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Instructor’s Manual 1-1 Chapter 1 Copyright © 2013 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this

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Kieso, Weygandt, Warfield, Young, Wiecek, McConomy Intermediate Accounting, Tenth Canadian Edition

CHAPTER 1

THE CANADIAN FINANCIAL REPORTING ENVIRONMENT

CICA HANDBOOK

Introduction and Overview: The CICA Accounting Handbook is comprised of the following:

Part I Accounting, Part I International Financial Reporting Standards (IFRS)

Part II Accounting, Part II Accounting Standards for Private Enterprises (ASPE)

Part III Accounting, Part III Accounting Standards for Not-for-profit organizations

Part IV Accounting, Part IV Accounting Standards for Pensions

Part V Accounting, Part V Pre-changeover accounting standards




Note that the focus of this text is on the first two parts. Part II (ASPE) was previously commonly referred to as Private Entity GAAP and includes many of the provisions in the pre-changeover accounting standards, though many have been simplified.

Both IFRS and ASPE are required for year-ends beginning on or after 2011. A private enterprise is one that has not issued, and is not in the process of issuing debt or equity instruments that are, or will be, outstanding and traded on a public market. A private enterprise does not hold assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses.

CHAPTER OBJECTIVES

Many students tend to skim through this chapter and, perhaps, dismiss it as of little importance since it does not contain any numbers and debits and credits— the things that they may believe accounting is all about. The chapter, however, provides a good opportunity to stretch their horizons and begin to build their own framework and perspective on this discipline. This can be done by emphasizing the broader role of accounting in society as a source of information about economic activity: that it involves much more than just making bookkeeping entries and deals with measurement and reporting alternatives that have an impact on resource allocation in our society, both at home and internationally. This is also a good time to point out the links between accounting and other courses in their curriculum, such as finance, economics, management, and organizational behaviour.




LEARNING OBJECTIVES

1. Explain how accounting makes it possible to use scarce resources more efficiently.

2. Explain the meaning of “stakeholder” and identify key stakeholders in

financial reporting, explaining what is at stake for each one.

3. Identify the objective of financial reporting.

4. Explain how information asymmetry and bias interferes with the objective of financial reporting.

5. Explain the need for accounting standards.

6. Identify the major entities that influence the standard-setting process and

explain how they influence financial reporting.

7. Explain the meaning of generally accepted accounting principles (GAAP).

8. Explain the significance of professional judgement in applying GAAP.

9. Discuss some of the challenges and opportunities for accounting.




CHAPTER REVIEW

Financial statements and financial reporting

1. World markets are becoming increasingly intertwined. And, due to technological advances and less onerous regulatory requirements, investors are able to engage in financial transactions across national borders, and to make investment, capital allocation, and financing decisions involving many foreign companies. As a result, an increasing number of investors are holding securities of foreign companies, and a significant number of foreign companies are found on national exchanges.

2. Accounting is a service activity, a descriptive/analytical discipline, and an

information system. It may be defined as the process of (1) identification, measurement, and communication of financial information about (2) economic entities to (3) interested persons. Its purpose is to help the interested person in making decisions.

3. The focus of this text is on the subset of the accounting discipline known as

financial accounting (financial reporting). This subset is concerned with the accumulation of financial information for the purpose of developing financial statements that report on an entity's financial position, the results of operations, and cash flows. The generalized format of these financial statements makes them useful to individuals both internal and external to the enterprise.

4. A principal means of communicating financial information to those outside

an enterprise is through financial statements: the balance sheet, income statement, statement of cash flows, and statement of owners’ or shareholders equity. Some alternative terminology used in IFRS for financial statement titles are: statement of financial position, statement of comprehensive income, statement of cash flows, and statement of changes in equity.

5. Note disclosure, an important part of each financial statement, must be

considered in conjunction with the information provided within the body of the statement. Additional financial information is often provided by means of financial reporting through other mechanisms such as the president’s letter, supplementary schedules in the corporate annual report, reports filed with government agencies, prospectuses and news releases. Such information may be required by authoritative pronouncements or regulatory agencies or disclosed because management wished to do so voluntarily.




6. The economic activities of a business enterprise represent a complex network of events that shape the financial position, results of operations, and cash flows of that enterprise. However, for those economic activities to be meaningful, they must be identified, measured, organized, and reported on in a manner that effectively serves users’ needs. Accounting is the process by which individual economic activities of an enterprise are accumulated into useful financial reports. This information affects perceptions of financial position and success. These perceptions can lead to changes in behaviour and, ultimately, decisions made about the company.

Accounting and capital allocation

7. The fact that markets and free enterprise determine whether a business is

successful places a substantial burden on the accounting profession to measure performance accurately and fairly on a timely basis. Investors must be able use the financial information provided to assess risk and relative returns associated with investment opportunities and thereby channel limited resources more effectively. In Canada, the primary exchange mechanisms for allocating resources are debt markets, equity markets, and financial institutions.

8. An effective processing of capital allocation promotes productivity,

encourages innovation, and provides an inefficient liquid market for buying and selling securities and obtaining and granting credit. When information is unreliable and irrelevant, poor capital allocation results.

Stakeholders

9. Stakeholders are those who have something to risk as a result of financial

reporting such as their jobs, salaries, investments, or reputation. Key stakeholders include traditional users of financial information (investors and creditors) who rely directly on the financial information for resource allocations. In broader terms, stakeholders include these traditional stakeholders as well as those who help in the efficient allocation of resources such as financial analysts, auditors, unions, industry groups, customers, employees, and regulators who review, audit and monitor information. Stakeholders also include management, the preparer of financial information.




Objective of Financial Reporting

10. The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers.

a. General-purpose financial statements provide at the least cost the most useful information possible to a wide variety of users.

b. Capital providers (investors) are the primary user group and have the most critical and immediate need for information in the financial statements. Investors need this information to assess a company’s ability to generate net cash inflows and to understand management’s ability to protect and enhance the assets of a company.

c. The entity perspective means that the company is viewed as being separate and distinct from its creditors and owners (shareholders). Therefore, the assets of the company belong to the company, not a specific creditor or shareholder. Financial reporting focused only on the needs of the shareholder—the proprietary perspective—is not considered appropriate.

d. Decision-usefulness means that information contained in the financial statements should help investors assess the amounts, timing, and uncertainty of prospective cash inflows from dividends or interest, and the proceeds from the sale, redemption, or maturity of securities or loans. In order for investors to make these assessments, the financial statements and related explanations must provide information about the company’s economic resources, the claims to those resources, and the changes in them.

11. Information generated using the accrual basis of accounting provides a

better indication of a company’s present and continuing ability to generate favourable cash flows than the cash basis.




Information Asymmetry

12. Ideally, to facilitate the flow of capital in the most efficient and effective manner, all stakeholders should have equal access to all relevant information. In other words, there should be symmetry of access to information (information symmetry). This is nice in theory but it does not always work in practice. Management may feel that disclosure of all information may hurt the company’s competitive advantage or position. For this reason (and others), perfect information symmetry does not exist and as a general rule, management rightly has access to more information than others since they run the company. In other words, there is information asymmetry. Accounting and economic theory tries to help us understand these issues. The efficient markets hypothesis proposes that market prices reflect all information about a company. There are two common types of information asymmetry problems that are studied by academics: adverse selection and moral hazard.

a. Adverse selection — This means that where information asymmetry exists, the capital marketplace may attract the wrong type of company; that is, those companies that have the most to gain from not disclosing information.

b. Moral hazard — This concept refers to human nature and notes that people will often shirk their responsibilities if they think that no one is watching, which encompasses the prejudices of management bias, aggressive accounting and conservative accounting. Any bias in financial reporting results in less useful information.

13. The financial statements that result from the accounting process are based

upon a conceptual framework and accounting standards developed by the accounting profession. The accounting profession has attempted to provide a body of accounting theory and practice that is generally accepted and applied. This body of accounting theory and practice serves to promote comparability in the preparation and analysis of financial statements. The accounting profession in each country, including Canada, has developed a common set of accounting concepts, standards, and procedures known as generally accepted accounting principles (GAAP). GAAP serves as a guide to the accounting practitioner in accumulating and reporting the financial information of a business enterprise. The ultimate adoption of some generally accepted accounting principles has caused controversy among accountants as well as members of the financial community. However, a majority of the members in each group recognizes the ultimate benefit an accepted set of accounting principles can bring to the financial reporting process.




Standard Setting

14. The organizations that are responsible for developing financial reporting standards in Canada include: a. Canadian Accounting Standards Board (AcSB); b. International Accounting Standards Board (IASB); c. The Financial Accounting Standards Board (FASB) and the Securities

Exchange Committee (SEC); and d. Provincial securities commissions such as the Ontario Securities

Commission (OSC).

15. The objectives of the AcSB are as follows: a. To establish financial reporting standards and guidance that improve the

quality of information reported by Canadian entities, principally annual and interim general purpose financial statements, with due consideration for the costs and the benefits to the preparers and users of financial statements of different categories of reporting entity, and changes in the economic environment.

b. To facilitate the capital allocation process in both the business and not- for-profit sectors through improved information.

c. To participate with other standard setters in the development of a single set of high quality internationally accepted financial reporting standards.

d. To support the implementation of financial reporting standards and the resolution of emerging application issues.

The Accounting Standards Oversight Council (AcSOC) oversees AcSB activities.

16. The AcSB has historically been responsible for setting standards for public

and private entities as well as not-for-profit entities (including some profit- oriented government entities). From 2011 onward, the AcSB is responsible for setting standards for private enterprises, not-for-profit entities, and pension plans only as these three groups do not generally operate in global markets and are simple business models. Private companies that are global and complex may choose to follow IFRS (particularly if they are planning in the future to go public). Standards for publicly accountable entities (public companies) will be set by the International Accounting Standards Board.




17. The International Accounting Standards Board (IASB) was created to aid in the development of a single set of high quality and understandable and international accounting standards for the preparation of general purpose financial statements for use in the world’s capital markets. This International GAAP is commonly referred to as International Financial Reporting Standards (IFRS). Much progress has been made, though eliminating differences is not easy as the financial reporting objectives in each country generally have strong national tendencies. The goal of the IASB is to promote the use of those standards while taking into account the different needs of the participants; and to bring about harmonization of national accounting standards and International Financial Reporting Standards (IFRS) to high quality solutions.

18. The international standard-setting structure is composed of four

organizations: the International Accounting Standards Committee Foundation (IASCF), the International Accounting Standards Board (IASB), a IFRS Standard Advisory Council (SAC), and an International Financial Reporting Interpretations Committee (IFRIC). a. The trustees of the IASCF select the members of the IASB and the

SAC, fund their activities, and oversee the IASB’s activities. b. The IASB develop, in the public interest, a single set of high-quality and

understand-able IFRS for general-purpose financial statements. The IASB relies on the expertise of various task force groups formed for various projects and on the SAC.

c. The SAC consults with the IASB on major policy and technical issues and also helps select task force members.

d. The IFRIC acts as the “problem filter” for the IASB, leaving the IASB to work on more pervasive long-term problems. It addresses controversial accounting problems as they arise, and determines whether it can quickly resolve them or whether to involve the IASB in solving them.

19. The IASB has a thorough, open and transparent due process in

establishing financial accounting standards. It consists of the following elements: a. An independent standard-setting board overseen by geographically and

professionally diverse body of trustees. b. A thorough and systematic process for developing standards. c. Engagement with investors, regulators, business leaders, and the

global accountancy profession at every stage of the process. d. Collaborative efforts with the worldwide standard-setting community.




20. To implement its due process, the IASB follows specific steps to develop a typical IFRS: a. Topics are identified and placed on the Board’s agenda. b. Research and analysis are conducted and discussion papers are

issued on the preliminary views of pros and cons. c. Public hearings are held on the proposed standard. d. Board evaluates research and public response and issues an exposure

draft. e. Board evaluates responses and changes exposure draft, if necessary.

Then final standard is issued.

21. The following characteristics of the Board are meant to insulate its members as much as possible from the political process, favoured industries, and national or cultural bias: a. Membership: The Board consists of 14 members, from 9 different

countries, serving 5-year renewable terms. Two members are part-time. b. Autonomy: The IASB is not part of any professional organization. It is

appointed by and answerable only to the IASCF. c. Independence: Full-time members must sever all ties with their former

employer. Members are selected for their expertise rather than to represent a given country.

d. Voting: Nine of 14 votes are needed to issue a new IFRS.




22. The IASB issues three major types of pronouncements: a. International Financial Reporting Standards: To date the IASB has

issued 13 IFRS standards. In addition, the previous international standard-setting body, the International Accounting Standards Committee (IASC) issued 40 International Accounting Standards (IAS). Those that have not been amended or superseded are considered under the umbrella of IFRS.

b. Framework for Financial Reporting: The IASC issued the Framework for the Preparation and Presentation of Financial Statements (referred to as the Framework) with the intent to create a conceptual framework that would serve as a tool for solving existing and emerging problems in a consistent manner. However, the Framework is not an IFRS and does not define standards for any particular measurement of disclosure issue. Nothing in the Framework overrides a specific IFRS.

c. International Financial Reporting Interpretations: Interpretations are issued by the IFRIC and are considered authoritative and must be followed. Seventeen have been issued to date. These interpretations cover (1) newly identified financial reporting issues not specifically dealt with in IFRS, and (2) issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop, in the absence of authoritative guidance.

23. The IASB has no regulatory mandate and no enforcement mechanism. It

relies on other regulators to enforce the use of its standards. For example, the European Union requires publicly traded member country companies to use IFRS. Any company indicating that it prepares its financial statements in conformity with IFRS must use all of the standards and interpretations. The hierarchy of authoritative pronouncements is: IFRS, IAS, Interpretations issued by either the IFRIC or its predecessor the SIC, the requirements and guidance in standards and interpretations dealing with similar and related issues, the Framework, and most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards.




24. In the United States, the Financial Accounting Standards Board (FASB) is the major standard-setting body, although it does not have final authority over standards—instead, the Securities and Exchange Commission (SEC) does. The SEC has confirmed its support for the FASB by stating that financial statements that conform to FASB standards will be presumed to have substantial authoritative support. U.S. GAAP has and will continue to have a significant impact on GAAP in Canada. First, since Canadian GAAP is based on principles and is fairly open to interpretation, accounting professionals have often relied on the more prescriptive, specific guidance provided in U.S. GAAP. Second, many Canadian companies are also listed on U.S. stock markets and exchanges.

25. Provincial Securities Commissions have laws and legislation that require

companies that issue shares to the public and the shares are traded on a Canadian stock exchange must produce GAAP financial statements. Stock exchanges, as well as securities commissions, have the ability to fine a company and/or delist the company’s shares so compliance with GAAP is mandatory.

Generally Accepted Accounting Principles (GAAP)

26. GAAP includes not only specific rules, practices, and procedures for

particular circumstances but also broad principles and conventions that apply generally, including underlying concepts.

27. As mentioned previously, GAAP is the standard followed by public

companies, private companies, pension plans, and not-for-profit entities. GAAP is divided into primary and other sources. The primary sources must be looked at first, but if a primary source does not specifically address an issue, the entity must use accounting policies that are consistent with the primary source through the used of professional judgement and in accordance with the conceptual framework embodied in the relevant Part of the CICA Handbook.

28. For public companies, the primary sources of GAAP incorporate:

a. International Financial Reporting Standards (IFRS), b. International Accounting Standards (IAS), and c. Interpretations (IFRIC)




29. Under ASPE, the GAAP hierarchy requires users to consider first the Handbook, Part II, Sections 1400 to 3870, including appendices and second, Accounting guidelines, including appendices. These are the primary source of GAAP. Other sources are noted in Section 1100 of the CICA Handbook, Part II and include Background information and basis for conclusion documents issued by the AcSB; AcSB implementation guidance; pronouncements; Approved drafts of previously non-existent primary sources; research studies, accounting textbooks, journals, studies, and articles; and other sources such as industry practices.

Professional Judgement

30. While IFRS and ASPE provide important guidance, the resolution of many

issues regarding financial statement reporting for particular companies and circumstances must still rely heavily on the exercise of professional judgement. Professional judgement plays an especially important role for Canadian and international accountants due to the basic philosophy that there cannot be a rule for every situation. Professional judgement reflects the ability to make an appropriate decision regarding unfamiliar and changing situations. Exercising professional judgement requires a thorough knowledge and understanding of IFRS and ASPE and reflects education, experience, and ethics.

Challenges and Opportunities for the Accounting Profession

31. The financial reporting environment is changing rapidly. Government

regulation in the capital marketplace has increased due to some major corporate scandals. The Sarbanes-Oxley Act (SOX) enacted in 2002 gave the SEC more resources to fight fraud and poor reporting practices. In addition, and accounting oversight board (Public Company Accounting Oversight Board) was established and given oversight and enforcement authority. In Canada, stronger independence rules, management accountability measures, and codes of ethics for financial officers were put in place. Essentially the effect of these measures has put more emphasis on government regulation and less on self-regulation.




32. Because accounting information is to help in decision-making, it can influence behaviour. Consequently, ethical behaviour by accountants is crucial to maintaining the integrity of the accounting profession. In accounting, ethical dilemmas are encountered frequently. The steps that may help in the process of developing ethical awareness and resolving ethical dilemmas are as follows:

a. Recognize an ethical situation or ethical dilemma. b. Move towards an ethical resolution by identifying and analysing the

principal elements in the situation. c. Identify the alternatives and weigh the impact of each alternative on

various stakeholders. d. Select the best or most ethical alternative considering all the

circumstances and the consequences.

33. While politics influences the development of standards, this is not necessarily a bad thing given the economic impact of those standards implemented. Nonetheless, politics should not be the main motivation for standard setting. Special interest groups are other stakeholders that will fight to get what they want as well. As more and more countries adopt IFRS, diverse political climate, as well as other cultural, economic, social and legal needs of the countries involved will need to be considered in the standard setting process.

34. A key issue with standard setters in various jurisdictions is the principles

versus rules debate regarding GAAP.

U.S. GAAP has historically been more prescriptive (even though it is based on principles) and thus has leaned toward the rules-based approach. In a rules-based approach—much like the Canadian tax system—there is a rule for most things (even though the rule may be based on a principle). The result is that the body of knowledge is significantly larger. Unfortunately, the rules-based approach does not always emphasize the importance of communicating the best information for users.

IFRS and ASPE are more principles-based. The body of knowledge is smaller and the idea is that one or more principles form the basis for decision-making in many differing scenarios. In addition, professional judgement is fundamental. There is less emphasis on right and wrong answers. Rather, the financial reporting is a result of carefully reasoned application of the principle to the business facts. In a principles-based body of knowledge, bright-line tests are minimized. Bright-line tests are numeric benchmarks for determining accounting




35. Other changes in the financial reporting environment are characterized by the following:

a. Globalization of companies and capital markets results in a greater

need for comparability of financial information across different countries.

b. As technology continues to advance, the need for timely information is rising sharply. A continuous reporting model is already under discussion in the capital markets arena.

c. Increased requirement for accountability. This has in part been brought on by the increase in institutional investors who have greater investment knowledge and representation on corporate boards. In addition the CICA has several initiatives dealing with risk management, governance, and performances reporting that take a broader view of an all-inclusive business reporting.

36. Integrated reporting is a term that incorporates aspects of financial

reporting as well as measurements used by management to evaluate the business (including non-financial information) and information regarding opportunities and risks, critical success factors, management and shareholders, and background about the company. Business reporting can also include reports on environmental matters, human resources, or technological issues. The Balance Scoreboard model takes financial, customer, internal processes, and learning and growth perspectives of a company to help a company achieve its strategic vision by developing objectives within each perspective.




LECTURE OUTLINE

The material in this chapter can usually be covered in one class session. The issues in this chapter may be addressed by organizing a lecture around the following questions.

A. What is accounting?

1. Recognition, measurement, and disclosure (communication) of

financial information (discuss difference between financial statements, financial reporting, and business reporting).

TEACHING TIP

Illustration 1-1 can be used to identify the essential characteristics of accounting, financial statements, financial reporting, and business reporting.

a) Financial statements:

i. Income Statement ii. Balance Sheet iii. Statement of Cash Flows iv. Statement of Owners' or Shareholders' Equity

b) Financial reporting:

i. President's Letter and Management's Discussion and Analysis

ii. Prospectuses iii. Reports filed with security commissions and other

government agencies iv. News releases

c) Business reporting:

i. Financial and non-financial data ii. Management's analysis iii. Forward looking information (forecasts) iv. Information about management and shareholders v. Background about the company




Note: While business reporting provides insight into the broad information needs of stakeholders, the focus of financial accounting and auditing is on information reported in financial statements.

2. About economic entities (discuss types of entities: corporations,

partnerships, and proprietorships).

3. For interested parties (discuss shareholders, creditors, government agencies, management, employees, consumers, labour unions, etc.).

B. What is the objective of financial statements?

Based on CICA Handbook, Part II, Section 1000 on "Financial Statement Concepts," the objective of financial statements is to:

. . . communicate information that is useful to investors, creditors and other users in making resource allocation decisions and/or assessing management stewardship. Consequently, financial statements provide information about:

(a) an entity's economic resources, obligations, and equity; (b) changes in an entity's economic resources, obligations, and

equity; and (c) the economic performance of the entity.

This statement is consistent with many statements of objectives (e.g., FASB, CICA, The International Accounting Standards Committee). All reflect the underlying theme that the objectives of financial statements are to:

1. Provide information that is useful to present and potential investors,

creditors, and other users in making rational investment, credit, and similar decisions;

2. To provide information to help present and potential investors,

creditors, and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans; and

3. To provide information about the economic resources of an

enterprise, the claims on those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources.




C. What is the nature of the environment in which accounting operates?

1. A world of scarce resources. Accounting helps to identify efficient and inefficient users of resources.

2. A society of legal and ethical concepts of property and other rights.

Accounting recognizes these concepts in determining equity among the varying interests in a business entity.

3. An economic system in which owners and investors entrust the

custodianship of and control over property to managers. The stewardship function of accounting is fulfilled by providing reliable, relevant, comparable financial data for owner-manager use (i.e., where funds came from, what funds were used for, what were the results of their use—an accountability report).

4. An economic system consisting of various groups having different

interests in a business. All interest groups seek information about the business. Consequently, there are many diverse users and uses for financial statements.

5. An economic system in which economic activity is continuous and

interdependent over time. Accounting statements, however, divide activities into particular time periods resulting in the need to make predictions about and estimates regarding the future.

6. An economic structure in which economic activity is conducted by

separately identifiable business enterprises.

7. An economic system that requires monetary measures of enterprise events that affect economic resources, obligations, and residual interests.

D. Why are ethics a crucial aspect of accounting?

1. Accounting information can influence behaviour (decision making).

2. Accounting information needs to be fair and unbiased.

3. Because estimates and judgements are required and there are

significant pressures that may tempt to sway these estimates and judgements into certain directions, accountants must always act ethically in doing their job. Without an ethical focus, the integrity of financial statement information would be non-existent.




E. Why are generally accepted accounting principles (GAAP) needed?

1. Because of the need for comparability, fairness, and understandability.

3. To minimize management bias, ambiguity, inexactness, and

misinterpretation.

F. What constitutes GAAP?

The CICA Handbook states that GAAP "encompasses not only specific rules, practices, and procedures relating to particular circumstances but also broad principles and conventions of general application, including underlying concepts." This definition is interpreted to mean that GAAP includes:

The Conceptual Framework - objectives; qualitative characteristics of information; definitions of

elements of financial statements; recognition and measurement guidelines; assumptions, principles, and constraints.

For private companies, pension plans, and not-for-profits, GAAP is divided into primary sources and other sources. Discuss the primary sources (CICA Handbook, Part II, Sections 1400 to 3870 including appendices and Accounting Guidelines, including appendices), and other sources. Discuss how these primary and secondary sources are applied (i.e. a secondary source is used when specific issues are not dealt with directly in a primary sources, however the secondary source must be consistent with primary sources, developed by applying professional judgement in accordance with Section 1000 concepts.

For public companies, IFRS will be followed, but the concepts are similar. Note that footnote 13 states: “Technically, IFRS will be considered to be part of the Canadian CICA Handbook for legal reasons although the CICA Handbook as it relates to IFRS will exactly mirror the IASB standards. This was done as an interim measure as many Canadian laws refer to Canadian GAAP. At some point, these laws will be amended to reflect the fact that GAAP for public companies in Canada is IFRS per the IASB.” This should help clarify for students that the shift to IFRS has been an ongoing harmonization process and that Canadian GAAP will not greatly differ in crucial areas from IFRS.




G. Who has authority to set standards?

The Accounting Standards Board (AcSB) of the CICA is responsible for the financial accounting recommendations in the CICA Handbook. Discuss the due process system for both Canadian and International standards.

TEACHING TIP

Use Illustration 1-7 in the text to illustrate the evolution of New or Revised Canadian Standards. Refer to Illustration 1-9 in the text to illustrate the evolution of a new or revised International financial reporting standard respectively. Have students compare the two processes for similarities and differences.

H. How are standards enforced?

1. CICA Handbook recommendations have legal status and, as such, violation could result in court proceedings and judgements.

2. Auditor's examination of financial statements related to rendering an auditor's report.

3. Professional codes of ethics.

4. Securities exchange requirements.

5. Reporting requirements of banks for accessing credit.

6. General acceptance.

I. Why are various groups interested in accounting?

TEACHING TIP

Illustration 1-2 can be used to discuss the major groups that are influential in the standard setting process.

1. Describe these groups, their composition and their interests.

2. Discuss the impact of accounting on the interests of each group.

3. Discuss the impact of these groups on accounting.




J. What is the role of government in standard setting?

1. Through the CBCA, development of standards has been left with the profession through the AcSB’s development of the CICA Handbook.

2. Discuss the Enron scandal as a major event that challenged the

viability of the capital market system. The end result was to increase government regulation in the marketplace. In 2002, the SEC approved new auditor independence rules and materiality guidelines for financial reporting. The Sarbanes-Oxley Act was signed into law.

3. Consider the Macdonald Commission report and its possible

consequences.



ILLUSTRATION 1-1


THE ESSENTIAL CHARACTERISTICS OF ACCOUNTING, FINANCIAL REPORTING, AND ELEMENTS NEEDED TO ACHIEVE A SINGLE SET OF HIGH-QUALITY ACCOUNTING STANDARDS

Economic Entity

Financial Information

Accounting? …………… Recognizes and

Financial Reporting

Financial Statements Additional Information

Measures and Discloses (communicates)

Balance Sheet Income Statement Statement of Cash Flows Statement of Owners’ or Shareholders’ Equity

Corporation annual reports President’s letter Supplement schedules Management Discussion Prospectuses News releases Management forecasts Etc.

Prepared in accordance Not necessarily covered with IFRS/ASPE by IFRS/ASPE

Elements of High-Quality Accounting Standards

- A single set of high-quality accounting standards established by a single standard setting body - Consistency in application and interpretation - Common high-quality auditing standards and practices - Common approach to regulatory review and enforcement - Education and training of market participants - Common delivery systems - Common approach to corporate governance and legal frameworks around the world.



ILLUSTRATION 1-2


USER GROUPS THAT ARE INTERESTED IN AND CAN INFLUENCE THE FORMULATION OF ACCOUNTING STANDARDS

Business entities

(management)

Public accounting firms Financial community (analysts, bankers, etc.)

Academics (CAAA)

Professional organizations (CICA, SMAC, CGAAC)

Government Non-Canadian Canada Customs and Revenue standard setters Securities commissions (IASB, FASB)

Stock exchanges

Investing public Industry associations

AcSB

CICA Handbook




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CHAPTER 2

CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL REPORTING

CHAPTER OBJECTIVES

Chapter 2 focuses on the conceptual framework underlying financial accounting. The objectives of the chapter are to (1) provide a framework for, and an understanding of, basic financial accounting theory; (2) describe the usefulness of, and attempts to construct, a conceptual framework; (3) define the objectives, qualitative characteristics, and basic elements of accounting; and (4) discuss the foundational principles (economic entity, control, revenue recognition and realization, matching, periodicity, monetary unit, going concern, historical cost, fair value and full disclosure) and the constraints of accounting (cost-benefit and materiality). These notions should enhance your understanding of the topics covered in intermediate accounting.




LEARNING OBJECTIVES

1. Indicate the usefulness and describe the main components of a conceptual framework for financial reporting.

2. Identify the qualitative characteristics of accounting information.

3. Define the basic elements of financial statements.

4. Describe the foundational principles and constraints of accounting.

5. Explain the factors that contribute to choice and/or bias in financial reporting

decisions.

6. Discuss current trends in standard setting for the conceptual framework.

7. Understand in greater detail how fair value is measured (Appendix 2A)




CHAPTER REVIEW

Conceptual Framework

1. A conceptual framework in accounting is a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribe the nature, function, and limits of financial accounting and financial statements. The benefits its development will generate can be characterized as follows:

a. The standard setters (AcSB, IASB, FASB) will be able to issue more useful and consistent standards in the future.

b. Problems in practice should be solved more rapidly and consistently by reference to a framework of basic theory.

c. Understanding of and confidence in the financial reporting process by financial statement users will be increased.

d. Comparability with respect to the financial statements of various companies will be enhanced.

2. The 1980 CICA research study Corporate Reporting: Its Future Evolution

represents the first major Canadian document related to the development of a conceptual framework. It discussed the objectives of financial statements and suggested criteria for the development of financial accounting standards. In 1987, Conceptual Framework for Financial Reporting was published by the Accounting Standards Authority of Canada to assist in standard setting, education, and preparation of financial statements. In 1988, Section 1000 on "Financial Statement Concepts" was incorporated into the CICA Handbook to be used by the AcSB to develop standards and to help preparers and auditors of financial statements in exercising professional judgement. While these documents were written with the tradition and environment of Canadian financial accounting in mind, the conclusions expressed regarding the composition of a conceptual framework closely paralleled those derived by the FASB in the U.S.




The IASB recognized the need for a conceptual framework upon which a consistent set of financial accounting standards could be based. The FASB and the IASB are currently working on a joint project to develop a common conceptual framework that provides a sound foundation for developing future accounting standards. The framework will consist of three levels. The first level identifies the objective of financial reporting. The second level provides the qualitative characteristics that make accounting information useful and the elements of financial statements. The third level identifies the assumptions, principles and constraints that describe the reporting environment. The AcSB has indicated it will likely adopt the framework for private enterprises as well.

First Level: Basic Objectives

3. The objective of financial reporting is the foundation of the Framework. The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers.

An implicit assumption is that users need reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This means that financial statement preparers assume a level of competence on the part of users, which impacts the way and the extent to which companies present information.

4. For ASPE, Section 1000 of the CICA Handbook states that the objective of

financial statements is to communicate information that is useful to investors, creditors, and others in making resource allocation decisions, including assessing management stewardship. As such, financial statements are to provide information that is (1) useful for making investment, credit, and other decisions; (2) useful in making resource allocation decisions. General purpose financial statements are intended to meet the needs of key users, creditors and investors.




Second Level: Fundamental Concepts

5. The fundamental qualitative characteristics that make information useful are relevance and representational faithfulness (or faithful representation). Added to this list is consistency, which the CICA Handbook recognizes as enhancing comparability. A brief description of each of these characteristics is given below.

a. Relevance: Accounting information is relevant if it can influence the decisions of users (i.e., it is capable of making a difference in a decision). Financial information is capable of making a difference when it has predictive value, confirmatory value, or both.

b. Representational faithfulness: Means that the numbers and descriptions contained in the financial statements match what really existed or happened. To be a faithful representation, information must be complete, neutral, and free of material error. Completeness means all information that portrays the events and transactions has been included and no pertinent information has been excluded. Neutrality means that information or accounting procedures are unbiased and that they have not been selected with an eye to favouring one group of stakeholders over another. Information that is free from material error or bias means that the information must be reliable. It does not mean total freedom from all error. It means that the information presented is as accurate as possible, given any estimates are based on the best information available at the time. Complicating this is that management estimates and judgement are often required, making it even more important to ensure information is complete, neutral, and free from material error or bias.

6. The enhancing qualities are complementary to the fundamental qualitative

characteristics. They include comparability, verifiability, timeliness, and understandability.

a. Comparability: Information that is measured and reported in a similar

manner for different companies is considered comparable. It enables users to identify the real similarities and differences in economic events between companies. Consistency is present when a company applies the same accounting treatment to similar events, from period to period.




b. Verifiability: Verifiability exists when knowledgeable, independent preparers or users, using the same methods, achieve similar results or reach a consensus regarding the accounting for a particular transaction.

c. Timeliness: Means having information available to decision-makers

before it loses its capacity to influence decisions.

d. Understandibility: Is the quality of information that lets reasonably informed users to see the connection between their decisions and the information contained in the financial statements. Understandability is enhanced when information is classified, characterized, and presented clearly and concisely.

Trade-offs of qualitative characteristics may be necessary in the presentation of financial information, but they should not render the information irrelevant. Similarly constraints of materiality and cost-benefit must be considered when preparing financial information. Something is considered material if leaving it out would make a difference in the decision process. A particular measurement or disclosure may not be warranted if the cost of providing it outweighs the benefits that accrue to the users.

Basic Elements

7. Knowledge of the specific meaning of certain basic elements is essential

for an understanding of financial accounting. However, the specific meaning that accountants attach to these basic elements sometimes differs from their meaning in a non-accounting context. These elements, as defined below, are further discussed and interpreted throughout the text. Note the difference in definitions for assets and liabilities between the existing standards and the current proposed definitions in Illustrations 2-7 and 2-9 in the text. Presented below are the definitions for assets and liabilities using the current proposed definitions.

Assets: Assets have two essential characteristics – (1) they involve present economic resources and (2) the entity has a right or access to these resources where others do not.

Liabilities: Liabilities also have two essential characteristics – (1) they represent an economic burden or obligation and (2) the entity has a present obligation (which is enforceable).




Equity/Net Assets: Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

Revenues: Increases in economic resources during the accounting period, either by inflows or other enhancements of assets or settlement of liabilities, resulting from the ordinary activities of an entity.

Expenses: Decreases in economic resources during the accounting period, either by outflows or the reduction of assets or the incurrence of liabilities, resulting from an entity’s ordinary revenue generating activities.

Gains: Increases in equity (net assets) from peripheral or incidental transactions and events affecting an entity and from all other transactions, events, and circumstances affecting the entity except those that result from revenues or equity contributions.

Losses: Decreases in equity from peripheral or incidental transactions and events affecting an entity and from all other transactions, events, and circumstances affecting the entity except those that result from expenses or distributions to owners.

Note that Other Comprehensive Income (OCI) could theoretically be excluded as a separate financial statement element as it includes elements already discussed (revenues, expenses, gains and losses) except that they are included in comprehensive income but excluded from net income. Comprehensive income includes both net income and other comprehensive income. Therefore, OCI could be considered just a subclassification on the income statement.

Third Level: Foundational Principles

8. In the practice of financial accounting, certain foundational principles are important to an understanding of the manner in which data are assembled and presented. The following principles underlie the financial accounting structure and can be loosely grouped under headings of recognition/derecognition; measurement; and presentation and disclosure.




Recognition/derecognition

Recognition/derecognition is concerned with those elements that should be included/removed from a company’s balance sheet or income statement. When determining what should be included or excluded, the following principles should be considered:

a. Economic Entity Assumption: The economic activities of an entity can be accumulated and reported in a manner that assumes that the entity is separate and distinct from its owners or other business units.

b. Control: If one reporting entity alone has the ability to direct the activities of another entity, even if they don’t exercise this option, and if they have access to the benefits of that entity, then the reporting entity has control, and the financial statement elements of both entities should be consolidated and reported on the controlling entity’s financial statements.

c. Revenue Recognition: Revenue is generally recognized when (1) risks and rewards have passed or the earnings process is substantially complete, (2) measurement is reasonably certain, and (3) collectibility is reasonably assured (realized or realizable).

d. Matching: Accountants attempt to match the expenses incurred to earn revenues with the revenues earned during a fiscal period. Use of accrual accounting procedures assists the accountant in allocating revenues and expenses among the fiscal periods that compose the life of a business enterprise. However, matching is an income statement focused concept whereas IASB and FASB accounting standard setters are more concerned with defining what constitutes assets and liabilities to ensure that costs that do not meet the definition of assets are not set up on the balance sheet. As a result, these costs would be expensed in the period in which they are incurred, regardless of when the revenue with which they are associated occurs.




Measurement

Elements are recognized in a financial statement if they meet the definition of an element and are measurable. Because measurement is complicated by the use of accrual accounting and estimates, accountants must determine an acceptable amount of uncertainty surrounding measurement with the use of measurement tools, and give sufficient disclosure to indicate the uncertainty that exists. The following principles are relevant to measurement issues:

a. Periodicity: The economic activities of an entity can be divided into artificial time periods for the purpose of providing periodic reports.

b. Monetary Unit.: Since money (dollars) is the common denominator by which economic activity is conducted, it is assumed that money provides an appropriate basis for accounting measurement and analysis. Additionally, it is generally assumed that the unit of measure—the dollar—remains reasonably stable in terms of purchasing power (stable dollar assumption).

c. Going Concern: In the absence of contrary information, it is assumed that a business entity will continue in operation for the foreseeable future and will be able to realise assets and discharge liabilities in the normal course of operations. This would not be the case if there was intent to liquidate the net assets of the company, to cease operations, or to cease trading in the company’s shares.

d. Historical Cost: GAAP requires that most transactions and events be recognized at the amount of cash or cash equivalents paid or received or the fair value ascribed to them when they took place. Historical acquisition cost is more reliable than other suggested valuation methods. However, in the interest of relevancy, there has been a movement toward a mixed valuation model that uses amortized cost, net realizable value or fair value, or a combination of the lower of cost and net realizable value, or lower of cost and fair value.




e. Fair Value: This is an emerging principle that may be more useful than historical cost for certain types of assets and liabilities, and for certain industries. Fair value is defined as “the price that would be received or the paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Standard setters have given companies the option to use fair value for most financial instruments (cash, investments, receivables, and payables) to promote the use of fair value. Certain IFRS standards further allow the use of fair value for non-financial assets such as investment properties, and property, plant and equipment.

Presentation and Disclosure

Presentation and disclosure indicates that anything that is relevant to decisions of the users should be included in the financial statements and should be disclosed. The principle relevant to this is:

Full Disclosure: In the preparation of financial statements, the accountant should include sufficient information to permit the reader to reach an informed decision about the financial condition and results of operation of the enterprise in question. This often results in a trade- off for preparers and users to ensure the information is detailed enough to make a difference to users but condensed enough to be understandable within the constraint of cost-benefits. Users can find information (1) within the main body of the financial statements, (2) in the notes to those statements, or (3) as supplementary information.




Factors Contributing to Choice in Financial Accounting

9. Many factors contribute to choice in financial reporting. The choices made should ensure financial information is of high quality. The accountant should be aware of factors that may affect the choices made to ensure the most appropriate choices are made. These factors include the following:

a. Canadian GAAP (both ASPE and IFRS) is principles-based meaning the

flexibility allowed requires the application of professional judgement, consistently applied;

b. The need to meet contractual and regulatory requirements (such as debt covenants)

c. Management bonuses based on earnings d. Capital markets focus on earnings and earnings per share.

