Fa Mod1 Ont 0910

CMA Ontario
Accelerated Program
FINANCIAL ACCOUNTING
IFRS
MODULE 1
Financial Accounting Module 1
Table of Contents
1.
Financial Statements and the Conceptual Framework
2.
The Statement of Cash Flow
3.
Revenue Recognition
110
4.
Cash
139
5.
Accounts Receivable
147
6.
Notes Receivable/Payable
163
7.
Inventory
187
8.
Capital Assets
214
9.
Liabilities
278
10.
Shareholders Equity
310
11.
Accounting for Pensions
341
12.
Earnings per Share
384
13.
Accounting for Leases
405
14.
Accounting for NonProfit Organizations
437
15.
Financial Statement Analysis
475
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3
77
CMA Ontario September 2009
1.
Financial Statements and the Conceptual Framework
The purpose of this section is to provide a high level review of the accounting cycle, the
preparation of financial statements and the conceptual framework. If you are reading this
before the course has started, we recommend that you spend as much time as you can
working in the Financial Accounting Primer that you received with the course materials.
In fact, we would recommend that you only spend time working with the primer until the
day the course starts.
Chapter 1 of the FA Primer should be read as a preamble to this chapter.
The Accounting Cycle

The accounting cycle describes the process whereby individual transactions get compiled
to eventually becoming financial statements. The cycle is as follows:
1.
Transaction: the company enters into a transaction, for example a sale on credit is
made.
2.
Transaction analysis: the accountant analyzes the transaction in terms of which
account has been impacted upon
3.
Journalization: the transaction gets recorded in a source journal. For example, the
credit sale would likely get recorded in a sales journal. Other journals are:
purchases journal, cash receipts journal, cash disbursements journal, payroll
journal and the general journal. Note that this is by no means a comprehensive
listing.
4.
Posting: the journals get posted to the general ledger. The general ledger shows
the details of all transactions in the companys accounts.
5.
Trial balance - the trial balance is a listing of all general account balances.
6.
Adjusting entries - analysis of the trial balance may require some entries to adjust
the accounts before the financial statements are prepared.
7.
Financial Statement Preparation.
8.
Closing entries - once the financial statements have been prepared, all revenue
and expense accounts are cleared out to zero and the residual amount (equal to net
income) is closed out to retained earnings.
Page 3
Example: Local Stationery Ltd. is a local store providing business supplies, furniture
and copy and fax services to local business and individuals. The trial balance as at
December 31, 20x5 is as follows:
Cash
Accounts Receivable
Allowance for Doubtful Accounts
Inventory
Note receivable, current
Prepaid insurance
Land
Building
Equipment
Accumulated amortization
Accounts payable and accrued liabilities
Accrued wages payable
Accrued income taxes payable
Unearned revenue
Long-term debt
Common stock
Retained Earnings
Debit
$14,500
74,000
Credit
$4,500
130,000
10,400
1,400
60,000
260,000
90,000
$640,300
40,000
25,000
2,800
3,600
15,000
150,000
250,000
149,400
$640,300
The following is a schedule of cash receipts and disbursements for the year 20x6:
Cash receipts
Cash sales
Collections on credit sales
Deposits received on furniture orders
Sale of depreciable assets (note 1)
Receipt of note receivable (note 2)
Note 1:
Page 4
$450,000
620,000
50,000
20,000
10,800
1,150,800
the assets sold had an original cost of $40,000 and accumulated

amortization of $25,000.
Note 2:
the note was taken out on July 2, 20x5 for $10,000, is due on July 2, 20x6
and bears 8% annual interest.
Cash disbursements
Purchase of inventory
Wages and salaries
Income tax installments paid
Operating expenses paid
Interest paid on long-term debt
Renewal of insurance policy
Long-term debt repaid (annual payment due every Dec 31)
Dividends paid
Purchase of equipment
$650,000
200,000
25,000
150,000
13,500
7,200
15,000
30,000
50,000
$1,140,700
The T-accounts shown on pages 11-12 simulate the general ledger accounts.
The following three journal entries will record cash receipts and disbursements:
(1)
(2)
(3)
Page 5
Cash
Sales
Accounts Receivable
Unearned revenues
Note Receivable
Interest revenue
Cash
Equipment
Gain on sale of depreciable assets
Inventory
Wages and salaries
Income tax expense
Operating expenses
Interest
Insurance expense
Long-term debt
Retained Earnings (dividends)
Equipment
Cash
$1,130,800
$450,000
620,000
50,000
10,400
400
20,000
25,000
40,000
5,000
650,000
200,000
25,000
150,000
13,500
7,200
15,000
30,000
50,000
1,140,700
Other information:
You find out that $3,600 of accounts receivable were written off as uncollectible this
year.
(4)
Allowance for doubtful accounts

Accounts Receivable
3,600
3,600
Accounts receivable at the end of the year total $98,000. After transaction #4, the
accounts receivable balance shows a $549,600 credit. This is because we credited the
account for collections but did not make an entry to record credit sales. Credit sales are:
$549,600 + 98,000 = $647,600.
(5)
Accounts Receivable
Sales
647,600
647,600
Analysis of the accounts receivable indicate that the allowance for doubtful accounts
should be $5,700. After transaction # 4, the balance in the allowance for doubtful
accounts was a credit of $900. We need to increase this to $5,700 as follows:
(6)
Bad debt expense

4,800
4,800
An inventory count shows that there is $145,000 of inventory on hand at December 31,
20x6.
(7)
Cost of goods sold

Inventory
635,000
635,000
The company's insurance policy expires on May 31 of every year. On May 31, 20x6, the
company renewed it's insurance policy for 2 years. Consequently, the prepaid insurance
on December 31, 20x6 should be: $7,200 x 17/24 = $5,100. The current balance in the
account is $1,400, thus it needs to be increased by $5,100 - 1,400 = $3,700.
(8)
Prepaid insurance
Insurance expense
3,700
3,700
The annual amortization on the building and equipment has been calculated to be
$20,000.
(9)
Page 6
Amortization expense
20,000
20,000
Accounts payable and accrued liabilities all relate to the purchase of inventory. The total
amount of accounts payable and accrued liabilities as at December 31, 20x6 is $35,000.
(10)
Cost of goods sold

10,000
10,000
Accrued wages payable at December 31, 20x6 is $1,300.

(11)

Wages and salaries
1,500
1,500
The balance in unearned revenues at December 31, 20x6 should be $10,000.

(12)
Unearned revenues
Sales
55,000
55,000
Income taxes are 40% of net income before taxes. Net income before taxes is $122,700.
Income tax expense is $122,700 x 40% = $49,080 - 25,000 =
(13)
Income tax expense

24,080
24,080
The following two pages posts the above transactions to t-accounts.
Page 7
ASSETS
Op
(1)
(2)
Cash
14,500 1,140,700
1,130,800
20,000
(3)
Op
(5)
Accounts Receivable
74,000 620,000
647,600 3,600
(1)
(4)
(4)
3,600 4,500
4,800
98,000
Op
(6)
5,700
24,600
Op
(3)
Inventory
130,000 635,000
650,000
(7)
Op
Note Receivable
10,400 10,400
Op
(8)
Prepaid Insurance
1,400
3,700
(1)
145,000
Land
60,000
Op
Op
Building
260,000
5,100
Accumulated Amortization
(2)
25,000 40,000
Op
20,000
(9)
Op
(3)
35,000
Equipment
90,000 40,000
50,000
(2)
100,000
LIABILITIES AND SHAREHOLDERS' EQUITY

Accounts Payable and Acc Liab.
25,000
Op
10,000
(10)
(11)
Accrued Wages Payable

1,500 2,800
Op
Accrued Inc Taxes Payable

3,600
Op
24,080
(13)
1,300
35,000
(12)
Unearned Revenues
55,000 15,000
50,000
27,680
Op
(1)
(3)
Long-Term Debt
15,000 150,000
Op
135,000
10,000
Common Stock
250,000
Page 8
Op
(3)
Retained Earnings
30,000 149,400
Op
REVENUES
Sales
450,000
647,600
55,000
(1)
(5)
(12)
Interest Revenue
400
(1)
Wages and Salaries

200,000 1,500
(11)
Gain on Disposal of Assets

5,000
(2)
1,152,600
EXPENSES
(7)
(10)
Cost of Goods Sold

635,000
10,000
(3)
(3)
Operating Expenses
150,000
(3)
Insurance
7,200 3,700
198,500
645,000
(3)
Interest
13,500
(9)
Amortization
20,000
(8)
3,500
(3)
(13)
Income Taxes
25,000
24,080
(6)
Bad debt expense

4,800
49,080
From the balances in the t-accounts, we can now prepare a full set of financial statements.
Page 9
Local Stationery Ltd.

Income Statement
for the year ended December 31, 20x6
Sales
Cost of goods sold
Gross margin
$1,152,600
645,000
507,600
Selling and general expenses

Wages and salaries
Depreciation expense
Insurance expense
Bad debt expense
Interest revenue
Gain on disposal of assets
Interest expense
(150,000)
(198,500)
(20,000)
(3,500)
(4,800)
400
5,000
(13,500)
Net income before taxes

Income tax expense
122,700
49,080
Net income
$73,620

Statement of Changes in Shareholders' Equity
Balance, December 31, 20x5

Net income
Dividends
Page 10
Common
Stock
$250,000
Retained
Earnings
$149,400
73,620
(30,000)
$250,000
$193,020

Statement of Financial Position
as at December 31, 20x6
ASSETS
Noncurrent
Land
Building
Equipment
Current
Cash
Accounts Receivable (net)
Inventory
Prepaid insurance
$ 60,000
260,000
100,000
-35,000
385,000
24,600
92,300
145,000
5,100
267,000
$652,000
SHAREHOLDERS' EQUITY AND LIABILTIES

Shareholders' equity
Common stock
Retained Earnings
Long-term debt
Current liabilities
Unearned revenues
Current portion of long-term debt
$250,000
193,020
443,020
120,000
35,000
1,300
27,680
10,000
15,000
88,980
$652,000
Page 11
Financial Statements
Components of Financial Statements

IAS 1 states that a complete set of financial statements comprises of the following:
(a)
a statement of financial position as at the end of the period,
(b)
a statement of comprehensive income for the period,
(c)
a statement of changes in equity for the period,
(d)
a statement of cash flows for the period
(e)
a set of notes, which provide a summary of the entity's significant accounting
policies along with other explanatory information
IAS 1 uses different terminology from what was used previously under both IAS's and
Canadian GAAP, for example a 'statement of financial position' is the equivalent of a
'balance sheet'. Nevertheless, an entity can continue to use financial statement titles other
than those used in IAS 1, as long as the titles are not misleading.
IAS 1.36 requires that financial statements be presented at least annually.
IAS 1.51 states that each financial statement and notes be clearly identified and
prominently displayed with the following information:
the name of the reporting entity,
whether the financial statements are for an individual entity or a group of entities,
the date of the end of the reporting period or the period covered by the set of
financial statements,
the presentation currency, and
the level of rounding used in presenting amount.
Page 12
The Statement of Financial Position

The following is a schematic of a typical Statement of Financial Position:
Share Capital
Long-term Assets
Retained Earnings
Long-Term Liabilities
Current Assets
Current Liabilities
A Statement of Financial Position is essentially a listing of all assets of an accounting

entity (the left side). The right side of the balance sheet shows how these assets are
financed: through external creditor financing (liabilities) or though internal financing,
either through direct shareholder financing (share capital) or though growth (retained
earnings).
Note that the above 'inverted' statement of financial position is not required by IAS 1, so
companies can continue to use the traditional balance sheet format, i.e. current assets
followed by current liabilities. The inverted format however, is used by all European
entities that have adopted IFRS and is used in all examples in IAS 1.
Assets are segregated into current and long-term assets.
A current asset is defined as follows (IAS 1.66)
it is expected to be realized in, or is intended for sale or consumption in, the

entitys normal operating cycle
it is held primarily for the purpose of being traded
it is expected to be realized within 12 months, or
it is cash or a cash equivalent.

The operating cycle of a business is defined as the amount of time it takes to convert raw
materials into a final product and sold. For most businesses this is much less than one
year. Some businesses' operating cycle last longer than one year: tree farms, nuclear
submarine contractors, scotch whisky distillers, etc For purposes of this course,
however, we can generally assume that current assets will be converted into cash or used
up in the business within one year.
Page 13
The most common current assets are: cash, short-term investments, accounts receivable,
inventory and prepaid expenses.
Non-current assets are defined by what they are not: they are not current assets.
Essentially, they are assets that will convert into cash or be used up in the business over
periods of longer than one year or the operating cycle of the business. The most common
long-term assets are: long-term investments, land, building, equipment, and intangible
assets (goodwill, patents and trademarks).
An entity should classify a liability as current when (IAS 1.69):
it expects to settle the liability in the entity's normal operating cycle,
it holds the liability primarily for the purpose of trading,
the liability is due to be settled within twelve months after the reporting period, or
the entity does not have an unconditional right to defer settlement of the liability
for at least twelve months after the reporting period.
The most common current liabilities are: accounts payable, accrued liabilities and the
current portion of long-term debt.
Non-current liabilities, like non-current assets, are defined by what they are not: they are
not current liabilities. Generally non-current liabilities represent those liabilities that are
due to be paid in periods exceeding one year or the operating cycle of the business. The
most common long-term liabilities are: long-term debt and future income tax liabilities.
Shareholders' equity is typically made up of two components: share capital and retained
earnings. Share capital represents the amount that shareholders have invested in the
corporation directly. There are generally two types of share capital: common shares and
preferred shares.
Retained earnings represent the sum total of past earnings that have not been distributed
to shareholders by way of dividends.
IAS 1.54 requires that, as a minimum, the following be disclosed on the face of the
statement of financial position:
property, plant and equipment
investment property
intangible assets
financial assets
investments accounted for using the equity method
biological assets (i.e. cattle)
inventories
trade and other receivables
cash and cash equivalents
the total of assets classified as held for sale and assets included in disposal groups
classified as held for sale
trade and other payables

Page 14
provisions
financial liabilities
liabilities and assets for current tax (i.e. income taxes payable/receivable)
deferred tax liabilities and deferred tax assets
liabilities included in disposal groups classified as held for sale
noncontrolling interest, presented within equity
issued capital and reserves attributable to the parent's equity holders
Current/noncurrent classification - IAS 1.60 requires that current / non-current assets and
current / non-current liabilities be disclosed separately except when a presentation based
on liquidity would provide information that is reliable and more relevant. If that
exception applies, all assets and liabilities should be presented broadly in order of
liquidity. Financial institutions, for example, would be more likely to present their
statement of financial position on a liquidity basis. IAS 1 acknowledges that the current /
non-current classification is useful when an entity supplies goods or services within a
clearly identifiable operating cycle (IAS 1.62).
The following page provides a illustrative Statement of Financial Position (adapted from
IAS 1 - Implementation Guidance).
Page 15
XYZ Group
Statement of financial position
(in thousands of currency units)
ASSETS
Non-current assets
Property, plant and equipment
Goodwill
Other intangible assets
Investments in associates
Available-for-sale financial assets
Current assets
Inventories
Trade receivables
Other current assets
Cash and cash equivalents
EQUITY AND LIABILITIES

Equity attributable to owners of the parent
Share capital
Retained earnings
Other components of equity
Non-controlling interests
Non-current liabilities
Long-term borrowings
Deferred tax
Long-term provisions
Current liabilities
Trade and other payables
Short-term borrowings
Current portion of long-term borrowings
Current tax payable
Short-term provisions
Total liabilities
Page 16
Dec 31, 20x7
Dec 31, 20x6
350,700
80,800
227,470
100,150
142,500
901,620
360,020
91,200
227,470
110,770
156,000
945,460
135,230
91,600
25,650
312,400
564,880
132,500
110,800
12,540
322,900
578,740
1,466,500
1,524,200
650,000
243,500
10,200
903,700
70,050
973,750
600,000
161,700
21,200
782,900
48,600
831,500
120,000
28,800
28,850
177,650
160,000
26,040
52,240
238,280
115,100
150,000
10,000
35,000
5,000
315,100
187,620
200,000
20,000
42,000
4,800
454,420
492,750
692,700
1,466,500
1,524,200
The Statement of Comprehensive Income

IAS 1 requires firms to present all income and expenses recognized in a period in either
(1) a single statement of comprehensive income or (2) in two statements: a statement of
income ending with net income/loss and a statement beginning with the net income/loss
and displaying components of other comprehensive income.
Components of other comprehensive income will in introduced in Module 2 of this
course so you will not understand what these mean until we cover the next module. They
are illustrated here for purposes of form only.
As a minimum, the statement of comprehensive income shall include the following line
items (IAS 1.82, 83 and 84):
(a)
Revenue.
(b)
Finance costs (interest expense).
(c)
Share of profits and losses of associates and joint ventures accounted for using the
equity method.
(d)
Tax expense.
(e)
A single amount comprising the total of(i)

the post-tax profit or loss of discontinued operations; and
(ii)
the post-tax gain or loss recognised on the measurement to fair value less
costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation.
(f)
Profit or loss.
(g)
Each component of other comprehensive income classified by nature.
(h)
Share of other comprehensive income of associates and joint ventures accounted

for using the equity method.
(i)
Total comprehensive income.
(j)
Allocations of profit or loss for the period:

(i)
Profit or loss attributable to minority interest.
(ii)
Profit or loss attributable to owners of the parent.
(k)
Allocations of total comprehensive income for the period:

(i)
Total comprehensive income attributable to minority interest.
(ii)
Total comprehensive income attributable to owners of the parent.
Page 17
An entity may present items (a) to (f) and (j) above in a separate income statement.
The following is a illustration of a statement of comprehensive income in two parts
(adapted from IAS 1 - Implementation Guidance):
XYZ group
Income statement (classification of expenses by nature)
20x7
20x6
390,000
20,667
355,000
11,300
(115,100)
16,000
(96,000)
(45,000)
(19,000)
(4,000)
(6,000)
(15,000)
35,100
(107,900)
15,000
(92,000)
(43,000)
(17,000)
(5,500)
(18,000)
30,100
Profit before tax

Income tax expense
161,667
(40,417)
128,000
(32,000)
Profit for the year from continuing operations

Loss for the year from discontinued operations
121,250
-
96,000
(30,500)
Profit for the year
121,250
65,500
97,000
24,250
121,250
52,400
13,100
65,500
0.46
0.30
Revenue
Other income
Changes in inventories of finished goods and work in
progress
Work performed by the entity and capitalized
Raw material and consumables used
Employee benefits expense
Depreciation and amortization expense
Impairment of property, plant and equipment
Other expenses
Finance costs
Share of profit of associates
Profit attributable to:

Owners of the parent
Minority interest
Earnings per share (in currency units)
Basic and diluted
Page 18
XYZ group
Statement of comprehensive income
Profit for the year
20x7
121,250
20x6
65,500
5,334
(24,000)
(667)
933
10,667
26,667
(4,000)
3,367
Other comprehensive income:

Exchange differences on translating foreign operations
Available-for-sale financial assets
Cash flow hedges
Gains on property revaluation
Actuarial gains(losses) in defined benefit pension
plans
Share of other comprehensive income of associates
Income tax relating to components of other
comprehensive income
Other comprehensive income for the year, net of tax
(667)
400
1,333
(700)
4,667
(14,000)
(9,334)
28,000
Total comprehensive income for the year
107,250
93,500
85,800
21,450
107,250
74,800
18,700
93,500
Total comprehensive income attributable to:

Minority interest
Note that an entity should not present any extraordinary items, either on the face of the
income statement or in the notes.
IAS 1.99 requires that expenses be presented in one of two forms on the statement of
income:
by nature of expense, i.e. depreciation, cost of materials, transport costs,
employee benefits, advertising.
by function of expense: COGS, selling costs, distribution costs, administrative
costs.
The choice ultimately depends on which method most fairly presents the elements of the
entity's performance and would likely be based on historical and industry factors and the
nature of the entity. The nature of expense method will require less analysis and be
simpler to use.
The income statement presented on the previous page was by nature of expense. The
same statement, but presented by function of expense is illustrated below.
Page 19
XYZ group
Income statement (classification of expenses by function)
20x7
20x6
390,000
(245,000)
355,000
(230,000)
Gross profit
Other income
Distribution costs
Administrative expenses
Other expenses
Finance costs
Share of profit of associates
145,000
20,667
(9,000)
(20,000)
(2,100)
(8,000)
35,100
125,000
11,300
(8,700)
(21,000)
(1,200)
(7,500)
30,100
Profit before tax

Income tax expense
161,667
(40,417)
128,000
(32,000)
Profit for the year from continuing operations

Loss for the year from discontinued operations
121,250
-
96,000
(30,500)
Profit for the year
121,250
65,500
97,000
24,250
121,250
52,400
13,100
65,500
0.46
0.30
Revenue
Cost of sales
Profit attributable to:

Minority interest
Earnings per share (in currency units)
Basic and diluted
Page 20
The Statement of Changes in Equity

The statement of changes in equity shows how each component of equity has changed
from the beginning of the year to the end of the year. A sample (simplified) statement is
as follows:
XYZ Company
Statement of Changes in Equity
For the year ended December 31, 20x6
Balance, Jan 1, 20x6

Net income
Increase in OCI
Issue of preferred
shares
Purchase of
common shares
Stock Dividend
Cash Dividends
- Preferred
- Common
Balance, Dec 31, 20x6
Page 21
Preferred
Shares
Common
Shares
Contributed
Surplus
Retained
Earnings
$200,000
$100,000
$155,000
$250,000
450,000
Other
Comprehensive
Income
$75,000
5,000
105,000
(14,800)
$305,000
(114,700)
95,850
(95,850)
$181,050
(24,000)
(46,860)
$533,290
$40,300
$80,000
The Conceptual Framework

A strong theoretical foundation is essential if accounting practice is to keep pace with a
changing business environment. Accountants are continuously faced with new situations
and business innovations that present accounting and reporting problems. These problems
must be dealt with in an organized and consistent manner. The conceptual framework
plays a vital role in the development of new standards and in the revision of previously
issued standards.
The Objective of Financial Statements
The objectives of financial statements are as follows:
to provide information about the financial position, performance and changes in

financial position of an entity that is useful to a wide range of users in making
economic decisions (although it acknowledged that this is limited by the fact that
financial statements primarily portray the financial effects of past events and do
not provide non-financial information). This includes:
the evaluation of the ability of the entity to generate cash and the timing
and certainty of this generation,
information about the economic resources controlled by the entity,
information about the financial structure of the entity,
information about liquidity and solvency of the entity,
information about the performance and the variability of performance of
the entity, particularly its profitability, and
information about changes in the financial position of the entity.
to show the results of the stewardship of management, defined as the

accountability of management for the resources entrusted to it.
Underlying Assumptions
The conceptual framework considers two underlying assumptions: the accrual basis and
the going concern principle. Under the accrual basis, the effects of transactions and other
events are recognized when they occur (and not when cash is received or paid) and they
are recorded in the accounting records and reported in the financial statements of the
periods to which they relate. The financial statements are prepared on the assumption that
an entity is a going concern and will continue in operation for the foreseeable future.
Page 22
Qualitative Characteristics of Financial Statements

There are four principal qualitative characteristics of financial statements:
Primary Characteristic
Secondary Characteristics
1.
Understandability financial
statements must be readily
understandable by users. Users are
assumed to have a reasonable
knowledge of business and economic
activities and accounting and a
willingness to study the information
with reasonable diligence. Note that this
does not preclude the inclusion of
complex matters.
2.
Relevance information is relevant

when it influences the economic
decisions of users by helping them
evaluate past, present or future events
(predictive value) or confirming, or
correcting, their past evaluations
(feedback value or confirmatory role).
Materiality information is material if

its omission or misstatement could
influence the economic decisions of
users taken on the basis of the financial
statements.
3.
Reliability information is reliable

when it is free from material error and
bias and can be depended upon by users
to represent faithfully that which it
either purports to represent or could
reasonably be expected to represent.
Information may be relevant but so
unreliable in nature or representation
that its recognition may be potentially
misleading.
Faithful Representation as defined in

the reliability definition.
Substance over form - it is necessary

that transactions are accounted for and
presented in accordance with their
substance and economic reality and not
merely their legal form.
Page 23
3.
Primary Characteristic
Secondary Characteristics
Reliability (contd)
Neutrality - financial statements are not

neutral if, by the selection or presentation
of information, they influence the making
of a decision
or judgment in order to achieve a
predetermined result or outcome.
Prudence the inclusion of a degree of
caution in the exercise of the judgments
needed in making the estimates required
under conditions of uncertainty, such that
assets or income are not overstated and
liabilities or expenses are not understated.
Note that the exercise of prudence does
not allow, for example, the creation of
hidden reserves or excessive provisions,
the deliberate understatement of assets
or income, or the deliberate overstatement
of liabilities or expenses, because the
financial statements would not be neutral
and, therefore, not have the quality of
reliability.
Completeness - the information in
financial statements must be complete
within the bounds of materiality and cost.
An omission can cause information to be
false or misleading and thus unreliable and
deficient in terms of its relevance.
4.
Comparability - implies that

accounting information is comparable
with previous periods (interperiod
comparability or consistency) and
comparable to other firms operating in
the same industry (interfirm
comparability). Consistency implies
that accounting principles are applied
from period to period in the same
manner. Users must be informed of
the accounting policies used in the
preparation of financial statements.
Page 24
The conceptual framework identifies three constraints on relevant and reliable

information:
1.
Timeliness - Management may need to balance the relative merits of timely

reporting and the provision of reliable information. In achieving a balance
between relevance and reliability, the overriding consideration is how best to
satisfy the economic decision-making needs of users.
2.
Balance between benefit and cost - the benefits derived from information should
exceed the cost of providing it.
3.
Balance between qualitative characteristics - generally the aim is to achieve an

appropriate balance among the characteristics in order to meet the objective of
financial statements.
The Elements of Financial Statements

An asset is defined as a resource controlled by the entity as a result of past events and
from which future economic benefits are expected to flow to the entity.
The future economic benefits embodied in an asset may flow to the entity in a
number of ways. For example, an asset may be:
(a)
used singly or in combination with other assets in the production of goods or
services to be sold by the entity;
(b)
exchanged for other assets;
(c)
used to settle a liability; or
(d)
distributed to the owners of the entity.
A liability is defined as a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits.
The settlement of a present obligation usually involves the entity giving up resources
embodying economic benefits in order to satisfy the claim of the other party. Settlement
of a present obligation may occur in a number of ways, for example, by:
(a)
payment of cash;
(b)
transfer of other assets;
(c)
provision of services;
(d)
replacement of that obligation with another obligation; or
(e)
conversion of the obligation to equity.
An obligation may also be extinguished by other means, such as a creditor waiving or
forfeiting its rights.
Equity is defined as the residual interest in the assets of the entity after deducting all
its liabilities.
Page 25
Income is defined as increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants.
The definition of income encompasses both revenues and gains. Revenue arises in
the course of the ordinary activities of an entity and is referred to by a variety of
different names including sales, fees, interest, dividends, royalties and rent. Gains
represent other items that meet the definition of income and may, or may not, arise in the
course of the ordinary activities of an entity. Gains represent increases in economic
benefits and as such are no different in nature from revenue.
Expenses are defined as decreases in economic benefits during the accounting period
in the form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants.
The definition of expenses encompasses losses as well as those expenses that arise in the
course of the ordinary activities of the entity. Expenses that arise in the course of the
ordinary activities of the entity include, for example, cost of sales, wages and
depreciation. They usually take the form of an outflow or depletion of assets such as cash
and cash equivalents, inventory, property, plant and equipment.
Capital maintenance adjustments - the revaluation or restatement of assets and
liabilities gives rise to increases or decreases in equity. While these increases or decreases
meet the definition of income and expenses, they are not included in the income
statement. Instead these items are included in equity as capital maintenance adjustments
or revaluation reserves.
Measurements of the Elements of Financial Statements

The current conceptual framework per section 1000 of the CICA handbook calls for one
measurement approach: historical cost. Although the most common basis is still historical
cost, there are four basis of measurement under IFRS:
Historical cost. Assets are recorded at the amount of cash or cash equivalents
paid or the fair value of the consideration given to acquire them at the time of
their acquisition. Liabilities are recorded at the amount of proceeds received in
exchange for the obligation, or in some circumstances (for example, income
taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy
the liability in the normal course of business.
Current cost. Assets are carried at the amount of cash or cash equivalents
that would have to be paid if the same or an equivalent asset was acquired
currently. Liabilities are carried at the undiscounted amount of cash or cash
equivalents that would be required to settle the obligation currently.
Page 26
Realizable (settlement) value. Assets are carried at the amount of cash or cash
equivalents that could currently be obtained by selling the asset in an orderly
disposal. Liabilities are carried at their settlement values; that is, the undiscounted
amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in
the normal course of business.
Present value. Assets are carried at the present discounted value of the future net
cash inflows that the item is expected to generate in the normal course of
business. Liabilities are carried at the present discounted value of the future net
cash outflows that are expected to be required to settle the liabilities in the normal
course of business.
Page 27
Financial Statements and the Accounting Cycle

Problems with Solutions
Multiple Choice Questions
1.
Beach Company paid $3,480 on June 1, 20x8 for a two-year insurance policy and
recorded the entire amount as Insurance Expense. The December 31, 20x8 adjusting
entry is
a.
Debit Insurance Expense and credit Prepaid Insurance, $1,015.
b. Debit Insurance Expense and credit Prepaid Insurance, $2,465.
c.
Debit Prepaid Insurance and credit Insurance Expense, $1,015.
d. Debit Prepaid Insurance and credit Insurance Expense, $2,465.
2.
Karr Corporation received cash of $7,200 on August 1, 20x8 for one year's rent in
advance and recorded the transaction with a credit to Rent Revenue. The December
31, 20x8 adjusting entry is
a.
Debit Rent Revenue and credit Unearned Rent, $3,000.
b. Debit Rent Revenue and credit Unearned Rent, $4,200.
c.
Debit Unearned Rent and credit Rent Revenue, $3,000.
d. Debit Cash and credit Unearned Rent, $4,200.
3.
Which of the following best illustrates the accounting concept of prudence?

a.
Use of the allowance method to recognize bad debt losses from credit sales
b.
Use of the lower of cost or market approach in valuing inventories
c.
Use of the same accounting method from one period to the next in calculating
amortization expense
d.
Utilization of a policy of deliberate understatement of asset values in order to
present a conservative net income figure
e.
Inclusion of a degree of caution when estimating the allowance for doubtful
accounts.
4.
Baker Corp.'s liability account balances at June 30, 20x2 included a 10 percent note
payable in the amount of $1,000,000. The note is dated October 1, 20x0 and is
payable in three equal annual payments of $500,000 plus interest. The first interest
and principal payment was made on October 1, 20x1. In Baker's June 30, 20x2
balance sheet, what amount should be reported as accrued interest payable for this
note?
a.
$112,500
b.
$75,000
c.
$37,500
d.
$25,000
Page 28
5.
Financial information exhibits the characteristic of consistency when

a.
expenses are reported as charges against revenue in the period in which they
are paid.
b.
accounting entities give accountable events the same accounting treatment
from period to period.
c.
extraordinary gains and losses are not included on the income statement.
d.
accounting procedures are adopted which give a consistent rate of net income.
6.
Rice Co. was incorporated on January 1, 20x1, with $500,000 from the issuance of
stock and borrowed funds of $75,000. During the first year of operations, net
income was $25,000. On December 15, Rice paid a $2,000 cash dividend. No
additional activities affected owners' equity in 20x1. At December 31, 20x1, Rice's
liabilities had increased to $94,000. In Rice's December 31, 20x1, balance sheet,
total assets should be reported at
a.
$598,000
b.
$600,000
c.
$617,000
d.
$692,000
7.
The purpose of recording prepaid expenses that are subsequently disclosed as

current assets on the balance sheet is
a.
to smooth income
b.
to record payments made on invoices prior to the invoice due date
c.
to allocate expenditures to the period in which they apply
d.
to recognize current expenditures that will convert into cash within the next
twelve months
e.
to record payments for services to be received over a period of years
Page 29
Problem 1
The following list of accounts and their balances represents the unadjusted trial balance
of Guy Ltd. at December 31, 20x4.
Cash
Accounts Receivable
Merchandise Inventory
Prepaid Insurance
Investment in Dude Co. Bonds (10%)
Land
Building
Accumulated Depreciation-Building
Equipment
Accumulated Depreciation-Equipment
Patents
Accounts Payable
Bonds Payable (20-year; 8%)
Common Shares
Retained Earnings
Sales
Rental Income
Advertising Expense
Supplies Expense
Purchases
Purchase Discounts
Office Salary Expense
Sales Salary Expense
Interest Expense
Dr.
$ 188,220
294,000
Cr.
$ 10,500
186,000
7,860
120,000
90,000
372,000
37,200
100,800
16,800
79,800
303,150
630,000
360,000
67,080
570,000
32,400
67,500
32,400
294,000
2,700
52,500
108,000
36,750
$2,029,830 $2,029,830
Additional information 1. Actual advertising costs in Whassup Magazine amounted to $1,000 per month. The
company has already paid for advertisements in Whassup Magazine for the first 6
months of 20x5.
2. The company uses straight-line depreciation for its building. The building was
purchased and occupied January 1, 20x2 with an estimated life of 20 years.
3. A portion of their building has been converted into a snack bar that has been rented to
Snack Shack Corp. since July 1, 20x3 at a rate of $21,600 per year payable each July
1st.
Page 30
4. Prepaid insurance contains the premium costs of two policies: Policy Excel, cost of
$2,880, one-year term taken out on Sept. 1, 20x3; Policy Access, cost of $5,940,
three-year term taken out on April 1,20x4.
5. One of the company's customers declared bankruptcy December 30, 20x4, and it has
been definitely established that the $8,100 due from him will never be collected. This
fact has not been recorded. In addition, Guy Ltd. estimates that 5% of the Accounts
Receivable balance on December 31, 20x4 will become uncollectible.
6. The equipment was purchased January 1, 20x2 with an estimated life of 12 years. The
company uses straight-line depreciation.
7. When the company purchased a competing firm on July 1, 20x2 it acquired a patent
in the amount of $114,000, which is being amortized over its estimated life. (5 years)
8. On November 1, 20x4 Guy issued 315, $2,000 bonds at par value. Interest payments
are made semiannually on April 30 and October 31. The interest expense shown in
the trial balance does not relate to the bonds.
9. Office salaries are paid on the first and 16th of each month for the following half
month. On December 31, 20x4, $1,800 was given as an advance to an office
secretary. The transaction was recorded in Guys books, and the $1,800 was charged
to Office Salary Expense.
10. On August 1, 20x4 Guy purchased 60, $2,000, 10% bonds maturing on August 31,
20x9 at par value. Interest payment dates are July 31 and January 31.
11. The inventory on hand at December 31, 20x4 was $222,000 per a physical inventory
count. Record the adjustment for inventory in the same entry that records the Cost of
Goods Sold for the year.
Required (a)
(b)
(c)
Page 31
Prepare adjusting and correcting entries for December 31, 20x4 using the
information given.
Prepare an adjusted trial balance as at December 31, 20x4.
Prepare year-end financial statements for 20x4. (excluding Statement of Cash
Flows)
Problem 2
Briar Place Construction was founded in January 20x0 by Tom Johnson and Ralph
Reinhart and specializes in home remodeling and repairs. Due to high real estate prices in
the local area, many residents have been repairing and remodeling their homes rather than
moving to larger or newer homes. As a consequence, Briar Place's business during the
first year was so successful that Johnson and Reinhart plan to expand their operations.
When Johnson approached the local bank for funds to finance the planned expansion, the
bank requested audited financial statements prepared on the accrual basis. At the time the
company was formed, cash planning was considered important to the successful
operation of the business so Reinhart and Johnson requested that their bookkeeping
service maintain the company's records on a cash basis. As a result of the bank's request,
Reinhart and Johnson hired Mary Anne Logan, an accountant, to convert the cash basis
financial statements to accrual basis financial statements.
From the company files and from discussions with Reinhart and Johnson, Logan has
gathered the following data concerning Briar Place's transactions during 20x0 and the
cash basis financial statements. In addition, the company's Statement of Financial
Position at January 1, 20x0, is presented below.
Summary of Cash Transactions for 20x0
Receipts:
Cash sales
Collections from customers
Proceeds from one-year, 12% note received March 1, 20x0
Disbursements:
Payments on account for supplies
Wages paid to employees
Payments to the utility company
Insurance premiums paid
Rent paid to landlord
Interest paid on September 1, 20x0, 12% note
$116,000
40,000
20,000
$176,000
$40,400
62,000
11,000
9,000
18,000
1,200
$141,600
Uncollected customers' bills totaled $34,900 at December 31, 20x0.
On March 1, 20x0, a supplier of Briar Place advanced the company $20,000 on a oneyear, 12 percent note payable with semi-annual interest payments to be made on
September 1, 20x0, and at maturity on March 1, 20x1.
Unpaid bills to suppliers totaled $5,600 at December 31, 20x0.
Supplies costing $4,000 were on hand at December 31, 20x0.
Page 32
Wages owed to employees at December 31, 20x0, were $2,800.
The December utility bill of $975 was unpaid at December 31, 20x0.
The insurance premium was paid for a one-year liability and property damage policy
effective February 1, 20x0.
The rent of $1,500 per month was paid to the landlord on the first of every month.
Logan recommends depreciating the company's construction equipment, purchased at

the time the company was founded, over its useful life of ten years using straight-line
depreciation. The equipment has no estimated residual value.
Logan has determined that Briar Place's effective tax rate is 40 percent. No taxes have
been paid.
Briar Place Construction
January 1, 20x0
Assets
Cash
Supplies inventory
Equipment
Liabilities and shareholders' equity

Purchases payable
Common stock
$ 24,800
12,000
110,000
$146,800
$ 14,000
132.800
$146,800
Required Prepare Briar Place Construction's Income Statement for the year ended December 31,
20x0 and Statement of Financial Position as at December 31, 20x0.
Page 33
Problem 3
The unadjusted trial balance for Martina Company is presented for the year ended
December 31, 20x5, along with some additional information.
Debits
Cash
Accounts Receivable
Inventory
Prepaid Expenses
Land
Building
Accumulated Depreciation
Equipment
Intangible Assets
Accounts Payable
Interest Payable
Taxes Payable
Bonds payable
Deferrred income taxes
Common Stock
Retained Earnings
Sales Revenue
Cost of Goods Sold
Selling expense
Administrative expense
Income tax expense
Interest Expense
Dividends
Page 34
Credits
$ 104,690
195,550
$ 2,950
289,776
30,376
152,500
445,938
96,812
320,700
117,500
26,960
162,876
20,312
46,000
481,500
21,000
250,000
107,758
3,329,440
2,049,170
85,000
348,300
451,188
46,000
40,000
50,000
$4,636,148
$4,636,148
Additional Information
Assume that all adjusting and correcting entries have been made except for the following
items:
1.
A sale in the amount of $9,100 and its related cost of goods sold was not recorded
as of December 31, 20x5. Martina sells its inventory at a 40% markup on cost and
uses a perpetual inventory system.
2.
Martina Company estimates bad debts to be equal to 0.25% of sales.
3.
On December 28, 20x5, a letter was received from a trustee in bankruptcy

informing us that one of our customers has been released from bankruptcy and
that we would not be receiving any money on the account owing. The amount
owing from this client was $5,000 and is included in the accounts receivable
balance at December 31, 20x5.
4.
As of December 31, no accrual for electricity expense had been made. An

electricity bill for the warehouse for $5,000 was received January 15, 20x6, for
electrical consumption from December 12, 20x5, through January 12, 20x6. The
bill was paid on February 16, 20x6, and debited to administrative expenses at that
time.
5.
Martina Company purchased equipment on July 1, 20x5, for $35,000 cash. This
amount was debited to selling expenses. The equipment has an estimated useful
life of ten years and a residual value of $10,000. The company uses the
diminishing balance method of depreciation at a rate of 20%.
6.
Insurance was paid on January 31, 20x5, for $5,580 for the time
period of January 31, 20x5, through January 31, 20x6. The full amount was
debited to administrative expenses at the time it was paid.
7.
Wages for the time period of December 25, 20x5, through January 7, 20x6, were
paid on January 15, 20x6, in the amount of $8,000.
8.
Total tax expense for 20x5 should be 34% of income before taxes.
Required a.
b.
Page 35
Prepare adjusting and correcting entries for the additional information.

Prepare the following financial statements for the year ending December 31,
20x5:
i.
An income statement.
ii.
A statement of changes in shareholders' equity.
iii.
A statement of financial position.
Problem 4
Heather Company Ltd. closes its books once a year, on December 31, but prepares
monthly financial statements by estimating month-end inventories. The company's trial
balance on January 31, 20x8 is presented below.
HEATHER COMPANY LTD.
Trial Balance January31, 20x8
Cash
Accounts Receivable
Notes Receivable
Inventory, Jan. 1, 20x8
Furniture and Fixtures
Accumulated Depreciation of Furniture and Fixtures
Unexpired Insurance
Supplies on Hand
Accounts Payable
Notes Payable
Common Shares
Retained Earnings
Sales
Sales Returns and Allowances
Purchases
Transportation-in
Selling Expenses
Administrative Expenses
Interest Revenue
Interest Expense
$ 11,000
23,000
3,000
$ 720
24,000
30,000
7,500
600
1,050
6,000
5,000
20,000
27,005
130,000
1,500
80,000
2,000
11,000
9,000
125
200
$196,350
$196,350
Required (a)
Page 36
Prepare adjusting entries in journal form

1.
Estimated bad debts, 0.4% of net sales (sales minus sales returns,
allowances, and discounts).
2.
Depreciation of furniture and fixtures, 10% of cost per year.
3.
Insurance expired in January, $80.
4.
Supplies used in January, $210.
5.
Office salaries accrued, $500.
6.
Interest accrued on notes payable, $200.
7.
Interest received but unearned on notes receivable, $75.
8.
Estimate the January 31 inventory and record the adjusting entry. The
average gross profit earned by the company is 30% of net sales. The gross
profit rate equals net sales minus cost of goods sold divided by net sales.
(b)
Prepare a Statement of Financial Position, an income statement, and a statement

of changes in Shareholders' Equity. Dividends of $3,000 were declared and paid
on the common shares during the month.
Problem 5
Shriver Co. began business as a corporation on December 3, 20x0. The accounting for the
business since its inception has been done by Bill Miles. Miles' primary responsibilities
are in the purchasing area and his previous experience in accounting was limited. Sam
Cray, a qualified accountant, was hired to perform the company's accounting functions in
December of 20x2. The first task he was assigned was to review the accounting for the
company's first two years and to make any corrections that might be necessary to ensure
that the company's 20x1-20x2 financial statements were proper.
The preclosing trial balance as of November 30, 20x2, that is presented below includes
year-end adjustments that were prepared by Miles.
Shriver Co.
Preclosing Trial Balance
November 30, 20x2
Dr.
Cash
Accounts receivable
Note receivable
Inventory
Land
Furniture and fixtures
Unexpired insurance
Accounts payable
Notes payable
Common shares
Retained earnings
Sales
Purchases
Purchase returns
Selling expenses
Total
Cr.
$ 1,150
9,350
3,000
10,500
8,000
20,000
600
$ 4,950
5,000
27,700
8,950
103,800
78,750
450
12,000
7,500
$150,850
$150,850
Cray's review of the accounting records and other records uncovered the following
additional information.
1. Cheques totaling $2,350 had been written to vendors and recorded in the November
20x2 cash disbursements journal but were still in the vault on December 7.
Page 37
2. All receivables from 20x0-20x1 credit sales either had been collected or written off.
The estimate for bad debts arising from 20x1-20x2 sales was $2,000, and the
following entry was made to recognize this fact.
Selling expense
Accounts receivable
2,000
2,000
3. The note receivable for $3,000 is from a customer. This three-month note is dated
November 1, 20x2, and has an annual interest rate of 18 percent.
4. The physical inventory on November 30, 20x2, includes $9,900 of product on hand
and $2,100 of inventory issued to Apex Co. on a consignment basis.
5. The furniture and fixtures were acquired on December 3, 20x0. These capital assets
are being depreciated on a straight-line basis over a ten-year life with no residual
value. The following adjusting entry was made by Miles in November 20x2 to
recognize depreciation.
Selling expense
2,000
500
2,500
The same adjusting entry was made for the 20x0-20x1 fiscal year.
6. The company has one prepaid insurance policy. The policy covers a one-year period
and was purchased for $1,200 on June 1, 20x2.
7. The notes payable were issued on November 1, 20x2, with an annual interest rate of
12 percent. The principal and interest are payable on August 1, 20x3.
8. On November 20, 20x2, the Board of Directors declared a cash dividend of $2,500
payable on December 14, 20x2. The dividend is payable to shareholders of record as
of December 3, 20x2.
9. The tax return for the 20x1-20x2 fiscal year appears to be properly prepared and
shows no tax liability.
Required a.
b.
Page 38
Prepare a Statement of Financial Position for the Shriver Co. as of November 30,
20x2.
Prepare a Statement of Income for the year ended November 30, 20x2.
Problem 6
Mr. Chicken and Mr. Rib decided to go into business together and start a new restaurant.
On June 1, 20x0, Mr. Chicken and Mr. Rib each invested $50,000 cash in exchange for
shares in the company. After doing a feasibility study and some preparatory work, they
opened the restaurant for business on July 1, 20x0.
The following preparatory events took place in getting the new restaurant ready for the
grand opening:
An ideal location was found in a shopping mall. Mr. Chicken and Mr. Rib signed a
lease for $3,000 per month starting July 1, 20x0.
Tables and chairs costing $25,000 were purchased on account. These assets were
expected to last five years with zero residual value. The assets were delivered to the
restaurant on July 1, 20x0.
Depreciation is calculated using the straight-line method.
As part of the promotion for the grand opening, beer mugs, purchased for $5 cash
each, were given away to the first 100 customers.
During the month of July, $30,000 worth of food supplies (chicken and ribs) was
purchased on account. Salad supplies costing $6,000 were purchased for cash on an
"as required" basis.
Four cooks and eight waiters were hired. The cooks were paid a monthly salary of
$2,000 each and the waiters were paid $1,000 each. The waiters also received
gratuities from the customers at an average of $500 per month.
Advertising in the newspaper for the grand opening cost $1,500, utilities totaled
$1,000 and janitorial services, $1,000. All of these costs were paid in cash.
In a rush to start up the restaurant, Mr. Chicken and Mr. Rib had neglected to hire an
accountant. They have approached you to handle their books. Additional information was
supplied by the owners:
In July, total accounts payable paid were $22,000.
On July 15, excess cash of $30,000 was invested in a money market fund as a
temporary investment. The return is estimated at 8 percent per year. However, the
interest will not be received until the fund is collapsed.
As of July 31, the owners had not drawn any money out of the business. It was
estimated that each owner deserved a modest amount of $1,250 per month as
management fees.
Page 39
On July 31, a rough estimate of unsold chicken and rib supplies remaining on hand
was $12,700.
Cash sales during July were $8,000. Sales to charge account customers, mainly
business people in the mall, were $18,000.
The owners would like to find out how much money they have made or lost during the
month of July.
Required Prepare an income statement for July 20x0, and a Statement of Financial Position as of
July 31, 20x0. Show all supporting calculations and state your assumptions, if any.
Page 40
Problem 7
You have been given the following trial balances of the Sandmeyer Company. The trial
balance as of December 31, 20x0, was taken on a gross basis; that is, the totals of the
debits and of the credits in each of the ledger accounts, including any balance from the
postclosing trial balance as of June 30, 20x0, rather than the final balance, have been
included. You are advised that the company records disbursements for expense items
through liability accounts before making payment.
The books are not available. The trial balance is out of balance by $270, which is shown
as "unlocated difference." You are told that cash in bank of $28,044 has been verified.
The Sandmeyer Company
Trial Balances
ACCOUNT
Cash in bank
Investments
Accounts receivable
Merchandise inventory
Office furniture and fixtures
Accumulated depreciation
Notes payable
Accounts payable
Income taxes payable
Common shares
Retained earnings
Sales
Cost of goods sold
Salaries expense
Other administrative expense
Selling expense
Uncollectible accounts expense
Write-down of obsolete
merchandise
Gain on sale of investment
Loss on sale of fixtures
Interest expense
Income tax expense
Unallocated difference
JUNE 30, 20x0

$ 21,849
30,500
47,420
55,542
8,663
$4,967
30,000
15,879
7,350
50,000
55,778
$ 275,016
40,712
301,425
208,856
11,164
176
10,000
211,658
5,658
10,000
481
151,914
15,500
21,567
25,348
665
$ 246,972
5,000
248,979
153,495
635
5,940
30,000
233,986
11,050
50,000
55,778
254,005
1,025
168
$163,974
Page 41
DECEMBER 31, 20x0
$163,974
23
850
3,700
270
$1,296,008
$1,296,008
Required Reconstruct the ledger accounts as they probably appear by recording the transactions for
the period in journal form and posting to the ledger accounts. You need not prepare
financial statements, but you should state where you think the error occurred in the books
and give reasons to support your conclusion.
Problem 8
The balances of the following accounts of ABC Travel Ltd. before and after the posting
of adjusting entries are:
Cash
Commissions receivable
Office supplies
Prepaid rent
Office equipment
Accumulated depreciation office equipment
Accounts payable
Note payable
Salaries payable
Interest payable
Capital
Retained earnings
Preliminary
Dr.
$ 6,112 $
1,805
175
310
980
Adjusted
Cr.
Dr.
$ 6,112 $
2,270
165
55
155
980
196
366
3,000
200
1,000
413
Cr.
210
294
366
3,000
200
290
180
1,000
413
Required Determine what adjusting entries were made and journalize these entries. Provide a
narrative to describe the purpose of each entry.
Page 42
Problem 9
Below are the account titles of a number of debit and credit accounts as they might
appear on the statement of financial position of the Saberhagen Corporation as of October
31, 20x1.
DEBITS
Cash in bank
Land
Inventory of operating parts and supplies
Inventory of raw materials
Patents
Cash and Canada Savings Bonds set
aside for property additions
Investment in subsidiary
Goodwill
Inventory of finished goods
Inventory of work in process
Deficit
Interest accrued on government
securities
Notes receivable
Petty cash fund
Accounts receivable
Government contracts
Regular
Instalments, due in 20x1
Instalments, due in 20x2-20x3
Government securities
Treasury shares
Unamortized bond discount
CREDITS
Accrued payroll
Provision for renegotiation of
government contracts
Notes payable
Accrued interest on bonds
Accounts payable
Accrued interest on notes payable
8% first mortgage bonds to be redeemed
in 20x1 out of current assets
Share capital, preferred
9 1/2% first mortgage bonds due in 20x8
Preferred shares dividend, payable 11/1/x1

receivable
Provision for federal income taxes
Customers' advances (on contracts to be
completed in 20x2)
Appropriation for possible decline in
value of raw materials inventory
Premium on bonds redeemable in 20x1
Officers' 20x1 bonus accrued
Required Select the current asset and current liability items from among these debits and credits. If
there appear to be certain borderline cases that you are unable to classify without further
information, give your reasons for making questionable classifications, if any.
Page 43
Problem 10
Mr. Janson, owner of Janson's Retail Hardware, states that he computes income on a cash
basis. At the end of each year he takes a physical inventory and computes the cost of all
merchandise on hand. To this amount he adds the ending balance of accounts receivable,
because he considers this to be a part of inventory on the cash basis. He deducts from this
total the ending balance of accounts payable for merchandise to arrive at what he calls
inventory (net).
The following information has been taken from Mr. Janson's cash-basis income
statements for the years indicated:
20x4
20x3
20x2
$ 173,000
$ 159,000
$ 150,000
Inventory(net), Jan.1
Total purchases
Goods available for sale
Inventory(net), Dec. 31
$ 8,000
109,000
117,000
-1,000
$ 11,000
100,000
111,000
-8,000
$ 3,000
95,000
98,000
-11,000
Cost of goods sold
116,000
103,000
87,000
$ 57,000
$ 56,000
$ 63,000
20x4
20x3
20x2
$151,000
24,000
3,000
33,000
$147,000
13,000
6,000
19,000
$141,000
14,000
5,000
12,000
Cash received
Cost of goods sold
Gross margin
Additional information is as follows for the years indicated:
Cash sales
Credit sales
Accounts receivable, Dec. 31
Accounts payable for merchandise, Dec. 31
Required 1.
2.
3.
Page 44
Without reference to the specific situation described above, discuss cash-basis and
accrual accounting and indicate their conceptual merits.
Is the gross margin for Janson's Retail Hardware being computed on a cash basis?
Evaluate and explain the approach used with illustrative computations of the cashbasis gross margin for 20x3.
Explain why the gross margin for Janson's Retail Hardware shows a decrease
while sales and cash receipts are increasing.
Problem 11
State whether you agree or disagree with the following and explain why. Consider each
statement independently.
a) Even though a division of a company is not incorporated separately, it is still a
separate entity.
b) The financial statements of a company are neutral and free from bias.
c) Accounting reports are exact, as they are based on numbers and numbers are exact.
d) The historical cost principle allows us to arrive at objective numbers on financial
statements.
Page 45
SOLUTIONS

1.
The amount of prepaid insurance at December 31, 20x8 is: $3,480 / 24

months x 17 months remaining = $2,465
2.
The amount of unearned rent at December 31, 20x8 is: $7,200 / 12 months x 7
months = $4,200
3.
4.
$1,000,000 x 10% x 9/12 = $75,000
5.
Consistency is when the enterprise uses accounting principles that are

consistent from one period to the next.
6.
$500,000 + 75,000 + 25,000 - 2,000 + (94,000 - 75,000) = $617,000
7.
Payments made for items (such as insurance premiums for the following year)
which do not have a benefit until the following year are set up in prepaids and
then expensed in the applicable year.
Page 46
Problem 1
1. Prepaid Advertising
Advertising Expense ($1,000 x 6 months)
6,000
6,000
2. Depreciation Expense
Accumulated Depreciation Building
($372,000 / 20 years)
18,600
3. Rental Revenue
Unearned Rental Revenue
($21,600 x 6/12)
10,800
18,600
10,800
4. Insurance Expense
Prepaid Insurance
[($2,880 x 8/12) + ($5,940 / 3 x 9/12)]
3,405
5. Allowance for Doubtful Accounts

Accounts Receivable
8,100
Bad Debt Expense

Allowance for doubtful accounts should be:
($294,000 8,100) x 5% = 14,295
Allowance for doubtful account balance before
adjustment is: $10,500 8,100 = $2,400
3,405
8,100
11,895
11,895
Bad debt expense= $14,295 2,400 = $11,895

6. Depreciation Expense
Accumulated Depreciation Equipment
($100,800 / 12 years)
7. Amortization Expense Patent
Patent
($114,000 / 5years)
8,400
8,400
22,800
22,800
8. Interest Expense
Interest Payable
($630,000 x 0.08 x 2/12)
8,400
9. Prepaid Salaries
1,800
Page 47
8,400
1,800
10. Interest Receivable

Interest Revenue
($120,000 x 10% x 5/12)
5,000
5,000
11. Cost of Goods Sold

Purchase Discounts
Purchases
255,300
222,000
2,700
294,000
186,000
(b)
Cash
Accounts Receivable
Interest Receivable
Prepaid Advertising
Prepaid Insurance
Prepaid Salaries
Investment in Dude Co. Bonds (10%)
Land
Building
Accumulated Depreciation-Building
Equipment
Accumulated Depreciation-Equipment
Patent
Accounts Payable
Interest Payable
Unearned Rental Income
Bonds Payable (20-year; 8%)
Common Shares
Retained Earnings
Sales
Cost of Goods Sold
Rental Income
Interest Income
Advertising Expense
Supplies Expense
Purchases
Purchase Discounts
Sales Salary Expense
Bad Debt Expense
Insurance Expense
Depreciation Expense
Amortization Expense Patent
Interest Expense
Unadjusted
Dr.
Cr.
$ 188,220
294,000
$ 10,500
186,000
$8,100
5,000
222,000
6,000
7,860
$8,100
11,895
186,000
3,405
1,800
120,000
90,000
372,000
37,200
18,600
16,800
8,400
22,800
100,800
79,800
303,150
8,400
10,800
630,000
360,000
67,080
570,000
32,400
255,300
10,800
5,000
6,000
67,500
32,400
294,000
Adjusted Trial Balance

Dr.
Cr.
$188,220
285,900
$14,295
5,000
222,000
6,000
4,455
1,800
120,000
90,000
372,000
55,800
100,800
25,200
57,000
303,150
8,400
10,800
630,000
360,000
67,080
570,000
255,300
21,600
5,000
61,500
32,400
294,000
2,700
2,700
52,500
108,000
1,800
50,700
108,000
11,895
3,405
27,000
22,800
45,150
$585,200
$2,071,325
11,895
3,405
27,000
22,800
8,400
36,750
$2,029,830
Page 48
Adjustments
Dr.
Cr.
$2,029,830
$585,200
$2,071,325
(c)
Guy Ltd.
Income Statement
Revenues
Sales
Less Cost of Goods Sold
Gross Margin
Rental Income
Interest Income
Total Income
Expenses
Advertising Expense
Supplies Expense
Office Salaries Expense
Sales Salaries Expense
Bad Debt Expense
Insurance Expense
Amortization Expense
Interest Expense
Total Expenses
Net Loss
570,000
(255,300)
314,700
21,600
5,000
341,300
61,500
32,400
50,700
108,000
11,895
3,405
27,000
22,800
45,150
362,850
(21,550)
Guy Ltd.
For the year ended December 31 20x4

Net loss
Page 49
Common
Stock
$360,000
Retained
Earnings
$67,080
(21,550)
$360,000
$45,530
Guy Ltd.
As at December 31 20x4
ASSETS
Long-Term Assets
Investment in Dude Co. Bonds
Land
Building
Less: Accumulated Depreciation
Equipment
Patent
Current Assets
Cash
Accounts Receivable (285,900 - 14,295)
Interest Receivable
Prepaid Advertising
Prepaid Insurance
Prepaid Salaries
$120,000
90,000
$372,000
55,800
100,800
25,200
316,200
75,600
57,000
658,800
188,220
271,605
5,000
222,000
6,000
4,455
1,800
699,080
$1,357,880
SHAREHOLDERS EQUITY AND LIABILITIES

Shareholders Equity
Common Shares
Retained Earnings
Long-Term Liability
Bonds Payable
Current Liabilities
Accounts Payable
Interest Payable
Unearned Rental Income
$360,000
45,530
405,530
630,000
303,150
8,400
10,800
322,350
$1,357,880
Page 50
Problem 2

Income Statement
For the Year Ended December 31, 20x0
Sales ($116,000 Cash Sales + 40,000 Collections on A/R + 34,900 A/R)
Supplies Used ($40,400 Paid - 4,400 Decrease in Payable + 8,000 Decrease in Inventory)
Wages expense ($62,000 Paid + 2,800 Wages Payable)
Utilities expense ($11,000 Paid + 975 Payable)
Insurance expense ($9,000 Paid x 11/12)
Rent expense
Depreciation expense ($110,000 / 10)
Interest expense ($1,200 Paid + 800 Payable)
Income tax expense (40%)
Net income
Page 51
$190,900
(44,000)
(64,800)
(11,975)
(8,250)
(18,000)
(11,000)
(2,000)
30,875
12,350
$18,525

December 31, 20x0
ASSETS
Fixed Assets
Equipment
Less: Accumulated depreciation
$110,000
11,000
Current Assets
Cash ($24,800 Beginning + 176,000 Cash Receipts - 141,600 Cash Disbursements)
Accounts receivable
Supplies inventory
Prepaid insurance (9,000 Paid - 8,250 Expense)
99,000
$59,200
34,900
4,000
750
98,850
$197,850
SHAREHOLDERS' EQUITY AND LIABILITIES

Common stock
Retained earnings
Current Liabilities
Accounts payable
Note payable
Wages payable
Utilities payable
Interest payable (2,000 Expense - 1,200 Paid)
Taxes payable
132,800
20,925
153,725
$5,600
20,000
2,800
975
800
13,950
44,125
$197,850
Page 52
Problem 3
a.
1.
2.
3.
4.
5.
Accounts receivable
Sales
7.
Page 53
$9,100
Cost of goods sold

Inventory
$9,100 / 1.40 = $6,500
6,500
Bad debt expense

($3,329,440 + 9,100) x 0.25%
8,346

Accounts receivable
5,000
Accounts payable
$5,000 x 19/31
3,065
Equipment
Selling expenses
$35,000 x 20% x
6.
$9,100
Prepaid expenses
$5,580 / 12
Selling expense
Accounts payable
$8,000 x 7/14
6,500
8,346
5,000
3,065
35,000
35,000
3,500
3,500
465
465
4,000
4,000
8.
Income tax expense

Income tax payable
Net income before taxes before adjustment
Adjustments
Transaction 1
Transaction 1
Transaction 2
Transaction 4
Transaction 5
Transaction 5
Transaction 6
Transaction 7
Net income before taxes adjusted
Page 54
81,478
81,478
$355,782
9,100
(6,500)
(8,346)
(3,065)
35,000
(3,500)
465
(4,000)
374,936
Income tax expense @ 34%
127,478
Less balance in income tax expense account
(46,000)
$81,478
Adjusted Trial Balance Debits

Cash
Accounts Receivable: $195,550 + 9,100 (1)
5,000 (3)
Allowance for doubtful accounts: $2,950 + 8,346 (2)
5,000 (3)
Inventory - 289,776 6,500 (1)
Prepaid Expenses - 30,376 + 465 (6)
Land
Building
Accumulated Amortization
Equipment - 320,700 + 35,000 (5)
Accumulated Depreciation - 117,500 + 3,500 (5)
Intangible Assets
Accounts Payable - 162,876 + 3,065 (4) + 4,000 (7)
Interest Payable
Taxes Payable: 46,000 + 81,478 (8)
Bonds payable
Deferred income taxes
Common Stock
Retained Earnings
Sales Revenue 3,329,440 + 9,100 (1)
Cost of Goods Sold 2,049,170 + 6,500 (1)
Depreciation expense - 85,000 + 3,500 (5)
Selling expense - 348,300 35,000 (5) + 4,000 (7)
Administrative expense - 451,188 + 3,065 (4)
465 (6)
Bad debt expense - $0 + 8,346 (2)
Income tax expense - 46,000 + 81,478 (8)
Interest Expense
Dividends
Page 55
Credits
$ 104,690
199,650
$6,296
283,276
30,841
152,500
445,938
96,812
355,700
121,000
26,960
169,941
20,312
127,478
481,500
21,000
250,000
107,758
3,338,540
2,055,670
88,500
317,300
453,788
8,346
127,478
40,000
50,000
$4,740,617
$4,740,617
b(i)
Martina Company
Income Statement
Sales
Cost of goods sold
Gross margin
$3,338,540
2,055,670
1,282,870
Selling expense
Administration expense
Bad debt expense
Interest expense
(88,500)
(317,300)
(453,788)
(8,346)
(40,000)

Provision for income taxes
374,936
127,478
Net income
b(ii)
Martina Company

Net income
Dividends
Page 56
$247,458
Common
Stock
$250,000
Retained
Earnings
$107,758
247,458
(50,000)
$250,000
$305,216
b(iii)
Martina Company
ASSETS
Noncurrent Assets
Land
$152,500
Building
$445,938
(96,812)
349,126
Equipment
355,700
(121,000)
234,700
Intangible assets
Current Assets
Cash
Accounts receivable
Inventory
Prepaid expenses
26,960
763,286
104,690
193,354
283,276
30,841
612,161
$1,375,447
SHAREHOLDERS EQUITY AND LIABILITIES

Shareholders Equity
Common Stock
Retained Earnings
Long-term Liabilities
Bonds payable
Current Liabilities
Accounts payable
Interest payable
Taxes payable
$250,000
305,216
555,216
481,500
21,000
502,500
169,941
20,312
127,478
317,731
$1,375,447
Page 57
Problem 4
1.
2.
3.
4.
5.
6.
7.
8.
Bad debt expense

($130,000 - 1,500) x .4%
$30,000 x 10% / 12
$514
$514
250
250
Insurance expense
Prepaid insurance
80
Supplies expense
Supplies on hand
210
Office Salaries
Salaries payable
500
Interest expense
Interest payable
200
Interest revenue
Unearned Interest Revenue
Cost of goods sold (130,000 - 1,500) x 70%
Inventory (plug)
Purchases
Transportation-in
Page 58
80
210
500
200
75
75
89,950
7,950
80,000
2,000
Heather Company Ltd.

Income Statement
for the month ended January 31, 20x8
Sales (net)
Cost of goods sold
Gross margin
$128,500
89,950
38,550
Selling expenses
Administrative expenses ($9,000 + 500)
Bad debt expense
Supplies expense
Insurance expense
Interest expense
Interest income
(11,000)
(9,500)
(250)
(514)
(210)
(80)
(400)
50
Net income
$16,646

Statement of changes in Shareholders' Equity
for the month ended January 31, 20x8

Net income
Dividends
Page 59
Common
Shares
$20,000
Retained
Earnings
$30,005
16,646
(3,000)
$20,000
$43,651

Statement of Financial Position as at January 31, 20x8
ASSETS
Noncurrent assets
Current Assets
Cash
Accounts receivable
Note receivable
Inventory
Supplies on hand
Unexpired insurance
$30,000
(7,750)
22,250
11,000
21,766
3,000
16,050
840
520
53,176
$75,426
SHAREHOLDERS' EQUITY & LIABILITIES

Shareholders' Equity
Common Shares
Retained earnings
20,000
43,651
63,651
Current liabilities
Accounts payable
Notes payable
Salaries payable
Interest payable and unearned interest revenue
$6,000
5,000
500
275
11,775
$75,426
Page 60
Problem 5
a.
Shriver Co.
Statement Of Financial Position
As at November 30, 20x2
ASSETS
Fixed Assets
Land
$ 8,000
25,000
(5,000)
28,000
Current assets
Cash ($1,150 + $2,350)
Accounts receivable, net of allowance for doubtful accounts of $2,000
Note receivable
Interest receivable ($3,000 x .18 x 1/12)
Inventory ($9,900 + $2,100)
Prepaid insurance
3,500
9,350
3,000
45
12,000
600
28,495
$56,495
SHAREHOLDERS' EQUITY AND LIABILITIES

Common shares
Retained earnings ($8,950 Beginning R/E + 7,495 Net Income - 2,500 Dividends)
Current liabilities:
Accounts payable ($4,950 + $2,350)
Notes payable
Interest payable ($5,000 x .12x 1/12)
Dividends payable
$27,700
13,945
41,645
$ 7,300
5,000
50
2,500
14,850
$56,495
Page 61
b.
Shriver Co.
Statement of Income
For the year ended November 30, 20x2
Sales
Cost of goods sold
Beginning inventory
Purchases
Purchase returns
Ending inventory
Gross profit
Selling expenses
Administration expense
Interest expense
Interest earned
Net income
Page 62
$103,800
$10,500
78,750
(450)
(12,000)
76,800
27,000
(10,000)
(7,000)
(2,500)
(50)
45
$ 7,495
Problem 6
Journal entries
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
Cash
Capital Stock
Rent expense
Cash
Tables and Chairs
Accounts payable
$100,000
$100,000
3,000
3,000
25,000
25,000
Depreciation expense (25,000 / 5 / 12)

417
Advertising and promotion

Cash
500
Food supplies
Accounts payable
Food supplies
Cash
Salaries and wages
Cash
Advertising and promotion
Utilities
Janitorial
Cash
417
500
30,000
30,000
6,000
6,000
16,000
16,000
1,500
1,000
1,000
3,500
Accounts payable
Cash
22,000
Temporary investment
Cash
30,000
Interest receivable (30,000 x 8% x 1/24)

Interest revenue
Page 63
22,000
30,000
100
100
(m) Salaries and wages

Salaries and wages payable
(n)
(o)
2,500
2,500
Cost of food supplies

Food Supplies
23,300
Cash
Accounts receivable
Sales
8,000
18,000
Page 64
23,300
26,000
ASSETS
Cash
(a) 100,000 (b)
(o)
8,000 (e)
(g)
(h)
(i)
(j)
(k)
27,000
3,000
500
6,000
16,000
3,500
22,000
30,000
Temporary Investments
(k)
30,000
(f)
(g)
Food Supplies
30,000 (n) 23,300
6,000
12,700
(d)
417
(c)
Tables and Chairs

25,000
(o)
Accounts Receivable
18,000
Interest Receivable
(l)
100
LIABILITIES AND SHAREHOLDERS' EQUITY

Accounts Payable
(j)
22,000 (c)
25,000
(f)
30,000
33,000
Salaries & Wages Payable

(m)
2,500
Capital Stock
(a) 100,000
REVENUES
Sales
(o)
26,000
Interest Revenue
(l)
100
EXPENSES
Cost of Food Supplies
(n) 23,300
Advertising and Promotion

(e)
500
(i)
1,500
2,000
(b)
Rent
3,000
(i)
Utilities
1,000
Salaries and wages

(h)
16,000
(m)
2,500
18,500
(i)
Janitorial
1,000
(d)
417
Page 65
Chicken & Rib

Income Statement
For the Month Ended, July 31, 20x0
Sales Revenue
Cost of food supplies
Gross Profit
$26,000
23,300
2,700
Rent expense
Salaries and wages expense
Advertising and promotion expense
Utilities expense
Janitorial expense
Interest revenue
(3,000)
(18,500)
(2,000)
(1,000)
(1,000)
(417)
100
Net Loss and Deficit, July 31, 20x0
$(23,117)
Page 66
Chicken & Rib

As at July 31, 20x0
Assets
Fixed Assets
Table and Chairs
Current Assets
Cash
Accounts Receivable
Interest Receivable
Food Supplies
$25,000
417
24,583
27,000
30,000
18,000
100
12,700
87,800
$112,383
Shareholders' Equity and Liabilities

Capital Stock
Deficit
Current Liabilities
Accounts Payable
Wages Payable
100,000
(23,117)
76,883
33,000
2,500
35,500
$112,383
Page 67
Problem 7
NOTE: In each entry below, the account with an asterisk has been imputed from the
nature of the transaction.
a)
b)
c)
d)
e)
f)
g)
h)
i)
Investments ($40,712 - $30,500)

*Cash
To record purchase of investments.
*Cash
Investments
Gain on sale of investment
To record sale of investments.
10,212
10,212
5,168
5,000
168
*Cash
Uncollectible accounts expense
Sales
Accounts receivable
To record collection of accounts receivable,
uncollectible accounts expense, and sales returns.
247,833
665
481
Accounts receivable ($301,425 - $47,420)

Sales
To record sales on account.
254,005
Cost of goods sold

*Inventory .
To record cost of goods sold.
151,914
Writedown of obsolete merchandise

*Inventory .
To record obsolete merchandise.
*Accounts payable
Inventory ($153,495 - $151,914 - $1,025)
To record purchase returns, perpetual inventory method.
Inventory ($208,856 - $55,542)
*Accounts payable
To record purchases on account.
Selling expense
*Accounts payable
To record selling expenses.
Page 68
248,979
254,005
151,914
1,025
1,025
556
556
153,314
153,314
25,348
25,348
j)
k)
1)
m)
n)
o)
p)
q)
r)
s)
Salaries expense
*Accounts payable
To record salaries expense.
15,500
Other administrative expense

*Accounts payable
To record other administrative expenses, including
depreciation.
21,567
Office furniture and fixtures ($11,164 - $8,663)

*Accounts payable
To record purchase of furniture.
Interest expense
*Accounts payable
To record interest expense.
Accounts payable ($211,658 - $556)
*Cash .
To record payments on account.
*Cash
Loss on sale of fixtures
Fixtures
To record sale of fixtures.
Note payable
*Cash
To record payment on note.
15,500
20,594
973
2,501
2,501
850
850
211,102
211,102
436
176
23
635
10,000
10,000
Income tax expense

Income taxes payable ($11,050 - $7,350)
To record income tax expense.
3,700

*Cash
To record payment of taxes.
5,658
Retained earnings
*Cash
To record dividends.
Page 69
3,700
5,658
10,000
10,000
Bal
b)
c)
o)
Cash*
a) 10,212
21,849 n) 211,102
5,168 p) 10,000
247,833 r)
5,658
436 s) 10,000
275,286
246,972
*The total debits to cash

exceed the book total by
$270; therefore one of the
debits is smaller than
shown here by the $270
which the books show as
"unlocated difference."
Investments
b) 5,000
30,500
10,212
40,712
Bal
a)
Uncollectible Accounts
Expense
c) 665
Office Furniture and

Fixtures
o) 635
Bal 8,663
l) 2,501
11,164
Note Payable
p) 10,000
Bal 30,000
Income Taxes Payable

r) 5,658
Bal 7,350
q) 3,700
11,050
Gain on Sale of
Investments
b) 168
Writedown of Obsolete
Merchandise
f) 1,025
Page 70
o)
176
Accounts Receivable
c) 248,979
Bal 47,420
d) 254,005
301,425
Inventory
e)
55,542 f)
h) 153,314 g)
208,856
Loss on Sale of Fixtures

o)
Bal
k)
481 d)
23
4,967
973
5,940
Income Tax Expense
q) 3,700
Sales
c)
151,914
1,025
556
153,495
Cost of Goods Sold

254,005
Selling Expense
i) 25,348
e) 151,914
j)
Salaries Expense
15,500
Other Administrative
Expense
k) 21,567
Interest Expense
m)
850
Retained Earnings
s)
10,000
Bal 55,778
Accounts Payable
g)
556
n) 211,102
Bal
15,879
h) 153,314
i)
25,348
j)
15,500
k)
20,594
l)
2,501
m)
850
211,658
233,986
Share Capital
Bal 50,000
LOCATION OF ERROR: The posting of transactions as they appear to have occurred

leaves the cash account with total debits of $275,286 instead of $275,016 and with a
balance of $28,314. However, the company's cash balance of $28,044 has been verified.
The difference of $270 likely arises from the same error which caused the "unlocated
difference" of $270 in the trial balance.
The fact that $270 is evenly divisible by nine indicates the possibility of a transposition.
Since the $270 discrepancy in the cash account in the solution and the bookkeeper's cash
account appears on the debit side of the account the error should be found in one of the
entries which included debits to cash.
In examining the debits in the cash account we can presume that the opening balance of
$21,849 is correct since it was included in the opening trial balance which showed no
discrepancies. By looking at entries b and c we see that neither entry contains a figure
which could include a transposition error of $270 if we assume that there were no other
errors. Entry o, however, contains a credit of $635 to the office furniture & fixtures
account. This entry might well be where the $270 transposition error occurred.
Page 71
If the $635 credit to office furniture & fixtures had been correct, the entry for the sale
would have been:
Cash
436
176
Loss on sale of furniture & fixtures
23
Office furniture & fixtures
635
Since this overstates cash by $270, the amount which was received, and which the
bookkeeper posted to the account, must have been $166 ($436 $270). The correct entry
would have been:
Cash
166
176
Loss on sale of furniture & fixtures
23
Office furniture & fixtures
365
It appears that the bookkeeper made a transposition error and posted a credit of $635
instead of $365 to office furniture & fixtures.
Page 72
Problem 8
1)
2)
3)
4)
5)
6)
7)
Commissions receivable
Commissions earned
To accrue commissions earned
$465
$465
Bad debt expense

