12.11: Solutions
Solutions
Chapter 2 Exercises
Information asymmetry simply means that one party to a business transaction has more information than the other party. This problem is demonstrated by the situation where business managers know more about the business's operations than outside parties (e.g., investors and lenders). The information asymmetry problem can take two forms—adverse selection and moral hazard. With adverse selection, a manager may choose to act on inside knowledge of the business in a way that harms outside parties. Insider trading by managers using non-public knowledge may distort market prices of securities and create distrust in investors. Accounting attempts to deal with the problem by providing as much timely information to the market as possible. Moral hazard occurs when a manager shirks or otherwise performs in a substandard fashion, knowing that his or her performance as an agent is not directly observable by the principal (owner). Accounting tries to deal with this problem by providing information to business owners that can help assess management's level of performance. Although the field of accounting does attempt to solve these problems through the provision of high quality information, information asymmetry can never be completely eliminated, so the accounting profession will always seek ways to improve the usefulness of accounting information.
Canada allows privately-owned businesses to use Accounting Standards for Private Enterprise (ASPE) or International Financial Reporting Standards (IFRS), while requiring publicly accountable enterprises to use IFRS. IFRS is partially or fully recognized in over 125 countries as the appropriate accounting standard for companies that trade shares in public markets. The main advantage of using a consistent standard around the world is that investors can understand and compare investment opportunities in different countries without having to make conversions or adjustments to reported results. This is an important feature as markets have become more globalized and capital more mobile. By requiring IFRS for publicly-traded companies, Canada has attempted to maintain the competitiveness of these companies in international financial markets. By allowing private companies the option to report under ASPE instead, standard setters have created an environment that could be more responsive to local needs and unique, Canadian business circumstances. As well, many features of ASPE are simpler to apply than IFRS, which may reduce accounting costs for small, non-public businesses.
The major disadvantage of maintaining two sets of standards is cost. The burden of standard setters is increased, and these costs will ultimately be passed on to businesses that are required to report. As well, having two sets of standards may create confusion among investors and lenders, as public and private company financial statements may not be directly comparable.
The conceptual framework is a high-level structure of concepts established by accounting standard setters to help facilitate the consistent and logical formulation of standards, and provide a basis for the use of judgment in resolving accounting issues. This framework is essential to standard setters as they develop new accounting standards in response to changes in the economic environment. The framework gives the standard setters a basis and set of defining principles from which to develop new standards. The framework is also useful to practicing accountants, as it can provide guidance to them when interpreting unusual or new business transactions. The framework gives practicing accountants the tools and support to critically evaluate accounting treatments of specific transactions that may not appear to fit into standard definitions or norms. Without a proper conceptual framework, accounting standards may become inconsistent and ad-hoc, and their application may result in financial statements that are not comparable, resulting in less confidence in capital markets.
The two fundamental characteristics of good accounting information are relevance and faithful representation. Relevance means that the piece of information has the ability to influence one's decisions. This characteristic exists if the information helps predict future events or confirm predictions made in the past. Some relevant information may have both predictive and confirmatory value, or it may only meet one of these needs. Faithful representation means that the information being presented represents the true economic state or condition of the item being reported on. Faithful representation is achieved if the information is complete, neutral, and free from error. Complete information reports all the factors necessary for the reader to fully understand the underlying nature of the economic event. This may mean that additional narrative disclosures are required as well as the quantitative value. Neutral information is unbiased and does not favour one particular outcome or prediction over another. Freedom from error means that the reported information is correct, but it does not have to be 100% error free. The concept of materiality allows for insignificant errors to still be present in the information, as long as those errors have no influence on a reader's decisions. Although both relevance and faithful representation need to be present for information to be considered useful, accountants face difficulties in achieving maximum levels of both characteristics simultaneously. As a result, trade-offs are often required, which may lead to imperfect information. Accountants are also often faced with a trade-off between costs and benefits. It may be too costly to guarantee 100% accuracy, so a little faithful representation may need to be given up to maintain the relevance of the information. This means that the accountant will need to apply good judgment in balancing the trade-offs in a way that maximizes the usefulness of the information.
The four enhancing qualitative characteristics are comparability, verifiability, timeliness, and understandability. Comparability means information from two or more different businesses or from the same business over different time periods can be compared. Verifiability means two independent and knowledgeable observers could come to the same conclusion about the information being presented. Timeliness means that information needs to be current and not out of date. The older the information, the less useful it becomes for decision-making purposes. Understandability means that a reader with a reasonable understanding of business transactions should be able to understand the meaning of the accounting information being disclosed. Timeliness is often in conflict with verifiability, as verification of information takes time. Financial statements are almost always issued under deadlines; the optimal level of verification may not be achieved. Likewise, understandability may be enhanced with more careful drafting of the supplemental disclosures, but time constraints may interfere with this function. Understandability and comparability may both be influenced by the company's need to keep certain information confidential in order to avoid giving away a competitive advantage. All of these characteristics may be influenced by matters of cost. Businesses will make rational decisions by weighing the costs of certain actions against the benefits received. Cost considerations may result in accounting information not achieving the maximum levels of all of the qualitative characteristics. Balancing the trade-offs of these characteristics with the cost considerations is one of the largest challenges faced by practicing accountants.
- A reduction of both assets and equity
- An exchange of equal value assets
- An exchange of assets of unequal value resulting in income and expense and a resulting increase in equity (assumes goods are sold for an amount greater than cost)
- Recognition of an expense, resulting in a decrease in equity and a liability
- An asset is received and an equal value liability is recognized
- Recognition of an expense, resulting in a decrease in equity and a liability
- An equal increase in an asset and equity
- An equal increase in an asset and a liability
- An exchange of assets of unequal value, resulting in income and an increase in equity
- A recognition of an expense, resulting in a decrease in equity, and a contra-asset
An item is recognized in the financial statements if it: (a) meets the definition of an element, (b) can result in probable future economic benefits to or from the entity, and (c) can be measured reliably. These criteria can be applied as follows.
- The company has received an asset, but the company has not yet achieved substantial performance of the contract. The contract will be performed as issues of the magazines are delivered. Thus, the appropriate offsetting element to the asset is a liability, as a future obligation is created. As each issue is delivered, the liability is reduced and income can be recognized. The amount can be measured reliably, as the cash has already been received and the price of each magazine issue has already been determined.
- The appropriate element here is the liability that is being created by the lawsuit. Because the lawsuit results from a past event that creates a present obligation to pay an amount in the future, the definition of a liability is met. It also appears that the outflow of economic benefits is probable, based on the lawyer's evaluation. However, if there really is no way to reliably measure the amount, then the liability should not be recognized. However, the lawyers should make a reasonable effort based on prior case law, the facts of the case, and so forth, to see if an amount can be reliably estimated. Even if the amount is not recognized, the lawsuit should still be disclosed in the notes to the financial statements as this information is likely relevant to those reading the financial statement.
- An asset is normally created and income recognized when the invoice is issued. The future economic benefit exists, is the result of a past event, and can be measured reliably, based on the terms of the contract. In this case, however, there is some issue regarding the probability of realizing the future economic benefits. A careful analysis of the situation is required to determine if recognition of an asset is appropriate. Only the amount whose collection can be deemed probable should be recognized. Even if the amount is not recognized, the contract should still be disclosed in the supplemental information, as this information is likely relevant to financial statement readers.
- The question of whether this meets the definition of an asset needs to be addressed. Is the goodwill being recorded a "resource controlled by the entity"? Goodwill, by definition, is intangible, but it is not clear what exactly is generating the goodwill in this case. It is difficult to say that this even meets the definition of an asset. If this definitional argument is stretched, it would still be difficult to recognize the element, as it is unlikely to pass the reliable measurement test. An asset based on the current share price is not reliably measured, as share prices are volatile and transitory. No recognition of the asset and corresponding equity amount is warranted in this case.
- This does appear to meet the definition of a liability, as the past event (the drilling) results in a present obligation (the requirement to clean up the site) in the future. This type of liability should normally be recorded at the present value of the expected outflow of resources in 10 years time, as this outflow is probable. The company may have some difficulty measuring the amount, as they have no experience with this type of operation. However, an estimate should be able to be made using engineering estimates, industry data, and so forth. The other item that needs to be estimated is the appropriate discount rate for the present value calculation. Again, the company can use its cost of capital or other appropriate measure for this purpose. This liability and an expense should be recognized, although estimation will be required. Additional details of the method of estimation would also need to be disclosed.
The four measurement bases are historical cost, current cost, realizable (settlement) value, and present value. Historical cost represents the actual transaction cost of an element. This is normally very reliably measured, but may not be particularly relevant for current decision making purposes. Current cost represents the amount required to replace the current capacity of the particular asset being considered, or the amount of undiscounted cash currently required to settle the liability. This base is considered more relevant than historical cost, as it attempts to use current market information to value the item. However, many items, particularly special purpose assets, do not have active markets and are, thus, not reliably measured by this approach. Realizable value represents the amount that an asset can currently be sold for in an orderly fashion (i.e., not a "fire-sale" price) or the amount required to settle a liability in the normal course of business. Again, this has the advantage of using current market conditions, making it more relevant than historical cost. However, as with current cost, active disposal markets for the asset may not exist. As well, realizable value is criticized as being irrelevant in cases where the company has no intention of disposing of the asset for many years. Present value is, perhaps, the most theoretically justified measurement base. In this case, all assets and liabilities are measured at the present value of the related future cash flows. This measure is highly relevant, as it represents the value in use to the organization. The problem with this approach is that it is difficult to reliably estimate the timing and probability of the future cash flows. As well, determinations need to be made regarding the appropriate discount rate, which may not always have a clear answer.
Capital maintenance refers to the amount of capital that investors would want to be maintained within the business. This concept is important to investors, as the level of capital maintenance required may influence an investor's choice as to which company to invest in. The measurement of an investor's capital can be defined in terms of financial capital or physical capital.
Financial capital maintenance simply looks at the amount of money in a business, measured by changes in the owners' equity. This can be measured simply by looking at monetary amounts reported in the financial statements. The problem with this approach is that it doesn't take into account purchasing power changes over time. The constant purchasing power model attempts to get around this problem by adjusting capital requirements for inflation by using a broadly based index, such as the Consumer Price Index. The problem with this approach is that the index chosen may not accurately reflect the actual level of inflation experienced by the company. Physical capital maintenance tries to get around this problem by measuring the physical capacity of the business, rather than the financial capacity. The advantage of this approach is that it measures the actual productivity of the business and is not affected by inflation. The disadvantage of this method is that it is not easy or cost-effective to measure the productive capacity of each asset within the business.
Because each capital maintenance model involves trade-offs, the conceptual framework does not draw a conclusion on which approach is the best. Rather, it suggests that end needs of the financial statement users be considered when determining to apply capital maintenance concepts to specific accounting standards.
Principles-based standards present a series of basic concepts that professional accountants can use to make decisions about the appropriate accounting treatment of individual transactions. Rules-based standards, on the other hand, are more prescriptive and detailed. These standards attempt to create a rule for any situation the accountant may encounter. The main advantage of principles-based systems is their flexibility. They allow the accountant the latitude to apply judgment to deal with new situations or unusual circumstances. This flexibility, however, can also cause problems for the accountant, as there could be pressure to stretch the professional judgment in a way that creates misleading financial statements. As well, the application of judgment in the preparation of financial statement could result in reports that are not comparable, as other accountants may arrive at different conclusions for similar transactions. This suggests that the verifiability characteristic may also be compromised. The main advantage of rules-based approaches is the certainty and comparability offered by detailed rules. Readers can have confidence that similar transactions are reported in similar ways. As well, this may reduce the accountant's professional liability, as long as the rules have been applied correctly. The main disadvantage of the rules-based systems is their inflexibility. Prescription of specific accounting treatments can result in financial engineering, wherein new transactions are designed solely for the purpose of circumventing the rules. This can create misleading financial reports, where the true nature of the transactions is not reflected correctly. As well, overly detailed rules can create a problem of understandability, not only for the readers, but even for the professional accountants themselves. As a practical matter, all systems of accounting regulation contain both broad principles and detailed rules. The challenge for accounting standard setters is to find the right balance of rules and principles.
Managers may attempt to influence the outcome of financial reporting for a number of reasons. Managers may have bonus or other compensation schemes that are directly tied to reported results. Managers are rational in attempting to influence their own compensation, as they understand that compensation earned now is more valuable than compensation that is deferred to future periods. Even if the manager's compensation is not directly tied to financial results, the manager may still have an incentive to make the company's results look as good as possible, as this would enhance the manager's reputation and future employment prospects. Managers will also feel pressure from shareholders to maintain a certain level of financial performance, as public securities markets can be very punitive to a company's share price when earnings targets are not reached. Shareholders do not like to see the price of the share fall drastically. On the other hand, shareholders also want to have a realistic assessment of the company's earning potential. These conflicting goals may create a complicated dynamic for the manager's behaviour in crafting the financial statements. Managers are also influenced by the conditions of certain contracts, such as loan agreements. Loan covenants may require the maintenance of certain financial ratios, which clearly puts pressure on managers to influence the financial reports in a certain fashion. Managers may also feel pressure to keep earnings low where there are political consequences of being too profitable. This may occur when a company has disproportionate power over the market, or where there is a public interest in the operations of the business. The company does not want to demonstrate earnings that are too high, as it risks attracting additional taxation, penalties, or other actions that may restrict future business.
The pressures that managers feel to influence financial results will eventually find their way to the accountant, as the accountant is ultimately responsible for creating the financial statements. Whether the accountant is internal or external to the business, his or her work must be performed ethically and professionally. The accountant must always act with integrity and objectivity, and must avoid being influenced by the pressures that may be exerted by managers or other parties. The accountant must demonstrate professional competence and must keep client information confidential. The accountant should not engage in any work that falls outside of the scope of that accountant's professional capabilities. As well, the accountant must not engage in any behaviour that discredits the profession. Although it is easy to describe the accountant's professional responsibilities, it is not always easy to put these concepts into practice. The accountant needs to be aware of the pressures faced in the reporting environment, and may need to seek outside advice when faced with ethical or professional problems. Ultimately, the accountant is a key player in establishing the overall credibility of financial reporting, and financial markets rely on this credibility to function in an efficient manner.
The vice-president finance's comments hint at a threat to my objectivity as financial controller. The potential reward of the vice-president finance position should not influence how I perform my professional duties. The specific issues identified by the vice-president finance can be addressed as follows.