10. Practice of financial engineering. Financial engineering is a process

whereby a business arrangement or transaction is legally structured such that it meets the company’s financial reporting objective (e.g., to maximize earnings, minimize a debt to equity ratio or other).

11. Factors that contribute to fraudulent financial reporting. Good financial

reporting should be a result of well-reasoned and supported analysis that is grounded in a conceptual framework. Fraudulent financial reporting, however, often results from pressures from individuals or the company. These pressures may arise from various sources, including worsening company, industry, or economic conditions; unrealistic internal budgets and financial statement focal points arising from contractual, regulatory or capital market expectation; and/or weak internal controls and governance.

The basic theory outlined in Chapter 2 is critical to a thorough understanding of the financial accounting process. In subsequent chapters, many problem areas are examined that use, build upon, and expand the framework developed in Chapter 2.

12. Compare IFRS to ASPE:

Both IFRS and ASPE are principles-based so fundamentally similar. The IASB and FASB are continuing to work on a joint project to complete a common conceptual framework. In Canada, it is the intent to use this framework for private enterprises as well. Standard setters continue to work on definitions for financial statement elements, recognition and measurement criteria, and presentation and disclosure issues.




13. Fair Value Measurements – the appendix looks at fair value measurement in greater detail. Fair value is market based, and if market data is readily available, the fair value is calculated based on a level one input, an objective measure. However level two and three inputs are more subjective and require valuation models and additional disclosure.




LECTURE OUTLINE

TEACHING TIP

Illustration 2-1 Intermediate Accounting Kieso et al. 10ce might be put up first to show the relationship between objectives, characteristics, elements, and foundational principles. The relationship between the three levels could be emphasized.

1. Need for a Conceptual Framework

a. Coherence in rules and standards b. Quicker solutions to new and emerging practical problems by reference to an existing framework of basic theory c. Increased user understanding of and confidence in financial reporting d. Enhanced comparability among companies' financial statements

2. Conceptual Framework for Financial Reporting

a. Objectives b. Qualitative characteristics c. Elements

Basic foundational concepts and constraints of accounting.

TEACHING TIP

Describe the components of the conceptual framework as shown in Illustration 2-1 and Illustration 2-4 of the textbook. You may wish to point out that the pyramid can be viewed as "upside down" in a sense. That is, the objectives of the first level form the characteristics and elements of the second level, which in turn support the basic foundational principles of the third level. The foundational principles used in establishing and applying accounting standards include 3 major groupings: Recognition/derecognition; measurement; and presentation and disclosure. These principles constitute an accepted theoretical base, both under IFRS and ASPE, upon which the qualitative characteristics, elements, and objectives have been developed.




3. First Level: Objectives (Recall that these were discussed in Chapter 1.)

a. Information that is useful in making rational investment, credit, and other decisions

b. Information to help in making resource allocation decisions c. Information that is useful in assessing management stewardship

4. Second Level: Qualitative Characteristics and Elements

Qualitative Characteristics: The overriding criterion for evaluating accounting information is that it be useful for decision making. To be useful, it must be understandable.

i. Fundamental Qualities:

Relevance: Accounting information is relevant if it is capable of making a difference in a decision. Relevant information has

(a) Predictive value (b) Feedback value

Representational Faithfulness: For accounting information to be useful, the numbers and descriptions contained in the financial statements must be transparent and faithfully represent what really existed or happened. To be a faithful representation, information must be:

(a) Complete (b) Neutral (c) Free from material error or bias

ii. Enhancing Qualities:

Comparability: Information that is measured and reported in a similar manner for different companies is considered comparable. Consistency is when a company applies the same accounting treatment to similar events, period to period.

Verifiability: Verifiability exists when knowledgeable, independent preparers or users achieve similar results or reach a consensus regarding the accounting for a particular transaction.




Timeliness: Information that is not provided in a timely manner loses its ability to influence the decisions of users.

Understandability: This quality or ability is relevant to both users and preparers of financial information. A user has the responsibility to obtain a reasonable knowledge of accounting information and business to use financial information to make decisions. Preparers have the responsibility to prepare information that is understandable to a reasonably informed user.

TEACHING TIP Discuss how trade-offs of qualitative characteristics and materiality and cost- benefit constraints may affect the presentation of financial information. Use the Brief Exercises as a quick tool to review the concepts.

iii. Elements

(a) Assets (emphasize existing standards with proposed standards for both assets and liabilities, as students coming from an introductory accounting course may not be familiar with the proposed standards).

(b) Liabilities (c) Equity (consists of investments by owners, less

distributions to owners) (d) Revenues. (e) Expenses. (f) Gains. (g) Losses.

In the above list: Items (a)–(c) are elements at a moment in time. Items (d)–(g) are elements during a period of time.

Explain how Other comprehensive income fits into the Elements components.




5. Third Level: Recognition, Measurement, and Presentation and Disclosure Principles

Recognition—the process of including an item in the financial statements of an entity.

Measurement—the process of determining the amount at which an item is recognized in the financial statements.

Presentation and Disclosure—the process of including information that is relevant to decisions of the users

Recognition, measurement, and presentation and disclosure in accounting are influenced by basic foundational principles and constraints.

a. Recognition/Derecognition—Elements are recognized in a financial

statement if they meet the definition of an element and are measurable. Relevant principles include:

• Economic entity—assumes economic activity can be identified

with a particular unit of accountability. • Control—requires that financial statement elements of another

entity be combined if one entity controls another • Revenue recognition—revenue generally recognized when

(1) risks and rewards have passed or the earnings process is substantially complete, (2) measurement is reasonably certain, and (3) collectibility is reasonably assured (realized or realizable).

• Matching—efforts (expenses) should be matched with accomplishments (revenues) whenever it is reasonable and practical to do so. Practical rules for expense matching:

• When direct association, costs are expensed against related revenues.

• When association exists but is difficult to determine, use rational and systematic allocation.

• When little if any association, expense.

• When a cost does not meet the definition of an asset,

expense




However, note that accounting standard setters are moving toward a balance sheet emphasis by ensuring that the balance sheet elements are property recognized and measured as a basis for measuring income which will have only an incidental relationship to the matching concept.

b. Measurement Principles—if an element is recognized, how much

should it be recorded at. Measurement principles include:

• Periodicity—activities of an enterprise can be divided into artificial time periods.

• Monetary unit—money is the common denominator by which economic activity is conducted and thus provides an appropriate basis for accounting measurement, aggregation, and analysis. A supporting assumption is that the monetary unit remains reasonably stable. Note that during periods of high inflation (e.g., the 1970s) this assumption is very tenuous.

• Going concern—assumes business enterprises will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the normal course of operations.

• Historical cost—most transactions and events are recognized at the amount of cash or cash equivalents paid or received or the fair value ascribed to them when they took place. A major advantage of historical cost is that it is verifiable.

• Fair value—Increasingly the historical cost measurement principle is giving way to other valuations, such as fair value, when this value is more relevant (such as for financial assets and liabilities).

c. Presentation and Disclosure Principles are concerned with where on the key financial statements should an item be shown (such as debt or equity) and how much detail should be given in the financial reports? Any transactions or balances that affect key numbers or ratios by a material amount become important and significant. The major principle here is:

• Full disclosure principle—revealing in financial statements any

facts of sufficient importance to influence the judgement and decisions of an informed reader. (Develop concept of a reasonably prudent investor.) Use of notes and supplementary information in financial reporting.




6. Factors that contribute to choice in financial reporting decisions. Many factors contribute to choice in financial reporting, including the following:

• GAAP in Canada is principles-based and therefore

requires the use of professional judgement. Principles- based GAAP provides consistency, flexibility, and neutrality, though principles-based GAAP is sometimes subject to criticism.

• The need to meet contractual and regulatory requirements (such as debt covenants)

• Management bonuses based on earnings • Capital markets focus on earnings and earnings per share • Measurement uncertainty (such as accrual accounting,

and complexity of business transactions).

7. Financial Engineering. This is often done by creating complex legal arrangements and financial instruments that meet the company’s desired objectives within GAAP; e.g., a company raising debt financing might want the instrument structured such that it meets the GAAP definition of equity versus debt. In this way, the debt to equity ratio is not affected. Since Enron, this practice has been curtailed.

8. Fraudulent Financial Reporting. Pressures may arise from the economic

or business environment, unrealistic budgets, analysts’ expectations, and others. These pressures cause the management to use the financial statements to portray something that doesn’t exist. If the situations are not controlled, major problems may arise. In order to minimize fraudulent financial reporting, various controls and solid governance structures may be put in place by a company, including:

• a vigilant, knowledgeable top management; • an independent audit committee; • an internal audit function; and • other internal controls at lower levels.

9. Discuss similarity between IFRS and ASPE. Both IFRS and ASPE are

principles-based and so are fundamentally similar. The IASB and FASB are continuing to work on a joint project to complete a common conceptual framework. In Canada, it is the intent to use this framework for private enterprises as well. Standard setters continue to work on definitions for




financial statement elements, recognition and measurement criteria, and presentation and disclosure issues.

10. Fair Value Measurement (Appendix 2A) — The appendix can be used to

look at fair value measurement in greater detail. If market data is readily available, the fair value can be calculated on this value as it is an objective measure (considered Level one input). However if market value is not available, valuation models are used (using level two and three inputs). Because these measures are more subjective, additional disclosure will be required.




ILLUSTRATION 2-1

CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING




ILLUSTRATION 2-2

EXPANDED CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING




LEGAL NOTICE







CHAPTER 3

THE ACCOUNTING INFORMATION SYSTEM

CHAPTER OBJECTIVES

Chapter 3 is intended to present a concise yet thorough review of the accounting process. Other objectives are to identify and explain the basic procedures of the accounting process and describe the way these procedures are combined in completing the accounting cycle.

Without doubt, this is the most procedural (bookkeeping) chapter in the text. Its importance, however, cannot be underestimated. A strong command of the material in this chapter is essential to knowing the language and process of accounting, which is used extensively in the remainder of the book.




LEARNING OBJECTIVES

1. Understand basic accounting terminology.

2. Explain double-entry rules.

3. Explain how transactions affect the accounting equation.

4. Identify the steps in the accounting cycle and the steps in the recording process.

5. Explain the reasons for and prepare adjusting entries.

6. Explain how the type of ownership structure affects the financial

statements.

7. Prepare closing entries and consider other matters relating to the closing process.

8. Prepare a 10-column work sheet and financial statements.

9. Identify adjusting entries that may be reversed (Appendix 3A).




CHAPTER REVIEW

1. The accounting process can be described as a set of procedures used in identifying, recording, classifying, and interpreting information related to the transactions and other events of a business enterprise. To understand the accounting process, it is important for an individual to be aware of the basic terminology employed in the process. The basic terminology includes: events, transactions, permanent (real) accounts, temporary (nominal) accounts, ledger, journal, posting, trial balance, adjusting entries, financial statements, closing entries, and reversing entries. These terms refer to the various activities that make up the accounting cycle. As we review the steps in the accounting cycle, the individual terms will be defined.

Double Entry Procedures: Debits and Credits

2. Once a transaction or other event has been identified as satisfying the criteria for recognition and measurement, it must be recorded in the accounts (step two). Double-entry accounting refers to the process used in recording transactions. The terms debit and credit are used in the accounting process to indicate the effect a transaction has on account balances. The debit side of any account is the left side, and the right side is the credit side. Assets and expenses are increased by debits and decreased by credits. Liabilities, equity, and revenues are decreased by debits and increased by credits.

3. In a double-entry system, for every debit there must be a credit and vice-

versa. This leads us to the accounting equation: Assets = Liabilities + Shareholders’ Equity.

4. The equity section of the statement of financial position reports the owners’

interest in the assets of the company. A corporation uses Share Capital, Contributed Surplus, Dividends, and Retained Earnings. A sole proprietorship or a partnership uses a Capital account and a Drawings account.

5. In a corporation, dividends, revenues, and expenses are transferred to

retained earnings at the end of a period, so a change in any one of these three accounts affects equity.




Transactions Analysis

6. The first step in the accounting cycle is analysis of transactions and selected other events. The purpose of this analysis is to determine which events should be recorded and, if recorded, at what amount (measurement). To be included (recognized) in the accounting process, a transaction or other economic event must affect an element of the financial statements and be reasonably (reliably) measurable.

7. Events can be classified as external or internal. External events are those

between the entity and its environment, whereas internal events relate to the accounting for activities totally within the entity. A transaction can have both external and internal elements. In recent years, the accounting profession has been looking at ways of reporting events that were previously not reported because they were considered too complex or immeasurable.

Journals

8. Transactions are initially recorded in a journal, sometimes referred to as the book of original entry. A general journal is a chronological listing of transactions expressed in terms of debits and credits to particular accounts. No distinction is made in a general journal concerning the type of transaction involved. In addition to a general journal, specialized journals are used to accumulate transactions possessing common characteristics. Special journals benefit the accounting process by summarizing similar transactions, such as sales on account, thus reducing the efforts associated with the posting process. Specialized journals are not examined in the text.

Posting

9. The next step in the accounting cycle involves transferring amounts entered the journal into the general ledger. The general ledger is a book (or computer file) that usually contains a separate page for each account. Transferring amounts from a journal to the ledger is called posting. Transactions recorded in a general journal must be posted individually, while entries made in special journals (sales, cash receipts, purchases, cash disbursements) are generally posted by columnar total.




10. The general ledger contains information related to the balance of accounts included therein. Many of the accounts listed in a general ledger are supported by subsidiary ledgers. Accounts such as accounts receivable and accounts payable represent an accumulation of many individual customer or creditor balances. An accounts receivable subledger contains a detailed listing of the individual customer account balances. The use of subsidiary ledgers frees the general ledger from details concerning numerous individual balances.

Trial Balance

11. The next step in the accounting cycle is the preparation of a trial balance. A trial balance is a list of all open accounts in the general ledger and their balances. An entity may prepare a trial balance at any time in the accounting cycle. A trial balance prepared after posting has been completed serves to check the mechanical accuracy of the journalizing and posting processes and provides a listing of accounts to be considered in making adjustments and preparing financial statements. While total debits may equal total credits, errors may still exist (e.g., entries may be posted to the wrong account, omitting a complete entry, journalizing incorrect amounts).

Adjusting Entries

12. Preparation of adjusting journal entries is the next step in the accounting cycle. Adjusting entries are entries made at the end of an accounting period to bring all accounts up to date on an accrual accounting basis so that financial statements can be prepared. Adjusting entries are necessary to achieve appropriate matching of revenues and expenses in determining net income for a period and to achieve an accurate statement of assets and equities existing at the end of the period. One common characteristic of adjusting entries is that they affect at least one permanent (real) account (asset, liability, or equity account) and one nominal (temporary) account (revenue or expense account). Adjusting entries are usually made for items classified as prepaid expenses, unearned revenues, accrued expenses, accrued revenues, and estimated items. An adjusting entry will never affect cash, although a correcting entry may affect cash.




13. Prepaid expenses and unearned revenues refer to situations where cash has been paid or received, but the corresponding expense or revenue will not be recognized until a future period. Accrued revenues (assets) and accrued expenses (liabilities) refer to revenues and expenses recognized in the current period, with the corresponding payment or receipt of cash to occur in a future period. Estimated items are expenses such as bad debts and depreciation whose amounts are a function of future events and developments.

Adjusted Trial Balance

14. After adjusting entries are recorded and posted, an adjusted trial balance is prepared. This trial balance serves as a basis for the preparation of the financial statements discussed in the next two chapters. Preparation of the adjusted trial balance and financial statements represents steps six and seven in the accounting cycle.

15. When inventory records are maintained on other than a perpetual basis, an

adjustment is usually needed to reflect the difference between the beginning and ending inventory. An adjusting/closing entry eliminates all temporary accounts related to the purchase of inventory by transferring them to Cost of Goods Sold and also adjusts the inventory account by crediting it for the beginning inventory amount and debiting the inventory account for the ending inventory amount. The ending amount is determined by a physical count and is the amount to be included on the statement of financial position (balance sheet).

A typical inventory adjusting/closing entry would include debits and credits to the following accounts:

Dr. Cr. Inventory (ending) XX,XXX Purchase Discounts X,XXX Purchase Allowances XXX Returned Purchases X,XXX Cost of Goods Sold XXX,XXX

Inventory (beginning) XX,XXX Purchases XXX,XXX Transportation-In X,XXX




Closing Entries

16. After financial statements have been prepared, nominal/temporary accounts (revenues and expenses) should be reduced to zero in preparation for recording the events and transactions of the next period. The closing process requires recording and posting of closing entries. All temporary accounts are reduced to zero by closing them through an Income Summary account. The net balance in the Income Summary account after closing is equal to net income or net loss for the period. The net income or net loss for the period is transferred to an equity account by closing the Income Summary account to the appropriate equity account. For a corporation, the equity account is Retained Earnings, for proprietorships and partnerships, it is a capital account. Dividends are closed directly to Retained Earnings.

Post-closing Trial Balance

17. A third trial balance may be prepared after the closing entries are recorded and posted. This post-closing trial balance serves to show that equal debits and credits have been posted through the Income Summary and that the company has properly journalized and posted the closing entries. This trial balance would consist of only permanent (real) accounts.

Accounting Cycle Summary

18. The steps in the accounting cycle performed in every fiscal period may be summarized as follows:

(a) Analyze transactions and other events, which will result in

identification and measurement decisions. (b) Enter the transactions of the period in appropriate journals. (c) Post from the journals to the ledger. (d) Take a trial balance (unadjusted trial balance). (e) Prepare adjusting journal entries, and post them to the ledger. (f) Take a trial balance after adjusting (adjusted trial balance). (g) Prepare the financial statements from the adjusted trial balance. (h) Prepare closing journal entries and post them to the ledger. (i) Take a post-closing trial balance (after-closing trial balance). (j) Prepare reversing entries and post them to the ledger.*

*As reversing entries are an optional step, it is covered in Appendix 3A.




19. The method used to process accounting information does not alter the steps in the accounting cycle. When computerized systems are used, the accounting records may change in appearance, but the steps performed are essentially the same as those in a manual system.

Work Sheet

20. A multicolumn (8, 10, 12, etc.) work sheet serves as an aid to the accountant in adjusting the account balances and preparing the financial statements. The work sheet provides an orderly format for the accumulation of information necessary for the preparation of financial statements. Use of a work sheet does not replace any financial statements, nor does it alter any of the steps in the accounting cycle.

Cash Versus Accrual-Basis Accounting

21. Under the strict cash basis of accounting, revenue is recognized only when cash is received, and expenses are recorded only when cash is paid. The accrual basis of accounting recognizes revenue when it is earned and expenses when incurred without regard to the time of receipt or payment of cash.

Appendix 3A—Reversing Entries

22. Preparation and posting of reversing entries is the final step in the accounting cycle. The entries subject to reversal are the adjusting entries for accrued assets, accrued liabilities, and prepaid expenses and unearned revenues initially entered in expense and revenue accounts. Reversing entries are optional.




LECTURE OUTLINE

TEACHING TIP

Chapter 3 provides a review of the procedures employed in carrying out the steps in the accounting cycle. Depending on time constraints and students' accounting course backgrounds, Chapter 3 can be approached in several different ways: (1) Spend 2-3 class sessions reviewing the chapter and Appendix 3A. (2) Spend 1-2 class sessions reviewing selected portions of the chapter and Appendix 3A. (3) Omit the chapter entirely.

It is assumed that all students have completed at least one course in financial accounting learning fundamental accounting principles. Therefore, students should already be familiar with the mechanics of journalizing, posting, and preparing adjusting entries and financial statements, etc. An important objective of a review of these procedural details is to prepare students:

(a) to progress from mere memorization of required journal entries to

understanding the impact of a journal entry on the financial statements, and

(b) to visualize the effect of errors (both the failure to record transactions and the improper recording of transaction) on the financial statements.

The following topics covered in Chapter 3 may warrant special emphasis because students' grasp of them may be weak and because understanding of them is particularly important in mastering later chapters of the text:

1. Transactions affecting equity—helpful in understanding adjustments or

prior periods and error analysis and the statement of changes in shareholders’ equity (statement of retained earnings in ASPE).

2. Year-end procedure for inventory and related accounts—helpful in

understanding the effect of inventory errors.

3. Reversing entries (Appendix 3A)—an understanding of reversing entries is assumed when accounting for accruals.

The following lecture outline can be expanded upon or reduced to suit your needs.




A. Basic Terminology. Review the terms defined in the "Basic Terminology" section presented in the beginning of the chapter.

B. Double-Entry Accounting.

• Review the mechanics of debits and credits.

TEACHING TIP

Use Illustration 3-1 in reviewing double-entry rules for increasing and decreasing accounts. Debits increase assets and expenses while credits increase liabilities, owners' equity, and revenues. The normal balance of an account is the same as the increase side.

Use Illustration 3-2 to discuss and provide examples of transactions affecting the equity accounts. Emphasize the difference between temporary (nominal) and permanent (real) accounts.

C. The Accounting Cycle.

TEACHING TIP

Present an overview of the accounting cycle by using Illustration 3-3.

1. Journalizing (general journal and special journals)

2. Posting to the Ledger

3. Trial Balance




TEACHING TIP

Now would be a good time to review the cash basis versus accrual basis accounting. Under the strict cash basis, revenues are recognized only when the cash is received, and expenses are recorded only when the cash is paid. The accrual basis of accounting recognizes revenues when they are realized (earned) and expenses when incurred to earn related revenues (matching), regardless of when the cash is paid or received.

4. Adjusting Entries. a. Prepaid expenses b. Unearned revenues c. Accrued liabilities (expenses) d. Accrued assets (revenues) e. Estimated items

TEACHING TIP

Use Illustration 3-4 in discussing adjusting entries. Provide examples of each type and discuss the effect on the financial statements of failure to make each type of entry.

5. Year-End Procedure for Inventory and Related Accounts.

TEACHING TIP

Review the adjusting and closing process for inventory and related accounts by using Illustration 3-5.

The direction of the error in beginning inventory and the temporary accounts with debit balances will cause an error in net income in the opposite direction; e.g., if beginning inventory is overstated, then cost of goods sold is overstated and net income will be understated. The direction of the error in ending inventory and the temporary accounts with credit balances will cause an error in net income in the same direction; e.g., if ending inventory is overstated then cost of goods sold is understated and net income will be overstated.




6. The Closing Process and Preparation of a Post-Closing Trial Balance. All temporary (nominal) accounts are closed out to permanent (real) accounts. The Post closing Trial Balance should mirror the Statement of Financial Position (Balance Sheet).

7. Use of a Work Sheet to Prepare Financial Statements.

The work sheet does not replace the financial statements. Use of a work sheet is optional. The work sheet format varies. The format used in the text may be different from the one students used in elementary accounting but the basic rules are the same. Work through the example in the text, or one of the exercises, to give hands on practice in completing a worksheet, paying particular attention to the work sheet columns required, the preparation of the work sheet, and preparing the financial statements from the work sheet.

Appendix 3A – Reversing Entries

C. Reversing Entries.

TEACHING TIP

Use Illustration 3-6 to demonstrate the journal entries to be made when reversing entries are made and when reversing entries are not made.

Emphasize that reversing entries are optional and that the financial statement amounts are identical whether or not reversing entries are used.

1. Use of reversing entries is optional.

2. In an accounting system that uses reversing entries, the following types of adjusting entries would be reversed:

a. adjusting entries for unearned and prepaid items where the

original amount was entered in a revenue or expense account (i.e., the adjusting entry "created" a liability or asset account).

b. adjusting entries for all accrued items (again, the adjusting entry

"creates" an asset or a liability account).




ILLUSTRATION 3-1

DOUBLE ENTRY ACCOUNTING FOR CORPORATIONS

Permanent Accounts Temporary Accounts

ASSETS AND LIABILITIES SHAREHOLDERS' EQUITY REVENUES AND EXPENSES

COMMON SHARES ASSETS and RELATED ACCOUNTS REVENUES (and GAINS)

Debit Credit Debit Credit Debit Credit +(increase) –(decrease) –(decrease) +(increase) – (decrease) +(increase)

LIABILITIES RETAINED EARNINGS EXPENSES (and LOSSES) Debit Credit Debit Credit Debit Credit

–(decrease) +(increase) –(decrease) +(increase) +(increase) –(decrease)

TEACHING TIP

Rules of Thumb • If the "normal balance" for an account is a debit, then the account is

increased by a debit and decreased by a credit. • If the "normal balance" for an account is a credit, then the account is

increased by a credit and decreased by a debit. • Contra accounts have "normal balances" that are the opposite of their

"parent" accounts.




ILLUSTRATION 3-2

TRANSACTIONS AFFECTING THE EQUITY ACCOUNTS

Ownership Structure Proprietorships and

Partnerships Corporations Transactions Nominal / Real / Nominal / Real /

Affecting Impact on Temporary Permanent Temporary Permanent Equity Equity Accounts Accounts Accounts Accounts

Investment by Owner(s) Increase Capital Share

Capital and

related accounts

Revenues Earned Increase Revenue Revenue

Expenses Incurred Decrease Expense Capital Expense Retained

Withdrawal by Owner(s) Decrease Drawing Dividends Earnings




Cash receipts journal Cash disbursements journal

Purchases journal Sales journal

Other special journals

ILLUSTRATION 3-3

THE ACCOUNTING CYCLE

Identification and Measurement of Transactions and Other Events

Reversing entries Journal entries (optional)

General journal

To next period

Posting

Post-closing General ledger (usually monthly) trial balance Subsidiary ledgers (usually daily) (optional)

Closing (temporary/nominal accounts)

Trial balance preparation

Statement preparation Adjustments

Statement of financial position Accruals Income statement Prepayments

Statement of cash flows Work sheet Estimated items Changes in equity (optional)

(retained earnings) Adjusted

trial balance




ILLUSTRATION 3-4

TYPES OF ADJUSTING ENTRIES

PREPAYMENTS

Asset Expense Liability Revenue

Original Entry Prepaid Insurance XX Cash XX

Cash XX Unearned Rent Revenue XX

Adjusting Entry Insurance Expense XX Unearned Rent Revenue XX

Prepaid Insurance XX Rent Revenue XX

OR OR Expense Asset Revenue Liability

Original Entry Insurance Expense XX Cash XX

Cash XX Rent Revenue XX

Adjusting Entry Prepaid Insurance XX Rent Revenue XX

Insurance Expense XX Unearned Rent Revenue XX

BEFORE

Cash is Paid or Received An Expense or Revenue is Recognized

Adjusting

AFTER

Expense/Liability Asset/Revenue

Entry Salaries Expense XX Interest Receivable XX Salaries Payable XX Interest Revenue XX

Subsequent Entry Salaries Payable XX Cash XX

Cash XX Interest Receivable XX

ACCRUALS




ILLUSTRATION 3-5

ADJUSTING AND CLOSING THE INVENTORY ACCOUNTS AND RELATED ACCOUNTS

Adjusting the Permanent Inventory

Beginning Inventory Ending Inventory

Account Adjust for beginning inventory by crediting Inventory and debiting Cost of Goods Sold

Adjust for ending inventory by debiting Inventory and Crediting Cost of Goods Sold

Cost of Goods Sold

Close these accounts by Close these accounts by crediting the account debiting the account and debiting Cost of and crediting Cost of

Closing the Goods Sold Goods Sold Temporary Accounts Accounts with Normal Accounts with Normal

Debit Balances: Credit Balances: Purchases Purchase Discounts Transportation-in Purchase Allowances

Purchase Returns

Beginning Inventory and Ending Inventory and Temporary Accounts with Temporary Accounts with Normal Debit Balances: Normal Credit Balances:

1. An overstatement of 1. An overstatement of these items results these items results in an overstatement in an understatement of Cost of Goods Sold of Cost of Goods Sold and an understatement and an overstatement of net income. of net income.

2. An understatement of 2. An understatement of these items results these items results in an understatement in an overstatement of Cost of Goods Sold of Cost of Goods Sold and an overstatement and an overstatement of net income. of net income.


ILLUSTRATION 3-6

REVERSING ENTRIES

Accounting System Where Accounting System Where JOURNAL ENTRIES Reversing Entries ARE Used Reversing Entries are NOT Used

(1a) During 2014 (1a) Sales Salaries Expense 409,600 (1a) Sales Salaries Expense 409,600

Salaries Payable 409,600 Salaries Payable 409,600

(1b) During 2014 (1b) Salaries Payable 409,600 (1b) Salaries Payable 409,600 Cash 409,600 Cash 409,600

(2) 12/31/14 Adjust. (2) Sales Salaries Expense Salaries Payable

6,400

6,400

(2) Sales Salaries Expense Salaries Payable

6,400

6,400

(3) 12/31/14 Closing (3) Income Summary Sales Salaries Expense

416,000 416,000

(3) Income Summary Sales Salaries Expense

416,000 416,000

(4) 1/1/15 Reversing (4) Salaries Payable 6,400 (4) No entry. Sales Salaries Expense 6,400

(5) 1/5/15 Payroll (5) Sales Salaries Expense 8,000 (5) Sales Salaries Expense 1,600 Cash 8,000 Salaries Payable 6,400

Cash 8,000

Instructor’s Manual 3-18 Chapter 3 Copyright © 2013 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.


ILLUSTRATION 3-6 (continued)

LEDGER ACCOUNT

POSTINGS Reversing Entries ARE Used Reversing Entries are NOT Used Sales Salaries

Expense Salaries Payable Sales Salaries

Expense Salaries Payable

(1a) During 2014 409,600 409,600 409,600 409,600

(1b) During 2014 409,600 409,600

(2) 12/31/14 Adjusting 6,400 6,400 6,400 6,400

(3) 12/31/14 Closing 416,000 416,000

(4) 1/1/15 Reversing 6,400 6,400

(5) 1/5/15 Payroll 8,000 1,600 6,400

FINANCIAL STATEMENTS

Reversing Entries ARE Used

Reversing Entries are NOT Used

Sales Salaries Expense for the year 2014 $416,000 $416,000 Balance of Salaries Payable at close of business on 12/31/14 $ 6,400 $ 6,400 Sales Salaries Expense for 1/1/15 through 1/5/15 $ 1,600 $ 1,600 Balance of Salaries Payable at close of business on 1/5/15 $ 0 $ 0



LEGAL NOTICE









CHAPTER 4

REPORTING FINANCIAL PERFORMANCE

CHAPTER TOPICS CROSS-REFERENCED WITH THE CICA HANDBOOK, Part II and IFRS

Financial Statement Presentation – General Standards

Section 1400 IAS 1

Income Statement Presentation, Purpose, and Scope

Section 1520 IAS 1

Income Statement Presentation: Discontinued Operations

Section 3475 IFRS 5

Statement of Changes in Shareholders’ Equity / Retained Earnings

Section 3251 IAS 1

Other Comprehensive Income / Comprehensive Income

ASPE — n/a IAS 1

Earnings Per Share ASPE — n/a IAS 1

Accounting Changes Section 1506 IAS 8




LEARNING OBJECTIVES

1. Appreciate how firms create value and manage performance.

2. Understand how users use information about performance to make decisions.

3. Understand the concept of and be able to assess quality of

earnings/information.

4. Understand the differing perspectives on how to measure income.

5. Measure and report results of discontinued operations.

6. Measure income and prepare the income statement and the statement of comprehensive income using various formats.

7. Prepare the statement of retained earnings and the statement of changes

in equity.

8. Understand how disclosures and analysis help users of financial statements assess performance.

9. Identify differences in accounting between IFRS and ASPE and potential

changes.

10. Explain the differences between the cash basis of accounting and the accrual basis of accounting (Appendix 4A).




CHAPTER REVIEW

Chapter 4 presents a detailed discussion of the concepts and techniques that underlie the preparation of the Income Statement and Statement of Retained Earnings. The requirements for adequate presentation of reported net income are described and illustrated throughout the chapter.

1. The income statement measures the success of enterprise operations for a

given period of time. This statement assists the business community in determining profitability, investment value, and credit worthiness of a particular business enterprise. The income statement provides investors and creditors with information that helps them to predict the amount, timing, and uncertainty of future cash flows. Through use of the income statement, investors and creditors are able to a) evaluate the past performance of an enterprise, and b) determine the risk of achieving particular cash flows.

2. The data accountants use in measuring an entity's net income must be

susceptible to reliable quantification. This approach has been criticized by economists for failing to include any of the qualitative benefits that they include in their definitions of income. Accountants are aware that income often includes qualitative aspects. However, these qualitative aspects have usually been discarded by accountants in determining net income because of the difficulty involved in their measurement. However, this limitation, along with the use of estimates, choice of accounting methods, and how to measure net income reduces the usefulness of the income statement.

3. The income statement helps users of financial statements (1) evaluate the

past performance of the company, (2) provide a basis for predicting future performance, and (3) help assess the risk or uncertainty of achieving future cash flows. The limitations of the income statement include (1) items from the income statement that they cannot measure reliably, (2) income numbers are affected by the accounting methods employed, and (3) income measurement involves judgment.




Quality of Earnings/Information

4. The quality of earnings is important because markets are based on trust, and it is imperative that investors have faith in the numbers reported. If that trust is damaged, capital markets will be damaged. Accountants must ensure financial information is unbiased, reflects reality, and is transparent and understandable. Capital markets will value information as high quality if is free from earnings management. Reliable information can be used by capital markets to determine if earnings are sustainable.

Comprehensive Income

5. Items that bypass the income statement are included under the concept of comprehensive income and are reported directly in equity. Comprehensive income includes all changes in equity during a period, except for those resulting from investments by owners and distributions to owners. Comprehensive income therefore includes net income, plus gains and losses that by-pass net income, but affect shareholders’ equity.

6. An example of one of these items is unrealized gains and losses associated

with available-for-sale securities. These items that bypass the income statement are often referred to as other comprehensive income. The AcSB decided that the components of other comprehensive income must be displayed in a separate financial statement (or an expanded income statement) with the same prominence as other key financial statements. Regardless of the format used, net income must be added to other comprehensive income to arrive at comprehensive income.




All-Inclusive Approach vs. Current Operating Performance Approach

7. For the most part, accountants tend to agree on the composition of items included on the income statement. However, certain unusual items have stirred controversy in regard to the effect they should have on the presentation of net income. Some accountants favour an all-inclusive approach that reports the unusual items directly in the income statement. Those who support the current operating performance approach to income measurement believe that the unusual items should be closed directly to retained earnings (not included in computing net income). The accounting profession currently favours a modified all-inclusive approach to income measurement over the current operating approach. This approach requires extraordinary items to be included in the income statement, but they are to be shown in a separate section. Additionally, the effects of changes in accounting policies, and the correction of errors, are to be shown as a retroactive adjustment to retained earnings on a net of tax basis.

Discontinued Operations

8. An entity is said to have experienced a discontinuance of operations when it disposes of a segment of its business. To qualify as discontinued operations, the assets, results of operations, and activities of a segment of a business must be clearly distinguishable, physically and operationally, from the other assets, results of operations, and activities of the entity. When an entity decides to dispose of a segment of its business, it must meet certain classification and disclosure requirements that have been established by the CICA Handbook.

9. The IASB defines a discontinued operation as a component of an entity that

either has been disposed of or is classified as held-for-sale, and (a) represents a major line of business or geographical area of operations, or (b) is part of a single, co-ordinated plan to dispose of a major line of business or geographical area of operations, or (c) is a subsidiary acquired exclusively with a view to resell. When an entity decides to dispose of a component of its business, a separate income statement category for gain or loss from disposal of a component of a business must be provided. In addition, the results of operations of a component that has been or will be disposed of are also reported separately from continuing operations.




Presentation

10. The major elements of the income statement, as described in Chapter 2, are revenues, expenses, gains, and losses. The distinction between revenues and gains and the distinction between expenses and losses depend to a great extent on the typical activities of a business enterprise. When inflows or enhancements of assets result from typical business activities (generally the activities the entity is in business to perform) revenues result. Likewise, outflows or the using up of assets resulting from typical business activities will generate expenses. Non-typical business activities resulting in inflows or outflows of assets will normally generate transactions classified as gains or losses. Other comprehensive income includes revenues, gains, and losses that are not recognized in net income. However, as mentioned in Chapter 2, there is some discussion on whether OCI is a separate financial statement element as it includes only other elements.

11. Companies generally provide some detail on revenues and expenses on

the face of the income statement, but may prepare a condensed income statement with details presented in the notes to the financial statements. Companies are required to present expenses classified either by their nature (nature-of-expense method) or their function (function-of-expense method). The function-of-expense method is generally used in practice, but then the individual expenses are itemized in the notes to the financial statements.

12. The IASB takes the position that both revenues and expenses and other

income and expenses should be reported as part of income from operations. Companies can provide additional line items, headings, and subtotals when such presentation is relevant to an understanding of the entity’s financial performance.

13. When the parent company’s interest in the subsidiary company is less than

100 percent the ownership of the subsidiary is divided into (a) the majority interest who own the controlling interest and (b) the non-controlling interest (the minority interest).




Unusual Gains and Losses

14. Material gains and losses that are either atypical or occur infrequently (but not both) and are primarily dependent on decisions or determinations of management and owners, are excluded from the extraordinary item classification. These items are presented with normal, recurring revenues, costs, and expenses. If material, these items are disclosed separately; if immaterial, they may be combined with other items in the statement.

Extraordinary Items

15. Extraordinary items are material, nonrecurring items that are significantly different from the entity’s typical business activities. Under U.S. GAAP they are presented separately on the income statement in order to provide enough detail to have predictive value. There are three criteria that must all be met for items to be considered extraordinary. They must:

1. Be infrequent; 2. Be atypical of the company’s normal business activities; 3. Not depend mainly on decisions or determinations by management

or owners. Under IFRS, extraordinary items are not allowed, and under ASPE, there is no guidance. All items are either presented as income from continuing operations or discontinued operations..

Basic Presentation Requirements

16. Items that bypass the income statement are included under the concept of

comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. The IASB evaluated approaches to providing more information about other comprehensive income items. It decided that the components of other comprehensive income must be displayed in one of two ways: (1) a second income statement or (2) a combined statement of comprehensive income.

17. The following items are required to be presented on the income statement:

(1) revenue, (2) finance costs, (3) share of profit (loss) of associates accounted for using the equity method, (4) tax expense, (5) amounts the post-tax profit or loss of discontinued operations and the post-tax gain or loss recognized on disposal of a discontinued operation, and (6) net income or net loss.




Single-Step vs. Multiple Step

18. The income statement may be presented in the single-step format or the multiple-step format. Single-step income statements derive their name from the fact that total costs and expenses are subtracted from total revenues in a "single step" to arrive at net income. Income taxes are shown as a separate item among the expenses (usually last) to indicate their relationship to income before taxes. The multiple-step format separates results achieved by regular operations of the entity from those obtained by non-operating activities. Expenses are also classified by function, such as cost of sales, selling, and administrative. The multiple-step format provides more detailed information to financial statement users than does the single- step format; however, both are found in practice.

19. An income statement is composed of various sections that relate to different

aspects of the earning process. Companies may prepare some or all of the following sections.

a. Sales or revenue section.

b. Cost of goods sold section.

c. Selling expenses.

d. Administrative or general expenses.

e. Other Income and Expense.

f. Financing Costs.

g. Income Tax.

h. Discontinued Operations. Gains and losses resulting from disposal of a component of a company.

i Non-Controlling Interest. Shows an allocation of net income to the

primary shareholders and to the non-controlling interest.

j. Earnings Per Share.

