payment = Ending cost @ 3% per period ($10,000 x 2%) amortized cost $ 9,147 $ 274 $ 200 $ 9,221 9,221 277 200 9,298 Dec 31, 2023 9,298 279 200 9,377 9,377 281 200 9,458 Dec 31, 2024 9,458 284 200 9,542 9,542 286 200 9,628 Dec 31, 2025 9,628 289 200 9,717 9,717 292 200 9,809 Dec 31, 2026 9,809 294 200 9,903 9,903 297 200 10,000 Dec 31, 2027

P7-42. Suggested solution: Since the $10,000 of bonds was purchased for $9,147, the discount is $853. Using the straightline method, the amortization per 6-month period over the 5-year life is $85.30 / period. Interest income = coupon payment + amortization = $200 + $85.30 = $285.30 / period, rounded to $285 for the first nine periods with the balance being picked up in the final period Period 1 2 3 4 5 6 7 8 9 10

Opening amortized - Coupon payment = Ending cost + Interest income ($10,000 x 2%) amortized cost $ 9,147 $ 285.00 $ 200 $ 9,232 9,232 285.00 200 $ 9,317 Dec 31, 2023 9,317 285.00 200 $ 9,402 9,402 285.00 200 $ 9,487 Dec 31, 2024 9,487 285.00 200 $ 9,572 9,572 285.00 200 $ 9,657 Dec 31, 2025 9,657 285.00 200 $ 9,742 9,742 285.00 200 $ 9,827 Dec 31, 2026 9,827 285.00 200 $ 9,912 9,912 288.00 200 $ 10,000 Dec 31, 2027

P7-43. Suggested solution: (b) is possible because the amount of amortization is increasing each year. (d) is possible if the investment was purchased at par. (a) is not possible because the amortization is decreasing each year, but it should be increasing instead. (c) is not possible because IFRS requires the effective interest method, which has amortization that is different each year. . 7-19

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-44. Suggested solution: (b) is possible because the amortized cost is increasing each year AND the amount of amortization is increasing each year. This pattern is produced by a zero-coupon bond that yields 4%. (d) is possible because the amortized cost is decreasing each year AND the amount of amortization is increasing each year. The pattern is produced by a bond with 8% coupon that yields 4%. (a) is not possible because the amount of amortization is decreasing over time. (c) is not possible because the amortized cost increases and decreases in different years. P7-45. Suggested solution: a. Effective interest rate The effective interest rate cannot be solved for directly using formulas and/or factor tables. Rather, you must adopt a time-consuming, iterative approach, where you solve for the rate by trial and error. Common industry practice is to use a financial calculator or a spreadsheet program to solve for the effective interest rate. This solutions manual follows industry practice, demonstrating the use of a financial calculator to solve for the effective interest rate. Determining the effective interest rate for the period using a Texas Instruments BAII Plus:  The net cost of the investment (PV) to Dudas Inc. was $922,783; PMT = $40,000 ($1,000,000 × 4.0%)  10 N, 922,783 +/– PV, 1000000 FV, 40000 PMT, CPT I/Y I/Y = 5.0% (rounded) Spreadsheet Effective period rate Date

Interest revenue

Jan. 1, 2023 Dec. 31, 2023 $46,139 (b) Dec. 31, 2024 46,446 (f) (a) $917,783 + $5,000 = $922,783 (b) $922,783 × 5% = $46,139 (c) $1,000,000 × 4% = $40,000 (d) $46,139 – $40,000 = $6,139 (e) $922,783 + $6,139 = $928,922 (f) $928,922 × 5% = $46,446

5.0% Interest received $40,000 (c) 40,000

b. Journal entry on acquisition (Jan. 1, 2023) Dr. Investment in financial assets at amortized cost Cr. Cash

. 7-20

Discount amortized $6,139 (d) 6,446

922,783

Amortized cost $922,783 (a) 928,922 (e) 935,368

922,783

Chapter 7: Financial Assets

c. Journal entry on interest payment date (Dec. 31, 2023) Dr. Cash Dr. Investment in financial assets at amortized cost ($46,139 $40,000) Cr. Interest income ($922,783 × 5%) d. Journal entry on interest payment date (Dec. 31, 2024) Dr. Cash Dr. Investment in financial assets at amortized cost ($46,446 $40,000) Cr. Interest income ($928,922 × 5%)

40,000 6,139 46,139 40,000 6,446 46,446

P7-46. Suggested solution: a.

Dr. Investment in financial assets at FVOCI 2,011,433 Cr. Investment in financial assets at FVPL 2,011,433 The investment is reported at fair value on the balance sheet at reclassification date. Dr. Investment in financial assets at amortized cost 3,951,914 Cr. Investment in financial assets at FVPL 3,951,914 The investment is reported at fair value on the balance sheet at reclassification date.

b. The effective interest rate cannot be solved for directly using formulas and/or factor tables. Rather, you must adopt a time-consuming, iterative approach, where you solve for the rate by trial and error. Common industry practice is to use a financial calculator or a spreadsheet program to solve for the effective interest rate. This solutions manual follows industry practice, demonstrating the use of a financial calculator to solve for the effective interest rate. The effective rate of interest per period is 2.1000% as calculated below using a Texas Instruments BAII Plus: N = 14 (7 years remaining × 2 periods per year); PMT = 80,000 ($4,000,000 × 4% / 2) +/- 3,951,914 PV, 4,000,000 FV, 14 N, 80,000 PMT, CPT I/YI/Y = 2.1000% (rounded)

. 7-21

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-47. Suggested solution: We must first determine the amortized cost and fair value of this investment at date of reclassification. N = 12 (6 years remaining × 2 periods per year); FV = $2,000,000; PMT = $40,000 ($2,000,000 × 4% / 2); I/Y (amortized cost) = 2.5% (5.0% / 2); I/Y (fair value) = 2.3% (4.6% / 2); $1,200,000 / $2,000,000 = 60%; $800,000 / $2,000,000 = 40% Amortized cost Value of principal Value of coupons Total Fair value Value of principal Value of coupons Total

$2,000,000 × PVF(2.5%, 12) = $2,000,000 × 0.743556 $40,000 × PVFA(2.5%, 12) = $40,000 × 10.257776 Small difference due to rounding

$1,487,112 410,311 $1,897,423

$2,000,000 × PVF(2.3%, 12) = $2,000,000 × 0.761189 $40,000 × PVFA(2.3%, 12) = $40,000 × 10.383095 Small difference due to rounding

$1,522,378 415,324 $1,937,702

Using a Texas Instruments BAII Plus: Amortized cost:12 N, 2.5 I/Y, 2,000,000 FV, 40,000 PMT, CPT PVPV = -1,897,422 (rounded) Fair value:12 N, 2.3 I/Y, 2,000,000 FV, 40,000 PMT, CPT PVPV = -1,937,701(rounded) FVPL AC: $1,897,422 × 60% = $1,138,453 (rounded): FV: $1,937,701 × 60% = $1,162,621 (rounded) FVOCI  AC: $1,897,422 × 40% = $758,969 (rounded): FV: $1,937,701 × 40% = $775,080 (rounded) a. Dr. Investment in financial assets at FVPL 1,162,621 Cr. Investment in financial assets at amortized cost 1,138,453 Cr. Gain on reclassification of investment at AC to FVPL *24,168 * The fair value – amortized cost is recognized in income ($1,162,621 - $1,138,453 = $24,168) b.

Dr. Investment in financial assets at FVOCI 775,080 Cr. Investment in financial assets at amortized cost 758,969 Cr. OCI - Gain on reclassification of investment at AC to *16,111 FVOCI * The fair value – amortized cost is recognized in OCI ($758,969 - $775,080 = $16,111)

. 7-22

Chapter 7: Financial Assets

P7-48. Suggested solution: a. Dr. Investment in financial assets at amortized cost Cr. Investment in financial assets at FVPL (given)

6,150,000

The fair value of the bonds becomes the amortized cost of the revalued asset. b. Dr. Investment in financial assets at FVPL (given) Cr. Investment in financial assets at FVOCI Dr. Loss on reclassification of financial asset at FVOCI Cr. Accumulated other comprehensive income (AOCI)

1,350,000

*41,292

41,292

* The investment is reported on the balance sheet at its fair value before and after reclassification. When the bonds were classified at FVOCI, though, the difference between the value of the bonds had they been reported at amortized cost, and the fair value of the bonds, flows through OCI (other comprehensive income), which is then closed out to AOCI at yearend. To determine the amount in AOCI at December 31, 2024, we need to calculate the amortized cost of the investment and compare that to its fair value. N = 8 (4 years × 2 periods per year); I/Y = 2.25% (4.5% / 2); FV = $1,500,000; PMT = $18,750 ($1,500,000 × 2.5% / 2) Value of principal $1,500,000 × PVF(2.25%, 8) = $1,500,000 × 0.836938 $1,255,407 Value of coupons $18,750 × PVFA(2.25%, 8) = $18,750 × 7.247185 135,885 Total $1,391,292 Using a Texas Instruments BAII Plus: 8 N, 2.25 I/Y, 1,500,000 FV, 18,750 PMT, CPT PVPV = -1,391,292 (rounded) $1,391,292 - $1,350,000 = $41,292 c. Dr. Investment in financial assets at amortized cost Dr. Accumulated other comprehensive income (AOCI) Cr. Investment in financial assets at FVOCI (given)

*9,719,928 *80,072

9.800,000

* We must first determine what the amortized cost of the investment is at date of reclassification: N = 6 (3 years remaining × 2 periods per year); I/Y = 2.0% (4.0% / 2); FV = $10,000,000; PMT = $150,000 ($10,000,000 × 3% / 2) Value of principal Value of coupons Total

$10,000,000 × PVF(2.0%, 6) $150,000 × PVFA(2.0%, 6)

. 7-23

= $10,000,000 × 0.887971 = $150,000 × 5.601431

$8,879,710 840,215

$ 9,719,925

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Using a Texas Instruments BAII Plus: 6 N, 2.0 I/Y, 10,000,000 FV, 150,000 PMT, CPT PVPV = -9,719,928 (rounded) $9,800,000 - $9,719,928 = $80,072 d. The effective interest rate cannot be solved for directly using formulas and/or factor tables. Rather, you must adopt a time-consuming, iterative approach, where you solve for the rate by trial and error. Common industry practice is to use a financial calculator or a spreadsheet program to solve for the effective interest rate. This solutions manual follows industry practice, demonstrating the use of a financial calculator to solve for the effective interest rate. The effective rate of interest being earned per period is 1.7257% as calculated below: N = 10 (5 years remaining × 2 periods per year); PMT = $120,000 ($6,000,000 × 4% / 2) +/- 6,150,000 PV, 6,000,000 FV, 10 N, 120,000 PMT, CPT I/YI/Y = 1.7257% (rounded) P7-49. Suggested solution: a. The investment should have been classified at amortized cost, because Bedford’s business model was to hold the investment to collect contractual cash flows. b. N = 4 (4 years × 2 periods per year); I/Y = 2.5% (5.0% / 2) Value of principal $1,000,000 × PVF(2.5%, 4) = $1,000,000 × 0.905951 Value of coupons $20,000 × PVFA(2.5%, 4) = $20,000 × 3.761974 Total

$905,951 75,239 $981,190

Using a Texas Instruments BAII Plus: FV = $1,000,000; PMT = $20,000 ($1,000,000 × 4.0% / 2) 4 N, 2.5 I/Y, 1,000,000 FV, 20,000 PMT, CPT PVPV = -981,190 (rounded) Dr. Investment in financial assets at amortized cost Cr. Cash c. 01/01/2023 06/30/2023 12/31/2023 06/30/2024 12/31/2024

Beginning bal. Interest revenue $981,190 985,720 990,363 995,122

$24,530 24,643 24,759 24,878

. 7-24

981,190 Cash received $20,000 20,000 20,000 20,000

981,190

Ending balance $ 981,190 985,720 990,363 995,122 1,000,000

Chapter 7: Financial Assets

d. 06/30/23 Dr. Cash Dr. Investment in financial assets at AC ($24,530 $20,000) Cr. Interest revenue

20,000 4,530 24,530

12/31/23 Dr. Cash Dr. Investment in financial assets at AC ($24,643 $20,000) Cr. Interest revenue

20,000 4,643

06/30/24 Dr. Cash Dr. Investment in financial assets at AC ($24,759 $20,000) Cr. Interest revenue

20,000 4,759

12/31/24 Dr. Cash Dr. Investment in financial assets at AC ($24,878 $20,000) Cr. Interest revenue

20,000 4,878

Dr. Cash Cr. Investment in financial assets at amortized cost

24,643

24,759

24,878 1,000,000

1,000,000

P7-50. Suggested solution: a. The investment is classified at FVOCI, because Bedford’s business model was to hold the investment to collect contractual cash flows and to profit from changes in value. b. N = 4 (4 years × 2 periods per year); I/Y = 2.5% (5.0% / 2); FV = $1,000,000; PMT = $20,000 ($1,000,000 × 4.0% / 2) Value of principal $1,000,000 × PVF(2.5%, 4) = $1,000,000 × 0.905951 $905,951 Value of coupons $20,000 × PVFA(2.5%, 4) = $20,000 × 3.761974 75,239 Total $981,190 Using a Texas Instruments BAII Plus: 4 N, 2.5 I/Y, 1,000,000 FV, 20,000 PMT, CPT PVPV = -981,190 (rounded) Dr. Investment in financial assets at FVOCI Cr. Cash

. 7-25

981,190

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

c. June 30, 2023: N = 4 – 1 = 3; I/Y = 4.6% / 2 = 2.3% Value of = $1,000,000 × 0.934056 $1,000,000 × PVF(2.3%, 3) principal Value of coupons $20,000 × PVFA(2.3%, 3) = $20,000 × 2.867113 Total Small difference due to rounding December 31, 2023: N = 4 – 2 = 2; I/Y = 5.2% / 2 = 2.6% Value of = $1,000,000 × 0.949960 $1,000,000 × PVF(2.6%, 2) principal Value of coupons $20,000 × PVFA(2.6%, 2) = $20,000 × 1.924619 Total June 30, 2024: N = 4 – 3 = 1; I/Y = 4.2% / 2 = 2.1% Value of = $1,000,000 × 0.979432 $1,000,000 × PVF(2.1%, 1) principal Value of coupons $20,000 × PVFA(2.1%, 1) = $20,000 × 0.979432 Total

$934,056 57,342 $991,398 $949,960 38,492 $988,452 $979,432 19,589 $999,021

c. June 30, 2023: N = 4 – 1 = 3; I/Y = 4.6% / 2 = 2.3% 3 N, 2.3 I/Y, 1,000,000 FV, 20,000 PMT, CPT PVPV = -991,399 (rounded) December 31, 2023: N = 4 – 2 = 2; I/Y = 5.2% / 2 = 2.6% 2 N, 2.6 I/Y, 1,000,000 FV, 20,000 PMT, CPT PVPV = -988,452 (rounded) June 30, 2024: N = 4 – 3 = 1; I/Y = 4.2% / 2 = 2.1% 1 N, 2.1 I/Y, 1,000,000 FV, 20,000 PMT, CPT PVPV = -999,021 (rounded) d.

01/01/2023 06/30/2023 12/31/2023 06/30/2024 12/31/2024

Beginning balance

$981,190 985,720 990,363 995,122

Interest revenue

$24,530 24,643 24,759 24,878

Cash received

Amortized Cost (AC)

Fair value (FV)

$20,000 20,000 20,000 20,000

$ 981,190 985,720 990,363 995,122 1,000,000

$ 981,190 991,399 988,452 999,021 1,000,000

As expected, the unrealized holding gains and losses net out to $0 at maturity date.

. 7-26

Cumulative unrealized gain or (loss) (FV - AC) $

0 5,679 (1,911) 3,899 0

Unrealized gain (loss) for period

$ 5,679 (7,590) 5,810 (3,899) $ 0

Chapter 7: Financial Assets

e. 06/30/23 Dr. Cash Dr. Investment in financial assets at FVOCI ($24,530 $20,000) Cr. Interest revenue

20,000 4,530 24,530

Dr. Investment in financial assets at FVOCI (from table above) Cr. OCI - Unrealized gain (loss) on investments at FVOCI

5,679

12/31/23 Dr. Cash Dr. Investment in financial assets at FVOCI ($24,643 $20,000) Cr. Interest revenue

20,000 4,643

Dr. OCI - Unrealized gain (loss) on investments at FVOCI Cr. Investment in financial assets at FVOCI (from table above)

7,590

06/30/24 Dr. Cash Dr. Investment in financial assets at FVOCI ($24,759 $20,000) Cr. Interest revenue

20,000 4,759

Dr. Investment in financial assets at FVOCI (from table above) Cr. OCI - Unrealized gain (loss) on investments at FVOCI

5,810

12/31/24 Dr. Cash Dr. Investment in financial assets at FVOCI ($24,878 $20,000) Cr. Interest revenue

20,000 4,878

Dr. OCI - Unrealized gain (loss) on investments at FVOCI Cr. Investment in financial assets at FVOCI (from table above)

3,899

Dr. Cash Cr. Investment in financial assets at FVOCI

. 7-27

5,679

24,643

7,590

24,759

5,810

24,878

3,899 1,000,000

1,000,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-51. Suggested solution: a. Year 2023 2024 2025 2026

Jan 1 amortized cost $93,225 94,751 96,384 98,131

Year 2023 2024

OCI $1,249 -633

+ Interest income 7% $6,526 6,633 6,747 6,869

– Coupon payment $5,000 5,000 5,000 5,000

Amortization $1,526 1,633 1,747 1,869

Dec 31 amortized cost $ 94,751 96,384 98,131 100,000

= market value – carrying amount = market value – (beg. B/S value + amortization) = 96,000 – (93,225 + 1,526) = 96,000 – 94,751 = 97,000 – (96,000 + 1,633)

Journal entry for sale on January 1, 2025 Dr. Cash Cr. Investment in financial assets at FVOCI Dr. OCI—investment in BCE ($1,249 – 633) Cr. Gain ($97,000 – $96,384)

97,000 616

P7-52. Suggested solution: a. Year 2023 2024 2025

Jan 1 amortized cost $10,267 $10,183 $10,094

+ Interest income 6% $616 $611 $606

– Coupon payment $700 $700 $700

. 7-28

Amortization $84 $89 $94

Dec 31 amort. cost $10,183 $10,094 $10,000

Chapter 7: Financial Assets

Purchase on January 1, 2023 Dr. Investment in financial assets at FVOCI Cr. Cash Interest income for 2023 Dr. Cash Cr. Interest income Cr. Investment in financial assets at FVOCI Fair value adjustment at end of 2023 Dr. Investment in financial assets at FVOCI Cr. OCI—investment in Hydro One ($10,200 – $10,183) Interest income for 2024 Dr. Cash Cr. Interest income Cr. Investment in financial assets at FVOCI Fair value adjustment at end of 2024 Dr. OCI—investment in Hydro One Cr. Investment in financial assets at FVOCI ($10,100 – ($10,200 – 89)) Interest income for first 6 months of 2025 Dr. Accrued interest receivable Cr. Accrued interest income Cr. Investment in financial assets at FVOCI Sale of investment at $10,030 Dr. Cash Dr. Loss (Proceeds – carrying value = $10,030 – 10,053) Cr. Investment in financial assets at FVOCI Dr. OCI—investment in Hydro One bonds Cr. Gain ($17 – 11 net gain recycled into income) Alternatively, record sale after adjusting investment to fair value: Dr. OCI—investment in Hydro One bonds Cr. Investment in financial assets at FVOCI ($10,030 – ($11,000 – 47)) Dr. Cash Cr. Investment in financial assets at FVOCI Dr. Loss Cr. OCI—investment in Hydro One bonds (OCI balance before sale = 17cr + 11dr + 23dr = 17dr)

. 7-29

10,267 700

700

350

10,030 23 6

23 10,030 17

10,267 616 84 17

611 89 11

303 47

10,053 6

23 10,030 17

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-53. Suggested solution: a. Using present value techniques, we can discount the coupon payments of $800,000/year for six years, plus the principal value upon maturity. The discount rate is 6% (i.e., the yield on the date of purchase). The price paid for the bond is $10,983,465, as shown in the following table. b. $10,410,020 (see below). c. $10,000,000. The market value exactly equals the face value since the market yield is the same as the coupon rate on this date Part (a) Part (b) Part (c) 2023 Jan 1 2023 Dec 31 2024 Dec 31 Face value (P) $10,000,000 $10,000,000 $10,000,000 Coupon rate 8% 8% 8% Coupon amount $800,000 $800,000 $800,000 (C) Market yield at 6% 7% 8% each date (r) Maturity date 2028 Dec 31 2028 Dec 31 2028 Dec 31 Number of periods to 6 5 4 maturity (n) PVF(n, r) PVFA(n, r) PV of principal = P × PVF PV of coupon pmts = C× PVFA PV of bond

0.70496 4.91732

0.71299 4.10020

0.73503 3.31213

$ 7,049,605

$ 7,129,862

$ 7,350,299

3,933,859

3,280,158

2,649,701

$10,983,465

$10,410,020

$10,000,000

Using a Texas Instruments BAII Plus: Part (a) N = 6; I/Y = 6%; FV = $10,000,000; PMT = $800,000 ($10,000,000 × 8%) 6 N, 6 I/Y, 10000000 FV, 800000 PMT, CPT PV PV = -10,983,465 (rounded) Part (b) N = 5; I/Y = 7%; FV = $10,000,000; PMT = $800,000 ($10,000,000 × 8%) 5 N, 7 I/Y, 10000000 FV, 800000 PMT, CPT PV PV = -10,410,020 (rounded) Part (c) N = 4; I/Y = 8%; FV = $10,000,000; PMT = $800,000 ($10,000,000 × 8%) 4 N, 8 I/Y, 10000000 FV, 800000 PMT, CPT PV PV = -10,000,000

. 7-30

Chapter 7: Financial Assets

d. Bond amortization schedule Amortized cost opening balance Year January 1 2023 10,983,465 2024 10,842,473 2025 10,693,021 2026 10,534,602 2027 10,366,679 2028 10,188,679 Balance sheet, 2023 Dec 31 Balance sheet, 2024 Dec 31

+ Interest @6% – coupon pmnt 659,008 800,000 650,548 800,000 641,581 800,000 632,076 800,000 622,001 800,000 611,321 800,000 Amortized cost FVOCI 10,842,473 10,410,020 10,693,021 10,000,000

2023 Interest income 2023 Unrealized gains (losses) 2023 Total investment income 2024 Interest income 2024 Unrealized gains (losses) 2024 Total investment income

659,008 — 659,008 650,548 — 650,548

= Amortized cost closing balance December 31 10,842,473 10,693,021 10,534,602 10,366,679 10,188,679 10,000,000 FVPL 10,410,020 10,000,000 800,000 (573,445) † 226,555 800,000 (410,020) † 389,980

Other comprehensive income (OCI), — (432,452) * — 2023 Accum. OCI, 2023 Dec 31 — (432,452) — Other comprehensive income, 2024 — (260,568) * — Accum. OCI, 2024 Dec 31 — (693,020) — * Unrealized gains (losses) = fair value – carrying value 2023 unrealized gains (losses) = 10,410,020 – 10,842,473 = -432,453 2024 unrealized gains (losses) = 10,000,000 – (10,410,020 + 650,548 – 800,000) = -260,568 † Unrealized gains (losses) = fair value – carrying value 2023 unrealized gains (losses) = 10,410,020 – 10,983,465 = –573,445 2024 unrealized gains (losses) = 10,000,000 – 10,410,020 = –410,020

. 7-31

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P7-54. Suggested solution: a. Adobe should account for these mortgages at amortized cost. This is the appropriate method because Adobe typically holds these mortgages to collect payments of interest and principal. b. The value that should be reported is the amortized cost at December 31, 2023. That value is obtained from the present value of the mortgage payments. Average maturity Scheduled semi-annual payments Average yield on loans at inception Principal amount outstanding as at Dec. 31, 2023

Up to one year 6 months $4m

1–3 years 2 years $5m

3–5 years 4 years $20m

6%/a

8%/a

$100m

$200m

$400m

1 3% 0.97087 0.97087 $ 97.09m 3.88m $100.97m

4 3% 0.88849 3.71710 $177.70m 18.59m $196.28m

8 4% 0.73069 6.73275 $292.28m 134.65m $426.93m

n r PVF(n, r) PVFA(n, r) PV of principal payments PV of interest payments PV of mortgages Total value of mortgages at amortized cost Using a Texas Instruments BAII Plus:

$724.19m

Up to one-year N = 1; I/Y = 3% (6% / 2); FV = $100m; PMT = $4m 1 N, 3 I/Y, 100 FV, 4 PMT, CPT PV PV = -100.97 (rounded) 1–3 years N = 4 (2 × 2); I/Y = 3% (6% / 2); FV = $200m; PMT = $5m 4 N, 3 I/Y, 200 FV, 5 PMT, CPT PV PV = -196.28 (rounded) 3–5 years N = 8 (4 × 2) ; I/Y = 4% (8% / 2); FV = $400m; PMT = $20m 8 N, 4 I/Y, 400 FV, 20 PMT, CPT PV PV = -426.93 (rounded)

. 7-32

Chapter 7: Financial Assets

c. The value of mortgages can be projected by using mortgage amortization schedules, as shown below. Only the two groups of mortgages that mature beyond the end of 2024 need to be considered. Amounts are in $millions. Note that the interest compounding period is semiannual, so we require two rows in the schedule for each year. Mortgages with 1–3 years maturity Beginnin = End of g of year + Interest − year amortize @ 3% Coupon amortized d cost yield* payment cost

Mortgages with 3–5 years maturity Amortized = End of cost at + Interest − year beginning @ 4% Coupon amortized of year yield* payment cost

End of June $196.28 $5.89 $5 $197.17 $426.93 $17.08 $20 424.01 2024 Dec 197.17 5.92 5 198.09 424.01 16.96 20 420.97 2024 June 198.09 5.94 5 199.03 420.97 16.84 20 417.81 2025 Dec 199.03 5.97 5 200.00 417.81 16.71 20 414.52 2025 * Interest = beginning of year amortized cost × effective interest rate; e.g., $196.28 × 3% = $5.89. All amounts are in millions.

P7-55. Suggested solution: a. The investment costs are $1,000,000, $1,044,518, and $920,146, calculated below. (Note that no calculations are required for the short-term government bonds because the yield equals the coupon rate, so these bonds are at par. The calculations are included below for completeness.) Short-term Medium-term government government bonds bonds Corporate bonds Face value (P) $1,000,000 $1,000,000 $1,000,000 Coupon rate 3% 5% 6% Coupon payments (C) 30,000 50,000 60,000 Yield (r) 3% 4% 8% Maturity Jan. 1, 2026 Jan. 1, 2029 Jan. 1, 2029 Interest frequency Annual Annual Annual Number of periods (n) 2 5 5 PVF(r, n) 0.94260 0.82193 0.68058 PVFA(r, n) 1.91347 4.45182 3.99271 PV of principal (P × PVF(r, n)) PV of coupons (C × PVFA(r, n)) PV of bonds

$ 942,596

$ 821,927

$680,583

57,404

222,591

$239,563

$1,000,000

$1,044,518

$920,146

. 7-33

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Using a Texas Instruments BAII Plus: Short-term government bonds N = 2; I/Y = 3%; FV = $1,000,000; PMT = $30,000 ($1,000,000 × 3%) 2 N, 3 I/Y, 1000000 FV, 30000 PMT, CPT PV PV = -1,000,000 Medium -term government bonds N = 5; I/Y = 4%; FV = $1,000,000; PMT = $50,000 ($1,000,000 × 5%) 5 N, 4 I/Y, 1000000 FV, 50000 PMT, CPT PV PV = -1,044,518 (rounded) Corporate bonds N = 5; I/Y = 8%; FV = $1,000,000; PMT = $60,000 ($1,000,000 × 6%) 5 N, 8 I/Y, 1000000 FV, 60000 PMT, CPT PV PV = -920,146 (rounded) b. The bond amortization schedules are as follows:

Dec. 31 2024

Medium-term government bonds (premium) Beginning = End of of year + Interest − year amortized @ 4% Coupon amortized cost yield* payment cost $1,044,518 $41,781 $50,000 $1,036,299

Corporate bonds (discount) Amortized = End of cost at + Interest − year beginning @ 8% Coupon amortized of year yield* payment cost $920,146 $73,612 $60,000 933,757

2025 1,036,299 41,452 50,000 1,027,751 933,757 74,701 60,000 2026 1,027,751 41,110 50,000 1,018,861 948,458 75,877 60,000 2027 1,018,861 40,754 50,000 1,009,615 964,335 77,147 60,000 2028 1,009,615 40,385 50,000 1,000,000 981,491 78,519 60,000 * Interest = beginning of year amortized cost × effective interest rate; e.g., $1,044,518 × 4% = $41,781.

c. The amounts to be reported in the financial statements are as follows: Short-term Medium-term government government bonds bonds Accounting classification Amortized cost FVOCI Balance sheet asset 2024 $1,000,000 $1,040,000 2025 $1,000,000 $1,028,000 2026 $1,020,000 2027 $1,010,000 2028 $1,000,000 1 Income 2024 $30,000 $ 41,781 2025 30,000 41,452 2026 — 41,110 2027 — 40,754 2028 — 40,385 $205,482 Other comprehensive income (OCI)2 2024 n/a $3,701 2025 n/a (3,452) 2026 n/a 890 . 7-34

948,458 964,335 981,491 1,000,000

Corporate bonds FVOCI $ 950,000 $ 970,000 $1,050,000 $1,010,000 $1,000,000 $ 73,612 74,701 75,877 77,147 78,519 $379,856 $ 16,243 5,299 64,123

Chapter 7: Financial Assets

2027 n/a (754) (57,147) 2028 n/a (385) (28,519) Total for five years $ 0 $ 0 3 Accumulated OCI 2024 n/a $3,701 $ 16,243 2025 n/a 249 21,542 2026 n/a 1,139 85,665 2027 n/a 385 28,509 2028 n/a 0 0 1 Since the first bond is a par bond, the income is equal to the coupon payments of $30,000 per year. The values for the second and third bonds are from the interest income column of the bond amortization schedules from part (b). As none of the three bonds are classified as FVPL, changes in fair value do not flow through income. 2 Other comprehensive income (OCI) for a particular year equals the change in fair value less the premium amortization (plus the discount amortization) for the year; e.g., medium-term government bonds for 2025: OCI = $1,028,000 – $1,040,000 – (41,452–50,000) = –$3,452. 3 Accumulated other comprehensive income (AOCI) is the sum of OCI from the current and past years. Alternatively, AOCI can be derived as the difference between the fair values and amortized cost. Amortized cost can be obtained from the amortization schedules in part (b). d. Had Gander Corp. classified the second and third bonds as amortized cost financial assets, the total income would remain the same as shown in part (c) above: $205,482 and $379,856. There would be no entries through other comprehensive income. e. Had Gander Corp. classified the second and third bonds as FVPL, the total income would again remain the same as shown in part (c). What would be different is that the amounts in each year shown as OCI in part (c) would be reported through income instead.

. 7-35

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

N. Mini-Cases Case 1: Good Fortune Co. Suggested solution: Report on options for $30 million of excess funds. Our company has at least two options with the funds made available by the postponement of expansion plans. We can either pay out the unneeded funds to shareholders or invest the funds. We should consider paying out the $30 million to our shareholders because we do not know how long the recession will last and when conditions will be ripe to resume our expansion. A special dividend payout will send a positive signal to the stock market and potentially increase our company’s stock price. An obvious drawback to this alternative is that we would likely need to seek financing if and when we decide to expand again. However, this limitation may not be a serious factor because it could be fairly easy to seek alternate financing through a bank loan, seeing that we currently have little debt. On the other hand, our low reliance on debt financing means that we may not have a strong relationship with any banks such that bank financing (or any similar alternative) could take some time to put into place. The more obvious alternative use of the $30 million is to purchase some investments until the funds are required for expansion. We could invest in any one or a combination of the following assets, listed in order of increasing risk. With increasing risk is also the prospect for higher returns. 1. Investments that are essentially risk-free, such as short-term government Treasury bills, certificates of deposit (CDs), and guaranteed investment certificates (GICs). 2. Investments in fixed-income instruments issued by governments, utilities, and large corporations. 3. Investments in shares of large publicly traded companies. While there are other possible investments such as derivatives, I limit my focus to the above three because these are the types of investments that are potentially suitable for our company. Regardless of the investment or combination of investments we choose, for accounting purposes we will need to designate the investments according to our business model. * If we intend to buy (and sell) the investments with the aim of making profitable trades, we will need to classify the investments as “fair value through profit or loss,” or FVPL. The value of FVPL investments must be marked to market (i.e., adjusted to the market price) at each balance sheet date, with the changes in values reported in the income statement. * If we intend to buy and hold the investments to collect payments of interest and principal, then we can classify the investments as “amortized cost.” Note that this classification is only available for investments in debt instruments (investment types #1 and 2 listed above). Recording investments at amortized cost means that we adjust the purchase cost by amortization of the difference between cost and maturity value. * If we intend to buy the investments to collect contractual cash flows and selling the assets at an opportune time, then we can classify the debt investments as FVOCI investments. These must also be marked to market, but the changes in value flow through “other . 7-36

Chapter 7: Financial Assets

comprehensive income” rather than through the income statement. Upon sale of these investments, the realized gain or loss is then recorded through the income statement. For the equity investments, we can make a one-time irrevocable election at the time of purchase. This election is to record changes in value through other comprehensive income, including the realized gains or losses that would result from the sale of these investments. There will be no impact on the income statement other than from any dividends received. Investments that are liquid and that do not have any significant risk of changes in value can also be classified as cash equivalents, providing that they are held to meet short-term cash commitments, which is not the case here.

Recommendation I recommend that we invest primarily in the first type of investments (risk-free investments) and secondarily in fixed-income instruments that are a bit riskier but still of high quality. Our company needs to be ready to act when the economy climbs out of the current recession. Historically, the end of a recession heralds a period of strong economic growth; we do not want too much of our funds tied up in long-term investments whose value can fluctuate significantly. We should classify the investments as FVOCI, rather than amortized cost or at FVPL as this most closely matches our intent. We should not designate any investments as amortized cost as we do not know when we will need to liquidate the investment. Similarly, we should not designate the investments as FVPL because we do not intend to trade them frequently for the purpose of making trading profits, and because any decline in security values would negatively affect our income statement, which in turn would likely lead to adverse reactions from our shareholders.

. 7-37

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Case 2: Tightrope Limited. Suggested solution: a. To: CEO From: CFO Date: March 11, 2026 Re: Repayment of bonds due March 30 The impending maturity of $300 million of bonds on the surface poses only minor issues due to the fact that our company has plentiful financial resources. Specifically, we currently have about $2 billion in financial assets. However, only $50 million of this amount is in cash and cash equivalents, so we would need to either sell some of our other investments or seek alternative financing for the remaining $250 million. The following table summarizes the financial assets that we could consider using: Market Carrying Investment (in $millions) Cost value amount Cash and cash equivalents $ 50 $ 50 $ 50 Affiliates under significant influence (cost approximates carrying value) 450 750 450 Equity investments carried at fair value through profit or loss (FVPL) (Note 1) 200 300 300 Debt investments carried at fair value through other comprehensive income (FVOCI) (Note 1) 350 300 300 Amortized cost debt instruments, purchased at par with average yield of 6%; five years remaining to maturity 800 500 800 Total $1,850 $1,900 $1900 Note 1: FVPL and FVOCI investments are carried at market value on the balance sheet. Obtaining funds by selling some of these investments has different consequences. The relevant considerations include impact on our long-term strategic position, impact on current period income, impact on our balance sheet position. As well, we need to be aware of the specific constraints we face due to our bond covenants. The following table summarizes these considerations for each of the alternatives. Of course, the alternatives are not mutually exclusive, since we can choose to use a combination of these alternatives. Affiliates

Strategic position Selling affiliates could harm long-term strategic position.

Equity carried at FVPL

No effect.

Debt investments

No effect.

Income Would result in gains since current market value exceeds carrying value. No effect since investments already reported at market value. This class of investments has unrealized losses . 7-38

Balance sheet Balance sheet would improve due to the realization of gains. No effect.

Balance sheet would not be affected since investments are

Covenants Reduced likelihood of covenant violation due to higher income and assets. No effect.

Could increase likelihood of covenant

Chapter 7: Financial Assets carried at FVOCI

Amortized cost (AC) investments

No effect.

Roll over financing

No effect.

reported in AOCI. Sale of some securities could trigger realized losses that would reduce net income). Would likely result in losses since market value of this class of investments is only 62.5% of carrying value. Marginally negative effect due to cost of financing (about 8%) being higher than investment rate of return (about 6%).

already reported at market value.

violation due to lower income.

Balance sheet position would worsen.

Increased likelihood of covenant violation due to worsened asset position and the reduction in income.

No effect.

Maintains ratios at levels prior to the debt repayment.

Since the consequences of violating our bond covenants can be severe, I have performed some additional analyses to project our ratios under the different alternatives. To do so, I have made the assumption that we will obtain $250 million from one of these alternatives and use up our cash reserve of $50 million. I also conservatively assume that we will earn about $380 million before tax, which is the lowest of the three amounts from the prior three years. Furthermore, I assume that we have non-financial assets (i.e., assets other than those noted above) of about $2.0 billion, long-term debt of $1.2 billion, and other liabilities of $400 million.

$millions Long-term debt Other liabilities Total liabilities Cash Affiliates FVPL investments FVOCI investments AC investments Financial assets Non-financial assets Total assets Debt-to-assets Income before interest, gains/losses, and taxes Gains (losses) on sale of financial assets Income before interest and taxes Interest expense (8% of long-term debt)

2025 Sell year-end affiliates 1,500 1,200 400 400 1,900 1,600 50 0 450 300 a 300 300 300 300 800 800 1,900 1,700 2,000 2,000 3,900 3,700 48.7% 43.2%

Alternatives Sell Sell FVPL FVOCI Sell AC 1,200 1,200 1,200 400 400 400 1,600 1,600 1,600 0 0 0 450 450 450 50 b 300 300 300 50 c 300 d 800 800 400 d 1,600 1,600 1,450 2,000 2,000 2,000 3,600 3,600 3,450 44.4% 44.4% 46.4%

Roll over financing 1,450 e 400 1,850 0 450 300 300 800 1,850 2,000 3,850 48.1%

380

—

100 a

(42) c

(150)d

—

380

480

380

338

230

380

120

116

. 7-39

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Interest coverage ratio 3.17 5.00 3.96 3.52 2.40 3.28 Notes: a. Affiliates had market value of $750m. Selling one-third of them would yield $250m. Assume carrying value of affiliates sold is proportional to proceeds, so 1/3 × $450m = $150m. Gain on sale = $250 – $150m = $100m. Carrying value of remaining affiliates = 2/3 × $450m = $300m. b. FVPL securities already marked to market; $250m sold with zero gains or losses. c. FVOCI securities already marked to market, but there are $50m of unrealized losses in cumulative other comprehensive income. To obtain $250m would require the sale of 5/6 of the $300m of investments in this class. Assuming losses are proportional to the amount sold, we would transfer 5/6 × $50m = $41.7m of losses from accumulated other comprehensive income (AOCI) to the income statement. d. To obtain $250m from debt securities at amortized cost requires the sale of half of this category (which is $500m at market, $800m at cost). We would recognize $150m of loss (proceeds of $250m – cost of $400m). e. Of the $300m required to satisfy maturing bonds, $50m would come from cash resources. The remainder of $250m would need to be borrowed under the refinancing alternative. As shown in the above table, the different alternatives result in considerably different ratios for debt-to-assets and interest coverage. It is comforting to note that we do not have a high risk of violating the debt-to-assets ratio since all alternatives result in ratios lower than at the last fiscal year-end and well under the 50% requirement. However, the interest coverage ratio is of more concern. The alternative involving selling amortized cost investments is likely to result in a violation of the 3:1 interest coverage requirement. While the other alternatives are expected to keep us in compliance with this covenant, I should note that we are exposed to the risk of a covenant breach should unexpected events occur. Compliance depends on our company’s ability to maintain a level of income that is consistent with the last few years of around $400m. At this early point in the year, it is too early to tell how the year will turn out, but it is essential that we remain abreast of the situation. If our income were to fall to $300m or less, we would have a high risk of violating the interest coverage covenant. In particular, if capital markets perform poorly, we would need to recognize losses on our FVPL investments. As shown above, selling some of our investments in our affiliates would allow us to realize some gains that would increase our income. We do not necessarily want to do that now, since we would lose some important strategic relationships we have with these affiliates. Instead, we should wait and see how the year progresses, and sell these assets as a last resort. For the immediate need to fund the bond repayment, we should sell other classes of assets. Recommendation After considering all the short- and long-term factors, I recommend that we sell some of our FVPL securities. This alternative results in the least impact on our balance sheet and income statement, does not impair our long-term strategic position, and does not put our company at risk of violating bond covenants.

. 7-40

Chapter 7: Financial Assets

b. Proposals for improving TRL’s financial position TRL is currently in a reasonably good financial position given the abundance of financial assets that can be converted to cash in a timely manner. However, there are some changes that could improve upon the current situation. First, there is arguably too much emphasis on liquidity. Currently, the company has invested about half of its assets in financial assets, of which about 60% or $1.1 billion is in portfolio investments of stocks and bonds. At the same time, there is more than a billion dollars of debt outstanding. If the company sold some of the portfolio investments to pay off some of the debt, leverage ratios would improve and decrease the company’s financial risk. Second, paying off debt with funds from portfolio investments is likely to increase income since borrowing rates tend to exceed returns on investments with similar risk. Third, having significant amounts of investments that are carried at FVPL can significantly increase the volatility of the company’s income. In any particular year, the value of these portfolio investments can swing quite dramatically, and any changes in value for FVPL investments flow directly to income. A particularly poor year in the capital markets could severely impact our reported income in a negative manner and force the company to fall afoul of covenants or other contractual commitments. For the above reason, the company should seriously reconsider its policy (i) to maintain such a large amount of portfolio investments and (ii) to maintain a significant amount of investments as FVPL. Case 3: Luca Merchandising Inc. Suggested Solution: a. LMI currently accounts for its investment using the equity method. The equity method is a method of accounting whereby the balance sheet value of the investment equals the cost adjusted by the investor’s share of the investee’s post-acquisition changes in net assets, and the income recognized equals the investor’s share of the investee’s net income. Considering LMI has a 22% share in the company, one might assume LMI has significant influence on TNI. However, one should also look into other factors when choosing the appropriate accounting method. Since the company does not have a seat on the board of directors and it does not have any business ties with TNI, it can be argued the influence of LMI on TNI is limited and the investment can be accounted for as portfolio investment and recorded at fair value through profit or loss (FVPL). Another option that is no longer available is to carry these at fair value with changes in fair value flowing through other comprehensive income (OCI); to do this requires an irrevocable election at the time of acquisition. As LMI is considering going public in the next year, it would want to show a positive financial position. Hence, it might be more beneficial for the company to classify the investment as FVPL instead of using the equity method, as the company can book the investment of TNI at its current fair value on the balance sheet and it can also recognize unrealized gains related to the changes in the fair value of the TNI investment on its income statement. TNI’s current share price of $28 is 40% higher than the purchase cost of $20. . 7-41

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

b. LMI currently accounts for its investment in ML at FVPL. The FVPL method is a method of accounting that recognizes unrealized gains and losses from investments on income statement. As noted above, had LMI made an irrevocable election, it could have account for its investment in ML at FVOCI. Considering share price of ML decreased in 2025, unrecognized losses would have to be recorded on the income statement under FVPL, but these losses would be in OCI under the alternative. Of course, we are using hindsight here, and at the time of purchase, it could not have been anticipated that the share price would fall. c. In real life, many investments are not traded within an efficient market. These investments can create additional financial reporting issues if carried at fair value, because it is difficult to arrive at reliable fair value estimates for these investments. While IFRS 9 requires that all investments in equity instruments be reported at fair value, it recognizes in paragraph 5.23 of Appendix B Application Guidance, that in limited circumstances, cost may be an appropriate estimate of fair value. That may be the case if insufficient more recent information is available to measure fair value, or if there is a wide range of possible fair value measurements and cost represents the best estimate of fair value within that range. If the investment is reported at cost, though, this decision would c trade-off relevance for representational faithfulness.

. 7-42

Chapter 8 Property, Plant, and Equipment L. Problems P8-1. Suggested solution: Item Lathe 1% discount

Include in cost of lathe $5,300,000 (53,000)

Freight in

75,000

Insurance

15,000

Expense

Voucher Installation

60,000

Testing

35,000

Damages Sales tax Shutdown Total cost

40,000 500,000 (45,000) $5,887,000

40,000

Justification Record amount paid as actual amount. Choice; could deduct from cost of machine or record as contra expense or revenue on income statement. Cost essential to put machine in working order. Cost essential to put machine in working order. Ignore. Reduce cost of next machine if/when acquired. Cost essential to put machine in working order. Cost essential to put machine in working order. Expense as has no future benefit. Only restores asset to original working condition Cost essential to put machine in working order. Subtract rebate as part of same event. Ignore opportunity costs.

. 8-1

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P8-2. Suggested solution:

Item ($000’s) Land Agent fee Title search Rezoning fee

Land $10,000 50 40

Site develop ment

Expense

$100

Unexpired property taxes

$30

Additional property taxes Demolition

Salvage proceeds Landscaping Entertainment

Part of cost of getting land ready for intended use. Offset/recovery of demolition costs.

(15) 200

Management salaries Advertising

10 5 35

Field maintenance

Consulting fee

Fence Total

$10,165

Justification Clearly cost of land. Essential cost to acquire land. Essential cost to acquire land. Rezoning creates value and consistent with corporate strategy. Expense as there is no clearly defined plan to actually build warehouse. Could be a matter for professional judgment. Same reason as unexpired taxes.

55 $355

$195

. 8-2

Part of rezoning plan. Benefit too remote and indirect relative to potential warehouse. Benefit too remote and indirect. General operating cost, part of normal operations Maintenance cost. Possible to argue for capitalization. Matter for professional judgment. General operating expense, part of normal operations

Chapter 8: Property, Plant, and Equipment

P8-3. Suggested solution: Item ($000’s) Contract price Changes and overruns Bidding legal fees Feasibility study President’s salary Drawings for abandoned project Carrying amount of demolished building Demolition costs Injured worker suit Interest Lost income Advertising Legal fee regarding challenges Property taxes while under construction Property taxes after construction finished Donated land

Factory Expense Justification $25,000 Direct cost of factory. 1,000 Part of construction process. 50 Essential cost to build factory. 100 Essential cost to build factory. 125 Part of normal operations. Cannot be directly traced. 200 Made mistake. These drawings have no future value to company. 750 Change in plans. As intent has changed, cannot add cost of mistake to new plan and project. 95 Part of cost of getting site ready. Unintended cost without future benefit. 300 Unintended and unexpected cost. No future benefit 350 Essential cost to build factory. Ignore Ignores opportunity costs. 40 Period or operating cost, no future benefit 125 Legal fees directly related to bringing the project to completion. Could be a matter for professional judgement. 110 Direct cost associated with construction project. 35 Factory usable; this is an inefficiency. Inefficiencies cannot be capitalized as they create no future benefit. 1,000 Essential cost to build factory. Alternatively, could leave in land account. (Matter for professional judgment.) $27,735 $1,545

. 8-3

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P8-4. Suggested solution:

Dr. Building (50K + 50K + 70K) Dr. Land (initial purchase cost) Dr. Land (cost of demolition) Cr. Land (proceeds of demolition) Dr. Land (for legal costs) Dr. Building (legal costs) Dr. Building (insurance: 3/12 months × $2,700) Dr. Building (plant superintendent) Dr. Land improvement (a depreciable asset) Dr. Organization costs (an intangible asset) Dr. Prepaid insurance (3/12 months × $2,700) Dr. Insurance expense (6/12 months × $2,700) Dr. Salaries expense (president) Dr. Retained earnings (reversal of write-up) Cr. Depreciation expense (reversal) Cr. Land and factory building Dr. Depreciation expense (correct amount of depreciation) Cr. Accumulated depreciation (see below)

Debit 170,000 220,000 9,000

Credit

3,000 1,300 1,500 675 4,400 5,500 700 675 1,350 20,000 23,500 18,224 437,376 4,414 4,414

Building cost = 170,000 + 1,500 + 675 + 4,400 = 176,575 Depreciation expense (6 months) = ½ × 5% × 176,575 = $4,414 Depreciation should also be recorded for the land improvements but there is insufficient information available for the computation. P8-5. Suggested solution: a. The relevant costs would be the cost of the additional materials of $1,000,000 and $300,000 in incremental hiring costs ($700,000 − $400,000), for a total of $1,300,000. b. Additional materials ($1,000,000), salaries paid to workers ($700,000), plus allocated fixed costs ($75,000) for a total cost of $1,775,000. c. Net income will increase by $475,000 ($400,000 + $75,000).

. 8-4

Chapter 8: Property, Plant, and Equipment

P8-6. Suggested solution: a. $45,000,000/2 × 6% = $1,350,000. The question says the company financed Building B by borrowing the $45,000,000 evenly over the year (i.e., zero at the beginning of the year and increasing to $45,000,000 by the end of the year). Since the total amount $45,000,000 was not borrowed at the beginning of the year, we cannot apply the annual interest rate to the total amount to get the interest cost on the loan. Instead, the solution takes the average of the loan [ (Beg. Balance + End. Balance)/2 = (0+45,000,000)/2] and use the average loan throughout the year to calculate the interest cost. b. Annual depreciation expense—Building A: $45,000,000 / 20 = $2,250,000. Annual depreciation expense—Building B: $46,350,000 / 20 = $2,317,500. c. Conceptually, interest cost is as much an essential cost of a self-constructed asset as the concrete and steel. Without the financing, the construction would not have occurred. The benefit of the interest expenditure on the debt used to finance the asset is realized over the period of time when the completed asset is used. Expensing immediately results in poor matching of expense with the realization of the benefit of the expenditure (which is the finished self-constructed asset). Therefore, this cost should be added to the cost of the selfconstructed asset and expensed via an increased depreciation expense. Further, there is a cost of funds regardless of whether those funds derive from debt or equity--if the construction of the asset were outsourced, the contractor would have included its cost of financing the project as part of the contracted price. Requiring the capitalization of only debt financing cost reduces management discretion, but leads to results that differ depending on a company’s capital structure and method of PPE acquisition (self-construction vs. contracting out), so the effect on comparability is unclear. ASPE’s approach of allowing different interest capitalization policies recognizes the difficulty in specifying a uniform requirement. d. Interest costs may be capitalized only during the construction period because once construction is completed there is no logistical reason why the owner of the asset cannot start to generate revenues or cost savings from the use of the asset. While under construction it is impossible to generate a benefit from the asset, and this is the condition that permits capitalization. Once construction is completed there is no impediment to delay the matching of expense to revenues as the item is available for use. Therefore, after completion of the construction process, interest is a period cost, not a product cost. P8-7. Suggested solution: a. Although the expenditures for the construction project came from the company’s internal funds, the company had significant debt outstanding, so there is interest attributable to the construction project. The warehouse was ready for its intended use on the completion date of October 31, 2024, so interest capitalization ceases at that date (not the later date of January 1, 2025 when the company started using the facility). The amount of debt exceeds the cost of the project, so we need not be concerned about the cap on the amount of interest capitalized.

. 8-5

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Payment date May 31, 2023 July 31, 2023 Sep. 30, 2023 Nov 30, 2024 Jun. 30, 2024 Aug. 31, 2024 Oct. 31, 2024 Total

Amount $ 900,000 700,000 700,000 700,000 800,000 800,000 400,000 $5,000,000

× annual interest rate 8% 8% 8% 8% 8% 8% 8%

× length of time to completion date 17/12 years 15/12 years 13/12 years 11/12 years 4/12 years 2/12 years 0/12 years

= Interest directly attributable to construction $102,000 70,000 60,667 51,333 21,333 10,667 0 $316,000

b. Under ASPE, the company can choose any interest capitalization policy as long as it discloses that policy. Therefore, the amount of interest capitalized can be as low as zero or as much as $316,000 as computed in part (a). P8-8. Suggested solution: The borrowing cost attributable to the renovation project comes from two sources: the $500,000 short-term loan obtained specifically for the project and the $300,000 from existing debt. For the project-specific debt, the borrowing costs begin accumulating on May 1, 2023, when the bank advanced the funds and renovations started, reduced by investment income. Interest capitalization ceases when the renovations were complete on October 31, 2023.

Financing source Renovation loan Less investment income Existing debt Existing debt Total

Payment date May 1, 2023

Amount $ 500,000

Sep. 30, 2023 Oct. 31, 2023

200,000 100,000 $800,000

× annual interest rate 6%

× length of time to completio n date 6/12 years

9% 9%

1/12 years 0/12 years

= Interest directly attributable to construction $15,000 (6,000) 1,500 0 $10,500

P8-9. Suggested solution: Case A: As this expenditure is a regular and recurring cost associated with this asset lasting its full useful life of 15 years, it should be expensed. Further, this cost is anticipated and expected as the asset is being depreciated over 15 years, which assumes regular replacement of this part. Dr. Maintenance expense 750,000 Cr. Cash 750,000

. 8-6

Chapter 8: Property, Plant, and Equipment

Case B: This expenditure is anticipated and considered essential for the machine to last 15 years. However, as Part #45 is set up separately as a PPE asset and depreciated over the part’s useful life of three years, a new Part #45 may be capitalized and the older part removed from the accounts. To derecognize old part Dr. Accumulated depreciation – Part #45 650,000 Cr. PPE – Part #45 650,000 To capitalize new part Dr. PPE – Part #45 Cash

750,000

Case C: That portion of the expenditure that increases the service potential of the PPE can be capitalized. The first $100,000 is recurring maintenance. Note that for the current and future years a remaining useful life of five years should be used to determine depreciation expense. Dr. PPE – new part 75,000 Dr. Maintenance expense 100,000 Cr. Cash 175,000 Case D: The self-unloading feature is an asset as it will save the company money in the future. However, the value of the asset cannot exceed the amount of this future benefit (which is $300,000, 6 × $50,000). Any amount spent above this amount must be expensed. Dr. PPE – unloader for earth mover 300,000 Dr. Maintenance expense 100,000 Cr. Cash 400,000 Case E: The entire cost of the energy-efficiency engine is an asset. However, the old engine must be removed from the accounts. The old motor is one-third of the cost of the truck (1/3 of $300,000 = $100,000) and 40% depreciated (40% × $100,000 = $40,000). The disposal of the old engine gives rise to a $60,000 loss, but the new engine can be entirely capitalized. To derecognize old engine Dr. Loss on engine disposal 60,000 Dr. Accumulated depreciation – truck (engine) 40,000 Cr. PPE – truck (engine) 100,000 To capitalize new engine cost Dr. Truck engine Cr. Cash

140,000

Case F: The oil change and tire rotation are considered regular repairs and maintenance. The satellite receiver can be classified as an asset as it is expected to generate additional rentals of the vehicle. The advertising to promote the satellite feature is a normal operating cost and should be expensed. Dr. PPE – satellite radio 1,500,000 Dr. Maintenance expense 6,000,000 Dr. Advertising expense 2,500,000 Cr. Cash 10,000,000 . 8-7

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P8-10. Suggested solution: Case A: As this expenditure is a regular and recurring cost associated with this asset lasting its full useful life of 15 years, it should be expensed. Further, this cost does not improve the quantity or quality of the machine or its output, so it is not a betterment. Dr. Maintenance expense 750,000 Cr. Cash 750,000 Case B: Since this part was initially recognized as a separate asset, when it is replaced, the old asset must be derecognized and a new asset established. To derecognize old part Dr. Accumulated depreciation – Part #45 650,000 Cr. PPE – Part #45 650,000 To capitalize new part Dr. PPE – Part #45 Cr. Cash

750,000

Case C: This expenditure would be considered to be a betterment because it extends the useful life of the machine by two years. As a betterment, the expenditure can be capitalized. Dr. PPE – betterment 175,000 Cr. Cash 175,000 Case D: The self-unloading feature can be either recorded as a separate asset or as a betterment as it will save the company money in the future. However, the value of the asset cannot exceed the amount of this future benefit (which is $300,000, 6 × $50,000). Any amount spent above this amount must be expensed. Dr. PPE – unloader for earth mover or betterment 300,000 Dr. Maintenance expense 100,000 Cr. Cash 400,000 Case E: The energy-efficient engine is a betterment and should be capitalized. While the old engine had not been identified as a separate component, it should still be derecognized by using management’s best estimate. The old motor is one-third of the cost of the truck (1/3 of $300,000 = $100,000) and 40% depreciated (40% × $100,000 = $40,000). The disposal of the old engine gives rise to a $60,000 loss, but the new engine can be entirely capitalized. To derecognize old engine Dr. Loss on engine disposal 60,000 Dr. Accumulated depreciation – truck (engine) 40,000 Cr. PPE – truck (engine) 100,000 To capitalize new engine cost Dr. Truck engine Cr. Cash

140,000

. 8-8

140,000

Chapter 8: Property, Plant, and Equipment

4,000,000

b. The rust-proofing has future benefits and therefore the cost can be capitalized into PPE. Note that the opportunity cost of lost revenue is not recorded: Dr. PPE - Trucks 3,500,000 Cr. Cash 3,500,000 c. The parcel tracking system has future benefits and therefore it can be capitalized into PPE: Dr. PPE – Parcel tracking system 5,000,000 Cr. Cash 5,000,000 d. All of these costs can be capitalized with the exception of interest, which can be partially capitalized to the date of construction completion: Dr. Land 5,000,000 Dr. Building (for materials) 15,000,000 Dr. Building (for labour) 20,000,000 Dr. Building (for project supervision) 1,200,000 Dr. Building (for construction insurance) 400,000 Dr. Building (interest capitalized) 1,400,000 May to Nov: 7/8 × 1.6m Dr. Interest expense (December: 1/8× 1.6m) 200,000 Cr. Cash 43,200,000

. 8-9

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P8-12. Suggested solution: a. These expenses are repairs and maintenance: Dr. Maintenance expense Cr. Cash

4,000,000

b. The rust-proofing has future benefits and therefore the cost can be capitalized into PPE. Note that the opportunity cost of lost revenue is not recorded: Dr. PPE – Trucks (betterment) 3,500,000 Cr. Cash 3,500,000 c. The parcel tracking system has future benefits and therefore it can be capitalized into PPE: Dr. PPE – Parcel tracking system 5,000,000 Cr. Cash 5,000,000 d. All of these costs can be capitalized with the exception of interest, which can be partially capitalized to the date of construction completion: Dr. Land 5,000,000 Dr. Building (for materials) 15,000,000 Dr. Building (for labour) 20,000,000 Dr. Building (for project supervision) 1,200,000 Dr. Building (for construction insurance) 400,000 Dr. Building (interest capitalized) 1,400,000 May to Nov: 7/8 × 1.6m Dr. Interest expense (December: 1/8× 1.6m) 200,000 Cr. Cash 43,200,000 P8-13. Suggested solution: a

PV (site restoration costs) = $2,000,000 / 1.0810 = $2,000,000 / 2.158925 = $926,387.

Or using a BAII PLUS financial calculator: 10 N, 8.0 I/Y, 2,000,000 FV, CPT PV = –926,387 (rounded) b. Annual depreciation = $926,387 / 10 years = $92,639. c. Interest 1st year = $926,387 × 8% = $74,111. Balance of obligation at end of 1st year = $926,387 + $74,111 = $1,000,498. Interest 2nd year = $1,000,498 × 8% = $80,040. Alternatively, interest 2nd year = $74,111 × 1.08 = $80,040. P8-14. Suggested solution: a

PV (site restoration costs) = $52,000,000 / 1.1032 = $52,000,000 / 21.11378 = $2,462,847. Or using a BAII PLUS financial calculator: 32 N, 10.0 I/Y, 52,000,000 FV, CPT PV = –2,462,847 (rounded)

. 8-10

Chapter 8: Property, Plant, and Equipment

b. Depr (2024) = $0 Depr (2025) = $0 Depr (2026) = $2,462,847 / 30 years = $82,095 Depreciation on the site restoration costs will be zero for the years ending March 31, 2024 and 2025 because depreciation should commence when the mine begins production, in the spring of 2025. c. Schedule of interest accruing on site restoration liability. Interest expense = opening obligation × Year # Year ending March 31 interest rate Opening balance 1 2024 $246,285 2 2025 270,913 3 2026 298,004 4 2027 327,805 5 2028 360,585 6 2029 396,644 7 2030 436,308 8 2031 479,939 9 2032 527,933 10 2033 580,726 11 2034 638,799 12 2035 702,679 13 2036 772,947 14 2037 850,242 15 2038 935,266 16 2039 1,028,792 17 2040 1,131,672 18 2041 1,244,839 19 2042 1,369,323 20 2043 1,506,255 21 2044 1,656,880 22 2045 1,822,568 23 2046 2,004,825 24 2047 2,205,308 25 2048 2,425,838 26 2049 2,668,422 27 2050 2,935,264 28 2051 3,228,791 29 2052 3,551,670 30 2053 3,906,837 31 2054 4,297,521 32 2055 4,727,273 Total $49,537,153

. 8-11

End-of-year balance of obligation for future site restoration $2,462,847 2,709,132 2,980,045 3,278,049 3,605,854 3,966,440 4,363,084 4,799,392 5,279,331 5,807,264 6,387,991 7,026,790 7,729,469 8,502,416 9,352,657 10,287,923 11,316,715 12,448,387 13,693,225 15,062,548 16,568,803 18,225,683 20,048,251 22,053,076 24,258,384 26,684,222 29,352,644 32,287,909 35,516,700 39,068,370 42,975,207 47,272,727 52,000,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

d. Journal entries for fiscal years ending 2024, 2025, and 2026: 2023 Apr Dr. Mine site restoration cost Cr. Obligation for future site restoration cost 2024 Mar Dr. Interest expense Cr. Obligation for future site restoration 2025 Mar Dr. Interest expense Cr. Obligation for future site restoration 2026 Mar

2,462,847

246,285

270,193

Dr. Interest expense Cr. Obligation for future site restoration

298,004

Dr. Depreciation expense Cr. Accum. depr – mine site restoration costs

82,095

270,913 298,004 82,095

P8-15. Suggested solution: a. Journal entries for transactions i. to vi. Dr. Ski lift Cr. Cash Dr. Ski chalet Cr. Cash Dr. Land improvement (site clearance: $40m – $10m) Cr. Cash Dr. Roads Cr. Cash Dr. Parking lot Cr. Cash

150,000,000 70,000,000 30,000,000 50,000,000 10,000,000

b. Journal entry for transaction vii. Total cost to restore site at the end of 20 years = $20m + $15m + $5m + $3m = $43m Present value of $43m due in 20 years at 6% = $43,000,000 / 1.0620 = 13,407,603. Or using a BAII PLUS financial calculator: 20 N, 6.0 I/Y, 43,000,000 FV, CPT PV = – 13,407,603 (rounded) Note that the $4 million scrap metal value of the lifts would be part of the salvage value of the lifts, and should not be counted again as an offset to site restoration costs: Dr. Site restoration cost 13,407,603 Cr. Obligation for future site restoration 13,407,603

. 8-12

Chapter 8: Property, Plant, and Equipment

c. Year-end journal entries for first year of operations: Dr. Depreciation expense ((150m − 4m) / 20) Cr. Accumulated depreciation − ski lifts Dr. Depreciation expense (70m / 20) Cr. Accumulated depreciation − ski chalet Dr. Depreciation expense (30m / 20) Cr. Accumulated depreciation − land improvement Dr. Depreciation expense (50m / 20) Cr. Accumulated depreciation − roads Dr. Depreciation expense (10m / 20) Cr. Accumulated depreciation − parking lot Dr. Depreciation expense (13,407,603 / 20) Cr. Accumulated depreciation − site restoration Dr. Interest expense (13,407,603 × 6%) Cr. Obligation for future site restoration

7,300,000 3,500,000 1,500,000 2,500,000 500,000 670,380 804,456

d. The only entries that would differ for the second and third year would be the Interest Expense accrual. Where the straight-line method is used, the depreciation charge would remain the same. Year 2 Dr. Interest expense (13,407,603 + 804,456) × 6% 852,724 Cr. Obligation for future site restoration 852,724 Year 3 Dr. Interest expense (13,407,603 × 1.062) × 6% Cr. Obligation for future site restoration

903,887

e. Balance sheet presentation of accounts involved, end of Year 3: Cost Accumulated depreciation Property, plant, and equipment Ski lift $150,000,000 $21,900,000 Ski chalet 70,000,000 10,500,000 Land improvement 30,000,000 4,500,000 Roads 50,000,000 7,500,000 Parking lot 10,000,000 1,500,000 Site restoration costs 13,407,603 2,011,140 Total $323,407,603 $47,911,140 Long-term liabilities Obligation for future site restoration

903,887 Net carrying amount $128,100,000 59,500,000 25,500,000 42,500,000 8,500,000 11,396,463 $275,496,463 $15,968,670*

*$13,407,603 × 1.063 = $15,968,670

. 8-13

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

f. Journal entry for site restoration at end of project: Dr. Obligation for future site restoration 43,000,000 Cr. Cash 43,000,000 g. The total expense relating to site restoration is the sum of depreciation and interest on the site restoration costs, as follows: Interest expense accrual Depreciation of site on obligation for future Total expense relating to Year restoration costs site restoration site restoration 1 $670,380 804,456 $1,474,836 2 670,380 852,724 1,523,104 20 670,380 2,433,963* 3,104,343 * Obligation for site restoration at beginning of Year 20 = $43,000,000 / 1.06 = $40,566,038 Interest on obligation = $40,566,038 × 6% = $2,433,963 P8-16. Suggested solution: PPE category Land Building Moving equipment HVAC system Total

Appraised value $28,000,000 21,000,000 4,000,000 3,000,000 $56,000,000

Fraction of total appraised value 28/56 21/56 4/56

×Total price 50,000,000 50,000,000 50,000,000

= Allocated price $25,000,000 18,750,000 3,571,429

3/56

50,000,000

2,678,571 $50,000,000

P8-17. Suggested solution: Appraised value $5,600,000 6,500,000

Fraction of total appraised value 5.6/15.4 6.5/15.4

PPE category × Total price = Allocated price Land $15,000,000 $5,454,545 Building 15,000,000 6,331,169 Computer network system 0 — — — Elevator system 2,400,000 2.4/15.4 15,000,000 2,337,663 Landscaping and site improvements 900,000 0.9/15.4 15,000,000 876,623 Total $15,400,000 $15,000,000 Since the company has no intention of using the existing computer network system, it will be ignored in the price allocation process.