To record estimated bad debts
45
45
Office supplies expense

Office supplies
To record the use of office supplies
120
Rent expense
Prepaid rent
To recognize the expiration of prepaid rent
155
120
155
Accumulated depreciation - office equipment
To record depreciation on office equipment for the period
98
98
Salary expense
Salaries payable
To accrue unpaid salaries
290
Interest expense
Interest payable
To accrue unpaid interest
180
Page 73
290
180
Problem 9
ACCOUNT TITLE
Cash in bank
ANALYSIS
Current asset if unrestricted
Inventory of operating parts and supplies
Current asset if expected to be used within

longer of one year or operating cycle
Inventory of raw materials
Current asset
Accounts receivable
Current assets if collectible within longer of

one year or operating cycle
Inventory of finished goods
Current asset
Inventory of work in
Current asset process
Interest accrued on government securities
Current asset
Notes receivable
Same analysis as accounts receivable
Petty cash fund
Current asset
Government securities
Current asset unless expected to be held

beyond longer of one year or operating
cycle
Contra account to current liability only if

related bonds appropriately classified as
current
Accrued payroll
Current liability
Provision for renegotiation

of government contracts
Current liability if expected to require use

of existing current assets
Notes payable
Current liability if expected to be paid with

existing current assets or through creation
of another current liability
Accrued interest on bonds
Current liability
Accounts payable
Current liability
Accrued interest on notes payable
Current liability
Page 74
8% first mortgage bonds
Current liability
Preferred share dividend
Current liability
Contra account to accounts receivable,

classified same as related receivables
Provision for federal income taxes
Current liability
Customers' advances
Current liability
Premium on bonds redeemable in 20x1
Current liability if related bonds are

appropriately classified as current
liability
Officers' 20x1 bonus accrued
Current liability
Problem 10
1.
Under cash-basis accounting, net income would be the net cash provided by
operations. Revenue would be recognized when cash is received from other than
investors and creditors r and expenses would be recognized when cash payments
are made for reasons other than financing (including distributions to owners). This
approach has very little conceptual merit because it fails to match expenses to
revenues so as to satisfactorily measure operating performance during a period.
In contrast, accrual accounting focuses on the transactions and events that affect
the assets and liabilities of the accounting entity, and attempts to recognize and
report those transactions and events in the accounting periods in which they
occur. Revenues are recognized when they are earned and expenses are matched
against revenues on the basis of: (a) cause and effect, (b) systematic and rational
allocation, or (c) immediate recognition.
2.
Gross margin for Janson's Retail Hardware is not being calculated on a pure cash
basis. Gross margin on a pure cash basis for 20x3 would be:
Cash received:
$147,000 Cash Sales + 13,000 Credit Sales - 1,000 Increase in AR
Cash payments for merchandise:
Accounts payable, Jan 1, 20x3
$ 12,000
Purchases during 20x3
100,000
112,000
Less: Accounts payable, Dec 31, 20x3
(19,000)
Page 75
$159,000
(93,000)
Gross margin (net cash inflows)
3.
$66,000
Gross margin shows a decrease because it is being calculated incorrectly. When

Mr. Janson adds the ending balance of accounts receivable to the cost of
merchandise on hand in his determination of net inventory, he is improperly
including the profit margin that is part of the accounts receivable. This results in
an overstatement of net inventory at both the beginning and end of the accounting
period.
The major error in calculating gross margin occurs when Mr. Janson subtracts the
accounts payable balance in arriving at the net inventory amounts. The increasing
balance of accounts payable each year results in an increasing overstatement of
cost of goods sold.
Problem 11
a) A division does not qualify as a separate entity for financial reporting purposes but
only for internal control purposes. Financial statements are prepared on a company
basis (entity concept).
b) Financial statements are neutral in the sense that they reflect certain facts about the
company but they are not neutral in the way that these facts are selected and then
shown. Financial statements may lack neutrality as many accounting methods may be
available and only one is chosen to be used by the accountant.
c) Numbers are exact in the sense that they can be added together. But the process
generating the numbers is not exact because often it is based on estimates and choices
of methods. (Example - depreciation.)
d) The historical cost principle allows us to reduce disagreements as to how items
should be recorded. Cost is more objective than, for example, market values, but it
does not necessarily give us objective numbers as cost is more than just an invoice
price in many situations.
Page 76
2.
The Statement of Cash Flows
Re-consider the following schematic of the Statement of Financial Position:

Share Capital
Long-term Assets
Retained Earnings
Current Assets
Current Liabilities
The purpose of the Cash Flow Statement is to report on sources and uses of cash over a
period of time as well as the net change in cash and cash equivalents. Reporting
information about the cash flows of a firm helps the users of the financial statements to
assess both the past performance of the entity in generating and controlling cash
resources and the entitys probable future cash inflows, outflows, and net cash flows. The
major components of the cash flow statement are the cash flows resulting from the
operating, investing, and financing activities of the firm. For the purpose of the cash flow
statement, cash is defined as cash and cash equivalents. Cash equivalents include shortterm, highly liquid investments that can be readily converted into known amounts of
cash. Cash equivalents are shown net of bank overdrafts where overdrafts are part of the
cash management strategy of the firm.
Investing - all changes in noncurrent assets except those that flow through the income
statement (i.e. amortization expense); the latter are considered operating activities. The
only possible changes to noncurrent assets are:
purchasing noncurrent assets - cash used for investing
proceeds on sale of noncurrent assets - cash provided by investing
equity income on long-term investments - deducted from net income in the operating
section.
Financing - all changes in noncurrent liabilities and share capital are financing activities
except for those items flowing through the income statement.
issue of long-term debt and share capital - cash provided by financing
redemption of long-term debt and share capital - cash used by financing
dividends paid (not just declared)
Page 77
The operating section of the Statement of Cash flow can be prepared using two formats.
These are the indirect or direct methods. Although both methods are acceptable under
IFRS, IAS 7.19 encourages entities to use the direct method. The direct method provides
information which may be useful in estimating future cash flows and which is not
available under the indirect method.
Cash Flow From Operations - Indirect method: we start with net income and adjust it for
non cash items: these are generally of two categories: (1) non cash revenue or expense
items and (2) any changes in non-cash working capital items. An indirect cash flow from
operations might look like this:
Net income
Adjust for items not requiring a cash outlay
Depreciation
Changes in noncash working capital items
Increase in accounts receivable
Decrease in inventory
Increase in accounts payable
Decrease in income taxes payable
Cash flow from operations
$12,000
2,000
-1,500
-2,500
500
1,500
-600
$11,400
Cash Flow From Operations - Direct method: as opposed to taking net income and
adjusting it, we essentially go through each line on the income statement and convert all
items into cash. For example, if the sales were $124,000 for the year and assuming that
the accounts receivable increased $2,500, then the cash sales would be calculated as
$124,000 2,500 = $121,500.
If we continue the example used for the indirect method and we assume that the income
statement was as follows:
Sales
Cost of goods sold
Operating expenses (all paid for in cash)
Amortization
Income tax expense (all current)
Net income
Page 78
$124,000
(75,000)
(28,500)
(2,000)
1,500
20,000
8,000
$12,000
The direct approach to determining cash flow from operations would be as follows:
Collections from customers ($124,000 Credit Sales
2,500 Increase in Accounts Receivable)
Payments to suppliers ($75,000 - 500 Decrease in Inventory
- 1,500 Increase in Accounts Payable)
Payments for operating expenses
Payments made for Income taxes ($8,000 Income Tax Expense
+ 600 Decrease in Income Tax Payable)
$121,500
(73,000)
(28,500)
(8,600)
$11,400
Noncash Investing and Financing Activities at times a corporation will enter into
noncash transactions. Examples of these could be the purchase of land by issuing new
shares as consideration or by taking out a mortgage; paying a stock dividend or
purchasing a company by issuing new shares. Since none of these transactions involve
cash, they do not belong on the Statement of Cash flows. Such transactions should be
disclosed elsewhere in the financial statements in a way that provides all the relevant
information about these investing and financing activities.
Specific required disclosures regardless of whether the direct or indirect method is
used, the following two items need to be disclosed:
cash paid on interest, and
cash paid on taxes

A few more details
a Statement of Cash Flows has to be prepared by all entities
cash includes cash and cash equivalents which are defined as short-term, highly
liquid investments that are readily convertible to known amounts of cash and
which are subject to an insignificant risk of changes in value.
short term bank loans: bank overdrafts may be included as a component of cash
and cash equivalents when the bank balance fluctuates frequently from being
positive to overdrawn; otherwise, bank overdrafts and short term demand loans
are considered as cash flow from financing.
available for sale, held-for-trading and held to maturity investments are

considered as part of cash flow from investing regardless of their classification as
current or long-term assets.
cash flows from dividends received and paid can be classified as either operating,
investing or financing cash flows as long as they are reported in a consistent
manner.
Page 79
Example 1: Karington Ltd. has been manufacturing equipment for making pasta for the
past ten years. The company's comparative Statement of Financial Position as at March
31, 20x5, its fiscal year end, is as follows:
Karington Ltd.
as at March 31, 20x5
ASSETS
Long-term Assets
Equipment
Investment in Kolbe Ltd.
Patents
Current Assets
Cash
Accounts receivable
Inventory
Prepaid expenses
LIABILITIES & SHAREHOLDERS' EQUITY

Capital stock
Retained earnings
Long-term Liability
Notes Payable
Current Liabilities
Bank overdraft
Accounts payable
Salaries payable
Deferred revenues
Interest payable
Dividends payable
Page 80
20x5
20x4
1,175,000
(370,125)
176,250
129,250
1,110,375
881,250
(282,000)
141,000
740,250
$82,250
282,000
458,250
23,500
846,000
$141,300
312,550
352,500
18,500
824,850
$1,956,375
$1,565,100
20x5
20x4
1,408,100
189,900
1,598,000
1,233,750
141,000
1,374,750
105,750
$ 61,100
105,925
32,900
25,000
10,000
3,600
14,100
252,625
$ 47,000
59,250
37,600
34,000
8,000
4,500
190,350
$1,956,375
$1,565,100
Karington Ltd.
Income Statement
for the year ended March 31, 20x5
Sales
Cost of goods sold
Gross margin
Salaries expense
Selling and administrative expenses
Interest expense
Gain on sale of equipment
$1,350,000
830,000
520,000
(220,000)
(197,600)
(12,400)
15,000

Income tax expense
105,000
42,000
Net income
$63,000
Additional Information:
The investment in Kolbe Ltd. was financed by issuing a 10-year note for $105,750
and providing the remainder in cash.
Equipment with an original cost of $50,000 which was 70% depreciated was sold
during the year.
Depreciation expense in included in selling and administrative expenses
Dividends of $14,100 were declared during the year.
Given the above information we can now construct the statement of cash flows as
follows.
Page 81
Karington Ltd.
Statement of Cash Flows
for the year ended March 31, 20x5
Cash Flow from Operations
Net income
Adjust for noncash items
Depreciation and amortization
Gain on sale of equipment
$63,000
1
134,875
(15,000)
Changes in non-cash working capital items:

Decrease in Accounts Receivable
Increase in Inventory
Increase in Prepaid Expenses
Increase in Accounts Payable
Decrease in Salaries Payable
Decrease in Income Taxes Payable
Increase in Deferred Revenues
Decrease in Interest Payable
30,550
(105,750)
(5,000)
46,675
(4,700)
(9,000)
2,000
(900)
136,750
Cash Flow from Financing

Issue of capital stock ($1,408,100 1,233,750)
174,350
Cash Flow from Investing

Investment in Kolbe Ltd. ($176,250 105,750)
Proceeds on sale of equipment ($15,000 Gain
+ 15,000 NBV of Asset Sold)
Purchase of equipment2
(70,500)
30,000
(343,750)
(384,250)
Decrease in cash and cash equivalents

Cash and cash equivalents*, March 31, 20x4
Cash and cash equivalents, March 31, 20x5
(73,150)
94,300
$21,150
* Cash and cash equivalents include Cash net of the Bank Overdraft.
1
Accumulated depreciation beginning

Less accumulated depreciation on asset sold: $50,000 x 70%
Less accumulated depreciation, ending
Depreciation expense on equipment
Add amortization on patent:
$141,000 Patent Opening Balance 129,250 Patent Ending Balance
Page 82
$282,000
(35,000)
(370,125)
123,125
11,750
$134,875
Equipment, end of year

Less equipment, beginning of year
Net increase
Add cost of equipment sold
$1,175,000
(881,250)
293,750
50,000
$343,750
If the direct method had been used, the cash flow from operations section would be as
follows:
Cash collected from customers ($1,350,000 Sales + 30,550 Decrease in A/R
+ 2,000 Increase in Deferred Revenues)
Cash paid to suppliers ($830,000
- 46,675
$1,382,550
COGS
+ 105,750
Increase in Inventory
Cash paid to employees ($220,000
(889,075)
Salaries Expense
+ 4,700 Decrease in Salaries Payable)

Cash paid for Selling and Administrative Expenses ($197,600
(224,700)
S&A Expenses
+ 5,000 Increase in Prepaid Expenses 134,875 Depreciation Expense)
(67,725)
Cash paid on interest ($12,400 Interest Expense + 900 Decrease in Interest Payable)
(13,300)
Cash paid on taxes ($42,000 Income Tax Expense

+ 9,000 Decrease in Income Taxes Payable)
(51,000)
$136,750
Page 83
Example 2 the Statement of Cash Flow for Local Stationery Ltd. (example on page 4)
is as follows:
Statement of Cash Flow
Net income
Adjust for items not affecting cash flow
Depreciation
Gain on disposal of assets
Changes in non-cash working capital items
Increase in inventory
Decrease in note receivable
Increase in prepaid insurance
Increase in accounts payable and accrued liabilities
Decrease in wages payable
Increase in accrued income taxes payable
Decrease in unearned revenues
Cash flow from investing

Sale of equipment
Cash flow from financing

Dividends
Repayment of long-term debt
Increase in cash
Cash, beginning of year
Cash, end of year
Page 84
$73,620
20,000
(5,000)
(22,800)
(15,000)
10,400
(3,700)
10,000
(1,500)
24,080
(5,000)
85,100
(50,000)
20,000
(30,000)
(30,000)
(15,000)
(45,000)
10,100
14,500
$24,600
If the direct method had been used, the cash flow from operations section would be as
follows:
Cash collected from customers ($1,152,600 Sales - 22,800 Increase in A/R
+ 10,400 Decrease in Note Receivable - 5,000 Decrease in Deferred Revenues
- 4,800 Bad Debt Expense*)
$1,130,400
Cash paid to suppliers ($645,000 COGS + 15,000 Increase in Inventory

(650,000)
Cash paid for Selling and Administrative Expenses

Cash paid to employees ($198,500
(150,000)
Wages and Salaries Expense
+ 1,500 Decrease in Salaries Payable)

Cash paid for insurance ($3,500
(200,000)
Insurance Expense
Cash collected on interest
(7,200)
400
Cash paid on interest

Cash paid on taxes ($49,080
+ 3,700
Increase in Prepaid Insurance
(13,500)
Income Tax Expense
- 24,080 Increase in Income Taxes Payable)
(25,000)
$85,100
Page 85
the concept of how bad debt expense and the change in the allowance for doubtful accounts will
be elaborated on when we cover Accounts Receivable.

1.
Lance Corp.'s statement of cash flows for the year ended September 30, 20x2, was
prepared using the indirect method and included the following:
Net income
Non-cash adjustments:
Decrease in inventory
Decrease in accounts payable
Net cash flows from operating activities
$60,000
9,000
(5,000)
40,000
(12,000)
$92,000
Lance reported revenues from customers of $75,000 in its 20x2 income statement.
What amount of cash did Lance receive from its customers during the year ended
September 30, 20x2?
a) $80,000
b) $70,000
c) $65,000
d) $55,000
2.
On June 30, 20x4, D Ltd., a manufacturing company, sold a piece of land for its
book value of $250,000. D Ltd. accepted $170,000 cash plus a mortgage in the
amount of $80,000 in exchange for the land. How would D Ltd. report this on its
December 31, 20x4, statement of cash flow?
a) $250,000 inflow under the investing activities heading.
b) $170,000 inflow under the investing activities heading.
c)
$250,000 inflow under the investing and $80,000 outflow under the
financing activities headings.
d)
$170,000 inflow under the investing and $80,000 outflow under the
financing activities headings.
e)
$250,000 inflow and $80,000 outflow under the investing activities
heading.
Page 86
3.
Consider the following information for a firms year ended December 31, 20x4:
Accounts receivable
Prepaid Rent
Unearned revenues
January
1, 20x4
$340,000
14,000
36,000
Revenues
December 31,
20x4
$385,000
6,000
54,000
1,600,000
Calculate the cash flow from customers for the year ended December 31, 20x4:
a) $1,537,000
b) $1,573,000
c) $1,600,000
d) $1,609,000
e) $1,663,000
4.
Net cash flow from operating activities for 20x2 for Graham Corporation was
$75,000. The following items are reported on the financial statements for 20x2:
Cash dividends paid on common shares
Increase in accrued receivables
$5,000
3,000
6,000
Based only on the information above, Graham's net income for 20x2 was:
a) $64,000
b) $66,000
c) $74,000
d) $76,000
e) None of the above.
5.
The following information is available for Ace Company for 20x2:

Disbursements for purchases
$500,000
Increase in trade accounts payable
50,000
Decrease in merchandise inventory
20,000
Costs of goods sold for 20x2 was
a) $570,000
b) $530,000
c) $470,000
d) $430,000
Page 87
6.
On September 1, 20x3, Canary Co. sold used equipment for a cash amount equaling
its carrying amount for both book and tax purposes. On September 15, 20x3,
Canary replaced the equipment by paying cash and signing a note payable for new
equipment. The cash paid for the new equipment exceeded the cash received for the
old equipment. How should these equipment transactions be reported in Canary's
2003 statement of cash flows?
a) Cash outflow equal to the cash paid less the cash received
b) Cash outflow equal to the cash paid and note payable less the cash received
c) Cash inflow equal to the cash received and a cash outflow equal to the cash
paid and note payable
d) Cash inflow equal to the cash received and a cash outflow equal to the cash
paid
Questions 7 through 9 are based on the following:

Flax Corp. uses the direct method to prepare its statement of cash flows. Flax's trial
balances at December 31, 20x1 and 20x0, are as follows:
Debits:
Cash
Accounts receivable
Inventory
Property, plant, & equipment
Cost of goods sold
Selling expenses
General and administrative expenses
Interest expense
Income tax expense
Credits:
Allowance for uncollectible accounts
Trade accounts payable
Future income taxes
8 % callable bonds payable
Common stock
Additional paid-in capital
Retained earnings
Sales
Page 88
December 31
20x1
20x0
$35,000
33,000
31,000
100,000
4,500
250,000
141,500
137,000
4,300
20,400
$756,700
$32,000
30,000
47,000
95,000
5,000
380,000
172,000
151,300
2,600
61,200
$976,100
$1,300
16,500
25,000
21,000
5,300
45,000
50,000
9,100
44,700
538,800
$756,700
1,100
15,000
17,500
27,100
4,600
20,000
40,000
7,500
64,600
778,700
$976,100
Flax purchased $5,000 in equipment during 20x1.

Flax allocated one-third of its depreciation expense to selling expenses and the remainder
to general and administrative expenses.
What amounts should Flax report in its statement of cash flows for the year ended
December 31, 20x1, for the following:
7.
Cash collected from customers?

a) $541,800
b) $541,600
c) $536,000
d) $535,800
8.
Cash paid for goods to be sold?

a) $258,500
b) $257,500
c) $242,500
d) $226,500
9.
Cash paid for interest?

a) $4,800
b) $4,300
c) $3,800
d) $1,700
Page 89
Problem 1
The income statement and comparative balance sheets of Harold Ltd. are shown below.
Harold Ltd.
Income Statement
Sales
Cost of goods sold
Operating expenses
Interest expense
Gain on sale of disposal of property, plant and equipment
Income tax expense
Net income
Page 90
$ 1,650,000
(1,236,000)
(197,000)
(120,000)
(25,000)
6,000
(27,000)
$ 51,000
Harold Inc.
Noncurrent Assets
Property, plant and equipment
Current assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Shareholders equity
Common shares
Retained earnings
Long-term debt
Current liabilities
Accounts payable
Salaries payable
Interest payable
Dividends payable
20x2
20x1
$850,000
(426,000)
424,000
$740,000
(356,000)
384,000
145,000
226,000
305,000
14,000
690,000
75,000
202,000
336,000
35,000
648,000
$1,114,000
$ 1,032,000
$ 450,000
177,000
627,000
$ 400,000
156,000
556,000
213,000
219,000
225,000
14,000
12,000
13,000
10,000
274,000
206,000
20,000
10,000
16,000
5,000
257,000
487,000
476,000
$1,114,000
$ 1,032,000
Additional information
During 20x4, property plant and equipment costing $100,000 was sold.
Required a.
b.
Page 91
Prepare a Statement of Cash Flows for Harold Inc. using the direct method.
Prepare the Cash Flow from Operations section using the indirect method.
Problem 2
The records of Dumbledore Company provided the following data for the accounting
year ended December 31, 20x5:
Comparative Statements of Financial Position
as at December 31
Assets
Cash
Investment, short term (cash equivalent)
Accounts receivable
Inventory
Prepaid interest
Land
Machinery
Other assets
Liabilities and Shareholders Equity

Accounts payable
Salaries payable
Bonds payable
Common shares
Preferred shares
Retained earnings
20x4
$30,000
10,000
56,000
20,000
-60,000
80,000
(20,000)
29,000
$265,000
20x5
$ 75,000
8,000
86,000
30,000
2,000
25,000
90,000
(26,900)
39,000
$328,100
39,000
5,000
2,000
70,000
100,000
20,000
29,000
$265,000
54,000
2,000
8,000
55,000
130,000
30,000
49,100
$328,100
Income Statement
Sales revenue
Cost of goods sold
Salaries
Interest expense
Remaining expenses
Gain on sale of land
Income tax expense
Net income
Page 92
$180,000
(90,000)
(6,900)
(33,900)
(6,000)
(4,000)
18,000
(12,100)
$ 45,100
Analysis of selected accounts and transactions:

a.
b.
c.
d.
e.
f.
Issued bonds payable for cash, $5,000.

Sold land for $53,000 cash; book value, $35,000.
Purchased machinery for cash, $10,000.
Retired $20,000 bonds payable by issuing common shares; the common shares
had a market value of $20,000.
Acquired other assets by issuing preferred shares with a market value of $10,000.
Statement of retained earnings:
Balance, January 1, 20x5
Net income for 20x5
Cash dividends
Stock dividend issued
$29,000
45,100
(15,000)
(10,000)
$49,100
Required a.
b.
Page 93
Prepare the Statement of Cash Flows, indirect method.

Prepare the operations section of the Statement of Cash Flows using the direct
method of presentation.
Problem 3
The Statement of Financial Positions of Sunrise Ski Company showed the following:
December December
31, 20x2
31, 20x1
Debits Cash
$ 10,000
$ 12,000
Accounts receivable (net)
18,000
10,000
20,000
Inventory
24,000
Long-term investments
10,000
24,000
Plant and equipment
104,000
60,000
$126,000
$166,000
Credits Accumulated depreciation
$ 14,000
$ 10,000
Accounts payable
16,000
12,000
32,000
Notes payable-long-term
40,000
Share capital
60,000
50,000
Retained earnings
36,000
22,000
$166,000
$126,000
The income statement for 20x2 appears below:
Sales
Cost of sales
Expenses, including income taxes, paid in cash
Depreciation
Loss on disposal of plant and equipment
Gain on disposal of plant assets
Net income
$320,000
(200,000)
(96,000)
(6,000)
(4,000)
2,000
$ 16,000
Additional data concerning changes in the noncurrent accounts:

a) Cash dividends paid, $2,000.
b) Issue of common shares for cash, $10,000.
c) Plant and equipment disposed of during the year cost $6,000.
Required a.
b.
Page 94
Prepare a statement of cash flows for 20x2. Use the direct method.
Calculate Cash flow from operations using the indirect method.
Problem 4
TGA Corporation, a publicly-held company, develops and sells software application
programs. TGA's Statement of Income and Retained Earnings for the year ended
December 31. 20x1, and Comparative Statement of Financial Position for 20x0 and 20x1
are presented below.
TGA Corporation
Statement of Income and Retained Earnings
Sales revenue
Cost of goods sold
Gross profit
Salaries expense
Loss on sale of equipment
Interest expense
Income before taxes
Income tax expense
Net income
Retained earnings, January 1, 20x1
Dividends
Retained earnings , December 31, 20x1
Page 95
$300,000
120,000
180,000
(50,000)
(6,000)
(2,500)
(2,500)
119,000
48,000
71,000
87,000
(8,000)
$150,000
TGA Corporation
Comparative Statement of Financial Position
As of December 31, 20x1 and 20x0
Assets
Dec 31, 20x1
Dec 31, 20x0
Change
Cash
Accounts receivable, net
Inventory
Land
Plant and equipment
Total assets
$ 98,500
50,000
70,000
200,000
80,000
(15,500)
$483,000
$ 86,000
30,000
55,000
200,000
69,500
(13,500)
$427,000
$ 12,500
20,000
15,000
10,500
(2,000)
$ 56,000
Liabilities & Shareholders' Equity

Accounts payable
Salaries payable
Taxes payable
10% convertible bonds payable
Common stock
Retained earnings
Total liabilities & shareholders' equity
$ 15,000
10,000
3,000
305,000
150,000
$483,000
$ 20,000
7,000
13,000
100,000
200,000
87,000
$427,000
$ (5,000)
3,000
(10,000)
(100,000)
105,000
63,000
$56,000
Additional Information
During the year, additional equipment was acquired by TGA for $20,000 cash. TGA
also sold equipment costing $9,500, with a book value of $5,500, for $3,000 cash.
On March 30, 20x1, $100,000 of 10% convertible bonds, issued at face value with
interest payment dates of June 30 and December 31, were converted into 2,000 shares
of TGA Corporation common stock.
An additional $5,000 of common stock were issued for cash.
Required Using the direct method, prepare a Statement of Cash Flows for TGA Corporation for
the year ended December 31, 20x1.
Page 96
Problem 5
Mr. Cumin, the president of Sage Ltd., presented you with the following Statement of
Financial Position and asked you to prepare a statement of cash flow.
Sage Ltd.
Comparative Statement of Financial Position
As at June 30, 20x5
20x5
Assets
Long-Term Assets
Government bonds held for expansion
Equipment
Leasehold improvements
Patents (net)
Current Assets
Cash
Accounts receivable
Inventories
97,500
602,550
(270,400)
18,850
18,070
20x4
466,570
420,550
(241,800)
18,850
19,500
217,100
$ 94,250
164,450
(9,100)
313,950
563,550
$ 162,500
177,450
(11,050)
313,950
642,850
$1,030,120
$859,950
Liabilities and Shareholders' Equity

Preferred stock
Common stock
Retained earnings
Long-term Liabilities
12% Bonds payable
Current Liabilities
Accounts payable
Cash dividends payable
Current portion of bonds payable
Page 97
58,500
325,000
274,300
65,000
325,000
174,200
657,800
564,200
162,500
195,000
$ 151,320
26,000
32,500
209,820
$ 68,250
32,500
$1,030,120
$859,950
100,750
At a meeting with the assistant controller, you learned that legal costs amounting to
$1,300 were incurred to defend a patent. A premium paid to retire preferred stock was
charged to retained earnings. Equipment with a book value of $39,650 was sold for
$31,200. Patent amortization amounted to $2,730. Equipment purchases amounted to
$250,900 and net income for the year was $126,750. Dividends in the amount of $26,000
were declared.
Required:
Prepare a statement of cash flows.
Problem 6
The Statement of Financial Positions for Carlos Ltd. as at December 31, 20x0 and 20x1,
and the income statement for the year ended December 31, 20x1 are presented below.
CARLOS LTD.
Statement of Financial Positions
December 31, 20x1
Assets
Cash
Accounts receivable
Inventory
Buildings and equipment, net of accumulated amortization
20x1
20x0
$ 46,000
100,000
90,000
82,000
$ 318,000
$ 40,000
80,000
50,000
80,000
$ 250,000
$ 20,000
6,000
1,000
53,000
120,000
118,000
$ 318,000
$ 65,000
4,000
2,000
59,000
100,000
20,000
$250,000

Accounts payable
Taxes payable
Interest payable
Notes payable
Common shares
Retained earnings
Page 98
CARLOS LTD.
Income Statement
year ended December 31, 20x1
Sales
Expenses
Cost of goods sold
Other expenses
Depreciation expensebuilding and equipment
Interest expense
Income tax expense
Net income
$ 520,000
$ 300,000
71,000
9,000
7,000
35,000
422,000
$ 98,000
Other Information 1.
2.
3.
Equipment costing $ 11,000 was purchased during the year.

The company issued 800 shares for $20,000 cash.
The note payable matures in 20x3.
Required a.
b.
Page 99
Prepare a cash flow statement for the year ended December 31, 20x1, using the
direct method of presenting the cash flows from operations.
Prepare the cash flow from operating activities using the indirect approach.
Solutions
1.
$75,000 - 5,000 Increase in A/R = $70,000
2.
Only the cash receipt would be shown on the statement of cash flows.
3.
$1,600,000 45,000 Increase in A/R + 18,000 Increase in Deferred Revenues

= $1,573,000
4.
75,000 + 6,000 5,000 = $76,000
5.
Purchases = $500,000 + 50,000 = $550,000

COGS = $550,000 + 20,000 = $570,000
6.
7.
$538,800 - $2,800 Increase in net receivables = $536,000
8.
Purchases = $250,000 - $16,000 decrease in inventory = $234,000

Cash purchases = $234,000 - 7,500 Increase in trade payables = $226,500
9.
$4,300 Interest expense - $500 Amortization of discount on bonds payable
Page 100
Problem 1
a.
Harold Inc.
Cash collected from customers ($1,650,000 Sales
24,000 Increase in Accounts Receivable)
Cash paid to suppliers ($1,236,000 31,000 Decrease in Inventory
19,000 Increase in Accounts Payable)
Cash paid for operating expenses ($197,000
21,000 Decrease in Prepaid Expenses + 6,000 Decrease in Salaries Payable)
Cash paid for interest ($25,000 2,000 Increase in Interest Expense)
Cash paid for income taxes ($27,000
+ 3,000 Decrease in Income Taxes Payable)
Cash flow from investing

Purchase of property, plant and equipment
$110,000 Increase in PPE + 100,000 Cost of Equipment Sold
Proceeds on sale of PPE
$50,000 NBV of PPE Sold* + 6,000 Gain on Sale
$1,626,000
(1,186,000)
(182,000)
(23,000)
(30,000)
205,000
(210,000)
56,000
(154,000)
Cash flow from financing

Issue of common shares
Dividends Paid **
50,000
(6,000)
(25,000)
19,000
Increase in cash
Cash, end of year
70,000
75,000
$145,000
* Accumulated Depreciation on PPE Sold =

$120,000 Depreciation Expense - $70,000 Increase in Accumulated Depreciation
** Dividends Declared = $51,000 Net Income
- 21,000 Increase in Retained earnings
Less Increase in Dividends Payable
Dividends paid
Page 101
$30,000
(5,000)
$25,000
b.
Cash Flow from Operations - Indirect

Net Income
$51,000
Adjust for non-cash items

Depreciation
Gain on sale of disposal of property, plant and equipment
120,000
(6,000)
Adjust for changes in non-cash working capital items

Increase in Accounts Receivable
Decrease in Inventory
Decrease in Prepaid Expenses
Decrease in Salaries Payable
Increase in Interest Payable
Decrease in Income Taxes Payable
Page 102
(24,000)
31,000
21,000
19,000
(6,000)
2,000
(3,000)
$205,000
Problem 2
a.
DUMBLEDORE CORPORATION
Cash Flow from Operations
Net income
Adjust for non-cash items:
Gain on sale of land
Depreciation
Adjust for changes in working capital
Increase in prepaid interest
Decrease in salaries payable
Increase in taxes payable
Cash Flow from Investing
Proceeds on sale of land
Purchase of machinery
Cash Flow From Financing

Issue bonds
Cash dividends
Net change in cash

Cash and cash equivalents, beginning of year
Cash and cash equivalents, end of year
Page 103
$45,100
(18,000)
6,900
34,000
(30,000)
(10,000)
(2,000)
15,000
(3,000)
6,000
10,000
53,000
(10,000)
43,000
5,000
(15,000)
(10,000)
43,000
40,000
$83,000
b.
Cash Flow from Operations - Direct
Cash collected from customers ($180,000 Sales 30,000 Increase in A/R)
Cash paid to Suppliers ($90,000 COGS + 10,000 Increase in Inventory
15,000 Increase in Accounts Payable)
Cash paid to employees ($33,900 Salary Expense + 3,000 Decrease in Salaries Payable)
Cash paid for remaining expenses
Cash paid for interest (6,000 Interest Expense + 2,000 Increase in Prepaid Interest)
Cash paid for Income taxes (12,100 Income Tax Expense
6,000 Increase in Income Taxes Payable)
Page 104
$150,000
(85,000)
(36,900)
(4,000)
(8,000)
(6,100)
10,000
Problem 3
a.
Sunrise Ski Company
Statement Of Cash Flows
Cash flows from operating activities
Cash collections from customers ($320,000 - 8,000 Increase in A/R)
Other expenses paid in cash
Cash flows from investing activities
Proceeds on sale of plant and equipment (Note 1)
Sale of long-term investments ($14,000 Decrease in Long-Term Investments
- 4,000 Loss on disposal of investments)
Purchase of equipment (Note 2)
Cash flows from financing activities
Issuance of common shares
Issue of notes payable
Payment of dividends ($16,000 Net Income - 14,000 Increase in R/E)
Net decrease in cash

Cash, January 1, 20x2
Cash, December 31, 20x2
Page 105
$312,000
(200,000)
(96,000)
16,000
6,000
10,000
(50,000)
(34,000)
10,000
8,000
(2,000)
16,000
(2,000)
12,000
$ 10,000
Note 1 - Proceeds on sale of plant and equipment

Net book value of plant and equipment sold
Cost
Less Accumulated depreciation
$6,000 Depreciation Expense - 4,000 Increase in Accumulated Depreciation
$6,000
Gain on disposal of plant and equipment

Proceeds
2,000
4,000
2,000
$ 6,000
Note 2 - Purchase of equipment

Increase in plant and equipment account
Add cost of equipment sold
Acquisitions during 20x2
$44,000
6,000
$50,000
b. Cash Flow from Operations - Indirect

Net income
Adjust for non-Cash Items
Depreciation
Loss on sale of long-term investments
Gain on disposal of fixed assets
Adjust for changes in non-cash working capital accounts
Page 106
$16,000
6,000
4,000
(2,000)
(8,000)
(4,000)
4,000
$16,000
Problem 4
TGA Corporation
Cash flow from operating activities:
Cash collected from customers ($300,000 Sales - 20,000 Increase in A/R)
+ 5,000 Decrease in Accounts Payable)
Cash paid to employees ($50,000 Salaries expense
- 3,000 Increase in Salaries Payable)
Cash paid for interest
Cash paid for taxes ($48,000 + 10,000 Decrease in Income Taxes Payable)
Cash flow from investing activities:

Proceeds from sale of equipment
Purchase of additional equipment
Cash flow from financing activities:

Common stock issued for cash
Cash dividend paid
Net increase in cash

Cash balance, December 31, 20x0
Cash balance, December 31, 20x1
Page 107
$280,000
(140,000)
(47,000)
(2,500)
(58,000)
32,500
3,000
(20,000)
(17,000)
5,000
(8,000)
(3,000)
12,500
86,000
$98,500
Problem 5
Sage Ltd.
for the year ended June 30, 20x5
Cash provided by operations
Net income
Add back items not requiring a cash outlay
Depreciation
Amortization of patent
Loss on sale of equipment ($39,650 - 31,200)
Decrease in accounts receivable (net)
Cash used by investing activities

Purchase of government bonds
Proceeds on sale of equipment
Patent defense costs
Cash used by financing activities

Repayment of bonds
Redemption of preferred shares (6,500 + 650 2)
Decrease in cash
Cash, end of year
1
$126,750
57,850
2,730
8,450
195,780
11,050
83,070
289,900
(97,500)
(250,900)
31,200
(1,300)
(318,500)
(32,500)
(7,150)
(39,650)
(68,250)
162,500
$ 94,250
Equipment - beginning balance

Additions
less ending balance
= cost of equipment sold
$420,550
250,900
(602,550)
$ 68,900
Accumulated depreciation - beginning balance

less accumulated depreciation on equipment sold:
$68,900 - 39,650
less ending balance
= depreciation expense
$241,800
Page 108
(29,250)
(270,400)
$ 57,850
Retained earnings - Beginning of year

Net income
Dividends
Retained earnings - End of year
Premium on retirement of preferred shares
$174,200
126,750
(26,000)
(274,300)
$
650
Problem 6
Part (a)
CARLOS LTD.
year ended December 31, 20x1
Cash receipts from customers (520,000 - 20,000 Increase in AR)
Cash payments for merchandise (300,000 + 40,000 Increase in Inventory
+ 45,000 Decrease in Accounts Payable)
Cash payment for other expenses
Interest payments (7,000 + 1,000 Decrease in Interest Payable)
Income tax payments (35,000 - 2,000 Increase in Taxes Payable)
Purchase of equipment (2,000 Increase in Buildings and Equipment
+ 9,000 Depreciation Expense)
Payments for notes payable (53,000 - 59,000)
Proceeds from common shares issued (120,000 - 100,000)
Net increase in cash

Cash, January 1, 20x1
Cash, December 31, 20x1
$500,000
(385,000)
(71,000)
(8,000)
(33,000)
3,000
(11,000)
(6,000)
20,000
14,000
6,000
40,000
$ 46,000
Part (b)
Net income
Add back depreciation which does not require a cash outlay
Changes in working capital items:
Decrease in accounts payable
Increase in taxes payable
Decrease in interest payable
Page 109
$98,000
9,000
(20,000)
(40,000)
(45,000)
2,000
(1,000)
$ 3,000
3.
Revenue Recognition
Revenue recognition under IFRS is governed by IAS 18 Revenue and IAS 11

Construction Contracts.
IAS 18 applies to the following types of revenues:
sale of goods,
rendering of services, and
interest, royalties and dividends.

Revenue is measured as the fair value of the consideration received or receivable (IAS
18.9). If the consideration is to be received over time and provides favorable financing
terms to the buyer, then the cash flows are discounted and the amount of revenue is
calculated based on the discounted value (IAS 18.11). The accounting for these
transactions will be discussed in section 6 of this Module.
Fair value is defined as the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm's length transaction (IAS 39.9).
Sale of Goods
Revenue from the sale of goods shall be recognized when all the following conditions
have been satisfied:
(a)
the entity has transferred to the buyer the significant risks and rewards of
ownership of the goods;
(b)
the entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold;
(c)
the amount of revenue can be measured reliably;
(d)
it is probable that the economic benefits associated with the transaction
will flow to the entity; and
(e)
the costs incurred or to be incurred in respect of the transaction can be
measured reliably (note that this item is also referred to as the matching
principle). (IAS 18.14)
Note that in most cases, i.e. retail sales, the transfer of risks and rewards of ownership
will coincide with the transfer of the legal title or the passing of possession to the buyer.
In some cases, the timing of transfer of title and transfer of risks and rewards of
ownership may not coincide. For example, if the seller holds the legal title to the goods
until payment has been made, then you would still recognize revenue on the day the
buyer takes possession of the goods since the significant risk and rewards of ownership of
the goods has transferred to the buyer.
Page 110
If you retain significant risks of ownership, then the transaction is deemed to not be a sale
and revenues cannot be recognized. The standard provides the following examples where
this could be the case:
when the entity retains an obligation for unsatisfactory performance not covered
by normal warranty provisions;
when the receipt of the revenue from a particular sale is contingent on the
derivation of revenue by the buyer from its sale of the goods;
when the goods are shipped subject to installation and the installation is a
significant part of the contract which has not yet been completed by the
entity; and
when the buyer has the right to rescind the purchase for a reason specified in the
sales contract and the entity is uncertain about the probability of return. (IAS
18.16)
However, if you retain only insignificant risks of ownership, then the transaction is
deemed to be a sale and revenue is recognized.
Example: Green Time Landscaping Inc. (GTL), a residential and commercial landscaping
contractor, is completing its first year of operations. According to the terms of the bank
loan, the audited financial statements must be presented to the bank within 60 days of the
company's year-end. The company's year-end is November 30.
Jill Grasslands, the controller of GTL, is currently completing the year-end financial
statements and is considering alternative methods of recording the annual revenues. The
first year of operations was very successful partly due to the high quality of plant
materials (i.e., trees, shrubs, etc.) used and the one-year guarantee given to all customers.
In addition, the original contract stipulates that GTL must check all plant materials at six
months and one year to ensure they are growing as expected. GTL's terms of payment are
net 30 days after completion of the initial planting.
What factors should Jill Grasslands consider when selecting GTL's revenue recognition
policy? What policy should she adopt based on the facts provided?
Jill Grassland should consider the following factors when selecting a revenue recognition
policy for GTL:
1. Revenue is earned when the vendor has accomplished, or virtually completed,
whatever it must do to be entitled to the revenue. GTL, as a landscaping business,
must plant trees and shrubs and check that they are growing as expected throughout
the following year. The major act of the contract is the planting of the trees and
shrubs. The maintenance is considered minimal, but there is some uncertainty
regarding the "success" of the plantings until the one year guarantee period has
expired. All other significant risks and rewards can be considered to have been
transferred to the customer once planting is completed.
Page 111
2. The amount of consideration to be received for goods and/or services must be

reasonably assured before revenue can be recognized. GTL works on a contract basis
with payment terms specified in the contract. It can be assumed that the amount of
consideration for the goods and services are also stipulated in the contract. Since most
major planting would have been completed by the end of October, the outstanding
amounts should be small by the end of November (i.e., at year end). Any estimate
required for uncollectible amounts should be made based on a review of outstanding
receivables by the reporting deadline.
3. When a "right of return" such as a warranty or guarantee exists, the extent of the
goods that can be expected to be returned will influence revenue recognition.
Warranties and guarantees entail future costs that should be recognized in the
accounts if they can be reasonably estimated.
In the case of GTL, a one-year guarantee on the plants is stipulated in the contract
with customers. Because this is GTL's first year of operations, there will be no past
company experience to draw from in estimating the amount of plants that will have to
be replaced during the guarantee period. GTL should look at industry practices in
estimating the returns. Considering that GTL uses a high quality of plant, it may be
reasonable to assume that returns/ replacements will not be great and that the expense
warranty treatment of accounting for warranty (guarantee) costs would be
appropriate.
Based on the above analysis, it is recommended that all revenue from all contracts that
were signed and completed during the year be recognized at year end and that an
allowance be made for estimated uncollectible accounts and for estimated cost of
replacing plants during the guarantee period.
In the appendix to IAS 18, some additional guidance is provided for some specific
transactions such as:
Bill and Hold Sales. These occur when the delivery of the goods is delayed at the
customer's request but the customer accepts billing and takes title of the goods.
Revenue can be recognized as long as the following criteria are met:
it is probable that delivery will be made,
the item is on hand, identified and ready for deliver to the buyer at the
time the sale is recognized,
the buyer specifically acknowledges the deferred delivery instructions, and
the usual payment terms apply.
Goods subject to Installation and Inspection. Generally, revenue can be

recognized when the goods have been installed and inspected, however if the
installation is simple in nature or if inspection is performed only for purposes of
determining the final contract price, then revenue can be recognized upon the
buyer's acceptance of delivery.
Page 112
Consignment Sales. A consignment is an arrangement whereby the owner of the

product (the consignee) provides the goods to the seller (the consignor) who then
sells the goods on behalf of the consignee. The consignor does not purchase the
goods, therefore these goods are not inventory of the consignor. Upon the sale, the
consignor typically keeps a certain percentage of the sale as a commission and
returns the remainder of the proceeds to the consignee. The revenue is recorded
by the consignee and consignor only when the goods are sold to the ultimate
consumer.
Lay away sales. These occur whenever delivery of the product takes place only
when the buyer makes the final payment in a series of installments. Generally
revenue is recorded when the last payment is made. However, if experience shows
that most lay away sales are taken to term, revenue may be recognized when a
significant deposit is received so long as the goods are on hand, identified and
ready for deliver to the buyer.
Orders when payment, or partial payment, is received in advance of delivery.

Recognize the cash received as deferred revenues and recognize revenues when
the goods are delivered to the buyer.
Subscriptions to publications and similar items. If the items involved are of

similar value, revenue is recognized on a straight-line basis. If not, revenue is
recognized on the basis of the sales value of the items dispatched in relation to the
total estimated sales value of all items covered by the subscription.
Installment Sales. Installment sales are sales whereby the customer pays the sales
consideration in installments over time. The sales price is determined by
discounting the cash flows. The mechanics of this process will be discussed in
Section 6 of this module - Notes Receivable/Payable.
Rendering of Services
Service revenue is to be recognized on the percentage of completion basis if the
following conditions are present:
the amount of revenue can be measured reliably;
it is probable that the economic benefits associated with the transaction will flow
to the entity;
the stage of completion of the transaction at the balance sheet date can be
measured reliably; and
the costs incurred for the transaction and the costs to complete the transaction can
be measured reliably. (IAS 18.20)
The last two items relate to long-term service contracts. The method referred to is called
the percentage of completion method and will be explained in more details later in this
section under 'Construction Contracts'.
Page 113
When the outcome of the transaction involving the rendering of services cannot be
estimated reliably, revenue shall be recognized only to the extent of the expenses
recognized that are recoverable. (IAS 18.26)
For example, say you sign a $500,000 three year contract to provide a service to one of
your clients. Because you cannot estimate the costs to complete the transaction at the end
of the first year, then the outcome of the transaction cannot be estimated reliably.
Assuming you incurred $75,000 of costs on this contract, then the amount of revenue you
could recognize in the first year is $75,000. As the outcome of the transaction cannot be
estimated reliably, no profit can be recognized. If you received $100,000 from your client
on this contract in the first year, you would then also record unearned revenues of
$25,000 on the Statement of Financial Position.
In the appendix to IAS 18, some additional guidance is provided for some specific
transactions:
Service fees included in the price of the product. If the selling price includes an
identifiable amount that relates to servicing the product over a period of time, then
that amount should be deferred and amortized over the time of the service
contract.
Advertising Commissions. Recognize only when the related advertisement appears

before the public. Production commissions are recognized in relation to the stage
of completion of the project.
Insurance Agency Commissions. If no further work is required on behalf of the

agent, the commission can be recognized as revenue on the
commencement/renewal date of the policy. If further work is required, then the
amount is deferred over the period which the work is performed.
Franchise Fees
-
supplies of equipment and other tangible assets: recognize revenue when

the items are delivered or title passes.
supplies of initial and subsequent services: the typical franchise agreement

calls for a franchise fee, usually to be paid up front but sometimes paid
over a number of years. Over the life of the franchise, the franchisee
usually agrees to pay a certain percentage of revenues to the franchisor.
For example, a restaurant franchise agreement may ask the franchisee to
pay $50,000 up front plus 6% of revenues - 4% royalty and 2% common
advertising pool. In exchange for this, the franchisor agrees to support the
franchisee on an ongoing basis. The issue is how to recognize the initial
franchise fee of $50,000 as revenue. The franchisor needs to determine the
Page 114
portion of the franchise fee that relates to continuing service and accrue
this portion over the period of time the services are provided.
-
continuing franchise fees - these are recognized as revenues as the services

are provided
Interest, royalties and dividends

The criteria for recognizing interest, royalties and dividends are:
it is probable that the economic benefits associated with the transaction will flow
to the entity; and
the amount of the revenue can be measured reliably. (IAS 18.29)

The bases for recognizing revenues are:
for interest using the effective interest method,
for royalties accrual basis in accordance with the substance of the relevant
agreement, and
for dividends when the right to receive payment is established (typically when
the dividends have been declared). (IAS 18.30)
Disclosure
The accounting policies adopted for the recognition of revenue, including the methods
adopted to determine the stage of completion of transactions involving the rendering of
services have to be disclosed in the notes to the financial statements. (IAS 18.35a)
The following revenue items have to be separately disclosed:
the sale of goods,
the rendering of services,
interest,
royalties,
dividends. (IAS 18.35b)
Page 115
Construction Contracts (IAS 11)

Accounting for construction contracts requires the use of the percentage of completion
method. The completed contract method is no longer acceptable.
There are two types of contracts: fixed price and cost plus. The measures of the outcome
(i.e. revenue recognition criteria) vary depending whether we are dealing with a fixed
price or a cost plus contract.
In the case of a fixed price contract, the outcome of a construction contract can be
estimated reliably when all the following conditions are satisfied:
(a)
total contract revenue can be measured reliably;
(b)
it is probable that the economic benefits associated with the contract will
flow to the entity;
(c)
both the contract costs to complete the contract and the stage of contract
completion at the balance sheet date can be measured reliably; and
(d)
the contract costs attributable to the contract can be clearly identified and
measured reliably so that actual contract costs incurred can be compared
with prior estimates. (IAS 11.23)
In the case of a cost plus contract, the outcome of a construction contract can be
estimated reliably when all the following conditions are satisfied:
(a)
it is probable that the economic benefits associated with the contract will
flow to the entity; and
(b)
the contract costs attributable to the contract, whether or not specifically
reimbursable, can be clearly identified and measured reliably. (IAS 11.24)
When the outcome of a construction contract cannot be estimated reliably:
(a)
revenue shall be recognized only to the extent of contract costs incurred
that it is probable will be recoverable; and
(b)
contract costs shall be recognized as an expense in the period in which they
are incurred. (IAS 11.32)
During the early stages of a contract it is often the case that the outcome of the contract
cannot be estimated reliably. Nevertheless, it may be probable that the entity will recover
the contract costs incurred. Therefore, contract revenue is recognized only to the extent of
costs incurred that are expected to be recoverable. As the outcome of the contract cannot
be estimated reliably, no profit is recognized.
Page 116
Application of the Percentage of Completion Method
actual construction costs incurred are accumulated in a construction-in-progress

(an inventory account);
accounts receivable is debited and a billings account is credited for progress
billings; the billings account is a contra-account to the construction-in-progress
account;
at year-end, the percentage of completion is determined:
% Completion = Total costs incurred to date Total estimated project costs
the revenue to be recognized on the contract is the total contract revenue
multiplied by the percentage of completion LESS any revenues recognized on the
contract in previous years;
the costs to be recognized on the contract are equal to the costs incurred to date
LESS any costs recognized on the contract in previous years;
any profit on the contract is debited to the construction-in-progress account;
at the end of the contract, the sum of the debits in the construction-in-progress
account should equal to the sum of the credits in the billings account. Both are
then removed from the accounts
When it is known that a loss will be incurred, the loss is considered to be a change in
accounting estimate and will be accrued in the period the loss becomes known.
Example: Assume that the Greenbank Construction Company was contracted to build a
roadway for a local municipality. The contract value is $6,000,000 and is expected to be
completed within three years. Data related to the contract are summarized as follows (all
amounts in '000s)
Costs incurred during the year

Expected additional costs to complete
Billings during the year
Cash collections during the year
20x1
$1,560
3,640
1,400
1,200
20x2
$2,340
1,600
3,000
2,500
20x3
$1,700
1,600
1,900
At the end of year 20x1, the percentage of completion is:

Costs incurred to date / Total expected project costs
= $1,560 / ($1,560 + $3,640)
= $1,560 / 5,200
= 30%
The amounts of revenues and expenses that can be recognized on this project in 20x1 are
as follows:
Revenues: $6,000 x 30%
$1,800
Costs
1,560
Profit
$240
Page 117
Journal entries in 20x1 would be as follows:

Construction-in-progress
Cash, accounts payable,
$1,560
$1,560
Accounts Receivable
Billings
1,400
Cash
Accounts Receivable
1,200
Cost of goods sold

Revenues
1,560
240
1,400
1,200
1,800
At the end of year 20x2, the percentage of completion is:

Costs incurred to date / Total expected project costs
= ($1,560 + 2,340) / ($1,560 + $2,340 + $1,600)
= $3,900 / 5,500
= 71%
as follows:
Less Amounts Amount to be
Previously recognized in
20x2
Recognized
Revenues: $6,000 x 71%
$4,260
$1,800
$2,460
Cost of goods sold
3,900
1,560
2,340
Profit
$360
$240
$120
Page 118

$2,340
$2,340
Accounts Receivable
Billings
3,000
Cash
Accounts Receivable
2,500
Cost of goods sold

Revenues
2,340
120
3,000
2,500
2,460
At the end of year 20x3, the percentage of completion is obviously 100% since the
project is complete.
as follows:
Less Amounts Amount to be
Previously recognized in
Recognized
20x2
Revenues: $6,000 x 100%
$6,000
$4,260
$1,740
Cost of goods sold
5,600
3,900
1,700
Profit
$400
$360
$40

$1,700
$1,700
Accounts Receivable
Billings
1,600
Cash
Accounts Receivable
1,900
Cost of goods sold

Revenues
1,700
40
1,600
1,900
1,740
The following T-accounts summarize the journal entries (entries to cash, accounts
payable, etc have been ignored):
Page 119
Construction-in-Progress
(x1)
1,560
(x1)
240
(x2)
2,340
(x2)
120
(x3)
1,700
(x3)
40
Bal
Billings
1,400
3,000
1,600
(x1)
(x2)
(x3)
(x1)
(x2)
(x3)
6,000
Bal
Bal
Accounts Receivable
1,400 1,200
(x1)
3,000 2,500
(x2)
1,600 1,900
(x3)
400
6,000
Revenue
1,800
2,460
1,740
(x1)
(x2)
(x3)
(x1)
(x2)
(x3)
Cost of Goods Sold

1,560
2,340
1,700
A few things to note:
at the end of 20x3, the debit in construction-in-progress is equal to the credit in

the billings account. These two accounts are then closed out.
the $400 accounts receivable represents the billings not yet collected
the revenue and cost of goods sold accounts would get closed off to Retained
Earnings at the end of each year
Losses on Long-Term Contracts

There are two types of losses that can occur on long-term contracts:
1.
The contract is profitable, but there is a loss in the current year. This happens
when the income recognized in previous periods exceeds the income that should
have been recognized to date. Such a loss should get recorded in the current
period.
2.
The contract as a whole is unprofitable. Such a loss will occur due to an

unexpected increase in costs. The entire loss on the contract must be recognized in
the year such a loss can be estimated. For example, if in 20x2, we estimated that
the additional costs to complete the project would be $2,600, this would imply
that an estimated project loss of $500. This loss would have to be absorbed in
20x2. However, we must take into account that a profit was recorded on this
contract in 20x1 of $240. In order to show an overall loss on the contract of $500,
a loss of $740 ($500 + $240) would have to be recorded in 20x2.
Page 120

1.
Gow Constructors, Inc. has consistently used the percentage-of-completion method

of recognizing income. In 20x5, Gow started work on an $18,000,000 construction
contract that will be completed in 20x7. The following information was taken from
Gow's 20x5 accounting records:
Progress billings
$6,600,000
Costs incurred
5,400,000
Collections
4,200,000
Estimated costs to complete
10,800,000
What amount of gross profit should Gow have recognized in 20x5 on this contract?
a) $1,400,000
b) $1,200,000
c) $ 900,000
d) $ 600,000
2.
Carson Construction Co. uses the percentage-of-completion method. In 20x2,

Carson began work on a contract for $1,650,000 and it was completed in 20x3.
Data on the costs are:
Year Ended December 31
20x2
20x3
Costs incurred
$585,000
$420,000
390,000
For the years 20x2 and 20x3, Carson should recognize gross profit of
a)
b)
c)
d)
Page 121
20x2
$
$387,000
$405,000
$405,000
20x3
$645,000
$258,000
$240,000
$645,000
3.
The Gerard Construction Company entered into a long-term construction contract

on January 2, 20x3 for a total contract price of $20,000,000. Project data for the
first three years of the project are as follows:
Costs incurred to date

20x3
$3,300,000
14,700,000
20x4
$7,800,000
11,700,000
20x5
$14,600,000
6,900,000
What amount of gain / loss will be recognized on this contract for the year ended
December 31, 20x5?
a) $818,605 Gain
b) $0
c) $1,300,000 Loss
d) $1,500,000 Loss
e) $1,700,000 Loss
4.
An independent automobile dealer acts as an agent for an automobile manufacturer

on a non-consignment basis. The automobile manufacturer should normally
recognize revenue when
a) an order for an automobile is received from the dealer.
b) an automobile comes off the assembly line.
c) an automobile is shipped to the dealer.
d) an automobile is picked up by the consumer from the dealer.
e) payment is received from the dealer.
5.
Bella Construction Co. uses the percentage-of-completion method. In 20x1, Bella

began work on a contract for $2,200,000; it was completed in 20x2. The following
cost data pertain to this contract:
Costs incurred during the year

Estimated costs to complete at the of year
Year ended December 31

20x2
20x1
$780,000
$560,000
520,000
--
The amount of gross profit to be recognized on the income statement for the year
ended December 31, 20x2 is
a) $320,000
b) $344,000
c) $360,000
d) $860,000
Page 122
Problem 1
Newcastle Health and Racquet Club (NHRC), which operates eight clubs in the Calgary
metropolitan area, offers one-year memberships. The members may use any of the eight
facilities but must reserve racquetball court time and pay a separate fee before using the
court. As an incentive to new customers, NHRC advertised that any customers not
satisfied for any reason could receive a refund of the remaining portion of unused
membership fees. Membership fees are due at the beginning of the individual
membership period; however, customers are given the option of financing the
membership fee over the membership period at a 15 percent interest rate.
Some customers have expressed a desire to take only the regularly scheduled aerobic
classes without paying for a full membership. During the current fiscal year, NHRC
began selling coupon books for aerobic classes only to accommodate these customers.
Each book is dated and contains 50 coupons that may be redeemed for any regularly
scheduled aerobic class over a one-year period. After the one-year period, unused
coupons are no longer valid.
During 20x0, NHRC expanded into the health equipment market by purchasing a local
company that manufactures rowing machines and cross-country ski machines. These
machines are used in NHRC's facilities and are sold through the clubs and mail order
catalogs. Customers must make a 20 percent down payment when placing an equipment
order; delivery is 60-90 days after order placement. The machines are sold with a twoyear unconditional guarantee. Based on past experience, NHRC expects the costs to
repair machines under guarantee to be 4 percent of sales.
NHRC is in the process of preparing financial statements as of May 31, 20x6, the end of
its fiscal year. James Hogan, corporate controller, expressed concern over the company's
performance for the year and decided to review the preliminary financial statements
prepared by Barbara Sullens, NHRC's assistant controller. After reviewing the
statements, Hogan proposed that the following changes be reflected in the May 31, 20x6,
published financial statements.
Membership revenue should be recognized when the membership fee is collected.
Revenue from the coupon books should be recognized when the books are sold.
Down payments on equipment purchases and expenses associated with the guarantee
on the rowing and cross-country machines should be recognized when paid.
Sullens indicated to Hogan that the proposed changes are not in accordance with
generally accepted accounting principles, but Hogan insisted that the changes be made.
Sullens believes that Hogan wants to manipulate income to forestall any potential
financial problems and increase his year-end bonus. At this point, Sullens is unsure what
action to take.
Page 123
Required A. 1. Describe when Newcastle Health and Racquet Club (NHRC) should recognize
revenue from membership fees, court rentals, and coupon book sales.
2. Describe how NHRC should account for the down payments on equipment sales,
explaining when this revenue should be recognized.
3. Indicate when NHRC should recognize the expense associated with the guarantee
of the rowing and cross-country machines.
B. Discuss why James Hogan's insistence that the financial statement changes be made
is unethical.
C. Identify all of the specific steps Barbara Sullens should take to resolve the situation
described above.
Problem 2
On April 1, 20x0, Butler, Inc., entered into a cost-plus-fixed-fee contract to construct an
electric generator for Dalton Corporation. At the contract date, Butler estimated that it
would take two years to complete the project, at a cost of $2 million. The fixed fee
stipulated in the contract is $300,000. Butler appropriately accounts for this contract
under the percentage-of completion method. During 20x0 Butler incurred costs of
$700,000 related to the project, and the estimated cost at December 31, 20x0, to complete
the contract is $1.4 million. Dalton was billed $500,000 under the contract and remitted
$300,000 to Butler.
Required 1.
2.
Prepare a schedule to compute the amount of gross profit to be recognized by

Butler under the contract for the year ended December 31, 20x0. Show supporting
computations in good form.
Prepare Butler's journal entries for the above data.
Page 124
Problem 3
The Rushmore Company obtained a construction contract to build a highway. It was
estimated at the beginning of the contract that it would take 3 years to complete the
project at an expected cost of $50 million. The contract price was $60 million. The
project actually took 4 years to complete. The following information describes the status
of the job at the close of production each year:
Actual Costs Incurred
Estimated Costs to Complete
Collections on Contract
Billings on Contract
20x1
$12,000,000
38,000,000
12,000,000
13,000,000
20x2
$18,160,000
27,840,000
13,500,000
15,500,000
20x3
$14,840,000
10,555,555
15,000,000
17,000,000
20x4
$10,000,000
15,000,000
14,500,000
20x5
$4,500,000
-
Required (a)
(b)
Using the percentage-of-completion method, calculate the estimated gross profit

(loss) to be recognized in the years 20x1 to 20x4.
Prepare all journal entries for the years 20x1 to 20x5 relative to this contract.
Problem 4
On February 1, 20x1, Dandan Inc. obtained a contract to build an athletic stadium. The
stadium was to be built at a total cost of $5.4 million and was scheduled for completion
by September 1, 20x4. Contract price was $6.6 million. Below are the data pertaining to
the construction period.
Costs to date
Progress billings to date
Cash collected to date
20x1
$1,782,000
3,618,000
1,200,000
1,000,000
20x2
$3,850,000
2,650,000
3,100,000
2,800,000
20x3
$6,300,000
900,000
5,000,000
4,500,000
Required (a)
(b)
(c)
Using the percentage-of-completion method, calculate the estimated gross profit

recognized in the years 20x1 to 20x3.
Prepare all journal entries for the years 20x1 to 20x3 relative to this contract.
Prepare a partial Statement of Financial Position for December 31, 20x2, showing
the balances in the receivable and inventory accounts.
Page 125
Problem 5
The board of directors of Jaworski Construction Company is meeting to choose between
the completed-contract method and the percentage-of-completion method of accounting
for long-term contracts in the company's financial statements. You have been engaged to
assist Jaworski's controller in the preparation of a presentation to be given at the board
meeting. The controller provides you with the following information:
a) Jaworski commenced doing business on January 1, 20x2.
b) Construction activities for the year ended December 31, 20x2, were as follows:
PROJECT
A
B
C
D
E
TOTAL CONTRACT
PRICE
$ 520,000
670,000
475,000
200,000
460,000
$2,325,000
PROJECT
A
B
C
D
E
BILLINGS THROUGH
12/31/x2
$ 350,000
210,000
475,000
70,000
400,000
$1,505,000
CONTRACT COSTS
INCURRED THROUGH
12/31/x2
$ 424,000
126,000
315,000
112,750
370,000
$1,347,750
CASH COLLECTIONS
THROUGH 12/31/x2
$310,000
210,000
395,000
50,000
400,000
$1,365,000
ESTIMATED
ADDITIONAL COSTS
TO COMPLETE CONTRACTS
$106,000
504,000
-092,250
30,000
$732,250
c) Each contract is with a different customer.

d) Any work remaining to be done on the contracts is expected to be completed in 20x3.
Required (a)
Prepare a schedule by project, computing the amount of income (or loss) before
selling, general, and administrative expenses for the year ended December 31,
20x2, which would be reported under the percentage-of-completion method.
Page 126
(b)
For each numbered space on the statement of financial position below, supply the
correct balance (indicating DR or CR as appropriate). Disregard income taxes.
Jaworski Construction Company
Assets
Cash
Accounts (contracts) receivable
Costs and estimated earnings in excess of billings on uncompleted contracts
Tangible capital assets, net
Other assets
$xx
1
2
xx
xx
$xx

Billings in excess of costs and estimated earnings on uncompleted contracts
Notes payable
Common shares
Retained earnings
$xx
3
xx
xx
xx
$xx
Page 127
SOLUTIONS
1.
Costs incurred
$ 5,400,000
10,800,000
Estimated total project costs
$16,200,000
Percentage complete $5,400,000 / 16,200,000
2.
3.
4.
5.
Page 128
33 1/3%
Total project revenue

Estimated total project costs
Estimated total project gross profit
$18,000,000
16,200,000
1,800,000
Amount to recognize in 20x5 - 33 1/3%
600,000
20x2 % of completion: $585,000 / (585,000 + 390,000) = 60%

Gross profit to be recognized in 20x2:
($1,650,000 585,000 390,000) x 60% = $405,000
20x3: Total profit = $1,650,000 585,000 420,000 = $645,000
Gross profit to be recognized in 2003: $645,000 405,000 = $240,000
Gross profit recognized to the end of 20x4:
% completion = 7,800 / 19,500 = 40%
$500,000 x 40% = $200,000
Expected contract loss at end of 20x5 = $1,500,000
Loss to be recognized in 20x5 - $1,500,000 + 200,000 = $1,700,000
2001 % Completion = 780 / (780 + 520) = 780 / 1,300 = 60%

Gross profit recognized in 2001 = 2,200 1,300 = 900 x 60% = $540
Gross profit recognized in 2002 = $2,200 1,340 540 = $320
Problem 1
A. 1. NHRC should recognize revenue on the following bases.
The membership fees, which are paid in advance and sold with a money-back
guarantee, should be recognized as revenue over the life of the membership.
Each month, NHRC earns one-twelfth of the revenue. This results in a liability
for the unearned and potentially refundable portion of the fee. For those
membership fees that are financed, interest is recognized as time passes at the
rate of 15 percent per annum.
Court rental fees should be recorded as revenue as the members use the courts.
Revenue from the sale of coupon books should be recorded when the coupons
are redeemed, i.e., when members attend aerobics classes. At year-end, an
adjustment should be made to recognize the revenue from the unused coupons
that have expired.
2. Since NHRC has not provided any service when the down payment for equipment
is received, the down payment should be treated as a current liability until
delivery of the equipment is made.
3. Since NHRC expects to incur costs under the guarantee and these costs can be
estimated, an amount equal to 4 percent of the total revenue should be accrued in
the accounting period in which the sale is recorded.
B. By insisting that the financial statement changes be made, James Hogan has violated
the following ethical standards:
Competence
Hogan has an obligation (1) to perform his professional duties in accordance with
relevant technical standards and (2) to prepare complete and clear reports after
appropriate analyses of relevant and reliable information. Hogan's proposed
changes to the financial statements are not in accordance with generally accepted
accounting principles and, therefore, will not result in clear reports based on
reliable information.
Page 129
Confidentiality
Hogan has an obligation to refrain from using or appearing to use confidential
information acquired in the course of his work for unethical personal advantage.
If Hogan is proposing the accounting changes to increase his year-end bonus, as
Sullens believes, he has misused confidential information.
Integrity
By insisting on making the adjustments to the financial statements to cover up
unfavorable information and increase his bonus, Hogan has (1) failed to avoid a
conflict of interest, (2) prejudiced his ability to carry out his duties ethically, (3)
subverted the attainment of the organization's legitimate and ethical objectives,
(4) failed to communicate unfavorable as well as favorable information, and (5)
engaged in an activity that discredits his profession.
Objectivity
Hogan's proposals do not communicate information fairly and objectively nor will
they disclose all relevant information that could reasonably be expected to
influence an intended user's understanding of the financial statements.
C. Barbara Sullens may wish to speak to Hogan again regarding the GAAP violations to
ensure that she understands his position. In order to resolve the situation, Sullens
should follow the policies established by NHRC for the resolution of ethical conflicts.
If the company does not have such a policy or the policy does not resolve the conflict,
Sullens should consider the following course of action:
Since her immediate supervisor is involved in the situation, Sullens should take
the issue to the next higher managerial level. Sullens need not inform Hogan of
this step because of his involvement.
If there is no resolution, Sullens should continue to present the problem to

successively higher levels of internal review, i.e., audit committee, Board of
Directors.
Sullens should have a confidential discussion of her options with an objective

advisor to obtain a clearer understanding of possible courses of action.
After exhausting all levels of internal review without resolution, Sullens may have
no other recourse than to resign her position. Upon doing so, she should submit an
informative memorandum to an appropriate representative of the organization.
Sullens should not communicate with individuals outside of the organization

about this situation unless legally prescribed to do so.
Page 130
Problem 2
1.
Estimated contract cost at completion ($700,000 + $1,400,000)

Fixed fee
Total contract price
Total estimated cost
Gross profit
Percentage-of-completion ($700,000 / $2,100,000)
Gross profit to be recognized ($300,000 x 33-1/3%)
2.
$ 2,100,000
300,000
$ 2,400,000
(2,100,000)
$ 300,000
33-1/3%
$ 100,000
Miscellaneous credits
To record costs incurred.
700,000
Accounts receivable
Billings on contract
To record billings.
500,000
Cash
Accounts receivable
To record collections.
300,000
Construction income
To record construction income.
100,000
700,000
500,000
300,000
100,000
Alternatively, the above entry could be recorded gross:

Costs of construction revenue
Construction revenue
Page 131
100,000
700,000
800,000
Problem 3
(a)
(b)
20x1
% of completion = $12,000,000 / (12,000,000 + 38,000,000) = 24%

Expected total contract profit = $60,000,000 - 50,000,000 = $10,000,000
Profit recognized in 20x1 = $10,000,000 x 24% = $2,400,000
20x2
% of completion = $30,160,000 / (30,160,000 + 27,840,000)

= $30,160,000 / 58,000,000 = 52%
Cumulative profit to be recognized to end of 20x2
= $2,000,000 x 52% = $1,040,000
Loss to be recognized in 20x2 = $1,040,000
- 2,400,000 Cumulative Profit to end of 20x2 = ($1,360,000)
20x3
% of completion = $45,000,000 / (45,000,000 + 10,555,555)

= $45,000,000 / 55,555,555 = 81%
Cumulative profit to be recognized to end of 20x3
= $4,444,445 x 81% = $3,600,000
Profit to be recognized in 20x3 = $3,600,000
- 1,040,000 Cumulative Profit to end of 20x2 = $2,560,000
20x4
% of completion = 100%
Actual total contract profit = $60,000,000 - 55,000,000 = $5,000,000
Profit to be recognized in 20x3 = $5,000,000
- 3,600,000 Cumulative Profit to end of 20x3 = $1,400,000
20x1
Construction in Process
Cash, Accounts Payable,
$12,000,000
$12,000,000
Accounts Receivable
Billings
13,000,000
Cash
Accounts Receivable
12,000,000
Cost of construction
Revenue
12,000,000
2,400,000
13,000,000
12,000,000
14,400,000
Revenue = $60,000,000 x 24% = $14,400,000

Cost of construction = $50,000,000 x 24% = 12,000,000
Page 132
20x2
18,160,000
Accounts Receivable
Billings
15,500,000
Cash
Accounts Receivable
13,500,000
Revenue
18,160,000
18,160,000
15,500,000
13,500,000
1,360,000
16,800,000
Revenue = $60,000,000 x 52%

= $31,200,000 - 14,400,000 Recognized in 20x1
= $16,800,000
Cost of construction = $58,000,000 x 52%
= $30,160,000- 12,000,000 Recognized in 20x1
= $18,160,000
20x3
14,840,000
Accounts Receivable
Billings
17,000,000
Cash
Accounts Receivable
15,000,000
Revenue
14,840,000
2,560,000
14,840,000
17,000,000
15,000,0000
17,400,000
Revenue = $60,000,000 x 81%

= $48,600,000 - 14,400,000 Recognized in 20x1 - 16,800,000 Recognized in 20x2
= $17,400,000
= $45,000,000 - 12,000,000 Recognized in 20x1 - 18,160,000 Recognized in 20x2
= $14,840,000
Page 133
20x4
10,000,000
Accounts Receivable
Billings
14,500,000
Cash
Accounts Receivable
15,000,000
Revenue
10,000,000
1,400,000
10,000,000
14,500,000
15,000,0000
11,400,000
Revenue = $60,000,000 - 14,400,000 Recognized in 20x1

- 16,800,000 Recognized in 20x2 - 17,400,000 Recognized in 20x3
= $11,400,000
Cost of construction = $55,000,000 - 12,000,000 Recognized in 20x1
- 18,160,000 Recognized in 20x2 - 14,840,000 Recognized in 20x2
= $10,000,000
20x5
Page 134
Cash
Accounts Receivable
4,500,000
4,500,000
Problem 4
(a)
20x1: % of completion: 1,782 / (1,782 + 3,618) = 33%

Gross profit to recognize: $6,600 - 5,400 = 1,200 x 33% = $396
20x2: % of completion: 3,850 / (3,850 + 2,650) = 59%
Gross profit to recognize to date: $6,600 - 6,500 = 100 x 59% = $59
Loss to recognize in 20x2: $396 - 59 = $337
20x3: Expected contract loss of $600
Loss to recognize in 20x3: $59 + 600 = $659
% of completion = $6,300 / (6,300 + 900) = 87.5%
(b)
20x1
$1,782,000
$1,782,000
Accounts Receivable
Billings
1,200,000
Cash
Accounts Receivable
1,000,000
Revenue
1,782,000
396,000
1,200,000
1,000,000
2,178,000
Revenue = $6,600,000 x 33% = $2,178,000

Cost of construction = $5,400,000 x 33% = 1,782,000
20x2
Page 135
2,068,000
Accounts Receivable
Billings
1,900,000
Cash
Accounts Receivable
1,800,000
Revenue
1,716,000
2,068,000
1,900,000
1,800,000
337,000
2,053,000
Revenue = $6,600,000 x 59% = 3,894,000 - 2,178,000 Recognized in 20x1

= 1,716,000
= 3,835,000 - 1,782,000 Recognized in 20x1 = 2,053,000
20x3
2,450,000
Accounts Receivable
Billings
1,900,000
Cash
Accounts Receivable
1,700,000
Revenue
2,540,000
2,450,000
1,900,000
1,700,000
659,000
1,881,000
Revenue = $6,600,000 x 87.5% = 5,775,000 - 2,178,000 Recognized in 20x1

- 1,716,000 Recognized in 20x2 = $1,881,000
Cost of construction = $1,881,000 + 659,000 Loss to be recognized in 20x2
= $2,540,000
(c)
Dandan Inc.
Partial Statement of Financial Position
As at December 31, 20x2
20x1
20x2
20x3
$1,782,000
396,000
-1,200,000
$ 978,000
$3,850,000
59,000
-3,100,000
$ 809,000
$6,300,000
-600,000
-5,000,000
$ 700,000
$200,000
$300,000
$500,000
Current Assets Construction in progress

Costs to date
Profits/loss
Less billings
Accounts receivable
Page 136
Problem 5
(a)
Project
A
B
C
D
E
Revenue to
be Reported
(Schedule 1)
Costs
Incurred
$416,000
134,000
475,000
110,000
425,500
$1,560,500
$424,000
126,000
315,000
112,750
370,000
$1,347,750
Income (Loss)
to be
Reported
$(10,000) *
8,000
160,000
(5,000) **
55,500
$208,500
*$520,000 - $530,000.
**$200,000 - $205,000.
Schedule 1
Project
A
$424,000
$530,000
x $520,000 =
$416,000
$126,000
$630,000
x $670,000 =
134,000
$315,000
$315,000
x $475,000 =
475,000
$112,750
$205,000
x $200,000 =
110,000
$370,000
$400,000
x $460,000 =
425,500
$1,560,500
Page 137
(b)
1 - total billings of $1,505,000 less cash collections of $1,365,000 = $140,000

2 - $127,250 - see Schedule 2
3 - $76,000 - see Schedule 2
Schedule 2
Project
A
B
D
E
Page 138
Costs
and Estimated
Earnings or
Losses
$414,000
134,000
107,750
425,500
$1,081,250
Related
Billings
$350,000
210,000
70,000
400,000
$1,030,000
Costs and
Estimated Earnings in
Excess of Billings
Billings in Excess
Estimated Earnings
$ 64,000
$76,000
37,750
25,500
$127,250
$76,000
4.
Cash
Petty Cash
Most companies have a petty cash account for small-dollar purchases and transactions.
Imprest petty cash funds provide a means of paying for small expenditures and purchases
evidenced by vouchers or receipts. The size of the fund is limited to relatively small
amounts in relation to the size of the organization. The amount is determined by how
often the fund is to be replenished, the estimated number of transactions per period, and
the average expenditure. The fund is established with a fixed sum and periodically
replenished based upon an approved request by the person responsible for administering
the fund. The request to bring the fund back to its authorized cash balance is supported by
signed vouchers or receipts, which provide control.
As an example, assume that Rizzo Industries establishes a petty cash fund for $200 on
October 1, 20x8, and makes the following disbursements out of the fund during October:
Supplies
Postage stamps
Delivery charges
$ 40
29
100
$169
The journal entries to establish the fund and, subsequently, to replenish it are as follows:
Oct 1, 20x8
Oct 31, 20x8
Page 139
Petty Cash
Cash
Supplies expense
Postage expense
Delivery expense
Cash
$200
$200
40
29
100
169
Bank Statement Reconciliation

Each month a bank statement is typically sent to depositors of demand accounts. Upon its
receipt, a bank reconciliation of the differences (if any) between the cash balance as
shown by the bank and the cash balance reflected on the books of the organization should
be made. For most organizations the Cash account has more activity than any other
account, making the reconciliation process extremely important, since it helps maintain
control of cash.
The proper method of reconciliation is to bring both balances up to date, reflecting the
correct cash amount, a point at which the book balance and bank balance should be the
same. This method highlights the adjustments required to bring the book balance to the
true cash position at the date of reconciliation. The book balance also could be reconciled
to the bank balance or the bank to the books. Neither of these procedures, however, will
provide the correct cash balance at the financial statement date.
The following example illustrates a bank reconciliation in which both the bank balance
and the book balance are brought to the true cash-available position. To adjust the bank
balance, any cheques outstanding are deducted and deposits in transit added. Any errors
made by the bank also must be corrected. The most frequent adjustments to the book
balance are for bank service charges, interest earned on the account, errors made in the
books, and cheques returned by the bank as nonsufficient funds (NSF) checks. These are
customer cheques deposited in an account that have been returned to the depositor's bank
because they failed to clear the customer's bank. Note that any correction to the book
balance requires an adjusting entry to correct the Cash account. Any adjustments to the
bank balance will be made by the bank and do not require adjusting entries on the
company books.
Example : You have been asked to calculate the balance in the Cash account of Tender
Footsies Ltd. as at December 31, 20x4, and have been supplied with the following data:
A bank statement dated January 31, 20x5, was found with an opening balance on January
1, 20x5, of $12,000 and a closing balance of $15,598. The canceled cheques returned
totaled $18,227: $1,888 were dated November 20x5; $13,429, December 20x5; and
$2,910, January 20x5. All cheques issued prior to January 20x5 had been cashed by the
end of January 20x5. Deposits totaled $32,940 and included: a 30-day promissory note
due January 15, 20x5, for $200 plus $26 of interest; a deposit dated December 31, 20x4,
for $1,080 relating to accounts collected on that day; and a $500 credit to correct a bank
error which occurred in December 20x4. The bank statement also showed one debit,
dated January 2, 20x5, for $11,115 which represented the last payment of a bank loan
including $115 of interest, and another debit for $8 which represented January's bank
charges. None of these amounts had yet been entered in the books of Tender Footsies.
Page 140
The bank reconciliation as at December 31, 20x4 would be as follows:

Cash in bank, December 31, 20x4
Less outstanding cheques:
November
December
Add outstanding deposit
Add bank error
Cash per books, December 31, 20x4
Page 141
$12,000
$ 1,888
13,429
-15,317
1,080
500
$ -1,737

1.
In preparing its August 31, 20x5, bank reconciliation, Apex Corp. has available the
following information:
Balance per bank statement, Aug 31, 20x5
Deposit in transit, Aug 31, 20x5
Return of customer's check for insufficient funds, Aug 31, 20x5
Outstanding cheques, Aug 31, 20x5
Bank service charges for August
$18,050
3,250
600
2,750
100
At August 31, 1995, Apex's correct cash balance is

a) $18,550
b) $17,950
c) $17,850
d) $17,550
2.
Mork, Ltd. had the following bank reconciliation at July 31, 20x6:
Balance per bank statement, July 31, 20x6
Add: Deposit in Transit
Less: Outstanding cheques
Balance per books, July 31, 20x6
$37,200
10,300
(12,600)
$34,900
Data per bank for the month of August 20x6 was as follows:
Deposits
Disbursements
$47,700
49,700
All reconciling items at July 31, 20x6 cleared the bank in August. Outstanding
cheques at August 31, 20x6 totalled $5,000. There were no deposits in transit at
August 31, 20x6. What is the cash balance per books at August 31, 20x6?
a) $30,200
b) $32,900
c) $35,200
d) $40,500
Page 142
Problem 1
In comparing the monthly bank statement for J.B. Enterprises with the cash ledger, the
following items were found to reconcile the difference:
1) Bank service charge of $8.
2) Cheque #0178 written in payment to a supplier for $175 was inadvertently recorded
in the ledger at $157.
3) Three cheques written in the month had not yet cleared the bank. The total amount
was $448.
4) The deposit made on the last day of the month for $2,650 was not included on the
bank statement.
5) The bank collected a note for $980 which included $80 interest for J.B. Enterprises.
6) A cheque written by J.B. Holdings, a sister company, had been charged against this
bank account in the amount of $320.
7) A customer cheque was returned N.S.F. with the bank statement. The cheque had
been made out for $28. There was a $5 fee charged by the bank for this.
Required a) Prepare a journal entry to record each of the reconciling items where necessary in
J.B.'s books. Also indicate where no entry is required.
b) If the cash ledger had an unadjusted ending balance of $6,161, what was the ending
balance per the bank statement?
c) Briefly explain why it is necessary to do a bank reconciliation upon receipt of the
bank statement.
Page 143
Problem 2
The following information for the month of December 20x6, with respect to cash
activities, was gathered by Tressa Ltd.s bookkeeper.
Cash balance per books, December 1
Cash received during December
Cash payments made during December
Cash balance per bank statement, December 31
Cheques outstanding, December 31
Bank service charges for December
Deposits in transit at December 31
Cheque issued by Sparg Ltd. deducted from Tressas
account in error by the bank
A $1,200 cheque received from a customer on December 13 in payment
of an account receivable was incorrectly recorded as
$ 3,700
77,000
77,548
6,300
5,300
52
1,700
580
1,020
Required
a.
b.
Prepare the December 20x6 bank reconciliation for Tressa.