The informative content of the income statement may be further enhanced by adding additional subsections to the above major sections.




Other Comprehensive Income (OCI) may be included if this information is not provided on a separate statement. OCI plus Net income = Comprehensive Income and can be combined into one statement. OCI includes such items as unrealized gains and losses on certain investments and certain foreign exchange gains and losses.

Condensed Financial Statements

20. In arriving at net income, the statement presents the following subtotals:

gross profit, income from operations, income before income tax, and net income. A company includes only the totals of components in condensed income statements, but prepare supplementary schedules to support the totals.

Presentation of Expenses – Nature versus Function

21. IFRS requires an entity to present an analysis of expenses based on either nature or function. For instance, if presentation is by nature, depreciation and employee benefits would be presented without breaking down into a function, such as selling or administration. Conversely, presentation by function requires expenses to be allocated to an entity’s functions, such as cost of sales and administrative costs. IFRS encourages presentation of this information in the income statement, though it may be presented elsewhere as a schedule. Under ASPE, this presentation is not mandatory but an entity may choose to provide it if it feels the disclosure would be decision relevant.

Intraperiod Tax Allocation

22. Intraperiod tax allocation is the process of relating the income tax effect on an unusual item to that item when it appears on the income statement. Income tax expense related to continuing operations is shown on the income statement at its appropriately calculated amount. All other items included on the income statement (discontinued operations, extraordinary items, and other comprehensive income) should be shown net of their related tax effect. The tax amount may be disclosed in the income statement or in a footnote.




Earnings per Share

23. In general, the earnings per share represent the ratio of net income minus preferred dividends (income available to common shareholders) divided by the weighted average number of common shares outstanding. It is considered by many financial statement users to be the most significant statistic presented in the financial statements and should be disclosed on the face of the income statement or in the notes. Per share amounts for gain or loss on discontinued operations must be disclosed on the face of the income statement or in the notes to the financial statements. Note that this area is of lesser relevance to private entities as most have shares that are closely held. Therefore, ASPE does not include guidance on presentation of EPS numbers.

Retained Earnings

24. Net income is closed out to retained earnings at the end of the period. Retained earnings show the company’s accumulated earnings (or deficit in the case of losses). Under ASPE, the statement of retained earnings shows this accumulated income (or deficit) as well as how much has been paid out as dividends. Recall that OCI only exists under IFRS and that OCI is closed out to accumulated other comprehensive income (AOCI). Therefore, under IFRS we need an expanded statement that shows the changes in retained earnings and AOCI. Therefore, under IFRS, instead of a statement of retained earnings, we use a statement of changes in equity and show all changes in all equity accounts including retained earnings and AOCI.

25. The statement of retained earnings serves to reconcile the balance of the

retained earnings account from the beginning to the end of the year. It can be combined with the income statement by adding it to the bottom. The important information communicated by the statement of retained earnings includes retroactive adjustments related to changes in accounting policies and correction of prior period errors, the dividend distributions for the period, and transfers to and from retained earnings. Retained earnings is often appropriated (restricted) in accordance with contractual requirements or a Board of Directors’ policy. The retained earnings section may therefore report two separate amounts: a) unrestricted and b) appropriated retained earnings.




Statement of Changes in Shareholders’ Equity

26. The statement of changes in retained earnings is a core GAAP statement, but not required under IFRS. Conversely, the statement of changes in shareholders’ equity is a required statement under IFRS, but not under GAAP. It reports the changes in each shareholders’ equity account and in total shareholders’ equity during the year, including comprehensive income, in columnar format. Main components include share capital, retained earnings, and accumulated other comprehensive income. Changes will result from the results of additional share issues, comprehensive income and dividend declarations.

IFRS versus ASPE Comparison

27. A summary comparison of IFRS and ASPE is outlined in the text, along with the relevant sections. These issues have been dealt with in this chapter; however the chart may help to identify the differences more easily.

Planned Changes in Financial Statement Presentation

28. The IASB and the FASB have been working to develop a joint, converged standard since April 2004. The project is currently named Financial Statement Presentation and consists of three phases:

• Phase A – What constitutes a complete set of financial statements • Phase B – Presentation of information on the face of the statements • Phase C – Interim financial reporting

Phase A is complete and embedded in IAS 1, and Phase B has developed agreed upon working principles.

Cash Basis versus Accrual Basis of Accounting – Appendix 4A

29. Accrual based accounting focuses on when revenues are earned and expenses recognized whereas cash basis focuses on when cash is received and when it is dispersed. However accrual accounting may be a better indicator of future cash flows as it identifies the amounts that will be received (such as accounts receivables) and the amounts that need to be paid (such as payables and loans) in the future. Cash based accounting is closely related to the cash flow statement, and this statement is a better indicator of cash flows than a cash based income statement as it identifies the specific uses and sources of cash from all activities of the organization

(operating, investing, and financing).




LECTURE OUTLINE

The material in this chapter can be covered in two to three class sessions. Most students have had previous exposure to the concepts presented in the chapter so concentration should be on the newer concepts of comprehensive income, IFRS and ASPE. Students should be made aware that private enterprises can choose to follow either IFRS or ASPE; however they cannot follow IFRS for SMEs (small to medium-sized enterprises) and be considered to be following ASPE in Canada even though there are a lot of similarities.

The lecture and assigned problems should be directed towards three areas of concentration:

1. An understanding of the concepts underlying the measurement and

presentation of income. These include concepts such as the quality of earnings, the all-inclusive approach versus the current operating performance approach, classification of expenses, IFRS versus ASPE, and the changing environment.

2. An understanding of each of the intermediate components of income and

other irregular items, extraordinary items, changes in accounting policy, discontinued operations, intraperiod tax allocations, and earnings per share. Students should be able to a) recognize these items when they encounter them in problem material, and b) identify the proper accounting and disclosure procedure for each of them.

3. An understanding of proper format for comprehensive income,

shareholders’ equity and retained earnings statements. Given transaction data or account balances, students should be able to prepare single- and multiple-step comprehensive income statements, retained earnings statements, and statement of changes in shareholders’ equity.

The material in the chapter can be presented with the following lecture outline:




A. Usefulness of the Income Statement

1. Income information helps interested parties predict the amount, timing, and uncertainty of future cash flows. Income information is useful:

a. for evaluating the past performance.

b. for predicting future performance.

c. for determining the risk (uncertainty) of achieving future cash flows.

Information about the various components of income—revenues, expenses, gains, and losses—is helpful for assessing the likelihood that particular cash flows will continue in the future.

TEACHING TIP

Illustrate the focus on earnings by the financial press by citing articles from the Globe and Mail, Financial Post, or some other business periodical.

Students may be asked why information about the earnings of a firm is needed. Stress the point that the ability of a firm to generate earnings is essential for its long-run survival. Investors and creditors use earnings information in making investment and credit decisions that involve the firm.

B. Limitations of the Income Statement

1. Companies omit items from the income statement that they cannot measure reliably. For example:

a. Unrealized gains and losses on certain investment securities.

b. The value of brand recognition, customer service, and product

quality.




2. Income numbers are affected by the accounting methods employed. Discuss the concept of the quality of earnings.

a. Discuss how earnings management can affect the quality of

earnings.

3. Income measurement involves judgement. Discuss this in terms of bad debt expense and depreciation expense.

C. Concepts of Income Measurement

1. Review concepts such as revenue recognition and periodicity.

2. Discuss differences between expenses based on nature and those

based on function.

3. Discuss the following question: Which of the transactions that produce changes in net assets should be included in income for the period? a. All-inclusive approach: any gain or loss, whether related to

operations or not, should be included in the calculation of net income.

b. Current operating performance approach: net income should

include only regular, recurring earnings from normal operations. Irregular gains and losses and other items, such as a change in accounting principle, should be closed directly to retained earnings.

c. The accounting profession has adopted a modified all-inclusive

approach: all changes in net assets except the following are included in net income:

i. capital transactions (investments by owners or distributions

to owners)

ii. corrections of errors from prior periods

iii. certain changes in net assets, such as the change in fair value of available for sale investments

iv. other comprehensive income – discuss how it is presented

on a separate statement, or combined with net income in a comprehensive statement of income.




D. Discontinued Operations—results from disposal of a segment of the business.

1. Examples of disposals of segments are:

a. The sale by a diversified company of a major division that

represents the company's only activity in the electronics industry. The assets and results of operations of the division are clearly segregated for internal financial reporting purposes from the other assets and results of operations of the company.

b. A sale by a meat packing company of a 25% interest in a

professional football team, which has been accounted for under the equity method. All other activities of the company are in the meat packing business.

2. Examples of disposals that do not qualify as disposals of segments

are:

a. The sale by a petrochemical company of a 25% interest in a petrochemical plant, which is accounted for as an investment in a corporate joint venture under the equity method, since the remaining activities of the company are in the same line of business.

b. A manufacturer of children's wear discontinues all of its

operations in Italy that were composed of designing and selling children's wear for the Italian market. In the context of determining a segment of a business by class of customer, the nationality of customers or slight variations in product lines in order to appeal to particular groups are not determining factors.

3. Disposals of segments are reported net of tax in the income statement

immediately below income from continuing operations. Results of the disposal are reported in two components:

a. Income or loss from operation of the discontinued segment up to

the measurement date, net of tax.

b. Gain or loss from disposal of the discontinued segment, net of tax.




4. Assets Held for Sale:

• Will be treated as a discontinued operation if an approved,

detailed plan exists to dispose of it within one year. • If these conditions do not exist, the assets will be measured and

presented separately (similar to discontinued operations) but any related gain or loss is reported as part of income from continuing operations.

E. Income Statement Format: Disclosure of the Intermediate Components of

Income.

1. What are the intermediate components of income? Review the definitions of the elements of income: revenues, expenses, gains, and losses.

2. Presentation of items before income from continuing operations.

a. Multiple-step format

TEACHING TIP

Use Illustration 4-1 to describe the multiple-step format. Emphasize the intermediate components such as gross profit, income from operations, and other revenues and expenses.

b. Single-step format

TEACHING TIP

Use Illustration 4-2 to describe the single-step format. Make comparisons with the multiple-step format in Illustration 4-1.




c. Point out that the difference between the two formats affects only the presentation of items before income from continuing operations.

d. GAAP permits the use of either multiple-step or single-step

format.

3. Presentation of items after income from continuing operations.

a. Discontinued Operations. (Discuss treatment required for extraordinary items under IFRS and ASPE).

b. Other comprehensive income (if a combined statement of

comprehensive income is being prepared).

c. GAAP requires presentation of these items net of tax.

F. Unusual Gains and Losses—items that are unusual or infrequent but not both, and result primarily from decisions of management or owners.

1. In a multiple-step statement, these are reported in the "other

revenues and gains" or "other expenses and losses" section.

2. These items may not be presented net of tax.

3. Extraordinary Items—Extraordinary items are material, nonrecurring items that are significantly different from the entity’s typical business activities. Under U.S. GAAP they are presented separately on the income statement in order to provide enough detail to have predictive value.

Under IFRS, extraordinary items are not allowed, and under ASPE, there is no guidance. All items are either presented as income from continuing operations or discontinued operations.




H. Tax Allocation—the process of associating income tax expense with related income. The principle is "let the tax follow the income."

1. Interperiod tax allocation involves procedures for recognizing

differences between taxable income and accounting income.

2. Intraperiod tax allocation involves a breakdown of total income tax expense into separate components, which are disclosed in different portions of the financial statements. Intraperiod tax allocation is applied to:

• income from continuing operations. • discontinued operations. • Other comprehensive income

TEACHING TIP

Point out that the net-of-tax amount of an item is calculated by multiplying the item by (1 minus the tax rate).

I. Earnings Per Share—a widely used measure of business performance.

1. Discuss the importance of EPS in the financial press using examples from The Globe and Mail or The Financial Post.

2. EPS is equal to:

Net Income – Preferred Dividends Weighted Average Common Shares Outstanding

3. Discuss the concept of dilution briefly. The existence of convertible

securities, stock options, and stock warrants may reduce EPS when these securities become common shares. The calculation of EPS in figures that reflect potential dilution is discussed in a subsequent chapter.

4. Per share figures must be disclosed in the income statement for each

component of net income, including income from continuing operations, income from discontinued operations, and net income




J. Statement of Retained Earnings—a summary disclosure of the changes in the balance of the Retained Earnings account from the beginning to the end of the year. Net income increases retained earnings, and a net loss decreases retained earnings. Both cash and stock dividends decrease retained earnings. Retroactively applied changes in accounting principles and corrections of errors may either increase or decrease retained earnings. Appropriated retained earnings may be reported separately from unrestricted retained earnings when such a condition exists due to a contractual requirement or a Board of Directors’ policy. This statement is not mandatory under IFRS.

K. Statement of Comprehensive Income (CI) — net income is the starting point

in the comprehensive income statement to which other comprehensive income is added. To show as an equation: NI + OCI = CI

TEACHING TIP

ILLUSTRATION 4-3 can be used to demonstrate a statement of income and comprehensive income.

L. Statement of Changes in Shareholders’ Equity. This is a required statement under IFRS, but not under ASPE.

TEACHING TIP

ILLUSTRATION 4-4 (text Illustration 4-22) can be used to demonstrate the columnar format of the Statement of Changes in Shareholders’ Equity required under IFRS.

M. Refer to the Comparison Chart in the text to review the differences between IFRS and ASPE.




N. International Perspective – In March 2006, the FASB and the IASB issued a joint exposure draft on Financial Statement Presentation that consists of three phases:

• Phase A: What constitutes a complete set of financial statements

and brings the IAS in line with US and Canadian standards on comprehensive income.

• Phase B: Presentation of information on the face of the financial statements to provide both a cohesive financial picture of the entity as well as more detail on such things as liquidity and asset measurement.

• Phase C: Interim financial reporting.

Phase A is complete and embedded in IAS 1, and agreed upon working principles have been agreed on for Phase B.

O. APPENDIX 4A. Cash Basis versus Accrual Basis Earnings—the following

points may be covered: a) difference between cash and accrual basis (ILLUSTRATION 4A-1, 2, 3 and 4 in the text may be used); b) conversion from cash to accrual basis; and c) theoretical weakness of the cash basis.




ILLUSTRATION 4-1

MULTIPLE-STEP

Company Name Statement Title

Time Period Covered

Sales $ XX

Cost of goods sold XX

Gross profit XX Selling expenses $ XX Administrative expenses XX XX

Income from operations XX Other income and expenses

Interest income Interest expense Dividend income Infrequent or unusual gains Infrequent or unusual losses

$ XX XX XX XX

XX

XX

Income from continuing operations Income taxes Income before discontinued operations Discontinued operations

Income from operations (net of tax)

$ XX

$ XX

$ XX

XX

Loss on disposal (net of tax) XX XX

Net income

$ XX

Earnings per share disclosures




ILLUSTRATION 4-2

SINGLE-STEP

Company Name Statement Title

Time Period Covered

Sales $ XX Interest income XX Dividend income XX Infrequent or unusual gains XX

Total revenues $ XX

Cost of goods sold XX Selling expenses XX Administrative expenses XX Interest expense XX Infrequent or unusual losses XX

Total expenses $XX

Income from continuing operations $ XX

Income taxes XX Income before discontinued operations $ XX Discontinued operations

Income from operations (net of tax) $ XX Loss on disposal (net of tax)

Net income Earnings per share disclosures

XX XX

$ XX




ILLUSTRATION 4-3

REPORTING OTHER COMPREHENSIVE INCOME AND COMPREHENSIVE INCOME


ILLUSTRATION 4-4



LEGAL NOTICE




Instructor’s Manual 4-25 Chapter 4 Copyright © 2013 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly

prohibited.

Instructor’s Manual 5-1 Chapter 5 Copyright © 2013 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page

is strictly prohibited.


CHAPTER 5

FINANCIAL POSITION AND CASH FLOWS


Financial Statement Presentation Section 1400 IAS 1

Balance Sheet

Section 1521

IAS 1

Current Assets and Current Liabilities

Section 1510

IAS 1

Statement of Cash Flows

Section 1540

IAS 7

Financial Instruments

Section 3856

IFRS 9, IAS 32 and 39

Contingencies

Section 3290

IAS 37




LEARNING OBJECTIVES

1. Understand the statement of financial position and statement of cash flows from a business perspective.

2. Identify the uses and limitations of a statement of financial position.

3. Identify the major classifications of a statement of financial position.

4. Prepare a classified statement of financial position.

5. Identify statement of financial position information that requires supplemental

disclosure.

6. Identify major disclosure techniques for the statement of financial position.

7. Indicate the purpose and identify the content of the statement of cash flows.

8. Prepare a statement of cash flows using the indirect method.

9. Understand the usefulness of the statement of cash flows.

10. Identify differences in accounting between ASPE and IFRS.

11. Identify the significant changes planned by the IASB regarding financial statement presentation.

12. Identify the major types of financial ratios and what they measure (Appendix

5A).




CHAPTER REVIEW

1. Chapter 5 presents a detailed discussion of the concepts and techniques that underlie the preparation and analysis of the statement of financial position. Along with the mechanics of preparation, acceptable disclosure requirements are examined and illustrated. The purpose, usefulness and content of the statement of cash flows is also presented. Presentation of cash flows from operating activities using the indirect approach is illustrated. The direct approach will be studied further in Intermediate Financial Accounting Volume 2. In Appendix 5B the financial statements, accompanying notes, and other information from the Annual Report of Shoppers Drug Mart Corporation are presented. These specimen financial statements may be referred to throughout your study of intermediate accounting, as it includes information relevant to many of the topics discussed in subsequent chapters.

Uses and Limitations of the Statement of Financial Position

2. For many years, financial statement users generally considered the income

statement to be superior to the statement of financial position as a basis for judging the economic well-being of an enterprise. However, the statement of financial position can be a very useful financial statement. If a statement of financial position is examined carefully, users can gain a considerable amount of information related to liquidity, solvency, and financial flexibility. Liquidity is generally related to the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid. Solvency refers to the ability of an enterprise to pay its debts and related interest. Financial flexibility is the ability of an enterprise to take effective action to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.

3. Criticism of the statement of financial position has revolved around the

limitations of the information presented therein. These limitations include: (a) the use of historical cost, thus the failure to reflect current value information, (b) the extensive use of judgements and estimates, and (c) failure to include items of financial value that cannot be recorded objectively, such as internally generated goodwill.




4. The problem with current value information concerns the reliability of such information. The estimation process involved in developing current-value type information causes a concern about the objectivity of the resulting financial information. The use of estimates is extensive in the development of balance sheet data. These estimates are required by generally accepted accounting principles (GAAP), but they reflect a limitation of the statement of financial position. The limitation concerns the fact that the estimates are only as good as the understanding and objectivity of the person(s) making the estimates. The final limitation of the statement of financial position concerns the fact that some significant assets of the entity cannot be recorded objectively. Items such as human resources (employee workforce), managerial skills, customer base, and reputation cannot be recorded, because such assets are difficult to quantify.

Classification in the Statement of Financial Position

5. The major classifications used in the statement of financial position are

assets, liabilities, and shareholders’ (owners’) equity. These items were defined in the discussion presented in Chapter 2. To provide the financial statement reader with additional information, these major classifications are divided into several sub-classifications.

Assets are classified as current or non-current, with the non-current divided among long-term investments; property, plant, and equipment; intangible assets; and other assets. Liabilities are classified as current or non-current. Shareholders’ equity includes share capital, contributed surplus, retained earnings, and accumulated other comprehensive income. These major classifications of the statement of financial position are defined as follows:

a. Assets: Present economic benefits that the entity has rights or access

to where others do not. b. Liabilities: Present economic burden or obligation that is enforceable. c. Equity/Net Assets: The residual interests in the entity’s assets that

remain after deducting its liabilities. In a business enterprise, the equity is the ownership interest.




6. Classification in financial statements helps analysts by grouping items with similar characteristics and separating items with different characteristics, for example:

a. Assets that differ in their type or function—merchandise inventory and

property, plant, and equipment; b. Liabilities that have different implications for the enterprise’s financial

flexibility—for example, separate reporting of current and long–term debt, and debt separate from equity;

c. Assets and liabilities with different general liquidity characteristics— cash versus accounts receivable;

d. Certain assets, liabilities, and equity instruments have attributes that allow them to be measured or valued more easily. Reporting these separately takes advantage of this characteristic. Monetary and non- monetary assets and liabilities are reported separately—accounts or notes receivable which are convertible to a specified monetary amount, and inventories or intangibles whose value is not fixed in terms of a monetary unit.

e. Financial instruments should be recorded separately since fair values for them are readily available so they are usually easy to measure. They include cash; contractual rights to receive, or obligations to deliver, cash or another financial instrument; and investments in other companies. GAAP generally allows an entity to choose to value financial instruments by choosing the fair value option where gains and losses go through net income. Generally, financial instruments should not be offset against each other.

Current Assets

7. Current assets are resources that are expected to be realized in cash, sold, or

consumed either in one year or in the operating cycle, whichever is longer. There are some exceptions to a literal interpretation of the current asset definition. These exceptions involve prepaid expenses, investments in common shares, and the subsequent year's depreciation of fixed assets. These exceptions are recognized in the accounting process and are understood by most financial statement users. Current assets are presented in the statement of financial position in the order of their liquidity and normally include cash, short-term investments, receivables, inventories, and prepaid expenses.




Short-term Investments

8. Investments in debt and equity securities are presented separately and valued at cost/amortized cost or fair value.

Receivables

9. Accounts receivable should be segregated so as to show ordinary trade

receivables, amounts owing by related parties, and other unusual items that are deemed material.

Inventories

10. Inventories are assets held for sale in the ordinary course of business, or in the

process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of service. They are valued at the lower of cost and net realizable value, with cost being determined using a cost formula such as FIFO, weighted average cost, or specific identification. These details must be disclosed to assist the users in understanding the amount of judgement involved in measuring inventory.

Prepaid expenses

11. Expenditures already made for benefits (usually services such as insurance or

rent) that will be received within one year or the operating cycle, whichever is longer. These items are current assets because cash does not need to be used for them again in the current year or operating cycle as they have already been paid for. Prepaid expenses are reported at the amount of the unexpired or unconsumed cost.




Non-current Investments

12. Non-current investments are presented just below current assets in a separate section called “Investments”. Investments that are readily marketable may be classified as current or long-term, depending on management’s intent for holding them. They normally consist of:

a. Debt securities (held-to-maturity and measured at amortized cost) b. Equity investments (subsidiaries, significant influence investment in

associates, non-consolidated subsidiaries, or no influence or control); c. Other (such as a sinking funds or tangible assets held as investments) –

generally measured at cost.

Non-current equity investments are accounted for as follows: • Subsidiaries – consolidation • Significant influence – Equity method • Non-consolidated subsidiaries or investments where no control or

influence exists – fair value or cost.

Property, Plant, and Equipment

13. Property, plant, and equipment are tangible capital assets (that is, properties of a durable nature) that are used in the ongoing business operations to generate income. Examples include land, buildings, machinery, furniture, tools, and wasting resources. Except for land, tangible assets are charged to income through depreciation (such as building or equipment) or depletion (for wasting resources). IFRS allows an option to carry these assets at fair value using a revaluation or fair value method. Like all other assets, property, plant and equipment are written down when impaired.




Intangible Assets

14. Intangible assets are capital assets that lack physical substance and usually have a higher degree of uncertainty concerning their future benefits; however, their benefit lies in the rights they convey to the holder. Intangibles are initially recorded at cost and classified into two groups for accounting purposes—those with finite lives, which are amortized over their useful lives, and those with infinite lives, which are not amortized. Examples include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Both types are tested for impairment.

15. Intangibles can represent significant economic resources but are often ignored

by financial analysts because valuation and measurement is difficult. This is because their valuation and measurement are difficult. Many intangible assets, especially those that are internally generated (such as goodwill), are never recognized at all on the statement of financial position.

Other Assets

16. Many companies include an other assets classification in the statement of

financial position after property, plant, and equipment. This section includes a wide variety of items that do not appear to fall clearly into one of the other classifications. Some of the more common items included in this section are deferred income tax assets, non-current receivables, intangible assets, assets in special funds, and advances to subsidiaries.

17. Deferred/future income taxes represent the taxes that may be avoided or

saved due to deductions that a company may take in the future. This tax deduction represents a benefit, which is recognized on the statement of financial position.




Current Liabilities

18. Current liabilities are the obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities. Items normally shown in the current liabilities section of the statement of financial position include notes and accounts payable, advances received from customers, current maturities of long-term debt, short-term financing payable on demand, taxes payable, accrued liabilities, and derivative financial instruments. Obligations due to be paid during the next year may be excluded from the current liability section if the item is expected to be refinanced through long-term debt or the item will be paid out of non-current assets.

19. Working capital is the excess of current assets over current liabilities. This

concept, sometimes referred to as net working capital, represents the net amount of a company's relatively liquid resources. By reference to this amount, a financial statement user is able to assess the equity's margin of safety for meeting financial demands of the operating cycle. While the amount of working capital has a definite relationship to liquidity, the reader must analyze the composition of the current assets to determine their nearness to cash.

Long-Term Debt/Liabilities

20. Long-term liabilities are obligations whose settlement date extends beyond

the normal operating cycle or one year, whichever is longer. Examples include bonds payable, notes payable, lease obligations, and pension obligations. Generally, the disclosure requirements for long-term liabilities are quite substantial as a result of various covenants and restrictions included for the protection of the lenders. Long-term liabilities that mature during the next operating cycle are classified as current liabilities if their liquidation requires use of current assets. Long-term liabilities generally fall into one of the three following categories: a. Obligations arising from specific financing situations, such as the

issuance of bonds, long-term lease obligations, and long-term notes payable.

b. Obligations arising from the ordinary enterprise operations, such as pensions and future income taxes payable.

c. Obligations that depend on the occurrence or non-occurrence of one or more future events to confirm the amount payable, the payee, or the date payable, such as warranties and other contingencies.




Owners' Equity

21. The shareholders' equity section of the statement of financial position includes information related to share capital, contributed surplus, retained earnings, and accumulated other comprehensive income. Preparation of the shareholders' equity section should be approached with caution because of the various restrictions imposed by corporation laws, liability agreements, and voluntary actions of the board of directors.

22. The shareholders’ equity section is divided into four parts:

a. Capital shares, which represents the exchange value of the shares

issued; b. Contributed surplus, which may include items such as gains from

certain related party transactions; c. Retained earnings, which includes undistributed earnings, and is

sometimes referred to as “earned surplus”; d. Accumulated other comprehensive income, which includes

unrealized gains and losses on certain investments; certain gains or losses from hedging activities; gains or losses on revalued property, plant, and equipment; and other. The does not need to be called “accumulated other comprehensive income”.

Additional Information Reported

23. Supplemental information related to contingencies, accounting policies such

as valuation methods and assumptions used, subsequent events, contractual situations, and additional detail on statement of financial position line items all provide for elaboration or qualification of items in the statement of financial position.

24. A contingency is an existing situation in which there is uncertainty about

whether a gain or loss will occur and that will finally be resolved when one or more future events occur or fail to occur. In short, contingencies are material (or potentially material) events that have an uncertain future. They are normally disclosed in notes to the financial statements and can represent a possible gain or a possible loss. An example of a gain contingency is company litigation against a third party. Typical loss contingencies relate to litigation, environmental issues, possible tax assessments, or government investigation.




25. The methods used to value assets and allocate costs vary considerably among statement of financial position accounts. To help users of the financial statements understand and evaluate financial statement components and their relationships, these valuation methods are normally disclosed in a separate summary of significant accounting policies preceding the financial statement notes. In addition to contingencies and valuation methods, any contracts and negotiations of significance should be disclosed. These items include pension obligations, lease contracts, stock options, etc.

26. Subsequent events are important transactions and events that occur after the

fiscal year end but before financial statements are prepared. If the events provide further evidence of conditions that existed at the statement of financial position date, financial statements must be adjusted. However, if the events indicate conditions that occurred after the financial statement date, they are disclosed in notes if the condition causes a significant change to assets, liabilities, and/or will have a significant impact on future operations.

27. Effective communication of the information required to be disclosed in financial

statements is an important consideration. Accountants have developed certain methods that have proven useful in disclosing pertinent information. These methods are parenthetical explanations, notes, supporting schedules, and cross-reference and contra items.

Statement of Financial Position Format

28. The statement of financial position can be presented to reflect the accounting

equation (assets on the left and liabilities and equity on the right), however a more common presentation of a classified statement of financial position lists liabilities and equity below assets. Refer to Illustration 5-12 in the text for an example of a classified statement of financial position.


29. A primary objective of financial reporting is to allow financial statement users

the opportunity to access the amounts, timing, and uncertainty of cash flows. The statement of financial position, income statement, and retained earnings statement do not provide a convenient source of information on cash flows. Thus, in an attempt to provide a vehicle to help achieve this objective, the CICA Handbook requires the presentation of the statement of cash flows as a basic financial statement.




30. The primary purpose of the statement of cash flows is to allow users to assess the capacity of the enterprise to generate cash and cash equivalents and the needs of the enterprise for cash resources. In accomplishing its purpose, the statement focuses attention on three different activities related to cash flows:

a) Operating activities represent the principal revenue-producing activities of

the enterprise and all other activities that are not investing or financing activities.

b) Investing activities represent the acquisition and disposal of long-term assets and other investments not included in "cash equivalents."

c) Financing activities represent activities that result in changes in the size and composition of the equity capital and borrowing of the enterprise.

The basic format of the statement of cash flows is shown below.


Cash flows from operating activities $ XXX Cash flows from investing activities XXX Cash flows from financing activities XXX Net increase (decrease) in cash XXX Cash at beginning of year XXX Cash at end of year $ XXX

31. Information required to prepare a statement of cash flows is obtained from the statement of financial position, the income statement, and selected transactions, primarily from the cash account. The steps require: a. Determine the cash provided by or used in operating, investing, and

financing activities. b. Determine the change (increase or decrease) in cash during the period. c. Reconcile the change in cash with the beginning and ending cash

balances.

The information included in this chapter on the preparation of the statement of cash flows provides a basic introduction to the concepts involved and uses a simple example to look briefly at how to calculate the cash provided by operating activities using the indirect method. The direct method is covered in Chapter 22. It is the method preferred under GAAP, though in practice, the indirect method is widely favoured. Regardless of the method used, the cash provided by operations will be the same.




32. The cash flow statement is especially useful to creditors. They look for answers to the following questions:

a. How successful is the company at generating cash from operating

activities? b. What are the trends in net cash flow from operating activities over time? c. What are the major reasons for the changes in cash from operating

activities? d. Are cash flows sustainable (i.e., can they be replicated over time?)?

33. Free cash flow is the amount of discretionary cash that a company has for

purchasing additional investments, retiring debt, or simply adding to its liquidity. Free cash flow is net cash provided by operating activities less capital expenditures and dividends.

34. IFRS and ASPE compared — Differences between IFRS and ASPE in the

accounting for assets, liabilities, and shareholders’ equity, and statement of financial position and statement of cash flow presentation is summarized in Illustration 5-24 of the text.

35. As mentioned in Chapter 4, the IASB and FASB are working on a financial

statement presentation standard that is expected to be issued in 2011.

36. Appendix 5A discusses ratio analysis as the relationship among selected financial data. The relationship can be expressed in terms of a percentage, a rate, or a simple proportion. Ratios can be classified into four major types:

a. Liquidity ratios—measure of the enterprise’s short-run ability to pay its

maturing obligations; b. Activity ratios—measure how effectively the enterprise is using the assets

employed; c. Profitability ratios—measure the degree of success or failure of a given

enterprise or division for a given period of time; and d. Solvency or coverage ratios—measure the degree of protection for long-

term creditors and investors.

37. Appendix 5B is an illustration of selected data from the 2011 Annual Report of Shoppers Drug Mart Corporation. This is an example of the kind of financial information provided annually by a major corporation.




LECTURE OUTLINE

TEACHING TIP

Appendix 5B in the text contains selected financial data for Shoppers Drug Mart Corporation that can be used to illustrate many of the concepts in this chapter.

It should be emphasized that this chapter is a review chapter and the intent is to provide an overview for topics that will be dealt with in greater detail in later chapters.

The material in the chapter can be covered in two class sessions. The first session can be used for a lecture on the concepts covered in the chapter. Most students should have had previous exposure to these concepts. The first session can also be used for reviewing some of the shorter cases and exercises. You may wish to call upon students for their answers to the items in these cases and exercises. Most items are straightforward, but some of them will stimulate class discussion and highlight areas of misunderstanding.

The second session can be used for final review and for going over the longer problem material. This material allows students to apply chapter concepts by critiquing and preparing financial statements.

TEACHING TIP

As a comprehensive review of Chapters 4 and 5, use Illustration 5-4 to discuss the specimen financial statements of Shoppers Drug Mart Corporation that appear in Appendix 5B in the textbook. Reproduce and distribute Illustration 5-4 and have students prepare answers as a homework assignment. Ask students for their answers in class.

The following lecture outline is appropriate for the chapter.




A. Usefulness and Purpose of the Statement of Financial Position

1. Provides information about entity's assets, liabilities, and equity. As the definition of assets and liabilities has undergone significant change, be sure that students, who have likely taken previous accounting courses, understand the new definition and why it is appropriate.

2. Evaluates liquidity and financial flexibility.

3. Aids in assessing risk and predicting future cash flows.

B. Limitations of the Statement of Financial Position

1. Current value is not reflected.

2. Estimates and judgements must be used:

a. in determining the collectibility of receivables. b. in assessing the saleability of inventory. c. in determining the useful lives of long-term assets.

3. Omits many items that are of financial value to the business.

a. Assets such as the value of a company's human resources and

research and development are not reported. b. Some liabilities and commitments such as leases and certain

contractual arrangements are reported in an "off balance sheet" manner.




C. Classifications in the Statement of Financial Position

Review definitions in text.

TEACHING TIP

Illustration 5-1 can be used in a discussion of the major classifications and sub-classifications in the balance sheet.

1. Assets 2. Liabilities 3. Equity

Major Sub-classifications in the Statement of Financial Position: The IASB and FASB are working to establish consistent principles for aggregating information and to identify the totals and subtotals that should be reported.

TEACHING TIP

Illustration 5-2 can be used in discussing the relationship among current assets, current liabilities, working capital, and the operating cycle.

1. Current assets

a. Definition: Resources that are expected to be turned into cash, sold, or consumed within a year or the operating cycle, whichever is longer. (Point out the distinction between the operating cycle and the accounting cycle.)

b. Emphasize that intent and marketability are important considerations in classifying certain assets, such as short-term investments, as current.




TEACHING TIP

Point out some conceptual weaknesses in the classification of current assets: Prepaid expenses will neither be turned into cash nor used to pay a current liability. Discuss the justification for including them in current assets.

Consumption of fixed assets during the current period: Conceptually, the current depreciation and depreciation charges should be classified as current assets, analogous to the "currently maturing portion of long-term debt."

c. Items included in the current asset section.

i. Cash—any cash restricted for purposes other than current obligations is excluded from current assets.

ii. Short-term investments—debt and equity securities are

presented separately and valued a cost/amortized cost or fair value.

iii. Receivables—the amounts of expected uncollectibles,

nontrade receivables, and accounts pledged or discounted should be disclosed.

iv. Inventories—the basis of valuation (e.g., cost or the lower of

cost and net realizable value), cost formula (e.g., FIFO, weighted-average, specific identification.), and stage of completion of manufactured inventories should be disclosed.

v. Prepaid expenses—expenses prepaid beyond the current

operating cycle – as they will not require cash in the current year/operating cycle, they are included with current assets.

TEACHING TIP

Discuss the differences in accounting for short-term and long-term investments.




2. Current liabilities

a. Definition: Obligations that are reasonably expected to be liquidated through the use of current assets or the creation of other current liabilities.

b. Examples:

i. Payables resulting from the acquisition of goods and services:

accounts payable, wages payable, taxes payable.

ii. Collections received in advance for the delivery of goods or the performance of services: prepaid rent, prepaid subscriptions.

iii. Other liabilities whose liquidation will take place within the

operating cycle: bonds maturing in the current period, short-term obligations arising from purchase of equipment.

c. Current liabilities are frequently reported on the statement of

financial position in the order they will be paid.

d. Some liabilities that will be paid within a year are reported as long- term liabilities. These include:

i. short-term debt expected to be refinanced

ii. debt that will be retired out of non-current assets. (Alternatively,

both the debt and the assets could be classified as current.)

TEACHING TIP

Use Illustration 5-2 to discuss working capital.




3. Non-current assets a. Non-current investments: are presented just below current assets

in a separate section called “Investments”. Investments that are readily marketable may be classified as current or long-term, depending on management’s intent for holding them. They normally consist of:

• Debt securities (held-to-maturity and measured at amortized cost)

• Equity investments (subsidiaries, significant influence, non-consolidated

subsidiaries, or no influence or control);

• Other (such as a sinking funds or tangible assets held as investments) – generally valued at cost

Non-current equity investments are accounted for as follows:

• Subsidiaries – consolidation

• Significant influence – Equity method

• Non-consolidated subsidiaries or investments where no control or influence exists – fair value or cost

b. Property, plant, and equipment: Durable physical property such as land, buildings, machinery, furniture, and "wasting resources" (timberland, minerals) used in operations.

i. Most assets in this category are either amortized (e.g., buildings) or depletable (e.g., timberlands). Land is not depreciated; however, land improvements (discussed in Chapter 11) are depreciated.

ii. FRS allows an option to carry these assets at fair value (rather

than historical cost) using a revaluation or fair value method. As with all assets, property, plant, and equipment is written down if impaired.




c. Intangible assets: Resources that lack physical substance but provide economic rights and advantages.

i. Examples include patents, franchises, trademarks, goodwill, and organization costs.

ii. Usually a high degree of uncertainty exists regarding realization of future benefits.

iii. Intangibles are carried at cost less accumulated amortization if they have finite lives, at cost if they have indefinite lives. Both kinds are written down if impaired. In practice, these items are often included in the section called "other assets."

iv. Expenditures for intangible assets, such as most R & D and internally developed goodwill, are not capitalized, but are expensed as incurred.

d. Other assets: A special classification for unusual items that cannot

be included in one of the other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current receivables, and advances to subsidiaries.

e. Point out that the classification of assets depends on both the

nature of the item and use to which it is put. For example:

i. Land used as factory site—classify as property, plant, and equipment.

ii. Land owned by a realty company and held for sale—classify as current asset.

iii. Land held for speculation—classify as long-term investment. iv. Idle land and facilities that have been withdrawn from

production—classify as other assets.