- This lawsuit appears to meet the definition of a liability, as it is a present obligation that results from a past transaction and will require a future outflow of economic resources. As well, it appears to have satisfied the recognition criteria, as the payment is probable and the amount can be estimated. This amount should be accrued this year, although prior years' financial statements do not need to be adjusted. Further consultation with the lawyers is required to determine the most reasonable amount to accrue within the range provided. Also, IFRS and ASPE use different approaches to accounting for provisions based on a range of values.
- A change in accounting policy should be disclosed in the notes to the financial statements. However, the change should also be accounted for in a retrospective fashion, where prior years' results are restated to show the effect of the change on those years. This retrospective treatment may result in a change in the effect on the current year's income. This treatment is necessary to maintain comparability with prior years' results.
- Prepayments from customers appear to meet the definition of a liability, as they represent a present obligation to deliver future resources to the customers (in this case, products to be manufactured). The recognition criteria also appear to have been met, so these amounts should be disclosed as liabilities. It is generally not appropriate to net assets and liabilities together, as this distorts the underlying nature of the individual financial statement elements.
- It is unlikely that this even meets the definition of an asset, as it cannot be said that we control the resource. Although we pay the research and development director's salary and likely have proprietary rights to his inventions, we cannot really say that the resource, his knowledge, is controlled by the company. Even if we stretch the definition of an asset here to include this knowledge, it still doesn't meet the recognition criteria, as there is no demonstration that the future flow of economic resources is either probable or measurable.
- The vice-president finance is indicating that year-end accounting adjustments need to be considered for their effects on the debt-to-equity ratio. All of the accounting treatments proposed by the vice-president finance would improve this ratio. However, all of the proposed accounting treatments are likely unsupportable under the conceptual framework. It appears that the vice-president finance's objectivity may have been impaired by his requirement to prevent a debt covenant violation. It is likely that the vice-president finance's proposed accounting treatments will be challenged by the company's external auditors, which may create delays and other problems in issuing the financial statements. This could also cause problems with the bank. In performing my duties as the financial controller, I need to be aware of the threats to my objectivity. Although there is no evidence of any ethical conflict yet, I will need to perform my duties with integrity. If my actions do result in a conflict with the vice-president finance, I will need to carefully consider my actions. I may need to seek outside advice from my professional association and others, if necessary. Ultimately, I must ensure that I do not prepare financial statements that are false or misleading in any way.
Chapter 3 Exercises
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Income from continuing operations = Income from operations + Gain on sale of FNVI investments – Income tax on income from continuing operations =
Net income = Income from continuing operations – Loss from operation of discontinued division (net of tax) – Loss from disposal of discontinued division (net of tax) =
Other comprehensive income = Unrealized holding gain – OCI (net of tax) = $12,000
Total comprehensive income = Net income + other comprehensive income =
- Under ASPE, other comprehensive income and comprehensive income do not apply.
Quality of Earnings : In terms of earnings quality, there are issues. The company's net income includes a significant gain on sale of idle assets, which means that a sizeable portion of earnings were not generated from ongoing core business activities. Wozzie also changed their inventory policy from FIFO to weighted average, which is contrary to the method used within their industry sector. This is cause for concern as it raises questions about whether management is purposely trying to manipulate income. A change in accounting policy is only allowed as a result of changes in a primary source of GAAP or may be applied voluntarily by management to enhance the relevance and reliability of information contained in the financial statements for IFRS. Unless Wozzie's inventory pricing is better reflected by the weighted average method, contrary to the other companies in their industry sector, the measurement of inventory and cost of goods sold may be biased.
Investing in the Company : Investors and analysts will review the financial statements and see that part of the company's net income results from a significant gain generated from non-core business activities (the sale of idle assets) and will also detect the lower cost of goods sold resulting from the change in inventory pricing policy disclosed in the notes to the financial statements. As a result, investors will assess the earnings reported as lower quality, and the capital markets will discount the earnings reported to compensate for the biased information. Had Wozzie not fully disclosed the accounting policy change for inventory, the market may have taken a bit longer to discount that portion of the company's net income due to lower quality information.
Eastern Cycles' sale of the corporate-owned stores to a franchisee would not qualify for discontinued operations treatment because the corporate-owned stores are not a separate major line of business. Under IFRS, a component of an entity comprises operations, cash flows, and financial elements that can be clearly distinguished from the rest of the enterprise, which is not the case as stated in the question information.
Under ASPE, selling the corporate-owned stores would also not qualify for discontinued operations treatment. The corporate-owned stores are likely a component of the company, but the franchisor is still involved with the franchisees because Eastern Cycles continues to provide product to them as well as advertising, training, and support. The cash flows of Eastern Cycles (the franchisor) are still affected by those of the franchisee since Eastern Cycles collects monthly fees based on revenues.
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Bunsheim Ltd. Statement of Changes in Equity For the Year Ended December 31, 2020 Common Comprehensive Retained Accumulated Other Total Shares Income Earnings Comprehensive Income Beginning balance as reported $ 707,000 $ 480,000 $ 50,000 $177,000 Correction of understatement in travel expenses from 2019 of $80,000 (net of tax of $21,600) (58,400) (58,400) Beginning balance as adjusted $ 648,600 $ 480,000 $ (8,400) $177,000 Comprehensive income: Net income 130,853 $ 130,853 130,853 Other comprehensive Income: Unrealized gain – FVOCI investments** 25,000 25,000 25,000 Dividends declared (45,000) (45,000) Comprehensive income $ 155,853 Ending balance $ 759,453 $ 480,000 $ 77,453 $202,000 ** net of tax of $5,000. May be reclassified subsequently to net income or loss
Disclosures – prior period adjustments are to be reported net of tax with the tax amount disclosed. Unrealized gain on FVOCI investments is to be disclosed net of tax with tax amount disclosed and that it may be reclassified subsequently to net income or loss.
| Bunsheim Ltd. | |||
| Statement of Retained Earnings | |||
| For the Year Ended December 31, 2020 | |||
| Balance, January 1, as reported | $ | 50,000 | |
| Correction for understatement in travel expenses | |||
| from 2019 of $80,000 (net of tax of $21,600) | (58,400) | ||
| Balance, January 1, as adjusted | (8,400) | ||
| Add: Net income | 130,853 | ||
| 122,453 | |||
| Less: Dividends | 45,000 | ||
| Balance, December 31 | $ | 77,453 |
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Patsy Inc. Partial Statement of Comprehensive Income For the Year Ended December 31, 2020 Income from continuing operations $ 1,500,000 Discontinued operations Loss from operation of discontinued Calgary division (net of tax of $52,500) $ (122,500) Loss from disposal of Calgary division (net of tax of $37,500) (87,500) (210,000) Net income 1,290,000 Other comprehensive income Items that may be reclassified subsequently to net income or loss: Unrealized gain on FVOCI investments (net of tax of $11,786*) 27,500 Total comprehensive income $ 1,317,500 Earnings per share Income from continuing operations** $ 30.00 Discontinued operations (4.20) Net income $ 25.80 *
**Continuing operations $1,500,000 50,000; discontinued operations ($210,000 50,000)Required disclosures: Items reported at their net of tax amounts must also disclose the tax amount. Earnings per share information related to income from continuing operations and discontinued operations are required under IFRS but earnings per share information related to comprehensive income are not required under IFRS.
- Had Patsy followed ASPE, other comprehensive income and total comprehensive income do not apply. Investments that are not quoted in an active market are accounted for at cost. This also assumes that the discontinued operations meet the definition of a discontinued operation under ASPE.
Calculation of increase or (decrease) in shareholders' equity:
| Increase in assets: | = | $243,370 | |
| Increase in liabilities: | = | 68,300 | |
| Increase in shareholders' equity: | $175,070 |
Breakdown of shareholders' equity account:
| Net increase | $ | 175,070 | ||||
| Increase in common shares | $ | 87,000 | ||||
| Increase in contributed surplus | 18,600 | |||||
| Decrease in retained earnings due to dividend declaration | (44,000) | 61,600 | ||||
| Increase in retained earnings due to net income | $ | 113,470 |
To solve algebraically use the basic accounting equation:
Restated:
Since equity is made up of then:
| $7.58 | per share |
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Opi Co. Income Statement For the Year Ended December 31, 2020 Revenues Net sales revenue* $ 1,778,400 Gain on sale of land 39,000 Rent revenue 23,400 Total revenues 1,840,800 Expenses Cost of goods sold 1,020,500 Selling expenses** 587,600 Administrative expenses*** 130,260 Total expenses 1,738,360 Income before income tax 102,440 Income tax 30,732 Income from continuing operations 71,708 Discontinued operations Gain on disposal of discontinued operations – South Division (net of tax of $8,268) 19,292 Net income $ 91,000 *
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***Disclosure notes – COGS and most Other Revenue and Expense items are to be disclosed separately. Discontinued operations items are to be separately disclosed, net of tax, with tax amount disclosed.
Opi Co. Statement of Retained Earnings For the Year Ended December 31, 2020 Retained earnings, January 1 as reported $ 338,000 Less error correction (net of tax of $4,050) 9,450 Retained earnings, January 1, as adjusted 328,550 Add: net income 91,000 419,550 Less: dividends 58,500 Retained earnings, December 31 $ 361,050 Prior period adjustments reported in retained earnings must be separately reported, net of tax with tax amount disclosed.
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Opi Co. Income Statement For the Year Ended December 31, 2020 Revenues Net sales revenue* $ 1,778,400 Gain on sale of land 39,000 Rent revenue 23,400 Total revenues 1,840,800 Expenses Cost of goods sold 1,020,500 Selling expenses** 587,600 Administrative expenses*** 130,260 Total expenses 1,738,360 Income before income tax 102,440 Income tax 30,732 Income from continuing operations 71,708 Discontinued operations: Gain on disposal of discontinued operations – South Division (net of tax of $8,268) 19,292 Net income 91,000 Retained earnings, January 1 as reported 338,000 Less error correction (net of tax of $4,050) 9,450 Retained earnings, January 1, as adjusted 328,550 419,550 Less dividends 58,500 Retained earnings, December 31 $ 361,050 *
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***Disclosure notes – COGS and most Other Revenue and Expense items are to be disclosed separately. Discontinued operations items are to be separately disclosed, net of tax, with tax amount disclosed. Prior period adjustments reported in retained earnings must be separately reported, net of tax with tax amount disclosed.
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Ace Retailing Ltd. Statement of Income For the Year Ended December 31, 2020 Sales revenue $ 1,500,000 Less cost of goods sold 750,000 Gross profit 750,000 Less selling and administrative expenses 245,000 Income from operations 505,000 Other revenues and gains Interest income $ 15,000 Gain on sale of FFNI investments 45,000 60,000 565,000 Other expenses and losses Loss on impairment of goodwill 12,000 Loss on disposal of equipment 82,000 Loss from warehouse fire 175,000 269,000 Income from continuing operations before income tax 296,000 Income tax expense 79,920 Income from continuing operations 216,080 Discontinued operations Loss from operations, net of income tax recovery of $76,950 208,050 Gain from disposal, net of income taxes of $31,050 83,950 124,100 Net income $ 91,980 Earnings per share Income from continuing operations* $ 0.34 Discontinued operations** (0.31) Net income $ 0.03 (rounded) *
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Ace Retailing Ltd. Statement of Income and Comprehensive Income For the Year Ended December 31, 2020 Sales revenue $ 1,500,000 Less cost of goods sold 750,000 Gross profit 750,000 Less selling and administrative expenses 245,000 Income from operations 505,000 Other revenues and gains Interest income $ 15,000 Gain on sale of FVNI investments 45,000 60,000 565,000 Other expenses and losses Loss on impairment of goodwill 12,000 Loss on disposal of equipment 82,000 Loss from warehouse fire 175,000 269,000 Income from continuing operations before income tax 296,000 Income tax expense 79,920 Income from continuing operations 216,080 Discontinued operations Loss from operations, net of tax recovery of $76,950 208,050 Gain from disposal, net of tax of $31,050 83,950 124,100 Net income $ 91,980 Other comprehensive income Items that may be reclassified subsequently to net income or loss: Unrealized gain on FVOCI investments, net of income tax of $5,022 13,578 Total comprehensive income $ 105,558 Earnings per share Income from continuing operations* $ 0.34 Discontinued operations** (0.31) Net income $ 0.03 (rounded) *
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Ace Retailing Ltd. Statement of Comprehensive Income For the Year Ended December 31, 2020 Net income $ 91,980 Other comprehensive income Items that may be reclassified subsequently to net income or loss: Unrealized gain on FVOCI investments, net of income tax of $5,022 13,578 Total comprehensive income $ 105,558 -
Ace Retailing Ltd. Income Statement For the Year Ended December 31, 2020 Revenues Sales revenue $ 1,500,000 Interest income 15,000 Gain on sale of FVNI investments 45,000 Total revenues 1,560,000 Expenses Cost of goods sold 750,000 Selling and administrative expenses 245,000 Loss on impairment of goodwill 12,000 Loss on disposal of equipment 82,000 Loss from warehouse fire 175,000 Total expenses 1,264,000 Income from continuing operations before income tax 296,000 Income tax 79,920 Income from continuing operations 216,080 Discontinued operations Loss from operations, net of income tax recovery of $76,950 208,050 Gain from disposal, net of income taxes of $31,050 83,950 124,100 Net income $ 91,980 Earnings per share Income from continuing operations* $ 0.34 Discontinued operations** (0.31) Net income $ 0.03 (rounded) *
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Items are to be reported as Other Revenue and Expenses when using the multiple-step format for the statement of income. These are revenues, expenses, gains, and losses that are not realized or incurred as part of ongoing operations (for a retail business in this case). Examples of items that do not normally recur in a retail business are:
- Dividend revenue (from investments)
- Gain or loss on sale or disposal of current or long-term assets (i.e., investments, property, plant, equipment, and certain intangible assets such as patents and copyrights)
- Interest income or expense from receivables or investments
- Impairment losses on various assets not recorded through OCI
- Loss from fire, flood, and storm damages in areas not known for this activity
- Loss on inventory due to decline in NRV
- Rent revenue or other revenues not normally associated with the usual business of the company
- Unrealized gains or losses on investments not recorded to OCI
Note that as a rule, if the item is unusual and material , (consider size, nature, and frequency), the item is presented separately but included in income from continuing operations. If the item is unusual but immaterial , the item is combined with other items in income from continuing operations. So, there is a trade-off between additional disclosures of relevant information and too much disclosure resulting in information overload. Moreover, IFRS and ASPE reporting requirements vary and the standards change over time, so different items may need to be separately reported in one standard but not necessarily in the other standard. It is important to check the standards periodically to ensure that the latest reporting requirements are known.
| Vivando Ltd. | ||||||
| Income Statement (Partial) | ||||||
| For the Year Ended December 31, 2020 | ||||||
| Income from continuing operations before income tax | $ | 1,891,000* | ||||
| Income tax | 472,750 | |||||
| Income from continuing operations | 1,418,250 | |||||
| Discontinued operations | ||||||
| Loss from operation of discontinued subsidiary | ||||||
| (net of tax of $17,000) | $ | (51,000) | ||||
| Loss from disposal of subsidiary (net of tax of $28,150) | (84,450) | 135,450 | ||||
| Net income | $ | 1,282,800 | ||||
| Earnings per share | ||||||
| Income from continuing operations | $ | 6.30 | ||||
| Discontinued operations | (0.60) | |||||
| Net income | $ | 5.70 | ||||
| *Income from continuing operations before income tax: | ||||||
| As previously stated | $ | 1,820,000 | ||||
| Gain on sale of equipment ( ) | 16,400 | |||||
| Settlement of lawsuit | 180,200 | |||||
| Write-off of accounts receivable | (125,600) | |||||
| Restated | $ | 1,891,000 |
Note: The prior year error related to the intangible asset was correctly charged to opening retained earnings.