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Chapter 8: Property, Plant, and Equipment

P8-18. Suggested solution:

PPE category Machine A Machine B Machine C Total

Intended use Operate Spare parts Scrap

Fraction of total appraised value 3.0/10.5 5.0/10.5 2.5/10.5

Appraised value in optimal use $3,000,000 5,000,000 2,500,000 $10,500,000

Total price $10,000,000 10,000,000 10,000,000

Allocated price $2,857,143 4,761,905 2,380,952 $10,000,000

P8-19. Suggested solution: Costs to be allocated Cost of purchase excluding taxes Refundable taxes Non-refundable taxes Legal fees Freight

PPE category Production equipment Motor vehicles Computers Furniture Total

$7,000,000 Exclude 220,000 50,000 20,000 $7,290,000

Estimated fair Fraction of total market value FMV $4,000,000 4 / 7.5 2,000,000 500,000 1,000,000 $7,500,000

2 / 7.5 0.5 / 7.5 1 / 7.5

× Costs to be allocated $7,290,000

= Allocated costs $3,888,000

7,290,000 7,290,000 7,290,000

1,944,000 486,000 972,000 $7,290,000

P8-20. Suggested solution: a. Cost Purchase price Customs duty Provincial sales tax (non-refundable tax) Goods and services tax (refundable tax)1 Freight in One-year insurance policy on excavator purchased February 1. The policy covered damage in transit and in use.2 Training costs of operator3 Historical cost base 1

Amount Include? $ 90,000 $ 90,000 10,000 10,000 7,000 7,000 5,000 0 4,000 4,000 6,000 1,000 3,000 0 $125,000 $112,000

Refundable taxes are not included in the asset’s cost base as they will be recovered from the taxation authority.

. 8-15

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition 2

One sixth of the insurance expense is included in the asset’s cost base, as the coverage for the months of February and March was to insure the asset while it was in transit, and hence getting it ready for its intended use. The balance of the policy relates to coverage while the excavator was ready for use, which is an operating expense. 3 Training costs are excluded from the cost base as they are not a cost of getting the asset ready for its intended use. Rather, the training costs benefit the employee who may or may not continue to work for BEC. Part b. Dr. Depreciation expense Cr. Accumulated depreciation

7,650

($112,000 - $10,000) / 20,000 hours = $5.10 per hour; 1,500 hours used × $5.10 per hour = $7,650 P8-21. Suggested solution: Part a. As identified in the question, the market rate of interest for similar transactions is 0.4% per month (4.8%/12 = 0.4%). Value of payments $5,000 × PVFA(0.4%, 24) = $5,000 × 22.840501 114,203 Alternatively, the present value of the consideration given up can be determined using a BAII PLUS financial calculator: 24 N, 0.4 I/Y, 5,000 PMT, CPT PV  PV = –114,203 (rounded). The cost base of the system is $114,203 (note payable) + $6,000 ($8,000 total taxes - $2,000 refundable taxes) + $7,000 (electrical costs) = $127,203. A receivable must be established for the refundable taxes and the training costs must be expensed, as they are not a cost of getting the asset ready for its intended use. Rather, the training costs benefit the employees, who may leave the organization at some point. Dr. Entertainment system Dr. Training expense Dr. Refundable taxes receivable Cr. Notes payable (from above) Cr. Cash ($8,000 taxes + $7,000 electrical + $6,000 training)

127,203 6,000 2,000

114,203 21,000

Part b. Dr. Depreciation expense 21,201 Cr. Accumulated depreciation 21,201 $127,203 / 6 = $21,201; MMC’s policy is to record a full year’s depreciation in the year of acquisition.

. 8-16

Chapter 8: Property, Plant, and Equipment

P8-22. Suggested solution: Part a. As identified in the question, the market rate of interest for similar transactions is 0.5% per month (6%/12 = 0.5%). The present value of the consideration given up and hence the purchase price under the three options is: Option i. Option ii. Option iii.

$400,000 $394,452 $397,213

Option ii.  PVFA(0.5%, 36) = (1/0.005) × (1 – (1/(1.00536)) = 32.8710  Payments = $43,200/36 = $1,200  PV of the note = $12,000 × PVFA(0.5%, 36) = $12,000 x 32.8710 = $394,452 Using a BAII PLUS financial calculator:  36 N, 0.50 I/Y, 12,000 PMT, CPT PV  PV = –394,452 (rounded) Option iii.  PVFA(0.75%, 36) = (1/0.0075) × (1 – (1/(1.007536)) = 31.4468  Required payment = $380,000/31.4468 = 12,084 (rounded)  PV of the note = $12,084 × PVFA(0.5%, 36) = $12,084 x 32.8710 = $397,213 (rounded) Using a BAII PLUS financial calculator:  36 N, 0.75 I/Y, +|- 380,000 PV, CPT PMT  PMT = 12,084 (rounded)  36 N, 0.5 I/Y, 12,084 PMT, CPT PV  PV = –397,213 (rounded) The best offer is option ii as the company can acquire the equipment for a cash equivalent price of $394,452. Part b. Dr. Machinery Cr. Notes payable

397,213

Part c. Dr. Depreciation expense 39,723 Cr. Accumulated depreciation 39,723 The straight-line rate would be 1/10 = 10%, so the double declining balance rate is 20%. Depreciation = $397,2131 × 20% × 6/122 = $39,723. 1 Note that when the declining balance method is used that the residual value is not directly considered in the calculation until the final year of depreciation. Rather, it establishes the minimum amount at which the asset should be reported on the financial statements. 2 Depreciation commences when the asset is first ready for use, rather than when it was actually received or used. In this instance that was July 1.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P8-23. Suggested solution: *

* *

First, PPE are assets. All assets have three qualities: (1) future benefits; (2) controlled by the entity; and (3) the result of past transactions or events. The first, most important, and most challenging of these qualities for PPE is to establish that the expenditure (outflow of cash) does cause the entity to experience a benefit or reward that will occur in later periods. These future economic benefits are realized in three different ways: (1) by directly causing or enhancing a revenue inflow—for example, buying a machine which makes a product that can be sold; (2) by directly allowing the entity to avoid a future expense or cash outflow—for example, buying a head office building so the company does not have to rent a premises; (3) by indirectly assisting the firm in generating revenue or a cash inflow—for example, buying a warehouse or retail outlet to store or display goods from which they are subsequently sold. The difficulty is to objectively and logically prove there is a connection behind the expenditure and a later future economic benefit. Second, the delay in the realization of the future benefit is over several fiscal periods. As PPE are non-current assets, it must be shown that several periods enjoy the reward of this expenditure by increased cash inflows or reduced cash outflows. Third is the matching concept. This perspective is the reverse of the first point. A future economic benefit implies that at some later point in time the benefit will be experienced. When this occurs, the expenditure should be expensed to merge or match the recognition of the benefit such that the appropriate income is determined. The method of subsequent allocation of the PPE to expense must be systematic, logical, and supportable by objective evidence and estimates. Fourth, if the expenditure relates to PPE, the object of the cash outflow must be tangible and have physical substance. You must be able to touch whatever was purchased (in contrast to intangible assets). Finally, the estimation of the future economic benefit must be reasonably assured. Hoping for a future economic benefit is not a sufficient or useful justification for capitalizing expenditure. The facts and circumstances surrounding the expenditure must afford management a reasonable basis to justify and quantify that the corporation will receive a future cash inflow or avoid a cash outflow that exceeds the cost being capitalized. The presumption is that the expenditure is an expense unless justification to the contrary can be supplied by management, and the auditor convinced of the soundness of management’s arguments.

P8-24. Suggested solution: First reason: Depreciation expense is not a process of asset valuation; rather, it is a process of cost allocation. Restated, the process of recording depreciation does not seek to value the longlived asset at its current or fair value; rather, it is an attempt to assign the cost of the asset (future benefit) to expense as the asset’s benefit is consumed. Second reason: Depreciation expense is the matching of the cost of the asset (future benefit) with the period when the future benefit is realized. Plant and equipment are classified as assets as they represent future service potential, when that service potential is utilized in the process of generating income. The depreciation process seeks to match the cost of the asset with the benefit . 8-18

Chapter 8: Property, Plant, and Equipment

realized in the form of revenue or cost savings. As such it is consistent with the underlying economic logic of the investment process. Few would argue that when a long-lived asset is acquired, that the asset’s cost should be immediately expensed. Most would suggest that the cost of the asset should be spread over the period when the asset is used, and this is what the depreciation process does. Third reason: One must be cautious in identifying which component of PPE increases in value. In real estate, it is usually the value of land that is increasing, not the value of the building. Financial accounting does not depreciate land. This raises another question as to whether increases in the value of land should be recognized, but this is different from the process of recording depreciation. Fourth reason: As we learned all too painfully, what goes up often comes down. Run-ups in asset prices often reverse, as they did in 2008 in spectacular fashion. Those who advocate not recording depreciation are suggesting that when PPE goes up in value, this increase should be recorded as income. Following this logic, when asset prices fall this decline should also be recorded. By not recording depreciation and rather recognizing the appreciation or depreciation of an asset’s fair market or current value, net income will become more volatile. Increased earnings volatility can increase a user’s risk perceptions, and likely result in lower firm valuations. (Chapter 10 will visit this interesting issue on revaluations in greater detail.) P8-25. Suggested solution: Building: The straight-line method most closely matches the loss in benefit as it is weather and the passage of time that causes buildings to lose usefulness. Factory equipment: The units-of-production method most closely matches the realization of the future benefit of these assets, as it is in their use that they create value. The machine produces goods which are sold for a profit, so it seems reasonable that an essential cost incurred in the production of the item, the depreciation of the cost of the machine used to make the product, should be included in its cost. Further, if no goods or more or fewer goods are produced it would be appropriate to adjust the aggregate depreciation charge in that period to match production levels. In this way the per unit depreciation charge would remain stable. Computers: The declining balance method is most appropriate as this method charges more depreciation expense in the earlier periods, with the charge declining over time. This resembles the realization of the benefit of the computer (or other higher technology items) in that its competitive advantage and novelty is most beneficial in the earlier periods of its adoption. As we know all too well with personal computers, what was fast and state-of-the-art a year ago may now be outdated or obsolete. Computers and other technology-related products lose their value quickly. While depreciation does not seek to value items, it should not be blind or indifferent to what is actually happening.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P8-26. Suggested solution: The office should be depreciated for six months. On June 30, the building had remaining useful life of 9.5 years. Therefore, depreciation = $95,000 / 9.5 years × 6/12 = $5,000, so income before tax would decrease by this amount. P8-27. Suggested solution: Since the company uses the straight-line method and there are no changes in assumptions, the depreciation is the same for each year of the assets’ useful lives. Annual Item depreciation Calculation Lathe $542,857 (4,000,000 – 200,000) / 7 Building $1,225,000 (25,000,000 – 500,000) / 20 Earth-moving truck $105,000 (700,000 – 70,000) / 6 Electric turbine $620,000 (7,000,000 – 800,000) / 10 Stamping machine $777,778 (10,000,000 – 3,000,000) / 9 P8-28. Suggested solution: The straight-line rate would be 1/8 = 12.5%, so the double declining balance rate is 25%. Depreciation = $30,000 × 25% × 9/12 = $5,625.

. 8-20

Chapter 8: Property, Plant, and Equipment

P8-29. Suggested solution: a. To facilitate calculation, you should note that the carrying amount at the end of a year equals Cost × (1 – DB rate)t. For example, with cost of $100 and a DB rate of 10%, the carrying amount at the end of Year 1 is $100 × 0.9 = $90. At the end of Year 2, it is $100 × 0.92 = $81. Item Year 1 Year 3 Year 5 Final year 4 Lathe 4,000,000 × 4,000,000 × 4,000,000 × (5/7) × Year 7: 4,000,000 × (5/7)6 × 2/7 = (5/7)2 × 2/7 2/7 = 2/7 = $1,142,857 = $297,495 531,241 × 2/7 = $583,090 $151,783 Building 25,000,000 25,000,000 25,000,000 × Year 20: 25,000,000 × × 2/20 = × (18/20)2 × (18/20)4 × 2/20 = (18/20)19 × 2/20 = $2,500,000 2/20 = $1,640,250 3,377,129 × 2/20 = $337,713 $2,025,000 Earth700,000 × 700,000 × 700,000 × (4/6)4 × Year 6: 700,000 × (4/6)5 × 2/6 moving 2/6 = (4/6)2 × 2/6 2/6 = = 92,181× 2/6 = 30,727 but truck $233,333 = $46,091 this would reduce carrying $103,704 amount below residual value of $70,000; therefore, only record $22,181 (= 92,181 – 70,000) Electric 7,000,000 × 7,000,000 × 7,000,000 × (8/10)4 Year 10: 7,000,000 × (8/10)9 × turbine 2/10 = (8/10)2 × × 2/10 = 2/10 = $1,400,000 2/10 = = $573,440 939,524 × 2/10 = 187,905 but $896,000 this would reduce carrying amount below residual value of $800,000; therefore, only record $139,524 (= 939,524 – 800,000) Stamping 10,000,000 10,000,000 10,000,000 × (7/9)4 N/A as carrying amount 2 machine × 2/9 = × (7/9) × × 2/9 = 3,659,503 × already reduced to residual $2,222,222 2/9 = 2/9 = value in Year 5. $1,344,307 813,223 but this would reduce carrying amount below residual value of $3,000,000; therefore, only record $659,503 (=3,659,503 – 3,000,000)

. 8-21

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

b. If the assets are sold at their estimated residual value, the following journal entries would be recorded. Per part (a), all except the lathe and the building have been fully depreciated down to their residual values. Lathe Dr. Cash 200,000 Dr. Loss on disposal [plug] 179,458 Dr. Accumulated depreciation – lathe 3,620,542 [4,000,000 – 4,000,000 × (5/7)7] Cr. Lathe 4,000,000 Building

Truck

Turbine

Machine

Dr. Cash Dr. Accumulated depreciation – building [25,000,000 – 25,000,000 × (18/20)20] Dr. Loss on disposal of building Cr. Building

500,000 21,960,584 2,539,416

Dr. Cash Dr. Accumulated depreciation – truck Cr. Earth-moving truck

70,000 630,000

Dr. Cash Dr. Accumulated depreciation – turbine Cr. Electric turbine

800,000 6,200,000

Dr. Cash Dr. Accumulated depreciation – stamping machine Cr. Stamping machine

3,000,000 7,000,000

25,000,000

700,000

7,000,000

10,000,000

P8-30. Suggested solution: Machine cost Residual value Depreciable amount Estimated total hours Depreciation per hour Hours used in the year Depreciation for the year

$200,000 20,000 180,000 ÷ 20,000 hours $9/hour ×2,920 hours $26,280

. 8-22

Chapter 8: Property, Plant, and Equipment

P8-31. Suggested solution: Cost Estimated residual value Depreciable amount Estimated total units Depreciation rate per unit

Machine A $9,000,000 – 600,000 8,400,000 ÷ 6,000,000 units $1.40 / unit

Machine B $1,400,000 – 90,000 1,310,000 ÷500,000 units $2.62 / unit

Machine C $2,400,000 – 300,000 2,100,000 ÷1,400,000 units $1.50 / unit

Actual production – Year 1 Depreciation rate per unit Depreciation – Year 1

750,000 units $1.40 / unit $1,050,000

25,000 units $2.62 / unit $65,500

100,000 units $1.50 / unit $150,000

Actual production – Year 3 Depreciation rate per unit Depreciation – Year 3

600,000 units $1.40 / unit $840,000

60,000 units $2.62 / unit $157,200

100,000 units $1.50 / unit $150,000

Actual production – Year 5 Depreciation rate per unit Depreciation – Year 5

900,000 units $1.40 / unit $1,260,000

35,000 units $2.62 / unit $91,700

100,000 units $1.50 / unit $150,000

Actual production – Final year Depreciation rate per unit Depreciation – Final year

350,000 units $1.40 / unit $490,000

62,000 units $2.62 / unit $162,440

100,000 units $1.50 / unit $150,000

P8-32. Suggested solution: Depreciation base Cost Delivery Installation Testing Refundable sales taxes

$100,000 1,000 6,000 3,000 exclude $110,000

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

a. Straight-line Cost Estimated residual value Depreciable amount Estimated useful life Depreciation rate per unit

$110,000 – 4,000 106,000 ÷ 8 years $13,250 / year

Depreciation – 2023 $13,250 × 10 (months) / 12 (months)

$11,042

Depreciation – 2024

$13,250

b. Declining balance Depreciation Year rate 2023 2024

Months to be depreciated

25% 25%

10 / 12 12 / 12

Depreciation 22,917 21,771

End-of-year carrying amount $110,000 87,083 65,312

c. Units-of-production Cost Estimated residual value Depreciable amount Estimated total units Depreciation rate per unit

$110,000 – 4,000 106,000 ÷ 40,000 units $2.65 / unit

Actual production – 2023 Depreciation rate per unit Depreciation – 2023

4,000 units $2.65 / unit $10,600

Actual production – 2024 Depreciation rate per unit Depreciation – 2024

7,000 units $2.65 / unit $18,550

P8-33. Suggested solution: Case A: Straight-line depreciation 2023 Dec 31 Dr. Depreciation expense Cr. Accumulated depreciation (5,000,000 – 500,000) / 5 × 9/12

675,000

2024 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation (5,000,000 – 500,000) / 5

900,000

2028 Apr 1

Dr. Depreciation expense

225,000 . 8-24

675,000

900,000

Chapter 8: Property, Plant, and Equipment

Cr. Accumulated depreciation (5,000,000 – 500,000) / 5 × 3/12 Dr. Cash Dr. Accumulated depreciation (5 × 900,000) Cr. Machine Cr. Gain on disposal [plug] Case B: Declining balance depreciation 2023 Dec 31 Dr. Depreciation expense Cr. Accumulated depreciation 5,000,000 × 40% × 9/12 2024 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation (5,000,000 – 1,500,000) × 40%

2028 Apr 1

No depreciation Machine would have been depreciated down to residual value by 2027.

Case C: 2023 June 1

225,000 625,000 4,500,000 5,000,000 125,000 1,500,000

1,400,000

Dr. Cash Dr. Accumulated depreciation Cr. Machine Cr. Gain on disposal [plug]

625,000 4,500,000

Dr. Land Dr. Building Cr. Cash

8,800,000 7,200,000

2023 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation (7,200,000 – 600,000) / 25 × 7/12

154,000

2024 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation (7,200,000 – 600,000) / 25

264,000

2033 Sep 1

Dr. Depreciation expense Cr. Accumulated depreciation (7,200,000 – 600,000) / 25 × 8/12

176,000

Dr. Cash (25% × $21,000,000) . 8-25

5,250,000

1,500,000

1,400,000

5,000,000 125,000

16,000,000 154,000

264,000

176,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Dr. Accumulated depreciation (9 × 264,000 + 154,000 + 176,000) Cr. Building Cr. Gain on disposal of building

2,706,000

Dr. Cash (75% × $21,000,000) Cr. Land Cr. Gain on disposal of land

15,750,000

7,200,000 756,000 8,800,000 6,950,000

P8-34. Suggested solution: Depreciation (Year 3) = ($60,000 - $4,000) / 8 years = $7,000 / year; or Depreciation (Year 3) = ($60,000 - $7,000 × 2 - $4,000) / 6 years = $7,000 / year. Depreciation (Year 4) = ($60,000 - $7,000 × 3 - $2,000) / 7 years = $5,286 / year. P8-35. Suggested solution: End-of-year carrying amount 1,000,000 1 20% 200,000 800,000 2 20% 160,000 640,000 3 20% 128,000 512,000 4 20% 102,400 409,600 5 20% 81,920 327,680 6 20% 65,536 262,144 7 10% 26,214 235,930 8 10% 23,593 212,337 9 10% 12,337 200,000 10 10% 0 200,000 Note that in Year 9, depreciation at 10% would have resulted in depreciation of $21,234, which would have reduced the carrying amount below the residual value of $200,000. Therefore, the depreciation is equal to the amount that leaves the end-of-year carrying amount equal to the residual value. For the same reason, no depreciation is recorded in Year 10. Year #

Depreciation rate

Depreciation

P8-36. Suggested solution: Case A: 2023 Dec 31

2025 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation (4,000,000 – 500,000) / 8

437,500

Dr. Depreciation expense Cr. Accumulated depreciation (4,000,000 – 437,500 × 2 – 300,000) /10

282,500

. 8-26

437,500

282,500

Chapter 8: Property, Plant, and Equipment

Case B: 2023 Dec 31

2025 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation 4,000,000 × 25%

1,000,000

Dr. Depreciation expense Cr. Accumulated depreciation 4,000,000× 0.752 × 2/12

375,000

1,000,000

375,000

P8-37. Suggested solution: Case A: Straight-line method with change during 2023 2017 Dec 31 Dr. Depreciation expense Cr. Accumulated depreciation 6,000,000 / 40 2023 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation (6,000,000 – 150,000×6 – 1,000,000) /6

Case B: Declining balance with change during 2023 2017 Dec 31 Dr. Depreciation expense Cr. Accumulated depreciation 6,000,000 × 5% 2023 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation 6,000,000 × 0.956 × 2/12

150,000

683,333

300,000

735,092

150,000

683,333

300,000

735,092

P8-38. Suggested solution: Straight-line with shortened useful life and change to declining balance 2023 Dec 31 Dr. Depreciation expense 577,500 Cr. Accumulated depreciation (7,000,000 – 70,000) / 12 2028 Dec 31

Dr. Depreciation expense Cr. Accumulated depreciation (7,000,000 – 577,500 ×5) × 25%

. 8-27

1,028,125

577,500

1,028,125

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P8-39. Suggested solution: a. Cost capitalization $millions Land Compensation to indigenous peoples who have land claims in the affected area Compensation to relocate non-indigenous residents Site preparation (e.g., clearing trees from land) Total land Facilities Materials for dam (e.g., concrete, steel) Construction labour on dam Interest capitalized ($5,000 × 6% × 10 years) Total facilities

$ 300 200 100 $ 600 $2,000 1,700 3,000 $6,700

b. Depreciation $millions Facilities (straight-line): $6,700m / 100 years Transmission lines (straight-line): $200m / 40 years Power generation equipment: $500m × (1-10%)9 × 10%

$67m $ 5m $19.371m

c. Change in estimates for transmission lines from 40 to 30 years Depreciation = remaining depreciable amount / remaining useful life = ($200m – $5m × 10) / (30 years – 10 years) = $150m / 20 years = $7.5m per year d. Journal entries for initial recognition of site restoration cost Dr. Dam site restoration costs ($2,000,000,000 / 1.06100) Cr. Obligation for future site restoration e. Year 1 journal entries for site restoration cost Dr. Depreciation expense ($5,894,452 / 100) Cr. Accumulated depreciation – dam site rest. cost Dr. Interest expense ($5,894,452 × 6%) Cr. Obligation for future site restoration

5,894,452

58,945 353,667

5,894,452

58,945 353,667

P8-40. Suggested solution: a. Amount to record in land and building.

Land $100,000 30,000 4,300

Land cost Demolition of warehouse Legal fees for transfer of title Construction costs of new building . 8-28

Building

$400,000

Chapter 8: Property, Plant, and Equipment

Proceeds from salvage of warehouse materials Installation of wiring and plumbing fixtures Title guarantee insurance for fiscal year 2023 Architectural fees Total b. Straight-line depreciation: Building cost Residual value Depreciable amount Estimated total hours Depreciation per year

Prepaid expense . $130,300

16,000 24,000 $440,000

$440,000 50,000 $390,000 40 years $ 9,750

Double declining balance depreciation: Building cost Depreciation rate (2/40) Depreciation c.

(4,000)

$440,000 5% $ 22,000

Dr. Cash Dr. Accumulated depreciation (9,750 × 3.5 years) Cr. Building Cr. Land Cr. Gain on disposal [plug]

680,000 34,125

440,000 130,300 143,825

P8-41. Suggested solution: Dr. Cash Dr. Accumulated depreciation ($200,000 / 48 (months) × 32* (months) Cr. PPE – equipment Cr. Gain on disposal ($101,500 + $133,333 – $200,000)

101,500 133,333 200,000 34,833

*Purchased Feb. 2023 and destroyed Sept. 2025 – available for use two full years (24 months) and 8 additional months (Feb. – Sept. inclusive). Depreciation taken in all months when available for use. Depreciation during the period between the destruction of the equipment and receipt of the insurance settlement is not appropriate as the equipment was not available for use.

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P8-42. Suggested solution: a. Journal entry to record the derecognition of the asset on August 1, 2027—straight-line depreciation. Dr. Cash 925,000 Dr. Accumulated depreciation 1,530,000 ($2,400,000 – $600,000) / 60 (months) × 51* (months) Cr. PPE – equipment 2,400,000 Cr. Gain on disposal 55,000 ($925,000 + $1,530,000 – $2,400,000) *Brought into use in May 2023 and sold Aug. 2027 – owned four full years (48 months) and 3 additional months (May, June, & July). Depreciation not taken in month of disposition (Aug.). b. Journal entry to record the derecognition of the asset on August 1, 2027—units-ofproduction depreciation. Dr. Cash 925,000 Dr. Accumulated depreciation 1,305,000 ($2,400,000 – $600,000) / 4,000,000 (casings) × 2,900,000 (casings) Cr. PPE – equipment 2,400,000 Dr. Loss on disposal 170,000 ($2,400,000 - ($925,000 + $1,305,000)) P8-43. Suggested solution: a. Journal entry to record the derecognition of the asset in 2029—straight-line depreciation. Dr. Cash 1,700,000 Dr. Accumulated depreciation 1,277,778 (3,000,000 – 700,000) / 9 × 5 Cr. PPE – machine 3,000,000 Dr. Loss on disposal [plug] 22,222 b. Journal entry to record the derecognition of the asset in 2029—declining balance depreciation. Dr. Cash 1,700,000 Dr. Accumulated depreciation 2,146,116 5 3,000,000 – 3,000,000 × (7/9) Cr. PPE – machine 3,000,000 Cr. Gain on disposal [plug] 846,116 c. Aggregate income statement effect of using straight-line or declining balance methods. Year Expense or income Straight-line method Declining balance method 2023 Depreciation $ 0 $ 0 2024 Depreciation (255,556) a (666,667) b 2025 Depreciation (255,556) a (518,519) c . 8-30

Chapter 8: Property, Plant, and Equipment

2026 Depreciation (255,556) a 2027 Depreciation (255,556) a 2028 Depreciation (255,556) a 2029 Depreciation 0 2029 Gain (loss) on disposal (22,222) Total ($1,300,002)* a (3,000,000 – 700,000) / 9 = 255,556 b 3,000,000 × 2/9 = 666,667 c 3,000,000 × 7/9 × 2/9 = 518,519 d 3,000,000 × (7/9)2 × 2/9 = 403,292 e 3,000,000 × (7/9)3 × 2/9 = 313,672 f 3,000,000 × (7/9)4 × 2/9 = 243,967 * Should be $1,300,000; difference due to rounding.

(403,292) d (313,672) e (243,967) f 0 846,116 ($1,300,001)*

The net cash outflow is purchase price less the proceeds from sale, which equals $3,000,000 – 1,700,000 = $1,300,000. Is this a coincidence? No, it is by design. The logic/nature of the accrual process is such that the cumulative consequence of the income statement adjustments equals the net cash outflow associated with the asset. It is the purpose and goal of the allocation process to spread the consequences of transactions to multiple periods. The overall effect will be the net cash flow of the complete transaction cycle. Estimates are required, especially as to the useful life and residual value of the depreciable asset at the start of the depreciation allocation process. These estimates will cause the carrying amount to over- or understate the asset value relative to its resale price, but the accounting gain or loss upon disposal settles up this difference. P8-44. Suggested solution: a. Depreciation expense, gains or losses on disposal—straight-line method Expense or Year income Amount Supporting calculation 2023 Depreciation $0 No depreciation in year of acquisition 2024 Depreciation (1,640,000) (9,000,000 – 800,000)/5 2025 Depreciation (1,640,000) (9,000,000 – 800,000)/5 2026 Loss on disposal (720,000) (9,000,000 – 1,640,000 × 2) – 5,000,000 Total ($4,000,000) b. Depreciation expense, gains or losses on disposal—declining balance method Expense or Year income Amount Supporting calculation 2023 Depreciation $0 No depreciation in year of acquisition 2024 Depreciation (3,600,000) 9,000,000 × 40% 2025 Depreciation (2,160,000) 9,000,000 × 0.6 × 40% 2026 Gain on disposal 1,760,000 9,000,000 – 3,600,000 – 2,160,000 – 5,000,000 Total ($4,000,000)

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The cumulative effect of depreciation is directly related to the amount of gain (or loss). The higher the amount of depreciation, the larger will be the gain (or smaller the loss) on disposal. In this case, the cumulative effect of the depreciation expense and any gain or loss is $4,000,000. c. The gain is the consequence of over-depreciating the equipment in 2024 and 2025. The loss is from under-depreciating the equipment in 2024 and 2025. Gains and losses do not suggest excellent or poor management, but rather are the result of incorrect expense allocations. At best, the relative size of the gain or loss may provide some insight into senior management’s ability to make accurate estimates. d. A gain on disposal tells us that prior years’ net income should have been higher as depreciation expense was too much. A loss on disposal tells us that prior years’ net incomes were too high as depreciation expense should have been higher. What such gains and losses definitely do not tell us is the ability of management in the year the gain or loss was recorded. P8-45. Suggested solution: First reason: The most important reason for not recording depreciation expense in the year of disposal is that this amount will exactly increase any gain on disposal or reduce any loss on disposal by the same amount. The recording of depreciation will reduce the carrying amount of the asset by the amount of the expense but increase the gain (reduce any loss) by the same amount. So, by recording depreciation the net effect on net income in the year of disposal is zero; net income stays the same. Second reason: This policy makes the recordkeeping function simpler since there is one less entry to derive and record. Third reason: Many companies record a full year of depreciation expense in the year of acquisition so that not recording depreciation expense in the year of disposal balances out this accounting simplification. Fourth reason: The amount of depreciation that would be recorded is immaterial. Note that the first reason given above is exactly correct for depreciation that is expensed. There is potentially a small income effect for PPE that is used in production, because the depreciation on such PPE becomes part of inventory cost. Any inventory not sold at the end of the year would result in depreciation remaining on the balance sheet rather than expensed, so that depreciation (or lack thereof) in the year of disposal will not exactly cancel out the gain or loss on disposal. However, this effect is likely to be immaterial. P8-46. Suggested solution: a. Dr. Land ($700,000 + $40,000 + $25,000)* Cr. Cash

765,000

b. Dr. PPE – new equipment** Dr. Accumulated depreciation Cr. PPE – old equipment Cr. Gain on sale of equipment

350,000 200,000

. 8-32

765,000

500,000 50,000

Chapter 8: Property, Plant, and Equipment

c. Dr. Land ($331,213 + $50,000) 381,213 Cr, Cash 50,000 Cr. Note payable*** 331,213 Dr. Interest expense ($331,213 × 8% × 3/12) 6,624 Cr. Note payable 6,624 * The cost of the purchase is allocated entirely to land as the building was demolished, rather than being allocated to land and buildings on the basis of the appraisal. The latter approach would be valid if the company used the building, rather than tearing it down. ** Non-monetary transaction with commercial substance are valued at the fair value of the asset

given or received, whichever is more reliably measured. If both assets are measured with equal reliability, it is preferable to use the fair value of the asset given up.

*** Value of payments = $100,000 × PVFA(8.0%, 4) = $100,000 × 3.312127 = $331,213; Using a Texas Instruments BAII Plus calculator: 4 N, 8 I/Y, 100,000 PMT, CPT PVPV = 331,213 (rounded)

P8-47. Suggested solution: a.

Transaction #1: This exchange has commercial substance. The two sets of cables have different risk, timing, and amount of cash flows because they serve different markets (i.e., continents). Therefore, use fair values to record the exchange. Dr. PPE – Europe-Asia cables 410 Dr. Accumulated depreciation – North-South America 90 cables Cr. PPE – North-South America cables 300 Cr. Gain on sale of cables 180 Cr. Cash 20

Transaction #2 assuming commercial substance Dr. Cash Dr. PPE – Toronto-Montreal inland cables Dr. Accumulated depreciation – Toronto-Montreal shoreline cables Cr. PPE – Toronto-Montreal shoreline cables Cr. Gain on sale of cables

Transaction #2 assuming no commercial substance Dr. Cash Dr. PPE – Toronto-Montreal inland cables Dr. Accumulated depreciation – Toronto-Montreal shoreline cables Cr. PPE – Toronto-Montreal shoreline cables

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P8-48. Suggested solution: a. With commercial substance Dr. Cash 100,000 Dr. Accumulated depreciation – building 780,000 ($2,600,000 / 30 (years) × 9 (years)) Cr. PPE – old building Cr. Land – old Dr. Land – new (at fair market value) 6,100,000 Cr. Gain on disposal ($100,000 + $780,000 + $6,100,000) – ($2,600,000 + $1,400,000) b. Lacking commercial substance Dr. Cash Dr. Accumulated depreciation – building ($2,600,000 / 30 (years) × 9 (years)) Cr. PPE – old building Cr. Land – old Dr. Land - new ($2,600,000 + $1,400,000) – ($100,000 + $780,000)

2,600,000 1,400,000 2,980,000

100,000 780,000

3,120,000

2,600,000 1,400,000

P8-49. Suggested solution: a. The transaction appears to have commercial substance. Recall that a transaction has commercial substance if either the assets being exchanged are dissimilar or the configuration of the cash flows is different. Both these tests have been met. Clearly the nature of a used forklift and cash are materially different from that of a piece of undeveloped land. Similarly, giving up cash and an asset that is being used in production (and hence contributing to cash flows) for a non-productive asset will impact on the configuration of QFC’s cash flows. b. With commercial substance Dr. Accumulated depreciation – forklift Cr. PPE – forklift Cr. Cash Dr. Land – new (at fair market value)* Cr. Gain on disposal ($12,000 + $87,000) – ($50,000 + $45,000)

12,000 87,000

50,000 45,000 4,000

*The fair market value of the assets given up is used to value the transaction if both the assets given up and received can be reliably measured. c. Lacking commercial substance Dr. Accumulated depreciation – forklift Cr. PPE – forklift Cr. Cash Dr. Land – new ($50,000 + $45,000) – $12,000 . 8-34

12,000 83,000

50,000 45,000

Chapter 8: Property, Plant, and Equipment

P8-50. Suggested solution: a. Douglas Company—no commercial substance Dr. Cash Dr. Accumulated depreciation Cr. PPE – old machine Dr. PPE – new machine b. Douglas Company—with commercial substance Dr. Cash Dr. Accumulated depreciation Cr. PPE – old machine Dr. PPE – new machine [at fair market value of machine sold – cash received] Cr. Gain on disposal [plug] c. Anthony Company—no commercial substance Dr. Accumulated depreciation Cr. PPE – old machine Cr. Cash Dr. PPE – new machine d. Anthony Company—with commercial substance Dr. Accumulated depreciation Cr. PPE – old machine Cr. Cash Dr. PPE – new machine [at fair market value] Dr. Loss on disposal [plug]

250,000 2,100,000 3,650,000 250,000 2,100,000 4,000,000

6,000,000

6,000,000 350,000

3,000,000 4,450,000 3,000,000 4,250,000 200,000

7,200,000 250,000

e. In the entry to part (c) the new machine is recorded at $4,450,000, which exceeds the fair market value of $4,250,000. This occurs because the loss on disposal has been carried forward (capitalized) into the new machine. f. When the transaction is considered not to have commercial substance, the gain on disposal reduces the value of the new asset acquired. Instead of recording $4,000,000 for the new asset as in part (b), the amount in part (a) is $3,650,000, which is $350,000 lower. P8-51. Suggested solution: a. No commercial substance Dr. Accumulated depreciation Cr. PPE – old machine Cr. Cash Dr. PPE – new machine [plug]

35,000 175,000

b. With commercial substance Dr. Accumulated depreciation Cr. PPE – old machine

35,000

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195,000 15,000

195,000

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Cr. Cash Dr. PPE – new machine [at fair market value] Cr. Gain on disposal [plug]

185,000

15,000 10,000

c. The rationale for the accounting treatment for exchanges without commercial substance is that such exchanges do not result in a culmination of the earnings process. Consequently, no gains or losses are recognized on the exchange. P8-52. Suggested solution: Transaction 1: No commercial substance—use carrying values (no gains or losses) Dr. Cash 10m Dr. Accumulated depreciation 70m Cr. Railroad tracks (Vancouver–Calgary–Winnipeg) Dr. Railroad tracks (Vancouver–Edmonton–Winnipeg) 20m [plug] Transaction 2: With commercial substance Dr. Accumulated depreciation Cr. Railcars Dr. Trucks [at fair value of railcars given up] Cr. Gain on sale of railcars [plug]

3m 4m

100m

5m 2m

Transaction 3: This transaction involves an exchange of services for goods, which are then given to employees. We separate the transaction into two parts: the exchange, and employee compensation. Dr. Cars (inventory) 0.3m Cr. Transportation revenue 0.3m Dr. Compensation expense 0.3m Cr. Cars 0.3m P8-53. Suggested solution: a. The costs need to be separated according to whether they relate to the factory, the mixing machine, or the packaging machine. Since the mixing machine and packaging machine weighed about the same and were received in identical containers, JSI should allocate the shipping costs equally. The duty should be allocated as a percentage of the purchase price, which was consistent with the manner charged by customs.

Invoice cost of item Freight cost (allocated equally) Duty (allocated as % of the purchase price) Total

Factory $100,000

$100,000 . 8-36

Mixing machine $20,000 4,000 8,000

Packaging machine $30,000 4,000 12,000

$32,000

$46,000

Chapter 8: Property, Plant, and Equipment

b. Depreciation entry for mixing machine. Dr. Depreciation expense ($32,000 / 20 years × 9/12) Cr. Accumulated depreciation – mixing machine

1,200

c. The exchange primarily involves non-monetary consideration. Since the machines have different capacities, it is reasonable to assume that the cash flow configuration of the two machines differ. Based on this assumption, this is a non-monetary exchange with commercial substance. As such, the fair value of the asset given up should be used, unless the fair value of the asset received is more clearly evident, which is the case here given that the only fair value available is that of the new machine. The $2,000 freight costs of the exchange are added to the $29,000 fair value of the machine to value the transaction.. Dr. Mixing machine (new) ($29,000 fair value + $2,000 freight) Dr. Accumulated depreciation – mixing machine ($32,000 / 20 × 1.75 years) Dr. Loss on exchange of mixing machine Cr. Cash ($5,000 + $2,000 freight) Cr. Mixing machine (old)

31,000 2,800 5,200

7,000 32,000

d. If the exchange is not considered to have commercial substance, then JSI should use the book value of the asset and the cash given up to value the exchange, resulting in no gain or loss. Dr. Mixing machine (new) ($32,000 + $7,000 - $2,800) 36,200 Dr. Accumulated depreciation – mixing machine 2,800 ($32,000 / 20 × 1.75 years) Dr. Cash ($5,000 + $2,000 freight) 7,000 Cr. Mixing machine (old) 32,000 P8-54. Suggested solution: a. As disclosed in Note 16, Thomson Reuters’ PPE consists primarily of land, buildings, and improvements ($898 million at cost), followed by computer equipment ($752 million) and furniture, fixtures, and equipment ($312 million). b. The company uses the cost basis. Depreciation follows the straight-line method. Note 1 discloses these accounting policies, as well as the estimated useful lives:

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c. Since the company uses the straight-line method, the average age can be estimated using the amount of accumulated depreciation divided by cost, assuming that residual values are negligible.

Acc. depreciation (A) Cost (B) % Depreciated (A/B) = average age as % of useful life

Land, buildings, and building improvements $481 898 53.6%

Computer hardware $ 634 752 84.3%

Furniture, fixtures, and equipment $232 312 74.3%

d. The average useful life for computer hardware can be estimated by dividing the cost of the assets by the year’s depreciation, assuming that residual values are negligible. Assume additions occur Include evenly through Exclude addition additions and year (use during year (use disposals during average of cost at cost at beginning year (use cost at beginning and of year) end of year) end of year) Cost (A) $774 $752 $763 Depreciation for the 54 54 54 year(B) Estimated useful life in 14.3 13.9 14.1 years (A/B) All three estimates result in the average useful life substantially exceeding the 3 years indicated in the company’s accounting policy (see part b). The most likely reason is that some of the computer hardware has been fully depreciated but remain in use, so their cost remains on the books until they are disposed. This conjecture is consistent with the 84.3% average age computed in part (c). If this is true, then the company has been conservative in over-depreciating its computer hardware in the past. P8-55. Suggested solution: a. Canadian Tire uses the cost method to measure PPE. Disclosure of this choice appears on page 81 (Note 3 of the financial statements). Also, Note 2 on page 71, which describes the company’s basis of presentation, indicates that the financial statements use the historical cost basis except for four items (and those four items do not include PPE). b. The balance sheet reports net “Property and equipment” at $4,283.3 million at the end of 2019. c. The income statement does not report depreciation because the company has chosen to report operating expenses by function (i.e., use), whereas depreciation would be reported had the company chosen to report by the nature of operating expenses.

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Chapter 8: Property, Plant, and Equipment

d. Depreciation appears in three places. Note 30 on page 122 discloses operating expenses by nature, which shows $274.3 million for “Depreciation of property and equipment, investment property, and assets held-for-sale” and references additional depreciation recorded in “cost of producing revenue” in Note 29 of $10.1 million. The two amounts together total $284.4 million. Second, Note 12 shows $6.2 million for depreciation on investment property. Third, Note 13 shows $277.5 million for depreciation on property and equipment. The amounts together are close to reconciling with the first total: $6.2m +277.5m = $283.7m. e. Note 3 on page 81 indicates that the company uses the straight-line method. The estimated useful lives are 10-45 years for buildings and 3-25 years for fixtures and equipment. f. Note 13 on pages 85 provides the information necessary to estimate the average useful lives: Fixtures and Buildings equipment Depreciation for the year (A) $ 84.8 $ 127.5 Cost, December 31, 2019 (B) 3,543.6 1,680.4 Estimated average useful lives (B/A) 41.8 years 13.2 years This calculation assumes that there is not a significant amount of assets that have been fully depreciated prior to 2019. The estimated numbers of years are within the range of useful lives indicated in Note 3. (More refined calculations of the average useful lives can be made by adjusting for asset additions and disposals during the year, but the additional precision is not necessary given the wide range of useful lives.) g. The company capitalized $5.0 million of interest into property and equipment, at an interest rate of 4.3% (see Note 13 just below table).

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M. Mini-Cases Case 1: Capitalization of PPE and Depreciation Policies. Suggested solution: To: William Chan, CEO From: CFO Date: February 14, 2021 Subject: Financial issues arising from your review of company operations The financial issues you raise are very important because aircraft comprise the most significant asset for our company. Below, I will address each of the three issues you have identified. Depreciation policy I believe that our current policy of using the declining balance method is appropriate and that we do not need to change our policy to match our competitors. There are four reasons for this: * Our company’s success is in large part due to our strategy of providing a better travelling experience to our customers, which in turn allows us to charge a premium price. As part of this strategy, it is crucial that we maintain a state-of-the-art fleet of aircraft that is superior to—and younger than—our competitors. Arguably, the early years of an aircraft’s life provide higher benefits than later years, so the matching concept in accounting suggests that a higher amount of depreciation be recorded in the earlier years. The declining balance method provides such a pattern of expense. * Related to the first point, our high-quality strategy requires us to replace our aircraft more frequently than other airlines. Since we have a decentralized organizational structure, each region is responsible for making its own aircraft replacement decisions. The corporate-wide depreciation policy can potentially facilitate or deter these necessary replacements. Our current policy of declining balance depreciation reduces an aircraft’s carrying value faster in the early years. (The carrying value is the original cost less the cumulative amount of depreciation.) At the time of replacement, the lower carrying amount for the old plane is more likely to result in a gain (or a smaller loss) on disposal. In contrast, the straight-line method will result in a relatively high carrying value, increasing the likelihood of a loss on disposal. Since each region is evaluated as a profit centre, regional managers will be more reluctant to replace aircraft if that replacement creates a significant accounting loss on disposal. * Financial analysts appear to be concerned about EBITDA, which is before the subtraction of depreciation expense. Therefore, a change in depreciation policy is unlikely to influence their assessment of our company’s prospects. They may even interpret our conservative depreciation policy to be a positive signal about the strength of our airline relative to our competitors. * We already have a high credit rating, so changing to the straight-line method would likely result in little benefit through the improvement of ratios such as debt-to-assets. Depreciation policy is often misunderstood to be irrelevant, particularly to those who have a background in finance, because depreciation is a non-cash expense. However, it is very relevant to our company because it is connected with our business strategy and organizational structure.

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Chapter 8: Property, Plant, and Equipment

Changing to the straight-line method can motivate dysfunctional managerial behaviour and damage our competitive position in the long term. Use of EBITDA While accounting standards specify a particular method of determining net income on the financial statements, users such as stock analysts are free to choose other measures of income for their specific purposes. For a company such as ours, depreciation is a significant charge against income and different companies in our industries follow different policies, so looking at an income measure that bypasses these differences could be useful. Prepayment discount Financially, the payment discount offer is an attractive offer. For example, suppose the aircraft would cost $40m if we were to pay upon delivery. If we prepay, the price would be only $34m. Financing this amount over two years at our current borrowing rate of 6% will cost $4.2m, 1 bringing the total to $38.2m, for a net savings of 4.5% relative to the original price of $40m. Given that this offer is attractive to our company, we need to ensure that our regional managers take this offer when available. However, financial accounting considerations may have a bearing on whether they take this offer or not. Specifically, how we treat the financing cost for each plane ($4.2m in the above example) will affect managers’ decisions. Normally, debt financing costs are expensed; if this were the accounting treatment, a region that takes up this discount offer will experience a short-term negative impact to earnings ($4.2m over two years, before tax). The negative impact is more than offset by lower depreciation on a plane that has a lower cost ($34m instead of $40m), but spread out over the long term. Under these circumstances, it is possible and even likely that the regional managers will forgo the discount even though it is in their long-term interest. In some circumstances, it is possible to capitalize interest cost to an asset (i.e., to add the interest cost to the amount recorded for the asset). In particular, accounting standards permit enterprises to capitalize interest on self-constructed assets, if that interest arises from debt specifically borrowed for the construction. However, the present circumstance does not qualify since we are not building the planes ourselves. Alternatively, it may be possible to treat the prepayment plan as a loan to the aircraft manufacturer. Under this treatment, the interest revenue on the loan would offset the interest expense on the borrowing over the two-year prepayment period. Upon delivery, the plane would be recorded at a cost that includes the accumulated interest ($38.2m in the above example). We should discuss this alternative with our auditors to determine if it is acceptable to them. Given the constraints of accounting rules, we should consider an alternative that would ensure that regional managers “do the right thing” by taking up the discount offer. We could, through internal accruals, shield the regions from the financing cost of prepaying for their aircraft orders.

Cost including interest = $34m × 1.062 = $38.2m. Interest = $38.2m – 34m = $4.2m. . 8-41

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Case 2: Intrawest’s Interest Capitalization Policy. Suggested solution: Decline in stock price Jan 17–21: * Not clear that decline can be attributed to the rumoured report. * Efficient market theory suggests that stock prices change in response to new information. – If the report has been available for a while, the stock price would have reflected that information much sooner than the week in question. – It is also debatable whether the report contains any new information. Rosen does not have access to inside information. His criticisms are based on publicly available information (annual report, financial statements) and investors would have known about the company’s accounting policies. However, he may bring superior knowledge or analysis that others have not performed. * Sharp drop during week and subsequent recovery in stock price is consistent with the following explanation: – Many naïve investors put too much weight on this rumoured report and sold the stock. – But since there is really no new information, these investors were overreacting. – Subsequently, more rational trading pushed price back up to the level before the controversy. The criticism on Intrawest and the company’s reaction: * The credibility of the parties involved affects how investors react to their disclosures. – Does Rosen gain publicity and improve the reputation of himself and his business by pointing out allegedly non-conservative accounting? – Why is Rosen refusing to confirm or deny the existence of the report? If the report doesn’t exist, then Rosen is being unethical by attracting publicity at the expense of the reputation of Intrawest. If the report does exist, he should be more forthcoming in defence of his position. – It is not surprising that Intrawest’s Executive VP (Jarvis) would argue that the company F/S are “rock solid,” because he is expected to do so. This is considered “cheap talk.” * The allegation that Intrawest’s earnings would be lower under more conservative accounting is rather silly. It is tautologically true the earnings are lower with more conservative accounting. Capitalization of interest and G&A expenses: * Intrawest is in the business of developing resort properties. – The nature of the business requires the company to construct properties and hold them in inventory before title is transferred to buyers. * Interest can be capitalized. While some accountants argue that only interest from specific debt can be capitalized, the CPA Canada Handbook does not prohibit the capitalization of interest from general debt nor imputed interest, as long as the policy is disclosed. Since the CPA Canada Handbook provides the ultimate authoritative accounting guidance, the criticism is invalid. – The article indicates that Intrawest has disclosed the policy as required by the Handbook. – Furthermore, users are unlikely to be misled since the policy is disclosed. . 8-42

Chapter 8: Property, Plant, and Equipment

–

Intrawest’s interest capitalization policy may be non-conservative, but it is not in violation of the Handbook. – On the other hand, Jarvis’s claim that the company’s policy is “required by GAAP” is also false. The practice is permitted, but not required. During construction and development, certain G&A expenses will necessarily be required, to manage the projects, etc. Such costs are no different from production costs, so it is acceptable to capitalize G&A expenditures directly related to resort development.

Overall, this article is intended to highlight the following: * It is important to distinguish what is news and what is old information. * Stock prices may change irrationally if enough naïve investors believe something. This may provide a good buying opportunity for sophisticated investors. * There is considerable disagreement over which interest costs can be capitalized. * It is easy to criticize any company’s financial statements as being “not conservative” enough. Companies have many objectives to satisfy, not just conservatism. If the policies are fully disclosed, criticizing those policies is an unproductive exercise, although some critics gain publicity for doing so. In this sense, it is useful to think about the incentives of any person making a disclosure, whether he/she is a company executive, reporter, or accountant. Case 3: Bedrock Quarries. Suggested solution: To: From: Date: Subject: Statements

MEMO TO THE PARTNER Jim Chapman, Chapman & Partner CA May 12, 2027 Bedrock Quarries Ltd (Bedrock) - False and Materially Misleading Financial

As requested, I have prepared this memo identifying all relevant issues with respect to our engagement with the Provincial Institute of Chartered Accountants (PICA). As you explained, Bedrock was sold to Mr. Flintstone on March 15, 2026. Mr. Flintstone submitted a complaint to the PICA alleging that HLC, and Mr. Harrison in particular, were associated with financial statements of Bedrock that were “false and materially misleading.” We have been asked by PICA to investigate this complaint. I have reviewed the following matters: – materiality – the professional conduct of Mr. Harrison, – possible deviations from International Financial Reporting Standards (IFRS), and – other related considerations. Overall conclusion I do not have sufficient information at present to determine, with certainty, whether Bedrock’s financial statements were “false and materially misleading.” However, based on the information provided, it appears that Bedrock’s financial statements did contain errors and incomplete . 8-43

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information. Most of the deficiencies discussed below do not necessarily result directly in false and materially misleading financial statements. Nor would they necessarily have a material impact on Mr. Flintstone’s purchase decision. I am also unable to determine whether the IFRS deviations resulted in false and materially misleading financial statements. The information provided does not permit the dollar impact of these errors to be determined. More important, numerous examples indicate that Mr. Harrison acted unethically in the course of his work on the Bedrock financial statements. I have outlined such examples in the analysis that follows. PICA’s ethics committee should assess this issue further. Materiality Mr. Flintstone is alleging that Bedrock’s financial statements were false and materially misleading. We must define this term and ensure that PICA agrees with our interpretation. In addition, we must clearly outline the approach that we take for this engagement and document in detail the work that we perform. Mr. Flintstone’s definition of the term “false and materially misleading” is likely to differ from ours and those of other users, including PICA. However, we must consider what dollar amount of errors would have caused Mr. Flintstone to change his purchase decision or materially change the purchase price ultimately paid. The total purchase price paid for the shares of Bedrock was $100 million plus three times net income for the fiscal years 2026 and 2027. For example, would Mr. Flintstone consider an adjustment of $1 million to the purchase price to be material? Mr. Flintstone will probably argue that any amount of error is material to him. On that basis, I will consider any error to be material for our review. Separately, for purposes of HLC’s audit, materiality was set at 1% of revenue for each year. However, the materiality figure used, and the basis for the calculation, should be reviewed and set each year. In 2026, the materiality figure used should have been lower to reflect the increased risk associated with the Bedrock engagement. Mr. Harrison was aware of the potential sale transaction and should have considered whether a materiality figure based on net income would have been more appropriate. Using a percentage of net income in order to calculate materiality, say 10%, would have reduced the materiality figure used in 2026 from $785,000 to $576,000. Such a reduction could have significantly affected the scope of testing required. Professional conduct of Mr. Harrison As you know, professional conduct issues are different from a negligence claim. We must consider, on the basis of the information provided, whether Mr. Harrison acted ethically and whether he was independent during the course of his engagement with Bedrock. I believe that Mr. Harrison would not be perceived to be independent of Bedrock and that he acted unethically. This conclusion is supported by the following facts: – Mr. Harrison is Betty Rubble’s cousin. As a result, his independence may have been compromised, or at a minimum, from the standpoint of an unbiased observer, perceived to have been compromised.

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– Mr. Flintstone stated that Mr. Harrison told him that the financial statements contained no material errors. If Mr. Harrison in fact made this statement, it was unreasonable and inappropriate to do so. – Mr. Harrison breached confidentiality by discussing Bedrock’s financial position with a personal friend who is unrelated to Bedrock. – The basis used by HLC to charge fees, 1% of sales, is unethical. PICA should discuss each of these items with Mr. Harrison to find out whether there is additional information that should be considered before deciding whether disciplinary action is necessary. Deviations from International Financial Reporting Standards (IFRS) In order to determine whether the financial statements were materially misleading, we must first establish whether they were in accordance with IFRS. If they were not in accordance with IFRS, we must then determine whether the error would result in materially misleading financial statements. There are a number of possible IFRS errors; however, additional information is needed in order to calculate any such errors. Some of the errors identified below are related to disclosure and presentation. I do not believe that these types of errors would result in materially misleading financial statements. For example, the balance sheet does not separate current and long-term assets and liabilities. However, given Mr. Flintstone’s background and knowledge of the industry, this error should not have affected his purchase decision, nor would it have changed the dollar amounts reported in the financial statements. A second example is that the receivable from Rubble Sales should have been separately disclosed in the financial statements—a related-party transaction. Whether this shortcoming is materially misleading depends on the amount of the receivable and the amount of the related annual sales. More information is required. The following describes other possible IFRS deviations Inventory valuation: Inventory is valued at net realizable value. Inventory should be valued at the lower of cost and net realizable value in accordance with IAS 2. If the costs of mining sand and gravel increase over time, then valuing inventory at its net realizable value will increase the value of inventory previously mined, and will thus reduce the cost of goods sold. Assuming mining costs increase, and given the fact that Bedrock’s gross margin increased from 15% to 32% in 2025, both Bedrock’s inventory balance and net income could be overstated. If inventory is overstated, net income is overstated, and so is the purchase price. Revenue recognition: According to IAS 18.14, “revenue from the sale of goods shall be recognised 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 . 8-45

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e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.” Bedrock’s revenue recognition policy may be “aggressive.” Specifically, it is unclear whether the significant risks and rewards of ownership have transferred at the time when the sale is recorded—that is, when the products are ready for delivery. We will need additional explanations and support for this policy. If the risks and rewards of ownership have not been transferred, the 2026 revenues are overstated. Depreciation and depletion policy: The ten-year depreciation and depletion period may not be reasonable. According to IAS 16.57, “the useful life of an asset is defined in terms of the asset’s expected utility to the entity. The asset management policy of the entity may involve the disposal of assets after a specified time or after consumption of a specified proportion of the future economic benefits embodied in the asset. Therefore, the useful life of an asset may be shorter than its economic life. The estimation of the useful life of the asset is a matter of judgment based on the experience of the entity with similar assets.” However, we do not have enough information to make this determination. We will have to conduct research to find out what the industry standards are. If it turns out that the depletion and amortization should be less than ten years, net income is overstated, and so is the purchase price. Site reclamation costs. There is no indication of a provision for site reclamation costs. These costs could represent a significant liability to Bedrock that was not disclosed, or accounted for in the financial statements. According to IAS 37.14, “a provision shall be recognized when: a) an entity has a present obligation (legal or constructive) as a result of a past event; b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognized.” As a result, Bedrock’s financial statements should include a decommissioning provision. Consolidation policy: It appears that Bedrock has improperly accounted for its investment in its associated company. Assuming that Bedrock has significant influence over the associated company, it should account for the investment using the equity method. We will need to obtain additional information about the investment to determine if significant influence exists. Accounts receivable (A/R): The only procedure HLC performed with respect to A/R was check the mathematical accuracy of the account. HLC did not test the existence or valuation of the A/R balances for the years under audit or under review even though the balance represented 30% of the total assets recorded in 2026 and increased by 70% from 2024 to 2026. In light of the significant fluctuations in the A/R balance, additional analytical procedures should have been performed. Finally, it appears that HLC did not independently test the related-party transactions. Other related considerations The purchase price was not based solely on the financial statements prepared prior to the closing date or on the financial statements prepared at the date on which the deal took effect. In fact, Mr. Flintstone was most optimistic about “the synergistic benefits that would accrue to the combined operations of Bedrock and Flintstone Sand and Gravel Ltd.” . 8-46

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Any concerns that Mr. Flintstone might have had could have been remedied by his insisting on the inclusion of representations and warranties in the final purchase and sale agreement. However, the information provided suggests that Mr. Flintstone, or his advisors, chose not to demand such warranties. In fact, Mr. Flintstone may have contributed to any negligence because he: – may have relied too much on his in-depth knowledge of the industry, – relied on draft financial statements prior to closing, – had no knowledge of the nature and extent of the procedures followed by HLC in the year of the purchase, – relied on verbal representations that the financial statements were free of material errors, and – kept HLC as his accountant. This is not to say that Mr. Flintstone is at fault. However, his own negligence may have contributed to his loss. Case 4: Dunstan Electric. Suggested solution: To: From: Date: Subject:

Anne Cooper CA December 12, 2024 Dunstan Electric Inc.

MEMORANDUM

As requested, I have considered the impact of the recent fire at Dunstan Electric’s Store #23. The fire has a number of significant consequences from an accounting standpoint. Before discussing the individual issues below, it is important to recognize the unique aspects of the current situation and their pervasive effects. As is typical in insurance cases, the recovery proceeds are based on replacement cost. Therefore, Jack Dunstan has an incentive to maximize the value of the assets being claimed so as to maximize the amount of insurance proceeds the company will receive. However, the insurance company is unlikely to rely much on the general-purpose financial statements and will rely much more on the information in the statement of claim, which will more directly address the issues pertaining to the fire. For our audit engagement, we need to focus on the accounts affected by the fire and be wary of potential overstatements of these assets. In particular, the insurance proceeds receivable amount will include amounts for the lost inventory and the destroyed building. Our procedures must therefore assess the reasonableness of the amounts being claimed for these assets given that the claim has not yet been submitted nor accepted by the insurance company. Building Two related events have to be accounted for: the destruction of the building by the fire and the recovery of the replacement cost of the destroyed building from the insurance company. Mr. Dunstan has recorded a loss of $545,000, representing the net book value of the building destroyed in the fire. He has not recorded any proceeds receivable from the insurer pending the completion of . 8-47

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negotiations that will determine which contractor will do the work and the amount the insurance company will pay. However, this approach results in the omission of a significant asset from the balance sheet. While the exact amount that will be received is not known, there is no doubt that an amount will be received. It is inappropriate not to record an amount under these circumstances. Two estimates are available, and the fact that negotiations are proceeding with the insurance company suggests that the minimum amount receivable is the lower of the two estimates, or $1.465 million. This amount represents the minimum amount that should be recorded. If the final agreement provides for a different amount, an adjustment could be made at that time. Estimates are routine in accounting and adjustments to estimates are always required. The amount receivable from the insurance company for the building is no different. In addition, not recording the receivable would mean that the income statement effect of the insurance recovery would also be deferred, resulting in a mismatching of the loss associated with the destruction of the building and the recovery from the insurance company. Clearly, the loss of the building has to be recorded in fiscal 2024 since to do otherwise would result in a destroyed building being reported as an asset on the balance sheet. As recovery from the insurance company is almost certain, it is appropriate to associate the loss and recovery in the same period. If the recovery were in doubt, it might be appropriate to defer recognition of the recovery. In this case, however, given that a minimum recovery is known, the recovery should be recognized. I recommend that the loss of the building and the estimated recovery from the insurance company be recorded in the 2024 financial statements. The balance sheet should report a receivable in the amount of $1.465 million (pending the outcome of negotiations). The original building should be written off in 2024. Furthermore, the insurance proceeds relating to property, plant and equipment (PPE) should be credited to the income statement separately from the fire loss. IAS 16.66 states that impairment of PPE, related claims for compensation, and any subsequent purchase or construction of replacement assets are separate economic events and should be accounted for as such. Therefore, the impairment of the PPE and insurance proceeds should be shown separately, not offset against each other. When destroyed assets are replaced, they should be recorded at replacement cost. In order to comply with IAS 1, the amounts relating to PPE should be shown separately in arriving at profit before tax. Inventory The reporting issue for inventory is the same as with the building. The amount recoverable from the insurance company should be reported as a receivable on the December 31, 2024 balance sheet. The initial accounting included is different from what was done for the building. Here, Mr. Dunstan has recorded $1.9 million as the amount due from the insurance company, but the amount is probably overstated. The amount is based on the inventory on hand on December 7 in store #37, which Mr. Dunstan thinks is the store that best approximates the destroyed store’s activities. Mr. Dunstan may be attempting to maximize the proceeds from the insurer by using the figure of $1.9 million. The insurer will want further validation of the amount rather than rely on an assertion from Mr. Dunstan that Store #23 and #37 are similar.

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Another, more objective, estimate can be obtained through a reconstruction of the week’s worth of sales and applying the gross margin method to estimate the cost of goods sold (COGS). The estimated COGS combined with the $1.6 million inventory balance on November 30 and data on purchased inventory would allow us to estimate the inventory on December 7. The proceeds receivable might be better based on the numbers we obtain from reconstructing one week’s worth of data (see above for audit procedures) rather than on Mr. Dunstan’s estimate. In addition to reconstructing the week’s worth of movement, the value of the inventory may in fact be lower than recorded due to general declines in value. Mr. Dunstan indicated that certain older goods were set aside at each of the locations. The value of these items will have to be estimated and backed out as obsolete items. A review of previous years’ audit files should help us determine whether a standard percentage can be applied to the value of the inventory we determine. Since Dunstan Electric sells electronic equipment, declines in value could be large as technology evolves quickly. The gain or loss relating to inventory destroyed would be shown separately in arriving at profit before tax under IAS 1. Other fire-related costs Demolition and site clean-up: Site clean-up costs are considered part of the cost of disposing of the old building. Since municipal by-laws require the building to be demolished within 30 days, these costs should be accrued for now and considered as part of the building disposal costs. As stated previously, the insurance policy should be reviewed to assess whether these costs are reimbursable as part of the insurance claim. If so, the proceeds will increase the gain from the disposal of the building. Salary costs: If the salary costs are not allowed as part of the insurance claim and Dunstan does not have business interruption insurance, they would be expensed as incurred. Case 5: MINID Property Corp. Suggested Solution: a. Silicon Valley: The firm paid $3.5 million for the property, which was the acquisition cost. The company was correct to use the relative appraisal values of the land and the building to allocate their costs, which would give a value of $1.17 million to the building and $2.33 million to the land. However, when the company paid too much for the property and therefore reassessed the value at the end of the year, it should consider impairment on both land and building. By only recording impairment loss to its land account, the company had overstated its value on building and thereby overstating current and future depreciation expenses. Napa Valley: The company should use the acquisition cost of $5 million to record the property. If the company wanted to report the asset at fair value, then it could change its accounting policy and choose the fair value method under IAS 40 In that case, it would be able to increase the property value to $5.5 million by the end of the year. Otherwise, it should be kept at $5 million under the cost model after acquisition. Furthermore, they could not recognize goodwill because it was the acquisition of one building and therefore negative goodwill was inapplicable. It seemed that, in this situation, the company would like to report the fair value

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of the assets and yet it would not want to recognize the increase in fair value as unrealized gains in the income statement. Note, though, that while the company can choose a policy to subsequently measure investment property at cost or fair value, that the policy, once chosen, must be applied to all investment property held. This is to say that MINID cannot subsequently measure some investment properties at cost and others at fair value. San Francisco: The cost of $300,000 was irrelevant in the company’s valuation of the property. The property was purchased for $750,000 and that should be the acquisition cost. At time of appraisal, the company would write down the asset to $600,000 and incur the $150,000 loss. However, it could also be argued that the fair value of the property was $600,000 so the extra $150,000 was related to CEO compensation expense at the time of acquisition. Whichever argument was chosen, the maximum expense would be $150,000 in 2023 and not $450,000 as the company had booked. b. There could be reasons other than tax MINID would want to decrease its income. Some companies may want to avoid hostile takeovers. Others may want to show a weaker financial position to shareholders such that they can pay out less dividends and retain more cash for future projects. Yet other companies may want to have a “Big Bath” in a particular fiscal year.