4. Long-term liabilities

a. Definition: Obligations that are not reasonably expected to be liquidated within the normal operating cycle, but instead, are payable at some date beyond that time.

b. Three types:

i. Obligations arising from specific financing situations where additional assets are acquired: issuance of bonds, long-term lease obligations, and long-term notes payable.

ii. Obligations arising from ordinary operations of the enterprise, such as pension obligations and deferred income taxes. (Pensions and income taxes are discussed in subsequent chapters.)

iii. Obligations that are dependent upon the occurrence or non- occurrence of one or more future events to confirm the amount payable, or the payee, or the date payable.

c. Any premium or discount on bonds payable is disclosed separately

as an addition to or subtraction from the bonds.

d. The currently maturing portion of long-term debt is classified as a current liability. Theoretically, any related premium or discount should also be reclassified as current.

e. Supplementary information that is usually disclosed in separate

schedules includes the existence of debt covenants and restrictions and the terms of the debt, such as maturity dates, interest rates, and amounts of any securities pledged to support the debt.




5. Shareholders' equity

a. Shareholders' equity of corporations.

i. Share capital—the amounts authorized, issued, and outstanding should be disclosed.

ii. Contributed surplus—includes premiums on shares issued and

capital donations.

iii. Retained earnings—the undistributed earnings of the corporation. Separate disclosure is made of unrestricted (available for dividends) and appropriated (restricted) retained earnings.

iv. Accumulated other comprehensive income— includes

unrealized gains and losses on certain investments, certain gains or losses from hedging activities, gains or losses on revalued property, plant, and equipment, and other. This does not need to be called “Accumulated other comprehensive income”.

TEACHING TIP

Discuss Illustration 5-11 from the text— the shareholders' equity section from Talisman Energy Inc.’s statement of financial position.

D. Additional Information.

1. Contingencies—Events that involve uncertainty as to possible gain (gain contingency) or loss (loss contingency) that will ultimately be resolved by a future event. An example of a gain contingency is company litigation against a third party. Typical loss contingencies relate to litigation, environmental issues, possible tax assessments or government investigation.




2. Valuations and accounting policies

a. A description of all significant accounting principles and methods that involve selection from among alternatives and/or those that are peculiar to a given industry should be disclosed.

b. This disclosure is usually given in the first note or in a separate summary of significant accounting policies preceding the notes.

3. Contractual situations. Contracts and negotiations: It is mandatory that

essential provisions of lease contracts, pension obligations, and stock option plans be clearly stated in the notes to the financial statements. Disclosure of other contracts and commitments of various natures (see Section 3280 of the CICA Handbook, Part II (ASPE), for example) is also required.

4. Subsequent events. Events that occur after the fiscal year end but

before financial statements are prepared. If the events provide further evidence of conditions that existed at the balance sheet date, adjust financial statements; if not, disclose in notes whether or not a significant change to assets, liabilities, and whether it will have a significant impact on future operations.

E. Techniques of Disclosure

1. Parenthetical explanations (example: prior year comparative).

2. Notes (example: accounting policies and contingencies).

3. Cross-reference and contra items (example: bond discounts).

4. Supporting schedules (example: lease disclosures).




F. Other Issues

1. Balance sheet format—account form versus report form.

2. Questions on terminology:

• The term "reserve" should be used only to describe an appropriation of retained earnings.

G. Cash Flow Statement

TEACHING TIP Use Illustration 5-14 to give an overview of the purpose and composition of the statement of cash flows.

1. Purposes of the statement:

a. To provide information about the amount, timing, and uncertainty of cash flows.

b. To summarize the operating, investing, and financing activities of the business.

2. The statement is useful because it provides answers to the following

important questions:

a. Where did cash come from?

b. What was cash used for?

c. What was the change in the cash balance?

3. Classification of cash flows. Cash flows from:

a. Operating activities.

b. Investing activities.

c. Financing activities.




4. Non-cash transactions, which would be reflected in the balance sheet, are not reported in the statement of cash flows. Examples of non-cash transactions include:

a. Conversion of long-term debt to common shares.

b. Acquisition of property through issuance of shares or through exchange for other property.

5. Investing activities and financing activities:

Investing Activities Financing Activities

Sale of non-current assets Issuance of equity securities

Sale of investments Issuance of debt

Collection of loans Payment of dividends

Purchase of non-current assets Retirement of debt or shares

Loans to other entities

6. One ratio often used in conjunction with the statement of cash flows to assess liquidity is the current cash debt coverage ratio calculated as:

net cash provided ÷

average current

=

current cash by operating activities liabilities debt coverage

7. A more long run measure, which provides information on financial flexibility, is the cash debt coverage ratio calculated as follows:

net cash provided ÷

average total

=

cash debt by operating activities liabilities coverage




8. Free cash flow is the net cash provided by operating activities less capital expenditures and dividends. Free cash flow is the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, or re-purchasing treasury shares.

TEACHING TIP

Point out that, under the CBCA, a company must cancel shares that it re- purchases. Therefore, treasury shares would only appear on the statement of financial position of U.S. companies and some provincially incorporated enterprises.

H. Compare IFRS and ASPE in the accounting for assets, liabilities, and shareholders’ equity, and statement of financial position and statement of cash flow presentation with reference to the summary in Illustration 5-24 of the text.

ILLUSTRATION 5-27




MAJOR STATEMENT OF FINANCIAL POSITION CLASSIFICATIONS

ASSETS LIABILITIES OWNERS’ EQUITY

Share Capital Current Assets Current Liabilities Preferred Shares

Common Shares

Non-current Long-Term Liabilities Investments

Property, Plant, and Equipment

Intangible

Assets

Contributed Surplus

Retained Earnings

Accumulated Other Comprehensive Income

Present economic benefits that the entity has rights or access to where others do not.

Present economic burden or obligation that is enforceable

Residual interests in the assets of an entity are those that remain after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

ILLUSTRATION 5-28




WORKING CAPITAL =

Current assets Current liabilities

CURRENT CLASSIFICATION

CURRENT ASSETS CURRENT LIABILITIES

1. Cash 1. Short-term debt 2. Short term investments 2. Accounts payable 3. Receivables 3.Advances from customers 4. Inventories 4. Income taxes payable 5. Prepaid expenses 5. Current portion of

long-term debt

Indication of entity’s liquidity

Indication of flexibility in meeting financial demands of

THE OPERATING CYCLE

Cash

Receivables Inventories

ILLUSTRATION 5-29




Investin Activitie

STATEMENT OF CASH FLOWS

CASH INFLOWS

Beginning Cash Ending Cash and Cash Operating Equivalent Activities

g Financing and Cash s Activities Equivalent

Balance Balance

CASH OUTFLOWS

Change in Cash and Cash Equivalents for the Period

ILLUSTRATION 5-30




QUESTIONS COVERING THE FINANCIAL STATEMENTS OF SHOPPERS DRUG MART CORPORTION

Examine the financial statements and accompanying notes for Shoppers Drug Mart Corporation (the “company”) in Appendix 5B. Answer the following questions (for 2011 only, unless otherwise specified).

1. What were the ending dates of the 2010 and 2011 statements given in the appendix?

2. Is the income statement presented in a multiple-step format or single-step

format?

3. Are the 2011 statements year end or interim financial statements?

4. Were there any material disposals of segments?

5. What country’s currency is used in the presentation of the company’s statements?

6. What major sub-classifications were used for assets? For liabilities? For

shareholders' equity?

7. Were there impairments of property, plant, & equipment during 2011?

8. How does the company classify its financial assets?

9. What basis was used for valuing inventories?

10. What were the primary depreciation methods used?

11. What basis does the company use in revenue recognition?

12. What was the amount of depletion and deprecation expense for 2011?

13. How much was 2011 earnings per share? How was it calculated?




14. What are the company’s operations primarily directed toward?

15. What percentage of total revenue for the quarter ended March 31, 2011 was attributable to foreign sales?

16. What discount and inflation rates were used to determine the present value

of environmental rehabilitation provisions at March 31, 2011?

17. What was the weighted average exercise price of the company’s stock options?

18. What was the number of preferred and common shares authorized?

19. What was the basic weighted number of common shares outstanding at

March 31, 2011?

20. What pricing model is used to estimate the value of options at the time they are granted?

21. What was the net effect of adopting IFRS on total assets as at December

31, 2011?

22. Were there any major acquisitions in 2011 of the controlling interest of other companies' shares? Did the acquisition price include a payment for goodwill?

23. What types of contingent liabilities were disclosed?




LEGAL NOTICE







CHAPTER 6

REVENUE RECOGNITION


Revenue Recognition and Measurement Section 4400 IAS 11 and IAS 18

Biological Assets (Agriculture) – Measurement

N/A IAS 41




LEARNING OBJECTIVES

1. Understand the economics and legalities of selling transactions from a business perspective.

2. Analyze and determine whether a company has earned revenues.

3. Discuss issues relating to measurement and measurement uncertainty.

4. Understand how to account for sales where there is collection uncertainty.

5. Prepare journal entries for consignment sales and long-term contracts.

6. Understand how to present sales transactions in the income statement and

prepare basic disclosures.

7. Discuss current trends in standard setting for revenue recognition including the contract based-approach.

8. Identify differences in accounting between ASPE and IFRS.




CHAPTER REVIEW

Understanding sales transactions from a business perspective

1. It is essential to understand the type of business an entity is engaged in to determine how to correctly account for its sales transactions. The general rule is that the risks and rewards of ownership must pass. However, we also need to consider:

• Are goods or services being sold — goods are tangible assets and

possession and control of the goods easier to define. Services not so much. Combinations of goods and services even more complicated in when to recognize revenue (e.g., sale of a product with a warranty).

• Barter transactions — need to understand the concept of fair

value in arm’s length transactions. Barter transactions are transactions where little or no monetary assets are received as consideration when goods or services are sold. As a general rule, the transaction should be treated as a sale and should be recorded at fair value of the assets given up unless the value of the assets or services received is more clearly determinable. If the transaction lacks commercial substance (i.e., there is no significant change in the timing, amount and/or riskiness of its future cash flows), book values are used to record the exchanged asset.

• Do concessionary terms exist — this may happen when one party

is in a better bargaining position than another and it must be determined if the concession significantly affects when revenue would otherwise be recognized. This may lead to measurement uncertainty.

• Legal issues and contract law — a sale is a contract. Shipping

terms may determine when legal title passes (example, FOB shipping point versus FOB destination).

• Other laws may apply even if not in the contract (example:

environmental laws) — this may create an obligation that should be recognized on the statement of financial position.




Revenue Recognition and the Earnings Approach

2. The earnings approach is current ASPE and IFRS. It is primarily an income statement approach and revenues are recognized when:

1. Performance is achieved which means:

(a) risks and rewards are transferred and/or the earnings

process is substantially complete; and

(b) measurability is reasonably assured;

2. Collectibility is reasonably assured.

The earnings process includes what a company does to add value to what they are selling. Often there is a critical event that signifies when the earnings process is substantially complete. For instance, for a company that sells goods, the critical event is at the point of delivery.

The transfer of risks and rewards of ownership is a core concept of the earnings approach. In determining at what point the risks and rewards of ownership are transferred in a sales transaction, it is important to look at who has possession of the goods and who has legal title. In business involving sale of goods, this is normally at the point of delivery. Where the earnings process has critical event, it is often referred to as a discrete earnings process.

Arrangements such as sales with buybacks and bill and hold transactions are examples where the economic substance of the transaction needs to be determined. A buyback agreement in a sales transaction might more appropriately be classified as a loan with the items transferred being held as collateral. With bill and hold transactions there may be bona fide business reasons for structuring a sale this way, such as lack of space at the purchasers warehouse. Professional judgement must be exercised to ensure that a particular transaction meets the criteria necessary to be classified as a sale.




In general, a contract to sell merchandise in the future is not recorded as a sale until the merchandise is delivered and the transaction is complete. In most business enterprises, a far greater proportion of total sales volume is handled on a credit basis than on an ordinary cash sale basis. The problem of revenue recognition becomes more complex when the sales contracts contain, for example, provisions allowing the purchaser the right to return any or all of the goods purchased. If the provision allows the customer to evaluate or try out the goods before purchase, the sale should not be recognized until the trial period expires or the customer commits to a firm sale. However, if the provision allows for a general right of return it will likely be appropriate to recognize the sale as long as the amount of returns can be reasonably estimated. Furthermore, the ability of the vendor to receive the proceeds of the transaction in cash is subject to varying degrees of uncertainty.

Problems with the Earnings Approach

Problems with the earnings approach include:

• Multiple and sometimes conflicting guidance • Difficult to apply due to differing views of what the earnings process

is and when revenues are earned • Often risks and rewards are split between buyer and seller so

difficult to determine when risks and rewards have transferred • Requires a great deal of subjective judgement • Does not consider when receivables should be recorded if the

revenues are not yet earned

Concessionary Terms

3. Concessionary terms are terms negotiated by a party to the contract that are more favourable than normal. Concessionary terms are terms that are more lenient than usual and are meant to induce sales.

Concessionary or abnormal terms may create additional obligations or may reflect the fact that the risks and rewards or control has not yet passed to the customer. These situations must be carefully analyzed as they create additional recognition and measurement uncertainty. They may even indicate that no sale has taken place at all.




Contract Law

4. When an entity sells something, both the entity and the customer enter into a contract. Regardless of whether the contract is written or verbal, the important thing is that two parties have promised to exchange assets and this creates a contract. There is a promissory (the seller), a promissee (the customer), and an agreement. Thus, the act of entering into a sales agreement creates legal rights and obligations.

In addition, the contract establishes the point in time when legal title passes (entitlement and ownership under law). When the customer takes physical possession of the goods straight away, legal title would normally pass at this point. If the goods are shipped, the point at which legal title passes is often indicated by the shipping terms as follows:

• FOB shipping point: title passes at the point of shipment. • FOB destination: title passes when the asset reaches the

customer.

Recognition and Measurement — Earnings Approach versus Contract- based approach

5. For the earnings approach and the contract-based approach, revenue is an inflow of economic benefits (cash, accounts receivable, or other consideration) arising from the business’ ordinary activities. Revenues can be accounted for using either:

• an earnings approach which focuses on the earnings process and

how a company adds value for its customers, or

• a contract-based approach which focuses on the contractual rights and obligations created by sales contracts.

Rendering of Services and Long-Term Contracts

Unlike the earnings process relating to the sale of goods, where the critical event is normally “delivery”, the focus in providing services is on performance of the service. Often the earnings process has numerous significant events as opposed to one critical event.




Another exception to the general rule of recognizing revenue on delivery can occur regarding long-term construction projects. The accounting measurements associated with long-term construction projects are difficult because events and amounts must be estimated for a period of years. Two basic methods of accounting for long-term construction contracts are recognised by the accounting profession under ASPE:

(a) the percentage-of-completion method—Revenues and gross profit are recognized each period based on progress made to a specific point in time, and

(b) the completed-contract method—Revenues and gross profit are recognized only when the contract is completed.

Choosing the Appropriate Method

The CICA Handbook, Part II, Section 3400.08 recommends the method that best matches the revenues to be recognized to the work performed. The determination of the relationship between revenue and work accomplished is left to the accountant's judgement. Reference to both international and U.S. standards may help in making difficult decisions. Both recommend that the percentage-of-completion method and the completed-contract method not be viewed as acceptable, interchangeable alternatives. The percentage-of- completion method should be used when estimates of progress toward completion, revenues, and costs are reasonably ascertainable. The completed-contract method should be used when performance consists of the execution of a single act or when the enterprise cannot reasonably estimate the extent of progress toward completion.

Measurement Uncertainty

6. Measurement uncertainty stems from the inability to measure the consideration itself (as with barter transactions or price protection clauses), inability to measure related costs, or inability to measure the outcomes of the transaction itself (such as where sales are contingent upon a future event). Examples of transactions with measurement uncertainty include:

a) Sales with buyback agreements. In the U.S., when a repurchase agreement exists at a set price, and this price covers all costs of inventory plus related holding costs, no sale is recorded. The inventory and the related liability remain on the seller’s books. In Canada, this type of transaction would have to be dealt with in terms of whether the risks and rewards of ownership have been transferred.




b) Sales When a Right of Return Exists. Companies who experience a high rate of returns merchandise often find it necessary to postpone reporting sales until the return privileges have expired.

Measuring Parts of a Sale

7. When a sale creates multiple deliverables, revenue for the products or services should be allocated between the deliverables. These are bundled sales or multiple element arrangements and can be accounted for separately if the deliverable has a value to the customer on a stand-alone basis; has a value that can be determined objectively; and (if a general right of return exists) completion of the contract is probable and within the control of the vendor.

Different services may also be accounted for differently depending on when the related revenues are earned. In order to accommodate this, the sale needs to be bifurcated, or divided up, into separate units or components.

Two method of bifurcation can be used. In the relative fair value method would, the fair value of each item (sometimes referred to as the stand-alone value) is determined and then the purchase price is allocated based on the relative fair values. Alternatively, the residual value method could be used. In this method, the fair value of the undelivered item is subtracted from the overall purchase price. The residual value is then used to value the delivered item.

Collectibility

8. If it is reasonably sure that collection of the receivable will ultimately occur and as long as it is possible to estimate any uncollectible amounts at the point of sale, the revenue is recognized and any potential uncollectible amount is accrued.

Certain types of sales transactions such as those that require or allow payment over an extended time period pose greater collectibility risk. If collectibility is established, but the uncollectible amounts are not estimable, one of two methods is generally used to account for the deferral of revenue recognition until cash is received:

(a) the instalment method




(b) the cost recovery method.

Instalment Method

Under the instalment method of accounting, the gross profit (sales less cost of goods sold) on instalment sales is deferred to those periods in which cash is collected. Proportional Gross Profit on Instalment Sales is generally treated as unearned income and classified as a current liability. Operating expenses, such as selling and administrative expenses, are treated as expenses in the period incurred. For instalment sales in any one year, the following procedures apply if the instalment method is being used:

Cost Recovery Method

Under the cost recovery method, no profit is recognised until cash payments by the buyer exceed the seller's cost of the merchandise sold. After all costs have been recovered, any additional cash collections are included in income. The cost recovery method is more conservative than the instalment method and is applicable only in situations when there is a great degree of uncertainty.

Consignment Sales

9. Using an earnings approach in a consignment arrangement, the vendor (consignor) retains the risks of ownership, namely that the merchandise might not sell, and relieves the dealer (consignee) of the need to commit part of its working capital to inventory. The consignor retains legal title to the goods and the goods are carried on the consignor’s inventory. It is not recorded as an asset by the consignee. When the merchandise is sold, the consignee has a liability for the net amount that it must remit to the consignor

Using a contract-based approach, both parties have rights and obligations when the consignment arrangement is first entered into. The consignee would record a net contract position of zero. As measurement uncertainty exists (i.e. there is no guarantee the consignee will sell any of the consigned merchandise) then no sales revenue is yet earned. The accounting for the consignor would be essentially the same under both the earnings and contract-based approach.




Percentage-of-Completion Method — Earnings Approach

10. Under the percentage-of-completion method, revenue on long-term contracts is recognized as construction progresses (i.e., before delivery). The accounting profession has for many years considered the percentage- of-completion method preferable when estimates of costs to complete and the extent of progress toward completion of long-term contracts are reasonably reliable. The amount of revenue recognised in each accounting period is based on a percentage of the total revenue to be recognised on the contract. This percentage may be based on input measures (costs incurred, labour hours worked), or output measures (tons produced, stories of a building completed, miles of highway completed). One of the popular measures used to determine the progress toward completion is cost— sometimes referred to as the cost-to-cost basis. Under this method, the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract, calculated as follows:

cost incurred to date = percent complete most recent estimate of total costs

Revenues are then calculated using the percentage that costs incurred bear to total estimated costs as follows:

percent complete × estimated total revenue = revenues to be recognized to date

With the earnings approach, no recognition is given to the contract when it is first entered into. A receivable is set up over the earnings period based on progress billings. The account “Billings on Construction in Process” is offset against the “Construction in Process” account. The Construction in Process account accumulates all the costs and profit recognized over the earnings period, so that at the end of the contract, the balance in both accounts completely offsets each other and a final entry is recorded to close both accounts.




Completed Contract Method — Earnings Approach

11. Under the completed-contract method, revenue, expenses and gross profit are recognized when the contract is completed. The principal advantage of the completed contract method is that reported revenue is based on final results rather than on estimates regarding unperformed work. Its major disadvantage is the distortion of earnings that may occur over the periods during which the work is done. The accounting entries made under the completed-contract method are the same as those made under the percentage-of-completion method, with the notable exception of periodic income recognition. The completed contract method is not allowed under IFRS.

Zero-Profit (Cost Recovery) Method

12. In the accounting for long-term contracts, an additional complexity may arise where the outcome of the contract is not determinable. This might occur, for example, at the beginning of the contract where it might be difficult to estimate costs to completion and therefore the percentage complete. In this case, as noted earlier, recoverable revenues equal to costs incurred would be recognized under IFRS. Under ASPE, if the outcome were not determinable, the accounting would default to the completed contract method.

Long Term Contract Losses

13. Long term contract losses can occur:

a. as a loss in the current period on a profitable contract. Under the percentage of completion method, a current period adjustment of any excess gross profit recognised in a prior period is necessary.

b. as a loss on an unprofitable contract. Under both the percentage of

completion and the completed contract method, the entire contract loss must be recognized in the current period.




Income Statement Presentation — reporting gross versus net revenues

14. Since the revenue number is a focus of many information users, reporting gross or net revenues is an important issue. If the company prefers to report gross revenue and cost of goods sold, there will be no impact on net income, however, it might leave a positive impact on the users of information. Factors to consider in determining whether to report net versus gross would be:

• Whether the company acts as a principal in the transaction or as an

agent or broker (who is buying and selling an item for commission).

• Whether the company takes title to the goods being sold.

• Whether the company has the risks and rewards of ownership of the goods being sold.

Contract-Based Revenue Recognition Model

15. The core principle of the contract-based model as noted in the revised exposure draft (RED) is as follows: “the entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled…”.

Under the proposed standard, the following steps should be followed in determining when and how to recognize revenues using the contract-based model:

(1) Identify the contract(s) with the customer—Essentially identify the

parties and what both parties have agreed to; that is, the economics and legalities of the transactions.




(2) Identify the separate performance obligations in the contract— Enforceable obligations under the contract are referred to as performance obligations. These obligations represent what the company has agreed to sell or do under the contract. If the performance obligations are distinct then they should be accounted for as separate performance obligations. Contracts with multiple distinct performance obligations represent bundled sales, as discussed earlier in the chapter. Where goods and services are highly interrelated, then they are not separated out as distinct or separate performance obligations and the whole contract is accounted for together.

(3) Determine the transaction price—The transaction price is the amount

of consideration (ie., payment) to which a company expects to be entitled in exchange for transferring promised goods or services to a customer.

Usually, the transaction price would be a fixed amount of customer consideration. Sometimes, the transaction price would include estimates of consideration that is variable or is in a form other than cash. The transaction price would also be adjusted for the effects of the time value of money (if significant to the contract) and for any consideration payable to the customer.

The effects of credit risk (collectibility) would not be reflected in the transaction price. Instead, those effects would be presented as a separate line item adjacent to revenue.

(4) Allocate the transaction price—A company would typically allocate the

transaction price to each separate performance obligation on the basis of the relative stand-alone selling price of each distinct good or service. If a stand-alone selling price is not observable, a company would estimate it (possibly using a residual estimation approach).

Sometimes, the transaction price would include a discount or a contingent amount of consideration that relates entirely to one of the performance obligations in a contract. The proposals specify when a company should allocate the discount or contingent consideration to one performance obligation rather than to all performance obligations in the contract.




(5) Recognize revenue when a performance obligation is satisfied—A company would recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). The amount of revenue a company recognises would be the amount allocated to the satisfied performance obligation.

A performance obligation may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time (typically for promises to transfer services to a customer). For performance obligations satisfied over time, a company would select an appropriate measure of progress to determine how much revenue should be recognized as the performance obligation is satisfied.

The proposed requirements would limit the cumulative amount of revenue a company recognizes to date to the amount to which the company is reasonably assured to be entitled.

Problems with the Contract-Based Approach

While it is a new method consistent with the new conceptual framework, it has not yet been tested. It does not deal with revenues that are not contract- based such as those where revenue is recognized before the goods/services are sold to the customer.




IASB and FASB

16. The IASB and FASB are currently working together on a new model for revenue recognition. That model was introduced in this chapter as the contract-based model. Still being discussed in the Revised Exposure Draft (RED) include:

• More guidance on measurement including use of the time value of

money, uncertainty due to credit risk and contingent consideration. This will likely link into another current project dealing with the use of fair value accounting.

• Additional guidance on measuring the separate account units in

multiple element arrangements/bundled sales.

• Whether rights and obligations under contracts should be presented net or gross.

• Guidance on when to present revenues as net or gross.

IFRS/ASPE comparisons

17. Differences were highlighted in the text and notes, but Illustration 6-25 in the text gives a summary of the key differences and similarities between revenue recognition issues.

Analysis

18. Revenue analysis focuses greatly on trends. Revenue trend is used as a measure of management performance and growth potential. Biased reporting is possible under both principle based and rule based accounting standards and it is often difficult to identify revenue misrepresentation in financial statements because note disclosure is often too general. The analyst must understand the business transactions, and any changes in the business model should be communicated to the reader. A company should not be entering into large and unusual transactions just to make the company’s performance look better than it really is.




LECTURE OUTLINE

A. Revenue Recognition—Basic Concepts

1. Earning Process, concept of value added.

2. Identify that it is necessary to understand the type of business to determine how to account for its sales transactions. Outline some of the complexities and issues in revenue recognition including;

a. Sale of goods versus sale of services b. Barter transactions and concept of fair value c. Concessionary terms in sales agreements d. Legal issues

TEACHING TIP

Illustration 6-1 identifies basic activities and events in the earning process of various types of business. This may be useful to illustrate differences in earning processes, raise the concept of value added, and discuss why accountants do not measure revenue on a value added basis. This then leads to addressing the question of when and why accountants do recognise revenue in the earning process.

3. Point out that revenue recognition (deciding in which period to record revenue) often requires judgement for particular situations, even though specific criteria for revenue recognition exist. Also, decisions pertaining to revenue recognition affect balance sheet as well as income statement accounts and amounts.

4. Discuss the Earnings Approach versus the Contract-based approach -

revenues can be accounted for using either:

• an earnings approach which focuses on the earnings process and how a company adds value for its customers, or

• a contract-based approach which focuses on the contractual rights

and obligations created by sales contracts




5. Revenue Recognition — Earnings Approach: Currently, ASPE and IFRS - Revenue is recognized when:

a. Performance is achieved which means:

i. risks and rewards are transferred and/or the earnings process is substantially complete; and

ii. Measurability is reasonably assured;

b. Collectibility is reasonably assured.

The earnings process includes what a company does to add value to what they are selling. Often there is a critical event that signifies when the earnings process is substantially complete. For instance, for a company that sells goods, the critical event is at the point of delivery.

6. Identify the problems with the Earnings approach:

• Multiple and sometimes conflicting guidance • Difficult to apply due to differing views of what the earnings process

is and when revenues are earned • Often risks and rewards are split between buyer and seller so

difficult to determine when risks and rewards have transferred • Requires a great deal of subjective judgement • Does not consider when receivables should be recorded if the

revenues are not yet earned

B. Measurement and Collection Uncertainty

a) Discuss why revenue is recognized at the point of delivery (sale) for most product sales situations. Demonstrate why it is at this time that revenue recognition criteria are satisfied.

b) Consider problems when a high rate of return of merchandise exists.

c) Discuss why revenue recognition at delivery for sales with buyback

agreements and for trade loading and channel stuffing would distort financial statement results.

d) Discuss issues that arise when collectibility is not reasonably assured

(briefly discuss cost recovery method and instalment method).




c) Discuss consignment sales using both the earnings approach and contract-based approach.

TEACHING TIP

Use the text Illustration 6-6 which provides a numerical example that demonstrates the journal entries to be made using the earnings approach for a consignment sale. If the contract-based approach had been used, the consignee would need to measure the value of the rights and obligations up front. As they would equal at that point, the net effect would be zero (for example in this case an asset of $36,000 and a liability of $36,000). However because there is measurement uncertainty as to whether there will even be a sale and revenue is contingent upon making a sale, no entry would be booked in this case. Therefore, in this case, the entries for both methods would be essentially the same.

C. Long-term Contracts

Percentage-of-completion method – earnings approach:

TEACHING TIP

Illustration 6-2 provides a numerical example that demonstrates the journal entries to be made using the percentage-of-completion method for a long-term construction contract under the earnings approach. It includes loss recognition on an overall profitable contract.

1. i. Gross profit is recognized periodically, based on the percentage of

the job that is complete, rather than when the entire job is completed.

ii. The method should be used when estimates of costs to complete

and extent of progress toward completion are reasonably determinable.

iii. Extent of progress toward completion is often measured by a cost-to-

cost method.




Completed-contract method – earnings approach

Gross profit is not recognised until the contract is completed. The completed contract method is not allowed under IFRS.

TEACHING TIP

Illustration 6-3 provides a numerical example of the journal entries made when using the completed-contract method for long-term contracts. The example data is the same as was used in Illustration 6-2 to demonstrate the percentage-of- completion method. Contrasting the two illustrations will emphasize the differences and similarities between the two methods of accounting for long-term contracts.

2. When estimates indicate that the entire contract will be unprofitable, the entire loss is recognised immediately under both methods. Such recognition would incorporate any recognition of gross profit in prior years when the percentage-of-completion method is used.

3. The two methods should not be viewed as acceptable alternatives in the

same circumstances. The percentage-of-completion method should be used when estimates of progress toward completion, revenues, and costs are reasonably reliable.

Completed-contract method – earnings approach

In the accounting for long-term contracts, an additional complexity may arise where the outcome of the contract is not determinable. This might occur, for example, at the beginning of the contract where it might be difficult to estimate costs to completion and therefore the percentage complete. In this case, as noted earlier, recoverable revenues equal to costs incurred would be recognized under IFRS. Under ASPE, if the outcome were not determinable, the accounting would default to the completed contract method




TEACHING TIP

Illustrations 6-8 to 6-17 in the text provide numerical examples of the journal entries made when using the percentage of completion method for long-term contracts under the earnings approach. Illustration 6-18 to 6-19 of the text then uses the same example data to demonstrate the completed contract method for long-term contracts as allowed under ASPE. Contrasting the two illustrations will emphasize the differences and similarities between the two approaches of accounting for long-term contracts.




D. Presentation, Analysis, and Evolving Standards

4. Income Statement Presentation - reporting gross versus net revenues

Since the revenue number is a focus of many information users, reporting gross or net revenues is an important issue. If the company prefers to report gross revenue and cost of goods sold, there will be no impact on net income, however, it might leave a positive impact on the users of information. Factors to consider in determining whether to report net versus gross would be:

• Whether the company acts as a principal in the transaction or as an

agent or broker (who is buying and selling an item for commission) • Whether the company takes title to the goods being sold • Whether the company has the risks and rewards of ownership of the

goods being sold

5. Contract-Based Revenue Recognition Model

The core principle of the contract-based model as noted in the revised exposure draft (RED) is as follows: “the entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled…”.

Under the proposed standard, the following steps should be followed in determining when and how to recognize revenues using the contract-based model: 1. Identify the contract(s) with the customer. 2. Identify the separate performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price. 5. Recognize revenue when a performance obligation is satisfied.




6. IFRS/ASPE comparisons

TEACHING TIP

Illustration 6-25 in the text provides a chart comparing ASPE, IFRS, and IASB Proposed Model for Revenue Recognition and Measurement. Discuss with students the differences and similarities and discuss whether the proposed model will promote better recognition and measurement guidance.

.

Analysis

7. Revenue analysis focuses greatly on trends. Revenue trend is used as a measure of management performance and growth potential. Biased reporting is possible under both principles based and rule based accounting standards and it is often difficult to identify revenue misrepresentation in financial statements because note disclosure is often too general. The analyst must understand the business transactions, and any changes in the business model should be communicated to the reader. A company should not be entering into large and unusual transactions just to make the company’s performance look better than it really is.




IASB and FASB

8. The IASB and FASB are currently working together on a new model for revenue recognition. That model was introduced in this chapter as the contract-based model. Still being discussed include:

• More guidance on measurement including use of the time value of

money, uncertainty due to credit risk and contingent consideration. This will likely link into another current project dealing with the use of fair value accounting.

• Additional guidance on measuring the separate account units in

multiple element arrangements/bundled sales.

• Whether rights and obligations under contracts should be presented net or gross.

• Guidance on when to present revenues as net or gross.




ILLUSTRATION 6-1

EARNING PROCESSES (CYCLES)

MERCHANDISING

ORDER RECEIVE STORE SELL COLLECT FROM GOODS AND ADVERTISE ON CASH

SUPPLIERS DISPLAY ACCOUNT

TIME

AGRICULTURE

ASSEMBLE PLANTING & WEED HARVEST DELIVER RECEIVE INPUTS FERTILIZING TREATMENT & STORE CASH

TIME

SERVICE

ASSEMBLE PROMOTION SIGN PERFORM BILL COLLECT RESOURCES CONTRACT SERVICE CLIENT CASH

TIME




To recognize revenue and gross profit Construction in Process 600

410

810 Construction Expense 1,800 290 2,910

Rev. from Long-Term Contracts 2,400 120

1,800

2,090

Percentage of completion 4,500 5,500 = 40% = 38%

ILLUSTRATION 6-2

PERCENTAGE-OF-COMPLETION METHOD

DATA Buildmore Construction Limited received a contract for $6,000,000 in Year 1 to build a parking complex for the federal government. The following data was accumulated during the construction period:

Year 1 Year 2 Year 3

Total costs to date $ 1,800,000 $ 2,090,000 $ 5,000,000 Estimated cost to complete 2,700,000 3,410,000 — Progress billings during year 2,000,000 2,000,000 2,000,000 Cash collected during year 1,500,000 2,000,000 2,500,000

To record costs of construction (000 omitted) Year 1 Year 2 Year 3

Construction in Process 1,800 290 2,910 Materials, Cash, Payables, etc. 1,800 290 2,910

To record progress billings Accounts Receivable 2,000 2,000 2,000

Billings on Construction 2,000 2,000 2,000

To record collections Cash 1,500 2,000 2,500

Accounts Receivable 1,500 2,000 2,500

3,720





Revenue to be recognized 6,000×40% 6,000×38% 6,000×100% = 2,400 = 2,280 = 6,000 – 2,400 – 2,280 (120) 3,720

Profit to be recognized 1,500 × 40% 500 × 38% 1,000 × 100% = 600 = 190 = 1,000 – 600 – 190 (410) 810

To record final approval of the contract Year 3

Billings on Construction 6,000 Construction in Process 6,000

Note: Loss on contract is recognized, in full, immediately under either the percentage-of-completion method or the completed-contract method.




ILLUSTRATION 6-3

COMPLETED-CONTRACT METHOD

DATA Buildmore Construction Limited received a contract for $6,000,000 in Year 1 to build a parking complex for the federal government. The following data was accumulated during the construction period:

Total costs to date

Year 1 Year 2 Year 3

$1,800,000 $2,090,000 $5,000,000 Estimated cost to complete 2,700,000 3,410,000 — Progress billings during year 2,000,000 2,000,000 2,000,000 Cash collected during year 1,500,000 2,000,000 2,500,000

To record costs of construction (,000 omitted) Year 1 Year 2 Year 3

Construction in Process 1,800 290 2,910 Materials, Cash, Payables, etc. 1,800 290 2,910

To record progress billings


Billings on Construction 2,000 2,000 2,000

To record collections Cash 1,500 2,000 2,500


To record final approval of the contract Billings on Construction 6,000

Revenue from Long-Term Contracts 6,000

Construction Expenses 5,000

Construction in Progress 5,000




LEGAL NOTICE







CHAPTER 7

CASH AND RECEIVABLES


Current Assets and Current Liabilities Section 1510 IAS 1

Cash and Cash Equivalents Section 1540 IAS 7

Financial Instruments —Recognition and Measurement

Section 3856 IFRS 9 and IAS 39

Financial Instruments—Presentation Section 3856 IAS 32

Financial Instruments—Disclosure Section 3856 IFRS 7

LEARNING OBJECTIVES

1. Understand cash and accounts receivable from a business perspective.

2. Define financial assets, and identify items that are considered cash and cash equivalents and how they are reported.

3. Define receivables and identify the different types of receivables from an

accounting perspective.

4. Account for and explain accounting issues related to the recognition and measurement of accounts receivable.

5. Account for and explain accounting issues related to the impairment in value of

accounts receivable.




6. Account for and explain the accounting issues related to the recognition and measurement of short-term notes and loans receivable.

7. Account for and explain the accounting issues related to the recognition and

measurement of long-term loans and loans receivable.

8. Account for and explain the basic accounting issues related to the derecognition of receivables.

9. Explain how receivables and loans are reported and analyzed.

10. Identify differences in accounting between accounting standards for private

enterprises (ASPE) and IFRS, and what changes are expected in the near future.

11. Explain common techniques for controlling cash (Appendix 7A).

CHAPTER REVIEW

Financial Assets 1. Chapter 7 presents a detailed discussion of two of the primary liquid assets of a

business enterprise, cash and receivables. Cash is the most liquid asset held by a business enterprise and possesses unique problems in its management and control. Receivables are composed of both accounts and notes receivables. Chapter coverage of accounts receivable places emphasis on trade receivables. In covering note receivables, the chapter includes both short-term and long-term notes.

2. A financial asset is defined by the CICA Handbook Section 3856.05(h) as “any

asset that is:

a. cash; b. a contractual right to receive cash or another financial asset from

another party; c. a contractual right to exchange financial instruments with another party

under conditions that are potentially favourable; or d. an equity instrument of another entity.”




Cash 3. Cash is a financial asset and a financial instrument. It consists of coin, currency,

bank deposits, and negotiable instruments such as money orders, cheques, and bank drafts. Cash that has been designated for some specific use, other than for payment of currently maturing obligations, is segregated from the general cash account. This amount may be classified as a current asset if it will be disbursed within one year or the operating cycle, whichever is longer. Otherwise, the amount should be shown as a non-current asset.

Cash and cash equivalents 4. Although the reporting of cash is relatively straightforward, there a number of

issues that merit special attention:

a. restricted cash b. bank overdrafts c. cash equivalents

5. It is common practice for an enterprise to have an agreement with a bank

concerning credit and borrowing arrangements. When such an agreement exists, the bank may require the enterprise to maintain a minimum cash balance on deposit. The minimum balance is known as a compensating balance. When material, compensating balances that result in legally restricted deposits must be separately classified in the balance sheet. The nature of the borrowing arrangement determines whether the compensating balance is classified as a current asset or a non-current asset.

6. Bank overdrafts occur when a cheque is written for more than the amount in the

cash account. Bank overdrafts should be accounted for as a current liability or, if material, separately disclosed.

7. Cash equivalents are short-term, highly liquid investments that are both (a) readily

convertible to known amounts of cash, and (b) so near their maturity that they present a insignificant risk of change in interest rates (e.g., 30-day treasury bill, short term commercial paper, money market funds).

8. While ASPE excludes equity investments from the definition of cash equivalents,

IFRS allows some equity investments, such as preferred shares close to their redemption date to be included as a cash equivalent.




9. Cash equivalents must be measured at their fair value. Investments classified as cash equivalents are very short term so therefore their cost (or cost plus accrued interest) is generally the same as their fair value.