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Spyder Inc. Income Statement For the Year Ended September 30, 2020 Sales Revenue Sales revenue $ 2,699,900 Less: Sales discounts $ 21,000 Sales returns and allowances 87,220 108,220 Net sales revenue 2,591,680 Cost of goods sold 1,500,478 Gross profit 1,091,202 Operating Expenses Selling expenses: Sales commissions expenses $ 136,640 Entertainment expenses 20,748 Freight-out 40,502 Telephone and Internet expenses 12,642 Depreciation expense 6,972 217,504 Administrative expenses: Salaries and wages expenses 78,764 Depreciation expense 10,150 Supplies expense 4,830 Telephone and Internet expense 3,948 Miscellaneous expense 6,601 104,293 321,797 Income from operations 769,405 Other Revenues Gain on sale of land 78,400 Dividend revenue 53,200 901,005 Other Expenses Interest expense 25,200 Income from continuing operations before income tax 875,805 Income tax 262,742 Income from continuing operations 613,063 Discontinued operations Loss on disposal of discontinued operations – Aphfflek Division (net of taxes of $14,700) 34,300 Net income $ 578,763 Earnings per share from continuing operations $ 4.94* from discontinued operations (0.28)** Net income $ 4.66 * common shares
** -
Spyder Inc. Statement of Changes in Shareholders' Equity For the Year Ended September 30, 2020 Accumulated Other Common Retained Comprehensive Shares Earnings Income Total Beginning balance as reported $454,000 $215,600 $162,000 $831,600 Correction of error for depreciation expense from 2019 (net of tax recovery of $7,434) (17,346) (17,346) Beginning balance as restated 454,000 198,254 162,000 814,254 Comprehensive income: Net income 578,763 578,763 Total comprehensive income 578,763 578,763 Dividends – common shares (12,600) (12,600) Ending balance $454,000 $764,417 $162,000 $1,380,417 -
Spyder Inc. Income Statement For the Year Ended September 30, 2020 Revenues Net sales revenue $ 2,591,680 Gain on sale of land 78,400 Dividend revenue 53,200 Total revenues 2,723,280 Expenses Cost of goods sold 1,500,478 Sales commissions expense 136,640 Entertainment expense 20,748 Freight-out 40,502 Telephone and Internet expense* 16,590 Depreciation expense** 17,122 Salaries and wages expense 78,764 Supplies expense 4,830 Miscellaneous operating expense 6,601 Interest expense 25,200 Total expenses 1,847,475 Net income from continuing operations before income tax 875,805 Income tax 262,742 Income from continuing operations 613,063 Discontinued operations Loss on disposal of discontinued operations – Aphfflek Division (net of taxes of $14,700) 34,300 Net income $ 578,763 Earnings per share from continuing operations 4.84*** from discontinued operations (0.28)**** Net income $ 4.56 *
**
*** common shares
****
| Spyder Inc. | |||
| Statement of Comprehensive Income | |||
| For the Year Ended September 30, 2020 | |||
| Net income | $ | 578,763 | |
| Other Comprehensive Income: | |||
| Items that may be reclassified subsequently to net income or loss: | |||
| Unrealized gain on FVOCI investments (net of tax of $7,500) | 17,500 | ||
| Comprehensive Income | $ | 596,263 |
Chapter 4 Exercises
| Account name | Classification |
| Preferred shares | Cap |
| Franchise agreement | IA |
| Salaries and wages payable | CL |
| Accounts payable | CL |
| Buildings (net) | PPE |
| Investment – Held for Trading | CA |
| Current portion of long-term debt | CL |
| Allowance for doubtful accounts | CA |
| Accounts receivable | CA |
| Bond payable (maturing in 10 years) | NCL |
| Notes payable (due next year) | CL |
| Office supplies | CA |
| Mortgage payable (maturing next year) | CL |
| Land | PPE |
| Bond sinking fund | LI |
| Inventory | CA |
| Prepaid insurance | CA |
| Income tax payable | CL |
| Cumulative unrealized gain or loss from an OCI investment | AOCI |
| Investment in associate | LI |
| Unearned subscriptions revenue | CL |
| Advances to suppliers | CA |
| Unearned rent revenue | CL |
| Copyrights | IA |
| Petty cash | CA |
| Foreign currency bank account or cash | CA |
-
Aztec Artworks Ltd. Statement of Financial Position As at December 31, 2021 Assets Current assets Cash $ 143,000 Investments (held for trading at fair value) 135,000 Accounts receivable $ 332,000 Allowance for doubtful accounts (12,000) 320,000 Inventory (at lower of FIFO cost and NRV) $ 960,000 Inventory on consignment 20,000 980,000 Prepaid expenses 30,000 Total current assets 1,608,000 Long-term investments: Investment in bonds (held to maturity at amortized cost) 200,000 Bond sinking fund 100,000 Land held for investment (at cost) 200,000 500,000 Property, plant, and equipment Building under construction $ 220,000 Land (at cost) 220,000 440,000 Building (at cost) $ 1,950,000 Accumulated depreciation (450,000) 1,500,000 Equipment (at cost) 500,000 Accumulated depreciation (120,000) 380,000 2,320,000 Intangible assets: Patents (net of accumulated amortization for $9,000) 21,000 Total assets $ 4,449,000 Liabilities and Shareholders' Equity Current liabilities Bank indebtedness $ 18,000 Accounts payable 370,000 Rent payable 120,000 Notes payable 300,000 Other payables 35,000 Income tax payable 80,000 Total current liabilities $ 923,000 Long-term liabilities: Bonds payable (20-year 5% bonds, due August 31, 2025) 800,000 Pension obligation 210,000 1,010,000 Total liabilities 1,933,000 Shareholders' equity Paid in capital Preferred, ($2, non-cumulative,participating–authorized 50,000, issued and outstanding, 20,000 shares) $ 900,000 Common (authorized, 900,000 shares; issued and outstanding 700,000 shares) 700,000 Contributed surplus 430,000 2,030,000 Retained earnings 326,000 Accumulated other comprehensive income 160,000 2,516,000 Total liabilities and shareholders' equity $ 4,449,000 1 Cash balance, Dec 31 $ 225,000 Plus bank overdraft 18,000 Less bond sinking fund (100,000) Adjusted cash balance, December 31 $ 143,000 2 Account receivable, Dec 31 $ 285,000 Plus AFDA 12,000 Plus credit balances to be separately reported 35,000 Adjusted balance, Dec 31 $ 332,000 3 Inventory, Dec 31 $ 960,000 Plus inventory on consignment 20,000 Adjusted balance, Dec 31 $ 980,000 Inventory, net realizable value, Dec 31 985,000 4 Land, Dec 31 $ 420,000 Less land held for investment (200,000) Adjusted land, Dec 31 $ 220,000 5 Building Equipment Balance, Dec 31 $ 1,500,000 $ 380,000 Plus accumulated depreciation 450,000 120,000 Adjusted balance, Dec 31 $ 1,950,000 $ 500,000 6 Goodwill, Dec 31 $ 190,000 Removed – internally generated goodwill cannot be recognized (190,000) Adjust balance, Dec 31 $ – 7 Patents, Dec 31 $ 21,000 Accum. amortization for 3 years ( ) $ 9,000
OR
Activity ratios:
Comments:
In terms of liquidity, Aztec's current ratio of 1.74 suggests at first glance that it can meet its short-term obligations. However, when inventory and prepaid expenses are removed, the ratio drops to .65, which is short of the general rule of 1:1 for quick ratios. This may mean that inventory levels are too high. The inventory turnover ratio below will confirm if this is the case or not.
Activity ratios, such as the accounts receivable turnover, measure how quickly accounts are converted into cash. For Aztec, accounts receivable are collected every 38.9 days on average. Looking at days' sales uncollected, if a guideline of 30–40 days to collect is considered reasonable, then Aztec is close to the top end of the 40-day benchmark. Management would be wise to take steps to improve its receivables collections somewhat.
Inventory turnover of every 200 days or so appears to be very low, which could mean that too much cash is being tied up in inventory or there is too much obsolete inventory that cannot be sold. A turnover ratio that is too high can signal inventory shortages that may result in lost sales. A turnover ratio for each major inventory category will help to determine if the situation is wide-spread or limited to a particular inventory category.
Asset turnover for .67 times appears low but without industry standard ratios to use as a comparison benchmark, ratios become less meaningful.
-
Johnson Berthgate Corp. Statement of Financial Position As at December 31, 2021 Assets Current assets Cash $ 131,000 Investments (held for trading at fair value) 120,000 Accounts receivable $ 330,000 Allowance for doubtful accounts (15,000) 315,000 Inventory (at lower of FIFO cost and NRV) 430,000 Prepaid expenses 6,000 Total current assets 1,002,000 Long-term investments: Investment in bonds (held to maturity at amortized cost) 190,000 Investment, FVOCI 180,000 370,000 Property, plant, and equipment Land (at cost) 170,000 Building (at cost) $ 660,000 Accumulated depreciation (110,000) 550,000 Equipment (at cost) 390,000 Accumulated depreciation (50,000) 340,000 1,060,000 Intangible assets: Patents (net of accum. amort. of $80,000 on a straight-line basis) 125,000 Franchise (net of accum. amort. of $45,000 on a straight-line basis) 115,000 240,000 Goodwill 30,000 Total assets $ 2,702,000 Liabilities and Shareholders' Equity Current liabilities Accounts payable $ 350,000 Accrued liabilities 70,000 Commissions payable 90,000 Notes payable 60,000 Unearned consulting fees 13,000 Total current liabilities 583,000 Long-term liabilities: Bonds payable (20-year 5% bonds, due December 31, 2025) 655,684 Note payable (3%, 5-year, due December 31, 2024) 571,875 1,227,559 Total liabilities 1,810,559 Shareholders' equity Paid in capital Preferred, ($3, non-cumulative, authorized 1200, issued and outstanding, 800 shares) $ 80,000 Common (unlimited authorized, issued and outstanding 260,000 shares) 520,000 600,000 Retained earnings* 236,441 Accumulated other comprehensive income 55,000 891,441 Total liabilities and shareholders' equity $ 2,702,000 *
-
Nearly 70% of all assets are provided by creditors, which is significant. Digging deeper and looking at the current ratio for 1.72 (1,002,000 583,000), it appears that the current assets will adequately cover the current liabilities. It follows that the $1.2M in long-term obligations is the true risk for this company. The company may have to re-finance the note payable when comes due in 3 more years, or sell off any assets not currently contributing to profit. Selling off long-term assets is a reasonable step provided that the assets are idle and will not be used in the foreseeable future to earn profits. This company's debt ratio is high, so it has very little financial flexibility.
-
The credit balances in accounts receivable represent amounts owing to specific customers. IFRS requires that significant credit balances be separated and reported as a current liability.
Current ratio without separation of the credit
Current ratio with separation of the creditManagers may not be aware of the impact that the reporting requirement (to classify credit receivables as current liabilities) can have on the current ratio. In this case, this ratio has weakened significantly once the credit amount of $250,000 is reclassified from a current asset to a current liability. If the company had a restrictive covenant to maintain a current ratio of 1.7 times, this could spell disaster for the company in two ways. First, creditors expect a restrictive covenant ratio to be maintained at all times . If this ratio slips below that threshold, any short-term notes owing to the creditor would become payable immediately as a demand loan. This would create significant pressure to raise enough cash in a short period of time to make the single, large payment. Second, if the debt owing to that creditor also includes any long-term debt, the creditor could also force the company to reclassify the long-term balances to current liabilities, driving the current ratio even lower . This might be all that it takes to drive a marginally performing company into bankruptcy, which is a no-win for either the company or its creditors.
The following are possible conditions or situations that would give rise to a credit balance in accounts receivable customer accounts.
- Customers returned goods after the account was paid.
- A customer has overpaid an account in error.
- The company policy may be no cash refunds. Any returns would therefore be credited to the customer account to be used later for a future purchase.
- Most of the accounting software applications apply customer prepayments (unearned revenues) as a credit balance in accounts receivable, since eventually the actual amounts when owed by the customer at the time the goods and services provided will be debited to the accounts receivable sub-ledger when the invoice is prepared.
- On the basis of materiality, the credit balances, if insignificant, will likely remain with the existing accounts receivable as small credit balances.