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Chapter 9 Intangible Assets, Goodwill, Mineral Resources, and Government Grants N. Problems P9-1. Suggested solution: Intangible asset (Yes / No) N Y Y N N* N* Y

Item a. Cash b. Costs of research and development c. Computer software applications d. A currency derivative e. Purchased goodwill f. Internally developed goodwill g. Trademark * Goodwill is not a separately identifiable, P9-2. Suggested solution:

a. b. c. d. e.

Has physical substance

Item Account receivable Investment in shares Cost of upgrading a computer system Purchased goodwill Development cost at a mineral site

√ √

Monetary

√ √

Not separately identifiable

√

P9-3. Suggested solution: a. This is an intangible asset. It provides the basis of operation as a corporation. It should be valued at cost ($500). b. This is an intangible asset. Both amounts ($200 and $800) should be capitalized to software. c. This is not an intangible asset. There is no clearly defined future benefit (i.e., not an asset.) The amount is not goodwill, because accounting goodwill only arises from the purchased of another business. The $400 should be expensed.

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P9-4. Suggested solution: a. b. c. d.

This is an intangible asset as it confers on the firm a contractual right. Further, the right is identifiable, transferrable, and easily measured. Paying these legal fees establishes that there is a legally enforceable, separable, and transferrable right; the company has exclusive right to the use and sale of the drug. Further, the future earnings are substantially more than the amount paid. Expense as the company lost the exclusive privilege. As the right is not exclusive, others can copy the drug without permission, so the right is not transferrable or enforceable. While there is clear evidence of payment to an outside party, and as such it is externally acquired, the “asset” is neither separable from the company for sale, nor does the company have a legal right to any benefits. The “asset” is the better educated employees which are not separable or legally owned by the firm. The firm cannot sell its employees as slavery is outlawed. The taxis should be set up as PPE. The licence’s value is easily determined, at $1,000,000 ($2,500,000 – $1,500,000). This licence permits the operation of taxis in Winnipeg. This right is identifiable, transferrable, separable, enforceable, and objectively valued. As such, it is a legitimate intangible asset.

P9-5. Suggested solution: a. b.

e. f.

Short- or long-term accounts receivable are treated as assets as they represent legally enforceable cash inflows. These monetary cash inflows are clearly identifiable and measurable future benefits and therefore assets. Prepaid expenses, such as the payments in advance or early for property taxes or insurance, are assets, as the future benefit is clearly identifiable and measurable and the allocation of the asset to expense is easily established. The passage of time causes the future benefit to expire. Deferred development costs are considered eligible for treatment as an asset if they satisfy all six of the criteria for deferral. These strict criteria (feasibility, intention, ability, market/usefulness, adequate resources, reliable measurement) must all be satisfied to qualify as an asset. Such rigour in analysis to qualify as an asset ensures that companies capitalize only development costs that have identifiable future benefits. Only the legal costs to successfully defend an internally developed patent or copyright are considered to be an asset. By successfully proving that the patent or copyright is valid and exclusively belongs to the firm, the firm proves that there is an identifiable, legally enforceable future right and benefit which the company has. Purchasing patents/copyrights and other privileges from others readily establishes the value and uniquely identifiable nature of these intangible assets. A franchise is an intangible asset as it confers on the buyer the legal right to use and be associated with certain exclusive brands or processes that have future revenue potential. The value and identifiable nature of this asset are easily established. Goodwill is not an intangible asset; rather, it is a residual amount that is derived by subtracting the fair value of the acquired assets and liabilities from the price paid of the business. Goodwill calculated this way is an attempt to value the economic goodwill or surplus earnings value/potential of the firm resulting from the successful deployment of its . 9-2

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assets to generate income. As the value of the various identifiable assets and liabilities is possible, this residual goodwill amount is a surrogate for the implied economic goodwill in the acquisition of another company. P9-6. Suggested solution: a. b.

Based on the historical cost principle, the company did not incur a cost of $500,000 for the mailing list so its value must remain at its historical or original cost of $0. As the charity paid $500,000 for the list, the value can readily be established. The item is identifiable and implies a legal right to use. The charity must have completed a financial analysis of the cost and benefits of buying the list. The list will be usable for four years. These conditions suggest the list is an asset for the charity. The signing bonus is identifiable, legally enforceable, contractual, and confers a benefit on the team for a three-year period. The player is expected to generate ticket sales for the team; there is a future benefit related to the contract and athlete. Further, the player can be sold or traded by the team. Overall, the $9,000,000 signing bonus qualifies as an intangible asset. The in-process technology is an intangible asset. It was valued and purchased as part of an arm’s-length transaction. The technological processes were identified and duly considered to have value when the company was purchased.

P9-7. Suggested solution: a. b.

As the advertising campaign has not been launched this $15,000,000 is really a deposit or retainer. As such it is an intangible current asset, correctly classified as a prepaid expense. In the fiscal period when the branding strategy is started, the full cost should be expensed. This payment arises from a legal or contractual obligation. Paying the fine permits the company to continue to operate in the future, which is why the fine was paid. The company paid the fine as the economic benefits of paying it exceed the amount paid. However, the cause of the payment was a past transgression, and therefore it should be expensed. The better trained player can be identified, is separable from the team, and can be sold as he is under a transferrable contract with the team. Financial analysis shows that this training will increase revenues for the team, which exceeds the $500,000 cost of the special training. Also, the player can be sold or traded, and the skills developed will go with the player. These costs of training the player can be treated as an asset. Because this training will not result in incremental revenue or income, the amount should be expensed as a normal operating cost of the hockey team.

P9-8. Suggested solution: a.

Arguments in support of expensing: First Argument: If one were to capitalize this expenditure, you would essentially be capitalizing human beings as assets of the company. The company does not control the use of future benefit as these are the employees who can easily leave and find employment elsewhere. . 9-3

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Second Argument: Can the future benefit of $15,000,000 be reasonably and accurately quantified as being equal to or more than $15,000,000? It is hard, if not impossible, to measure the future economic benefit of this training program, so it should be expensed. Third Argument: Training staff is an ongoing, recurring operating expense and, as such, should be expensed as incurred. Fourth Argument: As Public Co. Ltd. is a large public company, its investors are likely sophisticated and knowledgeable in interpreting financial statements; those who would like the expenditure capitalized will adjust the statements accordingly. [Note: this argument can also be used in part (b).] Arguments in support of capitalizing: First Argument: The reason why the company spent the $15,000,000 was to allow the successful installation of the new technology. The benefit of the training will be realized once the equipment is in use, which is in later fiscal periods. Expensing this amount in the current period results in poor matching of expenses with revenues. Second Argument: Whereas the company does not own or control its employees from leaving the firm, it reasonably can be suggested that most of the trained employees will continue employment with the company and so the “asset” will remain with the company. The inability to control the use of the benefit for extended periods can be handled by adjusting the amortization period to fewer than 15 years. Third Argument: The economic and financial decision-making process that supported this investment incorporated a multi-period perspective. Given the amount of this investment the company likely completed capital budgeting/net present value analysis techniques which discounted the benefits in later years to their present value equivalents to justify this expenditure. It seems appropriate that the accounting should be founded on a similar logic. The 15-year amortization period seems excessively long. To offset the fact that the company does not own or control the use of their employees, a short period of amortization would be recommended. Five years would seem a reasonable compromise as this affords some opportunity to spread the amount over several periods instead of reporting a one-time hit to earnings.

P9-9. Suggested solution: a. b.

Answer: $70 million (Stadium for $45 million and land for $25 million). 40% of the price is for tangible assets (70 / 175 = 40%). Player contracts: The athletes have signed contracts to play for several years in the future. These legal commitments allow the team to sell these players to other teams. This is the estimated re-sale value of these contracts. Leases on luxury spectator boxes: This is the present value of these lease contracts, plus renewal of these leases. Product licensing agreements: Present value of existing licensing agreements plus renewal of these arrangements. Season ticket subscriber list: Present value of the potential renewal of ticket sales to likely customers. Contracts and commitments for use of stadium: As the buyer owns the stadium there are other uses for it during the off-season and vacant days during the season. This is the imputed present value of these contracts. . 9-4

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The “team”: The value of the franchise (privilege) to be a part of this professional sports league. Easily measurable and identifiable: Cable television broadcast contract, leases on luxury spectator boxes, product licensing agreements, contracts and commitments for use of stadium. The common feature is there is a contract or legal agreement to substantiate their existence and these contracts have specified methods to determine their cash flows and related value. Reasonably measurable and identifiable: Player contracts, season ticket subscriber list. The common feature of these items is that they are identifiable but there is no clearly stated method for determining their cash flows or market value. Further, they have niche markets that are unique and volatile. Very difficult to measure and identify: The “team.” It is not clear what this is. There is no evidence this is economic goodwill given the team’s net losses over the past few years. This value must be based on non-financial considerations. The value may be psychological, being the fame and prestige that comes with ownership. Given the wealth of the buyer, this transaction may not have the traditional objective of earning income. I would capitalize all these amounts with the exception of the “team.” Given that the team has no apparent economic goodwill it would not qualify as “accounting goodwill.” This item is especially subjective and hard to quantify. I would conservatively and cautiously expense it.

P9-10. Suggested solution: a. IFRS makes a distinction between research and development costs as they are in fact different in nature. Common usage incorrectly groups these expenditures together for convenience and glamour, but the objective and focus of these two activities are very different. Separating research from development activities and defining the two terms allows for subsequent differences in how amounts spent on these activities can be accounted for. b. First, research focuses on new knowledge and understanding, whereas development focuses on commercializing this knowledge into defined applications and processes. Second, whereas both research and development activities (as undertaken by for-profit enterprises) implicitly expect an eventual financial reward, the connection is not definable or identifiable for research costs. For development costs, including those not capitalized, the association between the cost and the application is clear and definable. Third, research activities precede development activities. The distinctions encourage clarity and precision of thought and analysis, and set up the case for the potential capitalization of some development costs. This deliberate rigour empowers professional judgment, as it provides guidelines and principles that the accounting professional can apply to a given circumstance and thereby avoids a rule based methodology for resolving complex accounting issues.

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P9-11. Suggested solution: Technical feasibility: Development implies that there is an identified application; it does not guarantee that the application works. For an item to be classified as an asset it must embody the notion of a future benefit. If the enterprise cannot prove it works, then how can it be an asset? Projects that do not work cannot be assets, as there is no future for such an undertaking. Management intention to use or sell: Even if something works, this does not mean the company will commercialize it. Many investments with positive net present value are not implemented, due to capital rationing constraints and strategic considerations. For an asset to be recognized there must be a clear intent to undertake the venture. If there is no intent to complete a project, then the realization of a future benefit is jeopardized. Ability to use or sell: Intention does not guarantee success; one must also be able to complete the project or application. Without ability to use or sell, there is no hope of eventual realization of the future benefit. Demonstrate there is an external market or internal use: In a for-profit context, the present value of future cash inflows must exceed the present value of cash outflows to qualify as a viable investment. Management must be able to demonstrate by way of credible financial data and analysis that the undertaking will generate a profit in the future. Without credible financial data and analysis, there is no evidence to support the assertion by management that there is an asset. Adequate resources to complete: Projects require financing and other resources to complete. There needs to be a commitment of resources to finish the project. Without such a commitment, the project will not come to fruition and there will be no completed project or process. Reliable measurement of expenditures: Management must be able to show that the expenditure is related to the undertaking. Further, the amount of the expenditure must be quantifiable. Overhead and general expenditures allocated to a project may be arbitrary and suspicious; the connection must be reasonable and direct. Without this constraint, management could assign all expenditures to those projects that meet the first five criteria and abuse the spirit and first principle of classifying an expenditure as an asset. In summary, the onus is on management to prove the expenditure is an asset. Without such evidence, the amount involved must be expensed. As a majority of development activities are not commercialized, it seems reasonable that putting such strict tests into effect should ensure that there are impediments to recklessly capitalizing expenditures as intangible assets. P9-12. Suggested solution: a.

All these criteria are also relevant for tangible assets. The tangible quality of a machine or building easily establishes that most of these criteria are met. Tangibility does not establish that there is a market or use for the assets so management may have to prove this point as there may be impairment in the asset’s carrying value.

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b. Criteria Technical feasibility Management intention to use or sell Ability to use or sell Demonstrate there is an external market or internal use Adequate resources to complete Reliable measurement of expenditures

Evidence There is evidence the machine works. Using the machine proves intent. Using establishes ability to use. Use does not establish this point. If there is uncertainty or doubt, then tests to determine if the asset’s value has been impaired should be completed. Use established that the process is complete. The amount paid ($20 million) is easily determined and proved.

P9-13. Suggested solution: a. This activity is research related to general knowledge; therefore expense. b. Capitalize as development cost. The product component (battery) already exists and is used in existing products. The project was a success with demonstrated improvement in battery capacity. Therefore, the six criteria for capitalization of development costs would be satisfied. c. Capitalize as development cost. The six criteria for capitalization are likely satisfied. The fact that this is one of a series of similar projects is not important. That is, the everyday nature of the activity does not preclude the costs from being capitalized. For software companies such as this social media company, software improvements are frequently ongoing, and can be capitalized as software development cost. P9-14. Suggested solution: a.

Dr. Research expense 3,000,000 Cr. R&D costs 3,000,000 Testing on animals, even if successful, does not prove that it is effective on humans. Fails the technical feasibility criterion.

Dr. Research expense 10,000,000 Cr. R&D costs 10,000,000 Mixed test results do not prove the drug is effective on humans. Fails the technical feasibility criterion.

Dr. Development costs (asset) Cr. R&D costs Meets all six criteria for capitalization.

Dr. Research expense 35,000,000 Cr. R&D costs 35,000,000 Company does not have resources to complete, so it must expense the costs.

30,000,000

. 9-7

30,000,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P9-15. Suggested solution: The $5 million cost of manufacturing the testing equipment should be capitalized in the same manner as other tangible fixed assets. Depreciation should then be expensed over the equipment’s useful life. As the testing equipment is used to improve the quality of the electronic products manufactured, during the production process, the depreciation charge should be included in the inventoriable costs of the products tested (paragraph 49, IAS 16 and paragraph 2, IAS 2). The $2 million contribution to IU is a research expenditure and should be expensed. The fact that past research costs have been recouped through downstream commercial ventures is irrelevant, as the non-directed research now being funded does not meet the six development criteria set out in paragraph 57 of IAS 38. Paragraph 57 of IAS 38 requires that an asset shall be recognized for development costs, if, and only if all of the following criteria are met:  the project is technically feasible;  there is an intention to complete the project and either to sell the item or use it;  there is an ability to use or sell the asset;  the future economic benefits of the project can be demonstrated;  the company has adequate technical, financial, and other resources are available to enable the completion of the project; and  expenditures on the project can be reliably measured. These tests appear to have been met, and qualifying costs should be capitalized, subject to what is said below: If the criteria for capitalization are not met, the costs to date should be expensed, rather than capitalized. Only costs incurred after the project first met the six tests above are eligible for capitalization. That is to say that (research) costs previously expensed cannot be included in the cost of the asset. Paragraphs 65 and 71 of IAS 38 refer. Amortization of the capitalized costs should start once commercial production of the butler begins. The asset should be amortized over its useful life.

  

P9-16. Suggested solution: a.

Dr. Research expense 50,250,000 Dr. Development costs (asset) 6,750,000 Cr. R&D costs 57,000,000 Only one of the five drugs meets all six criteria. Unless costs such as supplies, rent, and utilities can be reliably attributable to the successful drug, they should be expensed. Most likely difficult to assign, so should expense. Allocated head office overhead is not reliably attributable to the successful drug and must be expensed. 15% of the salaries ($6,750,000) could likely be assigned to the successful drug.

. 9-8

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

Dr. Research expense 45,000,000 Cr. R&D costs 45,000,000 Company has not established market and technical feasibility, therefore expense.

Dr. Research expense 70,000,000 Cr. R&D costs 15,000,000 Cr. Development costs (asset) 55,000,000 Expense all of current year’s R&D costs ($15m) and write off prior year’s capitalized development costs ($55m).

P9-17. Suggested solution: a. b. c. d. e.

Item Copyright Trademark Brand purchased from another company Design for an office chair (industrial design) Goodwill purchased

Finite Life

√ √

Indefinite Life

√

P9-18. Suggested solution: a. b. c. d.

Do not amortize as the right is perpetual. Annually revisit this amount to see if there is impairment in value. Expense the $40,000,000 as this does not qualify as a development cost. This is an ongoing operating expense to maintain and enhance the brand. Amortize over two years as this is the expected duration of the product promotion strategy. There is no evidence provided that there is a use after this advertising campaign ends. Amortize over the six-year reasonably estimated useful life of the drug.

P9-19. Suggested solution: a. Finite life – amortize Goodwill Brand name Copyright Customer list Franchise Industrial design Licensing arrangement Patent Supply agreement Trademark

Indefinite life – do not amortize

Potentially either

√ √

√

√ √

. 9-9

√

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Franchises, licensing arrangements, and supply agreements may be granted for a specific period, an indefinite period, or in perpetuity. Limited life intangibles arising from contractual arrangements are amortized. Indefinite life and perpetual intangibles arising from contractual arrangements are amortized only if their useful life is expected to be limited.

P9-20. Suggested solution: a. b. c. d.

Intangible asset with indefinite life. Do not amortize but annually check for impairment in value. Without additional information, should expense this cost, as there is not sufficient evidence to establish that there is a demonstrated market for the book when it is finished. Amortize over not more than 20 years as this is consistent with the financial analysis. May consider reducing the amortization period to 10 years as much of the fame of the band and its music will likely have evaporated by then. Amortize the $15,000,000 over the three-year term of the contract. If the renewal option is exercised later, amortize that fee over four years. It is not reasonable to amortize the entire amount of $25,000,000 over seven years as this is contingent on renewing the option, which is not reasonably certain to occur at this point in time.

P9-21. Suggested solution:

2023 Apr-Dec

Remaining amortizable amount $24,000,000

÷ Months of useful life remaining 144

× Months of amortization in year 9

= Amount of amortization $1,500,000

2024

$22,500,000

135

$2,000,000*

2025 Jan-Sep 2025 Oct-Dec 2025 Total

$20,500,000 23,000,000**

123 114

9 3

$1,500,000 605,263 2,105,263

2026 $22,394,737 111 12 $2,421,053 * Can be alternately computed as $24,000,000 / 12 years = $2,000,000 / year. ** 2025 Oct 1 Remaining amortizable amount = $20,500,000 – $1,500,000 + $4,000,000 = $23,000,000. The cost of defending the patent should be included in the cost of the patent. P9-22. Suggested solution: a.

Further information is needed to determine whether the purchased copyright has a finite or an indefinite life. While copyright law can be very complicated, some basic considerations of whether amortization is appropriate include: whether TPC’s license to use the specific translation of The Bible ever expires; whether the terms of the license permit the narrative to be updated; and whether TPC intends to periodically update the narrator(s) and/or narrative. . 9-10

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

If the license expires, the maximum amortization period for the trademark would be the remaining term of the license. If the license does not permit the audio book narrative to be updated, the maximum amortization period for the trademark would be the remaining life of the trademark. If neither of these restrictions applies, and TPC intends to periodically update the narrator(s) and/or the narrative, the trademark should be tested for impairment annually, as discussed in chapter 10. b.

The carrying value of the novel copyright as at December 31, 2023 is $46,000. ($48,000 / 4 years = $12,000 per year; $12,000 × 2 / 12 = $2,000); $48,000 - $2,000 = $46,000).

P9-23. Suggested solution: a.

Dr. License Cr. Cash

150,000

Dr. Access rights Cr. Cash

30,000

Dr. Prepaid expense 9,000 Cr. Cash Paragraph 69(c) prohibits the capitalization of advertising expense.

150,000 30,000 9,000

Dr. Research expense 50,000 Cr. Cash 50,000 BC is still in the research phase of this project. Costs cannot be capitalized (an intangible asset recognized) until all of the six criteria set out in paragraph 57 of IAS 38 have been met. b.

Dr. Amortization expense - license Cr. License $150,000 / 5 years = $30,000 per year

30,000

Dr. Amortization expense – access rights Cr. Access rights $30,000 / 6 years = $5,000 per year; $5,000 × 9 / 12 = $3,750

3,750

Dr. Advertising expense Cr. Prepaid expense $9,000 / 12 months = $750 per month; $750 × 7 = $5,250

5,250

. 9-11

30,000

3,750

5,250

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P9-24. Suggested solution: Recognition

Dr. Accounting software - new ($26,000 + 28,000 $2,000) Dr. Wage expense 6,000 Cr. Cash 34,000 Capitalizable costs include the costs of materials and services used to create the software (the software developer) and the cost of employee benefits used to create the software (the cost of the employee who assisted the software developer). Training costs must always be expensed as per paragraphs 29 and 67 of IAS 38.

Derecognition Dr. Loss on derecognition of accounting 12,000 software Cr. Accounting software - old 12,000 There is no need to first update the amortization of the asset as BBC’s policy is to not record amortization in the year of derecognition. Amortization Dr. Amortization expense – accounting 7,000 software Cr. Accounting software – new 7,000 $28,000 / 4 = $7,000; BBC’s policy is to record an entire year’s amortization in the year of acquisition P9-25. Suggested solution: a.

Dr. Patent – Skate Sure 40,000 Dr. Legal expense – Score Goals 30,000 Cr. Cash 70,000 The costs of successfully defending the patent infringement are capitalized (added to the cost of the patent), whereas the costs of unsuccessful action are expensed.

Dr. Loss on derecognition of patent Cr. Patent – Score Goals

250,000

Dr. Amortization expense - patent Cr. Patent – Skate Sure ($300,000 + $40,000) / 8 = $42,500

42,500

. 9-12

250,000 42,500

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

P9-26. Suggested solution: We must first determine the cash equivalent sales price using present value techniques and then allocate the proceeds. The fair value of the note receivable is determined using present value techniques.  PVFA(6.0%, 6) = 1/0.06 - 1/0.06(1.06)6 = 4.917324  PV of the note = $1,000,000 × PVFA(6.0%, 6) = $1,000,000 × 4.917324 = $4,917,324 Or using a BAII PLUS financial calculator 6 N, 6.0 I/Y, 1,000,000 PMT, CPT PV = –4,917,324 (rounded) Allocation of sales proceeds Cash Fair value of the note receivable Sales proceeds to be allocated

$2,000,000 4,917,324 $6,917,324

Inventory Equipment Patent Trademark Allocated to identifiable assets Unattributed (goodwill arising on sale) Total

$ 110,000 1,300,000 3,000,000 55,000 4,465,000 2,452,324 $6,917,324

Dr. Cash Dr. Note receivable Cr. Inventory Cr. Gain on sale of division - inventory Cr. Equipment Dr. Accumulated depreciation equipment ($2,000,000 – $1,400,000) Dr. Loss on sale of division – equipment Cr. Patent Cr. Gain on sale of division – patent Cr. Trademark Cr. Gain on sale of division - trademark Cr. Gain on sale of division – goodwill

. 9-13

2,000,000 4,917,324

600,000 100,000

100,000 10,000 2,000,000

20,000 2,980,000 10,000 45,000 2,452,324

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P9-27. Suggested solution: Preliminaries • The fair market value of the note was $1.8 million as the interest rate charged approximated the market rate of interest for similar transactions. • The $240,000 cost of the copyright defence would have been capitalized in 2020. Depreciation of $20,000 ($240,000 / 12) would have been expensed in each of 2020 to 2022. Hence the book value of the copyright is $180,000 ($240,000 – (3 × $20,000)). • The book value of the goodwill is $225,000 ($310,000 paid less the $85,000 impairment). Allocation of sales proceeds Cash Fair value of the note Sales proceeds to be allocated

$2,700,000 1,800,000 $4,500,000

Land Building and equipment Copyright Allocated to identifiable assets Unattributed (goodwill arising on sale) Total

$2,100,000 1,000,000 850,000 3,950,000 550,000 $4,500,000

Dr. Cash Dr. Note receivable Cr. Land Cr. Gain on sale of division – land Cr. Building and equipment Dr. Accumulated depreciation building and equipment ($1,200,000 – $750,000) CR. Gain on sale of division – building and equipment Cr. Copyright Cr. Gain on sale of division – copyright Cr. Goodwill Cr. Gain on sale of division – goodwill

. 9-14

2,700,000 1,800,000

450,000

1,000,000 1,100,000 1,200,000 250,000 180,000 670,000 225,000 325,000

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

P9-28. Suggested solution: ($000’s) Cash Accounts receivable Inventories Prepaid expenses PPE, net Intangible assets Total assets Total liabilities Net assets Purchase price Accounting goodwill

Carrying value $ 4,000 35,000 45,000 3,000 100,000 1 187,001 120,000 $ 67,001

Fair value $ 4,000 32,000 41,000 0 132,000 25,000 234,000 115,000 119,000 119,000 $ 0

P9-29. Suggested solution: ($000’s) Cash Accounts receivable Inventories Prepaid expenses PPE, net Intangible assets Total assets Total liabilities Net assets Purchase price Accounting goodwill

Carrying value $ 7,000 43,000 25,000 2,000 90,000 0 167,000 92,000 $ 75,000

Fair value $ 7,000 40,000 31,000 1,000 102,000 21,000 202,000 105,000 97,000 121,000 $ 24,000

. 9-15

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P9-30. Suggested solution: ($000’s) Cash Accounts receivable Inventories PPE, net Intangible assets Total assets Total liabilities Net assets Purchase price Accounting goodwill

Carrying value $ 9,000 55,000 63,000 167,000 1 294,001 191,000 $103,001

Fair value $ 9,000 47,000 61,000 112,000 35,000 264,000 175,000 89,000 95,000 $ 6,000

P9-31. Suggested solution: a.

Economic profit is the earnings of the firm that exceed its risk-adjusted required rate of return on equity. For example, suppose a company has owners’ equity of $2 million and it should earn a rate of return on equity of 15% ($300,000) considering the company’s risk, while the business actually earns a return on equity of 18% ($360,000). The economic profit would be $60,000 (3% × $2,000,000). In comparison, accounting net income would have been $360,000. Accounting net income does not include a charge for the implicit cost of equity financing (like the interest cost on debt financing). Accounting net income ignores the fact that owners reasonably expect a reward for their investment of funds. Accounting net income should be reduced by an imputed capital charge for the shareholders’ equity investment in the firm. The economist would say that the company is profitable only if its rate of return on equity exceeds its cost of equity capital. In management accounting this has been called residual income or economic value added. In economics it is called abnormal earnings.

P9-32. Suggested solution: Economic profit would be $15 million for the year ($50 million – $350 million × 10%). If the firm were to become riskier and accounting income were to remain at $50 million, then economic profit would decrease, as the risk-adjusted rate of return would increase. For example, if the required rate of return were to increase to 12%, then economic profit would decrease to $8 million ($50 million – $350 million × 12%). P9-33. Suggested solution: The future stream of income is a perpetuity so its present value equals $900,000 / 13% = $6,923,000 (rounded to the nearest thousand). Since economic goodwill is the amount in excess of the invested capital of $6,000,000, economic goodwill is $923,000.

. 9-16

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

If this amount were negative, this would mean that the company is not profitable in an economic sense. The rate of return the firm earns is less than the required rate of return expected by owners. The owners are not being compensated for their investment and the risk they are assuming by tying up their funds in this venture. The firm is not earning sufficient profit to cover the opportunity cost of its equity financing. As risk increases the discount rate (cost of capital) must increase to compensate for the higher risk; if the economic goodwill is negative it means that after adjusting for risk and the time value of money the investment is unsuccessful or unprofitable. P9-34. Suggested solution: First Reason: As the text of this chapter notes, the market for mineral resources is well established; the market for ideas is not. The output of the exploration has a defined market and selling price, as commodities can be objectively valued and readily sold. The output of research by its nature is not defined as this is precisely what research is—new knowledge. Second Reason: Most exploration, especially by smaller operators, is done using a combination of joint ventures and a portfolio of exploration projects. By diversifying the exploration process into numerous small projects, it becomes reasonable to expect some of the undertakings to be successful. Third Reason: For small, junior public companies it is helpful to appear less unprofitable and have more assets and equity. This can increase the firm’s overall net book value and make it easier to raise new financing. Mineral exploration companies require significant up-front investments, and only much later are there cash inflows. Therefore, it is essential for the firm to be able to raise funds for exploration and development to allow for their survival. For these companies, geology is far more important than the financial statements; investors look more closely at the assay reports (about the existence and concentration of ore) than the financial reports and statements. Fourth Reason: Political pressure. Mineral exploration is vital to many countries and regions. Political lobbies and other influencers have dissuaded regulators from forcing the expensing of exploration costs. Vested interests have argued that expensing these costs would destroy the industry as they would look less financially attractive and therefore not be able to raise financing for exploration and development. While these views may be financially naive, they are not politically naive. Fifth Reason: Users of financial statements can easily ignore and implicitly expense mineral exploration costs if they disagree with the deferral approach. Sixth Reason: Capitalization of exploration costs may reduce the constraints of some debt solvency encumbrances.

. 9-17

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P9-35. Suggested solution: a. b. c. d.

Item Costs of mineral production are expensed.

T/F F

Costs incurred in the development phase are capitalized until production begins. Costs incurred in exploration are expensed as incurred Costs incurred in exploration are capitalized until the feasibility of the mineral site has been determined

T F T

Explanation The costs of mineral production are capitalized into inventories. The expense is recorded when the minerals are sold. With the site in the development phase, there is an expectation of future benefit flowing from the site. Exploration costs are expensed when the site is determined to be a failure. This is one of two policies acceptable under IFRS.

P9-36. Suggested solution: 2023

2024

Dr. Intangible assets – Andromeda site Dr. Intangible assets – Bode site Cr. Cash

2,380,000 950,000

Dr. Intangible assets – Andromeda site Dr. Intangible assets – Bode site Cr. Cash

1,470,000 1,950,000

Dr. Exploration and evaluation expense – Bode site Cr. Intangible assets – Bode site

2,900,000

3,330,000

3,420,000 2,900,000

P9-37. Suggested solution: 2023

Dr. Intangible assets – exploration and evaluation Cr. Cash

3,330,000

2024

Dr. Intangible assets – exploration and evaluation Cr. Cash

3,420,000

. 9-18

3,330,000 3,420,000

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

P9-38. Suggested solution: Production volume Reserves – beginning of year Rate for depletion and depreciation

Depletion $754,000 6.25% $ 47,125

Costs capitalized Rate for depletion and depreciation Amount of depletion or depreciation

15,000 240,000 6.25% Depreciation $1,348,000 6.25% $ 84,250

P9-39. Suggested solution: 2023

Dr. Intangible assets – Brass Mountain Cr. Cash

5,125,000

2024

Dr. Intangible assets – Brass Mountain Cr. Cash

3,500,000

2025

Dr. Depletion expense Cr. Intangible assets – Brass Mountain 400 tonnes / 5,000 tonnes × (5,125,000 + 3,500,000)

690,000

5,125,000 3,500,000 690,000

P9-40. Suggested solution: 2023

Dr. Intangible assets Cr. Cash

8,500,000

2023

Dr. Intangible assets Cr. Cash

4,000,000

2024

8,500,000 4,000,000

Dr. Depletion expense 1,250,000 Cr. Intangible assets 1,250,000 60,000 BOE / (540,000 + 60,000) BOE × 12,500,000 Note that the depreciation rate should use the best information available, which is the most recent estimate of reserves at the end of 2024, adjusted to the beginning of the year. End-of-year reserve + production during year = beginning-of-year reserves.

. 9-19

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P9-41. Suggested solution: Alpha Hills: Dr. Cash Cr. Revenue Dr. Operating expenses (or inventories) Cr. Cash Dr. Depletion expense (or inventories) (30/200 × $30m) Cr. Accum. depl. – exploration costs – Alpha Hills Dr. Depreciation expense (or inventories) (30/200 × $20m) Cr. Accum. depr. – development costs – Alpha Hills

34,500,000 15,000,000 4,500,000 3,000,000

Beta Valley: Dr. PPE – development cost – Beta Valley Cr. Cash

8,000,000

Chi Canyon: Dr. Intangible asset – exploration costs – Chi Canyon Cr. Cash

5,000,000

Delta Ridge: Dr. Exploration expense Cr. Cash

2,000,000

Research and development project: Dr. R&D expense Cr. Cash

12,000,000

34,500,000 15,000,000 4,500,000 3,000,000

8,000,000

5,000,000

2,000,000

12,000,000

P9-42. Suggested solution: Under the full cost method, exploration costs are capitalized independent of whether the exploration is successful. Furthermore, exploration costs are not identified by location, and the pool of exploration costs are depleted on a units-of-production basis. Record exploration costs incurred at Chi Canyon and Delta Ridge Dr. Intangible asset – exploration costs Dr. Intangible asset – exploration costs Cr. Cash

5,000,000 2,000,000

Record development costs incurred in Beta Valley: Dr. PPE – development cost – Beta Valley Cr. Cash

8,000,000

. 9-20

7,000,000

8,000,000

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

Record production revenue, operating expenses, depreciation, and depletion: Dr. Cash 34,500,000 Cr. Revenue 34,500,000 Dr. Operating expenses (or inventories) 15,000,000 Cr. Cash 15,000,000 Dr. Depletion expense (or inventories) (30/200 × ($30m+$7m)) Cr. Accum. depl. – exploration costs Dr. Depreciation expense (or inventories) (30/200 × $20m) Cr. Accum. depr. – development costs – Alpha Hills Record costs incurred in the research and development project: Dr. R&D expense Cr. Cash

5,550,000 3,000,000

12,000,000

P9-43. Suggested solution: Successful efforts method ($000’s) Cash Capitalized E&D costs Total assets

2019 45,000 0 45,000

2020 38,000 0 38,000

2021 30,000 0 30,000

2022 20,000 10,000 30,000

2023 9,000 21,000 30,000

2024 31,000 14,000 45,000

2025 66,000 5,250 71,250

2026 75,000 0 75,000

Share capital

50,000

(5,000)

21,250

25,000

45,000

50,000 (20,000 ) 30,000

50,000

Total owners’ equity

50,000 (20,000 ) 30,000

50,000

(5,000)

50,000 (20,000 ) 30,000

50,000

Retained earnings (deficit)

50,000 (12,000 ) 38,000

45,000

71,250

75,000

Revenue Exploration costs Extraction costs Amortization of capitalized E&D costs Net income (loss)

0 (5,000) 0

0 (7,000) 0

0 (8,000) 0

0 0 0

26,000 0 (4,000)

40,000 0 (5,000)

12,000 0 (3,000)

(7,000)

(8,750)

(5,250)

(5,000)

(7,000)

(8,000)

15,000

26,250

3,750

In the above table, the amortization of E&D costs is computed as follows: 2024 2025 E&D costs capitalized, beginning of year 21,000,000 14,000,000 Total estimated ore reserves, beginning of year ÷ 6,000,000 ÷ 4,000,000 Cost deferred per unit of ore 3.50 3.50 Production during year × 2,000,000 × 2,500,000 Amount to amortize for year $7,000,000 $8,750,000 E&D costs, end of year 14,000,000 5,250,000

. 9-21

2026 5,250,000 ÷ 1,500,000 3.50 × 1,500,000 $5,250,000 0

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P9-44. Suggested solution: Full-cost method ($000’s) Cash Capitalized E&D costs Total assets

2019 45,000 5,000 50,000

2020 38,000 12,000 50,000

2021 30,000 20,000 50,000

2022 20,000 30,000 50,000

2023 9,000 41,000 50,000

2024 31,000 27,333 58,333

2025 66,000 10,250 76,250

2026 75,000 0 75,000

Share capital Retained earnings (deficit) Total owners’ equity

50,000 0 50,000

50,000 8,333 58,333

50,000 26,250 76,250

50,000 25,000 75,000

Revenue Exploration costs Extraction costs Amortization of capitalized E&D costs Net income (loss)

0 0 0

26,000 0 (4,000) (13,667 ) 8,333

40,000 0 (5,000) (17,083 ) 17,917

12,000 0 (3,000) (10,250 ) (1,250)

In the above table, the amortization of E&D cost is computed as follows: 2024 2025 E&D costs capitalized, beginning of year 41,000,000 27,333,333 Total estimated ore reserves, beginning of year ÷ 6,000,000 ÷ 4,000,000 Cost deferred per unit of ore 6.8333 6.8333 Production during year × 2,000,000 × 2,500,000 Amount to amortize for year $13,666,667 $17,083,333 E&D costs, end of year 27,333,333 10,250,000

2026 10,250,000 ÷ 1,500,000 6.8333 × 1,500,000 $10,250,000 0

P9-45. Suggested solution: Gross method records government grants as income if the grant is a subsidy of expenses, and deferred income (a liability) if it subsidy of asset cost. Dr. Government grant receivable 150,000 Cr. Other income (government grant) 150,000 Dr. Government grant receivable Cr. Deferred income

80,000

. 9-22

80,000

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

P9-46. Suggested solution: Net method records government grants as reductions in expenses and assets that the grants subsidize. Dr. Government grant receivable 150,000 Cr. Wages expense 150,000 Dr. Government grant receivable Cr. Equipment

80,000

P9-47. Suggested solution: a. Gross method i. Dr. Cash or government grant receivable Cr. Other income (government grant)

750,000

ii.

No entry. Subsidy goes to buyers of turbines, not the sellers. Of course, the sellers also benefit as a result of higher demand for the turbines, which should result in higher sales volume or higher sale prices.

iii.

Dr. Cash or government grant receivable Cr. Deferred income

b. Net method i. Dr. Cash or government grant receivable Cr. R&D expense ii.

No entry.

iii.

Dr. Cash or government grant receivable Cr. PPE (turbine factory)

1,400,000

750,000

1,400,000

750,000 —

1,400,000

P9-48. Suggested solution: a. Gross method i. Dr. Cash Cr. Other income (government grant)

20,000

ii.

Dr. Cash Cr. Deferred income

200,000

iii.

Dr. Cash ($3,000,000 × 4%) Cr. Deferred income

120,000

. 9-23

20,000 200,000 120,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

b. Gross method Dr. Deferred income Cr. Other income (government grant) (($200,000 + $120,000) / 20)* Dr. Depreciation expense Cr. Accumulated depreciation (($4,000,000 - $400,000) / 20))

16,000

180,000

16,000

180,000

*The forgivable loan is taken into income on the same basis that is used to depreciate the asset (20 years), rather than the period of the loan (5 years). c. Net method i. Dr. Cash Cr. Property tax expense

20,000

ii.

Dr. Cash Cr. PPE (research facility)

200,000

iii.

Dr. Cash ($3,000,000 × 4%) Cr. PPE (research facility)

120,000

d. Net method Dr. Depreciation expense 164,000 Cr. Accumulated depreciation ((($4,000,000 - $400,000 – ($200,000 + $120,000)) / 20)))

20,000 200,000 120,000

164,000

P9-49. Suggested solution: a. Journal entries: i. Dr. Factory Cr. Cash

100,000,000

ii.

Dr. Land Cr. Other income – government grant

iii.

Dr. Property taxes payable (25% × 1,600,000) Cr. Property tax expense

iv.

Dr. Cash Cr. Factory

15,000,000

Dr. Cash Cr. Compensation expense

4,000,000

. 9-24

5,000,000 400,000

100,000,000 5,000,000 400,000 15,000,000 4,000,000

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

vi.

Dr. Cash Cr. Other income – government grant

2,000,000

vii.

It is not reasonable to accrue any of this amount, as its realization in five years is contingent on meeting a standard that is challenging and potentially not attainable. Further, in the first year, the goal of employing 700 workers was not met.

2,000,000

b. The annual depreciation will be (100,000,000 – 15,000,000) / 30 years = 2,833,333/year. c. Effect of subsidies on income: Item Free land Property tax discount (25% of 1,600,000) Training subsidy ($4,000,000 per year) Grant for past employment (one-time) Forgivable loan on factory (reduces factory cost by $15,000,000; therefore, depreciation decreases by $15,000,000/30 years; no depreciation in first year according to company policy) Total

Year 1 $5,000,000 400,000 4,000,000 2,000,000

Year 2 $

0 $11,400,000

500,000 $4,900,000

400,000 4,000,000

P9-50. Suggested solution: a. Amounts in $millions Depreciation / amortization begins in 2014 when production begins. Depreciable amount is cost adjusted by government subsidy of 20% for plant and equipment and 40% for development costs. At the beginning of 2020, the portions of the subsidies relating to the remaining used life of the plant and equipment need to be repaid. For the plant, the repayment is 14 years / 20 years × $20 million = $14 million. For the equipment, the repayment is 4 years / 10 years × $12 million = $4.8 million. Under IFRS, when government grants / subsidies need to repaid due to failure to comply with grant stipulations, the cumulative additional depreciation that would have been recognized without the grant needs to be recognized immediately in income.

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Plant

Net carrying value

Equipment

Net carrying value

DepreCost after Accum. Year ciation Gross cost subsidy depr. 2011 2012 2013 0 100 80 0 80 2014 4 100 80 ( 4.0) 76 2015 4 100 80 ( 8.0) 72 2016 4 100 80 (12.0) 68 2017 4 100 80 (16.0) 64 2018 4 100 80 (20.0) 60 2019 4 100 80 (24.0) 56 2020: Repayment of subsidy +14 +14 2020: Cumulative effect 4.2 ( 4.2) (4.2) 2020: Subtotal 94 (28.2) 65.8 2020: Annual depreciation 4.7 100 94 (32.9) 61.1 Years 2021 – 2034 of the amortization schedule is provided for expository purposes only; it was not part of the “required” in the question. 2021 4.7 100 94 (37.6) 56.4 2022 4.7 100 94 (42.3) 51.7 2023 4.7 100 94 (47.0) 47.0 2024 4.7 100 94 (51.7) 42.3 2025 4.7 100 94 (56.4) 37.6 2026 4.7 100 94 (61.1) 32.9 2027 4.7 100 94 (65.8) 28.2 2028 4.7 100 94 (70.5) 23.5 2029 4.7 100 94 (75.2) 18.8 2030 4.7 100 94 (79.9) 14.1 2031 4.7 100 94 (84.6) 9.4 2033 4.7 100 94 (89.3) 4.7 2034 4.7 100 94 (94.0) 0.0

Year 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020: Repayment of subsidy 2020: Cumulative effect

Depreciation

Gross cost

0 4.8 4.8 4.8 4.8 4.8 4.8

60 60 60 60 60 60 60

2.88 . 9-26

Cost after subsidy

Accum. depr.

48 48 48 48 48 48 48 +4.8 .

0 ( 4.8) ( 9.6) (14.4) (19.2) (24.0) (28.8) ( 2.88)

48.0 43.2 38.4 33.6 28.8 24.0 19.2 +4.8 ( 2.88)

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

2020: Subtotal 52.8 (31.68) 21.12 2020: Annual depreciation 5.28 60 52.8 (36.96) 15.84 Years 2021 – 2023 of the amortization schedule is provided for expository purposes only; it was not part of the “required” in the question. 2021 5.28 60 52.8 (42.24) 10.56 2022 5.28 60 52.8 (47.52 5.28 2023 5.28 60 52.8 (52.80) 0.00 Intangible asset – development costs Year 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Amortization 0 0 0.36 0.36 0.36 0.36 0.36 0.36 5.04

Gross cost

Cost after subsidy

Accum. amort.

Net carrying value

12 12 12 12 12 12 12 12 12

7.2 7.2 7.2 7.2 7.2 7.2 7.2 7.2 7.2

0 0 (0.36) (0.72) (1.08) (1.44) (1.80) (2.16) (7.20)

7.20 7.20 6.84 6.48 6.12 5.76 5.40 5.04 0.00

Note that the intangible asset relates to costs incurred to development the solar power generator, so it is impaired with a recoverable amount of zero in year 2020, so the balance should be written off. Impairment is covered in Chapter 10. b. Journal entries 2011 Dr. Research expense Cr. Cash Dr. Government grant receivable or cash Cr. Research expense (40% × $20,000,000)

20,000,000 8,000,000

2012 Dr. Development expense Dr. Intangible asset – development costs Cr. Cash Dr. Government grant receivable or cash Cr. Development expense (40% × 18,000,000 Cr. Intang. asset – dev. cost (40%×$12,000,000)

18,000,000 12,000,000

2013 Dr. Production plant Dr. Equipment Cr. Cash Dr. Government grant receivable or cash Cr. Production plant (20% × $100,000,000) Cr. Equipment (20% × $60,000,000)

100,000,000 60,000,000

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12,000,000 7,200,000

32,000,000

20,000,000 8,000,000

30,000,000 4,800,000

160,000,000 20,000,000 12,000,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

2014 Dr. Inventories ($80,000,000 / 20 years) Cr. Accumulated depreciation – plant Dr. Inventories ($48,000,000 / 10 years) Cr. Accumulated depreciation – equipment Dr. Inventories ($7,200,000 / 20 years) Cr. Accum. amort. – intangible asset – dev. cost 2020 Repayment of government grant: Dr. Production plant (14 years / 20 years × $20,000,000) Dr. Equipment (4 years / 10 years × $12,000,000) Cr. Cash

4,000,000 4,800,000 360,000

14,000,000

Cumulative effect of repayment on prior depreciation Dr. Depreciation expense – loss on grant repayment Cr. Accumulated depreciation – plant Cr. Accumulated depreciation – equipment Annual depreciation: Dr. Inventories ($65,800,000 / 14 years) Cr. Accumulated depreciation – plant Dr. Inventories ($21,120,000 / 4 years) Cr. Accumulated depreciation – equipment Impairment of intangible asset for development costs Dr. Loss on impairment Cr. Accum. amort. – intangible asset – dev. Cost

4,800,000

7,080,000

4,700,000 5,280,000

5,040,000

18,800,000

4,200,000 2,880,000

4,700,000 5,280,000

5,040,000

P9-51. Suggested solution: a. Amounts in $millions Depreciation / amortization begins in 2014 when production begins. Depreciable amount is cost adjusted by government subsidy of 20% for plant and equipment and 40% for development costs. At the beginning of 2020, the portions of the subsidies relating to the remaining used life of the plant and equipment need to be repaid. For the plant, the repayment is 14 years / 20 years × $20 million = $14 million. For the equipment, the repayment is 4 years / 10 years × $12 million = $4.8 million. Under ASPE, there is no cumulative adjustment for past depreciation that would have been recognized in the absence of the grant. The adjustments are prospective.

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Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

Plant

Net carrying value

DepreCost after Accum. Year ciation Gross cost subsidy depr. 2011 2012 2013 0 100 80 0 80 2014 4 100 80 ( 4) 76 2015 4 100 80 ( 8) 72 2016 4 100 80 (12) 68 2017 4 100 80 (16) 64 2018 4 100 80 (20) 60 2019 4 100 80 (24) 56 2020: Repayment of subsidy +14 +14 2020: Subtotal 94 (24) 70 2020: Annual depreciation 5 100 94 (29) 65 Years 2021 – 2034 of the amortization schedule is provided for expository purposes only; it was not part of the “required” in the question. 2021 5 100 94 (34) 60 2022 5 100 94 (39) 55 2023 5 100 94 (44) 50 2024 5 100 94 (49) 45 2025 5 100 94 (54) 40 2026 5 100 94 (59) 35 2027 5 100 94 (64) 30 2028 5 100 94 (69) 25 2029 5 100 94 (74) 20 2030 5 100 94 (79) 15 2031 5 100 94 (84) 10 2033 5 100 94 (89) 5 2034 5 100 94 (94) 0 Equipment Year 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020: Repayment of subsidy 2020: Subtotal 2020: Annual depreciation

Depreciation

Gross cost

0 4.8 4.8 4.8 4.8 4.8 4.8

60 60 60 60 60 60 60

60 . 9-29

Cost after subsidy

Accum. depr.

Net carrying value

48 48 48 48 48 48 48 +4.8 52.8 52.8

0 ( 4.8) ( 9.6) (14.4) (19.2) (24.0) (28.8) . (28.8) (34.8)

48.0 43.2 38.4 33.6 28.8 24.0 19.2 +4.8 24.0 18.0

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Years 2021 – 2023 of the amortization schedule is provided for expository purposes only; it was not part of the “required” in the question. 2021 6 60 52.8 (40.8) 12.0 2022 6 60 52.8 (46.8) 6.0 2023 6 60 52.8 (52.8) 0.0 Intangible asset – development costs Year 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Amortization 0 0.36 0.36 0.36 0.36 0.36 0.36 5.04

Gross cost

Cost after subsidy

Accum. amort.

Net carrying value

12 12 12 12 12 12 12 12

7.2 7.2 7.2 7.2 7.2 7.2 7.2 7.2

0 (0.36) (0.72) (1.08) (1.44) (1.80) (2.16) (7.20)

7.20 6.84 6.48 6.12 5.76 5.40 5.04 0.00

20,000,000 8,000,000

2012 Dr. Development expense Dr. Intangible asset – development costs Cr. Cash Dr. Government grant receivable or cash Cr. Intang. asset – dev. cost (40% × $12,000,000)

18,000,000 12,000,000

2013 Dr. Production plant Dr. Equipment Cr. Cash Dr. Government grant receivable or cash Cr. Production plant (20% × $100,000,000) Cr. Equipment (20% × $60,000,000)

100,000,000 60,000,000

2014 Dr. Inventories ($80,000,000 / 20 years) Cr. Accumulated depreciation – plant Dr. Inventories ($48,000,000 / 10 years) . 9-30

4,800,000

32,000,000

4,000,000 4,800,000

20,000,000 8,000,000

30,000,000 4,800,000

160,000,000 20,000,000 12,000,000 4,000,000

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

Cr. Accumulated depreciation – equipment Dr. Inventories ($7,200,000 / 20 years) Cr. Accum. amort. – intangible asset – dev. cost 2020 Repayment of government grant: Dr. Production plant (14 years / 20 years × $20,000,000) Dr. Equipment (4 years / 10 years × $12,000,000) Cr. Cash Annual depreciation: Dr. Inventories ($70,000,000 / 14 years) Cr Accumulated depreciation – plant Dr. Inventories ($24,000,000 / 4 years) Cr. Accumulated depreciation – equipment Impairment of intangible asset for development costs Dr. Loss on impairment Cr. Accum. amort. – intangible asset – dev. Cost

360,000

4,800,000 360,000

14,000,000 4,800,000

5,000,000 6,000,000

5,040,000

18,800,000

5,000,000 6,000,000

5,040,000

P9-52. Suggested solution: a.

Canadian Tire’s balance sheet as at December 28, 2019 and Note 11 reported goodwill and intangible assets totaling $2,414.3 million as set out below:

Asset Goodwill

Balance – Dec 28, 2019 ($millions) $891.1

Banners and trademarks Franchise agreements Total indefinite life intangibles excluding goodwill Software Other intangibles Total finite life intangibles

$932.3 167.7 $1,100.0 $423.2 0.0 $423.2

Total intangibles and goodwill

$2,414.3

Intangibles and goodwill / total assets = $2,414.3 / $19,518.3 = 12.4% b.

The average remaining useful life of finite intangible assets can be estimated as the net amount of finite intangible assets divided by the annual amortization. Note 11 shows $110.8m of amortization for software. Therefore, at the end of 2019, the estimated average remaining useful life of the software is $423.2m / $110.8m per year = 3.8 years.

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P9-53. Suggested solution: a.

c. d.

At the end of 2019, Thomson Reuters’s balance sheet shows intangible assets totalling $4,418 million. This is comprised of $900 million in computer software and $3,518 million in other identifiable intangible assets. Separately, goodwill amounted to $5,853 million. Intangible assets and goodwill together accounted for $10,271 million or 59.4% of the $17,295 million in total assets. The average remaining useful life of intangible assets can be estimated as the net amount of intangible assets divided by the annual amortization. At the end of 2019, the estimated average remaining useful life of computer software is $900m / $449m per year = 2.0 years. For other intangible assets, this figure is $3,518m / $114m per year = 30.9 years. (Amortization figures are available from the income statement.) There is no corresponding calculation for goodwill since goodwill is not amortized because it has an indefinite life. “Other identifiable intangible assets” include trade names, customer relationships, databases and content, and other intangible assets, as described in the portion of Note 1 dealing with intangible assets. The estimated average remaining useful lives are: Trade names with finite lives: $43m / $5m = 8.6 years Customer relationships: $685m / $66m = 10.4 years Databases and content: $119m / $22m = 5.4 year Other: $25m / $21m = 1.2 years. These estimates are lower that the estimate of 30.9 years from part (b) because the calculation in part (b) included intangible assets with indefinite lives. Excluding the $2,646 million of trade names with indefinite useful lives, the estimate becomes ($3,518m – $2,646m) / $114m = 7.6 years, which is within the range of useful lives for the four categories indicated in Note 1 (3 to 30 years).

P9-54. Suggested solution: a. b. c.

Note 8 of the financial statements (page 151) shows that $191 million of labour cost had been capitalized into “intangible assets subject to amortization.” Using information from Note 18, page 167, the estimate for the average remaining useful life of software intangible assets is $1,810m / $573m = 3.2 years or 38 months. This length of time looks reasonable considering the rapid advances in software. Intangible assets with indefinite useful lives are comprised of “Spectrum licenses” of $9,937 million. In Note 18(e), the company explains the following: “The spectrum license policy terms indicate that the spectrum licenses will likely be renewed [by Innovation, Science and Economic Development Canada]. We expect our spectrum licenses to be renewed every 20 years following a review of our compliance with license terms. In addition to current usage, our licensed spectrum can be used for planned and new technologies. As a result of our assessment of the combination of these significant factors, we currently consider our spectrum licenses to have indefinite lives and, as referred to in Note 1(b), this represents a significant judgment for us.”

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Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

P9-55. Suggested solution: a. b.

As shown in Note 6, the company spent $71 million of exploration and evaluation assets. (Note 21 provides a slightly different figure of $73 million based on cash spent of these activities in the year.) As shown in Note 6 below, $219 million was transferred from mineral exploration and evaluation to PPE.

O. Mini-Cases Case 1: Capitalization of Intangible Assets. Suggested solution: a. First Reason: While not an explicit or implicit requirement for an item being considered an asset, many naive, less sophisticated or non-expert users consider tangibility an essential feature of an asset. The lack of physical presence makes many users especially suspicious of intangible assets. Second Reason: Allowing management to classify some expenditures as intangible assets can result in abuses and earnings management. During good times management may generously capitalize expenditures as assets to inflate earnings and then write off such amounts during “bad” times. “Big baths” that resulted from such write-offs in the past were not uncommon. Third Reason: It is often difficult to reasonably measure the future economic benefit of an intangible asset. While we presume that management would not spend money if it did not expect

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to recover that amount in the future, the accounting test for recognition is stricter than the expectation (or hope) of management; accounting requires strict criteria to be met. Fourth Reason: Expensing expenditures on potential intangible assets does not affect cash flow, only net income. Fifth Reason: If a firm continuously spends money on items that might be capitalized, eventually the net effect on earnings is zero. Items that were capitalized in earlier periods would have to be amortized, and this amortization would equal the amount of expense if amounts were expensed immediately. The process of capitalization only provides a one-time increase to income, thereafter the amortizations will soon equal the amounts capitalized. Sixth Reason: Expensing potential intangible asset expenditures is conservative. Acting and appearing to be conservative or prudent has a reputation effect. Such caution could lower the cost of capital and reduce perceptions of risk, which could result in higher firm valuations in the longer run. Seventh Reason: Expensing immediately is easy, reduces recordkeeping costs, makes the audit less costly, and decreases the complexity of the financial statements. Eighth Reason: Requiring everyone to consistently expense expenditures related to intangible assets makes it easier to compare the financial statements of different companies. Comparability (and the subsequent consistency between periods) is a very important quality to accounting, and occasionally other features of accounting may have to be compromised to meet this objective. Ninth Reason: External auditors feel uneasy about intangible assets due to the difficulties of identification and measurement. Expensing these amounts immediately reduces the auditors’ liability. b. First Reason: The expectation that assets are tangible is naive. Accounting assumes the user is reasonably sophisticated and will exert effort to understate complex matters. Catering to the naive investor is against the underlying principles of GAAP (whether that is IFRS or ASPE). Second Reason: Delays between the timing of an expenditure and the realization of its economic benefit are common to most non-monetary assets. The challenge of reasonably quantifying the benefit should not preclude setting up an asset. Third Reason: Capitalization is consistent with the underlying perspective and process that justified the investment. By seeking to match the benefit with the period when the benefit is realized makes the financial accounting treatment resemble the economics of the investment decision. Fourth Reason: Expenditures related to non-monetary assets can be very material and lumpy. If such amounts were expensed when incurred, net income could become more volatile. Increased earnings volatility could increase risk perceptions, increase a firm’s cost of capital, and consequently reduce the firm’s value. . 9-34

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

Fifth Reason: The matching principle. Expenses should be matched with the benefits (revenue) realized from the expenditure; if there is a delay, an asset should be set up to accommodate this postponement. Sixth Reason: Admittedly some managers and companies will abuse the permission to capitalize intangibles, but honourable firms will respect the spirit of being permitted to capitalize such expenditures if the evidence supports such treatment. Seventh Reason: By capitalizing these expenditures the solvency ratios such as debt/equity are improved, as equity will be higher by the amount of the expenses avoided by treating these amounts as assets. Firms will appear more solvent and less challenged by financing encumbrances that are based on balance sheet solvency ratios. c. I would expense these amounts. There are several reasons for taking this position, including: First, expensing or capitalizing will have no material effect on earnings as the differences between the two methods will net out as our firm has been in operations for a long time. Second, the naive but real suspicion of some users of intangible assets could harm our share price and cost of capital. Restated, it is unlikely that our firm value would be higher if we capitalized these amounts. Third, whereas our firm has a reputation for being honourable, the negative stigma associated with the cases of abuse may unnecessarily and unfairly taint us. Fourth, it makes accounting and the subsequent external audit easier and cheaper. The auditor will rarely challenge our decision to expense. Fifth, in an efficient market it makes no difference which method of accounting is used for intangible expenditures; users will incorporate this difference into their analysis. d. I would capitalize these amounts. There are several reasons for taking this position, including: First, for smaller public companies there is less scrutiny of our financial statements. As a result, there is less market efficiency in the valuation of our firm. Naive and less sophisticated investors who read our financial statements may not appreciate the difference in treatment. Higher net income or reduced losses could result in higher share prices. Second, as a recently listed public company the pressure and expectation for higher earnings is extreme; capitalizing these expenditures will result in higher earnings in our formative years. Third, capitalizing these amounts will materially improve our solvency ratios. Appearing to be more solvent is essential to reducing our cost of capital.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Fourth, as we are in the start-up or early stages of our business strategy, expenditures on intangible assets are significant. There is a delay between when these expenditures in high technology are incurred and when the revenues from them occur; these costs are investments where the benefit will be reaped later. Our business model is based on higher investment in new technology in the early stages followed by strong revenue and income growth in later years. e. As an external auditor I would prefer for management to expense these amounts as it reduces our potential legal liability later on if it turns out these amounts are worthless (or worth much less than the amount shown on the balance sheet). As an auditor, I would generally encourage management to be conservative and cautious in their accounting treatments. Further, if management does want to capitalize these amounts it must provide the evidence to support this proposed treatment. For management to find credible evidence to satisfy all six criteria for capitalization as noted by IAS 38 paragraph 57 can be exhausting, controversial, and challenging for them—and tense for the external auditor as we must exercise professional skepticism in reviewing and evaluating their conclusion. This can make the auditor/firm relationship occasionally hostile and strained; expensing immediately avoids these hardships. Case 2: Creative Architects and Engineers. Suggested solution: a. The enhancements involve a number of distinct components that can be considered independently. Replacement of office furniture and fixture This enhancement is related to tangible property, plant, and equipment (PPE). IFRS requires the $800,000 of old equipment that was disposed to be derecognized from the accounts, and the new equipment to be recognized. In addition, CAE should distinguish items of different natures or with different useful lives. Depreciation will need to be recorded according to the estimated useful lives and the company’s depreciation policy for such PPE. Relaxation/entertainment areas The modifications made to these areas are eligible for capitalization as PPE. Similar to the replacement of furniture and fixtures, the components of items added should be separated according to their nature and useful lives, and subsequently amortized. It should be noted that the depreciation period for items relating to the building (i.e., fixtures) should not extend past the end of the lease term. Health and wellness program The program arguably creates an (intangible) asset that suggests possible capitalization. However, the nature of the program suggests that it is more appropriately considered a period expense. While the benefits of more healthy employees are likely to last beyond the period of the expenditure, that benefit is difficult if not impossible to quantify. Certainly, CAE does not control the benefits that result in better health (the employee does). Consequently, the item does not meet the criteria for recognition as an asset.

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Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

More specifically in relation to intangibles, the expenditure does not meet the criteria for an intangible asset because the asset (if it is considered an asset) is not separable from the company: it cannot be somehow sold or transferred to another entity in exchange for some financial return. Furthermore, most of the benefits of the program are likely to be realized in the same period of the expenditure. Therefore, expensing the cost will match costs to benefits. For example, the effect of reduced sick days will already be captured by the accounting system in terms of reduced costs or higher revenues, so expensing the cost of the health and wellness program appropriately matches costs to revenues. Professional development/continuing education program This cost of this program is potentially eligible for capitalization as an asset. The program requires employees to remain on staff for at least two years after the additional training. Therefore, the company is ensured of capturing at least some of the benefits of the more qualified, better trained, or otherwise more productive employee. Thus, the cost of this program satisfies the definitional criteria for an asset: it arises from past events, has future benefits, and is under the control of the company. However, similar to the health and wellness program, this expenditure fails the separability criterion for recognition as an intangible asset. Therefore, the company should expense these costs. Even if these costs are capitalized, they would then be amortized over a maximum of two years, the period over which employees are required to repay the company if they are no longer employed by the company. Therefore, the effects of capitalizing these costs are likely to be minor in any case. b. The treatments of the four programs differ depending on whether they relate to tangible items or intangible benefits. While all four programs have the aim of maintaining a healthy, productive, and happy workforce, the expenditures on tangible goods (office furniture and fixtures, renovations to create a relaxation/entertainment area) qualify for capitalization while those expenditures on staff have intangible benefits that do not meet the criteria for the capitalization of intangibles. To the extent that all four programs have similar objectives, this distinction between tangible and intangible items is somewhat arbitrary. In their defence, however, accounting standards need to also consider the ability of management, accountants, and auditors to measure the benefits of potential assets in order to decide whether they should be capitalized. The tangibility criterion is a convenient divider to separate those items that have benefits that are more easily quantified from those that are more subjective.