Accounts Receivable — Defined 10. Receivables are financial assets and financial instruments. They are defined as

claims held against customers and others for money, goods, or services. Accounts receivable are verbal or understood promises of the purchaser to pay for goods and services sold. Notes receivable are written promises to pay a certain sum of money on a specified future date. Open accounts receivable are short-term extensions of credit that are based on a purchaser’s oral promise to pay for goods and services and are usually collected within 30-60 days.

11. Receivables may generally be classified as current or non-current. Current

receivables are expected to be collected within one year or during the current operating cycle, whichever is longer. All other receivables are classified as non- current.

12. Receivables may be classified as trade or nontrade. Trade receivables (accounts

receivable and notes receivable) are usually the most significant receivables an enterprise possesses. Notes receivable are also loans receivable because they tend to arise from financial/investing transactions. Non-trade receivables arise from a variety of transactions and can be written promises either to pay or to deliver. Non-trade receivables are generally classified and reported as separate items in the balance sheet when they are material in amount.

Accounts Receivable — Recognition and Measurement

13. General standards exist for recognizing and measuring accounts receivable, which

includes when to recognize (when the entity becomes a party to the contractual provisions of the financial instrument; value to use initially (fair value); and subsequent valuation (amortized cost).

14. In most receivable transactions, the amount to be recognized is the exchange price

(amount due from the debtor) between two parties to a sales transaction. Two elements that must be considered in measuring receivables are (a) the availability of discounts (trade and cash), and (b) the length of time between the sale and the payment due date (the interest factor).




15. Two types of discounts that must be considered in determining the value of receivables are trade discounts and cash discounts. Trade discounts represent reductions from the list or catalogue prices of merchandise. They are often used to avoid frequent changes in catalogues or to quote different prices for different quantities purchased. Cash discounts (also called sales discounts) are offered as an inducement for prompt payment and are communicated in terms that read, for example, 2/10, n/30 (2% discount if paid within 10 days of the purchase or invoice date; otherwise the gross amount is due in 30 days).

16. Receivables should be measured at their net realizable value and using the net

method would reflect this; but in general practice, the gross method is used. However, if an allowance for sales discounts is used with the gross method, the net effect would result in recognizing accounts receivable at their realizable value.

(a) The gross method records sales and accounts receivable at the gross

amount of a sale. Sales discounts are recognized if the customer pays within the discount period. Sales Discounts are reported on the income statement as a deduction from Sales in the determination of net sales.

(b) The net method records sales and accounts receivable at an amount net of

any cash discount. If the customer does not pay within the discount period, Sales Discounts Forfeited is debited for the lost discount. Sales Discounts Forfeited is reported on the income statement under the other expense and income section.

Accounts Receivable — Special Allowance Accounts 17. To properly match expenses to sales revenues, it is sometimes necessary to

establish additional allowance accounts as contra accounts to accounts receivable if sales returns are expected to be significant. The most common allowance is the allowance for sales returns and allowances.

18. Ideally, receivables should be measured in terms of their present value. When

expected cash receipts require a waiting period, the amount actually received is not worth the receivable face amount. In practice, accountants have generally chosen to ignore this for accounts receivable because the amount of the discount is not usually material in relation to the net income for the period. In subsequent periods, accounts receivable should be measured at amortized cost. However, where there is no interest element that has been recognized, cost and amortized cost will be the same.




Impairment of Accounts Receivable

19. It is highly unlikely that a company that extends credit to its customers will be

successful in collecting all of its receivables. Thus, some method must be adopted to account for receivables that ultimately prove to be uncollectible. The most important indicator used to identify an impaired account receivable is how long the account has been outstanding. A company commonly estimates the amounts that will be uncollectible by using an aging method. Past experience is used to estimate the percentage of its outstanding receivables that will become uncollectible without identifying specific accounts. This is referred to as the percentage-of-receivables approach with the objective of reporting receivables on the balance sheet as the present value of the cash that is expected to be received. The percentage used may be a combined rate, or an individual percentage applied to each group within an aging category. An allowance method is used to account for the estimate of impairment. This method results in receivables being stated at the estimated realizable value on the balance sheet.

20. Use of the allowance method requires a year-end estimate of expected

uncollectible accounts based upon outstanding receivables. This method is in keeping with the current accounting model that emphasizes ensuring accurate measurement of assets and liabilities. The model assumes that if assets and liabilities are properly measured, so will the related revenues and expenses. The estimate is recorded by debiting an expense and crediting an allowance account. Then, in a subsequent period when an account is deemed to be uncollectible, an entry is made debiting the allowance account and crediting accounts receivable.

21. There are two accounting procedures that can be used when employing the

allowance method, both of which will result in the same ending balances in the Allowance and Bad Debt Expense accounts. They are:

a. Allowance Procedure Only – At month end, management

estimates uncollectible accounts by analyzing the Accounts Receivables balances. An entry is made to adjust the allowance account to reflect the estimated uncollectible amounts.

b. Mix of Procedures – At month end, management will estimate the

bad debt expense by using a percentage-of-sales method that estimates bad debt as a percentage of sales. If there is a fairly stable relationship between previous years’ credit sales and bad debts, then that relationship can be used as a percentage to estimate bad debts based on the current period’s sales. This can be done much more quickly on an interim basis than the aging process required by the percentage-of-receivables method. At the end of the fiscal year when financial statements are issued




however, the percentage-of-receivables procedure is applied and any adjustment required is made to ensure Accounts Receivable are accurately reported at its net realizable value.

22. Either of the above two methods can be used. Many companies use the mix of

procedures method. An estimate of bad debts is used for internal reporting using the percentage-of-completion throughout the year and an adjustment is made at year end based on the aged accounts receivable balances.

23. For some cash based businesses with few credit transactions, a simpler method of

recording a bad debt expense is the use of the direct write-off method. Under the direct write-off method, the receivable account is reduced, and an expense is recorded when a specific account is determined to be uncollectible. The direct write-off method is theoretically deficient because it usually does not result in receivables being stated at estimated realizable value on the balance sheet. The direct write-off method is regarded as inappropriate if the amount deemed uncollectible is material. A subsequent recovery is recorded in a revenue account, Uncollectible Amounts Recovered.

24. Advocates of the allowance method contend that its use provides for a proper

matching of revenues and expenses as well as reflecting a proper carrying value for accounts receivable at the end of the period. When the allowance method is used, the estimated amount of uncollectible accounts is normally based upon a percentage of sales or outstanding receivables. The percentage-of-sales method attempts to match costs with revenues, and is frequently referred to as the income statement approach. The percentage-of-receivables approach provides a reasonably accurate estimate of the net realizable value of receivables shown on the statement of financial position. This approach is commonly referred to as the statement of financial position approach.

25. The method used to determine the amount of bad debt expense each year affects

the amount of expense recorded. Under the percentage-of-sales method, the amount recorded as bad debt expense is the amount determined by multiplying the estimated percentage times the credit sales. However, under the percentage-of- receivables approach, the unadjusted ending balance in the allowance account must be considered in arriving at bad debts expense for the year.




26. The IASB provides detailed guidelines to be used in determining whether a receivable should be considered uncollectible or impaired. Assessing for impairment is done annually. Possible loss events include: (1) significant financial problems of a customer, (2) payment defaults, (3) renegotiation of receivable terms due to customer financial difficulties, and (4) a measurable decrease in future cash flows from a group of receivables since initial recognition, even though the decrease cannot be identified with individual asset in the group.

27. A receivable is considered impaired when a loss event indicates a negative impact

on the estimated future cash flows to be received from a receivable. The IASB requires that the impairment assessment should be performed as follows:

(a) Receivables that are individually significant should be considered for

impairment separately. If impaired, recognize it. Receivables that are not individually significant may, but do not have to be, assessed individually.

(b) Any receivable individually assessed that is not considered impaired should

be included with a group of assets with similar-risk characteristics and collectively assessed for impairment.

(c) Any receivables not individually assessed should be collectively assessed for

impairment.

Recognition, Measurement, and Valuation of Notes and Loans Receivable 28. The major differences between trade accounts receivable and trade notes

receivables are that (a) notes represent a formal promise to pay; and (b) notes bear an interest element, because of the time value of money. Notes always bear an interest element because of the time value of money, but they may be classified as interest-bearing or non-interest-bearing. Interest-bearing notes have a stated rate of interest, whereas non-interest-bearing notes (zero-interest bearing) include the interest as part of their face amount instead of stating it explicitly.

29. If financial statements are prepared while the note is outstanding, interest is

accrued to the balance sheet date for both interest and non-interest bearing notes.




30. With long-term loans receivable it is assumed that a note exists, but the difference is the length of time to maturity. Standards for recognition and measurement are the same for loans as they are for notes. Transaction costs in acquiring loans or notes receivable can be expensed when incurred or added to the fair value of the instrument and added to the discount or premium to be amortized over the life of the loan. Both ASPE and IFRS agree that the latter method be sued with transaction costs associated with financial assets carried at amortized cost.

31. Recognition and measurement standards require:

• A loan receivable is recognized when the entity becomes a party to the

contractual provisions of the financial instrument • When initially recognized, the loan receivable is measured at its fair value • After initial recognition, the loan receivable is measured at amortized cost, • Bad debt losses on the loans receivable are recognized when they are

deemed to be impaired. 32. Long-term notes receivable should be recorded and reported at the present value of

the cash expected to be collected. When the interest stated on an interest-bearing note is equal to the effective (market) rate of interest, the note sells at face value. When the stated rate is different from the market rate, the cash exchanged (present value) is different from the face value of the note. The difference between the face value and the cash exchanged, either a discount or a premium, is then recorded and amortized over the life of the note to approximate the effective interest rate. The discount or premium is shown on the balance sheet as a direct deduction from or addition to the face of the note.

33. Under IFRS the effective interest method of amortization is used for the discount or

premium, while under ASPE the amortization method is not specified. Some private entities prefer to use the straight-line method to amortize discounts and premiums because of its simplicity.




34. When a note or loan is issued with the sale of property, goods, or services, the selling price will be equal to the present value of cash flows promised by the note, discounted at the market rate of interest. Whenever the face amount of a note does not reasonably represent the present value of the consideration given or received in the exchange, the accountant must evaluate the entire arrangement to record properly the exchange and the subsequent interest. Notes receivable are sometimes issued with zero interest rate stated or at a stated rate that is unreasonable. In such instances the present value of the note is measured by the cash proceeds to the borrower or fair value of the property, goods, or services rendered. The difference between the face amount of the note and the cash proceeds or fair value of the property represents the total amount of interest during the life of the note. If the fair value of the property, goods, or services rendered is not determinable, estimation of the present value requires use of an imputed interest rate. The choice of a rate may be affected specifically by the credit standing of the issuer, restrictive covenants, collateral, payment, and the existing prime interest rate. Determination of the imputed interest rate is made when the note is received; any subsequent changes in prevailing interest rates are ignored.

35. The valuation of short-term notes receivable and the related recognition of bad

debt expense and allowance parallels that for accounts receivable. Companies often use one of the collective assessment methods (percentage-of-sales or percentage-of-receivables) to measure possible impairments.

36. The valuation of long-term notes receivable involves impairment testing on an

individual note basis. The test involves comparing the carrying amount of the note to the present value of the future cash flows discounted at the original effective interest rate. If the discounted amount is less than the carrying amount of the note, an impairment has occurred. The journal entry includes a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts.

37. A loan receivable is considered impaired when it is probable, based on current

information and events, that the company will be unable to collect all amounts due (both principal and interest). If a loan is considered impaired, the loss due to the impairment is calculated as the difference between the investment in the loan (generally the principal plus accrued interest) and the expected future cash flows discounted at the loan’s historical effective interest rate.




Derecognition of Receivables 38. Derecognition of a receivable occurs when it can no longer be included as an

asset of a company. For example, when a receivable no longer has any value because the customer is bankrupt. Or, when the company sells its receivables to another company, transferring the risks and rewards of ownership to the other company.

39. Receivables are often used as collateral in borrowing transactions to generate

immediate cash in two ways – secured borrowings or sales of receivables. In a secured borrowing, a creditor often requires that the debtor designate (assign) or pledge receivables as security for the loan. If the loan is not paid when due, the creditor has the right to convert the collateral to cash, that is, to collect the receivables. A company should account for transferred assets in a secured borrowing after the transaction in the same way it accounted for them prior to the borrowing and account for the liability in accordance with accounting policies for similar liabilities.

40. In order to accelerate the receipt of cash, companies may transfer accounts or

notes receivable to another company for cash. Companies wishing to avoid the 30- to 60-day collection period for accounts receivable can generate cash immediately by selling or factoring their accounts receivable. Factoring of accounts receivable is an outright sale of the receivables to a finance company or bank.

41. When accounts and notes receivable are factored (sold), the factoring arrangement

can be with recourse or without recourse. If receivables are factored on a with recourse basis, the seller guarantees payment to the factor in the event the debtor does not make payment. When a factor buys receivables without recourse, the factor assumes the risk of collectibility and absorbs any credit losses. Receivables that are factored with recourse should be accounted for as a sale, recognizing any gain or loss, if all three of the following conditions are met: (a) the transferred asset has been isolated from the transferor, (b) the transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interest in the transferred assets, and (c) the transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.




42. Increasingly common is the transfer of receivables through a process called securitization. Securitization is the transformation of financial assets, such as loans and receivables, into securities, called asset-backed securities. In such an arrangement, a special purpose entity (SPE) is transferred ownership of the loans or receivables, and is financed by the issuance of debt and equity securities.

43. Many companies have tended to account for transactions as sales of receivables

even when they had substantial controlling interest and control over the receivables. Accounting standards governing the derecognition of financial assets are not finalized. However, there are some key concepts that need to be considered when a transfer of receivables qualifies for treatment as a sale and when it is simply a secured borrowing.

44. IFRS 9 Financial Instruments states that the following conditions are used to

indicate whether control over the receivables has actually been transferred by an entity, supporting treatment as a sale.

a. The entity transfers the contractual rights to receive cash flows from the accounts receivable.

b. The entity retains the contractual rights to receive cash flows from the accounts receivable, but has a contractual obligation to pay the cash flows to one or more recipients. (Three additional conditions also must be met: (i) The entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts from the original receivable. (ii) The entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows. (iii) The entity has an obligation to remit any cash flows it collects on behalf of the eventual recipients without material delay.).




45. The following three conditions, which were used in the pre-2011 Canadian model, and continue to be used in ASPE, determine if control over the receivables has actually been transferred, which would support treatment as a sale:

a. The transferred assets have been isolated from the transferor—put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership.

b. Each transferee has the right to pledge or exchange the assets or beneficial interests it received, and no condition either constrains the transferee from taking advantage of this right or provides more than a trivial benefit to the transferor.

c. The transferor does not maintain effective control over the transferred assets through either an agreement to repurchase or redeem them before their maturity or through an ability to unilaterally cause the holder to return specific assets.

If all three conditions are not met, the seller must record the transaction as a secured borrowing.

Presentation, Disclosure, and Analysis of Receivables

46. The objective in presentation and disclosures related to receivables is to allow

users to evaluate the significance of these financial assets to the entity’s financial position and performance and to assess the nature and extent of the associated risks. The presentation of receivables on the balance sheet includes the following considerations:

a. Segregate the carrying amounts of the different categories of receivables; b. Indicate the receivables classified as current and non-current in the

statement of financial position; c. Appropriately offset the valuation accounts for receivables that are

impaired, including a discussion of individual and collectively determined impairments;

d. Disclose the fair value of receivables in such a way that permits it to be compared with its carrying amount;

e. Disclose information to assess the credit risk inherent in the receivables by providing information on (i) receivables that are neither past due nor impaired, (ii) the carrying amount of receivables that would otherwise be past due or impaired, whose terms have been renegotiated, (iii) receivables that are either past due or impaired, an analysis of the age of receivables that are past due;

f. Disclose any receivables pledged as collateral; and g. Disclose all significant concentrations of credit risk arising from

receivables.




47. Major disclosures are also required about the securitization or transfer of receivables, whether derecognized or not. Credit risk is the major concern associated with loans and receivables so IFRS requires more extensive information than what is required under ASPE. In evaluating the liquidity of receivables, the receivable turnover ratio is used.

48. The ratio used to assess the liquidity of receivables is the receivables turnover

ratio, which measures the number of times, on average, receivables are collected during the period.

Accounts Receivable

Turnover = Days to Collect

Accounts Receivable =

Net Sales Average Trade Receivables (net)

365 Accounts Receivable Turnover

Comparison of IFRS and ASPE 49. Refer to Illustration 7-19 in the text. While standards are similar, issues related to

impairment and derecognition are still under study by IFRS.

APPENDIX 7A

Cash Controls

50. Control over the handling of cash and cash transactions is an important consideration for any business enterprise. Cash presents special management and control problems because (a) cash enters into a great many transactions; (b) cash is the single asset readily convertible into any other type of asset; and (c) neither too much nor too little should be available at any time. Among the control procedures that are used for cash transactions is the use of bank accounts such as a general checking account, imprest bank account, and lockbox account.




Petty Cash

51. In an imprest petty cash system, a petty cash custodian is given a small amount of currency from which to make small payments (minor office supplies, taxi, postage, etc.). Each time a disbursement is made, the petty cashier obtains a signed receipt for the payment. When cash in the fund runs low, the petty cashier submits the signed receipts to the general cashier and a cheque is prepared to replenish the petty cash fund. This process is designed to promote control over small cash disbursements, which would be awkward to pay by cheque.

Bank Reconciliation

52. A basic cash control is the preparation of the monthly bank reconciliation. The bank reconciliation, when properly prepared, proves that the cash balance per bank and the cash balance per book are in agreement. The items that cause the bank and book balances to differ, and thus require preparation of bank reconciliation, are the following:

a. Deposits in Transit. Deposits recorded in the cash account in one period

but not received by the bank until the next period. b. Outstanding Cheques. Cheques written by the company that have yet to

be presented at the bank for collection. c. Bank Charges. Charges by the bank for services, which are deducted

from the account by the bank and that the company learns of when it receives the bank statement.

d. Bank Credits. Collections or deposits in the company's account that the company is not aware of until receipt of the bank statement.

e. Bank or Depositor Errors. Errors made by the company or the bank that must be corrected for the reconciliation to balance.

53. Two forms of bank reconciliation may be prepared. One form reconciles from the

bank statement balance to the book balance or vice versa. The other form is described as the reconciliation of bank and book balances to corrected cash balance. This form is composed of two separate sections that begin with the bank balance and book balance, respectively. Reconciling items that apply to the bank balance are added and subtracted to arrive at the corrected cash balance. Likewise, reconciling items that apply to the book balance are added and subtracted to arrive at the same corrected cash balance. The corrected cash balance is the amount that should be shown on the balance sheet at the reconciliation date.




LECTURE OUTLINE

Chapter 7 covers cash, accounts receivable, and notes and loans receivable. This chapter can be covered in two class sessions. With the exception of transfers of receivables with and without recourse, students will have had previous exposure to the many of the concepts in an introductory financial accounting course, but the new requirements for IFRS and/or ASPE may not be familiar to them. Some time should be spent on impairment of accounts receivable, particularly the application of the allowance method, the increased focus on the balance sheet rather than the income statement, and the other recognition, measurement, presentation, and disclosure issues.

The following lecture outline is appropriate for this chapter.

A. Define a financial asset and cash. A financial asset is cash; a contractual right

to receive cash or another financial asset from another party; a contractual right to exchange financial instruments with another party under conditions that are potentially favourable; or an equity instrument of another entity. Liquidity is an indication of an enterprise's ability to meet its obligations as they come due. Cash is the most liquid asset. Cash includes coin, currency, bank deposits including chequing and savings accounts, and negotiable instruments such as money orders, cashiers’ cheques, personal cheques, and bank drafts. Petty cash funds and change funds should be included in cash. Postdated cheques and I.O.U.s should be reported as receivables. Travel advances to employees should be reported as receivables or as prepaid expenses. Postage stamps on hand should be reported as office supplies or as prepaid expenses.

B. Cash

1. Cash includes coin, currency, bank deposits including chequing and savings

accounts, and negotiable instruments such as money orders, cashiers' cheques, personal cheques and bank drafts.

2. Bank overdrafts should be reported as current liabilities. They are not offset

against the cash account unless there is available cash in another account at the same bank.




3. Restricted cash.

a. Cash restricted for some special purpose (such as the retirement of bonds) is reported separately in either the current asset section or the non-current asset section of the balance sheet, depending on the date of availability or disbursement.

b. The IASB recommends that legally restricted deposits held as compensating balances against borrowing arrangements should be reported separately in either the current asset section or the non- current asset section, depending on whether the borrowing arrangement is a short-term or long-term one.

4. Cash equivalents

a. This category includes items that are both (1) readily convertible to known amounts of cash, and (2) so near their maturity that they present insignificant risk of changes in interest rates (generally 3 months or less). Some certificates of deposit, money market funds, and treasury bills are nearly "equivalent to cash" in terms of liquidity. Note for students that IFRS allows some equity investments, such as preferred shares close to their redemption date to be included as a cash equivalent.

b. Many companies now report these items in a current asset category called cash and cash equivalents, which include cash plus these items (e.g., short-term investment certificates). However, if these securities contain restrictions or penalties on their conversion to cash, they should be reported as short-term investments.

c. It now appears likely that the IASB will eliminate the cash-equivalent classification from financial statement presentations altogether

TEACHING TIP

Use Illustration 7-3 to explain the accounting for interest-bearing and non- interest-bearing debt instruments.

C. Receivables: Claims held against customers and others for money, goods, or services. They are classified as either trade or nontrade. They are also classified as either current or non-current.




1. Accounts receivable are oral promises of the purchaser to pay for goods and services sold.

2. Notes receivable are written promises to pay a certain sum of money on a

specified future date.

3. Nontrade receivable include advances to employees or subsidiaries and dividends and interest receivable.

D. Accounts Receivable—Recognition and Measurement Issues. These involve

the concepts of timing and measurement. Measurement is complicated by:

1. Trade discounts. These reductions from the list price are not recognized in the accounting records; customers are billed net of trade discounts.

2. Cash discounts (sales discounts). These are inducements for prompt

payment. Discuss the gross and net methods of recording receivables. Use Illustration 7-3 from the text to demonstrate the differences between these two methods.

a. Gross method (more practical than the net method). Sales and

receivables are recorded at the gross amount. Sales discounts taken by customers are debited to the sales discounts account, which is reported in the income statement as a reduction of sales. If an allowance account is used with the gross method, the net effect would result in recognizing accounts receivable at their realizable value as required by Section 3856.

b. Net method. Sales and receivables are recorded at the net amount. Sales discounts not taken by customers are credited to the sales discounts forfeited account, which is reported in the other revenue section of the income statement. This method is consistent with the requirements of Section 3856.

3. Interest element. Theoretically, receivables should be measured at their

present value but accountants have chosen to ignore the implicit interest element in receivables that are due within one year.

E. Accounts Receivable—Valuation and Impairment Issues. Receivables are

valued at net realizable value (the net amount expected to be received in cash).

1. Methods of accounting for uncollectible accounts:




a. Allowance method—At the end of each accounting period an estimate is made of expected losses from uncollectible accounts. This estimate is debited to bad debt expense and credited to the allowance for doubtful accounts. This method is justified, because a company has experienced a loss the moment customers receive goods or services that they will never pay for. This is true even if the specific identity of such customers will not be known for some time.

b. Direct write-off method—When a specific account is determined to be uncollectible (which may not occur in the period of sale), bad debt expense is debited and accounts receivable is credited. This method is theoretically undesirable, because it:

a. makes no attempt to match revenues and expenses. b. does not result in receivables being stated at net

realizable value in the balance sheet.

The direct write-off method is theoretically deficient because it usually does not result in receivables being stated at estimated realizable value on the balance sheet. However, it is simpler to apply if the amount deemed uncollectible is not material.

TEACHING TIP

Journal entries for receivables and bad debt accounting are demonstrated in Illustration 7-1. Emphasize the difference in valuing the realizable value of accounts receivable and estimating bad debt expense between applying the allowance method only procedure and the mix of procedures.

2. Procedures for estimating realizable value of accounts receivable (and bad debt expense) under the allowance method and using a mix of procedures. Discuss these, as demonstrated in Illustration 7-1.

a. Allowance Procedure Only – At month end, management estimates

uncollectible accounts by analyzing the Accounts Receivables balances. An entry is made to adjust the allowance account to reflect the estimated uncollectible amounts.

b. Mix of Procedures – At month end, management will estimate the bad

debt expense by using a percentage-of-sales method that estimates bad debt as a percentage of sales. If there is a fairly stable relationship between previous years’ credit sales and bad debts, then




that relationship can be used as a percentage to estimate bad debts based on the current period’s sales. This can be done much more quickly on an interim basis than the aging process required by the percentage-of-receivables method. At the end of the fiscal year when financial statements are issued however, the percentage-of- receivables procedure is applied and any adjustment required is made to ensure Accounts Receivable are accurately reported at its net realizable value.

Either of the above two methods can be used. Many companies use the mix of procedures method. An estimate of bad debts is used for internal reporting using the percentage-of-completion throughout the year and an adjustment is made at year end based on the aged accounts receivable balances. Emphasize that a better estimate will likely result if an aging of accounts receivable is used when estimating uncollectible accounts.

3. Discuss the impairment evaluation process required by IASB.

TEACHING TIP

Illustration 7-2 provides a numerical example of estimating the realizable value of accounts receivable using the allowance procedure only and the mix of procedures.

4. Allowance for sales returns and allowances is another example of a valuation allowances (contra assets) that may be established.

F. Notes Receivable—Valuation Issues. The present value of the future cash

flows is the proper amount to record for notes.

1. Review the basic terminology in accounting for notes: face value, stated interest rate, effective (market) rate of interest, present value, discount on notes receivable, premium on notes receivable, net carrying amount of the note, amortization, and effective-interest method.

2. Notes Bearing Interest Equal to the Effective Rate—The interest

element is ignored for short-term notes and therefore they are carried at face value. However, long-term notes are recorded at the present value of the cash expected to be collected.




3. Zero Interest or Unreasonable Interest-Bearing Notes—An appropriate rate of interest must be determined in order to compute the present value of the note.

(a) The present value of the note can be determined by measuring the fair

market value of the cash or other property, goods, and services exchanged for the note.

(b) If the fair market value of the note or other property is not determinable, an

interest rate may be imputed on the basis of the issuer’s credit standing, collateral, etc.

4. Notes should be reported at net realizable value, although allowance for

doubtful notes can be difficult to estimate for long-term notes. Recording bad debt expense and the related allowance for short-term notes receivable parallels that for trade accounts receivable.

5. Defaulted notes should be written off as a loss.

6. Companies must disclose the fair value of notes receivables in the notes to

the financial statements.

TEACHING TIP

Illustration 7-3 provides examples of an interest-bearing note and a zero-interest-bearing note, and demonstrates calculations of present values and amortization tables. Note that for explanatory purposes the amortization tables utilize slightly different headings from the ones used in the text.




G. Long-term Notes and Loans Receivable

1. Interest-bearing debt instruments: the company holding the security on the interest payment date receives all the interest since the last interest payment date. A transaction between interest payment dates means that the purchaser will pay an amount in excess of the face value of the debt to compensate. The purchaser then receives a full payment of interest at the next payment date.

2. For non-interest-bearing debt instruments, the difference between the

security’s purchase price and its face, or maturity value, represents the interest income.

3. Long-term notes receivable measure impairment as the difference between the

carrying value of the note at the note’s present value, discounted at its original effective interest rate.

4. Companies must disclose the fair value of notes and loans receivables in the

notes to the financial statements.

5. An impaired loan receivable exists when it is probable that the company will be unable to collect all amounts due (principal and interest) according to terms of the note.

6. The impairment loss is the difference between the carrying amount of the note

principle plus account interest and the present value of the future cash flows discounted at the note’s historical effective interest rate.

H. Accounts and Notes Receivable—Derecognition Issues. In order to accelerate the receipt of cash from receivables, they may be transferred to a third party for cash.

1. Secured borrowing (Assigning or Pledging). The owner of the

receivables borrows cash from a bank or another company by designating the accounts receivable as collateral.

(a) The borrower and lender agree as to the specific accounts that serve

as security. The assignor (borrower) typically makes collections on the assigned accounts and remits the collections plus a finance charge (interest cost) to the lender.

(b) The borrower also recognizes all discounts, returns and allowances,

and bad debts.




2. Sale (factoring). These transfers of receivables may be without recourse or with recourse.

TEACHING TIP

Illustration 7-4 can be used to highlight the rules pertaining to the sale of receivables with and without recourse.

(a) Transfer without recourse: The purchaser assumes the risk of collectibility and absorbs the credit losses. This is an outright sale of receivables both in form and substance. A loss on the sale is recognized for the excess of the face amount of the receivables over the cash proceeds.

(i) A Due From Factor account (reported as a receivable) is used to

account for any proceeds retained by the factor to cover probable sales discounts, sales returns, and sales allowances.

(ii) Derecognize the receivables.

(iii) The factor maintains a corresponding “Due To” account

(reported as a liability).

(b) Transfer with recourse—The seller guarantees payment to the purchaser for those receivables that become uncollectible.

(i) A controversy exists as to whether these transfers should be

recorded as a sale (with recognition of gain or loss) or as a collateralized borrowing (with recognition of a liability and accounting standards governing the derecognition of financial assets are not yet finalized.




(ii) IFRS 9 Financial Instruments states that the following conditions are used to indicate whether control over the receivables has actually been transferred by an entity, supporting treatment as a sale. • The entity transfers the contractual rights to receive cash

flows from the accounts receivable. • The entity retains the contractual rights to receive cash

flows from the accounts receivable, but has a contractual obligation to pay the cash flows to one or more recipients. (Recall that there are three additional conditions also must be met.)

(ii) ASPE (similar to the pre-2011 Canadian model) identifies that these transfers should be recognised as a sale if the following conditions are met: • The transferred assets have been isolated from the

transferor—put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership.

• Each transferee has the right to pledge or exchange the assets or beneficial interests it received and no condition either constrains the transferee from taking advantage of this right or provides more than a trivial benefit to the transferor.

• The transferor does not maintain effective control over the transferred assets through either an agreement to repurchase or redeem them before their maturity or through an ability to unilaterally cause the holder to return specific assets.

(iii) If the transfer with recourse does not meet these conditions, the transfer should be accounted for as a secured borrowing and a liability is recorded.

3. Instead of a loss, a finance charge is recognized.




I. Presentation, Disclosure and Analysis of Receivables

1. General classification rules:

(a) segregate the carrying amounts of the different categories of receivables.

(b) indicate the receivables classified as current and non-current in the balance sheet.

(c) appropriately offset the valuation accounts for receivables that are

impaired, including a discussion of individual and collectively determined impairments.

(d) disclose the fair value of receivables in such a way that permits it to be

compared with its carrying amount.

(e) disclose information to assess the credit risk inherent in the receivables by providing information on:

(i) receivables that are neither past due nor impaired, (ii) the carrying amount of receivables that would otherwise be past due

or impaired, whose terms have been renegotiated, (iii) receivables that are either past due or impaired, an analysis of the

age of receivables that are past due.

(f) disclose any receivables pledged as collateral, and

(g) disclose all significant concentrations of credit risk arising from receivables.




2. Major disclosures are also required about the securitization or transfer of receivables, whether derecognized or not. Credit risk is the major concern associated with loans and receivables so IFRS requires more extensive information than what is required under ASPE. In evaluating the liquidity of receivables, the receivable turnover ratio is used.

3. Accounts receivable turnover ratio: measures the number of times, on

average, receivables are collected during the period.

(a) A/R Turnover = Net Sales Average Trade Receivables (net)

(b) Days to Collect = 365 A/R Turnover

J. Comparison of IFRS and ASPE

Refer to Illustration 7-19 in the text. While standards are similar, issues related to impairment and derecognition are still under study by IFRS.

APPENDIX 7A – Cash Controls

Many control procedures exist for cash transactions. Two that are discussed in the text are the imprest petty cash system and the preparation of bank reconciliations.

K. Imprest Petty Cash System

1. Imprest bank accounts are used to make a specific amount of cash

available for a limited purpose.

2. Review the accounting procedures for a petty cash system.

(a) The petty cash account is debited or credited only when the fund is first established or is changed in size.

(b) Each disbursement from the fund should be evidenced by a signed receipt indicating the recipient and the purpose of the expenditure.

(c) Reimbursements of petty cash on hand are recorded by debiting the expenses, assets, or liabilities involved and crediting the cash account.




(d) The cash over and short account is used as a plug (miscellaneous expense or miscellaneous revenue) when the petty cash fund fails to prove out.

TEACHING TIP

Illustration 7-5 provides a numerical example of establishing a petty cash fund and its subsequent reimbursement.

L. Bank Reconciliations.

1. Two forms of bank reconciliations may be prepared:

(a) Reconciliation from the bank statement balance to the book balance or vice versa.

(b) Reconciliation of bank and book balances to the corrected cash balance.

(i) This form consists of two separate sections:

• Balance per bank statement section. • Balance per books section.

(ii) This is the form illustrated in the text. It is useful, because it facilitates calculation of the correct cash balance, which is the amount that should be reported on the balance sheet.

2. Describe the preparation of a two-section bank reconciliation.

TEACHING TIP

Illustration 7-6 provides the steps for preparing a bank reconciliation. It also provides an example format of a two-section bank reconciliation that reconciles the bank and book balances to a corrected cash balance.

(a) Balance per bank statement section. (i) The "balance per bank statement" is the amount shown on the

most recent bank statement as of the bank's closing date for the month.




(ii) Add deposits recorded in the company's books but not yet credited by the bank (e.g., deposits in transit).

(iii) Deduct charges recorded in the company's books but not yet recorded by the bank (e.g., outstanding cheques).

(b) Balance per books section.

(i) The balance per books is the amount shown in the company's cash or cash in chequing account general ledger account as of the desired reconciliation date (i.e., as of the balance sheet date, the month-end date, or whatever date for which it is desired to calculate the correct cash balance).

(ii) Add deposits credited by the bank but not yet recorded by the company (e.g., collection of notes, interest earned on interest- bearing chequing accounts, etc.).

(iii) Deduct charges recorded by the bank but not yet recorded by the company (e.g., service charges, NSF cheques, etc.).

(c) Both sections end with the correct cash balance, which is the amount that should be reported on the balance sheet.

(d) Every reconciling item that appears in the balance per books section requires an adjusting entry to bring the books to the correct cash balance.




ILLUSTRATION 7-1

ACCOUNTING FOR RECEIVABLES AND BAD DEBTS

The following amounts are entered in the T-accounts below:

(1) Beginning balance of Accounts Receivable.

(2) Beginning balance of Allowance for Doubtful Accounts.

(3) Credit sales. Accounts Receivable . . . . . . . . . . . . . . XXX

Sales . . . . . . . . . . . . . . . . . . . XXX

(4) Collections on account. Cash . . . . . . . . . . . . . . . . . . . . . . XXX

Accounts Receivable . . . . . . . . . . . . . XXX

(5) Write-offs of uncollectible accounts. Allowance for Doubtful Accounts . . . . . . . . . XXX

Accounts Receivable . . . . . . . . . . . . . XXX

(6) Year-end adjusting entry for bad debts. Bad Debt Expense . . . . . . . . . . . . . . . . XXX

Allowance for Doubtful Accounts . . . . . . . XXX

(7) Ending balance of Accounts Receivable. (8) Ending balance of Allowance for Doubtful Accounts.

ALLOWANCE FOR DOUBTFUL

ACCOUNTS RECEIVABLE ACCOUNTS

(1) Beginning (2) Beginning balance XXX Balance XXX

(3) Credit (4) Collections (5) Write-offs of sales XXX on account XXX uncollectible

accounts XXX (5) Write-offs (6) Year-end

of uncol- adjusting entry lectable for bad debts XXX accounts XXX

(7) Ending (8) Ending balance XXX balance XXX





PROCEDURES FOR ACCOUNTING FOR IMPAIRMENT OF ACCOUNTS

RECEIVABLE USING THE ALLOWANCE METHOD

(for simplicity, a percentage has been applied to the ending balance in accounts receivable – however a better approach is to do an aging schedule first and apply applicable percentages to each aging category)

(A) Allowance method

First Step: Required ending balance in Ending balance in

Allowance for Doubtful Accounts = Percentage × Accounts Receivable

(8) = Percentage × (7)

Second Step:

Required Year-end adjusting Current balance in ending balance Write offs of entry for bad debts = in Allowance for Doubtful – Allowance for Doubtful + uncollectible

Accounts Accounts Accounts (6) = (8) – (2) + (5)

(B) Mix of procedures

First Step: Determine relationship between credit sales and bad debts in prior periods to estimate percentage of bad debts in current period Percentage × Credit sales (3)

Second Step: Apply percentage to credit sales to record bad debt expense: Dr Bad debt expense, credit Allowance account

Third Step: Prepare year end adjusting entry which will be the same as the Second Step in the Allowance Method, however the calculation will need to also deduct the adjustment made in the Second Step of the Mix of Procedures.





Comparison of Methods for Estimating Uncollectibles

Both methods will result in the same value reported on the balance sheet. However the mix of procedures may be useful for internal reporting and management of receivables during the interim when full financial statements are not prepared.

ILLUSTRATION 7-2




Charge sales $ 500,000 Estimated % of credit sales not collectible 1 % Accounts receivable balance $ 72,500 Estimated % of accounts receivable not collectible 8%

ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS/BAD DEBT EXPENSE

Data

Case I Allowance for Doubtful Accounts $ 150 (Credit balance) Case II Allowance for Doubtful Accounts $ 150 (Debit balance)

Mix of Procedures Allowance Approach Only

Step 1: Determine relationship between Step 1: Determine balance in the credit sales sales and bad debts Accounts Receivable account.

(1% in our example) Credit sales = $500,000 Accounts Receivable balance

= $72,500.

Step 2: Calculate estimated Step 2: Calculate required balance for expense. the Allowance for Doubtful

.01 × $500,000 = $5,000 Accounts. .08 × $72,500 = $5,800

Step 3: Not necessary. Step 3: Calculate estimated bad debt expense.

Step 4: Interim entry. Bad Debt Expense

5,000 Case I

Desired balance $5,800 Cr. Allowance for Doubtful Accounts

5,000

Actual balance 150 Cr. Amount of new expense $5,650

Step 5: Make adjusting entry. See Step 3 Allowance method for

Case II Desired balance $5,800 Cr. Actual balance 150 Dr. Amount of new expense $5,950

required balance Step 4: Make entry





Case I (5,800 – 150 – 5,000 = $650) Case I Bad Debt Expense 650 Bad Debt Expense 5,650 Allowance for Allowance for Doubtful Accounts 650 Doubtful Accounts 5,650

Case II (5,800 + 150 – 5,000 = $950) Case II Bad Debt Expense 950 Bad Debt Expense 5,950 Allowance for Allowance for Doubtful Accounts 950 Doubtful Accounts 5,950



ILLUSTRATION 7-3


INTEREST INCOME ON INTEREST-BEARING AND NON-INTEREST- BEARING NOTES RECEIVABLE

COMPANY A: Lends Company C $20,000 July 1, 2014 in exchange for a 2 year note

that pays interest at a stated rate of 10% semi-annually on Jan. 1 and July 1. The market rate of interest for a similar note is also 10%. Company B has a December 31 year end.