-
Hughey Ltd. Statement of Financial Position As at December 31, 2021 Assets Current assets Cash $ 250,000 Accounts receivable $ 1,015,000 Less allowance for doubtful accounts (55,000) 960,000 Inventory–at lower of FIFO cost and NRV 1,300,000 Prepaid insurance 40,000 Total current assets $ 2,550,000 Long-term investments Investments, FVOCI, of which investments costing $800,000 have been pledged as security for notes payable to bank 2,250,000 Property, plant, and equipment Land 530,000 Building 770,000 Accumulated depreciation (300,000) 470,000 Equipment 2,500,000 Accumulated depreciation (1,200,000) 1,300,000 2,300,000 Intangible assets Patents (net of accumulated amortization of $35,000) 25,000 Total assets $ 7,125,000 Liabilities and Shareholders' Equity Current liabilities 7% notes payable to bank, secured by investments which cost $800,000; $ 600,000 Accounts payable 900,000 Accrued liabilities 300,000 Total current liabilities 1,800,000 Long-term liabilities Bonds payable, 25-yr, 8%, due December 31, 2030, at amortized cost 1,100,000 Total liabilities 2,900,000 Shareholders' equity Paid-in capital Common shares; 100,000 shares authorized, 80,000 shares issued and outstanding 2,500,000 Retained earnings 1,330,000 Accumulated other comprehensive income 395,000* 4,225,000 Total liabilities and shareholders' equity $ 7,125,000 * Opening balance of for unrealized holding gain – OCI on FVOCI investments.
-
Patent annual amortization:
total amortization for the period January 1, 2015 to December 31, 2021 or 7 years amortized since its purchase.
- This company follows IFRS because it has classified and reported some of its investments as available for sale (OCI) which is a classification only permitted by IFRS companies. ASPE does not have this classification.
| Description | Section | Amount |
| Issue of bonds payable of $500 cash | Financing | 500 |
| Sale of land and building of $60,000 cash | Investing | 60,000 |
| Retirement of bonds payable of $20,000 cash | Financing | (20,000) |
| Current portion of long-term debt changed from $56,000 to $50,000 | Financing | * |
| Repurchase of company's own shares of $120,000 cash | Financing | (120,000) |
| Issuance of common shares of $80,000 cash | Financing | 80,000 |
| Payment of cash dividend of $25,000 recorded to retained earnings | Financing | (25,000) |
| Purchase of land of $60,000 cash and a $100,000 note | Investing | (60,000) |
| Cash dividends received from a trading investment of $5,000 | Operating | 5,000 |
| Interest income received in cash from an investment of $2,000 | Operating | 2,000 |
| Interest and finance charges paid of $15,000 | Operating | (15,000) |
| Purchase of equipment for $32,000 | Investing | (32,000) |
| Increase in accounts receivable of $75,000 | Operating | (75,000) |
| Decrease in a short-term note payable of $10,000 | Operating | (10,000) |
| Increase in income taxes payable of $3,000 | Operating | 3,000 |
| Purchase of equipment in exchange for a $14,000 long-term note | None: non-cash | - |
* The current portion of long-term debt for both years would be added to their respective long-term debt payable accounts and reported as a single line item in the financing section.
-
Carmel Corp. Balance Sheet As at December 31, 2021 Assets Current assets Cash $ 247,600 Accounts receivable (net) * 109,040 Total current assets 356,640 Investment in land (at cost) 220,000 Property, plant, and equipment Land $ 200,000 Building (net) 87,200 Equipment (net) 198,000 485,200 Total assets $ 1,061,840 Liabilities and Shareholders' Equity Current liabilities Accounts payable $ 55,200 Current portion of long-term debt 32,000 Total current liabilities 87,200 Long-term liabilities Mortgage payable 110,200 Total liabilities 197,400 Shareholders' equity Common shares $ 470,000 Retained earnings 394,440 864,440 Total liabilities and shareholders' equity $ 1,061,840 The required disclosures discussed in Chapter 3 that were missed were the AFDA, the accumulated depreciation for the building and equipment, the interest rate, securitization and due date for the mortgage payable classified as a long-term liability, and the authorized and issued common shares in the equity section.
Calculations Worksheet:
Adjustments Dr Cr Dr Cr Cash $ 84,000 1,356,600 2 1,193,000 3 247,600 Accounts receivable (net) 89,040 1,000,000 980,000 109,040 Investments – trading 134,400 134,400 - Buildings (net) 340,200 225,000 28,000 87,200 Equipment (net) 168,000 50,000 20,000 198,000 Land 200,000 220,000 420,000 $ 1,015,640 $1,061,840 Accounts payable $146,000 900,000 809,200 55,200 Mortgage payable 172,200 30,000 142,200 Common shares 400,000 70,000 470,000 Retained earnings 297,440 8,000 105,000 394,440 $ 1,015,640 2,123,680 $1,061,840 Revenues $ 1,000,000 A/R 1,000,000 Gain 2,200 2,200 Total revenue 1,002,200 Expenses Operating expenses 809,200 809,200 Interest expenses 35,000 35,000 Depreciation 48,000 48,000 Loss 5,000 5,000 897,200 Net Income $ 105,000 4,461,800 4,566,800 net income 4,461,800 4,461,800 to retained earnings -
Carmel Corp. Statement of Cash Flows For the Year Ended December 31, 2021 Cash flows from operating activities Net income $ 105,000 Adjustments for non-cash revenue and expense items in the income statement: Depreciation expense $ 48,000 Gain on sale of investments (2,200) Loss on sale of building 5,000 Decrease in investments – trading 136,600 Increase in accounts receivable ( ) (20,000) Decrease in accounts payable ( ) (90,800) 76,600 Net cash from operating activities 181,600 Cash flows from investing activities Proceeds from sale of building ( ) 220,000 Purchase of land (220,000) Net cash from investing activities 0 Cash flows from financing activities Reduction in long-term mortgage principal (30,000) Issuance of common shares 20,000 Payment of cash dividends (8,000) Net cash from financing activities (18,000) Net increase in cash 163,600 Cash at beginning of year 84,000 Cash at end of year $ 247,600 Note:
- The purchase of equipment through the issuance of $50,000 of common shares is a significant non-cash financing transaction that would be disclosed in the notes to the financial statements.
-
Cash paid interest
$35,000
Had there been cash paid income taxes, this would also be disclosed.
-
Free cash flow:
Net cash provided by operating activities $ 181,600 Capital purchases – land (220,000) Cash paid dividends (8,000) Free cash flow $(46,400) An analysis of Carmel's free cash flow indicates it is negative as shown above. Including dividends paid is optional, but it would not have made a difference in this case. What does make the difference in this case is that the capital expenditures are those needed to sustain the current level of operations. In Carmel's case, the land was purchased for investment purposes and not to meet operational requirements. The free cash flow would more accurately be:
Net cash from operating activities $ 181,600 Capital purchases 0 Cash paid dividends (8,000) Free cash flow $ 173,600 This makes intuitive sense and is supported by the results from one of the coverage ratios.
The current cash debt coverage provides information about how well Carmel can cover its current liabilities from its net cash flows from operations:
Carmel's current cash debt coverage is . The company has adequate cash flows to cover its current liabilities as they come due and so overall, its financial flexibility looks positive.
In terms of cash flow patterns, Carmel has managed to more than triple its cash balance in the year mainly from cash generated from operating activities, which is a good trend. Carmel was able to pay $8,000 in dividends, or a 1.7% return. If dividends are paid several times throughout the year, the return is more than adequate to investors. Carmel also sold off its traded investments for a profit and some idle buildings at a small loss to obtain sufficient internal funding for some land that it wants as an investment. Carmel also managed to lower its accounts payable levels by close to 60%. All this supports the assessment that Carmel's financial flexibility looks reasonable.
- The information reported in the statement of cash flows is useful for assessing the amount, timing, and uncertainty of future cash flows. The statement identifies the specific cash inflows and outflows from operating activities, investing activities, and financing activities. This gives stakeholders a better understanding of the liquidity and financial flexibility of the enterprise. Some stakeholders have concerns about the quality of the earnings because of the various bases that can be used to record accruals and estimates, which can vary widely and be subjective. As a result, the higher the ratio of cash provided by operating activities to net income, the more stakeholders can rely on the earnings reported.
| Lambrinetta Industries Ltd. | ||||||
| Statement of Cash Flows | ||||||
| Year Ended December 31, 2021 | ||||||
| Cash flows from operating activities | ||||||
| Net income | $ | 161,500 | ||||
| Adjustments | ||||||
| Depreciation expense* | $ | 25,500 | ||||
| Change in A/R | 27,200 | |||||
| Change in A/P | 11,900 | |||||
| Unrealized loss on investments–trading** | 5,200 | |||||
| Investments purchased | (12,000) | |||||
| 57,800 | ||||||
| Net cash from operating activities | 219,300 | |||||
| Cash flows from investing activities | ||||||
| Sold plant assets | 37,400 | |||||
| Purchase plant assets*** | (130,900) | |||||
| Net cash from investing activities | (93,500) | |||||
| Cash flows from financing activities | ||||||
| Note issued**** | 42,500 | |||||
| Shares issued for cash (81,600+37,400 in exch for land | ||||||
| – 130,900 ending balance) | 11,900 | |||||
| Cash dividends paid***** | (188,700) | |||||
| Net cash from financing activities | (134,300) | |||||
| Net decrease in cash | (8,500) | |||||
| Cash at beginning of year | 40,800 | |||||
| Cash at end of year | $ | 32,300 |
*
**
***
****
*****
Disclosures:
Additional land for $37,400 was acquired in exchange for issuing additional common shares.
-
Egglestone Vibe Inc. Statement of Cash Flows For the Year Ended December 31, 2021 Cash flows from operating activities Net income $ 24,700 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense (Note 1) $ 55,900 Loss on sale of equipment (Note 2) 10,100 Gain on sale of land (Note 3) (38,200) Impairment loss–goodwill 63,700 Increase in accounts receivable (36,400) Increase in inventory (67,600) Decrease in accounts payable (28,200) (40,700) Net cash used by operating activities (16,000) Cash flows from investing activities Purchase of investments (FVOCI) (20,000) Proceeds from sale of equipment 27,300 Purchase of land (Note 4) 62,400 Proceeds from sale of land 150,000 Net cash provided by investing activities 94,900 Cash flows used by financing activities Payment of cash dividends (Note 5) (42,600) Issuance of notes payable 10,500 Net cash used by financing activities (32,100) Net increase in cash 46,800 Cash at beginning of year 37,700 Cash at end of year $ 84,500 Note: During the year, $160,000 in notes payable were retired by issuing common shares.
Notes:
- ;
-
Retained earnings account: ; Dividend declared but not paid = $20,500
Dividends payable account: cash paid dividends
- Negative cash flows from operating activities may signal trouble ahead with regard to Egglestone's daily operations, including profitability of operations and management of its current assets such as accounts receivable, inventory and accounts payable. All three of these increased the cash outflows over the year. In fact, net cash provided by investing activities funded the net cash used by both operating and financing activities. Specifically, proceeds from sale of equipment and land were used to fund operating and financing activities, which may be cause for concern if the assets sold were used to generate significant revenue. Shareholders did receive cash dividends, but investors may wonder if these payments will be sustainable over the long term. Consider that dividends declared was $20,500, which was quite high compared to the net income for $24,700. In addition, the dividends payable account still had a balance payable for $41,600 from prior dividend declarations not yet paid. All this adds up to increasing the pressure on the company to find enough funds to catch up with the cash payments to investors. Egglestone may not be able to sustain payment of cash dividends of this size in the long term if improvement regarding its profitability and management of receivables, payables and inventory are not implemented quickly.
Chapter 5 Exercises
Scenario 1: Amount to be received =
Allocate using relative fair values:
| Phone: | 626 | |
| Air-time: | 2,254 |
Therefore, $626 will be recognized immediately and $2,254 will be deferred and recognized over the 3-year term of the contract.
Scenario 2: Amount to be received =
Allocate using relative fair values:
| Phone: | 794 | |
| Air-time: | 1,906 |
Therefore, $794 will be recognized immediately and $1,906 will be deferred and recognized over the 2-year term of the contract.
Scenario 1: Allocate using residual values:
| Phone: | 1,080 | |
| Air-time: | 1,800 |
Therefore, $1,080 will be recognized immediately and $1,800 will be deferred and recognized over the 3-year term of the contract.
Scenario 2: Allocate using residual values:
| Phone: | 1,500 | |
| Air-time: | 1,200 |
Therefore, $1,500 will be recognized immediately and $1,200 will be deferred and recognized over the 2-year term of the contract.
Art Attack Ltd. (consignor)
The Print Haus. (consignee)
-
-
At the time of sale, it was estimated that 4 desks would be returned during the refund period ( ). If a further 3 desks are returned before the refund period ends, journal entries similar to the one above would be made. If the refund period expires and the number of desks returned differs from the original estimate, the refund asset and refund liability account will need to be adjusted through net income. As a practical matter, the company will likely review the balances of the refund asset and liability accounts as part of the year-end adjustment process.