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Case 3: Autotech. Suggested solution: Memo to: Partner Memo from: CA Date: April 23, 2026 Subject: Autotech Corp. Engagement Overview There are a number of factors that affect our exposure (business risk) and the audit risk associated with this engagement. These factors must be carefully assessed before we decide whether to accept the engagement. Autotech is a company in distress. It has made a large investment in a new product that does not appear to have a market. A competitor dominates the market and Autotech is having difficulty making inroads. The liquidity and cash flow positions of the company are very poor—it has considerably more current liabilities than current assets and over 85% of the current assets are inventory that does not appear saleable at present. The company's bank loan could be called depending on the outcome of an environmental assessment, and the government grants have to be repaid if the terms of the grant have been violated. All told, these circumstances suggest that the company may not be a going concern and thus poses a significant audit and business risk for us. If we take the engagement, we will have to be very careful with the audit so that we have a high probability of successfully defending ourselves in court, should we be sued. Further increasing the risk associated with the engagement is the fact that Autotech has two incentives to “window dress” the financial statements. First, the company is considering a share issue to raise cash. The financial statements in a prospectus are an important source of information, and prospective investors will likely rely on them. If Autotech fails soon after the share issue, the investors will likely contend that the financial statements were misleading. Although we would be able to defend our audit approach in court, we could still lose and incur significant losses. Even if we did not lose, we would have incurred significant legal costs. Second, if the bank decides that lending money to Autotech has become too risky, it will call the loan. The bank financing is crucial for the time being. Since the bank has taken all assets as security, it will likely be concerned about asset valuation as well as performance measures. These situations add audit risk; thus, we have to ensure that the extent of testing is adequate to detect any attempts to window dress. Another factor increasing risk is the resignation of the previous auditor over a disagreement with the client, suggesting that the client may be difficult to deal with. We should contact the previous auditor to obtain additional information about the disagreement. Perhaps most importantly, there are some issues surrounding the relationship between Mr. Douglas as president of Autotech and Mr. Douglas as the major shareholder of JDP. Significant activity has taken place between the two companies, and a conflict of interest between the two is possible. In essence, Mr. Douglas could transfer wealth from Autotech to JDP to his own advantage. The board of directors of Autotech seems concerned about this relationship. There is no evidence of a problem at this time, but we will have to be wary when conducting our audit and check terms and conditions of transactions between Autotech and JDP. . 9-38

Chapter 9: Intangible Assets, Goodwill, Mineral Resources, and Government Grants

Finally, Autotech operates in an environmentally sensitive industry, which poses additional risk with respect to environmental liabilities. If we fail to ensure adequate disclosure of such liabilities we could be sued if users believe or argue that the financial statements were misleading. A. Going concern Ultimately, the most difficult issue we will have to face in the audit of Autotech is whether the company is a going concern. The difficulties faced by the company are severe, and survival is by no means likely. Among the circumstances that suggest that Autotech is not a going concern is the serious working capital deficiency of $577,000. The deficiency may actually be worse than that because 60% of the inventory is Synlube, which may not be saleable. The deficiency is more severe than at the March 2025 year-end. More immediately, Autotech has no cash on hand to pay the accounts payable and the current portion of long-term debt that is due. These circumstances indicate that the company needs short-term cash to survive. Even if Synlube proves to be successful, Autotech may not be able to survive the current crisis. In addition, the company has suffered substantial losses over the last three years. While losses do not necessarily imply that the company's survival is in doubt, they do give some indication that it is not successful. Since the company's product base has fully matured, the poor income performance suggests that it is not able to make money from its existing products (which is why it has developed Synlube). However, Autotech's recognition of the need to diversify may have come too late. It seems to be relying heavily on Synlube for survival even though the prospects do not appear good for the product, given the difficulty the company is having in marketing it. In addition, the company may be liable to the provincial government for the grant if it does not meet the employment levels required by the grant. Since Synlube is not selling, the company may not have the financial resources or the sales volume to justify the number of employees required. Without Synlube sales, Autotech may be unable to generate sufficient cash to pay the current portion of the bank loans that are due. If so, the bank may call its loans. Regardless, the company’s poor financial condition may motivate the bank to call its loans once it sees the financial statements (whether or not going concern issues are discussed in the statements). The bank may be inclined to pull the loan since it has a claim against all the company’s assets, and calling the loan now will likely minimize its loss. If the bank does call its loans, Autotech is almost certainly doomed. Of course, if going concern issues are raised in the statements, the bank will almost certainly call the loan. The dilemma of the self-fulfilling prophecy arises: if going concern issues are raised in the statements, the likely reaction will probably result in the demise of the entity. Therefore, care must be exercised in coming to a decision on the going concern question. If we determine that Autotech is not a going concern, we must ensure that there is adequate disclosure in the statements so that readers are aware of the going concern issue. Autotech will have to include a note to the financial statements outlining the problem, and the valuation will have to be on a liquidation basis rather than a historical cost basis.

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B. Related party transactions Transactions between Autotech and JDP are between related parties because the president of Autotech controls JDP. While IFRS does not include any special recognition or measurement requirements for related party transaction, IFRS does outline a number of required disclosures in IAS 24. For example, IAS 24.13 states that “relationships between parents and subsidiaries shall be disclosed irrespective of whether there have been transactions between those related parties. An entity shall disclose the name of the entity’s parent and, if different, the ultimate controlling party. If neither the entity’s parent nor the ultimate controlling party produces financial statements available for public use, the name of the next most senior parent that does so shall also be disclosed.” Therefore, the relationship and the details of these transactions must be disclosed in the financial statements. Although sales of Synlube have been insignificant, royalty payments may be material because they are based on production not sales. Inventory has increased by $1 million in the last year, suggesting that Autotech is producing a lot of Synlube but not selling it. Despite poor sales, Mr. Douglas may be directing the company to produce Synlube because, as the major shareholder of JDP, he benefits from each unit of Synlube produced. Finally, because of the relationship between JDP and Mr. Douglas and the extent of the business carried out between JDP and Autotech, we should consider the possibility that some of the costs billed by JDP are fictitious or not valid, and claims for reimbursement are intended to transfer wealth from the stakeholders in Autotech to Mr. Douglas. C. Government grant Autotech received a grant of $900,000 from the provincial government on condition it maintains certain employment levels in the province over three years. Autotech has recognized the grant as a reduction in arriving at the carrying amount of the building. According to IAS 20.24, “government grants related to assets, including non-monetary grants at fair value, shall be presented in the balance sheet either by setting up the grant as deferred income or by deducting the grant in arriving at the carrying amount of the asset.” Therefore, the company could also elect to present the government grant as deferred income and amortize the amount into income. However, given Autotech’s lack of success in marketing Synlube, it is possible that the employment levels required by the grant will not be met, in which case the grant is repayable. According to IAS 20.7, “government grants, including non-monetary grants at fair value, shall not be recognized until there is reasonable assurance that: a. the entity will comply with the conditions attaching to them; and b. the grants will be received.” As a result, it may not have been appropriate for Autotech to recognize the government grant. If management believes that the conditions may not be met, a liability for repayment of the grant must be included in the statements at the fair value at the date it is determined that the conditions may not be met. The amounts previously credited to income should be reversed in the period management determines that it is not going to meet the conditions. Furthermore, the reduction in depreciation due to the grant offsetting the building cost would need to be reversed retroactively.

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We will have to determine employment levels to find out whether the terms of the grant have been met D. Deferred development costs/patent Almost 30% of Autotech's assets are deferred costs incurred in the development of Synlube. The costs include material, labour and subcontracting costs (80% of the subcontracting costs were paid to JDP). The previous auditors resigned over these costs because they believed that the deferred development costs should be written down to $1. Under IAS 38, “development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.” Many of the costs incurred with regard to Synlube likely fit the definition of development costs. What is in doubt is whether they can be capitalized as development costs. According to IAS 38.57, to capitalize development costs Autotech must be able to demonstrate all of the following: a. the technical feasibility of completing the intangible asset, so that is will be available for sale or use; b. its intention to complete the intangible asset and use or sell the intangible asset; c. its ability to use or sell the intangible asset; d. how the intangible asset will generate probable future economic benefits; e. the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and f. its ability to reliably measure the expenses attributable The deferred development costs cannot exceed the amount reasonably expected to be recovered. It appears that criteria (a) to (b) are met since production facilities are in place and the product is being produced. Criteria (c) and (d) are in doubt because a market has not been established for the product and it is not selling. Furthermore, it is very much in doubt whether resources exist to complete the project and whether the costs incurred can be recovered, considering both the difficulty Autotech is having making inroads in the market place and the company’s troubled financial position. Thus, since Synlube may never be profitable, it is difficult to justify capitalizing the costs. Autotech has not yet begun amortizing the deferred costs. Assuming that capitalizing development costs is acceptable; amortization should begin with commercial production of the product. Since the production facility became operational in December 2025, that would be a reasonable time to begin amortization. The company thinks that amortizing the product over 20 years makes sense. This period may be too long in light of the problems faced by the company and the nature of the product. We need to ascertain the average life span of this type of product to determine whether 20 years is reasonable. At this point, however, assuming that capitalization

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can be justified at all, a shorter period of amortization should be used because of the weak financial position of the company. The deferred development costs are a crucial part of the engagement. These costs plus the patent represent over 40% of the assets on the balance sheet. If the costs related to Synlube are capitalized, the implication is that these costs have future benefits and that the costs will at least be recovered. Users such as the bank and prospective shareholders may rely on this information in making their decisions. If the company ultimately fails, these users may point to these costs as making the financial statements materially misleading. In such circumstances, our firm will be subject to lawsuits and significant liabilities. E. Inventory Synlube represents 60% of Autotech's inventory. It is not clear whether any of the Synlube product will ever be sold given the difficulties the company has had in developing a market for the product. As a result, the inventory may be overvalued if it is kept on the balance sheet at cost. In that case we are at risk because the bank is relying on the statements for the loan (collateral is tied to all assets). If the inventory proves to be overvalued because there is no market for the product, the statements will be materially misleading. Once again, we need to satisfy ourselves that a market for Synlube will develop soon to justify keeping that part of the inventory on the books. According to IAS 2.9, “Inventories shall be measured at the lower of cost and net realizable value.” Should it be determined that the inventory recorded at cost is overvalued, it should be written down to its net realizable value. Since we are taking over the audit of this client, we have to rely on the previous auditors regarding the year-end count of inventory (and ensure that the previous auditor did in fact count the year-end inventory). If we are unable to rely on the previous auditors' work, we will have to do additional work to establish the closing inventory balance. We must also investigate the bookto-physical adjustment. The adjustment should be viewed with suspicion because Mr. Douglas has the incentive to overstate production because of the royalty payments made to JDP. Pending investigation of the problem, we should exercise caution in relying on internal controls. F. Start-up costs It appears that Autotech is attempting to defer the start-up costs associated with Synlube as they are capitalized along with the land, building, and equipment. Under IFRS, a company cannot capitalize start-up costs. [IAS 38.69(a)] G. Lawsuit Autotech has launched a lawsuit against its major competitor for patent infringement and industrial espionage. Autotech’s survival may depend on the success of this suit. The company is confident of winning the suit and wishes to accrue a $4 million gain in the statements. Such accounting would be attractive to Autotech, as it would boost income and create the perception of a pending significant cash inflow (which would be important for users of the information such as the banker or prospective investors). IFRS states that “an entity shall not recognise a . 9-42

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contingent asset…however, when the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate [IAS 37.31-33].” Given that the other party to the lawsuit is vigorously defending their position, there does not appear to be enough certainty to recognize a contingent asset. As for disclosing the contingent asset, “where an inflow of economic benefits is probable, an entity shall disclose a brief description of the nature of the contingent assets at the balance sheet date, and, where practicable, an estimate of their financial effect, measured using the principles set out for provisions in paragraphs 36–52.” [IAS 37.89] Therefore, the existence of the lawsuit can be disclosed in the notes if management does indeed have evidence that the lawsuit will be successful, but care must be exercised in disclosing the amount of the gain. It is very difficult to predict the outcome of such cases and, even if it appears Autotech will win, it will not necessarily receive $4 million. It is possible that Autotech will not be able to survive the fight because of its poor financial condition. This means that even if Autotech could eventually win, there may not be an Autotech around to reap the benefits. Case 4: Air Technologies. Suggested solution: To: Head of internal audit From: CA Date: January 21, 2024 Subject: Air Technologies Ltd. I have completed my initial review of Air Technologies Ltd. (Air), and I have identified a number of areas of concern. It appears that Air has performed well in 2023, but it is possible that Air’s accounting methods aided in enhancing its performance. There are accounting issues that raise questions about how well the financial statement numbers reflect Air’s economic activity for 2023 and internal control issues that raise doubts about the reliability of the information being produced by Air’s accounting systems. These problems may be attributable to Louis’s inexperience as a manager and to his exuberance and optimism as the inventor of the product that he wants to believe will be a success. The problems may also be related to his contract with International Products Inc. (IPI) that pays him a $1 million termination bonus if certain conditions are met. Some of the findings in my report are preliminary and will require further investigation before the implications can be fully determined. A. Internal control My review revealed major problems with Air’s internal controls, both with operations and with the accounting systems.

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There appears to be a significant problem with cut-off because of override by management in the shipping department. The accounting department records sales and trade receivables when an order is confirmed and sent to the shipping department. It is not clear how the accounting records are adjusted for Louis’s last-minute changes to orders. Louis makes changes to orders on the loading dock, but sales and trade receivables are recorded when the documents are sent from accounting to shipping. It may be that the over-shipments are not included in revenue. Further investigation is required. Also, the shipper says that he is two to three weeks behind in getting orders out. That means that orders sent to shipping in the last part of December 2023 may have been recorded in 2023 sales but are not actually shipped until 2024, resulting in a cut-off error. Controls should be put in place to ensure that the goods are only recorded as shipped once they are actually out of the door. For example, Air should consider generating the billing invoice and recording the sale only after shipment is confirmed by the shipper. The delay in shipment has implications for Louis’ bonus because the number of units recognized as sold may be overstated. (See also the revenue recognition discussion below for more detail.) In addition, the inventory records are updated using the quantities actually shipped. The inventory records are adjusted daily using the shipper’s log of units shipped. As a result, there is a mismatching of revenues and expenses. Cost of goods sold will not correspond to the number of units recognized as revenue because revenue is recognized when the paperwork is sent to shipping whereas inventory is relieved when the goods are actually shipped. This means that the number of units included as sold in cost of goods sold is correct (as far as cut-off goes), but revenue is misstated. There is a problem with segregation of duties because the trade receivables person is also responsible for doing the bank reconciliation. Assuming that no one else oversees the bank reconciliation, it is possible for the trade receivables person to misappropriate assets and cover up the defalcation. A closer examination of responsibilities within Air is necessary to see whether duties are adequately segregated and activities are properly overseen. Louis said that Air was understaffed because of budget constraints imposed by IPI. It may be necessary to make funds available to add needed staff. Doing so may also help overcome some of the problems in the shipping department. B. Policy breaches IPI’s policy is that rental costs that relate to production facilities only be included in inventory. It appears that Air is violating this policy by treating 100% of the rental cost as a product cost and including it in inventory when only 45% of the building is actually occupied by the production department. Note that under IFRS, only costs that are necessary to bring the inventory items to their present condition can be inventoried. Cost of office staff and managers must be expensed. Air’s draft internal financial statements state Air’s revenue recognition policy as follows: “Air recognizes revenue when merchandise is shipped to customers.” The method is noted as being consistent with IPI’s policy for other manufactured products. When I reviewed the accounting . 9-44

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system, I noted that trade receivables and sales are recorded as soon as an order is confirmed and sent to the shipping department. As long as the shipments are going out of the door quickly, this approach does not create a problem. However, as a result of the shipping delays currently occurring, this approach results in recognizing revenue before the shipments have occurred. C. Accounting issues Revenue recognition First, on Louis’s instructions, more units are often shipped to customers than are ordered. Louis has assured these customers that they do not have to pay for the excess units for six months and that those units can be returned to Air at the end of six months if they are not sold. While this might be a prudent strategy by Louis if his sense of market conditions is accurate and customers are being cautious by under-ordering, these excess units should not be recognized as sales. It seems clear to me that the rights and risks of ownership have not transferred to the customer because they do not have to pay for the goods and they can be returned without penalty. In addition, since they were shipped without consent from the customer, it is not even clear that the customer is responsible should something happen to the excess. IFRS 15.38 describes the conditions that must be considered in determining the point in time when the customer obtains control of the promised asset and the vendor satisfies the performance obligation. These considerations include Air having the present right to payment for the asset, which is not the case here, as customers do not have to pay for the additional units for six months, and can return the unsold units to Air at the end of that period. Indeed, as discussed above, it is not even clear whether the records show the actual number of units shipped to customers because Louis frequently changes the quantity on the loading dock. The shipper records the actual shipments in a logbook every day, and the log is used to update the inventory records. Thus, it appears that the actual shipments are being properly recorded in the inventory records. However, the shipping documents themselves, which are likely the basis for what is recorded in sales, do not agree to the actual amounts shipped. Thus, there is a mismatch between sales and inventory. The fact that there are delays in shipments of up to three weeks compounds the mismatch. If Louis wishes to continue shipping extra units to the distributors, he should formalize the arrangement through some sort of “consignment” agreement. The shipments would be treated as consignment inventory. Under IFRS, the inventory would continue to be reported on Air’s books until Air is notified of their sale by the distributors, at which time revenue would be recognized. Alternatively, Air may wish to enter into formal agreements with its distributors clearly documenting their right of return, and the terms of payment for the excess items. The timing of revenue recognition will be determined to some extent by the nature of the contract and the payment terms. The provisions of IFRS 15, including paragraphs 50-59 “variable consideration”, which is supported by the application guidance in B20-27, must be considered. Briefly, as per paragraph B21, these requirements can be summarized as follows: a)

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(b) a refund liability; and (c) an asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability. Note, however, that there are constraints on this accounting treatment, specifically, as set out in pp. 56-57, variable consideration can only be recognized to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved. This test is unlikely to be met as given that the product is new and improved, there would not be enough historical information available to make a proper estimate. Accordingly, the variable consideration arising from the (partial) sale of the overs-shipped product should only be recognized when the product is sold by the distributor or the right-of-return expires. Development costs Air has recorded $607,000 in development costs on its December 31, 2023 balance sheet. According to IAS 38, internally created intangible assets that relate to development costs can be capitalized only if they meet certain criteria. It is not clear that all the costs that have been capitalized meet the criteria. IAS 38, paragraph 57, states that development costs can be capitalized only if the asset will generate future economic benefits for the company, which is demonstrated by meeting the six criteria outline in parts a – f of paragraph 57 These requirements include that the company’s management can demonstrate that “its intention is to produce and market, or use, the product or process”, that “technical feasibility is available to ensure completion of the product, it can show how this intangible asset will generate future economic benefits” and that “adequate technical, financial and other resources are available to complete the project.” We know that Louis did not have the financial resources available to complete the project. Although IPE bought the shared of Air in late 2022, IPI committed the actual funds to get production under way only in late April, 2023. It therefore could be argued that at least some of the $607,000 was spent before the financial commitment was made and that those costs would not meet the capitalization criteria, and they would be considered research costs. However, it could also be argued that the funds were effectively committed at the time of purchasing Air, on the basis that Air produces only one product and that IPI paid a significant amount ($250,000) for the company and its product. At the time of the purchase, IPI stated that it agreed to finance the remaining research and development necessary to bring the product to market. The next issue is which of the costs incurred relate to research, development costs, or production. IAS 38, paragraph 59 lists examples of development activities: (a) the design, construction and testing of pre-production or pre-use prototypes and models; (b) the design of tools, jigs, moulds and dies involving new technology; (c) the design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production; and (d) the design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.

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If one uses the April date as the commitment date, the $65,000 in marketing survey costs and the $92,000 for the production facility feasibility study would have occurred before final approval for financing from IPI was received. It is likely that the $80,000 consultant’s report on air quality issues and the $70,000 search costs for production facilities also occurred before approval was received. These costs should therefore be expensed rather than be included in development costs. Many of the other costs Air has classified as development costs do not qualify as development costs. For example, set-up costs ($37,000), training costs ($48,000), and production cost overruns ($97,000) do not qualify, as they are related to the start up of operations. These costs should therefore be expensed. Property, plant and equipment Air moved into the production mode in August, 2023. Under IFRS, IAS 16, costs incurred to bring the plant to its operational state can be capitalized. Consequently, the costs of setting up the production facility could be capitalized as part of the plant cost to ready the asset for operation. Finally, the selling, marketing and promotion costs would all have to be expensed since these relate to operations. Depreciation would be required on the capitalized plant costs. Air will have to put some effort into identifying the various components of the property, plant and equipment. Under IFRS, plant, property and equipment can be measured using either the revaluation method or the cost method. Revaluation would require that the assets be measured at current fair value, and that the revaluation surplus be recorded as equity (unless losses had been earlier recognized in income), or a revaluation loss would be taken to the profit and loss statement (unless there is a revaluation surplus in equity related to the asset.) In this instance, there is no business reason to support using the revaluation model. It is presumed that Air would use the cost method for these assets. D. Conclusion Louis’ bonus depends on three things: bringing the product to market, selling at least 10,000 units at $65 per unit, and Air being profitable in 2023. The first criterion has been met. It is questionable whether the remaining two criteria are met. The initial examination of the December financial statements indicates that Air’s performance has been good. Air has met the contractual terms related to the bonus. The company reports that it sold in excess of 11,000 units (the contract requires that at least 10,000 be sold), the average selling price of the units is $66 ($770,352/11,672 units) (the contract requires an average selling price of $65), and Air is profitable (net income is $166,600). However, things may not be as they appear. If all of the developments costs except for the costs of setting up the production facility are expensed, this would result in $570,000 additional expenses. In addition, there would have to be some depreciation on the plant costs related to the setting up the facility. Using a straight-line life of 20 years, the depreciation expense would be increased by $771 ($37,000 / 20 X 5/12). With these two adjustments, net income before taxes for 2023 would be adjusted to be a loss of $328,771 ($242,000 – 570,000 – 771). In addition, there would have to be write down in inventory values for the amounts related to the cost of office staff and managers and the 55% of rental costs that have

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been included in the cost of inventory. Finally, net income would also have to be adjusted for the effect of the possible inventory write-down related to the 900 defective units. Thus far, the following adjustments have been identified: Adjustments to units sold: • Over-shipments by Louis—quantity to be determined • Demonstration units—500 (recorded at $0) • Number of units affected by cut-off problem—quantity to be determined • Number of units affected by accounting problems—quantity to be determined Adjustments to net income: • Write-off of 900 defective units—$22,746 • Changes to revenue and cost of sales due to cut-off and accounting problems—amount to be determined • Write down of inventory for staff and manager costs • Write-off of development costs—minimum $570,000 ($65,000+$92,000+$80,000+$70,000+ $48,000 + $97,000 + $118,000) (pending additional work to confirm) • Depreciation of facility costs—$771 (pending additional work on classification of these costs) • Adjustments due to policy breach problems—amount to be determined Depending on the net results of these adjustments, Air’s performance is likely not as good as the statements portray. As a result, Louis may not be eligible to receive his termination bonus. The question we must ask ourselves is whether Louis intentionally influenced the results to ensure he would obtain his bonus or whether he was simply naïve in his zealousness to sell a product he strongly believes in. Louis may have been biased to want to meet the bonus terms due to its significant size. However, the poor state of the current records makes it difficult to believe that Louis deliberately created the results he wanted. Sorting through the situation with shipping and revenue recognition will take considerable effort. It is impossible to know from my initial review what actual sales are—whether they are over- or understated. It is therefore not possible to assess whether the cost of goods sold is correct, although we do know that there is an over-allocation of costs to inventory, as explained earlier. I will need to do a lot more work before I can determine actual sales and cost of goods sold. It will be necessary to compare shipping documents with actual units shipped and match them to amounts recorded as sales. Recommendation I suggest holding off payment of Louis’s bonus pending resolution of the problems identified during the audit. This work should not take too long. However, proper documentation will be essential to supporting IPI’s position, particularly if the findings support not paying the bonus. I will have to take the time necessary to complete the work. Undoubtedly, Louis believes he met the terms of the payout and will be expecting the $1 million payment. Louis should be advised immediately that the statement results are being verified.

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Case 5: Clare Cherry Cola. Suggested Solution: a.

i. Brand Name: It is an intangible asset that can be capitalized. In this case, the company valued its brand name at $300,000. Registered trademark in Canada can be renewed indefinitely in 15-year increments; hence no amortization is recorded as long as CCC has the intention to renew the trademark. Instead, it should be reviewed for impairment annually. ii. Client List: Internally generated intangible assets such as client lists cannot be capitalized. The company must remove the asset from its balance sheet and expense costs associated with generating the client list. iii. Research and Development Costs: Research costs cannot be capitalized and therefore the company must expense the $150,000 related to research. Furthermore, development costs may be capitalized if they satisfy the criteria for capitalization of development costs. In this case, the auditor would need more information to assess whether these costs should be capitalized. iv. Patent: The company has correctly capitalized the patent and deprecating it over 10 years seems to be appropriate, provided that the company expects the useful life of the patent lasts as long as its legal life. Nonetheless, CCC must do evaluate the patent annually to confirm that the intangible asset has not impaired. v. Goodwill: Goodwill can only be generated externally through acquisition of an asset for value that is higher than the fair value of the asset. The company cannot capitalize the $100,000 of goodwill in this case.

b. There is high potential for earnings management with intangible assets primarily because it is harder to assess the values for these assets. Intangible assets usually do not have an active market, and it is also sometimes difficult to determine the useful lives of these assets. When these assets are impaired, companies might keep the acquisition costs on the financial statements without making appropriate impairment charges. Furthermore, companies can inappropriately capitalize expenses as intangible assets to defer expensing some of the period costs. For instance, many companies abuse the flexibility allowed in the capitalization criteria for software development costs and inappropriately recognize these costs as an intangible asset. c. It is arguable whether a company should capitalize intangible assets. Companies should be allowed to capitalize intangible assets because there can be future benefits associated with these assets. On the other hand, intangible assets are lack of physical substance, and their values are typically harder to determine.

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Chapter 10 Applications of Fair Value to Non-Current Assets L. Problems P10-1. Suggested solution: a.

Benefits of using the revaluation model to subsequently measure real estate assets include:   



A more relevant balance sheet. The land and building are reported at fair value, which is more useful to most users than the assets’ historical cost. This improves both the predictive value and confirmatory value of the balance sheet. A more comparable balance sheet as assets acquired in different time periods remain comparable as the fair value of the asset includes the effects of factors like inflation and obsolescence, whereas the historical cost of the asset does not. The change in the value of the real estate assets is reported in comprehensive income (net gains in OCI, net losses in profit or loss), which provides many stakeholders with a clearer view of the company’s economic, or “real” profit for the period, versus accounting income under the historical cost model. More meaningful select financial ratios. When real-estate assets are reported at historical cost, their subsequent change in value is not captured in either the asset valuation or equity, or for that matter, reported comprehensive income. Assume for a moment that a company that subsequently measures its real-estate assets at historical cost reports earnings of $100,000 and equity of $1,000,000. Its ROA is $100,000 / $1,000,000 = 10.0%. Further assume that the fair value of its real-estate holdings was $500,000 higher than its carrying cost, with the increase having occurred in past years. Its economic ROA is $100,000 / $1,500,000 = 6.7%, which would be readily evident if the company used the revaluation model. The 6.7% figure is more meaningful to many stakeholders including existing shareholders and potential investors, as it more faithfully represents the actual economic returns earned by the company. Drawbacks of using the revaluation model to subsequently measure real estate assets include:



The reported balance sheet values are less reliable than those reported at historical cost. It remains that however frequently revaluations are undertaken, that the reported values are usually estimates of some sort, e.g. appraisals, whereas the only way to establish the assets’ actual value is to sell it in an arms-length transaction between two parties with no compulsion to act. Historical cost information is thus more representationally faithful as it is both free from error, and more verifiable. There is a financial cost to using the revaluation model as the assets fair value must be regularly determined. In many cases this involves paying an outside party to prepare the

. 10-1

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition



valuation. Internally prepared evaluations are not costless either, as they use company resources that could be deployed elsewhere. Reporting changes in fair value in the statement of comprehensive income, introduces additional volatility in the reported comprehensive income unrelated to the company’s principal operations. This in turn diminishes the comparability of this metric. Moreover, cumulative gains are reported in other comprehensive income and accumulated other comprehensive income whereas cumulative losses are reported in net income and retained earnings. This asymmetrical accounting treatment reduces the understandability of the financial statements.

P10-2. Suggested solution: Dr. Land Cr. Other comprehensive income–revaluation gain

250,000

P10-3. Suggested solution: Dr. Loss on land revaluation Cr. Land

100,000

P10-4. Suggested solution: Dr. Land ($1,100,000 – 600,000) 500,000 Cr. Gain on land revaluation* 400,000 Cr. OCI – revaluation gain* 100,000 * Gain of $500,000 recorded through net income for amount up to original cost. Amount above cost goes to other comprehensive income (OCI). P10-5. Suggested solution: Dr. OCI – revaluation loss 250,000 Dr. Loss on revaluation 200,000 Cr. Land ($800,000 – $1,250,000) 450,000 * Loss of $250,000 recorded through OCI for amount down to original cost. Amount below cost goes through net income.

. 10-2

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-6. Suggested solution: Historical cost basis ($000’s) Revenue Expenses Gain on disposal of land Net income (= comprehensive income) Opening retained earnings Closing retained earnings

2023 $2,500 (2,300) 0 200

2024 $3,000 (2,600) 0 400

2025 $2,000 (1,700) 0 300

2026 $1,500 (1,400) 200 300

4-year total $9,000 (8,000) 200 1,200

0 $ 200

200 $ 600

600 $ 900

900 $1,200

0 $1,200

Cash Land Total assets

$ 300 900 $1,200

$ 700 900 $1,600

$1,000 900 $1,900

$2,200 0 $2,200

Share capital Retained earnings Total shareholder’s equity

$1,000 200 $1,200

$1,000 600 $1,600

$1,000 900 $1,900

$1,000 1,200 $2,200

Revaluation model ($000’s) Revenue Expenses Gain on disposal of land Net income OCI for revaluation gain (loss) Comprehensive income

2023 $2,500 (2,300) 0 200 0 $ 200

2024 $3,000 (2,600) 0 400 100 $ 500

2025 $2,000 (1,700) 0 300 200 $ 500

2026 $1,500 (1,400) 200 300 (300) $ 0

Cash Land Total assets

$ 300 900 $1,200

$ 700 1,000 $1,700

$1,000 1,200 $2,200

$2,200 0 $2,200

Share capital Accumulated revaluation surplus Retained earnings Total shareholder’s equity

$1,000 0 200 $1,200

$1,000 100 600 $1,700

$1,000 300 900 $2,200

$1,000 0 1,200 $2,200

4-year total $9,000 (8,000) 200 1,200 0 $1,200

The total income over the four years is the same under both methods. While comprehensive income is higher in 2024 and 2025 under the revaluation model, the historical cost model catches up when it recognizes the gain on disposal.

. 10-3

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

The balance sheet at the end of 2026 is the same under both methods, including retained earnings. While revaluation increases the value of assets and the accumulated revaluation surplus component of equity when the land value increased in 2024 and 2025, the historical cost model catches up once the land is sold. P10-7. Suggested solution: Historical cost basis ($000’s) Revenue Expenses Gain on disposal of land Net income (= comprehensive income) Opening retained earnings Closing retained earnings

2023 $2,500 (2,300) 0 200

2024 $3,000 (2,600) 0 400

2025 $2,000 (1,700) 0 300

2026 $1,500 (1,400) 200 300

4-year total $9,000 (8,000) 200 1,200

0 $ 200

200 $ 600

600 900

900 $1,200

0 $1,200

Cash Land Total assets

$ 300 900 $1,200

700 900 $1,600

$1,000 900 $1,900

$2,200 0 $2,200

Share capital Retained earnings Total shareholder’s equity

$1,000 200 $1,200

$1,000 600 $1,600

$1,000 900 $1,900

$1,000 1,200 $2,200

. 10-4

Chapter 10: Applications of Fair Value to Non-Current Assets

Revaluation model ($000’s) Revenue Expenses Revaluation gain (loss)* Gain on disposal of land Net income OCI for revaluation gain (loss)* Comprehensive income

2023 $2,500 (2,300) 0 0 200 250 $ 450

2024 $3,000 (2,600) (100) 0 300 (250) $ 50

2025 $2,000 (1,700) 100 0 400 150 $ 550

2026 $1,500 (1,400) 0 200 300 (150) $ 150

Cash Land Total assets

300 1,150 $1,450

700 800 $1,500

$1,000 1,050 $2,050

$2,200 0 $2,200

Share capital Accumulated revaluation surplus Retained earnings Total shareholder’s equity

$1,000 250 200 $1,450

$1,000 0 500 $1,500

$1,000 150 900 $2,050

$1,000 0 1,200 $2,200

4-year total $9,000 (8,000) 0 200 1,200 0 $1,200

* Changes in fair value above cost ($900k) go to other comprehensive income. Changes below cost go through net income. 2023: Fair value = $1,150k; increase of $250k above cost goes to comprehensive income. 2024: Fair value = $800k; decrease of $350k from 2023 value, of which $250k ($1,150k – $900k) reduces comprehensive income previously recorded in 2023, and $100k ($900k – $800k) is a loss through net income. 2025: Fair value = $1,050k; increase of $250k from 2024 value, of which $100k ($900k – $800k) is a recovery of the loss recorded in 2024, and $150k is a fair value increase above cost which goes to other comprehensive income. 2026: Sale price = $1,100k; gain on sale of $200k recorded for proceeds in excess of cost ($1,100k – $900k); accumulated revaluation reserve is closed out on disposal of asset. P10-8. Suggested solution: a.

Elimination method Cr. Equipment 100,000 Dr. Accumulated depreciation* 400,000 Cr. OCI – revaluation gain ($900,000 – $600,000) 300,000 * Elimination of accumulated depreciation. $300,000 is from prior years’ depreciation ($1,000,000 – $700,000) and $100,000 is for current year’s depreciation.

. 10-5

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Proportional method Dr. Equipment (+50% × $1,000,000) 500,000 Cr. Accumulated depreciation (+50% × $400,000) 200,000 Cr. OCI – revaluation gain ($900,000 – $600,000)* 300,000 * Just prior to the year-end revaluation, the carrying amount is $600,000 (i.e., cost of $1,000,000 less accumulated depreciation of $400,000). The fair value of $900,000 is a 50% increase. Therefore, under the proportional method, both the gross carrying amount and accumulated depreciation increase by 50%. P10-9. Suggested solution: a.

Elimination method Cr. Equipment 520,000 Dr. Accumulated depreciation* 400,000 Dr. Revaluation loss ($480,000 – 600,000) 120,000 * Elimination of accumulated depreciation. $300,000 is from prior years’ depreciation ($1,000,000 – 700,000) and $100,000 is for current year’s depreciation. b.

Proportional method Cr. Equipment (–20% × $1,000,000) 200,000 Dr. Accumulated depreciation (–20% × $400,000) 80,000 Dr. Revaluation loss ($900,000 – $600,000)* 120,000 * Just prior to the year-end revaluation, the carrying amount is $600,000 (i.e., cost of $1,000,000 less accumulated depreciation of $400,000). The fair value of $480,000 is 0.8 of the carrying amount, or a 20% decrease. Therefore, under the proportional method, both the gross carrying amount and accumulated depreciation decrease by 20%. P10-10. Suggested solution: First 12 years: Depreciation = $5,000,000 / 20 = $250,000. Last 8 years: Depreciation = $4,000,000 / 8 = $500,000. P10-11. Suggested solution: The double declining balance rate is 2 × 1/8 = 25%. Year 1: Depreciation = $400,000 × 25% = $100,000. Undepreciated balance = $400,000 – $100,000 = $300,000. Year 2: Depreciation = $300,000 × 25% = $75,000. Undepreciated balance = $300,000 – $75,000 = $225,000. Revalue to $320,000, an increase of $95,000 Year 3: Depreciation = $320,000 × 25% = $80,000. Undepreciated balance = $320,000 – $80,000 = $240,000 Year 4: Depreciation = $240,000 × 25% = $60,000. . 10-6

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-12. Suggested solution: a. Depreciation before revaluation Cost $1,000,000 Residual value 200,000 Depreciable amount 800,000 Estimated useful life ÷ 10 years Depreciation per year $80,000

b. Depreciation after revaluation Revalued amount Residual value Depreciable amount Remaining useful life Depreciation per year

$800,000 200,000 600,000 ÷ 6 years $100,000

c. Journal entry for revaluation Note that the carrying amount of the equipment is $1,000,000 – $320,000 = $680,000 Cr. Equipment ($800,000 – $1,000,000) 200,000 Dr. Accumulated depreciation (4 × $80,000) 320,000 Cr. OCI – revaluation gain 120,000 d.

Carrying value for all 10 years (in $000’s). Historical cost Gross carrying Accumulated Net carrying Year value deprecation value 1 $1,000 $ 80 $920 2 1,000 160 840 3 1,000 240 760 4 1,000 320 680 5 1,000 400 600 6 1,000 480 520 7 1,000 560 440 8 1,000 640 360 9 1,000 720 280 10 1,000 800 200

. 10-7

Gross carrying value $1,000 1,000 1,000 800 800 800 800 800 800 800

Revaluation method Accumulated deprecation $ 80 160 240 0 100 200 300 400 500 600

Net carrying value $920 840 760 800 700 600 500 400 300 200

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-13. Suggested solution: a. Depreciation before revaluation Cost $2,000,000 Residual value 500,000 Depreciable amount 1,500,000 Estimated useful life ÷ 6 years Depreciation per year $250,000 b. Depreciation after revaluation Revalued amount $1,650,000 Residual value 500,000 Depreciable amount 1,150,000 Remaining useful life ÷ 4 years Depreciation per year $287,500 c.

Journal entry for revaluation

Note that the carrying amount of the equipment is $2,000,000 – $500,000 = $1,500,000. The fair value of $1,650,000 is an increase of 10%. Dr. Equipment (10% × 2,000,000) 200,000 Cr. Accumulated depreciation (10% × $500,000) 50,000 Cr. OCI – revaluation gain 150,000 d.

Carrying value for all 6 years (in $000’s). Historical cost Gross carrying Accumulated Net carrying Year value deprecation value 1 $2,000 $ 250 $1,750 2 2,000 500 1,500 3 2,000 750 1,250 4 2,000 1,000 1,000 5 2,000 1,250 750 6 2,000 1,500 500

Gross carrying value $2,000 2,200 2,200 2,200 2,200 2,200

Revaluation method Accumulated deprecation $ 250 550 837.5 1,125 1,412.5 1,700

Net carrying value $1,750 1,650 1,362.5 1,075 787.5 500

P10-14. Suggested solution: The impairment test compares the carrying amount in the books with the recoverable amount. The recoverable amount under IFRS is the higher of (i) the fair value less cost to sell and (ii) the value in use. In order to estimate the value in use, it is necessary to forecast the future cash flows that management expects to be derived. To be able to make such cash flow forecasts, it is necessary that assets be grouped by cash generating units. . 10-8

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-15. Suggested solution:

a. b. c. d. e.

True / Statement false Enterprises should test all tangible False assets for impairment annually. Enterprises should test all intangible False assets for impairment annually. Enterprises should test goodwill for impairment annually. For all tangible assets, enterprises should annually search for indications of impairment. For all intangible assets, enterprises should annually search for indications of impairment.

True

Enterprises should annually search for indications that goodwill is impaired.

False

Explanation Tangible assets should be tested when there are indications of impairment. Some intangible assets should be tested for impairment annually, depending on whether they have a finite or indefinite life.

True False

Only intangibles with finite lives require a search for indications of impairment. Those with indefinite lives would be tested for impairment regardless of whether there are indications of impairment. Goodwill must go through impairment annually regardless of whether there are indications of impairment.

P10-16. Suggested solution: Enterprises must amortize intangible assets with finite lives, so their carrying amount is systematically allocated over their useful lives, meaning their carrying amounts decline over time (unless there is a revaluation). In contrast, enterprises are not required to amortize intangible assets with indefinite lives, so their carrying amounts do not automatically decline over time. Those intangible assets with indefinite lives need to be evaluated for impairment because there is a higher risk that their carrying amounts are overstated relative to their recoverable amount. P10-17. Suggested solution: a.

The golf club moulding machine is likely to be only a component of a cash generating unit that includes other machines. It needs to be considered with other assets that would be used in conjunction to generate cash flows. In any case, this is a tangible asset, and there does not appear to be any indication that it is impaired, so no impairment evaluation is required. Since Golf Pro purchases the golf balls, stamping and packaging equipment is likely to be sufficiently self-contained to form a cash generating unit. If there were indicators of adverse conditions, this tangible equipment would be evaluated for impairment. However, there are no such indications as the company is stable and profitable, so no impairment test is required this year. . 10-9

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

c. d. e.

This patent is an intangible asset with a finite life. It would be evaluated for impairment if there are indications of impairment. With no such indications, no impairment test is required. A brand name that is the name of the company has indefinite life (it will be valid as long as the company continues in operation). Therefore, it needs to be evaluated for impairment annually. Goodwill needs to be evaluated for impairment annually.

P10-18. Suggested solution: First, the proprietary system is the main revenue generator for the company, so it constitutes a cash generating unit. Second, note that the question is intentionally vague regarding whether this intangible asset has a finite or indefinite life. If it is argued that the system has an indefinite life, then it needs to be evaluated for impairment annually. However, common business sense suggests that a system such as the one described has a finite life because technological advances will allow competitors to come up with something better. If the intangible is considered to have a finite life, then it would need to be evaluated for impairment only if there are adverse indications. The slump in travel potentially suggests that the asset is impaired, but on the other hand it may be the case that cost-conscious travellers could be attracted to discounted hotel prices and use Hotel Consolidators more. Nevertheless, the potential for impairment is a sufficient indication that a formal impairment test be carried out. Thus, in either case of finite or indefinite life, an impairment test is required. P10-19. Suggested solution: Fair value Costs to sell Fair value less costs to sell (a) Value in use (b) Higher of (a) and (b) Carrying amount Amount of impairment

$32,000,000 (100,000) 31,900,000 28,000,000 31,900,000 35,000,000 $ 3,100,000

P10-20. Suggested solution: Nominal amount 500,000 400,000 700,000 800,000

Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Incremental cash flow 2027 Value in use

Discount factor 1/1.12 1/1.122 1/1.123 1/1.124

Or using a BAII PLUS financial calculator: 1N, 12 I/Y, 500,000 FV, CPT PV  PV = –446,429 (rounded) .

10-10

PV of cash flows $ 446,429 318,878 498,246 508,414 $1,771,967

Chapter 10: Applications of Fair Value to Non-Current Assets

2N, 12 I/Y, 400,000 FV, CPT PV  PV = –318,878 (rounded) 3N, 12 I/Y, 700,000 FV, CPT PV  PV = –498,246 (rounded) 4N, 12 I/Y, 800,000 FV, CPT PV  PV = –508,414 (rounded) $446,429 + $318,878 + $498,246 + $508,414 = $1,771,967 Fair value Costs to sell Fair value less costs to sell

$1,700,000 (100,000) $1,600,000

Original cost Accumulated depreciation Net carrying value Less: recoverable amount (higher of value in use and FV less costs to sell) Impairment loss

$4,000,000 (1,200,000) 2,800,000 1,771,967 $1,028,033

P10-21. Suggested solution: Nominal amount $ 500,000 400,000 700,000 800,000 $2,400,000

Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Incremental cash flow 2027 Recoverable amount

Original cost Accumulated depreciation Net carrying value The recoverable amount is less than the carrying value, so the asset is impaired.

$4,000,000 (1,200,000) $2,800,000

Net carrying value Less: fair value Impairment loss

$2,800,000 1,700,000 $1,100,000

. 10-11

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-22. Suggested solution: Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Incremental cash flow 2027 Value in use

Nominal amount 800,000 900,000 900,000 10,00,000

Discount factor 1/1.10 1/1.102 1/1.103 1/1.104

PV of cash flows $ 727,273 743,802 676,183 683,013 $2,830,271

Or using a BAII PLUS financial calculator: 1N, 10 I/Y, 800,000 FV, CPT PV  PV = –727,273 (rounded) 2N, 10 I/Y, 900,000 FV, CPT PV  PV = –743,802 (rounded) 3N, 10 I/Y, 900,000 FV, CPT PV  PV = –676,183 (rounded) 4N, 10 I/Y, 1,000,000 FV, CPT PV  PV = –683,013 (rounded) $727,273 + $743,802 + $676,183 + $683,013 = $2,830,271 Fair value Costs to sell Fair value less costs to sell

$3,200,000 (145,000) $3,055,000

Original cost Accumulated depreciation Net carrying value Less: recoverable amount (higher of value in use and FV less costs to sell) Impairment loss (0 if negative)

$7,000,000 (4,300,000) 2,700,000 3,055,000 $ 0

P10-23. Suggested solution: Nominal amount $ 800,000 900,000 900,000 10,00,000 $3,600,000

Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Incremental cash flow 2027 Recoverable amount

Original cost $7,000,000 Accumulated depreciation (4,300,000) Net carrying value $2,700,000 The recoverable amount is more than the carrying value, so the asset is not impaired.

. 10-12

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-24. Suggested solution: Dried product line Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Incremental cash flow 2027 Value in use

Nominal amount $1,100,000 1,400,000 1,700,000 2,000,000

Discount factor 1/1.12 1/1.122 1/1.123 1/1.124

PV of cash flows $ 982,143 1,116,071 1,210,026 1,271,036 $4,579,276

Or using a BAII PLUS financial calculator: 1N, 12 I/Y, 1,100,000 FV, CPT PV  PV = –982,143 (rounded) 2N, 12 I/Y, 1,400,000 FV, CPT PV  PV = –1,116,071 (rounded) 3N, 12 I/Y, 1,700,000 FV, CPT PV  PV = –1,210,026 (rounded) 4N, 12 I/Y, 2,000,000 FV, CPT PV  PV = –1,271,036 (rounded) $982,143 + $1,116,071 + $1,210,026 + $1,271,036 = $4,579,276 Fair value Costs to sell Fair value less costs to sell

$6,100,000 (180,000) $5,920,000

Original cost Accumulated depreciation Net carrying value Less: recoverable amount (higher of value in use and FV less costs to sell) Impairment loss (0 if negative)

$9,000,000 (3,700,000) 5,300,000 5,920,000 $ 0

. 10-13

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Canned product line Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Value in use

Nominal amount $2,200,000 3,000,000 3,500,000

Discount factor 1/1.12 1/1.122 1/1.123

PV of cash flows $1,964,286 2,391,582 2,491,231 $6,847,099

Or using a BAII PLUS financial calculator: 1N, 12 I/Y, 2,200,000 FV, CPT PV  PV = –1,964,286 (rounded) 2 N, 12 I/Y, 3,000,000 FV, CPT PV  PV = –2,391,582 (rounded) 3 N, 12 I/Y, 3,500,000 FV, CPT PV  PV = –2,491,231 (rounded) $1,964,286 + $2,391,582 + $2,491,231 = $6,847,099 Fair value Costs to sell Fair value less costs to sell

$7,300,000 (310,000) $6,990,000

Original cost Accumulated depreciation Net carrying value Less: recoverable amount (higher of value in use and FV less costs to sell) Impairment loss

$12,000,000 (4,500,000) 7,500,000 6,990,000 $ 510,000

P10-25. Suggested solution: Dried product line Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Incremental cash flow 2027 Recoverable amount

Nominal amount $1,100,000 1,400,000 1,700,000 2,000,000 $6,200,000

Original cost $9,000,000 Accumulated depreciation (3,700,000) Net carrying value $5,300,000 The recoverable amount is more than the carrying value, so this product line is not impaired. Canned product line Nominal amount Incremental cash flow 2024 $2,200,000 Incremental cash flow 2025 3,000,000 Incremental cash flow 2026 3,500,000 Recoverable amount $8,700,000 Original cost $12,000,000 Accumulated depreciation (4,500,000) Net carrying value $7,500,000 The recoverable amount is more than the carrying value, so this product line is not impaired.

. 10-14

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-26. Suggested solution: a. b.

The total impairment in the cash generating unit is $100,000. The bending machine has 60% of the carrying value ($300,000 / $500,000), so it bears 60% of the impairment loss, or $60,000. The welding machine absorbs the remaining 40%, or $40,000. The total impairment in the cash generating unit is $100,000 (= $500,000 – $400,000). Since the welding machine’s fair value less costs to sell exceeds its carrying amount, it is not impaired. Therefore, the entire impairment must be allocated to the bending machine to reduce its carrying value from $300,000 by $100,000.

P10-27. Suggested solution: a.

Depreciation prior to revaluations: Equipment: $4,800,000 / 6 years Building: ($13,250,000 – $2,000,000) / 25 years

Revaluation journal entries Equipment—Proportional method of recording revaluation Before revaluation After revaluation Equipment $8,000,000 Equipment Acc. depreciation 3,200,000 Acc. depreciation Carrying amount $4,800,000 Carrying amount Dr. Accumulated depreciation – equipment Dr. Loss on revaluation – equipment Cr. Equipment Building – elimination method of recording revaluation Before revaluation After revaluation Building $20,000,000 Building Acc. depreciation 6,750,000 Acc. depreciation Carrying amount $13,250,000 Carrying amount Dr. Accumulated depreciation – building Cr. Building Cr. Revaluation surplus

Depreciation after revaluation Equipment: $4,320,000 / 6 years Building: ($18,000,000 – $2,000,000) / 25 years

Journal entries for revaluation in 2025

. 10-15

= $800,000/year = $450,000/year

Change –10% –10% –10%

$7,200,000 2,880,000 $4,320,000 320,000 480,000

800,000

$18,000,000 0 $18,000,000 6,750,000

2,000,000 4,750,000

= $720,000/year = $640,000/year

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Equipment – proportional method Before revaluation Equipment $7,200,000 Acc. depreciation 3,600,000 Carrying amount $3,600,000

After revaluation Equipment Acc. depreciation Carrying amount

$7,600,000 3,800,000 $3,800,000

Change +5.55% +5.55% +5.55%

Dr. Equipment 400,000 Dr. Accumulated depreciation – equipment 200,000 Cr. Gain on revaluation of machinery (income) 200,000 Since this is a partial recovery of the loss recorded in 2024, the gain can be recorded in the income statement. Building – elimination method Before revaluation Building $18,000,000 Acc. depreciation 640,000 Carrying amount $17,360,000

After revaluation Building Acc. depreciation Carrying amount

$16,000,000 0 $16,000,000

Dr. Accumulated depreciation – building 640,000 Cr. Building 2,000,000 Dr. Revaluation surplus 1,360,000 The decline in fair value is first charged against the revaluation surplus account until it is eliminated. After the revaluation in 2025, the balance in revaluation surplus is $4,750,000 – $1,360,000 = $3,390,000. P10-28. Suggested solution: Note that Machine A is not impaired because its fair value less costs to sell is at least as high as its carrying amount. Machine A Machine B Machine C CGU Total Net carrying amount $1,000,000 $1,500,000 $2,000,000 $4,500,000 Recoverable amount 4,000,000 Impairment loss $ 500,000 Net carrying amount Percentage of total carrying amount* Total impairment loss Impairment loss allocated

—

$1,500,000 42.857% × 500,000 $ 214,286

$2,000,000 57.143% × 500,000 $ 285,714

$3,500,000 100% × 500,000 $ 500,000

*Percentage of total carrying amount: $1,500,000 / $3,500,000 = 42.857%; $2,000,000 / $3,500,000 = 57.143%.

. 10-16

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-29. Suggested solution: a.

Completed table

Net carrying value Fair value less cost to sell Value in use

Machine A $900,000 600,000 n/a

Machine B $1,300,000 1,400,000 n/a

Machine C $1,700,000 1,300,000 n/a

Net carrying value for CGU Less: recoverable amount for CGU Impairment loss for CGU

CGU total $3,900,000 3,300,000 3,400,000 $3,900,000 3,400,000 $ 500,000

Net carrying value for loss allocation Percentage of total carrying amount* × Total impairment loss Impairment loss allocated

$900,000 34.62% × 500,000 $173,077

unimpaired

$1,700,000 $2,600,000 65.38% 100% × 500,000 × 500,000 $ 326,923 $ 500,000

Carrying value before impairment Less: impairment loss Carrying value after impairment

$900,000 173,077 $726,923

$1,300,000 0 $1,300,000

$1,700,000 326,923 $1,373,077

$3,900,000 500,000 $3,400,000

* Percentage of total carrying amount: $900,000 / $2,600,000 = 34.62%; $1,700,000 / $2,600,000 = 65.38%. b.

Journal entries with no prior revaluations Dr. Impairment loss – Machine A Cr. Accumulated depreciation – Machine A Dr. Impairment loss – Machine C Cr. Accumulated depreciation – Machine C

Journal entries with prior revaluations Dr. OCI (revaluation surplus – Machine A) Dr. Impairment loss – Machine A Cr. Accumulated depreciation – Machine A

173,077 326,923

50,000 123,077

173,077 326,923

173,077

Dr. Impairment loss – Machine C 326,923 Cr. Accumulated depreciation – Machine C 326,923 The impairment loss first reduces or eliminates any revaluation surplus, with the remainder recorded as an impairment loss through net income. Note that the revaluation surpluses are identified with each asset, not with a CGU. Therefore, the $100,000 revaluation surplus for Machine B should NOT be used to offset the impairment losses of Machine A or C.

. 10-17

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-30. Suggested solution: Land

Building

$15,000,000 n/a n/a

$10,000,000 ÷ 20 $ 500,000

b. First impairment Gross carrying value, 2014 Jan 1 Accumulated depreciation (3 × 500,000) Carrying value, 2014 Jan 1 Less: recoverable amount Impairment loss

$15,000,000 12,000,000 $ 3,000,000

$10,000,000 1,500,000 8,500,000 6,800,000 $ 1,700,000

c. Depreciation 2014–2020 Net carrying value after impairment Estimated remaining useful life Annual depreciation (2014 to 2020)

$12,000,000 n/a n/a

$6,800,000 ÷ 17 $ 400,000

$12,000,000

$10,000,000 6,000,000 4,000,000

( 15,000,000) ($ 3,000,000)

( 5,000,000) ($1,000,000)

$15,000,000 n/a 15,000,000 16,000,000

$10,000,000 5,000,000 5,000,000 6,000,000

$15,000,000

$5,000,000

a. Depreciation 2011–2013 Purchase cost Estimated useful life Annual depreciation (2011 to 2013)

d. Second impairment (reversal) Gross carrying value, 2021 Jan 1 Acc. depr. (1,500k + 1,700k + 7 × 400k) Carrying value, 2021 Jan 1 Less: lesser of recoverable amount or unimpaired net carrying value (see below) Impairment loss (recovery if negative) Cap on impairment reversal Cost Acc. depr. if no impairment recorded (10 × 500k) Unimpaired net carrying value Recoverable amount Lesser of recoverable amount and unimpaired net carrying value

e. Depreciation 2021–2030 Net carrying value after impairment $15,000,000 $5,000,000 Estimated remaining useful life n/a ÷ 10 Annual depreciation (2021 to 2030) n/a $ 500,000 Note the depreciation on the equipment reverts to its original level since the impairment completely reverses.

. 10-18

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-31. Suggested solution: a. Depreciation 2021–2025 Purchase cost Estimated useful life Annual depreciation (2021 to 2025)

Plant

Equipment

$150,000,000 ÷ 25 $ 6,000,000

$84,000,000 ÷ 12 $ 7,000,000

b. First impairment Gross carrying value, 2026 Jan 1 Accumulated depreciation (5 years) Carrying value, 2026 Jan 1 Less: recoverable amount Impairment loss

$150,000,000 30,000,000 120,000,000 110,000,000 $ 10,000,000

$84,000,000 35,000,000 49,000,000 42,000,000 $7,000,000

c. Depreciation 2026 to 2028 Net carrying value after impairment Estimated remaining useful life Annual depreciation (2026 to 2028)

$110,000,000 ÷ 20 $ 5,500,000

$42,000,000 ÷ 7 $ 6,000,000

$150,000,000 56,500,000

$84,000,000

d. Second impairment (reversal) Gross carrying value, 2029 Jan 1 Acc. depr. – plant (30m + 10m + 3 × 5.5m) Acc. depr. – equip (35m + 7m + 3 × 6m) Carrying value, 2029 Jan 1 Less: lesser of recoverable amount or unimpaired net carrying value (see below) Impairment loss (recovery if negative) Cap on impairment reversal Cost Acc. depr. if no impairment recorded (8 years) Unimpaired net carrying value Recoverable amount Lesser of recoverable amount and unimpaired net carrying value

93,500,000

60,000,000 24,000,000

(102,000,000) ($ 8,500,000)

( 25,000,000) ( $1,000,000)

$150,000,000 48,000,000 102,000,000 105,000,000

$84,000,000 56,000,000 28,000,000 25,000,000

$102,000,000

$25,000,000

e. Depreciation 2029 Net carrying value after impairment $102,000,000 $25,000,000 Estimated remaining useful life ÷ 17 ÷ 4 Annual depreciation (2029) $ 6,000,000 $ 6,250,000 Note the depreciation on the plant reverts to its original level since the impairment completely reverses. In comparison, the depreciation on the equipment remains different because the impairment has not fully reversed.

. 10-19

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-32. Suggested solution: a. Evaluation Dec. 31, 2023 Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Value in use

Nominal amount 550,000 550,000 550,000

Discount factor 1/1.09 1/1.092 1/1.093

PV of cash flows $ 504,587 462,924 424,701 $1,392,212

Or using a BAII PLUS financial calculator 3N, 9 I/Y, 550,000 PMT, CPT PV PV = –1,392,212 (rounded) Fair value Costs to sell Fair value less costs to sell

$1,400,000 (50,000) $1,350,000

Original cost Accumulated depreciation Net carrying value Less: recoverable amount (higher of value in use and FV less costs to sell) Impairment loss

$2,400,000 (600,000) 1,800,000 1,392,212 $ 407,788

12/31/2023 Dr. Impairment loss – Machine Cr. Accumulated depreciation – Machine

407,788

b. Evaluation Dec. 31, 2024 Incremental cash flow 2025 Incremental cash flow 2026 Value in use

Nominal amount 550,000 550,000

407,788

Discount factor 1/1.09 1/1.092

PV of cash flows $504,587 462,924 $967,511

Or using a BAII PLUS financial calculator 2N, 9 I/Y, 550,000 PMT, CPT PV PV = –967,511 (rounded) Fair value less costs to sell

$975,000

Depreciation 2024 Net carrying value after impairment (recoverable amount from above) Estimated remaining useful life 2024 depreciation

$1,392,212 ÷ 3 $ 464,071

Original cost Impairment Accumulated depreciation (600,000 + 464,071) Net carrying value Less: recoverable amount (higher of value in use and FV less costs to sell) Impairment recovery

$2,400,000 (407,788) (1,064,071) 928,141 975,000 $ 46,859

. 10-20

Chapter 10: Applications of Fair Value to Non-Current Assets

12/31/2024 Dr. Accumulated depreciation – Machine Cr. Impairment loss recovery – Machine

46,859

P10-33. Suggested solution: a. Evaluation Dec. 31, 2023 Incremental cash flow 2024 Incremental cash flow 2025 Incremental cash flow 2026 Recoverable amount

Nominal amount $ 550,000 550,000 550,000 $1,650,000

Original cost $2,400,000 Accumulated depreciation (600,000) Net carrying value $1,800,000 The recoverable amount is less than the carrying value, so the asset is impaired. Net carrying value Less: fair value Impairment loss

$1,800,000 1,400,000 $400,000

12/31/2023 Dr. Impairment loss – Machine Cr. Accumulated depreciation – Machine b. Evaluation Dec. 31, 2024 Incremental cash flow 2025 Incremental cash flow 2026 Recoverable amount

400,000

Nominal amount 550,000 550,000 $1,100,000

Depreciation 2024 Net carrying value after impairment (2,400,000 – 600,000 – 400,000) Estimated remaining useful life 2024 depreciation

$1,400,000 ÷ 3 $ 466,667

Original cost Accumulated depreciation (600,000 + 400,000 + 466,667) Net carrying value

$2,400,000 (1,466,667) $933,333

The recoverable amount is greater than the carrying value, so the asset is not further impaired. Note that under ASPE reversal of previous impairment losses is not permitted.

. 10-21

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-34. Suggested solution:

a. b. c. d. e.

Description of asset A residential apartment building owned by an apartment rental company. A building owned and used by a hotel operator as a hotel. A building owned by Company A and rented to Company B which operates a hotel in the building. Land, above which is a company’s production facilities. An empty parcel of land adjacent to a company’s production facilities.

Investment property?

Explanation Property held to earn rental income Property used in operations (PPE).

Y N

Property held to earn rental income

Property used in operations (PPE). Property held for capital appreciation.

N Y

P10-35. Suggested solution: Accounting issue Measurement on balance sheet Frequency of measurement Unrealized gains and losses

Depreciation

IAS 16 PPE At fair value Annual or less frequently Record through OCI or profit or loss depending on cumulative revaluation adjustments Required

IAS 40 Investment Property At fair value Annual Record through profit or loss

None

P10-36. Suggested solution: a.

Based on the facts as presented, the property should be classified as investment property because it is used to earn rental income from leasing to the hotel company. The adjusting entry would be as follows: 2023 Dr. Investment property – Halifax building 1,400,000 Dr. Loss on fair value adjustment 1,100,000 Cr. Investment property – Halifax land 2,500,000 2024 Dr. Investment property – Halifax building Dr. Investment property – Halifax land Cr. Gain on fair value adjustment

. 10-22

600,000 2,000,000

2,600,000

Chapter 10: Applications of Fair Value to Non-Current Assets

If HPMC also operates the property as a hotel, then the property would be considered PPE. Since the company uses the revaluation model with the elimination method, the adjusting entries would be as follows

2023

To record depreciation for the year. Dr. Depr. expense (($30m – $5m) / 25 yrs) 1,000,000 Cr. Accum. depreciation – Halifax building (Carrying amount after depreciation = $30m – 1$ m = $29m) To record building revaluation from $29m to $31.4m. Dr. PPE – Halifax building - gross Dr. Accum. depreciation – Halifax building Cr. Revaluation reserve – Halifax building (OCI)

1,400,000 1,000,000

To record land revaluation from $20 million to $17.5 million. Dr. Loss on revaluation – Halifax land 2,500,000 Dr. PPE – Halifax land 2024

To record depreciation for the year. Dr. Depr. expense (($31.4m – $5m) /24 yrs) 1,100,000 Cr. Accum. depreciation – Halifax building (Carrying amount after depreciation = $31.4 m – 1.1m = $30.3m) To record building revaluation from $30.3m to $32. Dr. PPE – Halifax building - gross Dr. Accum. depreciation – Halifax building Cr. Revaluation reserve – Halifax building (OCI)

600,000 1,100,000

To record land revaluation from $17.5m to $19.5m. Dr. PPE – Halifax land Dr. Loss recovery on revaluation – Halifax land

2,000,000

1,000,000

2,400,000

2,500,000

1,100,000

1,700,000

2,000,000

P10-37. Suggested solution: a.

Under ASPE, there is no separate classification of investment property. The standards for PPE apply. The fair value model is not permitted; HPMC must use the cost model. 2023 Dr. Depr. expense (($30m – $5m) / 25 yrs) 1,000,000 Cr. Accum. depreciation – Halifax building 1,000,000 2024 Dr. Depr. expense (($29m – $5m) / 24 yrs) Cr. Accum. depreciation – Halifax building

1,000,000

ASPE does not distinguish property held for use and property held to earn rental income— both are considered PPE. Therefore, the journal entries are the same as for part a.

. 10-23

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-38. Suggested solution: a. 07/01/2023

Dr. Invest property – land (6,200,000 × 20%) Dr. Invest property – building (6,200,000 × 80%) Cr. Cash (6,000,000 + 200,000)* *The $100,000 fee for arranging the rental agreement does not pertain to the acquisition of the building and would not be capitalized as part of the initial cost.

1,240,000 4,960,000

b. 12/31/2023

Cost model Depreciation expense investment property* Cr. Accum. depreciation investment property *((4,960,000 – 0) / 30) × (6/12)

c. 12/31/2023

Fair value model Dr. Invest property – land (1,300,000 – 1,240,000) Dr. Invest property – build. (5,100,00 – 4,960,000) Cr. Gain on fair value revaluation Note that the building is not depreciated when the fair value model is used.

6,200,000

82,667

60,000 140,000

200,000

P10-39. Suggested solution: a. 10/15/2023 Dr. Investment property ($10,000,000 + $150,000 + $45,000) Cr. Cash b. 12/31/2024 Dr. Investment property ($12,000,000 $10,195,000) Cr. Holding gain on investment property c. 12/31/2025 Dr. Holding loss on investment property Cr. Investment property ($12,000,000 $11,500,000)

. 10-24

10,195,000 10,195,000 1,805,000 1,805,000 500,000

500,000

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-40. Suggested solution: a. 11/01/2023 Dr. Investment property – land Dr. Investment property – apartment building Cr. Cash b. 12/31/2023 Dr. Depreciation expense Cr. Accumulated depreciation – invest. property apartment ($5,000,000 - $500,000) / 40 years = $112,500 per year; $112,500 × 2 months / 12 months = $18,750 12/31/2024 Dr. Depreciation expense Cr. Accumulated depreciation – invest. property apartment ($5,000,000 - $500,000) / 40 years = $112,500 per year c. 12/31/2024 Dr. Impairment loss (from below) Cr. Accumulated depreciation – apartment building d. 12/31/2024 Dr. Holding loss on investment property Cr. Investment property – land ($7.0m - $6.5m) Cr. Investment property – apartment building ($5.0m - $3.5m) The investment property is not depreciated as it is subsequently measured using the fair value model.

7,000,000 5,000,000

18,750

112,500

1,668,750

2,000,000

Calculation of impairment loss for part c. Fair value Costs to sell Fair value less costs to sell (a) Value in use (b) Higher of (a) and (b) Carrying amount ($12,000,000 - $18,750 - $112,500) Impairment loss

. 10-25

$10,000,000 (500,000) 9,500,000 10,200,000 10,200,000 11,868,750 $ 1,668,750

12,000,000

18,750

112,500

1,668,750

500,000 1,500,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-41. Suggested solution: As the company uses the fair value model for its investment property, the following entries would be recorded: Jan. 1, Before recording the transfer, we first revalue the land and building to their fair 2023 value at date of transfer. Dr. Accumulated depreciation on PPE – office building 300,000 (given) Dr. Holding loss on PPE ($400,000 + $100,000 200,000 $300,000) Cr. PPE – land ($1,000,000 - $900,000) 100,000 Cr. PPE – office building ($1,500,000 – 400,000 $1,100,000) The holding loss flows through profit and loss, rather than OCI, as a net loss is evident.