Prepare any adjusting journal entries that would result from the December 20x6
bank reconciliation.
Problem 3
The bank statement of Wills Golf Shop indicated a balance of $15,670 at May 31, 20x3.
The bank balance did not include a deposit of $4,300 made by Will on May 31. Total
outstanding cheques as at May 31 totalled $7,650. In addition, the bank statement
revealed the following:
i)
ii)
iii)
iv)
the bank statement included a cheque in the amount of $500 written out by
another local business Jim the Undertaker,
service charges of $25 were charged by the bank,
cheque # 345 was recorded on the books in the amount of $4,546 was actually
written out for $4,456. This cheque was for golf supplies. The correct amount of
the invoice was $4,456.
a deposit made on May 26 included a cheque from a customer that was returned
marked Insufficient Funds. The amount of the cheque was for $630. The bank
charged a $10 fee for handling this returned cheque.
The May 31, 20x3 general ledger balance in the cash account was $13,395.
Required
Prepare a bank reconciliation as at May 31 for Wills Golf Shop and any adjusting entries
required.
Page 144
SOLUTIONS

1.
2.
Balance per statement

Add deposit in transit
Less Outstanding cheques
$18,050
3,250
(2,750)
Balance per books
$18,550
$34,900 + (47,700 - 10,300) - (49,700 - 12,600 + 5,000) = $30,200
Problem 1
a)
1.
2.
Other expenses
Cash
$8
Accounts payable
Cash
18
$8
18
3.
No entry required. These cheques have already been recorded.
4.
No entry required. This deposit has already been recorded.
5.
Cash
Note receivable
Interest revenue
6.
No entry required. Notify bank of error.
7.
Accounts receivable
Cash
980
900
80
33
33
b.
Adjusted cash balance = $6,161 - 8 - 18 + 980 - 33 = $7,082

Balance per bank = $7,082 + 448 Outstanding Cheques - 2,650 Outstanding deposits
- 320 Bank error = $4,560
c.
The bank reconciliation must be done for control purposes. Any errors made by
the bank or the entity should be detected by this process. It also serves to identify
any unrecorded transactions regarding cash. When these are identified, the records
of the entity can be updated to the correct cash balance.
Page 145
Problem 2
a.
Cash balance per books, Dec 1

Add cash received during December
Less cash payments made during December
Cash balance per books, Dec 31, before adjustments
Less bank service charges
Add error in recording cheque ($1,200 - $1,020)
Adjusted cash balance per books, Dec 31
$3,700
77,000
(77,548)
3,152
(52)
180
$3,280
Cash balance per bank, December 31

Add Sparg cheque deducted in error
Add deposits in transit
Less outstanding cheques
Cash balance per books
b.
Cash
Accounts receivable
$6,300
580
1,700
(5,300)
$3,280
$180
$180
Bank service charges

Cash
52
52
Problem 3
Adjusting Journal Entries Bank service charges
Cash
Cash
Golf supplies
$4,546 4,456
Accounts receivable ($630 + 10)
Cash
$25
$25
90
90
640
640
Revised bank balance = $13,395 25 + 90 640 = $12,820

Bank Reconciliation Balance per bank
Add: Bank error
Deposits in transit
Less: Outstanding cheques
Balance per books
Page 146
$15,670
500
4,300
(7,650)
$12,820
5.
Accounts Receivable
Accounts receivable arises whenever sales are made on account and our credit policy
allows customers a certain amount of time before payment is due. The recognition of
accounts receivable on the Statement of Financial Position derives from the revenue
recognition criteria developed in section 3. Once the revenue recognition criteria are
applied and it is deemed that we can record the revenue, the offsetting entry is typically
to accounts receivable.
Consequently, the only accounting issue dealt with in this section is that of the valuation
of accounts receivable - specifically, how to calculate the allowance for doubtful
accounts and bad debt expense. GAAP requires that accounts receivable be recorded at
the lower of cost or market. In the case of accounts receivable, we define market to be net
realizable value of the receivables (Accounts Receivable less the Allowance for Doubtful
Accounts).
There are two general theoretical approaches to the recording of bad debts: the direct
write-off approach and the allowance method. The direct write-off approach writes off
accounts receivable to bad debts when the probability of collecting an account becomes
low. There are two problems with this method: (1) it does not meet the lower of cost or
market criteria for the recording of accounts receivable in that receivables would be
recorded at their gross amount on the Statement of Financial Position and (2) it does not
meet the matching principle since accounts could get written off years after the sale was
recorded. Consequently, the direct write-off method is not acceptable under GAAP.
The allowance method is in accordance with GAAP and is the method we will use and
elaborate on. There are two distinct ways to apply the allowance method: the Statement
of Financial Position approach and the Income Statement approach.
Statement of Financial Position Approach

The Statement of Financial Position approach involves the estimation of the allowance
for doubtful accounts. Bad debt expense is the used as a residual account. Rework
sentence
The allowance for doubtful accounts can be generally estimated in one of three ways:
1.
by a review of individual accounts,
2.
as a percentage of accounts receivable,
3.
by aging the accounts receivable and taking a percentage for each category of
receivables as potentially doubtful.
Page 147
During the year, any account that has been deemed uncollectible is written off against the
allowance for doubtful accounts: Allowance is already set up.
Accounts receivable
XXX
XXX
Any recoveries of accounts previously written off are first recovered by reversing the
above entry and then collected:
Accounts receivable
XXX
Cash
XXX
Accounts receivable
XXX
XXX
At period-end, the balance in the allowance for doubtful accounts is estimated. Any
corresponding entry is made to the bad debt expense account. Note that under this
method, it is possible for the bad debt expense account to have a credit balance.
Income Statement Approach

The income statement approach estimates the bad debt expense and uses the allowance
for doubtful accounts as a residual. This method is typically used by companies that offer
revolving credit to their customers (VISA, American Express) and therefore cannot
properly age their accounts receivable. They will normally estimate bad debts as a
percentage of credit sales and credit the amount to the allowance for doubtful accounts.
The transactions to record the write-off and recovery of accounts is the same as for the
Statement of Financial Position approach.
Example 1: All of Tender Footsies sales are on credit. Sales for 20x4 totaled $934,800.
Included in the 20x4 sales were $10,000, representing the cost of goods which were sent
on consignment during the year. None of these goods had been sold by the end of 20x4.
The allowance for doubtful accounts had a balance of $4,540 on December 31, 20x3.
During 20x4, Tender Footsies wrote off $14,690 as uncollectible, but collected $3,300
which it had previously written off. The company follows the practice of allowing 2% of
net sales as uncollectible. Sales returns for 20x4 were $3,670.
Page 148
The Allowance for doubtful accounts at December 31, 20x4 is as follows:

Accounts written off as uncollectible
Collection of account previously written off
Bad debt expense for the year:
($934,800 -10,000 - 3,670) x 2%
$4,540
(14,690)
3,300
18,423
$11,573
Example 2: As an employee of Dunlop Company, you are provided with the following
information:
Account Balances
as at December 31
Accounts receivable
$659,600 Dr.
13,000 Cr.
Sales on credit for the year amounted to $2,500,000. An aging schedule shows the
following totals:
Number of Days Past Due
Total
Balance
$659,600
Current
$325,000
1-30
$177,000
30-60
$72,000
61-90
$65,000
Over 90
$20,600
It is estimated that the following percentage of accounts receivable balances wil1 be

uncollectible:
Number of
Days Past Due
Percentage
Estimated
Uncollectible
Current
1-30
31-60
61-90
Over 90
2%
4
12
25
50
It is assessed that 3 percent of all credit sales during the year will be uncollectible.
Page 149
Required:
a.
(1)
Assuming that Dunlop Company uses the aging analysis method,

determine the balance required in the Allowance for Doubtful Accounts.
(2)
Prepare a journal entry to adjust the balance in the Allowance for Doubtful
Accounts.
b.
Assuming that Dunlop Company uses the percentage-of-credit-sales method

instead of the aging method, calculate the required addition to the Allowance for
Doubtful Accounts as of December 31 and prepare the required entry.
c.
Prepare the journal entry to write off the account of Titus Kanbee, who owes the
company $1,200.
SOLUTION
Part (a)
Current: $325,000 x 2%
1-30: $177,000 x 4%
31-60: $72,000 x 12%
61-90: $65,000 x 25%
Over 90: $20,600 x 50%
Bad Debt Expense ($48,770 13,000)

$6,500
7,080
8,640
16,250
10,300
$48,770
$35,770
$35,770
Part (b)
Bad debt expense = $2,500,000 x 3% = $75,000
Bad Debt Expense
$75,000
$75,000
Part (c)
Accounts Receivable
Page 150
$1,200
$1,200

Problem 1
Mr. N. Eedy, president of Scotland Corporation, approached Mr. P. L. Enty, manager of
Old Halifax Bank, for a loan. After reviewing the December 31, 20x0, financial
statements of Scotland Corporation, Mr. P. L. Enty asked for more information since a
few things bothered him: (a) Scotland Corporation has its accounts with Old Halifax
Bank and the balances of these accounts total the amount reported as cash on the
Statement of Financial Position. (b) The accounts receivable balance appears large
compared to the previous year.
Mr. P. L. Enty requested a copy of the bank reconciliation and an aging schedule of the
accounts receivable prior to making a decision as to whether or not the loan should be
granted.
The bank reconciliation has not been prepared. The total balances in the bank accounts
were reported as cash. However, Mr. N. Eedy provided the following data:
i)
ii)
iii)
iv)
v)
vi)
vii)
viii)
Total balances in bank accounts

Outstanding cheques
Outstanding deposits
Bank charges for December
Adjusted cash balance per the November 30,
20x0, bank reconciliation
The bank had collected a loan receivable for
Scotland Corporation and deposited it in
December
An NSF cheque had been debited to the account
by the bank
There was an error in the books of Scotland
Corporation. A receipt of cash had been credited
rather than debited to the cash account
Page 151
$14,349.18
$24,327.16
$3,619.22
$57.02
$2,027.03
$2,000.00
$150.00
$290.00
Mr. N. Eedy provided you with the following aging schedule of accounts receivable:
Aged Accounts Receivable
Days Outstanding
December 31, 20x0
AB Ltd.
CD Ltd.
EF Ltd.
GH Ltd.
IJ Ltd.
Others
Total
0-30
31-60
$14,360
22,000
6,900
14,900
2,050
10,600
$12,200
19,360
3,600
4,900
$ 1,800
7,500
2,350
$70,810
$42,410
61-90
Over 90
$ 2,160
$2,640
4,700
1,500
2,000
2,050
2,500
1,050
$14,000
$10,210
$4,190
500
Mr. Eedy apologized for the fact that the control account for accounts receivable on the
Statement of Financial Position shows $75,500. He assured you that his customers are
large well-known companies and that they are good credit risks.
Required Mr. P. L. Enty approaches you, as the assistant bank manager, and asks you to determine
whether or not the bank should loan $50,000 to Scotland Corporation for a period of 90
days. Include in your reply the current cash balance, your opinion of the accounts
receivable and your opinion of Scotland Corporation as a whole.
Page 152
Problem 2
The following are transactions affecting accounts receivable for the Jurdi Company
during the year ended December 31, 20x5:
Total Sales (all credit)
$620,000
Cash collected on account (note that one half of customers took

advantage of the trade discount 2/10, net 30)
Accounts receivable written off
589,050
5,450
Credit issued to customers for sales returns and allowances
14,500
Recoveries of accounts receivable written off as uncollectible in prior

periods (not include in cash collected above)
3,400
The following balances were taken from the Balance Sheet dated December 31, 20x4:
Accounts receivable
$96,400
9,700
The Jurdi Company estimated bad debts to be equal to 0.5% of credit sales net of sales
returns and allowances.
Required
Calculate the Accounts Receivable and Allowance for Doubtful Accounts balance as at
December 31, 20x5.
Page 153
Problem 3
The Webster Company uses the aging method to estimate the allowance for doubtful
accounts. The following schedule of accounts receivable was prepared as at December
31, 20x6:
Age
0-30 days
31-60 days
61-90 days
91-120 days
Over 120 Days
Balance
$674,000
186,000
65,400
19,500
7,800
$952,700
%
uncollectible
0.5%
1.2%
10%
50%
75%
The balance in the allowance for doubtful accounts at the beginning of the year was
$31,150 (cr). The following transactions were recorded during the year:
Accounts receivable written off
Recoveries of accounts receivable written off as
uncollectible in prior periods
34,500
2,300
Required
Calculate the bad debt expense for the year 20x6.
Page 154
Problem 4
The following information pertains to Bedford Company's accounts receivable for the
year ended December 31, 20x2:
Accounts receivable at January 1
Credit sales for 20x2
Allowance for doubtful accounts at January 1
Collections from 20x2 credit sales
Accounts written off August 31
Previously written off accounts received September 20
$ 900,000
5,800,000
55,000
4,900,000
70,000
6,000
An aging analysis estimates uncollectible receivables at December 31, 20x2, to be

$80,000.
Required:
a.
b.
c.
Prepare all relevant journal entries.

What is the accounts receivable balance at December 31?
What effect did the accounts written off at August 31 have on the net realizable
value of accounts receivable?
Problem 5
Any company that has a policy of extending credit when making sales must expect a
portion of these sales to become uncollectible. As a result, the company must recognize
bad debt expense either as a direct write-off or as an allowance.
Required a) Describe the difference between the direct write-off method and the allowance
method of recognizing bad debts.
b) Are these methods in accordance with GAAP? Discuss the reasons, if any, why one
of the above methods would be preferable to the other.
Page 155
Problem 6
During the audit of accounts receivable, your client asks why the current year's income
statement reports bad debt expense when some accounts may become uncollectible next
year. He then said that he had read that financial statements should be based on
verifiable, objective evidence, and that it seemed to him to be much more objective to
wait until individual accounts receivable were actually determined to be uncollectible
before recording them as expenses.
Required 1. Discuss the theoretical justification of the allowance method as contrasted with the
direct write-off method of accounting for bad debts.
2. Describe the percentage-of-sales method and the aging method of estimating bad
debts. Explain how well each method accomplishes the objectives of the allowance
method of accounting for bad debts.
3. Of what merit is your client's contention that the allowance method lacks the
objectivity of the direct writeoff method? Discuss in terms of accounting's
measurement function.
Page 156
SOLUTIONS
Problem 1
Cash Balance
Bank Balance
Less outstanding cheques
Add outstanding deposits
$14,349.18
(24,327.16)
3,619.22
Book Balance - Overdraft
$(6,358.76)
Other items: Bank charges, loan collection, NSF cheque, book error are already adjusted
by using the bank balance.
Accounts Receivable
The control account does not equal the subledger total. This is an indication of
unrecorded sales or errors.
Some customers may not be as good of a credit risk as the president believes. GH, for
example, and others owe amounts three months past due.
Since many accounts are past due, it is an indication that the credit department may not
be aggressive enough in its collection policies (or credit applications are not screened).
CD, as an example, owes amounts currently in addition to some old amounts. This is an
indication of errors or problems in the credit area.
Overall, an adjustment for doubtful accounts appears necessary to properly value the
accounts receivable.
Scotland Corporation
The system of internal control does not appear to be functioning properly. There is no
bank reconciliation and the control account does not balance to the accounts receivable
subledger. The net realizable value of the accounts receivable is much less than $70,810
and there is a bank overdraft on the books of Scotland Corporation.
Should the Bank Loan the $50,000?
Yes/No. Depends on arguments above.
Page 157
Problem 2
Accounts Receivable Balance, January 1, 20x5
Sales
Collections ($297,500* x 2)
Accounts written off
Credits issued to customers
$ 96,400
620,000
(595,000)
(5,450)
(14,500)
$101,450
* Let X = one half of sales before cash discount

X + 0.98X = $589,050
1.98X = $589,050
X = $297,500
Allowance for doubtful accounts Balance, January 1, 20x5
Account recoveries
Bad debt expense: ($620,000 14,500 Sales Returns and Allowances)
x 0.5%
$9,700
(5,450)
3,400
3,027
$10,677
Problem 3
Allowance for doubtful accounts, December 31, 20x6:
$674,000 x 0.5%
186,000 x 1.2%
65,400 x 10%
19,500 x 50%
7,800 x 75%
Allowance for doubtful accounts, January 1, 20x6

Account recoveries
Balance before adjustment for bad debt expense
Allowance for doubtful accounts, December 31, 20x6
Bad debt expense
Page 158
$3,370
2,232
6,540
9,750
5,850
$27,742
$31,150
(34,500)
2,300
1,050 dr.
27,742 cr.
$28,792 dr.
Problem 4
Part (a)
Accounts Receivable
Sales
Cash
Accounts receivable
Accounts receivable
$5,800,000
$5,800,000
4,900,000
4,900,000
70,000
70,000
Accounts receivable
6,000
Cash
Accounts receivable
6,000
Bad debt expense

6,000
6,000
89,000
89,000
Part (b)
900,000 Opening Balance + 5,800,000 Credit Sales - 4,900,000 Collections

- 70,000 Write-Offs + 6,000 Recovery - 6,000 Collection on Recovery = $1,730,000
Part (c)
No effect (decreased both the accounts receivable and the allowance)
Page 159
Problem 5
a)
Direct write-off:
i)
identify an uncollectible account
ii)
remove it from the accounts receivable
iii)
recognize bad debt expense
Allowance method:
i)
estimate bad debts expense by either % of sales or aging of accounts receivable at
the end of a period
ii)
adjust the allowance for doubtful accounts
iii)
record the bad debt expense
iv)
when an uncollectible is identified, write it off against the allowance for doubtful
accounts
In the direct write-off method, the net accounts receivable are reduced when an account is
written off; but in the allowance method, the net accounts receivable do not change.
In the allowance method, the expense is recognized in the same period as the sales; but in
the direct write-off method the expense may be recognized in a different period.
b)
Allowance method:
matches sales in the period with possible bad debts
achieves proper carrying value of the accounts receivable (because of the allowance
for doubtful accounts)
Direct write-off:
Write-off and thus bad debt expense occurs in the period in which an account becomes
uncollectible and this is not necessarily the same period in which the sale was recorded;
therefore the expense and revenue may not be matched.
The allowance method is in accordance with GAAP but the direct write-off method may
also be if the bad debt expense is not material.
Page 160
Problem 6
1. The theoretical superiority of the allowance method over the direct write-off
method of accounting for bad debts is twofold. First, because revenue is recognized
at the point of sale on the assumption that the resulting receivables are valid liquid
assets merely awaiting collection, periodic income will be overstated to the extent of
any receivables that eventually become uncollectible.
Second, accounts receivable on the Statement of Financial Position should be stated
at their estimated net realizable value. The allowance method accomplishes this
objective by deducting from gross receivables the allowance for doubtful accounts.
2. THE PERCENTAGE OF SALES METHOD: Under this method bad debt expense is
debited and the allowance for uncollectible accounts is credited with a percentage of
the current year's credit or total sales. The rate is determined by reference to the
relationship between prior years' credit or total sales and actual bad debts arising
therefrom.
The percentage of sales method of providing for estimated uncollectible receivables is
intended to record bad debt expense in the period in which the corresponding sales
are recorded. Cumulatively significant errors in the experience rate may result in
either an excessive or inadequate balance in the allowance account, however, this
method may not accurately report accounts receivable at their estimated net realizable
value. This result can be prevented by periodically reviewing and, if necessary,
adjusting the balance in the allowance account. The materiality of any such
adjustment would govern its treatment for reporting purposes.
THE AGING METHOD: Under this method each year's debit to the expense account
and credit to the valuation account is determined by an evaluation of the collectibility
of open accounts receivable at the close of the year. An analysis of the accounts
according to their due dates is the usual procedure. For each of the age categories
established in the analysis, average percentage rates may be developed on the basis of
past experience and applied to the accounts in the respective age categories. This
method may also utilize individual analysis for some accounts, especially those that
are considerably past due, in arriving at estimated uncollectible receivables. On the
basis of the foregoing analysis the balance in the valuation account is then adjusted to
the amount estimated to be uncollectible.
This method of providing for uncollectible accounts is quite accurate for purposes of
reporting accounts receivable at their estimated net realizable value in the Statement
of Financial Position. From the standpoint of the income statement, however, the
aging method may not match accurately bad debt expenses with the sales which
caused them because the charge to bad debt expense is not based on sales.
Page 161
3. A major part of accounting is the measurement of financial data. Changes in value

should be recognized as soon as they are measurable in objective terms in order that
accounting may provide useful information on a periodic basis.
Accountants have had to develop a philosophy regarding an acceptable degree of
uncertainty in order to make their work useful. The accountant's term "objectivity"
does not imply certainty. Estimates can be objective, though by definition they are not
certain. To be considered objective, they must be based on evidence that is reliable
and subject to verification by another competent investigator. This kind of criterion
permits the preparation of meaningful periodic financial statements through such
conventions as the sales method of revenue recognition and the allowance method of
accounting for bad debts.
The very existence of accounts receivable is based on the decision that a credit sale is
an objective indication that revenue should be recognized. The alternative is to wait
until the debt is paid in cash. If revenue is to be recognized and an asset recorded at
the time of a credit sale, the need for fairness in the statements requires that both
expenses and the asset should be adjusted for the estimated amounts of the asset that
experience, which is subject to verification by competent investigators, indicates will
not be collected.
Page 162
6.
Notes Receivable / Payable
A note receivable is usually created in one of the following two ways:
a customer with a current account receivable re-negotiates the terms of repayment

by agreeing to pay the balance by a specified date. When this happens, the
account balance should be removed from accounts receivable and set up as a note
receivable:
Dr. Notes Receivable
Cr. Accounts Receivable
XXX
XXX
a credit sale is made and the terms of repayment exceed the usual normal credit
terms. For example, a furniture company makes a sale and agrees to delay the
payment for 18 months. Such a receivable would be classified as a note
receivable.
Whether a note receivable is classified as a current or long-term asset depends on the

terms of the note receivable. If at the Statement of Financial Position date, the note is due
within the next 12 months, then it is classified as current. Otherwise, it is classified as
long-term.
Notes receivable are usually interest bearing. If the amount of interest charged is equal to
the imputed interest rate (defined on the next page), the note gets recorded at its face
value and the interest gets recorded as it accrues.
Example 1: On January 2, 20x0 you sell equipment to one of your customers. The value
of the sale is $10,000 and you agree to take back a note receivable for two years. Interest
of 10% (equal to the imputed interest rate) is charged on the note and is payable on
December 31 of each year. The note is repayable on December 31, 20x1.
Given that the interest rate on the note is equal to market interest rates, the note would get
recorded as follows:
Jan 1, 20x0
Note Receivable
Sales
$10,000
$10,000
The following journal entries will record the remaining transactions:

Dec 31, 20x0
Dec 31, 20x1
Page 163
Cash
Interest Revenue
$1,000
Cash
Note Receivable
Interest Revenue
$11,000
$1,000
$10,000
1,000
The complication arises when the interest rate on the note receivable is less than the
imputed interest rate. In this case, the note receivable gets recorded at the sum of the
discounted cash flows to be received on the note receivable. The cash flows are
discounted at the imputed rate of interest.
The imputed rate of interest is the more clearly determinable of the following two rates:
(a)
the prevailing rate for a similar instrument of an issuer with a similar credit rating,
or
(b)
a rate of interest that discounts the nominal amount of the instrument to the
current cash sales price of the goods or services. (IAS 18.11)
Note that when establishing an imputed rate of interest for a note receivable, the imputed
interest rate in part (a) above is based on the credit rating of your customer. For a note
payable, it would be based on your own credit rating.
Example 2: Assume that in example 1, the seller of equipment agrees to only charge 4%
interest on the note.
Enter
Compute
N
2
I/Y
10
PV
PMT
400
FV
10000
X=
8,959
The note would get recorded as follows:

Jan 1, 20x0
Note Receivable
Sales
$8,959
$8,959
On December 31, 20x0, the interest revenue on the note will be equal to the carrying
value of the note times the market rate of interest: $8,959 x 10% = $896. The difference
between the interest revenue of $896 and the interest of $400 received increases the
carrying value of the note:
Dec 31, 20x0
Cash
Note receivable
Interest Revenue
$400
496
$896
value of the note times the market rate of interest: ($8,959 +$ 496) = $9,455 x 10% =
$945. The difference between the interest revenue of $945 and the interest of $400
received increases the carrying value of the note:
Dec 31, 20x1
Page 164
Cash
Note Receivable
Interest Revenue
$400
545
$945
Note that the carrying value of the note is now: $9,455 + $545 = $10,000. The journal
entry to record the receipt of the principal amount of the note is as follows:
Dec 31, 20x1
Cash
Note Receivable
$10,000
$10,000
To summarize, whenever you have a note receivable (or payable) whose interest rate is
less than the market interest rate, you first determine the cash flows that are expected
from the note receivable and then discount these cash flows at the market rate of interest.
Example 3: assuming the same information as for Example 2, but assume instead that the
best measure of the imputed interest rate is based on the cash price of the equipment sold
of $9,200.
The note would get recorded as follows:
Jan 1, 20x0
Note Receivable
Sales
$9,200
$9,200
In order to calculate the interest revenue, we need to determine the imputed interest rate:
Enter
Compute
N
2
I/Y
PV
-9,200
PMT
400
FV
10000
I/Y =
8.518%
value of the note times the market rate of interest: $9,200 x 8.518% = $784. The
difference between the interest revenue of $896 and the interest of $400 received
increases the carrying value of the note:
Dec 31, 20x0
Cash
Note receivable
Interest Revenue
$400
384
$784
value of the note times the market rate of interest: ($9,200 +$384) = $9,584 x 8.518% =
$816. The difference between the interest revenue of $945 and the interest of $400
received increases the carrying value of the note:
Dec 31, 20x1
Page 165
Cash
Note Receivable
Interest Revenue
$400
416
$816
Note that the carrying value of the note is now: $9,584 + $416 = $10,000. The journal
entry to record the receipt of the principal amount of the note is as follows:
Dec 31, 20x1
Cash
Note Receivable
$10,000
$10,000
Appendix Using your Financial Calculator

The format for solutions using a financial calculator used throughout this module and
other Accelerated Program modules is as follows:
Enter
Compute
N
5
I/Y
6
PV
PMT
FV
1000
In the above example, we are trying the calculate the present value of $1,000 to be
received in 5 years from now at an interest rate of 6%.
If you are using the Texas Instruments BA II Plus, you need to do the following:
set the calculator to accept one payment per year as follows:
1
2ND N
You only need to do this once.
clear the Time Value of Money memory as follows:
2ND FV
You should do this every time you do a time value of money calculation.
enter the numbers above in the TVM memory registers
to solve, press CPT and the TVM register you are attempting to solve for, in this
case PV
the answer provided is -747.26. This means that if you were to invest $747.26
today (money out of pocket and therefore the negative sign) and invest it for 5
years at 6% compounded annually, the amount would grow to $1,000.
If you are using the Hewlett Packard 10BII, you need to do the following:
set the calculator to accept one payment per year as follows:
1
then Orange Button
then PMT
You only need to do this once.
clear the Time Value of Money memory as follows:
Orange Button
C ALL
You should do this every time you do a time value of money calculation.
enter the numbers above in the TVM memory registers
to solve, press the TVM register you are attempting to solve for, in this case PV
the answer provided is -747.26. This means that if you were to invest $747.26
today (money out of pocket and therefore the negative sign) and invest it for 5
years at 6% compounded annually, the amount would grow to $1,000.
Page 166

Problem 1 Present Value Exercises
a.
b.
c.
d.
e.
f.
You just came into some money - $50,000 and want to invest it for 12 years at
6%. How much will you have in 12 years?
You plan to deposit $5,000 in your RRSP each year for the next 30 years. The
first payment will be in one year from now. How much will accumulate if i=7%?
Continuation of part (b). It is now 30 years later and you have $472,303.93 in
your RRSP account. You expect to live another 30 years - how much can you
withdraw each year? Assume that the interest rate is still 7%.
Continuation of part (b). It is now 30 years later, you are wondering what the
purchasing power of $38,061.28 is compared to 30 years ago. You find out that
the average inflation rate for the past 30 years was 2.5%.
You need to purchase a vehicle costing $70,000. The dealership is offering you
4.9% on a 5 year loan. What is your annual loan payment?
Continuation of part (e). You purchased the car and have just made your 3rd loan
payment. What is the balance of your loan?
Problem 2
The Low Quality Furniture Company allows you to purchase $5,000 of furniture on the
following terms:
i.
0% down, no interest for 2 years, full $5,000 to be repaid in 2 years
ii.
50% down, no interest for 3 years, balance of $2,500 to be repaid in 3 years
iii.
0% down, no interest for 5 years, required annual repayments of $1,000 at the end
of each year for 5 years
iv.
0% down, annual interest repayments of 5% for 4 years, balance payable at the
end of 4 years
v.
0% down, annual payments of $1,200 per year for 5 years.
Assuming a market interest rate of 8%, and assuming that each of the above situation is
independent, prepare all journal entries made by the store for each of the situations for all
years in question.
Page 167
Problem 3
The Bertolo Corporation sold equipment with a list price of $50,000 to Chan Ltd. on the
following terms: $5,000 payable on December 31, 20x1 (the day the equipment was
delivered) and four payments of $11,250 payable on December 31 of each year starting
on December 31, 20x2. The cash price of the equipment is $43,106.
Required Prepare all journal entries for the Bertolo Corporation for the years ended December 31,
20x1 through to December 31, 20x3.
Problem 4
On December 31, 20x2, Kyle Corporation sold for $30,000 an old machine having an
original cost of $50,000 and a book value of $12,000. The terms of the sale were as
follows:
a) $10,000 down payment.
b) $10,000 payable on December 31 for each of the next two years.
The agreement of sale made no mention of interest; however, 10 percent would be a fair
rate for this type of transaction.
Required 1. Prepare the entry to record the sale on December 31, 20x2.
2. Prepare the entry to record the receipt of $10,000 on December 31, 20x3 and on
December 31, 20x4.
Page 168
Problem 5
Linden, Inc., had the following long-term receivable account balances at December 31,
20x2:
Note receivable from sale of division
Note receivable from officer
$1,500,000
400,000
Transactions during 20x3 and other information relating to Linden's long-term

receivables were as follows:
a) The $1.5 million note receivable is dated May 1, 20x2, bears interest at 9 percent, and
represents the balance of the consideration received from the sale of Linden's
electronics division to Pitt Company.
Principal payments of $500,000 plus appropriate interest are due on May 1, 20x3,
20x4, and 20x5. The first principal and interest payment was made on May 1, 20x3.
Collection of the note instalments is reasonably assured.
b) The $400,000 note receivable is dated December 31, 20x0, bears interest at 8 percent,
and is due on December 31, 20x5. The note is due from Robert Finley, president of
Linden, Inc., and is collateralized by 10,000 of Linden's common shares. Interest is
payable annually on December 31 and all interest payments were paid on their due
dates through December 31, 20x3. The quoted market price of Linden's common
shares was $45 per share on December 31, 20x3.
c) On April 1, 20x3, Linden sold a patent to Bell Company in exchange for a $100,000
noninterest-bearing note due on April 1, 20x5. There was no established exchange
price for the patent, and the note had no ready market. The prevailing rate of interest
for a note of this type at April 1, 20x3, was 15 percent. The patent had a carrying
value of $40,000 at January 1, 20x3, and the amortization for the year ended
December 31, 20x3, would have been $8,000. The collection of the note receivable
from Bell is reasonably assured.
d) On July 1, 20x3, Linden sold a parcel of land to Carr Company for $200,000 under an
instalment sale contract. Carr made a $60,000 cash down payment on July 1, 20x3,
and signed a four-year, 16 percent note for the $140,000 balance. The equal annual
payments of principal and interest on the note will be $50,000 payable on July 1,
20x4, through July 1, 20x7. The land could have been sold at an established cash
price of $200,000. The cost of the land to Linden was $150,000. Circumstances are
such that the collection of the instalments on the note is reasonably assured.
Required 1. Prepare the long-term receivables section of Linden's Statement of Financial Position
at December 31, 20x3.
Page 169
2. Prepare a schedule showing the current portion of the long-term receivables and
accrued interest receivable that would appear in Linden's Statement of Financial
Position at December 31, 20x3.
3. Prepare a schedule showing interest revenue from the long-term receivables and gains
recognized on sale of assets that would appear on Linden's income statement for the
year ended December 31, 20x3.
Problem 6
On January 2, 20x1, the Harry Company acquired a truck with a list price of $500,000.
The Harry Company's incremental borrowing rate is 8%. Assume that the truck
manufacturer is offering Harry the following terms (each situation is independent). For
each of the terms, prepare the journal entries for the life of the note. Assume a December
31 year end.
a)
b)
c)
d)
e)
f)
Harry Company has to make equal annual payments of principal and interest over
five years. Payments are due on December 31 of every year. The interest rate
charged is 10%.
Harry Company pays the $500,000 in three years. No interest is charged on the
note.
Harry Company pays the $500,000 in three years. Interest of 3% is charged on the
note payable on December 31 of every year.
Harry Company pays $100,000 on the principal at the end of every year. No
interest is charged.
Harry Company pays $100,000 on the principal at the end of every year. Interest
of 4% is charged on the balance.
Harry Company has to make equal annual payments of principal and interest over
five years. The interest rate charged is 4%.
Problem 7
Business transactions often involve the exchange of property, goods, or services for notes
or similar instruments that may stipulate no interest rate or an interest rate that varies
from prevailing rates.
Required 1. When a note is received in exchange for property, goods, or services, what value
should be placed on the note if it bears interest at a reasonable rate and is issued in a
bargained transaction? If it bears no interest or is not issued in a bargained
transaction? Explain.
2. If the recorded value of a note differs from the face value, how should the difference
be accounted for? How should this difference be presented in the financial
statements? Explain.
Page 170
SOLUTIONS
Problem 1
a.
N = 12, I = 6, PV = 50000, Solve for FV = 100,609.82
b.
N = 30, I = 7, PMT = 5000, Solve for FV = 472,303.93
c.
N = 30, I = 7, PV = 472303.93, Solve for PMT = 38,061.28
d.
N = 30, I = 2.5, FV = 38061.28, Solve for PV = 18,145.44
e.
N = 5, I = 4.9, PV = 70000, Solve for PMT = 16,123.57
f.
N = 2, I = 4.9, PMT = 16123.57, Solve for PV = 30,022.87
Problem 2
Part (i)
PV of note:
Enter
Compute
Initial
End Yr 1
End Yr 2
N
2
PV
PMT
FV
5000
X=
4,287
Note receivable
Sales
$4,287
$4,287
Note Receivable
Interest revenue (4,287 x 8%)
343
Note Receivable
Interest Revenue (4,287 + 343) x 8%
370
Cash
Note receivable
Page 171
I/Y
8
343
370
5,000
5,000
Part (ii)
PV of note:
Enter
Compute
Initial
End Yr 1
End Yr 2
End Yr 3
N
3
PV
PMT
FV
2500
X=
1,985
Note receivable
Cash
Sales
$1,985
2,500
$4,485
Note Receivable
159
Note Receivable
Interest Revenue (1,985 + 159) x 8%
172
Note Receivable
Interest Revenue (1,985 + 159 + 172) x 8%
185
Cash
Note receivable
Page 172
I/Y
8
159
172
185
2,500
2,500
Part (iii)
PV of note:
Enter
Compute
Initial
End Yr 1
End Yr 2
End Yr 3
End Yr 4
End Yr 5
Page 173
N
5
I/Y
8
PV
PMT
1000
FV
X=
3,993
Note receivable
Sales
$3,993
$3,993
Cash
Note Receivable
1,000
Cash
Note Receivable
Interest revenue (3,993 - 681) = 3,312 x 8%
1,000
Cash
Note Receivable
1,000
Cash
Note Receivable
1,000
Cash
Note Receivable
Interest revenue (1,783 - 857) = 926 x 8%
1,000
681
319
735
265
794
206
857
143
926
74
Part (iv)
PV of note:
Enter
Compute
Initial
End Yr 1
End Yr 2
End Yr 3
End Yr 4
N
4
PV
PMT
250
FV
5000
X=
4,503
Note receivable
Sales
$4,503
$4,503
Cash
Note Receivable
250
110
Cash
Note Receivable
Interest revenue (4,503 + 110) = 4,613 x 8%
250
119
Cash
Note Receivable
250
129
Cash
Note Receivable
250
139
Cash
Note Receivable
Page 174
I/Y
8
360
369
379
389
5,000
5,000
Part (v)
PV of note:
Enter
Compute
Initial
End Yr 1
End Yr 2
End Yr 3
End Yr 4
End Yr 5
Page 175
N
5
I/Y
8
PV
PMT
1200
FV
X=
4,791
Note receivable
Sales
$4,791
$4,791
Cash
Note Receivable
1,200
Cash
Note Receivable
1,200
Cash
Note Receivable
1,200
Cash
Note Receivable
1,200
Cash
Note Receivable
Interest revenue (2,139 - 1,029) = 1,110 x 8%
1,200
817
383
882
318
953
247
1,029
171
1,111
89
Problem 3
The first step is to determine the imputed interest rate. Note that the PV amount is equal
to the cash price of $43,106 less the initial deposit of $5,000.
Enter
Compute
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
N
4
I/Y
PV
-38,106
PMT
11,250
FV
X = 7%
Note receivable
Cash
Sales
$38,106
5,000
$43,106
Cash
Note receivable
Interest revenue ($38,106 x 7%)
11,250
Cash
Note receivable
Interest revenue ($38,106 - 8,583) x 7%
11,250
8,583
2,667
9,184
2,067
Problem 4
1.
Cash
Note receivable*
Accumulated depreciation ($50,000 - $12,000)
Machine
Gain on sale of machine
$10,000
17,355
38,000
$50,000
15,355
* N=2, i=10, PMT=10000, solve for PV = 17,355

2.
Dec 31, 20x3
Dec 31, 20x4
Page 176
Cash
Interest revenue ($17,355 x 10%)
Note receivable
10,000
Cash
Interest revenue ($17,355 - 8,264)
x 10%
Note receivable
10,000
1,736
8,264
909
9,091
Problem 5
1.
Long-term receivables:
9% note receivable from sale of division, due in annual
installments of $500,000 to May 1, 20x5, less current
portion
8% note receivable from officer, due December 31, 20x5,
collateralized by 10,000 shares of Linden, Inc.,
common shares with a fair market value of $450,000
Non-interest-bearing note from sale of patent, net of
15% imputed interest, due April 1, 20x5
Installment contract receivable, due in annual installments of
$50,000 to July 1, 20x7, less current installment
Total long-term receivables .
2.
Current portion of long-term receivables:
Installment contract receivable
Total current portion of long-term receivables
Accrued interest receivable:
Installment contract receivable
Total accrued interest receivable
3.
Interest income:
Note receivable from sale of patent
Note receivable from officer
Installment contract receivable from sale of land
Total interest income
Gains on sale of assets:
Patent
Land
Total gains on sale of assets
Total interest income and gains
Page 177
$ 500,000 (1)
400,000
84,121 (2)
112,400 (3)
$1,096,521
$ 500,000 (1)
27,600 (3)
$527,600
$ 60,000 (4)
11,200 (5)
$ 71,200
$ 105,000
8,507
32,000
11,200
$ 156,707
(6)
(2)
(7)
(5)
$ 37,600 (8)
50,000 (9)
$ 87,600
$ 244,305
Explanations of amounts:
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Long-term portion of 9% note receivable at Dec 31, 20x3:

Face value
Less installment received, May 1, 20x3
Less installment due May 31, 20x4 (current portion)
Long-term portion, December 31, 20x3
Non-interest bearing note, net of imputed interest at
December 31, 20x3:
Discounted value of note: N = 2, I = 15, FV = 100000,
solve for PV:
Add: Interest earned to December 31, 20x3
$75,615 x 15% x 9/12
$1,500,000
(500,000)
$1,000,000
(500,000)
$ 500,000
$75,614
8,507
$ 84,121
Long-term portion of installment contract receivable at

December 31, 20x3
Contract selling price, July 1, 20x3
Less: Down payment, July 1, 20x3
Balance December 31, 20x3
Less: Installment due, July 1, 20x4
[$50,000 - ($140,000 x 16%)]
Long-term portion, December 31, 20x3
$ 200,000
(60,000)
$ 140,000
(27,600)
$ 112,400
Accrued interest--note receivable, sale of division, at

December 31, 20x3:
Interest accrued from May 1, 20x3 to Dec 31, 20x3:
$1,000,000 x 9% x 8/12
$ 60,000
Accrued interest--installment contract at Dec 31, 20x3:

Interest accrued from July 1, 20x3 to Dec 31, 20x3
$140,000 x 16% x 1/2
$ 11,200
Interest income--note receivable, sale of division,

Interest earned from Jan 1, 20x3 to Apr 30, 20x3
$1,500,000 x 9% x 4/12
Interest earned from May 1, 20x3 to Dec 31, 20x3 (#4 above)
Interest income
Interest income--note receivable from officer:
400,000 x 8%
Page 178
$ 45,000
60,000
$ 105,000
$ 32,000
(8)
(9)
Gain on sale of patent:

Selling price (part 2)
Less: Cost of patent (net):
Carrying value Jan 1, 20x3
Less: Amortization Jan 1, 20x3 to Apr 1, 20x3
$8,000 x 1/4
Gain on sale of land:

Selling price
Less cost
Page 179
$ 75,600
$40,000
(2,000)
(38,000)
$ 37,600
$ 200,000
(150,000)
$ 50,000
Problem 6
a)
Annual payment:
N = 5, I = 10, PV = 500000, solve for PMT = $131,899
Since the rate implied in the note is higher than the company's incremental
borrowing rate, we do not discount the cash flows of the note at the incremental
borrowing rate.
Jan 2, 20x1
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Page 180
Equipment
Note payable
Interest expense
($500,000 x 10%)
Note payable
Cash
Interest expense
($418,101* x 10%)
Note payable
Cash
* $500,000 - 81,899
Interest expense
($328,012* x 10%)
Note payable
Cash
* $418,101 - 90,089
Interest expense
($228,914* x 10%)
Note payable
Cash
* $328,012 - 99,098
Interest expense
($119,906* x 10%)
Note payable
Cash
* $228,914 109,008
** difference due to rounding
$500,000
$500,000
50,000
81,899
131,899
41,810
90,089
131,899
32,801
99,098
131,899
22,891
109,008
131,899
11,993**
119,906
131,899
b)
PV of note:
N = 3, I = 8, FV = 500000, Solve for PV = $396,916
Jan 2, 20x1
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
Equipment
Note payable
Interest expense
($396,916 x 8%)
Note payable
Interest expense
($396,916 + 31,753)
= $428,669 x 8%
Note payable
Interest expense
($428,669 + 34,294) x 8%
Note payable
Note payable
Cash
Page 181
$396,916
$396,916
31,753
31,753
34,294
34,294
37,037
37,037
500,000
500,000
c)
PV of note : N = 3, I = 8, PMT = 15000, FV = 500000, Solve for PV = $435,573

Jan 2, 20x1
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
Equipment
Note payable
Interest expense
($435,573 x 8%)
Cash
Note payable
$435,573
$435,573
34,846
15,000
19,846
Interest expense
($435,573 + 19,846)
= $455,419 x 8%
Cash
Note payable
36,434
Interest expense
($455,419 + 21,434)
= $476,853 x 8%
Cash
Note payable
38,147*
Note payable
Cash
15,000
21,434
15,000
23,147
500,000
500,000
* rounded to balance
Page 182
d)
PV of note: N = 5, I = 8, PMT = 100000, Solve for PV = $399,271

Jan 2, 20x1
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Page 183
Equipment
Note payable
Interest expense
($399,271 x 8%)
Note payable
Cash
Interest expense
($399,271 - 68,058)
= $331,213 x 8%
Note payable
Cash
Interest expense
($331,213 - 73,503)
= 257,710 x 8%
Note payable
Cash
Interest expense
($257,710 - 79,383)
= $178,327 x 8%
Note payable
Cash
Interest expense
($178,327 - 85,734)
= $92,593 x 8%
Note payable
Cash
$399,271
$399,271
31,942
68,058
100,000
26,497
73,503
100,000
20,617
79,383
100,000
14,266
85,734
100,000
7,407
92,593
100,000
e)
Interest in 20x1 = $500,000 x 4% = $20,000

20x2 = $400,000 x 4% = $16,000
20x3 = $300,000 x 4% = $12,000
20x4 = $200,000 x 4% = $8,000
20x5 = $100,000 x 4% = $4,000
PV of note:
20x1: N = 1, I = 8, FV = 20,000, Solve for PV =
Principal annuity: N = 5, I = 8, PMT = 100,000, Solve for PV =
Jan 2, 20x1
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Page 184
Equipment
Note payable
Interest expense ($449,636 x 8%)
Note payable
Cash
Interest expense
($449,636 - 84,029)
= $365,607 x 8%
Note payable
Cash
Interest expense
($365,607 - 86,751)
= $278,856 x 8%
Note payable
Cash
Interest expense
($278,856 - 89,692)
= $189,164 x 8%
Note payable
Cash
Interest expense
($189,164 - 92,867)
= $96,297 x 8%
Note payable
Cash
$18,518.52
13,717.42
9,525.99
5,880.24
2,722.33
399,271.00
$449,636.00
$449,636
$449,636
35,971
84,029
120,000
29,249
86,751
116,000
22,308
89,692
112,000
15,133
92,867
108,000
7,703
96,297
104,000
f)
Annual payment: N = 5, I = 4, PV = 500000, Solve for PMT = $112,314

PV of note: N = 5, I = 8, PMT = 112314, Solve for PV = $448,437
Jan 2, 20x1
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Page 185
Equipment
Note payable
Interest expense
($448,437 x 8%)
Note payable
Cash
Interest expense
($448,437 76,439)
= $371,998 x 8%
Note payable
Cash
Interest expense
($371,998 82,554)
= $289,444 x 8%
Note payable
Cash
Interest expense
($289,444 89,158)
= $200,286 x 8%
Note payable
Cash
Interest expense
($200,286 96,291)
= $103,995 x 8%
Note payable
Cash
$448,437
$448,437
35,875
76,439
112,314
29,760
82,554
112,314
23,156
89,158
112,314
16,023
96,291
112,314
8,319
103,995
112,314
Problem 7
1. A note received in exchange for property, goods, or services should be recorded at its
present value, which is presumably the value of the property exchanged. In the case
of a note bearing interest at a reasonable rate and issued in an arm's-length
transaction, the face value of the note should be used, as explained below.
A note received for property, goods, or services represents two elements, which may
or may not be stipulated in the note: (a) the principal amount, equivalent to the cash
exchange price of the property, goods, or services as established between the seller
and the buyer and (b) an interest factor to compensate the seller over the life of the
note for the use of funds he would have received in a cash transaction at the time of
the exchange. Notes so exchanged are accordingly valued and accounted for at the
present value of the consideration exchanged between the contracting parties at the
date of the transaction in a manner similar to that followed for a cash transaction.
When a note is exchanged for property, goods, or services in a bargained transaction
entered into at arm's length, there is a presumption that the rate of interest stipulated
by the parties to the transaction represents fair and adequate compensation to the
seller for the use of the related funds. In these circumstances the note's present value
is identical with its face value. Furthermore, where the rate of interest is reasonable
and separately stated, the face value of the note is equal to the bargained exchange
price for the property. When a note bears no interest (or has a stated interest rate that
differs sharply from the prevailing rate and/or is not issued in an arm's-length
transaction), the present value must be determined through consideration of the
economic substance of the transaction.
The note and the sales price of the property, goods, or services exchanged for the note
should be recorded at the fair value of the property, goods, or services or at an amount
that reasonably approximates the present value of the note, whichever is the more
clearly determinable.
That amount may or may not be the same as the face amount; any resulting discount
or premium should be accounted for as an element of interest over the life of the note.
In the absence of established exchange prices for the related property, goods, or
services or evidence of the market value of the note, the present value of a note that
stipulates no interest (or a rate of interest that differs sharply from the prevailing rate)
should be determined by discounting all future payments on the note, using an
imputed (implicit) rate of interest.
2. If the recorded value of a note differs from its face value, the difference is amortized
as interest over the life of the note in such a way as to result in a constant rate of
interest when applied to the amount outstanding at the beginning of any given period.
This method is the "effective interest" method.
Page 186
7.
Inventory
Inventory is defined as assets

(a)
held for sale in the ordinary course of business;
(b)
in the process of production for such sale; or
(c)
in the form of materials or supplies to be consumed in the production process or
in the rendering of services. (IAS 2.6)
Cost of Inventories
The cost of inventories is measured at the lower of cost and net realizable value (IAS
2.9).
Cost is defined as all costs of purchase, costs of conversion and other costs incurred in
bringing the inventories to their present location and condition (IAS 2.10).
Costs of purchase would include the purchase price, import duties, transport, handling
and any other costs directly attributable to the purchase of inventory. Any trade discounts
or rebates should be deducted against the cost of inventory.
Costs of conversion refer to a manufacturing environment and will be explored in detail
in Segment 2 (on Management Accounting) of this program. The following are the
requirements for the financial reporting of any work-in-process or finished goods
manufactured inventories:
the allocation of fixed production overhead to inventory should be based on

normal capacity,
normal capacity is defined as the production expected to be achieved over a

number of periods under normal circumstances;
unallocated overhead is recognized as an expense in the period in which it is

incurred; and
variable overhead is allocated to inventory on the basis of the actual use of

production facilities.
Goods in transit - following the general rule that title to the merchandise is evidence of
ownership, any goods in transit belong to whomever has title or legal ownership. When
merchandise is in transit between buyer and seller, title or legal ownership is dependent
on the shipping terms between the buyer and seller. If the goods are shipped F.O.B.
shipping point, title passes to the buyer at the time the goods are loaded on the common
carrier. The buyer assumes the responsibilities of ownership, including freight charges,
insurance, and risk of loss or damage, and includes the merchandise in inventory. When
the terms of the sale are F.O.B. destination, title transfers to the buyer at the time the
goods are off-loaded to the buyer from the common carrier. In this case, the seller
assumes responsibility for the freight charge, insurance, and risk of loss, and includes the
merchandise as part of inventory until the buyer takes possession.
Page 187
Perpetual vs. periodic inventory systems - A periodic inventory system records all
merchandise purchases in a purchases account and determines the inventory quantity and
value periodically (usually at the time of preparation of the financial statements) by
actual physical count. This system makes no attempt to maintain a current balance in the
inventory account.
In contrast, a perpetual inventory system does maintain a current balance in the inventory
account. Increases to the inventory account occur with each new purchase, while
decreases are made with each sale. Compared to the periodic system, the perpetual
system requires more record keeping, but it affords greater control over the inventory.
A periodic inventory system requires the use of several temporary accounts:
Purchases all inventory purchases are recorded in this account
Purchase returns and allowance any returns of merchandise to the supplier or
any credits provided by the supplier for non-returned merchandise are
credited to this account
Purchase discounts any purchase discounts taken on terms of payment
(i.e. 2/10, n30) are credited to this account.
Transportation-in any freight costs paid for the acquisition of inventory are
debited to this account.
At year-end, the inventory is counted, all of these accounts are closed off and cost of
goods sold is recorded.
Example assume that a company using a periodic system has the following account
balances:
Inventory (beginning of year)

Purchases
Purchase returns and allowances
Purchase discounts
Transportation-in
Dr.
$ 655,000
3,540,000
Cr.
$46,300
5,800
67,500
The year-end inventory count establishes the total cost of inventory at $768,000.
The journal entry to record cost of goods sold would be as follows:
Cost of goods sold
Inventory
Purchase discounts
Purchases
Transportation-in
Page 188
$3,442,400
113,000
46,300
5,800
$3,540,000
67,500
In the above entry, cost of goods sold was calculated as a plug figure to balance the
journal entry. If you were to calculate cost of goods sold directly you would get the same
amount:
Inventory, beginning of year
Purchases Purchases
Transportation-in
Purchase discounts
Less inventory, end of year
$655,000
$3,540,000
67,500
(46,300)
(5,800)
3,555,400
(768,000)
$3,442,400
Inventory Valuation Methods

When inventory items are of high value and can be identified individually (for example,
by way of serial numbers), the specific identification method of inventory valuation has
to used. This method is quite simple and assigns the invoice price to each inventory item.
Note that specific identification is not appropriate when there are large numbers of
inventory items that are ordinarily interchangeable.
When the specific identification method is not used, then the cost of inventory is to be
assigned using one of two cost flow methods: FIFO or Weighted Average. IAS 2 requires
that the same method be used for all inventories having a similar nature and use. For
inventories with a different nature or use, different cost formulas can be used (IAS2.25).
Note that LIFO is no longer considered an acceptable method.
FIFO (First-in, First-out)
The FIFO method assumes that older goods get sold first. FIFO assigns the more recent
purchase price to the Statement of Financial Position inventory account; the older costs
go to the COGS account. It is convenient to use and produces an inventory asset value
close to current cost.
Weighted Average
The weighted average method of inventory is based on the assumption that all costs can
be aggregated and that the cost to be assigned to any particular unit should be the
weighted average of the costs of the units held during the accounting period. The
weighted average method assumes no particular flow of goods. Weighted average assigns
the available cost equally to the inventory asset and to cost of goods sold expense. It is
used for inventories that are a mixture of recent and older purchases and that are not
particularly perishable.
Page 189
Example: The Madison Company had the following inventory transactions for the month
of June 20x2:
Date
Opening Balance
June 2
June 5
June 12
June 15
June 20
Number of Units
1,000
2,000
-1,400
1,500
-2,800
1,000
Total Purchase cost

$11,000
23,000
Cost of goods available for sale Opening Inventory

Purchases: June 2
June 12
June 20
18,000
12,300
Balance (Units)
1,000
3,000
1,600
3,100
300
1,300
$11,000
$23,000
18,000
12,300
53,300
$64,300
Calculations of cost of goods sold and final inventory values under all four methods of
accounting for inventory are as follows.
FIFO Periodic
Ending inventory = 1,000 units from the June 20 purchase @ $12.30
Plus 300 units from the June 12 purchase @ $12.00
= $12,300 + 3,600
= $15,900
Cost of goods sold = $64,300 15,900 = $48,400
Weighted Average Periodic

Weighted average cost per unit
= Cost of goods available for sale number of units available for sale
= $64,300 5,500
= $11.69
Ending inventory = 1,300 units x $11.69 = $15,197
Page 190
FIFO - Perpetual
The ending inventory and Cost of Goods Sold for FIFO Perpetual are identical as for
FIFO Periodic. The following table is for illustration purposes only.
Number of Total Purchase
Units
cost
1,000
$11,000
23,000
2,000
-1,000
-400
June 12
1,500
18,000
June 15
-1,600
-1,200
June 20
1,000
12,300
Unit
Cost
$11.00
11.50
11.00
11.50
12.00
11.50
12.00
12.30
Date
Opening Balance
June 2
June 5
Balance
($)
$11,000
34,000
23,000
18,400
36,400
18,000
3,600
15,900
Moving Weighted Average Perpetual
Number of Balance in
Units
Units
Date
Opening Balance
1,000
1,000
June 2
2,000
3,000
June 5
-1,400
1,600
June 12
1,500
3,100
June 15
-2,800
300
June 20
1,000
1,300
Page 191
Total
Purchase
cost
$11,000
23,000
18,000
12,300
Average
Cost
$11.0000
11.3333
11.3333
11.6558
11.6558
12.1515
Balance
($)
$11,000
34,000
18,133
36,133
3,497
15,797
Application of the Lower of Cost or Market Method

Market is defined as net realizable value. Net realizable value is the estimated selling
price in the ordinary course of business less the estimated costs of completion and the
estimated costs necessary to make the sale. The lower of cost or market rule is applied to
inventory on an item by item basis (IAS 2.29). Note that net realizable value is not the
same as fair value.
The standard allows for the reversal of a write-down in a subsequent period if the net
realizable value of the inventory increases, but not above the original cost (IAS 2.34).
Example: Assume that a company has 5 items of inventory whose cost and net realizable
value at year-end are as follows:
Item
A
B
C
D
E
Original
Cost
$30,000
56,000
12,000
32,000
4,000
Net Realizable
Value
$36,000
55,000
14,000
45,000
2,500
Inventory items B and E need to be written down to net realizable value as follows:
Periodic Inventory System: the values assigned to the ending inventory for items B and E
are $55,000 and $2,500.
Perpetual Inventory System: the following journal entry will be recorded:
Cost of goods sold (or an Inventory loss account)
Inventory
$3,500
$3,500
Estimating Inventories
Estimating Inventories there are two approaches to estimate the values of ending
inventory: the gross profit and retail method.
The gross profit method uses historical estimates of gross profit as a percentage of sales
to estimate cost of goods sold. Once cost of goods sold has been estimated, we can
estimate the value of ending inventory. The gross-profit method is useful in situations
where a physical inventory is not practical, such as a fire loss or a suspected theft loss.
The gross-profit method is not acceptable for financial reporting purposes (except during
interim reporting periods), because it provides only an estimate of the inventory. A
physical count must be taken for annual financial reporting purposes.
Page 192
Example: you are given the following information for the first quarter ending March 31,
20x4:
Beginning inventory
Purchases
Transportation-in
Sales
Historical gross profit margin
$80,000
1,020,000
35,000
18,000
1,500,000
30%
The estimated cost of goods sold is $1,500,000 x (1 - 0.30) = $1,050,000

The cost of goods available for sale is:
Beginning inventory
+ Purchases
+ Transportation-in
- Purchase returns and allowances
80,000
1,020,000
35,000
(18,000)
$1,117,000
The estimate of ending inventory is $1,117,000 - 1,050,000 = $67,000.

Two major assumptions underlie the gross-profit method: (1) the rate of gross profit is
constant from one period to the next, and (2) the sales mix of products is constant from
one period to the next. The historical records of the company provide the information
necessary to use the gross profit method. The rate of gross profit is based on the weighted
average of the gross profit rates of all the individual products. This assumes that the gross
profit rates of the individual products are constant from one period to the next and that
the mix of products sold is constant from one year to the next. Finally, the gross profit
method assumes that if any changes in the gross profit rates or the product mix sold did
occur, the changes would offset each other with no resulting differences in the composite
gross profit rate. If any of these assumptions is violated, the gross profit method gives a
faulty estimate of the inventory value.
The retail inventory method is commonplace in the retail industry. As purchased
merchandise is received, it is displayed immediately for sale at the retail price. Most retail
concerns follow a consistent, observable pattern of markup on the cost of the
merchandise, thereby allowing the use of the retail method to estimate the cost of the
ending inventory.
The records required for the retail method include beginning inventory, purchases at cost
and retail, total sales, and any changes in selling price resulting from additional markups
and markdowns. A cost-to-retail ratio is calculated from these data and then applied to
the ending inventory at retail to estimate the ending inventory at cost.
Page 193
Note that for financial reporting purposes, the gross profit method can only be used for
interim reporting. It cannot be used to estimate the ending inventory at the end of a
company's fiscal year. The retail method, however, can be used to estimate the ending
inventory at the end of a company's fiscal year.
Disclosure Requirements
The following information must be disclosed with regards to inventories (IAS 2.36):
the accounting policies adopted in measuring inventories, including the cost

formula used;
the total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity;
the carrying amount of inventories carried at fair value less costs to sell;
the amount of inventories recognized as an expense during the period;
the amount of any write-down of inventories recognized as an expense in the

period;
the amount of any reversal of any write-down that is recognized as a reduction in

the amount of inventories recognized as expense in the period;
the circumstances of events that led to the reversal of a write-down of inventories;

and
the carrying amount of inventories pledged as security for liabilities.
Page 194

The Following Data Apply to Items 1-3
Addison Hardware began the month of November with 150 large brass switchplates on
hand at a cost of $4.00 each. These switchplates sell for $7.00 each. The following
schedule presents the sales and purchases of this item during the month of November.
Transaction
November 5
November 7
November 9
November 11
November 17
November 22
November 29
Purchases
Date of
Received
Quantity
Unit Cost
200
$4.20
200
4.40
250
4.80
Units Sold
100
150
220
100
1.
If Addison uses FIFO inventory pricing, the value of the inventory on November 30
would be
a) $936.
b) $1,012.
c) $1,046.
d) $1,076.
e) $1,104.
2.
If Addison uses perpetual moving average inventory pricing, the sale of 220 items
on November 17 would be recorded at a unit cost of
a) $4.00.
b) $4.16.
c) $4.20.
d) $4.32.
e) $4.40.
3.
If Addison uses weighted average inventory pricing (periodic), the gross profit for
November would be
a) $1,046.
b) $1,482.
c) $1,516.
d) $1,548.
e) $1,574.
Page 195
4.
Miller, Ltd. estimates the cost of its physical inventory at March 31 for use in an
interim financial statement. The rate of markup on cost is 25%. The following
account balances are available:
Inventory, March 1
Purchases
Purchase returns
Sales during March
$220,000
172,000
8,000
350,000
The estimate of the cost of inventory at March 31 would be

a) $34,000
b) $104,000
c) $121,500
d) $78,000
Problem 1
So Slow Ltd.s record of transactions for the month of April was as follows:
April 1
April 3
April 4
April 8
April 9
April 11
April 13
April 21
April 23
April 27
April 29
Purchases
600 @ $6.20
Sales
500 @ $10.00
1,500 @ 6.00
800 @ 6.40
1,400 @ 10.00
600 @ 11.00
1,200 @ 6.50
700 @ 6.60
1,200 @ 11.00
900 @ 12.00
500 @ 6.79
Required
1.
2.
Assuming that the periodic system is used, compute the inventory at April 30
using (1) FIFO and (2) weighted-average cost.
Assuming that the perpetual system is used, compute the inventory at April 30
using (1) FIFO and (2) weighted-average cost.
Page 196
Problem 2
High Tech Manufacturing Company uses a special alloy called Moly in its manufacturing
process.
In 20x0, the beginning inventory and the purchases of Moly during the year were as
follows:
kg
Price/kg
January 1
Inventory
300
$11.50
April 12
Purchase
400
12.00
July 7
Purchase
240
11.70
November 2
Purchase
320
12.30
At December 31, 20x0, a physical inventory count showed that 360 kg of Moly were still
in inventory.
Required a) Determine the dollar value of the December 31, 20x0, inventory using:
i)
FIFO
ii)
Weighted Average Costs.
b) Which inventory valuation method will produce the highest net income for 20x0?
Explain.
Page 197
Problem 3
Manning Company Ltd. purchases and sells one product. Information regarding this
product for the first period of operations was as follows:
Quantity
Purchased
2,000
1,500
1,800
5,300
Unit Cost
$12
14
15
Acquisition
Cost
$24,000
21,000
27,000
$72,000
The Manning Company uses a periodic inventory system. Sales for the period were 5,000
units at $20 per unit. Assume that all sales took place at the end of the period at which
time the replacement cost of the product was $16.50 per unit.
Required
Compute the cost of goods sold expense and the ending inventory balance under the
FIFO assumption.
Problem 4
You are a member of the internal audit team performing the year end examination of the
inventory of Pilfer Limited, as of December 31, 20x0, and are confronted with the
following situations:
1. On December 30, Pilfer had completed and packed a special order for delivery to
Steel Ltd. Pilfer had invoiced Steel on December 30, and had excluded the items in
this special order from its December 31 inventory count. However, because of the
unavailability of a courier during the holiday season, Pilfer did not ship the order until
January 3, 20x1. The order had a cost of $600, and a selling price to Steel of $900.
2. During your observation, you noted several cartons being unloaded on January 2.
These had been shipped FOB shipping point on December 20, and the invoice for
$350 had been received and recorded at that time.
3. You noted that invoices totalling $450 from your customs broker for his fees relative
to incoming merchandise had been charged to "Brokerage expense". One third of the
current year's purchases were still in inventory at December 31.
4. It was noted that purchases later in the year were at generally much lower prices than
those earlier in the year. Pilfer uses the weighted-average method of inventory
valuation, which provided a recorded value of $32,000 for inventory; market value
for inventory was $30,000 at December 31.
Page 198
Required a) As a member of the internal audit team, make a recommendation to your team leader
as to what action should be taken, as a result of the above information. You should
fully justify your recommended treatment in terms of normal accounting practice and
accounting principles as they relate to these situations.
b) Prepare the necessary journal entries to correct or update the books of the Pilfer
Company as at December 31, with respect to the four situations.
Problem 5
Port Debit Marina buys and sells new and used sailboats. At the end of the 20x0 season, a
B&B 27 built in 1979 was purchased for $20,000 and placed in inventory. The boat was
white with blue trim. At the beginning of the 20x1 season, the marina purchased another
B&B 27, also built in 1979, for $24,000 and placed it in inventory. This boat was white
but had green trim.
During the 20x1 season, 1979 B&B 27s are selling for $28,000. The white and blue boat
and the white and green boat are identical boats in similar condition except for the trim
colors. These colors are equally popular with sailors.
The marina uses the specific identification method to value inventory because boats are
usually different. The accountant for the marina is concerned about this. He wants to
change the method from specific identification to another "fairer" method to value
inventory of similar boats. He is considering FIFO or weighted average but feels that the
weighted-average method will be better to achieve his purpose, which is to make gross
profit the same for either B&B 27.
There are only three working days left in April, 20x1, and this month's sales have been
slow. The manager of Port Debit Marina wants to report as high a profit as possible for
April, 20x1. He receives a bonus based on income before income taxes. Because of this,
he wants the salesmen to concentrate on selling the white and blue sailboat rather than the
white and green one. It is expected that one B&B 27 will be sold before the month is
over.
Required Discuss the accountant's concerns and the manager's point of view. Is it to the advantage
of Port Debit Marina to use the weighted-average method to value inventory? Discuss.
Page 199
Problem 6
Sapphire Company lost the previous month's records. The current month's records show
the following:
Transportation-In
Purchase Returns and Allowances
Ending Inventory
Purchases
Cost of Goods Sold
$ 1,800
2,100
32,300
75,900
72,500
Required i)
ii)
Calculate the current month's beginning inventory.

If the inventory at the end of the current year is overstated and the error is not
caught during the following year, what is the effect on income for both years?
Briefly explain.
Problem 7
The Simpson Company supplies you with the following information:
Freight-in
Freight-out (selling expense)
Gross sales
Merchandise inventory, Jan 1, 20x2
Merchandise inventory, Dec 31, 20x2
Purchases
Office supplies used
Purchase discounts
Sales returns and allowances
Supplies inventory, Dec 31, 20x2
$ 3,000
2,000
100,000
12,000
14,000
72,000
7,000
4,000
6,000
10,000
5,000
Required Calculate the cost of goods sold for Simpson Company. Make entries to (1) record cost
of goods sold and (2) close all temporary accounts to cost of goods sold. Simpson uses a
periodic inventory system.
Page 200
Problem 8
The Wicks Company was formed on January 1, 20x2. The following information is
available from Wicks' inventory records:
Beginning inventory, 1/1/x2

Purchases
1/5/x2
1/25/x2
2/16/x2
3/26/x2
UNITS
800
UNIT
COST
$ 9.00
1,500
1,200
600
800
9.50
10.50
11.00
11.50
A physical inventory on March 31, 20x2, shows 1,600 units on hand.