COMPANY B: purchases a six-month $20,000 note for $19,231 on March 15. The note

matures on Sept 15 and was purchased to yield an 8% return.

COMPANY A COMPANY B

July 1, 2014 March 15

DR Note receivable $20,000 DR Note receivable $19,231 CR Cash $20,000 CR Cash $19,231

To record purchase To record purchase

December 31, 2014 Sept 15

DR Interest receivable $1,000 DR Cash $20,000 CR Interest Revenue $1,000 CR Note receivable $19,231

Accrue semi-annual interest CR Interest revenue $769 [$20,000 × 10% × ½] To record proceeds on maturity

Jan 1, 2015 DR Cash $1,000

CR Interest receivable $1,000 To record payment of accrued interest

To record payment of note at maturity: July 1, 2016 DR Cash $21,000

CR Notes receivable $20,000 CR interest revenue $1,000




Transfer with Recourse

Report as Sale

Report as Secured Borrowing

ILLUSTRATION 7-4

SALE (FACTORING) OF RECEIVABLES

Accounts Receivable Are Transferred

Transfer without Recourse

Does it meet three conditions? 1. Transferor surrenders benefits. 2. Transferor's obligation can be

reasonably estimated 3. Transferee cannot require

Reduce Receivable repurchase. Record Gain or Loss

YES NO

Report as Sale

Reduce Receivable Increase Liability Record Gain or Loss Record Interest

Expense

Source: Paul Munter and Tommy Moores, "Transfers of Receivables with Recourse."The CPA Journal, July, 1984, pp. 52-60.


ILLUSTRATION 7-5

PETTY CASH

Imprest system—an advance of money

Accounting for a designated purpose Action

(What people are doing)

1. A person is chosen to be the petty cash custodian

*A cheque is written, cashed, and the

money given to the petty cash custodian.

2. The petty cash custodian pays for

such things as office supplies, postage, entertainment, etc.

*A receipt is obtained from the person

to whom cash is paid.

3. When the cash fund is low The cash is counted $127 The receipts are totalled 171 The two are added $298 This total is compared to the original amount 300

The difference represents ($2) the cash shortage or overage.

*A cheque is written for the amount

necessary to get the fund amount back to the original total. ($300 – $127 = $173)

*The cheque is cashed and the money

given to the petty cash custodian.

(Making—or not making entries)

1. Petty Cash Fund 300 Cash 300

To record cheque no. ### and to

set up the petty cash account.

2. No entries.

3. Office Supplies Expense 42 Postage Expense 53 Entertainment Exp. 76 Cash Over and Short 2

Cash 173

To record the petty cash receipts and cash shortage




ILLUSTRATION 7-6

BANK RECONCILIATION

Balance per bank statement $xxx

Add: Deposits recorded by business but not by bank xxx (Example: Deposits in transit)

Deduct:Charges recorded by business but not by bank (xxx)

(Example: Outstanding cheques) Corrected balance $ XXX.

Balance per books $xxx

Add: Deposits recorded by bank but not by business xxx (Example: Note collection)

Deduct:Charges recorded by bank but not by business (xxx)

(Examples: Service charges, NSF cheques) Corrected balance $ XXX.

Note: Information recorded by the bank but not the business will have to be recorded by journal entries (such as bank charges).

Instructor’s Manual 7-37 Chapter 7 Copyright © 2013 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of

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CHAPTER 8

INVENTORY


Inventory Section 3031 IAS 2

Interest/Borrowing Costs

Section 3850

IAS 23

Inventory – Onerous contractual obligations

N/A

IAS 11

Inventory – Biological assets/Agriculture

N/A

IAS 41




LEARNING OBJECTIVES

1. Understand inventory from a business perspective.

2. Define inventory from an accounting perspective.

3. Identify which inventory items should be included in ending inventory.

4. Identify the effects of inventory errors on the financial statements and adjust for them.

5. Determine the components of inventory cost.

6. Distinguish between perpetual and periodic inventory systems and account

for them.

7. Identify and apply GAAP cost formula options and indicate when each cost formula is appropriate.

8. Explain why inventory is measured at the lower of cost and market, and

apply the lower of cost and net realizable value standard.

9. Identify inventories that are or may be valued at amounts other than the lower of cost and net realizable value.

10. Apply the gross profit method of estimating inventory.

11. Identify how inventory should be presented and the type of inventory disclosures required by ASPE and IFRS.

12. Explain how inventory analysis provides useful information and apply ratio

analysis to inventory.

13. Identify differences in accounting between ASPE and IFRS, and what changes are expected in the near future.

After studying Appendices 8A and 8B, you should be able to:

14. Apply the retail method of estimating inventory (Appendix 8A)

15. Identify other primary sources of GAAP for inventory (Appendix 8B)




CHAPTER REVIEW

Major Categories of Inventory

1. Careful attention is given to the inventory account by many business organizations because it represents one of the most significant assets held by the enterprise. Inventories are of particular importance to merchandising and manufacturing companies because they represent the primary source of revenue for the organization. Inventories are also significant because of their impact on both the statement of financial position and the income statement.

2. Inventories are asset items held for sale in the ordinary course of business

or goods that will be used or consumed in the production of goods to be sold. Merchandise inventory refers to the goods held for resale by a merchandising business, which ordinarily purchases its inventory in a form ready for sale. The inventory of a manufacturing firm is composed of three separate items: raw materials, work in process, and finished goods. Construction work-in-progress and inventories that qualify as financial instruments are specifically excluded from the definition of inventory in 3031 but are covered in other sections. Others such as biological assets and agricultural products, mineral products, and inventories held by producers of agricultural and forest products and by commodity broker-traders are excluded from the measurement provisions of Section 3031 and IAS 2.

Inventory Planning and Control

3. Inventory planning and control is of vital importance to the success of a merchandising or manufacturing concern. If an excessive amount of inventory is accumulated, there is the danger of loss owing to obsolescence. If the supply of inventory is inadequate, the potential for lost sales exists. This dilemma makes inventory an asset to which management must devote a great deal of attention.

Inventory defined

4. Inventories are defined in the CICA Handbook, Part I, IFRS, IAS 2.6 and Part II, ASPE, 3031.07 as “assets:

(a) held for sale in the ordinary course of business; (b) in the process of production for sale; or (c) in the form of materials or supplies to be consumed in the production

process or in rendering of services.”




Inventory Accounting Model

5. Determining the value to report on the balance sheet requires answers to the following questions:

1. Which physical goods should be included as part of inventory? 2. What costs should be included as part of inventory cost? 3. What cost formula should be used? 4. Has there been an impairment in value of the inventory items?

Physical Goods Included in Inventory

6. Normally, goods are included in inventory when they are received from the supplier. However, at the end of the period, appropriate accounting requires that all goods in which the company has the risks and rewards of ownership (i.e., legal title) be included in ending inventory. Goods in transit at the end of the period, shipped f.o.b. shipping point, should be included in the buyer's ending inventory. If the goods are shipped f.o.b. destination, they belong to the seller until received by the buyer. Inventory held on consignment belongs to the consignor’s inventory and should be excluded from the consignee's inventory.

7. In practice a few exceptions exist regarding the general rule that inventory

is recorded by the company that has legal title to the merchandise. These exceptions are known as special sale agreements. Three of the more common special sale agreements are (a) sales with buybacks (product financing arrangements), (b) sales with high rates of return, and (c) sales with delayed payment terms. In the case of sales with buybacks, the inventory is the seller’s. In the other two cases, the inventory is the buyer’s if returns or collectability can be measured.

8. Purchase commitments represent contracts for the purchase of inventory at a specified price in a future period. If the contract price exceeds the market price and a loss is reasonably expected to occur, the loss should be recognized in the period during which the market decline took place. This is known as an onerous contract.

The loss is shown on the income statement under other expenses and losses. The accrued liability on purchase contracts is reported on the balance sheet.




Inventory Errors

9. Errors in recording inventory can affect the statement of financial position, the income statement, or both, because inventory is used in the preparation of both financial statements. For example, the failure to include certain inventory items in a year-end physical inventory count would result in the following items being overstated (O) or understated (U): ending inventory (U); working capital (U); cost of goods sold (O); and net income (U). If merchandise was not recorded as a purchase nor counted in the ending inventory, the result would be an under-statement of inventory and accounts payable in the statement of financial position and an understatement of purchases and inventory in the income statement. Net income would be unaffected by this omission as purchases and ending inventory would be misstated by the same amount.

Costs Included in Inventory

10. Inventories are recorded at cost when acquired. Both IFRS and ASPE indicate that inventory cost includes all expenditures that are reasonable and necessary in acquiring the goods and converting them to a saleable condition.

Purchase discounts are treated as a reduction in the purchase price of inventory. When purchases are recorded net of discounts, failure to pay within the discount period results in the treatment of lost discounts as a financial expense (e.g., interest). If the gross method is used, purchase discounts should be reported as a deduction from purchases on the income statement. If the net method is used, purchase discounts lost should be considered a financial expense and reported in the "other expense and loss" section of the income statement.

Vendor rebates can be recognized before they are received as a vendor receivable if they meet both the definition of an asset and its recognition criteria, Otherwise they are not recorded as the effect would be to overstate income.




Product costs are costs that “attach” to inventory and are recorded in the inventory account (i.e., they are capitalized). Such charges would include freight charges on the goods purchased and labour, other production costs incurred in processing the goods up to the time of sale, other direct costs of acquisition, and non-recoverable taxes would all be recorded in inventory. Under IFRS, product costs also include any eventual decommissioning or restoration costs incurred as a result of production, even though the related expenditures may not be incurred until far into the future. Under ASPE, such costs are generally added to the cost of the property, plant, and equipment. Period costs, such as selling expenses and general and administrative expenses, are not considered inventoriable costs. The reason these costs are not included as a part of the inventory valuation concerns the fact that, in most instances, these costs are unrelated to the immediate production process.

Borrowing costs. Capitalization of interest cost associated with the acquisition of an asset when a significant period of time will be required to get the asset ready for its intended use may occur under IFRS, although interest cost can be expensed when incurred if the inventories are manufactured or produced in large quantities and on a repetitive basis. ASPE requires that if interest is capitalized, it must be disclosed.

Standard Costs: Unit costs for material, labour, and manufacturing overhead are predetermined. These costs are based on the costs that should be incurred per unit of finished goods when the plant is operating at normal capacity. Reporting inventory at costs is acceptable when it is calculated using normal levels of materials and supplies, labour, efficiency, and capacity utilization. Unallocated overheads are expensed as they are incurred.

Cost of Service Providers’ Work-in-Process: Work-in-process inventories comprised of “production” costs that include service personnel and overhead costs associated with the “direct labour”. Supervisory and other overhead costs are allocated using the same principles as for manufactured products.

Costs Excluded from Inventory – storage costs (unless related to storage before next stage of production), abnormal spoilage or wastage of materials, labour, or other production costs, or interest costs when inventories that are ready for use or sale are purchased on delayed payment terms.




Basket Purchases and Joint Product Costs: When a group of varying inventory items is purchased for a lump sum price, a problem exists relative to the cost per item. The relative sales value method apportions the total cost to individual items on the basis of the selling price of each item.

Inventory Accounting Systems

11. Inventory records may be maintained on a perpetual or periodic inventory system basis. A perpetual inventory system provides a means for generating up-to-date records related to inventory quantities and, possibly, amounts. Under this inventory system, data are available at any time relative to the quantity of material or type of merchandise on hand. In a perpetual inventory system, all purchases and sales of goods are recorded directly in the Inventory account as they occur. A Cost of Goods Sold account is used to accumulate the issuances from inventory. A perpetual inventory system can be implemented through the use of a detailed subsidiary ledger supporting the general ledger control account. Alternatively, a perpetual system can be maintained independent of the general ledger with a separate record outside the double-entry system. Under a computerized record-keeping system, additions to and issuances from inventory can be recorded nearly instantaneously.

Reconciliation between the recorded inventory amount and the actual amount of inventory on hand is normally performed at least once a year. This is accomplished by taking a physical inventory, and involves counting all inventory items and comparing the amount counted with the amount shown in the detailed inventory records. The records are corrected to agree with the physical count.

12. When the inventory is accounted for on a periodic inventory system, the

acquisition of inventory is debited to a Purchases account. Cost of goods sold must be calculated when a periodic inventory system is in use. The computation of cost of goods sold is made by adding beginning inventory to net purchases and then subtracting ending inventory. Ending inventory is determined by a physical count at the end of the year under a periodic inventory system. Even in a perpetual inventory system, a physical inventory count at year-end is normally taken due to the potential for loss, error, or shrinkage of inventory during the year.

13. Most companies need more current information regarding their inventory

levels to protect against stock-outs or over-purchasing and to aid in the preparation of monthly or quarterly financial statements. As a consequence, many companies use a supplementary system – quantities only, which increases and decreases in quantities only, not dollars.




Cost Formulas

14. Determining the cost of inventory items that have been sold as well as those remaining in ending inventory is sometimes a difficult process. Thus, the consistent use of a cost formula is required in accounting for inventories. Inventory cost formulas include specific identification; first-in, first-out (FIFO); and weighted average cost. It should be remembered that these assumptions relate to the flow of costs and not the physical flow of inventory items into and out of the company.

15. The specific identification method requires that each item sold needs to

be identified and the original cost assigned to it. It is most appropriate when the goods are not interchangeable and are easily identifiable (e.g., by serial number or special markings). In manufacturing, it would include special orders and products manufactured under a job cost system. Items sold are allocated to cost of goods sold, and items on hand to inventory.

16. The average cost method prices items in inventory on the basis of the

average cost of the goods available for sale during the period. The weighted-average cost formula, used in the periodic inventory system, takes into account that the volume of goods purchased at each price is different. Another average cost method is the moving-average cost formula. This method is used with perpetual inventory records that are kept in both units and dollars. This method requires that a new average unit cost be calculated each time a purchase is made because the cost of goods sold at average cost has to be recognized each time a sale is made. Justification for use of the average cost is that the costs it assigns to inventory closely follows physical flow of an interchangeable inventory. It is also simple to apply, objective, and not as subject to income manipulation as some of the other inventory costing methods.

17. Use of the FIFO inventory method (first-in, first-out) assumes that the

first goods purchased (i.e., the oldest inventory costs) are the first goods used or sold (i.e., the first costs recorded for cost of goods sold). Under this method, the cost flow formula may approximate the normal physical flow of goods. A major advantage of the FIFO method is that the ending inventory is stated in terms of an approximate current cost figure. However, because FIFO tends to reflect more recent costs on the balance sheet, a basic disadvantage of this method is that recent costs are not matched against recent revenues on the income statement. The FIFO inventory method will give the same result regardless of whether a perpetual or periodic inventory system is used.




18. The last-in, first-out (LIFO) cost formula is no longer permitted under ASPE and IFRS. LIFO assigns costs based on the assumption that the cost of the most recent purchase is the first cost to be charged to cost of goods sold. The cost assigned to the inventory remaining therefore comes from the earliest acquisitions (those that are “first-in, still-here”) and is made up of the oldest costs. Because the Canada Revenue Agency has never allowed companies to use LIFO to calculate their income for tax purposes, this method was not widely used in Canada. However, it is permitted under U.S. GAAP, and allowed for tax purposes there if a company also uses the method for financial reporting purposes.

Choice of Cost Formula

19. The inventory standards limit the ability of preparers to choose a cost formula. Specific identification is required when inventory is made up of goods that are not ordinarily interchangeable, and when goods and services are produced and segregated for specific projects. Otherwise, the choice is between a weighted average method and FIFO. The choice is further restricted by the requirement that companies apply the same inventory cost formula to all inventories of a similar nature and use. The primary objective of financial reporting of inventories is to provide a value that is representationally faithful and to thereby increase reliability. The inventory valuation method that leads to the accomplishment of this objective should be the one selected. Once selected, the inventory method should be applied consistently.

The requirements are consistent with standard setters’ emphasis on the definitions and measurements of assets and liabilities for measurement of the amount and timing of revenues and expenses. Companies may tend to be more interested in the income figure that results because of investor expectations. Also, compared to the FIFO cost formula, an average cost formula results in recent costs being reflected more in the cost of goods sold and older costs in ending inventory. In a period of rising prices, there may be a tax advantage to the average cost formula.

Lower of Cost and Net Realizable Value (LCNRV)

20. When the future revenue-producing ability associated with inventory is below its original cost, the inventory should be written down to reflect this loss. Thus, the historical cost principle is abandoned when the future utility of inventory is no longer as great as its original cost. This is known as the lower of cost and net realizable value (LCNRV) method. This loss of utility in inventory should be charged against revenue in the period in which the loss occurs.




21. The term “net realizable value” is calculated as the estimated selling price of the inventory in the normal course of business less the estimated costs to complete and sell the item. A departure from cost is justified because inventories should not be reported at amounts higher than their expected realization from sale or use.

22. The lower cost and net realizable value rule may be applied on an

individual item basis, on a category basis, or to the total of the inventory. Increases in market prices of some goods tend to offset decreases in market prices of other goods if the category method, or the total inventory method, is followed. The item-by-item approach is the most conservative of the three methods, because market values above cost are never taken into account. This is the recommended method. The new accounting standards recognize, however, that it may be more appropriate in some circumstances to group similar or related items and then compare their cost and NRV as a group (1) if the items are closely related in terms of their use; (2) if they are produced and marketed in the same geographical area; and (3) the items cannot be evaluated separately from other items in the product line in a practical and reasonable way.

23. Two methods are used to record inventory at net realizable value when net

realizable value is below cost. The two methods are the direct method, and the indirect or allowance method. The direct method substitutes the net realizable value figure for cost when valuing the inventory. Thus, the loss is buried in the cost of goods sold, and no individual loss account is reported in the income statement. Under the indirect method, an entry is made debiting a loss and crediting an allowance account for the difference between cost and net realizable value. Separately recording the loss and a contra account is preferable, as it does not distort the cost of goods sold and clearly displays the loss from net realizable value decline.

24. In periods following a write-down, the net realizable value of inventory

previously written down may increase. The write-down may be reversed, with the reversal limited to the amount of the original write-down. The entry will consist of a debit to the allowance account and a credit to Recovery of Inventory Loss.




25. The lower of cost and net realizable value rule has some conceptual deficiencies: a. it is inconsistent, because decreases in inventory values are

recognized in the period when a loss in utility occurs, but increases in value are recognized only when the inventory is sold;

b. there may be an inconsistency in that inventory valuation is at cost one year and at market value in the next year;

c. application of the LCNRV method values inventory conservatively on the balance sheet, but it may have the opposite effect on the income statement in subsequent periods if expected reductions in sales prices do not materialize; and because NRV is an estimate, management has the opportunity to over-or underestimate realizable values depending on the results it would like to report for the period.

Exceptions to the Lower of Cost and Net Realizable Value Model

26. There are some situations where companies depart from the LCNRV rule.

Such treatment may be justified in situations where cost is difficult to determine, the items are readily marketable at quoted markets prices, and units of product are interchangeable. Two common situations where net realizable value is the general rule for valuing inventory are agricultural assets and commodities held by broker-traders.

27. Under IFRS, net realizable value measurement is used for inventory when

the inventory is related to agricultural activity in the form of biological assets or agricultural produce at the point of harvest. A biological asset (classified as a long-term asset) is a living animal or plant. Agricultural produce is the harvested product from a biological asset.

28. Biological assets are measured at initial recognition and at the end of

each reporting period at net realizable value (fair value less cost to sell). The change in NRV is recognized as an unrealized gain or loss and reported in the income statement.

29. Agricultural produce (which is harvested from biological assets) is

measured at NRV (fair value less cost to sell) at the point of harvest. The NRV debited to an inventory account (establishing cost) and credited to an unrealized gain account. When the inventory is subsequently sold the cost (NRV) of the inventory is debited to Cost of Goods Sold and credited to the inventory account.




30. Commodity broker-traders buy and sell commodities (e.g., grains, precious metals, oil, etc.) for others or on their own account in order to generate profit from fluctuations in price. Their inventories are measured at NRV (fair value less costs to sell). If other services such as distribution, storage, or packaging are being provided, then the company is not acting as a broker-trader and NRV is not the proper method to be used in measuring inventory.

Recognition of Inventory Costs as an Expense

31. The cost of goods sold during any accounting period is defined as the cost

of all the goods available for sale during the period less the cost of any unsold goods on hand at the end of the period (ending inventory). The process of computing cost of goods sold is complicated, because of the need to determine (a) the goods to be included in inventory, (b) the costs to be included in inventory, (c) the cost flow formula to be used, and (d) any impairment in the value of the inventory.

Estimating Inventory – Gross Profit Method

32. The gross profit method is used to estimate the amount of ending

inventory. Its use is not appropriate for annual financial reporting purposes; however, it can serve a useful purpose when an approximation of ending inventory is needed. Such approximations are sometimes required by auditors (e.g., as a check on a physical count), or when inventory and inventory records are destroyed by fire or some other catastrophe, or when interim statements are being prepared. The gross profit method should never be used as a substitute for a yearly physical inventory unless the inventory has been destroyed. The gross profit method is based on the assumptions that (a) the beginning inventory plus purchases equal total goods to be accounted for; (b) goods not sold must be on hand; and (c) if sales, reduced to cost, are deducted from the sum of the opening inventory plus purchases, the result is the ending inventory.

33. The major disadvantages of the gross profit method are: (a) it provides an

estimate, therefore companies must take a physical count to verify the inventory; (b) it uses past percentages, so if significant changes have occurred the percentages must be adjusted; and (c) companies must be careful in applying a blanket gross profit rate as different merchandise groups have different rates of gross profit.




Disclosure, Presentation and Analysis

34. Inventories often represent one of the most significant assets held by a business entity. Therefore, the accounting profession has mandated certain disclosure requirements related to inventories. The following disclosures are required in the financial statement with respect to inventories:

a. the choice of accounting policies adopted to measure the inventory; b. the carrying amount of the inventory in total and by classification (such

as supplies, material, work in process, and finished goods). c. The amount of inventories recognized as an expense in the period,

including unabsorbed and abnormal amounts of production overheads; and

d. The carrying amount inventory pledged as collateral for loans

IFRS require additional disclosures, such as the carrying amount of inventory carried at fair value less costs to sell, and details about inventory writedowns and reversals of write downs. Additional information is required for biological assets and agricultural products.

Analysis of Inventories

35. Common ratios used in the evaluation of inventory levels are inventory

turnover and average days to sell inventory. As with most ratios, comparison to industry standards is necessary to arrive at meaningful conclusions.

IFRS/ASPE Comparison

36. Because CICA Handbook, Part II (ASPE), Section 3031 was issued in 2007

and was based on IAS 2, no major differences exist in general inventory standards. As well, no changes are expected in International or in Canada as these changes are relatively new.

Illustration 8-34 summarizes the differences in accounting between IFRS and ASPE, and what changes are expected in the near future.

Appendix 8A — Retail Inventory Method

37. The retail inventory method is an inventory estimation technique

based upon an observable pattern between cost and sales price that exists in most retail concerns. This method requires that a record be kept of (a) the total cost of goods available for sale, (b) the total retail value of the goods available for sale, and (c) the sales for the period.




38. Basically, the retail method requires the determination of the cost-to-retail ratio of inventory available for sale. This ratio is calculated by dividing the cost of the goods available for sale by the retail value (selling price) of goods available for sale. Once the ratio is determined, total sales for the period are deducted from the retail value of inventory available for sale. The resulting amount represents ending inventory priced at retail. When this amount is multiplied by the cost-to-retail ratio, an approximation of the cost of ending inventory results. Use of this method eliminates the need for a physical count of inventory each time an income statement is prepared. However, a physical count is made at least yearly to determine the accuracy of the records and to avoid overstatements due to theft, loss, and breakage. When a physical count is taken at the retail amount, this is converted to the chosen basis by multiplying it by the appropriate cost to retail ratio.

39. An understanding of the terminology common to the retail method is

necessary for appropriate application. The terms and their definitions are:

a. Original Retail Price. The price at which the item was originally marked for sale. This price consists of the item's cost plus an original mark-up or mark on.

b. Mark-up. An increase above the original retail price.

c. Mark-up Cancellation. A decrease in the selling price of an item that had been previously marked up above the original price. A mark-up cancellation will never reduce the selling price below the original retail price.

d. Markdowns. A decrease below the original retail price.

e. Markdown Cancellation. An increase in the selling price that follows a markdown. A markdown cancellation cannot exceed the original markdown.

40. When the cost to retail ratio is calculated by including net mark-ups (mark-

ups less mark-up cancellations) but excluding net markdowns, the retail inventory method approximates lower of average cost and net realizable value less normal profit margin. This is known as the conventional retail inventory method. If both net mark-ups and net markdowns are included before the cost to retail ratio is calculated, the retail inventory method approximates average cost.




41. The retail inventory method becomes more complicated when such items as freight-in, purchase returns and allowances, and purchase discounts are involved. In essence, the treatment of the items affecting the cost column of the retail inventory approach follows the calculation of cost of goods available for sale. In essence, the treatment of the items affecting the cost column of the retail inventory approach follows the computation of cost of goods available for sale. Freight costs are treated as a part of the purchase cost; purchase returns and allowances are ordinarily considered a reduction of the price at both cost and retail; and purchase discounts usually are considered as a reduction of the cost of purchases.

42. Other items that require careful consideration include transfers-in, normal

shortages, abnormal shortages, and employee discounts. Transfers-in from another department should be reported in the same way as purchases from an outside enterprise. Normal shortages should reduce the retail column because these goods are no longer available for sale. Abnormal shortages should be deducted from both the cost and retail columns and reported as a special inventory amount or as a loss. Employee discounts should be deducted from the retail column in the same way as sales.

43. The retail inventory method is widely used (a) to permit the computation of

net income without a physical count of inventory, (b) as a control measure in determining inventory shortages, (c) in regulating quantities of inventory on hand, and (d) for insurance information. The retail inventory method has an averaging effect on averaging rates of gross profit. The method makes no allowances for inventories with varying rates of gross profit. In the final analysis, the ultimate decision concerning which retail inventory method to use is often based on the method that results in the lower taxable income.

Appendix 8B — Accounting Guidance for Specific Inventory

44. Illustration 8B-1 provides a summary of the primary sources of GAAP for

most types of inventory.




LECTURE OUTLINE

A. Inventory – Valuation

Among the most significant assets of many enterprises are inventories. Inventories are asset items held for sale in the ordinary course of business, or goods that will be used or consumed in the production of goods to be sold.

1. For manufacturing firms the inventory amount is categorized into raw

materials, work in process, and finished goods. Construction work-in- progress and inventories that qualify as financial instruments are specifically excluded from the definition of inventory in Section 3031 but are covered in other sections. Others such as biological assets and agricultural products, mineral products, and inventories held by producers of agricultural and forest products and by commodity broker- traders are excluded from the measurement provisions of Section 3031 and IAS 2.

2. Management is vitally interested in inventories in order to prevent

stocking up on excessive and un-saleable inventories or being caught without items for sale. Also, since inventory amounts affect balance sheet and income statement amounts, they are important in terms of management bonus contracts linked to income earned and bond covenants requiring specific debt to equity ratios.

3. Inventory is valued under the Lower of Cost and Net Realizable Value

Model. However, determining the value to report on the statement of financial position requires answers to the following questions:

Which physical goods should be included as part of inventory? What costs should be included as part of inventory cost? What cost formula should be used? Has there been an impairment in value of the inventory items?

B. Inclusions in Physical Inventory

Technically, purchases should be recorded when the risks and rewards of ownership pass to the buyer. This is typically when legal title passes to the buyer. The following items require careful judgement.




1. Goods in Transit: If the goods are shipped f.o.b. shipping point, title passes to the buyer when the seller delivers the goods to the common carrier. If the goods are shipped f.o.b. destination, title passes only when the buyer receives the goods.

2. Consigned Goods: Goods out on consignment remain the property of

the consignor.

3. Special Sale Agreements, in which the transfer of legal title may not be accompanied by a transfer of the risks of ownership. These special arrangements were discussed in Chapter 6 in terms of revenue recognition implications.

a. Product financing arrangements (sales with buybacks). These

transactions are often referred to as "parking transactions" because the seller simply "parks" the inventory on another firm's balance sheet and uses it as a financing device. While no specific Canadian pronouncements yet exist regarding such arrangements (thereby requiring reliance on judgement), in the U.S. the profession has decided that in such arrangements the inventory and the related liability from the repurchase agreement should be shown on the seller's books.

b. Sales with high rates of return. If returns are unpredictable,

these goods should not be removed from inventory. If the amount of returns can be reasonably estimated, the goods should be considered sold, and an allowance for expected returns established.

c. Sales with delayed payment terms. The goods should be

removed from the seller's inventory (i.e., considered sold) if the percentage of bad debts can be reasonably estimated. Otherwise, the instalment sales method (Chapter 6) may be used.




C. Costs Included in Inventory Systems

Charges directly connected with bringing goods to the place of business of the buyer and converting such goods to a saleable condition are inventoriable, or product costs.

1. IFRS allows borrowing costs to be capitalized for inventory items that

take an extended period of time to produce. Interest costs, however, are generally expensed as incurred because they are considered a cost of financing for ongoing production.

2. Items such as selling expenses and general and administrative

expenses are considered period expenses.

3. Vendor rebates can be recognized before they are received as a vendor receivable if they meet both the definition of an asset and its recognition criteria, Otherwise they are not recorded as the effect would be to overstate income.

4. Product costs are costs that attach to inventory and are recorded in

the inventory account (i.e., they are capitalized). For example, freight charges on goods purchased, other direct costs of acquisition, and non-recoverable taxes would all be recorded in inventory. Under IFRS, product costs also include any eventual decommissioning or restoration costs incurred as a result of production, even though the related expenditures may not be incurred until far into the future. Under ASPE, such costs are generally added to the cost of the property, plant, and equipment.

5. Purchase Discounts: Either the gross or net method may be used in

handling discounts.

Gross method: Purchases and accounts payable are recorded at the gross amount. Purchase discounts taken are credited to the Purchase Discounts account, which is reported in the income statement as a reduction of purchases.

Net method: Purchases and accounts payable are recorded at the net amount. Purchase discounts not taken are debited to the Purchase Discounts Lost account, which is reported in the other expense section of the income statement.




6. Standard Costs: Unit costs for material, labour, and manufacturing overhead are predetermined based on the costs that should be incurred per unit of finished goods when the plant is operating at normal capacity.

7. Service Providers’ Work-in-Process: Work-in-process inventories

comprised of “production” costs that include service personnel and overhead costs associated with the direct labour.

Costs excluded from inventory – storage costs (unless related to storage before next stage of production), abnormal spoilage or wastage of materials, labour, or other production costs, or interest costs when inventories that are ready for use or sale are purchased on delayed payment terms.

Basket purchases allocate the cost based on the relative sales value of the basket of products purchased.

D. Inventory Record Systems

TEACHING TIP

Contrast the accounting journal entries under the perpetual and periodic inventory systems by using Illustration 8-1.

Illustration 8-2 uses the same information but shows it in T-account form. This example is based on an exhibit in the textbook.

1. In a perpetual inventory system, purchases and issues of goods are recorded directly in the Inventory account.

2. In the supplementary system – quantities only, the cost of

purchases is recorded directly in the inventory account. The cost of sales is not recorded at the time of sale, but a record is kept of the number of units sold (perpetual record kept in units only).

3. With a periodic inventory system, a Purchases account is used and

the beginning inventory account is unchanged during the period. At the end of the period, the ending inventory is recorded. Costs of goods sold are determined by adding the beginning inventory to the Purchases and deducting the ending inventory.




E. Inventory Valuation

The method of inventory valuation chosen will depend on a number of factors. Among the available inventory valuation methods are the following:

1. Cost Formula.

a. Specific Identification.

b First-In, First-Out (FIFO).

c. Average Cost (weighted average or moving average).

Comments on other cost determinations:

Last-In, First-Out (LIFO) – is not an option under IFRS or ASPE

TEACHING TIP

Illustration 8-5 in this teaching note provides a comparison of ending inventory computations under FIFO and Weighted Average Cost under periodic and perpetual systems.

F. Choice of Cost Formula

A problem arises when numerous purchases have been made at different prices, and it is necessary to identify which costs remain on hand and which have been the costs of goods sold. One approach to selecting a method is to identify objectives, know acceptable methods and their assumptions, evaluate the advantages and disadvantages of the various methods, and choose the method appropriate to the situation.

Methods:

1. Specific Identification: Used where a small number of costly,

distinctive items are sold. It offers the opportunity to manipulate income.

2. First-In, First-Out (FIFO): Assumes goods are used or sold in the

order purchased. While this method presents an ending inventory approximately at recent cost, it does not match recent costs against recent revenues.




3. Weighted Average Cost: Cost items in inventory on the basis of all similar goods available during the period. A weighted average (periodic) or a moving average (perpetual) method may be used.

4. Among the advantages cited for FIFO are improved reflection of

physical inventory flows and presentations of inventory at their approximate current cost.

5. Specific identification, FIFO, and average cost are all generally

acceptable for financial reporting purposes. The method chosen should report inventories that are representationally faithful and be consistent with standard setters’ emphasis on the definitions and measurements of assets and liabilities.

G. Lower of Cost and Net Realizable Value

1. The general rule is that the historical cost principle is abandoned when the future utility (e.g., revenue producing ability) of the asset is no longer as great as its original cost.

2. In the U.S., “market” may be defined as net realizable value, net

realizable value less normal profit margin, or replacement cost. However, in Canada, net realizable value (NRV) must be used. This may not be a significant change as this was the value that was used most frequently in Canada.

3. The lower cost and net realizable value model should be applied

directly to each item. It may be appropriate, however, to apply it to the total of the inventory or to the total of the components of each major category if the items are closely related in terms of their use, they are produced and marketed in the same geographical area, and it is not practical or reasonable to value them separately.

4. Two possibilities exist for recording net realizable value declines in

inventory:

a. Direct method—Shows the inventory at NRV in both the statement of financial position and cost of goods sold section of the income statement. The disadvantage is that the NRV decline is buried in the cost of goods sold figure.

b. Allowance method—Records the NRV decline with a debit to a loss account and a credit to an allowance account, which is deducted from Inventory on the statement of financial position. The allowance account would be adjusted each period.




5. The conceptual deficiencies of the LC&NRV rule include the non- recognition of utility increases. Also, while it may result in "conservative" amounts in the period of a write-down, future periods are correspondingly inflated. Application of the rule results in inconsistency, because the inventory may be valued at cost in one year and at market in the next year.

6. Inventory costs are recognized as an expense in the same accounting

period when the associated revenue is reported, and most often is reported as cost of goods sold. Write downs and any recoveries are recognized in the accounting period when the loss or recovery takes place.

H. Effect of Inventory Errors

a. The three most common types of inventory errors:

1. Correct recording of purchases but incorrect measurement and/or recording of ending inventory count.

2. Recording purchase transactions in the wrong accounting

period. However, ending inventory is measured and recorded correctly.

3. Failure to include an item as a recorded purchase combined

with failure to include the item in the ending inventory count.

b. Corrections of inventory errors may involve two procedures:

1. Preparation of correcting journal entries. Generally, a

purchase is recorded when the invoice arrives. If this does not coincide with passage of legal title by the end of the accounting period, correcting entries may be required to prevent "cut-off errors."

2. Calculation of the correct amounts of inventory and related items including purchases, cost of goods sold, net income, retained earnings, accounts payable, working capital, and the current ratio.




i. Impact of errors. This is a good place to reinforce understanding of the basic inventory equation of:

Beginning Inventory + Purchases – Ending Inventory = Cost of

Goods Sold

ii. Point out the obvious, but useful, fact that the ending inventory of one period is the beginning inventory of the next period.

iii. Discuss the impact of inventory errors on the affected

accounts. Also, since financial statement amounts are affected by inventory errors, various ratios are also affected. The effects on the current ratio, debt to total assets ratio, and rate of return on total assets may be demonstrated.

TEACHING TIP

Illustration 8-3 in this teaching note demonstrates the effects of inventory errors on the income statement by emphasizing the debit or credit balance of the affected items.

Illustration 8-4 in this teaching note summarizes the effects of inventory errors on the income statement and the statement of financial position.

H. Gross Profit Method of Estimating Inventory

1. The gross profit method is used when only an estimate of a firm's inventory is required or possible. The gross profit method is based on the assumptions that the beginning inventory plus purchases equal total goods to be accounted for; goods not sold must be on hand; and if the sales, reduced to cost, are deducted from the goods to be accounted for, the resulting figure gives the cost of the ending inventory. A gross profit on selling price is required to do the calculations.




Gross Profit $15

Cost = $60 = 25%

2. Point out that four items of information are sufficient to estimate the cost of ending inventory:

a. Cost of beginning inventory, b. Cost of purchases for the period, c. Sales during the period, d. Percent of gross profit (or percent of mark-up, which can be

converted to a percent of gross profit).

3. With respect to the gross profit method, the most common mistake is confusing mark-up based on cost with gross profit based on selling price. Discuss the distinction between mark-up expressed as a percentage of cost and gross profit expressed as a percentage of sales.

For example, an item that costs $60 and is sold for $75 has a gross profit of $15.

Mark-up as a percent of gross profit on selling price:

Gross profit $15 Selling price = $60 = 20%

Percent of mark-up on cost

4. Describe how to convert a mark-up on cost to gross profit on sales. A simple method is to use fractions. For example, a 25% (20/80) mark- up on cost is 1/4. The gross profit on sales is 1/5 (20/100) because the 1 (gross profit) plus the 4 (cost) is equal to 5 (sales). A 33-1/3% (25/75) mark-up on cost is 1/3. The gross profit on sales is 1/4 (25/100). A 40% (40/100) mark-up on cost is 2/5. The gross profit on sales is 2/7 (40/140).

TEACHING TIP

Discuss the steps in solving gross profit problems as demonstrated by the example in Illustration 8-6 in this teaching note.




5. Appraisal of the gross profit method.

a. It provides an estimate based on past percentages, which may not necessarily be representative of future performance; therefore, its use is limited;

b. Use of a blanket gross profit rate is not appropriate when a

company handles different lines of merchandise with widely varying rates of gross profit.

I. Additional Issues Related to Inventory Valuation

1. Valuation at net realizable value:

Recording inventory at net realizable value (selling price less estimated cost to complete and sell), even though cost may be lower than NRV, may be acceptable in certain instances. To qualify for this treatment the item should:

a. have a controlled market with a quoted price applicable to all

quantities, and

b. have relatively insignificant disposal costs. Certain minerals and agricultural products may be accounted for at NRV.

2. Purchase commitments:

a. These are commitments for ordering goods and/or contracts for

goods that have not been shipped. They are not reflected in the financial statements as assets or liabilities, because: i) They are usually cancellable; or ii) Even if they are not cancellable, they are executory, and

neither party has fulfilled its part of the contract.

b. Any expected losses because of a decline in prices should be reflected, in the accounts, in the period in which the price declines. Contracts of a material nature may otherwise be reported in the notes to the financial statements.

TEACHING TIP

Discuss the practise of recognizing a loss on a purchase commitment immediately. Does it make sense to report a decline in market value of the goods to be purchased, when they have not been recorded as an asset?