Jun. 15, 2028

We then record the transfer from PPE to investment property To record transfer from PPE to investment property. Dr. Investment property – land 900,000 Dr. Investment property – office building 1,100,000 Cr. PPE – land 900,000 Cr. PPE – office building 1,100,000 To record sale of investment property. Dr. Cash Cr. Investment property – land (12/31/07 revaluation amount) Cr. Investment property – office building (12/31/07 revaluation amount) Cr. Gain on sale of investment property ($2,650,000 - $1,200,000 - $1,400,000)

. 10-26

2,650,000

1,200,000 1,400,000 50,000

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-42. Suggested solution: As the company uses the fair value model for its investment property, the following entries would be recorded: Jan. Before recording the transfer, we first revalue the land and building to their fair 2023 value at date of transfer. Dr. Accumulated depreciation on PPE – office 400,000 building (given) Dr. PPE – land ($2,000,000 - $1,500,000) 500,000 Dr. PPE – building ($1,500,000 - $1,300,000) 200,000 Cr. OCI - Revaluation reserve on PPE ($400,000 1,100,000 + $500,000 + $200,000) As part of the closing entry process, this revaluation reserve in OCI is closed out to AOCI in the equity section of the balance sheet, and remains there until the investment property is sold.

Nov. 2030

We then record the transfer from PPE to investment property To record transfer from PPE to investment property. Dr. Investment property – land 2,000,000 Dr. Investment property – office building 1,500,000 Cr. PPE – land Cr. PPE – office building To record sale of investment property. Dr. Cash Dr. Loss on sale of investment property ($2,600,000 + $1,500,000 - $3,900,000) Cr. Investment property – land (12/31/2029 revalued amount) Cr. Investment property – office building (12/31/2029 revalued amount)

2,000,000 1,500,000

3,900,000 200,000 2,600,000 1,500,000

To record the closing out of the AOCI pertaining to the investment property sold Dr. AOCI Revaluation reserve on PPE 1,100,000 Cr. Retained earnings 1,100,000

. 10-27

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-43. Suggested solution: Assuming that the company uses the cost model for investment property, the following entries would be recorded: Jan To record transfer from investment property to PPE. Note that the warehouse would 2023 have 10 years of depreciation at $24,000 per year ($720,000 / 30 years) Dr. PPE – Winnipeg warehouse 720,000 Dr. Accum. depr. on investment property – Winnipeg 240,000 warehouse Cr. Accum. depr. on PPE – Winnipeg warehouse 240,000 Cr. Investment property – Winnipeg warehouse 720,000 Jan To record transfer from PPE to investment property. The warehouse would have 12 2025 years of depreciation at $24,000 per year. Dr. Investment property – Winnipeg warehouse 720,000 Dr. Accum. depr. on PPE – Winnipeg warehouse 288,000 Cr. Accum. depr. on investment property – 288,000 Winnipeg warehouse Cr. PPE – Winnipeg warehouse 720,000 Notice that nothing changes substantively—there are just reclassifications from one non-current asset account to another non-current asset account 2029 To record sale of building. Dr. Cash Dr. Accum. depr. – Winnipeg warehouse (16 × $24,000) Cr. Investment property – Winnipeg warehouse Cr. Gain on sale of investment property

. 10-28

450,000 384,000

720,000 114,000

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-44. Suggested solution: Assuming that the company uses the fair value model for investment property, the following entries would be recorded: Jan To record transfer from investment property to PPE. No depreciation would have been 2023 recorded while the property was classified as investment property Dr. PPE – Winnipeg warehouse 500,000 Cr. Investment property – Winnipeg warehouse 500,000 Jan Before recording transfer, first revalue building to fair value of $480,000 on the date of 2025 transfer. The warehouse would have 2 years of depreciation while classified as PPE accounted for using the cost model. Annual depreciation = $500,000 / 20 years = $25,000. Dr. Accum. depr. on PPE – Winnipeg warehouse 50,000 Cr. PPE – Winnipeg warehouse 20,000 Cr. Reval. reserve – Winnipeg warehouse (OCI) 30,000 This revaluation reserve remains in AOCI in the equity section of the balance sheet until the warehouse is sold. To record transfer from PPE to investment property. Dr. Investment property – Winnipeg warehouse Cr. PPE – Winnipeg warehouse 2029 To record sale of building. Dr. Cash Cr. Investment property – Winnipeg warehouse Dr. Reval. Reserve – Winnipeg warehouse (AOCI) Cr. Retained earnings

480,000

450,000 30,000

480,000

450,000 30,000

P10-45. Suggested solution: According to IAS 41, an agricultural activity (i) involves active management of growth, reproduction, and decay, and (ii) occurs up to and including the point of harvest. Item relates to Both “yes”  Related activity activity up to an agricultural involves active and including activity  IAS management point of harvest 41 applies Item (Yes / No) (Yes / No) (Yes / No) i. Strawberries Yes Yes Yes ii. Strawberry jam Yes No (After) No iii. Trees in a virgin forest No Yes No iv. Christmas trees on a tree farm Yes Yes Yes v. Peach trees Yes Yes Yes

. 10-29

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-46. Suggested solution: Biological assets are items used in agricultural activities up to the point of harvest. Agricultural produce are items harvested from biological assets, but unprocessed. Agricultural Item Biological asset produce Neither i. Strawberries √ ii. Strawberry jam √ iii. Trees in a virgin forest √ iv. Christmas trees on a tree farm √ v. Peach trees √ P10-47. Suggested solution: According to IAS 41, an agricultural activity both (i) involves active management of growth, reproduction, and decay, and (ii) occurs up to and including the point of harvest. Item relates to Both “yes”  Related activity activity up to an agricultural involves active and including activity  IAS management point of harvest 41 applies Item (Yes / No) (Yes / No) (Yes / No) i. Tuna fish in the ocean No Yes No ii. Farmed salmon Yes Yes Yes iii. Wheat Yes Yes Yes iv. Potted tropical plants in nursery Yes Yes Yes v. Cattle used in breeding Yes Yes Yes P10-48. Suggested solution: Biological assets are items used in agricultural activities up to the point of harvest. Agricultural produce are items harvested from biological assets, but unprocessed. Agricultural Item Biological asset produce Neither i. Tuna fish in the ocean √ ii. Farmed salmon √ iii. Wheat √ iv. Potted tropical plants in nursery √ v. Cattle used in breeding √

. 10-30

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-49. Suggested solution: Year 1 Dr. Biological assets – apple trees Cr. Cash

3,000,000

Years 1 and 2 Dr. Biological assets – apple trees Cr. Cash

450,000

Year 11 Dr. Apples (40,000 trees × 100 kg/tree × $0.50/kg) Cr. Revenue

2,000,000

3,000,000

450,000

2,000,000

Dr. Operating expenses (water, fertilizer, labour) 450,000 Dr. Operating expenses (harvesting) 500,000 Cr. Cash 950,000 Once trees are mature and producing, the company should stop capitalizing costs to them. P10-50. Suggested solution: a.

The following table shows the computation of the fair value of Highland’s biological assets at the end of 2024: Llama age Quantity Fair value per llama Total 8 years 20 $10,000 $200,000 4 years 10 14,000 140,000 3 years 10 15,000 150,000 2 years 10 10,000 100,000 1 year 15 5,000 75,000 Total 65 $665,000

The journal entries relating to Highland’s biological and intangible assets for 2024 are as follows: Dr. Biological assets – llamas ($665,000 – 520,000) 145,000 Cr. Income from fair value increase on biological assets 145,000 Dr. Operating expenses 120,000 Cr. Cash 90,000 Cr. Accumulated depreciation – barn 30,000 Dr. Amortization expense ($100,000 / 10 years) 10,000 Cr. Accumulated amortization – llama knowledge 10,000

. 10-31

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

P10-51. Suggested solution: Classify as non-current Current or Available for Expected to sell assets held for Asset non-current sale within year within year sale a. Accounts receivable Current Yes Yes No b. Land – vacant Non-current Yes No No c. Land – occupied Non-current No n/a* No Office Non-current No n/a* No Storage facility Non-current Yes Yes Yes *The partnership plans to continue its operations, so the office and related land is not available for sale. Given this intention, it is not relevant to consider whether these assets could be expected to sell within a year. P10-52. Suggested solution: a. b.

Non-current assets held for sale (NCAHFS) should be presented separately to help users identify the ongoing cash flows of the enterprise separately from those cash flows that are unlikely to recur. Doing so helps users forecast future results more accurately. NCAHFS should be recorded at the lower of the two amounts (essentially lower of cost and market) in order to (i) present a realistic estimate of the amount that can be realized from the sale, while (ii) not providing management an opportunity to manage earnings. If managers were allowed to simply use the fair value less cost to sell (rather than the lower of the two amounts), they could potentially classify assets as NCAHFS in order to recognize gains on non-current assets that have appreciated in value while not having any intention to actually sell these assets. Fair value less cost to sell is the more appropriate measure of market value than value in use because the NCAHFS classification indicates that the enterprise intends to discontinue using these assets and sell them instead.

P10-53. Suggested solution: Deficiencies: * The “income from discontinued operations” on the income statement is pre-tax, whereas it should instead be on an after-tax net profit basis. The amounts should be $5,502 and $5,978 as shown in the note disclosure. * The note disclosure should disaggregate the pre-tax profit into revenues and expenses from the discontinued operations. * Sierra needs to disclose the cash flows from the discontinued operations either in the notes or on the cash flow statement, separated into operating, investing, and financing activities.

. 10-32

Chapter 10: Applications of Fair Value to Non-Current Assets

P10-54. Suggested solution: a.

Meagan Brandon Inc. Statement of Profit or Loss (Partial) For the Year Ended December 31, 2023 Profit before tax from continuing operations $1,100,000 Income tax (220,000) Profit from continuing operations 880,000 Loss from discontinued operations Loss on operations ($200,000) Income tax 40,000 ($160,000) Gain on disposal 100,000 Income tax (20,000) 80,000 (80,000) Profit for the year $800,000

b.      

The after-tax gain or loss attributable to discontinued operations must be disaggregated into the following parts on either the statement of comprehensive income or the notes to the financial statements: Revenue Expenses Pre-tax profit Income tax expense Gain or loss on disposal or from impairment of assets used in discontinued operations Income tax expense on the gain or loss

P10-55. Suggested solution: 08/31/2023

Dr. Machinery held for sale (370,000* – 15,000) Dr. Accumulated depreciation Dr. Impairment loss (600,000 – 355,000 – 240,000) Cr. Machinery

355,000 240,000 5,000

12/31/2023

Dr. Impairment loss (355,000 – (350,000 – 15,000)) Cr. Machinery held for sale

20,000

01/15/2024

Dr. Cash (368,000 –19,000) Cr. Machinery held for sale Cr. Gain on disposal (349,000 – 335,000)

349,000

600,000 20,000 335,000 14,000

* Assets held for sale are valued at the lower of the carrying amount and fair value less costs to sell. Value in use is not a relevant measure as it is the entity’s intent to dispose of the asset within one year. Note: Depreciation is no longer taken once the asset is classified as held for sale.

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M. Mini-Cases Case 1: Capilano Forest Products. Suggested solution: Memo to: Engagement Partner From: CA Subject: Analysis of Accounting Issues Concerning Capilano Forest Company Ltd. (CFCL or the Company) Overview It should be noted at the outset that financial statements may be of limited usefulness in the valuation of this company. Although the purchasers may use the statements to assess logging costs or management performance, they will probably focus on timber reserves, since that is the primary value of a forestry company. Therefore, as auditors working for Don Strom, we must ensure that the controller is not changing the financial statements simply for his own benefit, given that his bonus is based on net income. Such changes would clearly not be in the best interests of Mr. Strom. In fact, Mr. Strom’s primary concern may be to minimize income thereby reducing bonus and tax costs. As mentioned, the buyers may not be too concerned with the financial statements in valuing CFCL, so Mr. Strom may not be well served by the controller’s efforts to increase income. Rights granted for Crown land An argument could be made for recording the fair market value of the rights, as the controller has suggested in the financial statements. Future value will be associated with the rights because revenues from logging will probably exceed the payments to the government for logs harvested and the costs of reforestation. In addition, one could argue that fair market value is appropriate since this is essentially a non-monetary transaction—obtaining logging rights may be considered the culmination of an earnings process in the forestry industry. This viewpoint is, however, difficult to defend. We will also have to consider the basis of amortization of these rights. Alternatives include expensing as trees are sold or amortizing the cost evenly over the life of the right. There are strong arguments against recording the rights in the financial statements. The historical cost principle as well as prudence/conservatism support no recognition in the accounts: essentially, no asset was given up to obtain these rights. In addition, it is unlikely that this transaction could be accepted as a culmination of an earnings process. It should therefore be recorded at the amount of the asset that was given up, which is nil in this case. The controller’s proposal to reflect the fair market value of the timber rights on the financial statements may be intended solely to generate a windfall profit and is thus self-serving. Disclosure of these rights in a note may be sufficient for the purposes of the purchasers in valuing the Company. The rights granted in the prior periods should be accounted for in a manner consistent with that of the current rights. If it is decided to record them at fair market value, then it would be . 10-34

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necessary to restate prior years’ amounts retroactively since recording them at fair market value represents a change in accounting policy. Logging fees Fees paid to the government for logs cut could be recognized as a period expense, instead of being expensed when the trees are sold. We would have to view the logging records and the agreement with the government to gain assurance that year-end accruals are done properly. There is unlikely to be a lot of inventory on hand at any given time, so it is likely that expenses will be reasonably well matched to revenues. The costs of reforestation, although difficult to verify, will have to be systematically accrued and matched to revenues. Reforestation costs The current year’s financial statements for CFCL must show an accrual for the reforestation costs associated with trees logged under the Ministry rights. It will also be necessary to accrue costs for the reforestation of the rights granted in prior years. This cost would be expensed in the current year since it is a result of events occurring in the current year. CFCL may want to consider separate line disclosure of this cost, as it is not tied to the current year’s operations and would not be relevant for the buyers in trying to estimate logging costs. If CFCL is able to log the reforested trees in the future, then an alternative would be to capitalize the reforestation costs since a future benefit will be derived. Purchased rights at mine site There is a serious valuation problem with regard to the five-year timber rights acquired at a future mine site. Due to insect infestation, a write-down in the value of the purchase rights may be appropriate given that a net future benefit may no longer be associated with these timber rights. The fact that the controller may not agree is not surprising given his bonus arrangement. Assuming that a future net benefit is associated with the timber rights, the cost of the timber rights must be amortized in a manner that matches the income from the logs. The alternatives are as follows: 1. Amortize the cost of the rights based on the total number of trees cut, or 2. Allocate the cost based only on good trees cut during the time period, or 3. Expense the cost evenly over five periods. The first two alternatives will be difficult to implement because it will be difficult to ascertain how many trees can be logged in five years, let alone how many good logs as opposed to insectinfested logs can be logged. Assuming it is likely that the same number of logs can be logged in most seasons and given that the Company has a demonstrated ability to sell all logs cut, it may be simpler to amortize the rights equally over the five years. Tree costing It seems illogical to suggest that little or no cost is associated with the trees that are harvested. The purchase price of forest property is based on the trees on the property rather than on the land. If the Company had purchased the land with no timber on it some time ago and had regenerated the timber, the controller’s argument would have some merit. However, since it . 10-35

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takes 60 to 80 years to grow trees to maturity for logging, trees that will be grown through reforestation have no present value. Ongoing maintenance costs of timber properties could be expensed because the cost of replanting and spraying pesticides is not large in comparison to other expenditures of the company. An argument can be made that they should be capitalized, as the expenditures relate to revenues that will be earned in the future. Similarly, a case could be made to capitalize other carrying costs such as property taxes. Pacific tract acquisition In order to assess whether the $25,000 allocated to the sold parcel is an appropriate amount, it is necessary to determine the value of this tract to CFCL upon its purchase. The $25,000 allocation may be considered reasonable considering its limited usefulness to CFCL at the time of purchase. However, it is important to note that any allocation is arbitrary and will be difficult to substantiate. The gain or loss on the sale of this land to developers should be disclosed separately in the income statement since it is not part of recurring operations. Again, this information may be useful to the purchasers in assessing ongoing costs. A write-down of the remaining timber property may be warranted. Value may be impaired since the generation of revenue may have been permanently halted by the environmentalists. If it is found that the question of logging on the property has not been settled and a write-down is inappropriate, a potential contingent loss exists and should be disclosed in the financial statements, if material. The controller’s interest in capitalizing costs for legal fees, public relations, and idle time appears to be motivated by furthering his own objectives of maximizing current income. These costs cannot be capitalized as goodwill since goodwill can arise only upon the purchase of a business. However, these costs may be capitalized as part of the costs of the trees since the costs were necessary to obtain a future benefit—the ability to log the trees in the future. However, this future benefit is highly questionable in light of the significant uncertainty involved, and conservatism would suggest expensing these costs. Forest fires The costs of the forest fires cannot be capitalized as goodwill since, as mentioned previously, goodwill arises only upon the purchase of a business. However, they can be capitalized as part of the protected trees. These costs were incurred to ensure a future benefit from these trees. However, this treatment may not be appropriate given the uncertainty of this future benefit. In fact, we must investigate whether these fires still present a threat to CFCL’s forests, since there may be a significant impairment in value of these sites. The $300,000 commitment should be disclosed in the notes to the financial statements. There is very little justification for including a liability in the financial statements for this amount since it may not relate to past firefighting efforts, and is probably not a legally enforceable commitment.

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Chapter 10: Applications of Fair Value to Non-Current Assets

Revenue recognition from sales of pine and wood chips The strong demand for the pine produced by the Company is not sufficient to support the recognition of revenue when the logs are cut, as suggested by the controller. Many uncertainties still exist at that time, with the result that the risks and rewards of ownership have not transferred and that revenues and costs cannot be measured within a reasonable degree of accuracy. Specifically: * * *

CFCL retains the risks associated with the wood until it is accepted by the purchasers (i.e., title to the wood is not transferred until delivery in Japan). The risk also exists that CFCL may become unable to provide satisfactory delivery to the purchasers. The price can change by up to 5%, depending on the grade. This may be a material amount on large orders. The price can also change due to foreign-currency fluctuations.

It is also not appropriate to recognize the revenue on the wood chips as they are produced. Again, significant uncertainties still exist at that time. CFCL retains the risks associated with these chips until they are in the hands of the buyer. Furthermore, delivery may be difficult, as the current strike may last a long time, despite the controller’s probably optimistic assumption to the contrary. Furthermore, the strike settlement may increase the costs associated with these sales, thereby decreasing the estimated profit. Case 2: WW Development Inc. Suggested solution: [For completeness, the following solution includes discussions of audit issues that would not be expected of students using this textbook. Although useful for classroom discussion, such audit issues should be omitted from the evaluation of student responses.] Memo to: From: Date: Re:

Partner-in-charge of quality control Manager in quality control department September 8, 2024 WW Development engagement

Overview The purpose of this internal quality control review of the working papers of the WW Development Inc. (WW) engagement is to determine whether the audit was conducted in accordance with GAAS and that the financial statements were prepared in accordance with IFRS. The goal is to ensure that Samuel and Samuel is not at risk, that the file is properly documented, and that the engagement partner exercised adequate judgment. The users of WW’s financial statements include the owners of the company and the lenders. The lenders are of particular significance because they have loaned WW large sums of money, and they have indicated concern about WW’s financial position. Based on my review of the working papers, there are serious problems with the financial statements and they will have to be restated before they can be released. Also, the competence of WW’s management appears to be open to question. As is discussed below, a number of decisions have been made that put WW at risk and these decisions seem to reflect poor judgment on the part of management. . 10-37

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Audit risk Based on my review, the audit risk assessment of the WW engagement should be higher than last year. Lenders are concerned about WW’s financial situation, and one lender has already indicated that it will not be renewing its loan. Other lenders may follow that lead if they are not comfortable with WW’s performance. In addition, WW is unable to finance its residential project, the company performed poorly recently and has suffered losses for at least the last two periods. Also, WW is in violation of its interest coverage ratio covenant after the financial statements have been restated based on my review. Violation of the interest coverage ratio covenant may result in the bank calling its loan. It is clear that the partner on the WW engagement was not correct in concluding that audit risk was low. The partner’s conclusion was based on his knowledge of the industry and the client. While this knowledge may mitigate some of the risks associated with the engagement, the concerns of the lenders, proximity to the interest coverage ratio covenant, and recent poor performance strongly indicate increased audit risk despite the partner’s knowledge of the client and industry. Reliance on management The partner-in-charge of the WW audit appears to have placed excessive reliance on WW’s management. His close relationship with the founders of the company may have caused him to have too much confidence in what management told him. Because the partner accepted the representations of management, our firm did not look at forecasted earnings or perform tests of value in use on the Rosdell and WW properties. The partner also accepted management claims that WW will not have trouble replacing the anchor tenant despite contrary information from an independent source (rental agency). In addition, the partner accepted that the situation regarding the WW Building will turn around soon, apparently without obtaining any additional supporting facts. Revenue producing properties The company has investment properties and is accounting for these investments at cost. Under the cost model, after initial recognition, an entity shall measure all of its investment property in accordance with IAS 16’s Property, Plant and Equipment requirements for the cost model, other than those that meet the criteria to be classified as held for sale (or are included in a disposal group that is classified as held for sale) in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. Investment properties that meet the criteria to be classified as held for sale (or are included in a disposal group that is classified as held for sale) shall be measured in accordance with IFRS 5. The Rosdell shopping centre has negative cash from operations. Rental revenue less rental operation expenses less interest yields negative cash from operations of $1,194,000 ($2,518,000 $1,908,000 - $1,803,000). There may be an indication of impairment. To determine whether an item of property, plant and equipment is impaired, an entity applies IAS 36 Impairment of Assets. We must determine the recoverable amount of the asset to determine whether a writedown is required, and if so, the amount. The company appears to prepare financial information for each investment property, therefore, should be testing at the individual asset level. The recoverable amount is the greater of the fair value less costs to sell and value in use. The value . 10-38

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in use is the discounted future net cash flows from the continuing use and ultimate disposal of the asset. The best indicator of the fair value of the shopping centre would be an offer to buy; however, there may be a comparable property that could be used to assist in determining the fair value. There are a number of events that should be considered when calculating the fair value of the property, as the cash flows used should be specific to the entity. These include the loss of the anchor tenant in January 2024 and the failure to replace it, and the anticipated difficulty in replacing the tenant. Also, some tenants are threatening to cancel their leases, and additional vacant space will be difficult to lease without an anchor tenant. The value in use calculation is based on an estimate of revenue less operating expenses and interest expense. The amount for 2025 is calculated below, using the 2024 historical data as the base. Item Rosdell rental revenue in 2024 Adjustment for lost anchor tenant

Adjustment for cancellation fee Adjustment for increased vacancy due to loss of anchor tenant Rental operation expenses Interest expense

$000’s Explanation $ 2,518 348 Assume anchor tenant will not be replaced in 2025, so reduce estimate for 2025 by an additional $348 for 12 months vs. 6 months. 450 Cancellation fee was included in revenue and is non-recurring 100 Assume an additional $100 in lost revenue for the rest of the year. 1,908 Assume operation expenses are not affected by vacancies. 1,803 Assume interest costs remain the same. $(2,091)

Net cash flow in 2026 will likely increase with the addition of a new anchor tenant and reduction in the vacancy rate, which I have assumed will add $700,000 in additional revenues. I have assumed that rent for the new anchor tenant and other tenants will be less than in the past because the difficulty in obtaining a new anchor tenant suggests that rent concessions might be necessary. Assuming that interest costs and operating costs remain the same, net revenues in 2026 and beyond are estimated to be negative $1,391,000. Based on this analysis, cash flow over the next five years will be negative $7,655,000. The 2020 municipal valuation of $13,034,000 is our best indicator of the fair value less costs to sell. As the fair value less costs to sell is greater than the value in use, the fair value less cost to sell should be used to determine the recoverable amount. The recoverable amount is greater than the net book value, so it does not appear that a write-down is required. However, given the large disparity between the value in use and fair value less cost to sell, the company should consider if this is really a good indicator of the fair value. The company may need an appraisal to be performed. We must also determine the net recoverable amount of the WW building because negative operating cash flow is an indicator that there might be impairment. . 10-39

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Item Rental revenue in 2024 Rental operation expenses Interest expense

$000’s Explanation $ 4,873 2,041 Assume operation expenses are not affected by vacancies. 4,685 Assume interest costs remain the same. $(1,853)

Assuming this analysis applies to the next five years, estimated future cash flow is negative $9,265,000. The fair value less cost to sell would be $48,920,000 based on the municipal valuation, which is greater than the value in use, so should be used to determine the net recoverable amount. As the net recoverable amount is greater than the net book value of the asset, no write-down is required. However, the company should consider if the use of the 2020 appraisal is really a good indicator of fair value and if not, the company should have an appraisal performed. The other properties in WW’s portfolio have net recoverable amounts in excess of book value, so no write-down is required. Land held for development Three years ago, WW acquired a piece of land at a bargain price that it wants to develop into a large residential complex. There is some question as to whether the land should be written down. WW has had trouble obtaining financing for the project—the company has been looking without success for a year and a half—because prospective lenders think the land has no resale value. Given the reluctance of lenders to provide financing, it is reasonable to think that WW will not get the financing it requires. If WW cannot get financing, the project will not proceed and the land can be considered worthless. Also, WW seems to be the only party that has expressed any interest in this land for many years. While WW’s management may have insights that others do not, one has to question whether the residential project is viable. On the other hand, if the founding Wang brothers give personal guarantees for loans to develop the land, it is quite possible that financing will be obtained because the guarantees will mitigate the risk that lenders face. If this is the case, the carrying amount of the land of $1,287,000 is reasonable because WW will make a profit of $16 million from the project, assuming its estimates are correct. While there is some possibility that this land will not be developed, I do not think it is necessary to write-down the land. This conclusion is predicated on the assumptions that personal guarantees from the Wang brothers will be sufficient to obtain financing and that we can satisfy ourselves that this project is economically viable. If we are not satisfied that either assumption is reasonable, then the land must be written down, probably to zero. Mortgages receivable Mortgage A Mortgage A is for $2,147,000 on a property that has a fair value of about $1,559,000 in a town where the main industry recently shut down. In addition, no payments have been made on the mortgage since April 2023. The mortgage has recently been renegotiated, and the borrower has . 10-40

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indicated that payments will begin again in January 2025. The borrower’s commitment to pay provides some support for the loan not being impaired. However, overall, the facts indicate that the collectability of the mortgage is in doubt and may be impaired. Assuming that the mortgage is classified as a loan receivable, then WW should determine the future expected cash flows from the mortgage and discount them using the effective interest rate of the initial mortgage. If the carrying amount of Mortgage A (i.e. at amortized cost) is greater than the present value of the expected cash flows, the mortgage should be written down to that amount. If the company expects that it will have to foreclose on the loan in order to recover the value of their investment, then it should include the amount that they expect that they would be able to recover in their calculation of fair value.. Any impairment loss should be recognized in net income. As the company has not foreclosed on the loan at this point, it is still bearing the risk and rewards of the loan and should be entitled to recognize interest income on this amount. Mortgage B We do not have much information on Mortgage B, but no payments have been made since 2022. The developer has indicated, according to the Wongs at least, that payments will be resuming “as soon as possible,” but there is no indication when “as soon as possible” is or if it will happen. These points are evidence that Mortgage B is impaired and should be written down. WW should determine the expected future cash flows and discounted them using the effective interest rate to determine if the amount is less the current amortized cost. It does not appear that the holder of Mortgage B will be able to resume making payments and therefore, the only further cash flow that would be included in the calculation would be the estimated proceeds from selling the property less costs to sell. Recasting of net earnings The effect of the above adjustments on reported net income is summarized below: Item Net loss as reported Adjustment for write-down of Rosdell Adjustment for write-down of WW Building Adjustment for interest revenue on impaired loan Adjustment for cancellation fee on renegotiated mortgage ($1,230 - $123) Adjustment to net realizable value of impaired loan Adjustment for Mortgage B

$000’s $(5,130) 0 0 (159 (1,107) (429) ? $(6,825)

Based on my analysis, WW’s net loss should be $6,825,000. Recalculation of interest coverage ratio It is necessary to recalculate the interest coverage ratio to determine whether WW is in violation of its covenant with the bank. The revised calculation is shown in the table below. The analysis assumes that taxes and interest are not affected by the adjustments (in thousands of dollars):

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Item Net loss as revised Add: Income taxes Add: Interest on debt Earnings before interest and taxes (EBIT) Interest coverage (EBIT / interest)

$000’s $(6,825) 117 12,407 $5,699 0.47

WW is in violation of the interest coverage ratio covenant by a significant amount. The covenant requires a minimum ratio of 0.5, while WW’s ratio is 0.47. As a result, the lender can recall its loan at any time, which has going concern implications for WW, as discussed below. A waiver from the lender is required to provide assurance that the loan will not be called. Other issues Lease cancellation fee The lease cancellation fee has been accounted for correctly by WW. Accounting for investment in joint venture IFRS 11 is the standard applicable to joint arrangements. A company uses proportionate consolidation for joint operations or equity accounting for joint ventures. The crucial difference is whether the parties to the joint arrangement have rights to the assets and obligations to the liabilities of the arrangement (joint operations) or just rights to the net assets (joint venture). The latter case is typically exemplified by a corporate entity giving rise to limited liability. In the case of WW’s investment in Glass Tower, the legal entity/ownership structure (e.g., partnership or corporation) needs to be identified to determine if the equity method is appropriate. Financial statements of joint venture The financial statements of the Glass Tower joint venture were not audited. Instead, another accountant carried out a review. The joint venture contributed $589,000 to WW’s bottom line in 2024, and this amount seems material. A review is not sufficient for the purposes of the WW audit because it does not provide an adequate level of assurance for what appears to be a material amount. Based on the equity pick-up, the joint venture appears to be doing well, but the amount is not adequate evidence. It is necessary to perform procedures on rental revenue and expenses, and appropriate to calculate the NRA of the property. If these procedures are not carried out it, the auditors’ report on WW’s statements should be qualified. Additionally, IFRS requires that consistent accounting policies be applied to Glass Tower and WW; therefore, WW we must ensure that this is accurate. Audit opinion on statement of operating expenses The work done as part of the regular financial statement audit is not sufficient to support an opinion on the statement of operating expenses. The work performed as part of the regular audit is based on the materiality of the financial statements as a whole, while the opinion on the statement of operating expenses applies to that statement only. Different users will be using the statement of operating expenses and relying on our opinion. Materiality should be lower than the amount used for the regular audit. As a result, additional audit procedures may be required to support our opinion on the statement of operating expenses. . 10-42

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Going concern issue WW probably has a going concern problem. Already during the year one lender has indicated that it would not be renewing its loan, and other lenders are uneasy and are waiting for the 2024 financial statements to evaluate their positions. WW has a number of its mortgages coming due in 2025. If those lenders decide not to renew and adequate financing is not available elsewhere, WW will not be a going concern. Compounding the problem is the fact that the amount of debt outstanding on the revenue producing properties appears to be significantly more than the value of the properties. This assessment is based on the municipal market value assessment in 2020, which admittedly may not be a good indicator (because it both dates from 2020 and is for property tax purposes), but it does signal a potential problem that needs to be investigated. If the market values are less that the amount borrowed against them, WW may not be able to obtain as much cash as in the past when the new round of financing comes up. If so, there could be going concern consequences. Two of WW’s properties have negative cash from operations. There do not appear to be recoverability problems with any properties other than the Rosdell shopping centre and the WW building It is doubtful that any cash could be realized on the sale of the land held for residential development. The land was on the market for a long time before WW bought it, and lenders have not been prepared to take a mortgage on the property because they say that it has no resale value. The Wang brothers appear willing to personally guarantee loans against these properties, which mitigates some of the issues with this particular land. Perhaps the brothers will be willing to guarantee the other mortgages to ensure the availability of financing. Such a commitment would also mitigate some of the going concern problems associated with financing the company. Also, there have been collection problems on two mortgages held by WW and, despite management’s optimism that payment is forthcoming, there is significant doubt that these mortgages are collectable. WW has managed to renegotiate one of these mortgages at reasonable terms, which is a positive step, but payments have not begun on the renegotiated mortgage, so one has to remain skeptical at this time as to whether cash will be realized. As shown above, WW is in default of its interest coverage ratio covenant after net income has been restated in accordance with this report. Violating the covenant means that the bank can call its loan, which at year-end was for $6.434 million. The lender has not indicated whether it will waive the covenant violation but, given the low ratio required by the loan agreement, there is a good chance that the lender will take its money and run. In conclusion, the preceding analysis strongly suggests that WW may not be a going concern. In particular, if WW is unable to refinance the mortgages on its properties, WW will probably not be a going concern. The financial statements as they stand give no indication of any problems.

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Conclusions Impact on financial statements As currently prepared, WW’s financial statements are materially misstated and cannot be issued. The discussion above describes a number of deviations from IFRS that must be rectified before an unqualified opinion can be provided. In addition, WW should provide a going concern note because of the serious financial problems pending as a result of upcoming mortgage renegotiations and violation of the interest coverage ratio covenant. Impact on firm/engagement partner Mr. Baseden has not done a good job on this engagement. The audit was not conducted in accordance with GAAS because sufficient evidence was not obtained to support the opinion, as is amply demonstrated in this report. Many of the decisions made by Mr. Baseden call his competence into question. Mr. Baseden placed far too much reliance on representations of management. It appears that his close relationship with the founders of the company impaired his ability to see the serious problems WW was facing. The evidence clearly indicated that the risk associated with this engagement was higher this year, yet Mr. Baseden did not recognize the increased risk. To Mr. Baseden’s credit, he approached the quality control department to review the file. Perhaps he recognized certain weaknesses in this particular engagement and decided to use the quality control department to mitigate these weaknesses. I believe that it is in the best interests of Samuel & Samuel that a post-release review of Mr. Baseden’s other clients be carried out as soon as possible to determine whether there are problems with those engagements as well. Failure to do so places the firm at significant risk. Pending the outcome of this review, a number of remedial steps can be taken to protect the firm. These possibilities should be discussed with Mr. Baseden as soon as possible. First, it would probably be wise to have the quality control department review all of Mr. Baseden’s files before they are released. This requirement would allow problems to be identified and addressed before our opinion is made public. Second, Mr. Baseden should be teamed with technically strong managers who can ensure that GAAS and IFRS are adhered to and that good judgement is exercised. Third, Mr. Baseden should be advised to take refresher courses to upgrade his skills. Case 3: Ryland Storage Park. Suggested Solution a.

Investment property under IAS 40 is defined as properties held, or being constructed or developed to earn rental income, or capital appreciation. On the other hand, property, plant, and equipment refer to non-current assets used in the production or supply of goods and services in the ordinary course of business. The real estate properties owned by RSP are for the purpose of earning rental income and capital appreciation. However, one could also argue that for a REIT, the ordinary business activities include predominantly renting and investing real estate properties for long-term capital appreciation. Ultimately, it is likely more appropriate for RSP to classify these real estate properties as investment properties under IAS 40. In fact, this occurred with many European real estate firms when the European Union adopted IFRS in 2005.

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IAS 16 allows firms to choose between the cost model and the revaluation model to account for their property, plant, and equipment. IAS 40 allows firms to choose between the cost model and the fair value model for their investment properties. While there is minimal difference between the accounting rules if the firms decide to choose the cost model for their IAS 16 and IAS 40 assets, the immediate financial statement impact can be very different under the revaluation model in IAS 16 and the fair value model in IAS 40. Under a burgeoning market, RSP would have huge unrealized gains in its real estate portfolio. IAS 40 would imply these gains be recognized in the income statement, and IAS 16 would require RSP to recognize the gains in revaluation surplus (other comprehensive income) instead. Note the impact on the balance sheet would be the same under both models and the assets would be recognized at the current values on the balance sheet.

It is more likely that firms would adopt the alternative model for their IAS 40 assets. First, this is assumed because IAS 40 nonetheless requires fair value information to be reported in the notes of the financial statements even if the cost model is used for reporting investment properties. There is no such disclosure requirement under IAS 16. Second, while IAS 40 would allow firms to recognize both unrealized gains and losses to the income statement, IAS 16 would require firms to recognize downward revaluation in the income statement, but upward revaluation in the revaluation surplus in other comprehensive income. In fact, a recent study by Edesltein, Fortin, and Tsang (2012) 1 shows that over 80% of firms in their sample chose the fair value model to account for their investment properties, but less than 30% chose the revaluation model to account for property, plant, and equipment.

The use of the fair value model could definitely provide more up-to-date information for investors. Moreover, the accounting is pretty straightforward. The downside of the fair value model is that it would introduce higher volatility in earnings, as all unrealized gains and losses from changes in fair values are now included in net income. As firms need to maintain consistent accounting policies, once a model is adopted, it is not easy for the firm to switch without strong justification. Hence, it is unlikely that firms can exercise earnings management by alternating between the cost and the fair value model. However, there could be some self-selection bias at the time of adoption, as firms that forecast a burgeoning real estate market and larger potential gains from their investment property portfolios may have more incentives to adopt the fair value model.

Edelstein, R., Fortin, S., & Tsang, D. (2012). An international exploration of financial reporting practices in the real estate industry,” International Real Estate Review, 15, 347–372.

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APPENDIX A Financial Statement Analysis and Using Accounting Information to Value a Company J. Problems PA-1. Suggested solution:

(in thousands of dollars)

Car Dealer Corp. Common Size Income Statement For the years ended December 31 2025 2025

Revenue Cost of goods sold Gross profit Operating expenses Operating profit before other income Lease and other income Operating profit Interest and finance costs Income before taxation Income taxes Net income

(in thousands of dollars)

$3,476,111 2,905,616 570,495 499,768 70,727 10,701 81,428 68,784 12,644 3,793 $ 8,851

Car Dealer Corp. Common Size Balance Sheet As at December 31 2025

Assets Current assets Cash and cash equivalents Accounts receivable Inventories Prepaid assets Current assets Non-current assets Total Assets

55,555 132,625 821,455 8,502 1,018,137 1,984,784 3,002,921

. A-1

2024

100.0% 83.6% 16.4% 14.4% 2.0% 0.3% 2.3% 2.0% 0.4% 0.1% 0.3%

$3,150,781 2,642,818 507,963 474,804 33,159 16,215 49,374 47,193 2,181 54 $ 2,127

100.0% 83.9% 16.1% 15.1% 1.1% 0.5% 1.6% 1.5% 0.1% 0.0% 0.1%

2025

2024

25,324 131,152 760,865 65,313 982,654 1,548,088 $2,530,742

1.0% 5.2% 30.1% 2.6% 38.8% 61.2% 100.0%

1.9% 4.4% 27.4% 0.3% 33.9% 66.1% 100.0%

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Liabilities Current liabilities Accounts payable Other current liabilities Current liabilities Long-term liabilities Total liabilities Equity Common shareholders Preferred shareholders Equity Total liabilities and equity

$ 134,971 878,033 1,013,004 1,621,818 2,634,822

4.5% 29.2% 33.7% 54.0% 87.7%

$ 101,280 782,939 884,219 1,281,275 2,165,494

4.0% 30.9% 34.9% 50.6% 85.6%

343,099 25,000 368,099 $3,002,921

11.4% 0.8% 12.3% 100.0%

340,248 25,000 365,248 $2,530,742

13.4% 1.0% 14.4% 100.0%

2024

$46,693 32,499 14,194 12,271 1,923 564 1,359 606 $ 753

100.0% 69.6% 30.4% 26.3% 4.1% 1.2% 2.9% 1.3% 1.6%

PA-2. Suggested solution:

(in millions of dollars)

Supermarket Chain Inc. Common Size Income Statement For the years ended December 31 2024 2025

Revenue Cost of goods sold Gross profit Operating expenses Operating profit Interest and finance costs Income before taxation Income taxes Net income

$48,037 33,281 14,756 12,486 2,270 747 1,523 392 $ 1,131

. A-2

100.0% 69.3% 30.7% 26.0% 4.7% 1.6% 3.2% 0.8% 2.4%

Appendix A: Financial Statement Analysis and Using Accounting Information to Value a Company Supermarket Chain Inc. Common Size Balance Sheet As at December 31 2025 2025

(in millions of dollars) Assets Current assets Cash and cash equivalents Accounts receivable Inventories Prepaid assets Current assets Non-current assets Total Assets Liabilities Current liabilities Accounts payable Other current liabilities Current liabilities Long-term liabilities Total liabilities Equity Common shareholders Preferred shareholders Equity Total liabilities and equity

2024

$ 1,133 4,808 5,076 131 11,148 25,174 $36,322

3.1% 13.2% 14.0% 0.4% 30.7% 69.3% 100.0%

$ 1,065 4,527 4,803 304 10,699 17,884 $28,583

3.7% 15.8% 16.8% 1.1% 37.4% 62.6% 100.0%

$ 5,321 3,906 9,227 15,761 24,988

14.6% 10.8% 25.4% 43.4% 68.8%

$ 5,302 3,402 8,704 9,271 17,975

18.5% 11.9% 30.5% 32.4% 62.9%

11,234 100 11,334 $36,322

30.9% 0.3% 31.2% 100.0%

10,508 100 10,608 $28,583

36.8% 0.3% 37.1% 100.0%

2025 as % of 024 99.6% 101.9% 98.3% 100.4%

2024

PA-3. Suggested solution: High-End Jewellery Corp. Trend Analysis Income Statement For the years ending December 31 2025

(in millions of dollars) Revenue Cost of goods sold Gross profit Operating expenses

$4,424 1,662 2,762 2,029 . A-3

$4,442 1,631 2,811 2,021

ISM for Lo/Fisher, Intermediate Accounting, Vol. 2, Fifth Canadian Edition

Operating profit Interest and finance costs Income before taxation Income taxes Net income

(in millions of dollars)

733 39 694 149 $ 545 High-End Jewellery Corp. Trend Analysis Balance Sheet As at December 31 2025

Assets Current assets Cash and cash equivalents Accounts receivable Inventories Prepaid assets Current assets Non-current assets Total assets Liabilities Current liabilities Accounts payable Other current liabilities Current liabilities Long-term liabilities Total liabilities Equity Common shareholders Preferred shareholders Total equity

. A-4

92.8% 97.5% 92.5% 94.9% 91.9%

2025 as % of 2024

790 40 750 157 $ 593

2024

$ 875 240 2,464 274 3,853 2,896 $6,749

110.3% 98.0% 101.5% 118.6% 104.2% 174.0% 125.9%

$ 793 245 2,428 231 3,697 1,664 $5,361

$ 542 428 970 2,354 3,324

105.7% 208.8% 135.1% 158.7% 151.0%

$ 513 205 718 1,483 2,201

3,350 75 3,425 $6,749

108.6% 100.0% 108.4% 125.9%

3,085 75 3,160 $5,361

Appendix A: Financial Statement Analysis and Using Accounting Information to Value a Company PA-4. Suggested solution:

(in millions of dollars)

Pulp Mills Ltd. Trend Analysis Income Statement For the years ended December 31 2025

Revenue Cost of goods sold Gross profit Operating expenses Operating profit Interest and finance costs Income before taxation Income taxes Net income

(in millions of dollars)

$1,088 948 140 172 (32) 7 (39) (11) $ (28)

2025 as % of 2024 79.2% 99.7% 33.1% 97.2% (113.0)% 175.0% (116.1)% (116.4)% (116.0)%

2024

2025 as % of 2024

2024

Pulp Mills Ltd. Trend Analysis Balance Sheet As at December 31 2025

Assets Current assets Cash and cash equivalents Accounts receivable Inventories Prepaid assets Current assets Non-current assets Total assets Liabilities Accounts payable and accruals Long-term liabilities Total liabilities Equity Common shareholders . A-5

$1,374 951 423 177 246 4 242 67 $ 175

6 87 194 15 302 592 $894

85.7% 73.1% 93.7% 125.0% 87.5% 104.2% 97.9%

7 119 207 12 345 568 $913

$157 205 362

86.3% 134.0% 108.1%

$182 153 335

512

91.8%

558

ISM for Lo/Fisher, Intermediate Accounting, Vol. 2, Fifth Canadian Edition

Preferred shareholders Total equity Total liabilities and equity

20 532 $894

100.0% 92.0% 97.9%

20 578 $913

PA-5. Suggested solution: 2025

Average assets = (beginning + ending) / 2 Average common equity = (beginning + ending) / 2 Income available to common shareholders = net income preferred dividends NOPAT* = net income + interest expense (1 - tax rate) Tax rate = income taxes / income before taxation *NOPAT→ net operating profit after taxes Operating profit margin = NOPAT* / sales Asset turnover = sales / average assets ROA = operating profit margin × asset turnover Earnings leverage = income available to common shareholders / NOPAT ROA = operating profit margin × asset turnover Financial leverage = average assets / average common equity ROCE = earnings leverage × ROA × financial leverage Current ratio = current assets / current liabilities Quick ratio = (cash + accounts receivables) / current liabilities Accounts receivable turnover ratio = credit sales* / average accounts receivables Inventory turn ratio = cost of goods sold / average inventory Accounts payable turnover ratio = purchases* / average accounts payable *Used sales and cost of goods sold as proxies Long-term debt to equity ratio = long-term debt / shareholders' equity Interest coverage = earnings before interest and taxes (EBIT) / interest expense

2025

2024

($3,002,921 + $2,530,742) / 2

$2,766,832

($2,530,742 + $1,356,839) / 2

$1,943,791

($343,099 + $340,248) / 2

$341,674

($340,248 + $344,121) / 2

$342,185

$8,851 - $1,000

$7,851

$2,127 - $1,000

$1,127

$8,851 + $68,784 × (1 - 30.00%)

$57,000

$2,127 + $47,193 × (1 - 2.48%)

$48,150

$3,793 / $12,644

30.00%

$54 / $2,181

2.48%

$57,000 / $3,476,111

1.64%

$48,150 / $3,150,781

1.53%

125.64%

$3,150,781 / $1,943,791

162.09%

$3,476,111 / $2,766,832 1.64% × 125.64%

2.06%

1.53% × 162.09%

2.48%

$7,851 / $57,000

13.77%

$1,127 / $48,150

2.34%

from part a

2.06%

from part a

2.48%

$2,766,832 / $341,674

809.79%

$1,943,791 / $342,185

568.05%

13.77% × 2.06% × 809.79%

2.30%

$1,018,137 / $1,013,004

1.0

$982,654 / $884,219

1.1

($55,555 + $132,625) / $1,013,004

0.2

($25,324 + $131,152) / $884,219

0.2

$3,476,111 / (($132,625 + $131,152) / 2)

26.4

$3,150,781 / (($131,152 + $79,931) / 2)

29.9

$2,905,616 / (($821,455 + $760,865) / 2)

3.7

$2,642,818 / (($760,865 + $639,593) / 2)

3.8

$2,905,616 / (($134,971 + $101,280) / 2)

24.6

$2,642,818 / (($101,280 + $63,295) / 2)

32.1

$1,621,818 / $368,099

4.4

$1,281,275 / $365,248

3.5

$81,428 / $68,784

1.2

$49,374 / $47,193

1.0

. A-6

2.34% × 2.48% × 568.05%

0.33%

Appendix A: Financial Statement Analysis and Using Accounting Information to Value a Company PA-6. Suggested solution: 2025

2025

2024

Average assets = (beginning + ending) / 2

($36,322 + $28,583) / 2

$32,453

($28,583 + $32,273) / 2

$30,428

Average common equity = (beginning + ending) / 2 Income available to common shareholders = net income - preferred dividends NOPAT* = net income + interest expense (1 - tax rate) Tax rate = income taxes / income before taxation *NOPAT→ net operating profit after taxes

($11,234 + $10,508) / 2

$10,871

($10,508 + $10,160) / 2

$10,334

$1,131 - $5

$1,126

$753 - $5

$748

$1,131 + $747 × (1 - 25.74%)

$1,686

$753 + $564 × (1 - 44.59%)

$1,066

$392 / $1,523

25.74%

$606 / $1,359

44.59%

Operating profit margin = NOPAT* / sales

$1,686 / $48,037

3.51%

$1,066 / $46,693

2.28%

Asset turnover = sales / average assets

$48,037 / $32,453

148.02%

$46,693 / $30,428

153.45%

ROA = operating profit margin × asset turnover Earnings leverage = income available to common shareholders / NOPAT ROA = operating profit margin × asset turnover Financial leverage = average assets / average common equity ROCE = earnings leverage × ROA × financial leverage Current ratio = current assets / current liabilities Quick ratio = (cash + accounts receivables) / current liabilities Accounts receivable turnover ratio = credit sales* / average accounts receivables Inventory turn ratio = cost of goods sold / average inventory Accounts payable turnover ratio = purchases* / average accounts payable *Used sales and cost of goods sold as proxies Long-term debt to equity ratio = long-term debt / shareholders' equity Interest coverage = earnings before interest and taxes (EBIT) / interest expense

3.51% × 148.02%

5.20%

2.28% × 153.45%

3.50%

$1,126 / $1,686

66.79%

$748 / $1,066

70.17%

from part a

5.20%

from part a

3.50%

$32,453 / $10,871

298.53%

$30,428 / $10,334

66.79% × 5.20% × 298.53%

10.37%

70.17% × 3.50% × 294.45%

294.45% 7.23%

$11,148 / $9,227

1.2

$10,699 / $8,704

1.2

($1,133 + $4,808) / $9,227

0.6

($1,065 + $4,527) / $8,704

0.6

$48,037 / (($4,808 + $4,527) / 2)

10.3

$46,693 / (($4,527 + $4,288) / 2)

10.6

$33,281 / (($5,076 + $4,803) / 2)

6.7

$32,499 / (($4,803 +$4,438) / 2)

7.0

$33,281 / (($5,321 + $5,302) / 2)

6.3

$32,499 / (($5,302 + $5,233) / 2)

6.2

$15,761 / $11,334

1.4

$9,271 / $10,608

0.9

$2,270 / $747

3.0

$1,923 / $564

3.4

PA-7. Suggested solution: 2025

2025

2024

Average assets = (beginning + ending) / 2

($6,749 + $5,361) / 2

$6,055

($5,361 + $5,067) / 2

$5,214

($3,350 + $3,085) / 2

$3,218

($3,085 + $2,772) / 2

$2,929

$545 - $5

$540

$593 - $5

$588

$545 + $39 × (1 - 21.47%)

$576

$593 + $40 × (1 - 20.93%)

$625

$149 / $694

21.47%

. A-7

$157 / $750

20.93%

ISM for Lo/Fisher, Intermediate Accounting, Vol. 2, Fifth Canadian Edition a

Operating profit margin = NOPAT* / sales

$576 / $4,424

13.02%

$625 / $4,442

14.07%

Asset turnover = sales / average assets

$4,424 / $6,055

73.06%

$4,442 / $5,214

85.19%

ROA = operating profit margin × asset turnover Earnings leverage = income available to common shareholders / NOPAT ROA = operating profit margin × asset turnover Financial leverage = average assets / average common equity ROCE = earnings leverage × ROA × financial leverage Current ratio = current assets / current liabilities Quick ratio = (cash + accounts receivables) / current liabilities Days accounts receivable outstanding = credit sales* / average accounts receivables Days inventory outstanding = cost of goods sold / average inventory Days accounts payable outstanding = purchases* / average accounts payable *Used sales and cost of goods sold as proxies Long-term debt to equity ratio = long-term debt / shareholders' equity Interest coverage = earnings before interest and taxes (EBIT) / interest expense

13.02% × 73.06%

9.51%

14.07% × 85.19%

11.99%

$540 / $576

93.75%

$588 / $625

94.08%

from part a

9.51%

from part a

11.99%

$6,055 / $3,218

188.16%

$5,214 / $2,929

178.01%

93.75% × 9.51% × 188.16%

16.78%

94.08% × 11.99% × 178.01%

20.08%

$3,853 / $970

4.0

$3,697 / $718

5.1

($875 + $240) / $970

1.1

($793 + $245) / $718

1.4

365 / ($4,424 / (($240 + $245) / 2))

20.0

365 / ($4,442 / (($245 + $231) / 2))

19.6

365 / ($1,662 / (($2,464 + $2,428) / 2))

537.2

365 / ($1,631 / (($2,428 +$2,254) / 2))

523.9

365 / ($1,662 / (($542 + $513) / 2))

115.8

365 / ($1,631 / (($513 + $437) / 2))

106.3

$2,354 / $3,425

0.7

$1,483 / $3,160

0.5

$733 / $39

18.8

$790 / $40

19.8

PA-8. Suggested solution: 2025

2025

2024

Average assets = (beginning + ending) / 2 Average common equity = (beginning + ending) / 2 Income available to common shareholders = net income - preferred dividends NOPAT* = net income + interest expense (1 - tax rate) Tax rate = income taxes / income before taxation *NOPAT→ net operating profit after taxes Operating profit margin = NOPAT* / sales Asset turnover = sales / average assets

($894 + $913) / 2

$904

($913 + $891) / 2

$902

($512 + $558) / 2

$535

($558 + $550) / 2

$554

($28) - $2

($30.00)

$175 - $2

$173

($28) + $7 × (1 - 28.21%)

($23.00)

$175 + $4 × (1 - 27.69%)

$178

($11) / ($39)

28.21%

$67 / $242

27.69%

($23) / $1088

(2.11%)

$178 / $1,374

12.95%

$1,088 / $904

120.35%

$1,374 / $902

152.33%

(2.11)% × 120.35%

(2.54%)

12.95% × 152.33%

19.73%

($30) / ($23)

130.43%

$173 / $178

97.19%

from part a

(2.54%)

from part a

19.73%

$904 / $535

168.97%

$902 / $554

162.82%

130.43% × (2.54%) × 168.97%

(5.60%)

97.19% × 19.73% × 162.82%

31.22%

1.9

$302 / $157

. A-8

$345 / $182

1.9

Appendix A: Financial Statement Analysis and Using Accounting Information to Value a Company

Quick ratio = (cash + accounts receivables) / current liabilities Days accounts receivable outstanding = credit sales* / average accounts receivables Days inventory outstanding = cost of goods sold / average inventory Days accounts payable outstanding = purchases* / average accounts payable *Used sales and cost of goods sold as proxies Long-term debt to equity ratio = longterm debt / shareholders' equity Interest coverage = earnings before interest and taxes (EBIT) / interest expense

($6 + $87) / $157

0.6

($7 + $119) / $182

0.7

365 / ($1,088 / (($87 + $119) / 2))

34.6

365 / ($1,374 / (($119 + $116) / 2))

31.2

365 / ($948 / (($194 + $207) / 2))

77.2

365 / ($951 / (($207 +$166) / 2))

71.6

365 / ($948 / (($157 + $182) / 2))

65.3

365 / ($951 / (($182 + $162) / 2))

66.0

$205 / $532

0.4

$153 / $578

0.3

($32) / $7

(4.6)

$246 / $4

61.5

PA-9. Suggested solution:

a .

b .

Book value of common equity Value of common shareholders’ equity / # of common shares Dividends Value = (DPS0 × (1 + g)) / (r − g)

c .

Value per share

(000s)

$343,099 / 27,000

12.71

(($5,000 (1 + 0.02) / 27,000)) / (0.10 − 0.02)

2.36

(($0.29 (1 + 0.02)) / (0.10 − 0.02)

3.70

Earnings and earnings multiples Value = (EPS0 × (1 + g)) / (r − g)

PA-10. Suggested solution:

a . b .

Book value of common equity Value of common shareholders’ equity / # of common shares Dividends - 3% growth rate Value = (DPS0 × (1 + g)) / (r − g)

c .

Value per share

(millions)

Dividends - 4% growth rate Value = (DPS0 × (1 + g)) / (r − g)

. A-9

$11,234 / 380

29.56

(($400 (1 + 0.03) / 380)) / (0.07 − 0.03)

27.11

(($400 (1 + 0.04) / 380)) / 0(.07 − 0.04)

36.49

ISM for Lo/Fisher, Intermediate Accounting, Vol. 2, Fifth Canadian Edition

d .

Earnings and earnings multiples Value = (EPS0 × (1 + g)) / (r − g)

(($2.96 (1 + 0.03)) / (0.07 − 0.03)

76.22

PA-11. Suggested solution: a. Free cash flow Year 2026

Cash flow Calculations ($millions) $510 CF1 / (1 + r) = $510 / 1.07

Present value $477

2027

$530 CF2 / (1 + r)2 = $530 / 1.072

$463

2028

$520 CF3 / (1 + r)3 = $520 / 1.073 (CF4 / (r − g)) / (1 + r)3 = ($541 / (0.07 − 0.04)) / $541 1.073**

$424

2029 and thereafter* Enterprise value

$14,721 $16,085

Value per common share

$16,085 / 120

$134.04

* $520 × (1 + 4%) = $541 ** Note that the present value of a growing perpetuity at the beginning of Year 1 (2026) for payments commencing at the end of Year 1 (2026) is (CF1 / (r − g). In this example, the first payment of the growing annuity is due at the end of Year 4 (2029), or three years after the end of Year 1 (2026). The present value of this payment stream thus needs to be brought back three years, hence the discount factor of 1.073. b. Residual income 2026

$400 RI1 / (1 + r) = $400 / 1.07

Present value $374

2027

$420 RI2 / (1 + r)2 = $420 / 1.072

$367

2028

$410 RI3 / (1 + r)3 = $410 / 1.073 (RI4 / (r − g)) / (1 + r)I = ($426 / (0.07 − 0.04)) / $426 1.073**

$335

Year

Residual income

2029 and thereafter* Book value

Calculations

Enterprise value Value per common share

$11,591 $3,350 $16,017

$16,017 / 120

$133.48

* $410 × (1 + 4%) = $426 ** Note that the present value of a growing perpetuity at the beginning of Year 1 (2026) for payments commencing at the end of Year 1 (2026) is (RI1 / (r − g). In this example, the first payment of the growing annuity is due at the end of Year 4 (2029), or three years after the end of Year 1 (2026). The present value of this payment stream thus needs to be brought back three years, hence the discount factor of 1.073.

PA-12. Suggested solution: . A-10

Appendix A: Financial Statement Analysis and Using Accounting Information to Value a Company a. Free cash flow - 9% discount rate Cash flow Year Calculations ($millions) 2026 $30 CF1 / (1 + r) = $30 / 1.10

Present value $27

2027

$90 CF2 / (1 + r)2 = $90 / 1.102

$74

2028 2029 and thereafter* Enterprise value

$40 CF3 / (1 + r)3 = $40 / 1.103 (CF4 / (r − g)) / (1 + r)3 = ($41 / (0.10 − 0.02)) / $41 1.103**

$30

Value per common share

$385 $516

$516 / 65

$7.94

* $40 × (1 + 2%) = $41 ** Note that the present value of a growing perpetuity at the beginning of Year 1 (2026) for payments commencing at the end of Year 1 (2026) is (CF1 / (r − g). In this example, the first payment of the growing annuity is due at the end of Year 4 (2029), or three years after the end of Year 1 (2026). The present value of this payment stream thus needs to be brought back three years, hence the discount factor of 1.103. b. Free cash flow - 10% discount rate Cash flow Year Calculations ($millions) 2026 $30 CF1 / (1 + r) = $30 / 1.09

Present value $28

2027

$90 CF2 / (1 + r)2 = $90 / 1.092

$76

2028 2029 and thereafter* Enterprise value

$40 CF3 / (1 + r)3 = $40 / 1.093 (CF4 / (r − g)) / (1 + r)3 = ($41 / (0.09 − 0.02)) / $41 1.093**

$31

Value per common share

$452 $587

$587 / 65

$9.03

. A-11

ISM for Lo/Fisher, Intermediate Accounting, Vol. 2, Fifth Canadian Edition

c. Residual income - 10% discount rate 2026

$10 RI1 / (1 + r) = $10 / 1.10

Present value 9.00

2027

$25 RI2 / (1 + r)2 = $25 / 1.102

21.00

2028 2029 and thereafter* Book value

$15 RI3 / (1 + r)3 = $15 / 1.103 (RI4 / (r − g)) / (1 + r)3 = ($15 / (0.10 − 0.02)) / $15 1.103**

11.00

Year

Residual income

Calculations

Enterprise value Value per common share

141.00 512.00 694.00

$694 / 65

$10.68

* $15 × (1 + 2%) = $15 ** Note that the present value of a growing perpetuity at the beginning of Year 1 (2026) for payments commencing at the end of Year 1 (2026) is (RI1 / (r − g). In this example, the first payment of the growing annuity is due at the end of Year 4 (2029), or three years after the end of Year 1 (2026). The present value of this payment stream thus needs to be brought back three years, hence the discount factor of 1.103.

. A-12

APPENDIX C Statement of Cash Flows J. Problems PC-1. Suggested solution: The statement of cash flows (SCF) is a required financial statement that explains the reported change in an entity’s cash and cash equivalents during the period. The SCF categorizes the sources and uses of cash so as to assist investors, creditors, and other interested parties in assessing the company’s ability to make payments when due and pay dividends. The SCF is also used to ascertain the firm’s quality of earnings. Income statements are prepared on an accrual basis and consequently net income seldom equals the change in cash during the period. Net income is an important metric as it measures the financial performance of the company. The firm’s ability to generate cash is equally important, though, as cash— not net income—pays bills. If a company generates insufficient cash to meet its obligations, creditors will eventually force it into bankruptcy. PC-2. Suggested solution: Stakeholders may use the statement of cash flows to: i) analyze the company’s liquidity (its ability to meet its obligations when due); ii) prepare more accurate forecasts of future cash flows than those based solely on income statements; and iii) evaluate the firm’s quality of earnings. PC-3. Suggested solution: a. Liberty Corp. will report $43,000 as cash and cash equivalents on its balance sheet as at December 31, 2023 as set out below. Canadian dollars cash in bank Canadian dollar equivalent of US $3,000 dollars cash in bank Petty cash Bank overdraft that is an integral part of Liberty’s cash management system and the balance frequently fluctuates between a positive balance and an overdraft Term deposit that matures in 100 days Investment in debt securities at FVPL that are held for trading purposes Investment in 60-day treasury bills that are held for the purpose of meeting short-term cash commitments Investment in equity securities at FVPL that are held for the purpose of meeting short-term cash commitments

. C-1

$18,000 4,000

Include $18,000 4,000

Exclude Comments 1

1,000 1,000 (22,000) (22,000) 100,000 24,000 42,000

2 $100,000 24,000

42,000

3 4 5

13,000

$180,000

$43,000 $137,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Comments 1. Report foreign currencies at their Canadian dollar equivalent. 2. The overdraft is an integral part of Liberty’s cash management system and the balance frequently fluctuates between a positive balance and an overdraft. 3. The term deposit does not meet the highly liquid test as it matures in more than 90 days. 4. The investment is not held to meet short-term cash commitments. 5. The investment meets the liquidity and insignificant change in value tests and is held to meet shortterm cash commitments. 6. Investments in equity securities do not meet the insignificant change in value test. b. Under ASPE, investments in securities that meet these criteria of cash equivalents may be reported as a cash equivalent, or alternatively as a trading asset or investment. The company must establish a policy outlining which short-term, highly liquid investments in debt securities will be classified as cash equivalents. PC-4. Suggested solution: a. Cash equivalents are 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. Cash equivalents are held for the purpose of meeting short-term cash commitments rather than investment or other purposes. IAS 7 suggests that only short-term investments that mature in three months or less can be classified as cash equivalents. This category typically includes treasury bills, bankers’ acceptances, and money market funds. Equity instruments, even if readily marketable, cannot be treated as cash equivalents because the risk of a change in value is not insignificant. Indeed, the market value of equities fluctuates on an ongoing basis. b. When an investment in a qualifying security is held for the purpose of meeting short-term cash commitments it is reported as a cash equivalent. Cash inflows and outflows arising from investments designated as cash equivalents are not reported as cash flows. Rather, they are part of the change in cash and cash equivalents that must be explained. If, however, the qualifying investment is held for other reasons, then the cash flows resulting from the purchase and sale of the investment are classified as: an operating activity if the investment is held for trading purposes; or as an investing activity if the investment is not held for trading purposes. c. Bank borrowings, including those by way of overdraft, are generally classified as financing activities. In Canada and some other countries, bank overdrafts frequently form an integral part of a company’s cash management strategy. In these circumstances, and if the balance often fluctuates between a positive balance and an overdraft, bank overdrafts are included as a component of cash and cash equivalents, the change in which must be explained.