Required:
Prepare schedules to calculate the ending inventory at March 31, 20x2, under each of the
following inventory methods (assume a periodic inventory system):
1. FIFO.
2. Weighted average.
Problem 9
D Ltd.'s December 31, 20x2, Statement of Financial Position reported inventory of
$55,000. There were 10,000 units of inventory on hand at December 31, 20x2. During
20x3, D Ltd. engaged in the following inventory transactions:
Jan. 31
Feb. 20
Mar. 30
June 29
Aug. 4
Oct. 15
bought
sold
sold
bought
sold
bought
6,000
4,000
2,000
6,000
12,000
9,000
units for
units for
units for
units for
units for
units for
$ 27,000
32,000
16,500
28,800
102,000
36,000
Calculate D Ltd.'s reported gross profit from the above inventory transactions assuming
that D Ltd. uses:
a) FIFO - Periodic
b) Weighted Average - Periodic
d) FIFO - Perpetual
d) Moving Weighted Average - Perpetual
Page 201
Problem 10
The Windsor Company has the following inventory transactions for item #A203 for the
month of August:
Date
August
1
5
8
10
13
17
21
Units
1,000
200
600
400
800
500
800
Balance
Purchase
Sale
Sale
Purchase
Sale
Purchase
Unit Cost
$12.00
12.20
12.60
13.00
Calculate Windors ending inventory from the above inventory transactions assuming
that Windsor uses:
a.
FIFO - Periodic
b.
Weighted Average - Periodic
c.
FIFO - Perpetual
d.
Moving Weighted Average Perpetual
Problem 11
The Schmitt Corporation carries four items in inventory. The following data are available
at December 31, 20x5:
A301
A302
A303
A304
Units
Cost
2,500
1,500
4,500
2,400
$11.00
12.00
5.00
14.00
Replacement
Cost
$10.50
12.00
4.00
15.00
Estimated
Selling Price
$12.00
18.50
8.40
15.00
Selling
Cost
$1.80
1.60
1.90
2.40
Normal
Profit
$4.00
2.50
1.00
3.50
Required
Calculate the value of inventory and the journal entry (if any) to adjust the ending
inventory value.
Page 202
Problem 12
A fire destroyed the inventory of the Udit Company on October 16, 20x3. Data for the
20x2 fiscal year and for the year to data on 20x3 is as follows:
Sales
Beginning inventory
Purchases
Ending inventory
Year ended
December 31, 20x2
$5,000,000
840,000
4,300,000
850,000
Period ended
October 16, 20x3
$3,600,000
850,000
2,800,000
????
Required
Estimate the cost of the inventory destroyed on October 16, 20x3.
Page 203
SOLUTIONS

1.
2.
3.
Cost of goods available for sale

= (150 x 4.00) + (200 x 4.20) + (200 x 4.40) + (250 x 4.80) = $3,520
Unit cost = $3,520 / 800 = $4.40
Gross Profit = 570 units sold x (7.00 - 4.40) = $1,482
4.
Gross profit % = 25 / 125 = 20%

Cost of goods sold = $350,000 x 80% = $280,000
Ending inventory = $220,000 + 172,000 8,000 280,000 = $104,000
Page 204
230 x $4.80 = 1,104

50
200
250
-150
100
200
300
@
@
@
@
@
@
4.00
4.20
4.16
4.16
4.16
4.40
4.32
200
840
1,040
-624
416
880
1,296
Problem 1
a.
(1)
FIFO
500 x 6.79
200 x 6.60
$3,395
1,320
$4,715
(2)
Sum of purchases = (600 x 6.20) + (1,500 x 6.00) + (800 x 6.40)

+ (1,200 x 6.50) + (700 x 6.60) + (500 x 6.79) = $33,655
Average cost = 33,655 5,300 = $6.35
Inventory = $6.35 x 700 units = $4,445
b.
(1)
FIFO
Date
Apr 1
Apr 3
Apr 4
Apr 8
Apr 9
Apr 11
Apr 13
Apr 21
Apr 23
Apr 27
Apr 29
Page 205
Change
in Units
600
-500
Balance
600
100
Unit
Cost
6.20
6.20
Change
In Cost
3,720
-3,100
Inventory
Balance
3,720
620
1,500
800
-100
-1,300
-200
-400
1,200
700
-400
-800
-400
-500
500
1,600
2,400
2,300
1,000
800
400
1,600
2,300
1,900
1,100
700
200
700
6.00
6.40
6.20
6.00
6.00
6.40
6.50
6.60
6.40
6.50
6.50
6.60
6.79
9,000
5,120
-620
-7,800
-1,200
-2,560
7,800
4,626
-2,560
-5,200
-2,600
-3,300
3,395
9,620
14,740
14,120
6,320
2,560
10,360
14,980
7,220
1,320
4,715
(2)
Moving Average
Date
Apr 1
Apr 3
Apr 4
Apr 8
Apr 9
Apr 11
Apr 13
Apr 21
Apr 23
Apr 27
Apr 29
Change
in Units
600
-500
1,500
800
-1,400
-600
1,200
700
-1,200
-900
500
Balance
600
100
Unit
Cost
6.20000
6.20000
Change
In Cost
3,720
-3,100
Inventory
Balance
3,720
620
1,600
2,400
1,000
400
1,600
2,300
1,100
200
700
6.01250
6.14167
6.14167
6.14167
6.41063
6.46826
6.46826
6.46826
6.69857
9,000
5,120
-8,598
-3,685
7,800
4,620
-7,762
-5,821
3,395
9,620
14,740
6,142
2,457
10,257
14,877
7,115
1,294
4,689
Problem 2
a)
i)
ii)
FIFO Ending Inventory

320 kg at 12.30 =
40 kg at 11.70 =
360 kg
$3,936
468
$4,404
Weighted Average Cost Ending Inventory
January 1
April 12
July 7
November 2
Inventory
Purchase
Purchase
Purchase
kg
300
400
240
320
1,260
x
x
x
x
Cost/kg
$11.50
12.00
11.70
12.30
=
=
=
=
$3,450
4,800
2,808
3,936
$14,994
$14,994/1,260 kg = $11.90/kg
Ending Inventory: 360 kg x $11.90/kg = $4,284
b) Net Income = revenue - cost of goods sold
FIFO produces the highest ending inventory value which results in a lower cost of goods
sold and, therefore, the highest net income.
Page 206
Problem 3
a)
FIFO: cost of goods sold
= (2,000 x $12) + (1,500 x $14) + (1,500 x $15)

= $67,500
Ending inventory = 300 x $15 = $4,500
Problem 4
a)
b)
1)
This item is properly excluded from the inventory count, as it is a special

order item that has been completed and segregated from inventory. The
essential criteria of completion of the earnings process appears complete,
so that revenue may be recognized, and it is normal accounting practice to
recognize revenue for special orders in this manner. That is especially true
in this case, as the only item which precluded delivery was the
unavailability of a courier.
2)
The terms of the sale are FOB shipping point, so risk transferred to Pilfer
on December 20, and these items should be included in the ending
inventory count. The purchase and related liability are correctly recorded
in the year just ended.
3)
The brokerage fees should be included as a part of the cost of inventory, as

they are directly attributable to the acquisition of merchandise. They are
included as a result of the cost principle, which specifies that inventories
be valued at the "net laid-down cost." An appropriate portion should be
charged to the cost of goods sold.
4)
The company should recognize the decline in value as a charge against

income in the period just ended.
1)
No entry required.
2)
No entry required, but these items should be included in the inventory

count.
3)
Inventory
Cost of goods sold
Brokerage expense
Page 207
$150
300
$450
4)
Unrealized loss on decline in market value of
inventory
Inventory
$2,000
$2,000
Problem 5
Accountant's proposal
Specific identification may indicate different costs for similar items. This portrays reality
since the items' costs vary.
The method selected to determine costs should be the one which results in the fairest
matching of costs against revenues. However, changing methods frequently inhibits
comparability.
When specific identification is possible it has to be used unless the products are
interchangeable. In the case of sailboats, these normally would not be interchangeable.
Therefore, the use of the specific identification method should be used.
Weighted-average method can only be used if the items are all identical. Aside from the
color of the trim, this is the case for these boats. FIFO assumes that goods are sold on a
FIFO basis, which is not the case for boats.
Manager's point of view
Since his objectives are to maximize profit (i.e., his bonus), the manager's logic cannot be
faulted under the existing accounting scheme. He would want to use specific
identification if the white and blue sailboat is sold and weighted average if the white and
green sailboat is sold.
Is it to the advantage of Port Debit to use the weighted-average method?
Port Debit Marina is a going concern and therefore we must not only consider the profits
to be reported today but also those to be reported in the future.
Under the current system, when the marina sells the white and blue boat it will report
$8,000 profit. When the white and green boat is sold it will generate $4,000 profit. Based
on specific identification, the profit to be reported first will depend on which boat is sold
first.
There is no difference to the cash flows whichever inventory method is used (except that
the manager's bonus is higher this year and lower next).
Average cost would smooth out income. The desirability of this should be examined.
Page 208
The decision of which method to use should be based on sound accounting principles and
not on the manager's potential bonus.
From a control (and matching) point of view, Port Debit is probably better off with
specific identification.
Problem 6
i)
ii)
Purchases
- Purchase Returns & Allowances
+ Transportation-In
Cost of Gross Purchases
75,900
(2,100)
1,800
75,600
Cost of Goods Sold

+ Ending Inventory
Cost of Goods Available for Sale
- Cost of Gross Purchases
Beginning Inventory
72,500
32,300
104,800
75,600
29,200
To overstate income this year and understate income next year.
Page 209
Problem 7
Cost of goods sold (a residual)
Inventory
Purchase discounts
Purchases
Freight in
63,000
2,000
4,000
6,000
72,000
3,000
Problem 8
1.
2.
FIFO:
Ending inventory by physical count = 1,600 units
Purchased March 26
800 units @ $11.50 per unit =
Purchased February 16
Purchased January 25
FIFO ending inventory
1,600 units
=
$ 9,200
6,600
2,100
$17,900
WEIGHTED AVERAGE:
Inventory, January 1
800 units
Purchase, January 5
1,500 units
Purchase, January 25
1,200 units
Purchase, February 16
600 units
Purchase, March 26
800 units
4,900 units
$ 7,200
14,250
12,600
6,600
9,200
$49,850
Total cost of goods available

Total units of goods available
Weighted average ending inventory
Page 210
@ $ 9.00 per unit =

@ $ 9.50 per unit =
@ $10.50 per unit =
@ $11.00 per unit =
@ $11.50 per unit =
=
49,850
= $10.173
4,900
= 1,600 units @ $10.173 per unit
= $16,277
Problem 9
a)
Ending inventory = 13,000 units

9,000 x $4.00
4,000 x $4.80
$36,000
19,200
$55,200
Sales (32,000 + 16,500 + 102,000)

COS
Opening inventory
Purchases (27,000 + 28,800 + 36,000)
Ending inventory
Gross margin
b)
$150,500
55,000
91,800
-55,200
91,600
$58,900
Average cost
= Cost of goods available for sale Units available for sale
= ($55,000 + 91,800) (10,000 + 6,000 + 6,000 + 9,000)
= $146,800 31,000
= $4.735484
Ending inventory = 13,000 units x $4.735484
$61,560
Sales (32,000 + 16,500 + 102,000)

COS
Opening inventory
Purchases (27,000 + 28,800 + 36,000)
Ending inventory
Gross margin
c)
Same as for periodic system.
d)
Date
Jan 1
Jan 31
Feb 20
Mar 30
Jun 29
Aug 4
Oct 15
Purchases
Sales
6,000
4,000
2,000
6,000
12,000
9,000
Sales (32,000 + 16,500 + 102,000)

COS
Opening inventory
Purchases (27,000 + 28,800 + 36,000)
Ending inventory
Gross margin
Page 211
$150,500
55,000
91,800
-61,560
Balance
10,000
16,000
12,000
10,000
16,000
4,000
13,000
Cost
55,000
82,000
61,500
51,250
80,050
20,013
56,013
85,240
$65,260
Cost/Unit
5.5000
5.1250
5.1250
5.1250
5.0031
5.0031
4.3087
$150,500
55,000
91,800
-56,013
90,787
$59,713
Problem 10
a.
Ending inventory in units = 1,300 units

(800 units x $13.00) + (500 units x $12.60) = $16,700
b.
Cost of goods available for sale

= (1,000 x $12.00) + (200 x $12.20) + (800 x $12.60) + (800 x $13.00)
= $12,000 + 2,440 + 10,080 + 10,400
= $34,920
Units available for sale = 1,000 + 200 + 800 + 800 = 2,800
Average cost = $34,920 / 2,800 = $12.471
Cost of ending inventory = 1,300 units x $12.471 = $16,212
c.
Date
August 1
August 5
August 8
August 10
August 13
August 17
August 21
d.
Date
August 1
August 5
August 8
August 10
August 13
August 17
August 21
*
Change
in Units
200
-600
-400
800
-200
-300
800
Change
in Units
200
-600
-400
800
-500
800
Balance
1,000
1,200
600
200
1,000
800
500
1,300
Unit
Cost
12.00
12.20
12.00
12.00
12.60
12.20
12.60
13.00
Change
In Cost
Balance
1,000
1,200
600
200
1,000
500
1,300
Unit
Cost*
12.00
12.03333
12.03333
12.03333
12.48700
12.48700
12.80308
Change
In Cost
2,440
-7,200
-4,800
10,080
-2,440
-3,780
10,400
2,440
-7,220
-4,813
10,080
6,243
10,400
Inventory
Balance
12,000
14,440
7,240
2,440
12,520
10,080
6,300
16,700
Inventory
Balance
12,000
14,440
7,220
2,407
12,487
6,244
16,644
the unit cost is recalculated each time a purchase is made, for example, the unit
cost on August 5 is calculated by taking the inventory balance of $14,440 and
dividing it by the unit balance of 1,200.
Page 212
Problem 11
Market is defined as Net Realizable Value = estimated selling price less selling costs.
A301
A302
A303
A304
Units
2,500
1,500
4,500
2,400
Unit Cost
$11.00
12.00
5.00
14.00
Total Cost
$27,500
18,000
22,500
33,600
Unit NRV
$10.20
16.90
6.50
12.60
Unrealized loss on inventory

Inventory (Unit A301)
$2,000
Unrealized loss on inventory

Inventory (Unit A304)
3,360
Total NRV
$25,500
25,350
29,250
30,240
$2,000
3,360
Problem 12
Cost of goods sold in 20x2 = $840,000 + 4,300,000 850,000 = $4,290,000
Cost of goods sold as a % of sale in 20x2 = $4,290,000 / 5,000,000 = 85.8%
Estimated cost of goods sold in 20x3 = $3,600,000 x 85.8% = $3,088,800
Estimated ending inventory => $850,000 + 2,800,000 EI = $3,088,800
= $3,650,000 3,088,800 = $561,200
Page 213
8.
Capital Assets
Property, Plant and Equipment - General Recognition Principle

Property, plant and equipment are defined as tangible items that:
(a)
are held for use in the production or supply of goods and services, for rental to
others, or for administrative purposes; and
(b)
are expected to be used during more than one period. (IAS16.6)
The general recognition principle applies to (i) the initial recognition of an asset, (ii)
when parts of that asset are replaced, and (iii) when costs are incurred relative to that
asset during its useful life. The standard does not distinguish between costs capitalized at
acquisition and costs capitalized post-acquisition. It specifies that the cost of an item of
property, plant and equipment as an asset if, and only if:
(a)
it is probable that future economic benefits associated with the item will flow to
the entity, and
(b)
the cost of the item can be measured reliably. (IAS 16.7)
Assets acquired for safety or environmental reasons should be capitalized as property,
plant and equipment even though these do not meet the strict general recognition
principle. This is because these expenditures have to be incurred in order for the
productive assets to generate future benefits. (IAS 16.11)
Capital assets should be recorded at cost. Cost should be interpreted fairly broadly and is
meant to include all costs incurred in order to put the asset to productive use. For
example, this would include, in addition to the cost of acquiring the asset, freight,
installation costs, and testing of equipment.
There are three components of the initial cost of an asset:
(1) the purchase price the amount of cash or cash equivalents paid or the fair value of
the other consideration given to acquire the asset. If the asset is acquired in exchange for
a note payable, the asset is recorded at the present value of the note. Purchases of groups
of assets are allocated to the assets based on their relative fair market values.
For example, say we purchase a building that comprises several pieces of equipment for
$1,000,000. If we obtain separate market values for the land, building and equipment, we
would break down the cost as follows:
Page 214
Land
Building
Equipment
Separate
Market
Value
Allocation
of Cost
$200,000
900,000
300,000
14.3%
64.3%
21.4%
$143,000
643,000
214,000
$1,400,000 100.0%
$1,000,000
(2) directly attributable costs these are defined as costs necessary to bring the asset to
the location and condition necessary for it to be capable of operating in the manner
intended by management (IAS 16.20).
Examples of directly attributable costs (IAS 16.17):
costs of employee benefits arising from the construction or acquisition of the item
of property, plant and equipment
costs of site preparation
initial delivery and handling costs
installation and assembly costs
costs of testing whether the asset is functioning properly
professional fees
Note the use of the words necessary which implies that in order to be capitalized, that
these costs could not have been avoided. An additional cost that can be capitalized are
borrowing costs. This is discussed further in this section.
The following costs are specifically excluded (IAS 16.19 and 16.20):
costs of opening a new facility, such as an open house. These costs are incurred
after the asset is capable of being used.
costs of introducing a new product or service, including costs of advertising and

promotional activities.
administrative and other general overhead costs.
costs incurred while waiting for the asset to be used, but subsequent to the asset
being capable of being used.
operating losses incurred in the initial stages of operating the asset.

(3) the initial estimate of the cost of dismantling, removal or restoration this refers to
costs of dismantling, removing or restoring an asset, also known as decommissioning
costs. These costs are typically at the end of the useful life of the asset. The present value
of these costs are added to the cost of the asset and depreciated over the useful life of the
asset. The resulting asset retirement obligation is shown as a long-term liability. Interest
accrued on the asset retirement obligation over the life of the asset is expensed as a
finance cost on the income statement.
Page 215
Example: an oil refinery is purchased on December 31, 20x1 at a cost of $50 million cash
(allocated $10 million to land and $40 million to the refinery itself). The company has a
legal/constructive obligation1 to dismantle the site at the end of its 30 year useful life.
The best estimate of this cost is $10 million.
Assuming a discount rate of 5%, the present value of the asset retirement obligation is
$2,313,774:
Enter
Compute
N
30
I/Y
5
PV
PMT
FV
10,000,000
X=
2,313,774
The journal entry to record the purchase of the oil refinery would be as follows:
Dec 31, 20x1
Land
Refinery
Cash
Asset Retirement Obligation
$10,000,000
42,313,774
$50,000,000
2,313,774
Assuming the refinery has no residual value and that the company uses the straight line
method of depreciation, the journal entry to record depreciation expense at December 31,
20x2 would be as follows:
Dec 31, 20x2
$42,313,774 / 30 years
$1,057,844
$1,057,844
The interest accrued on the asset retirement obligation would be recorded as follows:
Dec 31, 20x2
Interest expense
$2,313,774 x 5%
$115,689
$115,689
At December 31, 20x3, the following entries would be recorded:

Dec 31, 20x2
$42,313,774 / 30 years
Interest expense
($2,313,774 + 115,689) x 5%
$1,057,844
$1,057,844
121,473
121,473
1 The distinction between a legal and constructive obligation will be explained in the Liabilities section of
this module.
Page 216
Assume now that, in 20x14, the estimate of the asset retirement obligation at the end of
the useful life of the refinery will be $16 million.
We first calculate the present value of the new estimate as at January 1, 20x14:
Enter
Compute
N
18
I/Y
5
PV
PMT
FV
15,000,000
X=
6,232,810
The book value of the asset retirement obligation as at December 31, 20x13 is:
Enter
Compute
N
18
I/Y
5
PV
PMT
FV
10,000,000
X=
4,155,207
The following entry would be recorded in 20x14 to increase the asset retirement
obligation:
20x14
Refinery
Asset retirement obligation
$6,232,810 - 4,155,207
$2,077,603
$2,077,603
The net book value of the refinery at December 31, 20x13 is: $42,313,774 x 18/30 =
25,388,264. The journal entries to record depreciation expense on the refinery and
interest expense on the asset retirement obligation at December 31, 20x14 are as follows:
Dec 31, 20x14
($25,388,264 + 2,077,603) / 18 years
Interest expense
$6,232,810 x 5%
$1,525,882
$1,525,882
311,641
311,641
Note that the increase in the carrying value of the refinery is subject to the general
recognition principle in that it is probable that future economic benefits associated with
the item will flow to the entity (IFRIC 1.5).
Page 217
Component Approach
The standard requires a component approach to asset recognition i.e. significant parts
of an asset have to be recorded in separate accounts and depreciated separately. These are
generally parts that have a significant cost in relation to the total cost of the asset. For
example, an asset costing $100,000 may be made up of two distinct parts Part A which
has a useful life of 10 years and Part B which has a useful life of 5 years. On the date of
acquisition, the cost of the asset would have to be split between the two parts and the two
parts would have to be depreciated separately. (IAS 16.9)
Note that the decision to breakdown an asset into components is based on managerial
judgment and materiality.
Example - on December 31, 20x1 a truck is purchased at a cost of $250,000. The
components of the truck are as follows:
Truck Body
Engine
Tires
Cost
$150,000
90,000
10,000
Useful Life
20 years
10 years
5 years
Each of the three components would be recorded and depreciated separately.
Depreciation
There are generally speaking, three methods used to depreciate capital assets: units of
production, straight-line and the diminishing balance method.
The residual value of an asset is defined as the estimated amount that could be currently
obtained from disposal of the asset, after deducting the estimated costs of disposal, on the
assumption that the asset were already of the age and condition expected at the end of its
useful life (IAS 16.6).
Depreciation starts when an asset is available for use.
1.
Units of Production
Units of production method is used when the asset use (mileage, machine hours) can
be measured. For example, if a machine has a useful life of 200,000 machine hours and it
is possible (and economically feasible) to measure these machine hours, then the units of
production method of depreciation may be used.
Page 218
Assume that the original cost of the asset was $150,000 and has a residual value of
$20,000. We would then depreciate $130,000 ($150,000 20,000) over the 200,000
machine hours: $130,000 200,000 = $0.65 per machine hour.
If, in the first year, we used 24,000 machine hours, then the depreciation charge would
be: 24,000 x $0.65 = $15,600.
This method is not often used. The probable reason is that it requires that each piece of
equipment be metered and measured.
2.
Straight-line method
The straight-line method depreciates assets evenly over time. The depreciation expense is
the same year after year.
Continuing with the same example, if we assume that the useful life of the asset is 5
years, then the annual depreciation would be: $130,000 5 years = $26,000.
3.
Diminishing Balance method
This method provides depreciation charges be higher in the first year and dropping off
afterwards.
Example: you purchase a piece of equipment costing $200,000 with a $20,000 residual
value and you decide to depreciate it at the rate of 20%, the following would be the
depreciation charges over the life of the asset:
Year
1
2
3
4
5
6
7
8
9
10
11
Net Book Value

Beginning
$200,000
160,000
128,000
102,400
81,920
65,536
52,428
41,942
33,554
26,843
21,474
Depreciation
$40,000
32,000
25,600
20,480
16,384
13,108
10,586
8,388
6,711
5,369
1,474
Net Book Value

Ending
$160,000
128,000
102,400
81,920
65,536
52,428
41,942
33,554
26,843
21,474
20,000
Note that the depreciation expense in a given year is equal to the Net Book Value of the
asset times the depreciation rate. Also, the asset is depreciated down to its residual value
and no more. In the 11th year, the calculated depreciation would have been: $21,474 x
20% = 4,295. But this would have brought the net book value of the asset below its
Page 219
residual value. Therefore, the amount of depreciation taken in the 11th year was equal to
$1,474 which is just enough to bring the book value down to $20,000.
If you are required to determine the net book value of an asset at the end of the nth year,
you can do so by using the following formula:
Net Book Value at end of nth year = Original cost x (1- depreciation rate)n
For example, the net book value at the end of the 10th year is:
$200,000 (1 - .20)10
= $200,000(.8)10
= $21,474
Choice of Depreciation Methods
The choice of depreciation method is driven by the patters in which the asset's future
economic benefits are expected to be consumed by the entity (IAS 16.60) and has little to
do with the economic depreciation of the asset itself. A common misconception is that if
an asset depreciates at a greater amount in the early years of its useful life, then the
diminishing balance method must be used.
The choice depreciation method is based on the expected revenue stream to be generated
by the asset itself:
if an asset is expected to generate revenues evenly over the assets useful life,
then the straight line method should be used,
if the asset is expected to generate higher revenues in the early years of the assets
useful life, then the diminishing balance method should be used, and
if the asset is expected to generate revenues based in the assets use, then the units
of production method should be used.
Both the depreciation method used and the residual values of assets have to be assessed
on an annual basis.
Self-Constructed Assets and Borrowing Costs

A self-constructed asset is one where the company uses its own equipment and labour to
produce the asset. The cost of the self-constructed asset should include all direct out-of
pocket costs and should also include appropriate cost allocations of joint costs consumed
by the construction of the asset. For example, if a construction company decides to pave
its company headquarters parking lot, it will put depreciable assets to use (trucks, paving
equipment). It would make sense that a reasonable amount of depreciation on this
equipment be capitalized to the cost of the parking lot. Note that the general recognition
criteria applies to self-constructed assets, i.e., the costs can be capitalized if, and only if:
Page 220
(a)
(b)
the entity, and
the cost of the item can be measured reliably.
The capitalization of borrowing costs is covered by IAS 23. The standard defines a
qualifying asset as an asset that necessarily takes a substantial amount of time to get
ready for its intended use or sale (IAS 23.5). This includes intangible assets and
inventory, but excludes inventories that are routinely manufactured or otherwise
produced in large quantities or on a repetitive basis. Examples of these would include
items that take some time to manufacture but that are sold as standard items such as
residential housing, subway cars, aircraft, etc (IAS 23.4).
Borrowing costs are defined as interest on short-term and long-term debt and includes
any amortization of discounts and premiums and finance charges on leases. The
capitalization rate is defined as the annual borrowing costs divided by the weighted
average debt that generated borrowing costs. The capitalization rate is applied to the
weighted average expenditures made on qualifying assets. The resulting amount is the
amount of borrowing costs to be capitalized to the asset. Note that the borrowing costs
capitalized can be on borrowings made for the direct purpose of financing the selfconstructed asset and/or can be on the firm's general borrowings. If the proceeds of an
asset-specific loan are invested to generate investment income, the proceeds of the
investment income reduce the borrowing costs capitalized.
Commencement of capitalization occurs when the earliest of all of the following three
conditions are met:
(a) expenditures for the asset are being incurred;
(b) borrowing costs are being incurred; and
(c) activities that are necessary to prepare the asset for its intended use or sale are in
progress. (IAS 23.17)
Cessation of capitalization occurs when substantially all the activities necessary to
prepare the qualifying asset for its intended use of sale are complete. (IAS 23.22)
Note that the capitalization of borrowing costs is mandatory.
Example: On March 1, 20x3, a company begins the construction of an asset. Construction
ended on October 31, 20x3. The company's year end coincides with the calendar year.
The following costs were incurred in the construction of the asset:
Mar 1, 20x3
May 1, 20x3
June 1, 20x3
July 15, 20x3
Sep 1, 20x3
Oct 1, 20x3
Page 221
$200,000
100,000
50,000
130,000
200,000
150,000
The company's borrowings are as follows:
a $200,000, 7% one year note dated January 1, 20x3. This note relates
specifically to the self-constructed asset.
bonds payable in the amount of $5,000,000. The annual interest on these bonds is
8.5%.
other long-term debt in the amount of $2,000,000 bearing interest at 6%.

First, we calculate the average investment in the project:
Date
Costs Proportion of time

Incurred to October 31, 20x3
Mar 1, 20x3
May 1, 20x3
June 1, 20x3
July 15, 20x3
Sep 1, 20x3
Oct 1, 20x3
$180,000
120,000
60,000
150,000
240,000
150,000
Average
Investment
8/12
6/12
5/12
3.5/12
2/12
1/12
$120,000
60,000
25,000
43,750
40,000
12,500
$301,250
Borrowing costs on specific borrowings are charged first to the asset, then we will
allocate general borrowings based on the weighted average borrowing rate of 7.8%:
8.5% x ($5,000,000 / 7,000,000) + 6% x (2,000,000 / 7,000,000) = 7.8%
Borrowing costs to be capitalized:
Asset specific note: $200,000 x 7%
General borrowings: ($301,250 - 200,000) x 7.8%
$14,000
7,898
$21,898
Disclosure requirements - the entity must disclose (1) the amount of borrowing costs
capitalized and (2) the capitalization rate used to determine the amount if borrowing costs
eligible for capitalization.
The Revaluation Model

Companies can choose between two models for accounting for property, plant and
equipment: the cost model and the revaluation model. The revaluation model measures
the carrying amount of the assets at their fair value which is defined as the amount for
which an asset could be exchanged between knowledgeable, willing parties in an arms
length transaction. In most cases this would be equal to the market value of the asset.
However, when there is no active market for the assets in question, the use of surrogate
measures such as depreciated replacement cost or use of market indices can be used.
Page 222
The standard is silent on the nature of the frequency of revaluations. The only guideline
provided is that revaluations should be done in sufficient regularity such that the carrying
amount of the asset does not materially differ from fair value. The frequency of
revaluation should ultimately depend on the nature of the assets. If the assets are subject
to rapid obsolescence, then revaluations should occur more frequently.
The revaluation model is not applied to individual asset items but to classes of assets, i.e.
land, buildings, machinery, etc For each asset class, management can choose between
the cost and revaluation model as long as these are applied consistently for all
components in the class. For example, it is possible to use the revaluation model for land
and buildings and the cost model for all other classes of assets.
The best way to describe the application of the revaluation model is by way of example.
Assume that Company X is formed on January 1, 20x1. The following assets are
purchased on this date:
Land
Building
$500,000
1,500,000
Useful life = 40 years

Residual value = $300,000
Company X chooses to apply the revaluation model. Because the market for real estate is
relatively stable, the company chooses to revalue the assets every three years, i.e. the first
revaluation will be made in January 20x4, the second in January 20x7
For years 20x1 20x3, the building will be depreciated at the rate of $30,000 per year.
The net book value of the building on January 1, 20x4 will be:
$1,500,000 (30,000 x 3 years) = $1,410,000
January 20x4 revaluation - The appraisals of the land and building in January 20x4 are
$600,000 for land and $1,460,000 for the building.
The increase in the value of land will be as follows:
Land
Revaluation Surplus (OCI)
$100,000
$100,000
The Revaluation Surplus account will be part of Other Comprehensive Income, which in
turn, is part of Shareholders Equity.
For the building, two approaches can be used:
1.
restate proportionately with the change in the gross carrying amount of the
asset so that the carrying amount of the asset after revaluation equals its
revalued amount, or
Page 223
2.
eliminate the accumulated depreciation balance against the gross carrying

amount of the asset and the net amount is then restated to the fair value of the
asset. (IAS 16.35)
Using the first approach, which we will label the Proportional Method, we first
recalculate the original cost and the accumulated depreciation on the building by
multiplying each by the revalued amount divided by the current net book value of the
assets, 1,460 / 1,410:
Building
Carrying
amount before
revaluation
$1,500,000 1,460 / 1,410
(90,000) 1,460 / 1,410
Carrying
amount after
revaluation
$1,553,191
(93,191)
$1,410,000
$1,460,000
The journal entry to record the revaluation of the building under the proportional method
will be:
Building
$53,191
$3,191
50,000
Under the second approach, which we will label the Gross Carrying Amount method, we
first eliminate the accumulated depreciation of the building against the building account,
and then increase the carrying amount of the building:
Building
Building
$90,000
$90,000
50,000
50,000
The depreciation expense for 20x4 through to 20x6 will be:

($1,460,000 300,000) / 37 = $31,351
January 20x7 revaluation - The appraisals of the land and building in January 20x7 are
$540,000 for land and $1,300,000 for the building.
The decrease in value of land will offset the previous revaluation surplus on land of
$100,000 reducing it to $40,000:
Page 224

Land
$60,000
$60,000
The net book value of the building is $1,460,000 ($31,351 x 3) = $1,365,947. We need
to decrease the carrying value of the building by $65,947 which exceeds the revaluation
surplus on the building of $50,000. In this situation, we would first apply the decrease in
value to the balance in the revaluation surplus and any excess would be an expense that
would flow to the income statement.
Using the proportional approach, the analysis would be as follows:
Building
Carrying
amount before
revaluation
$1,553,191
(187,244)
1,300,000 /
1,365,947
1,300,000 /
1,365,947
Carrying
amount after
revaluation
$1,478,204
$1,365,947
(178,204)
$1,300,000
The journal entry would be as follows:

($187,244- 178,204)
Loss on asset revaluation (I/S)
Building ($1,553,191 1,478,204)
$9,040
50,000
15,947
$74,987
Under the Gross Carrying Amount Method, the journal entries would be as follows:
Accumulated Depreciation ($31,351 x 3)
Building
Loss on asset revaluation (I/S)
Building
$94,053
$94,053
50,000
15,947
65,947
Note that the new carrying value of the building under the Gross Carrying Amount
Method would be:
Page 225
Carrying amount, net January 1, 20x4

Less accumulated depreciation from 20x4 to 20x6:
$31,351 x 3 years
Less revaluation reduction in January 20x6
$1,460,000
Gross value of building on January 1, 20x6
$1,300,000
(94,053)
(65,947)
The depreciation expense for the years 20x6 through 20x8 will be:
($1,300,000 300,000) / 34 years remaining = $29,412
To summarize the accounting treatment for revaluations:
when the revaluation results in an increase in carrying values, we credit the

Revaluation Surplus Account. This account is part of Other Comprehensive
Income in Shareholders Equity. This was the case for the 20x4 revaluation in our
example. What was not illustrated was the situation where an increase in carrying
value occurs, but this asset incurred a decrease in the past that was expensed to
the income statement. In this case, the increase is first credited to income to the
extent of previous accumulated losses and then to the revaluation surplus. The
credit to income is reduced by the following:
Accumulated depreciation taken on the asset
Less the accumulated depreciation on the asset assuming the historical
cost model was used.
when the revaluation results in a decrease in carrying values, we debit the
Revaluation Surplus to the extent that we have a balance relating to the asset. If
the decrease in revaluation surplus is not enough to cover the decrease in value,
any excess is charged as an expense to the income statement. This was the case
for the 20x7 revaluation.
Disposition of the Revaluation Surplus Account

There are two ways to dispose of the Revaluation Surplus Account:
1. when an asset is derecognized, any Revaluation Surplus relative to that asset
should also be disposed of through Retained Earnings, and
2. the standard also allows the option of transferring amounts from the Revaluation
Surplus directly to Retained Earnings throughout the assets useful life as it is
being depreciated. The amount of surplus transferred would be equal to the
difference between depreciation based on the original cost, and the depreciation
based on the revalued amount.
Page 226
Derecognition of Assets
When an asset is disposed of, the proceeds on disposal are compared to the net book
value of the asset. If the proceeds on disposal exceed the net book value of the asset, then
we record a gain on disposal. If the proceeds on disposal are less than the net book value
of the asset, we record a loss on disposal.
The carrying amount of an item of property, plant and equipment shall be derecognized:
(a)
on disposal; or
(b)
when no future economic benefits are expected from its use or disposal.
(IAS 16.67)
For example, an asset with an original cost of $140,000 was purchased on January 2,
20x1 and is depreciated using the diminishing balance method at the rate of 30% per
year. On December 31, 20x6, the asset is sold for proceeds of $35,000.
The net book value of the asset on December 31, 20x6 is: $140,000 x .76 = $16,471. The
gain on sale of the depreciable asset is $35,000 16,471 = $18,529.
The journal entry to record the disposal of asset is:
Cash
Accumulated depreciation ($140,000 16,471)
Asset
Gain on sale of asset
$35,000
123,529
$140,000
18,529
Note that when assets are traded in, the market value of the asset traded in becomes the
proceeds on disposal and not the trade-in value. The reason for this is that the trade-in
value often reflects a discount on the purchase price of the new asset purchased, which
should be recorded as such.
Example 2 - recall the example used when discussing the component approach: on
December 31, 20x1 a truck is purchased at a cost of $250,000. The components of the
truck are as follows:
Truck Body
Engine
Tires
Cost
$150,000
90,000
10,000
Useful Life
20 years
10 years
5 years
Assume that on July 1, 20x10 the engine is replaced at a cost of $120,000. We would first
have to derecognize the old engine:
Net book value of old engine:
$90,000 x 1.5 years remaining /10 years useful life = $13,500
Page 227
The journal entry to record the derecognition of the old engine would be:
Accumulated depreciation ($90,000 13,500)
Loss on derecognition of engine
Engine
$76,500
13,500
$90,000
We would then record the acquisition of the new engine:

Engine
Cash
$120,000
$120,000
Exchanges of Assets
Nonmonetary asset exchanges are exchanges of one productive asset for another. The
cost of the asset received is measured at fair market value unless:
the exchange transaction lacks commercial substance, or
the fair value of neither the asset received differs nor the asset given up is reliably
measurable.
If the asset received is not measured at fair value, its cost is measured at the carrying
amount of the asset given up (IAS 16.24).
The determination of commercial substance is based on the extent to which the entity's
future cash flows are expected to change as a result of the transaction. An exchange
transaction has commercial substance if:
the configuration (risk, timing and amount) of the cash flows of the asset received
differs from the configuration of the cash flows of the asset transferred; or
the entity-specific value of the portion of the entity's operations affected by the
transaction changes as a result of the exchange;
AND
the difference in the above two items is significant relative to the fair value of the
assets exchanged.
Example - a hotel chain exchanges Hotel A for Hotel B from another hotel chain - they
receive $100,000 cash as a result of the transaction. The carrying and fair values of both
hotels is as follows:
Hotel A
Hotel B
Page 228
Carrying
Value
$1,200,000
900,000
Fair
Value
$1,500,000
1,400,000
Assuming no commercial substance, the journal entry to record this transaction is:
Property, plant and Equipment - Hotel B*
Cash
Property, plant and Equipment - Hotel A
$1,100,000
100,000
$1,200,000
* carrying value of $1,200,000 less cash received of $100,000

Assuming commercial substance, the journal entry to record this transaction is:
Property, plant and Equipment - Hotel B
Cash
Property, plant and Equipment - Hotel A
Gain on sale of property, plant and equipment
$1,400,000
100,000
$1,200,000
300,000
Impairment of Assets
Because IFRS is moving from a historical cost model to a fair value model of accounting,
there must be a control mechanism to prevent overvaluations of assets. The impairment
test performs this function. It applies to all assets2, regardless of how these are classified,
although in practice they apply mostly to property, plant and equipment and intangible
assets.
The purpose of the test is to ensure that assets are not carried at an amount that is greater
than their recoverable amount. The recoverable amount is defined as the greater of:
(i)
the fair market value of the assets less costs to sell (FV), or
(ii)
their value in use (VIU) this is defined as the present value of cash flows
expected from the future use and sale of the assets at the end of their useful
lives.
Because the principle is the higher of the two, management may have to calculate both.
However, if one exceeds the carrying amount, then the other does not have to be
calculated.
One of the key concepts behind the impairment of asset test is that of the Cash
Generating Unit (CGU). A CGU is defined as the smallest identifiable group of assets
that together have cash inflows that are largely independent of the cash flows of another
asset, i.e. the part of a business that generates income and which is largely dependent of
other parts of a business. At a minimum, a company has as many CGUs as they have
operating segments for the purposes of segment reporting. For example, Rogers
Communications Incs 2007 Annual Report3 shows that the company operates in three
segments: wireless, cable and media. At a minimum, Rogers would have three CGUs.
2 With the exception of inventories, assets arising from construction contracts, deferred tax assets, assets
arising from employee benefits, financial assets, assets held for sale and investment properties carried at
fair value.
3 http://downloads.rogers.com/RCI_2007_Annual_Report.pdf, p.88
Page 229
However if one of the segments is made up of smaller identifiable businesses, then it

could potentially be broken down into separate CGUs. Examples of typical CGU's are
single retain stores and factories. Note that a CGU can be a single asset.
Value-in-use starts with an approved cash flow forecast for the CGU. This forecast has to
be reasonable, supportable, reflect an expected outcome and should not exceed a period
of 5 years. A terminal value is also calculated representing the value of the CGU at the
end of the 5 years. These cash flows are then discounted at an appropriate risk-adjusted
discount rate to obtain their value-in-use.
Fair value of an asset is defined as the value that an external market participant would
place on the asset
Impairment tests do not have to be done on an annual basis, rather they only need to be
done if there is some indication that impairment has occurred. However, some assets
have to be tested for impairment annually (IAS 36.10):
intangible assets with indefinite useful lives,
intangible assets not yet available for use, and
goodwill acquired in a business combination (the specific requirements for the

impairment test for goodwill will be discussed in Module 2 of the Accelerated
Program).
The reason for requiring annual impairment tests for the above is due to the fact that their
values may be more uncertain than other assets. In addition, these assets are not
amortized on a regular basis.
The standards provide indicators of impairment and are classified as external and internal
sources (IAS 36.12):
External indicators:
indicators that the market value of the assets has decreased
significant changes in the external environment the firm operates in
changes in market interest rates
comparison of the market capitalization of the firm with the carrying value of its
assets
Internal indicators:
obsolescence or physical damage to the assets
change in use of the assets
changes in the economic performance of the assets

If an impairment loss is required, this loss must be allocated to the assets within the CGU
on a pro-rata basis. The standard allows for a subsequent reversal of any impairment
losses (with the exception of goodwill) (IAS 36.123).
Page 230
Assets held for Sale

Noncurrent assets held for sale need to be disclosed as such on the statement of financial
position, i.e. they need to be disclosed separately from other capital assets.
To qualify as held for sale, the following two criteria must be met:
they must be available for immediate sale in their existing condition and the sale
must be highly probable (meaning there is an active plan to sell and the price is
reasonable); and
the sale will occur within a year from the date the assets are classified as held for
sale
A discontinued operations is defined as a subset of assets held for sale or disposed of
during the year and:
represents a separate major line of business or geographical area of operations,
is part of a single co-ordinated plan to dispose of a separate major line of business

or geographical area of operations, or
is a subsidiary acquired exclusively with a view to resale

On the date an asset, disposal group or discontinued operation is classified as held for
sale, they are measured at the lower of carrying costs and fair market less costs to sell. If
the selling costs exceed one year, they must be discounted. Any losses on measurement
are classified as an impairment loss. If, at a subsequent balance sheet date, the remeasurement of fair market value indicates a recovery, then such recovery can be
recorded as a gain, but only to the extent of previous losses. Assets held for sale are not
depreciated.
Discontinued operations are presented as a single amount comprising:
the post-tax profit or loss from discontinued operations, and
the post-tax gain or loss recognized on the measurement to fair value less costs to
sell on the disposal of the assets or disposal group constituting the discontinued
operations
This single amount needs to broken down further in the notes into
the revenue, expenses and pre-tax profit of the discontinued operations;
the gain or loss recognized on the measurement to fair value less costs to sell or
on the disposal of the assets
separately for each of the two items above, the related income tax expense.
Page 231
Disclosure Requirements - Property, Plant and Equipment

For each class of property, plant and equipment, the following have to be disclosed:
the measurement bases used for determining the gross carrying amount;
the depreciation methods used;
the useful lives or the depreciation rates used;
the gross carrying amount and the accumulated depreciation at the beginning and
end of the period; and
a reconciliation of the carrying amount at the beginning and end of the period
showing:
additions;
assets classified as held for sale or included as held for sale and other
disposals;
acquisitions through business combinations;
increases or decreased resulting from revaluations and from impairment
losses recognized or reversed in other comprehensive income;
impairment losses recognized or reversed on the income statement;
depreciation expense recognized during the period; and
any other changes. (IAS 16.73)
If items of property, plant and equipment are stated at revalued amounts, the following
have to be disclosed:
the effective date of the revaluation;
whether an independent valuer was involved;
the methods and significant assumptions applied in estimating fair values;
the extent to which the fair values were determined directly bu reference to
observable prices in an active market or recent market transactions on arm's
length terms or were estimated using other valuation techniques;
for each class of property, plant and equipment, the carrying amount that would
have been recognized had the assets been carried under the cost model; and
the revaluation surplus, indicating the change for the period and any restrictions
on the distribution of the balance to shareholders.
Page 232
Intangible Assets
IAS 38 defines an intangible asset as an identifiable non-monetary asset without physical
substance. Intangible assets can be distinguished between those that are identifiable and
non-identifiable. Identifiable intangible assets are those whose existence can be clearly
identified such as patents, copyrights and franchises. Non-identifiable intangible assets
exist but cannot be associated with a particular asset. Goodwill is the best example of a
non-identifiable intangible asset.
A distinction can also be made between purchased and internally developed intangible
assets.
To be considered identifiable, an intangible asset must meet one of the following two
criteria:
the intangible asset is separable, i.e. is capable of being separated or divided from
the entity and sold, transferred, licensed, rented or exchanged, either individually
or together with a related contract, asset or liability; or
arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations (IAS
38.12)
The same recognition criteria applies for intangible assets as for any other asset; the cost
of an intangible asset can be recognized as an asset if, and only if:
(a)
the entity, and
(b)
the cost of the item can be measured reliably. (IAS 38.9)
The accounting for intangible assets is based on whether or not the intangible asset has a
useful life. Amortization of intangible assets:
intangible assets with a finite useful life should be amortized over the lessor of
their useful lives or legal life (IAS 38.97)
intangible assets with an indefinite life are subject to an annual impairment test
(IAS 38.109)
Examples of intangible assets:
1.
2.
3.
4.
5.
Patents: a legal right to the exclusive use of a process, design, product or plan and
the right to permit others to use it under license, generally for 17 years.
Trademark: a distinctive word or symbol. These have an unlimited life.
Copyright: right to publish materials such as books, CDs, tapes, and computer
programs. Life: person's life plus 50 years for an individual or 75 years for a
company.
Franchise: the right to operate under the name of the franchisor.
Goodwill. The definition of this term and the accounting thereof is described in
Lesson 9. Generally goodwill has an unlimited life.
Page 233
Internally developed intangible assets

Internally developed intangible assets such as research and development are accounted
for as follows: research expenditures are written off to the income statement whereas
development costs are to be capitalized if they meet the following six criteria:
(a)
the technical feasibility of completing the intangible asset so that it will be
available for use or sale.
(b)
its intention to complete the intangible asset and use or sell it.
(c)
its ability to use or sell the intangible asset.
(d)
how the intangible asset will generate probable future economic benefits. Among
other things, the entity can demonstrate the existence of a market for the output of
the intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset.
(e)
the availability of adequate technical, financial and other resources to complete
the development and to use or sell the intangible asset.
(f)
its ability to measure reliably the expenditure attributable to the intangible asset
during its development. (IAS 38.57)
Research is defined as 'original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding'. Development is the
application of research findings or other knowledge to a plan or design for the production
of new or substantially improved materials, devises, products, processes, systems or
services before the start of commercial production or use. (IAS 38.8)
Revaluation Model
It is possible to use the revaluation model for intangibles whose value can be determined
in an active market. The accounting for revaluation of intangible assets is the same as for
property, plant and equipment.
Disclosure Requirements - Intangible Assets
The following must be disclosed for each class of intangible assets, distinguishing
between internally generated intangible assets and other intangible assets:
whether the useful lives are indefinite or finite, and if finite, the useful lives, the
amortization rates and methods used;
the gross carrying amount and any accumulated amortization t the beginning and
end of period;
the line item(s) of the statement of comprehensive income in which any

amortization of intangible assets is included; and
a reconciliation of the carrying amount at the beginning and end of the period
showing:
additions, indicating separately those form internal development, those
acquired separately and those acquired through business combinations;
assets classified as held for sale or included as held for sale and other
disposals;
Page 234
increases or decreased resulting from revaluations and from impairment

losses recognized or reversed in other comprehensive income;
impairment losses recognized or reversed on the income statement;
amortization expense recognized during the period; and
any other changes. (IAS 16.73)
Depletion and Accounting for Natural Resources

When a mine has been developed, an oil well proved or a parcel of land purchased for
clearing, the cost of the asset should be charged against accounting periods in a manner
that matches the cost against the revenue reported. The usual procedure is as follows:
1.
an estimate is made of the total amount of resources that can be economically
recovered.
2.
the capitalized cost is then written off as a function of the resources taken out. The
amount of expense is called depletion.
Note that this method is essentially a variation of the units of production method.
Page 235
Capital Assets - Examples

Example 1: Tender Footsies owned the land they were on and the building they were in,
along with much machinery and equipment used both in the factory and in the office.
The land had cost $14,000, the building $89,000 and the machinery and equipment
$143,000. Since the company had been in operation for forty-five years, everything was
fully depreciated. But since all the assets had been well maintained, they could be used
for many years to come.
Tender Footsies acquired two new assets in 20x4. The first was an adjacent piece of
land, which was used to construct a warehouse; the other was a new state-of-the-art
packaging machine for the shipping department.
The land cost $115,000 and came with an old building which had to be demolished. The
materials obtained from the demolition were sold as scrap for $2,300. The following
additional costs were incurred and paid:
Legal fees
Land transfer tax
Cost of company hired to demolish the old building
Cost of company hired to dig the hole for the foundation
Cost of constructing the warehouse
Cost of changing the locks after master key was stolen
Cost of moving the goods to the new warehouse on July 1, 20x4
$4,100
1,450
2,770
14,940
361,700
210
1,390
The warehouse was to last 50 years and has a residual value of $2,640. The company
used the straight-line method of depreciation for the building. The packaging machine
was purchased on October 1, 20x4, at a cost of $24,000 plus delivery of $800. The
company had to build a special base to hold the machine which cost $700. The machine
could package 50,000 boxes over its life span. It was used to package 100 boxes in 20x4
in its three months of use. It had no estimated residual value. The company uses the units
of production method for depreciating the packaging machine. Management believes that
the cost of the warehouse cannot be broken down into further components.
Page 236
Cost of new warehouse:

Land Land cost
Legal fees
Land transfer tax
Proceeds on sale of scrap materials
Cost to demolish old building
Warehouse Cost of foundation
Construction cost
$115,000
4,100
1,450
(2,300)
2,770
$121,020
$ 14,940
361,700
$376,640
Note: the cost of changing the locks and moving the goods should not be capitalized, but
rather, be expensed since they do not add value to the warehouse.
Depreciation expense for the year Depreciation base ($376,640 - 2,640)
Years
Annual depreciation expense
20x4 Depreciation expense (1/2)
Cost of packaging machine Cost of machine
Delivery cost
Cost of special base
Depreciation expense - $25,500 x 100/50,000
Page 237
$374,000
50
7,480
$
3,740
$24,000
800
700
$25,500
$
51
Example 2: Wilson Ltd. started a business on July 1, 20x3 and has a June 30 year end.
The following information was available on June 30, 20x5:
on July 1, 20x3, a new office complex complete with new office equipment
was purchased for $400,000. A municipal tax bill showed an assessed value
of $100,000 for the land and $150,000 for the building. The fair market
values of the land and building at that time were estimated to be $175,000 and
$200,000 respectively. A quote from an office equipment store for equipment
similar to that bought on July 1, 20x3, showed a price of $125,000. The
residual value of the building was estimated to be $25,000 while that of the
equipment was $7,000. Management believes that the cost of the building
cannot be broken down into further components.
also on July 1, 20x3, three identical display trucks were purchased for a total
of $75,000. The trucks have a residual value of $5,000 each.
on December 31, 20x4, Wilson Ltd. traded one of the display trucks plus
$9,000 cash for a new truck. The new truck's residual value was estimated to
be $2,000. The trade-in allowance was $15,000. The old truck could have
been sold for $12,000.
on March 31, 20x5, office equipment was sold for $1,000. The cost of this
equipment had been properly recorded on July 1, 20x3, at $5,000. At that
time, the expected residual value was $ 500 .
also on March 31, 20x5, new office equipment was purchased for $24,000.
This equipment has a residual value of $1,500 .
The following expenditures associated with the purchase of the new office equipment
were charged to expense:
Installation fees
Freight-in
Purchase discount
Repairs to machine for damage during installation
Wages during testing
Testing supplies
$ 730
1,050
650
380
490
150
the company depreciates all of its assets using the 10% diminishing balance
method
Land - July 1, 20x3, lump-sum acquisition (Note 1)
$140,000
Building - July 1, 20x3, lump-sum acquisition (Note 1)
$160,000
Office Equipment
Page 238
July 1, 20x3, lump-sum acquisition (Note 1)

Sale - March 31, 20x5
Purchase - March 31, 20x5
Cost
Installation fee
Freight-in
Purchase discount
Wages - testing
Testing supplies
$100,000
(5,000)
$24,000
730
1,050
(650)
490
150
25,770
$120,770
Trucks
Purchase - July 1, 20x3
Sale of truck - December 31, 20x4
Purchase of truck - December 31, 20x4 (9,000 + 12,000)
Page 239
$75,000
(25,000)
21,000
$71,000
Depreciation expense / Accumulated Depreciation
Y/E June 30, 20x4

Depreciation (Note 2)
Y/E June 30, 20x5
Disposals (Note 3)
Depreciation (Note 4)
Office
Building
Equip.
Trucks
Total
$16,000
$10,000
$7,500
$33,500
14,400
$30,400
(838)
9,532
$18,694
(3,625)
6,675
$10,550
(4,463)
30,607
$59,644
Loss or gain on disposal Equipment:

Proceeds
Net book value
Cost
Accumulated
Depreciation
Loss on disposal
$1,000
$5,000
(838)
4,162
$(3,162)
Truck:
Proceeds (FMV)
Net book value
Cost
Accumulated
Depreciation
Loss on disposal
$12,000
$25,000
(3,625)
21,375
$(9,375)
Notes
(1) Allocation of cost between properties
Total fair market value:
Land
Building
Equipment
Allocation of total cost Land: $400,000 x 35%

Building: $400,000 x 40%
Equipment: $400,000 x 25%
Page 240
$175,000
200,000
125,000
35%
40%
25%
$500,000
100%
$140,000
160,000
100,000
$400,000
(2) Depreciation expense for the year ended June 30, 20x4:
Building: $160,000 x 10%
Equipment: $100,000 x 10%
Trucks: $75,000 x 10%
$16,000
10,000
7,500
(3) Accumulated Depreciation on disposals for the year ended June 30, 20x5:
Equipment July 1, x3 - June 30, x4: $5,000 x 10%
July 1, x4 - March 31, x5: $4,500 x 10% x 9/12
$ 500
338
$ 838
Truck July 1, x3 - June 30, x4: $25,000 x 10%

July 1, x4 - Dec 31, x4: 22,500 x 10% x 6/12
(4) Depreciation expense for the year ended June 30, 20x5:
Building: $160,000 - 16,000 = 144,000 x 10%
Page 241
$2,500
1,125
$3,625
$14,400
Equipment:
July 1, x4 - Jun 30, x5: $95,000 - 9,500
= 85,500 x 10%
July 1, x4- Mar 31, x5 (on equipment sold)
Mar 31, x5 - June 30, x5 (on new equipment):
$25,770 x 10% x 3/12
$ 8,550
338
Trucks July 1, x4 - Jun 30, x5: $50,000 - 5,000

= 45,000 x 10%
July 1, x4 - Dec 31, x4 (on truck sold)
Dec 31, x4 - June 30, x5 (on new truck):
$21,000 x 10% x 6/12
$ 4,500
1,125
644
$ 9,532
1,050
$ 6,675

1.
During 20x4, Yvo Corp. installed a production assembly line to manufacture

furniture. In 20x5, Yvo purchased a new machine and rearranged the assembly
line to install this machine. The rearrangement did not increase the estimated
useful life of the assembly line, but it did result in significantly more efficient
production. The following expenditures were incurred in connection with this
project:
Machine
$75,000
Labor to install machine
14,000
Parts added in rearranging the assembly line
to provide future benefits
40,000
Labor and overhead to rearrange the assembly line
18,000
What amount of the above expenditures should be capitalized in 20x5?
a.
$147,000
b.
$107,000
c.
$ 89,000
d.
$ 75,000
2.
Zahn Corp.'s comparative balance sheet at December 31, 20x5 and 20x4,
reported accumulated depreciation balances of $800,000 and $600,000
respectively. Property with a cost of $50,000 and a carrying amount of $40,000
was the only property sold in 20x5. Depreciation charged to operations in 20x5
was
a.
$190,000
b.
$200,000
c.
$210,000
d.
$220,000
3.
Weston Company purchased a tooling machine on January 3, 20x1 for $600,000.

The machine was being amortized on the straight-line method over an estimated
useful life of ten years, with no residual value. At the beginning of 20x8, the
company paid $150,000 to overhaul the machine. As a result of this improvement,
the company estimated that the useful life of the machine would be extended an
additional five years (15 years total). What should be the amortization expense
recorded for the machine in 20x8?
a) $41,250
b) $50,000
c) $60,000
d) $66,000
Page 242
4.
A company installed an assembly line costing $50,000 in 20x1. In 20x6, the

company invested $100,000 to automate the line. The automation increased the
market value and productive capacity of the assembly line but did not affect its
useful life. Proper accounting for the cost of the automation should be to
a) report it as an expense in 20x6.
b) debit the accumulated depreciation account by $100,000.
c) allocate it between the fixed asset and accumulated depreciation accounts.
d) debit the fixed asset account by $100,000.
e) none of the above.
5.
Assume you are employed as the chief accountant for DrawPro Inc., a computer
software company. The company was developing a new software program called
Graphics Tool. At the end of the year, the director of research estimated that $1
million was spent during the year for the Graphics Tool program. He asked you to
reduce his expenses by capitalizing $1 million as research and development costs.
Prior to capitalizing the research and development costs, which of the following
questions would NOT be considered in ensuring that your statements would be in
accordance with generally accepted accounting principles?
a) Has the future market for Graphics Tool been clearly defined?
b) Is the Graphics Tool program technology feasible?
c) Are the costs related to research activities or development activities?
d) Does management have the desire to launch the Graphics Tool program upon
completion?
e) All of the above questions would be considered.
Page 243
Problem 1
The Flour Co. Ltd. wanted to build a new factory in Montreal. In June, 20x0, the
company purchased a block of land as a factory site for $190,000. Two small office
buildings were standing on the site. The buildings had a market value of $50,000
(included in the purchase price of $190,000).
The company paid $12,500 to demolish the old buildings. The bricks from the old
buildings were salvaged and sold for $1,400. Legal fees of $475 were paid for a land title
search. Property taxes in arrears of $1,500 were paid by Flour Co. Ltd.. Payment of
$20,000 was made to an engineering firm for drawing factory building plans. A
construction contractor agreed to build the factory on a fixed-fee basis. The contractor's
fixed fee charge for construction was $390,000. Special lighting was added to the
building for $10,000. The factory building was completed on October 31, 20x0. The
Flour Company's year end is December 31.
Required a.
b.
Calculate the cost of the land and building.

Assuming the factory building (and special lighting) has a 10 year life, compute
the depreciation expense for both 20x0 and 20x1 on each of the following bases:
i) straight-line
ii) diminishing balance at 20%
Page 244
Problem 2
Vesley Air Freight is a small freight forwarder operating out of Baltimore and serving the
Chesapeake Bay area. The company is in the process of preparing annual financial
statements for the fiscal year ended May 31, 20x1. Neal Kaiser, assistant controller, has
gathered the following data concerning accounts receivable and depreciable assets.
At May 31, 20x1, Vesley's Accounts Receivable were $525,000, and the Allowance for
Doubtful Accounts had a balance of $1,400. Kaiser prepared an aging report accounts
receivable at May 31, 20x1, and the schedule below summarizes the relevant information
from that aging report.
Amount
Age
Under 30 days
31 - 90 days
91 150 days
Over 150 days
$420,000
31,000
26,000
48,000
Probability of Collection
97%
85
80
70
To update its fleet, Vesley purchased three Colt airplanes and two Parker airplanes during
January 20x0 for $2,930,000. The airplanes were put into service on June 1, 20x0. The
details concerning cost, residual value, and the expected life of each of the airplanes are
given below. Vesley has decided to depreciate the airplanes using the straight-line
method of depreciation. On May 27, 20x1, one of the Colt airplanes (the N05110),
costing $610,500, was damaged beyond repair when it caught fire during a refueling
accident. The insurance proceeds amounted to $420,000. On May 30, 20x1, the company
purchased another Colt airplane for $593,200.
Airplane
Colt
Parker
Parker
Colt
Colt
Identification
Number
N16313
N70224
N42326
N05110
N62199
Total
Page 245
Cost
Residual
Value
$ 576,000
563,800
562,500
610,500
617,200
$ 94,050
55,600
55,950
60,900
60,800
$2,930,000
$327,300
Expected
Life
9 years
11
11
12
13
Required A.
1.
2.
B.
1.
2.
Calculate the proper balance in the Allowance for Doubtful Accounts

using the percentage-of-receivable approach.
Prepare the entry to adjust the Allowance for Doubtful Accounts as of
May 31, 20x1.
Prepare the journal entries to record the depreciation expense as at May
31, 20x1.
Record the retirement of the Colt Airplane on May 27, 20x1 and the
purchase of the new plane.
Problem 3
The Verdini Company made a lump-sum purchase of three pieces of machinery for
$120,000. At the time of acquisition, Verdini paid $5,000 to determine the appraised
value of the machinery. The appraisal disclosed the following values:
Machine 1
Machine 2
Machine 3
$70,000
52,000
23,000
Required Calculate the amount that Verdini should record in the accounts for each machine.
Page 246
Problem 4
The Jurasni Company acquired a building on December 31, 20x1 at a total cost of
$1,500,000. The contractor provided the following breakdown of the major components
of the building:
Component
Structure & frame
Heating & AC System
Elevators (2)
Roof
Cost
$1,000,000
200,000
225,000
75,000
Useful Life
Residual
Value
40 years
15 years
20 years
25 years
$100,000
0
25,000
0
The company depreciates the structure & frame and roof using the straight line method.
The heating & AC system and elevators are depreciated using the diminishing balance
method at a rate of 15% and 10% respectively.
Required a.
b.
c.
Calculate the depreciation expense on the building's components for the year 20x2
and 20x3.
On June 30, 20x15 one of the two elevators is replaced at a cost of $150,000. The
useful life of the new elevator is expected to be 20 years with a $20,000 residual
value. The parts of the old elevator are sold for $10,000.
i.
Prepare the journal entries to record these transactions.
ii.
Calculate the depreciation expense on the elevators for the year 20x15.
On January 2, 20x23, the roof is replaced at a cost of $120,000. The useful life of
the new roof is 25 years. Prepare the journal entries for these transactions.
Page 247
Problem 5 - Borrowing Costs

On January 1, 20x4, the Britton Corporation started the construction of a self-constructed
asset. Construction of the asset was completed on August 31, 20x4 and was put in
productive use on that date.
The following is a schedule of direct costs incurred in the construction of the asset:
January 1, 20x4
February 1, 20x4
April 1, 20x4
May 15, 20x4
July 1, 20x4
Aug 1, 20x4
$30,000
50,000
75,000
40,000
60,000
45,000
The company's borrowings are as follows:
a $100,000, 6.5% one year note dated January 1, 20x4. This note relates
specifically to the self-constructed asset. The note was repaid on August 31, 20x4.
bonds payable in the amount of $10,000,000. The annual interest on these bonds
is 7.5%.
a bank loan payable in the amount of $15,000,000 bearing interest at 5%.

Required Calculate the cost of the asset at August 31, 20x4.
Page 248
Problem 6
The following is the income statement for the Jen-Ward Company for the year ended
December 31, 20x7:
Sales
Cost of goods sold
$9,500,000
6,000,000
Gross margin
Operating expenses
3,500,000
2,000,000

Income taxes (@ 40%)
1,500,000
600,000
Net income
$9000,000
During December 20x7, the companys board of directors passed a resolution to dispose
of one of the companys three divisions. This division had revenues of $2,500,000, cost
of goods sold of $1,500,000 and operating expenses of $800,000. These amounts are
included in the above income statement.
The carrying value of the net assets of the division (net of current liabilities) was
$6,900,000. The fair market value of the net assets is estimated to be $6,200,000 and the
costs to sell the division are expected to be equal to 5% of the fair value of the net assets.
None of these have been taken into account in preparing the above income statement
Required
Prepare an income statement for the Jen-Ward Company for the year ended December
31, 20x7.
Page 249
Problem 7
The controller for Murdock, Inc., has asked a member of the staff to review the repair and
maintenance expense account to determine if all of the charges are appropriate. The staff
member has reviewed this account and has identified the following ten transactions for
further scrutiny. All of these transactions are considered material in amount.
DATE
a)
b)
1/3/x2
3/7/x2
4/12/x2
d)
e)
4/20/x2
5/12/x2
f)
g)
h)
5/18/x2
6/19/x2
7/3/x2
i)
9/14/x2
j)
10/18/x2
AMOUNT
DESCRIPTION
$10,000 Service contract on office equipment.

10,000 Initial design fee for proposed extension of office building.
18,500 New condenser for central air-conditioning unit located on
the roof of office building.
7,000 Purchase of two executive chairs and desks.
40,850 Purchase of storm and screen windows and installation of
same on all office windows.
38,450 Sealing of roof leaks over entire production plant.
28,740 Replacement of large door to production area.
11,740 Installation of automatic door-opening system on the above
door to speed opening.
38,500 Purchase of overhead crane for the Assembly Department
to speed up production,
11,000 Replacement of broken gear on machine in the Machining
Department.
Required For each of the ten transactions identified by the controller's staff member, indicate
whether the transaction is properly charged to the repair and maintenance expense
account, and if not, indicate the appropriate account to which the transaction should be
charged. Explain your reasoning in each case.
Problem 8
Pinewood Corporation sells and erects shell houses-frame structures that are completely
finished on the outside but are unfinished on the inside except for flooring, partition
studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy
with tools and who have time to do the interior wiring, plumbing, wall completion and
finishing, and other work necessary to make the houses livable.
Pinewood buys shell houses from a manufacturer in unassembled packages consisting of
all lumber, roofing, doors, windows, and similar materials necessary to complete a shell
house. Upon commencing operations in a new area, Pinewood buys or leases land as a
site for its local warehouse, field office, and display houses. Sample display houses are
erected at a total cost of from $3,000 to $7,000, including the cost of the unassembled
Page 250
packages. The chief element of cost of the display houses is the unassembled packages,
since erection is a short, low-cost operation. Old sample models are torn down or altered
into new models every three to seven years. Sample display houses have little residual
value because dismantling and moving costs amount to nearly as much as the cost of an
unassembled package.
Required Would it be preferable to depreciate the cost of display houses on the basis of (a) the
passage of time or (b) the number of shell houses sold? Explain.
Problem 9
On December 31, 20x5, Harwale Corporation had the following property, plant and
equipment on its balance sheet:
Buildings
Equipment
Cost
Accumulated
Depreciation
Net Carrying
Value
$900,000
450,000
$300,000
180,000
$600,000
270,000
Harwale uses the revaluation model for its buildings and equipment and applies
revaluations using the gross carrying amount method. The revaluation surplus account
has a balance of $60,000 for the buildings and $0 for the equipment. The equipment
revaluation resulted in a charge to income of $20,000 in the year ended December 31,
20x2 the last time the company revalued its assets.
An independent appraiser assessed the fair value of the buildings to be $700,000 and the
fair value of the equipment to be $300,000.
Required
Prepare the journal entries at December 31, 20x5 to reflect the revaluation of the
buildings and equipment.
Page 251
Problem 10
The JZ Company acquired a building on January 2, 20x1 at a cost of $600,000. The
expected useful life of the building is 30 years with a residual value of $120,000. JZ uses
the revaluation model and applies revaluations using the gross carrying amount method.
The buildings appraisals are as follows:
December 31, 20x1
December 31, 20x2
December 31, 20x3
$596,000
550,000
565,000
The building was sold on January 2, 20x4 for $560,000.

Required
Prepare the journal entries for the years 20x1-20x4.
Problem 11
The Jerome Property Corporations capital asset policy is to use the revaluation model for
land and buildings and the historical cost model for equipment. The latest revaluation
occurred on December 31, 20x2. Jerome uses the Gross Carrying Amount method when
applying the revaluation model. Selected balance sheet data relating to the most current
fiscal year ending December 31, 20x2 is as follows:
Long-Term Assets
Land
Buildings
Equipment
Less accumulated depreciation
$1,200,000
5,600,000
900,000
(300,000)
Shareholders Equity
Revaluation Surplus Land
Revaluation Surplus Buildings
600,000
$7,400,000
$400,000
300,000
The buildings have a remaining useful life of 25 years. The equipment has a total useful
life of 10 years. The straight line method is used. Residual values are assumed to be zero.
The assets are revalued every two years. The appraisal results for the years ended
December 31, 20x4 and 20x6 are as follows:
Land
Buildings
Page 252
Dec 31,
20x4
$1,000,000
4,600,000
Dec 31,
20x6
$1,500,000
4,500,000
There were no additions or disposals to the land, building and equipment accounts for the
years 20x3 to 20x6.
Required
Prepare all journal entries for the years 20x3 to 20x6 for the Land, and Buildings
accounts.
Problem 12
On December 31, 20x1, certain accounts included in the capital assets section of the
Townsand Company's Statement of Financial Position had the following balances:
Land
Buildings
Leasehold improvements
Machinery and equipment
$500,000
900,000
400,000
500,000
During 20x2 the following transactions occurred:

a) Land site number 621 was acquired for $1 million. In addition, Townsand paid a
$60,000 commission to a real estate agent. Costs of $15,000 were incurred to clear
the land. During the course of clearing the land, timber and gravel were recovered and
sold for $5,000.
b) A second tract of land (site number 622) with a building was acquired for $300,000.
The closing statement indicated that the land's value was $200,000 and the building's
value was $100,000. Shortly after acquisition, the building was demolished at a cost
of $30,000. A new building was constructed for $150,000 plus the following costs:
Excavation fees
Architectural design fees
Building permit fee
Imputed interest on funds used during construction
$11,000
8,000
1,000
6,000
The building was completed and occupied on September 30, 20x2.

c) A third tract of land (site number 623) was acquired for $600,000 and was put on the
market for resale.
d) Extensive work was done to a building occupied by Townsand under a lease
agreement that expires on December 31, 20x8. The total cost of the work was
$125,000, which consisted of the following:
Page 253
Work Done
Cost
Ceilings painted
Electrical work
Extension to current work area constructed
Total
$10,000
35,000
80,000
Estimated Useful
Life (years)
1
10
30
$125,000
The lessor paid one-half of the costs incurred in connection with the extension to the
current working area.
e) During December 20x2 costs of $65,000 were incurred to improve leased office
space. The related lease will terminate on December 31, 20x4, and is not expected to
be renewed.
f) A group of new machines was purchased under a royalty agreement that provides for
payment of royalties based on units of production for the machines. The invoice price
of the machines was $75,000, freight costs were $2,000, unloading charges were
$1,500, and royalty payments for 20x2 were $13,000.
Required Prepare a detailed analysis of the changes in each of the following Statement of Financial
Position accounts for 20x2:
1. Land.
2. Buildings.
3. Leasehold improvements.
4. Machinery and equipment.
Disregard the related accumulated depreciation accounts.
Page 254
Problem 13
Illini Technologies designs and manufactures aircraft parts and subsystems for several
large airplane manufacturers, and the company is known for its strong research and
development. Occasionally, Illini assigns patent rights to other companies and has also
acquired patent rights from outside companies.
The transactions listed below occurred during the current fiscal year ending December
31, 20x0. Illini has a policy of amortizing patent costs using the straight-line method,
calculated to the nearest month.
(1) On March 1, 20x0, Illini acquired a patent from Lucas Industries covering a new
landing gear system for small, high performance jet aircraft. Lucas accepted a
$75,000, 6% note due September 1, 20x0, in exchange for the patent. On September
1, 20x0, Illini paid Lucas $77,250, the maturity value of the note. Illini believes that
the patent will be technologically obsolete in six years.
(2) On July 1, 20x0, Illini received notification that a recent application for a patent was
granted. Over the past three years, the company's Research and Development
Department has expended $1.2 million on this project, including $485,000 spent
during 20x0. The attorney's and filing fees for this patent totaled $104,800. Illini's
engineers estimate that this patent has a useful life of ten years.
(3) In August 20x0, Illini was notified that an application for a patent covering a bonding
process was denied. Illini's Research and Development Department expended
$460,000 on this project. The attorney's and filing fees spent on this patent
application totaled $34,950.
(4) During the first quarter of 20x0, Illini reevaluated the useful life of several patents.
The engineering staff determined that three patents had no future value. The book
value of these patents at the beginning of January 20x0 was $171,255. The
engineering staff recommended that the useful life of another patent be reduced from
four to two years. The book value of this patent at the beginning of January 20x0 was
$40,700.
(5) During 20x0, Illini was successful as a plaintiff in a patent infringement suit. Legal
costs incurred in this suit totaled $431,000. Of this amount, $380,000 had been
expensed in prior years. The remaining $51,000 represents legal costs of this case
incurred during 20x0.
(6) During January 20x0, Illini granted a license to Savey Company to manufacture a
gear reduction unit for light aircraft engines. The manufacturing process is covered by
one of Illini's patents. The licensing agreement calls for Savey to pay Illini a fee for
each unit produced. Savey reported $103,260 as due under this agreement for the
fiscal year ending December 31, 20x0.
Page 255
Required A. Describe how each of the six transactions would be presented on Illini Technologies'
financial statements at December 31, 20x0, identifying the appropriate dollar amount
where applicable. Footnote disclosure requirements should be ignored.
B. Describe the factors that should be considered when determining the useful life of a
patent.
Problem 14
Company A and Company B are independent companies in a similar line of business.
They have each just purchased identical pick-up trucks for company use.
Company A purchased its truck for $13,000 cash.
Company B paid $9,000 cash and traded in a truck which it had bought three years ago
for $8,500. The older truck had been depreciated on a 30% diminishing balance basis.
This truck could have been sold for $4,500 had it not been traded in. Both trucks were
listed with the dealer at a selling price of $14,500.
Required a) Will the estimated lives of both trucks be the same for the purposes of computing
depreciation? What information must be considered by the companies in estimating
the useful lives of their trucks for depreciation purposes?
b) Should the companies use the same depreciation methods? Explain.
c) What is the acquisition cost of Company B's new truck? Explain.
d) Prepare the journal entry to record the purchase of the truck by Company B.
Page 256
Problem 15
The Morash Company Ltd. purchased a commercial lot for $100,000. An old building on
the site was demolished at a cost of $8,000. Building stone from this old building was
sold for $1,500. Legal fees of $1,300 were incurred in connection with this acquisition,
and, in addition, land survey fees of $600 were paid in order to obtain preliminary
approval for the financing of the new construction. An engineering firm prepared factory
plans at a cost of $25,000. The contract price for the new building was $950,000.
During the construction, which lasted four months, a Morash foreman with an annual
salary of $24,000 acted exclusively as the liaison between the Morash Company and the
contractor, in order to supervise construction. Insurance premiums paid for the new
premises during construction totalled $600.
Required Determine the amount that should be debited to each of the land and building accounts
for this project. Show all calculations, and label the components of each of the asset
accounts.
Page 257
Problem 16
During 20x6, the Alfaro Corporation purchased land with an existing building at a cost of
$860,000. The land was valued at $780,000 with the difference allocated to the building.
Alfaro demolished the existing building and began construction of a new office building
for its own use. The following represent costs incurred during the construction of the
building:
architects fees of $130,000

interest of $130,000 on construction financing taken on March 1, 20x6 and repaid
on October 31, 20x6.
cost of $40,000 to demolish the existing building
proceeds on sale of materials from existing building = $8,000
costs to move from current building to new one = $106,000
payment of $15,000 of delinquent property taxes when the existing land and
building were purchased
land survey fees of $6,000
cost to build new building = $1,200,000
liability insurance during construction = $5,000
The land and building were purchased on March 1, 20x6. Construction of the new
building started on April 1, 20x6 and was completed on October 31, 20x6.
Required
a)
b)
Calculate the cost of the land and building.