October journal entry:
November journal entry:
December journal entry:
-
Construction Contract
2020 2021 Costs to date (A) $ 20,000,000 $ 31,000,000 Estimated costs to complete project 10,000,000 0 Total estimated project costs (B) 30,000,000 31,000,000 Percent complete (C = A B) 66.67% 100.00% Total contract price (D) 35,000,000 35,000,000 Revenue to date (C D) 23,333,333 35,000,000 Less previously recognized revenue - (23,333,333) Revenue to recognize in the year 23,333,333 11,666,667 Costs incurred the year 20,000,000 11,000,000 Gross profit for the year $ 3,333,333 $ 666,667 -
2020 Journal Entry:
2021 Journal Entry:
-
Construction Contract
2021 2022 2023 Costs to date (A) $ 1,100,000 $ 3,400,000 $ 4,500,000 Estimated costs to complete project 3,200,000 1,000,000 - Total estimated project costs (B) 4,300,000 4,400,000 4,500,000 Percent complete (C = A B) 25.58% 77.27% 100.00% Total contract price (D) 5,200,000 5,200,000 5,200,000 Revenue to date (C D) 1,330,160 4,018,040 5,200,000 Less previously recognized revenue - (1,330,160) (4,018,040) Revenue to recognize in the year 1,330,160 2,687,880 1,181,960 Costs incurred the year 1,100,000 2,300,000 1,100,000 Gross profit for the year $ 230,160 $ 387,880 $ 81,960 -
Balance Sheet
Current assets Accounts receivable 300,000* Recognized contract revenues in excess of billings 718,040** * calculated as
** calculated asIncome Statement
Contract revenues 2,687,880 Contract costs 2,300,000 Gross profit 387,880
-
Construction Contract
2020 2021 2022 Costs to date (A) $ 800,000 $ 2,400,000 $ 3,900,000 Estimated costs to complete project 2,100,000 1,600,000 - Total estimated project costs (B) 2,900,000 4,000,000 3,900,000 Percent complete (C = A B) 27.59% 60.00% 100.00% Total contract price (D) 3,500,000 3,800,000 3,800,000 Revenue to date (C D) 965,650 2,280,000 3,800,000 Less previously recognized revenue - (965,650) (2,280,000) Revenue to recognize in the year 965,650 1,314,350 1,520,000 Costs incurred the year 800,000 1,600,000 1,500,000 Gross profit (loss) for the year $ 165,650 (285,650) 20,000 Additional loss to recognize (NOTE) (80,000) 80,000 Gross profit (loss) for the year $ (365,650) $ 100,000 NOTE: Additional loss represents the expected loss on work not yet completed
-
Journal Entries
* includes actual costs incurred plus additional loss to recognize
-
Zero Profit Method
2020 2021 2022 Revenues recognized 800,000 1,600,000 1,400,000 Expenses 800,000 1,800,000 1,300,000 Gross profit (200,000) 100,000 -
Completed Contract Method
2020 2021 2022 Revenues recognized 0 0 3,800,000 Expenses 0 0 3,700,000 Gross profit 0 0 100,000 Loss on unprofitable contract (200,000)
Chapter 6 Exercises
- Cash $600,000
- Cash equivalent $22,000
- Cash advance received from customer of $2,670 should be included as a debit to cash and a credit to a liability account
- Cash advance of $5,000 to company executive should be reported as a receivable
- Refundable deposit of $13,000 to developer should be reported as a receivable or a prepaid expense
- Cash restricted for future plant expansion of $545,000 should be reported as restricted cash in noncurrent assets
- The certificate of deposit of $575,000 matures in nine months so it should be reported as a temporary investment
- The utility deposit of $500 should be identified as a receivable or prepaid expense from the utility company
- The cash advance to subsidiary of $100,000 should be reported as a receivable
- The post-dated cheque of $30,000 should be reported as a payment of receivable when the post-date occurs; until the post-date, the $30,000 is classified as a receivable
- Details of the $115,000 cash restriction are to be separately disclosed in the balance sheet with further disclosures in the notes to the financial statements indicating the type of arrangement and amounts
- Cash $13,000
- Postage stamps on hand are reported as part of supplies or prepaid expenses
- Cash $520,000
- Cash held in a bond sinking fund is restricted; since the bonds are noncurrent, the restricted cash is also reported as noncurrent
- Cash $1,200
- Cash $13,000
- Cash equivalent $75,400
- The NSF cheque of $8,000 should be reported as a receivable
-
(Partial SFP):
Current assets Cash and cash equivalent* $ 3,385,750 Restricted cash balance 175,000 Non-current assets Cash restricted for retirement of long-term debt 2,000,000 Current liabilities Bank indebtedness** 150,000 For Cash and cash equivalent*:
Commercial savings account – First Royal Bank ( ) $ 400,000 Commercial chequing account – First Royal Bank 450,000 Money market fund – Commercial Bank of British Columbia 2,500,000 Petty cash 1,500 Cash floats ( ) 1,250 60-day treasury bill** 18,000 Currency and coin on hand 15,000 Cash reported on December 31, 2020 balance sheet as a current asset $ 3,385,750 ** The treasury bill for $18,000 is to be classified as a cash equivalent because the original maturity is less than 90 days.
*** The bank overdraft at the Lemon Bank for $150,000 is to be reported separately as a current liability because there are no other accounts at Lemon Bank available for offset. -
Other items classified as follows:
- The minimum balance at First Royal Bank of $175,000 is reported separately as a restricted cash balance as a current asset cash balance. In addition, a description of the details of the arrangement should be disclosed in the notes.
- The post-dated cheque for $25,000 is for a payment on accounts receivable and should not be recognized until the cheque is deposited on January 18. It will be held in a secure location until then.
- The post-dated cheque for $1,800 is for unearned revenue and will not be recorded as unearned revenue until the cheque can be deposited on January 12. It will be held in a secure location until then. Revenue will be recorded and unearned revenue offset when legal title to the goods passes to the customer on January 20.
- Travel advances for $15,000 are to be reported as prepaid travel.
- The $2,300 amount paid to the employee is to be reported as a receivable from the employee. It will be offset when collected from salary in January.
- The treasury bill for $50,000 should be classified as a temporary investment (current asset). It cannot be reported as a cash equivalent because the original maturity exceeds 90 days.
- Commercial paper should be reported as temporary investments (current asset).
- Investments in shares should be classified with trading securities (current asset) at their fair value of $4,060 ( ).
Partial classified balance sheet:
| Current assets | ||||||
| Accounts receivable | ||||||
| Customer Accounts (of which accounts in the amount of | ||||||
| $30,000 have been pledged as security for a bank loan) | $ | 275,000 | ||||
| Other* ( ) | 8,500 | $ | 283,500 | |||
| Non-Current Assets | ||||||
| Accounts Receivable | ||||||
| Advance to related company** | 30,000 | |||||
| Instalment accounts receivable due after December 31, 2021 | 50,000 |
* These items could be separately classified, if considered material.
** This classification assumes that these receivables are not collectible in the near term based on the fact that they were advanced in 2015 and remain outstanding.
-
- The implied interest rate on accounts receivable paid to Busy Beaver from Heintoch within the 15-day discount period = . This means that Heintoch would be using funds from the bank at a lower rate of 8% to save 24.33% interest on early payment of amounts owing to Busy Beaver. It is worthwhile to take advantage of the early payment discount terms in this case.
-
-
Calculation of cost of goods sold: Opening inventory $ 35,000 Merchandise purchased 600,000 Less: Ending inventory 225,000 Cost of goods sold $ 410,000 Sales on account ( ) 553,500 Less collections deposited in bank 420,000 Uncollected balance 133,500 Balance per ledger 85,000 Unaccounted for shortage $ 48,500 -
Accounts receivable balance per ledger of $85,000 is less than estimated accounts receivable of $133,500, suggesting that some accounts receivable collections may have been received but not actually deposited to the company's bank account.
Controls to help prevent theft include proper segregation of duties among the person initially in receipt of the cheque, the person depositing it, and the person recording the collection. Customers should be encouraged to pay by cheque so an audit trail is maintained. A timely completion of the monthly bank reconciliation would help detect if any cash was recorded as collected, but not actually deposited to the company's bank account.
-
- An unadjusted debit balance in the AFDA at year-end is usually the result of write-offs during the year exceeding the total AFDA opening credit balance. The purpose of the AFDA is to ensure that the net accounts receivable is valued at net realizable value on the balance sheet.
-
Balance, January 1, 2020 $ 575,000 Bad debt expense accrual ( ) 120,000 695,000 Uncollectible receivables written off (40,000) Balance, December 31, 2020, before adjustment 655,000 Allowance adjustment 155,000 Balance, December 31, 2020 $ 500,000 -
(Partial classified balance sheet as at December 31)
Current assets Accounts receivable $ 50,950,000 Less allowance for doubtful accounts 500,000 Net accounts receivable 50,450,000 The net accounts receivable balance is intended to measure the net realizable value of the accounts receivable at December 31.
- The direct write-off approach is not in compliance with GAAP unless the amount of the write-off is immaterial. Direct write-off does not match (bad debt) expense with revenues of the period, nor does it result in receivables being stated at estimated net realizable value on the balance sheet.
-
** rounded so that the carrying value was equal to $336,000 at maturity
*** can be netted together into one amount for $327,703 credit -
Using a financial calculator input the following variables:
-
(Partial balance sheet):
Non-current assets Notes receivable, no-interest-bearing, due May 1, 2025 $ 260,142* *
Unamortized discount as at December 31, 2021, is .
As at December 31, 2024, the note would be classified as a current asset on the SFP because the maturity date of May 1, 2025, is within the next fiscal year.
- The fair value of the services provided can be used to value and record the transaction, instead of fair value of the note received.
-
Scenario i:
Scenario ii:
Scenario iii:
-
Calculate interest from January 1 to July 1:
Calculate the loss from impairment:
-
PV = (0 PMT, 4 N, 7.5 I/Y, 18000 FV) = $13,478
Fair value of equipment (present value of note) $ 13,478 Carrying amount 12,600 Gain on sale of equipment $ 878 -
Since Harrison uses ASPE, either straight-line or the effective interest method can be used for recognizing interest income. Below is the calculation using the straight-line method. Interest income for $1,131 for each of the next four consecutive years will be recorded.
-
To be recorded as a sale under IFRS, both of the following conditions must be met:
- The transferred assets risks and rewards of ownership have been transferred to the transferee. This is evidenced by transferring the rights to receive the cash flows from the receivables. Where the transferor continues to receive the cash flows, there must be a contractual obligation to pay these cash flows to the transferee without material delay.
- The transferee has obtained the right to pledge or to sell the transferred assets to an unrelated party (concept of control).
To be recorded as a sale under ASPE, the control over the receivables has been surrendered as evidenced by all of the following three conditions being met:
- The transferred assets have been isolated from the transferor.
- The transferee has obtained the right to pledge or to sell the transferred assets.
- The transferor does not maintain effective control of the transferred assets through a repurchase agreement.
- Management would likely prefer the receivables transfer transaction to be treated as a sale and derecognized from the accounts rather than a secured borrowing because the company would not have to record and report the additional debt in the SFP.
-
* )
** - Factoring the accounts receivable will improve the accounts receivable turnover ratio immediately after recording the entry on February 1 because the average accounts receivable amount in the denominator will decrease, making the ratio larger. For example, if sales were $3.2M and accounts receivable before the sale was $1.8M, the turnover ratio would be 1.78 ( ) compared to 3.2 ( ). If the calculation is made at the December 31 fiscal year-end, the balances of sales and average accounts receivable would no longer be affected by this transaction, and the accounts receivable turnover ratio would not be affected. This is because time has passed and many of the accounts would have been collected by year-end, had the company not sold them to a factor.
-
-
Land in exchange for a note:
PV = (0 PMT, 3 N, 11 I/Y, 530,000 FV) = $387,531
-
Services in exchange for a note:
Interest payment =
PV = (15000 PMT, 6 N, 11 I/Y, 500,000 FV) = $330,778 -
Partial settlement of account in exchange for a note:
PV = (12000 PMT, 5 N, 12 I/Y, 0 FV) = $43,257
-
Land in exchange for a note:
- From the perspective of Brew It Again, an instalment note reduces the risk of non-collection when compared to a non-interest-bearing note. In the case of the non-interest-bearing note, the full amount is due at the maturity of the note. The instalment note provides a regular reduction of the principal balance in every payment received annually. This is demonstrated in the effective interest table illustrated above for the instalment note.
-
*
** Opening balance closing balance. Note that the write-off of $12,500 does not affect net accounts receivable.
The average receivable is therefore about 72 days old ( ).
-
Credit sales are a better measure in the calculation of accounts receivable turnover ratio since cash sales do not affect accounts receivable balances. On this basis, Corvid Company's accounts receivable turnover ratio has declined from the previous year. The average number of days to collect the accounts was 62 days (
) compared to 72 days for 2020. This could be an unfavourable trend for future liquidity, if customers continue to pay slowly. Corvid may want to consider offering discounts for early payments of accounts or tighten their credit policy.
It should be noted that credit sales are not always available when performing analysis and calculating the accounts receivables turnover ratio. When not available, the figure of net sales should be used. As long as the calculation is done consistently between years, or between businesses, the comparison will remain relevant.
-
Jersey Shores:
Fast factors:
-
Jersey Shores:
*
**
Chapter 7 Exercises
Inventory would normally include the following items:
- Salaries of assembly line workers
- Raw materials
- Salary of factory foreman
- Heating cost for the factory
- Miscellaneous supplies used in production process
- Costs to ship raw materials from the supplier to the factory
- Electricity cost for the factory
- Depreciation of factory machines
- Property taxes on factory building
- Discounts for early payment of raw material purchases
- Salaries of the factory's janitorial staff
All of these costs can be considered either direct costs or attributable overhead costs. The CEO's and sales team salaries would not be considered costs directly attributable to the purchase and conversion of inventory.
| FOB Shipping | FOB Destination | |
| Owns the goods while in transit | P | S |
| Is responsible for the loss if goods are damaged in transit | P | S |
| Pays for the shipping costs | P | S |
- The company would allocate $150,000 of overhead at the rate of $150,000 105,000 = $1.4286 per unit. As a practical matter, the company may choose to simply allocate based on the standard rate of $1.50 per unit and record a small overhead recovery through cost of sales. This would be reasonable as the volume produced is close to the standard volume used to determine the rate.
- The company would allocate $45,000 of overhead, using the standard rate of $1.50 per unit. The remaining overhead would need to be expensed. This is necessary to avoid over-valuing the inventory.