. C-2

Appendix C: Statement of Cash Flows

PC-5. Suggested solution: a. On December 31, 2023, the only cash flow is the $20,000 payment on the lease. ASC would have reported this as a cash outflow from investing activities on its statement of cash flow for its year ended December 31, 2023. The remaining $180,000 ($200,000 - $20,000 = $180,000) of the transaction is a non-cash expense and would have been disclosed in ASC’s notes to the financial statements. b. ASC would have reported the $11,000 reduction of the lease liability as a cash outflow from financing activities on its statement of cash flows for its year ended December 31, 2024. The $9,000 interest payment would have been reported as either a cash outflow from operating activities or a cash outflow from financing activities with the classification determined by ASC’s policy in this regard. PC-6. Suggested solution: a. Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities. Cash flows from operating activities arise from the dayto-day running of the business. Operating activities include: cash sales; payment and collection of accounts receivable; receipt of rents, royalties, and fees; receipt of deposits; payment of salaries and wages; payment of income tax and other tax payments; receipt and payment of interest and dividends*; and the purchase and sale of investments held for trading purposes. (*Alternative classifications are permitted.) Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. There are two distinct components to investing activities. The first is the acquisition and disposal of fixed assets, the second investing in the more traditional sense: i) To establish and maintain the infrastructure necessary to run the business, companies purchase and sell fixed assets. ii) Investing in the more traditional sense involves buying and selling debt and equity securities, with certain exceptions. For example, investments that are reported as cash equivalents (part of the cash being explained), and investments held for trading purposes (recorded as an operating activity) are not recorded as an investing activity. Investing activities include: the sale of property, plant, and equipment; purchase and sale of investments other than those held for trading purposes or reported as cash equivalents; the making of loans and the collection of loans receivable; the purchase of property, plant, and equipment; and the receipt of interest and dividends.* (*Alternative classifications are permitted.) Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity. Companies raise money by issuing debt and selling equity, using the proceeds to acquire fixed assets. Financing activities record the cash flows associated with the issuance and retirement of debt and equity. This comment applies only to the capital flows, as there are some options available with respect to the payment of interest and dividends. Cash flows arising from supplier-provided financing including accounts payable are an operating activity, however. Financing activities include: issuing and repurchasing shares; issuing debt, including bonds, mortgages, and notes; repayment of the principal amount of lease liabilities, bonds, mortgages, and notes; borrowing and repaying the principal of bank loans; and the payment of interest and dividends.* (*Alternative classification options are available.)

. C-3

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

b. Cash flows from operating activities give considerable insight into a firm’s ability to generate sufficient cash to maintain its business, repay loans, and make new investments without having to arrange external financing. Cash flows related to investing summarize net expenditures for assets meant to generate future income. Financing-related cash flows gauge future claims on cash flows by both debt and equity holders. c. IAS 7 permits a business entity to classify the receipt of interest and dividends as either an operating or an investing activity. The standard also permits companies to report the payment of interest and dividends as either an operating or a financing activity. Once the business chooses its accounting policy it must apply it consistently to all similar transactions. ASPE does not permit a choice. The receipt of interest and dividends and the payment of interest must normally be classified as an operating activity; the payment of dividends a financing activity. PC-7. Suggested solution: Item Transaction 1. Receipt of dividends 2. Increase in accounts receivable 3. Decrease in deferred income tax liability 4. Sale of a at fair value through profit or loss investment held for trading purposes 5. Issuing (selling) shares 6. Depreciation expense 7. 8. 9. 10. 11. 12. 13. 14. 15.

Loss on the sale of a financial asset at amortized cost investment Payment of interest Goodwill impairment loss Purchase of an at fair value through other comprehensive income investment Decrease in accounts payable Conversion of bonds to ordinary shares Borrowing money from the bank Sale of a computer at book value Retirement of bonds

Categorization on the statement of cash flows H (cash inflow from operating activities or investing) B B (not reported on the statement of cash flows when the direct method is used) A (cash inflow from operating activities) E A (not reported on the statement of cash flows when the direct method is used) A (not reported on the statement of cash flows when the direct method is used) H (cash outflow from operating activities or financing) A (not reported on the statement of cash flows when the direct method is used) D B G (reported in the notes to the financial statements) E C F

PC-8. Suggested solution: Item Transaction 1. Sale of land at a loss 2. Gain on the sale of equipment 3.

Repurchasing own shares

Categorization on the statement of cash flows C G (deducted from net income in the operating activities section when the indirect method is used) F . C-4

Appendix C: Statement of Cash Flows

4. 5. 6.

Receipt of interest Purchase of an investment that meets the criteria of a cash equivalent held to meet short-term cash commitments Depreciation expense

7. 8. 9. 10.

Leased right-of-use equipment Payment of dividends Other comprehensive income Impairment loss on a patent

H (cash inflow from operating activities or investing) I (this forms part of cash and cash equivalents, the change of which must be explained) G (added to net income in the operating activities section when the indirect method is used) G (reported in the notes to the financial statements) H (cash outflow from operating activities or financing) G G (added to net income in the operating activities section when the indirect method is used)

PC-9. Suggested solution: a. The amount received from the sale of plant assets to be reported on the statement of cash flows is $90,000 (given in question). b. The amount paid for assets purchased to be reported on the statement of cash flows is $339,000 as calculated below. Note that the $200,000 acquired by way of share issuance is a non-cash transaction that is not reported on the statement of cash flows. Rather, this amount would be disclosed in the notes to the financial statements. c. The company declared $341,000 in cash dividends during the year and paid out $358.000. See below for how these amounts were determined. It is instructive to use T-accounts to help solve for the unknowns: Opening balance Solve for accumulated depreciation on plant asset sold Depreciation expense Closing balance

Accumulated Depreciation 180,000 114,000 74,000 140,000

$125,000 net book value + $114,000 accumulated depreciation = $239,000 cost. Plant Assets Opening balance 500,000 Cost of plant asset sold 239,000 Plant assets acquired by share issuance 200,000 Solve for plant assets purchased 339,000 Closing balance 800,000 Retained Earnings Opening balance 1,029,000 Net income 400,000 Stock dividend 30,000 Solve for cash dividends declared 341,000 Closing balance 1,058,000 Opening balance

Dividends Payable 52,000 . C-5

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Cash dividends declared Solve for cash dividends paid Closing balance

358,000

341,000 35,000

PC-10. Suggested solution: a. Other comprehensive income is not reported on the statement of cash flows prepared using the direct method of presenting cash flows from operating activities as other comprehensive income does not give rise to cash flows. b. Other comprehensive income is not reported on the statement of cash flows prepared using the indirect method. Net income, rather than comprehensive income, is the first item in cash flow arising from operating activities as items that are included in other comprehensive income do not affect cash flows. c. Non-cash transactions do not involve cash. This event is not recorded on the statement of cash flows as this statement reports only the cash effect of a company’s activities. Some transactions are only partially settled in cash; for example, a company acquires a building for $1,000,000 by paying $200,000 in cash and signing an $800,000 note payable. The statement of cash flows records only the $200,000 cash paid as an outflow in the investing activities section. Non-cash transactions are disclosed in the notes to the financial statements. d. Common non-cash transactions include: exchanging assets with another entity; converting bonds or preferred shares into ordinary shares; stock dividends; and the initial acquisition of right-of-use assets under lease. PC-11. Suggested solution: a.

Hobnob Corp. Statement of Cash Flows (partial) For the year ended December 31, 2023

Cash flows from operating activities Net income Adjustments for: Depreciation Gain on sale of at fair value through profit or loss investment held for trading purposes Recycling of loss on sale of at fair value through other comprehensive income investment Goodwill impairment loss Decrease in accounts receivable Sale of at fair value through profit or loss investment Interest income Cash generated from operating activities Interest received ($12,000 + $3,000)* Dividends paid (–$20,000 – $12,000)* Net cash from operating activities

$125,000 8,000 (2,000) 1,000 10,000 32,000 12,000 (12,000) 174,000 15,000 (32,000)

$157,000

* Note that while interest received and dividends paid can also be recorded as investing and financing activities, respectively, that Hobnob has adopted a policy of reporting these transactions as operating activities.

. C-6

Appendix C: Statement of Cash Flows

b.  The stock dividend is a non-cash activity and is not reported on the statement of cash flows. Note disclosure is appropriate.  The $8,000 proceeds from the sale of the FVOCI securities is reported as an increase in the cash flows from investing section. PC-12. Suggested solution: a.

Hobnob Corp. Cash Flow Statement (partial) For the year ended December 31, 2023

Cash flows from operating activities Net income Adjustments for: Depreciation Gain on sale of investment acquired for trading purposes Loss on sale of investment acquired for other than trading purposes Goodwill impairment loss Decrease in accounts receivable Sale of investment acquired for trading purposes Decrease in interest receivable Net cash from operating activities

$125,000 8,000 (2,000) 1,000 10,000 32,000 12,000 3,000

$189,000

b.  The stock dividend is a non-cash activity and is not reported on the cash flow statement. Note disclosure is appropriate.  The $8,000 proceeds from the sale of the securities acquired for other than trading purposes is reported as an increase in the cash flows from investing section.  The $32,000 in cash dividends paid (–$20,000 – $12,000) is reported as a cash outflow from financing. PC-13. Suggested solution: a.

Jill K. Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2023

Cash flow from operating activities Cash receipts from customers

$ 630,000

Cash paid to suppliers

(320,000)

Selling and administrative expenses paid Cash generated from operating activities

$650,000 sales – $20,000 increase in AR –$325,000 COGS + $15,000 decrease in inventory – $10,000 decrease in AP

(200,000) 110,000 . C-7

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Interest paid*

(11,000)

Income taxes paid Dividends paid* Net cash from operating activities

(30,000) (10,000) $ 59,000

–$12,000 interest expense + $1,000 increase in interest payable account

* Note that while interest paid and dividends paid can also be recorded as a financing activity, Jill has adopted a policy of reporting this type of transaction as an operating activity. b.  The sale of the at fair value through other comprehensive income investment will be recorded as an $8,000 cash inflow from investing. The $1,000 loss recycled through net income does not involve cash and is not reported on the statement of cash flows prepared using the direct method.  Depreciation expense does not involve cash and is not reported on the statement of cash flows prepared using the direct method. PC-14. Suggested solution: a.

Jill K. Ltd. Cash Flow Statement (partial) For the year ended December 31, 2023

Cash flow from operating activities Cash receipts from customers

$ 630,000

Cash paid to suppliers

(320,000)

Selling and administrative expenses paid Cash generated from operating activities

$650,000 sales – $20,000 increase in AR –$325,000 COGS + $15,000 decrease in inventory – $10,000 decrease in AP

(200,000) 110,000

Interest paid

(11,000)

Income taxes paid Net cash from operating activities

(30,000) $ 69,000

–$12,000 interest expense + $1,000 increase in interest payable account

b.  The sale of the investment acquired for other than trading purposes will be recorded as an $8,000 cash inflow from investing. The $1,000 loss on sale does not involve cash and is not reported on the cash flow statement prepared using the direct method.  Depreciation expense does not involve cash and is not reported on the cash flow statement prepared using the direct method.  The $10,000 in cash dividends paid is reported as a cash outflow from financing.

. C-8

Appendix C: Statement of Cash Flows

PC-15. Suggested solution: a.

Meagan’s Psychologist Practice Ltd. Cash Flow Statement (partial) For the year ended December 31, 2023

Cash flows from operating activities Net income ($110,000 - $20,000) Adjustments for: Depreciation Amortization of bond discount Decrease in accounts receivable Increase in accounts payable Decrease in prepaid expenses Purchase of investment acquired for trading purposes Net cash from operating activities

$90,000 10,000 2,000 15,000 16,000 2,000 (5,000)

$130,000

b.  The $100,000 repayment of bank indebtedness is a cash outflow from financing. The $5,000 interest expense was already considered in determining net income (the starting point for cash flows from operations) and hence no further adjustments are needed.  The $38,000 in cash dividends paid [($110,000 - $20,000) - $52,000] is reported as a cash outflow from financing. While not required it may be instructive to visualize the summary journal entry with respect to the payment of bond interest so as to reconcile the cash outflow. Dr. Interest expense (bonds) Cr. Bonds payable (amortization of the bond discount) Cr. Cash $14,000 has been expensed versus $12,000 paid so the required adjustment is a $2,000 increase in cash from operations

. C-9

14,000

2,000 12,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

PC-16. Suggested solution: a.

Gail’s Restaurant Ltd. Cash Flow Statement (partial) For the year ended December 31, 2023

Cash flows from operating activities Net income Adjustments for: Depreciation Impairment loss on patent Increase in accounts receivable Increase in accounts payable Increase in interest payable Sale of investment acquired for trading purposes Net cash from operating activities

$75,000 15,000 5,000 (18,000) 12,000 6,000 9,000

$104,000

b.  The stock split is a non-cash activity and is not reported on the cash flow statement. Note disclosure is appropriate.  The $10,000 proceeds from the sale of the securities acquired for other than trading purposes is reported as a cash inflow from investing.  The $2,000 amortization of the bond premium is reported as a cash outflow from financing.  The $5,000 in cash dividends paid ($20,000 - $15,000) is reported as a cash outflow from financing. While not required it may be instructive to visualize the summary journal entry with respect to the payment of bond interest so as to reconcile the cash outflow. Dr. Bonds payable (amortization of the bond premium) Dr. Interest expense Cr. Interest payable Cr. Cash

2,000 10,000

6,000 6,0001

$4,0002 of the cash outflow is recorded in the operating section and $2,000 as an outflow in the financing section. 2 $10,000 interest expense (included in net income) - $6,000 increase in interest payable = $4,000 outflow from operations. PC-17. Suggested solution: a.

Anne Gapper Crafts Inc. Statement of Cash Flows (partial) For the year ended December 31, 2023

Cash flows from investing activities Purchase of FVOCI investment Purchase of bond Sale of equipment Investment income* ($10,000 + $5,000) .

($ 10,000) (85,000) 20,000 15,000

C-10

Appendix C: Statement of Cash Flows

Purchase of land and buildings Net cash from (used in) investing activities

(110,000)

$(170,000)

* Note that while interest and dividends received can also be classified as an operating activity, Anne Gapper Crafts has adopted a policy of reporting interest and dividend income as investment activities. b.  The purchase of an investment that met the criteria of a cash equivalent and is held to meet short-term cash commitments is not reported as a cash outflow on the statement of cash flows. Rather, the investment is reported as a cash equivalent. The change in cash and cash equivalents for the period must be reconciled.  The repayment of the $20,000 loan plus $1,000 in interest is recorded as a cash outflow from financing. Note that while interest paid can also be designated as an operating activity, Anne Gapper Crafts has adopted a policy of reporting interest paid as a financing activity.  The $10,000 loss on sale of equipment will be added to net income in the operating activities section (indirect method).  The acquisition of the land and buildings was only partially settled in cash. The $90,000 settled by issuing a note payable is a non-cash activity. Non-cash transactions are reported in the notes to the financial statements. PC-18. Suggested solution: a.

Recon Cile Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2023

Cash flows from investing activities Purchase of FVOCI investment Sale of equipment Purchase of bonds Net cash from (used in) investing activities

$(16,000) 20,000 (95,000)

$(91,000)

b.  The sale of the at fair value through profit or loss investment is recorded as an $11,000 cash inflow in the operating activities section as it is held for trading purposes. The $1,000 gain on sale will be deducted from net income in the operating activities section (indirect method).  The $50,000 loan is recorded as a cash inflow from financing.  The $5,000 loss on sale of equipment will be added back to net income in the operating activities section (indirect method).  The $45,000 inventory purchase will decrease cash from operating activities.  The receipt of interest and dividend income is reported as a $15,000 increase in cash from operating activities. Note that while the receipt of interest and dividends received can also be classified as an investing activity, Recon Cile has adopted a policy of reporting interest and dividend activities as operating activities.  The acquisition of the right-of-use forklift is a non-cash activity and is not reported on the statement of cash flows. Non-cash transactions are reported in the notes to the financial statements.  The acquisition of the land and buildings is a non-cash activity. Non-cash transactions are reported in the notes to the financial statements.

. C-11

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

PC-19. Suggested solution: a.

Jamie Bleay Law Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2023

Cash flows from investing activities Sale of FVPL investment not held for trading purposes Sale of FVOCI investment Sale of equipment Investment income* ($8,000 + $9,000) Purchase of land and buildings Purchase of bonds Net cash from (used in) investing activities

$ 11,000 12,000 30,000 17,000 (300,000) (105,000)

$(335,000)

* Note that while interest and dividends received can also be classified as an operating activity, Jamie Bleay Law has adopted a policy of reporting interest and dividend income as investment activities. b.  The $1,000 holding loss on the investment at FVOCI does not involve cash. Moreover, it flows through the statement of comprehensive income, rather than the income statements and as such is not reported on the statement of cash flows.  The $2,000 realized gain on the investment at FVOCI recycled through net income does not involve cash. It is subtracted from net income in the operating activities section (indirect method).  The $40,000 loan is recorded as a cash inflow from financing.  The $10,000 gain on sale of equipment will be subtracted from net income in the operating activities section (indirect method).  The $2,000 payment of interest is recorded as a cash outflow from financing. Note that while interest paid can also be designated as an operating activity, Jamie Bleay Law has adopted a policy of reporting interest paid as a financing activity.  The acquisition of the land and buildings was only partially settled in cash. The $200,000 settled by issuing ordinary shares is a non-cash activity. Non-cash transactions are reported in the notes to the financial statements. PC-20. Suggested solution: a.

Angela’s Angels Corp. Statement of Cash Flows (partial) For the year ended December 31, 2023

Cash flows from financing activities Sale of ordinary shares Repurchase bonds Principal reduction of bank loan Interest expense (–$18,000 + $2,000) Net cash from (used in) financing activities

$ 500,000 (985,000) (10,000) (16,000)

. C-12

$(511,000)

Appendix C: Statement of Cash Flows

* Note that while interest paid can also be classified as an operating activity, Angela’s has adopted a policy of reporting interest and dividend paid as financing activities. b.  The stock dividend is a non-cash activity and is not reported on the statement of cash flows. Note disclosure is appropriate.  The $28,000 decrease in accounts payable is reported as a decrease in cash from operating activities.  The $15,000 gain on repurchase of bonds will be deducted from net income in the operating activities section (indirect method).  The declaration of the $10,000 dividend is not reported on the statement of cash flows as it was not paid in 2023. Rather, this amount is used to explain the change in retained earnings during the year.  The acquisition of the right-of-use automobile is a non-cash activity and is not reported on the statement of cash flows. Non-cash transactions are reported in the notes to the financial statements. PC-21. Suggested solution: a.

Boboto Inc. Statement of Cash Flows (partial) For the year ended December 31, 2023

Cash flows from financing activities Repurchase ordinary shares Principal reduction of bank loan Sale of bonds Net cash from financing activities

$ (40,000) (20,000) 985,000

$925,000

b.  The stock dividend is a non-cash activity and is not reported on the statement of cash flows. Note disclosure is appropriate.  The $10,000 loss on repurchase of shares is a non-cash item and is not reported on the statement of cash flows. As this is a capital transaction, the $10,000 is deducted directly from equity and does not flow through the income statement. Hence, this amount will be used to explain the change in equity.  The $32,000 increase in accounts payable is reported as an increase in cash from operating activities.  The $17,000 interest paid ($15,000 + $2,000) is reported as a decrease in cash from operating activities. Note that while interest paid can also be classified as a financing activity, Boboto has adopted a policy of reporting interest and dividend activities as operating activities.  The declaration of the $20,000 dividend is not reported on the statement of cash flows as it was not paid in 2023. Rather, this amount is used to explain the change in retained earnings during the year.

. C-13

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

PC-22. Suggested solution: a.

Jane’s Bookkeeping Services Inc. Statement of Cash Flows (partial) For the year ended December 31, 2024

Cash flows from financing activities Repurchase bonds Proceeds of bank loan* Repayment of lease liability* Interest expense (–$10,000 – $2,000)** Payment of cash dividend Net cash from (used in) financing activities

(505,000) 40,000 (30,000) (12,000) (20,000)

$(527,000)

*Using money from a bank loan to repay a lease liability is not a non-cash transaction as there were cash flows involved. The bank advanced Jane’s $40,000 and then Jane’s used $30,000 of the loan to repay the lease liability. ** Note that while interest paid can also be classified as an operating activity, Jane’s has adopted a policy of reporting interest and dividend paid as financing activities. b.  The stock split and stock dividend are non-cash activities and are not reported on the statement of cash flows. Note disclosure is appropriate.  The conversion of preferred shares to ordinary shares is a non-cash activity and is not reported on the statement of cash flows. Note disclosure is appropriate.  The $5,000 increase in accounts payable is reported as an increase in cash from operating activities.  The $5,000 loss on repurchase of bonds will be added to net income in the operating activities section (indirect method). PC-23. Suggested solution: 1. The $14,500 paid would be reported as a cash outflow from investments. 2. MFTI would use the $200,000 net income as a starting point. Other comprehensive income does not involve cash flows and companies are not required to report it on the statement of cash flows. 3. The distribution of stock dividends is a non-cash activity and is not reported on the statement of cash flows. The transaction would normally be disclosed in the notes to the financial statements because changes in equity must be explained. 4. Net income was $200,000 but retained earnings only increased $150,000 meaning that $50,000 was declared in dividends. $20,000 of this amount was by way of stock dividend (see #3 above) so $30,000 had to be by way of cash dividend. The net cash outflow of $70,000 ($30,000 declared + $40,000 decrease in the dividends payable account) would be reported as either a cash outflow from operating activities or a cash outflow from financing. 5. The $20,000 payment was comprised of $6,000 interest (given) and $14,000 in principal ($20,000 – $6,000). The interest payment would be reported as a cash outflow from operations or a cash outflow from financing; the $14,000 principal payment would be reported as a cash outflow from financing. 6 The $40,000 cash received would be reported as a cash inflow from investments. The balance of the transaction ($100,000 – $40,000 = $60,000) is a non-cash activity. The transaction should have been disclosed in the notes to the financial statements. . C-14

Appendix C: Statement of Cash Flows

7. The $7,000 net cash paid for taxes would be reported as a cash outflow from operating activities ($10,000 income tax expense + $5,000 decrease in income taxes payable account – $8,000 increase in deferred income taxes payable account = $7,000). Alternatively, the $3,000 net increase in the taxes payable accounts could be added back to net income in the cash flow from operating activities section with the net cash paid for income taxes being disclosed. 8. The $40,000 is a non-cash activity and would not be reported on the statement of cash flows as it did not impact on the net accounts receivables. 9. The $10,000 would be added to interest expense to determine interest paid. (Further adjustments may have been required for changes in interest payable and the like.) Interest paid could be reported as either a cash outflow from operating activities or a cash outflow from financing. 10. This transaction had no effect on the statement of cash flows as the treasury bill was reported as a cash equivalent. When it was sold the $100,000 cash equivalent was replaced by $100,000 cash and as such cash and cash equivalents remained unchanged. PC-24. Suggested solution: 1. The $100,000 would be reported as a cash outflow in the operating activities section as it is held for trading purposes. 2. The $30,000 was a non-cash expense. It would be deducted from interest expense to determine interest paid. (Further adjustments may have been required for changes in interest payable and the like.) Interest paid could be reported as either a cash outflow from operating activities or a cash outflow from financing. 3. The $50,000 was a non-cash expense and would be added back to net income as an adjusting entry in the cash flow from operating activities section. From a practical perspective, this function would be accomplished by adjusting net income by the increase or decrease in net accounts receivable. 4. The $43,000 net cash paid for taxes would be reported as a cash outflow from operating activities ($40,000 income tax expense + $10,000 decrease in deferred income taxes payable account – $7,000 increase in income taxes payable account = $43,000). Alternatively, the $3,000 net decrease in the taxes payable accounts could be subtracted from net income in the cash flow from operating activities section with the net cash paid for income taxes being disclosed. 5. The acquisition of right-of-use equipment under lease was a non-cash activity. The transaction should have been disclosed in the notes to the financial statements. 6. The distribution of stock dividends was a non-cash activity and would not be reported on the statement of cash flows. The transaction would normally be disclosed in the notes to the financial statements because changes in equity must be explained. 7. The net cash outflow of $5,000 ($20,000 declared – $15,000 increase in the dividends payable account) would be reported as either a cash outflow from operating activities or a cash outflow from financing. 8. JLAI would use the $150,000 net income as a starting point. Other comprehensive income does not involve cash flows and companies are not required to report it on the statement of cash flows. 9. The $2,000 gain on sale ($12,000 – $10,000 = $2,000) would be deducted as an adjustment from net income in the cash flows from operating activities section. The $12,000 cash received would be reported as a cash inflow from investments.

. C-15

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

PC-25. Suggested solution: Parts a. (Journal entries) and b. (effect on statement of cash flows). 1.

Lease of right-of-use equipment ROU equipment— 92,598 Lease liability 72,598 Cash 20,000 $20,000 reported as a cash outflow from investing, rather than, a cash outflow from financing, as the payment was made on or before the commencement date of the lease. The increase in the ROU asset and lease liability are not reported on the SCF. Disclose the transaction in the notes. Interest expense 2,904 Lease liability 2,904 Non-cash expense. Not reported on the SCF (direct). Add back to net income in the cash flow from operating activities on the SCF (indirect).

Depreciation expense—ROU equipment 18,520 Accumulated depreciation—ROU equipment 18,520 Non-cash expense. Not reported on the SCF (direct). Add back to net income in the cash flow from operating activities on the SCF (indirect). Replacement of computer equipment Accumulated depreciation—computers 8,000 Loss on disposal 2,000 Computers 10,000 Non-cash loss. Not reported on the SCF (direct). Add back to net income in the cash flow from operating activities on the SCF (indirect). Computers Cash Cash outflow from investing

*20,000

20,000

Depreciation expense—computers **19,000 Accumulated depreciation—computers 19,000 *$70,000 - $10,000 + X = $90,000; X = $20,000 **$42,000 - ($10,000 - $2,000) + X = $53,000; X = $19,000 Non-cash expense. Not reported on the SCF (direct). Add back to net income in the cash flow from operating activities on the SCF (indirect). Loan repayment using land Loan payable 50,000 Land (old) 40,000 Gain on exchange of land 10,000 Non-cash gain. Not reported on the SCF (direct). Subtract from net income in the cash flow from operating activities on the SCF (indirect). Disclose in the notes. Land (new) Cash Cash outflow from investing. *$250,000 - $40,000 + X = $300,000; X = $90,000 . C-16

*90,000

90,000

Appendix C: Statement of Cash Flows

c. The IASB requires that companies categorize the sources and uses of cash so as to assist investors, creditors, and other interested parties in assessing the company’s ability to make payments when due and pay dividends. PC-26. Suggested solution: Parts a. (Journal entries) and b. (effect on statement of cash flows). 1.

Conversion of bonds payable Bonds payable Contributed surplus – conversion option Ordinary shares Not reported on the SCF. Disclose in the notes.

1,950,000 75,000

2,025,000

Interest expense 8,000 Cash 8,000 Direct - reported on the SCF as a cash outflow from operations or financing. Indirect - already included in net income but needs to be disclosed. Add back to net income in the operating activities section and then report the amount of interest paid as either a cash outflow from operations or financing. Replacement of production equipment Cash 8,000 Accumulated depreciation—production equipment ($20,000 – 15,000 $5,000) Gain on disposal ($8,000 + $15,000 - $20,000) 3,000 Production equipment 20,000 Cash received is reported as a cash inflow from investing on the SCF. The non-cash gain is not reported on the SCF (direct). The gain is subtracted from net income in the cash flow from operating activities on the SCF (indirect). Loan repayment using land Loan payable 70,000 Land (old) 60,000 Gain on exchange of land 10,000 Non-cash gain. Not reported on the SCF (direct). Subtract from net income in the cash flow from operating activities on the SCF (indirect). Disclose in the notes. Land (new) ($225,000 – ($200,000 - $60,000)) Cash Cash outflow from investing.

85,000

PC-27. Suggested solution: a. The only difference between the direct and indirect methods is the composition of the information explaining “Net cash from (used in) operating activities.” The total cash reported will be the same under the two formats. Moreover, “Net cash from (used in) investing activities” and “Net cash from (used in) financing activities” is identical under both approaches. b. The vast majority of companies (99%?) use the indirect method to present the statement of cash flows. Probable motives include those of comparability and ease of preparation. . C-17

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

c. The IASB encourages the use of the direct method of presenting the statement of cash flows with the governing standards, reading in part “Entities are encouraged to report cash flows from operating activities using the direct method.” The IASB is currently considering requiring all entities to report cash flows from operating activities using the direct method. PC-28. Suggested solution: An entity’s financial statements must include a statement of cash flows to comply with paragraph 10 of IAS 1, Presentation of Financial Statements. IAS 7 sets out the manner in which the statement of cash flows is to be prepared and stipulates minimum presentation and disclosure requirements. A summary of the principal requirements follows: Presentation  Cash flows must be classified as arising from operating, investing, or financing activities  The change in cash and cash equivalents must be explained Reporting  Cash flows from operating activities may be reported using either the direct or indirect method  Major classes of cash inflows and outflows for both investing and financing activities must be separately reported  Cash flows from interest paid and received, dividends paid and received, and income taxes paid must be individually disclosed. This information may be included directly on the statement of cash flows or discussed in the supporting notes to the financial statements. Disclosure  Non-cash transactions are not reported on the statement of cash flows, but must be disclosed elsewhere in the financial statements  The components of cash and cash equivalents must be disclosed  The policy adopted to determine the composition of cash and cash equivalents must be disclosed PC-29. Suggested solution: Gretta’s Cat Emporium Inc.’s cash receipts from customers in 2023 totalled $971,000 determined as follows: a. Cash receipts from customers = Sales – Change in gross accounts receivables – Write offs = $1,000,000 – ($260,000 - $240,000) - $9,000 = $971,000. b. Cash receipts from customers = Sales – Change in net accounts receivables – Bad debt expense = $1,000,000 – ($225,000 - $210,000) - $14,000 = $971,000. PC-30. Suggested solution: The amount paid to suppliers and employees by Belle’s Dance Studio Ltd. in 2023 totalled $2,285,000 determined as follows:

. C-18

Appendix C: Statement of Cash Flows

  

Cash paid for inventories = Cost of goods sold + Changes in Inventory – Changes in Accounts payable = $1,400,000 + ($370,000 - $350,000) – ($115,000 - $125,000) = $1,400,000 + $20,000 + $10,000 = $1,430,000. Cash paid for operating expenses = Operating expenses + Change in prepaid expenses = $850,000 + ($20,000 - $15,000) = $850,000 + $5,000 = $855,000. Cash paid to suppliers and employees = $1,430,000 + $855,000 = $2,285,000.

PC-31. Suggested solution: To solve this question, we must first reconcile the changes in the property, plant, and equipment and accumulated depreciation accounts for the year. PPE 01/01/2023 Land sold

225,000

Equipment sold Equipment purchased - solve for 12/31/2023

01/01/2023

1,500,000

260,000 285,000

Depreciation expense 2023 Equipment sold - solve for 12/31/2023

Accumulated Depreciation 400,000 155,000 135,000 420,000

1,300,000

We then use this additional information, coupled with that provided in the question to determine the company’s 2023 cash flows from investing activities.  



Cash received from the sale of the land = cost (given) + gain on sale of land (given) = $225,000 + $35,000 = $260,000 Cash received from the sale of the equipment = net book value of equipment – loss on sale of equipment = cost of equipment (given) – accumulated depreciation on equipment (from T-account reconciliation above) – loss on sale of equipment (given) = $260,000 - $135,000 - $15,000 = $110,000. Cash paid for equipment purchased = $285,000 (from T-account reconciliation above).

a. Zach’s Zebras Inc.’s cash inflows from investing activities in 2023 totalled $370,000 ($260,000 sale of land + $110,000 sale of equipment). b.

Zach’s Zebras Inc.’s cash outflows from investing activities in 2023 were $285,000 for the equipment purchase.

PC-32. Suggested solution: a. Unrealized gains and losses on trading investments are recorded in the income statement. When the indirect method of presentation is used, the unrealized profit or loss must be reversed in the cash flow from operating activities section of the statement of cash flows. Gains and losses are not reported on the statement of cash flows prepared using the direct method as gains and losses do not give rise to cash flows. b. Income taxes are classified as cash flows from operating activities unless they can be specifically linked to financing or investing activities. . C-19

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

c. Stock splits and dividends are non-cash transactions. They are not recorded on the statement of cash flows. d. Cash flows from the purchase and sale of treasury shares are reported as a financing activity. PC-33. Suggested solution: a. IAS 7, Statement of Cash Flows, does not specifically address the classification of the amortization of discounts and premiums on financial instruments. Interest payments may be classified as cash outflows from operating activities or cash outflows from financing activities. b. Other comprehensive income (OCI) is not normally reported on the statement of cash flows as OCI does not affect cash since it records only unrealized gains and losses on select items. c. Investments in associates are typically accounted for using the equity method. The statement of cash flows is concerned only with the cash received or advanced, rather than investment income. The required adjustment for the indirect method of presentation entails deducting income from investments in the operating section and recording dividends received in either the operating or investing section. d. Section 1540 of Part II of the CPA Handbook, Cash Flow Statement, requires that the amortization of discounts be reported as an operating activity and the amortization of premiums be reported as a financing activity. PC-34. Suggested solution: a. The three primary sources of information required to prepare a statement of cash flows are the company’s comparative balance sheet, its income statement for the period, and select transaction data. b. The indirect method ignores the component parts and reports the change in the net receivables as an adjustment to net income in the cash flow from operating activities section. The direct method of presentation deals with the two elements separately. Cash from sales is adjusted for the change in the gross amount of the receivables and the operating component of the cash paid to suppliers and employees is adjusted for the change in the allowance account. c. Cash flows from discontinued operating activities are shown separately in the operating, investing, and financing activities of the statement of cash flows according to their nature. Alternatively, this information may be disclosed in the notes to the financial statements. PC-35. Suggested solution: a.

Coastal Cares Inc. Statement of Cash Flows (partial) For the year ended December 31, 2024

Cash flows from operating activities Net income* Adjustments for: Depreciation Loss on sale of financial asset at amortized cost investment Impairment loss—patent Interest expense Increase in accounts receivable Decrease in accounts payable Cash generated from operating activities Interest paid* [–$30,000 – ($25,000 – $10,000)] .

C-20

$300,000 37,000 2,000 12,000 30,000 (24,000) (18,000) 339,000 (45,000)

Appendix C: Statement of Cash Flows

Dividends paid** Net cash from operating activities

(50,000)

$244,000

*$350,000 comprehensive income less $50,000 other comprehensive income = $300,000 net income ** Note that while interest and dividends paid can also be recorded as financing activities, Coastal has adopted a policy of reporting these transactions as operating activities. b.  The $47,000 cash paid for equipment is reported as a cash outflow in the investing section.  The $18,000 proceeds from the sale of the financial asset at amortized cost securities is reported as an increase in cash flows from investing section.  The stock split is a non-cash activity and is not reported on the statement of cash flows. Note disclosure is appropriate. PC-36. Suggested solution: Coastal Cares Inc. Statement of Cash Flows (partial) For the year ended December 31, 2024 Cash flows from operating activities Comprehensive income Less: Other comprehensive income Net income Adjustments for: Depreciation Loss on sale of financial asset at amortized cost investment Impairment loss—patent Interest expense Increase in accounts receivable Decrease in accounts payable Net cash from operating activities

$350,000 (50,000) 300,000 37,000 2,000 12,000 30,000 (24,000) (18,000)

$339,000

Note that while interest and dividends paid can also be classified as an operating activity Coastal has adopted a policy of reporting these transactions as financing activities. PC-37. Suggested solution: a.

Liz Hicks Accounting Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2024

Cash flows from operating activities Net income Adjustments for: Depreciation Gain on sale .

625,000 62,000 (1,000)

C-21

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Interest expense Income tax expense Investment income from associate Decrease in accounts receivable Decrease in accounts payable Cash generated from operating activities Dividends received from associate* Interest paid** [–$28,000 – ($17,000 – $21,000)] Income taxes paid (-$65,000 + $3,000 + $5,000) Net cash from operating activities

28,000 65,000 (60,000) 16,000 (14,000) 721,000 20,000 (24,000) (57,000)

$660,000

* Note that while interest and dividends received can also be reported as investing activities LHA has adopted a policy of reporting these transactions as operating activities. ** Note that while interest and dividends paid can also be reported as financing activities LHA has adopted a policy of reporting these transactions as operating activities. b.  The $15,000 cash received from the sale of equipment is reported as a cash inflow from investing activities.  The declaration of the $40,000 cash dividend is a non-cash activity as it had not been paid by yearend.  The acquisition of an ROU asset under lease is a non-cash activity and is not reported on the statement of cash flows. Note disclosure is appropriate.  $2,900 of the $4,500 lease payment was allocated to interest expense. The expense would have been included in the income statement and no further adjustments are required. The remaining $1,600 ($4,500 - $2,900) would be reported as a cash outflow for financing activities. PC-38. Suggested solution: a.

Valley Hospitality Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2023

Cash flows from operating activities Net income ($400,000 – $40,000 - $10,000) Adjustments for: Depreciation Recycled loss on sale of at fair value through other comprehensive income investment Gain on sale of equipment Impairment loss—goodwill Interest expense Income tax expense ($40,000 + $10,000) Decrease in accounts receivable Increase in accounts payable Increase in inventory Cash generated from operating activities Interest paid* (–$20,000 + $12,000) . C-22

350,000 22,000 3,000 (2,000) 15,000 20,000 50,000 18,000 40,000 (14,000) 502,000 (8,000)

Appendix C: Statement of Cash Flows

Dividends paid* ($400,000 – $40,000 – $10,000 = $350,000); ($350,000 – $340,000 – $5,000 = $5,000) Income taxes paid (– $40,000 – $10,000 – $4,000 + $6,000) Net cash from operating activities

(5,000) (48,000)

$441,000

* Note that while interest paid and dividends paid can also be recorded as financing activities, Valley has adopted a policy of reporting these transactions as operating activities. b.  The $42,000 cash received for equipment is reported as a cash inflow in the investing section.  The $1,000 holding gain for the period on the investment at FVOCI does not involve cash. Moreover, it flows through the statement of comprehensive income, rather than the income statements and as such is not reported on the statement of cash flows.  The $12,000 proceeds from the sale of the FVOCI securities is reported as an increase in cash flows from investing section.  The $20,000 cash down payment is recorded as a cash outflow from investing activities. The $180,000 balance financed by way of lease is a non-cash activity. Non-cash transactions are reported in the notes to the financial statements. PC-39. Suggested solution: Valley Hospitality Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2023 Cash flows from operating activities Net income ($400,000 – $40,000 - $10,000) Adjustments for: Depreciation Recycled loss on sale of at fair value through other comprehensive income investment Gain on sale of equipment Impairment loss—goodwill Interest expense Income tax expense ($40,000 + $10,000) Decrease in accounts receivable Increase in accounts payable Increase in inventory Cash generated from operating activities Income taxes paid (– $40,000 – $10,000 – $4,000 + $6,000) Net cash from operating activities

350,000 22,000 3,000 (2,000) 15,000 20,000 50,000 18,000 40,000 (14,000) 502,000 (48,000)

$454,000

Note that while interest and dividends paid can also be classified as an operating activity Valley has adopted a policy of reporting interest and dividend payments as financing activities.

. C-23

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

PC-40. Suggested solution: Valley Hospitality Ltd. Cash Flow Statement (partial) For the year ended December 31, 2023 Cash flows from operating activities Net income ($400,000 – $40,000 – $10,000) Adjustments for: Depreciation Loss on sale of investment acquired for other than trading purposes Gain on sale of equipment Impairment loss—goodwill Decrease in accounts receivable Increase in accounts payable Increase in inventory Increase in interest payable Increase in current income taxes payable Decrease in future income taxes payable Net cash from operating activities

350,000 22,000 3,000 (2,000) 15,000 18,000 40,000 (14,000) 12,000 (4,000) 6,000

$446,000

PC-41. Suggested solution: a.

Brigitte’s Bathrooms Ltd. Statement of Cash Flows For the year ended December 31, 2024

Cash flows from operating activities Net income Adjustments for: Depreciation Loss on sale of land Gain on sale of building Interest expense Income tax expense Investment income

Explanation 1 2 3

Increase in accounts receivable Increase in inventory Increase in prepaid expenses Decrease in accounts payable Cash generated from operating activities Dividends received Interest paid Income taxes paid Net cash from operating activities

5 6 7

. C-24

$146,000 180,000 50,000 (25,000) 30,000 40,000 (10,000) 411,000 (14,000) (15,000) (3,000) (10,000) 369,000 25,000 (33,000) (30,000)

$331,000

Appendix C: Statement of Cash Flows

Cash flows from investing activities Purchase of land Sale of land Purchase of building Sale of building Purchase of long-term investment Net cash used in investing activities

8 9 10 11

Cash flows from financing activities Issue notes payable Proceeds of bank loan Issue ordinary shares Redeem preferred shares Payment of cash dividends Net cash from financing activities Net decrease in cash Cash, January 1, 2024 Cash, December 31, 2024

(491,000) 200,000 (250,000) 75,000 (9,000)

13,000 200,000 55,000 (100,000) (50,000)

(475,000)

118,000 (26,000) 43,000 $ 17,000

Explanations 1. It is instructive to use a T-account to help determine net income for the year: Opening balance Solve for net income Stock dividend Cash dividends Closing balance

Retained Earnings 316,000 146,000 20,000 50,000 392,000

2. Using a T-account Accumulated Depreciation Opening balance 220,000 Accumulated depreciation on building sold 150,000 Solve for depreciation expense 180,000 Closing balance 250,000 3. $200,000 sales proceeds – $250,000 cost = $50,000 loss. 4. 25% claim on GFF’s income of $40,000; $40,000 × 25% = $10,000. The investment is accounted for using the equity method and accordingly the recorded income does not represent cash received. 5. GFF paid $100,000 in dividends; $100,000 × 25% = $25,000. The investment is accounted for using the equity method and accordingly this cash inflow was recorded as a reduction in the investment account. 6. $30,000 interest expense plus $3,000 decrease in the accrued interest payable account = $33,000 interest paid. 7. $40,000 income tax expense minus $10,000 increase in the deferred income tax liability payable account = $30,000 income taxes paid 8.Using a T-account Opening balance Cost of land sold

Land 310,000 250,000 . C-25

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Solve for land purchased 491,000 Closing balance 551,000 9. Using a T-account Buildings Opening balance 810,000 Cost of building sold 200,000 Solve for building purchased 250,000 Closing balance 860,000 10. $200,000 cost – $150,000 accumulated depreciation = $50,000 net book value plus $25,000 gain on sale = $75,000 sales price. 11. Using a T-account Long-term investment Opening balance 90,000 Dividends received 25,000 Percentile earnings 10,000 Solve for purchase of shares 9,000 Closing balance 84,000 12. $285,000 closing balance less $210,000 opening balance = $75,000 increase of which $20,000 was by way of stock dividend. $75,000 – $20,000 = $55,000 ordinary shares sold for cash. b. Brigitte should disclose the details of the stock dividend.

. C-26

Appendix C: Statement of Cash Flows

PC-42. Suggested solution: a.

Golf Is Great Corp. Statement of Cash Flows For the year ended December 31, 2024

Cash flows from operating activities Net income Adjustments for: Depreciation Recycled loss on sale of at fair value through other comprehensive income investment Increase in inventory Increase in accounts payable Net cash from operating activities

$27,000 20,000 3,000 (10,000) 10,000

Cash flows from investing activities Sale of at fair value through other comprehensive income securities Net cash from investing activities

19,000

Cash flows from financing activities Dividends paid Issued preferred shares Bank loan payment Cash flow used in financing activities

(25,000) 20,000 (10,000)

Net increase in cash Cash, January 1, 2024 Cash, December 31, 2024

$50,000

19,000

(15,000) 54,000 30,000 $84,000

b.  The $3,000 holding loss on the investment at FVOCI does not involve cash. Moreover, it flows through the statement of comprehensive income, rather than the income statements and as such is not reported on the statement of cash flows.  The issuance of bonds to acquire land will be disclosed in the notes to the financial statements. c.

Cash Inventory Other current assets Investments—at fair value through other comprehensive income Plant and equipment (net)

Golf Is Great Corp. Balance Sheet As at December 31, 2024 $ 84,000 60,000 60,000 18,000 80,000

Accounts payable Other current liabilities Bank loans Bonds payable Share capital

C-27

$ 30,000 60,000 40,000 200,000 30,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Land

180,000

Retained earnings

$482,000

122,000 $482,000

d. Cash paid as dividends may alternatively be shown as a cash outflow from operating activities. Had Golf adopted this method of presentation, net cash from operating activities would have decreased $25,000 to $25,000 and net cash flows from financing activities would have increased $25,000 from a $15,000 outflow to a $10,000 inflow. The net increase in cash would remain unchanged at $54,000. PC-43. Suggested solution: a.

Squash Forever Corp. Statement of Cash Flows For the year ended December 31, 2023

Cash flows from operating activities Net income Adjustments for: Depreciation Interest expense Income tax expense

$29,000

Recycled gain on sale of at fair value through other comprehensive income investment Increase in accounts receivables ($300,000 – $190,000) Increase in inventory ($200,000 – $140,000) Increase in accounts payable ($200,000 - $40,000) Cash generated from operating activities Interest paid Income taxes paid Net cash from operating activities

10,000 4,000 20,000 63,000 (3,000) (110,000) (60,000) 160,000 50,000 (4,000) (20,000)

Cash flows from investing activities Purchase of at fair value through other comprehensive income securities Sale of at fair value through other comprehensive income securities Net cash from investing activities

(20,000) 23,000

Cash flows from financing activities Dividends paid Issued preferred shares Issued ordinary shares Redeemed ordinary shares Reduction of lease liability ($15,000 – $4,000) Net cash from financing activities

(20,000) 20,000 50,000 (20,000) (11,000)

Net increase in cash Cash, January 1, 2023 Cash, December 31, 2023

$26,000

3,000

19,000 48,000 0 $48,000

. C-28

Appendix C: Statement of Cash Flows

Squash Forever Corp. Income Statement For the year ended December 31, 2023 Sales $300,000 Less: Cost of goods sold 140,000 Gross profit 160,000 Administrative expenses 100,000 Interest expense 4,000 Depreciation expense 10,000 Income from operations 46,000 Recycled gain on sale of FVOCI securities 3,000 Income before income taxes 49,000 Income tax expense 20,000 Net income $29,000 c.

Squash Forever Corp. Balance Sheet As at December 31, 2023

Cash $ 48,000 Accounts receivable 110,000 Inventory 60,000 ROU equipment (net) 70,000 $288,000

Accounts payable $ 160,000 Lease liability 69,000 Preferred shares 20,000 Ordinary shares 30,000 Retained earnings 9,000 $288,000

d.  The lease of ROU equipment valued at $80,000 will be disclosed in the notes to the financial statements.  The $3,000 holding gain on the investment at FVOCI does not involve cash. Moreover, it flows through the statement of comprehensive income, rather than the income statements and as such is not reported on the statement of cash flows. e. Interest paid may alternatively be shown as a cash outflow from financing activities. Cash paid as dividends may alternatively be shown as a cash outflow from operating activities. Had Squash adopted a policy of classifying the receipt and payment of interest and dividends as operating activities then, net cash from operating activities would have decreased $20,000 to $6,000 and net cash from financing activities would have increased $20,000 to $39,000. The net increase in cash would remain unchanged at $48,000. PC-44. Suggested solution: Quitzau’s Supplies Inc. Statement of Cash Flows (partial) For the year ended December 31, 2023 Cash flow from operating activities Cash receipts from customers Cash paid to suppliers

$1,020,000 (385,000)

. C-29

$1,000,000 sales + $20,000 decrease in AR –$400,000 purchases + $15,000 increase in AP*

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Operating expenses paid

(205,000)

Cash generated from operating activities Interest paid

430,000

Income taxes paid

(43,000)

Net cash from operating activities

$379,000

(8,000)

–$200,000 – $5,000 increase in prepaid expenses –$10,000 interest expense + $2,000 increase in accrued interest payable –$40,000 income tax expense – $3,000 decrease in income taxes payable

*Alternatively—Cost of goods sold –$600,000 + $200,000 decrease in inventory + $15,000 increase in accounts payable = –$385,000 PC-45. Suggested solution: a. (At fair value through profit or loss investment held for trading purposes) Solnickova Inc. Statement of Cash Flows For the year ended December 31, 2024 Cash flow from operating activities Net income Adjustments for: Depreciation Interest expense Income tax expense

Explanation 1

Decrease in accounts receivable Increase in accounts payable Increase in inventory Purchase of at fair value through profit or loss investments held for trading purposes Cash generated from operating activities Interest paid Income taxes paid Net cash from operating activities

Cash flow from investing activities Purchase of financial asset at amortized cost investment Cash used in investing activities

80,000 250,000 125,000 20,000 475,000 100,000 220,000 (200,000) (100,000) 495,000 (122,200) (20,000)

352,800

(200,000) (200,000)

Cash flow from financing activities Bank loan Bank loan repayment Issuance of ordinary shares Cash dividends Cash used in financing activities Net decrease in cash

3 4 5

. C-30

250,000 (832,800) 86,000 (6,000)

(502,800) (350,000)

Appendix C: Statement of Cash Flows

Cash, January 1, 2024 Cash, December 31, 2024

500,000 $150,000

Explanations 1. $1,950,000 closing accumulated depreciation – $1,700,000 opening accumulated depreciation = $250,000 depreciation for the year. 2. $125,000 interest expense – $2,800 decrease in the discount on bonds payable ($382,800 – $380,000) = $122,200 interest paid. 3. It is instructive to use a T-account to help determine the bank loans repaid during the year: Bank loans Opening balance 2,550,000 New borrowing 250,000 Solve for repayment 832,800 Closing balance 1,967,200 4. Using a T-account Opening balance Conversion of preference shares Stock dividend Solve for new issue Closing balance

Ordinary shares 500,000 10,000 4,000 86,000 600,000

5. Using a T-account Retained earnings Opening balance 410,000 Net income 80,000 Stock dividend 4,000 Solve for cash dividends 6,000 Closing balance 480,000 b. The conversion of preferred shares to ordinary shares and the stock dividend would be disclosed in the notes to the financial statements. c. Had the $100,000 investment been held to meet short-term cash commitments, it would be reported as a cash equivalent. It would thus form part of the cash and cash equivalent to be explained, rather than being an explanatory item. The $100,000 outflow would be removed from the cash flow from operating activities section, increasing the net cash from operating activities to $452,800. The net decrease in cash would be decreased to $250,000 and the closing cash on December 31, 2024 would be increased to $250,000. The changes are illustrated below. Solnickova Inc. Statement of Cash Flows For the year ended December 31, 2024 (Investment held to meet short-term cash commitments) Cash flow from operating activities Net income Adjustments for:

. C-31

80,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Depreciation Interest expense Income tax expense

250,000 125,000 20,000 475,000 100,000 220,000 (200,000) 595,000 (122,200) (20,000)

Decrease in accounts receivable Increase in accounts payable Increase in inventory Cash generated from operating activities Interest paid Income taxes paid Net cash from operating activities Cash flow from investing activities Purchase of financial asset at amortized cost investment Cash used in investing activities Cash flow from financing activities Bank loan Bank loan repayment Issuance of ordinary shares Cash dividends Cash used in financing activities Net decrease in cash Cash, January 1, 2024 Cash, December 31, 2024

(200,000)

250,000 (832,800) 86,000 (6,000)

452,800

(200,000)

(502,800) (250,000) 500,000 $250,000

PC-46. Suggested solution: a.

Solnickova Inc. Statement of Cash Flows (partial) For the year ended December 31, 2024

Cash flow from operating activities Cash receipts from customers ($1,600,000 sales + $100,000 decrease in AR) Cash paid to suppliers ($600,000 COGS – $220,000 increase in AP + $200,000 increase in inventory) Sales and admin expenses Cash generated from operating activities Purchase of at fair value through profit or loss investments held for trading purposes Interest paid ($125,000 interest expense – $2,800 amortization of bond discount) Income taxes paid Net cash from operating activities

$1,700,000 (580,000) (525,000) 595,000 (100,000) (122,200) (20,000)

$352,800

b. The net cash from operating activities, $352,800, is the same under both methods. The indirect method starts with net income and then systematically adjusts the company’s accrual-based financial statements to cash-based statements. For example, depreciation expense is added back to net income as it is a non-cash expense. In contrast, the direct method specifically identifies cash inflows and outflows from identified activities, for example sales. . C-32

Appendix C: Statement of Cash Flows

Statements prepared using the direct method provide more useful information as the reader can clearly see how much cash was generated from sales; how much cash was paid to suppliers; how much cash was paid to meet operating expenses; and so on. PC-47. Suggested solution: a. Robinson Inc. Statement of Cash Flows For the year ended December 31, 2024 Cash flow from operating activities Net income Adjustments for: Depreciation Interest expense Income tax expense Gain on sale of equipment

Explanation 1

Decrease in accounts receivable Decrease in accounts payable Decrease in inventory Cash generated from operating activities Interest paid Cash dividends paid Income taxes paid Net cash from operating activities

550,000 100,000 50,000 (30,000) 770,000 200,000 (50,000) 200,000 1,120,000 (102,989) (127,011) (50,000)

2 3

Cash flow from investing activities Sale of PPE Purchase of PPE Purchase of financial asset at amortized cost investment Cash used in investing activities

$100,000

4 5

840,000

180,000 (750,000) (100,000) (670,000)

Cash flow from financing activities Bank loan Bank loan repayment Issued preferred shares Redemption of ordinary shares Cash from financing activities Net increase in cash Cash, January 1, 2024 Cash, December 31, 2024

6 7

. C-33

500,000 (450,000) 300,000 (120,000)

230,000 400,000 400,000 $800,000

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Explanations 1. It is instructive to use a T-account to help determine the depreciation expense during the year: Accumulated Depreciation Opening balance 1,500,000 AD on sale of equipment - from below 50,000 Solve for depreciation expense 550,000 Closing balance 2,000,000 Cost (given) $200,000 Solve for accumulated depreciation 50,000 Bet book value (given) $150,000 2. $100,000 interest expense + $2,989 decrease in the premium on bonds payable ($416,849 – $413,860) = $102,989 interest paid. 3. Using a T-account Retained earnings Opening balance 833,151 Net income 100,000 Stock dividend 20,000 Solve for cash dividends 127,011 Closing balance 786,140 4. $150,000 net book value + $30,000 gain on sale = $180,000 sales price. 5. Using a T-account Property, Plant, & Equipment Opening balance 3,400,000 Cost of equipment sold 200,000 ROU equipment 250,000 Solve for PP&E purchase 750,000 Closing balance 4,200,000 6. Using a T-account Bank loans Opening balance 2,400,000 Lease liability 250,000 Bank loan 500,000 Solve for repayment 450,000 Closing balance 2,700,000 7. Using a T-account Ordinary shares Opening balance 400,000 Stock dividend 20,000 Solve for redemption 120,000 Closing balance 300,000 . C-34

Appendix C: Statement of Cash Flows

8. The closing cash includes cash and cash equivalents. The investment held to meet short-term cash commitments is a cash equivalent. $600,000 + $200,000 = $800,000. b. The stock dividend and the leased right-of-use equipment would be disclosed in the notes to the financial statements. PC-48. Suggested solution: a.

Robinson Inc. Statement of Cash Flows (partial) For the year ended December 31, 2024

Cash flow from operating activities Cash receipts from customers ($2,000,000 sales + $200,000 decrease in AR) Cash paid to suppliers ($1,200,000 COGS + $50,000 decrease in AP – $200,000 decrease in inventory) Sales and admin expenses Cash generated from operating activities Interest paid ($100,000 interest expense + $2,989 amortization of bond premium) Cash dividends paid Income taxes paid Net cash from operating activities

$2,200,000 (1,050,000) (30,000) 1,120,000 (102,989) (127,011) (50,000)

$840,000

PC-49. Suggested solution: a.

Zippo Ltd. Statement of Cash Flows For the year ended December 31, 2024

Cash flows from operating activities Net income Adjustments for: Depreciation Intangibles amortization Deferred development cost amortization Interest expense Income tax expense

Explanation

Gain on sale of fixed assets Decrease in accounts receivable Increase in inventory Decrease in accounts payable Cash generated from operating activities Income taxes paid Net cash from operating activities

2 3

. C-35

$ 289,100 334,400 9,000 65,000 75,000 300,000 1,072,500 (23,000) 70,000 (77,000) (3,000) 1,039,500 (290,000)

$749,500

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Cash flows from investing activities Proceeds from sale of capital assets Acquired capital asset for cash Payment of deferred development costs Net cash used in investing activities

Cash flows from financing activities Interest paid Dividends paid Net cash used in financing activities Net increase in cash Cash and cash equivalents January 1, 2024 Cash and cash equivalents December 31, 2024

6 7

422,000 (708,000) (212,000)

(89,500) (100,000)

(498,000)

(189,500) 62,000 110,000 $172,000

Explanations 1. It is instructive to use a T-account to help determine the amortization expense pertaining to the deferred product development costs during the year: Opening balance Given (expenditure) Solve for amortization expense Closing balance

Deferred Product Development Costs 417,000 212,000 65,000 564,000

2. To determine the gain or loss on sale we must first ascertain the net book value of the asset disposed of. We are given the cost hence we must determine the accumulated depreciation on the asset. Again, it is instructive to use a T-account: Opening balance Given (depreciation expense) Solve for accumulated depreciation on asset sold Closing balance

Accumulated Depreciation 487,000 334,400 171,000 650,400

$570,000 cost – $171,000 accumulated depreciation = $399,000 net book value. $422,000 sales proceeds – $399,000 net book value = $23,000 gain on sale 3. Net accounts receivable declined – [($375,000 – $15,000) – ($300,000 – $10,000)] = $70,000 4. Income tax expense less the increase in the income tax payable account – [$300,000 – ($12,000 – $2,000)] = $290,000 5. Using a T-account Capital Assets Opening balance 1,396,000 Exchange of shares for equipment 450,000 Given—equipment sold 570,000 Solve for cost of capital assets acquired 708,000 Closing balance 1,984,000

. C-36

Appendix C: Statement of Cash Flows

6. $75,000 interest expense + $14,500 amortization of bond premium = $89,500 cash paid 7. Using a T-account

Retained Earnings Opening balance 969,000 Net income 289,100 Solve for dividends paid 100,000 Closing balance 1,158,100 b. Zippo should disclose that it issued shares to acquire equipment. c. Before making a decision as to whether to invest in Zippo, I would review its past results for purposes of trend analysis as well as compare this year’s results to that of their competitors. As an investor I am interested in the profitability, growth rate, and financial stability of Zippo. Its dividend payout ratio is not that important to me as I am not currently in need of investment income. This aspect may be important to other classes of investors, such as retirees, however. Also, a fundamental question that needs to be answered is how much Zippo’s shares are selling for. What is the price/earnings ratio? What is the dividend yield based on market values? For the year ended December 31, 2024, Zippo’s cash from operating activities of $749,500 on sales of $2.511 million was extremely strong and is a positive indicator. A possible detracting factor is that of the $212,000 cash outflow related to funding the deferred development costs. Further investigation is required to ascertain how close this project is to completion and the downstream impact on cash flow. Cash used in financing activities are nominal, which reflects the company’s low financial leverage (debt to equity) level. The dividend payout ratio of 35% ($100,000 / $289,100) is healthy, even more so considering that the company’s cash position improved during the year. Initial indicators are positive. However, as stated above, further analysis is required with respect to the company’s historical performance; its performance relative to its peer group; the prospects and cash flow implications of the product undergoing development; and the price of the company’s shares. PC-50. Suggested solution: Zippo Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2024 Cash flows from operating activities Cash receipts from customers ($2,511,100 sales + $70,000 decrease in net AR - $8,000 bad debt expense)

$2,573,100

Cash paid to suppliers (–$1,256,000 COGS – $3,000 decrease in AP – $77,000 increase in inventory)

(1,336,000)

Other expenses (–$256,600 – $23,000 gain on sale + $65,000 product development amortization + $9,000 intangibles amortization + $8,000 bad debt expense)

(197,600)

Cash generated from operating activities

1,039,500

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Income taxes paid (–$300,000 income tax expense + $10,000 increase in deferred income taxes payable)

(290,000)

Net cash from operating activities

$749,500

PC-51. Suggested solution: a.

Tymen Ltd. Statement of Cash Flows For the year ended December 31, 2024

Cash flows from operating activities Net income Adjustments for: Depreciation Patent impairment Interest expense ($36,000 + $4,500) Income tax expense Investment income from associate

Explanation

Loss on sale of fixed assets Increase in accounts receivable Decrease in inventory Decrease in accounts payable Cash generated from operating activities Dividends received from associate Interest paid Dividends paid Income taxes paid Net cash from operating activities

2 3 4 5

Cash flows from investing activities Sale of investment at fair value through profit or loss held for other than trading purposes ($13,000 $11,000) Proceeds from sale of PPE Acquired PPE for cash Payment of legal costs defending the patent Net cash used in investing activities Cash flows from financing activities Repayment of lease liability Net cash used in financing activities Net increase in cash Cash and cash equivalents January 1, 2024 Cash and cash equivalents December 31, 2024

. C-38

$ 429,500 318,700 40,000 40,500 293,000 (288,000) 833,700 49,300 (32,000) 21,000 (3,000) 869,000 135,000 (57,500) (138,500) (343,000)

$465,000

2,000 6 7

75,000 (511,000) (18,000)

(7,000)

(452,000)

(7,000) 6,000 85,000 $91,000

Appendix C: Statement of Cash Flows

Explanations 1. To determine the gain or loss on sale we must first ascertain the net book value of the asset disposed of. We are given the cost hence we must determine the accumulated depreciation on the asset. It is instructive to use a T-account to help solve: Accumulated Depreciation Opening balance 389,000 Given (depreciation expense) 318,700 Solve for accumulated depreciation on asset sold 295,700 Closing balance 412,000 $420,000 cost – $295,700 accumulated depreciation = $124,300 net book value. $75,000 sales proceeds – $124,300 net book value = $49,300 loss on sale 2. Again, it is instructive to use a T-account to help determine the dividends received from the associated during the year: Opening balance Investment income Solve for dividends received Closing balance

Investment in Associate 312,000 288,000 135,000 465,000

3. $36,000 interest expense (bonds) + $4,500 interest expense (lease) + $17,000 amortization of bond premium = $57,500 interest paid 4. Using a T-account Retained Earnings Opening balance 644,000 Net income 429,500 Solve for dividends paid 138,500 Closing balance 935,000 5. Income tax expense plus the decrease in the income taxes payable and deferred tax liability accounts – [$293,000 + ($16,000 – $12,000) + ($442,000 - $396,000)] = $343,000 6. Using a T-account PPE Opening balance 1,344,000 Exchange of shares for equipment 110,000 ROU asset 100,000 Given—equipment sold 420,000 Solve for cost of PPE acquired 511,000 Closing balance 1,645,000 7. Using a T-account for reconciliation Patent Opening balance 162,000 Impairment 40,000 Capitalization of costs of successful defence of patent 18,000 Closing balance 140,000 . C-39

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8. $100,000 lease liability at inception - $93,000 closing balance = $7,000 repayment. b. Tymen should disclose that it issued ordinary and preferred shares to acquire equipment and that it leased a right-of-use asset. PC-52. Suggested solution: Tymen Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2024 Cash flows from operating activities Cash receipts from customers ($3,218,575 sales - $32,000 increase in AR) Cash paid to suppliers (–$1,649,125 COGS – $3,000 decrease in AP + $21,000 decrease in inventory) Other expenses (–$735,750 + $49,300 loss on sale) Cash generated from operating activities Dividends received from associate Interest paid Dividends paid Income taxes paid Net cash from operating activities

$3,186,575 (1,631,125) (686,450) 869,000 135,000 (57,500) (138,500) (343,000)

PC-53. Suggested solution: a.

Luke and Angie Inc. Statement of Cash Flows For the year ended December 31, 2024

Cash flows from operating activities Net income Adjustments for: Depreciation Goodwill impairment loss Gain on redemption of financial asset at amortized cost investment Gain on sale of equipment Interest expense Income tax expense Decrease in accounts receivable Increase in inventory Increase in prepaid expenses Increase in accounts payable Decrease in accrued liabilities Cash generated from operating activities Cash paid for interest

Explanation 1

70,000 40,000 (1,000)

2 . C-40

$107,000

(10,000) 10,000 42,000 258,000 7,000 (6,000) (2,000) 4,000 (3,000) 258,000 (12,000)

$465,000

Appendix C: Statement of Cash Flows

Cash paid for dividends Cash paid for taxes Net cash used in operating activities Cash flows from investing activities Sale of financial asset at amortized cost investment Sale of equipment Cash paid for purchase of ROU asset Purchase of plant assets Net cash used in investing activities Cash flows from financing activities Borrowing by way of mortgage payable Sale of ordinary shares Net cash from financing activities Net increase in cash Cash, January 1, 2024 Cash, December 31, 2024

3 4

(333,000) (37,000)

11,000 80,000 (10,000) (200,000)

100,000 126,000

7 8

($124,000)

(119,000)

226,000 (17,000) 128,000 $111,000

Explanations 1. Other comprehensive income (OCI) represents unrealized gains and losses that do not involve cash flows. Net income of $107,000 is the starting point for the statement of cash flows prepared using the indirect method. Note that the $5,000 loss in OCI reflects the recorded decrease in the value of the at fair value through other comprehensive income investments. 2. $10,000 interest expense + $2,000 ($54,000 – $52,000) amortization of bond premium = $12,000 interest paid. 3. It is instructive to use T-accounts to assist in determining the cash dividends paid. Retained Earnings Opening balance 286,000 Net income 107,000 Stock dividend 10,000 Solve for cash dividends declared 325,000 Closing balance 58,000 $325,000 cash dividends declared + $8,000 decrease in dividends payable ($18,000 – $10,000) = $333,000 cash dividends paid. 4. $42,000 income tax expense – $5,000 increase in deferred income taxes = $37,000 income taxes paid. 5. Using a T-account. Opening balance Given (depreciation expense) Solve for accumulated depreciation on asset sold Closing balance

Accumulated Depreciation 110,000 70,000 20,000 160,000

$70,000 net book value + $20,000 accumulated depreciation = $90,000 original cost .