Assume that the company moved into the new building on December 1, 20x6 and
that the straight line method of depreciation is used. Calculate the depreciation
expense on the building for the year ended December 31, 20x6. Assume a useful
life of 50 years and a residual value of $200,000.
Page 258
Problem 17
Lavoie Company's records show the following property acquisitions and disposals during
the first two years of operations:
Year
Acquisition
Cost of
Property
20x5
20x6
$50,000
20,000
Estimated
Useful Life
(years)
Disposals
Year of
Acquisition
10
10
20x5
Amount
Cost - $7,000
Proceeds - $4,000
The Lavoie Companys capital asset policy is to depreciate assets for one-half year in the
year of acquisition and in its year of disposal.
Required 1.
2.
Compute depreciation expense for 20x5 and for 20x6 and the balances of the
property and related accumulated depreciation accounts at the end of each year
under the following depreciation methods. Show computations and round to the
nearest dollar.
a.
Straight-line method.
b.
Diminishing balance method at a rate of 20%.
Prepare the journal entry to record the disposal of property in 20x6 under the
straight-line method.
Problem 18
The Linnay Company purchased a machine costing $500,000 on January 2, 20x1. The
expected useful life of the machine is 8 years and the residual value is expected to be
$100,000. The company uses the diminishing balance method of depreciation. The rate
used for machines is 25%. The Linnay Company has a December 31 year end.
Required
Calculate the depreciation on the equipment in the year 20x6.
Page 259
SOLUTIONS

1.
All amounts provide future benefits and should therefore be capitalized.
2.
Accumulated depreciation, December 31, 20x4

Accumulated depreciation on property sold: $50,000 - 40,000
Accumulated depreciation, December 31, 20x5
Depreciation expense, 20x5
3.
NBV at beginning of 20x8: $600,000 /10 x 3 = $180,000

NBV with improvement = $180,000 + 150,000 = $330,000
Amortization = $330,000 / 8 = $41,250
4.
The cost of an item of property, plant and equipment as an asset if, and only
if:
(a)
it is probable that future economic benefits associated with the item
will flow to the entity, and
(b)
the cost of the item can be measured reliably
All of the items meet the recognition principle and should be capitalized.
5.
Development costs (but not research costs) can be capitalized if certain

criteria are met. All choices need to be met in order to capitalize internally
generated intangible assets.
Page 260
$600,000
-10,000
-800,000
$210,000
Problem 1
a.
Land
Purchase price of land
Cost to demolish existing buildings
Salvage
Land title search
Property taxes in arrears
Factory building plans
Construction costs
Special lighting
$190,000
12,500
(1,400)
475
1,500
$203,075
b.
Building
$20,000
390,000
10,000
$420,000
20x0
20x1
420,000 / 10 x 2/12
= 7,000
420,000 / 10
= 42,000
420,000 x 20% x 2/12

= 14,000
406,000 x 20%
= 81,200
Depreciation of Building:
i) Straight-line
ii) Diminishing Balance
Page 261
Problem 2
A.
1. The proper balance in Vesley Air Freight's Allowance for Doubtful Accounts using the
percentage-of-receivable approach is $36,850 as calculated below.
Vesley Air Freight
Percentage
Amount
Uncollectible
$420,000
.03
Age
Under 30 days
Required Balance
in Allowance
$12,600
31-90 days
31,000
.15
4,650
91-150 days
26,000
.20
5,200
Over 150 days
48,000
.30
14,400
$36,850
Required balance in Allowance
2. The entry to adjust Allowance for Doubtful Accounts as of May 31, 20x1, is as
follows.
Bad Debt Expense
$35,450
$35,450
To adjust the Allowance for Doubtful Accounts as of May 31, 20x1, in accordance with
calculations below.
Balance required in Allowance
Less current balance
Amount of adjustment
$36,850
1,400
$35,450
B.
1.
Airplane
Colt
Parker
Parker
Colt
Colt
Cost
Residual
Value
Depreciable
Cost
$ 576,000
563,800
562,500
610,500
617,200
$ 94,050
55,600
55, 950
60,900
60,800
$481,950
508,200
506,550
549,600
556,400
Expected
Life
9 yrs.
11
11
12
13
Annual
Depreciation
$ 53,550
46,200
46,050
45,800
42,800
$234,400
Page 262
$234,400
$234,400
To record the depreciation expense for the fiscal year ended May 31, 20x1, for Vesley
Air Freight.
2.
Cash
$420,000
45,800
Loss on disposal of fixed assets
144,700
Fixed Assets Airplanes
To record retirement of damaged airplane, as of May 20x1.
Fixed Assets - Airplanes
$593,200
Cash
To record the acquisition of a new airplane as of May 20x1.
$610,500
$593,200
Problem 3
Machine 1
Machine 2
Machine 3
Page 263
Appraisal
Values
$70,000
52,000
23,000
$145,000
%
48.27%
35.86%
15.87%
Allocation of
Purchase Price
60,345
44,828
19,827
$125,000
Problem 4
a.
20x2 Structure & Frame - ($1,000,000 - 100,000) / 40 years

Heating & AC System - $200,000 x 15%
Elevators: $225,000 x 10%
Roof: $75,000 / 25 years
$22,500
30,000
22,500
3,000
$78,000
20x3 Structure & Frame - ($1,000,000 - 100,000) / 40 years

Heating & AC System - ($200,000 - 30,000) x 15%
Elevators: ($225,000 - 22,500) x 10%
Roof: $75,000 / 25 years
b.
i.
$22,500
25,500
20,250
3,000
$71,250
Cost of elevator = $225,000 / 2 = $112,500

Net book value of elevator at December 31, 20x14:
$112,500 x (1 - 0.10)13 = $28,596
Net book value of elevator at June 30, 20x15:
$28,596 - (28,596 x 10% x ) = $27,166
ii.
c.
Cash
Accumulated depreciation ($112,500 - 27,166)
Loss on derecognition of asset
Elevator
$10,000
85,334
17,166
Elevator
Cash
150,000
$112,500
150,000
Depreciation expense to June 30, 20x15 on elevator derecognized:

$28,596 x 10% x
Depreciation expense from July 1 to Dec 31, 20x15:
$150,000 x 10% x
Depreciation expense on other elevator:
$112,500 x (1 - 0.10)13 x 10%
$1,430
7,500
2,860
$11,790
Net book value of original roof as at Dec 31, 20x22:

$75,000 / 25 x 4 years remaining = $12,000
Loss on derecognition of asset
Accumulated depreciation ($75,000 - 12,000)
Roof
Page 264
$12,000
63,000
$75,000
Roof
Cash
120,000
120,000
Problem 5
The average investment in the project:
Date
Costs
Incurred
Proportion of time
to Aug 31, 20x4
January 1, 20x4
February 1, 20x4
April 1, 20x4
May 15, 20x4
July 1, 20x4
August 1, 20x4
$30,000
50,000
75,000
40,000
60,000
45,000
8/12
7/12
5/12
3.5/12
2/12
1/12
Average
Investment
$20,000
29,167
31,250
11,667
10,000
3,750
$105,084
Borrowing costs on specific borrowings are charged first to the asset, then we will
allocate general borrowings based on the weighted average borrowing rate of 7.8%:
7.5% x ($10,000,000 / 25,000,000) + 5% x (15,000,000 / 25,000,000) = 6%
Borrowing costs to be capitalized:
Asset specific note: $100,000 x 8/12
= 66,667 x 6.5%
General borrowings: ($105,084 - 66,667) x 6%
Page 265
$4,333
2,305
$6,638
Problem 6
Jen-Ward Company
Statement of Income
Sales ($9,500,000 - 2,500,000)
Cost of goods sold ($6,000,000 1,500,000)
$7,000,000
4,500,000
Gross margin
Operating expenses ($2,000,000 800,000)
Income taxes (40%)
Net income before discontinued operations
Net loss from discontinued operations (note)
2,500,000
1,200,000
1,300,000
520,000
780,000
486,000
Net income
$294,000
Discontinued operations Income from operations: $2,500,000 1,500,000 800,000

Writedown to market value: $6,900,000 (6,200,000 x 0.95)
Page 266
$200,000
(1,010,000)
810,000
x 0.6
($486,000)
Problem 7
a) If the service contract does not extend beyond the current period, it is properly
included in repair and maintenance expense. If the service contract does extend
beyond the current period, then the portion of the contract price related to future
periods should be recorded as a prepaid expense and amortized to repair and
maintenance expense over the periods benefited. In either case, the cost of the service
contract should not be added to the cost of the assets to which the contracts apply,
because the contracts do not enhance the future service potential of the assets.
b) The design fee should not be recorded as repair and maintenance expense. The fee is
a capital expenditure which should be recorded as a part of the cost of the building
addition. It is a necessary expenditure to provide future benefits from the building
addition.
c) The cost of the new condenser should be capitalized and depreciated over its useful
life. The old condenser should be derecognized.
d) The cost of the furniture should not be recorded as repair and maintenance expense.
The desks and chairs have future service potential. Therefore, the cost is a capital
expenditure and should be recorded as an asset, furniture and fixtures, and
depreciated over the useful life of the furniture.
e) The cost of the storms and screens should not be recorded as repair and maintenance
expense. The implication from the problem wording is that there were no storms and
screens prior to this expenditure. Thus, the storms and screens constitute an
improvement to the office building. Future service potential has been added to the
building. The capital expenditure should be recorded as a part of the cost of the office
building and depreciated over the remaining life of the building.
f) The cost of sealing the roof leaks is properly recorded as repair and maintenance
expense. It is a revenue expenditure because it does not enhance the service potential
of the plant. The expenditure merely enables the entity to obtain the originally
anticipated service potential of the plant.
g) The cost of the new door should be capitalized and depreciated over its useful life.
The old door should be derecognized.
h) The installation of the automatic door opening system constitutes an improvement,
because it enhances the efficiency of the plant, thereby providing future service
potential. Assuming the door opener will last beyond the current period, the cost
should be capitalized and depreciated over its useful life.
i) The cost of the overhead crane should not be recorded as repair and maintenance
expense. The crane enhances the service potential of the plant and therefore
Page 267
constitutes a capital expenditure. The cost should be capitalized and depreciated over
the useful life of the crane.
j) The cost of the new gear should be capitalized and depreciated over its useful life.
The old gear should be derecognized.
Problem 8
If all of the shell houses are to be sold at the same price, it may be appropriate to
depreciate the costs of the display houses on the basis of the number of shell houses sold.
This method would be similar to the units-of-production method of depreciation and
would result in proper matching of costs with revenues. The success of this method is
dependent upon accurate estimates of the number and selling price of shell houses to be
sold.
Depreciation based upon the passage of time may be preferable when the life of the
models can be estimated with a great deal more accuracy than can the number of units
which will be sold. If unit sales and selling prices are uniform over the life of the display
house, a satisfactory matching of costs and revenues may be achieved using this straightline procedure.
Problem 9
Accumulated Depreciation Buildings
Buildings
$300,000
$300,000
Building
100,000
Accumulated Depreciation Equipment

Equipment
180,000
Equipment
Revaluation Gain (I/S)
Page 268
100,000
180,000
30,000
20,000
10,000
Problem 10
Jan 2, 20x1
Dec 31, 20x1
Dec 31, 20x2
Page 269
Building
Cash
$600,000
$600,000
($600,000 120,000) / 30
16,000
Building
16,000
Building
Note: book value of building becomes
$596,000
12,000
($596,000 120,000) / 29
16,414
Building
Book value of building becomes: $596,000
16,414 = $579,586
16,414
Revaluation surplus (OCI)

Revaluation loss (I/S)
Building
This will bring the book value of the building
to: $579,586 29,586 = $550,000 (its
appraisal value)
12,000
17,586
16,000
16,000
12,000
16,414
16,414
29,586
Dec 31, 20x3
Jan 2, 20x4
($550,000 120,000) / 28
15,357
Building
Book value of building becomes: $550,000
15,357 = $534,643
15,357
Building
Revaluation Gain* (I/S)
30,357
Cash
Loss on disposal of building
Building
560,000
13,000
5,000
Retained Earnings
15,357
15,357
17,357
13,000
565,000
13,000
* the credit to income is reduced by the amount of the deficit previously charged to
income as a lower depreciation charge for 20x1, 20x2 and 20x3: the total depreciation
expense for the years 20x1 - 20x3 was $16,000 + 16,414 + 15,357 = $47,771. This is
compared to the total depreciation charge had the historical cost model been used of
$48,000. Because the actual cumulative depreciation charge of $47,771 is lower than
what it would had been using the historical cost model, the credit to the income statement
is reduced by the difference: $17,586 - (48,000 - 47,771) = $17,357.
Page 270
Problem 11
(a)
Land
Dec 31, 20x4
Dec 31, 20x5
Revaluation Surplus - Land

Land
$200,000
$200,000
Land
Revaluation Surplus Land
500,000
$5,600,000 / 25
224,000
224,000
Buildings
448,000
Revaluation Surplus Buildings

Revaluation Loss (I/S)
Buildings
300,000
252,000
$4,600,000 / 23
200,000
200,000
Buildings
400,000
Buildings
Revaluation gain (I/S)
Revaluation surplus Buildings
300,000
500,000
Buildings
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Dec 31, 20x6
Page 271
224,000
224,000
448,000
552,000
200,000
200,000
400,000
252,000
48,000
Problem 12
1.
2.
LAND
Beginning balance
Add: Site number 621
$1,000,000
Real estate commission (621)
60,000
Clearing costs (621)
15,000
Site number (622)
300,000
Demolition (622)
30,000
Deduct: Residual (621)
Ending balance
a
The cost of Site 623 is included as Land held for sale because it is
held for re-sale.
BUILDINGS
Beginning balance
Add: Construction costs (site 622)
Excavation fees (622)
Architectural fees (622)
Building permit (622)
Interest (622)
Ending balance
$500,000
1,405,000a
(5,000)
$1,900,000
$ 900,000
$150,000
11,000
8,000
1,000
6,000
176,000
$1,076,000
3.
LEASEHOLD IMPROVEMENTS
Beginning balance
$400,000
Add: Electrical work (leased building)
$35,000
Extension to leased building ($80,000 x 50%)
40,000
Improvements to leased offices
65,000
140,000c
Ending balance
$540,000
c
The cost of painting the ceilings is a normal maintenance expenditure and thus
must be expensed as incurred.
4.
MACHINERY AND EQUIPMENT

Beginning balance
$500,000
Add: Cost of new machines
$75,000
Freight on new machines
2,000
Handling charges, new machines
1,500
78,500d
Ending balance
$578,500
d
The royalty payments are not costs associated with getting the machines ready to
use. They must be expensed as incurred.
Page 272
Problem 13
A. The six transactions should be presented on Illini Technologies' December 31, 20x0,
financial statements in the following manner.
(1) The patent for the landing gear system should appear on Illini's Statement of
Financial Position at cost less ten months of amortization.
Cost
Amortization
($75,000 / 6) x 10/12
Book value
$75,000
10,417
$64,583
The Income Statement presentation for this patent should include $10,417 of amortization
expense and $2,250 of interest expense ($75,000 x .06 x 6/12).
(2) This patent should appear on the Statement of Financial Position at cost less six
months of amortization.
Cost
Amortization
($104,800 / 10) x 6/12
Book value
$104,800
5,240
$99,560
The Income Statement presentation for this patent should include $5,240 of
amortization expense. All research and development costs should be expensed in
the year in which they occur unless the criteria for capitalization of development
costs have been met.
(3)
There should be no patent costs reflected on the company's Statement of Financial

Position as the patent application was denied. The filing fees of $34,950 should be
expensed on the current Income Statement.
(4)
The three patents determined to have no future value should no longer appear on
the company's Statement of Financial Position. The Income Statement should
include the write-off of $171,255 for these patents.
The patent account on the Statement of Financial Position should include $20,350
($40,700 / 2) for the patent with the revised useful life. Patent amortization on the
Income Statement should include $20,350 for this patent.
(5)
Since the lawsuit was successful, the legal fees of $51,000 should be capitalized
and included on Illini's Statement of Financial Position. In general, the total costs
expended to establish the validity of a patent can be capitalized; however, the
previously expensed $380,000 should not be capitalized. The expensing was not
Page 273
the result of an error but was a properly recorded estimate at the time, and
changes in estimates must be accounted for prospectively.
(6)
The $103,260 reported by Savey Company should be reported as revenue on

Illini's Income Statement and as License Fees Receivable on the company's
Statement of Financial Position.
B. Factors that should be considered when determining the useful life of a patent include
the following.
Consideration should be given to factors that may cause a patent to become

economically ineffective, e.g., obsolescence due to changing technology.
The maximum life of a patent cannot exceed its legal life of 17 years.
Page 274
Problem 14
a) The estimated lives of the trucks need not be the same for depreciation purposes. The
depreciation process is one of allocating the cost of the asset to the periods of its use.
The useful life to each company will depend upon the planned intensity of use,
maintenance policy, and the retirement policy. There is no reason to believe that each
company would be identical with respect to these considerations.
b) The methods by which each company chooses to allocate the cost of the assets might
also be different. The allocation over the useful life should be reasonable and orderly.
Depreciation seeks to measure realistically the expiration of the asset; i.e., the pattern
of services consumed during the period. The problem is that this is not observable.
Therefore, firms are free to select from among the methods allowed. Each will select
what it feels is most appropriate for reporting purposes, and these need not be the
same.
c) The asset should be recorded at the cash and/or cash equivalent given up to acquire it
according to the cost principle. In this instance, cost will be cash plus the fair market
value of the truck traded in.
Cost = $9,000 + $4,500 = $13,500
d)
Automotive equipment
Automotive equipment
Cash
Gain on trade of equipment
$13,500.00
5,584.50
$8,500.00
9,000.00
1,584.50
Problem 15
Purchase of lot
Demolition
Sale of building stone
Legal fees
Land survey fees
Factory plans
Contract price
Foreman's salary ($24,000 x 4/12)
Insurance
Land
$100,000
8,000
(1,500)
1,300
600
$108,400
Page 275
Building
$ 25,000
950,000
8,000
600
$983,600
Problem 16
a)
Land
Cost of land with existing building
Architect fees
Interest on construction financing
Cost to demolish the old building
Proceeds on sale of materials
Payment of delinquent taxes
Land survey fees
Cost of new building
Liability insurance during construction
Building
$860,000
$130,000
130,000
40,000
(8,000)
15,000
6,000
$913,000
1,200,000
5,000
$1,465,000
The moving costs would be expensed.

b)
($1,465,000 200,000) / 50 x 1/12
Page 276
$2,108
Problem 17
1.
a.
b.
20x5: $50,000 /10 x
$2,500
20x6: 20x5 Acquisitions: $43,000 / 10

$7,000 / 10 x
20x6 Acquisitions: $20,000 / 10 x
$4,300
350
1,000
$5,650
20x5: $50,000 x 20% x
$5,000
20x6: 20x5 Acquisitions: $38,700* x 20%

$6,300* x 20% x 1/2
20x6 Acquisitions: $20,000 x 20% x 1/2
$7,740
630
2,000
$10,370
Ending balance on $43,000 of assets acquired in 20x5 = $43,000 x .9 =

$38,700 (i.e. the depreciation in the first year is 10%, the ending net book
value of the asset is the acquisition cost times one minus the depreciation
rate)
** $7,000 x .9 = $6,300
2.
Cash
Accumulated amortization $350 x 2
Loss on disposal of equipment
Equipment
$4,000
700
2,300
$7,000
Problem 18
Net book value of equipment at January 1, 20x6
= $500,000 x (1 - .25)5 = $118,652
Amortization in 20x6 = lesser of:
$118,652 x 25% = $29,663
$118,652 100,000 Salvage Value = $18,652

=>
Page 277
$18,652
9.
Liabilities
A liability is defined s a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits (IAS 37.10).
Current Liabilities
An entity should classify a liability as current when (IAS 1.69):
it expects to settle the liability in the entity's normal operating cycle,
it holds the liability primarily for the purpose of trading,
the liability is due to be settled within twelve months after the reporting period, or
the entity does not have an unconditional right to defer settlement of the liability
for at least twelve months after the reporting period.
Accounts Payable and Accrued Liabilities

Accounts payable are those debts to suppliers that arise from the normal purchasing
activities of the company.
Accrued liabilities are typically not legally payable at the financial statement date but will
become payable later. For example, if the electrical utility takes meter readings on the
15th of every month, an estimate of electricity usage to the end of the fiscal period will
usually be made.
Other types of current liabilities include: provisions, notes payable (the accounting
thereof is similar to notes receivable), customer deposits, income taxes payable,
vacation/sick pay payable, and current portion of long-term debt.
Provisions
A provision is to be recognized as a liability when all of the following three criteria are
met:
the entity has a present obligation (legal or constructive) as a result of a past

event;
it is probable that an outflow of resources embodying economic benefits will be

required to settle the obligation; and
a reliable estimate can be made of the amount of the obligation (IAS 37.14).
If all of the above criteria are not met, then no recognition can take place. Provisions
differ from other liabilities such accounts payables and accrued liabilities because there is
uncertainty about the timing or amount of the future expenditure. Consequently,
Page 278
provisions should be reported separately from accounts payable and accrued liabilities
(IAS 37.11).
A past event is deemed to give rise to a present obligation ig, taking account of all
available evidence, it is more likely than not that a present obligation exists at the end of
the reporting period (IAS 37.15).
A legal obligation is an obligation that derives from:
a contract,
legislation, or
other operation of law (IAS 37.10).

A constructive obligation is an obligation that derives from an entity's actions where:
by an established pattern of past practice, published policies of a sufficiently

specific current statement, the entity has indicated to other parties that it will
accept certain responsibilities; and
as a result, the entity has created a valid expectation on the part of those other
parties that it will discharge those responsibilities (IAS 37.10).
Examples of constructive obligations:
the entity announces that they will provide an additional one year warranty
beyond the three year contractual warranty;
the right to return merchandise, although not legally required, is published as a
policy on the firm's website; and
the entity publishes its environmental policy with goes beyond what is legally
required of them.
A provision is measured as the best estimate of the expenditure required to settle the
present obligation at the end of the reporting period (IAS 37.36). If the range of outcomes
is discrete, i.e. if the provision involves several estimates, the obligation is estimated by
calculating the expected value. If the range of outcomes is continuous, and each point in
that range is as likely as any other, the mid-point of the range is used (IAS 37.39).
Example4: an entity in the oil industry causes contamination and operates in a country
where there is no environmental legislation. However, the entity has a widely published
environmental policy in which it undertakes to clean up all contamination that it causes
and has a record of honouring this published policy. The estimates for the costs of
cleaning up this contamination along with the associated probabilities are as follows:
4 this is an adaptation of Example 2B of Appendix C of IAS 37.
Page 279
Cost
Probability
$400,000
500,000
600,000
700,000
800,000
0.10
0.30
0.45
0.09
0.06
This is a provision because:
the entity has a constructive obligation to decontaminate the land; and
the outflow of resources is probable

The provision would be recorded at its expected value of $571,000.
($400,000 x 10%) + ($500,000 x 30%) + ($600,000 x 45%)
+ ($700,000 x 9%) + ($800,000 x 6%)
= $571,000
If the range of possible outcomes ranges from $400,000 to $800,000 as a continuous
range (i.e. no estimate is better than the other), then we would accrue the mid-point, or
$600,000.
Of course, this assumes that the provision would need to be settled in the near future. If
the expenditures resulting from this provision are expected to be incurred in several years
from now and that the effect of time value of money is material, then the amount has to
be discounted (IAS 37.45). The discount rate to be used is the pre-tax rate that reflects
current market assessments of the time value of money and risks specific to the liability
(IAS 37.47).
Example: assume the same facts as in the previous example and that it is expected that
these expenditures will be incurred in 15 years. At a discount rate of 6%, the present
value of the provision is
Enter
Compute
N
15
I/Y
6
PV
PMT
FV
571,000
X=
$238,258
If the difference between the undiscounted amount of $571,000 and the discounted
amount of $238,258 is material, then we have to accrue the discounted amount. The
provision would then be treated as decommissioning cost.
A provision can only be used for expenditures for which the provision was originally
recognized (IAS 37.61).
Specific examples of provisions are expense warranties and premiums.
Page 280
Expense Warranties
An expense warranty is an undertaking by a vendor to maintain and repair a product or
service. For example, a new car is usually sold with a warranty that contains some
distance limits. According to the revenue recognition criteria, the cost of the warranty
should be charged to the period in which the profit on the sale is recognized. Usually
much of the warranty work is done in accounting periods following the sale. Thus, the
estimated cost of the warranty is recorded in the year of sale through the following
journal entry:
Dr. Warranty expense
Cr. Warranty Liability
When warranty work is actually done, it is charged against this liability account:
Dr. Warranty Liability
Cr. Cash, Accounts Payable
Example: Company X provides a 3 year warranty on all of the products it sells. Sales for
the current year were $3,000,000 and it is estimated that the warranty expense is equal to
5% of sales. The warranty liability at the beginning of the year was $165,000 and actual
costs incurred to service warranties during the year amounted to $130,000.
The journal entry to record warranty expense is:
Warranty expense ($3,000,000 x 5%)
Warranty Liability
$150,000
$150,000
The journal entry to record actual warranty costs incurred is:

Warranty Liability
Cash
130,000
130,000
The warranty liability at the end of the year will be $165,000 Opening Balance + 150,000
Warranty Expense
130,000 Warranty Costs Incurred = $185,000.
Premiums
A premium liability arises when a company offers its customers redeemable coupons,
frequent flyer points or any program whereby the customer can receive something of
value in the future based on current purchases. Like warranties, the matching principle
requires that the premium expense accrued in a given year be properly matched to its
revenues. The accounting for premiums is very similar to that of warranties.
Page 281
Example for every dollar of revenue, you give your customers one coupon. They can
then redeem 10,000 coupons to receive a gizmo that is valued at $50. You estimate that
only 60% of coupons will be redeemed. Your sales for the year amount to $5,600,000,
the opening balance in the premium liability was $15,000 and 4,800,000 coupons were
redeemed.
The journal entry to record the premium expense is:
Premium expense ($5,600,000 / 10,000 x $50 x 60%)
Premium Liability
$16,800
$16,800
The journal entry to record actual premium costs incurred is:

Premium Liability (4,800,000 / 10,000 x $50)
Cash
24,000
24,000
The premium liability at the end of the year will be $15,000 Opening Balance + 16,800 Premium
Expense
24,000 Premium Rewards Incurred = $7,800.
Note that the premium expense is not shown as part of expenses on the Statement if
Income, but as a reduction of sales (IFRIC 13).
Disclosure Requirements - Provisions

For each class of provision, the following has to be disclosed:
the carrying amount at the beginning and end of the period;
additional provisions made in the period, including increases to existing

provisions;
amounts used (i.e. incurred and charged against the provision) during the period;
unused amounts reversed during the period;
the increase during the period on the discounted amount arising from the passage
of time and the effect of any change in the discount rate;
a brief description of the nature of the obligation and the expected timing of any
resulting outflows of economic benefits;
an indication of the uncertainties about the amount and timing of those outflows;
and
the amount of the any expected reimbursement, stating the amount of any asset
that has been recognized for that expected reimbursement (IAS 37.84:85).
Page 282
Sales Warranties
In addition to providing warranties that come with products, some manufacturers/retailers
often sell extended warranties. The accounting for the expense warranty (the one that
comes with the product) was explained above. The accounting for the sales warranty is as
follows:
on date of sale, the sale warranty is recorded as unearned revenue:

dr. Cash
Cr. Unearned sales warranty revenue
as the sales warranty period progresses, the sales warranty is earned:

dr. Unearned sales warranty revenue
cr. Sales warranty revenue
as expenses are incurred under the sales warranty, they are simply charged to
expense:
dr. Sales warranty expense
cr. Cash or Accounts Payable
Note that we accrue the sales warranty revenue over the life of the sales warranty.
However, unlike expense warranties, warranty expense is not accrued but expensed as
incurred.
Example assume that you sell a product that comes with a one year warranty. In
addition, you provide your customers an optional two year extended warranty. The
product sells for $1,000, you estimate that the warranty costs will equal to 2% of sales on
average. The extended warranty costs the customer $120.
The journal entries to record the sale of product and extended warranty on January 2,
20x2 are as follows. Assume a calendar year end and that the product is returned for
repairs on September 15, 20x2 at a cost of $30 and on July 23, 20x4 at a cost of $160.
Jan 2, 20x2
Sep 15, 20x2
Page 283
Cash ($1,000 + 120)

Sales
Unearned sales warranty revenues
$1,120
$1,000
120
Warranty expense ($1,000 x 2%)

Warranty liability
20
Warranty liability
Cash
30
20
30
Dec 31, 20x3
Jul 23, 20x4
Dec 31, 20x4

Sales warranty revenues
(Note that the accrual could be on a monthly
basis)
Sales warranty expense
Cash
Sales warranty revenues
60
60
160
160
60
60
Contingent Liabilities and Contingent Assets

A contingent liability is defined as:
a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one of more uncertain
future events not wholly within the control of the entity; or
a present obligation that arises from past events but is not recognized because:
it is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; or
the amount of the obligation cannot be measured with sufficient reliability
(IAS 37.10).
Contingent liabilities are not recognized (IAS 37.27). Unless the possibility of any
outflow in settlement is remote, an entity shall disclose for each class of contingent
liability a brief description of the nature of the contingent liability and, where practicable,
an estimate of the financial effect;
an indication of the uncertainties relating to the amount or timing of any outflow;

and
the possibility of any reimbursement.

Appendix A of the standard provides the following table which outlines the key
differences between provisions and contingent liabilities:
There is a present
obligation that probably
requires an outflow of
resources.
There is a possible
obligation or a present
obligation that may, but
probably will not, require
an outflow of resources.
There is a possible
obligation or a present
obligation where the
likelihood of an outflow of
resources is remote.
A provision is recognized.
No provision is recognized.
No provision is recognized.
Disclosures are required for

the provision.
Disclosures are required for

the contingent liability.
No disclosure is required.
Page 284
Contingent Assets
A contingent asset arises from an unplanned or other unexpected event that gives rise to
the possibility of an inflow of economic benefit to the entity. For example, a claim that an
entity is pursuing through the legal system, where the outcome is uncertain.
Contingent assets cannot be recognized since this may result in the recognition of income
that may never be realized (IAS 37.31 and 37.33). If an inflow of economic benefit is
probable, contingent assets must be disclosed in the notes to the financial statements (IAS
37.34).
Accounting for Bonds Payable

A bond is a legal document giving evidence of a contractual obligation by a company,
starting at a time referred to as the inception date, to
(i)
(ii)
redeem the bond for a stated amount (the face amount or par value) at some stated
time in the future called the maturity date and
make periodic interest payments during the term of the bond.
These interest payments are normally stated as a percentage of the face amount, and this
percentage is termed the coupon rate (or stated rate). The length of time between the
inception and maturity dates is known as the term of the bond. Bonds may be secured by
the pledge of specific assets of the company, such as land and buildings, in which case
they are referred to as mortgage bonds. If there is no pledge of specific assets but rather a
general charge against all assets, the bonds are referred to as debentures.
The legal terms of the bond are very important because the sums borrowed are often very
large (e.g., $25 million). Moreover, as any given issue is often widely held, renegotiation
of the terms is usually expensive and difficult. The terms of the bond issue are set out in a
trust indenture, which is a legal agreement between the issuing company and a trust
company acting on behalf of the bondholders. The trust company is referred to as the
bond trustee. It is the bond trustee's duty to see that the issuing company lives up to the
terms of the trust indenture and to take whatever steps are necessary to protect the
bondholders (ie., seize the assets given as security for the bond issue).
Here is an example of a straightforward bond issue. On July 1, 20x1, Gamma
Corporation issued bonds with a face value of $500,000 and a coupon rate of 10%. The
bonds pay interest semi-annually on January 1 and July 1 and are due in five years. If the
bonds were sold for their face amount, they would be selling at par value; if less than
their face amount, they would be selling at a discount; and if more than their face value,
they would be selling at a premium.
Page 285
Assume that the going market interest rate for similar bonds on July 1, 20x1 is 8%.
Because the Gamma bonds pay a higher amount of interest, investors will be willing to
pay more for these bonds and will purchase them at a premium. The bonds will sell for
the discounted value of the bond's cash flow. The cash flows are discounted at the market
rate of interest. Note also that because the interest is paid semi-annually, that we are
dealing with semi-annual amortization.
The value of the bond issue will be as follows:
Enter
Compute
N
10
I/Y
4
PV
PMT
25000
FV
500000
X=
540,554
The journal entry to record the issuance of these bonds is as follows:

July 1, 20x1
Cash
Bonds payable
$540,554
$540,554
On January 1, 20x2, the first interest payment is made to bondholders of $25,000

($500,000 x 10% x 1/2). However, because the firm is effectively paying 8% interest on
these bonds (the market rate), the interest expense will be lower than $25,000. The
difference will be handled through the amortization of the premium on bonds payable
($540,554 Proceeds 500,000 Face Value = $40,554). This premium will be amortized and
reduce the balance of the bonds payable to $500,000 by the end of the bond term.
The method used to account for the amortization of the discount or premium on bonds is
called the effective interest method. The journal entry to record the interest payments is
as follows:
Jan 1, 20x2
Bonds payable
Interest expense (540,554 x 4%)
Cash
$3,378
21,622
25,000
Note that the amount of interest expense is calculated directly and that the amount of the
premium on bonds payable is imputed as Cash - Interest expense. The interest expense is
calculated as the carrying value of the bond times the market rate of interest.
The journal entry to record the interest payment of July 1, 20x2 would be as follows:
Jul 1, 20x2
Bonds
Interest expense (540,554 - 3,378) x 4%
Cash
$3,513
21,487
25,000
If we now assume that the going rate of interest at the time of issue is 14%, then the
bonds would sell at a discount since investors want to be compensated for the fact that the
bonds are paying a coupon rate of only 10%.
Page 286
The value of each $1,000 bond will be as follows:
Enter
Compute
N
10
I/Y
7
PV
PMT
25000
FV
500000
X=
429,764
The journal entry to record the issuance of the bonds would be as follows:
July 1, 20x1
Cash
Bonds payable
$429,764
$429,764
The journal entry to record the first interest payment if the straight-line method of
amortization is used is as follows:
Jan 1, 20x2
Interest expense
Bonds payable ($70,236 10)
Cash
$32,024
7,024
25,000
Note that the interest expense is higher because the firm is effectively paying 14%
interest even though they are paying coupon payments of 10% of the face value.
The journal entry to record the first two interest payments if the effective interest method
of amortization is used is as follows:
Jan 1, 20x2
Jul 1, 20x2

Bonds payable
Cash
$30,083
Interest expense (429,764 + 5,083) x 7%

Bonds payable
Cash
$30,439
5,083
25,000
5,439
25,000
Accounting for bonds can be summarized as follows:

1.
On date of issue, we calculate the present value of the bonds by discounting the
coupon payments and face value at the yield to maturity (market interest rate). If
the resulting amount is less than the face value of the bonds, then the bonds have
issued at a discount. If the resulting amount is higher than the face value of the
bonds, then the bonds have issued at a premium. The journal entry to record the
bond issue is as follows:
Cash
Bonds Payable
Page 287
XXX
XXX
2.
On coupon payment dates, we record the interest expense using the effective
interest method. The interest expense is equal to the book value of the bonds
payable times the yield to maturity. Since bonds pay coupons semi-annually, the
yield to maturity rate must be divided by two. The difference between the interest
expense and the coupon paid is equal to the amortization of the bond premium or
discount and gets recorded directly to the Bonds Payable Account.
If the bonds were issued at a discount, the journal entry would be as follows:
Interest expense
Bonds Payable
Cash
XXX
XXX
XXX
If the bonds were issued at a premium, the journal entry would be as follows:
Interest expense
Bonds Payable
Cash
3.
XXX
XXX
XXX
If the coupon payment date does not coincide with the companys year-end, then
interest on the bond issue must be accrued at year end.
The accrued interest = book value of bonds payable x YTM x prorata for time
since last coupon payment date
The journal entry would be as follows (note that this journal entry would be
reversed at the beginning of the next period):
Interest expense
Interest Payable
4.
XXX
XXX
If the bonds are redeemed before the maturity date of the bonds, we must first
calculate the book value of the bonds and then remove these from the books. Any
difference between the cash paid to retire the bonds and the book value of the
bonds retired gets debited/credited to loss/gain on redemption of bonds payable.
If the bonds are retired at a loss, the journal entry would be as follows:
Bonds Payable
Loss on retirement of Bonds Payable
Cash
Page 288
XXX
XXX
XXX
Example: In order to finance a major expansion program, Aughey Ltd. issued bonds
dated May 31, 20x5, on July 2, 20x5, with a face amount of $3,000,000 and a coupon rate
of 10%. Interest is payable on November 30 and May 31. The bonds were issued to
yield 12% plus accrued interest and mature in twelve years. Aughey Ltd. uses the
effective interest rate method.
Assume that the company retires $900,000 face amount of the bonds on September 30,
20x8, at 97 plus accrued interest. The fiscal year end of Aughey Ltd. is December 31.
The proceeds received on the bond issue will equal to:
1.
The present value of the bond issue:
Enter
Compute
2.
N
24
I/Y
6
PV
PMT
150000
FV
3000000
X=
2,623,489
The accrued coupon payments received by bondholders:

= $3,000,000 x 10% x 1/12 = $25,000
The journal entry to record the bond issue on July 2, 20x5 will be:
Jul 2, 20x5
Page 289
Cash
Interest expense
Bonds payable
$2,648,489
$25,000
2,623,489
The journal entries for 20x5 to May 31, 20x6 and the journal entry to record the
retirement of the bonds on September 30, 20x8 will be:
Nov 30, 20x5
Dec 31, 20x5
Jan 1, 20x6
May 31, 20x6
Interest expense ($2,623,489 x 6%)

Bonds payable
Cash
$157,409
7,409
150,000
Interest expense
Interest payable
($2,623,489 + 7,409) x 6% x 1/6
= $2,630,898 x 6% x 1/6
26,309
Interest payable
Interest expense
26,309
26,309
26,309

Bonds payable
Cash
157,854
7,854
150,000
In order to prepare the journal entry for the bond redemption on September 30, 20x8, we
need to calculate the book value of the bonds payable at May 31, 20x8 (the most recent
interest payment date).
Book value of bonds payable = the present value of the remaining cash flows at the
original yield to maturity
Enter
Compute
N
18
I/Y
6
PV
PMT
150000
FV
3000000
X=
2,675,172
The first thing we need to do is accrue interest expense on these bonds to September 30,
20x8:
Sep 30, 20x8
Interest expense ($2,675,172 x 6% x 4/6)

Bonds payable
Interest payable ($150,000 x 4/6)
107,007
7,007
100,000
This brings the book value of the bonds payable at: $2,675,172 + 7,007 = $2,682,179
We will have to pay the bondholders 4 months coupon:
$900,000 x 5% x 4/6 = $30,000
Sep 30, 20x8
Interest payable
Cash
The entry to record the redemption of the bonds payable is:
Page 290
30,000
30,000
Sep 30, 20x8
Bonds payable ($2,682,179 x 900/3,000)

Loss on redemption of bonds payable
Cash ($900,000 x .97)
804,654
68,346
873,000
Bond Issue Costs

Any direct costs incurred to issue bonds, i.e. underwriting, legal and accounting fees
reduce the bond proceeds.
Events after the reporting period

Events after the reporting period are events arising between the end of the reporting
period and the date the financial statements are authorized to be issued.
There are two types of subsequent events:
adjusting events after the reporting period - those which provide further evidence
of conditions which existed at the financial statement date - these will result in an
adjustment to the financial statements, and
non-adjusting events after the reporting period - those which are indicative of
conditions which arose subsequent to the financial statement date that do not
provide further evidence of conditions which existed at the financial statement
date - if material, these have to be disclosed in the notes to the financial
statements (IAS 10.3)
Examples of adjusting events after the reporting period:
institution of bankruptcy proceedings against a debtor - you may have to revise

the allowance for doubtful accounts;
a long-term investment in which you hold a significant influence announces its

worst annual results since inception - you may have to determine whether a writedown is required;
a court case confirms the existence of a previously recorded provision or a

previously disclosed contingent liability.
Examples of non-adjusting events after the reporting period:
an event such as a fire or flood which results in a loss;
purchase of a business;
commencement of litigation where the cause of action arose subsequent to the

date of the financial statements;
changes in foreign currency exchange rates;
the issue of capital stock or long term debt.

Financial statements should be adjusted when events occurring between the date of the
financial statements and the date the financial statements are authorized to be issued since
Page 291
these provide additional evidence relating to conditions that existed at the date of the
financial statements (IAS 10.8).
Disclosure Requirements
If non-adjusting events after the reporting period are material, non-disclosure could
influence the economic decisions that users make on the basis of the financial statements.
Accordingly, an entity shall disclose the following for each material category of nonadjusting event after the reporting period:
the nature of the event, and
an estimate of its financial effect, or a statement that such an estimate cannot be

made (IAS 10.21).
Page 292

1.
Robb Company requires advance payments with special orders from customers or
machinery constructed to their specifications. Information for 20x5 is as follows:
Customer advances - balance December 31, 20x4
Advances received with orders in 20x5
Advances applied to orders shipped in 20x5
Advances applicable to orders cancelled in 20x5
$295,000
460,000
410,000
125,000
At December 31, 20x5, what amount should Robb report as a current liability for
customer deposits?
a.
$0.
b.
$220,000.
c.
$345,000.
d.
$370,000.
2.
Cobb Company sells appliance service contracts to repair appliances for a two
year period. Cobb's past experience is that, of the total amount spent for repairs on
service contracts, 40% is incurred evenly (per month) during the first contract
year and 60%, evenly during the second contract year. Receipts from service
contract sales for the two years ended December 31, 20x5, are $500,000 in 20x4
and $600,000 in 20X5. Receipts from contracts are credited to unearned service
contract revenue. Assume that all contract sales are made evenly (per month) the
during the year. What amount should Cobb report as unearned service contract
revenue at December 31, 20x5?
a.
$360,000.
b.
$470,000.
c.
$480,000.
d.
$630,000.
Page 293
3.
Farr Company sells its products in expensive, reusable containers. The customer
is charged a deposit for each container delivered and receives a refund for each
container returned within two years after the year of delivery. Farr accounts for
the cash received for containers not returned within the time limit as a sale at the
deposit amount when the time limit expires. Information for 20x5 is as follows:
Containers held by customers at December 31, 20x4, from deliveries in:
20x3
20x4
Containers delivered in 20x5

Containers returned in 20x5, from deliveries in:
20x3
20x4
20x5
$ 75,000
215,000
$290,000
$390,000
$ 45,000 (Eligible for refund)

125,000
143,000
$313,000
What amount should Farr report as a liability for returnable containers at

December 31, 20x5?
a.
$247,000.
b.
$322,000.
c.
$337,000.
d.
$367,000.
4.
Bonds due in 5 years were sold at $104,158 on January 1 to yield an effective

interest rate of 7% compounded semiannually. Face value of the bonds is $100,000
and the annual coupon rate is 8%. Cash interest is paid semiannually. What is the
interest expense for the first 6-month period using the effective interest method?
a.
$3,500.
b. $3,646.
c.
$3,584.
d. $4,166.
e.
$4,416.
Page 294
5.
The 10% bonds payable of Issac Company had a net carrying amount of $760,000
on January 2, 20x3. The bonds, which had a face value of $800,000, were issued at
a discount to yield 12%. The amortization of the bond discount was recorded under
the effective interest method. Interest was paid on January 1 and July 1 of each
year. On July 2, 20x3, several years before their maturity, Issac retired the bonds at
102. The interest payment on July 1, 20x2 was made as scheduled. What is the loss
that Issac should record on the early retirement of the bonds on July 2, 20x3?
Ignore taxes.
a) $16,000
b) $50,400
c) $44,800
d) $56,000
6.
Which of the following situations would NOT require disclosure in the notes to the
financial statements of Company A?
a) Company A is being sued by an employee for wrongful dismissal and is
unsure as to whether it will lose. If Company A does lose, the most likely loss
will be $400,000, a material amount. No amount has been accrued.
b) Company A changed its inventory valuation method from FIFO to average
cost.
c) There is a high probability that a lawsuit launched by Company A against a
competitor for breach of copyright will be successful, resulting in significant
proceeds.
d) Company A is being sued by a former customer for $40,000 relating to some
deficient work. Company A is sure that it will lose and has therefore accrued a
liability of $40,000.
e) Company A recently determined that it under-remitted payroll taxes in a
previous fiscal year. Although the under-remittance has been accrued,
Company A is unsure as to whether the maximum amount of $100,000 of
penalties will be charged.
Page 295
7.
On November 5, 20x1, a Dunn Corp. truck was in an accident with an auto driven
by Bell. Dunn received notice on January 12, 20x2, of a lawsuit for $700,000
damages for personal injuries suffered by Bell. Dunn Corp.'s counsel believes it is
probable that Bell will be awarded an estimated amount in the range between
$200,000 and $450,000, and that $300,000 is a better estimate of potential liability
than any other amount. Dunn's accounting year ends on December 31, and the 20x1
financial statements were issued on March 2, 20x2. What amount of provision
should Dunn accrue at December 31, 20x1?
a) $0
b) $200,000
c) $300,000
d) $450,000
8.
On March 1, 20x5, Cain Corp. issued at 103 plus accrued interest, two hundred of
its 9%, $1,000 bonds. The bonds are dated January 1, 20x5, and mature on January
1, 20x15. Interest is payable semiannually on January 1 and July 1. Cain paid bond
issue costs of $10,000. Cain should realize net cash receipts from the bond issuance
of :
a) $216,000
b) $209,000
c) $206,000
d) $199,000
Page 296
Problem 1
Early in 20x0, Draeger Incorporated decided to retool its automotive engine plant to
produce a newly designed 24-valve, six-cylinder automotive engine. This engine is
capable of attaining a high gas mileage rating with low emissions. The advance notices in
several national automotive magazines were very favorable.
In order to finance the retooling, Draeger issued $200 million of 8% registered
debentures due in ten years June 30. Interest is payable semi-annually on December 31
and June 30. As a result of the favorable notices in the automotive magazines, the
noncallable bonds were sold to yield 7%. The issue was sold through underwriters on
July 1, 20x0.
The company's fiscal year ends December 31.
Required a. Prepare the journal entries for Draeger Incorporated to record the issuance of the
bonds on July 1, 20x0.
b. Prepare the journal entries for Draeger Incorporated to reflect the bond issuance on
the financial statements dated December 31,20x0.
Problem 2
Alpha Corporation sold $400,000 of 8% (payable semi-annually on June 30 and
December 31), three-year bonds. The bonds were dated and sold on January 1, 20x2, at
an effective interest rate of 10%. The accounting period for the company ends on 31
December.
Required
1.
2.
3.
4.
5.
Compute the price of the bonds.

Prepare a debt amortization schedule for the life of the bonds (use the effective
interest method and round to the nearest dollar).
Prepare entries for Alpha through December 31, 20x2.
Show how Alpha would report the bonds on its Statement of Financial Position at
December 31, 20x2.
What would be reported on the income statement for the year ended December
31, 20x2?
Page 297
Problem 3
On April 1, 20x0, Hanson Industries Ltd. issued ten year bonds with a face value of
$5,000,000. The proceeds of the issue were $5,159,133. The bonds have a stated interest
rate of 10%, payable semi-annually at October 1 and April 1. Hanson Industries has a
December 31 year end.
Required a) Prepare all of the journal entries necessary from April 1, 20x0 to April 1, 20x1.
b) Assume that one-half of the bonds were retired on April 1, 20x4 at 102. Prepare the
journal entry to record the retirement of the bonds.
Problem 4
On January 1 20x0, the Nolan Trust Ltd. issued for $519,641 five-year, 12% bonds that
have a maturity value of $500,000 and pay interest semi-annually on June 30 and
December 31 of each year. The yield to maturity on that date was 5.1%. A call price of
105 exists on these bonds.
Required a) What does the issue price of the bonds tell you about the market interest rate on
January 1, 20x0? Explain your answer.
b) If the bonds are called by Nolan Trust Ltd. at any time during their life, would you
expect a gain or a loss to be realized upon the early retirement? Explain your answer.
c) What is the interest expense as reported on the income statement for the year ended
December 31, 20x0? Show your calculations.
d) Present the liability for these bonds as it would be reported on the Statement of
Financial Position as at December 31, 20x0.
Page 298
Problem 5
Maston Company is a manufacturer of toys. During the year, the following situations
arose:
Situation 1: A safety hazard related to one of Maston's toy products was discovered. It is
considered likely that liabilities have been incurred. A reasonable estimate of the amount
of loss can be made on the basis of past experience.
Situation 2: One of Maston's small warehouses is located on the bank of a river and can
no longer be insured against flood losses. No flood losses have occurred since the date
when the insurance became unavailable.
Required 1. How should Maston report the safety hazard? Why?
2. How should Maston report the uninsurable flood risk? Why?
Problem 6
The following two independent sets of facts relate to the possible accrual of a loss
contingency or its possible disclosure by other means.
Situation 1: A company offers a one-year warranty for the product that it manufactures.
A history of warranty claims has been compiled and the likely amount of claims related
to sales for a given period can be determined.
Situation 2: A company has adopted a policy of recording self-insurance for any possible
losses resulting from injury to others by its vehicles. The premium for an insurance
policy for the same risk from an independent insurance company would have an annual
cost of $2,000. During the period covered by the financial statements, there were no
accidents involving the company's vehicles which resulted in injury to others.
Required For each of the two independent sets of facts above, discuss the accrual or type of
disclosure necessary (if any) and the reason why such disclosure is appropriate.
Page 299
Problem 7
In May 20x2 the Dennon Company became involved in litigation. As a result, it is likely
that Dennon will have to pay $1.3 million. In July 20x2 a competitor commenced a suit
against Dennon alleging violation of antitrust laws and seeking damages of $2.2 million.
Dennon denies the allegations, and the likelihood that Dennon will have to pay any
damages is remote. In September 20x2 Blane County brought action against Dennon for
$1.8 million for polluting Bass Lake. It is possible that the county's suit will be
successful, but the amount of damages Dennon will have to pay is not reasonably
determinable.
Required 1. What amount, if any, should be accrued in 20x2?
2. Draft the disclosures, if any, that should appear in Dennon Company's 20x2 financial
statements as the result of the litigation in 20x2.
Problem 8
On January 1, 20x4, H. Ltd. issued 10% bonds, maturing in ten years, with a face value
of $200,000 at a price to yield 8% compounded semi-annually. The bonds pay interest
semi-annually. H. Ltd. uses the effective interest rate method to account for bond
discounts and premiums. What amount of bond interest expense will H. Ltd. report on its
fiscal year ended December 31, 20x4, financial statements?
Problem 9
The Canadian Chocolate Company (CCC) is a manufacturer of chocolate candy products.
Earlier this year, one of CCC's subsidiaries was the victim of an extortion attempt. The
extortionists demanded $24 million from the company. When CCC refused to comply,
the extortionists carried out the threat to poison "Treat" bars in three large cities,
apparently chosen at random. As a result, six people died and 12 others became seriously
ill. The company responded by removing every "Treat" bar from the shelves of all
retailers and destroying the stock. The company also introduced a tamper-proof wrapper
for new stock and hired a public relations firm to undertake a special campaign to rebuild
consumer confidence in the bar.
All costs were transferred to the head office to allow for one consolidated insurance
claim. The company has estimated that the total cost resulting from the poisoning is about
$25 million: $2 million for the new wrapping machinery, $8 million for the products
destroyed, $2 million for the public relations firm, and $14 million for profits lost through
reduced product sales. CCC does not want to include the insurance settlement in income
in the current year but wants to defer and amortize the amount over a five-year term (on
the same basis as the costs of machinery and equipment are depreciated).
Page 300
Legal proceedings have been commenced against CCC and its subsidiaries by the estates
of the deceased parties and by those who became ill. They are suing for $450 million.
Required How should CCC reflect the above facts in the current year-end financial statements?
Provide calculations where possible.
Problem 10
Foster Music Emporium carries a wide variety of musical instruments, sound
reproduction equipment, recorded music, and sheet music. As a sales promotion
technique, Foster uses warranties to attract customers. Musical instruments and sound
equipment are sold with a one year warranty for replacement of parts and labour. The
estimated warranty cost, based on experience, is 1.5 percent of sales. Sales for these items
were $5.4 million in 20x2. Foster uses the accrual method to account for the warranty
costs for financial reporting purposes. The balance in the account related to warranties on
January 1, 20x2, was as shown below.
Estimated liability from warranties
$63,000
Replacement parts and labour for warranty work totalled $80,000 during 20x2.
Required Foster Music Emporium is preparing its financial statements for the year ended
December 31, 20x2. Determine the amount that will be shown on the 20x2 financial
statements for the following:
a) Warranty expense.
b) Estimated liability from warranties.
Page 301
SOLUTIONS

1.
The outstanding contracts at Dec 31, 20x5:

20x4: $500,000 x 60% x 1/2 = $150,000
20x5: $600,000 x 40% x 1/2 = $120,000
600,000 x 60% = $360,000
Total = $630,000
3.
$290,000 + 390,000 - 313,000 - 30,000 = $337,000
4.
The interest expense for the first 6 months that the bonds are outstanding is
calculated as (7% x $104,158) x .5 = $3,646.
5.
Book value of bonds on July 2, 20x3 =

$760,000 + [(760,000 x 6%) (800,000 x 5%)]
$760,000 + (45,600 40,000)
$765,600
Cost to retire bond issue = $800,000 x 1.02 = $816,000
Loss on retirement = $816,000 765,600 = $50,400
6.
No disclosure is necessary since no further exposure exists in addition to the

amount accrued. Choices a), b), c) and e) all describe situations where
disclosure in the notes would be required.
7.
A provision should be accrued if it is probable that a liability has been

incurred at the balance sheet date and the amount of the loss is reasonably
estimable. This loss must be accrued because it meets both criteria. Notice
that even though the lawsuit was not initiated until 1/12/x2, the liability was
incurred on 11/5/x1 when the accident occurred. When some amount within
an estimated range is a better estimate than any other amount in the range, that
amount is accrued. Therefore, a loss of $300,000 should be accrued. If no
amount within the range is a better estimate than any other amount, the
amount at the low end of the range is accrued and the amount at the high end
is disclosed.
8.
d.
Bond: 200 bonds x $1,000 x 1.03

Accrued interest: $200,000 x 9% x 2/12 months
Bond issue costs
Net cash proceeds on bond issue
Page 302
$206,000
3,000
-10,000
$199,000
Problem 1
a.
The journal entries to record Draeger Incorporated's issuance of bonds and

payment of related costs at July 1, 20x0 are presented below.
The proceeds on the bond issue:
Enter
Compute
N
20
I/Y
3.5
PV
FV
200000000
X=
214,212,403
Cash
Bonds payable
To record bond issuance at July 1, 20x0.
b.
PMT
8000000
$214,212,403
$214,212,403
The journal entries to record Draeger Incorporated's bond issuance on the

financial statements dated December 31, 20x0 are presented below.
Interest expense ($214,212,403 x 3.5%)
$7,497,434
Bonds payable
502,566
Cash
To record interest and premium at December 31, 20x0.
Page 303
$8,000,000
Problem 2
1.
N
6
Enter
Compute
I/Y
5
PV
FV
400000
X=
$379,697
2.
Time
0
1
2
3
4
5
6
PMT
16000
Date
Jan 1, x2
Jun 30, x2
Dec 31, x2
Jun 30, x3
Dec 31, x3
Jun 30, x4
Dec 31, x4
Discount
Amortization
Interest
18,985
19,134
19,290
19,455
19,628
19,811*
2,985
3,134
3,290
3,455
3,628
3,811
Balance
$379,697
382,682
385,816
389,106
392,561
396,189
400,000
* rounded to balance
3.
Jan 1, x2
Jun 30, x2
Dec 31, x2
Cash
Bonds Payable
379,697
Interest expense
Bonds payable
Cash
18,985
Interest expense
Bonds payable
Cash
19,134
4.
Bonds payable
5.
Interest expense (18,985 + 19,134)
Page 304
379,697
2,985
16,000
3,134
16,000
$385,816
$38,119
Problem 3
a)
First, we have to calculate the YTM on the bonds:
Enter
Compute
Apr 1, 20x0
Oct 1, 20x0
Dec 31, 20x0
Apr 1, 20x1
N
20
I/Y
PV
5,159,133
PMT
-250,000
FV
-5,000,000
4.75%
Cash
Bonds payable
$5,159,133
$5,159,133
Interest expense
($5,159,133 x 4.75%)
Bonds payable
Cash
$245,059
4,941
250,000
Interest expense
($5,159,133 - 4,941) x 4.75%
x 3/6
Interest payable
Interest expense
Bonds payable
Interest payable
Cash
122,412
122,412
122,412
5,176
122,412
250,000
b) Book value of bonds payable at April 1, 20x4:
Enter
Compute
N
12
I/Y
4.75
Bonds payable ($5,112,369 x 50%)

Gain on retirement of bonds
Cash ($2,500,000 x 1.02)
Page 305
PV
PMT
250,000
FV
5,000,000
5,112,369
$2,556,185
$ 6,185
2,550,000
Problem 4
a) Since the bonds were issued at a premium (i.e., the proceeds exceeded the face value),
this indicates that the market interest rate at January 1, 20x0 must be less than the
12% offered by the bond issue. Otherwise, investors would not be willing to pay more
than the face value for this investment.
b) If the bonds are called by Nolan Trust Ltd., the company will have to pay the call
price of 105. The bonds were issued at 104 ($520,000 / $500,000) . The four percent
premium will be amortized over the life of the bonds. The bonds at face value plus
the unamortized premium represent the carrying value of the bonds. At any time the
call price would exceed the carrying value of the bonds in this case; therefore, there
would be a loss on retirement realized by Nolan Trust Ltd.
c) 1st half of the year: $519,641 x 2.55%
2nd half of the year: $519,641
- (15,000 Coupon Pmt - 13,251 Interest Exp - 1st Half) x 2.55%
= $517,892 x 2.55%
$13,251
13,206
$26,457
d) Bonds payable [$517,892 - (15,000 Coupon Pmt - 13,251 Interest Exp - 2nd Half)]
Page 306
$516,098
Problem 5
1. Maston should report the estimated loss from the safety hazard as an expense in the
income statement and a provision in the Statement of Financial Position because both
of the following conditions were met:
the entity has a present obligation (legal or constructive) as a result of a past
event;
a reliable estimate can be made of the amount of the obligation (IAS 37.14).
2. Maston should not report the estimated loss from the uninsurable flood risk as an
expense in the income statement or as provision in the Statement of Financial
Position because no losses have occurred since the warehouse has 'been uninsured.
Furthermore, disclosure of the uninsurable risk in the notes to the financial statements
is not required because no losses have occurred since the warehouse has been
uninsured. Disclosure in the notes to the financial statements is, however, desirable to
alert the reader to the exposure created by the lack of insurance.
Problem 6
SITUATION 1. When a company sells a product subject to a warranty, it is likely that
there will be expenses incurred in future accounting periods relating to revenues
recognized in the current period. As such, a liability has been incurred to honour the
warranty at the same date as the recognition of the revenue and a provision should be
taken for the warranty liability. Based on prior experience or technical analysis, the
occurrence of warranty claims can be reasonably estimated and a likely dollar estimate of
the liability can be made.
SITUATION 2. The fact that a company chooses to self-insure the contingency of injury
to others caused by its vehicles is not basis enough to accrue a provision that has not
occurred at the date of the financial statements. An accrual or "reserve" cannot be made
for the amount of insurance premium that would have been paid had a policy been
obtained to insure the company against this particular risk. A provision may only be
accrued if prior to the date of the financial statements a specific event has occurred that
will impair an asset or create a liability and an amount related to that specific occurrence
can be reasonably estimated. The fact that the company is self-insuring this risk should be
disclosed by means of a note to alert the financial statement reader to the exposure
created by the lack of insurance.
Page 307
Problem 7
1. An amount of $1,300,000 should be accrued as a provision on the first lawsuit since:
Dennon has a present obligation as a result of a past event;
a reliable estimate can be made of the amount of the obligation.
The $2.2 million dollar lawsuit does not qualify as a contingent liability since the
likelihood of paying damages is remote. No disclosure is necessary.
The $1.8 million dollar lawsuit qualifies as a contingent liability since it is possible
for the lawsuit to be successful. Disclosure of the contingency is required.
2. NOTE - LOSS CONTINGENCY: In September of 20x2, Blane County filed suit
against Dennon Company for polluting Bass Lake. Blane County is requesting
$1,800,000 from Dennon. It is likely that Blane County will be successful, but the
amount of damages Dennon will have to pay is not reasonably determinable.
Problem 8
Issue Price
Enter
Compute
N
20
I/Y
4
PV
PMT
10000
FV
200000
X=
$227,181
Bond Interest:
Period 1 = $227,181 x 4% =
Period 2 = [$227,181 - ($10,000 - $9,087)] x 4%
= $226,268 x 4% =
$ 9,087
9,051
$18,138
Page 308
Problem 9
The net book value of the equipment taken out of service, the cost of the destroyed
products, and the public relations cost do not represent future benefits so they should not
be capitalized and amortized over time. CCC should recognize them as an expense on the
Statement of Income.
CCC should accrue a provision with respect to the lawsuits if a loss is likely and if an
amount can be reasonably estimated. If not, then the company needs to assess if the
outcome of the lawsuit is possible and if so, then the lawsuit is a contingent liability and
the details of the litigation should be disclosed by way of note.
Problem 10
a)
Sales of musical instruments and sound equipment

Estimated warranty cost
Warranty expense for 20x2
b)
Estimated liability from warranties--January 1, 20x2

20x2 Warranty expense (Requirement a)
$5,400,000
x .015
$81,000
Actual warranty costs during 20x2

Estimated liability from warranties--December 31,20x2
Page 309
$63,000
81,000
$144,000
(80,000)
$64,000
10.
Shareholders Equity
Historically, companies had common shareholders, or those entitled to elect the board of
directors, and preferred shareholders, who were entitled to receive a dividend of a stated
minimum amount before any dividends were paid to common shareholders. The voting
rights of preferred shareholders were usually minimal or nil unless they failed to receive a
dividend, at which time their voting rights increased according to the terms under which
the shares were issued. In effect, the preferred shareholders had to play a more passive
role, but their dividend and rights on the winding-up of the company were better
protected.
This simple distinction between common and preferred shareholders has been blurred
over time, as companies have developed classes of common shareholders with differing
rights between them. The Canada Business Corporations Act (CBCA) now makes no
distinction between common and preferred shares, but allows for different classes whose
rights, privileges, restrictions, and conditions must be set out in the articles of
incorporation of the company. However, at least one of the classes of shares must contain
(i) the right to vote at all meetings of that class of shareholder and (ii) the right to
dividends and distribution of assets when the company is wound up. These are the
traditional rights of common shareholders. Thus, in effect the act requires that at least one
class of shares must have the minimum attributes of common shares. For convenience we
will refer to this class of shares as common shares.
Apart from disclosure requirements (which were discussed in Chapter 1 of this Module),
Share Based Payments and Stock Option Grants to Employees (discussed later in this
chapter), there are no IFRS's dealing with accounting for shareholders' equity items.
Therefore, the discussion in this section are based on pre-IFRS Canadian GAAP.
A typical shareholders' equity section of a statement of financial position could look as
follows:
No Name Company Ltd.
Partial Statement of Financial Position
Common Shares, 1,000,000 shares issued and outstanding
Preferred Shares, $5, cumulative, 250,000 shares issued and
outstanding
Contributed Surplus
Retained Earnings
Accumulated Other Comprehensive Income
Page 310
$26,000,000
12,000,000
3,000,000
9,500,000
(750,000)
$49,750,000
Common Shares
Common shares typically have the following features:
they provide the right to vote at annual meetings,
upon liquidation of the company, any cash remaining after all obligations have
been settled revert back to common shareholders, and
they are a perpetuity, meaning they never become due.

The corporation is under no obligation to provide a financial return to common
shareholders, that is, any dividend declarations are at the sole discretion of the companys
board of directors. Dividends become a liability of the corporation only when the board
of directors declares them.
Note that the IFRS standards refer to common shares as 'ordinary shares'. This is because
some countries do not use common share terminology. These lesson notes will refer to
these shares as common shares.
Preferred Shares
Preferred shares have the following characteristics:
they are generally non-voting shares,
they carry a stated dividend per share,
like common shares, they are a perpetuity, and
they have preference on liquidation.

Like common shares, the corporation is under no obligation to provide a financial return
to preferred shareholders, that is, any dividend declarations are at the sole discretion of
the companys board of directors. Dividends become a liability of the corporation only
when the board of directors declares them. However, in most cases preferred shares are
cumulative. This means that if dividends are missed, any preferred dividends in arrears
must be paid before any dividends can be paid to common shareholders.
Example Assume the shareholders' equity as outlined on the previous page. The
preferred share dividends were last paid on December 31, 20x3. It is now December 1,
20x6 and management wants to pay a dividend of $8 per common shares.
First, the preferred dividends in arrears for 20x4 and 20x5 will have to be paid:
250,000 shares x $5.00 x 2 years = $2,500,000
Next, the preferred dividends for the year 20x6 must be paid:
250,000 shares x $5.00 x 1 year = $1,250,000
Finally, the dividend to common shareholders can be paid:
1,000,000 shares x $8 = $8,000,000
The total dividend to be declared will be: $2,500,000 + 1,250,000 + 8,000,000
= $11,750,000
Page 311
Contributed Surplus
Contributed Surplus arises when
shares are repurchased at an amount less than the average amount of cash that was
raised when they were issued (see the Issuance, Reacquisition and Retirement of
Shares section of this chapter); and
when a share based payment plan is put in place (discussed later in this chapter),
and
when subscribed shares are defaulted.
Retained Earnings
Retained earnings represents the accumulated earnings of the corporation net of any
dividends paid. Any premiums paid on retirement of shares are also charged to retained
earnings.
The statement of retained earnings is as follows:
Retained earnings, beginning of year
Premium on redemption of shares
Net income (loss) for the year
Dividends
$ XXX
-XXX
XXX
-XXX
Retained earnings, end of year
$ XXX
Accumulated Other Comprehensive Income

At its fundamental level, accumulated other comprehensive income consists of unrealized
gains or losses that do not flow to net income but get placed in accumulated other
comprehensive income until realized, at which time they flow from accumulated other
comprehensive income to net income. These include:
the funded status on a pension plan (discussed in Chapter 11 of this Module);
unrealized gains or losses on investments in available-for-sale securities

(discussed in Chapter 1 of Module 2);
unrealized gains or losses on cash flow hedges (discussed in Chapter 6 and 8 of

Module 2); and
unrealized gains and losses on the translation of the financial statements of

foreign subsidiaries when the functional currency is the Canadian dollar
(discussed in Chapter 7 of Module 2).
Page 312
Differences between classes of shares

Current Canadian GAAP requires that the following types of differences between classes
of shares be disclosed:
1.
Dividend preferences: It is common for some classes of shares to have a

predetermined annual dividend (i.e. $1.50 per share) that must be paid before any
dividends can be paid on the common shares or any other class of shares ranking
lower in preference. While there is no legal requirement that any dividend should
be paid until the directors actually declare it, the provision that it be paid in
preference to common shareholders' dividends would normally put pressure on
the directors to declare a preferred dividend. In addition, the dividend may be
made cumulative, so that any arrears in preferred dividends must be paid before
any dividends can be paid on common shares.
2.
Redemption, call, and retraction privileges: certain classes of shares may be

issued on the condition that they can be redeemed at the option of either the
shareholder or the company (depending on the terms of issue). If redeemable at
the option of the shareholder, they are often called redeemable shares5. If
redeemable at the option of the company, they are usually referred to as
retractable preferred shares or callable preferred shares.
3.
Voting privileges: The voting privileges set out in the articles of incorporation
may eliminate or restrict the right of certain classes of shares to vote to elect
directors, thus keeping the bulk of the power to influence company affairs in the
hands of the common shareholders. However, in certain circumstances, the shares
with restricted voting rights may have these restrictions changed to increase their
voting power. Typically, this happens when dividends have not been paid on these
shares for a period of time, such as two years.
4.
Conversion privileges: The articles of incorporation may provide that holders of a

particular class of share have the privilege of converting their shares into shares of
another class. Typically, this would be the right to convert shares with a fixed
annual dividend into common shares or to convert voting (but non-marketable)
shares into non-voting (but marketable) shares
In some circumstances, retractable preferred shares which are redeemable at the option of the
shareholders could be classified as financial liabilities. This will be discussed in more depth in
Chapter 8 of Module 2.
Page 313
Issuance, Reacquisition and Retirement of Shares

Issuance of Shares
A company may issue shares for cash or non-cash consideration. When issuing shares for
cash consideration, the journal entry to reflect the issuance of shares is quite simple:
Dr. Cash
Cr. Common Stock (or Preferred Stock)
When shares are issued for non-cash consideration, the fair value of the asset(s) or
service acquired in exchange for the shares must be determined. The assets/services are
recorded at their fair market value of the goods or services received at the date they are
received with the corresponding entry to common stock. If the fair value of the goods or
services cannot be determined, then the value shall be determined by reference to the fair
value of the equity instruments granted. (IFRS 2.10)
Dr. Asset(s) or Expense (service)
Cr. Common Stock (or Preferred Stock)
Issue Costs
Corporations generally contract with underwriters who sell or issue stock to investors. A
percentage of the proceeds from issuing stock is normally retained as a fee by the
underwriters. Other costs associated with a stock issue include legal fees, registration fees
with the Securities Commission, accounting fees and printing costs. These direct costs of
issuing stock are deducted from the proceeds of the stock issuance and the net proceeds
are credited to the Capital Stock account. Indirect costs such as management time spent
on the stock issue are expensed.
Issuance of Shares by way of Subscription
At times, companies may conduct a share issue on a subscription basis. Generally, this is
done when a small company goes public for the first time or when shares are offered to
employees. For example, a company issues, on a subscription basis, 1,000,000 shares of
its stock at $30 per share. The terms of the contract require that a down payment of 20%
be made at the time the contract is signed with the balance payable in 90 days.
On the date the contracts are signed, the following entries will be made:
Share Subscriptions Receivable (1,000,000 x $30)
Common Stock Subscribed
$30,000,000
$30,000,000
Cash (1,000,000 x $6)

Share Subscriptions Receivable
6,000,000
Page 314
6,000,000
The Common Shares Subscribed account will become part of Shareholders' Equity. The
Share Subscriptions Receivable account can be disclosed in one of two ways: as a current
asset or as a reduction of shareholders' equity. I believe it is best shown as a reduction of
shareholders' equity because current assets are generally used for operating purposes,
which share subscriptions receivable are not.
On the date the final payment is received, the following entries are made - the first entry
records the final receipt of cash; the second entry records the issuance of common stock.
Cash (1,000,000 x $24)
24,000,000
Common Stock Subscribed

Common Stock
30,000,000
24,000,000
30,000,000
The above entries assume that 100% of the final payments were received. Generally,
some subscribers will default on their final payment. How we account for defaults
depends on whether the down payment is refundable. If we assume that 95% of the shares
are fully paid and that the down payment is fully refundable, then the journal entries
would be as follows:
Cash (950,000 x $24)
Common Shares Subscribed (50,000 x $30)
Share Subscriptions Receivable (50,000 x $24)
Cash (50,000 x $6)
Common Stock Subscribed (950,000 x $30)
Common Stock
22,800,000
22,800,000
1,500,000
1,200,000
300,000
28,500,000
28,500,000
If the down payment is not refundable, then we would credit Contributed Surplus instead
of Cash in the second entry above.
Page 315
Reacquisition and Retirement of Shares

When a company reacquires its own shares, it has to cancel them and effectively retire
the shares. The journal entry will comprise of the following:
a debit to common shares in an amount equal to the number of shares retired

times the average book value per common share, and
a credit to cash in the amount of the net cost to retire the shares.
A debit or credit will be required to balance the entry:
if a credit is required, then the we credit Contributed Surplus,
if a debit is required, then we first debit Contributed Surplus to the extent it was
created by a similar transaction in the past, if there is not enough Contributed
Surplus, then we debit the remaining amount directly to Retained Earnings.
For example, assume that a company has 1,000,000 common shares issued with a book
value of $2,750,000 on January 1, 20x2. On March 16, 20x2 the company issues an
additional 200,000 shares for a total of $750,000. On June 22, 20x2, the company
repurchases 50,000 of these shares at a price of $2.80, the journal entry to record the
repurchase of the shares would be as follows:
Common shares (50,000 x $2.9167)
Contributed Surplus
Cash (50,000 x $2.80)
$145,835
$5,835
140,000
* Average book value per share = ($2,750,000 + 750,000) / (1,000,000 + 200,000)

= $2.9167
If, on August 31, 20x2, the company repurchased 30,000 shares at a price of $3.30, the
journal entry would be as follows:
Common shares (30,000 x $2.9167)
Contributed Surplus
Retained earnings
Cash (30,000 x $3.30)
$87,501
5,835
5,664
99,000
Accounting for Stock Splits and Stock Dividends

A stock dividend is a dividend paid in any class of shares of the company's own shares to
holders of the same class of shares. Usually it is paid to common shareholders in common
shares. The shareholders' proportionate share in the equity of the company has not
changed after the dividend. They are essentially in the same position as before - they
simply have more share certificates to represent the same interest in the company.
Nevertheless, it is common to capitalize a portion of the retained earnings which is
thought to represent the value of the new shares that have been issued, thus reducing the
retained earnings available for cash dividends.
Page 316
The Canada Business Corporations Act requires that shares must be issued for their fair
market value. Thus the issue of such shares would increase the stated capital and decrease
the retained earnings correspondingly.
Darren Inc declared a stock dividend of ten common share for each 100 common shares
held (10% stock dividend). There were 400,000 shares outstanding before the declaration
of the dividend, and their market value at the time the dividend was declared was $15
each. The entry at the time the dividend was declared would be as follows:
Retained Earnings (40,000 x $15)
Common Stock
$600,000
$600,000
Note that we are implicitly assuming that the share price of $15 is the share price after the
stock dividend is announced. Since a stock dividend does not increase the value of the
firm, the share price will go down once a stock dividend is announced.
For example, if the $15 was the share price before the stock dividend was announced,
then the share price after the stock dividend would be equal to the value of the firm's
equity divided by the number of shares outstanding after the stock dividend:
Value of the firm's equity = 400,000 shares x $15 = $6,000,000
Share price after the stock dividend = $6,000,000 440,000 shares = $13.64
If this was the case, we would have capitalized the retained earnings at a share price of
$13.64 and not $15.00.
A stock dividend should be distinguished from a stock split, which is an increase in the
number of existing shares outstanding. A share split is often used to decrease the price at
which the company's shares are traded on the stock market, often with the intention of
increasing their appeal to a wider group of small investors. Under a stock split there is no
increase in the common shares of the firm, only an increase in the number of shares
outstanding. No journal entries are required to record a stock split.
Page 317
Stock Option Grants to Employees (IFRS 2)

When a company provides stock options to executives and employees as part of their
compensation package, we must measure and accrue the compensation expense arising
out of the stock option grant. In order to do so, we need to know three things:
1.
The market value of the stock options on the date of grant. This can be calculated
by using an accepted stock option pricing model such as the Black-Scholes or the
binomial option pricing models.
2.
The vesting period for which it is expected the executives will provide services.
This is usually the period in which the options cannot be exercised. For example,
if stock options are issued on January 1, 20x3 and are exercisable anytime after
January 1, 20x6, then the vesting period is the period Jan 1, 20x3 to Dec 31, 20x5.
3.
An estimate as to what percentage of the stock options will vest.
The market value of the stock options are accrued over the vesting period as follows:
dr. Compensation Expense
cr. Contributed Surplus - Unexpired Stock Options
If the vesting period exceeds the current year, then the total market value of the options
on the date of grant is accrued over the vesting period. At the end of each of the year of
the vesting period, the compensation expense is calculated as follows:
Total cumulative value of the stock options earned to the end of the period times
the estimated percentage of stock options that will vest.
Less the cumulative compensation expense recorded on this stock option plan to
as of the end of the previous fiscal period.
For example, assuming the options are granted on January 1, 20x3, the vesting period is
20x3-20x5, the total market value of the options is $300,000, and in 20x3 management
estimates that 85% of the options will vest, then the compensation expense for 20x3
would be: $300,000 x 1/3 x 85% = $85,000. At the end of 20x4, assume that
management revises their estimate and believes that 90% of the options will vest, then the
compensation expense for 20x4 would be:
Cumulative value of the stock options earned for the period
20x3 - 20x4: $300,000 x 2/3 x 90%
Less cumulative compensation expense to the end of 20x3
Compensation expense - 20x4
$180,000
85,000
$ 95,000
If, by the end of 20x5, 92% of the stock options actually vested, then the compensation
expense for 20x5 would be calculated as follows:
Page 318

20x3 - 20x5: $300,000 x 100% x 92%
Less cumulative compensation expense to the end of 20x4:
$85,000 + 95,000
$276,000
180,000
$ 96,000
After the vesting period, but during the exercise period, one of two events will occur with
regards to the options:
1.
They will be exercised, in which case we record the issuance of the stock as
follows:
dr.
dr.
Cash
Contributed Surplus - Unexpired Stock Options
cr.
Common Stock
The credit to common stock is simply the sum of the cash received on the exercise
of the options plus the prorata amount of contributed surplus created by these
stock options. Note that the market value of the shares on the date of exercise has
absolutely no impact on the above entry.
2.
The options will expire due to the holders of the options letting the options expire.
The journal entry to record expired stock options is as follows:
dr.
Contributed Surplus - Unexpired Stock Options

cr.
Contributed Surplus - Expired Stock Options
Example: on January 2, 20x2 the Solomons Company issued 140,000 stock options to
their executive team and senior managers. The market price of the company's stock on
January 2, 20x2 was $16. The exercise or strike price of the options was also $16. The
employment contract stated that the executives had to provide services to Solomons
Company for the period January 1, 20x2 to December 31, 20x4. The stock options were
exercisable in the fiscal year ended December 31, 20x5. The Black-Scholes model puts
the market value at $2.25 per option. At the end of 20x2, management estimates that 95%
of the stock options will vest. At the end of 20x3, this estimate was revised to 90%. At
December 31, 20x4 the actual number of options that vested amounted to 120,000.
During 20x5, 90,000 of the options were exercised when the stock price was $28 per
share. The remaining 30,000 options expired at December 31, 20x5.
The total value of the options on the date of grant is: 140,000 x $2.25 = $315,000.
Dec 31, 20x2
Page 319
Compensation expense
($315,000 x 1/3 x 95%)
Contributed Surplus
Unexpired Stock Options
$99,750
$99,750
The compensation expense for the 20x3 is calculated as follows:

20x2 - 20x3: $315,000 x 2/3 x 90%
Dec 31, 20x3
Contributed Surplus
$189,000
99,750
$ 89,250
89,250
89,250

20x2 - 20x4: 120,000 options vested x $2.25
Less cumulative compensation expense to the end of 20x3:
$99,750 + 89,250
Dec 31, 20x4
Contributed Surplus
$270,000
189,000
$ 81,000
81,000
81,000
In 20x5, we record the conversion of 90,000 options. Note that the stock market price at
that date is not relevant to this transaction.
20x5
Cash (90,000 x $16)

Contributed Surplus
(90,000 x $2.25)
Common stock
1,440,000
202,500
1,642500
Finally, on December 31, 20x5 we record the expiration of the remaining 30,000 stock
options:
Dec 31, 20x5
Page 320
Contributed Surplus
Contributed Surplus
30,000 x $2.25
67,500
67,500

1.
How would the declaration of a 15 % stock dividend by a corporation affect

each of the following?
Total
Retained earnings
a.
b.
c.
d.
No effect
No effect
Decrease
Decrease
No effect
Decrease
No effect
Decrease
Use the following information for questions 2-3:

Gott Co. was organized on January 1, 20x2, with 300,000 no par value common shares
authorized. During 20x2, Gott had the following shares transactions:
Jan 4
Mar 8
May 17
Jul 6
Aug 27
Issued 120,000 shares at $10 per share.