- The company would allocate $150,000 of overhead at the rate of $150,000 160,000 = $0.9375 per unit. The standard rate cannot be used here, as it would over-absorb the overhead cost into inventory.
| Date | Purchase | Sale | Balance | Balance of |
| Units | ||||
| May 1 | 8 $550.00 = $4,400 | 8 | ||
| May 5 | 50 $560.00 | (8 $550.00) + (50 $560.00) = | 58 | |
| $32,400 | ||||
| May 8 | 10 $575.00 | (8 $550.00) + (50 $560.00) + | 68 | |
| (10 $575.00) = $38,150 | ||||
| May 15 | (8 $550.00)+ (7 | (43 $560.00) + (10 $575.00) = | 53 | |
| $560.00) = $8,320 | $29,830 | |||
| May 22 | 12 $572.00 | (43 $560.00) + (10 $575.00) + | 65 | |
| (12 $572) = $36,694 | ||||
| May 25 | (23 $560.00) = | (20 $560.00) + (10 $575.00) + | 42 | |
| $12,880 | (12 $572) = $23,814 |
Cost of Goods Sold for May = ( ) = $21,200
Ending Inventory on May 31 = $23,814
| Date | Purchase | Sale | Balance | Average | Balance of |
| Cost | Units | ||||
| May 1 | 8 $550.00 = $4,400 | 8 | |||
| May 5 | 50 $560.00 | (8 $550.00) + (50 | 58 | ||
| $560.00) = $32,400 | |||||
| May 8 | 10 $575.00 | (8 $550.00) + (50 | $561.03 | 68 | |
| $560.00) + (10 | |||||
| $575.00) = $38,150 | |||||
| May 15 | 15 ($38,150 68) = | (53 $561.03) = | $561.03 | 53 | |
| $8,415.45 | $29,734.55 | ||||
| May 22 | 12 $572.00 | (53 $561.03) + (12 | $563.05 | 65 | |
| $572.00) = $36,598.55 | |||||
| May 25 | 23 ($36,598.55 65) = | (42 $563.05) = | $563.05 | 42 | |
| $12,950.15 | $23,648.40 |
Cost of Goods Sold for May = ( ) = $21,365.60
Ending Inventory on May 31 = $23,648.40
-
No grouping
Description Category Cost ($) Selling LCNRV Price ($) Brake pad #1 Brake pads 159 140 140 Brake pad #2 Brake pads 175 180 175 Total brake pads 334 320 315 Soft tire Tires 325 337 325 Hard tire Tires 312 303 303 Total tires 637 640 628 Total LCNRV = ( ) = 943
Current carrying value = ( ) = 971
Adjustment required = ( ) = (28)Journal entry required:
-
With grouping
Description Category Cost ($) Selling LCNRV Price ($) Brake pad #1 Brake pads 159 140 Brake pad #2 Brake pads 175 180 Total brake pads 334 320 320 Soft tire Tires 325 337 Hard tire Tires 312 303 Total tires 637 640 637 Only the brake pad category needs to be written down. Total adjustment required = ( ) = 14
Journal entry required:
NOTE: Positive amounts represent overstatements and negative amounts represent understatements.
| Item | Inventory | A/R | A/P | Net Income |
| A | (82,000) | - | (82,000) | |
| B | (4,000) | - | (6,000) | 2,000 |
| C | (27,000) | - | - | (27,000) |
| D | (2,000) | 3,500 | - | 1,500 |
| Total | (115,000) | 3,500 | (6,000) | (105,500) |
-
- The journal entries would be the same, except any income statement accounts (cost of goods sold and sales returns) would be replaced with an adjustment to retained earnings.
| Inventory on January 1 | $ | 275,000 | ||||
| Purchases (net of returns) | 634,000 | |||||
| Goods available for sale | 909,000 | |||||
| Sales | $ | 955,000 | ||||
| Less gross profit ( ) | 334,250 | |||||
| Estimated cost of goods sold | 620,750 | |||||
| Estimated inventory on March 4 | 288,250 | |||||
| Less undamaged goods ( )) | (58,500) | |||||
| Inventory damaged by fire | $ | 229,750 |
Gross profit margin, by year:
2020:
2019:
The company's sales increased significantly between 2019 and 2020. This appears to be a positive result. The company's gross profit also increased. However, the gross profit margin decreased by 5.5%, which represents potential loss profits of approximately $1.1 billion on the current sales volume. To investigate further, one should look at budgets and other management plans, as well as industry averages and competitor information. It would also be useful to look at longer trends to see if this decline in profitability is unique to this year or the sign of a longer term trend. Management explanations of the declining margin percentage, contained in the annual report, should also be evaluated to determine if the causes relate to slashing sales prices to increase volumes, increasing cost structures, or some combination of the two. Other macroeconomic data may also be useful in explaining the change.
Inventory Turnover Period, by year:
2020:
2019:
Inventory turnover has slowed from the previous year, indicating that goods are being held longer. This is also indicated by the build up of inventory over the three year period. Although the increased inventory may be reasonable as sales increase, the increase in the turnover period could create cash flow problems if the trend continues. Again, other comparative data is needed, such as budgets and industry averages, to evaluate the meaning of this result.
Chapter 8 Exercises
- This investment will be classified as equity investments at cost less any reduction for impairment, because these are equity investments that are not publicly traded. They would be reported as either current or long-term, depending upon the intention of management to hold or sell within one year.
-
Journal entries
-
To purchase the investment:
To receive the cash dividends:
Year-end adjusting entry to fair value for FVNI investments:
For sale of investment:
No year-end adjustments are needed under the cost method.
- Under ASPE, if the shares traded on an active market, they would be classified as a short-term trading investment at FVNI. The entries would be identical to the ones in part (c) above, including the adjustment to fair values at year end.
-
Using a business calculator present value functions, solve for interest I/Y when the present value, payment, number of periods and future values are given:
PV = (PMT, I/Y, N, FV)
+/- 25,523PV = 1000 PMT, unknown I/Y, 10 N, 25000 FV = 3.745% (rounded) -
Face value of the bond $ 25,000 Present value of the bond 25,523 Bond premium $ 523 -
Journal entries for a AC investment using amortized cost:
Alternative calculation to the effective interest rate schedule below using a business calculator and present value functions:
PV = 1000 PMT, 2 N, 3.745 I/Y, 25000 FV = 25,120.68 where N is 2 years left to maturity.
EFFECTIVE INTEREST RATE SCHEDULE
-
Total interest income is $9,477 - 941 - 938 =
$7,598
after holding the investment for eight out of ten years.
Total net cash flows for Smythe is cash received upon sale = $7,727 over the life of the investment.
The difference of $129.48 ( ) is the gain on the sale of the investment of $130 at the end of eight years. (The small difference is due to rounding.)
- If Smythe followed ASPE, then the investment would be accounted for using amortized cost. However, in this case, there would be a choice regarding the method used to amortize the bond premium of $523 calculated in part (b). The choices are straight-line amortization over the bond's life or the effective interest rate method shown in part (c). If the straight-line method was used, then the yearly amortization amount would have been or $52.30 per year for 8 years until the bonds were sold in 2028. The interest income would be the same over the 8 years.
-
Face value of bond $ 100,000 Amount paid 88,580 Discount amount $ 11,420 The market value of an existing bond will fluctuate with changes in the market interest rates and with changes in the financial condition of the corporation that issued the bond. For example, a 9% bond will become more valuable if market interest rates decrease to 8% because the interest payment is at a higher rate than what investors would receive if they invested in a market that yielded only 8%.
In this case, the issued bond promises to pay 4% interest for the next 10 years in a marketplace where interest has now risen to 5.5% for bonds with similar characteristics and risks. This bond will now become less valuable because the market interest rate has risen, and investors would receive a higher return in the market than with the 4% bond. When the financial condition of the issuing corporation deteriorates, the market value of the bond is likely to decline as well.
-
-
- Imperial Mark will classify this investment as an investment in bonds – FVNI and will report the investment as a current asset.
-
Investment purchase:
Payment of interest using the effective interest rate (IFRS):
Interest accrual using the effective interest rate (IFRS):
Fair value adjustment at year-end:
-
If Imperial Mark follows ASPE, it would classify the investment in bonds as Short-Term Trading Investments, FVNI, and report it as a current investment since management intends to sell it. The alternate method to amortize the premium is using straight-line method. The premium to amortize is the face value minus the investment cost over the life of the bond or
. The interest income at year-end would be the investment amount at the face rate of interest minus the premium amortized using SL for that reporting period.
Investment purchase:
Interest payment using straight-line amortization of premium:
Interest accrual using straight-line method (ASPE):
Fair value adjustment at year-end:
- Halberton would classify this as an investment in shares – FVOCI equities, without recycling, which is a special irrevocable election. Even though it may be for sale, there is no specific intention as to exactly when it will be sold, so it does not fit the business model for shares that are being actively traded. The investment will be reported as a long-term asset because it is unknown when it will be sold.
-
Purchase of investment:
Dividend payment:
Fair-value adjustment through OCI:
The drop in price is not due to investment impairments, it is due to market fluctuations. For this reason, it is a fair value adjustment through OCI. Had the credit risk for this investment increased due to increased expected defaults, management would have revised the ECL and adjusted the investment and loss accounts (to net income due to impairment) accordingly.
-
Sale entries – step 1 – first, record the fair value change to the investment and OCI:
Step 2 – record the cash proceeds and remove the investment:
NOTE – steps 1 and 2 can be combined as shown in the chapter illustrations. They have been separated here for illustration purposes. Either method is acceptable.
Step 3 – remove the OCI amount that related to the investment sold:
- If Halberton followed ASPE, this investment would likely be classified as a short-term trading investment with fair value adjustments at each reporting date, since the investment for shares appears to have active market prices and the investment is for sale (though no specific intention to sell exists at the moment). If the shares were not publicly traded, then the investment would likely be classified as an Other Investment – at cost, with no fair value adjustments.
NOTE – An alternative treatment is to debit interest income at the date of purchase of the bonds instead of interest receivable. This procedure is correct, assuming that when the cash is received for the interest, an appropriate credit to interest income is recorded. Consistency is key.
- Verex follows IFRS because only IFRS companies can account for investments using the FVOCI classification. In this case, the FVOCI is without recycling because these are equities.
-
Purchase of investment:
Cash dividend declared:
Year-end fair value adjusting entry:
Sale entries – step 1 – first, record the fair value change to the investment and OCI:
Step 2 – record the cash proceeds and remove the investment:
Step 3 – reclassify the OCI amount related to the investment sold from AOCI to OCI:
NOTE – steps 1 and 2 are combined in the chapter illustrations. They have been separated here for illustration purposes.
Other Comprehensive Income (OCI) = unrealized holding gain in FVOCI investments = = $30,000
Comprehensive Income (CI) = net income + OCI = = $280,000
Accumulated Other Comprehensive Income (AOCI) = AOCI opening balance + OCI = = $45,000
Entry for impairment:
Note: For ASPE, the impaired value is the higher of the discounted cash flow using the current market interest rate and the net realizable value (NRV) either through sale or by exercising the company's rights to collateral. Since the NRV information is not available, the discounted cash flow using the current market interest rate is the measure used to determine impairment.
Entry for impairment recovery:
-
-
-
- If Camille followed ASPE, these equity investments would be classified as FVNI since there appears to be an active market for these shares. The entries would be the same as those shown for parts (a), (b), and (c). No impairment measurements are required since the investments are already accounted for using fair values.
-
-
Partial balance sheet As at December 31, 2019 Current assets Interest receivable $ 1,500 Investments in bonds – FVNI ( ) 230,850 Partial income statement For the Year Ended December 31, 2019 Other income Interest income ( ) $ 2,250 Unrealized gain on FVNI investments 5,850 - ASPE requires separate reporting of interest income from net gains or losses recognized on financial instruments ( CPA Canada Handbook, Part II, Accounting Standards for Private Enterprises , Section 3856.52) whereas IFRS can choose to disclose whether the net gains or losses on financial assets measured at fair value and reported on the income statement include interest and gains or losses, but it is not mandatory. (For purposes of this text, the preferred treatment for either standard is to separate unrealized gains/loss, interest income and dividend income separately since some of the information is required when completing the corporate tax returns for either ASPE or IFRS companies.)
-
The overall returns generated from the bond investment was $10,050, calculated as follows:
Interest Oct 31, 2019 $ 750 Interest accrued Dec 31, 2019 1,500 Unrealized gain to Dec 31, 2019 5,850 Interest accrued Mar 1, 2020 1,500 Gain on sale of bonds Mar 1, 2020 450 Total investment returns (income and gains) 10,050 This return represents a 10.72% annual return on the investment [ ]. This return is more than anything the company might be able to earn in a typical savings account.
-
December 31, 2020 entry:
Under ASPE, the carrying amount is reduced to the higher of the discounted cash flow using a current market rate or the bond's net realizable value NRV. Impairment reversals are permitted under ASPE for both debt and equity instruments.
-
December 31, 2020 entry:
The investment account remains at its current carrying amount and it is offset by the credit balance in the asset valuation allowance account.
-
Purchase of bonds:
Interest payment:
Fair value adjustment:
Interest payment:
Fair value adjustment:
Interest payment:
Fair value adjustment:
Interest payment:
Fair value adjustment:
-
Part (a) uses a fair values to measures for FVNI investments and are re-measured to their FV at each year-end. No, separate impairment measurement if required because they are already at their fair values. If Helsinky had accounted for this investment at amortized cost, the impairment model would change to an incurred loss model. When there is objective evidence that the expected future cash flows have been significantly reduced, an impairment loss is measured and recognized as follows:
The loss is measured as the difference between the carrying amount and higher of the present value of the revised expected cash flows, discounted at the current market discount rate and the estimated net realizable value of the investment.
The impairment losses can be reversed if the investment values increase.
-
Dec 31, 2019: No entry as there was no trigger or loss event in 2019.
-
- For in investment in equities classified as FVOCI, there are no impairment evaluations required because the investment is remeasured to its fair value each reporting date and the gains/losses upon sale are reclassified from AOCI to retained earnings. Had the investment been a debt investment and classified as FVOCI, such as bonds, an impairment evaluation would be required initially upon acquisition and based on either a 12-month or lifetime ECL valuation. This is because the gains/losses are recycled through net income upon sale. Any impairment loss would be immediately recorded to net income in this case and not to OCI.
-
Since Yarder's shares were quoted in an active market, Sandar is required to apply the FVNI classification to account for its investment. If the shares were not quoted in an active market, the cost method would have been required.
FVNI – where the shares are traded in an active market:
-
Cost method – where there is no active market for the shares:
Dec 31, 2020: No entry required.
-
Equity method:
NOTE: Even though Sandar has significant influence over the operations of Outlander, companies that follow ASPE have a choice between the equity method and the held-for-trading (active market), or the equity method and the cost method (no active markets).
- Investee's total net income =
- Investee's total dividend payout =
- Investor's share of net income =
- Investor's annual depreciation of the excess payment for net capital assets is the only other credit amount recorded in the T-account for $1,500
- Goodwill =
- Investor's share of dividends =
-
2019:
2020:
-
Recall that comprehensive income is:
Net income + Other Comprehensive Income (i.e., unrealized fair value gains/losses from FVOCI investments) = Comprehensive Income
With this in mind, comprehensive income will be the same amount as net income because there is no Other Comprehensive Income (OCI) amount to report as the investment is classified as FVNI with unrealized gains and losses due to fair value adjustments being recorded to net income. Had the investment been classified as FVOCI, then the $20,000 fair value change would have been reported as OCI and not in net income, thus increasing comprehensive income by $20,000 more than net income in 2019, and by $40,000 in 2020.
-
2019:
NOTE: there is no entry to adjust the investment to its fair value under the equity method.
2020:
NOTE: there is no entry to adjust the investment to its fair value under the equity method.
-
Carrying amount of the investment:
Cost $ 380,000 Dividend received in 2019 (7,500) Income earned in 2019 (15,000 – 2,000) 13,000 Loss incurred in 2020 (4,500 + 2,000) (6,500) Carrying amount at December 31, 2020 $ 379,000 Fair value of investment at December 31, 2020 $ 360,000 -
For part (c), if the investee had reported a loss from discontinued operations, all entries would stay the same except for the entry recording the 2019 share of income. This entry would change to reflect the investor's share of the loss from discontinued operations separately from its share of the loss from continuing operations because separate reporting of discontinued operations is a reporting requirement for IFRS and ASPE.