C-41

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Plant Assets Opening balance 490,000 Exchange of preferred shares for equipment 150,000 ROU equipment 100,000 Equipment sold - calculated above 90,000 Solve for cost of capital assets acquired 200,000 Closing balance 850,000 6. Using a T-account Opening balance Stock dividend Solve for share issue Closing balance

Ordinary shares 400,000 10,000 126,000 536,000

7. $102,000 cash + $26,000 investment reported as a cash equivalent = $128,000. 8. $85,000 cash + $26,000 investment reported as a cash equivalent = $111,000. b.

• • •

During the year the company issued 1,000 ordinary shares as a stock dividend. The market value of the transaction was $10,000. During the year the company issued 1,500 preferred shares in exchange for plant assets having a fair value of $150,000. During the year the company paid $10,000 cash and incurred a lease liability of $90,000 to acquire a right-of-use asset valued at $100,000.

PC-54. Suggested solution: Luke and Angie Inc. Statement of Cash Flows (partial) For the year ended December 31, 2024 Cash flows from operating activities Cash receipts from customers ($860,000 sales + $7,000 decrease in AR) Cash paid to suppliers ($422,000 COGS – $4,000 increase in AP + $6,000 increase in inventory) Operating expenses ($180,000 + $2,000 increase in prepaid expenses + $3,000 decrease in accrued liabilities) Cash generated from operating activities Interest paid ($10,000 interest expense + $2,000 amortization of bond premium) Cash dividends paid ($325,000 related decrease in retained earning + $8,000 decreased in dividends payable) Income taxes paid ($42,000 income tax expense – $5,000 increase in deferred income tax liability) Net cash used in operating activities

. C-42

$867,000 (424,000) (185,000) 258,000 (12,000) (333,000) (37,000) ($124,000)

Appendix C: Statement of Cash Flows

PC-55. Suggested solution: a.

Valli Ltd. Statement of Cash Flows For the year ended December 31, 2024

Cash flows from operating activities Net income Adjustments for: Depreciation Goodwill impairment Holding gain on at fair value through profit or loss security Interest expense Income tax expense Subtotal Increase in accounts receivable Decrease in inventory Decrease in prepaid expenses Decrease in accounts payable Increase in accrued liabilities Cash generated from operating activities Cash paid for interest Cash paid for taxes Net cash from operating activities

Explanation 1

$67,000 25,000 7,000 (3,000)

Cash flows from investing activities Sale of equipment Purchase of plant assets Net cash used in investing activities Cash flows from financing activities Payment of cash dividends Retirement of mortgage payable Sale of preferred shares Net cash from financing activities Net increase in cash Cash, January 1, 2024 Cash, December 31, 2024

2 3

6,000 39,000 141,000 (14,000) 10,000 3,000 (5,000) 9,000 144,000 (3,000) (42,000)

30,000 (100,000)

(46,000) (136,000) 201,000

$99,000

(70,000)

19,000 48,000 21,000 $ 69,000

Explanations 1. Other comprehensive income (OCI) represents unrealized gains and losses that do not involve cash flows. Net income of $67,000 ($72,000 comprehensive income less $5,000 gain in other comprehensive income) is the starting point for the statement of cash flows prepared using the indirect method. Note that the $5,000 OCI reflects the recorded increase in the value of the at fair value through other comprehensive income investments. 2. $6,000 interest expense – $3,000 ($50,000 – $47,000) amortization of bond discount = $3,000 interest paid. 3. $39,000 income tax expense + $3,000 decrease in deferred income taxes = $42,000 income taxes paid. . C-43

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

4. It is instructive to use T-accounts to assist in determining the amount paid for the purchase of plant assets and ascertain whether there was a gain or loss on sale of equipment. Opening balance Given (depreciation expense) Solve for accumulated depreciation on asset sold Closing balance

Accumulated Depreciation 125,000 25,000 10,000 140,000

$40,000 cost – $10,000 accumulated depreciation = $30,000 net book value. $30,000 sales proceeds – $30,000 net book value = no gain or loss on sale Opening balance Exchange of shares for equipment Given—equipment sold Solve for cost of capital assets acquired Closing balance

Capital Assets 380,000 100,000 40,000 100,000 540,000

5. $22,000 opening retained earnings + $67,000 net income – $20,000 transferred to ordinary share capital – $21,000 closing balance = $48,000 cash dividends declared. $48,000 dividends declared – $2,000 increase in dividends payable = $46,000 cash dividends paid. b.

Valli Ltd. Statement of Cash Flows (partial) For the year ended December 31, 2024

Cash flows from operating activities Cash receipts from customers ($660,000 sales – $14,000 increase in AR) Cash paid to suppliers ($359,000 COGS + $5,000 decrease in AP – $10,000 decrease in inventory) Operating expenses ($160,000 – $3,000 decrease in prepaid expenses – $9,000 increase in accrued liabilities) Cash generated from operating activities Interest paid ($6,000 interest expense – $3,000 amortization of bond discount) Income taxes paid ($39,000 income tax expense + $3,000 decrease in deferred income tax liability) Net cash from operating activities

$646,000 (354,000) (148,000) 144,000 (3,000) (42,000) $99,000

c. During the year the company issued 1,000 ordinary shares as a stock dividend. The market value of the transaction was $20,000. During the year the company issued 5,000 ordinary shares in exchange for plant assets having a fair value of $100,000.

. C-44

Appendix C: Statement of Cash Flows

K. Mini-Cases Case 1: CompuCo Ltd. Suggested solution: Part 1

CompuCo Ltd. Statement of Cash Flows For the year ended December 31, 2024 (in thousands of dollars)

Cash generated from (used in): Operating activities: Net loss Adjustments for: Depreciation and amortization Goodwill write-off Loss on sale of capital assets Loss from associates Interest revenue Interest expense Income tax recovery

$(23,057)

Increase in accounts receivable Increase in inventories Decrease in prepaid expenses Decrease in accounts payable Cash outflow from operating activities Interest revenue Interest paid Income taxes paid [($2,775) + ($145 – $0) + ($4,875 – $2,245)] Net cash from operating activities

10,220 12,737 394 2,518 (1,310) 1,289 (2,775) 16 (5,345) (4,522) 211 (1,469) (11,109) 1,310 (1,289) 0 (11,088)

Investing activities: Purchase of capital assets Disposal of capital assets Intangible assets (note 1) Purchase of financial asset at amortized cost investments Cash used for investment activities

(2,290) 250 (2,686) (1,516) (6,242)

Financing activities: Issue of shares with warrants Increase in bank indebtedness Increase in long-term debt Payments on long-term debt Cash generated from financing activities

15,292 564 2,200 (1,200) 16,856

Net decrease in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year

(474) 3,739 $3,265

. C-45

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Note 1—Intangible assets: Depreciation of capital assets: Opening balance, capital assets Plus: purchases Less: disposal (250) + loss (394) Less: closing balance, capital assets Depreciation of capital assets

$45,700 2,290 (644) (37,332) $10,014

Amortization of intangible assets: Total amortization and depreciation Less: depreciation of capital assets Amortization of intangible assets

$10,220 10,014 $ 206

Intangible assets: Closing balance Less: opening balance Add back amortization of intangible assets Increase in intangible assets

$4,391 (1,911) 206 $2,686

Part 2

CompuCo Ltd. Statement of Cash Flows—Operating Activities For the year ended December 31, 2024 (in thousands of dollars)

Cash generated from (used in) operating activities: Cash receipts from customers ($89,821 – $5,345) Cash paid to suppliers and employees ($76,766 + $1,469 + $13,039 – $211 + $4,522) Cash generated from operating activities Interest received Interest paid Income taxes paid [($2,775) + ($145 – $0) + ($4,875 – $2,245)] Net cash from operating activities

$ 84,476 (95,585) (11,109) 1,310 (1,289) (0) $(11,088)

Part 3 The objective of the statement of cash flows is to require the provision of information about the historical changes in cash and cash equivalents of an entity by means of a statement of cash flows which classifies cash flows during the period from operating, investing, and financing activities. Information about the cash flows of an entity is useful in providing users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilize those cash flows. The economic decisions that are taken by users require an evaluation of the ability of an entity to generate cash and cash equivalents and the timing and certainty of their generation.

. C-46

Appendix C: Statement of Cash Flows

Case 2: Big City Gymnastics. Suggested solution: Draft Financial Report to the Board of Directors of Big City Gymnastics Club (BCG) As the newly appointed treasurer of BCG, I am enclosing some financial information for the board to consider and act upon. As you know, the board is responsible for ensuring that BCG’s operating activities are properly run and its finances are properly managed. There are some critical financial issues that the board needs to address immediately. I present a cash flow analysis (see my report below) which shows that BCG will be in a negative cash position and needs to obtain a credit line or a loan for the first time ever. As discussed in my report, the need for fund sources, in my view, stems from two problems. Cash flows of BCG are inadequate, apparently because of the failure to accommodate the seasonality of cash inflows and outflows and because spending is not controlled. In addition, the possibility of an illegal withdrawal of funds by the previous office manager may have contributed to the need for credit. Further investigation into this possibility is required before a firm conclusion can be drawn. In any case, the board must take steps to approach the bank as soon as possible. I believe it is important for the board to take a more active role in monitoring BCG. I have therefore included a plan for presenting additional information to the board so that issues can be identified and resolved in a timely manner. Cash needs BCG has used $22,628 of cash in the past 10 months, with $15,000 of this expenditure occurring in the last two months according to its financial records. With less than $5,000 left in the bank, and being in the middle of the seasonal summer downturn in its operating activities, BCG is expected to be in a cash deficit position as at August 31, 2024 (see Exhibit I below). This means that BCG must act immediately to fund the projected cash deficit. I suggest that BCG approach the bank for a small overdraft ($10,000), pledging some of its equipment as security. As treasurer, I would be willing to approach the bank on BCG’s behalf, with the permission of the board. Exhibit I Projection of Cash Needs for BCG Cash at June 30, 2024 Cash inflows: July and August revenue based on 2023* ($317,509 × 10%) Monthly grant ($1,200 × 2) Chocolate bar sales Future chocolate bar sales ($3 × 1500) – $3,750 Cash outflows: Coach salaries ($20,000 × 2 months) Fixed costs ($2,000 × 2 months) Cost of chocolate bars Net the supplier’s discount (20% × $3,300) Outstanding cheques

$ 4,324 31,751 2,400 3,750 750 38,651

(40,000) (4,000) (3,300) 660 (820) (47,460) Projected cash deficit, August 31, 2024 $ (4,485) Alternative sources of funding may be available, such as seeking out additional grants or raising money through new fundraising initiatives. This funding could help to improve cash flows in the future; however, BCG needs cash immediately, so obtaining a line of credit will likely still be necessary. BCG will also have other costs in the summer besides the fixed costs. Based on my projection, BCG will have a cash deficit before the fall sessions start in September. . C-47

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NB: Using the 2024 revenues results in a larger cash deficit. This is an equally acceptable approach. Financial reports The board currently receives a report on only the cash balance at its monthly meetings. This information is not sufficient to keep the board abreast of the financial issues facing BCG. Regular monthly financial statements are a must. In addition, BCG should prepare a budget for 2027 and future fiscal years. This information would assist the board in knowing early in the year whether it is meeting its targets, allowing it to take corrective action where necessary. Since fall and winter are BCG’s high-revenue months, BCG will need to generate a cash surplus in those months to sustain itself through the seasonal downturn in spring and summer. A monthly report comparing actual results to the budget for revenues and expenses will assist the board greatly in its monitoring activities. The board should also obtain reports that show how each of the men’s competitive, women’s competitive, and recreational/preschool programs is doing. Monitoring by program will assist BCG in determining how much each of the programs is contributing to BCG’s overhead (common) costs. It will also assist the board in directing resources to the programs that provide the largest contribution to overheads (such as new equipment or training and recruiting of coaches). In addition, it will give BCG a means of confirming that it can afford the pay for the coaches that it has, as well as determining whether the pricing of its programs covers their operating costs. The board may wish to consider putting someone in charge of each program and making that individual accountable for reporting on its operating activities, for example the coach. The board should also have reports on the individual fundraising activities showing the amount of profit generated from each activity. It should then compare the profit from each activity with the amount of effort required to organize and run it, in order to concentrate BCG’s efforts on those fundraisers that provide the best payback for the effort expended. Having an annual budget will also assist the board in determining the total amount of funds that need to be raised each year to keep the club financially viable. Other non-financial measures, such as enrollment numbers by program or competitions won by program, would allow the board to evaluate the success of the individual programs and help them make operational decisions about what programs to run. Case 3: Community Care Services. Suggested solution: Introduction Community Care Services (CCS) is a not-for-profit organization formed in January 2025 and located in a rural community of Thomas County. CCS is dedicated to servicing the needs of seniors. Yelt and Rerdan has been engaged by Janet Admer, CCS’s new executive director, to provide advice on the issues facing CCS as it moves from the construction phase to the operating phase. Our review of the information provided indicates that CCS faces an immediate cash shortfall and potential liquidity problems in the near future. In addition, there are issues regarding the performance of the three operating divisions of CCS that require immediate attention. If these issues are not addressed quickly, there could be severe cash consequences for the organization as well as violation of the covenants associated with Mr. MacDougall’s donation. These issues are discussed in detail in the sections below. Cash Flow and Operational Analysis Adequate cash flow and cash management are crucial for the success and survival of CCS. The board has expressed concern that CCS may run out of cash before the end of 2025 and wants to make sure that it will have the necessary cash flow for 2026. The analysis below indicates that CCS will have a small cash deficiency as of December 31, 2025. Because the amount is small, it should not be difficult to obtain financing to cover the shortfall. Cash flow for 2026 looks satisfactory with a small surplus at the end of 2026 projected. However, there are some potential problems that could cause cash difficulties.

. C-48

Appendix C: Statement of Cash Flows

Cash flow analysis: 2025 Appendix I provides a forecast of CCS’s cash position on December 31, 2025. APPENDIX I Estimated cash position on December 31, 2025 Cash inflows (Exhibit l)

$ 1,400,000

Interest income earned (Exhibit III)

29,000

Expenses to December 31 (Exhibit II “Other”)

(115,000)

Capital expenditures (Exhibit I)

(1,359,000)

Estimated cash position at December 31, 2025

(45,000)

Interpretation: The current cash position, projected to December 31, 2025, is weak, as indicated by the negative cash position of $45,000. This projection does not make any allowance for additional costs associated with completing the recreation centre, which is now estimated to be completed significantly over budget. If the revised budget for completing the recreation centre is erroneous, then the shortfall could increase. It also does not consider any additional unanticipated costs. CCS should be considering alternative sources of contributions, including donations from Mr. MacDougall or others, additional government funding, fees for services, etc. Given the small size of the shortfall, it should be possible to obtain a short-term loan from a bank. Cash flow analysis: 2026 The next step is to prepare an analysis of the cash flows for CCS for 2026. The cash budget prepared by CCS has a number of flaws that need adjustment. A revised cash flow projection for 2026 is presented in Appendix II.

. C-49

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

APPENDIX II Estimated cash flow for 2026 (in thousands of dollars) Estimated cash at December 31, 2025, per Appendix I

$(45)

Cash inflows projected by CCS (from Exhibit III in the question)

$1,202

Adjustments: Bank loan payments (10 × $20,000)

(200)

Interest on bank loan (note 1)

(7)

Proceeds from sale of retirement home units not available for general use (note 2)

(550)

Required repayment to Ministry (note 3)

(189)

Furniture purchases

(44)

Training costs

(34)

Additional costs to finish Building D (note 4)

(50)

Rent reduction on retirement home rental units (note 5)

(27)

Estimated cash at December 31, 2026

Notes: 1. Estimated interest at 5% on average/declining balance—say, $7,000. 2. The terms of Mr. MacDougall’s donation require that half of the proceeds from the sale of the retirement units be maintained in a separate account to be used for the maintenance and capital repairs of the complex. This means that $550,000 is not available for general use by CCS. 3. The Ministry requires that any surplus from the operation of the nursing home be returned to the Ministry. Our preliminary calculation shows a surplus of $189,000 (see Appendix III). Additional analysis may be able to reduce this amount (see discussion below). 4. It does not appear that Building D will be finished on December 31, 2025 (or will be completed significantly under budget). Assuming the former, it is reasonable to expect an additional $50,000 in expenditures to complete the building. Additional discussion will clarify this issue. 5. Terms of Mr. MacDougall’s donation require that the rent charged on the rental retirement units cannot generate a surplus on the operation of these units. Our analysis shows a surplus of $27,000, which will require a reduction in rent to tenants of that amount. Discussion The preceding analysis shows that CCS’s cash situation for 2026 is adequate for the year. However, the surplus is relatively small, and any unforeseen reductions in inflows or increases in outflows could put CCS into a deficit. It is important for management to keep in mind a number of issues:    

Half the proceeds from the sale of the retirement units cannot be used for general operating purposes. Thus, while there may be a large amount of cash in the bank, the full amount will not be available for general use. The analysis assumes that all units/beds will be filled/sold 100% of the time. In reality there may be periods where this is not the case, with a resulting decrease in cash flow. The analysis assumes that there will not be any turnover in the retirement units. If this assumption proves false, some bridge financing may be needed to span the period from when a unit is sold back to CCS until a new purchaser is found and the deal closes. The terms of Mr. MacDougall’s donation specify that the rent charged on the rental retirement units cannot generate a surplus on the operation of these units. . C-50

Appendix C: Statement of Cash Flows



The Ministry requires that any surplus from operation of the nursing home be returned to the Ministry. Our preliminary calculation shows a surplus of $189,000 (see Appendix III). It may be possible to decrease the amount of the repayment by adjusting the allocation of costs to the nursing home. However, additional steps should be taken to attempt to mitigate this problem, perhaps by asking the Ministry whether the funding terms can be altered. The proceeds from the sale of the retirement units are non-recurring. This means that CCS cannot count on almost 50% of its inflows in 2026 to occur in 2027 and beyond. At the same time, cash outflows are not expected to decrease in future years. Thus, a false sense of security may arise as a result of the inflows that are expected in 2026. Note that this conclusion has no impact on 2026’s cash situation.

CCS faces some serious cash flow problems in the future. In 2027 and beyond CCS will not have the proceeds from the sale of the retirement units, which will significantly decrease cash flow and place it in an ongoing negative cash flow situation. Management and the board should focus on this issue immediately so that remedies can be put in place well in advance of the end of 2026. APPENDIX III Operational analysis by program for 2026 (in thousands of dollars) Purpose: to estimate the surplus/deficit by program and to assess whether any obligations arise.

Revenue Government funding—Building A Government funding—Building C Sales proceeds—Building B Occupancy fees—Building B Rent—Building C Interest Expenses Salaries and benefits Medical supplies Interest on bank loan Food costs—Building A Staff training Repairs and maintenance Communications, office etc. Utilities and taxes Insurance Excess of revenues over expenses before allocation and depreciation Allocations: Building D Admin

Note 1 2 3 4

6 6 6

Origin al

Bldg A

949 200 0 66 72 29 1,316

949

272

850 55 7 160 34 23 15 23 10 1,177

320 55

535

34 23 15 23 10 462

139

414

212

(60)

(433)

20 144

20 145

7 7 . C-51

Bldg B

Bldg C

Bldg D Recrea tion

Admin

200 66

29 29 60

350 7

160

433

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Depreciation 8 100 58 17 18 7 Allocation of Building D Depreciation 8 3 2 2 (7) Excess of revenues over expenses 39 189 (177) 27 0 0 Notes: 1. Government Funding—Building A, 20 beds × $130 × 365 = $949,000. 2. Sales Proceeds—Building B, 5 units at $100,000 plus 5 units at $120,000: $1,100,000. The proceeds from building B may not be recognized as revenue (see the discussion of this aspect below). 3. Occupancy fees—Building B, 10 units × $550 × 12 months: $66,000. 4. Rent—Building C, 15 units × $400 × 12 months: $72,000. 5. Salaries and benefits: Building A

Total salaries

Total 850

Medical staff

(260)

260

Directors 4 × $60,000

(240)

Other unallocated

(350)

Total

Building B

Building C

Building D

Admin

350 320

350

6. CCS must develop an internal reporting system to allocate these costs to the different buildings. For now, they have been allocated to administration, then allocated evenly. A cost allocation method should be developed that incorporates the purpose of the item, etc. 7. Administration (including Janet’s salary, which could be allocated separately) and the recreation building are allocated evenly to other buildings to assess performance. Program directors will want only those costs allocated that they can control if performance measurement is based on net surplus/deficit. The allocation of administrative items is done equally but could be based on actual costs if such records are maintained, or based on square footage, in proportion to budget, revenues, etc. The allocation will affect the decisions and assessment of funding, given the restrictions. For example, for Building A, CCS must return the surplus to the Ministry. For Building B, CCS must not generate a surplus or could lose the land to MacDougall, and so on. Building D—$60,000/3: $20,000 each. Administrative $433,000/3: $144,333 each. 8. Depreciation of the buildings is on a straight-line basis using an estimated life of 15 years. Furniture and fixtures for the nursing home are depreciated on a straight-line basis over five years. Depreciation of Building D is allocated equally to the other three buildings, Discussion This analysis indicates that the nursing home (Building A) is generating a surplus of $189,000. According to the terms of Ministry funding, this surplus will have to be paid back to the Ministry. This is the amount that was included in the projected cash flow for 2026 that was shown in Appendix II. However, the allocation of costs is an important issue in determining what the net operating surplus is. The method used in Appendix III simply allocated the common costs evenly across the three programs. This is not necessarily the best or most appropriate method to use. Indeed, it can be argued that a larger proportion should be allocated to the nursing home because it will likely be attracting a . C-52

Appendix C: Statement of Cash Flows

significant share of the common costs (nursing home patients may require more resources). The nursing home also generates more revenue than the other programs and incurs more expenses. These could also be bases for allocating the common costs. If allocation methods that allocate a larger proportion of the common costs to the nursing home can be used, the surplus would be smaller. It is clearly in the interests of CCS to make the surplus of the nursing home as small as possible. This objective can be achieved by allocating as much of the common costs to the nursing home as possible (while still meeting the Ministry’s requirements). Building B shows a deficit of $177,000. This means that the cost of operating Building B exceeds the monthly fee charged to occupants. To remedy this problem, it will be necessary to increase the monthly fee. Increasing the fee may be a serious problem because to cover the $177,000 deficit it will be necessary to increase the monthly charge to residents by $1,475, an increase of 268% over the proposed amount. If the units have not yet been sold, the purchasers will be aware of the monthly charge before deciding to buy. The problem will be more severe if the units have already been sold on the understanding that the monthly fee will be $550. In that case the residents may be unwilling or unable to pay the larger fee. Regardless, I think it is safe to say that a monthly occupancy fee of over $2,000 may be impossible to support. However, this raises some important management issues as to how CCS will operate properly. It certainly does not make sense that the retirement home sales units should be subsidized. This issue will have to be explored in more depth. The rental units in Building C show a surplus of $27,000. Under the terms of Mr. MacDougall’s donation, a surplus is not allowable, and so rent will have to be decreased by $150 per unit per month, a decrease of 38%. The Ministry may also need to agree to the definition of costs since they are providing an annual grant of $200,000. Like the nursing home, it will be in CCS’s interests to allocate more costs to the rental units and less to the sales units, if possible. Mr. MacDougall might also be approached to relax the conditions of his donation so that a surplus of some size would be allowable. Case 4: Enviro Ltd. Suggested solution: This memo presents an analysis of the company’s cash flow. The audited statements provided do not include the statement of cash flows. Having this additional statement would allow CFC to assess Enviro’s cash flow to a certain extent. However, simply adding a statement of cash flows is not the ideal solution. A future-oriented cash flow projection would be more useful. Cash flow analysis The qualitative observations confirm that a change has occurred in Enviro’s operating activities over the past couple of years. In order to assess the impact of this change on the cash position of the company, a cash flow analysis is necessary. Ideally, a cash flow projection should be prepared. However, the information necessary to prepare a projection is not available. In order to estimate Enviro’s normalized cash flow position, I have used the 2025 income statement as a starting point (in thousands of dollars):

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Opening reported net income

270

Adjustments: Depreciation (non-cash item)

950

Non-recurring gain—securities

(360)

Non-recurring gain—land

(1,105)

KB’s equity pickup

(1,260)

Changes in working capital: Increase in inventory

(2,540)

Increase in accounts payable and other liabilities

2,145

Other—net (A/R and prepaids)

(175)

Estimated cash flow from operating activities

$ (2,075)

Cash flow generated from operating activities is negative. Investing and financing activities also affect cash and should be taken into account in the estimated cash flow: WDC’s capitalized expenditures $ (751) Other investing—net (securities/land/B&E/development/ goodwill) 2,056 Dividends on preferred shares (11% of $4 million) (440) Other financing—net (bank loans/mortgage) 1,120 Estimated cash flow from investing and financing activities $1,985 Estimated cash flow “generated” in 2025 ($1,985 – $2,075)

$ (90)

I have assumed that the 2026 cash flow, after investing and financing activities, will be similar to 2025 and thus will also be negative. Additional cash flow drains in 2026 will be the repayment of the mortgage of $2.3 million and the notes payable of $4 million, and the purchase of the disposal equipment for $7 million. When the possibility of the federal government contract of $1.875 million not being renewed is factored in, the negative cash flow increases to over $17 million. Even if Enviro’s government contract is renewed and it is able to sell off some of the inventory (say, $3 million), thus returning to the 2023 level, Enviro will have to obtain at least $14 million in financing to cover its cash flow requirements. If $10 million is obtained from CFC, that still leaves $4 million to be financed. In 2027, Enviro will have to cover the repayment of the bank term loan of $2.5 million. The company will undoubtedly be looking to refinance the loan. Overall, the cash flow analysis shows that Enviro may have some difficulty obtaining the funds it needs to repay its debt, and without refinancing it may no longer be a going concern. Enviro’s negative cash flow from operating activities is not indicative of a strong company.

. C-54

Appendix C: Statement of Cash Flows

Case 5: Statement of Cash Flows. Suggested solution: 1. Net income as reported on the income statement is the normal starting point for preparing the statement of cash flows using the indirect method. While you do not have the income statement, sufficient other information has been provided to you to determine net income. In this respect, the balance sheet details the opening and closing balances of the retained earnings account and you have been given the amount of dividends that were declared. You know that opening retained earnings, plus net income, less dividends declared, equals closing retained earnings. It is therefore a simple manner to solve for 2024’s net income as set out in the table that follows: Transactions affecting the retained earnings account 5% stock dividend Dr. Retained earnings Cr. Common shares (20,000 × 5% × $10) Cash dividend Dr. Retained earnings Cr. Cash

10,000

18,000

10,000

18,000

Retained earnings 22,000 10,000 18,000 37,000 31,000

Balance 12/31/2023 Stock dividend Cash dividend Solve for net income Balance 12/31/2024

2. There are a number of preliminary calculations required before you can prepare the statement of cash flows. These are set out in the tables that follow: Extinguishment of Debt Amount paid Bond carrying value 12/31/2023 Loss on retirement of bonds

($150,000 × 0.99) + $10,000

Convertible bonds The fair value of the bond at issuance is determined using discounted cash flow analysis. Interest - PVFA (8.0%, 5) = 3.99271; $150,000 × 9% = $13,500 × 3.99271 Principle - (8.0%, 5) = 0.68058; $150,000 × 0.68058 Fair value of bond = $53,902 + $102,087 Fair value of conversion rights at issuance Proceeds from the bond issue

$158,500 146,500 $ 12,000

$ 53,902 102,087 155,989 25,000 $180,989

Or using a BAII PLUS financial calculator: 5N, 8.0 I/Y, 13,500 PMT, 150,000 FV, CPT PV = –155,989 (rounded); $155,989 + $25,000 = $180,989 Bond amortization Interest payment in 2024 Interest expense in 2024 Amortization of premium

$150,000 x 9% $155,989 x 8%

. C-55

$13,500 12,479 $ 1,021

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Edition

Reconciliation Issue price 01/01/2024 Less: amortization of premium Book value 12/31/2024

$155,989 1,021 $154,968 Common shares 200,000 10,000 20,000 230,000

Balance 12/31/2023 Stock dividend Solve for issuance of shares Balance 12/31/2024

Accumulated depreciation 125,000 25,000

Balance 12/31/2023 Accumulated depreciation on equipment sold (given) Solve for 2024’s depreciation expense Balance 12/31/2024

50,000 150,000 Plant assets 380,000 30,000 100,000

Balance 12/31/2023 Cost of equipment sold (given) Solve for assets purchased in 2024 Balance 12/31/2024

450,000

Determination of the proceeds from the sale of plant assets Gross book value (given) Less: Accumulated depreciation (given) Plus/minus gain or loss on sale (given) Proceeds from sale

$30,000 25,000 0 $ 5,000

Investments Both investments are reported at fair value on the balance sheet.  The unrealized gain of $1,500 on the investment in Prot-In is reported in net income.  The unrealized gain on $2,000 on the investment of ProBar is reported in other comprehensive income and as such is not included on the statement of cash flows. StrongBar Ltd. Statement of Cash Flows For the year ended December 31, 2024 Cash flow from operating activities Net income Adjustments for: Depreciation Unrealized gain on at fair value through profit or loss securities Amortization of bond premium Loss on debt retirement . C-56

$37,000 50,000 (1,500) (1,021) 12,000

Appendix C: Statement of Cash Flows

96,479 Increase in accounts receivable Decrease in inventory Decrease in prepaid expenses Increase in accounts payable Decrease in accrued liabilities Decrease in deferred income taxes Net cash flow from operating activities

(18,000) 14,000 3,000 7,032 (1,000) (3,000)

Cash flow from investing activities Purchase of plant assets Sale of plant assets Cash used in investing activities

(100,000) 5,000

Cash flow from financing activities Cash dividends paid Issuance of convertible bonds Retirement of bonds Issuance of common shares Cash from financing activities

(18,000) 180,989 (158,500) 20,000

Net increase in cash Cash, January 1, 2024 Cash, December 31, 2024

$98,511

(95,000)

24,489 28,000 41,000 $69,000

3. If StrongBar classified its dividend payments as an operating activity, then the $18,000 cash outflow would be reported in the operating activities section instead of in the financing activities section. As a result, the cash flow from operating activities would be reduced by $18,000 to $80,511. Total cash flow would remain unchanged; however, as cash flow from financing activities would increase $18,000 to $42,489. 4. If investors are unaware of the choices available to companies with respect to the classification of interest and dividends received and paid and income taxes paid then they may misinterpret the magnitude of the largely non-discretionary core cash flow arising from operating activities. For example, in our case, when the company classified the dividends paid as a financing activity, it appears that StrongBar’s $98,511 cash inflow from operations was sufficient to wholly finance its net investment outflows of $95,000. However, had it classified the dividend paid as an operating activity, then this would not seem to be the case. Misinterpreting the source of these types of cash flows should not be an issue, though, as the nature of the choices made by the companies is readily evident given the requirement to separately disclose interest and dividends received and paid and income taxes paid.

. C-57

Appendix E Case Solving and Comprehensive Cases Case 1: Cineplex Inc. Suggested Solution: The typical accounting student is not qualified to provide investment advice; therefore, their response should include a caveat to this effect. Business Prospects The main objective of financial statements is to provide information useful for investment and lending decisions. While closure of DVD stores improves the future prospects for Cineplex, there are other sources of competition such as Netflix that could erode future profits. It is likely that current financial performance reflects the benefit of DVD store closures since it happened several years ago, but overstates the future performance if profits should erode due to competition in the near future. Students should recognize that any benefit from the closure of DVD stores will be reflected in share price by now, therefore this alone would not be a good basis for investing in Cineplex. Qualitative characteristics While Goodwill and PPE represent material and relevant numbers, the PPE is likely to better achieve representational faithfulness than Goodwill. This is aided by the neutrality, understandability, and verifiability of the PPE based on information available at the originating transaction as well as its current value. The film rental cost may not exhibit the characteristic of neutrality since its value is estimated by management; who appears to have an incentive to understate operating expenses. Since December is one of the peak months and also the year-end, this estimate could be material, and therefore a concern. This is one example of accruals to record events as they occur rather than when cash is paid. The gift card system presents another example of the need for accruals since in this case the cash is received before earned. The liability for this item also requires significant estimation, reducing its neutrality. The estimation is at year-end, which makes it material. Change in accounting standard for leases Students should contemplate the standard setting process to first understand why lease accounting is under revision. A user’s perspective suggests it is creditors who have demanded stricter rules for recognition of finance leases so that they might get more completeness in the reporting of liabilities, thereby improving representational faithfulness. This is consistent with the fundamental objective of financial reporting, being to help potential investors, lenders, and other creditors make decisions about providing resources to the entity. The new accounting standard improves information on claims against the entity. However, this standard is likely to have economic consequences to Cineplex and to the economy in general. Firms that have structured their leases to keep them off the balance sheet may begin entering into suboptimal . E-1

ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Canadian Edition

contracts (or arguably even less optimal then current ones) to avoid recognition on their balance sheet. They may alternatively curtail some operations that require the leasing of assets, in order to avoid reporting capital leases. Firms that keep large amounts of leases off their balance sheet are likely involved as much as constituents can be in standard setting process. Executive compensation Moral hazard creates a need for a compensation contract that aligns the CEO motives with those of shareholders. The contract described in this case reflects elements the Board of Directors felt would align incentives, such as share ownership and a bonus based on profits and income. While the targets should reduce moral hazard overall, they may also influence the CEO to spend too much time and effort achieving the specific targets, resulting in suboptimal choices. For example, one way to increase concession revenue is to decrease the price of tickets in their Food & Drink Combo. Another downside to having a bonus based on net income may be an increase in biased reporting in order to report numbers which earn him his bonus. Case 2: Canada Post Suggested Solution: The student is in the role of an audit senior, therefore should focus on financial reporting issues. It is not appropriate, for example, to discuss business strategies (such as suggesting a change in product mix away from rural deliveries to the more lucrative Purolator deliveries) except to the extent they may represent audit risks. Part a. Revenue recognition : Stamp revenue Students could evaluate the valuation creation process according to Exhibit 4-1. Stamp revenue offers an interesting version of the process, in particular because: − Point 7 (complete cash collection) happens before Point 5 (time of sale or delivery) − Point 9 (expiry of the warranty) happens after Point 5 rather than Point 7 Students could evaluate stamp revenue from the perspective of the five steps prescribed by IFRS 15—Revenue from contracts with customers (see Chapter 4 Section B). The five steps are as follows: 1. Identify the contract with the customer. 2. Identify the performance obligations. 3. Determine the transaction price. 4. Allocate the transaction price to performance obligations. 5. Recognize revenue in accordance with performance. For stamp revenue, Steps 1 – 4 are fairly straightforward, while Step 5 require further discussion. Step 2: A portion of stamp sales never results delivery activity as they are held for collection or lost. Canada Post would be able to recognize a portion of stamp sales over time for this portion of stamp sales. Step 4: Stamps are sometimes held for long periods of time, especially now they are issued at “no value” (i.e., is always accepted at current postal prices) such that, the longer the customer . E-2

Appendix E: Case Solving and Comprehensive Cases

holds a stamp, the higher the cost to deliver the letter, based on increasing postal worker wages. Therefore, while the cash received for a stamp is certain, the timing and cost of the performance obligation remains uncertain until these stamps are used. Canada Post needs to estimate these parameters when deciding how much stamp revenue to recognize in a given reporting period (due to the need for periodicity). Fortunately, they have many years of history behind them to assist in this. Step 5: stamp revenue relates to a performance obligation that is satisfied over a period of time. IFRS 15 paragraph 35 states that revenue can be recognized when one of the following three criteria are met: a. “the customer simultaneously receives and consumes the benefits” of the service; b. “the entity’s performance creates or enhances an asset that the customer controls"; or c. “the entity’s performance does not create an asset with an alternative use and the entity has an enforceable right to payment for the performance completed to date.” For non-registered mail, Canada Post would satisfy it performance obligation under criterion (a) once the letter/parcel is dropped off in a mailbox or post office, because delivery is not guaranteed. i.e., the stamp fee is used up regardless of whether delivery occurs. For registered/tracked mail, Canada Post would satisfy criterion (a) when the letter/parcel has been delivered and acknowledged by the recipient. Delivery satisfies criterion. Revenue recognition : other Revenue recognition on the other items in the case is straightforward. The pension gains/losses are based on actuarial valuation conducted at year-end, and the gains on sale of property are recognized when the transactions take place. Part b. User perspective This is a type of organization that is not very well served by accounting standards for several reasons: − The users are not investors or creditors − Students should consider who the users are, such as politicians, taxpayers, news media, and Canada Post’s labour union; however, as with investors and creditors these users want a depiction of resources, claims against the entity, and entity performance. − Their public service requirement makes it likely they will incur losses on a continual basis; due to federal support they are a going concern in spite of their performance, and are not as constrained by the requirement of financial capital maintenance as regular corporations − The financial statements do not readily serve as a measure of management performance; a better metric would be cost minimization, customer satisfaction, or some type of evaluation relative to peers Students may want to discuss whether Canada Post should use Public Sector Accounting rules instead of IFRS, and why.

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ISM for Lo/Fisher, Intermediate Accounting, Vol. 1, Fifth Canadian Edition

It would be unreasonable to have specific accounting standards that meet the need of such a small set of users like Canada Post. This is an example of the cost/benefit tradeoffs in standard setting, Part c. Class-action lawsuit. Although contingencies are not discussed until Chapter 11, students should be able to ascertain that the lawsuit leads to a liability because it is: − A present obligation of the entity − Arising from past events − The obligation requires a transfer of economic resources (Although the case is not set at a particular date, in actuality, Canada Post paid over $5million to settle this lawsuit in January, 2015.) A point to discuss is how this item might be recognized from the perspective of periodicity and cut-off. If Canada Post was aware of the lawsuit before year-end, a liability should be recorded in the financial statement. The measurement of the liability could be based on information in the subsequent-events period, if this information is more accurate. Alternatively, if the event occurred within the subsequent-events period and is material, it should be disclosed. Case 3: Electronic Arts Inc. Suggested Solution: Note: Although the company reports using U.S. GAAP, applying IFRS to the case does not materially change the analysis. There are many cost allocation decisions and estimations made in preparing EA’s financial statements, and these can significantly affect reported performance, even at the profit margin level. Revenues: Since some of their products are sold to retailers (the disks, in particular) therefore this firm has the potential for channel stuffing, which could overstate revenues and understate inventories. Multiple deliverables / performance obligations: When EA sells a good that has both a product and service element, management must allocate the revenue between the two. This is subjective, and can lead to measurement issues. The notes to EA’s financial statements state that, “ For Games with Services, generally 75 percent of the sales price is allocated to the software license performance obligation and recognized at a point in time when control of the license has been transferred to the customer (which is usually at or near the same time as the booking of the transaction). The remaining 25 percent is allocated to the future update rights and the online hosting performance obligations and recognized ratably as the service is provided (over the Estimated Offering Period). ” (source: EA 2020 Annual Report, page 53). Research and Development: The capitalization of software development costs to an asset contains subjectivity. In particular, the labour portion of may be difficult to estimate, and . E-4

Appendix E: Case Solving and Comprehensive Cases

management may have some latitude in its estimation. This could lead to expenses being understated (overstated) if too much (too little) is capitalized in the asset. The asset would also be correspondingly misstated. Once the product is available for sale, management must amortize this asset, but it is difficult to estimate the expected future revenue stream against which they need to match costs, both in terms of how long the game will sell, and the pattern of revenues. Cash and cash equivalents: there is not much to say about this. Deferred revenue: the cost of updates and the time span until they are completed is difficult for management to estimate. Based on their annual report, EA’s practice is to defer revenues over six to nine months (source: EA 2020 Annual Report, page 55). Inventory: • EA does not report their basis for assigning inventories to cost of goods for income statement purposes (i.e., LIFO, FIFO, etc.) Students may want to discuss how alternative policies would affect the financial statements. • While the cost of materials can be traced to units sold, these are minimal. The bulk of the cost is from software development and royalties, where development here is not R&D. Unlike manufacturing firms, where overhead has a direct relationship with production, software development and royalties have no capacity limits that affect the number of units one can allocate overhead to in absorption costing. This makes it difficult to get an accurate allocation, and could facilitate certain earnings management practices, such as overproducing inventories to meet earnings targets (by reducing the unit value of cost of goods sold). • Obsolescence is a frequent occurrence in this industry, as older games can quickly go out of demand. Investments: • AE fully owns all its investments. There is no minority interest on their financial statements. This means all the assets, liabilities, income, and revenues of subsidiaries are included in AE’s consolidated figures. It also means there is a significant amount of Goodwill (representing 17% of total assets in 2020). • The client is not likely to be acquiring strategic investments in equities in the near future. Non-strategic holdings (less than 20%) are more likely, and would result in the client reporting them as “held for trading” or “available for sale” in their balance sheet. EA’s current short-term investments are classified as available-for-sale / FVOCI. (source: EA 2020 Annual Report, page 51.) Students can expand on the IFRS 9 rules for reporting these.

. E-5

INSTRUCTOR’S RESOURCE MANUAL Ann-Marie Cederholm Capilano University

Intermediate Accounting Volume 1

Fifth Edition Kin Lo

University of British Columbia

George Fisher Douglas College

Contents

Preface

.................................................................................................................... iii

Volume 1 Chapter

Fundamentals of Financial Accounting Theory .......................................... 1

Chapter

Conceptual Frameworks for Financial Reporting ....................................... 4

Chapter

Accrual Accounting .................................................................................... 8

Chapter

Revenue Recognition ................................................................................ 13

Chapter

Cash and Receivables ............................................................................... 18

Chapter

Inventories................................................................................................. 23

Chapter

Financial Assets ........................................................................................ 29

Chapter

Property, Plant, and Equipment ................................................................ 34

Chapter

Intangible Assets, Goodwill, Mineral Resources, and Government Grants ........................................................................................................ 40

Chapter 10

Applications of Fair Value to Non-Current Assets ................................... 45

Appendix A

Financial Statement Analysis and Using Accounting Information to Value a Company ................................................................................................ 50

Appendix B

Data Analytics ........................................................................................... 55

. ii

Preface

Intermediate accounting involves a significant jump in depth and breadth of material relative to introductory accounting. The quantity and difficulty of some of the topics can be overwhelming for both students to understand and for instructors to deliver. This text takes into account these significant challenges by (i) using straightforward language, (ii) streamlining as much as possible the content within and between chapters, and (iii) helping students understand the “why” behind the “how” of accounting. At the beginning of each chapter in the text is a section titled “CPA competencies addressed in this chapter.” This is a helpful guide to illustrate which CPA competencies are addressed throughout each chapter. Essential to (iii) are the first three chapters, which lay out a number of threshold concepts. (In the remainder of this resource manual, these threshold concepts will be in bold font.) Chapter 1 introduces students to the fundamentals of financial accounting theory. While many accounting programs examine financial accounting theory in some depth, this coverage usually occurs near the end of the program. While Chapter 1 does not replace an entire course on accounting theory, students will benefit from being introduced to financial accounting theory at the beginning of intermediate accounting so that they can see its application in various contexts. Chapters 2 and 3 build on the foundation provided in the first chapter. Chapter 2 explains the conceptual frameworks for financial reporting in the context of the supply and demand of information, a concept that naturally follows from Chapter 1. Chapter 3 then leads students to understand the more specific way that we prepare financial reports— using accrual accounting. This chapter emphasizes that the issue of timing in accrual accounting is not just a minor issue, but rather that timing is everything. The remaining chapters in Volume 1 (4 through 10) then go through specific issues relating to the four key financial statements. Chapter 4 covers revenues and expenses, and revenue recognition for contracts. The remainder of Volume 1, Chapters 5 to 10, covers the asset side of the balance sheet. There are four appendices that can be used to either supplement, or use on an individual basis for intermediate financial accounting. Appendix A focuses on Financial Statement Analysis and Using Accounting Information to Value a Company. Appendix B focuses on Data Analytics. Appendix C focuses on the Statement of Cash Flows. Appendix D focuses on the Time Value of Money. Appendix E focuses on Case Solving and Comprehensive Cases. Appendix F provides the Canadian Tire Corporation 2019 Consolidated Financial Statements. . iii

To help manage the volume of material, the following tables provide suggested time allocations for the various chapters, assuming one 13-week course covers one volume. Suggested time allocations for Volume 1 (scenario 1) Chapter 1 2 3 4 5 6 7 8 9 10 — — Total

Title Fundamentals of Financial Accounting Theory Conceptual Frameworks for Financial Reporting Accrual Accounting Revenue Recognition Cash and Receivables Inventories Financial Assets Property, Plant, and Equipment Intangible Assets, Goodwill, Mineral Resources, and Government Grants Applications of Fair Value to Non-Current Assets Time for instructor-specific emphasis Exams, quizzes, administration, public holidays

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Portion of course 7.7% 7.7 7.7 11.5 5.4 7.7 10.0 11.5

Duration (weeks) 1.0 1.0 1.0 1.5 0.7 1.0 1.3 1.5

7.7 7.7 7.7 7.7 ~100%

1.0 1.0 1.0 1.0 13.0

Suggested time allocations for Volume 1 (scenario 2) Chapter 1 2 3 4 5 6 7 8 9 10 — — Total

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Portion of course 7.7% 7.7 7.7 11.5 7.7 7.7 7.7 11.5

Duration (weeks) 1.0 1.0 1.0 1.5 1.0 1.0 1.0 1.5

7.7 7.7 7.7 7.7 ~100%

1.0 1.0 1.0 1.0 13.0

STUDENT HANDOUT Tips on how to use the resources and online tools to get an A in this class: ■

READ the chapter. Yes, I know it can be challenging, but it is important to spend at least 30-60 minutes thoroughly reading each chapter.

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PRACTISE homework online. Sure, it makes sense when your professor goes over the assignment—they have been doing this for a long time. There is no substitute for doing problems/exercises. That is how you learn accounting. And the online homework assignments are algorithmic, so they are already set up for you to practise problems until you “get it.”

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STUDY in groups. Creating study groups is a great way to expand your learning. These groups will not only increase your number of resources to go to for help, but they also create a sort of accountability that will help keep you on track for success.

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Learn WHY as well as HOW. Sure, the “how” to do it is a big part of accounting, but if you can learn why you are doing a particular accounting task, it will be much easier to perform the task.

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RELATE topics to your personal life or job. The best way to ensure you understand a topic is to apply it to your life or job.

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ASK questions. When online, use the “Ask my instructor” button to ask specific homework questions at the point you have them. Also, ask questions while in class. You are most likely not the only one who may not understand a topic or concept. Your questions help you and other students learn.

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Tips for Taking Your Course from Traditional to Hybrid, Blended, or Online 1. It is recommended that you do not take the “entire” course online in one semester. Decide on a two-semester strategy for implementation, implementing graded online homework FIRST. By only implementing the homework portion of the online solution, you do not overwhelm yourself with having to learn every piece of the online component in one semester, regardless of whether it is MyLab Accounting or some other solution. Additionally, this allows you the flexibility to add other graded assignments later that first semester, if you choose. 2. Define homework by chapter in your syllabi, rather than identifying specific exercises or problems. During the first semester, as you and your students get accustomed to the online resources, you may need to be more flexible. Further, this gets your students used to looking “online” for their assignments. 3. Schedule one day in class in a computer lab (or some class time, if you are not able to use a computer lab), to demonstrate. This allows you to gain a “captive audience” so that you can show the class some of the resources you want them to use. It also allows you to highlight some of the resources that they may find useful in their learning. 4. Use MyLab’s static/bookmatch problems to demonstrate in-class problems or exercises. This is a good way to not only save you time in setting up in-class assignments, but it also demonstrates to the student the completion ease of the MyLab homework solution. You can set up a “static” course that has all the bookmatch problems in it and use that course for demonstrating this in class. 5. The first assignments I give after demonstrating the online login/registration are submitted via their online e-mail account. For this, I use the e-mail students option from the gradebook. I submit their first assignment via e-mail to try in myaccountinglab.com. This is a “bonus” points only assignment; the students are eager to try online tools (no penalty—only bonus point reward) and it gets them registered more quickly in myaccountinglab.com. I suggest using something like the built-in pre-test chapter questions. 6. Have students give each other feedback. One of the problems with teaching online is that giving feedback to all of your students all the time can quickly get out of control. The way to deal with this is to have students give the initial drafts of their papers to other students for feedback. You give a grade to the feedback based on how helpful the original author finds it. Then you only have to review papers one time, and many of the problems should be worked out before you see them. 7. Set up discussion forums. You might, for example, ask a critical thinking question on one of the key chapter topics. Your students will have a certain amount of time to (1) post an answer to your question, and (2) post a response or comment on the answer of another student. You can offer extra credit for the “best” response. Alternatively, you might ask students to answer one of the end-of-chapter or additional online questions/case problems within a set period of time. The first one to respond can get an extra credit point. The first student who “adds value” to the answer can also get an extra point.

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CHAPTER 1 Fundamentals of Financial Accounting Theory

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.1 Evaluates financial reporting needs (Level B) 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) 1.1.3 Evaluates reporting systems, data requirements, and business processes to support reliable financial reporting (Level B) 1.2.1 Develops or evaluates appropriate accounting policies and procedures (Level B)

LEARNING OBJECTIVES 1-1. Explain the sources of demand and supply of accounting information. 1-2. Apply concepts of information asymmetry, adverse selection, and moral hazard to a variety of accounting, management, and related situations. 1-3. Describe the qualitative characteristics of accounting information that help to alleviate adverse selection and moral hazard. 1-4. Evaluate whether and what type of earnings management is more likely in a particular circumstance. 1-5. Explain how accounting information interacts with security markets.

OVERALL APPROACH Students often say that accounting theory is boring and irrelevant. At the same time, they continuously express curiosity about why we account for particular transactions in particular ways. These sentiments reflect a separation between accounting theory and practical reality, at least in students’ minds. Students want to understand “why,” and accounting theory can provide many of those answers, but unfortunately students are often not exposed to theory until the end of their accounting programs. To reconcile these two conflicting sentiments, this opening chapter introduces students to the foundations of financial accounting theory in a way that is approachable and applicable to situations with which they will be familiar. The opening vignette highlights the importance of theory in the context of a sailing trip and lays out the general approach of the textbook. This vignette augments the flowchart in the front matter and the imagery of the book cover.

KEY POINTS The chapter begins with a brief discussion of the supply and demand for information. This is a straightforward idea that is approachable by post-secondary students. It is a .

Chapter 1 threshold concept that opens up students’ perspective of what accountants do, and it leads naturally to two other threshold concepts in this chapter (decision making under uncertainty and information asymmetry) and the conceptual framework in Chapter 2. It is important to establish the idea of uncertainty at the beginning of intermediate accounting. Most students coming out of introductory accounting have the impression that accounting is very precise with only one correct answer. Indeed, many students say they choose to major in accounting as opposed to another field in business because they like the certainty in accounting. To dispel this misconception, it is important to stress that there is a considerable amount of uncertainty in accounting, thus professional judgement is needed. First, there is inherent uncertainty in making decisions, because decisions involve the future. The need to make decisions with uncertain outcomes generates the demand for information. Second, useful accounting information is not just backward-looking, but it also includes estimates about the future. In particular, accrual accounting (to be explored in Chapter 3) includes estimates for future bad debts, the value of inventory in terms of sales in the future, useful life for equipment, etc. The concept of information asymmetry can seem foreign to many students, so the chapter deliberately links this concept with the well-understood idea of supply and demand. It is important to note that it is information asymmetry that drives the supply and demand for financial reporting. Therefore, information asymmetry is a fundamental concept that needs to be understood. The chapter goes on to discuss two types of information asymmetry: adverse selection and moral hazard. The words in these terms are not very intuitive. To make these concepts approachable, the chapter first provides examples of these concepts before formally defining them. The financial crisis of 2008 provides a powerful illustration of moral hazard, as discussed on page 8. The two types of information asymmetry lead to two desirable characteristics (relevance and reliability), which will be explored in more detail in the conceptual framework in Chapter 2. Importantly, the presence of both adverse selection and moral hazard means that both relevance and reliability are desirable, thus trade-offs between them are a necessary consequence. The presence of uncertainty results in a diversity of accounting choices in the form of accounting policies and estimates. Combined with information asymmetry, insiders have the opportunity to exploit their information advantage through their accounting choices. These choices have economic consequences (affecting bonuses, borrowing rates, labour relations, etc.) and this can lead into a discussion about earnings management. When students understand that accounting choices have economic consequences, they appreciate the importance of such accounting choices. Otherwise, accounting choices will seem to be arbitrary decisions that have no consequences outside of the accounting reports.

Chapter 1 The final section of this chapter discusses the interaction between accounting and securities markets. Accounting not only informs the securities markets, but market prices also affect how we do accounting. The concept of efficient securities markets appears here, and it is important for students to recognize when this concept is applicable and when it is not.

USE OF END-OF-CHAPTER PROBLEMS AND CASES In addition to lectures, discussion of some of the end-of-chapter problems and cases will help students apply the concepts. The following table identifies all of the problems and cases that can be used in class, and problems and cases that can be used for homework assignments. (Depending on the time allocation between lectures and examples, it may not be feasible to cover all of the suggested items.) Table 1-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 1-1. Explain the sources of demand and 16 P1-2 P1-1 supply of accounting information. P1-3 1-2. Apply concepts of information 16-19 P1-4 P1-5 asymmetry, adverse selection, and P1-8 P1-6 moral hazard to a variety of P1-9 P1-7 accounting, management, and related P1-11 P1-10 situations. P1-12 P1-16 1-3. Describe the qualitative characteristics 18-21 P1-18 P1-15 of accounting information that help to P1-22 alleviate adverse selection and moral hazard. 1-4. Evaluate whether and what type of 20-21 P1-19 P1-20 earnings management is more likely in P1-21 a particular circumstance. 1-5. Explain how accounting information 21-22 P1-24 P1-23 interacts with security markets. P1-26 P1-25 — Integrative 23-26 Case 3 Case 1 Case 2 Case 4 Problem P1-14 (p. 18) can be a fun exercise to conduct in class to illustrate adverse selection. Using a real deck of playing cards would be most helpful. Case 3 involves in-substance defeasance of long-term debt. Being that this is a difficult case, students may not be sufficiently prepared to analyze it by themselves, so guided classroom discussion is encouraged.

CHAPTER 2 Conceptual Frameworks for Financial Reporting

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.1 Evaluates financial reporting needs (Level B) a. Framework of standard setting b. Financial statement users and their broad needs, standard setting, and requirement for accountability c. Objectives of financial reporting 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) a. Fundamental accounting concepts and principles (qualitative characteristics of accounting information, basic elements) b. Methods of measurement c. Standard setting process 1.2.1 Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B)

LEARNING OBJECTIVES 2-1. Explain the role of a conceptual framework for financial reporting and the reasons for having conceptual frameworks. 2-2. Explain the rationale for each of the eight major components of these frameworks and synthesize these components into an integrated whole. 2-3. Apply the conceptual frameworks in IFRS and ASPE to specific circumstances and evaluate the trade-offs among different concepts within the frameworks. 2-4. Describe the standard-setting environment in Canada.

OVERALL APPROACH The overall objective of financial reporting is to provide useful information to financial statement users. When determining what is useful, we need to consider what information is important to financial statement users. Conceptual frameworks help to identify and organize concepts that are important. Conceptual frameworks are an important set of foundational concepts in intermediate financial accounting. Many of the terms, concepts, and principles covered in this chapter provide a foundation for upcoming chapters. Students often struggle with this chapter because conceptual frameworks are a set of concepts rather than concrete objects. This chapter builds on the ideas of supply and demand for information as discussed in Chapter 1. This chapter describes conceptual frameworks (there is more than one, such as

Chapter 2 one for IFRS, one for ASPE) as business plans that lay out the demand for financial information and how accounting should supply information that responds to that demand. Since supply and demand should be second nature to accounting / business students, this linkage makes conceptual frameworks understandable. Another benefit of portraying conceptual frameworks as business plans is that doing so makes apparent that more than one framework can be valid, and that these frameworks are not set in stone—they can and do change over time.

KEY POINTS The chapter focuses on the concept of supply and demand for information as discussed in Chapter 1. The chapter focuses the discussion using the conceptual framework in IFRS. Exhibit 2-9 (p. 45) provides a summary comparison of the conceptual frameworks in IFRS and ASPE. Similar to many other business situations, it is useful to separately analyze the demand and the supply. From the standpoint of accounting standard setters and financial statement preparers, the demand for information is external and largely out of their control. The supply side, on the other hand, is more directly managed by accountants. The diagrams in Exhibits 2-1 (p. 29), 2-2 (p. 30), and 2-3 (p. 31) convey this separation and other logical connections among the eight major components of the IFRS Framework. In particular: ▪ ▪ ▪

The five supply side components are encased in an arrowhead pointing toward demand to show the need to have supply meet demand. Constraints can be thought of as limits, so the diagrams position them at the top. Meanwhile, underlying assumptions are positioned at the bottom. Constraints and assumptions are positioned on the periphery; while they are important considerations, they are not at the “core” of what accountants do. The core involves the elements of the financial statements, recognition, and measurement.

Once the IFRS Framework has been introduced in the context of supply and demand, the remaining details of the framework flow naturally. Section C is new to this edition. Current accounting standards use a mixedmeasurement model that includes applications of historical cost, current cost, fair value, and value in use/fulfillment value. This section provides a high-level examination of the various costs’ effects on the balance sheet and income statement using a numerical example, with the results of the example summarized in Exhibit 2-7 (p. 42). Entry and exit values are discussed, and Exhibit 2-8 (p. 44) summarizes the treatment of transaction costs under the four measurement bases. Deeper exploration of the various measurement bases will be provided when specific financial statement 5 .

Chapter 2 items are examined in later chapters, shown in the table at the end of the section on page 44.

Section E provides a description of the standard-setting process internationally and in Canada. In this context, it is important to distinguish a publicly accountable enterprise from a private enterprise, particularly because the latter term has a more restrictive meaning in accounting than in business and economics. Exhibit 2-10 (p. 47) provides an illustration of the standards that are applicable to different types of reporting entities. Exhibit 2-11 (p. 48) provides an excellent illustration of the structure of standard setting in Canada.

USE OF END-OF-CHAPTER PROBLEMS AND CASES In addition to lectures, discussion of some of the end-of-chapter problems and cases will help students apply the concepts. The following table identifies all of the problems and cases that can be used in class, and problems and cases that can be used for homework assignments. (Depending on the time allocation between lectures and questions, it may not be feasible to cover all of the suggested items.) Table 2-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 2-1. Explain the role of a conceptual 59 P2-1 P2-2 framework for financial reporting and the reasons for having conceptual frameworks. 2-2. Explain the rationale for each of the 59-62 P2-5 P2-3 eight major components of these P2-9 P2-4 frameworks and synthesize these P2-10 P2-6 components into an integrated whole. P2-12 P2-7 P2-13 P2-8 P2-11 2-3. Apply the conceptual frameworks in 62-65 P2-14 P2-15 IFRS and ASPE to specific P2-16 P2-17 circumstances and evaluate the tradeP2-18 P2-19 offs among different concepts within P2-22 P2-20 the frameworks. P2-23 P2-21 2-4. Describe the standard-setting 66-68 P2-27 P2-31 environment in Canada. P2-28 P2-33 P2-30 P2-34 — Integrative 69-73 Case 1 Case 2 .

Chapter 2 Case 5

Case 3 Case 4

Case 1 (p. 69) presents scenarios that a public financial institution is facing. Students are asked to provide arguments, using ideas from the conceptual framework in IFRS, to address concerns that are raised by the Ontario Securities Commission. Case 5 (p. 73) is a practical question that looks at a public company that is considering whether to acquire a private company. Students are asked to consider the reporting requirements for a private company and to explain the qualitative characteristics that will help to meet the needs of the financial statement users.

CHAPTER 3 Accrual Accounting

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.1 Evaluates financial reporting needs (Level B) b.

Financial statement users and their broad needs, standard setting, and requirement for accountability

1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) c.

Difference between accrual accounting compared to cash accounting

1.2.1 Develops or evaluates appropriate accounting policies and procedures—Ethical professional judgement (Level B) 1.2.2 Evaluates treatment for routine transactions (Level A) o.

Changes in accounting policies and estimates, and errors

1.2.2 Evaluates treatment for routine transactions (Level A) r.

Events after the reporting period

1.3.1 Prepares financial statements (Level A) a.

The accounting cycle

LEARNING OBJECTIVES 3-1. Explain the source of demand for periodic reporting and how accrual accounting satisfies that demand. 3-2. Explain why accrual accounting is fundamentally inexact, why estimates are central to accrual accounting, and why there is no “true” income for typical situations; evaluate the “quality of earnings.” 3-3. Apply accrual accounting in relation to issues of timing: periodicity, cut-off, and subsequent events. 3-4. Evaluate whether an accounting change is an error, a change in accounting policy, or a change in estimate, and apply the retrospective and prospective treatments appropriate to that type of accounting change. 3-5. Integrate the structure and connections among the four financial statements and explain how this structure relates to accrual accounting.

Chapter 3

OVERALL APPROACH Chapter 3 plays a crucial role in this textbook—it is the transition between the more theoretical and conceptual ideas in the first two chapters and the practical implementation of those ideas in the form of financial statements prepared under the accrual basis. As a transition, the chapter begins with the conceptual understanding of accrual accounting and the consequences of using accrual accounting (approximation and the need for estimates), followed by important practical issues related to the use of reporting periods: cut-off, subsequent events, and accounting changes. Finally, the chapter provides an overview of the periodic financial statements that result from the accrual accounting system. The presentation requirements of IFRS are the focus of this discussion.

KEY POINTS From introductory accounting, students know that the accepted basis of accounting is the accrual basis; however, many students may not know why. The conceptual framework refers to the accrual basis and asserts that this basis is superior to the cash basis of accounting, but the framework does not elaborate on the reasons for this assertion. The first part of this chapter does so by going through a brief history of accrual accounting and the role played by the creation of indefinite-life corporations such as the Dutch East India Company. The example of the Hudson’s Bay Company solidifies the point with a company that is widely known in Canada. The threshold concept that relates to accrual accounting is timing of recognition. Timing is very important in accrual accounting because accruals are deviations from the timing of cash flows, so the key judgment in accrual accounting is when to recognize a transaction in the accounting system. Following the discussion of the Dutch East India Company, Section B of the chapter uses an example of Tradewinds Company to compare and contrast the results of accrual and cash accounting. Intentionally, this is not the easiest example to illustrate the differences between the two accounting systems; the moderate level of complexity serves to review some of the basic accruals that students should have learned in introductory accounting. Section C of the chapter makes the important point that accrual accounting involves incomplete cash cycles, and therefore accruals involve judgments about what will happen later in the cash cycles. Future cash flows are inherently uncertain, so accountants need to make estimates to determine the amount of accruals. Professional judgment is a key skill that accounting students should develop, and Section C of this chapter describes why this skill is so important. Section D of the chapter looks at Quality of earnings and earnings management. A consequence of accrual accounting is that there is no “true” accounting income number. However, this does not mean that any number is as good as any other. Some accounting estimates are better than others, so it is more useful to think in terms of quality of earnings on a continuum from high to low. .

Chapter 3 To make the quality of earnings assessment, there needs to be a benchmark. The benchmark is unbiased earnings, which would be the average amount reported by accountants who are disinterested in the accounting outcome. With the benchmark in place, students are prepared to think about whether accruals are unbiased or excessive. The threshold concept of economic consequences of accounting choice introduced in Chapter 1 resurfaces here in the form of earnings management and the source of excessive accruals. As noted above, the use of accrual accounting is related to the demand for periodic reports. Section E addresses issues that result from Periodicity, cut-off, and subsequent events. While other textbooks choose to address these issues much later, we believe this chapter is the appropriate place for them because they all flow from periodicity and the timing of recognition. Furthermore, proper coverage of the later chapters requires these ideas (e.g., change in depreciation methods), so students are encouraged to learn these concepts earlier rather than later. Section F focuses on Accounting changes: errors, changes in accounting policy, and changes in estimates. Note that the example of an accounting policy change illustrated in Exhibit 3-9 (p. 86) is just an example. Depending on the circumstances, changes in depreciation methods can be considered to be changes in estimates (see Chapter 8). One point of confusion that students seem to have is to mix up subsequent events with accounting changes. It is sometimes difficult for them to identify when they should be using one or the other. It will be helpful to use a timeline for this purpose. Starting with the timeline illustrated in Exhibit 3-8 (p. 84), then extending this timeline forward (to the right) we can then show that subsequent events occur before the issuance of the financial statements, while accounting changes are relevant after that point in time. Figure 3-1: Timeline from Exhibit 3-8 from text with extension for accounting changes Beginning of fiscal period

End of fiscal period

Reporting period

Date financial statements authorized for issue

Subsequent events period Cut-off for recognition of transactions and events

Accounting changes

End of period for gathering information pertaining to measurement of recognized events

Chapter 3 The final learning objective in this chapter is to understand the structure and connections among the four financial statements. As a result, this chapter discusses all of the financial statements in a succinct and integrated manner. This integrated approach also opens up the possibility of discussing the threshold concept of articulation. This concept is important for students to grasp in order for them to appreciate the full implications of various accounting treatments on all of the financial statements.