Purchased 15,000 shares at $12 per share and cancelled them.
2.
The total amount in the share capital account at December 31, 20x2 is
a) $2,170,000
b) $2,016,250
c) $2,007,250
d) $1,990,000
3.
The total amount of contributed surplus at December 31, 20x2 is

a) $-0b) $26,250
c) $153,750
d) $180,000
Page 321
4.
Renn Corporation was organized on January 1, 20x2, with an authorization of

400,000 no par value common shares. During 20x2, the corporation had the
following capital transactions:
January 5
April 6
June 8
July 28
December 31
issued 150,000 shares @ $10 per share

purchased 20,000 shares @ $11 per share and
cancelled them
What is the total amount of contributed surplus as of December 31, 20x2?

a) $0
b) $4,000
c) $20,000
d) $220,000
Page 322
Problem 1
The following is the Shareholders' Equity section of Parsely Industry Ltd.'s Statement of
Financial Position at its fiscal year end, September 30.
Common Shares, 1,000 shares outstanding

at end of 20x0
Preferred Shares
Contributed Surplus
Retained Earnings
Total Shareholders' Equity
20x1
20x0
$ 105,880
10,000
5,040
199,500
$320,420
$105,000
10,000
177,300
$292,300
The company's net income for 20x1 was $30,300. On January 2, 20x1, Parsely Industry
Ltd. re-acquired and cancelled 120 of its common shares at $63 per share.
Required Prepare journal entries to record all the transactions affecting shareholders' equity during
the 20x1 fiscal year.
Problem 2
The shareholders' equity section of Parsley Ltd. at September 30, 20x0, was as follows:
Common stock, 40,000 shares issued and outstanding
Retained earnings
Total shareholders' equity
$800,000
480,000
$1,280,000
On October 1, 20x0, the corporation declared and issued 4,000 shares as a dividend.
The market value of the capital stock was $30 per share on October 2, 20x0. (after
market adjustment to the stock dividend news)
Parsley Ltd. reacquired and cancelled 3,000 of its own shares for $24 per share on
October 31, 20x0.
A cash dividend of $2.50 per share was declared on December 31, 20x0, to
shareholders of record on this date. The dividend was to be paid out on February 1,
20x1.
Page 323
Required
a)
b)
c)
i)
ii)
Prepare a journal entry to record the stock dividend.

Explain what effect, if any, the stock dividend had on the shareholders'
equity section of the Statement of Financial Position and on the individual
shareholders of Parsley Ltd.
i)
Prepare a journal entry to record the cash dividend.
ii)
What effect, if any, would the cash dividend have on the company's
financial statements, assuming that Parsley Ltd.'s year end is December
31? Explain.
Prepare a journal entry to record the reacquisition and cancellation of the
corporation's own stock.
Problem 3
The shareholders' equity section of Kolbe Co. Ltd. as at May 31, 20x0, was as follows:
Common shares, no par value; authorized 20,000
shares, issued and outstanding 5,000 shares
Retained earnings
$ 60,000
60,000
$120,000
On May 1, 20x1, when the fair market value of common shares was $15, a 10% stock
dividend was declared (assume that the price is before stock market reaction to the stock
dividend). Shares will be issued on May 31, the company's year end. Kolbe Co. Ltd.
sustained a loss for 20x1 in the amount of $10,000.
Required i)
ii)
Prepare the journal entry for the declaration of the dividend.

Prepare the shareholders' equity section as it would appear on a Statement of
Financial Position prepared at May 31, 20x1. (Show all computations.)
Page 324
Problem 4
At the beginning of 20x2, the shareholders' equity section of Barnes Incorporated was as
follows:
$5 cumulative preferred shares,
authorized 15,000 shares,
issued and outstanding 5,000 shares
Common shares, no par value; issued and
outstanding, 175,000 shares
Retained earnings
$500,000
700,000
1,000,000
$2,200,000
The preferred shares did not receive dividends in either 20x1 or 20x0. They are
redeemable at $105. The company is subject to a 50% tax rate.
The following affected shareholders' equity during 20x2:
1) The company purchased a building in exchange for 5,000 preferred shares. The
preferred shares were trading at $115. The fair value of the building on the date of
purchase was $600,000.
2) Paid dividends of $1 per share to common shareholders.
3) Net income for the year was $750,000.
Required Prepare all the necessary journal entries for the above transactions.
Problem 5
The J-Mo Corporation offered 1,000,000 common shares at $70 on a subscription basis
on June 30, 20x5. The terms of the contract stipulated that a downpayment equal to 35%
of the subscription price had to be made when the subscription contract was signed. The
balance was due on September 30, 20x5. By July 5, 20x5 all of the shares were
subscribed.
Required
1.
2.
Record the all transactions assuming that the subscribers all paid the final
payment on the shares and that all of the shares were issued.
Record all of the transactions on the assumption that 90% of subscribers paid the
final balance and that the contract requires the company to reimburse the deposits
on un-issued shares.
Page 325
3.
Record all of the transactions on the assumption that 90% of subscribers paid the
final balance and that the contract does not require the company to reimburse the
deposits on un-issued shares.
Problem 6
The Shlee Company was formed on July 1, 20x0. It was authorized to issue 200,000
shares and 50,000, $.60, and cumulative and nonparticipating preferred shares. Shlee
Company's fiscal year ends June 30.
The following information relates to the shareholders' equity accounts of Shlee Company:
COMMON SHARES
Before the 20x2-20x3 fiscal year, Shlee Company had 105,000 outstanding common
shares issued as follows:
a) 95,000 shares were issued for cash on July 1, 20x0, at $20 per share.
b) On July 24, 20x0, 5,000 shares were exchanged for a plot of land that cost the seller
$70,000 in 19x4 and had an estimated fair market value of $102,000 on July 24,
20x0.
c) 5,000 shares were issued on March 1, 20x2; the shares had been subscribed for $32
per share of October 31, 20x1.
d) During the 20x2-20x3 fiscal year, the following common share transactions took
place:
October 1, 20x2
Subscriptions were received for 10,000 shares at $40 per share. Cash of $80,000 was
received in full payment for 2,000 shares and stock certificates were issued. The
remaining subscriptions for 8,000 shares were to be paid in full by 9/30/x3, at which
time the certificates were to be issued.
November 30, 20x2
Shlee purchased and cancelled 2,000 of its own shares on the open market at $38 per
share.
December 15, 20x2
Shlee declared a 2 percent stock dividend for shareholders of record on 1/15/x3, to be
issued on 1/31/x3. Shlee was having a liquidity problem and could not afford a cash
dividend at the time. Shlee's common shares were selling at $43 per share on
December 16 after they adjusted for the announcement of the stock dividend. (Stock
Page 326
dividends are not distributed on subscribed shares until the subscriptions are fully
paid.)
PREFERRED SHARES
e) Shlee issued 30,000 preferred shares at $15 per share on July 1, 20x1.
CASH DIVIDENDS
f) Shlee has followed a schedule of declaring cash dividends in December and June,
with payment being made to shareholders of record in the following month. The cash
dividends that have been declared through June 30, 20x3, are shown below.
Declaration
Date
January 15, 20x1
June 15, 20x2
December 15, 20x2
Common
Shares
(per share)
Preferred
Shares
(per share)
$0.10
0.10
-
$0.30
0.30
No cash dividends were declared in June 20x3 because of Shlee's liquidity problems.
RETAINED EARNINGS
g) As of June 30, 20x2, Shlee's retained earnings account had a balance of $370,000. For
the fiscal year ended June 30, 20x3, Shlee reported net income of $20,000.
h) In March 20x2, Shlee received a term loan from the National Bank. The bank requires
Shlee to establish a sinking fund and restrict retained earnings in an amount equal to
the sinking fund deposit. The annual sinking fund payment of $40,000 is due on April
30 each year; the first payment was made on schedule on April 30, 20x3.
Required Prepare the shareholders' equity section of the Statement of Financial Position, including
appropriate notes, for Shlee Company as of June 30, 20x3.
Page 327
Problem 7
Howard Corporation is a publicly owned company whose shares are traded on the TSE.
At December 31, 20x4, Howard had unlimited shares of common shares authorized, of
which 15,000,000 shares were issued. The shareholders' equity accounts at December 31,
20x4, had the following balances:
Common shares (15,000,000 shares)
Retained earnings
$230,000,000
50,000,000
During 20x5, Howard had the following transactions:

a.
b.
c.
d.
e.
f.
g.
h.
On February 1, a distribution of 2,000,000 common shares was completed. The

shares were sold for $18 per share.
On February 15, Howard issued, at $110 per share, 100,000 of no-par value, $8,
cumulative preferred shares.
On March 1, Howard reacquired and retired 20,000 common shares for $14.50
per share.
On March 15, Howard reacquired and retired 10,000 common shares for $20
per share.
On March 31, Howard declared a semi-annual cash dividend on common shares
of $0.10 per share, payable on April 30, 20x5, to shareholders of record on April
10, 20x5. (Record the dividend declaration and payment.)
On April 15, 18,000 common shares were reacquired and retired for $17.50 per
share.
On May 31, when the market price of the common was $23 per share, Howard
declared a 5% stock dividend distributable on July 1, 20x5, to common
shareholders of record on June 1, 20x5. On June 1, immediately after the
announcement of the stock dividend, the market price of the common dropped to
$20.
On September 30, Howard declared a semi-annual cash dividend on common
shares of $0.10 per share and the yearly dividend on preferred shares, both
payable on October 30, 20x5, to shareholders of record on October 10, 20x5.
(Record the dividend declaration and payment.)
Required:
Prepare journal entries to record the various transactions. Round per share amounts to
two decimal places.
Page 328
Problem 8
On January 3, 20x4 the Bailey Company granted 200,000 stock options to its executives.
The exercise price of the options is $25 and was equal to the stock price on that date. An
option pricing model puts the total value of these stock options at $125,000. The options
are exercisable during the fiscal period ending December 31, 20x6 on the condition that
the executives are still in the employ of Bailey Company as of December 31, 20x5. The
Bailey Company estimates that 80% of the stock options will vest at December 31, 20x4.
The actual number of options that vested on December 31, 20x5 was 175,000.
During the year 20x6, 160,000 options were exercised and the remaining 15,000 options
expired.
Required
Prepare the journal entries for the years 20x4 through to 20x6
Problem 9
50 executives are given a stock option grant of 1,000 options each on January 2, 20x4.
The vesting period is 4 years and the market value of each option is estimated to be $20.
It is estimated that 75% of the options will vest. At the end of 20x5 (the second year),
management estimates that 80% of the executives will remain. This estimate still holds
for the year ended December 31, 20x6. At the end of 20x7, there are 41 executives left.
Required Calculate compensation expense for the years 20x4 - 20x7.
Page 329
Problem 10
At December 31, 20x1, the shareholders' equity of the Page Golf Club Company totalled
$3,707,500. The balances of various accounts at that date were as follows:
$4 preferred shares (10,000 shares authorized, 5,000 shares issued)
Common shares (100,000 shares authorized, 50,000 shares issued)
Retained earnings (unappropriated)
$ 507,500
750,000
2,450,000
The following transactions occurred during 20x2:

MARCH 20
The regular semi-annual preferred dividend was declared, payable April 1.
APRIL 1
Payment of previously declared dividend.
JUNE 15
The regular semi-annual common dividend of 40 cents per share was

declared, payable July 10.
JULY 10
Payment of the previously declared dividend.
SEP 20
Regular semi-annual preferred dividend was declared, payable October 1.
OCT 1
Payment of previously declared dividend.
DEC 15
The regular semi-annual dividend of 40 cents per common share was

declared payable January 10. In addition, a 10 percent stock dividend
(5,000 shares) was declared to common shareholders of record as of
December 20, to be issued January 20. The market price of the shares was
$20 per share (which is the amount that should be transferred from
retained earnings to contributed capital).
Required 1. Prepare all journal entries necessary to reflect the above transactions during 20x2.
2. Prepare a statement of shareholders' equity at December 31, 20x2, assuming net
income for 20x2 amounted to $165,000.
3. Prepare a statement of changes in shareholders' equity for the year ended December
31, 20x2.
Page 330
SOLUTIONS

1.
2.
(120,000 x 10) + (40,000 x 11)

15,000 x $10.25 (1,640,000 / 160,000)
(30,000 x $13) + (10,000 x $14)
3.
15,000 x (12.00 10.25) = $26,250 debit to retained earnings, No Contributed

Surplus.
4.
Book value per share = [(150,000 x $10) + (50,000 x $12) + (50,000 x $14)]
250,000 = $11.20
Increase in contributed surplus = 20,000 shares x ($11.20 11.00)
= $4,000
$1,640,000
-153,750
530,000
$2,016,250
Problem 1
Common Shares ($105,000 / 1,000) x 120
Cash (120 x $63)
Contributed Surplus
$12,600
7,560
5,040
Retained Earnings1
Dividends Payable
8,100
Cash
Common Shares2
13,480
1.
2.
8,100
13,480
$30,300 Net Income 22,200 Increase in retained earnings = $8,100

$105,880 - $105,000 = $880 net Increase in common Stock + 12,600 Common
Stock repurchases = $13,480.
Page 331
Problem 2
a)
b)
i)
Oct. 1, 20x0
Retained earnings (4,000 shares x $30)
Common stock
120,000
120,000
ii)
Total shareholders' equity is unchanged since the stock dividend causes no

change in the assets or liabilities of Parsley Ltd. That is, the shareholders
did not receive anything they did not have before. The only change the
stock dividend resulted in was to alter the components of shareholders'
equity to recognize the capitalization of retained earnings equivalent to the
market value of the shares resulting from the dividend. The number of
shares held by each shareholder increased but each shareholder's
percentage of ownership in Parsley Ltd. was unchanged.
i)
Dec. 31, 20x0

Retained Earnings
Dividends payable
Issued and outstanding
Stock dividend
Re-acquired shares
102,500
102,500
40,000 shares
4,000 shares
(3,000)shares
41,000
41,000 x 2.50 = 102,500

ii)
c)
The cash dividend created an obligation (liability) for Parsley Ltd, to pay
cash to its shareholders of record on December 31, 20x0. It' a current
liability because it is payable within one year of that date. The company's
Statement of Financial Position dated December 31, 20x0, would be
affected to the extent of an increase in current liabilities and a decrease in
retained earnings.
i)
Oct. 31, 20x0
Common Stock ($920,000 / 44,000) x 3,000
Retained Earnings
Cash (3,000 x $24)
Page 332
62,728
9,272
72,000
Problem 3
PART A
i)
ii)
Retained Earnings
Stock Dividend Distributable
Theoretical market price after adjustment to stock
dividend news = $15 /1.1 = $13.64
5,000 shares x 10% x $13.64 = $6,820
$6,820
$6,820
Common shares authorized 20,000 shares, issued and

outstanding 5,500 shares
Retained Earnings
$66,820
43,180
$110,000
PART B
i)
Building
Preferred Shares
600,000
Retained Earnings (note)

Cash
275,000
600,000
Calculation of total dividend declaration Dividends Preferred Arrears: (5,000 x 5) x 2

Current year: 10,000 x 5
Common (175,000 x $1)
Page 333
275,000
$50,000
50,000
175,000
$275,000
Problem 5
1.
Jul 5, 20x5
Sep 30, 20x5
2.
Share subscriptions receivable

Common shares subscribed
1,000,000 shares x $70
$70,000,000
Cash ($70,000,000 x 35%)

24,500,000
Cash ($70,000,000 x 65%)

45,500,000
Common shares subscribed

Common shares
70,000,000
July 5, 20x5
Same as in part (1).
Sep 30, 20x5
Cash ($70,000,000 x 90% x 65%)

Common stock subscribed
Cash ($24,500,000 x 10%)
Subscription receivable
Common stock subscribed
Common Stock
3.
$70,000,000
24,500,000
45,500,000
70,000,000
40,950,000
40,950,000
7,000,000
2,450,000
4,550,000
63,000,000
63,000,000
All entries are the same with one exception. In the second journal entry in part (2),
we would credit Contributed Surplus and not Cash.
Page 334
Problem 6
Shlee Company
SHAREHOLDERS' EQUITY
JUNE 30, 20x3
Share capital:
$.60 Preferred shares, no par, cumulative and
nonparticipating, 50,000 shares authorized, 30,000
shares issued and outstandingNote A
Common shares, no par, 200,000 shares authorized,
107,100 shares issued and outstanding
Common shares subscribed, 8,000 shares
Total common shares issued and subscribed
Retained earnings:
Appropriated--Note B
Unappropriated
$ 450,000
$ 2,290,400a
320,000
2,610,400
$ 40,000
216,600b
256,600
$3,317,000
NOTE A: Shlee Company is in arrears on the preferred shares in the amount of $9,000.
NOTE B: Shlee Company is required to appropriate retained earnings in an amount that
is equal to the sinking fund deposit that is to be accumulated to retire a term loan.
a
$ 2,162,000
80,000
(41,900)
90,300
$ 2,290,400
$ 370,000
20,000
(40,000)
(90,300)
(9,000)
Outstanding prior to current year (105,000)

Subscribed shares fully paid (2,000 x $40)
Shares cancelled [($2,242,000 / 107,000) x 2,000)
2% stock dividend [.02(107,000 - 2,000) x $43]
Beginning
Net Income
Appropriation
Stock dividend (2,100 x$43)
Preferred dividend ($.30 x 30,000)
Common share retirement in excess of carrying value
($76,000 - $41,900)
Page 335
(34,100)
$216,600
Problem 7
Feb 1
Feb 15
Mar 1
Mar 15
Mar 31
Apr 30
Apr 15
May 31
Sep 30
Page 336
Cash
Common Shares
$36,000,000
Cash
Preferred shares
11,000,000
$36,000,000
11,000,000
Common shares (20,000 x 15.65*)

Contributed Surplus (20,000 x 1.15)
Cash (20,000 x 14.50)
* 266,000,000 / 17,000,000 = $15.65
313,000
Common shares (10,000 x 15.65)

Contributed Surplus
Retained earnings
Cash (10,000 x 20)
156,500
23,000
20,500
23,000
290,000
200,000
Retained earnings (16,970,000 x .10)

Dividends Payable
1,697,000
Dividends Payable
Cash
1,697,000
Common shares (18,000 x 15.65)

Retained earnings
Cash (18,000 x $17.50)
1,697,000
1,697,000
281,700
33,300
315,000
Retained Earnings (16,952,000 x 5% x $20)

Stock dividend distributable
16,952,000
Stock dividend distributable

Common stock
16,952,000
16,952,000
16,952,000
Retained Earnings *
Dividends payable
* (17,799,600 x .1) + (100,000 x 8)
2,579,960
Dividends payable
Cash
2,579,960
2,579,960
2,579,960
Problem 8
Dec 31, 20x4
($125,000 x 1/2 x 80%)
Contributed Surplus
$50,000
$50,000

20x4 - 20x5: $125,000 x 100% x 175,000 / 200,000
Dec 31, 20x5
20x6
Dec 31, 20x5
Page 337
Contributed Surplus
Cash (160,000 x $25)
Contributed Surplus
($109,375 x 160,000 / 175,000)
Common stock
Contributed Surplus
Contributed Surplus
$109,375
50,000
$ 59,375
59,375
59,375
4,000,000
100,000
4,100,000
9,375
9,375
Problem 9
20x4
50,000 options x $20 x 75% x
20x5
Cumulative compensation expense to end of 20x5:

50,000 options x $20 x 80% x 2/4
Less 20x4 compensation expense
20x6
20x7
Page 338
$187,500
Cumulative compensation expense to end of 20x6:

50,000 options x $20 x 80% x 3/4
Less cumulative compensation expense to end of 20x5:
$187,500 + 212,500
Total cumulative compensation expense to the end of 20x7:

1,000 shares x 41 executives x $20
Less cumulative compensation expense to end of 20x6:
$187,500 + 212,500 + 200,000
$400,000
187,500
$212,500
$600,000
400,000
$200,000
$820,000
600,000
$220,000
Problem 10
1.
March 20
April 1
June 15
July 10
Sept. 20
Oct. 1
Dec. 15
Retained earnings (or dividends--preferred)

Dividends payable
(5,000 x $4 x 1/2)
10,000
Dividends payable
Cash
10,000
Retained earnings (or dividends--common)

Dividends payable
($.40 x 50,000 shares)
20,000
Dividends payable
Cash
20,000
Retained earnings (or dividends--preferred)

Dividends payable
(5,000 x $4 x 1/2)
10,000
Dividends payable
Cash
10,000
Retained earnings (or dividends--common)

Dividends payable
($.40 x 50,000 shares)
20,000
Retained earnings ($20 x 5,000 shares)

Stock dividends distributable ($20x 5,000)
Page 339
10,000
10,000
20,000
20,000
10,000
10,000
20,000
100,000
100,000
2.
Page Golf Club Company
Statement of Shareholders' Equity
Preferred shares
Common shares
Common share dividend distributable
Total contributed capital
Retained earnings
$ 507,500
750,000
100,000
1,357,500
2,455,000
$3,812,500
3.
Page Golf Club Company
Preferred
Shares
Common
Shares
Common
Share
Dividend
Distrib.
Balance, January 1, 20x2

Net income for the year
ended December 31, 20x2
Cash dividends declared
and paid
Stock dividend declared
$507,500
$750,000
$ -
$507,500
Page 340
$750,000
Retained
Earnings
Total
$2,450,000
$3,707,500
165,000
165,000
100,000
(60,000)
(100,000)
(60,000)
-
$100,000
$2,455,000
$3,812,500
11.
Accounting for Pensions
Accounting for Pension Plans is covered by IAS 19 - Employee Benefit. As its title
would suggest, this standard covers the accounting issues broadly related to employee
benefits. Employee benefits are defined as all forms of consideration given by an entity in
exchange for service rendered by employees (IAS19.7). These include
short-term employee benefits such as social security contributions, short-term

compensated absences, non-monetary benefits, and profit-sharing and bonus plans
post-employment benefits (defined benefit and defined contribution pension

plans).
This chapter will focus on post-employment benefits.
A pension plan is any arrangement (contractual or otherwise) by which a program is
established to provide retirement income to employees.
There are two basic types of pension plans. The first type is a defined benefit pension
plan. This type specifies either the benefits to be received by employees after retirement
or the method for determining those benefits. Benefits are typically determined by the
number of years of service and by the employee's earnings during those years of service.
For example, the standard benefit formula used by public service pension plans is as
follows - retirement income is based on the following formula: 2% x the average five best
years of salary x number of years of service to a maximum of 35 years. An employee
with 32 years of service whose average five best years of salary is $120,000 would be
eligible for a pension equal to $120,000 x 2% x 32 = $76,800.
The second type is a defined contribution pension plan. This is one in which the
employer's contributions are fixed, usually as a percentage of compensation, and
allocated to specific individuals. Pension benefits are a direct function of accumulated
contributions of the employer, employee, and earnings from investing those
contributions.
For the accountant, a defined contribution pension plan presents few problems. The
pension plan agreement provides a formula to be used in determining the employer's
contributions. Since these contributions represent the employer's only obligation to the
plan, there is usually no issues in determining the employer's annual cost the pension
expense is usually equal to the contributions made to the employees pension plan by the
employer.
Defined benefit pension plans are considerably more complex. The future benefits to be
obtained by retirees under the pension plan is influenced by such things as the future rates
of return, mortality rates, early retirements/termination of employment prior to retirement
and future salary levels. Calculations of the plan's cost are based on actuarial estimates.
When creating a pension plan, the employer must examine the level of economic risk that
the firm will assume. For a defined contribution pension plan, the employer contributes
Page 341
the amount that was determined in the pension plan agreement. This is the employer's
only obligation. In other words, the employer assumes no risk for the accumulation of
the pension plan funds. It is the employee who assumes this risk as well as the risk of
what the prevailing economic conditions will be like at the time of retirement (as this
affects the amounts to be paid out as benefits).
The reverse is true for a defined benefit pension plan. The employer assumes the risk for
the benefits that are paid out to employees and these are not known with certainty until
paid. As stated previously, a number of things influence the total amount to be paid out as
benefits and these are all based on estimates. Therefore, there is risk inherent with this
type of plan. Also, the employer assumes the risk of the accumulation of the fund's assets
and its investments. It is the employer who must make up any shortfall caused by a
deficiency in the expected returns of the fund's investments.
This chapter will therefore focus on the accounting for defined benefit pension plans.
Pension Expense
For defined benefit pension plans, the pension expense for a period potentially includes
the following five items:
1)
2)
3)
4)
5)
Current service cost

Interest accrued on the defined benefit obligation
Expected return on plan assets
Amortization of plan amendments / past service cost
Amortization of actuarial gains or losses
Each of these items is now briefly discussed individually:

1) Current service cost
Current service cost is the increase in the present value of a defined benefit obligation
resulting from employee service in the current period (IAS 19.7). The accountant has no
involvement in the determination of this amount. It is calculated by the actuary and
provided to the accounting staff for inclusion in the determination of pension expense for
financial statement purposes.
2) Interest accrued on the defined benefit obligation
The present value of the defined benefit obligation (DBO) is the present value of
expected future payments required to settle the obligation resulting from employee
service in the current and future periods (IAS 19.7). Because the defined benefit
obligation is a discounted value, we must accrue interest on an annual basis. Each period
the interest on the DBO increases the pension expense for financial statement purposes.
The interest rate used in this calculation is based on managements best estimate of an
appropriate rate. This interest cost is generally provided by the actuary.
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3) Expected return on plan assets

In order to provide for pension benefits that must be paid to employees in the future, the
employer usually makes regular payments or contributions to an asset pool. This pool of
funds is managed by a trustee and is invested in a number of different investment
vehicles such that the pool of assets will grow to meet the future pension obligation. The
expected return on the pension fund assets in the period, reduces the pension expense for
the corresponding period.
At this point let's look at a simple example incorporating these three components of
pension expense.
Example 1 - The following information relates to the defined benefit pension plan of
Milkweed Company for the year ended December 31, 20x6:
January 1, 20x6 balances
- Defined benefit obligation

- Pension Plan Assets
- Pension Account on Statement of
Financial Position

Pension benefit payments
Employer contributions
Interest on Pension Obligation
Interest on Pension Fund Assets (expected and actual)
$
2,400,000
2,300,000
100,000 cr.
190,000
100,000
300,000
192,000
265,000
It's helpful to analyze the Defined benefit obligation and Pension Plan Assets, then use
that information to determine the pension expense for the period.
Opening balance
Contributions to plan assets
Benefits paid
Accrued interest on Accrued
Benefit Obligation
Closing balance
Pension expense:
Interest on Accrued Pension Obligation
Total
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Pension
Plan
Assets
$2,300,000
Accrued
Benefit
Obligation
$2,400,000
190,000
300,000
(100,000)
265,000
(100,000)
192,000
$2,682,000
$2,765,000
$190,000
192,000
(265,000)
$117,000
The journal entry to record the pension expense for the period, and the funding for the
period is:
Pension expense
Pension account
Cash
$117,000
183,000
300,000
The balance in the pension account represents the funded status of the pension plan at the
end of the year. At the beginning of the year the balance of the DBO was greater than the
Pension Fund Assets, indicating the pension plan was underfunded. The value of the
pension assets was not sufficient to relinquish the defined benefit obligation. By year end
the situation is reversed and the balance of the Pension Fund Assets exceeds the Defined
benefit obligation. This situation indicates the plan is overfunded. The value of the asset
pool exceeds the expected liability. The funded status of the pension plan at this point is
reflected on the Statement of Financial Position in the account called the pension account.
In this example the opening balance in this account is a credit of $100,000, indicating the
plan is underfunded. The account changes by a debit of $183,000 during the year
resulting in a closing debit balance of $83,000. The plan is overfunded at year end by
$83,000, the difference between the Pension Fund Assets balance of $2,765,000 and the
Defined benefit obligation balance of $2,682,000.
As note on interest accrual
In most pension textbook situations, for simplicity, it is assumed that the current service
cost, benefits paid to pension plan participants and contributions to the pension plan
assets are made at the end of the year. Consequently, we calculate the accrued interest on
the defined benefit obligation based on the opening balance. Similarly, the expected
return on the plan assets is based on the opening pension plan asset balance.
If you are told, for example, that the contributions to the pension plan assets were made
halfway through the year, then in addition to the expected return on the opening balance,
you would have to include an expected return on the contribution made by accruing
interest for one-half of the year.
Now let's look at the more complex adjustments to pension expense.
4) Amortization of plan amendments/past service costs
When a defined benefit pension plan is introduced or amended, employee services
provided prior to the introduction/amendment of the plan often qualify for future pension
benefits. These employee services are referred to as past service costs. These past
service costs also often arise on the amendment of the pension plan. The past service
costs are amortized on a straight line basis over the average period until the past service
costs become vested. This amortization increases pension expense for the period. The
rationale for this treatment is that the employer expects to receive future benefits from
this employee group and therefore is willing to allow the prior years' service to qualify
for pension benefits. The total lump sum of past service costs increases the balance in the
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DBO. If the past service cost vest immediately, they are recognized as an expense
immediately.
5) Actuarial Gains and losses
Actuarial gains and losses are changes in the value of the defined benefit obligation and
the pension plan assets resulting from:
i)
experience different from that assumed; and/or
ii)
changes in actuarial assumptions.
With respect to the Pension Plan Assets, experience gains and losses arise when the
expected return generated by the pension fund assets is different than the actual return
generated. An experience gain is generated when the actual return exceeds the expected
return. An experience loss is generated when the actual return falls short of the expected
return.
The expected Defined benefit obligation balance at year end differs from the actual year
end balance when the actuarial assumptions change. The actuary will audit the pension
plan every so often and will calculate what the defined benefit obligation balance should
be. This is compared with the amount of defined benefit obligation that was calculated.
Any difference is an actuarial revaluation and will either increase or reduce the DBO.
Actuarial gains and losses are amortized only if, in the aggregate, they exceed 10% of the
greater of:
i)
the defined benefit obligation at the beginning of the year, or
ii)
the fair value of the pension fund assets at the beginning of the year.
This is referred to as the corridor test.
When amortization is required, the minimum amortization should be that excess divided
by the estimated average remaining service life of the employees under the plan.
Example 2 - Assume that a firm initiated a pension plan on January 1, 20x1, and the
actuary arrived at a current service cost of $200,000 per year by using a 10% discount
rate. Now assume, however, that the firm will recognize past service costs of $500,000.
This represents the present value of the company's past service costs at the date of the
plan initiation. Assume also that the firm will fund current service costs by making a
payment of $200,000 per year to the pension plan trustee.
The terms of the new pension plan require that the firm fund, in addition to the full
current service cost, the past service costs in three annual installments of $201,058
beginning December 31, 20x1. The past service costs vest in three years and therefore
will be amortized to pension expense over three years.
The annual amount of amortization of past service cost is simply:
$500,000 / 3 = $166,667.
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Funding of the current service costs and past service costs occurs at the end of the year.
Let's begin by analyzing the Pension Plan Assets and Pension Obligation.
Pension
Plan
Assets
Accrued
Benefit
Obligation
20x1
Opening balance
Accrued Interest
Contributions - current
- past
$200,000
201,058
Closing Balance
$401,058
$750,000
$401,058
40,106
$ 750,000
75,000
200,000
$500,000
50,000
200,000
20x2
Opening balance
Expected return / Accrued interest
- past
200,000
201,058
Closing balance
20x3
Opening balance
Expected return / Accrued interest
- past
$842,222
$1,025,000
$ 842,222
84,222
$1,025,000
102,500
200,000
200,000
201,058
Closing balance
$1,327,502
$1,327,500
The pension expense for each year is as follows:

Accrued interest on pension obligation
Amortization of past service costs
20x1
$200,000
50,000
166,667
416,667
20x2
$200,000
75,000
(40,106)
166,667
401,561
20x3
200,000
102,500
(84,222)
166,667
384,945
Journal entries for the first three years would be as follows:

20x1
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Pension expense
Pension account
Cash ($201,058 + 200,000)
$416,667
$15,609
401,058
20x2
20x3
Pension expense
Pension account
Cash ($201,058 + 200,000)
$401,561
Pension expense
Pension account
Cash ($201,058 + 200,000)
$384,945
16,113
$ 503
401,058
$401,058
Note that at the end of 20x1 the Defined benefit obligation exceeds the Pension Fund
Assets by $348,942 ($750,000 - 401,058), which indicates the pension plan is
underfunded. In simple situations, this underfunded amount would be reflected in the
pension account on the Statement of Financial Position. In this case, at the end of 20x1
the pension account has a credit balance of $15,609. The difference between these two
amounts ($348,942 - 15,609 = $333,333) is due to the balance of unrecognized past
service costs ($500,000 - 166,667 = $333,333). The past service costs increase the
balance in the defined benefit obligation as soon as the past employee service qualifies
for pension benefits. These costs are recognized in the financial statements to pension
expense over the period of time these benefits vest.
It's also important to note that at the end of 20x3 the balance in the pension account is
zero. This result is consistent with the fully funded status of the plan, where the defined
benefit obligation is equal to the Pension Fund Assets, and the full recognition for
accounting purposes of the past service costs.
Example 3 - Refer to Example 2. Assume that at the end of 20x1 the actual balance in the
Pension Fund Assets was $420,000, and the Pension Obligation at year-end was
determined to be $765,000. Assume that the estimated average remaining service life
(EARSL) of the employee group is 3 years. Now let's determine pension expense. We
start by looking at the Pension Plan Assets and the Pension Obligation.
Pension
Plan
Assets
Defined
benefit
obligation
$401,058
$750,000
Actual balance at year-end
420,000
765,000
Experience gain
Actuarial revaluation
$18,942
20x1
Year-end balance as calculated
gain
$15,000 loss
The net gain is $3,942.

The pension expense for 20x1 will be the same as previously calculated. The
amortization of the net actuarial gain (if any) will begin in 20x2 and would decrease
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pension expense. To determine whether or not we need to amortize the actuarial gain, we
must compare it to the corridor:
10% of pension obligation as at the beginning of 20x2:
$765,000 x 10%
10% of the pension fund assets as at the beginning of 20x2:
$420,000 x 10%
$76,500
$42,000
Since our actuarial gain of $3,942 is less than $76,500, we do not need to amortize it.
Reconcilation of the Funded Status
At any point in time, there will be a difference between the funded status of the plan and
the pension account on the Statement of Financial Position. The funded status is defined
as the difference between the defined benefit obligation and the plan assets. The funded
status represents the true economic liability (or asset) of the firm vis a vis the pension
plan. For example, if the balance in the defined benefit obligation is $20,000,000 and the
balance in the pension assets is $16,000,00, then the funded status is a liability of
$4,000,000. If the pension account shows a balance of $1,000,000 cr., then we have an
unrecorded liability of $3,000,000.
The unrecorded liability at any point in time will always equal the sum of:
any unamortized plan amendments, and
any unamortized actuarial gains and losses (actuarial revaluations and/or

experience gains and losses).
Pension accounting and future income taxes

For tax purposes, the pension expense amount is not deductible. The amount deductible
is the cash payment made to the trustee of the pension fund. The difference between the
two (i.e. the balance in the pension account) constitutes a temporary difference. This will
be covered further in Module 2.
Actuarial Gains and Losses - Additional Options

Until now, we have assumed that the entity applies the corridor test to the accumulated
actuarial gains and losses and amortized only if the corridor is exceeded. Although it is
expected that the majority of entities will do just that, IAS 19 allows for two additional
options:
1.
the entity may adopt any systematic method that results in faster recognition of
actuarial gains and losses, provided that the same basis is applied to both gains
and losses and the basis is applied consistently from period to period (IAS 19.93).
Page 348
2.
the entity may adopt a policy of recognizing actuarial gains and losses in the
period in which they occur in other comprehensive income providing it does so
for all of its defined benefit plans and all of its actuarial gains and losses (IAS
19.93A). If the entity chooses this option, then the corridor test still has to be done
and any amortization required gets transferred from other comprehensive income
directly to retained earnings (IAS 19.93C).
Summary of Calculations
Defined benefit obligation
Balance, beginning of year
+ Accrued interest
+ Current service cost
- Benefits paid to retirees
New plan amendment
= Balance, end of year
Plan Assets
+ Expected return
+ Contributions to plan
- Benefits paid to retirees
Experience gains/losses
= Balance, end of year
Pension Expense
+ Accrued interest on DBO
- Expected return on plan assets
Amortization of plan amendments / past service costs
Amortization of actuarial gains/losses, per corridor test
Page 349
Comprehensive example
You are provided with the following data for the Tarrant Company pension plan. The
company has a fiscal year coinciding with the calendar year.
Balances as at January, 1, 20x5:
Plan Assets
Pension account balance
Unamortized plan amendment (the plan amendment was made on
January 2, 20x3 and is being amortized over a total of 12 years
to full vesting)
Data for the year ended December 31, 20x5:
Benefits paid to retirees
Actual return on plan assets
Contributions made to pension plan
$26,000,000
19,500,000
2,000,000 cr.
1,600,000
$3,000,000
1,800,000
2,200,000
4,000,000
The interest rate used for both the defined benefit obligation and the plan assets is 7%.
The actuary audited the defined benefit obligation at December 31, 20x5 and calculated
the balance to be $30,400,000. The expected remaining service live of the employees at
January 1, 20x5 is 8 years.
The first thing we want to do is reconcile the funded status at the beginning of the year.
This will tell us if we need to take into account any unrecognized actuarial gains and
losses at that time.
Funded status ($26,000,000 19,500,000)
Less balance in pension account
Unrecognized liability
Less Unamortized plan amendment
Unamortized actuarial losses, January 1, 20x5
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$6,500,000
2,000,000
4,500,000
1,600,000
$2,900,000
The corridor test shows that we have to amortize some of these actuarial losses:
Unamortized actuarial losses, January 1, 20x5
Corridor: $26,000,000 x 10%
Excess
$2,900,000
2,600,000
$300,000
Amortization: $300,000 / 8 years
$37,500
The pension expense is calculated as follows:

Accrued interest on DBO: $26,000,000 x 7%
Expected return on plan assets: $19,500,000 x 7%
Amortization of plan amendment: $1,600,000 / 10 years remaining
Amortization of actuarial losses
$3,000,000
1,820,000
(1,365,000)
160,000
37,500
$3,652,500
The journal entry to record pension expense will be as follows:

Pension expense
Pension account
Cash
$3,652,500
347,500
$4,000,000
The balance in the pension account at the end of the year will be:
$2,000,000 cr + 347,500 dr. = $1,652,500 cr.
In order to reconcile the funded status at the end of the year, we must calculate the ending
balances of both the defined benefit obligation and plan assets.
Accrued interest
Balance, end of year
$26,000,000
1,820,000
3,000,000
(1,800,000)
1,380,000
$30,400,000
Plan assets
Expected return
Contributions
Experience gain: $2,200,000 1,365,000
$19,500,000
1,365,000
4,000,000
(1,800,000)
835,000
$23,900,000
Page 351
Reconciliation of funded status as at December 31, 20x5:

Funded status: $30,400,000 23,900,000
Less balance in pension account
$6,500,000
1,652,500
$4,847,500
Accounted for:
Unamortized plan amendment: $1,600,000 160,000 Amortization
Unamortized actuarial losses
$2,900,000
1,380,000
Experience gain
(835,000)
Amortization of actuarial losses
(37,500)
Page 352
$1,440,000
3,407,500
$4,847,500
Problems with Solution

1.
Defined contribution plans and defined benefit plans are two common types of
pension plans. Choose the correct statement concerning these plans.
a.
The required annual contribution to the plan is determined by formula or
contract in a defined contribution plan.
b.
Both plans provide the same retirement benefits.
c.
The retirement benefit is usually determinable well before retirement in a
defined contribution plan.
d.
In both types of plans, pension expense is generally the amount funded
during the year.
2.
Which of the following is never one of the five continuing components of pension
expense (or part of a component)?
a.
Amortization of excess actuarial gain or loss.
b.
Expected return on plan assets.
c.
Amount paid to the pension trustee for current service during the period.
d.
Growth (interest cost) in accrued pension obligation since the beginning of
the period.
3.
The following information for Gamez Enterprises is given below:

Plan assets (at fair value), Dec 31, 20x8
Accrued Pension Obligation, Dec 31, 20x8
Unrecognized past service costs, Dec 31, 20x8
Unrecognized actuarial gains (net), Dec 31, 20x8
Pension Account (on balance sheet) Jan 1, 20x8
Pension expense for 20x8
Contributions to plan assets during 20x8
$2,476,000
2,760,000
410,000
(210,000)
48,000 cr.
360,000
324,000
What is the amount that Gamez Enterprises should report as Pension Account as
of December 31, 20x8?
a.
$84,000 cr.
b.
$120,000 cr.
c.
$72,000 cr.
d.
$12,000 cr.
Page 353
The following information relates to questions 4 - 5:

On January 1, 20x8, Moore Co. has the following balances:
Accrued pension obligation
Fair value of plan assets
$2,800,000
2,500,000
The current interest rate is 10%. Other data related to the pension plan for 20x8 are:
Amortization of unrecognized prior service costs
Contribution to plan assets
Benefits paid
Amortization of unrecognized net gain
$160,000
37,000
180,000
150,000
176,000
12,000
4.
The balance of the defined benefit obligation at December 31, 20x8 is

a.
$3,048,000
b.
$3,060,000
c.
$3,085,000
d.
$3,090,000
5.
The fair value of plan assets at December 31, 20x8 is

a.
$2,354,000.
b.
$2,526,000.
c.
$2,706,000.
d.
$2,856,000.
Page 354
Problem 1
Mullen Company, a manufacturer of photographic equipment, is in the process of
preparing year-end financial statements. Susan Thawley was recently hired as assistant
controller of Mullen, and her first responsibility is to prepare the annual pension accrual.
Mullen established a noncontributory, defined benefit pension plan covering its 190
employees at the beginning of the fiscal year ended May 31, 20x0. At that time, the prior
service cost for the existing employee group was $11,300, and the average time to full
vesting of past service costs was 20 years. Mullen's corporate controller, Roger Kaplan,
has provided Thawley with last year's workpapers and copies of the annual reports from
the actuary and the fund trustee for Mullen. The following additional data is available:
Average remaining service life, May 31, 20x3
Benefits paid
Contributions to plan assets
Fair value of plan assets, May 31, 20x2
Fair value of plan assets, May 31, 20x3
Defined benefit obligation, May 31, 20x2
Interest rate used for accrued pension obligation
16 years
$ 1,778
$ 3,680
10%
$32,650
$39,500
$ 2,430
$43,800
8%
There were no unamortized actuarial gains and losses at May 31, 20x2.
Required a) Calculate the Defined benefit obligation, Plan Assets for the year ended May 31,
20x3. Also calculate the pension expense for the year. Reconcile the funded status.
b) 1. Explain why pension gains and losses are not recognized on the income statement
in the period in which they arise.
2. Briefly describe how pension gains and losses are recognized.
Page 355
Problem 2
The Chisnall Corporation Ltd began a pension fund in the year 20x3, effective January 1,
20x4. Terms of the pension plan follow:
the discount rate on plan assets is 6%

employees will receive partial credit for past service. The defined benefit
obligation, valued by the actuary using a discount rate of 6%, is $216,000 as of
January 1, 20x4.
past service cost will be funded over 15 years. The initial payment, on January1,
20x4 is $20,000. After that, another $20,000 will be added to the December 31
current service funding amount, including the December 31, 20x4 payment. The
amount of past service funding will be reviewed every five years to ensure its
adequacy.
the average number of years to full vesting of past service costs at January 1, 20x4
was 20 years.
the current service cost will be fully funded each December 31, plus or minus any
actuarial or experience gains related to the defined benefit obligation (i.e.
actuarial revaluations). Experience gains and losses related to the difference
between actual and expected earnings on fund assets will not affect plan funding
in the short-run, as they are expected to offset over time.
Data for 20x4 and 20x5 Current service cost
Funding amount, January 1, 20x4
Funding amount, December 31
Actual return on fund assets
Increase in actuarial liability at year-end due
to an actuarial revaluation
Expected Average Remaining Service Life for all
employees
20x4
$51,000
20,000
??
1,000
20x5
$57,000
??
6,800
16,000
26 years
25 years
Required:
Prepare journal entries to record pension expense and funding for 20x4 and 20x5. Also
prepare a reconciliation of funding status to the pension account as it would appear on the
Statement of Financial Position.
Page 356
Problem 3
Bufflehead Ltd. has a noncontributory pension plan which was instituted on January 1,
20x0. the current data as at December 31, 20x1 are as follows:
Actuarys discount rate

Anticipated earnings on plan assets
Defined benefit obligation, January 1, 20x1
Pension Account balance on Statement of Financial Position
at Jan 1, 20x1
Pension plan assets at fair value, January 1, 20x1
Current service cost 20x1
Contributions to pension fund by Bufflehead, Ltd. in 20x1
Unamortized past service cost, January 1, 20x1
(this is being amortized at the rate of $26,250 per year)
Pension benefits paid to retirees during 20x1
Pension plan assets at fair value, December 31, 20x1
Defined benefit obligation, December 31, 20x1
(per actuarial estimate)
Estimated remaining service life of employees,
as at January 1, 20x0
10%
8%
658,000
5,000 cr.
$245,000
148,000
95,000
420,000
174,000
261,000
710,000
17 years
Assume all payments to and from the plan are made at the end of the year.
Required
a.
b.
c.
Calculate:
i.
defined benefit obligation
ii.
plan assets
iii.
pension expense
Prepare the journal entry required to record the pension plan for 20x1.
Reconcile the funded status of the plan with the pension account that would appear
on the Statement of Financial Position as at December 31, 20x1.
Page 357
Problem 4
Patti Company has a defined benefit pension plan. The following is partial information
related to the plan:
Defined benefit obligation, January 1, 20x0
Actuarial losses, January 1, 20x0
Pension Plan Assets, January 1, 20x0
$ 32,000
$ 15,000
$ 30,000

Discount rate
Average remaining service time, January 1, 20x0
10%
11 %
30 years
Current service cost for 20x0

Benefit payments to retired employees for 20x0
Contributions to the pension fund for 20x0
Actual return on plan assets for 20x0
$ 2,000
$ 4,000
$ 3,000
$ 4,000
Required
a.
b.
c.
d.
Compute the defined benefit obligation as at December 31, 20x0.

Compute the pension plan assets as at December 31, 20x0.
Compute the pension expense for the year 20x0.
Prepare the reconciliation of funded status as at December 31, 20x0.
Page 358
Problem 5
As controller of Tumeric Ltd., you have been asked by the president to attend a
subcommittee meeting as an observer on December 30, 20x5. Those present included the
president, treasurer, and vice-president of sales.
President
Treasurer:
President:
Treasurer:
President:
Treasurer:
President:
VP Sales:
Treasurer:
President:
As we decided at our last annual meeting, the company adopted a pension

plan for its employees starting on January 1, 20x5. You were all present
yesterday at the office of Hoskins Ltd., the actuarial firm handling the plan
for us. Do you have any questions?
What is it going to cost us?
Hoskins determined that the value of past service benefits at January 1,
20x5, was $883,212.
What I meant was, since Hoskins recommended that we cover the past
service costs by making annual deposits of $266,660 at the end of each
year for 4 years at an expected return of 8% per annum, what will be the
annual expense for 20x6 and 20x7?
At the moment, I don't know. We do know, however, that the pension cost
for current service will be $225,000 for 20x5. This is estimated to increase
annually by $5,000, and will be fully funded at the end of each year. As
far as I understand, we can amortize the past service costs independently
from the funding period. The expected average time to full vesting of the
past service costs is 6 years. The accruals for service, and all necessary
payments will be made at year-end.
What I want to know is, what effect would all this have on the journal
entries for 20x5 through to 20x7?
I'm not sure.
Don't forget that Hoskins estimated an annual benefit payment of $25,000,
to be made at the end of each year.
What effect would there be, if any, if on December 31, 20x6, the pension
fund earned $15,000 more than expected?
I'm afraid we'll have to address these questions ourselves. It's getting late,
and if there are no further questions, I'd like to adjourn today's meeting.
Required:
Answer the queries raised by the subcommittee. Also, reconcile the defined benefit
obligation and plan assets to the Statement of Financial Position account. Assume an
interest rate of 8% on both the defined benefit obligation and the plan assets. The
estimated average remaining service life is 10 years for all years.
Page 359
Problem 6
This problem is a continuation of the Do-Re-Mi problem taken up in class. It assumes
you have completed the in-class problem.
Assume the following additional data:

Interest rate on accrued benefits and fund assets
Annual funding payments to trustee
Changes in actuarial assumptions establishes a
December 31 benefit obligation of
EARSL
20x4
20x5
20x6
$120,000
$134,000
$165,000
8%
7%
7%
120,000
10,000
50,000
300,000
600,000
45,000
65,000
90,000
$1,400,000
13 years
$2,000,000
14 years
12 years
On January 2, 20x5, the company amended the pension plan formula this caused an
increase in the Defined benefit obligation of $252,000. The number of years to full
vesting was 14 years.
Page 360
Problem 7
The Harold Corporation operates a defined benefit plan for its employees. Data relative to
the plan for the year 20x8 is as follows:
Data relative to balances at January 1, 20x8:
Plan assets
Pension account balance
Unamortized past service cost arising from a plan amendment
made on January 1, 20x1 (amortized at the rate of $75,000 per
year)
Benefits paid to employees
Contributions to pension assets
January 2, 20x8
July 2, 20x8
December 31, 20x8
Actual return on pension assets
Discount rate used for Defined benefit obligation and Pension Assets
$5,600,000
6,700,000
800,000 dr.
500,000
260,000
210,000
60,000
80,000
150,000
450,000
6%
The actuary estimates that the defined benefit obligation as at December 31, 20x8 is
$6,500,000.
The estimated average service life of the employees as at January 1, 20x8 is 10 years.
Required
Reconcile the opening balance of the Defined benefit obligation and Plan assets to their
ending balances. Calculate pension expense for the year 20x8 and reconcile the funded
status at December 31, 20x8.
Page 361
Problem 8
The following information is given DBOut a defined benefit plan. The present value of
the obligation and the fair market value of the plan assets at January 1, 20x1 were both
$1,000. The net cumulative unrecognized actuarial gains at that date were $140.
20x1
20x2
20x3
Discount rate
10.0%
9.0%
8.0%
Expected rate of return on plan assets
12.0%
11.1%
10.3%
130
140
150
Benefits paid
150
180
190
90
100
110
Present value of obligation at December 31
1,141
1,197
1,295
Fair value of plan assets at December 31
1,092
1,109
1,093
10
10
10
Contributions paid
Expected average remaining service lives of

employees (years)
In 20x2, the plan was amended to provide additional benefits. The present value at
January 1, 20x2 of the additional benefits for employee service before January 1, 20x3
was $50 for vested benefits and $30 for non-vested benefits. As at January 1, 20x3, it was
estimated that the average period until the non-vested benefits would become vested was
three years.
Required
Calculate pension expense for the years 20x1 - 20x3 and reconcile the funded status at
the end of each of these years. (Adapted from IAS 19 Appendix A)
Page 362
Problem 9
As Controller of Barns Ltd. you were presented with the pension plan information shown
below. The company's plan commenced in 20x0 when past service costs (PSC) were
estimated to be $566,000. The estimated remaining service life of the employees at that
time was 15 years. Assume that there will be no payments to retirees during this period.
Past Service Costs
Year
20x0
20x1
20x2
20x3
20x4
20x5
20x6
20x7
20x8
20x9
20x10
20x11
20x12
20x13
20x14
Current
Service
Cost
$49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
PSC
Amortization
Amount
$37,733
37,733
37,733
37,733
37,733
37,733
37,733
37,733
37,733
37,733
37,733
37,733
37,733
37,733
37,733
Net
Interest
$56,600
50,634
44,072
36,853
28,912
20,178
10,570
0
0
0
0
0
0
0
0
Cash
Payment
To Plan
Trustee
$165,259
165,259
165,259
165,259
165,259
165,259
165,265
49,000
49,000
49,000
49,000
49,000
49,000
49,000
49,000
Pension
Account
- debit
$21,926
49,818
84,272
125,945
175,559
233,907
301,869
264,136
226,403
188,670
150,937
113,204
75,471
37,738
0
Required a)
b)
c)
d)
e)
f)
g)
h)
What is the interest rate used in the above schedule? Justify your answer.
What does the net interest amount represent? Show how it is calculated for the
year 20x1.
Calculate the Defined benefit obligation and the Plan Asset balances at the end of
20x2 and reconcile the funded status to the Pension Account.
At the end of 20x7, how would the amount $264,136 be disclosed on the financial
statements and what does this amount represent?
Show how the annual amount for the amortization of past service costs was
calculated.
Show how the annual cash payments were determined.
Prepare the necessary journal entry with respect to the pension plan for the year
20x3.
Prepare the necessary journal entry with respect to the pension plan for the year
20x9.
Page 363
Problem 10
On January 2, 20x0, Mount Royal adopted a defined benefit pension plan. At the time of
adoption, the past service cost amounted to $883,212. This amount is being funded over
15 years, at the beginning of each year, in an equal amount per year of $95,544. The
management of Mount Royal, using their best estimates, determined the long-run interest
rate to be 8%. The expected return on plan assets is also 8%. Of the total past service
costs of $883,212, $400,000 vest immediately and the remainder vest in 5 years.
The current service cost, determined using the projected benefits method prorated on
services, is funded in full at the beginning of each year. Other information is as follows:
Actual pension fund assets, Dec. 31

Defined benefit obligation (per actuary), Dec. 31
Current service costs (assumed to occur at the end of the
year, for purposes of DBO calculations)
EARSL
20x0
$355,000
$1,200,000
20x1
$750,000
$1,560,000
$225,720
20 years
$254,700
19 years
Mount Royal has a December 31 year-end.

Required Prepare required journal entries for 20x0 and 20x1 to record pensions in Mount Royal's
books. Reconcile the funded status for both years.
Page 364
Solutions
1.
2.
3.
Accrued Pension liability, beginning of year

Increase during the year:
$360,000 Pension Expense - 324,000 Contributions
Accrued Pension liability, end of year
$48,000
36,000
$84,000
4.
Pension Obligation, beginning balance

Interest @ 10%
Benefits paid
Pension Obligation, ending balance
$2,800,000
280,000
160,000
-150,000
$3,090,000
5.
Plan assets, beginning of year

Contributions
Benefits paid
Actual return
$2,500,000
180,000
-150,000
176,000
$2,706,000
Page 365
Problem 1
a)
Accrued interest @ 8%
CSC
Benefits paid
$43,800
3,504
2,430
-1,778
$47,956
Pension Plan Assets

Expected return @ 10%
Contributions
Benefits paid
Experience gain
$32,650
3,265
3,680
-1,778
1,683
$39,500
Pension Expense
CSC
Accrued interest on DBO
Expected return on Plan Assets
Amortization of Past Service Costs
$11,300 / 20
$2,430
3,504
-3,265
565
$3,234
Journal Entry Pension expense

Pension account
Cash
Pension Account balance, May 31, 20x3
Funded Status at beginning of year: $43,800 - 32,650
Less unamortized PSC: $11,300 x 17/20
Pension account balance, May 31, 20x2, credit
Less 20x3 journal entry
Pension account balance, May 31, 20x3, credit
Page 366
$3,234
446
$3,680
$11,150
9,605
1,545
446
$1,099
Reconciliation to funded status DBO

Plan assets
Funded Status
Less Pension Account
Reconciles to:
Unamortized Past Service Cost: $11,300 x 16/20
Experience Gain
b) 1.
$47,956
39,500
8,456
1,099
$7,357
$9,040
-1,683
$7,357
Pension gains and losses result from changes in the value of the accrued benefit
obligation or the fair value of the plan assets. The volatility of these gains and
losses may reflect an unavoidable inability to predict compensation levels, length
of employee service, mortality, retirement ages, and other relevant events
accurately for a period, or several periods. Therefore, fully recognizing the gains
or losses on the income statement may result in volatility that does not reflect
actual changes in the funded state of the plan in that period.
2. In order to decrease the volatility of reporting pension gains and losses, these
gains and losses are accumulated from year to year in a "memo" or "off-Statement
of Financial Position" account. When the unrecognized balance in this account
(gain or loss) exceeds 10 percent of the greater of the defined benefit obligation or
the market-related value of the plan assets, the "corridor approach" is used to
amortize the accumulated balance. The excess balance, the amount outside the
corridor, must be amortized using any systematic method as long as it is not less
than the amount computed using the straight-line method over the average
remaining service life of all active employees.
Page 367
Problem 2

Beginning balance
Interest @ 6%
Pension Assets
Beginning Balance
Funding payment - beginning of year
Expected Return @ 6%
Funding payment - end of year
(51,000 + 20,000) | (57,000 + 20,000 + 16,000)
Experience gain (loss)
Corridor Test
Unrecognized gains/losses
Corridor: 10% of opening PO
Pension Expense
Interest on Defined benefit obligation
Expected Return on Pension Assets
Amortization of Past Service Costs (216,000 / 20)
20x4
20x5
$216,000
12,960
51,000
$279,960
$279,960
16,798
57,000
16,000
$369,758
$0
20,000
1,200
$92,000
71,000
-200
$92,000
93,000
1,280
$191,800
-200
21,600
27,996
$51,000
12,960
-1,200
10,800
$73,560
$57,000
16,798
-5,520
10,800
$79,078
5,520
Journal Entries 20x4: Pension expense

Pension Account
Cash
73,560
17,440
20x5: Pension expense

Pension Account
Cash
79,078
13,922
Page 368
91,000
93,000
Reconciliation
Plan Assets
Funded Status
Add Pension Account
Accounted for:
Unamortized past service cost
Experience (gain) loss
20x4
20x5
$279,960
92,000
187,960
17,440
$205,400
$369,758
191,800
177,958
31,362
$209,320
$205,200
200
$194,400
-1,080
16,000
$209,320
$205,400
Problem 3
Before you start, it is always wise to do a reconciliation of the opening balances to
determine if there are any unrecognized amounts outstanding at the beginning of the year.
Funded status at beginning of year
$658,000 - 245,000
Less pension account balance
Unrecorded liability
$413,000
5,000
$408,000
Reconciles to
Unrecognized amounts (gains)*
$420,000
(12,000)
$408,000
* this number, although not given, was imputed from the data.
a.
Beginning balance
Interest @ 10%
Benefits paid
Ending balance
Page 369
$658,000
65,800
148,000
(174,000)
12,200
$710,000
Pension Assets
Beginning balance
Expected Return @ 8%
Employer contributions
Benefits paid
Experience gain
Ending balance
$245,000
19,600
95,000
(174,000)
75,400
$261,000
Corridor Test Corridor: $658,000 x 10%

Unrecognized amounts (gains)
No amortization necessary.
$65,800
12,000
Pension Expense
Interest on defined benefit obligation
Expected return plan assets
Amortization of past service cost
b.
Pension expense
Cash
Pension Account
$148,000
65,800
(19,600)
26,250
$220,450
$220,450
$95,000
125,450
Balance in pension account at end of year = $5,000 + 125,450 = $130,450

c.
Funded status at end of year
$710,000 - 261,000
Less pension account balance
Reconciles to
Unrecognized amounts
$12,000 Op Gain - 12,200 Actuarial Revaluation
+ 75,400 Experience Gain
Page 370
$449,000
130,450
$318,550
$393,750
(75,200)
$318,550
Problem 4
a.
Balance, beginning
Interest: $32,000 x 11%
Benefit payments
$32,000
3,520
2,000
(4,000)
$33,520
b.
Balance, beginning
Expected return: $30,000 x 10%
Experience gain
Contributions
Benefit payments
$30,000
3,000
1,000
3,000
(4,000)
$33,000
c.
Corridor Test Corridor: $32,000 x 10%

Excess
$3,200
15,000
11,800
Divide by EARSL
/ 30
Amortization required
$393

Amortization of unrecognized amounts per corridor test
Pension expense, 20x0
$2,000
3,520
(3,000)
393
$2,913
Journal entry Pension expense

Pension asset
Cash
d.
$2,913
87
$3,000
First we must calculate the balance in the pension account:

Balance at the beginning of year =
Funded Status at beginning of year ($32,000 - 30,000)
Less unrecognized amounts
Pension account (asset) at beginning of year
Increase during year
Page 371
$ 2,000
15,000
13,000
87
$13,087
Reconciliation Funded Status: $33,520 - 33,000

Add pension account
$520
13,087
$13,607
Unrecognized amounts:
$15,000 Balance Beginning of year - 1,000 Experience Gain - 393 Amortization
$13,607
Problem 5
20x5
Opening balance
Interest @ 8%
Current Service Cost
Benefit Payment
Ending Balance
Plan Assets
Opening balance
Funding on Past Service Cost
Funding on Current Service Cost
Benefit payments
Experience gain
Ending Balance
Corridor Test
Corridor = 10% of Opening DBO
Actuarial gains/losses
20x6
20x7
$ 883,212
70,657
225,000
(25,000)
$1,153,869
$1,153,869
92,310
230,000
(25,000)
$1,451,179
$1,451,179
116,094
235,000
(25,000)
$1,777,273
$ 466,660
266,660
230,000
(25,000)
37,333
15,000
$ 990,653
$ 990,653
266,660
235,000
(25,000)
79,252
$1,546,565
$115,357
15,000
$145,118
15,000
$ 230,000
92,310
(37,333)
147,202
$ 432,179
$ 235,000
116,094
(79,252)
147,202
$ 419,044
266,660
225,000
(25,000)
$ 466,660
$88,321
No amortization necessary
Pension Expense
Current Service Cost
Interest on PBO
Amortization of PSC 1
1
$ 225,000
70,657
147,202
$ 442,859
$883,212 / 6 = $147,202
Page 372
Journal entries:
20x5
20x6
20x7
Pension expense
Pension Account
Cash ($266,660 + $225,000)
$442,859
48,801
Pension expense
Pension Account
Cash ($266,660 + $230,000)
$432,179
64,481
Pension expense
Pension Account
Cash ($266,660 + $235,000)
$419,044
82,616
$491,660
$496,660
$501,660
Reconciliation Defined benefit obligation

Plan Assets
Funded Status
Add Pension Account (asset)
Accounted for:
Unamortized PSC
Experience gain
20x5
$1,153,869
466,660
687,209
48,801
$736,010
20x6
$1,451,179
990,653
460,526
113,282
$573,808
20x7
$1,777,273
1,546,565
230,708
195,898
$426,606
$736,010
$588,808
-15,000
$573,808
$441,606
-15,000
$426,606
$736,010
Page 373
Problem 6
20x4
Plan amendment
Accrued interest @ 8% | 7% | 7%
Actuarial revaluation gain/loss
Pension Plan Assets

Expected return @ 8% | 7% | 7%
Contributions
Experience gain/loss
Corridor test 10% of the greater of the opening plan assets

or defined benefit obligation
Unrecognized amounts at beginning of year
Excess
EARSL
Pension expense
Amortization of plan amendment - initial
- 20x5 amendment
Amortization of unrecognized amounts
Page 374
20x5
20x6
$1,053,000 $1,400,000 $1,836,640

252,000
84,240
115,640
128,565
120,000
134,000
165,000
(45,000)
(65,000)
(90,000)
187,760
(40,205)
$1,400,000 $1,836,640 $2,000,000
$458,000
36,640
(45,000)
83,360
$533,000
$533,000
$778,000
37,310
54,460
300,000
600,000
(65,000)
(90,000)
(27,310)
(4,460)
$778,000 $1,338,000
$105,300
55,367
-
$140,000
159,767
19,767
14
$1,412
$183,664
185,665
2,001
12
$167
120,000
84,240
(36,640)
44,000
134,000
115,640
(37,310)
44,000
18,000
1,412
$275,742
165,000
128,565
(54,460)
44,000
18,000
167
$301,272
$211,600
Journal entries
20x4
Pension expense
Pension Account
20x5
20x6
$211,600
$211,600
Pension expense
Pension account
Cash
275,742
24,258
Pension expense
Pension account
Cash
301,272
298,728
300,000
600,000
Balance in Pension Account

Dr.
Cr.
Balance
$11,633 cr.
223,233 cr.
198,975 cr.
99,753 dr.
Jan 1, 20x4
Dec 31, 20x4
Dec 31, 20x5
Dec 31, 20x6
24,258
298,728
Reconciliation Funded status

Pension liability (asset)
Difference
$867,000
(223,233)
$643,767
$1,058,640
(198,975)
$859,665
$662,000
99,753
$761,753
(6,660)
166,460
(33)
159,767
484,000
20,650
166,460
(1,445)
185,665
440,000
234,000
$859,665
25,110
126,255
(1,612)
149,753
396,000
216,000
$761,753
Accounted for Unrecognized amounts

Less amortization to date
Unamortized plan amendment intial
- 20x5 amendment
211,600
$643,767
Page 375
Problem 7
Reconciliation of Funded Status, Jan 1, 20x8

Plan assets
Funded status (asset)
Less pension account
Unrecorded asset
Unamortized past service cost (liability)
Actuarial gain
$5,600,000
6,700,000
1,100,000
800,000
300,000
500,000
$800,000
Corridor Test
Corridor: $6,700,000 x 10%
Actuarial gain
Excess
$670,000
800,000
130,000
Average remaining service life
10 years
Amortization of actuarial gain
$13,000

Balance, Jan 1
Accrued interest
Benefits paid
$5,600,000
336,000
260,000
(210,000)
514,000
$6,500,000
Pension Assets
Balance, Jan 1
Expected return:
On Opening Balance + Jan 2 Contribution: $6,760,000 x 6%
On July 2 contribution: $80,000 x 6% x
Contributions
Benefits paid
Experience gain
Pension expense
Interest on defined benefit obligation
Amortization of past service costs
Amortization of actuarial gains per corridor test
Page 376
$6,700,000
405,600
2,400
290,000
(210,000)
42,000
7,230,000
$260,000
336,000
(408,000)
75,000
(13,000)
$250,000
Journal entry to record pension expense Pension expense

Pension account
Cash
$250,000
40,000
$290,000
Balance in pension account at December 31, 20x8:

$800,000 dr + 40,000 dr. = $840,000 dr.
Reconciliation of Funded Status December 31, 20x8 Defined benefit obligation
Plan assets
Funded status (asset)
Less pension account
Accounted for
Unamortized past service cost ($500,000 75,000)
Actuarial gains ($800,000 Beginning 13,000 Amortization
- 514,000 Actuarial Revaluation + 42,000 Experience Gain)
Page 377
$6,500,000
7,230,000
730,000
840,000
$110,000
$425,000
(315,000)
$110,000
Problem 8

Accrued interest
Plan amendment vested
- nonvested
Actuarial revaluation gain/loss
Pension Plan Assets

Expected return
Contributions
Experience gain/loss
Corridor test 10% of the greater of the opening plan assets

or defined benefit obligation
Excess
Expected average remaining working lives of
employees
Pension expense
Plan amendment non-vested benefits
Plan amendment vested benefits
Net actuarial gain recognized in year
Page 378
20x1
20x2
20x3
$1,000
100
130
(150)
$1,197
96
150
(190)
61
$1,141
$1,141
103
140
(180)
50
30
(87)
$1,197
42
$1,295
$1,000
120
90
(150)
32
$1,092
$1,092
121
100
(180)
(24)
$1,109
$1,109
114
110
(190)
(50)
$1,093
$100
140
40
$114
107
-
$120
170
50
10
$4
10
$5
$130
100
(120)
(4)
$106
$140
103
(121)
10
50
$182
$150
96
(114)
10
(5)
$137
Journal Entries
20x1
20x2
20x3
Pension expense
Pension liability
Cash
$106
Pension expense
Pension liability
Cash
182
Pension expense
Pension liability
Cash
137
16
90
82
100
27
110
Pension Liability Account Balance, January 1, 20x1

December 31, 20x1
December 31, 20x2
December 31, 20x3
Reconciliation Funded status

Pension assets
Less pension liability
Difference
Accounted for Unrecognized amounts
Less amortization to date
16 cr.
82 cr.
27 cr.
$1,141
1,092
49
156
$107
$1,197
1,109
88
238
$150
$1,295
1,093
202
265
$63
140
(61)
32
(4)
107
107
87
(24)
170
(42)
(50)
(5)
73
(10)
$63
Unamortized plan amendment

$107
Page 379
$140 cr.
156 cr.
238 cr.
265 cr.
170
(20)
$150
Problem 9
a)
The interest rate used is 10%. The opening balance of the Defined benefit
obligation is $566,000 and the opening balance of the Pension Plan Assets is zero.
Therefore, the net interest amount for the year 20x0 will be the interest accrued on
the DBO only: $566,000 x 10% = $56,600
b)
The net interest amount is equal to the difference between the accrued interest on
the DBO and the expected return on the plan assets. The following schedule
calculates the amount for 20x1:

Accrued Interest / Expected Return
CSC / Funding
Accrued Interest / Expected Return (10%)
DBO
$566,000
56,600
49,000
671,600
67,160
Plan Assets
$0
0
165,259
165,259
16,526
The net amount is calculated as: $67,160 - 16,526 = $50,634

c)
Continuing the schedule started in part (b) to the end of 20x2:

CSC / Funding
CSC / Funding
DBO
$671,600
67,160
49,000
787,760
78,776
49,000
$915,536
Plan Assets
$165,259
16,526
165,259
347,044
34,704
165,259
$547,007
Funded Status ($915,536 - 547,007)

Add Pension Account (asset)
$368,529
84,272
$452,801
Unamortized Past Service Cost

$566,000 - (37,733 x 3 years)
$452,801
d)
The amount, $264,136, would appear on the Statement of Financial Position as

"Prepaid Pension Costs" or "Deferred Pension Expense", a non-current asset.
e)
$566,000 / 15 years = $37,733
Page 380
f)
N=7
I = 10
PV = 566,000 (the Past Service Cost)
Solve for PMT = $116,229
Total funding amount = $116,259 + 49,000 CSC = 165,259
g)
20x3
Pension Expense*
Pension Account
Cash
123,586
41,673
165,259
* 49,000 CSC+ 36,853 Net Interest + 37,733 Amort PSC

h)
20x9
Pension Expense (2)
Pension Account
Cash
86,733
37,733
49,000
* 49,000 CSC+ 0 Net Interest + 37,733 Amort PSC = 86,733
Page 381
Problem 10
20x0
20x1
$883,212
70,657
225,720
20,411
$1,200,000
$1,200,000
96,000
254,700
9,300
$1,560,000
$0
321,264
25,701
8,035
$355,000
$355,000
350,244
56,420
-11,664
$750,000
$88,321
0
$120,000

Accrued interest @ 8%
CSC
Actuarial revaluation (loss)
Pension Plan Assets
Funding at beginning of year: $95,544 + CSC
Expected return @ 8%
Corridor Test
Corridor ($883,212 x 10% | $1,200,000 x 10%)
($20,411 8,035)
No amortization necessary.
Pension Expense
CSC
Accrued interest on DBO
Expected return on Plan Assets
Amortization of Past Service Costs
Fully vested
Amortization of remainder: $483,212 / 5 years
$12,376
$225,720
70,657
-25,701
$254,700
96,000
-56,420
400,000
96,642
$767,318
96,642
$390,922
Journal Entries 20x0
20x1
Page 382
Pension expense
Pension account
Cash
$767,318
Pension expense
Pension account
Cash
390,054
446,054
$321,264
40,678
350,244
20x0
20x1
$1,200,000
355,000
845,000
446,054
$398,946
$1,560,000
750,000
810,000
486,732
$323,268
$386,540
$289,928
Reconciliation to Funded Status DBO

Plan assets
Funded Status
Less Pension Account
Reconciles to:
Unamortized Past Service Cost $483,212 - 96,642 | $483,212 - 96,642 - 96,642
$20,411 8,035
$12,376 + 9,300 + 11,664
12,376
$398,946
Page 383
33,340
$323,268
12.
Earnings Per Share
Earnings per share data have to be disclosed by entities (i) whose shares are traded in a
public market, or (ii) that files, or is in the process of filing, its financial statements with a
securities commission or other regulatory organization for the purpose of issuing shares
in a public market (IAS 33.2).
Two earnings per share numbers have to be disclosed: basic earnings per share and
diluted earnings per share. This chapter discuses the details on how to calculate each of
these EPS numbers.
If income from continuing operations is calculated, then earning per share numbers have
to be presented for both profit and loss attributed to common shareholders and on profit
or loss from continuing operations attributable to those common shareholders (IAS 33.9).
Basic Earnings Per Share

Basic earnings per share is calculated as follows:
Net income available to common shareholders
Weighted average number of common shares outstanding during the period
The numerator of the computation is equal to net income less dividends declared on noncumulative preferred shares and annual dividend entitlements on cumulative preferred
shares, whether or not declared (IAS 33.14)
The denominator of the computation is an amount representing the weighted average
number of common shares outstanding during the period.
Note that common shares issued, during the year or after the year-end but prior to the
issuance of the annual report, in connection with a common stock dividend or stock split
are considered to have been issued at the beginning of the accounting period (or at the
time of issue, in the case of common stock issued during the year). Stock dividends and
stock splits do not change the proportionate ownership of the shareholders. However,
shareholders will be assessing the value of their investment in terms of the number of
shares currently owned. To avoid misleading shareholders into thinking their investment
is worth more than it really is, the stock dividends and stock splits are considered
outstanding for the entire period (IAS 33.26). If a stock split and stock dividend is
declared during the year, this is applied retrospectively to previous fiscal years. For
example, if a 2:1 split is declared in the year ended December 31, 20x4, then the EPS for
previous years are recalculated on the assumption that the stock split done at that time.
Page 384
Example 1: The long-term liabilities and stockholders' equity section of Thompson Ltd.
at January 1, 20x3, was as follows:
8% convertible bonds, each $1,000 bond convertible into 50 common
shares, interest payable June 30 and December 31
$4,000,000
4% non-cumulative series A preferred shares, $100 par value,
outstanding 20,000 shares
$2,000,000
5% cumulative convertible series B preferred shares, $100 par value,

convertible into 2 common shares, outstanding 50,000 shares
5,000,000
Common Stock - no par value, 400,000 shares outstanding (Note 1)
6,000,000
Retained Earnings
3,000,000
16,000,000
$20,000,000
At January 1, 20x3, there were stock options outstanding enabling the option holders to
acquire 100,000 common shares at $60 per share. Information for 20x3:
1) Net income was $2,410,0000.
2) On July 1, all the 8% convertible bonds were converted. The company had no
interest obligation on these bonds in the month of July.
3) Dividends were declared and paid on the A and B preferred shares respectively.
4) The company is subject to a 40% tax rate.
5) The average share price during the year 20x3 was $80.
We start by determining net income available to common shareholders:
Net income
Less: preferred dividend entitlements
A - 20,000 x 4
B - 50,000 x 5
Net income available to common shareholders
Weighted average number of common shares outstanding:
Shares outstanding at January 1
Half-Year
=
Conversion of bonds on July 1: 200,000* x 6/12
* (4,000,000/ 1,000 x 50)
$2,410,000
(80,000)
(250,000)
$2,080,000
400,000
100,000
500,000
Basic E.P.S = $2,080,000 / 500,000 = $4.16
Page 385
Diluted earnings per share

Companies with complex capital structures have various securities outstanding which can
potentially be converted into common shares at the option of the holder. These securities
include convertible debt, convertible preferred shares, common share warrants and stock
options. The exercise of any of these securities would reduce the ownership percentage
of the existing common shareholders.
Diluted earnings per share indicates what basic earnings per share would have been if the
potentially dilutive securities outstanding at the end of the year had been converted at the
later of the beginning of the year or the date of issue of the convertible security. The
objective is to report the most pessimistic earnings per share figure so it is necessary to
rank the potentially dilutive items (IAS 33.41).
The steps in the calculation of diluted earnings per share are (IAS 33.44):
(1) Individually analyze each outstanding convertible security to determine its impact on
basic earnings per share. The denominator in the analysis is the additional common
shares due to the conversion of the particular item. The numerator is the additional
amount of after-tax income available assuming the item was converted. This
additional income is generally one of the following two items:
(a) the amount of dividends applicable to convertible preferred shares for the period.
(b) the amount of interest expensed for the period, net of income taxes, on convertible
debt.
(2) Compare the individual earnings per share figures with basic EPS to determine which
items are dilutive (decrease earnings per share), and which are anti-dilutive (increase
earnings per share). The anti-dilutive securities are excluded from the calculation, as
we are trying to determine the lowest possible earnings per share figure assuming all
convertible items were converted.
(3) Rank the dilutive items from most dilutive to least dilutive.
(4) Individually add the dilutive items to the basic EPS beginning with the most dilutive.
Calculate the new earnings per share figure after each dilutive item is added.
Continue to add dilutive items as long as the earnings per share figure decreases. The
lowest earnings per share figure is the fully-dilutive earnings per share.
If conversion rights associated with convertible debt, shares, warrants and options do not
become effective for a period of at least ten years from the date of the Statement of
Financial Position, these items may be ignored in calculating fully diluted earnings per
share.
Impact on conversion of warrants and options: the exercise of options and warrants is
assumed at the beginning of the period and common shares are assumed to be used. The
proceeds from the exercise are then assumed to be used to purchase common shares at the
Page 386
average market price for the period. The difference between the number of shares
assumed issued and the number of shares assumed purchased are included in the
denominator of the fully diluted earnings per share computation (IAS 33.45). Stock
options that are in the money (i.e. when the exercise price is greater than the average
market price of the stock) are always dilutive. If they are out of the money (i.e. when the
exercise price is less than the average market price of the stock), then they would be
antidilutive and would not be included in the diluted EPS calculations.
For example, a company has 20,000 options outstanding exercisable at $67.50 per share.
The average market price per common share during the year was $90. The assumed
exercise of these options would generate $67.50 x 20,000 = $1,350,000 which is an
amount sufficient to acquire 15,000 shares ($1,350,000 / $90). Thus, 5,000 incremental
shares (20,000 15,000) are added to the denominator in computing fully diluted
earnings per shares
Page 387
Example 2: Refer to the Thompson Ltd. data in Example 1.