2019:
Income Statement details:
Income from continuing operations $ 65,000 Loss from discontinued operations (15,000) Net income $ 50,000
| Cost of 35% investment | $ | 600,000 | ||||
| Carrying values: | ||||||
| Assets ( ) | $ | 1,680,000 | ||||
| Liabilities | 225,000 | |||||
| 1,455,000 | ||||||
| 509,250 | ||||||
| Excess paid over share of carrying value | $ | 90,750 |
Excess of $90,750 allocated to:
| Assets subject to amortization | |||
| [ ] | 52,500 | ||
| Residual to goodwill | 38,250 | ||
| $ | 90,750 |
| a) ASPE | b) IFRS | |
| i. | FVNI since an active market exists. No separate impairment evaluation needed since investment is adjusted to fair value. | FVOCI without recycling, with unrealized gain/loss through OCI since there is no specific intention to sell for trading purposes. No separate impairment evaluation needed since investment is adjusted to fair value and not recycled through net income. |
| ii. | Other investment in equities at cost, since no active market exists. No fair value adjustments are done. Impairment adjustment is possible if a trigger event occurs. Impairment reversal is possible. When 30% is obtained, management will need to re-measure. | FVOCI without recycling, with unrealized gain/loss through OCI since there is a long-term strategy regarding this investment. No separate impairment evaluation needed since investment is adjusted to fair value and not recycled through net income. When 30% is obtained, management will need to reclassify to investment in associates, if significant influence exists. |
| iii. | Other investment at amortized cost since the intention was to originally hold to maturity. No fair value adjustments are done. Impairment adjustment is possible if a trigger event occurs. Impairment reversal is possible. | Amortized cost since this investment has been accounted for since the initial purchase at amortized cost. Impairment evaluation is done based on an assessment of probability-based estimated default scenarios and +/- adjustments going forward until bond has matured. |
| iv. | Other investment in equities at cost. The FV of the shares is not a factor as they are being held to improve business relations. No fair value adjustments are done. Impairment adjustment is possible if a trigger event occurs. Impairment reversal is possible. | Likely FVOCI without recycling with unrealized gain/loss through OCI since there is no intention to actively trade them. No separate impairment evaluation needed since investment is adjusted to fair value and not recycled through net income. |
| v. | FVNI since the bonds trade on the market. Management intent is to sell as soon as the market price increases. No separate impairment evaluation needed since investment is adjusted to fair value. | FVNI. No separate impairment evaluation needed since investment is adjusted to fair value. |
| vi. | Other investments at amortized since the intention is to hold to maturity. No fair value adjustments are done. Impairment adjustment is possible if a trigger event occurs. Impairment reversal is possible. | At amortized cost since this investment will be held until maturity. Impairment evaluation is done based on an assessment of probability-based estimated default scenarios and +/- adjustments going forward until bond has matured. |
| vii. | FVNI since management intends to sell them within one year. No separate impairment evaluation needed since investment is adjusted to fair value. | FVNI since management intent is to sell within one year. No separate impairment evaluation needed since investment is adjusted to fair value. |
The intent is to hold the investment and to collect interest and principal until maturity, so the classification should be amortized cost.
( ) = 1,725 ECL over the next 12 months
Carrying value of the investment in bonds is ( ) = $1,148,275
(
) = 34,500 ECL over the investment's lifetime
Carrying value of the investment in bonds is therefore 1,115,500.
The ECL increase is deemed to be significant by management and as a result, the ECL has changed from a 12-month ECL to the investment's lifetime (Lifetime ECL).
Chapter 9 Exercises
The following costs should be capitalized with respect to this equipment:
| Cash price paid, net of $1,600 discount, excluding $3,900 of recoverable tax | $ | 78,400 | |
| Freight cost to ship equipment to factory | 3,300 | ||
| Direct employee wages to install equipment | 5,600 | ||
| External specialist technician needed to complete final installation | 4,100 | ||
| Materials consumed in the testing process | 2,200 | ||
| Direct employee wages to test equipment | 1,300 | ||
| Legal fees to draft the equipment purchase contract | 2,400 | ||
| Government grant received on purchase of the equipment | (8,000) | ||
| Total cost capitalized | 89,300 |
The recoverable tax should be disclosed as an amount receivable on the balance sheet.
The repair costs, costs of training employees, overhead costs, and insurance cost would all be expensed as regular operating expenses on the income statement.
An alternative treatment for the government grant would be to defer it as an unearned revenue liability and then amortize it on the same basis as the equipment depreciation.
The following costs would be capitalized with respect to the mine:
| Direct material | $ | 2,200,000 | |
| Direct labour | 1,600,000 | ||
| Interest ( ) | 180,000 | ||
| Less interest on excess funds | (30,000) | ||
| Present value of restoration costs (FV=100,000, I=10, N=10) | 38,554 | ||
| Total cost capitalized | 3,988,554 |
With a lump sum purchase, the cost of each asset should be determined based on the relative fair value of that component. The total fair value of the asset bundle is $250,000. Therefore, the allocation of the purchase price would be as follows:
| Specialized lathe | = | 26,400 | |
| Robotic assembly machine | = | 79,200 | |
| Laser guided cutting machine | = | 96,800 | |
| Delivery truck | = | 17,600 | |
| Total | 220,000 |
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Prabhu
Zhang
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Prabhu
Zhang
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Prabhu
NOTE: Loss must be recorded, as the asset acquired cannot be recorded at an amount greater than its fair value.
Zhang
Transaction 1:
IFRS requires assets acquired in exchange for the company's shares to be reported at the fair value of the asset acquired. The list price is not relevant, as the salesman has already indicated that this can be negotiated downward. If the $80,000 negotiated price is considered a reliable representation of the fair value of the asset, this amount should be used:
If the $80,000 price is not considered a reliable fair value, then the fair value of the shares given up ($78,750) should be used, as the shares are actively traded.
Transaction 2:
The asset acquired by issuing a non-interest bearing note needs to be reported at its fair value. As the interest rate of zero is not reasonable, based on market conditions, the payments for the asset need to be adjusted to their present value to properly reflect the current fair value of the asset.
The note payable amount represents the present value of a $45,000 payment due in one year, discounted at 9%.
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Deferral Method
-
Offset Method
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The deferral method will result in annual depreciation expense of $625,000
30 years = $20,833, with an offsetting annual grant income amount recognized = $90,000
30 years = $ 3,000 per year.
The offset method will result in an annual depreciation expense of $535,000 30 years = $17,833 with no grant income being recognized.
The net difference in net income between the two methods is zero.
NOTE: Depreciation expense = $1,200,000 27 years remaining = $44,444
NOTE: Depreciation expense = $1,250,000 26 years = $48,077
NOTE: Depreciation expense = $1,000,000 25 years = $40,000
The replacement of the boiler should be treated as the disposal of a separate component. The original cost of the old boiler can be estimated as follows:
The old boiler would have been depreciated as part of the building as follows:
(NOTE: per company policy, no depreciation is taken in the year of disposal)
The purchase of the new boiler should be treated as a separate component:
This cannot be identified as a separate component, but it does extend the useful life of the asset, so capitalization is warranted.
Original depreciation:
Up to the end of 2019 = $120,000 (6 years)
Based on the journal entries above, revised depreciation is calculated as follows:
NOTE: the boiler has been depreciated over the same useful life as the building (44 years). As this is a separate component, a different useful life could be determined by management and used instead. Per company policy a full year of depreciation is taken in the year of acquisition.
Chapter 10 Exercises
-
Straight line:
= $23,000 per year (same for all years)
-
Activity based on input:
= $11.50 per hour of use
2021 depreciation = = $24,725 -
Activity based on output:
= $0.115 per unit produced
2021 depreciation = = $23,805 -
Double declining balance:
Depreciation rate (assume straight-line unless otherwise indicated):
Depreciation per year calculated as follows:
| 2020: | $ | 1,500 | |
| 2021: | Full year | $ | 3,000 |
| 2022: | Full year | $ | 3,000 |
| 2023: | $ | 1,500 | |
| Total depreciation: | $ | 9,000 |
(Note: in 2023, only 6 months depreciation can be recorded, as the asset has reached the end of its useful life.)
- No journal entry is required as this is considered a change in estimate. Depreciation will be adjusted prospectively only, with no adjustment made to prior years.
-
Original depreciation:
Depreciation taken 2018–2020 =
Revised depreciation for 2021 and future years:
-
Depreciation from 2006–2011:
Total depreciation taken =
-
Depreciation from 2012–2019:
Total depreciation taken =
-
Depreciation for 2020 and future years:
-
Determine the recoverable amount:
Value in use = $110,000 Fair value less costs of disposal = $116,000 The recoverable amount is the greater amount: $116,000
Carrying value =
As the carrying value exceeds the recoverable amount, the asset is impaired by
-
-
New carrying value =
-
Determine the recoverable amount:
Value in use $ 90,000 Fair value less costs to sell $ 111,000 The recoverable amount is the greater amount: $111,000
The carrying value is now
The asset is no longer impaired. However, the reversal of the impairment loss is limited. If the impairment had never occurred, the carrying value of the asset would have been:
Unimpaired carrying value on Jan 1, 2021 $ 150,000 Depreciation for 2021 ( ) (50,000) Unimpaired carrying value at Dec 31, 2021 100,000 Therefore, the reversal of the impairment loss is limited to:
The journal entry will be:
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ASPE 3063 uses a two-step process for determining impairment losses. The first step is to determine if the asset is impaired by comparing the undiscounted future cash flows to the carrying value:
Undiscounted future cash flows: $ 140,000 Carrying value $ 150,000 Therefore, the asset is impaired.
The second step is to determine the amount of the impairment. This amount is the difference between the carrying value and the fair value of the asset:
Carrying value $ 150,000 Fair value $ 125,000 Impairment loss $ 25,000 Thus, the journal entry will be:
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Depreciation will now be based on the new carrying value:
- The carrying value is now . As this is less than the undiscounted future cash flows, the asset is no longer impaired. However, under ASPE 3063, reversals of impairment losses are not allowed, so no adjustment can be made in this case.
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The total carrying value of the division is $95,000. The fair values of the individual assets cannot be determined, so the value in use is the appropriate measure. In this case, the value in use is $80,000, which means the division is impaired by $15,000. This impairment will be allocated on a pro-rata basis to the individual assets:
Carrying Proportion Impairment Amount Loss Computers $55,000 55/95 $8,684 Furniture 27,000 27/95 4,263 Equipment 13,000 13/95 2,053 95,000 15,000 -
The journal entry would be:
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The value in use ($80,000) is greater than the fair value less costs to sell ($60,000) so the calculation of impairment loss is the same as in part (a) (i.e., $15,000). However, none of the impairment loss should be allocated to the computers, as their carrying value ($55,000) is less than their recoverable amount ($60,000). The impairment loss would therefore be allocated as follows:
Carrying Proportion Impairment Amount Loss Furniture $27,000 27/40 $10,125 Equipment 13,000 13/40 4,875 40,000 15,000 -
The impairment loss is still calculated as $15,000. However, this time the computers are also impaired, as their carrying value ($55,000) is greater than their recoverable amount ($50,000). In this case, the computers are reduced to their recoverable amount and the remaining impairment loss (
) is allocated to the furniture and equipment on a pro-rata basis:
Carrying Proportion Impairment Amount Loss Computers $55,000 $5,000 Furniture 27,000 27/40 6,750 Equipment 13,000 13/40 3,250 95,000 15,000
Chapter 11 Exercises
The items below are identified as capitalized as an intangible asset or expensed, with the account each item would be recorded to.
- Expense as research and development expense
- Capitalize if the development phase criteria for capitalization are all met; else expense
- If reporting under IFRS, then capitalize the borrowing costs if the development phase criteria for capitalization are all met; else expense; if reporting under ASPE, then a policy choice exists for both borrowing costs and research and development costs
- Expense as salaries and wages expense
- Expense as marketing expenses
- Capitalize as part of the patent asset amount
- Expense as research expenses
- Expense to salaries, travel etc. as incurred
- Capitalize as part of the patent asset amount
- Capitalize as part of the software asset amount
- Expense as training expenses
- Capitalize as part of the software asset amount
- Organization expense
- Operating expense
- Capitalized to the franchise asset
- Under IFRS, will be capitalized only if the development costs meet all six development-phase criteria for capitalization; under ASPE, may be capitalized or expensed, depending on company's policy when it meets the six criteria in the development stage
- Capitalized to the patent asset
- Capitalized to the patent asset
- Capitalized to the copyright
- Capitalized as development costs only if they meet all six development phase criteria for capitalization.
- Expensed to research and development expenses
- Expensed on the income statement
- Under IFRS, borrowing costs that are directly attributable to project that meet the six development phase criteria are capitalized; under ASPE, interest costs directly attributable to the project that meet the six development phase capitalization criteria can be either capitalized or expensed as set by the company's policies
- Under IFRS, will be capitalized to the intangible asset only if the development costs meet all six development-phase criteria for capitalization
- Expensed to research and development expenses
- Expensed to interest expenses
- Expensed to research and development expenses
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Intangible assets likely include:
- purchased trademark Aromatica Organica and its related internet domain name
- purchased patented soap recipes
- expenditures related to infrastructure and graphical design development of Harman's unique website through which the retailers review the product offerings and place their orders.
- The majority of Harman's assets are intangible. They include the Aromatica Organica trademark, the patented soap and oil recipes, and the company's own product and ordering website. The intangible assets help to protect the revenues from competitor companies, so Harman can sell a unique product with a specific brand name that customers recognize for its fine quality and through a unique website developed by Harman.
- The intangible assets meet the definition of an asset because they involve past and present economic resources for which there are probable future economic benefits that are obtained and controlled by Harman. Recording intangible assets on the company's SFP/BS provides users with relevant and faithfully representative information about the company's expected future economic benefits, as well as financial statements that are complete and free from error or bias.
| Amortization | ||||
| Jan 1 Carrying value | 288,000 | 14 years | = | 20,571 |
| Sept 1 Legal fees | 42,000 | (4 months 160 months)* | = | 1,050 |
| Total amortization for 2020 | 330,000 | 21,621 |
* September 1 was the date that the patent was legally upheld thus meeting the definition of an asset subject to amortization. There are 4 months remaining in 2020 starting September 1. If on January 1, 2020 there were 14 years remaining, then as at September 1, 2020, there would be 13 years + 4 months remaining. Converting this to months is . For 2020, there are 4 months to year-end to amortize the legal fees, so months would be the prorated amount of the legal fees capitalized for 2020.