Chapter 3 Table 3-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 3-1. Explain the source of demand for 121-123 P3-2 P3-1 periodic reporting and how accrual P3-4 P3-3 accounting satisfies that demand. P3-7 P3-5 P3-6 3-2. Explain why accrual accounting is 124-128 P3-10 P3-9 fundamentally inexact, why estimates P3-11 P3-14 are central to accrual accounting, and P3-13 P3-16 why there is no “true” income for P3-15 typical situations; evaluate the “quality of earnings.” 3-3. Apply accrual accounting in relation to 124-131 P3-12 P3-19 issues of timing: periodicity, cut-off, P3-17 P3-21 and subsequent events. P3-18 P3-24 P3-20 P3-23 P3-25 3-4. Evaluate whether an accounting 132-135 P3-28 P3-26 change is an error, a change in P3-30 P3-27 accounting policy, or a change in P3-32 P3-29 estimate, and apply the retrospective P3-33 P3-31 and prospective treatments appropriate to that type of accounting change. 3-5. Integrate the structure and connections 135-147 P3-38 P3-34 among the four financial statements P3-39 P3-35 and explain how this structure relates P3-42 P3-37 to accrual accounting. P3-43 P3-40 P3-48 P3-42 P3-50 P3-46 P3-52 P3-47 P3-53 P3-49 P3-55 P3-51 P3-54 — Integrative 148-149 Case 2 Case 1 Case 3 Case 2 (pp. 148-149) is a difficult case intended for guided classroom discussion. A good analysis and discussion of this case does not require technical knowledge specific to redeemable preferred shares. Students are asked to discuss the relevant accounting issues while paying particular attention to the timing of events while applying the IFRS Framework.

CHAPTER 4 Revenue Recognition

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) a.

Fundamental accounting concepts and principles (qualitative characteristics of accounting information, basic elements)

Methods of measurement

Differences between accrual accounting compared to cash accounting

1.2.1 Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B) 1.2.2 Evaluates treatment for routine transactions (Level A) m. Revenue recognition/revenue from contracts with customers, and accounting for revenue and related expenses o.

Changes in accounting policies and estimates, and errors

1.3.2 Prepares routine financial statement note disclosure (Level B) 1.4.2 Evaluates financial statements including note disclosures (Level B) c.

Financial statements in accordance with applicable standards

LEARNING OBJECTIVES 4-1. Explain why there is a range of alternatives for revenue recognition that are conceptually valid and the rationale for accounting standards to prescribe a smaller set of alternatives. 4-2. Apply the general revenue and expense recognition criteria to a variety of contexts. 4-3. Apply the revenue and expense recognition criteria for long-term contracts, including the prospective treatment applicable to changes in estimates. 4-4. Apply the accounting standards for long-term contracts when profitability is in doubt. 4-5. Evaluate the risks of revenue misstatements and the appropriateness of revenue recognition policies in specific circumstances by applying professional judgment.

OVERALL APPROACH Recognition is the process of presenting an item in the financial statements, as opposed to merely disclosing that item in the notes. In theory, there is a wide range of possible points at which revenue could be recognized. The breadth of this range reflects a business’s value creation process, as illustrated in Exhibit 4-1 (p. 151).

Chapter 4 The chapter moves from a general focus to a specific focus. It leads students through the value creation process (which should be intuitive) and links that process with revenue recognition at a conceptual level. The focus then narrows to the actual revenue recognition standards. Later in the chapter, the focus narrows even further to explore the accounting for longterm contracts. Related to long-term contracts is the issue of anticipated losses, and how information asymmetry in the form of the winner’s curse can contribute to those losses.

KEY POINTS Exhibit 4-1 (p. 151) in Section A summarizes a business’s value creation process. This timeline is useful for motivating a discussion of when accounting should record the value created, and how much that revenue should be. Relating back to Chapter 3, this is the core issue in accrual accounting: the timing of recognition of value creation in revenue. Section B provides an overview of revenue recognition criteria as per IFRS 15 – Revenue from contracts with customers. It is important to note that the term “contract” relates to all forms of contracts; written and verbal, formal or implied by customary business practice. The standard covers any contract with a customer. Notable exclusions from IFRS 15 include lease contracts (IFRS 16 and covered in Chapter 17), insurance contracts (IFRS 4, a specialized field not covered in this text), financial instruments (IFRS 9 and covered in Chapters 7, 11-14), and non-monetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers. There are five steps for revenue recognition as illustrated in Exhibit 4-2 (p. 153), which are: (1) Identify the contract with the customer. (2) Identify the performance obligations. (3) Determine the transaction price. (4) Allocate the transaction price to performance obligations. (5) Recognize revenue in accordance with performance. An example of applying the five-step revenue recognition process is provided in Exhibit 4-3 (pp. 153154). Section C builds on the information provided in Section B and looks at the Revenue recognition criteria in more detail. The key requirements in the five steps of revenue recognition are provided in Exhibit 4-4 (p. 155). The end of this section concludes with a discussion on franchise fees, and journal entries to record franchise revenue are provided in Exhibit 4-8 (p. 162). Section D considers Other related issues such as expense recognition, contract costs, warranties, and onerous contracts. The information provided for warranties includes both assurance-type warranties and service-type warranties. Section E considers Specific revenue recognition situations such as (1) consignment sales, (2) installment sales, and (3) bill-and-hold arrangements. Sample journal entries for installment sales are provided in Exhibit 4-9 (p. 165) and Exhibit 4-10 (p. 165). .

Chapter 4 Accounting for long-term contracts is covered in Section F. This section starts with a discussion on (1) Revenue recognition for cost-plus contracts, and an example is provided in Exhibit 4-11 (p. 166). The next discussion looks at (2) Revenue recognition for fixed-price contracts: Application of changes in estimates. Exhibit 4-12 (p. 167) provides an example of a fixed-price contract with no uncertainty, and Exhibit 4-13 (p. 167) provides an example of a fixed-price contract with uncertainly. Revenue recognition for fixed-price contracts: The cost-to-cost approach is covered in part (3) of Section F. An example of the percentage of completion method using cost-tocost approach is provided in Exhibit 4-17 (p. 169). The next discussion looks at (4) Accounting cycle for long-term contracts. Exhibit 4-20 (p. 170) and Exhibit 4-21 (p. 171) consider the journal entries through the accounting cycle for a long-term contract. Onerous contracts are covered in part (5) of Section F. Exhibit 4-23 (p. 172) provides an example of a long-term contract with an expected loss, and Exhibit 4-24 (p. 173) provides an example of percentage of completion method using cost-to-cost approach with expected loss. Section F concludes with part (6) Revenue recognition when outcome of a contract is uncertain: Cost recovery method, and part (7) Alternative in ASPE: Completed contract method. Section G considers the Risk of earnings overstatement in long-term contracts. Two primary topics are discussed: (1) Intentional overstatement: Earnings management, and (2) Unintentional overstatement: The winner’s curse. Presentation and Disclosure is discussed in Section H. Two primary topics are discussed: (1) General presentation and disclosure requirements, and (2) Presentation and disclosure for long-term contracts. Substantive differences between IFRS and ASPE are provided in Section I.

Chapter 4 Table 4-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 4-1. Explain why there is a range of 180-181 P4-2 P4-1 alternatives for revenue recognition P4-4 P4-3 that are conceptually valid and the rationale for accounting standards to prescribe a smaller set of alternatives. 4-2. Apply the general revenue and 181-191 P4-8 P4-5 expense recognition criteria to a P4-9 P4-6 variety of contexts. P4-12 P4-7 P4-13 P4-10 P4-14 P4-11 P4-16 P4-15 P4-17 P4-18 P4-24 P4-19 P4-25 P4-20 P4-26 P4-21 P4-27 P4-22 P4-28 P4-23 P4-29 P4-30 P4-31 4-3. Apply the revenue and expense 191-193 P4-32 P4-33 recognition criteria for long-term P4-34 P4-35 contracts, including the prospective P4-37 P4-38 treatment applicable to changes in estimates. 4-4. Apply the accounting standards for 192-197 P4-36 P4-39 long-term contracts when profitability P4-40 P4-41 is in doubt. P4-42 P4-43 P4-44 P4-45 P4-46 P4-47 P4-48 P4-49 P4-50 4-5. Evaluate the risks of revenue 197-198 P4-51 P4-52 misstatements and the appropriateness P4-53 P4-54 of revenue recognition policies in P4-55 specific circumstances by applying professional judgment. — Integrative 199-204 Case 5 Case 1 Case 6 Case 2 Case 7 Case 3 Case 4

Chapter 4 Case 6 (p. 203) focuses on revenue recognition in governments, which is important for students to know and to understand. This case is integrated and asks students to apply financial accounting theory, the Conceptual Framework for financial reporting, and accrual accounting concepts. Thus it is a good review of the material that is covered in previous chapters and may be a great case to cover before an exam or multi-chapter assignment. Case 7 (p. 204) focuses on how to account for revenue using three alternatives: sales on consignment, installments sales, and franchise revenue. It helps students to understand why one method may be preferred over another method, and it provides students with an opportunity to account for each alternative using the same data, which is helpful for comparative purposes.

CHAPTER 5 Cash and Receivables

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) c.

Difference between accrual accounting compared to cash accounting

1.2.1 Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B) 1.2.2 Evaluates treatment for routine transactions (Level A) a.

Cash and cash equivalents

Receivables

Changes in accounting policies and estimates, and errors

1.3.1 Prepares financial statements (Level A) a.

Internal control and cash (bank reconciliation, control over cash receipts and disbursements)

1.4.1 Analyzes complex financial statement note disclosure (Level C)

LEARNING OBJECTIVES 5-1. Apply the standards and procedures for recording, reconciling, and reporting cash and cash equivalents. 5-2. Explain the need for internal controls for cash specifically and other assets more generally, and evaluate the adequacy of cash controls in different situations. 5-3. Apply the standards and procedures for the initial recognition, subsequent measurement at the balance sheet date, and derecognition of trade receivables. 5-4. Apply the standards to account for non-trade receivables.

OVERALL APPROACH This is the first of six chapters covering assets. Among assets, cash and receivables are in some ways the easiest in terms of their accounting. Fundamentally, cash cannot have many accounting issues because accrual accounting is about deviations from cash accounting. The first part of the chapter covers topics related to cash such as items to be included in cash and excluded from cash, cash held in foreign currencies, negative balances, and implications for the cash flow statement. The chapter also includes bank reconciliations, .

Chapter 5 although this topic has most likely been sufficiently covered in introductory accounting. The last part of the cash section, Section C, covers Cash management, internal controls, and fraud prevention and considers such things as segregation of duties. The second part of the chapter dealing with receivables includes an overview of accounting for non-cash assets. It is important to spend some time on this portion of the chapter because it establishes the idea that non-cash assets arise from accrual accounting whereby expenditures of cash are not immediately recorded as expense; rather, we capitalize the expenditure as an asset, and defer the expense to a later time.

KEY POINTS Accounting standards permit cash equivalents to be aggregated with cash. Students will have little difficulty with the concept of cash, but what can and cannot be considered to be equivalent to cash will be somewhat less straightforward. To be a cash equivalent, an item must be both readily convertible to known amounts of cash and subject to insignificant risk of changes in value. Exhibit 5-1 (p. 207) provides some examples to demonstrate what can and cannot be included in the category of cash and cash equivalents. For completeness, this chapter covers bank reconciliation, but many instructors will choose to omit this section because it has been sufficiently covered in introductory accounting. Cash management provides a useful illustration of the importance of internal controls. The importance of this issue will be immediately apparent to students. It is also important to point out that internal controls for other assets are equally important, especially in light of research that finds people to be less honest with respect to non-cash assets. After the relatively brief coverage of cash, the chapter proceeds to provide an overview of the accounting for non-cash assets. As noted above in the overall approach, this section is critical for establishing the flow of the later chapters covering the remaining assets. The three stages of accounting for non-cash assets as described in Section D are: 1. Initial recognition and measurement: Asset or expense? 2. Asset valuation on the balance sheet; and 3. Derecognition: Removal of an asset from the balance sheet. It is useful to note that IFRS and ASPE largely follow this structure in the accounting standards relating to specific assets. Sections E, F, and G follows this structure in the coverage of trade receivables. Trade Receivables: Initial classification, recognition, and measurement is covered in Section E. The only issue of significance is the gross and net methods. This is an instance in which practical considerations (gross method) dominates conceptual merit (net .

Chapter 5 method). Arguably, the direct and indirect method for presenting cash flows is another example (discussed in Chapter 20). Subsequent measurement of trade receivables: accounting for bad debts is covered in Section F. Most students will have experience with this issue from introductory accounting, but many will need to review this topic and study it more carefully. It is important to establish the percentage of sales as the income statement approach, and the aging of accounts method as the balance sheet approach. The contrast in the conceptual basis of the two methods helps students to understand why there are two alternatives. In addition, the income statement and balance sheet approaches will resurface in other chapters (e.g., inventories, income taxes). In addition to matching of bad debts expense with revenue and ensuring that the valuation of accounts receivable is neutral or prudent, it is important to point out other reasons for estimating bad debts. That is, the accrual for bad debts also reduces moral hazard by use of the company’s credit policy and increases the quality of earnings. Derecognition of receivables: collection, write-offs, and disposals is covered in Section G. This section includes the straightforward collection of trade receivables: (1) collection (2) write-offs, and (3) transfer of receivables (factoring). In the discussion of recoveries, it is useful to mention the two step process of re-establishing the account receivable prior to recording the cash receipt. An illustration is provided in Exhibit 5-12 (p. 220). Doing so helps students to understand why there is an accounts receivable sub-ledger as well as a general ledger account for accounts receivable. Transfers can be done with recourse and without recourse. The accounting treatment depends primarily on whether there is a transfer of risks and rewards of ownership. Transfers with recourse are borrowing transactions, whereas transfers without recourse are sales of receivables. Exhibit 5-13 (p. 221) provides an illustration of a journal entry for factoring accounts receivable without recourse. Exhibit 5-14 (p. 221) provides an illustration of a journal entry for factoring accounts receivable with recourse. Section H provides a Comprehensive illustration of initial recognition, subsequent measurement, and derecognition of accounts receivable. Information for Tough Sell Corporation is provided in Exhibit 5-19 (p. 224) and a full solution, including the use of T-accounts, is provided. After covering trade receivables, the chapter discusses Non-trade receivables such as promissory notes in Section I. These receivables are typically discounted for the time value of money, and this provides an opportunity to introduce the amortized cost method of accounting for financial assets, which will be covered more in Chapter 7. Section J looks at accounting for restructured loans (from the Lender’s perspective), and Section K considers Potential earnings management using receivables. This discussion .

Chapter 5 ties the chapter back to important ideas in prior ones: quality of earnings in Chapter 1 and revenue recognition in Chapter 4. The discussion exposes students to the range of possible earnings management techniques of which they should be aware. The chapter material concludes with Section L that provides a Practical illustration using data from Canadian Tire Corporation. It is valuable for students to see how items related to loans receivable are recorded and related items are disclosed.

Chapter 5

Table 5-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 5-1. Apply the standards and procedures 233-235 P5-5 P5-1 for recording, reconciling, and P5-8 P5-2 reporting cash and cash equivalents. P5-9 P5-3 P5-11 P5-4 P5-12 P5-6 P5-7 P5-10 5-2. Explain the need for internal controls 236 P5-13 P5-14 for cash specifically and other assets P5-15 more generally, and evaluate the adequacy of cash controls in different situations. 5-3. Apply the standards and procedures 236-245 P5-19 P5-16 for the initial recognition, subsequent P5-20 P5-17 measurement at the balance sheet P5-24 P5-18 date, and derecognition of trade P5-26 P5-21 receivables. P5-28 P5-22 P5-29 P5-23 P5-32 P5-25 P5-33 P5-27 P5-34 P5-30 P5-36 P5-31 P5-37 P5-35 P5-40 P5-38 P5-41 P5-39 P5-43 P5-42 5-4. Apply the standards to account for 245-248 P5-44 P5-45 non-trade receivables. P5-47 P5-46 P5-49 P5-48 P5-50 P5-51 P5-52 P5-53 P5-54 P5-55 — Integrative 249-253 Case 1 Case 2 Case 3 Case 4 Case 1 (pp. 249-251) picks up the chapter’s opening vignette and explores it in more detail. The case requires students to evaluate the adequacy of the bad debts provision by looking at quantitative and qualitative considerations. This case tests whether students understand the accounting for bad debts, and whether they understand what the results mean in the context of a real business environment. .

CHAPTER 6 Inventories

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER: 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) b.

Methods of measurement

1.1.3 Evaluates reporting systems, data requirements, and business processes to support reliable financial reporting (Level B) a.

Accounting information systems

1.2.1 Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B) 1.2.2 Evaluates treatment for routine transactions (Level A) c.

Inventories

Changes in accounting policies and estimates, and errors

1.3.2 Prepares routine financial statement note disclosure (Level B)

LEARNING OBJECTIVES 6-1. Describe the informational differences between perpetual and periodic systems of inventory control. 6-2. Analyze costing information to determine the types and amounts of costs that can be included in the cost of inventories. 6-3. Apply the different methods of allocating costs between inventory and cost of sales. 6-4. Evaluate whether and by how much inventories should be written down. 6-5 Synthesize the relationship between the income statement and balance sheet through analysis of inventory errors.

OVERALL APPROACH The core of this chapter continues the coverage of inventories from introductory accounting and examines in more depth the three issues that are relevant to any asset: Initial recognition and measurement in Section B looks at which expenditures enterprises should capitalize for (1) purchased goods, and (2) manufactured goods. Subsequent measurement and derecognition: Cost allocation between the balance sheet and income statement in Sections C looks at how much of the costs recognized in .

Chapter 6 inventories should be expensed through the income statement and how much should remain as inventories on the balance sheet. Subsequent measurement: Interaction of cost flow assumptions and information systems for inventory control in Sections D looks at the valuation of inventories that remain on hand on the balance sheet date and at what value they should be reported. Subsequent measurement: Avoiding overvaluation of inventories in Section E looks at the meaning of “market” and the issues regarding overvaluation of inventory. Surrounding this core is a discussion of perpetual and periodic information systems for inventory control at the beginning in Section A, as well as illustrations of inventory errors towards the end of the chapter in Section F.

KEY POINTS Entering intermediate accounting, students should already have some familiarity with inventory accounting. Most students will already have been exposed to cost flow assumptions such as first-in, first-out (FIFO) and weighted average cost in introductory accounting. After the opening vignette, the chapter starts with the statement “Inventories are assets held for sale” (p. 255). This seemingly innocuous statement deserves some emphasis and contrast against assets held for use. Without this distinction, students may wonder whether certain items should be inventory or property, plant, and equipment (PPE). It may be helpful to provide an example to students. Provide two companies: one is a car dealership and one is a distribution company. How would each company account for vehicles? The car dealership shall consider vehicles to be inventory as the vehicles are assets held for sale. The distribution company shall consider vehicles to be PPE as the vehicles are available for use and are not assets held for sale (and is estimated that the vehicles will have a useful life that is greater than one year). Information systems for inventory control: Section A of the chapter compares the perpetual and periodic systems. The objective here is threefold: to show the differences in the bookkeeping entries, to show that the perpetual system produces better information, and to allow for the later discussion of the interaction of inventory systems and cost flow assumptions. Initial recognition and measurement is covered in Section B. The initial recognition for purchased goods is relatively straightforward, except for the concept of free on board (F.O.B.). This concept in supply chain management/logistics can be complex, but accounting discussion for this issue need not delve into the intricacies; interested students should refer to Wikipedia or other reference sources.

Chapter 6 For manufactured products, we need to distinguish product from period costs. For purposes of financial reporting, IFRS and ASPE both require the use of absorption costing, not variable costing. Subsequent measurement and derecognition: Cost allocation between the balance sheet and incomes statement. These two issues are inherently linked through the inventory cost flow equation, which is in Exhibit 6-5 (p. 261) and repeated here: Beginning inventory + Purchases = Cost of goods sold + Ending inventory Note that Beginning inventory + Purchases = Cost of goods available for sale It is important to introduce this equation early because it is useful in much of the discussions of inventory, including cost flow assumptions, and identifying the effect of inventory errors. The allocation of costs between cost of goods sold and ending inventory depends on the context (type of business and type of inventory). For the specific identification method, it is important to note that the items of inventory cannot be interchangeable (i.e., the inventory must be specifically identifiable by serial numbers, vehicle identification numbers, or other identification). Otherwise, management would have the opportunity to expense the costs that are most in its favour. For items that are interchangeable, it is appropriate to use cost flow assumptions: FIFO and weighted-average. Although IFRS and ASPE do not permit LIFO, the inclusion of LIFO is for the conceptual comparison of the methods as well as for its frequency of use in the United States. Usage of LIFO is included in Exhibits 6-9 (p. 263), 6-12 (p. 264), and 6-13 (p. 265). The retail inventory method of cost allocation is fairly straightforward to apply. Some of the specific retail pricing terminology (mark-up, mark-down, mark-up cancellation, etc.) can be quite confusing to students. Therefore, it is best to focus on what matters—the profit margin and its complement, cost as a percentage of retail price. Details are provided in Section C. Subsequent measurement: Interaction of cost flow assumptions and information systems for inventory control: Section D explores the differences that could arise depending on whether an enterprise uses the perpetual or periodic system. The main difference is in the weighted average method because the average needs to be recomputed each time there is an inflow of inventory. An illustration of this is provided in Exhibit 6-18 (p. 269). The result under FIFO remains the same regardless of whether the perpetual or periodic system is used; an illustration of this is provided in Exhibit 6-19 (pp. 269-270).

Chapter 6 Section E covers Subsequent measurement: Avoiding overvaluation of inventories. Representational faithfulness requires assets not to be overvalued on the balance sheet. This principle of course applies to inventories, so accounting standards require inventories to be reported at the lower of cost and market (LOCM). The meaning of “market” is described in part 1 of Section E. Accounting for inventory errors is covered in Section F. Students often have difficulty figuring out the effects of inventory errors due to the articulation of balance sheet and income statement accounts. The best approach is to demonstrate the effects of various errors using the inventory cost flow equation. Exhibit 6-20 (p. 273) helps to demonstrate the effect of inventory errors on inventories and cost of goods sold.

Chapter 6 Table 6-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 6-1. Describe the informational 280-281 P6-2 P6-1 differences between perpetual and P6-3 periodic systems of inventory control. 6-2. Analyze costing information to 281-288 P6-7 P6-4 determine the types and amounts of P6-8 P6-5 costs that can be included in the cost P6-10 P6-6 of inventories. P6-14 P6-9 P6-15 P6-11 P6-17 P6-12 P6-18 P6-13 P6-19 P6-16 P6-20 6-3. Apply the different methods of 288-293 P6-21 P6-22 allocating costs between inventory P6-23 P6-24 and cost of sales. P6-25 P6-26 P6-27 P6-28 P6-29 P6-30 P6-31 P6-32 P6-33 P6-34 P6-35 P6-36 P6-37 P6-38 P6-39 6-4 Evaluate whether and by how much 294-295 P6-40 P6-41 inventories should be written down. P6-42 P6-43 P6-44 6-5. Synthesize the relationship between 295-301 P6-45 P6-46 the income statement and balance P6-47 P6-48 sheet through analysis of inventory P6-49 P6-50 errors. P6-51 P6-52 P6-53 P6-54 P6-55 — Integrative 302-307 Case 2 Case 1 Case 4 Case 3

Case 2 (pp. 302-303) requires students to play the role of an internal auditor. As this role could be unfamiliar to students, it would be helpful to describe some of the duties of an internal auditor. The scenario presents the students with the output of the accounting system and they need to work backwards to infer what could have generated those results.

Chapter 6 The objective of this case is to illustrate the economic consequences of accounting when accounting standards for inventories interact with compensation incentives. It also illustrates a case of earnings management through real operating activities (as opposed to through accounting choice). Students are asked to prepare recommendations to the Board of Directors. Case 4 (pp. 306-307) is an integrated question that covers topics such as absorption costing and variable costing and asks the student to consider whether a company is using the optimal inventory system (perpetual) along with which method (i.e. FIFO, weighted average) is being used to account for a company’s inventory. Students are then asked to consider both financial and non-financial information to determine whether the company should continue to purchase the product from a manufacturer, or if the company should diversity into a new product line.

CHAPTER 7 Financial Assets

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) b.

Methods of measurement

1.2.1 Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B) 1.2.2 Evaluates treatment for routine transactions (Level A) k.

Financial instruments

Investments in associates/significant influence

1.2.3 Evaluates treatment of non-routine transactions (Level B) g. i.

Consolidated financial statements subsequent to acquisition date Joint arrangements

1.3.2 Prepares routine financial statement note disclosure (Level B)

LEARNING OBJECTIVES 7-1. Explain what financial assets are, how they differ from other types of assets, and why there is a variety of measurement standards for different categories of financial assets. 7-2. Evaluate the nature of a financial asset to classify it into one of seven categories: subsidiaries, joint operations, joint ventures, associates, fair value through profit or loss, fair value through OCI, and amortized cost. 7-3. Identify the measurement approach appropriate to the seven categories of financial assets and explain the general nature of the various measurement approaches. 7-4. Analyze historical cost and fair value information to determine the appropriate balance sheet measurement and income recognition subsequent to purchase for three categories of financial assets: fair value through profit or loss, fair value through OCI, and amortized cost. 7-5 Apply present value techniques to account for investments in debt instruments.

OVERALL APPROACH This chapter provides a comprehensive overview of financial assets, including both strategic investments and non-strategic investments. This chapter is presented in a broadto-narrow approach, which is necessary to first give students a solid overview of financial assets and to provide the business context of these investments. Understanding this context then facilitates their learning of the specific accounting procedures. .

Chapter 7

KEY POINTS One of the difficulties students have with financial assets simply has to do with knowing what they are and what they are not. While most are able to name several examples readily, most are likely to have difficulty coming up with the defining characteristic of financial assets. In Section A, a straightforward definition of a financial asset is provided: “An asset arising from contractual agreements on future cash flows” (p. 309). For financial assets, the most important accounting issue is measurement at each balance sheet date (i.e., subsequent measurement). The measurement basis depends on the financial asset’s classification for accounting purposes. The seven categories that are listed on page 310 include four that relate to strategic equity investments. This chapter provides an overview of the accounting outcomes for these four categories (subsidiaries, joint operations, joint ventures, associated companies), leaving the details of the accounting procedures for advanced accounting. Section B provides an Overview of financial asset classification. Exhibit 7-1 (p. 311) illustrates the accounting classification of financial assets and the corresponding accounting treatment. Specifically, this exhibit looks at four key areas: general type of financial instrument, business model, specific accounting classification, and accounting treatment. Section C looks at Strategic equity investments and provides a series of three examples that have been carefully crafted to identify the similarities and differences among the three accounting methods (consolidation, proportionate consolidation, and equity method). Exhibit 7-6 (p. 317) highlights these similarities and differences by presenting the three examples side by side. In Section C, students may find it helpful to review Exhibit 7-2 (p. 312), which shows equity investment classification and accounting according to degree of influence. When reviewing this exhibit, students may understand that the specific accounting classifications (subsidiaries, joint operations, joint ventures, and associates) are important to determine, as it will directly affect the accounting treatment to be used (consolidation, proportionate consolidation, equity method). For Non-strategic investments, the chapter goes into considerably more depth in Section D. Three non-strategic investments are explored: fair value through profit or loss (FVPL), fair value through other comprehensive income (FVOCI), and amortized cost. In Section D, an example is provided to illustrate the differences among the three nonstrategic investments. This example includes Exhibit 7-12 (p. 324) that illustrates the accounting treatment of bond investments, followed by Exhibit 7-13(p. 325) that illustrates the journal entries for bond investments using FVPL, FVOCI, and amortized cost.

Chapter 7 Amortization of debt investments is covered in Section E. This section begins with a discussion of the effective interest method, followed by using amortized cost in the accounting for financial assets.

Chapter 7 Table 7-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 7-1. Explain what financial assets are, how 335-336 P7-3 P7-1 they differ from other types of assets, P7-4 P7-2 and why there is a variety of P7-5 measurement standards for different categories of financial assets. 7-2. Evaluate the nature of a financial 336-338 P7-9 P7-6 asset to classify it into one of seven P7-10 P7-7 categories: subsidiaries, joint P7-11 P7-8 operations, joint ventures, associates, P7-12 P7-13 fair value through profit or loss, fair 342 P7-26 value through OCI, and amortized cost. 7-3. Identify the measurement approach 338-340 P7-14 P7-16 appropriate to the seven categories of P7-17 P7-18 financial assets and explain the P7-20 P7-19 general nature of the various measurement approaches. 7-4. Analyze historical cost and fair value 338, 340 P7-15 P7-21 information to determine the 340-345 P7-23 P7-22 appropriate balance sheet P7-24 P7-27 measurement and income recognition P7-25 P7-31 subsequent to purchase for three P7-28 P7-32 categories of financial assets: fair P7-29 P7-33 value through profit or loss, fair value P7-30 P7-34 through OCI, and amortized cost. P7-35 P7-36 7-5. Apply present value techniques to 345-351 P7-39 P7-37 account for investments in debt P7-40 P7-38 instruments. P7-45 P7-41 P7-47 P7-42 P7-48 P7-43 P7-49 P7-44 P7-50 P7-46 P7-51 P7-52 P7-53 P7-54 P7-55 — Integrative 352-353 Case 2 Case 1 Case 3 Case 2 (pp. 352-353) requires students to think about the company’s financial investments together with its financing requirements while keeping in mind the

Chapter 7 accounting implications of these decisions. Furthermore, these decisions are constrained by debt covenants. Thus, the case provides another opportunity to illustrate the threshold concept of economic consequences of accounting choice. Case 3 (p. 353) looks at how a private company should account for its investments when it is considering going public. Students are asked to advise on which accounting method(s) should be applied and to consider alternative accounting methods that are available for the company. This case also asks the student to discuss the reporting issues related to the securities that are held by the company.

CHAPTER 8 Property, Plant, and Equipment

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) b. Methods of measurement c. Difference between accrual accounting compared to cash accounting 1.2.1 Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B) 1.2.2 Evaluates treatment for routine transactions (Level A) d.

Property, plant, and equipment

Depreciation, amortization, impairment, and disposition/derecognition

Changes in accounting policies and estimates, and errors

1.2.3 Evaluates treatment for non-routine transactions (Level B) a. Uncommon capital assets (exchange of assets, decommissioning costs) 1.3.2 Prepares routine financial statement note disclosure (Level B) 1.4.1 Analyzes complex financial statement note disclosure (Level C) 1.4.5 Analyzes and predicts the impact of strategic and operational decisions on financial results (Level C) b.

Impact of financial results on the whole organization

LEARNING OBJECTIVES 8-1. Evaluate whether a cost should be included in property, plant, and equipment, and how much should be classified in each category of asset or expense. 8-2. Apply different depreciation methods, including the effect of changes in estimates on depreciation calculations. 8-3. Apply the standards for derecognition of property, plant, and equipment and understand the meaning of gains and losses arising from derecognition. 8-4. Analyze transactions with non-monetary consideration and apply the accounting standards for non-monetary transactions.

OVERALL APPROACH This chapter and the following two chapters form a block of content dealing with what has been traditionally known as capital assets. This chapter addresses tangible assets .

Chapter 8 while Chapter 9 covers intangible assets. These two chapters primarily focus on the initial recognition of these non-current assets while also covering derecognition and subsequent measurement in the form of depreciation/amortization under the cost model. Chapter 10 covers the challenging issues related to the applications of fair value to non-current assets. This chapter starts with discussing whether a cost should be included in Property, Plant, and Equipment (PPE) or expensed. This is an important concept since these decisions affect the financial statements and financial ratios. Following this concept is the topic of depreciation methods. Although students should be familiar with deprecation methods and calculations from introductory financial accounting, it is important to discuss the effects of changes in estimates on depreciation calculations. The concept of derecognition is discussed and it is important for students to learn and understand the meaning of gains and losses that arise from derecognition. This chapter concludes with applying the accounting standards for non-monetary transactions.

KEY POINTS PPE are tangible assets lasting more than one year and are assets held for use. It is useful to distinguish PPE from inventories, which are held for sale. Section A covers Initial recognition and measurement. The initial recognition of PPE is a substantially more important issue than for current assets simply because the period of deferral is so much longer. While capitalizing too much into inventories defers costs for perhaps one accounting period, capitalizing too much into PPE results in deferral for many years or even indefinitely in the case of land. Allocation of costs to different types of PPE (land, building, equipment) is important because of the different estimated useful lives and the length of expense deferral. It is useful to note that the basic principle behind initial recognition is similar to that used for inventories: capitalize all costs required to acquire or to construct the asset and to prepare it for its intended use. Also similar to inventories, there are more issues for selfconstructed items in comparison to purchased items. To help identify which costs should be capitalized into which asset, a useful question to ask is, “How much would the enterprise have to pay if the enterprise had to purchase the item in the state that it wants?” (e.g., Demolition cost added to land, not building.) IFRS distinguishes replacements versus repairs. Replacement leads to the derecognition of the old asset and recognition of a new asset, which is logically sound: the reported asset reflects, and only reflects, what provides future benefits. On the other hand, betterments permit the capitalization of costs that improve the asset, but not costs that simply restore an asset to its original condition, which can result in dramatic differences

Chapter 8 in accounting treatment for slight differences in expenditures depending on whether there is a betterment. This section on initial recognition also covers the costs of dismantlement, removal, and site restoration because these costs need to be recorded as liabilities and a corresponding asset when the enterprise acquires the related PPE. After initial recognition, there is essentially separate accounting for the site restoration asset (depreciated) and obligation (interest expense). The issue of componentization is about the boundaries of a particular item of PPE. IFRS require an item to be recorded as a separate component if it has (i) a cost that is significant in relation to the total cost of the item, and (ii) a different useful life from other components of the item. (e.g., recording car tires as a component separate from the rest of the car.) This requirement makes sense in terms of cost and benefits of componentization and the effect on subsequent depreciation. Related to defining the boundary of a particular PPE is the allocation of costs to different PPE in bundled purchases. The commonality is that the total cost needs to be allocated to different items, whether those items are normally considered as a whole (a car) or components (car frame, engine, wheels, tires, etc.). Section B covers Subsequent measurement. This section first discusses the different measurement models, such as historical cost versus current value, in conceptual terms. We defer detailed coverage of revaluation until Chapter 10. The focus of this chapter is on depreciation under the historical cost basis. Depreciation is defined by three parameters: depreciable amount, period of depreciation, and pattern of depreciation. Specifying depreciation using these parameters is a useful commitment device; it requires management to select these parameters in advance instead of using their discretion to determine the amount of depreciation in each particular period. The result is higher quality of earnings compared with discretionary depreciation. Students should be familiar with how to calculate depreciation when the parameters do not change, as this would have been covered in their introductory financial accounting course(s). What will be new is how to revise the depreciation to reflect changes in the depreciable amount (usually due to changes in estimated residual values), the period of depreciation (estimated useful life), and the pattern of depreciation. Changes in the pattern of depreciation (straight-line, declining balance, etc.) can be considered changes in estimates if management can support the change as reflecting new information. Otherwise, it would be considered a change in accounting policy.

Chapter 8 Derecognition is covered in Section C and the accounting for derecognition is relatively simple. The important point to highlight is the interpretation of any gains or losses that arise from the disposal. That is, gains reflect over-depreciation in prior years, whereas losses reflect under-depreciation. This discussion brings back the threshold concept of timing of recognition: the amount of depreciation recorded affects the timing of when we recognize expenses (including losses), not the total amount. Managers’ aversion to recording losses provides a good opportunity to discuss the economic consequences of accounting choice. The traditional view is that depreciation policy does not matter (e.g., emphasis on EBITDA by finance professionals, rational financial statement users adjusting for differences in depreciation policy, efficient securities markets). Recent accounting research demonstrates that people would rather make a decision to avoid an accounting loss rather than to do the alternative that is valuemaximizing. Section D covers Non-monetary transactions. The accounting for non-monetary transactions has two cases: a general case using fair values and an exception case that uses book values. The exception case applies if one of two conditions is met: (i) there is no commercial substance to the transaction; or (ii) the fair values of the assets exchanged are not reliably measurable. The chapter concludes with three remaining sections: Section E looks at Potential earnings management using PPE, Section F covers Presentation and disclosure of PPE, and Section G looks at Substantive differences between IFRS and ASPE.

Chapter 8

Apply different depreciation methods, including the effect of changes in estimates on depreciation calculations.

391-397

8-3.

Apply the standards for derecognition of property, plant, and equipment and understand the meaning of gains and losses arising from derecognition. Analyze transactions with nonmonetary consideration and apply the accounting standards for nonmonetary transactions.

398-399

Integrative

404-411

8-4.

—

399-403

P8-22 P8-24 P8-26 P8-28 P8-29 P8-33 P8-34 P8-36 P8-37 P8-38 P8-40 P8-42 P8-44

P8-20 P8-21 P8-23 P8-25 P8-27 P8-30 P8-31 P8-32 P8-35 P8-39 P8-41 P8-43 P8-45

P8-46 P8-48 P8-50 P8-52 P8-54 Case 1 Case 4

P8-47 P8-49 P8-51 P8-53 P8-55 Case 2 Case 3

Chapter 8 Case 5 Case 1 (p. 404) is a fictitious simulation that requires students to make decisions/recommendations for an airline. In particular, students need to consider what depreciation policy to recommend and whether depreciation policy matters in the context of this company, its corporate structure, and compensation arrangements. Another important issue relates to a significant pre-payment discount offered by the aircraft manufacturer: is the offer advantageous, how would the discount be reflected in the accounting numbers, and how should the company motivate the right divisional decisions? Case 4 (pp. 408-410) looks at a private company specializing in home appliances. Only weeks before year end, one of its largest stores was destroyed by a fire. In this case, students are asked to assume the role of an auditor and prepare a memo to the engagement partner that outlines the financial accounting considerations for this year’s engagement along with identifying other issues resulting from the fire.

CHAPTER 9 Intangible Assets, Goodwill, Mineral Resources, and Government Grants

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) b.

Methods of measurement

1.2.1 Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B) 1.2.2 Evaluates treatment for routine transactions (Level A) e.

Goodwill and intangible assets

Depreciation, amortization, impairment, and disposition/derecognition

Changes in accounting policies and estimates, and errors

1.2.3 Evaluates treatment for non-routine transactions (Level B) a.

Uncommon capital assets (natural resources, government grants)

1.3.2 Prepares routine financial statement note disclosure (Level B) 1.4.1 Analyzes complex financial statement note disclosure (Level C)

LEARNING OBJECTIVES 9-1. Evaluate whether a cost qualifies for capitalization as an intangible asset or goodwill. 9-2. Evaluate whether a recognized intangible asset has an indefinite life or a finite life, and in the latter case, determine the appropriate useful life for amortization. 9-3. Apply the specialized standards for the initial recognition of assets relating to mineral resource exploration and evaluation. 9-4. Apply the standards for accounting for government grants.

OVERALL APPROACH This chapter covers four main topics: (i) intangible assets, (ii) goodwill, (iii) mineral resources, and (iv) government grants. Similar to property, plant, and equipment (PPE), the main issue for intangible assets and goodwill is their initial recognition, so most of the discussion focuses on this issue. Initial recognition is also the main issue for mineral resource accounting. For government grants, this chapter looks at four main topics: (i) how should enterprises recognize government grants (as equity capital or income), (ii) when should an enterprise .

Chapter 9 recognize government grants, (iii) how should enterprises present government grants, and (iv) repayment of government grants.

KEY POINTS Section A looks at Intangible assets-Initial recognition and measurement. Three characteristics define an intangible asset for accounting purposes. First, the item must lack physical substance (i.e., be intangible). Second, it must be non-monetary in nature (i.e., financial assets are also intangible but not intangible assets). Third, the item must be separately identifiable (i.e., goodwill is intangible but not an intangible asset). Regarding this last criterion, goodwill is thus an intangible, but not an “intangible asset” for accounting purposes. Beyond satisfying the definition of an intangible asset, the item must also meet the relevant recognition criteria in IAS 38, which are an extension of the criteria for recognizing assets in general: there must be probable future benefits and the costs must be measurable. For intangible assets, the probability and amount of future benefits are more uncertain than for financial and tangible assets. Therefore, IFRS provides more specific guidance for acquired intangibles and internally developed intangibles. Internally developed intangibles require the enterprise to analyze its activities to distinguish research from development activities. Research costs are expensed because the activities do not relate to an identifiable product or process. Enterprises should capitalize development costs that satisfy all six criteria in IAS 38 ¶57. These six criteria are provided on page 417, and Exhibits 9-2 (p. 418) and 9-3 (p.418) provide scenarios, analysis, and conclusions for R&D. Five criteria relate to whether future benefits are probable (technical feasibility, intention to complete, ability to use or sell, market/usefulness, and availability of adequate resources), and one relates to identifying the costs associated with the intangible asset. Enterprises must expense costs incurred after the development phase (i.e., when the intangible asset is ready for intended use). Section B looks at Intangible assets—Subsequent measurement. The only point to emphasize here is that amortization only applies to intangible assets having finite useful lives. Those with indefinite lives are tested for impairment, which is discussed in Chapter 10. Section C looks at Intangible assets—Derecognition. Derecognition of an intangible asset is the same as for an item of PPE. The difference between the proceeds and the carrying amount is a gain or loss that flows through profit or loss. The enterprise removes both the cost and the accumulated amortization from the accounts.

Chapter 9 Section D discusses Goodwill. Students only need a general understanding of what goodwill is and how it arises. Exhibit 9-6 (p. 421) provides an illustration showing goodwill as the excess of the purchase price over the total fair value of the identifiable assets net of liabilities. Section E considers Presentation and Disclosure. For intangible assets, disclosures should group together assets with similar nature and use. An enterprise should also separately identify internally developed intangible assets from acquired intangible assets. Section F looks at Mineral resources. IFRS 6 and IAS 38 address accounting issues specific to costs incurred in the three phases in mineral activities. Exhibit 9-8 (p. 424) summarizes the key points in this section regarding the exploration and evaluation phase, the development phase, and the extraction phase. Exhibit 9-10 (p. 427) illustrates the accounting for the cost of a company’s mineral resource activities. Section G looks at Government Grants. IFRS require an enterprise to use the income approach and IAS 20 indicates that government grants should be recognized in profit or loss. An enterprise should recognize a government grant when the enterprise has complied with the conditions of the grant and there needs to be a reasonable level of assurance that the grant will indeed be received. An enterprise can present government grants using one of two methods: the gross method and the net method. Exhibits 9-13 (p. 430) and 9-14 (p. 430) provide excellent illustrations of the journal entries needed using both the gross method and the net method. Section H, the last section of this chapter, looks at Potential earnings management. As the accounting for intangible assets, mineral resources, and government grants requires extensive use of professional judgement, this can result in instances of earnings management.

Chapter 9

USE OF END-OF-CHAPTER PROBLEMS AND CASES In addition to lectures, discussion of some of the end-of-chapter problems and cases will help students apply the concepts. The following table identifies all of the problems and cases that can be used in class, and problems and cases that can be used for homework assignments. (Depending on the time allocation between lectures and examples, it may not be feasible to cover all of the suggested items.) Table 9-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 9-1. Evaluate whether a cost qualifies 437-442 P9-2 P9-1 for capitalization as an intangible P9-4 P9-3 asset or goodwill. P9-6 P9-5 P9-11 P9-7 P9-12 P9-8 P9-15 P9-10 P9-16 P9-13 P9-14 9-2. Evaluate whether a recognized 439, 442 P9-9 P9-17 intangible asset has an indefinite 442-447 P9-18 P9-19 life or a finite life, and in the latter P9-20 P9-21 case, determine the appropriate P9-22 P9-23 useful life for amortization. P9-24 P9-25 P9-26 P9-27 P9-28 P9-29 P9-30 P9-31 P9-32 P9-33 453-454 P9-52 P9-53 454 P9-54 9-3. Apply the specialized standards for 447-450 P9-34 P9-35 the initial recognition of assets P9-36 P9-37 relating to mineral resource P9-38 P9-39 exploration and evaluation. P9-40 P9-41 P9-42 P9-43 450, 454 P9-44 P9-55 9-4. Apply the standards for accounting 450-453 P9-45 P9-46 for government grants. P9-47 P9-48 P9-49 P9-50 P9-51 — Integrative 455-463 Case 1 Case 3 Case 2 Case 4 Case 5

Chapter 9 Case 1 (p. 455) is a short case to stimulate discussion of the standards surrounding the capitalization of intangible assets. Students should use concepts from prior chapters, particularly those from Chapters 1, 2, and 3 in their discussions. Case 2 (pp. 455-456) is a simulation intended to lead students to analyze and to evaluate whether various expenditures could be capitalized as tangible assets, intangible assets, or goodwill. The analysis should lead students to consider the similarities and differences in the different accounting standards that apply to the different expenditures. Case 5 (pp. 462-463) is a shorter case whereby students are asked to assume the role of an auditor and comment on the accounting policies for some of Clare Cherry Cola’s intangible assets such as brand name, client list, research and development costs, patent, and goodwill. In addition, students are asked to discuss the earnings management potential in regards to intangible assets and the case concludes by asking students to consider whether intangible assets should be capitalized.

CHAPTER 10 Applications of Fair Value to Non-Current Assets

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.2 Evaluates the appropriateness of the basis of financial reporting (Level B) b. Methods of measurement 1 2.1 Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B) 1.2.2 Evaluates treatment for routine transactions (Level A) d. Property, plant, and equipment f. Depreciation, amortization, impairment, and disposition/derecognition 1.2.3 Evaluates treatment for non-routine transactions (Level B) a. Uncommon capital assets (investment properties, biological assets) c. Assets held for sale and discontinued operations 1.3.2 Prepares routine financial statement note disclosure (Level B) 1.4.1 Analyzes complex financial statement note disclosure (Level C) 5.4.1 Determines the value of a tangible asset (Level C) 5.4.2 Applies appropriate methods to estimate the value of a business (Level C) 5.4.3 Estimates the value of an intangible asset (Level C)

LEARNING OBJECTIVES 10-1. Apply the revaluation model of accounting for non-current assets. 10-2. Evaluate whether a non-current asset should be tested for impairment, whether the asset is impaired, and the extent of impairment. 10-3. Account for the impairment of different types of non-current assets. 10-4. Apply the specialized standards for the recognition and measurement of assets relating to investment properties and agricultural activities. 10-5. Apply the accounting standards relating to non-current assets held for sale and discontinued operations.

OVERALL APPROACH This chapter covers the revaluation model of measuring carrying values subsequent to initial acquisition, impairment, investment property, agriculture, and non-current assets .

Chapter 10 held for sale and discontinued operations. The chapter concludes with an excellent comparison of the substantive differences between IFRS and ASPE. While Chapters 8 and 9 focused on using the historical cost basis for accounting for noncurrent assets, this chapter focuses on the revaluation method, which uses fair values. Although historical costs are reliable, they can provide irrelevant information if the prices of assets have changed significantly due to changes in technology, inflation, and other such market conditions. For those reasons, IFRS permits the revaluation method as fair values provide more relevant information to financial statement users since fair values better reflect current market conditions. It is important to note that ASPE does not allow for revaluations.

KEY POINTS An enterprise may choose the revaluation model instead of the cost model when it can determine fair values reliably. If it chooses the revaluation model, it shall apply it to an entire class of assets rather than to selective assets. A “class” is a group of assets with similar nature, such as land, buildings, machinery, motor vehicles, and licenses. Many intangibles are unlikely to satisfy the criterion of having reliable fair values because they are unique assets (e.g., intellectual property such as patents and trademarks). Other intangibles such as licenses and carbon credits could have reliable fair values. The two sides of the revaluation adjustment are distinct. On the asset side, the enterprise has a choice of the proportional method (adjust both gross carrying amount and accumulated depreciation in the same proportion) or the elimination method (remove accumulated depreciation and adjust carrying amount to fair value). Exhibit 10-1 (p. 467) illustrates the proportional method and Exhibit 10-2 (p. 467) illustrates the elimination method. On the equity side, the enterprise has no choice for how to record the adjustment to fair value, but the journal entries will vary depending on the circumstances. Increases or decreases in fair value go through either net income or other comprehensive income (OCI), depending on whether the cumulative revaluation adjustment on the asset is below or above zero (whether the asset is “under water”). Exhibit 10-4 (p. 468) is useful for summarizing this issue. Impairment is covered in Section B. Exhibit 10-7 (p. 471) provides a comprehensive overview of impairment accounting, which involves three stages: 1. Preliminary steps—determining what to test for impairment; 2. Impairment test—computing the amount of impairment, if any; and 3. Recognition of impairment in financial statements.

Chapter 10 Students will often wonder about the differences between revaluation and impairment. The differences are three-fold, as explained on page 481: the unit of measure (by asset or by cash generating unit), the frequency of evaluation (annual or less frequently), and the value measurement (fair value, fair value less costs to sell, value in use). It is important to bring the students back to the reasons for recording impairments beyond the obvious reason that the balance sheet should not overstate the value of recorded assets. Impairments serve economically important roles by reducing earnings management opportunities and increasing the quality of earnings, and thereby increase the efficiency of contracts (debt, compensation) that rely on accounting numbers. Section C looks at Investment Property. Land or buildings that are held by a company that earn rental income or are held for capital appreciation are classified as investment property. The key issue in accounting for investment property is the value at which an enterprise reports the investment property on the balance sheet date. Thus subsequent measurement is important. The initial recognition of investment property is at cost that also includes transaction costs. For subsequent recognition, IAS 40 indicates that an enterprise can choose either to apply the cost model or the fair value model. If an enterprise does choose to use the cost model, it is important to note that the enterprise must then disclose the fair values in the notes to the financial statements. Agriculture is covered in Section D. Determining what qualifies as agriculture is important. Exhibit 10-25 (p. 490) provides an excellent overview for students to see which types of activities should be included and which types of activities are not. There are unique issues in the accounting for the assets of an agricultural enterprise. The issues are unique because of two characteristics: agriculture involves managing regular cycles of change, and historical cost’s lack of relevance when applied to biological assets and agricultural produce. Non-current assets held for sale and discontinued operations are covered in Section E. IFRS 5 provides guidance on non-current assets held for sale. To be classified as held for sale, the non-current assets must be both available for immediate sale and expected to sell within a year. Assets so classified would be carried at the lower of carrying value and fair value less cost to sell. Assets held for sale (or sold during the reporting period) that comprise a component of an entity would be classified as discontinued operations, which entail separate reporting on the statement of comprehensive income as well as note disclosure of revenues, expenses, and cash flows. The goal is to allow for better predictions of continuing operations.

Chapter 10

USE OF END-OF-CHAPTER PROBLEMS AND CASES In addition to lectures, discussion of some of the end-of-chapter problems and cases will help students apply the concepts. The following table identifies all of the problems and cases that can be used in class, and problems and cases that can be used for homework assignments. (Depending on the time allocation between lectures and examples, it may not be feasible to cover all of the suggested items.) Table 10-1: Summary of learning objectives, chapter content, and suggested problems and cases Suggestions Suggestions L.O. for in-class for number Learning objective Pages discussion assignments 10-1. Apply the revaluation model of 501-505 P10-5 P10-1 accounting for non-current assets. P10-6 P10-2 P10-8 P10-3 P10-11 P10-4 P10-12 P10-7 P10-9 P10-10 P10-11 P10-12 P10-13 10-2. Evaluate whether a non-current 505-508 P10-14 P10-15 asset should be tested for P10-16 P10-17 impairment, whether the asset is P10-18 P10-19 impaired, and the extent of P10-20 P10-21 impairment. P10-22 P10-23 P10-24 P10-25 10-3. Account for the impairment of 508-511 P10-26 P10-27 different types of non-current P10-28 P10-29 assets. P10-30 P10-31 P10-32 P10-33 10-4. Apply the specialized standards for 511-516 P10-34 P10-35 the recognition and measurement of P10-36 P10-37 assets relating to investment P10-38 P10-39 properties and agricultural P10-40 P10-41 activities. P10-42 P10-43 P10-44 P10-45 P10-46 P10-47 P10-48 P10-49 P10-50 10-5. Apply the accounting standards 516-518 P10-51 P10-52 relating to non-current assets held P10-53 P10-54 for sale and discontinued P10-55 operations. — Integrative 519-524 Case 1 Case 2 Case 3

Chapter 10

Case 1(pp. 519-520) integrates issues relating to this chapter as well as issues from several earlier chapters. These issues include: impairment of non-current assets, recognition of intangible assets and goodwill (Chapter 9), cost allocation for PPE (Chapter 8), site restoration costs (Chapter 8), revenue recognition (Chapter 4), quality of earnings and earnings management (Chapter 3), application of the conceptual framework (Chapter 2), and economic consequences of accounting choice (Chapter 1). It may be appropriate to assign this case as a group assignment so that students have an opportunity to discuss and debate the various issues. Case 3 (p. 524) is about a publicly held real estate trust (REIT) in Canada and whether the real estate properties should be classified as property, plant, and equipment or as investment properties. This case also asks students to consider the effects of gains and losses on the financial statements if the properties were classified as investments. The case concludes by asking students to compare IAS 16 and IAS 40, and how they think the investments should be recorded and why.

APPENDIX A Financial Statement Analysis and Using Accounting Information to Value a Company

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.4.2 Evaluates financial statements including note disclosures (Level B) 1.4.3 Analyzes and provides input in the preparation of management communications (e.g., management discussion and analysis (MD&A)) (Level C) 1.4.4 Interprets financial reporting results for stakeholders (external or internal) (Level B) 1.4.5 Analyzes and predicts the impact of strategic and operational decisions on financial results (Level C) 5.1.1 Evaluates the entity’s financial state (Level B) 5.4.2 Applies appropriate methods to estimate the value of a business (Level C)

LEARNING OBJECTIVES A-1. Describe the purpose of common size financial statements and the information they convey. A-2. Describe the purpose of ratio analysis and the information the output conveys. A-3. Describe some challenges faced by financial statement analysts. A-4. Describe different methods of using accounting information to value a company.

OVERALL APPROACH The first part of the appendix introduces students to financial statement analysis and explores widely adopted approaches such as vertical and ratio analysis. The later part of the appendix focuses on valuation methods used for valuing a company based on the following inputs: book values, dividends, earnings and earnings multiples, free cash flow, and residual income.

KEY POINTS Introduction to Financial Statement Analysis: Section A investigates the Accounting Standards Board (AcSB) Framework for Reporting Performance Measures (The Framework), the process of analyzing financial statements and how ratios are categorized. .

Appendix A 1. Currently, there is no standardized approach to analyzing financial statements, due in large part to users' diverse needs and, to a lesser degree, to the lack of guidance from the standards-setting bodies. The AcSB recognized this issue, and in 2018, issued the Framework to address it. The Framework is voluntary, and it is improbable that the guidance will lead to a standardization of the methodology used by companies to report financial measures not included in financial statements. 2. With the absence of a standardized methodology, students should be familiar with some common widely adopted approaches explored in this appendix, including common size financial statements and ratio analysis 3. The appendix focuses on what are generally characterized as profitability and credit risk ratios. Common Size Financial Statement – Vertical Analysis: Section B describes the purpose of common size financial statements and how to apply the analysis to the income statement and balance sheet. 1. The common size income statement expresses income statement items as a percentage of sales, as illustrated in Exhibit A-1 (p. A3). Students should perform the analysis with questions like the following in mind: • What was the gross margin? • How much did the company spend on research and development (R&D) in relation to sales? • Did the percentage of investment in R&D increase this year compared to last year? • Did the net profit margin increase this year compared to last year? 2. The common size balance sheet reports assets, liabilities, and equity amounts as a percentage of total assets, as illustrated in Exhibit A-2 (p. A4). Students should perform this analysis with questions like the following in mind: • What was the composition of the assets? Were they mostly current or noncurrent in nature? • How liquid were the company’s assets? • Was the company highly leveraged (is there a high percentage of debt relative to equity)? Ratio Analysis: Section C describes the purpose of ratio analysis and the information the output conveys through benchmarking, trend analysis, profitability ratios, and credit risk ratios.

Appendix A 1. Peer group analysis and benchmarking refer to the practice of comparing a company’s financial results to that of the industry average, primary competitors, or industry frontrunners. 2. Trend analysis, also known as horizontal analysis, is the practice of comparing financial statement items on a year-over-year basis to see how they have changed over time to gain insight into areas of interest, as illustrated in Exhibit A-3 (p. A6). Students should perform this analysis with questions like the following in mind: • How fast did sales grow? • Did net income grow? Was the rate of growth higher or lower than that of sales? • Did the company invest more in assets? What kinds of assets? • Did debt grow faster than assets? 3. Profitability ratios help evaluate a company’s profitability. Common measures of profitability-related ratios include: • gross (profit) margin • profit margin on sales • return on assets (ROA) • return on equity (ROE) and • earnings per share (ESP). Exhibit A-4 (p. A7) defines the ROA formula whereas Exhibit A-5 (p. A8) provides an alternative formula for ROA. Exhibit A-6 (p. A8) defines the return on common equity (ROCE) formula whereas Exhibit A-7 (p. A9) provides an alternative formula for ROCE. Exhibits A-8a through c (pp. A9-A10) use an example to illustrate the impact of financial leverage on ROCE, determination of net income available to the common shareholders, and calculating ROCE. 4. Credit risk ratios can be categorized as relating to the possibility of a loss arising from the borrower defaulting on its payments, and include elements of asset management, most notably those pertaining to the control of accounts receivable and inventory. Credit risk ratios can be categorized as follows: • Liquidity ratios (current ratio, quick ratio, accounts receivable turnover ratio, inventory ratio, accounts payable turnover ratio, and days accounts receivable outstanding). See Exhibit A-9 (p. A10) and Exhibit A-10 (p. A11) for the definition of the formulas. • Solvency ratios (long-term debt to equity ratio and interest coverage ratio). See Exhibit A-11 (p. A12) and Exhibit A-12 (p. A13) for the definition of the formulas. Challenging aspects of financial statement analysis: Financial statement analysis isn’t without its limitations. The appendix discusses three of the most significant limitations.

Appendix A 1. Students need to look at the bigger picture when assessing a company’s performance because the numbers do not always tell the whole story. They need to analyze the underlying causes of the observed outcome or trend, rather than jumping to conclusions based solely on the result indicated by the ratio. 2. The company’s choice of accounting policies and estimates of value matter because they collectively reduce the comparability of a company’s reported results to that of its competitors and other benchmarks. 3. The scarcity of directly comparable results exists because directly comparable data can be difficult or impossible to find. Using accounting information to value a company: Section E describes different methods of using accounting information to value a company based on the following five inputs: book values, dividends, earnings and earnings multiples, free cash flow, and residual income. 1. The most straightforward way of valuing shares is using a company’s book value per share (BVPS). See Exhibit A-13 (p. A16) for the definition of the formula. Although this method is easy to apply, it should only be used under the following assumptions: • Completeness: The company’s balance sheet has recorded all significant assets and liabilities. • Neutrality: Accounting policies are neutral such that the recorded values of assets and liabilities on the balance sheet approximate their current values. • Stability: The company’s operations are stable rather than growing or declining. 2. The valuation formula using expected dividends is expressed in Exhibit A-14 (p. Al6). The formula is modified, as in Exhibit A-15 (p. A17), when the dividend payout is expected to grow at a constant rate. 3. The valuation formulas using expected earnings is expressed in Exhibit A-16 (p. A17) and earnings multiples in Exhibit A-18 (p. A18). Exhibit A-17 (p. A17) and Exhibit A-19 (p. A18) illustrates the approach using assumptions about Alpha Corporation. Another way to use the earnings multiple is by using the price-earnings ratio as expressed in Exhibit A-20 (p. A18). Exhibit A-21 (p. A19) summarizes all three approaches to earnings valuation for Alpha Corporation. 4. Valuation using free cash flow involves valuation of stock prices if free cash flow remains constant in the future, as in Exhibits A-22 (p. A19) and if cash flow changes in the future, as in Exhibit A-23 (p. A19). The application of this method is demonstrated in Exhibit A-24a through c (pp. A19-A20). 5. Another approach to valuing equity is the residual income method. The valuation formula using residual income is demonstrated in Exhibit A-25 (p. A21) and the .

Appendix A equation to determine residual income is demonstrated in Exhibit A-26 (p. A21). The application of the residual income method is demonstrated in Exhibit A-27a and b (pp. A21-A22).

APPENDIX B Data Analytics

CPA COMPETENCIES ADDRESSED IN THIS CHAPTER 1.1.3 Evaluates reporting systems, data requirements and business processes to support reliable financial reporting (Level B) c.

Explains data integrity risks in data integration and aggregation processes

1.1.4 Explains implications of current trends, emerging issues and technologies in financial reporting (Level C) d.

Explains the potential impact of automated data capture, artificial intelligence technologies and real time reporting

1.4.4 Interprets financial reporting results for stakeholders (external and internal) (Level B) b.

Explains results using data visualization techniques, where appropriate

LEARNING OBJECTIVES B-1. Describe the purpose of data analytics. B-2. Explain the importance of data analytics to the future of accounting. B-3. Define fundamental data concepts. B-4. Explain the primary technical steps used in the data analytics process. B-5. Tell a story to effectively guide data analysis to address a variety of business issues. B-6 Explain why skepticism is important in data analytics.

OVERALL APPROACH The first part of the appendix answers the question, what is data analytics? The remainder of the appendix defines fundamental data concepts by comparing traditional (structured) and big data (unstructured data), discusses the "Extract, Transform, Load" process, and concludes by asking us to consider data as a storyteller while maintaining our professional skepticism.

KEY POINTS Introduction: Consider how the role of accountants has changed over time and how computers have automated a large part of the accounting process that accountants .

Appendix B historically performed. Instead of perceiving machine learning and artificial intelligence as a threat to the accounting profession, we should see them as opportunities. Accountants no longer have to spend their time on mundane, time-consuming transactions; they can leverage their newfound time driving business strategy by applying data analytics. Fundamental data analytics concepts: Section B discusses traditional data versus big data (structured versus unstructured data), the technical approach to the data analytics process, data as storyteller, and maintaining skepticism. 1. Students may already be familiar with structured data through their study of the accounting cycle. Journal entries get posted to the general ledger, which can then be filtered and searched to find specific transactions. Custom reports and subledgers can be used to derive further insights into the data, while the financial statements can be prepared to summarize and present the data to external decision-makers. Unstructured data usually have data collection and analysis as their secondary purpose. Ask students to think about the primary purpose of text messages and emails. Then ask them if they can easily count the number of times a specific word is used across 10,000 emails. Their answer should be “no” since emails contain unstructured data, and their primary purpose is to communicate with another individual. Students should understand that structured data are clearly formatted, well-organized, and designed for manipulation and interpretation, whereas unstructured data are not. “Big Data” includes massive volumes of structured and unstructured data. Students need to understand the five “Vs” of Big Data: • Velocity – how quickly the data are generated. • Volume – how much data are created. • Variety – the different types of data. • Veracity – the quality of the data. • Value – how the business can benefit from the data. Managing these characteristics appropriately is key to a high-functioning data analytics process. 2. Many students may have performed the Extract, Transform, Load (ETL) process in the past without realizing it. The three-step process is defined below: • Extract – the initial part of the ETL process, where data are extracted directly from the data source. • Transform – includes data cleansing, data validation, and transformation. • Load – involves loading data into the analysis system. There are a massive number of tools in the marketplace that are designed to assist with the ETL process. Most small and medium-sized companies use an all-in-one ETL system because of their lower cost and ease of use.

Appendix B

3. Data should be explored in a clear strategic direction for the data to tell their story. This process involves eight steps: • Step 1 – Consider the overarching corporate values that drive the analysis. • Step 2 – Identify the problem currently facing the organization. • Step 3 – Create a defined objective. • Step 4 – Create business questions. • Step 5 – Create visualizations and analytics to answer the business questions. • Step 6 – Interpret results and adjust strategy. • Step 7 – Track results of analysis by comparing to the objective. • Step 8 – Start again. 4. Data can be tailored or obscured to suit virtually any result desired. Since professional accountants are governed by a code of professional conduct that prohibits association with false or misleading documents, it is critical that accountants approach data analyses with transparency and present the full story that the data appear to tell.

USE OF DATA ANALYTICS PROJECTS Two data analytics projects have been provided to give students hands-on experience in using data analytics tools to analyze inventory and accounts receivable valuation. Students can access these data analytics projects from MyLab Accounting under Chapter Resources. For each project—Allowance for Doubtful Accounts and Inventory Valuation—students are provided with project instructions and multiple-choice questions in a Word file, and data files in Excel, along with any other relevant data in separate files. Because the datasets are in Excel, students can use any software, such as Power BI or Tableau, to conduct their data analyses. In the Instructor Resources section in MyLab, instructors are supplied with the project files for instructors, which contain the answers to the multiple-choice questions in the student’s files. Instructors also have a Solutions Guide that shows in detail how to manipulate the data in Excel, along with detailed instructions on how students can perform the analysis using Power BI and Tableau. The solutions in Power BI and Tableau files are also provided. Thus, instructors have the flexibility to choose which software tool they would like students to use to perform their analyses for the data analytics projects.