We first analyze the dilutive effect of each convertible item:
a) Convertible bonds - impact on EPS had the bonds been converted on January 1 instead
of July 1:
Impact on numerator: $4,000,000 x 8% x 6/12 x 0.6 = $96,000
Impact on denominator: 4,000 bonds x 50 shares x 6/12 = 100,000
Incremental impact: $96,000 / 100,000 = $0.96
=> Dilutive since it is lower than Basic EPS of $4.16
b) Convertible B preferred shares
Impact on numerator: $5,000,000 x .05 = $250,000
Impact on denominator: 50,000 x 2 = 100,000
Incremental impact: $250,000 / 100,000 = $2.50
=> Dilutive since it is lower than Basic EPS of $4.16
c) Stock options
Proceeds on assumed conversion = 100,000 x $60
$6,000,000
These could be used to purchase $6,000,000 / $80 = 75,000 shares
Increase in denominator = 100,000 75,000 = 25,000 shares
The order of entry into the diluted EPS calculation is as follows:
1 - Stock options
2 - Convertible Bonds
3 - Convertible Preferred Shares
Basic EPS
Stock options
Convertible bonds
Preferred shares
Diluted EPS
Page 388
Income
Shares
EPS
2,080,000
500,000
$4.16
25,000
2,080,000
525,000
96,000
100,000
2,176,000
625,000
250,000
100,000
2,426,000
725,000
$3.96
3.48
$3.35
Example 3 Assume the following information for the Skyview Inc.:

Skyview has income available to common shareholders of $10,000,000 for the
year 20x6 (i.e. preferred dividends were already deducted in arriving at this
amount)
2,000,000 weighted average common shares were outstanding for the year 20x6
the average market price of common shares was $75 during the year 20x6
Skyview has the following potential convertible instruments outstanding during
the year:
options to purchase 100,000 common shares at $60 each
800,000 convertible preferred shares entitled to a cumulative dividend of $8 per
share. Each preferred share is convertible into two common shares.
5% convertible debentures with a principal amount of $100,000,000 (issued at
par). Each $1,000 debenture is convertible into 20 common shares.
the tax rate was 40% for 20x6
Determination of earnings per incremental share:
Increase in
Income
$6,400,000
3,000,000
Options (1)
Convertible preferred shares (2)
5% convertible debentures (3)
Increase in
number of
common shares
20,000
1,600,000
2,000,000
Earnings per
incremental
share
$4.00
1.50
(1) 100,000 options x $60 = $6,000,000 / $75 = 80,000; 100,000 80,000 = 20,000
(2) Income: 800,000 shares x $8 = $6,400,000; shares = 800,000 x 2
(3) Income: $100,000,000 x 5% x .6 = $3,000,000
Shares: $100,000,000 / 1000 x 20 = 2,000,000
Order of entry: options first; convertible debentures second and preferred shares last.
Computation of diluted earnings per share:
As reported
Options
5% convertible debentures
Convertible preferred shares
Income
$10,000,000
10,000,000
3,000,000
13,000,000
6,400,000
$19,400,000
Shares
2,000,000
20,000
2,020,000
2,000,000
4,020,000
1,600,000
5,620,000
EPS
$5.00
4.95
3.23
$3.45
Diluted earnings per share is therefore $3.23 since the convertible preferred shares are
anti-dilutive.
Page 389
Example 4 - Net Loss Situation

The Loser Corporation's net loss for the year ending December 31, 20x4 was $1,500,000.
The weighted average number of shares for the year was calculated as 1,000,000. The
company has convertible, cumulative preferred shares outstanding. There are 100,000
shares outstanding with an annual dividend rate per share of $2.00. The conversion ratio
is 2 common shares for one preferred share.
The company also has $10,000,000 of 6% convertible bonds outstanding. The conversion
ratio is 20 common shares for each $1,000 bond. The companys tax rate is 35%.
The basic EPS would be calculated as follows:
[($1,500,000) - 200,000] / 1,000,000
= (1,700,000) / 1,000,000
= ($1.70)
Note that the inclusion of the preferred shares in the diluted EPS calculations would
cause EPS to be equal to: ($1,500,000) / 1,200,000 = ($1.25). Because this causes the loss
per share to decrease, the preferred shares are antidilutive.
The inclusion of the bonds would cause EPS to become:
($1,500,000) + 390,000 / (1,000,000 + 200,000)
= ($1,110,000) / 1,300,000
= ($0.85)
Again antidutive. The point of this example is that when the company is in a loss
situation, the inclusion or ordinarily dilutive convertible instruments will cause the loss
per share to reduce and become antidilutive.
Page 390

1.
Poe Co. had 300,000 shares of common stock issued and outstanding at December
31, 20x4. On January 1, 20x5, Poe issued 200,000 shares of nonconvertible
preferred stock. During 20x5, Poe declared and paid $75,000 cash dividends on
the common stock and $60,000 on the preferred stock. Net income for the year
ended December 31, 20x5, was $330,000. What should be Poe's 20x5 earnings
per common share?
a.
$1.10
b.
$0.90
c.
$0.85
d.
$0.65
2.
Timp, Inc. had the following common stock balances and transactions during
20x5:
January 1, x5
February 1, x5
March 1, x5
July 1, x5
Common stock outstanding

Issued a 10% common stock dividend
Issued common stock
Issued common stock
30,000
3,000
9,000
8,000
Dec 31, x5
50,000
What was Timp's 20x5 weighted average shares outstanding?

a.
40,000
b.
44,250
c.
44,500
d.
46,000
Page 391
3.
On June 30, 20x4, Lomond, Inc. issued twenty, $10,000, 7% bonds at par. Each
bond was convertible into 200 shares of common stock. On January 1, 20x5,
10,000 shares of common stock were outstanding. The bondholders converted all
the bonds on July 1, 20x5. The following amounts were reported in Lomond's
income statement for the year ended December 31, 20x5:
Revenues
Operating expenses
Interest on bonds
Income before income tax
Income tax at 30%
Net income
$977,000
920,000
7,000
50,000
15,000
$ 35,000
What amount should Lomond report as its 20x5 basic earnings per share?
a.
$2.50
b.
$2.86
c.
$2.92
d.
$3.50
4.
Dextar Corporation had 300,000 common shares outstanding at December 31,

20x1. On April 1, 20x2 an additional 120,000 common shares were issued. On June
1, 20x2 a 10% stock dividend was declared. In addition, it had 90,000 stock options
outstanding, which had been granted to certain executives, and which gave them the
right to purchase Dextar's shares at an option price of $37 per share. The average
market price of Dextar's common shares for 20x2 was $50. What is the number of
shares that should be used in calculating diluted earnings per share for the year
ended December 31, 20x2?
a) 420,000
b) 449,000
c) 466,600
d) 454,740
5.
On January 2, 20x2, Starr Co. issued at par $10,000 of 6% bonds convertible in

total into 1,000 of Starr's common shares. No bonds were converted during 20x2.
Throughout 20x2, Starr had 1,000 shares of common shares outstanding. Starr's
20x2 net income was $6,000. Starr's income tax rate is 30%.
No potentially dilutive securities other than the convertible bonds were outstanding
during 20x2. Starr's diluted earnings per share for 20x2 would be (rounded to the
nearest penny)
a) $3.00.
b) $3.21
c) $3.30
d) $6.42
Page 392
Problem 1
The December 31, 20x2 Statement of Financial Position of Davis Company included the
following items:
4,000 9% convertible bonds outstanding. The 20-year bonds mature December 31,
20x5. Each $1,000 bond is convertible into 30 common shares.
270,000 convertible, cumulative, preferred shares. These preferred shares have an

annual dividend of $2.00 per share and each preferred share can be exchanged for 3
common shares.
1,500,000 common shares issued and outstanding.
125,000 Series 1 share options outstanding with an exercise price of $45.
100,000 Series 2 share options outstanding with an exercise price of $60.

During 20x2, the following occurred:
Net income was $4,000,000.
On June 1, 20x2, Davis issued 150,000 new common shares for cash
The dividends on the preferred shares were paid on June 30, 20x2.
A $0.25 per share dividend was paid to common shareholders (date of record was
April 15) on April 30, 20x2.
The tax rate for the year was 40%.
The market value of the common shares averaged $50 for the year.
RRR Companys after-tax return on assets was 12%.

Required a)
Compute basic and diluted earnings per common share for 20x2. Show your
calculations.
b)
Assume that on Nov 31, 20x2, Davis issued a 10% stock dividend to common
shareholders. Calculate the weighted average number of common shares for
purposes of calculation of basic earnings per share.
Page 393
Problem 2
The following data is available for the Culum Company for its 20x4 fiscal year.
Net income for the year ended December 31, 20x4 amounted to $1,650,000.
the Culum company had 1,500,000 common shares outstanding at January 1,

20x4.
The following share issues took place:

March 31
100,000 shares @ $15.67 per share
November 1
200,000 shares @ $17.60 per share
On May 18, the company declared a 10% stock dividend.
the Company has $1,000,000 of convertible, cumulative preferred shares

outstanding. These shares pay a dividend of 6%. The last time a preferred share
dividend was paid was on December 31, 20x1. Each $1,000 par value preferred
share converts into 120 common shares
the company also has $3,000,000 of convertible bonds outstanding. These bonds
were issued at par when the market interest rates were 7%. The bonds pay interest
semi-annually. Each $1,000 bond is convertible into 50 common shares.
there are 60,000 stock options outstanding that expire on July 16, 20x8. The
holder of the stock options can purchase a share of stock for $7.50.
the average market price of the shares for 20x4 was $16.00.
the tax rate is 40%.
Required
Compute the basic and diluted earnings per share.
Page 394
Problem 3
Marion Tess, controller, at Norris Pharmaceutical Industries, a public company, is
currently preparing the calculation for basic and fully diluted earnings per share and the
related disclosure for Norris' external financial statements. Below is selected financial
information for the fiscal year ended June 30, 20x2.
Norris Pharmaceutical Industries

Selected Statement of
Financial Position Information
June 30, 20x2
Long-term debt
Notes payable, 10%
7% convertible bonds payable
10% bonds payable
Total long-term debt
Preferred stock, 8.5% cumulative,
$50 par value, 100,000 shares
authorized, 25,000 shares issued
and outstanding
Common stock, $1 par, 10,000,000
shares authorized. 1,000,000 shares
issued and outstanding
Additional paid-in capital
Retained earnings
$ 1,000,000
5,000,000
6,000,000
$12,000,000
$ 1,250,000
1,000,000
4,000,000
6,000,000
$12,250,000
The following transactions have also occurred at Norris.
Options were granted in 20x0 to purchase 100,000 shares at $15 per share. Although
no options were exercised during 20x2, the average price per common share during
fiscal year 20x2 was $20 per share, while the market price on June 30, 20x2, was $25
per common share.
Each bond was issued at face value. The 7% convertible debenture will convert into
common stock at 50 shares per $1,000 bond. They are exercisable after five years.
The 8.5% preferred stock was issued in 20x0.
There are no preferred dividends in arrears; however, preferred dividends were not
declared in fiscal year 20x2.
Page 395
The 1,000,000 shares of common stock were outstanding for the entire 20x2 fiscal
year.
Net income for fiscal year 20x2 was $1,500,000, and the average income tax rate is
40%.
Required a. For the fiscal year ended June 30, 20x2, calculate Norris Pharmaceutical Industries'
1. basic earnings per share.
2. diluted earnings per share.
b. Describe the appropriate disclosure required for earnings per share for Norris
Pharmaceutical Industries for the fiscal year ended June 30, 20x2.
Problem 4
Perfume Inc. had the following securities outstanding at January 1, 1998:
Preferred shares, $6.00, no par value, cumulative convertible shares;
authorized 500,000 shares; outstanding 200,000 shares
$ 15,000,000
Common shares, no par value; authorized 2,000,000 shares;

outstanding 1,050,000 shares
$ 10,500,000
The preferred shares are convertible into common shares on a one-for-one basis and pay
dividends February 28 and August 31. During 1998, Perfume reported net income of
$14,400,000 and had the following transactions:
June 30
September 30
450,000 common shares (market value $5,400,000) were issued

to acquire a competitor.
90,000 common shares were purchased for $13.00 each and
retired.
The tax rate for 1998 was 40% and the pretax internal rate of return was 12%.
Required
a.
b.
Compute basic earnings per share for 1998.

Compute diluted earnings per share for 1998.
Page 396
Problem 5
Ruby Company was incorporated on January 1, 20x0, with the following authorized
capital structure:
100,000 non-cumulative no par value preferred shares, which pay a $6 dividend,
and 1,000,000 no par value common shares.
In January 20x0, 500,000 common shares were sold for $1 per share, and 10,000 noncumulative preferred shares were sold for $90 each.
On September 30, 20x1, an additional 200,000 common shares were issued at $1 each.
Net income after taxes for 20x0 and 20x1 was $75,000 and $88,000 respectively. No
dividends were declared.
Required a)
b)
Calculate the earnings per share for 20x0 and 20x1.

Calculate the earnings per share assuming the preferred shares are cumulative.
Problem 6
Spray, Inc., had 4 million common shares outstanding on December 31, 20x1. An
additional 1 million common shares were issued on April 1, 20x2, and 500,000 more
shares were issued on July 1, 20x2. On October 1, 20x2, Spray issued 10,000, $1,000
face value, 7 percent convertible bonds. Each bond is convertible into 40 common shares.
No bonds were converted into common shares in 20x2.
Required What is the number of shares to be used in calculating basic EPS and fully diluted EPS,
respectively? Assume that the convertible bonds are dilutive.
Page 397
Problem 7
Davis, Inc., earned $700,000 after taxes in 20x2. Davis began 20x2 with 200,000
common shares outstanding. On May 1, 30,000 new shares were issued and on October
31, 10,000 shares were acquired as treasury shares. On December 1 Davis split its
common shares 2 for 1.
In addition to common shares, Davis had 50,000 $100 par, 8 percent cumulative
nonconvertible preferred shares outstanding during all of 20x2.
Required Calculate Davis' EPS for 20x2. Provide a schedule showing determination of the
weighted average number of common shares used in the EPS calculation.
Page 398
SOLUTIONS
1.
($330,000 60,000) / 300,000 = $0.90
2.
Opening balance
Feb 1 Stock Dividend - 3,000 x 12/12
Mar 1 Issue - 9,000 x 10/12
Jul 1 Issue - 8,000 x 6/12
3.
Weighted average number of common shares:

Outstanding at beginning of year
July 1 conversion: 200 x 20 x 6/12
30,000
3,000
7,500
4,000
$44,500
10,000
2,000
12,000
Basic earnings per share = $35,000 / 12,000

4.
$2.92
Free shares = 90,000 (90,000 x 37 / 50) = 23,400 x 1.1 = 25,740

Weighted average number of CS =
Opening balance
April 1 issue: 120,000 x 9/12
June 1 stock dividend: 390,000 x 10%
300,000
90,000
39,000
429,000
Increase in denominator = 429,000 + 25,740 = 454,740

5.
Basic EPS = $6,000 / 1,000 = $6.00

Increase in numerator $10,000 x 6% x .7 = $420
Increase in denominator = 1,000
Incremental impact = $420/1,000 = $0.42 => Dilutive
Diluted-EPS = ($6,000 + 420) / (1,000 + 1,000) = $3.21
Page 399
Problem 1
a)
Weighted Average # of Common Shares

Common Shares outstanding at beginning of year
1,500,000 150,000
June 1 Issue: 150,000 x 7/12
1,350,000
87,500
1,437,500
Basic EPS = ($4,000,000 540,000) / 1,437,500 = $2.41

Effect of Dilution:
Convertible bonds:
Increase in numerator: $4,000,000 x 9% x .6 = $216,000
Increase in denominator: 4,000 x 30 = 120,000
Incremental impact = $216,000 / 120,000 = $1.80
Preferred Shares: $540,000 / 810,000 = $0.67
Series 1 share options:
Free shares = 125,000 - 125,000 x $45 / 50 = 125,000 112,500 = 12,500
Series 2 share options are out of the money and therefore antidilutive.
Basic EPS
Series 1 share options
Preferred shares
Diluted EPS
Numerator Denominator
$3,460,000
1,437,500
12,500
$3,460,000
1,450,000
540,000
810,000
$4,000,000
2,260,000
EPS
$2.41
2.39
$1.77
Convertible bonds are not included since they would have an antidilutive effect.
b)
Common Shares outstanding at beginning of year

(1,500,000 / 1.1) 150,000
June 1 Issue: 150,000 x 7/12
Nov 31 Stock Dividend: 1,213,636 x 10%
87,500 x 10%
Page 400
1,213,636
87,500
121,364
8,750
1,431,250
Problem 2
Basic EPS Calculations Weighted average number of common shares Shares outstanding at beginning of year
March 31 issue: 100,000 x 9/12
May 18 stock dividend 1,575,000 x 10%
November 1 issue: 200,000 x 2/12
1,500,000
75,000
157,500
33,333
1,765,833
Basic EPS = (1,650,000 60,000) / 1,765,833

= 1,590,000 / 1,765,833 = 0.90
Diluted EPS Calculations Impact of preferred shares: 60,000 / (1,000,000 / 1,000 x 120 x 1.1)
= 60,000 / 132,000 = $0.45
Impact of convertible bonds:
= ($3,000,000 x 7% x .6) / (3,000,000 / 1,000 x 50 x 1.1)
= $126,000 / 165,000
= $0.76
Impact of options: [60,000 (60,000 x $7.50 / 16)] x 1.1
= (60,000 28,125) x 1.1
= 35,063
Order of entry: options, preferred shares, bonds
Basic EPS
Options
Preferred shares
Convertible bonds
Diluted EPS
Page 401
Numerator
Denominator
EPS
$1,590,000
$0.90
1,590,000
60,000
1,650,000
126,000
1,765,833
35,063
1,800,896
132,000
1,932,896
165,000
$1,776,000
2,097,896
$0.85
0.88
0.85
Problem 3
a.
Basic EPS = $1,500,000 - 106,2501 / 1,000,000

=
$1,393,750 / 1,000,000
=
$1.39
1
25,000 shares x $50 x 8.5%
Fully Diluted EPS:

Incremental impact of the exercise of options:
Number of shares assumed purchased:
100,000 x $15 = $1,500,000 / $20 = 75,000
Increase in shares (free shares): 100,000 75,000 = 25,000
Incremental impact of the exercise of bonds:
Increase in income = $5,000,000 x 7% x .6 = $210,000
Increase in shares = $5,000,000/1,000 x 50 = 250,000
Incremental impact = $0.84
Basic EPS
Options
Convertible Bonds
b.
Numerator Denominator
$1,393,750
1,000,000
25,000
1,025,000
$1,393,750
210,000
250,000
1,275,000
1,603,750
EPS
$1.39
$1.36
$1.26
Norris Pharmaceutical Industries should disclose both basic earnings per share
and fully diluted earnings per share on the face of the income Statement for all
periods presented.
Page 402
Problem 4
a.
Weighted average number of common shares

Shares outstanding at the beginning of the year
June 30 Issue: 450,000 x 1/2
September 30 retirement: 90,000 x 3/12
b.
1,050,000
225,000
-22,500
1,252,500
Basic EPS = (14,400,000 - 1,200,000) 1,252,500
$10.54
Diluted EPS: 14,400,000 (1,252,500 + 200,000)
$9.91
Problem 5
a)
Weighted Average number of common shares Balance, beginning of year
Issue: 200,000 x 3/12
Basic EPS: $75,000 / 500,000

$88,000 / 550,000
b)
Basic EPS: ($75,000 - 60,000) / 500,000

($88,000 - 60,000) / 550,000
Page 403
20x1
20x0
500,000
50,000
550,000
500,000
500,000
$0.15
$0.16
$0.03
$0.05
Problem 6
Weighted Average Number of Shares - Basic EPS:
April 1, 20x2: 1,000,000 x 9/12
July 1, 20x2: 500,000 x 6/12
4,000,000
750,000
250,000
5,000,000
Weighted Average Number of Shares Diluted EPS:

Basic EPS Weighted Average number of shares
Add: shares assumed on conversion (400,000 x 3/12)
Number of shares to be used for fully diluted EPS
5,000,000
100,000
5,100,000
Problem 7
Weighted Average Number of Shares - Basic EPS:
May 1, 20x2: 30,000 x 8/12
October 31, 20x2: 10,000 x 2/12
December 1 Stock Split:
(200,000 + 20,000 - 1,667) x 2
200,000
20,000
-1,667
218,333
436,666
Basic EPS = [$700,000 - (50,000 x $100 x 8%)] / 436,666 = $0.69
Page 404
13.
Accounting for Leases
A lease is a contract between a lessor, the owner of the property involved, and the lessee,
the person or entity wishing to use that property in exchange for a certain number of cash
payments.
Prior to 1979, accounting for leases was based simply on the legal form of the
transaction. The existence of a leasing agreement ensured that a leasing transaction would
be regarded as a non-capital transaction (i.e. the asset and the lease liability were kept off
the Statement of Financial Position), regardless of whether in substance, the arrangement
amounted to an outright sale of the asset by the lessor and purchase of the asset by the
lessee. This helped to make leasing a popular alternative to outright purchase. If a
company chose to lease a piece of equipment, its debt-to-equity ratio would generally be
lower than if the asset was purchased on credit.
Starting in 1979, the accounting for leases became a function of the economic substance
of the transaction rather than the form. In essence, it stated that when a leasing
arrangement results in a transfer to the lessee of virtually all of the risks and benefits
associated with ownership of the asset then the arrangement should be treated as a capital
transaction - the sale of an asset by the lessor and the purchase of an asset by the lessee.
A finance lease is defined as a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset. Title may or may not eventually be transferred. (IAS
17.4)
An operating lease is defined as a lease other than a finance lease (IAS 17.4).
Classification of leases
IAS 17.10 provides the following guidance when classifying a lease. The following
situations, individually or in combination, would normally lease to a lease being
classified as a finance lease:
(a)
the lease transfers ownership of the asset to the lessee by the end of the lease
term;
(b)
the lessee has the option to purchase the asset at a price that is expected to be
substantially lower than the fair value at the date the option becomes exercisable
for it to be reasonably certain, at the inception of the lease, that the option will be
exercised (often referred to as a bargain purchase option);
(c)
the lease term is for the major part of the economic life of the asset even if title is
not transferred;
(d)
at the inception of the lease the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset; and
(e)
the leased assets are of such a specialized nature that only the lessee can use them
without major modification.
Page 405
Clearly, if situations (a) or (b) were to occur, the lease would be considered a finance
lease since title to the asset is expected to pass.
Under previous Canadian GAAP, the numerical criteria for item (c) was that if the lease
term was 75% or more of the economic life of the asset, then the lease was deemed to be
a finance lease. The numerical criteria for item (d) was that if the present value of the
minimum lease payments was 90% of more of the fair value of the asset, then the lease
was deemed to be a finance lease. Although, these numerical criteria do not apply under
IFRS, they will likely be used as guidelines for some time to come.
The minimum lease payments are equal to the payments over the lease term that the
lessee is or can be required to make (excludes contingent rent, costs for services and taxes
to be paid by and reimbursed to the lessor6) together with:
any amounts guaranteed by the lessee such as a guaranteed residual value, or
a bargain purchase option.
IAS 17.12 makes it clear that if there are other features that the lease does not transfer
substantially all risks and rewards incidental to ownership, the lease can be classified as
an operating lease. Ultimately, the classification of a lease as a finance lease is subject to
managerial judgment.
At the commencement of the lease term, the lessee recognizes finance leases as assets
and liabilities in the statement of financial position at amounts equal to the fair value of
the leased property or, if lower, the present value of the minimum lease payments, each
determined at the inception of the lease. The discount rate to be used is the interest rate
implicit in the lease, if this is practicable to determine; if not, the lessee's incremental
borrowing rate shall be used. (IAS 17.20).
Depreciation Expense on Leased Assets

If there will be a transfer of ownership either directly of through a bargain purchase
option, then the asset is depreciated over its useful life . If the asset reverts back to the
lessor, then the asset is depreciated over the lease term.
Accounting for bargain purchase options and residual values

With a bargain purchase option (BPO), the lessee obtains legal title to the leased asset at
the end of the lease term and has use of the asset for its entire economic life. Both the
lessee and the lessor include the BPO as part of the minimum lease payments (MLP).
Guaranteed and unguaranteed residual value can only exist when the leased property
returns to the lessor at the end of the lease term. The lessee would completely disregard
6 These are referred to as executory costs.
Page 406
the unguaranteed residual value (URV) in his/her MLP and depreciation computations.
The lessor on the other hand, would treat the URV as part of the calculation of the lease
payment. The lessor is in effect charging less than he would otherwise because he/she is
expecting the leased property to be of some additional value after the lease term has
expired.
Both the lessee and lessor would regard any guaranteed residual value (GRV) as part of
the MLP because, at the end of the lease term the lessee would expect the leased property
to have a value equal to the GRV, he/she would depreciate on that basis. An amount
equal to the GRV should still be in his/her leased property and liability accounts at the
end of the lease term. The lessor would have an outstanding receivable in the amount of
the GRV until the lessee discharged his/her liability.
The following example will include coverage of bargain purchase options and guaranteed
and unguaranteed residual values.
Example 1A: Sampson Ltd. leases equipment to Bowie Ltd. on January 1, 20x0, for five
years. The following information pertains to the lease agreement:
Sampson Ltd. paid $43,438 to acquire the equipment on January 1, 20x0.

Rental payments are $10,000 annually for five years; the first payment is due in
January 1, 20x0, subsequent payments are due on December 31 of each year (i.e. the
second payment is due on December 31, 20x0).
A purchase option to buy the asset for $3,000 exists at the end of the fifth year.
The fair value of the leased equipment is $43,438.
Estimated economic life of the equipment is eight years.
Sampson Ltd. pays executory costs related to the leased property. A fair estimate of
such costs included in the annual rental payments is $400 annually.
Bowie Ltd.'s incremental borrowing rate is 6%. The interest rate implicit in the lease,
known to the lessee, is 8%.
the residual value of the equipment at the end of five years is $8,000; residual value at
the end of eight years is $1,000.
Bowie Ltd. depreciates similar equipment on the straight-line basis.
Bowie Ltd. has a calendar year-end.
Page 407
Classification of lease contract by Bowie Ltd.:

Criteria
1.
The lease transfers ownership of the asset to
the lessee by the end of the lease term.
Assessment
No
2.
The lessee has the option to purchase the asset

at a price that is expected to be substantially
lower than the fair value at the date the option
becomes exercisable for it to be reasonably
certain, at the inception of the lease, that the
option will be exercised.
Yes. Bowie Ltd. can acquire the

equipment for $3,000 at the end
of the lease term when its
estimated fair market value is
$8,000.
3.
The lease term is for the major part of the

economic life of the asset even if title is not
transferred.
No. The lease term of 5 years is

about 63% of the equipment' s
economic life of 8 years.
4.
At the inception of the lease the present value

of the minimum lease payments amounts to at
least substantially all of the fair value of the
leased asset.
Yes - the present value of the

minimum lease payments is equal
to 100% of the fair value of the
asset. See schedule below.
5.
The leased assets are of such a specialized

nature that only the lessee can use them
Unknown.
The present value of annual lease payments and bargain purchase option set your
financial calculator to assume that the cash flows occur at the beginning of the year
(BGN mode). Once you have completed the calculation, set it back to normal mode.
[BGN]
Enter
Compute
N
5
I/Y
8
PV
PMT
9600
FV
3000
X=
$43,438
Conclusion: due to the existence of the bargain purchase option, this is a finance lease.
Page 408
The interest expense and liability reduction schedule is as follows:
Date
Jan 2, 20x0
Jan 2, 20x0
Dec 31, 20x0
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
Dec 31, 20x4
Payment
Interest
Principal
Reduction
$9,600
9,600
9,600
9,600
9,600
3,000
2,707
2,156
1,560
917
222
$9,600
6,893
7,444
8,040
8,683
2,778
Balance
$43,438
33,838
26,945
19,501
11,461
2,778
0
Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows:
Jan 1, 20x0
Dec 31, 20x0
Jan 1, 20x1
Dec 31, 20x1
Page 409
Equipment under finance lease

Obligation under finance lease
$43,438
$43,438
Executory costs
Cash
400
9,600
Prepaid executory costs

Interest expense
Cash
400
2,707
6,893
($43,438 - 1,000) / 8
5,305
Executory Costs
Prepaid Executory Costs
10,000
10,000
5,305
400
400

Interest expense
Cash
400
2,156
7,444
($43,438 - 1,000) / 8
5,305
10,000
5,305
The December 31, 20x4, journal entries follow:

Interest expense
Cash
222
2,778
3,000
Equipment
43,438
43,438
Example 1B - Assume the same facts as in Example 1A, with the following exception:
there is no option to purchase the asset at the end of the 5th year. The equipment reverts
back to the lessor at the end of the 5th year. The lessee guarantees the residual value of
the asset ($8,000). Annual lease payments are $9,211 (including the $400 executory
costs).
Criteria
1.
Assessment
No
2.
The lessee has the option to purchase the asset No.

3.

transferred.

4.

leased asset.

5.

Unknown.
Page 410
[BGN]
Enter
Compute
N
5
I/Y
8
PV
PMT
8,811
FV
8,000
X=
$43,438
Conclusion: due to the existence of the bargain purchase option, this is a finance lease.
Principal
Date
Payment
Interest
Reduction
Jan 2, 20x0
Jan 2, 20x0
$8,811
$8,811
2,770
6,041
Dec 31, 20x0
8,811
Dec 31, 20x1
8,811
2,287
6,524
Dec 31, 20x2
8,811
1,765
7,046
1,201
7,610
Dec 31, 20x3
8,811
Dec 31, 20x4
594
Balance
$43,438
34,627
28,586
22,062
15,016
7,406
8,000
Jan 1, 20x0
Dec 31, 20x0
Jan 1, 20x1
Dec 31, 20x1
Page 411

$43,438
$43,438
Executory costs
Cash
400
8,811

Interest expense
Cash
400
2,770
6,041
($43,438 - 8,000) / 5
7,088
Executory Costs
9,211
9,241
7,088
400
400

Interest expense
Cash
400
2,287
6,524
7,088
9,241
7,088
The December 31, 20x4, journal entries follow:

Interest expense
594
35,438
8,000
594
43,438
If the appraisal value of the equipment works out to less than $8,000, then the lessee will
have to make up the difference. This difference will simply be expensed at the time it is
known.
The differences between example 1A (Bargain Purchase Option) and example 1B
(guaranteed residual value) can be summarized as follows:
in example 1B, the asset reverts back to the lessor at the end of the lease term,
the guaranteed residual value is included as part of the minimum lease payments,
the asset is depreciated over 5 years down to its residual value of $8,000
at the end of the lease term, just before the asset reverts to the lessor, the lessee
has an net asset balance of $8,000 and an obligation under capital lease of $8,000.
These net out against the other when the asset is removed from the books.
Page 412
Example 1C - Assume the same facts as in Example 1A, with the following exception:
there is no option to purchase the asset at the end of the 5th year. The equipment reverts
back to the lessor at the end of the 5th year. The lessee does not guarantee the residual
value of the asset ($8,000). Annual lease payments are $9,211 (including the $400
executory costs).
Criteria
1.
Assessment
No
2.

3.

transferred.

4.

leased asset.

5.

Unknown.
[BGN]
Enter
Compute
N
5
I/Y
8
PV
PMT
8,811
FV
X=
$37,994
Conclusion: the most likely conclusion would be that this lease is an operating lease,
given that the lease term is 63% of the economic life and that the present value of the
minimum lease payments is equal to 87% of the fair value of the asset. The classification
of this lease would be based on managerial judgment and may consider other factors.
Page 413
Two solutions will be presented: the first assuming that the lease classification is a
finance lease and the second on the assumption that it is an operating lease.
Finance Lease Assumption Per IAS 17.20, the lease would be recorded as an asset and liability of $37,994.
Date
Jan 2, 20x0
Jan 2, 20x0
Dec 31, 20x0
Dec 31, 20x1
Dec 31, 20x2
Dec 31, 20x3
Payment
Interest
Principal
Reduction
$8,811
8,811
8,811
8,811
8,811
2,335
1,817
1,257
653
$8,811
6,476
6,994
7,554
8,158
Balance
$37,994
29,183
22,707
15,712
8,158
0
Jan 1, 20x0
Dec 31, 20x0
Jan 1, 20x1
Dec 31, 20x1
Page 414

$37,994
$37,994
Executory costs
Cash
400
8,811

Interest expense
Cash
400
2,335
6,476
$37,994 / 5
7,599
Executory Costs
Interest expense
Cash
9,211
9,211
7,599
400
400
400
1,817
6,994
9,211
7,599
7,599
The differences between example 1B (guaranteed residual value) and 1C (unguaranteed

residual value) can be summarized as follows:
the unguaranteed residual value is included as part of the minimum lease

payments,
the lessor will likely include the residual value as part of the calculation of the
lease payment,
the asset is depreciated over 5 years down to zero.
Operating Lease Assumption

Jan 1, 20x0
Dec 31, 20x0
Jan 1, 20x1
Dec 31, 20x0
Prepaid lease payment

Cash
9,211
Lease expense
9,211

Cash
9,211
Lease expense
9,211
9,211
9,211
9,211
9,211
Leases of Land and Buildings

A characteristic of land is that it normally has an indefinite economic life. If title is not
expected to pass to the lessee by the end of the lease term, the lessee normally does not
receive substantially all of the risks and rewards incidental to ownership, in which case
the lease of land will be an operating lease (IAS 17.14). An exception to this is if the
value of the land relative to the total value of the lease is immaterial, in which case the
land can be combined with the value of the building (IAS 17.17).
This means that a lease for both land and building would have to be considered separately
for purpose of lease classification. The minimum lease payments would be allocated to
land and building elements based on the relative fair values of the leasehold interests in
the land element and buildings element of the lease at the inception of the lease. If the
lease payments cannot be allocated reliably between these two elements, the entire lease
is classified as a finance lease. (IAS 17.16)
Page 415
Lessor Accounting
The criteria for determining whether or not a lease is a finance lease are the same as those
used by the lessee. Fundamentally, lessor accounting is a mirror image of lessee
accounting, in that:
the lessor recognizes a receivable at an amount equal to the net investment in the
lease (IAS 17.36); and
the lessor recognizes finance income based on a pattern reflecting a constant

periodic rate of return on the lessor's net investment in the finance lease (IAS
17.39).
Note that, unlike previous Canadian GAAP, IAS 17 does not distinguish between a
sales-type and direct financing lease for lessor accounting.
The lessor will calculate the lease payments as follows:
they will want to recover the initial cost or fair value of the asset being leased, and
they will consider the bargain purchase option, the guaranteed or unguaranteed
residual values as a future cash inflow.
Example - the fair value of the asset leased is $400,000. The lease term is 6 years and
there is a bargain purchase option to purchase the asset at the end of the lease term of
$20,000. Assuming that the first payment is due at the signing of the lease agreement and
that the lessor requires a 7% return, the lease payment will be $75,815.33:
[BGN]
N=6
I/Y = 7%
Compute PMT = $75,815.33
PV = -400,000
FV = 20,000
Sale and Leaseback transactions

A sale and leaseback transaction involves the sale of property with the seller concurrently
leasing the same property back to the seller. The same criteria outlined above are used to
determine whether the lease is classified as an operating or finance lease.
One feature of sale and leaseback transactions is that the lessee may show a gain or loss
on sale of the property to the lessor. If the sale and leaseback transaction results in a
finance lease, any gain or loss on the transaction shall be deferred and amortized over the
lease term (IAS 17.59).
If the sale and leaseback transaction results in an operating lease, and it is clear that the
transaction is established at fair value, any gain or loss shall be recognized immediately.
If the sales price is below fair value, any gain or loss are recognized immediately except
that, if the loss is compensated for by future lease payments at below market price, it
shall be deferred and amortized in proportion to the lease payments over the period for
which the asset is expected to be used. If the sales price is above fair value, the excess
over fair value shall be deferred and amortized over the period for which the asset is
expected to be used. (IAS 17.61)
Page 416

1.
On December 30, 20x1, Rafferty Corp. leased equipment under a finance lease.
Annual lease payments of $20,000 are due December 31 for 10 years. The
equipment's useful life is 10 years, and the interest rate implicit in the lease is
10%. The finance lease obligation was recorded on December 30, 20x1, at
$135,000, and the first lease payment was made on that date. What amount
should Rafferty include in current liabilities for this capital lease in its December
31, 20x1, balance sheet?
a.
$ 6,500
b.
$ 8,500
c.
$11,500
d.
$20,000
2.
On December 29, 20x1, Action Corp. signed a 7-year capital lease for an airplane
to transport its sports team around the country. The airplane's fair value was
$841,500. Action made the first annual lease payment of $153,000 on December
29, 20x1. Action's incremental borrowing rate was 12 %, and the interest rate
implicit in the lease, which was known by Action, was 9%.
What amount should Action report as capital lease liability in its December 31,
20x1, balance sheet?
a.
$841,500
b.
$780,300
c.
$688,500
d.
$627,300
3.
Hammer Company leased equipment from the King Company on July 1, 20x8, for
an eight-year period expiring June 30, 20x16. Equal annual payments under the
lease are $400,000 and are due on July 1 of each year. The first payment was
made on July 1, 20x8. The rate of interest contemplated by Hammer and King is
8%. The cash selling price of the equipment is $2,482,500 and the cost of the
equipment on King's accounting records was $2.2 million. Assuming that the
lease is appropriately recorded as a sale for accounting purposes by King, what is
the amount of profit on the sale and the interest income that King would record
for the year ended December 31, 20x8?
a.
$0 and $0.
b.
$0 and $83,300.
c.
$282,500 and $83,300.
d.
$282,500 and $99,300.
Page 417
Problem 1
JKL Company manufactures and distributes heavy equipment. One of its popular lathes
costs $67,500 to make and sells for $100,000. On January 1, 20x8, MNO agrees to lease
a lathe for 4 years from JKL. The lathe is expected to have a useful life of 6 years and no
residual value at that time. However, it is expected to have a residual value of $9,000 at
the end of the lease at which time MNO has the option to purchase it for $3,000. The first
payment is due on January 1, 20x8. The rate implicit in the lease, known to MNO, is 12%
while MNO's incremental borrowing rate is 14%.
Required
a.
b.
c.
Compute the lease payment.

Prepare all 20x8 journal entries for MNO.
Prepare all January 1, 20x8, journal entries for JKL.
Problem 2
The McGrath Corporation entered into a 5 year lease agreement for equipment on
December 31, 20x3. Data relative to this transaction is as follows:
Fair value of equipment
Economic life of equipment
Residual value at end of economic life
$250,000
10 years
20,000
For each of the independent situations below, prepare all journal entries relative to this
lease for the year 20x4 and 20x5.
(a)
(b)
(c)
(d)
Page 418
The rate implicit in the lease is 8%. The lease agreement includes an option to
purchase the equipment at the end of the lease term for $10,000. The fair
value of the equipment at the end of the lease term is estimated to be $60,000.
The rate implicit in the lease is 8%. The lease agreement requires McGrath to
return the equipment at the end of the lease term and to guarantee the residual
value of $60,000.
The rate implicit in the lease is 8%. The lease agreement requires McGrath to
return the equipment at the end of the lease term. The residual value of
$60,000 was considered in calculating the lease payments by the lessor but is
unguaranteed.
The rate implicit in the lease is not known, nor is the fair value of the
equipment. The lease term is for 8 years. McGraths incremental borrowing
rate is 7% and the annual lease payment is $42,000.
Problem 3
On January 3, 20x5, Thermotech Inc. leased a specialized piece of diagnostic equipment
to Eastview Medical Clinic. Details are as follows:
Cost to manufacture to Thermotech
Normal sales price
Lease term
Economic Life
Residual value at the end of the lease term
Residual value at end of useful life
Lease payment (1st payment payable January 3, 20x5)
Purchase option (exercisable at end of year 8)
Incremental borrowing rate of Eastview
Rate implicit in the lease
$ 80,000
$100,000
8 years
10 years
$20,000
$ 500
$16,881
$ 2,000
12%
10%
Assume that Thermotech has reasonable assurance that Eastview will make the remaining
lease payments. All costs of operating the leased equipment are borne by Eastview.
Assume that subsequent payments are due on December 31st of every year.
Required.
Prepare the journal entries and disclosure for Thermotech Inc. and Eastview Medical
Clinic for 20x5 and 20x6. Assume that both companies have a December 31 year-end.
Problem 4
The Johnson Company leased equipment from the Ike Company on October 1, 20x2. For
accounting purposes the lease is appropriately recorded as a finance lease. The lease is
for an eight-year period that expires September 30, 20x10. Equal annual payments under
the lease are $600,000 and are due on October 1 of each year. The first payment was
made on October 1, 20x2. The cost of the equipment on Ike's accounting records was $3
million. The equipment has an estimated useful life of eight years with no residual value
expected. Johnson uses straight-line depreciation. The implicit rate of interest in the lease
is 10 percent.
Required 1. What expense should Johnson record for the year ended December 31, 20x2?
2. What income or loss before income taxes should Ike record for the year ended
December 31, 20x2?
Page 419
Problem 5
At the beginning of 20x2, Agudelo entered into a 20-year, non-cancellable, long-term
lease agreement for a truck terminal that had been constructed on Agudelos land. The
terminal has a useful life of 40 years, and Agudelo can acquire title to the facility at the
end of the lease term by paying the lessor $1. The annual lease payments over the lease
term, payable at the beginning of the year, are as follows:
First 10 years
Second 10 years
$1,000,000 per year

300,000 per year
Agudelo also must make annual payments to the lessor of $75,000 for property taxes and
$125,000 for insurance. The implicit rate in the lease (known to Agudelo) was 6%. On
January 1, 20x2, Agudelo made the first payment of $1.2 million to the lessor.
Required
a.
b.
Discuss how Agudelo should classify the truck terminal lease.

Prepare all necessary entries for Agudelo for the year 20x2.
Problem 6
On December 31, 20x3, Cooray Inc. sold a building with a net book value of $1,800,000
to Gardner Industries for $1,757,346. Cooray immediately entered into a leasing
agreement whereby Cooray would lease the building back for an annual payment of
$260,000. The term of the lease is 10 years, the expected remaining useful life of the
building. The first annual lease payment is to be made immediately, and future payments
will be made on December 31 of each succeeding year. Gardners implicit interest rate is
10%. The building has a residual value of $0 and the Cooray Company amortizes its
buildings using the straight-line method.
Required 1.
2.
Prepare the journal entries that should be made by Cooray on December 31, 20x3,
relating to this sale and leaseback transaction.
Prepare the journal entries that should be made by Cooray for the year ended
December 31, 20x4, relating to this sale and leaseback transaction.
Page 420
Problem 7
On November 1, 20x0, the president of Pepper Ltd. summoned you, the controller, to an
emergency meeting of the officers of the company.
President:
I'm sorry I had to call this meeting on short notice but we have a
problem. The bank has turned down our loan request for $600,000.
V.P. Production:
Is that the $600,000 for my equipment?
President:
Yes.
V.P. Production:
I thought that might happen, so I took the liberty of contacting White

Star Leasing. They are prepared to offer us the same equipment on a
lease basis for seven years, the same period that we had requested for
the bank loan.
Treasurer:
Why did the bank turn us down?
President:
I don't really know. We were willing to pay 14% and that's high.
V.P. Production:
We don't need the bank loan. White Star's lease will carry only a 10%
interest rate and the bottom line is we won't have to show anything
concerning the lease on our financial statements.
President:
I would want to see all calculations and explanations supporting your

statement. I'm sure the lease would have to appear on the Statement
of Financial Position.
Treasurer:
What will this lease cost?
V.P. Production:
The annual payments will be $98,595, due on January 1st of each

year.
Treasurer:
Who will own the equipment at the end of the lease term?
V.P. Production:
White Star retains ownership.
President:
Can we add an option-to-purchase clause?
V.P. Production:
I asked that, but White Star said it's not their policy. Who cares
anyway? I know the equipment is supposed to have a useful life of
ten years, but I don't think it will be in any great shape after seven.
Treasurer:
You said that the installments start January 1, 20x1. When does the
lease term begin?
Page 421
V.P. Production:
That same day.
Treasurer:
I don't understand why the leasing company can charge us only 10%
when the bank won't give us the loan at 14%.
President:
Before we adjourn today, there is one other thing to consider. In

terms of the effects on our income statement and Statement of
Financial Position, would the lease or the bank loan be better?
The following day the president presented you with a copy of the minutes of the meeting
and asked you to write a report addressing the questions and concerns raised at the
meeting.
Required As the controller of Pepper Ltd., write the report to the president.
Problem 8
Aaron, Inc., was incorporated in 20x1 to operate as a computer software service firm with
a fiscal year ending August 31. Aaron's primary product is a sophisticated on-line
inventory control system; its customers pay a fixed fee plus a charge for using the system.
Aaron has leased a large, BIG-I computer system from the manufacturer. The lease calls
for an annual rental payment of $700,000 for the 12 year lease term. The estimated useful
life of the computer is 15 years. The computer is installed on August 31.
Each scheduled annual payment includes $120,000 for full-service maintenance on the
computer to be performed by the manufacturer. All rentals are payable on August 1 of
each year beginning with August 31, 20x2. The lease is noncancellable for its 12-year
term, and it is secured only by the manufacturer's chattel lien on the BIG-1 system. On
any anniversary date of the lease after August 20x7, Aaron can purchase the BIG-1
system from the manufacturer at the then current fair market value of the computer.
This lease is to be accounted for as a finance lease by Aaron, and it will be depreciated by
the straight-line method with no expected residual value. Borrowed funds for this type of
transaction would cost Aaron 10 percent per year.
Required a.
b.
Why is the lease a finance lease to Aaron?

Prepare all entries Aaron should have made in its accounting records from August
31, 20x2 and August 31, 20x3.
Page 422
Solutions
1.
Lease payment, Dec 31, 20x2

Interest: ($135,000 - 20,000) x 10%
Principal reduction = current portion
2.
$841,500 - 153,000
$688,500
3.
Profit: $2,482,500 - 2,200,000

Interest: ($2,482,500 - 400,000) x 8% x 1/2
$282,500
83,300
Page 423
$20,000
11,500
$8,500
Problem 1
a.
Calculation of lease payments [BGN]

Enter
Compute
b.
I/Y
12
PV
-100000
PMT
FV
3000
X=
$28,835
Lease is a finance lease due to the presence of bargain purchase option.

Jan 1, x8
Dec 31, x8
Dec 31, x8
c.
N
4
Jan 1, x8
Asset under finance lease

Lease liability (100,000 - 28,836)
Cash
Interest payable
(100,000 6)
Lease receivable
Cash
Revenue
Cost of sales
Inventory
Dec 31, x8
Page 424
Interest receivable
Interest revenue
$100,000
$71,165
28,835
8,540
8,540
16,667
16,667
$71,165
28,835
$100,000
67,500
67,500
8,540
8,540
Problem 2
(a)
This is a finance lease due to the presence of the bargain purchase option. It is
assumed that the lessee will exercise the bargain purchase option and keep the asset
for its economic life.
Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -10,000
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Equipment under Finance Lease

Cash
Lease Obligation
$56,398
193,602

Lease obligation
Cash
15,488
40,910
($250,000 20,000) / 10
23,000
Interest expense
($193,602 40,910) x 8%
Lease obligation
Cash
Page 425
$250,000
56,398
23,000
12,215
44,183
56,398
23,000
23,000
(b)
This is a finance lease since the existence of the guaranteed residual value makes
the present value of the minimum lease payments equal the fair value of the
equipment.
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Equipment under Financel Lease

Cash
Lease Obligation
$250,000

Lease obligation
Cash
16,120
32,386
($250,000 60,000) / 5
38,000
Interest expense
($201,494 32,386) x 8%
Lease obligation
Cash
Page 426
$48,506
201,494
48,506
38,000
13,529
34,977
48,506
38,000
38,000
(c)

Present value of lease payments: N = 5, I = 8, PMT = 48,506
Solve for PV = 209,164
PV as a % of the fair value of equipment = $209,164 / 250,000 = 84%
Lease term as a % of economic life = 5/10 = 50%
This lease should be classified as an operating lease since it does not transfer the
rights, rewards and risks of ownership to McGrath.
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Page 427
Prepaid rent
Cash
$48,506
Rent expense
Cash
48,506
Rent expense
Cash
48,506
$48,506
48,506
48,506
(d)
PV of minimum lease payments: [BGN] N = 8, I = 7, PMT = 42,000

Solve for PV = $268,350
This one is a little trickier. The lease term is 80% of the economic life of the asset
which is an indicator of a finance lease, however we cannot compare the present
value of the minimum lease payments to the fair value of the equipment since the
latter is unknown. It would be up to managerial judgment to determine whether the
present value of the minimum lease payments covers a substantial portion of the
fair value of the equipment. The fact that the lease term covers 80% of the
economic life of the asset is significant and therefore, we will classify this lease as a
finance lease.
Dec 31, 20x3
Dec 31, 20x4
Dec 31, 20x5
Equipment under Finance Lease

Cash
Lease Obligation
$42,000
226,350

Lease obligation
Cash
15,844
26,156
$268,350 / 8
33,544
Interest expense
($226,350 26,156) x 7%
Lease obligation
Cash
Page 428
$268,350
42,000
33,544
14,014
27,986
42,000
33,544
33,544
Problem 3
Lease Classification
Criteria
Assessment
1.

No
2.
The lessee has the option to purchase the asset Yes. Purchase option is $2,000
when equipment is estimated to
lower than the fair value at the date the option have a residual value of $20,000
3.

transferred.
Yes. The lease term is about 80%

of the equipment' s economic life.
4.

leased asset.
Yes. The present value of the

property. See schedule below.
5.

Unknown.
[BGN]
Enter
Compute
N
8
I/Y
10
PV
PMT
16881
FV
2000
X=
$99,998
Therefore, lease is a finance lease from the lessee's point of view
Page 429
Journal Entries - Lessee

Jan 1, 20x5
Dec 31, 20x5
Dec 31, 20x6
Asset Under Finance Lease

Cash
Finance Lease Obligation
$100,000
$16,881
83,119
Interest Expense (83,119 x 10%)

Cash
8,312
8,569
(100,000 - 500 ) 10 years
9,950
Interest Expense (83,119 - 8,569) x 10%

Cash
7,455
9,426
16,881
9,950
16,881
Depreciation entry same as for 20x5
Journal Entries - Lessor

Jan 1, 20x5
Dec 31, 20x5
Dec 31, 20x6
Page 430
Lease receivable
Cash
Sales
$83,119
16,881
$100,000
Cost of goods sold

Finished Goods Inventory
80,000
Cash
Lease Receivable
Interest Revenue
16,881
Cash
Lease Receivable
Interest Revenue
16,881
80,000
8,569
8,312
9,426
7,455
Problem 4
1.
Depreciation [$3,521,040 (Schedule 1) / 8 x 3/12]

Interest expense (Schedule 2)
2.
Profit on sale:
Sales price (Schedule 1)
Cost of equipment
$110,033
73,026
$183,059
$3,521,051
(3,000,000)
$521,051
73,026
$594,066
Finance income (Schedule 2)
Schedule 1
[BGN]
Enter
Compute
N
8
I/Y
10
PV
PMT
600000
FV
X=
$3,521,051
Schedule 2
Calculation of Interest
Purchase price of equipment
Payment made on October 1, 20x2
Interest rate
Interest expense (October 1, 20x2 to October 1, 20x3)
Interest expense applicable to 20x2 (3/12 months)
Page 431
$3,521,051
(600,000)
$2,921,051
x 10%
$292,105
x 25%
$73,026
Problem 5
a.
Criteria
Assessment
1.

No
2.
The lessee has the option to purchase the asset Yes.

3.

transferred.
No. The lease term is about 75%

4.

leased asset.
Unknown since we do not know

the FMV of the property
5.

Unknown.
Lease is a finance lease due to the bargain purchase option.

b.
PV of the first 10 years of payments:

[BGN]
Enter
Compute
N
10
I/Y
6
PV
PMT
1000000
FV
X=
$7,801,692
PV of the last 10 years of payments (remember to take your calculator off the
BEGIN mode:
Enter
Compute
Page 432
N
10
I/Y
6
PV
PMT
300000
FV
X=
$2,208,026
This is a present value at t=9, so we need to bring it back to t=0:
Enter
Compute
N
9
I/Y
6
PV
PMT
FV
2208026
X=
$1,306,927
Total PV of minimum lease payments: $7,801,692 + 1,306,927 = $9,108,619

Jan 1, x2
Jan 1, x2
Terminal under finance lease

Lease liability
Lease liability
Property taxes (or prepaid)
Insurance (or prepaid)
Cash
$9,108,619
$9,108,619
1,000,000
75,000
125,000
$1,200,000
Dec 31, x2 Interest expense

Interest payable
(9,108,619 1,000,000) x 6% = 486,518
486,517
Dec 31, x2 Depreciation expense

$9,108,619 / 40 years
227,715
486,517
227,715
Problem 6
1.
Dec 31, 20x3
Building under Finance Lease

Deferred loss on sale-leaseback
Building
Cash ($1,757,346 260,000)
Lease obligation
2.
Dec 31, 20x4
$1,800,000
1,497,346
1,497,346

Lease obligation
Cash
149,735
110,265
$1,757,346 / 10
175,735
Deferred loss on sale-leaseback
$42,654 / 10
Page 433
$1,757,346
42,654
260,000
175,735
4,265
4,265
Problem 7
Report to the President
Date:
November 2, 20x0
From:
CMA Student, Controller
Regarding:
Issues raised at the meeting of November 1, 20x0
Whether or not the lease must be shown on the Statement of Financial Position depends
on the kind of lease it is deemed to be. A lease must be capitalized based on managerial
judgment based on the following criteria; otherwise, it may be accounted for as an
operating lease.
Criteria
1.
Assessment
No
2.

3.

transferred.

equal to 70% of the equipment' s
4.

leased asset.

5.

Unknown.
Enter
Compute
Page 434
N
7
I/Y
10
PV
PMT
98595
FV
X=
$528,002
The lease is therefore an operating lease and requires only the following journal entry
annually:
Lease rental expense
Cash
$98,595
$98,595
Since the lease is not a finance lease, neither the assets nor the liabilities of Pepper Ltd.
are affected. It should be noted that had the company been able to secure the bank loan to
buy the equipment, both long-term assets and liabilities would increase by $600,000. This
would place the company in a more leveraged financial position than it is in at the
moment which will have a detrimental effect on the company's ability to incur additional
debt financing.
Pepper Ltd. received the relatively low 10% rate of interest from White Star because the
financing terms of the lease may have been sufficient to provide an adequate profit to the
lessor.
From an earnings point of view, the following shows that the lease option would be the
more favorable of the two options discussed:
Operating Lease
Expected before interest and lease installment
(assumed)
Depreciation expense ($600,000/10)
Interest expense ($600,000 x .14)
Lease rental cost
Earnings before taxes
$4,680,000
( 98,595)
$4,581405
Bank Loan
$4,680,000
(60,000)
(84,000)
$4,536,000
Conclusion The above shows that Pepper Ltd. need not be concerned that the bank turned down its
loan request. The lease option would afford a cleaner Statement of Financial Position
presentation notwithstanding the fact that a long-term liability exists, assuming that the
lease is an irrevocable one. In addition, the lease option would help to improve the
company's cash flow situation.
Page 435
Problem 8
a.
Criteria
Assessment
1.

No
2.

3.

transferred.
Yes. The lease term is about 80%

4.

leased asset.
Unknown since we do not know

the FMV of the property.
5.

Unknown.
Lease is a finance lease since the lease term is 80% of the equipment's economic
life.
b.
[BGN] N = 12, I = 10, PMT = $700,000 -120,000 = $580,000

PV = $4,347,135
Aug 31, x2
Aug 31, x3
Page 436
Computer under finance lease

Prepaid maintenance
Cash
Lease obligation
$4,347,135
120,000
$700,000
3,767,135
Maintenance expense
Lease obligation
Cash
120,000
376,714
203,286
Depreciation expense ($4,347,135 / 12)

362,261
780,000
362,261
14.
Accounting for Non-Profit Organizations
Note that there are no IFRS standards covering accounting for non-profit organizations.
The material in this chapter is based on current CICA handbook pronouncements.
Differences and similarities of not-for-profit organizations with business enterprises.

The following table summarizes the major differences:
Factors
Business Enterprises
Not-for-Profit Enterprises
Ownership
Private or share ownership

that is transferable.
No specific individual ownership

and therefore no transferable
ownership interests.
Organization
Objectives
Profit Maximization (an over

simplification)
Usually some form of service

function. In many not-for-profit
organizations, the objectives are
specific and tend to make the
organizations less flexible than
businesses.
Board of Directors
Elected by shareholders.
Usually the board is elected by

members. In cases where there is
a large amount of government
financing, a certain percentage of
the board may be appointed by the
specific government. If an
organization has a closed
membership, the board can
basically elect itself and is selfperpetuating. The make-up of the
board impacts on user needs and
therefore the type of financial
reporting required.
Major Source of
Funds
Equity and debt. In an

ongoing sense, the
organization funds itself.
Fees, grants, donations.
Page 437
Cost Control and

General
Expenditures
The profit motive provides a

measurement of the effectiveness of cost controls.
Since there is no bottom line, and

the provision of some specific
service will probably seem to
require more funds than are
available, cost control and
expenditure control are very
serious issues in accounting for
not-for-profit organizations. The
analysis of what is needed and
how efficiently and effectively
funds are used is extremely
subjective.
Need to segregate
funds
Not generally an issue.

Usually this can be done by
management discretion.
Certain government grants
may require funds to be used
for specific purposes;
therefore, these funds need to
be tracked separately.
Not-for-profit organizations may

have a number of restrictions on
sources of funds and therefore
need to account for various funds
individually.
A brief summary of the above table can be stated in two words: profit and nonprofit. The
profit objective has led to widely held transferable ownership. It makes the operations of
the organization flexible in that resources can be moved from one industry to another as
long as the move has profit potential. Profit, the basic measurement of success, has a
built-in incentive to make expenditures that will generate revenue and has, relatively
speaking, automatic cost control. Nonprofit organizations are usually set up for specific
purposes and, although ownership cannot be transferred, members tend to perpetuate the
organization because of their interest in the specific purpose - e.g., Church, Art Gallery,
etc. Except for fee-for-service organizations, revenues are not generated by resource
expenditures - expenditures are limited by revenues and measurement of success, or what
is optimal, tends to be difficult. Because sources of funds often have restrictions,
accounting records need to be segregated by type of fund.
Both business and not-for-profit organizations should be run effectively and efficiently.
Both have goals or objectives; both wish to be productive in the sense of achieving these
goals with a minimum of input. The measurement issue involved is a relatively easy one
for business organizations - net income is the success indicator. Measuring the success
of not-for-profit organizations has varying degrees of difficulty depending on the nature
of the organization. Fee-for-service organizations are very similar to business
organizations. Service organizations which depend almost exclusively on grants and
donations are on the opposite end of the continuum.
Page 438
Objectives of financial reporting

The basic objective of financial reporting for both business and not-for-profit
organizations is to provide information that is useful for decision making. Who are the
users of these statements? The following table lists some of the users for business and
not-for-profit organizations, and from the list, it is apparent that there is a strong overlap
in users and the types of information they would require.
The types of information are:
a)
b)
c)
performance evaluation
stewardship
cash flow predictions
Business Users
Not-for-Profit Users
managers
shareholders
creditors
employees
investors in general
governments
general public
managers
members/directors
creditors
employees
donors
governments
general public
The relative importance of each type of information would depend on the nature of the
organization. Not-for-profit organizations have tended to stress the stewardship function
because members/donors are concerned with how the money has been spent and because
it involves relatively easier measurements. However, this may not provide the most
useful information.
Given similar user groups, the same principles of relevance, materiality, etc. should apply
to reporting of business and not-for-profit organizations.
The following table summarizes how financial statements relate to required information
for both business and not-for-profit organizations.
Page 439
Type of Information
Business Organizations
Not-for-Profit Organizations
Performance Evaluation
Income statements; profit Statements don't really measure

can be compared to other this; they can show a deficit or
firms in the same industry. surplus but generating income
dollars is not the primary
function.
Stewardship
Income statement,
Statement of Financial
Position, etc.
Statements can show if the

organization stayed within
budget and can report on the use
and segregation of funds.
Basically, this is seen by many
users and preparers as the
primary function of statements
for the not-for-profit
organizations and explains the
lack of allocations.
Cash Flow
Statements and external

assessments.
Statements can indicate the

sources of funds and the
organization's expenditures, but
external factors which predict
future sources and liquidity are
of major importance.
Non-profit Organizations defined

A non-profit organization is defined as an entity, normally without transferable
ownership interests, organized and operated exclusively for social, educational,
professional, religious, health, charitable or any other not-for-profit purpose. A nonprofit's members and contributors do not receive any financial return directly from the
organization.
Therefore, there are three essential characteristics to a non-profit organization:
no transferable ownership interest,
they are operated exclusively for non-profit purposes, and
resource providers do not stand to benefit because of their status as resource
providers.
This definition is important, because the accounting requirements for non-profit
organizations will not apply if the organization has not met all of the criteria.
Page 440
The statements normally required for financial reporting are:

Statement of Financial Position (in the for-profit world: Statement of Financial
Position)
Statement of Operations (in the for-profit world: income statement)
Statement of Changes in Net Assets (in the for-profit world: statement of changes
in Retained Earnings)
All revenues and expenditures should be shown at their gross amounts. For example, a
charitable organization that conducts a weekly bingo often pays out all prizes and
expenses of running the bingo out of receipts and deposits and discloses the remainder as
net bingo revenues. Such an organization would have to disclose the gross bingo receipts
and related expenses.
The notes to the financial statements have to provide a clear and concise description of
the non-profit's purpose, its intended community of service, its status under income tax
legislation and its legal form.
Fund Accounting
In a simple not-for-profit organization, there might be a single service function and a
single source of funds. Accounting for such an organization would be fairly
straightforward. The organization would simply keep track of a single set of expenditures
to relate to its source of funds. However, many not-for-profit organizations have various
sources and uses of funds which require separate tracking because of restrictions - donors
specify uses, or there are legal requirements; or simply because specific funds are raised
for specific purposes and stewardship requires tracking these particular sources and uses.
A brief review of common types of funds and their purposes follows:
Operating funds - sources and uses of funds to conduct the organization's day-today functions.
Self-sustaining funds - sources and uses of a revenue-generating activity in an
organization such as the sale of prints in an art gallery.
Special funds - sources and uses of funds for a special project or event such as a
benefit concert given by a local symphony or a survey carried on by a health
service organization to assess local needs.
Trust funds - accounting for funds held for other organizations or groups; the
benefit does not go to the holding organization itself, but is a service provided to
others.
Page 441
Endowed funds - these funds are provided mainly so that only the investment
income from them is available to the organization. Such funds may be established
to provide scholarships or operating funds to a museum.
Capital funds - as the name implies, these funds are segregated for asset purchase
or improvement.
Each type of fund requires its own record keeping and its own statements. This results in
some rather complex accounting statements, but serves to meet the stewardship
requirements of nonprofit organizations. It should be noted that a Statement of Financial
Position must be prepared for each segregated fund. Many of the items contained on the
fund Statement of Financial Position are similar to those found on a Statement of
Financial Position for a business enterprise. The major difference between not-for-profit
Statement of Financial Positions and the business enterprise Statement of Financial
Position is in the equity section. The equity section of a nonprofit business Statement
of Financial Position is called Net assets and must disclose the following:
1) restricted balances - those which cannot be expended because of legal or contractual
conditions.
2) unappropriated - the amounts available for future operations.
If fund accounting is used, a brief description of the purpose of each fund reported should
be provided in the notes to the financial statements.
Accounting for Contributions

There are three types of contributions:
restricted contributions: these are subject to externally imposed stipulations

specifying the purpose for which they must be used. The organization has a
responsibility to the external contributor to use these resources in a specific way.
The reporting of contributions depends on which of the two methods of
accounting for contributions the organization uses (discussed below).
endowment contributions: these are a special type of restricted contribution. The

assets endowed are usually held as investments and cannot be used by the
organization. Only the income generated by the investments can be used. Again,
the reporting of contributions depends on which of the two methods of accounting
for contributions the organization uses.
unrestricted contributions: these contributions were received with 'no strings

attached'. The organization is free to use these funds as they see fit. Unrestricted
contributions are recognized as revenue immediately, regardless of which method
the organization uses to account for contributions.
Page 442
The two methods of accounting referred to above are (1) the deferral method and (2) the
restricted fund method.
- if the organization uses fund accounting to show restrictions, then it should use the
restricted fund method,
- if the organization uses fund accounting to show activities, then it should use the
deferral method
- if the organization does not use fund accounting, then it should use the deferral
method.
An organization using fund accounting to show restrictions would normally have a
general fund and one or more restricted funds - each restricted fund showing the receipt
of restricted funds as revenues and the related allowable expenses. For example, assume
the Canadian Heart Institute, a national clinic for people with severe heart problems,
operates two programs: the regular clinical program where doctors treat patients and a
research program. Sources of funding are as follows:
unrestricted government contributions for the treatment program
unrestricted government contributions for the research program
restricted contributions received from various sources for the research program
endowment funds
If the Canadian Heart Institute does not use fund accounting, then it must follow the
deferral method of accounting for these contributions.
If the Canadian Heart Institute uses fund accounting, then the choice of method to
account for contributions will depend on how funds are structured. If funds are structured
according to activities: Clinic Fund, Research Fund and Endowment Fund, then it would
still use the deferral method. Note that the Research Fund receives both restricted and
unrestricted contributions, consequently the restricted fund method does not apply to the
Research Fund.
If the Institute's funds were organized on the basis of restrictions: a general fund where
all clinical work and research funded by unrestricted funds, a research fund showing only
restricted revenues and related expenditures, and an endowment fund. In this case, the
restricted fund method would apply.
Page 443
The following schematic summarizes the above discussion:

Fund Accounting
Currently Used?
Yes
No
Objective of
Fund Accounting?
Show
Restrictions
Restricted
Fund Method
Page 444
Show
Activities
Deferral
Method
Deferral Method
The majority of non-profit organizations will likely adopt the deferral method. The
following describes the accounting treatment of different types of contributions under the
deferral method:
Type of Contribution
Accounting Treatment
Endowment
Contributions
Direct increases in net assets. The contribution by-passes the

statement of operations and essentially increases assets
(investments - restricted) and increases net assets - restricted.
Restricted
Contributions for
expenses of future
periods
This is the non-profit equivalent of deferred revenues. These

contributions are set up as deferred contributions when
received. As expenditures are made against these funds, an
equivalent amount of revenue is recognized in the statement of
operations.
Restricted
Contributions for the
purchase of capital
assets
These are deferred and amortized on the same basis as the

amortization of the related capital asset. For example, if we
receive a $100,000 contribution for the purchase of a building
which will get amortized over 40 years, then the contribution
will also get deferred and amortized over 40 years. The net
effect is that the amortization of the contribution offsets the
related amortization expense.
If the contribution is received for an asset that does not
amortize, then it is recorded as a direct increase in net assets.
Any restricted contributions for expenses in the current period and unrestricted
contributions should be recognized in the current period.
Disclosure requirements are as follows:
deferred contributions should be presented in the liabilities section of the

the nature and amount of changes in deferred contribution balances should be

disclosed (likely as a note to the financial statements)
Restricted Fund Method

Generally, all revenues reported in a restricted fund should be externally restricted. An
external restriction is one imposed by the funder. All unrestricted funds should be
reported in the General Fund.
Page 445
Endowment contributions should be recognized as revenue of the endowment fund in the

current period. Note that any revenues generated by the endowment fund are recorded as
revenues of the general fund since these are usually unrestricted. If revenues are restricted
for a specific purpose, they should be recorded as revenues of the appropriate restricted
fund.
Restricted contributions are recorded as revenues of the period in the related restricted
fund. However, restricted contributions for which no corresponding restricted fund is
presented should be recognized in the general fund in accordance with the deferral
method.
Contributions Receivable
Not-for-profit organizations which rely on donations as a source of revenues often
receive pledges from donators. The United Way is such an organization. Their fund
raising campaign is in the fall of each year and serves to finance the following calendar
year. Most of the donation revenue received by the United Way is by means of payroll
deductions. Employees will pledge a certain amount to be deducted from their pay
cheques in the upcoming year; for example, you might pledge to give $20 every pay. If
you get paid every two weeks, such a pledge amounts to $520. When preparing its
financial statements at December 31, the United Way will include these pledges as
pledges receivable on their Statement of Financial Position.
However, pledges have one important difference with ordinary accounts receivable.
Pledges are not legally enforceable. Therefore, if you decide to not fulfill your promise,
the not-for-profit organization to which you made the pledge has no recourse against you.
The reason for this lies in contract law: for a claim to be legally enforceable, good
consideration must have occurred. In this case, there has been no good consideration
since there has been no exchange between the parties.
Is it possible to record an asset we do not own? The answer is yes. If you refer to the
definition of an asset you will note that an asset is defined as economic resources
controlled by an entity. Thus, it is not necessary to have legal ownership of an asset.
Another example of this are capital leases where the ownership of the asset lies with the
lessor.
Consequently, a contribution receivable should be recognized as an asset when it meets
the following criteria:
the amount can be reasonably estimated, and
ultimate collection is reasonably assured.
Note that these are simply the same revenue recognition criteria that apply to any
organization. Also, as for any organization, an allowance for uncollectible contributions
should be set up.
Page 446
The amount recognized as assets and the amount recognized as revenues need to be
disclosed.
Capital Assets
In the past, there were three principal accounting methods allowed:
1.
2.
3.
Expense immediately
Capitalize and depreciate
Capitalize but do not depreciate.
Expensing immediately was the most common method used; the main reason for its
popularity relates to the nature of the revenue used to acquire the assets. Not-for-profit
organizations often receive capital grants which are given for the purpose of purchasing
specific assets - the capital grant is shown in income with the corresponding asset shown
as an expense. If the organization were to capitalize and depreciate the asset, then
recognition of the revenue in the period of acquisition without the offsetting expenditure
would make it appear that the organization has a substantial surplus and, in future
periods, the depreciation would put the organization in an operating deficit position.
Sometimes capital grants are given only for major assets (buildings) while smaller
acquisitions (furniture & fixtures) must be financed through the operating grants - in that
case, different accounting policies might be used for the two types of assets due to the
differing relationship to revenues. For example, you could capitalize and depreciate
those capital items financed as part of normal ongoing operations and expense those
capital items financed through capital grants.
There are two side effects of expensing capital assets. First, the Statement of Financial
Position does not disclose the existence of, or investment in, capital assets, and second,
future operations bear no part of the cost of the capital assets.
The first problem is often solved by creating a capital fund whereby capital assets are
shown on the Statement of Financial Position and an offsetting amount called the capital
fund balance is shown on the liabilities and surplus side of the Statement of Financial
Position.
Capitalization without depreciation is only appropriate when the assets do not decline in
value or in usefulness; i.e. collections of art galleries and museums.
Only not-for-profit organizations whose average gross revenues for the last two years are
under $500,000 have the above options available to them. All others must depreciate
assets over their useful lives.
Page 447
Donated Goods & Services and Capital Assets

The issue can be summarized as follows. Not-for-profit organizations often receive
goods and services. Should these goods and services received be recognized in the
financial statements of the not-for-profit organization? A simple example will put this
issue to light.
Assume a not-for-profit organization has an audit done for free. The substance of the
transaction is that the auditors are donating their time (which has value) to the
organization. One way to do this would be for the not-for-profit organization to pay for
this service and then have the auditor remit a donation to the organization of the same
amount. Such a transaction would have the effect of increasing donation revenues and
audit expense by the same amount. However, when the audit is done for free, there is no
exchange of cheques and the transaction may never make it to the financial statements.
The basic issue, however, is that there is absolutely no difference between the two
transactions. Therefore, why should the accounting for these transactions be different.
The recognition criteria set out by the CICA handbook becomes one of (1) whether or not
a value can be put on these goods or services and (2) whether or not the organization
would otherwise have to pay for these goods or services.
In all cases, criteria 1 must be met if these transactions are to be recorded in the financial
records. In the case of donated fixed assets, if criteria 1 is met, then the asset must be
recorded. In the case of donated materials and services (non capital), the organization
may choose to record these, so long as criteria 2 is met.
Donated property, plant and equipment should be recorded at fair value when
fair value can be reasonably estimated.
The nature and amount of donated property, plant and equipment received in the
period and recorded in the financial statements should be disclosed.
An organization may choose to record the value of donated materials and
services, but should do so only when a fair value can be reasonably estimated and
when the materials and services are normally purchased by the organization and
would be paid for if not donated. When donated materials and services are
recorded, fair value should be used as the basis of measurement.
The policy followed in accounting for donated materials and services should be
disclosed.
The nature and amount of donated materials and services received in the period
and recorded in the financial statements should be disclosed.7
7 CICA Handbook, 4230.04 to .08
Page 448
When donated goods or services are assigned a value and recorded by the organization,
the credit to revenues offsets the debit to expenditures and there is no impact in the net
operating results - however, the absolute values of the revenues and expenses are
affected, and it is possible that management performance could be evaluated differently.
Encumbrance System
An encumbrance system results from the need to control expenditures and/or keep track
of financial commitments. Basically, it is a built-in device to record transactions at the
decision/commitment stage rather than when an actual transaction occurs. In a business
organization, you would record the purchase of inventory when the goods are in your
possession, not when ordered. In an encumbrance system, an entry is made at the time of
the order. The result of such a system is that the records clearly show what funds are
available - or encumbered. Given the fact that nonprofit organizations have limited
sources of funds, the system provides a cost control function.
Page 449

1.
George Rogers takes a 6-month leave of absence from his job to work full-time for
an NPO. George's employer continues paying his salary. Rogers fills the position of
finance director because the incumbent is on paid sick leave during this period. This
position normally pays $38,000 per year. How should Roger's contribution be
recorded (assuming that the NPO chooses to record the contribution)?
a) As revenue of $19,000 and expense of $19,000
b) As revenue of $19,000
c) As deferred revenue of $19,000
d) No entry should be recorded
2.
In 20x9, Mercy Clinic, a not-for-profit health care facility, received an unrestricted

bequest of common stock with a fair market value of $50,000 in accordance with
the will of a deceased benefactor. The testator had paid $20,000 for the stock in
20x0. The clinic should record the bequest as
a) Unrestricted revenue of $20,000
b) Unrestricted revenue of $50,000
c) Endowment revenue of $50,000
d) Deferred revenue of $50,000
3.
The Smythe family lost its possessions in a fire. On December 23, 20x4, an
anonymous benefactor sent money to the Aylmer Benevolent Society, an NPO, to
purchase furniture for the Smythe family. During January 20x5, Aylmer purchased
this furniture for the Smythe family. How should Aylmer report the receipt of this
money in its 20x4 financial statements? Assume the deferred method is used.
a)
b)
c)
d)
Page 450
As an unrestricted contribution
As a restricted contribution
As a deferred contribution
As a liability
The following information applies to questions 4 and 5 although each question should be
considered independently.
First Harvest (FH) collects food for distribution to people in need. During November
1998, its first month of operations, the organization collected a substantial amount of
food and also $26,000 in cash from a very wealthy donor. The donor specified that the
money was to be used to pay down a loan that the organization had with the local bank.
The loan had been taken out to buy land, on which the organization plans to build a
warehouse facility. A warehouse is needed since, although the organization does not plan
to keep a lot of food in stock, sorting and distribution facilities are crucial. FH has also
received $100,000, which according to the donor is to be deposited, with any income
earned to be used as FH sees fit.
4.
In which of the following ways should the food donation and the $26,000 be
reflected in the financial statements. Assume that fair market values are available
and that FH uses the deferral method and does not maintain separate funds.
a)
b)
c)
d)
5.
$26, 000 cash donation