J. Financial Statement Presentation and Disclosure.

The following items must be disclosed:

the choice of accounting policies adopted to measure the inventory; the carrying amount of the inventory in total and by classification (such as supplies, material, work in process, and finished goods).

The amount of inventories recognized as an expense in the period, including unabsorbed and abnormal amounts of production overheads; and

The carrying amount inventory pledged as collateral for loans

IFRS require additional disclosures, such as the carrying amount of inventory carried at fair value less costs to sell, and details about inventory write downs and reversals of write downs. Additional information is required for biological assets and agricultural products.

K. Analysis

1. Inventory turnover = cost of goods sold average inventory on hand

The inventory turnover ratio measures the number of times inventory was sold during the period. Its purpose is to determine the liquidity of the investment in inventory. Seasonal factors should be considered when defining average inventory.

2. # days required = 365 to sell inventory inventory turnover

This represents the average number of days to sell inventory, which in turn represents the average age of inventory, or the number of days it takes to sell inventory once it is purchased.

L. IFRS/ASPE Comparison

Because CICA Handbook, Part II (ASPE), Section 3031 was issued in 2007 and was based on IAS 2 Inventories, and no major differences exist in general inventory standards. As well, no changes are expected in International or in Canada as these changes are relatively new.

Illustration 8-34 summarizes the differences in accounting between IFRS and ASPE, and what changes are expected in the near future.




M. The Retail Inventory Method of Estimating Inventory Cost (Appendix 8A)

1. The retail inventory method requires that a record be kept of the total

cost of goods available for sale, the total retail value of the goods available for sale, and the sales for the period. A cost-to-retail ratio is calculated by dividing the cost of the goods available for sale by their retail value. This ratio is then applied to the ending inventory at retail to reduce it to cost.

2. Discuss the terms “net mark-ups” and “net markdowns.”

3. The conventional retail inventory method is designed to

approximate the lower of average cost and market (net realizable value less normal profit). Thus, the cost percentage is calculated after the net mark-ups but before the net markdowns.

TEACHING TIP

The gross profit method and the conventional retail method can be demonstrated and contrasted with the numerical example given in Illustration 8-7 in this teaching note.

4. Special items: The retail inventory method becomes more complicated when items such as freight, purchase returns and allowances, purchase discounts, normal and abnormal spoilage, and transfers have to be dealt with.

5. Variations of the retail method.

The retail method can be adapted for use with:

a. any of the major inventory cost flow assumptions: FIFO or average.

b. either of the inventory valuation methods: cost or LCNRV.




6. There are three basic steps in computing all retail inventory method problems:

a. Calculate ending inventory at retail using a physical count or

information in the accounting system. This step is the same regardless of which variation (FIFO cost or average LCNRV, etc.) is used. The illustration in the text provides a good example of the major items (normal and abnormal shortage, employee discounts, etc.) that may arise in the calculation of ending inventory at retail.

b. Calculate the cost-to-retail ratio. This step will vary depending on

which variation of the retail method is used. The following formulas may be used:

Conventional retail (average LCM): Purchase

At Beginning Returns Freight- Abnormal Cost Inventory + Purchases – Allowances, + in – Spoilage

Discounts

Purchase At Beginning Returns, Abnormal Net Retail Inventory + Purchases – Allowances, – Spoilage + Mark-ups

Discounts

c. Apply the cost-to-retail ratio (step b) to the ending inventory at retail (step a) to obtain the ending inventory at cost or at LCNRV. The amount will vary depending on which variation of the retail method is used.

7. Appraisal of the Retail Inventory Method.

a. The method permits:

i. the calculation of net income without a physical count of

inventory; ii. a control measure in determining the cost of inventory

shortages when used in conjunction with a physical inventory at retail (i.e., difference between inventory estimate from records and from the physical count);

iii. regulation of quantities of merchandise on hand; iv. a basis for information needed for insurance claims and/or

tax purposes.




b. The method has an averaging effect on varying rates of gross margin. Problems arise when the averages being used are not reflective of underlying conditions.

N. Appendix 8B – Accounting Guidance for Specific Inventory

Illustration 8B-1 provides a summary of the primary sources of GAAP for most types of inventory.



ILLUSTRATION 8-1

INVENTORY RECORD SYSTEMS: JOURNAL ENTRIES

Assumptions: Beginning inventory 100 units at $6 = $ 600 Purchases 900 units at $6 = $5,400 Sales 600 units at $12 = $7,200 Ending inventory 400 units at $6 = $2,400

To record purchases

Perpetual Inventory System

Inventory 5,400 Accounts Payable 5,400

Supplementary System – quantities

Inventory 5,400 Accounts Payable 5,400

Periodic Inventory System

Purchases 5,400 Accounts Payable 5,400

To record sales

Accounts Receivable 7,200 Sales 7,200



Cost of Goods Sold 3,600 Inventory 3,600 (600 × $6)

Post this entry to the perpetual inventory records.

A record is kept of the fact that 600 units were sold, but their cost is not computed. Therefore no journal entry is made to record the cost of goods sold at this time.

No record is kept of the number of units sold or their cost. Therefore no journal entry is made to record the cost of goods sold at this time.



At the end of the period

Perpetual Inventory System Because inventory costs were computed and journal entries were made whenever units were sold, the records show that: (1) 900 units costing $5,400 were purchased. (2) 600 units costing $3,600 were sold. (3) 400 units costing $2,400 remain on hand.

The balance in the inventory account is correctly stated at $2,400.

No entry is required to adjust the Inventory account.

Supplementary System – quantities only. The records show that: (1) 900 units costing $5,400 were purchased. (2) 600 units were sold. (3) 400 units remain on hand.

Periodic inventory procedures must be used to determine that the cost of the 400 units in ending inventory is $2,400.

The balance in inventory account is $6,000 (beginning inventory plus purchases).

The following entries are required to adjust the inventory account (see Illustration 8-2):

Cost of Goods Sold 6,000

Inventory 6,000 (Beginning & Purchases)

Inventory (Ending) 2,400

Cost of Goods Sold 2,400

Periodic Inventory System The records show only that 900 units costing $5,400 were purchased.

A physical count must be taken to determine that 400 units remain on hand.

Periodic inventory procedures must be used to determine that the cost of the 400 units in ending inventory is $2,400.

The balance in the inventory account is $600 from the beginning of the period.)

The following entries are required to adjust the inventory account (see Illustration 8-2):

Cost of Goods Sold 600 Inventory 600 (Beginning)

Inventory (Ending) 2,400

Cost of Goods Sold 2,400 Cost of Goods Sold 5,400

Purchases 5,400




A: Beginning Inventory 100 units at $6 =

$ 600 B: Purchases 900 units at $6 = $5,400 C: Sales 600 units at $12 = $7,200 D: Ending inventory 400 units at $6 = $2,400

ILLUSTRATION 8-2

INVENTORY RECORDING SYSTEMS: T-ACCOUNTS

Transaction

PERIODIC

SALES ACCOUNTS RECEIVABLE INVENTORY

7,200 C C 7,200 A 600

D 2,400 600 D

COST OF GOODS SOLD ACCOUNTS PAYABLE PURCHASES

B 5,400 D 3,600 5,400 B 5,400 D

PERPETUAL

SALES ACCOUNTS RECEIVABLE INVENTORY A 600

7,200 C C 7,200 B 5,400

D 2,400 3,600 C

COST OF GOODS SOLD ACCOUNTS PAYABLE

C 3,600 5,400 B

NO CLOSING ENTRY REQUIRED




ILLUSTRATION 8-3

ADJUSTING AND CLOSING THE INVENTORY ACCOUNTS Adjusting the Permanent Inventory

Beginning Inventory Ending Inventory

Account Adjust for beginning Adjust for ending Inventory by crediting inventory by debiting Inventory and debiting Inventory and crediting Cost of Goods Sold Cost of Goods Sold

Cost of Goods Sold

Close these accounts by Close these accounts by crediting the account debiting the account

and crediting Cost of Goods Sold

Accounts with Normal Debit balances:

Purchases Transportation-in

Accounts with Normal Credit Balances:

Purchase Discounts Purchase Allowances Returned Purchases (Purchases Returns)

Beginning Inventory and Ending Inventory and Temporary Accounts with Temporary Accounts with

Normal Debit Balances: Normal Credit Balances: 1. An overstatement of these 1. An overstatement of items results in an overstatement these items results in an of Cost of Goods Sold and an understatement of Costs understatement of net income. of Goods Sold and an

overstatement of net income.

2. An understatement of these 2. An understatement of items results in an understatement these items results in an of Costs of Goods Sold and an overstatement of Costs overstatement of net income. of Goods Sold and an

understatement of net income.




ILLUSTRATION 8-4

EFFECT OF INVENTORY ERRORS

Error

Effect on Income Statement

Effect on Balance Sheet

Beginning Inventory is understated.

Cost of Goods Sold is understated.

Retained Earnings is correct, assuming that Ending Inventory for the preceding period was understated.*

Beginning Inventory is overstated.

Cost of Goods Sold is overstated. Gross Profit and Net Income are understated.

Retained Earnings is correct, assuming that Ending Inventory for the preceding period was overstated.

Purchases are understated


Gross Profit and Net Income are overstated.

Accounts Payable is understated.

Retained Earnings is overstated.

Purchases are overstated.

Cost of Goods Sold is overstated.

Gross Profit and Net Income are understated.

Accounts Payable is overstated.

Retained Earnings is understated.

Ending Inventory is understated

Cost of Goods Sold is overstated. Gross profit and Net Income are understated.

Inventory is understated. Retained Earnings is understated.

Ending Inventory is overstated.


Gross Profit and Net Income are overstated.

Inventory is overstated. Retained Earnings is overstated.

* If beginning inventory for the current period is understated, then ending inventory for the preceding period must also have been understated. Retained Earnings at the end of the preceding period was therefore understated. Retained Earnings will be correct at the end of the current period after the current period’s overstated Net Income is closed into the Retained Earnings account.


ILLUSTRATION 8-5

CALCULATION OF ENDING INVENTORY

Inventory Data

1/1 Begin with 1,000 units @ $5 1/10 Purchase 200 units @ $8 1/15 Sell 400 units 1/20 Purchase 300 units @ $6 1/31 Ending inventory is 1,100 units (1,000 + 200 – 400 + 300)

Ending inventory calculations for 1,100 units

FIFO (periodic or perpetual) = (300 @ $6) + (200 @ 8) + (600 @ $5) = $6,400

Weighted average (periodic) =

($5 1,000) ($8 200) ($6 300) 1,500

Weighted average (perpetual) =

$5.60

1,100 units

$6,160

($5 1,000) ($8 200) $5.50

800 units

$6 300 units

$6,200 1,200

SUMMARY

PERIODIC PERPETUAL

Average Average FIFO Cost FIFO Cost

Goods available for sale $8,400 $8,400 $8,400 $8,400 ($5 × 1,000) + ($8 × 200)

+ ($6 × 300) Ending inventory 6,400 6,160 6,400 6,200 Cost of goods sold $2,000 $2,240 $2,000 $2,200




ILLUSTRATION 8-6

THE GROSS PROFIT METHOD

There is one general approach to estimating the cost of ending inventory using the gross profit method. It makes use of the percent of gross profit on sales. If given the percent mark-up on cost, calculate the percent of gross profit on sales.

Assume that the following information is given:

Beginning inventory $ 60,000 Purchases 90,000 Sales 100,000 Percent of mark-up on cost 25%

You are to use the gross profit method to solve for the cost of ending inventory.

1. Calculate percent of gross profit on sales (if not given):

Gross profit on Sales %omf -uaorpcknost 1%0o0mf -uaorpcknost 2%5 2%5 2%0

1%020%51%25

2. Calculate cost of goods sold:

Cost of Goods Sold = Sales × (100% – % Gross profit on Sales)

= $100,000 × (100% – 20%)

= $100,000 × 80%

= $80,000

3. Calculate estimated cost of ending inventory:

+ Cost of beginning inventory Cost of purchases

$ 60,000 + 90,000

–

Cost of goods available for sale Cost of goods sold

150,000 – 80,000

= Estimated cost of ending inventory $ 70,000

Instructor’s Manual

8-36

Chapter 8

Copyright © 2013 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.


ILLUSTRATION 8-7

NUMERICAL EXAMPLE OF THE GROSS PROFIT AND CONVENTIONAL RETAIL INVENTORY METHODS

Assume that the following information is given:

Beginning Inventory At Cost $100,000 At Retail 125,000

Net Purchases

Net Sales at Retail $280,000

At Cost $300,000 Average Cost per Unit $ 8.00 At Retail 360,000 Average Selling Price per Unit $10.00

Net Mark-ups 15,000 Net Markdowns 10,000

GROSS PROFIT METHOD

% Gross profit on sales = Avg. Selling Price – Avg. Cost = $2 / $10 = 20% Avg. Selling Price

Cost of goods sold = $280,000 × (100% – 20%) = $280,000 × 80%

= $224,000 (using gross profit on sales)

Ending inventory = $100,000 + $300,000 – $224,000 = $176,000

CONVENTIONAL RETAIL METHOD

Ending inventory at retail = $125,000 + $360,000 + $15,000 – $10,000 – $280,000

= $210,000

Cost-to-retail ratio = $100,000 + $300,000 = $400,000 $125,000 + $360,000 + $15,000 $500,000

= 80%

Ending inventory at lower of average cost and net realizable value less normal profit) = 80% × $210,000 = $168,000




LEGAL NOTICE









CHAPTER 9

INVESTMENTS


Statement of Comprehensive Income N/A IAS1 and

IFRS 7

Business Combinations Section 1582 IFRS 3

Non-controlling interest Section 1602 IFRS 3

Consolidated Financial Statements Section 1601 IAS 27

Investments in Associates Section 3051 IAS 28

Financial Instruments—Recognition and Measurement

Section 3856 IFRS 9 and IAS 39

Financial Instruments—Presentation Section 3856 IAS 32

Financial Instruments—Disclosure Section 3856 IFRS 7




LEARNING OBJECTIVES

1. Understand the nature of investments including which types of companies have significant investments.

2. Explain and apply the cost/amortized cost model of accounting for

investments.

3. Explain and apply the fair value through net income model of accounting for investments.

4. Explain and apply the fair value through other comprehensive income

model of accounting for investments.

5. Explain and apply the incurred loss, expected loss, and fair value loss impairment models.

6. Explain the concept of significant influence and apply the equity method.

7. Explain the concept of control and when consolidation is appropriate.

8. Explain how investments are presented and disclosed in the financial

statements noting how this facilitates analysis.

9. Identify differences in accounting between IFRS and ASPE, and what changes are expected in the near future.




CHAPTER REVIEW

The main concepts covered in this chapter are the different types of financial asset investments in basic equity and debt instruments and the various models used to account for them. The material covers investments held for short term profit, as well as longer term investments held for strategic purposes that give the holder significant influence or control. The chapter focuses on the recent changes required by international standards. The accounting standards brought about by these changes were intended to address the deficiencies of the historical cost method of accounting for investments but the fair value measurements that resulted were complicated. This chapter focuses on the basic accounting models used to account for investments in debt and equity securities in general and which underlie current initiatives.

Financial Assets and Types of Investments

1. A Financial asset is defined as being “any asset that is:

a. cash; b. an equity instrument of another entity; or c. a contractual right:

i. to receive cash or another financial asset from another party; or

ii. to exchange financial assets or liabilities with another party under conditions that are potentially favourable to the entity.”

The IASB requires companies to classify financial assets into two measurement categories—amortized cost and fair value—depending on the circumstances.

2. Debt instruments represent a creditor relationship with an enterprise and

include debt instruments such as investments in government securities, municipal securities, corporate bonds, convertible debt, and commercial paper.

3. Equity instruments represent ownership interest, such as common,

preferred, or other capital stock or shares and is any contract that is evidence of a residual interest in the assets of an entity after deducting all its liabilities.

4. A company will invest in debt and equity instruments issued by other

companies to make a return, such as interest, dividends, or capital appreciation, on excess cash not needed for other purposes. The investment may be intended to generate short-term or long-term returns, depending on




the company’s goals and need for the excess cash (this type of investment if referred to as a non-strategic or passive investment). A company may also invest for strategic reasons. Strategic investments are entered into to give the investing company (the investor) significant influence or control over the operating, investing, or financing decisions of the company in which it has invested (the investee).

5. Accounting for the investments depends on the type of instrument (debt or

equity), management’s intent, the ability to reliably measure fair value, or the extent to which a company can influence the activities of the investee company.

6. Accounting for initial investments requires them to be measured on acquisition

at fair value, which is generally the price paid. Transaction costs are added to the acquisition cost if the cost/amortized cost method is used and are expensed if the fair value method is used.

7. Subsequent to acquisition, the change in the fair value carrying amount of

financial instruments measure at fair value are called unrealized holding gains or losses. These gains and losses are usually identified separately on the financial statements.

8. There are three accounting models used for the various non-strategic debt

and equity investments. They include:

a. Cost/amortized cost model. Measured at cost on acquisition (equal to fair value + transaction

costs) At each reporting date, measure at cost or amortized cost Unrealized holding gains or losses are not applicable Realized holding gains and losses are reported in net income

b. Fair value through net income model (FV-NI).

Measured at fair value on acquisition At each reporting date, measure at fair value Unrealized holding gains or losses reported in net income Realized holding gains and losses are reported in net income

c. Fair value through other comprehensive income model (FV-OCI).

Measured at fair value on acquisition At each reporting date, measure at fair value




Unrealized holding gains or losses reported in other comprehensive income (OCI)

Realized holding gains and losses are transferred to net income (“recycling”) or directly to retained earnings (“without recycling”)

Cost/Amortized Cost Model

9. A cost-based model is applicable to both debt and equity investments.

However as shares are not amortized, the term cost is applicable for investments in equity investments. The amortized cost model applies only to investments in debt instruments and long-term notes and loans receivable.

Application of the cost model for an equity investment is as

follows: o Cost of the investment = fair value of the shares

acquired (or fair value of what was given up to acquire them if more reliable) plus any transaction costs on acquisition.

o Unless impaired, investment reported at its cost each statement of financial position date.

o Recognize dividend income when the entity has a claim to the dividend.

o When the shares are disposed of, derecognize them and report a gain or loss on disposal in net income. Gain or loss is the difference between the investment’s carrying amount and the proceeds on disposal.

Application of the Cost model to debt investments is as follows:

o Cost of the investment = fair value of the debt instrument acquired (or fair value of what was given up to acquire them if more reliable) plus any transaction costs on acquisition.

o Unless impaired, investment reported at its amortized cost plus any outstanding interest each balance sheet date.

o Recognize interest income as it is earned, amortizing any premium or discount at the same time by adjusting the carrying amount of the investment.

o When the investment is disposed of, first bring the accrued interest and discount or premium amortization up to date. Derecognize the investment, reporting any gain or loss on disposal in net income. Gain or loss is the difference between the investment’s amortized costs at the date of disposal and the proceeds received for the




security.

IFRS requires that the bond premium or discount use the effective interest method. ASPE allows the straight line method. In practice, the discount or premium on a bond investment is not usually recognized and reported separately, though it could be.

Fair Value through Net Income (FV-NI) Model

10. FV-NI Model The Fair Value through Net Income (FV-NI) model is also

applicable to both debt and equity investments. This model is also referred to as fair value through profit or loss (FVTPL) in International Standards. Application of the FV-NI model is as follows:

o Measurement at acquisition = fair value of the investment

acquired (or fair value of what was given up to acquire them if more reliable). Transaction costs are expensed.

o Carrying amount of each FV-NI investment is adjusted to its fair value at each reporting date with all resulting unrealized holding gains and losses reported in net income along with any dividends or interest income earned.

o For FV-NI investments held for trading purposes (i.e. held to sell in the near term or to generate a profit from short-term fluctuations in price) both interest and dividend income need not be reported separately from the holding gains or losses, but rather accounted for and reported together to mirror how such investments are managed.

o When the entity holding the investment needs to or wants to track the holding gains and losses separately, the dividend is recognized in an account such as Dividend Income, and the adjustment to fair value at each reporting date is recognized in a separate account such as Gain (or Loss) on FV-NI Investment in Shares.

o For debt investments, separate reporting is more complex because the recognition of the interest income separately requires that the discount or premium be amortized before the change in fair value is recognized. The amortization of the discount/premium changes the investment’s carrying amount so the fair value




adjustment entry has to take this into account. There are several ways the bookkeeping for this can be handled, but the text takes the approach that maintains the investment account at fair value and the necessary amortized cost information is kept in supplementary records. The steps are as follows: § Recognize the interest as Interest Income on FV-

NI Debt Investments: as it is earned, adjusting the book value of the investment by the amount of any discount or premium amortization.

§ The change arising from the adjustment of the investment to its current fair value at each reporting date is recognized as Gain (or Loss) on FV-NI Debt Investments.

o When the investment is disposed of, the realized gain or loss on disposal is equal to the fair value at the last measurement date and the proceeds of disposal.

Fair Value through Other Comprehensive Income (FV-OCI) Model

11. Chapter 4 introduced the concept of other comprehensive income (OCI). To

recap the terms associated with OCI:

o Comprehensive income – change in equity (or net assets) of an entity during a period from non-owner source transactions and events. It is the total of net income and other comprehensive income.

o Other comprehensive income (OCI) – made up of revenues, gains, expenses, and losses that accounting standards say are included in comprehensive income, but excluded from net income.

o Accumulated other comprehensive income (AOCI) – the balance of all past charges and credits to other comprehensive income to the statement of financial position date.

The Fair Value through Other Comprehensive Income (FV-

OCI) model for financial instruments normally will be limited to equity investments in other companies. However, because the proposed financial instruments standard under FASB differs from IFRS 9, the IASB has agreed to consider some amendments to IFRS 9 including allowing debt instruments to be classified as FV-OCI. Application of the model is as follows:

o Measurement at acquisition = fair value of the investment acquired (or fair value of what was given up to acquire




them if more reliable). Unlike FV-NI investments, transaction costs tend to be added to the carrying amount of the investment. When the investment is adjusted at the first reporting date, the transaction costs will automatically become part of the holding gain or loss recognized in OCI.

o Carrying amount of each FV-OCI investment is adjusted to its fair value at each reporting date with all resulting unrealized holding gains and losses reported in other comprehensive income.

o Any dividend or interest income earned is reported in net income.

o When the investment is disposed of, there are two versions of how the FV-OCI model can be applied the when holding gains and losses are realized: § FV-OCI with recycling – previously unrealized

gains and losses to the date of disposal are transferred (recycled) into net income.

§ FV-OCI without recycling – previously unrealized gains and losses to the date of disposal are transferred directly into retained earnings.

12. GAAP classifications Standards are in a state of transition. ASPE was approved by the accounting Standards Board and released in December 2009 and was effective January 1, 2011 with earlier adoption allowed.

13. IFRS 9 Financial Instruments was released in late 2009. They are not

required to be implemented prior to 2015 though earlier adoption is permitted.

14. Illustration 9-13 in the text outlines the differences between ASPE and IFRS when accounting for financial asset investments where no significant influence or control exists. Most of these issues have been addressed in the notes above, but this is a useful summary. Other issues include:

15. IFRS

- investments measured at amortized cost if a portfolio of instruments is managed with intent to hold on the basis of yield to maturity, otherwise measurement is at fair value through net income (FV-NI). A special election is available to choose FV-OCI without recycling for longer term strategic investments even though the investor does not have significant influence or control.




- reclassification not allowed except in rare occasion that there is a change in the entity’s business model.

16. ASPE:

- cost-based method generally applied for all investments except where they are equity investments that are quoted in an active market or are derivatives

- allows entities to choose the FV-NI model for financial instruments with interest earned and dividends received recognized in net income

- if choice is made for a fair value option, the choice is irrevocable - the FV-OCI model is not permitted

17. Impairments

Review for impairment is generally only applicable to investments valued at cost/amortized cost because fair value investments would automatically reflect any impairment. Both IFRS and ASPE require entities adjust for impairment at each reporting date, preferably on an individual investment basis unless doing so would not be timely, in which case investment portfolios with similar characteristics could be grouped and assessed. Impairments on investments are recognized when there is no longer reasonable assurance that the future cash flows associated with them will be either collected in their entirety or when due.

18. Three models could be used to calculate and record the losses. A loss

assessed under all models would be recognized in net income and reversals are generally permitted up to amortized cost, though there are some limitations on reversals. These models are:

Incurred loss model Expected loss model Fair value loss model

19. Under ASPE, the incurred loss model is applied using a current discount rate.

Under IFRS, the existing standards use a combination of the incurred loss model (using the original discount rate) and a fair value model and the impairment losses may be reversed. The IASB is also working toward a new model for impairments and has proposed the use of the expected loss approach where investments are divided into three categories for impairment assessment. These categories are general, group or portfolio of investments with similar risk, and individual investments..

20. Strategic Investments

Strategic investments are classified as:




Significant influence investments bought to give the holder significant influence over the operating, financing, and investing decisions of the investee.

Control investments bought to give the holder control over the operating, financing, and investing decisions of the investee.

21. The degree to which one corporation (investor) acquires an interest in the

common shares of another corporation (investee) generally determines the accounting treatment for the investment subsequent to acquisition. Investments by one corporation in the common share of another and the accounting method to be used can be classified according to the percentage of the voting share of the investee held by the investor (however this is only a guideline and other factors also need to be considered):

Holding (percentage ownership) Method a Less than 20%—investor has passive interest Fair Value b Between 20% and 50%—investor has significant

interest Equity Method

c More than 50%—investor has controlling interest Consolidation

22. Other factors in addition to percentage ownership would include representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or provision of technical information.

Equity Method

23. When an investor can exercise significant influence over operating and financial policies of the investee company they are considered to have "significant influence," and the investor is required to account for the investment using the equity method.

24. Under the equity method the investment's carrying amount is periodically

increased (decreased) by the investor's proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee. The adjustments made to the carrying amount will also result in increases or decreases to investment income.

25. When the investment is originally purchased, the difference between the

carrying amount of the company being purchased and the actual amount paid is allocated to the appropriate assets and liabilities purchased. These




may be tangible assets (such as inventories), intangible assets (such as patents), or unrecorded assets (such as a customer base). Any excess amount that cannot be allocated to an identifiable tangible or intangible asset/liability as a fair value adjustment is allocated to goodwill. The subsequent accounting for the excess fair value or goodwill follows accounting procedures that would normally be followed for these assets and recognized as either decreases or increases in the investment income.

Under both IFRS and ASPE, impairments in value are assessed at each statement of financial position date and a loss is recorded if the carrying amount is more than the investment’s recoverable amount. The loss may be reversed if future events indicate that the recoverable amount has improved.

26. On disposal of investment in an associate, the investment account and

investment account are brought up to date as at the date of sale and the investment carrying amount is removed from the books through the recording of a gain or loss on the sale.

Consolidation

27. When one corporation (the parent) acquires a voting interest of more than 50% in another corporation (the subsidiary), the investor corporation is deemed to have a controlling interest. When the parent treats the subsidiary as an investment, consolidated financial statements are generally prepared instead of separate financial statements for the parent and the subsidiary. If the parent and the subsidiary prepare separate financial statements, the investment in the common shares of the subsidiary is presented as a long-term investment on the financial statements of the parent under the equity method. The equity method is sometimes called one line consolidation because the results for net income and retained earnings will be the same whether financial statements are prepared using the equity method or prepared using consolidation. The subject of when and how to prepare consolidated financial statements is discussed extensively in advanced accounting.

28. Presentation, Disclosure, and Analysis

Investments – presentation and disclosure are similar under IFRS and ASPE with some differences, but generally will be:

Current

o Classification: under IFRS, if it is expected to be sold or otherwise realized with the entity’s normal operating cycle or




within 12 months from the balance sheet date, held primarily for trading, or is a cash equivalent. Under ASPE, if it is usually realizable within 12 months from the statement of financial position date (or operating cycle if longer) and it can be readily converted into cash).

o Could include debt and equity instruments measured at cost or amortized cost and those at FV-NI.

o Disclosure: under both IFRS and ASPE, the carrying amount of investments and the method used; net gains or losses recognized by method of accounting; interest income, impairment losses and reversals.

o Under IFRS, need to provide quantitative measures of their risk exposures and concentrations, and information on how management manages these risks.

Noncurrent assets

o Could include investments held at cost or amortized cost or FV- NI if they don’t meet the requirement to be classified as current, and FV-OCI investments as they are usually held for long-term strategic purposes.

o Investments in Associates (unless held for sale). § Income is reported as income before discontinued

operations, discontinued operations, or other comprehensive income, according to its nature in the associate’s financial statements.

§ Disclosure for associates accounted for under the equity method include disclosure of the investment category, method of accounting used, fair value of any of these investments if they have an active market, separate disclosure of the income from investments under the equity method, and information about the associate’s year ends that are different than the investors.

29. Analysis

Accounting standards require disclosures that make it possible for a reader to:

Separate investment results from operating results Understand the relationship between the investment asset and related returns (income), and

Understand the effect of accounting methods that are used (such as consolidation).

30. IFRS/ASPE Comparison Refer to Illustration 9-23 in the text for a comparison of the differences and




similarities in accounting for investments where no significant influence or control exists under IFRS and ASPE.




LECTURE OUTLINE

The material in this chapter is very recent and in a state of ongoing change. It can be covered in three class periods. Some students may have difficulty understanding the accounting for current and noncurrent investments and the differences between IFRS and ASPE.

TEACHING TIP

There are numerous charts in the text to illustrate the accounting methods and models discussed that will be helpful in summarizing the concepts covered.

Companies have different motivations for investing in securities issued by other companies. One motivation relates to the returns provided by investments and another motivation relates to strategy.

A. Financial Assets and Investments 1. Review terminology:

Financial asset Debt instruments Equity instruments

2. Discuss concept that investments on acquisition are all measured at their fair value, but determining fair value will depend on model being followed.

3. Three accounting models for non-strategic debt and equity investments:

Cost/Amortized Cost model Fair Value through Net Income Model (FV-NI) Fair Value through Other Comprehensive Income Model (FV- OCI)

B. Cost/Amortized Cost Model

Measured at cost on acquisition (equal to fair value + transaction costs)

At each reporting date, measure at cost or amortized cost Unrealized holding gains or losses are not applicable Realized holding gains and losses are reported in net income




C. Fair Value through Net Income Model (FV-NI)

Measured at fair value on acquisition At each reporting date, measure at fair value Unrealized holding gains or losses reported in net income Realized holding gains and losses are reported in net income

D. Fair Value through Other Comprehensive Income Model (FV-OCI)

Measured at fair value on acquisition At each reporting date, measure at fair value Unrealized holding gains or losses reported in other comprehensive income (OCI) Realized holding gains and losses are transferred to net income or directly to net income

TEACHING TIP

Refer to Illustration 9-1 in this teaching note to help students understand how the three accounting models for investments are applied. The application of each of these models are illustrated in the relevant sections of the text and they can be used to illustrate the concepts, with reference back to Teaching Note Illustration 9-1 (measurement and recording at acquisition, measurement at each statement of financial position date, and reporting unrealized and realized holding gains and losses).

E. GAAP Classifications and Impairment

1. Standards are in a state of transition. ASPE was approved by the accounting Standards Board and released in December 2009, effective January 1, 2011 with earlier adoption allowed.

2. IFRS 9 Financial Instruments was released in late 2009. They are not

required to be implemented prior to 2015 though earlier adoption is permitted.




TEACHING TIP

Teaching Note Illustration 9-1 summarizes the classifications of financial asset investments that have no significant influence or control under both ASPE and IFRS. (this is also Illustration 9-13 in the text).

Impairments

3. Review for impairment is generally only applicable to investments valued at cost/amortized cost because fair value investments would automatically reflect any impairment. Both IFRS and ASPE require entities adjust for impairment at each reporting date, preferably on an individual investment basis unless doing so would not be timely, in which case investment portfolios with similar characteristics could be grouped and assessed. Impairments on investments are recognized when there is no longer reasonable assurance that the future cash flows associated with them will be either collected in their entirety or when due.

4. Three models could be used to calculate and record the losses. A loss

assessed under all models would be recognized in net income and reversals are generally permitted up to amortized cost, though there are some limitations on reversals. These models are:

Incurred loss model Expected loss model Fair value loss model

5. Under ASPE, the incurred loss model is applied using a current discount rate.

Under IFRS, the existing standards use a combination of the incurred loss model (using the original discount rate) and a fair value model and the impairment losses may be reversed. The IASB is also working toward a new model for impairments and has proposed the use of the expected loss approach where investments are divided into three categories for impairment assessment. These categories are general, group or portfolio of investments with similar risk, and individual investments.




TEACHING TIP

Illustration 9-14 in the text is a summary that can be used to compare the differences and similarities between the impairment loss models.

F. Strategic Investments – Significant Influence and Control

1. Equity investments, when acquired, are recognized initially at the fair value of the consideration given. Investments by one corporation in the common shares of another can be classified according to percentage ownership. (Keep in mind that this percentage is just a guideline – other factors, such as ability to have representation on the board of directors, play a part in determining whether any significant influence or control exists.)

a. Holdings of less than 20% (cost or a fair value method as previously discussed).

b. Holdings between 20% and 50% (equity method).

c. Holdings of more than 50% (consolidation).

2. Holdings between 20% and 50%. Use the equity method. The investment account is increased (decreased) by the investor's share of the earnings (losses and discontinued operations, etc) of the investee and decreased by all dividends received. The investor will also account for any fair value adjustments that were required when the investment was first acquired. The fair value adjustments are a result of the difference between the carrying value of the investee on acquisition and the amount paid for the investment.

3. Holding over 50%. Generally consolidated

TEACHING TIP

Teaching Note Illustration 9-2 provides a comparison between IFRS and ASPE when accounting for investments under the equity method for investments where significant influence exists.

G. Presentation, Disclosure, and Analysis




1. Investments – presentation and disclosure are similar under IFRS and ASPE but there are some differences:

o Investments are classified as current under IFRS, if it is expected to be sold or otherwise realized with the entity’s normal operating cycle or within 12 months from the statement of financial position date, held primarily for trading, or is a cash equivalent. Under ASPE, it is classified as current if realizable within 12 months from the statement of financial position date (or operating cycle if longer) and it can be readily converted into cash).

o Could include debt and equity instruments measured at cost or amortized cost and those at FV-NI.

o Under both IFRS and ASPE, the carrying amount of investments and the method used; net gains or losses recognized by method of accounting; interest income, impairment losses and reversals are disclosed. Also under IFRS quantitative measures of the investments’ risk exposures and concentrations, and information on how management manages these risks is needed.

o Investments classified as noncurrent assets could include investments held at cost/amortized cost or FV-NI if they don’t meet the requirement to be classified as current, and FV-OCI investments as they are usually held for long-term strategic purposes.

o Investments in Associates (unless held for sale). § Income is reported as income before discontinued

operations, discontinued operations, or other comprehensive income, according to its nature in the associate’s financial statements.

§ Disclosure for associates accounted for under the equity method include disclosure of the investment category, method of accounting used, fair value of any of these investments if they have an active market, separate disclosure of the income from investments under the equity method, and information about the associate’s year ends that are different than the investors.

2. Analysis

Accounting standards require disclosures that make it possible for a reader to be able to:

Separate investment results from operating results Understand the relationship between the investment asset and related returns (income), and




Understand the effect of accounting methods that are used (such as consolidation)

H. IFRS/ASPE Comparison

Refer to Illustration 9-23 in the text for a comparison of the differences and similarities in accounting for investments where no significant influence or control exists under IFRS and ASPE.




ILLUSTRATON 9-1

ASPE IFRS Measurement attributes

• Cost/amortized cost • Fair value

• Amortized cost • Fair value

Classification categories

Fair value through income (FV- NI): equity investments quoted in an active market.

Cost/amortized cost: all other investments.

Amortized cost: if the entity’s business model is to manage the instrument on the basis of yield to maturity and the instrument has contractual basic loan cash flows. Fair value through net income (FV- NI): all other financial assets. Fair value through OCI (FV-OCI) (with or without recycling): investments in equity instruments that are not held for the purposes of trading (special election).

Is there a fair value option?

Yes; can designate FV-NI category for any financial asset on initial recognition.

Yes; can designate FV-NI category on initial recognition for instruments that would otherwise be classified at amortized cost if it reduces or eliminates an accounting mismatch.

What to do with transaction costs

Capitalize for instruments measured at cost/amortized cost; otherwise, expense.

Capitalize for all instruments except FV-NI.

What to do with realized gains and losses from disposal

Recognize in net income. Recognize in net income for all instruments except for FV-OCI classified instruments where they are recognized in OCI (with or without recycling).

What to do with interest and dividend accruals

Recognize in net income. Recognize in net income for all instruments. An exception is permitted for FV-OCI classified instruments where dividends are a return of capital, in which case they are recognized in OCI without recycling.

Is separate reporting of dividend and interest income required?

There is no requirement for dividend income. Total interest income is required to be disclosed separately.

There is no requirement for dividend income. Total interest income is required to be disclosed separately for financial asset investments that are not accounted for at FV-NI; that is, for those accounted for at amortized cost, and at FV-OCI, if any.

What to do with transfers between categories

Fair value option designation is irrevocable; otherwise the issue is not addressed.

No reclassifications are permitted except on the rare occasion that there is a change in the entity’s business model.




ILLUSTRATION 9-2

Measurement IFRS ASPE

after recognition Equity method Equity method is used for all or the cost method If shares are quoted is used for all. in an active market,

cannot use cost method;

Unrealized holding

Not recognized

Equity method Not recognized

Cost method Not recognized

may use FV-NI Recognized in net

gains/losses income

Investment income

Percentage of

Percentage of

Dividends received

Dividends received

associate’s income, adjusted for differences between cost and share of book value

associate’s income, adjusted for differences between cost and share of book value

or receivable or receivable

Impairment, when assessment indicates possibility

Loss = carrying amount less recoverable amount (higher of value in use and fair value less costs to sell)



Not applicable

Impairment reversal

Permitted

Permitted

Permitted

Not applicable




LEGAL NOTICE







CHAPTER 10

PROPERTY, PLANT, AND EQUIPMENT: Accounting Model Basics


Property, Plant and Equipment Section 3061 IAS 16

Asset Retirement Section 3110 IAS 37

Accounting for Government Assistance/Grants

Section 3800 IAS 20

Interest/Borrowing Costs Section 3850 IAS 23

Non-monetary Transactions Section 3831 IAS 16

Oil and Gas Accounting/Mineral Resources AcG-16 IFRS 6

Investment Property Section 3061 IAS 40

Agriculture and Biological Assets Section 3061 IAS 41




LEARNING OBJECTIVES

1. Understand the importance of property, plant, and equipment from a business perspective.

2. Identify the characteristics of property, plant, and equipment assets.

3. Identify the recognition criteria for property, plant, and equipment.

4. Identify the costs to include in the measurement of property, plant, and

equipment assets at acquisition.

5. Determine asset cost when the transaction has delayed payment terms or is a lump-sum purchase, a non-monetary exchange, or a contributed asset.

6. Identify the costs included in specific types of property, plant, and

equipment.