Carrying amount as at Dec 31, 2020:
The accounting for the research expense of $140,000 is to be expensed when incurred because it can only be recognized from the development phase of an internal project when the six criteria for capitalization are met.
(Partial SFP/BS):
(Partial income statement):
| Amortization expense ( ) | $ | 5,000 |
Note – item (b), purchased copyright and item (c), purchased Internet domain name have indefinite useful lives so they would not be amortized.
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Under ASPE, Trembeld has the option either to expense all costs as incurred or to recognize the costs as an internally generated intangible asset when the six development phase criteria for capitalization are met. If Trembeld expenses all costs as incurred, they will be expensed as research and development expenses.
Research and development expense* 634,000 *$180,000 + 64,000 + 270,000 + 86,000 + 25,400 + 8,600
If Trembeld chooses, it can capitalize all costs incurred after April 1. The costs incurred prior to April 1 must be expensed as research and development expenses.
Intangible assets – development costs* 390,000 Research and development expense ( ) 244,000 *
Note: Under ASPE, once interest costs directly attributable to the acquisition, construction, or development of an intangible asset meet the six criteria to be capitalized, they may be capitalized or expensed depending on the company's accounting policy for borrowing costs.
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If Trembeld followed IFRS, all costs associated with the development of internally generated intangible assets would be capitalized when the six development phase criteria for capitalization are met. The costs incurred prior to the date the required criteria were met would be expensed as research and development expense.
Intangible assets – development costs* 390,000 Research and development expense ( ) 244,000 *
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Under ASPE
Recoverability test:
The undiscounted future cash flows of $152,000 < the carrying amount $100,500, therefore the asset is impaired.
The impairment loss is calculated as the difference between the asset's carrying amount $100,500 and fair value $55,000.
In this case, the undiscounted future cash flows ($152,000) > Carrying amount ($100,500), therefore the asset is not impaired.
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Under IFRS
If carrying amount $100,500 > recoverable amount $115,000 (where recoverable amount is the higher of value in use $115,000 and fair value less costs to sell $50,000), the asset is impaired.
The impairment loss is calculated as the difference between carrying amount $100,500 and recoverable amount $115,000.
In this case, the carrying amount $100,500 is < the recoverable amount of $115,000 so there is no impairment loss.
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Under ASPE, for indefinite-life intangible assets:
If the carrying amount $100,500 > the asset's fair value $55,000, then the asset is impaired.
The impairment loss is calculated as $45,500 ( ).
Under IFRS, there is no impairment loss as the carrying amount of $100,500 < the recoverable amount of $115,000 (where recoverable amount is the higher of value in use and fair value less costs to sell).
| Fair Value | % of Total | Cost = | Recorded | |
| Amount | ||||
| (rounded) | ||||
| Trade name | $380,000 | 30.89% | $1.2 million | $370,680 |
| Patented process | 400,000 | 32.52% | $1.2 million | 390,240 |
| Customer list | 450,000 | 36.59% | $1.2 million | 439,080 |
| $1,230,000 | $1.2 million |
Note: The asset purchase is to be capitalized using the relative fair value method and assets separately reported so that the amortization expense can be separately determined for each based on their respective useful life.
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At December 31, 2020, Bartek reports the patent:
Intangible assets Patent $ 800,000 Accumulated amortization* 425,000 $ 375,000 * Amortization 2017 to 2019: = $300,000
Amortization for 2020:
Accumulated amortization 2017 to 2020: = $425,000
- The amount of amortization of the franchise for the year ended December 31, 2019, is $25,000: ( ). Reason: Bartek should amortize the franchise over 20 years which is the period of the identifiable cash flows. Even though the franchise is considered as "perpetual," the company believes it will generate future economic benefits for only the next 20 years.
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Unamortized development costs would be reported as $50,000 ($250,000 net of $200,000 accumulated amortization) at December 31, 2020 on the SFP/BS.
Amortization for 2017 to 2020:
-
Cash purchase price $ 863,000 Fair value of assets $ 1,160,000 Less liabilities (carrying value = fair value) (460,000) Fair value of net assets 700,000 Value assigned to goodwill $ 163,000 -
Under IFRS, the recoverable amount of the CGU of $1,850,000 (which is the greater of the fair value, less costs to sell $1,600,000, and the value in use $1,850,000) is compared with its carrying amount $1,925,000 to determine if there is any impairment.
The goodwill is impaired because carrying amount of the CGU $1,925,000 > recoverable amount of the CGU $1,850,000. The goodwill impairment loss is $75,000 ( ). A reversal of an impairment loss on goodwill is not permitted.
- Under ASPE, goodwill is assigned to a reporting unit at the acquisition date. Goodwill is tested for impairment when events or changes in circumstances indicate impairment may exist. An impairment exists if the carrying amount of the reporting unit $1,925,000 exceeds the fair value of the reporting unit $1,860,000. In this case there is an impairment loss of $65,000 ( ). A reversal of an impairment loss on goodwill is not permitted.
| a. | Goodwill as a separate line item on the SFP/BS |
| b., c., d. | Research costs, organization cost, and the annual franchise fee would be classified as operating expenses |
| e., f., g., h. | Cash, accounts receivable, notes receivable due within one year from balance sheet date and prepaid expenses would be classified as current assets |
| i. | Intangible assets, if development criteria met at the acquisition date |
| j. | Non-current assets in the tangible property, plant, and equipment section. (Some accountants classify them as intangible assets on the basis that the improvements revert to the lessor at the end of the lease and therefore are more of a right than a tangible asset.) |
| k. | Intangible assets |
| l. | Intangible assets |
| m. | Investments section on the SFP/BS |
| n. | Intangible assets |
| o. | Discount on notes payable is shown as a deduction from the related notes payable on the SFP/BS as a liability |
| p., q. | Long-term assets in the tangible property, under plant, and equipment section |
| r. | Intangible asset |
| s. | Intangible asset |
| t. | Goodwill as a separate line item on the SFP/BS |
| u. | Expensed as part of research and development expense. (Development expenses are expensed unless all six criteria for capitalization are met.) |
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The determination of useful life by management can have a material effect on the balance sheet as well as on the income statement. The following are the variables to consider when determining the appropriate useful life for a limited-life intangible.
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The legal life for a patent in Canada is twenty years but management can deem a shorter useful life based on
- the expected use of the patent
- economic factors such as demand and competition
- the period over which its benefits are expected to be provided.
- The estimated useful life of the patent should be based on neutral and unbiased consideration of the factors above, which requires a degree of professional judgment.
-
The legal life for a patent in Canada is twenty years but management can deem a shorter useful life based on
-
December 31, 2019:
Amortization:
Carrying amount:
December 31, 2020:
Amortization: (rounded)
Carrying amount:
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Dec 31, 2019 carrying amount from (b): $23,750
2020 amortization: (rounded)
Carrying amount:
- If it has an indefinite life, then do not amortize. If classified as indefinite life, management must review useful life annually to ensure that conditions and circumstances continue to support the indefinite life assessment. Any change in useful life is to be accounted as a change in estimate, which is accounted for prospectively. Also, management would have to test annually for impairment or whenever indicators of such a possibility exist.
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Situation (i) Journal Entries:
Situation (ii) Journal Entries:
Situation (iii) Journal Entries:
Situation (iv) Journal Entries:
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Partial income statement:
Hilde Co. Statement of Income (partial) For the Year Ending December 31, 2020 Revenue from franchise $ 5,600,000 Expenses Research and development expenses* $ 470,000 Franchise fee expense 112,000 Amortization expense** 122,000 704,000 Income from operations before taxes 4,896,000 Income tax expense 1,321,920 Net income $ 3,574,080 * ( )
** ( )Partial balance sheet:
Hilde Co. Balance Sheet (partial) As at December 31, 2020 Intangible assets: Intangible assets – patents $ 900,000 Accumulated amortization 60,000 $ 840,000 Intangible assets – electronic product 170,000 Accumulated amortization 17,000 153,000 Intangible assets – franchise 1,800,000 Accumulated amortization 45,000 1,755,000 Total intangible assets $ 2,748,000 Note: The balance sheet reporting requirement is to disclose the net amount for each intangible asset separately, its related accumulated amortization, any accumulated impairment losses, and a total for net intangible assets. With these requirements in mind, an alternative reporting format for the balance sheet would be to report the net amounts for each intangible asset as shown in the right-hand column with disclosure of the accumulated amortization, any accumulated impairment losses and the net amount for each intangible asset in an additional schedule in the notes to the financial statements.
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Under IFRS, if the costs meet the six development phase criteria for capitalization, then they are to be capitalized. Under ASPE, costs that meet the six development phase criteria for capitalization may either be capitalized or expensed, depending on the entity's accounting policy. In this case, Hilde's policy is to capitalize costs that meet the criteria; therefore, the accounting entries would be the same as the solution above.
Under IFRS there is an option to use the revaluation model for subsequent measurement of intangible assets after acquisition if there is an active market for the intangible assets. Refer to the chapter on property, plant, and equipment for details about this model. In addition, under IFRS, an assessment of estimated useful life is required at each reporting date.
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Impairment testing for limited-life assets under ASPE:
Limited-life intangible assets would be tested for possible impairment whenever events and circumstances indicate the carrying amount may not be recoverable. The carrying amount of the asset is compared to undiscounted future net cash flows of the asset, to determine if the asset is impaired. If impaired, the difference between the asset's carrying amount and its fair value will be the impairment amount. Under ASPE, an impairment loss for intangible assets may not be reversed.
Impairment testing for limited-life intangibles under IFRS:
At the end of each reporting period, the asset is to be assessed for possible impairment. If impairment is suspected, and the carrying amount is higher than the recoverable amount (which is the higher of the value in use, and the fair value less costs to sell), the asset is impaired. The impairment loss is the difference between the asset's carrying amount and its recoverable amount. Under IFRS, an impairment loss may be reversed in the future, although the reversal is limited to what the asset's carrying amount would have been had there been no impairment.
Entry:
* Present value calculation:
PV = (4,800** PMT, 9 I/Y***, 5 N, 60,000 FV)
PV = $57,666 (rounded)
**
*** PV calculations use the market rate while the interest payment of $4,800 uses the stated rate.
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- Under IFRS, costs associated with the development of internally generated intangible assets are capitalized when the six specific criteria for capitalization are met in the development stage. The $250,000 must be expensed as it was incurred before the future benefits were reasonably certain. Costs incurred after the six specific criteria for capitalization are met, are capitalized. The $50,000 costs incurred indicates the company's intention and ability to generate future economic benefits. As a result, the $50,000 would be capitalized as development costs. The $50,000 capitalized costs would be amortized over periods benefiting after manufacturing begins.
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Impairment for limited-life under IFRS:
Carrying value: 1,000,000
Recoverable amount: higher of value in use and fair value less costs to sell
= higher of [$1,100,000 and ( )] = 1,100,000
Carrying value is less than 1,100,000, therefore the franchise is not impaired.
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Carrying value: 1,000,000
Recoverable amount: 950,000
Carrying value is more than the recoverable amount therefore the franchise is impaired by $50,000.
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Carrying value: 1,000,000
Recoverable amount: higher of value in use and fair value less costs to sell
= higher of [$1,100,000 and ( )] = 1,305,000
Carrying value is less than 1,305,000, therefore the franchise is not impaired.
- Under IFRS, indefinite-life intangible assets are tested for impairment annually (even if there is no indication of impairment), which is the same as was done for limited-life intangible assets. So the answers in parts (a) to (c) will not change because the franchise has an unlimited life.
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Under ASPE for limited-life intangibles, if there is reason to suspect impairment, then management can complete an assessment of the franchise. If the carrying value is greater than the undiscounted cash flows then it is impaired. The impairment amount is the difference between the carrying value and the fair value.
Part (a) Carrying value: 1,000,000
Undiscounted future cash flow = 1,200,000
Carrying value is less than 1,200,000, therefore the franchise is not impaired.
Part (b) Carrying value: 1,000,000
Recoverable amount (discounted future cash flows) = 950,000
Carrying value is more than the recoverable amount therefore the franchise is impaired by $50,000.
Part (c) Fair value changed to $1.35 million. Fair value is not relevant for ASPE to assess recoverability, so the answer does not change from part (b).
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Part (a) Under ASPE, indefinite-life intangible assets are tested for impairment when circumstances indicate that the asset may be impaired same as with limited-life intangibles. However, the test differs from the test for limited-life assets. Here, a fair value test is used, and an impairment loss is recorded when the carrying amount exceeds the fair value of the intangible asset.
Carrying value: 1,000,000
Fair value: 1,000,000
Carrying value is equal to the fair value for 1,000,000; therefore, the franchise is not impaired.
Part (b) Under ASPE, the recoverable amount refers to undiscounted future cash flows, which does not affect the impairment test for indefinite-life intangible assets, which compares the carrying value to the fair value of the asset. The fair value remains at 1,000,000, therefore the asset is not impaired.
Part (c) Carrying value: 1,000,000
Fair value: 1,350,000
Carrying value is less than the fair value for 1,350,000, therefore the franchise is not impaired under ASPE for an indefinite-life asset.
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- Payment of total consideration of $280,000 for Candelabra resulted in payment for goodwill of $65,000. Goodwill is defined as an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified or separately recognized. In paying for goodwill of $65,000, Boxlight may have considered the value of Candelabra's established customers for repeat business, the company's reputation, the competence and ability of its management team to strategize effectively, its credit rating with its suppliers, and whether the company has highly qualified and motivated employees. Together, these could make the value of the business greater than the sum of the fair value of its net identifiable assets.
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Carrying value $ 200,000 Fair value 180,000 Impairment amount 20,000 Entry:
-
Carrying value: 180,000
Recoverable amount: higher of value in use and fair value less costs to sell
= higher of [$170,000 and ( )] = 170,000
Carrying value is greater than 170,000; therefore, the franchise is impaired by $10,000 ( ).
Note: Had the impairment amount exceeded the $65,000 goodwill carrying value, the amount of the difference would be allocated to the remaining net identifiable assets on a prorated basis.
- For part (c), reversal of goodwill if impairment losses exist is not permitted under ASPE. For part (d), reversal of goodwill impairment losses is not permitted under IFRS.