Deferred revenues
Increase in net assets
Increase in net assets
Deferred revenues
In which of the following ways should the $100,000 contribution be accounted for
under the following revenue recognition methods?
a)
b)
c)
d)
6.
Food donations
Deferred revenues
Deferred revenues
Revenues
Revenues
Deferral method
Direct increase in net assets
Direct increase in net assets
Revenue
Revenue
Restricted fund method

Revenue of the endowment fund
Revenue of the general fund
Revenue of the endowment fund
Revenue of the general fund
Home Care Services Inc. (HCS), an NPO, has a roster of volunteers who visit sick
and elderly people to provide companionship. These volunteers do not provide any
other services. HCS staff estimate that these services have a fair value of $6.00 per
hour. If these services were not contributed on a volunteer basis, HCS would not
pay for them. How should HCS account for these contributed services?
a) Do not recognize these donated services in the financial statements.
b) Recognize contributed services as revenue, and record salaries expense for
only the number of hours for which time sheets were kept.
c) Recognize these donated services as contributed services revenue and as
salaries expense.
d) Recognize these donated services as salaries expense and as increase in
the unrestricted fund balance.
Page 451
7.
Jubilee Home Care is a not-for-profit organization. It uses the deferral method of

accounting for contributions. Which of the following contributions should be
reported as deferred revenue?
a) Restricted contributions for expenses of one or more future periods
b) Restricted contributions for the purchase of capital assets that will not be
amortized
c) Restricted contributions for setting up an endowment fund
d) Unrestricted contributions
8.
On January 1, 20x2, NP, a not-for-profit organization, received a $650,000

contribution from a wealthy benefactor. The contribution was to be used to build a
subsidized housing complex on vacant land that NP had owned for several years.
Construction was to begin in the summer of 20x3. Any interest earned on the
$650,000 was to be used for the same purchase. NP uses restricted fund
accounting, and it has established a separate fund for the housing complex. How
should the contribution and related earned interest be treated under GAAP?
a) In 20x2, the contribution should be shown as a deferred contribution in the
restricted fund, and earned interest should be recognized as revenue.
b) In 20x2, both the contribution and earned interest should be shown as deferred
revenue in the restricted fund.
c) In 20x2, both the contribution and earned interest should be immediately
recognized as revenue in the restricted fund.
d) The amount of contribution recognized as revenue should be equal to any
eligible expenses incurred (such as maintenance expense or amortization).
Therefore, revenue recognition will commence in 20x3.
9.
Durali Festival Corp. (DFC) is a not-for-profit organization with annual revenues of

$350,000. Which of the following policies VIOLATES generally accepted
accounting principles?
a) DFC expenses capital assets when acquired. This policy is fully disclosed in
DFCs notes.
b) DFC uses the restricted fund method for contributions to its restricted funds
and it accounts for restricted contributions to the general fund in accordance
with the deferral method.
c) Membership revenues are recognized on an accrual basis.
d) DFC recognizes both a revenue and expense equal to the fair value of services
donated by a local singer who performs at the festival. The singer would be
hired for a fee if he did not donate his time.
e) All transfers between funds are reported in the statement of operations as
revenue of the receiving fund and as an expense of the fund being transferred
from.
Page 452
10.
A not-for-profit seniors home is preparing its year-end financial statements. Which

of the following should be included in the current assets section of the balance
sheet?
a) A bank savings account with a balance of $52,000 representing a restricted
capital fund for an expansion project to take place in two years.
b) A $20,000 grant application for a project that has been completed. There is a
20% likelihood of the grant application being accepted; however, at the time of
preparing the financial statements, no word on the grants status has been
received.
c) Inventory totalling $80,000 representing gift items held on consignment. When
the items are sold, the seniors home receives 20% of the revenue to aid in the
expansion of one of the wings of the building.
d) Cash held in trust in a bank account for the residents of the seniors home.
e) None of the above.
Page 453
Problem 1
City Youth Services (CYS) is a not-for-profit organization established to provide
counselling and other services to children under the age of 18. It concentrates on troubled
teenagers who are typically referred to CYS by the courts, police, and hospitals. In years
past, the majority of the operating budget of CYS has been funded by the Provincial
Government; increasingly, however, CYS is turning to private donors for support.
Two years ago, CYS engaged in a major funding drive in order to raise funds for a group
home for troubled teenagers. The drive was a success; $110,000 was raised during 20x0
and a mortgage of $90,000 was negotiated so that CYS was able to purchase a house for
$200,000 in January 20x1. Since then, CYS continued its fund raising activities and was
able to raise $125,000 in donations in 20x1. The funds raised annually for the group
home are used to employ several in-house social workers on an hourly basis and pay the
operating expenses of the home.
CYS has continued to operate in separate rented premises and employs 12 social workers
to provide counselling. Increasingly, time spent by the regular social workers has
involved overload group home work that cannot be handled by in-house social workers.
As a result of the increase in group home related work, and the resulting increase in the
payroll costs of regular CYS social workers, CYS is currently running a deficit in its
operating fund. Fund raising for the counselling activities, which is separate from fund
raising for the group home, has been insufficient to offset the operating deficit. A major
fund raising drive to secure donations for CYS and the group home is planned for 20x2.
Twenty volunteers from the community have assisted the social workers in the group
home and in the regular counselling services. Two of these volunteers have also assisted
with clerical duties in the office.
You are Mary Jones, CMA, a friend of the Executive Director of CYS, James Smith. You
attend a meeting of the Board of Directors of CYS, where Smith says the following: "As
you know, Mary, our needs for private donations are greater than ever, especially with
government funding freezes. The trouble with private donations is that we are competing
with so many other worthwhile causes. Some of the people we approach for donations
have complained about a lack of information regarding where we spent past donations,
our current financial position, and our effectiveness in achieving the purposes for which
we receive money. Accordingly, we have decided to provide all donors in 20x2 with a
copy of our 20x1 annual report. Since you are an accounting expert, perhaps you could
advise us on ways in which we might improve our annual report to enhance the
information value for donors." He then gave you the statement of operations and the
Statement of Financial Position of CYS (see attached).
Page 454
Required:
As Mary Jones, comment on ways in which the reporting of CYS might be improved to
enhance the informational value for donors.
City Youth Services

Statement of Operations
Operating Fund
Revenues:
Donations to City Youth Services
Program funding from Provincial Government
Investment income
Expenses:
Staff salaries
Payroll - social workers
Office expenses
Excess of expenses over revenues
Net Assets (deficit) - January 1
- December 31
Capital Fund
Revenues:
Donations to Group Home
Expenses:
Payroll - social workers
Operating expenses
Home purchase
Mortgage payments
Excess of expenses over revenues
Capital fund balance (deficit) - January 1
- December 31
Page 455
$104,500
300,000
500
405,000
70,000
300,000
50,000
420,000
(15,000)
(7,000)
$(22,000)
$125,000
50,000
30,000
200,000
10,000
290,000
(165,000)
110,000
$(55,000)
City Youth Services

Assets
Cash
Donor pledges
Liabilities
Accounts payable
Mortgage
Net Assets
Operating fund
Capital fund
$ 6,000
10,000
$16,000
$ 3,000
90,000
93,000
(22,000)
(55,000)
$16,000
1. Included in office expenses in the Operating Fund are outlays of $6,000 for two
typewriters, a personal computer, and a used photocopier. CYS charges capital
expenditures to the current period.
2. CYS maintains one bank account into which it deposits donations for both CYS and
the group home.
Page 456
Problem 2
Lark Opera Company (LOC) was formed and registered as a charity under the Provincial
Charities Act. The original idea to form the association was from Marcia Braun. She has
been LOC's artistic director and general manager, as well as a board member, since
LOC's inception. Marcia owns and operates a singing school that trains students for the
opera. Ninety percent of the performers in LOC's productions are her students and the
others are professional performers. LOC is recognized in the artistic community for the
high quality of its productions.
The City of Lark has a population of 550,000 and is a suburb of the metropolis of Oriole
which is the location of the well established National Opera. The City of Lark has many
opera fans who patronize the National Opera.
As a registered charity, LOC has several sources of funds, as follows:
Grants from the City of Lark

Bingo
Donations
Box office ticket sales
Advertising.
For every LOC production, the City of Lark grants an amount equal to revenue from
ticket sales. Before every major production, the city advances funds based on projected
ticket sales. Once the production is finished, the funding amount is to be adjusted to equal
actual revenue from ticket sales.
ED Corporation (EDC), the major donor to LOC, makes donations for specific opera
productions. Recently, EDC has expressed concern that it has not seen any financial
statements and is questioning the possible use of its donations for activities not related to
the specified opera productions.
LOC has a volunteer board of eight directors. All are members of the local arts
community with little business experience. The banking and accounting functions for
LOC are performed by various members of the board. Marcia Braun and Vince George,
the treasurer, are authorized to sign cheques against LOC's main operating bank account.
Only one of their signatures is required on a cheque. A separate bank account is
maintained by another board member, Lou Smith, for LOC's fund raising bingo
operations.
Under the Provincial Charities Act, audited financial statements must be prepared
annually. The last audited statements available are for 20x4. During 20x5 and 20x6, LOC
has put on four productions and the financial impact of these productions is unclear. The
last auditor moved to Europe and the board has not yet appointed a new auditor.
Page 457
Once the board approves a new production, a rough estimate of revenue from ticket sales
is made and submitted to the City of Lark, which uses the information to determine its
advance funding. The advance funds received from the city are deposited to the main
operating bank account and are not segregated for the production. Further, no budget is
drawn up, nor is a forecast of expenses made. Cash is drawn out of the main operating
account as and when needed during the production.
As the artistic director, Marcia Braun has total control of who is hired to provide the
various services required to produce the opera (i.e., choreographer, vocal trainer,
orchestra, etc.). She also negotiates the terms of payment to these people.
As the general manager, Marcia Braun developed a system of segregated duties that she
felt would ensure internal control. Financial information (i.e., invoices, cheques and bank
statements) is placed in the hands of different people. All invoices are sent to Vince
George who approves and pays them, and then keeps them in a file in his home.
Payments to performers are usually made by Marcia Braun. Anne Warne, another
member of the board, makes all deposits to the main operating account and the bankbook
is in her care. The bank sends the canceled cheques together with bank statements to
Anne Warne.
Since 20x5, LOC has run a bingo as a major source of funds. Lou Smith, a board
member, runs all aspects of the bingo, including all banking. His only help is casual labor
needed on bingo nights. These workers are paid cash from the bingo revenues before
deposits are made to the bingo bank account. Each month, Lou transfers money from the
bingo bank account to LOC's main operating bank account. In the past, other board
members have offered to help Lou, but he has rejected all such offers.
The city recently indicated that no further funds will be granted in the future unless
audited financial statements are made available and the future viability of LOC is
demonstrated. In June 20x7, at the request of the board, the city appointed Ren Laberge,
CMA, from the municipality's program review division to help LOC's board of directors
produce financial statements in accordance with generally accepted accounting principles
and conduct an assessment of the viability of LOC.
After an initial review, Ren Laberge made the following observations:
1.
There appear to be no accounting records for the bingo operations. Except for
answering a few questions over the phone, Lou Smith was unavailable to meet with
Rene and unable to provide any records.
2.
At times, payments have been made with no supporting invoices and some
duplicate payments have been made.
3.
Attendance at LOC's productions has been dropping despite good reviews of the
productions. An initial survey of opera lovers in the City of Lark indicated that
95% of them patronized the National Opera's productions in Oriole, but only 25%
of them patronized LOC's productions. Fifty percent of those surveyed were not
Page 458
even aware of the existence of LOC. Of those who attended productions by both,
most commented that LOC's ticket prices averaged one-quarter the ticket prices of
the National Opera Company's productions.
4.
A detailed review of the financial account balances prepared by the treasurer for
20x5 and 20x6 (see Exhibit 1) revealed a number of additional observations (see
Exhibit 2).
A special board meeting has been called to review Rene Laberge's report.
Required:
As Ren Laberge, prepare the requested report for Lark Opera Company's board of
directors. The report should include a comparative statement of financial position and
statement of operations for 20x5 and 20x6, as well as recommendations regarding
nonfinancial and management control issues.
Exhibit 1
Lark Opera Company
Balance of Accounts
As at December 31
20x6
20x5
Accounts payable
$ 53,100
Accounts receivable
$ 2,000
Advertising expense
4,000
Advertising revenue
3,000
Bank overdraft
16,000
Bingo revenue (net)
63,000
Computer equipment
2,500
Donations revenue
27,000
Grants from the city
25,000
Interest expense
2,600
Marcia Braun's salary
48,000
Net assets (liabilities) - beginning balance 50,000
Office expense
10,000
Prepaids
0
Production costs
76,500
Suspense
5,000
Ticket sales
13,500
Totals
$200,600 $200,600
Page 459
$ 38,200
$0
6,000
4,000
12,000
59,000
0
30,000
25,000
2,400
48,000
39,000
12,000
200
75,600
0
15,000
$183,200 $183,200
Exhibit 2
Additional Observations Made by Rene Laberge
1.
Since its inception, LOC has run fund-raising campaigns for which pledges are
usually recorded only when the cash is received. In the 20x6 fund-raising campaign,
$6,500 of pledges were made. Of these pledges, $3,000 have been received to date
and recorded as donations. Past experience has shown that about 75% of the
remaining pledges will be received, but this has not been recognized in the
accounting records.
2.
LOC purchased a computer in January 20x6 for Marcia Braun's use in planning
opera productions. The cost of the computer has been capitalized, but no
depreciation has been recorded. The computer is expected to have a five-year useful
life.
3.
In 20x5, a $5,400 payment was made to a professional singer for a production held
in 20x5. The National Opera had made this particular singer available to LOC for
the production and a payment for this singer had already been made to the National
Opera. These payments were both recorded as production costs in 20x5. No
attempt has been made to recover this overpayment or adjust the accounting
records.
4.
Grants from the city have not been adjusted to match actual ticket sales.
5.
In 20x6, a donation of props and costumes for the latest production was received
from a private donor. A tax receipt of $5,000 was issued for this donation and
$5,000 was recorded as donations revenue. Since there was no invoice submitted by
the donor, no expense was recorded. Instead, a suspense asset account was debited
for $5,000.
6.
The donations revenue recorded for 20x6 includes a $9,000 donation from EDC.
According to EDC, this donation was to be used specifically for a production
planned for 20x8.
7.
Bingo revenues represent the amounts that Lou Smith transfers monthly to LOC's
general operating bank account. These monthly transfers are made after the casual
workers hired to help at the bingos are paid in cash. Lou has not been able to
provide a reconciliation of the bingo account, but has confirmed that the amounts
reported in the bingo revenue account for 20x5 and 20x6 were the actual amounts
transferred to LOC's operating bank account. He also confirmed that there were no
outstanding accounts payable for the bingo operation at the end of the two years.
The bank confirmed that the December 31 bank balances in the bingo account were
$4,000 for 20x5 and $8,500 for 20x6.
8.
Included in the 20x6 production costs is a $17,000 advance paid to performers who
will appear in a 20x7 opera production.
Page 460
SOLUTIONS
1.
2.
3.
4.
5.
6.
7.
8.
9.
According to section 4400.17 of the CICA Handbook, transfers between

funds do not result in increases or decreases in the economic resources of the
organization as a whole and therefore are reported in the statement of changes
in net assets rather than in the statement of operations. Choices a), b), c) and
d) all are in accordance with generally accepted accounting principles.
10.
Choice a) is a restricted fund that can only be used for a specific project to
take place in two years; therefore, it is not liquid. The project costs in choice
b) must be expensed in the year because the grant is not guaranteed and
cannot be recorded as a receivable. For choice c), the seniors home does not
have ownership of the gift items; therefore, they cannot be recorded as assets.
For choice d), the account is held in trust and is therefore not accessible to the
seniors home. Therefore, choice e) is the correct answer.
Page 461
Problem 1
MEMORANDUM
TO:
FROM:
SUBJECT:
James Smith
Executive Director of CYS
Mary Jones
Reporting of City Youth Services
There are several groups of potential users of the annual report of CYS, but you have
asked me to comment on how the reporting might be improved to enhance the
information value for donors. The following issues will be discussed with respect to
donors specifically.
Program Effectiveness
Donors are especially interested in seeing what their donations will accomplish. A
brochure, or notes to the financial statements, should include a description of the
objectives of CYS, the number of children who have been counselled or helped in other
ways, the number of social workers and volunteers, and a description of the services that
they typically perform, a description of the home purchased, the number of children in
the home and their average length of stay, what happens to them after they leave the
home, etc.
Financial Statements
The financial statements, including notes, should provide information to enable donors to
assess the stewardship of management. The current statement of operations and the
statement of financial position (balance sheet) of CYS may be misleading. The following
discussion and suggestions may enhance the information value.
Notes to the Financial Statements
The notes to the financial statements should provide a clear description of the not-forprofit organization's purpose, the community it intends to serve, its status under income
tax legislation, and its legal form.
Net Assets
"Net Assets" is the terminology in the emerging not-for-profit accounting literature that
replaces the term "surplus" in describing a not-for-profit organization's equity on its
statement of financial position.
Net assets should be presented for each fund. Net assets that represent investments in
capital assets are not available for general use by the not-for-profit organization and
should be distinguished on the statement of financial position. For this reason, the use of
a "Net assets invested in capital assets" account is recommended.
Page 462
Revenue Recognition
There are two alternative methods for accounting for contributions under GAAP for notfor-profit organizations: the deferral method and the restricted fund method.
The restricted fund method is a specialized type of fund accounting that presents details
of financial statement elements by fund. Restricted contributions (those contributions that
are "earmarked" by the contributors for a specific purpose) would be recorded as revenue
in the corresponding restricted fund in the period that they were received or receivable.
The deferral method relates restricted contributions to the expenses that they are intended
to finance. Restricted revenue that pertains to expenses of future periods is deferred and
recognized as revenue in the period in which the related expenses are incurred. The
deferral method can be used with either a fund accounting or "corporate" style of
financial statement presentation.
A statement of cash flow should be presented along with the statement of financial
position, the statement of revenue and expenditures, and the statement of changes in net
assets.
Fund Accounting
It should be noted that fund accounting involves an accounting segregation of funds and
not necessarily a physical segregation of funds. From the perspective of internal control
and to aid the board in understanding fund accounting, it may be appropriate to have
separate bank accounts for the operating fund and the group home fund.
City Youth Services should provide a brief description in the notes to the financial
statements as to the purpose of each fund.
The statement of financial position should indicate if any of the assets are restricted. The
statement of operations should present a total that includes all funds reported. In other
words, total revenues, expenditures, and the total excess or deficiency for the period
should be reported in the statement of operations (i.e., the statement of revenue and
expenditures). This assumes that the deferral method is the appropriate method of
accounting for contributions received by CYS.
Segregation of Funds
At present, there is a lack of clear segregation between the operating fund and the capital
fund. Some of the social worker payroll costs charged to the operating fund should have
been charged to the capital fund, since the costs relate to group home activities and are
the major reason why the operating fund is showing a deficit. All of the financial
activities related to running the group home should be segregated in the statement of
operations so that donors to either CYS or the group home can get a clear picture of
money spent on group home activities. This segregation will likely show that revenues
are covering expenses for the regular operations of CYS. The segregation of funds would
Page 463
be facilitated by the use of separate bank accounts. Service charges and interest revenue
or deductions would then be allocated accurately.
The name of the capital fund should be changed to the group home fund to better reflect
its use. A separate capital fund could be set up for future projects.
Donor Pledges
A pledge is a non-enforceable promise to contribute cash or some other asset or economic
benefit to a not-for-profit organization. Because of the nature of pledges, it is likely that
less than 100% of the pledges will ultimately be collected. In order for CYS to recognize
pledges as revenue in the current year's financial statement, CYS needs to demonstrate
that the pledges can be reasonably estimated and that their ultimate collection is
reasonably assured. Alternatively, contributions would not be recognized until they were
collected.
Donated Services
The service of the volunteers could be credited to revenue offset by a debit to expenses.
This would only be appropriate where the services provided are used in the course of
CYS's operations and would otherwise have been purchased. However, because of the
difficulty of estimating the value, I would recommend simply describing the donated
services in the annual report.
Comparative Statements
Comparative information for 20x0 should be provided to enhance the assessment of
trends and also to emphasize the success of the fund raising drive for the group home.
Budgets
The donors would likely be interested in seeing a comparison of actual revenues and
expenses to those budgeted for the year, along with the budget for next year. It should not
be necessary to use budgetary accounts or an encumbrance system, however. It would be
best to keep the accounting system as uncomplicated as possible, especially because
volunteers are required in the office.
Capital Assets
The expensing of the home has produced a large deficit in the capital fund. This treatment
does not charge any of the cost to future periods that will benefit from the expenditure.
Also, the investment is not shown on the CYS statement of financial position. GAAP
recommends that not-for-profit organizations with annual gross revenues of $500,000 or
greater should capitalize and amortize capital assets.
Average revenues of City Youth Services appear to exceed $500,000; therefore, CYS
should capitalize its purchases of both the home and the office equipment and amortize
these assets over their useful lives. This amortization must be recognized as an expense in
City Youth Services' statement of operations. The choice of fund to which the
amortization expense is charged would be based on providing the most meaningful
information to the user. Showing it as an expense of the operating fund emphasizes that it
Page 464
is a cost of delivery. Showing it as an expense of the capital fund or group home fund
presents all revenues and expenses associated with the group home in a single fund.
Mortgage Payments
If the mortgage payments included a repayment of principal, then the mortgage liability
on the statement of financial position should be reduced. In accounting for the mortgage
payments, CYS should expense the interest portion and debit the principal repayment
directly to the mortgage liability.
Conclusion
The above recommendations should assist you to provide the most useful information to
prospective donors. If you have any questions, please do not hesitate to call me.
Page 465
Problem 2
A. Financial Statements
1.
Pledges receivable
GAAP allows pledges to be shown on the balance sheet as pledges receivable

provided that (i) reasonable assurance of collection exists and (ii) the amount
can be reasonably estimated
LOC has enough past history to estimate collectibility
recommend that pledges receivable be recorded at their net realizable value

of: $3,500 x 75% = $2,626
dr. Pledged receivable
cr. Donation revenues
2.
the amount of pledges recorded as revenue will have to be disclosed in the

notes to the financial statements
Computer Equipment
GAAP requires that NPOs whose average revenues are in excess of $500,000
capitalize and depreciate capital assets. Those NPOs whose average revenues
are less than $500,000 have three options:
I. capitalize and depreciate
ii. expense in the year of purchase, or
iii. capitalize and do not depreciate.
given the small size of this organization, I would recommend that they
expense the computer equipment - no accounting adjustment required
Page 466
3.
4.
Duplicate Payment
the duplicate payment should be treated as a recoverable amount
however, if the National Opera forces LOC to recover the payment from the
singer, collectibility may prove to be a problem - consideration should be then
given to the need to set up an allowance against this amount
dr. Accounts receivable

cr. Production costs (20x5)
$5,400
Donation of Props and Costumes
assuming the props and costumes are good for one production only, then we
are dealing with donated materials and services (as opposed to a capital item)
GAAP allows NPOs the option of recording donated materials and services if
two criteria are met:
(i) a monetary value can be ascribed to the donated goods or services, and
(ii) the donated goods or services would have been purchased if not donated
the two criteria are met in this case. Therefore, I recommend that the value of
the donated props and costumes be recorded since it would show the true cost
of producing the specific opera
dr. Production costs
cr. Suspense account
5.
$5,400
$5,000
$5,000
Matching of City grant against ticket sales
20x5: $25,000 - 15,000 = $10,000 due to city

20x6: $25,000 - 13,500 = $11,500 due to city
dr. Grants from the City (20x5)
dr. Grants from the City (20x6)
cr. Payable to City
Page 467
$10,000
$11,500
$21,500
6.
Donation revenue from EDC
the $9,000 donation should be removed from current revenues and set up as a
deferred contribution since it relates to a future production
dr. Donations revenues
cr. Deferred Contributions
7.
$9,000
Bingo Revenues
GAAP requires that such revenues be reported using the gross method. That
is, the gross revenues must be reported separately from the expenses.
given that no accounting records were kept, we will be unable to do this

year. However, it is recommended that starting this year, detailed records be
kept of revenues and expenditures
the Bingo revenues need to be adjusted for the changes in the bingo bank
account and the bingo bank account needs to be brought on LACs Statement
of Financial Position:
dr.
8.
$9,000
Cash
cr. Bingo revenues (20x5)
cr. Bingo revenues (20x6)
8,500
4,000
4,500
Prepaid Production costs
Page 468
the $17,000 should be set up as a prepaid Production Cost since the payment
relates to a future period
Revised Financial Statements:
Lark Opera Company

Statement of Operations
Revenues
Ticket sales
Grant from City
Donations (27,000 + 2,625 Pledges
- 9,000 Deferred Contribution from EDC)
Bingo - net (63,000 + 4,500 | 59,000 + 4,000)
Advertising
Expenses
Advertising
Computer equipment
Interest
Salary
Office
Production costs (76,500 - 17,000 Prepaid Production
Costs
+ 5,000 Donation of Props and Costumes)
(75,600 - 5,400 Duplicate Payment)
Excess of revenues over expenses

Net Assets - beginning
Net Assets - end
Page 469
20x6
20x5
$13,500
13,500
$15,000
15,000
20,625
67,500
3,000
118,125
30,000
63,000
4,000
127,000
4,000
2,500
2,600
48,000
10,000
6,000
2,400
48,000
12,000
64,500
131,600
70,200
138,600
(13,475)
(50,600)
$(64,075)
(11,600)
(39,000)
$(50,600)
Lark Opera Company

20x6
20x5
$8,500
10,025
17,000
$35,525
$4,000
5,400
200
$9,600
$16,000
21,500
53,100
9,000
99,600
$12,000
10,000
38,200
0
60,200
(64,075)
(50,600)
$35,525
$9,600
ASSETS
Current
Cash
Accounts receivable (2,000 + 2,625 + 5,400)
Prepaid production costs
LIABILITIES AND NET ASSETS

Current
Bank overdraft
Due to city
Accounts payable
Deferred contribution
Net Assets
Page 470
B.
Internal Controls
most of the problems of LOC rise from the fact that the internal controls
implemented by Marcia Braun were not working as anticipated. For example, there
is no indication that bank reconciliations were done after Anne Warne collected the
bank statements. Both Marcia Braun and Vince George, who approve payments and
write cheques, have authority to sign the cheques they prepare without the other's
approval. This and the fact that payments were made without supporting backup
caused duplicate payments to be made.
a contributing factor to LOC's problems was the fact that financial information was
not being prepared for the board of directors on a timely basis. No financial
statements have been prepared since 20x4; therefore, it is assumed that no financial
information has been presented to the board in two years.
it is difficult to have any separation of duties because of the shortage of people but,
as a start, the following can be done:
1. Ideally, whoever writes and prepares the cheques should not have signing
authority. At least there should be a requirement that each cheque be signed
by two officers of LOC who have cheque signing authority.
2. All payments should be supported by approved supporting invoices.
3. All bank statements, deposit books and invoices should be in one centralized
place.
4. Bank reconciliations should be done every month, independent of those
handling the banking.
5. Budgeted financial statements, using accrual accounting, should be produced
and given to the board regularly (e.g., quarterly).
6. An auditor should be appointed immediately.
7. The bingo operation should be considered part of LOC's operation. Details of
the bingo operation's expenses and revenues should be accounted for in LOC's
books.
Page 471
C. Budgeting
in a nonprofit organization like LOC where profit is not the bottom line and funds
are allocated, budgets are important as a control mechanism to ensure that the
expenses do not exceed revenues and cash resources are available as needed.
Allocations should also be made in the context of the organization's goals and
objectives.
as well, the city has made it clear that no further funds will be granted to LOC
unless audited financial statements are made available and future viability is
demonstrated. This will require the implementation of a budgeting process as
follows:
1. Prepare quarterly and annual cash flow budgets.
2. Prepare a budget for each production based on realistic estimates of projected
revenues from ticket sales, advertising, grants and donations.
3. Ensure that the production budgets are reviewed and approved by the board
prior to submission to the city for review.
4. Monitor actual revenues, expenses and cash flows against the budgets and
prepare variance reports to be circulated to the board on a timely basis.
D. Business Involvement
the current board's appointment of Marcia Braun as both artistic director and
general manager has allowed her to use LOC as a platform to give her students
public exposure which could be construed as a conflict of interest. As well, Marcia's
position as a director may conflict with her role as general manager.
the board has approved a large salary for Marcia Braun (i.e., almost 50% of total
revenues) which could be viewed as inappropriate for a board member.
LOC's board of directors, though strong in artistic background, lacks business

involvement which may account for its poor marketing efforts, its failure to attract
more corporate donors and its failure to run the affairs of LOC in a fiscally prudent
manner.
it is recommended that leaders in the business community of Lark be invited to sit

on the board and that an accountant (able to prepare appropriate financial
information and manage the funds) be appointed as the treasurer. The combination
of business acumen with artistic talent is essential.
Page 472
E.
Management of Bingo Operations
there is concern when any one individual manages a function of LOC separately
from other operations. This is the case with Lou Smith who manages the bingo
operations on his own and without reporting to the board in detail. He does not
make any reports on the bingo operations, has not made himself available to meet
with me, and has refused any offers of help from other board members. It also
appears that there are no accounting records for the bingo operations and that casual
labor payments are made in cash, therefore, there is likely no audit trail to follow.
This lack of accountability presents an opportunity for Lou and/or his workers to
pocket cash raised at the bingo (i.e., high risk of fraud). The gross revenue and the
expenses from the bingo operations should be recorded in LOC's accounts. As well,
records should be kept to track the payments to the bingo workers so that T4 slips
can be issued to them at the end of the year.
without Lou's input, it is impossible for me to assess the management of these

operations. It is important for all board members to realize that the board requires
some regular reports on the bingo operations and that co-operation with other board
members and management requests will result in better service.
an improved system in internal control will also serve to protect LOC and all its
directors against potential loss of assets.
Page 473
F.
Marketing and Pricing
LOC has concentrated on its artistic merit but has failed to effectively promote its
productions. Despite good reviews and the fact that the ticket prices for LOC's
productions are only one quarter the prices for the National Opera Company's
productions, sales of tickets to LOC's productions have been decreasing. A survey
of opera lovers in the City of Lark has revealed that 50% of them are not even
aware of LOC's existence. If LOC is to survive, it should increase its efforts on
marketing its productions and at least make the opera lovers in the city of Lark
aware of its existence.
it is recommended that ticket prices for its productions should be increased (by say
200%) and some of the extra revenues generated should be invested in an
aggressive marketing campaign targeted at the opera lovers in the cities of Lark and
Oriole. Assuming such a campaign results in doubling ticket sales, LOC could
generate approximately $13,500 x 2 x 200% = $54,000 more in revenue. If $20,000
of that amount is required for the marketing campaign, the net effect will be an
increase in revenues over expenses of over $34,000 which would wipe out the
deficit experienced in both 20x5 and 20x6 and substantially reduce the net
liabilities. LOC has a good product. The key to its success is an effective marketing
strategy. This must be made a top priority.
LOC should also explore ways of taking advantage of the presence of the National
Opera to generate some synergistic spin-offs.
Page 474
15.
Financial Statement Analysis
The broad purpose of financial statement analysis is to enable a user to make predictions
about the firm that will assist his/her decision making. Published financial statements are
the sources of information generally available to users. The nature of the analysis of
financial statement information is primarily in the form of ratios. Before getting into the
specifics of financial statement analysis, it seems worthwhile to inquire into the exact
nature of the information a particular user needs in order to make his/her decision. As an
example, consider the situation where an investor is trying to decide whether or not to sell
his/her shares in a company. Alternatively, an analogous situation is one in which a
prospective investor is trying to decide whether or not to buy shares in a particular
company. Specifically, what information does this investor need?
The corporate finance literature is replete with stock valuation models. There is a
common element, however, to all of these models. Essentially, the value of a share of
common stock is considered to be the present value of all future dividends expected to be
received on the share. This includes the final liquidating dividend. If we accept this
basic premise, then the investor would like to estimate the future cash dividends that
he/she will receive if he/she invests in the company's shares.
In order to predict the company's future dividend policy, the investor must predict those
things that affect dividend policy. The following are the variables that affect a firm's
future dividend policy:
1. Net cash flows from future operations.
2. Expected non-operating cash flows; i.e., from activities considered incidental to the
firm's main function.
3. Future cash flows from changes in the levels of investments made by shareholders
and creditors.
4. The amount of cash expected to be invested in the firm's long lived assets as well as
in working capital.
5. The amount of future cash flow to service debt requirements; i.e., interest payments,
repayment of principal, sinking fund provisions, etc.
6. The amount of future cash flow from random events such as windfall gain or
casualties.
7. The firm's future policy regarding the holding of cash balances (for precautionary and
liquidity reasons) in excess of those required to maintain the expected level of
operations.
8. Management's attitude toward future cash dividend policy.
Page 475
Each of these eight variables that affect future dividend policy is in turn affected by
others, which the investor would like to predict.
However, published financial statements are historical in nature and do not provide the
information we have just outlined. Nonetheless, historical information can be used to
make projections and is sometimes extremely useful in this respect. The limitations of
using historical information must, of course, be recognized.
Financial Analysis Techniques
1.
Horizontal (trend), Vertical and Percentage (common size) analysis
Horizontal analysis expresses financial data in terms of a single designated base period,
or as compared to an amount of the preceding period. For example, the historical
financial performance data for a company for the years 20x3 to 20x6 (all data is in
millions of dollars)
Revenue
Expenses
Income taxes
Net income
20x3
20x4
20x5
20x6
$7,975
7,369
606
200
$406
$8,509
7,882
627
207
$420
$11,500
10,673
827
273
$554
$13,619
12,546
1,073
354
$719
Horizontal analysis of the data as a percentage of the year 20x3 amounts:
Revenue
Expenses
Income taxes
Net income
20x3
20x4
20x5
20x6
100%
100%
100%
100%
100%
107%
107%
103%
104%
103%
144%
145%
136%
137%
136%
171%
170%
177%
177%
177%
Horizontal analysis of the data as a percentage of the previous year's amounts:
Revenue
Expenses
Income taxes
Net income
20x3
20x4
20x5
20x6
100%
100%
100%
100%
100%
107%
107%
103%
104%
103%
135%
135%
132%
132%
132%
118%
118%
130%
130%
130%
Vertical Analysis (also referred to as common size financial statements), presents all the
data in a financial statement as a percentage of a single line item. Generally, when
Page 476
performing vertical analysis on a balance sheet, all numbers are expressed as a percentage
of total assets; on the income statement as a percentage of sales.
Vertical analysis of the above data is as follows:
Revenue
Expenses
Income taxes
Net income
2.
20x3
20x4
20x5
20x6
100%
92%
8%
3%
5%
100%
93%
7%
2%
5%
100%
93%
7%
2%
5%
100%
92%
8%
3%
5%
Ratio Analysis
Ratio analysis is performed in order to evaluate the firm's liquidity, solvency, profitability
and asset management:
liquidity: assessment of the firm's ability to meet current liabilities as they come
due,
solvency: ability of the firm to pay both current and long-term debt,
profitability: evaluation of manager's abilities in generating returns to capital

providers,
asset management (or activity ratios): how well are the firm's assets managed.
Liquidity Analysis - the following ratios are typically used in assessing the liquidity of a
firm:
Current Ratio
Current Assets Current Liabilities
Quick Ratio
(Acid-Test Ratio)
(Cash + Accounts Receivable + Temporary Investments)

Current Liabilities
Defensive Interval
Ratio
(Cash + Accounts Receivable + Temporary Investments)

(Cash operating expenses 365)
Where Cash operating expenses = Cost of Goods Sold + Operating
Expenses - Depreciation
The current ratio tells us how much current assets there are relative to current liabilities.
The quick ratio tells us how much liquid current assets there are relative to current
liabilities. The defensive interval tells us, all other things remaining equal, how many
days the firm can survive without any cash inflow.
Caution must be applied when using the current ratio. Assume that two companies have a
current ratio of 1.5. One cannot draw a conclusion that these companies face a similar
Page 477
liquidity situation. Upon further investigation you find out that the companies have the
following current asset structure:
Current Assets
Cash
Accounts Receivable
Inventory
Current Liabilities
Company A
Company B
$1,000
34,000
100,000
$135,000
$5,000
20,000
60,000
50,000
$135,000
$90,000
$90,000
Clearly Company B is more liquid than Company A - it has significantly less inventory
relative to Company A.
The Quick Ratio for the two companies is much more conclusive:
Company A: (1,000 + 34,000) 90,000 = .39
Company B: (5,000 + 20,000 + 60,000) 90,000 = .94
All things being the same, the quick ratio and defensive interval are much better
measures of liquidity.
Many people rely on 'rules of thumb' to assess the quality of a liquidity ratio. The most
often quoted rule of thumb for the current ratio is 2.0 and for the quick ratio, 1.0. All
rules of thumb, by definition are incorrect and must be used with caution. The rule of
thumb for the quick ratio is much firmer than that for the current ratio.
Solvency Analysis - the following ratios are typically used in assessing the solvency of a
firm:
Debt-to-Equity
Ratio
Long-term Debt Shareholders' Equity
Times Interest
Earned
Income before Interest and Taxes Interest expense
The debt-to-equity ratio must be compared (1) to the firm's historical data (interperiod)
and/or (2) to other companies operating in the same industry or industry averages
(interfirm). As Lesson 12 will show, it is wrong to say that the lower the debt-to-equity
ratio, the better off the firm is. All firms have a theoretical optimal debt-to-equity ratio
they should be aiming for. Firms whose debt-to-equity ratio is optimal will maximize the
value of the firm and minimize their weighted average cost of capital. The problem is that
the finance literature does not provide us with a mechanism to establish this optimal debt-
Page 478
to equity ratio. We tend to use the industry average as a surrogate for the optimal debt-toequity ratio. Take the following two firms:
Debt-to-equity Ratio
Company A
0
Company B
2.5
Industry Average
3.0
Although, Company A is clearly more solvent than Company B, one could argue that
Company B is better off than Company A since it's weighted average cost of capital
should be lower.
The times interest earned ratio is a good judge of a firm's solvency. A firm with a times
interest earned ratio of 2.0 is generating operating income that is only twice as high as
interest charges. Such a firm's exposure to fluctuations in interest rates is high.
Profitability Analysis - the following ratios are typically used in assessing the profitability
of a firm:
Return on Sales
Operating Income Sales
Return on Assets
Operating Income Average total assets
Return on Equity
Net Income Average shareholders' equity
The rationale for using operating income for the return on assets ratio is that this ratio is
used to compare how well firms use their assets regardless of how the assets are
financed. When comparing two firms with different capital structures, the return on
assets will be comparable. Using operating income also removes unusual items,
extraordinary items, discontinued operations and income tax expense from the ratio.
Also note that we are using averages in the denominators. This is the theoretically correct
way to calculate the ratios. Whenever you divide an income statement number into a
balance sheet number (or vice-versa), the balance sheet number must always be an
average. However, there are times where this may be either impossible or impractical to
do. In situations where you only have one year of data, it is impossible. When you have
two years of data, you can calculate the ratios for one year only and you do not have any
comparatives. In these situations, one can assume that the year-end balances are good
surrogates for the average and simply use the year end balances. Note that multiple
choice exams will always assume you use averages.
Page 479
Asset Management Ratios (activity ratios) - the following ratios are typically used in
assessing the solvency of a firm:
Inventory turnover
Cost of goods sold Average Inventory
Days Sales in
Accounts
Receivable
Average Accounts Receivable

(Net Credit Sales 365)
Total asset
turnover
Sales Average total assets
The inventory turnover measures the number of times the inventory rolls over within a
year. The days sales in accounts receivable tells us what the average number of days our
accounts receivable have been outstanding. The total asset turnover tells us how many
sales dollars are generated by each dollar of asset invested.
Often in an examination setting, you will be presented with a company's financial
statements and the industry average accounts receivable and inventory turnover ratios.
Given these, it is possible to perform some comparative analysis and, more importantly,
determine how much cash could be generated by the company if it were able to reduce its
accounts receivable and inventory balances. (More often than not, the question mentions
that the company is cash strapped.)
Example 1 - Assume the following balances taken from the Harlow Company's
December 31, 20x5, financial statements:
Accounts receivable - net

Inventory
20x5
$2,450,000
3,545,000
20x4
$1,975,000
3,345,000
Sales (all on credit)

Cost of goods sold
$9,500,000
6,650,000
$9,200,000
5,980,000
Industry averages Days Sales in Accounts Receivable

Inventory turnover
Page 480
61 days
3.5
The Harlow Company's ratios are as follows:

Days sales in accounts receivable = Average accounts receivable / Sales 365
=
[($2,450,000 + 1,975,000) / 2)] / ($9,500,000/365)
=
85 days
Inventory turnover = Cost of goods sold / Average Inventory
=
$6,650,000 / [($3,545,000 + 3,345,000) / 2)]
=
1.93
Clearly, there is room for improvement. The company has the potential to generate a
one-time cash saving by reducing their accounts receivable and inventory balances to a
level where the turnover ratios are in line with the industry average. The amount of cash
inflow from such a reduction is calculated as follows:
Current average accounts receivable balance
Accounts receivable balance if days sales in accounts
receivable was 61 days:
$9,500,000 / 365 x 61
$2,212,500
Current average inventory balance

Inventory balance if turnover was 3.5
$6,650,000 / 3.5
Total potential one time cash inflow from reduction
$3,445,000
1,587,671
1,900,000
$ 624,829
1,545,000
$2,169,829
It is not enough to perform the above calculations since this reduction will not happen by
itself. It is very important to provide management with means to reduce the accounts
receivable and inventory balance.
Measures to reduce accounts receivable include:
offering discounts for early payment,
charging interest on overdue accounts,
sending late payment notices with follow-up phone calls, and
turning accounts over to a collection agency.
Measures to reduce inventory include:
dispose of obsolete inventories,
improve production throughput,
stop production for a short period of time, and
consider implementing a just-in-time purchasing and production system.
Note that when performing financial statement analysis on examinations, it is usually not
necessary to calculate all of the ratios shown above. All you really need to do is calculate
enough ratios per category to feel comfortable in drawing a conclusion. For example, the
Page 481
calculation of the quick ratio of 0.11 is usually enough to indicate that the company has a
liquidity problem.
Limitations of Financial Statement Analysis

Changes in ratios can only be interpreted by understanding the underlying economic
events. For example a sudden increase in the current ratio may simply be due to the fact
that a short-term bank loan was converted to a long-term loan.
Ratios may change as a result of non-economic events that affect the financial statements
e.g., change in accounting method or estimate
Comparisons of a companys ratios with another companys or with industry averages
involve certain restrictive assumptions: that all companies being compared are:
structurally similar
use the same (or similar) accounting principles
experience a common set of external influences

Example 2 - on the following pages, you will find the financial statements for Sample
Company Inc. for the year ended December 31, 20x5. The following financial statement
analysis will use year-end balances as a surrogate for averages given that we only have
two years of financial data on the balance sheet.
Liquidity Analysis:
20x5
20x4
Current Ratio
14,791.1 7,974.7 = 1.85
12,155.0 7,791.8 = 1.56
Quick Ratio
(Acid-Test Ratio)
(1,664.0 + 7,765.6)
7,974.7 = 1.18
(1,738.7 + 5,840.1)
7,791.8 = 0.97
Defensive Interval
Ratio
(1,664.0 + 7,765.6)
(12,220.4 365)
= 282 days
(1,738.7 + 5,840.1)
(10,398.8 365)
= 266 days
I would draw two conclusions on Sample Company's liquidity situation: (1) it is

improving and (2) the quick ratio and defensive interval imply that the company is liquid.
Page 482
Solvency Analysis:
Debt-to-Equity Ratio
20x5
20x4
(4,795.0 + 652.6) 3,611.8

= 1.51
(2,575.9 + 421.7) 3,488.5

= .86
Times Interest Earned (1,072.9 + 94.9) 94.9

= 12.3
(826.9 + 114.3) 114.3

= 8.23
Based solely on the times interest earned ratio, Sample Company appears to be solvent.
The debt-to-equity ratio tells us that solvency is decreasing. Whether or not the company
is better or worse off depends on how the debt-to-equity ratio of 1.51 compares with
industry averages.
Profitability Analysis
20x5
20x4
Return on Sales
1,170.6* 13,618.5 = 8.6%
868.7 11,500.1 = 7.6%
Return on Assets
1,170.6 17,034.1 = 6.9%
868.7 14,277.9 = 6.1%
Return on Equity
718.8 3,611.8 = 19.9%
554.0 3,488.5 = 15.9%
* Sales less cost of sales and operating expenses less depreciation and amortization
One can conclude that profitability is increasing. The assessment of how profitable they
are would depend on how they compare to competitor ratios.
Page 483
Asset Management (Activity Ratios)

20x5
20x4
Inventory turnover
Cannot be calculated since cost of goods sold is not provided.
Days Sales in
Accounts Receivable
7,765.6 (13,618.5 365)

= 208 days
5,840.1 (11,500.1 365)

= 185 days
Total asset turnover
13,618.5 17,034.1 = .80
11,500.1 14,277.9 = .81
The days sales in accounts receivable is typically compared to the credit terms. In this
case, the amount is likely low because much of their contracts are long-term in nature and
require substantial deposits before work is even started. The days sales in accounts
receivable appears to be deteriorating, but this is inconclusive given the nature of the
business.
The total asset turnover indicates that each dollar of asset generates $0.80 in sales. This is
consistent with the previous year.
To properly assess the company's asset management, we would need to compare the
ratios with industry averages.
Page 484
Sample Company Inc.

Consolidated Statement of Financial Positions
As at December 31, 20x5 and 20x4
(millions of dollars)
Assets
Cash and cash equivalents
Accounts receivable
Inventories
Fixed assets
Other assets
Liabilities
Short-term borrowings
Advances and progress billings in excess
of related costs
Long-term debt
Other liabilities
Shareholders equity
Page 485
20x5
20x4
$1,664.0
7,765.6
5,361.5
14,791.1
1,898.7
344.3
$1,738.7
5,840.1
4,576.2
12,155.0
1,842.7
280.2
$17,034.1
$14,277.9
$2,002.7
3,335.2
$2,363.5
3,099.7
2,636.8
7,974.7
4,795.0
652.6
2,328.6
7,791.8
2,575.9
421.7
13,422.3
3,611.8
10,789.4
3,488.5
$17,034.1
$14,277.9
Sample Company Inc.

Consolidated Statement of Shareholders Equity
For the years ended December 31, 20x5 and 20x4
Share capital
Preferred shares - Series 2
Common Shares
Class A Shares (multiple voting)
Balance at beginning of year
Converted to Class B
Balance at end of year
Class B Subordinate Voting Shares
Issued under the share option
plans
Issued to employees for cash
Converted from Class A
Balance at end of year common
shares
Total share capital
Retained Earnings
Net income
Dividends:
Preferred shares
Common shares
Redemption of convertible notes
Other
Convertible notes equity
component
Deferred translation adjustment
Total shareholders equity
Page 486
Number
20x5
Amount
Number
20x4
Amount
12,000,000
$300.0
12,000,000
$300.0
176,707,676
(910,612)
175,797,064
49.1
(0.5)
48.6
177,265,658
(557,982)
176,707,676
49.3
(0.2)
49.1
506,465,319
5,635,420
796.4
16.8
501,652,790
1,871,250
746.9
7.4
593
910,612
513,011,944
688,809,008
0.5
813.7
862.3
2,383,297
557,982
506,465,319
683,172,995
41.9
0.2
796.4
845.5
1,162.3
1,145.5
1,900.4
718.8
1,491.0
554.0
(16.5)
(152.3)
(51.5)
(6.4)
2,392.5
-
(16.5)
(117.3)
(10.8)
1,900.4
180.5
57.0
$3,611.8
262.1
$3,488.5
Sample Company Inc.

Consolidated Statement of Income
For the years ended December 31, 20x5 and 20x4
(millions of dollars, except per share amounts)
Revenues
Expenses
Cost of sales and operating expenses
Interest expense
Interest income
Income before unusual items and
income taxes
Unusual items, net
Income before income taxes
Income taxes
Net Income
Earnings per share:
Basic
Fully diluted
Average number of common shares
outstanding during the year
Page 487
20x5
$13,618.5
20x4
$11,500.1
12,220.4
227.5
94.9
(48.3)
12,494.5
10,398.8
232.6
114.3
(72.5)
10,673.2
1,124.0
51.1
1,072.9
354.1
$718.8
826.9
826.9
272.9
$554.0
$1.02
$1.00
$0.77
$0.76
684,492,101
680,385,027
Sample Company Inc.

Consolidated Statement of Cash Flows
For the years ended January 31, 20x5 and 20x4
Operating activities
Net income
Non-cash items:
Provision for credit losses
Unusual items, net
Net changes in non-cash balances
related to operations
Investing activities
Additions to fixed assets
Net investment in asset-based
financing items
Disposal of businesses
Other
Financing activities
Net variation in short-term borrowings
Proceeds from issuance of long-term debt
Redemption of convertible notes
Issuance of shares, net of related costs
Dividends paid
Effect of exchange rate changes on cash and cash
equivalents
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
Page 488
20x5
20x4
$718.8
$554.0
227.5
31.7
240.9
51.1
232.6
(12.9)
146.0
-
(389.3)
880.7
1,074.6
1,994.3
(419.5)
(364.2)
(2,251.4)
145.6
(27.7)
(2,553.0)
(2,145.0)
(2.8)
(2,512.0)
(284.0)
2,464.5
(133.1)
(243.2)
16.8
(168.8)
1,652.2
141.4
1,056.6
(165.0)
49.3
(133.8)
948.5
(54.6)
(74.7)
1,738.7
$1,664.0
80.2
511.0
1,227.7
$1,738.7

The Following Data Apply to Items 1-5
Selected data from Ostrander Corporation's financial statements for the years indicated
are presented below in thousands.
December 31
20x1
20x0
Cash
$32
$28
Marketable securities
169
172
210
204
440
420
Tangible fixed assets
480
440
Total assets
1,397
1,320
Current liabilities
370
368
Total liabilities
790
750
226
210
Retained earnings
381
360
20x1 Operations
Net sales
Cost of goods sold
Interest expense
Income tax
Gain on disposal of a segment
(net of tax)
Net income
1.
$4,175
2,880
50
120
210
385
The acid test (quick) ratio for Ostrander Corporation in 20x1 is

a) 1.73
b) 1.87
c) 1.11
d) 0.54
e) 2.30
Page 489
2.
Merchandise inventory turnover for Ostrander Corporation in 20x1 is

a) 6.54 times
b) 6.69 times
c) 6.85 times
d) 9.70 times
e) 9.94 times
3.
Accounts receivable turnover in days (using 365 days) for Ostrander Corporation in
20x1 is
a) 18.10 days
b) 26.61 days
c) 17.83 days
d) 18.36 days
e) 26.23 days
4.
Times interest earned for Ostrander Corporation for 20x1 is

a) 4.50 times
b) 7.70 times
c) 3.50 times
d) 6.90 times
e) 5.90 times
5.
The total debt to equity ratio for Ostrander Corporation in 20x1 is

a) 3.49
b) 1.85
c) 2.07
d) 1.30
e) 0.69
Page 490
Problem 1 - Financial Statement Analysis

Two-Rivers Inc. (TRI) manufactures a variety of consumer products. The company's
founders have run the company for thirty years and are now interested in retiring.
Consequently, they are seeking a purchaser who will continue its operations, and a group
of investors, RayWalsh Inc., is looking into the acquisition of TRI. To evaluate its
financial stability and operating efficiency, TRI was requested to provide the latest
financial statements and selected financial ratios. Summary information provided by TRI
is presented below and in the next column.
TRI
Statement of Income
For the Year Ended November 30, 20x2
(in thousands)
Sales (net)
Interest income
Total revenue
Costs and expenses
Cost of goods sold
Selling and administrative expense
Depreciation and amortization expense
Interest expense
Total costs and expenses
Income before taxes
Income taxes
Net income
$30,500
500
31,000
17,600
3,550
1,890
900
23,940
7,060
2,900
$4,160
Selected Financial Ratios
Current ratio
Quick ratio
Times interest earned
Return on sales
Total debt to equity
Inventory turnover
Page 491
TRI
20x0
1.62
.63
8.50
12.1 %
1.02
1.83
3.21
20x1
1.61
.64
8.55
13.2%
.86
1.84
3.17
Current
Industry
Average
1.63
.68
8.45
13.0%
1.03
1.84
3.18
TRI
As of November 30
(in thousands)
Cash
Marketable securities (at cost)
Inventory
Total current assets
Property, plant, & equipment (net)
Total assets
Accounts payable
Accrued expenses
Total current liabilities
Long-term debt
Total liabilities
Common stock ($1 par value)
Paid-in capital in excess of par
Retained earnings
Total liabilities and shareholders' equity
20x2
20x1
$400
500
3,200
5,800
9,900
7,100
17,000
$500
200
2,900
5,400
9,000
7,000
16,000
$ 3,700
900
1,700
6,300
2,000
8,300
2,700
1,000
5,000
8,700
$17,000
$ 3,400
800
1,400
5,600
1,800
7,400
2,700
1,000
4,900
8,600
$16,000
Required A. Calculate a new set of ratios for the fiscal year 20x2 for TRI based on the financial
statements presented.
B. Explain the analytical use of each of the seven ratios presented, describing what the
investors can learn about TRI's financial stability and operating efficiency.
C. Identify two limitations of ratio analysis.
Page 492

The following partial information has been extracted from the financial statements of
Toss Away Ltd., a recycling plant:
20x6
Current assets
Current liabilities
Cash and temporary investments
Net accounts receivable
Net income
Sales
Cost of goods sold
Interest expense
Income tax rate
20x5
$800,000
450,000
400,000
250,000
300,000
2,200,000
1,350,000
100,000
150,000
40%
$750,000
430,000
380,000
175,000
220,000
1,895,000
1,130,000
105,000
145,000
40%
The following industry averages have been obtained:

Average collection period
Gross margin
70 days
34%
10 times
Calculate and interpret each of the following ratios for 20x6 for Toss Away Ltd.:
i)
ii)
iii)
iv)
v)
current ratio
quick ratio (acid test)
accounts receivable turnover
gross margin
times interest earned.
Page 493

Arnold, Inc., manufactures and sells portable radios. Condensed comparative income
statements for 20x1 and 20x2 are as follows:
Arnold, Inc.
Comparative Income Statements
Sales
Sales returns
Beginning inventories
Cost of manufactured radios
Ending inventories
Cost of goods sold
Selling expenses
Income before tax
20x2
20x1
$486,100
(20,400)
131,250
291,600
(160,400)
262,450
107,500
48,600
47,150
$305,200
(6,100)
110,100
143,700
(131,250)
122,550
91,500
45,750
39,300
Required 1. Prepare a horizontal percentage analysis using 20x1 as the base year. Round each
figure to the nearest percentage point.
2. Prepare a vertical percentage analysis for both 20x1 and 20x2, using sales as the basis
for comparison. Round each figure to the nearest percentage point.
3. Arnold is concerned with its 20x2 profit. On the basis of your analysis in parts 1 and
2, identify those financial statement items that appear to be problem areas for Arnold.
Give reasons for your choices.
Page 494

The following selected financial data are taken from the financial statements of Jackson
Corporation:
Cash
Short-term marketable securities
Land and buildings (net)
Mortgage payable (noncurrent)
Accounts payable (trade)
Short-term notes payable
12/31/x2
12/31/x1
$ 20,000
50,000
90,000
30,000
340,000
270,000
70,000
20,000
$ 80,000
150,000
150,000
10,000
360,000
280,000
110,000
40,000
YEAR ENDED
12/31/x1
12/31/x2
Cash sales
Credit sales
Cost of goods sold
$1,800,000
600,000
1,200,000
$1,600,000
800,000
1,400,000
Required Calculate Jackson Corporation's 20x2:

1.
2.
3.
4.
Quick ratio.
Receivable turnover.
Merchandise inventory turnover.
Current ratio.
Page 495

The December 31, 20x2, balance sheet of Cook, Inc., is presented below. These are the
only accounts in Cook's balance sheet. Amounts indicated by a question mark (?) can be
calculated from the additional information given.
Assets
Cash
Accounts receivable(net)
Inventory
Tangible capital assets (net)
$ 24,000
?
?
281,600
$432,000

Accounts payable (trade)
Income taxes payable (current)
Long-term debt
Common shares
Retained earnings
$?
25,000
?
300,000
?
?
Additional information
Current ratio (at year-end)
Total liabilities divided by total shareholders' equity
Inventory turnover based on sales and ending inventory
Inventory turnover based on cost of goods sold and ending inventory
Gross margin,20x2
1.6:1
.8
15 times
11 times
$315,000
Required 1. What was Cook's December 31, 20x2, balance in accounts payable?
2. What was Cook's December 31, 20x2, balance in retained earnings?
3. What was Cook's December 31, 20x2, balance in the inventory account?
Page 496

The Rayon Company is listed on the Toronto Stock Exchange. The market value of its
common shares was quoted at $18 per share on both December 31, 20x2, and December
31, 20x1. Rayon's balance sheets as of December 31, 20x2, and December 31, 20x1, and
statements of income and retained earnings for the years then ended are presented below:
Statement of Financial Positions
12/31/x2 12/31/x1
($ in 000s)
Assets
Current assets
Cash
Marketable securities, at cost that approximates market
Accounts receivable, net of allowance for doubtful accounts
Inventories at lower of cost or market
Prepaid expenses
Total current assets
Tangible capital assets, net of accumulated depreciation
Other assets
Total assets
Current liabilities
Notes payable
Accounts payable and accrued expenses
Payments due within one year on long-term debt
Total current liabilities
Long-term debt
Deferred taxes
Other liabilities
Total liabilities
Common shares, no-par value: authorized, 20,000,000 shares;
issued and outstanding, 10,000,000 shares
Retained earnings
Total liabilities and shareholders' equity
Page 497
$ 3,600
$ 3,800
13,000
11,000
105,000
95,000
134,000 154,000
2,500
2,400
$258,300 $266,000
311,000 308,000
29,000
34,000
$598,300 $608,000
$5,000 $ 15,000
74,500
62,500
1,000
1,000
6,500
7,500
$ 75,000 $ 98,000
177,300 180,000
67,000
74,000
9,000
8,000
$335,300 $353,000
$121,000 $121,000
142,000 134,000
$263,000 $255,000
$598,300 $608,000
Statements of Income and Retained Earnings

YEAR ENDED
12/31/x2
$600,000
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
expenses
Interest expense
Other expenses, net
Total costs and expenses
Income before income taxes
Income taxes
Net income
Retained earnings at beginning
of period, as previously reported
Adjustment required for correction
of error
Retained earnings at beginning
of period, as restated
Dividends on common shares
Retained earnings at end of period
12/31/x1
$500,000
$400,000
$325,000
64,000
80,000
2,000
17,000
58,500
75,000
1,500
6,000
(563,000)
$37,000
(16,800)
$20,200
(466,000)
$34,000
(15,800)
$18,200
$141,000
$132,000
(7,000)
(6,000)
134,000
(12,200)
$142,000
126,000
(10,200)
$134,000
Additional facts are as follows:

a) Selling, general, and administrative expenses for 20x2 included an usual but
infrequently occurring loss of $10 million.
b) Other expenses, net, for 20x2 included an extraordinary item (loss) of $10 million. If
the extraordinary item (loss) had not occurred, income taxes for 20x2 would have
been $21.8 million instead of $16.8 million.
c) Adjustment required for correction of error was a result of a change from an
accounting principle that is not generally accepted to one that is generally accepted.
d) Rayon Company has a simple capital structure and has disclosed earnings per
common share for net income in the notes to the financial statements.
Page 498
Required 1. Determine from the additional facts above whether the presentation of those facts in
Rayon Company's statements of income and retained earnings is appropriate. If the
presentation is appropriate, discuss the theoretical rationale for the presentation. If the
presentation is not appropriate, describe the appropriate presentation and discuss its
theoretical rationale. Do not discuss disclosure requirements for the notes to the
financial statements.
2. Describe the general significance of the following financial analysis tools:
a) Quick (acid-test) ratio.
b) Inventory turnover.
c) Return on shareholders' equity.
3. Perform a financial statement analysis of Rayon Company.
Page 499
SOLUTIONS

1.
(32 + 169 + 210) / 370 = 1.11
2.
2,880 / [(440 + 420) 2] = 6.69x
3.
[(210 + 204) 2] / (4,175 365) = 18.1
4.
EBIT = 385 - 210 + 120 + 50 = 345

EBIT / I = 345 / 50 = 6.9x
5.
790 / (226 + 381) = 1.30
Page 500
Problem 1
A.
The calculation of selected financial ratios for TRI for the fiscal year 20x2 is as
follows.
Current ratio = Current Assets / Current Liabilities
= $9,900 / $6,300
= 1.57
Quick ratio
= (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
= ($400 + 500 + 3,200) / 6,300
= 0.65
Times interest earned = Income before interest and taxes / Interest expense
= ($7,060 + 900) / 900
= 8.8
Return on sales = Operating income / Sales
= $7,460* / 30,500
* $7,060 Net Income Before Taxes + 900 Interest
= 24.5%
- 500 Interest Income
Total debt to equity = Total debt / Total Shareholders' Equity
= $8,300 / 8,700
= 0.95
Total asset turnover = Sales / Average total assets
= $30,500 / 16,500
= 1.85
Inventory turnover = Cost of goods sold / Average inventory
= 17,600 / 5,600
= 3.14
Page 501
B. The analytical use of each of the seven ratios presented above and what investors can
learn about TRI's financial stability and operating efficiency are presented below.
Current ratio
Measures the ability to meet short-term obligations using short-term assets.
TRI's current ratio has declined over the last three years from 1.62 to 1.57. This
declining trend, coupled with the fact that it is below the industry average, is not yet a
major concern; however, the company should be watched in the future as the ratio
assumes that non-cash current assets (particularly inventory) can be quickly converted
to cash at/or close to book value.
Quick ratio
Measures the ability to meet short-term debt using the most liquid assets.
TRI has improved its liquidity ratio over the last three years: however, it is still below
industry average. Furthermore, a liquidity ratio below 1 indicates that TRI may have
difficulty meeting its short-term obligations if inventory does not turn over fast
enough.

Measures the ability to meet interest commitments from current earnings. The higher
the ratio, the more safety for long-term creditors.
TRI's ratio has been improving over the last three years and is above the industry
average. This provides an indication that TRI has been paying down or refinancing
debt and/or increasing sales and profits which indicates long-term stability.
Return on Sales
Measures the operating income generated by each dollar of sales. It provides some
indication of the ability to absorb cost increases or sales declines.
TRI's profit margin has been improving and is currently above the industry average
indicating a trend towards marginal operating efficiency. Furthermore, it improves the
ability to absorb soft economic periods, pay down debt, or take on additional debt for
expansion.
Total debt to equity

Measures how well protected creditors are in case of possible insolvency. Measures
the degree of leverage and whether or not the entity will be able to obtain additional
financing through borrowing.
TRI's ratio has deteriorated slightly in 20x2 but has been below the industry average
over the last three years. This indicates that TRI should be able to raise additional
financing through debt and still remain below the industry average which indicates
there is long-term stability.
Page 502

Measures the efficiency of resource use, i.e., the ability to generate sales through the
use of assets.
TRI's ratio has been steadily improving and is above the industry average, indicating
good use of assets and ability to generate sales.
Inventory turnover
Measures how quickly inventory is sold, as well as, how effectively investment in
inventory is used. It also provides a basis for determining if obsolete inventory is
present or pricing problems exist.
TRI's ratio has been steadily declining and is below the industry average. This slower
than average situation may indicate a decline in operating efficiency, hidden obsolete
inventory, or overpriced stock items.
C. Limitations of ratio analysis include
difficulty making comparisons among firms in the industry due to accounting

differences. Different accounting methods may cause different results in straight line
depreciation versus accelerated methods, LIFO versus FIFO, etc.
the fact that no one ratio is conclusive.
Page 503
Problem 2
i)
Current ratio = current assets/current liabilities = $800,000/$450,000 = 1.78

The current ratio is one of the ratios that are useful in determining the liquidity of
a company. That is, it helps determine the company's short-term debt-paying
ability. To properly interpret this ratio, it should be compared with a benchmark,
such as the industry standard, or compared with the ratio for the past few years.
Without this information, we can only compare it with the general rule of thumb
that a current ratio of 2 or more is satisfactory. Based on this, it appears that Toss
Away Ltd.'s ability to pay short-term debt is below a satisfactory level.
ii)
Quick ratio = (cash + temporary investments + accounts receivable)

/current liabilities
= ($400,000 + $250,000)/$450,000 = 1.44
The quick ratio is another ratio that is useful in determining the liquidity of a
company. It eliminates slow-moving inventories from the current ratio formula.
Again, this ratio should be compared with an industry standard or with past years.
A general rule of thumb is that a quick ratio of 1 or more is satisfactory. Based on
this, Toss Away Ltd. has a very favorable quick ratio. Because inventories of the
company represent only a small proportion of current assets (i.e., 18.75% in
20x6), it can be concluded that the company has satisfactory ability to pay shortterm debt.
iii)
Accounts receivable turnover= sales/average accounts receivable

=
$2,200,000/[($250,000 + $175,000)/2]
=
10.35 times
Another way of evaluating liquidity is to determine how quickly certain assets,
such as receivables, can be turned into cash. Such ratios, called activity ratios,
provide information related to how efficiently the company utilizes its assets. The
receivables turnover provides some information on the quality of the receivables
and how successful the company is in collecting its outstanding receivables. The
higher this turnover, the more credence the current ratio and quick ratio have in
the financial analysis. The industry average collection period of 70 days may be
converted to the accounts receivable turnover (i.e., 365/70 days = 5.21 times).
Toss Away Ltd.'s accounts receivable turnover of 10.35 is significantly higher
than the industry average of 5.21 times which indicates that Toss Away Ltd. is
converting its receivables to cash more quickly than the industry average.
However, to properly assess receivables turnover, we need to compare it to the
desired turnover implied in the company's credit terms. For example, if it extends
30 days credit, Toss Away Ltd. would expect a receivables turnover of 12 times.
Page 504
iv)
Gross margin = (sales - cost of goods sold)/sales

=
($2,200,000-$1,350,000)/$2,200,000
=
$850,000/$2,200,000
=
38.6%.
When compared with trends or industry norms, this ratio provides information
about a company's profitability. Toss Away Ltd. has a favorable gross margin of
38 6% which is 4.6% above the 34% industry average.
v)
Times interest earned = income before taxes and interest charges/interest charges
=
[($300,000 / .6) + $100,000]/$100,000
=
$600,000/$100,000
=
6 times.
This is considered one of the coverage ratios. The coverage ratios help in
predicting the long-run solvency of a company and are of interest primarily to
long-term debtors who need some indication of the measure of protection
available to them. The times interest earned ratio stresses the importance of a
company covering all interest charges. Toss Away Ltd.'s times interest earned
ratio of 6 indicates that its profits are sufficient to cover interest, but is below the
industry average of 10 times. This, together with a higher than industry average
gross margin could signify that the company has higher interest charges (i.e.,
more debt) than the industry average.
Page 505
Problem 3
1.
Sales
Sales returns
Ending inventories
Cost of goods sold
Selling expenses
Income before tax
20x2 AMOUNTS AS A
PERCENTAGE OF 20x1 AMOUNTS
159%
334%
119%
203%
122%
214%
117%
106%
120%
2.
Sales
Sales returns
Ending inventories
Cost of goods sold
Selling expenses
Income before tax
20x2
Dollars
Percentage
$ 486,100
100%
(20,400)
4%
131,250
27%
291,600
60%
(160,400)
33%
262,450
54%
107,500
22%
48,600
10%
47,150
10%
20x1
Dollars
Percentage
$ 305,200
100%
(6,100)
2%
110,100
36%
143,700
47%
43%
(131,250)
122,550
40%
30%
91,500
45,750
15%
39,300
13%
3. The problem areas for Arnold appear to be:

a) Sales returns, which increased from 2% to 4%. Sales returns in 20x2 are 334%
of the 20x1 amount.
b) Cost of manufactured radios, which increased from 47% to 60%. Cost of
manufactured radios in 20x2 is 203% of the 20x1 amount.
c) Cost of goods sold, which increased from 40% to 54%. The 20x2 amount is
214% of the 20x1 amount, primarily because of the increase in cost of
manufactured radios.
Arnold should take a hard look at why its manufacturing costs and sales returns increased
in 20x2.
Page 506
Problem 4
1.
Quick ratio
Cash + Short-term Mkt.Sec. + Net short-term receivables
=
Current liabilities
=
$20,000 + $30,000 + $50,000

$70,000 + $20,000
$100,000
$90,000
1.11
2. Receivable turnover
Net credit sales
=
Average Receivables
=
$600,000
($50,000 + $150,000) / 2
$600,000
$100,000
3. Merchandise inventory turnover

Cost of goods sold
=
Average inventory
=
$1,200,000
($90,000 + $150,000) / 2
$1,200,000
$120,000
Page 507
10.0 times
4. Current ratio
Current Assets
Current Liabilities
$20,000 + $50,000 + $90,000 + $30,000

$90,000
$190,000
$90,000
2.11
Problem 5
1. Current Ratio
Current Assets
=
Current Liabilities
$432,000 - $281,600
Accounts payable + $25,000
1.6 =
(Accounts payable + $25,000) x 1.6 = $150,400

Accounts payable + $25,000 = $94,000
Accounts payable
= $69,000
2.
Total liabilities
.8
$432,000 ($300,000 + X)
$300,000 + X
.8
$132,000 X
$240,000 + .8X
1.8X
$(108,000)
($60,000)
Retained earnings
$(60,000)
Page 508
3.
Sales
Inventory
15
Sales
15 x Inventory
Gross margin =
Cost of goods sold

Inventory
Cost of goods sold
11
11 x Inventory
Sales - Cost of goods sold
$315,000 =
(15 x Inventory) - (11 x Inventory)
$315,000 =
4 x Inventory
Inventory =
$78,750
Problem 6
1. A usual but infrequently occurring charge of $10,000,000 was included in 20x2
selling, general, and administrative expenses. Per CICA Handbook Section 3480,
events that are unusual or infrequent, but not extraordinary, are normally reported as a
separate component of income from continuing operations. Therefore, selling,
general, and administrative expenses should be reported at $54,000,000 for 20x2, and
the infrequent charge should be a separate line item ($10,000,000). This separate
disclosure is necessary to ensure that the income statement is not misleading.
The extraordinary item of $10,000,000 included in the "other, net" category should be
reported in the income statement as an extraordinary item in accordance with CICA
Handbook Section 3480. The extraordinary loss should appear net of a $5,000,000 tax
effect in a separate section of Rayon's income statement immediately above net
income. The "other, net" category should then show an amount of $7,000,000. The
justification for this treatment is that such items are not representative of an
enterprise's earning potential and must be separated from normal operations to
facilitate user analysis.
The presentation of the adjustment required for correction of an error is appropriate.
A change from an accounting principle that is not generally accepted to one that is
generally accepted is treated retroactively per CICA Handbook Section 1506. It is
reported as a net-of-tax adjustment to beginning retained earnings. This treatment is
supported by the fact that a prior period error is unrelated to operations of the current
period. Also, prior period financials must be restated to fairly reflect Rayon's
financial condition at those points in time.
The presentation of per share data in the Notes to the Financial Statements is
inappropriate. Rayon's per share data should include income before extraordinary
items and net income. The rationale for this treatment is the significance attached to
Page 509
EPS by financial statement users and the importance of analyzing EPS in conjunction
with the entire set of financial statements.
Bottom portion of Income Statement:
Income before extraordinary item and taxes
Income taxes
Income before extraordinary item
Extraordinary item (net of $5,000 tax)
Net income
EPS on income before extraordinary item
Net income per share
$ 47,000
(21,800)
$ 25,200
(5,000)
$ 20,200
$2.52
2.02
2. The three financial analysis tools listed are ratios. Ratio analysis is used as an aid in
interpreting the relationships between various financial data. a) The quick (acid-test)
ratio attempts to measure the ability of the firm to pay its current liabilities as they
come due. It is a test similar to, although stricter than, the current ratio in that less
liquid current assets (such as inventory and prepaid expenses) are omitted from the
numerator. The ratio is concerned with the relationship between near-cash items and
current liabilities. b) Inventory turnover attempts to measure how quickly inventory is
sold. It can also aid in isolating problem areas such as obsolete inventory and pricing
errors. This ratio is concerned with the relationship between cost of goods sold and
inventories. c) Return on shareholders' equity attempts to measure the adequacy of net
income in relation to shareholders' investment. It is the percentage return earned on
funds invested by owners.
3.
Liquidity Analysis
20x2
20x1
Current Ratio
258,300 75,000 = 3.44
266,000 98,000 = 2.71
Quick Ratio
(Acid-Test Ratio)
(3,800 + 105,000 + 13,000)

75,000 = 1.62
(3,600 + 95,000 + 11,000)

98,000 = 1.12
Defensive Interval
Ratio
(3,800 + 105,000 + 13,000)

[(563,000 10,000 10,000
80,000) 365]
= 96 days
(3,600 + 95,000 + 11,000)

[(466,000 75,000) 365]
= 102 days
Page 510
Solvency Analysis
Debt-to-Equity Ratio
20x2
20x1
(177,300 + 74,000 + 9,000)

263,000
= .99
(180,000 + 67,000 + 8,000)

255,000
= 1.00
Times Interest Earned (37,000 + 10,000 + 10,000 +

2,000 ) 2,000
= 29.5
(34,000 + 1,500) 1,500

= 23.67
Profitability Analysis
20x2
20x1
Return on Sales
39,000* 600,000 = 6.5%
35,500* 500,000 = 7.1%
Return on Assets
39,000* 598,300 = 6.5%
35,500* 608,000 = 5.8%
Return on Equity
20,200 263,000 = 7.68%
18,200 255,000 = 7.14%
* excludes interest expense

Activity Analysis
Inventory turnover
20x2
400,000 / 134,000
= 2.99
20x1
325,000 / 154,000
= 2.11
Days Sales in
Accounts Receivable
105,000 (600,000 365)

= 64 days
95,000 (500,000 365)

= 69 days
600,000 598,300 = 1.00
500,000 608,000 = .822
Page 511

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CMA Ontario

Financial Accounting Module 1

Financial Statements and the Conceptual Framework

The Statement of Cash Flow

Accounting for Pensions

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Accounting for Leases

Accounting for NonProfit Organizations

Financial Statement Analysis

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Financial Accounting Module 1

Financial Statements and the Conceptual Framework

The Accounting Cycle

CMA Ontario September 2009

Financial Accounting Module 1

the assets sold had an original cost of $40,000 and accumulated

CMA Ontario September 2009

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CMA Ontario September 2009

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CMA Ontario September 2009

Financial Accounting Module 1

Cost of goods sold

Accrued wages payable at December 31, 20x6 is $1,300.

Accrued wages payable

The balance in unearned revenues at December 31, 20x6 should be $10,000.

Income tax expense

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

CMA Ontario September 2009

Financial Accounting Module 1

Allowance for Doubtful Accounts

LIABILITIES AND SHAREHOLDERS' EQUITY

Accrued Wages Payable

Accrued Inc Taxes Payable

CMA Ontario September 2009

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Wages and Salaries

Gain on Disposal of Assets

Cost of Goods Sold

Bad debt expense

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Net income before taxes

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Balance, December 31, 20x5

CMA Ontario September 2009

Financial Accounting Module 1

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CMA Ontario September 2009

Financial Accounting Module 1

Components of Financial Statements

the name of the reporting entity,

the presentation currency, and

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CMA Ontario September 2009

Financial Accounting Module 1

The Statement of Financial Position