7. Understand and apply the cost model.

8. Understand the revaluation model and apply it using the asset adjustment method.

9. Understand and apply the fair value model.

10. Explain and apply the accounting treatment for costs incurred after

acquisition.

11. Identify differences in accounting between ASPE and IFRS, and what changes are expected in the near future.

12. Calculate the amount of borrowing costs to capitalize for qualifying assets

(Appendix 10A).

13. Apply the revaluation model using the proportionate method (Appendix 10B).




CHAPTER REVIEW

1. Chapter 10 presents a discussion of the basic accounting problems associated with the incurrence of costs related to property, plant, and equipment; and the accounting methods used to retire or dispose of these costs. These assets, also referred to as plant assets, tangible fixed assets or tangible long-lived assets, are of a durable nature and include land, building structures, and equipment and natural resources. Property, plant, and equipment assets are an important part of the operations of most business organizations. They provide the major means of support for the production and/or distribution of a company's product or service. Too little investment in these assets result in lost opportunities whereas too much investment results in overcapacity. Therefore to assess a company’s use of investments and the potential future cash flows, users must be given sufficient information about these assets.

2. Property, plant, and equipment possess certain characteristics that

distinguish them from other assets owned by a business enterprise. These characteristics may be expressed as follows:

a. acquired for use in operations and not for resale; b. long term in nature and usually depreciated; and c. possess physical substance (tangible).

These assets last for a number of years and their costs must be allocated to the periods that benefit from their use.

Recognition Principle

3. Property, plant, and equipment accounts are valued at historical cost at

acquisition, the cash or cash equivalent price of obtaining the asset, bringing it to the location, and getting it ready for its intended use. Property, plant, and equipment is recognized when the cost of the asset can be measured reliably and it is probable that it generate future economic benefits. Typically costs include purchase price, import duties, non- refundable purchase taxes, delivery costs, less discounts and rebates.




4. In subsequent periods, property, plant, and equipment is valued at either cost or fair value. Companies can apply either method to all items of property, plant, and equipment or to a single class of property, plant, and equipment. Most companies use the cost method because it is less expensive. In addition, the fair value method generally leads to higher asset values, higher depreciation amounts, and lower net income.

5. The degree to which asset components are combined and recognized

separately requires professional judgement. Factors to consider include the cost/benefit of separate recognition with reference to the significance of the component to related components, if they have different useful lives, or if they have different patterns of delivering benefits. If an item of property, plant, and equipment meets to the definition and recognition criteria two issues are addressed:

1. The elements of cost to be capitalized 2. How cost is measured

Cost Elements

6. The cost of an item of property, plant, and equipment includes all expenditures needed to acquire the asset and bring it to its location and ready it for use. These include:

(a) Purchase price net of trade discounts and rebates, plus any non-

refundable purchase taxes and duties (b) Expenditures necessary to bring the asset to its required location and

condition to operate as management intended, including employee costs needed to acquire or construct the asset; delivery and handling costs; site preparation, installation, and assembly costs; net material and labour costs incurred to ensure it is working property; and professional fees.

(c) The estimate of the costs of obligations associated with the asset’s eventual disposal. This includes some or all of the costs of the asset’s decommissioning and site restorations.

(d) Excluded costs include:

Initial operating losses Costs of training employees to use the asset Costs associated with a reorganization of operations




Administration and general overhead costs Costs of opening a new facility, introducing a new product or service, and operating in a new location

(e) The above general principle applies to both IFRS and ASPE, however there are some differences in application, specifically as it relates to:

costs incurred when assets are constructed internally rather than

purchased outright associated borrowing costs, and site restoration or asset retirement costs.

Self-Constructed Assets

7 When plant and equipment to be used by an entity are constructed rather than purchased, the cost of materials and direct labour are easy to identify and allocated to the constructed asset. However, a problem exists concerning the allocation of overhead costs. These costs may be handled in one of two ways:

a. assign a portion of all overhead to the constructed asset; or b. assign no fixed overhead to the cost of the constructed asset.

8. For PP&E, only directly attributable costs can be allocated to the asset

cost, therefore none of the fixed overhead is usually charged unless the company is involved in significant self-construction activity in which some of its fixed costs may be considered “directly attributable”.

Borrowing Costs During Construction

9. Interest costs incurred in connection with financing the construction or acquisition of property, plant, and equipment may be capitalized if directly attributable to the asset to the extent that the costs are avoidable and incurred during the period that the asset is being brought to its required location and condition to operate as management intended.

10. This is the method that is required under IFRS. ASPE will permit the choice

of capitalizing or expensing, but the policy chosen and amount capitalized must be disclosed. This enables users of financial statements to determine




the impact of capitalized interest on the financial statements. The appendix looks at this issue in more detail.

Dismantling and Restoration Costs

11. Asset retirement obligations are those costs associated with the eventual retirement of long-lived assets.

Under IFRS, costs of both legal and constructive obligations are

recognized, whereas ASPE recognizes only costs associated with legal obligations.

Under IFRS, costs include those related to the acquisition of the asset,

not those related to the use of the asset in the production of goods and services whereas under ASPE, costs include both.

Measurement of Cost

12. A number of accounting problems are involved in the acquisition and valuation of tangible capital assets. In general, an asset should be recorded at the fair value of what is given up to acquire it or its own fair value, whichever is more clearly evident. This appears to be a rather straightforward approach that can be easily followed. However, determining the fair value is not always as easy as it might appear. Some of the problems one encounters in determining proper valuation are discussed in the paragraphs that follow.

13. The purchase of a plant asset is often accompanied by a cash discount for

prompt payment. If the discount is taken, it results in a reduction in the purchase price of the asset. It is not recognized as a Purchase Discount because purchase discounts are related to inventory purchases and form a part of the cost of goods sold. However, when the discount is allowed to lapse, should a loss be recorded or should the asset be recorded at a higher purchase price? Currently, while recognizing the asset at its lower “cash cost” is preferred, both methods are employed in practice.

14. Plant assets purchased on deferred payment contracts should be

accounted for at the present value of the consideration exchanged on the date of purchase. When the obligation stipulates no interest rate, an imputed rate of interest must be determined for use in calculating the present value. Factors to be considered in imputing an interest rate are the




borrower’s credit rating, the amount and maturity date of the note, and prevailing interest rates. If determinable, the cash exchange price of the asset acquired should be used as the basis for recording the asset and measuring the interest element.

15. In some instances a company may purchase a group of plant assets at a

single lump sum price (basket purchase). The best way to allocate the purchase price of the assets to the individual items is based on the relative fair values of the assets acquired. To determine fair value, an appraisal for insurance purposes, the assessed valuation for property taxes, or simply an independent appraisal by a qualified appraiser might be used.

16. When assets are acquired for an entity’s shares, the best measure of the

cost is the fair value of the shares issued if they are publicly traded. IFRS allows using the fair value of the shares only if the fair value of the assets cannot be determined whereas ASPE allows whichever one is more reliably determinable.

Exchanges of Assets

17. Non-monetary exchanges of assets involving transactions where non- monetary assets are exchanged for other non-monetary assets, with little or no cash or other monetary assets changing hands requires that the economic substance of the transaction be assessed.

18. As stated previously, ordinarily companies account for the exchange of non-

monetary assets on the basis of the fair value of the asset given up or the fair value of the asset received, whichever is clearly more evident. Thus, companies should recognize immediately any gains or losses on the exchange. The rationale for immediate recognition is that most transactions have commercial substance and therefore should be recognized. An exchange has commercial substance if the future cash flows change as a result of the transaction. An exchange of trucks with different useful lives might have commercial substance while an exchange of trucks with no significant difference in useful lives would probably not.




19. The requirement to use fair value will not apply if fair values are not reliably measurable or the transaction lacks commercial substance (commercial substance is a significant change in the company’s expected future cash flows and therefore its value). In an exchange that lacks commercial substance, the book (carrying) value of the assets given up, including/minus any monetary consideration given/received. In no circumstance can an asset be recognized at more than its fair value, so if the book value of assets given up exceeds the fair value of assets received, the new asset is recorded at its lower fair value amount and a loss is recognized.

20. Companies immediately recognize losses they incur on all exchanges.

The accounting for gains depends on whether the exchange has commercial substance. If the exchange has commercial substance, the company recognizes the gain immediately. If an exchange lacks commercial substance the gain is deferred.

21. A gain or loss on the exchange on nonmonetary assets is computed by

comparing the book value of the asset given up with the fair value of that same asset. The examples shown below are designed to demonstrate the various situations where exchanges of nonmonetary assets are included.

Exchange with Commercial Substance

Al Company exchanged a used machine with a book value of $26,000 (cost $54,000 less $28,000 accumulated depreciation) and cash of $8,000 for a delivery truck. The machine is estimated to have a fair value of $36,000.

Cost of truck: Fair value of machine exchanged.............. $36,000 Cash paid .................................................. 8,000 Cost of truck .............................................. $44,000

Journal entry: Truck ......................................................... 44,000 Accumulated Depreciation—Machine........ 28,000

Machine............................................. 54,000 Gain on Machine Disposal................. 10,000 Cash .................................................. 8,000




Equipment ............................................. 31,000 Accumulated depreciation ..................... 21,000 Loss on disposal of equipment .............. 3,000

Equipment ..................................... 32,000 Cash .............................................. 23,000

Gain verification: Fair market value of machine .................... $36,000 Book value of machine .............................. (26,000) Gain or disposal of machine ...................... $10,000

Exchange with No Commercial Substance

Al Company trades drill press A for drill press B from another company. Drill Press A has a book value of $11,000 (cost $32,000 less $21,000 accumulated depreciation) and a fair value of $8,000. Drill press B has a list price of $38,000, and the seller has allowed a trade-in allowance of $15,000 on the press.

Cost of new machine: List price of drill press B ........................ $38,000 Less trade-in allowance......................... 15,000 Cash payment due ................................ 23,000 Fair value of drill press A ....................... 8,000 Cost of drill press B ............................... $31,000

Journal entry:

Loss verification: Book value of drill press A ..................... $11,000 Fair value of drill press A ....................... (8,000) Loss on disposal of drill press A ............ $ 3,000




Exchange with No Commercial Substance

Al Company contracts with Peg Company to exchange delivery vans. Al Company will trade four Dodge Caravans for four Ford Freestars owned by Peg Company. The fair value of the Caravans is $51,000 with a book value of $38,000 (cost $65,000 less $27,000 accumulated depreciation). The Freestars have a fair value of $66,000 and Al Company gives $15,000 in cash in addition to the Caravans.

Computation of Gain: Fair value of Caravans .......................... $51,000 Book value, of Caravans ....................... 38,000 Total gain (unrecognized)...................... $13,000

Basis of new vans to Al Company:

Fair value of Freestars........................... $66,000 Less gain deferred................................. 13,000 OR

Basis of Freestar vans........................... $53,000

Book value of Caravans ........................

$38,000 Cash paid .............................................. 15,000 Basis of Freestar vans........................... $53,000

Al Company journal entry: Freestar vans ........................................ 53,000 Accumulated depreciation .....................

Caravan vans ................................ 27,000

65,000 Cash .............................................. 15,000

Contributed Assets and Government Grants

22. Many companies receive assets through donations from other organizations, individuals, or the federal government. These transactions are known as nonreciprocal transfers because nothing is given in exchange. When an asset is received through donation, the appraisal or fair value of the asset should be used to establish its value on the books.




23. Two general approaches are possible to record the credit for a nonreciprocal transfer transaction:

a) the use of a contributed surplus account, such as donated capital,

that would appear in the shareholders' equity section (capital approach). Crediting a donated capital account would only be appropriate, however, if the contribution was by an owner or shareholder.

b) as revenue (income approach). If the contribution was by a non- owner (such as a government) it is reflective of the income approach in that the contribution is a non-owner source of changes in net assets. The issue under the income approach is whether the revenue should be reported immediately or over the periods that benefit from the grant. The amount received should be deferred and recognized over the period the related assets are used. There are two approaches that could be used:

cost reduction of the asset (which will have the effect of reducing depreciation in future periods). The weakness with the cost reduction approach is that it reports assets at less than their fair value.

deferral of the amount of the grant in a separate account and amortizing it to revenue over the life of the related asset. The weakness of the deferral method is that the Deferred Revenue account does not really meet the definition of a liability.

A donation of land is more problematic because it is not depreciated. In this case the donation may be deferred and taken into income over the future periods that will benefit. If there is no way to associate the grant with future periods, the full grant is recognized as revenue. Whichever method is used, the policy must be disclosed.

24. Government grants that are awarded to a company for incurring certain

current expenditures, such as those related to payroll, are recognized in income in the same period as the related expenses. If grants or donations that have been received have a condition attached to them that requires a future event to occur—such as being required to maintain a specified number of employees on the payroll—the contingency is reported in the notes to the financial statements.




Costs Associated with Specific Assets

25. The assets normally classified on the statement of financial position as property, plant, and equipment include land, buildings, and various kinds of machinery and equipment, as well as natural resources, such as gas and oil. The cost of each item includes the acquisition price plus those expenditures incurred in getting the asset ready for its intended use.

26. Land acquired for operational use is classified as property, plant, and

equipment. Land costs include (a) purchase price; (b) closing costs; (c) cost of grading, filling, draining and clearing; (d) assumption of any liens, mortgages, or encumbrances on the property; and (e) any additional land improvements that have an indefinite life. In addition, the cost of removing any existing structures less any salvage value is a land cost. Also, any special assessments for local improvements that are permanent in nature are includable as land costs. Any improvements with limited lives should be classified as Land Improvements. Land purchased for speculative purposes are appropriately classified as an Investment. If a real estate concern holds land for resale, it is classified as Inventory.

The cost of removing an old building from land purchased for the purpose of constructing a new building is properly charged to the land account. Also, when improvements that have a limited life (fences, driveways, etc.) are made to the land, they should be set up in a separate land improvements account so that they can be depreciated over their estimated useful life.

27. Building costs include materials, labour, and overhead costs incurred

during construction. Also, any fees, such as building permits or the services of an attorney or architect, are included in acquisition cost. In general, all costs incurred from excavation of the site to completion of the building are considered part of the building costs. If a company has a building that it owns and has been using, the cost costs of demolition, net of any cost recoveries are expensed as disposal costs which will increase any loss on disposal of the old asset. An exception is allowed under ASPE when a building is torn down to redevelop rental real estate, in which case the demolition costs, along with the remaining carrying amount of the building are capitalized as part of the redeveloped property to the extent that the costs can be recovered from the project in the future.




28. Leasehold Improvements revert to the lessor at the end of the lease. Because the lessee has the right to use those assets over the life of the lease, however, the costs are capitalized as Leasehold Improvements and depreciated as an operating expense over the life of the lease or the useful life of the improvements, which is shorter.

29. Equipment cost includes purchase price plus all expenditures related to the

purchase that occur subsequent to acquisition but prior to actual use. These related costs would include such items as freight charges, insurance charges on the asset while in transit, assembly and installation, special preparation of facilities, and asset testing costs.

30. Investment Property, or rental real estate, is a separate category of PP&E

that is defined as property held to generate rentals and/or appreciate in value rather than to sell in the ordinary course of business or to use in production, administration, or supplying goods and services. The cost of the property under IFRS and ASPE is determined following the same rules used for PP&E. If the property continues to be accounted for at cost, the components of the property (for example, apartment buildings on the investment property) are accounted for separately for purposes of depreciation.

Cost of Natural Resource Property

31. Natural resources are characterized by two main features: (a) complete removal and/or consumption of the asset, and (b) replacement of the asset only by an act of nature.

Such resources include oil and gas and mining properties.

32. Significant expenditures are required to find natural resources, and for

every success there are many failed attempts where nothing is discovered. Costs that are capitalized are related to:

a. Acquisition costs: the price paid to the property rights to search and

find an undiscovered natural resource, or the price paid for an already discovered resource.

b. Exploration costs: costs incurred to identify areas that have potential. These include depreciation and operating cost of special equipment dedicated to these activities. Exploration costs may be: i. expensed in entirety;




ii. capitalized to the extent that they relate to successful projects— known as the successful efforts approach; or

iii. capitalized in entirety to all projects whether or not they are successful. This method is known as the full-cost approach.

c. Development costs: costs incurred to obtain access to proven reserves and to provide facilities for extracting, treating, and storing the resource. Such costs include depreciation and operating costs of support equipment, drilling costs, tunnels, shafts, and wells.

d. Decommissioning and site restoration costs are those costs associated with the retirement of the capital asset for which the entity is legally responsible and are estimated based on present values and are included in the asset cost and depletion base.

The above costs comprise the depletion base of the natural resource. Through depletion, these costs of the natural resource become part of the cost of inventory that is produced, similar to how the cost of direct materials used in production become part of the cost of a manufactured product.

33. Biological Assets: Examples of biological assets include fruit trees,

grapevines, and livestock. Under ASPE, the general principles applicable to PP&E are also applicable to biological assets. However, under IFRS these assets are measured both initially and at each statement of financial position date at fair value less costs to sell, with changes in value recognized in the income statement similar to the Fair Value model. If the fair value is not reliably available, cost less accumulated depreciation and impairment losses is used.

Measurement after Acquisition

34. Companies have a choice between three different models depending on the type of asset and whether international or private entity standards are being applied. The three models are:

A cost model (CM) A revaluation model (RM) A fair value model (FVM)




Cost Model

35. The cost model is the most widely used and familiar model – PP&E is measured at its cost to acquire less accumulated depreciation and any accumulated impairment losses (depreciation and impairment losses are covered in Chapter 11. The process of allocating the historical cost of property, plant, and equipment to the periods benefited by that asset is known as depreciation.)

Revaluation Model

36. Under the revaluation model, PP&E assets that can be reliably measured at fair value are carried after acquisition at fair value less any subsequent accumulated depreciation and subsequent impairment losses. While not required to be undertaken at each reporting date, the revaluation must be carried out often enough that the carrying amount reported is not materially different from the assets’ fair value. Fair value is the price agreed to in an arm’s length transaction. Professional valuators will use active market or market-related evidence when possible, but if the asset is very specialized, alternative methods will be needed.

If the change results in an increase in the asset’s value, the amount is recorded as a credit to Revaluation Surplus, an equity account, unless the increase reverses a revaluation decrease previously recognized in income. If so, the increase is recognized in income to the extent of the prior decrease.

If the change results in a decrease in the asset’s carrying

amount, the amount is recorded as a debit to the Revaluation Surplus, and equity account, to the extent of any credit balance associated with that asset (in other words, this account cannot have a debit balance). Any remaining amount is recognized in income.

Amounts debited/credited to the Revaluation Surplus account are

reported in the statement of comprehensive income as other comprehensive income (OCI) item so that there is no net increase in net income from revaluing the asset. The balance in the Revaluation Surplus account can be transferred to Retained Earnings at the end of each period, or remain there until the asset is retired or disposed.




The effect on the revaluation of the associated asset can either be accomplished by adjusting the account proportionately (between the carrying amount of the asset and the accumulated depreciation) (proportionate method) or by eliminating the accumulated depreciation account (asset adjustment method).

Fair Value Model

37. Investment property is the only tangible capital asset that may be accounted for under the fair value model. Changes in its value are reported in net income in the period of the change, and no deprecation is recognized over the life of the asset. Once this method is chosen over the cost method, the property will be continued to be valued at fair value until disposal, becomes owner-occupied, or is developed for sale in the ordinary course of business. Biological assets are measured at fair value less costs to sell rather than fair value.

Costs Subsequent to Acquisition

38. Costs related to plant assets, which are incurred before the asset is placed in use, are either added to the asset account (capitalized) or charged against operations (expensed) when incurred. In general, costs incurred to achieve greater future benefits from the asset should be capitalized, whereas expenditures that simply maintain a given level of service should be expensed. For costs to be capitalized, there has to be an increase in the future economic benefits, such as:

a. the useful life of the asset must be increased; b. the quantity of service produced from the asset must be increased; c. the quality of the units produced must be enhanced; d. the associated operating costs must be reduced.

39. In many instances, a considerable amount of judgement is required in

deciding whether to capitalize or expense an item. However, consistent application of a capital/expense policy is normally more important than attempting to provide specific guidelines for each transaction.




40. Generally, expenditures related to plant assets being used in a productive capacity may be classified as: (a) additions, (b) replacements, major overhauls, and inspections, (c) reinstallation and rearrangement, and (d) repairs. Because additions result in the creation of new assets, they should be capitalized.

41. Replacements, Major Overhauls, and Inspections. Replacements are

substitutions of one asset for another. Improvements substitute a better asset for the one currently used, whereas a replacement substitutes a similar asset. Major overhauls and inspections are similar to replacements in that they recur and are often needed to permit continued use of an asset. The major problem in accounting for improvements and replacements is differentiating these expenditures from normal repairs. If an improvement or replacement increases the future service potential of the asset, it should be capitalized. Capitalization may be accomplished by capitalizing the improvement cost and eliminating the carrying value of the old asset (original cost, the associated accumulated depreciation, and any loss on the removal). This process is essentially the same regardless of whether the cost, revaluation, or fair value model is used, however when the fair value method is applied to investment property the property’s fair value may already reflect the reduced value of the part to be replaced. IFRS requires each significant component of an asset be identified and its depreciable base determined and depreciated using component depreciation. If a company does not keep its accounting records based on components, it must generate estimates.

42. Reinstallation and rearrangement costs could be handled as a

replacement, however if the original installation cost and accumulated depreciation to date on it cannot be determined, the costs are expensed in the current period. If the amounts are material, ASPE may capitalize the costs on the basis that the original costs have been significantly depreciated.

43. Ordinary repairs are expenditures made to maintain plant assets in

operating condition. They are charged to an expense account in the period in which they are incurred. Major repairs (such as an overhaul), that benefit several periods, should be handled as an improvement or replacement.




IFRS/ASPE Comparison

44. Refer to Illustration 10-15 in the text for a comparison of the differences and similarities in accounting for property, plant, & equipment under IFRS and ASPE.

Capitalization of Borrowing Costs (Appendix 10A)

45. Borrowing costs are defined as “interest and other costs than an entity incurs in connection with the borrowing of funds”. Interest and other costs include interest expense resulting from applying the effective interest method, finance charges on finance leases, and exchange adjustments on foreign currency borrowings if they are viewed as adjustments to interest costs. There are four issues that need to be considered in determining the amount of borrowing costs to be capitalized and how to report them:

1. The assets that qualify 2. The capitalization period 3. Avoidable borrowing costs – the amount eligible to capitalize 4. The disclosures needed

46. To qualify for interest capitalization, the costs must be directly attributable to

the acquisition, construction, or production of a qualifying asset, and meet both recognition criteria (it is probable that associated future economic benefits will flow to the entity, and the cost can be reliably measured). Qualifying assets must require a substantial period of time to get them ready for their intended use. Assets that qualify for interest cost capitalization include assets under construction for an enterprise's own use (such as buildings, plants, and machinery), investment properties, or intangible assets and assets intended for sale or lease that are constructed or otherwise produced as discrete projects (like ships or real estate developments).




47. The period during which interest may be capitalized begins when three conditions are present:

a. expenditures for the asset have been made; b. activities that are necessary to get the asset ready for its intended use

are in progress; and c. borrowing cost is being incurred.

The capitalization period ends when substantially all the activities needed to prepare the asset for its intended use or sale are complete.

48. The amount of interest that may be capitalized is limited to the lower of:

a. actual interest cost incurred during the period, or b. the amount of interest cost incurred during the period that theoretically

could have been avoided if expenditure for the asset had not been made (avoidable interest).

The potential amount of interest that may be capitalized during an accounting period is determined by multiplying an interest rate(s) by the weighted-average accumulated expenditures for qualifying assets during the period. Illustrations 10A-1 through 10A-5 in the text give a comprehensive illustration of the 4 steps to calculate the borrowing costs to calculate.

49. Two special issues relate to interest capitalization. If a company purchases

land as a site for a structure, interest costs capitalized during the period of construction are part of the cost of the plant, not the land. In addition, IFRS requires that interest revenue earned on specific borrowing, not other general borrowing, should offset interest costs capitalized.

50. Disclosures required: the amount capitalized and the capitalization rate.




Revaluation: The Proportionate Method (Appendix 10B)

51. The revaluation model may be applied using the proportionate method, provided fair value can be measured reliably. Similar to the asset adjustment method, the amounts debited or credited to the Revaluation Surplus (OCI) account are reported in the statement of comprehensive income as other comprehensive income (OCI) items. However, when revaluing an asset, the account is adjusted proportionately so that both the carrying amount of the asset and the accumulated depreciation are adjusted (upwards if there has been an increase in fair value, or downwards for a decrease in fair value). After adjustment, the net balance is the fair value of the asset at the revaluation date.




LECTURE OUTLINE

Chapter 10 presents issues related to the acquisition of fixed assets. The chapter, which can generally be covered in two class sessions, deals with three major topics:

1. General principles involved in accounting for the acquisition of long-

lived non-financial assets.

2. The three different accounting models used to measure these assets: Students will likely not be familiar with these models from previous accounting courses.

3. Accounting treatment for costs incurred after acquisition: This is a

difficult topic for some students.

As with all chapters in this course, a summary of significant differences between IFRS and ASPE is provided.

The following lecture outline is appropriate for this chapter.

A. Definition and Characteristics of Property, Plant, and Equipment

1. Acquired for use and not resale.

2. Long term in nature and usually subject to depreciation.

3. Possessing physical substance.

Professional judgement applied to determine which asset components are combined and which recognized separately. Must consider the cost/benefit of separate recognition and whether the components have differing useful lives and/or patterns of delivering benefits to future periods. Once an asset meets the definition and recognition criteria for capitalization, two issues are then addressed:

1. The elements of cost to be capitalized

2. How cost is measured.




B. Cost Elements

1. Cost of an item of property, plant, and equipment includes all expenditures needed to bring it to its location and ready to use, including:

a. Purchase price net of trade discounts and rebates plus non-

refundable taxes b. Expenditures required to bring the asset to its required location

and condition to operate as management intended c. Discuss which specific costs are included (delivery and handling

costs, site preparation, etc.) and which are excluded (initial losses, costs of training employees to use the asset, administration and general overhead costs, etc.)

d. Principles of costs to capitalize similar for both IFRS and ASPE with some differences in application particularly for internally constructed assets, borrowing costs, and site restoration/asset retirement costs.

TEACHING TIP

Refer to Illustration 10-14 when discussing the similarities and differences under IFRS and ASPE.

2. Self-Constructed Assets: Such assets may cause valuation problems because of the assignment of overhead. The options are to assign a portion of all overheads or assign no fixed overhead. For PP&E only directly attributable costs can be allocated to the asset cost so no fixed overhead can be assigned (unless the company is involved in significant self-construction activities in which some of the fixed costs may be considered ‘directly attributable’).

3. Borrowing costs during construction:

Basic principle: Interest cost incurred during construction of fixed assets is part of the cost of acquiring the assets and preparing them for their intended use. Under IFRS, interest cost is capitalized if directly attributable to the asset to the extent that the costs are avoidable and incurred during the period that the asset is being brought to its required location and condition to operate as




management intended. ASPE will allow a choice of capitalizing or expensing, but the policy and the amount capitalized must be disclosed. This topic is covered in more detail in Appendix 10A.

4. Asset retirement obligations are those costs associated with the

eventual retirement of long-lived assets.

Under IFRS, costs of both legal and constructive obligations are recognized, whereas ASPE recognizes only costs associated with legal obligations.

Under IFRS, costs include those related to the acquisition of the asset, not those related to the use of the asset in the production of goods and services whereas under ASPE, costs include both.

C. Measurement of Cost

An asset should be recorded at the fair value of what is given up to acquire it. This is usually straight forward as this generally is equal to the cash equivalent price of obtaining the asset and getting it ready for its intended use. However fair value may be more difficult to determine in some of the following situations:

1. Cash discounts: The asset could be recorded at the discounted or

undiscounted price. If the latter, a loss would be recorded if the discount is missed. Currently, it is preferable to record the asset at its lower “cash cost” whether the discount is taken or not though both methods are employed in practice.

2. Deferred payment contracts: Assets purchased on long-term credit

contracts should be accounted for at the present value of the consideration exchanged. When no interest rate is stated, or if the specified rate is unreasonable, an appropriate rate should be imputed.




TEACHING TIP

Review the procedure for computing the present value of a $10,000 note payable in 4 years. [PVIF4yrs 10% = .683 OR 1 ÷ (1 + i)n ]. Use the text example to demonstrate the accounting.

3. Lump sum purchases: Total cost should be allocated on the basis of relative market values. Insurance appraisals, property tax assessments, or independent appraisals may be used as indicators of relative market values.

4. Issuance of shares: Fair value of the assets received or fair value of

shares issued could be used as an indication of the cost of the property acquired if the shares are publicly traded. However, IFRS allows using the fair value of the shares only if the fair value of the assets cannot be determined. ASPE allows using the fair value of whichever one is more reliably determinable.

5. Exchange of Assets: Exchanges of property, plant, and equipment

(non-monetary assets) for other non-monetary assets. In presenting this topic, it is important to emphasize both the basic accounting procedures and the basic accounting principles involved.

(a) Basic accounting procedures:

i. Determine if the transaction has commercial substance ii. Calculate the net book value or fair value of the old asset. iii. Calculate the realized gain or loss (remind students that an

cannot be recognized at more than its fair value, so if book value of assets given up exceeds fair value of assets received, a loss is recorded)

iv. Prepare the journal entry to record the exchange.

(b) Basic accounting principles related to evaluating non-monetary transactions:

i. The general principle is that non-monetary transactions are

accounted for using fair values, which means that the cost of the asset acquired is equal to the fair value of the




asset(s) given up or the asset acquired, whichever one is more easily determined.

ii. The requirement to use fair value will not apply if the

transaction lacks commercial substance; fair values are not reliably measurable; or the exchange was only done to facilitate a sale to customers who are not parties to the exchange. In these situations, the book (carrying) value of the assets given up, including/minus any monetary consideration given/received is used.

6. Contributed Assets and Government Grants: Non-reciprocal transfers:

a) How to value a donated asset: It is reasonable to record a donated

asset at its fair value even though its cost is zero or very low.

b) How to account for a donated asset:

i. Capital approach: a contributed surplus account to be included in shareholders’ equity (if contributed by owner)

ii. Income approach (contribution by non-owner):

1. A revenue account that is reported immediately. 2. A revenue account that is deferred and reported over

the period of asset use (income approach—deferral method).

3. A reduction in the cost of the asset (income approach— cost reduction method).

4. When the asset is land, two approaches could be used: recognize the full value of land in OCI; recognize the full value of land in revenue (if there is no way to associate the grant with future periods). Policy must be disclosed.

TEACHING TIP

Demonstrate the accounting for the above assets using the examples in the text (lump sum purchases; Exchange of assets Illustrations 10-3 to 10-7 in the text, and Contributed Assets.




D. Specific Assets

1. The assets normally classified on the balance sheet as property, plant, and equipment include land, buildings, and various kinds of machinery and equipment, as well as natural resources, such as gas and oil. The cost of each item includes the acquisition price plus those expenditures incurred in getting the asset ready for its intended use.

2. Components of cost.

a. Cost of land: All expenditures made to acquire land and ready it

for use are included in the cost of the land. Special assessments for relatively permanent improvements such as pavements and drainage systems are included in the land account. Improvements with limited lives are recorded separately as land improvements and depreciated over their estimated lives. Cost of removing a building, net of salvage, is charged to land. Exception is when the land and building have been in use prior to the building removal and the building is removed to build a new one. In this situation, the cost would be charged to the new building.

b. Cost of buildings: All expenditures related directly to acquisition

or construction are included. These include attorneys’ and architects' fees, building permits, and all costs incurred beginning with excavation and ending with completion of the building.

c. Leasehold improvements: Because the lessee has the right to

use these assets over the life of the lease, the costs are capitalized as Leasehold Improvements and depreciated as an operating expense over the life of the lease or the useful life of the improvements, which is shorter.

d. Cost of equipment: All expenditures incurred in acquiring the

equipment and preparing it for use are included. These include freight charges, insurance while in transit, assembly costs, and the cost of conducting trial runs.

e. Investment property: in a separate category of PP&E that is

defined as property held to generate rentals and/or appreciate in




value rather than to sell in ordinary course of building or to use in production, administration or supplying goods or services.

f. Natural Resources: Two main features: complete removal and/or

consumption of the asset, and replacement of the asset only by an act of nature. This would include oil, gas, and mining properties for instance, but not logging as trees are renewable and are not completely removed (as they can be re-planted by man). They would be classified with biological assets. Since many properties must be explored, and only a few produce results, the main issue is how to account for exploration costs.

Acquisition costs: the price paid to the property rights to search and find an undiscovered natural resource, or the price paid for an already discovered resource.

Exploration costs: costs incurred to identify areas that have potential. These include depreciation and operating cost of special equipment dedicated to these activities. Exploration costs may be:

i. expensed in entirety; ii. capitalized to the extent that they relate to successful

projects, known as the successful efforts approach; or iii. capitalized in entirety to all projects whether or not they are

successful. This method is known as the full-cost approach.

Development costs: costs incurred to obtain access to proven reserves and to provide facilities for extracting, treating and storing the resource. Such costs include depreciation and operating costs of support equipment, drilling costs, tunnels, shafts, wells, etc.

Restoration costs: costs associated with the retirement of the capital asset for which the entity is legally responsible and are estimated based on present values and are included in the asset cost and depletion base.

g. Biological Assets: Examples of biological assets include fruit

trees, grapevines, and livestock. Under ASPE, the general principles applicable to PP&E are also applicable to biological assets. However, under IFRS these assets are measured both initially and at each statement of financial position date at fair




value less costs to sell, with changes in value recognized in the income statement similar to the Fair Value Model. If the fair value is not reliably available, cost less accumulated depreciation and impairment losses is used.

E. Measurement after Acquisition

1. Companies have a choice between three different models depending on the type of asset and whether international or private entity standards are being applied. The three models are:

A cost model (CM) A revaluation model (RM) A fair value model (FVM)

2. Cost Model

The most widely used and familiar model – PP&E is measured at

its cost to acquire less accumulated depreciation and any accumulated impairment losses.

Only method allowed under ASPE, but is also an option under IFRS. Can be used in measuring PP&E and Investment property.

3. Revaluation Model

PP&E assets that can be reliably measured at fair value are

carried after acquisition at fair value less any subsequent accumulated depreciation and subsequent impairment losses.

The revaluation must be carried out often enough that the carrying amount reported is not materially different from the assets’ fair value.

A method applicable to IFRS and only available for measuring PP&E, not investment property.

Adjustments recorded in a Revaluation Surplus account




TEACHING TIP

To demonstrate the application of the revaluation model, work through Illustrations 10-9 to 10-11 in the text. This will help students understand the accounting required when using this model.

4. Fair Value Model

Investment property is the only tangible capital asset that

may be accounted for under the fair value model. Applicable only to IFRS.

Changes in value are reported in net income in the period of the change, and no deprecation is recognized over the life of the asset. Once this method is chosen over the cost method, the property will be continued to be valued at fair value until disposal, becomes owner-occupied, or is developed for sale in the ordinary course of business.

Biological assets are measured at fair value less costs to sell rather than fair value.

F. Costs Subsequent to Acquisition

Students have some difficulty in distinguishing the different natures of costs subsequent to acquisition such as additions, replacements, major overhauls and inspections, reinstallation and rearrangement, and repairs.

TEACHING TIP

Refer to the comparative table in Illustration 10-1 of this teaching note for different types of costs subsequent to acquisition.

1. Additions: Any additions should be capitalized.

2. Replacements, Major Overhauls, and Inspections: The proper accounting treatment depends on whether the carrying value of the old component is known or unknown. The net book value of the part is removed if the cost and accumulated depreciation are known and the replacement is capitalized.




3. Reinstallation and rearrangement: The proper accounting treatment depends on whether the carrying value of the original installation is known or unknown. If not, the amount is expensed. If it is material, ASPE may capitalize the cost on the basis that the original cost is not known but is likely to have been greatly depreciated.

4. Repairs: Ordinary repairs should be expensed in the period incurred.

Major repairs should be treated as an addition, overhaul, or replacement.

G. IFRS/ASPE Comparison

1. Refer again to Illustration 10-15 in the text for a comparison of the differences and similarities in accounting for property, plant, & equipment under IFRS and ASPE. However, as noted at the beginning of this Lecture Outline, it would be helpful to use this summary throughout the lesson to highlight the differences between the two standards.

H. Capitalization of Borrowing Costs (Appendix 10A)

1. Four issues involved in determining the amount of borrowing costs to be capitalized:

a. Determine which assets qualify for capitalization (must be directly

attributable to the qualifying assets and meet both recognition criteria).

b. Determine the capitalization period (begins when expenditures are being made, asset building is in process, and borrowing costs are being incurred).

c. Calculate avoidable borrowing costs (i.e., the amount eligible to

capitalize). The four steps are:

Determine the expenditures on the qualifying asset Determine the avoidable borrowing costs on the asset- specific debt

Determine the avoidable borrowing costs on the non- asset-specific debt Determine the borrowing costs to capitalize




d. Determine the disclosures needed – only two: the amount capitalized and the capitalization rate.

TEACHING TIP

Use the numerical example in Appendix 10A of the text to demonstrate the calculation of avoidable borrowing costs using weighted-average accumulated expenditures and an appropriate interest rate.




ILLUSTRATION 10-1

COSTS SUBSEQUENT TO ACQUISITION OF PROPERTY, PLANT, AND EQUIPMENT

Type of Expenditure Normal Accounting Treatment

Additions Capitalize cost of addition to asset account.

Replacements, Major Overhauls, Inspections

(a) Depreciated carrying value known: Remove cost of and accumulated depreciation on old asset, recognizing any gain or loss. Capitalize cost of improvement/replacement.

(b) Depreciated carrying value unknown: Estimate

the cost of the original asset using the replacement asset as a guide. Remove cost of and accumulated depreciation on old asset, recognizing any gain or loss. Capitalize cost of improvement/replacement.

Rearrangement and Reinstallation

(a) If original installation cost is known, account for cost of rearrangement/reinstallation as a replacement (carrying value known).

(b) If original installation cost is unknown and

rearrangement/reinstallation cost is material in amount and benefits future periods, capitalize as an asset.

(c) If original installation cost is unknown and

rearrangement/reinstallation cost is not material or future benefit is questionable, expense the cost when incurred.

Repairs (a) Ordinary: Expense cost of repairs when incurred.

(b) Major: As appropriate, treat as an addition, improvement, or replacement.




LEGAL NOTICE







CHAPTER 11

DEPRECIATION, IMPAIRMENTS, AND DISPOSITION


Disclosure of Accounting Policies Section 1505 IAS 8

Accounting Changes Section 1506 IAS 8

Property, Plant, and Equipment Section 3061 IAS 16

Depreciation Section 3061 IAS 16

Investment Property Section 3061 IAS 40

Impairment of Long-lived Assets Section 3063 IAS 36

Long-lived Assets Held for Sale and Discontinued Operations

Section 3475 IFRS 5




LEARNING OBJECTIVES

1. Understand the importance of depreciation, impairment, and disposition from a business perspective.

2. Explain the concept of depreciation and identify the factors to consider

when determining depreciation charges.

3. Identify how depreciation methods are selected.

4. Calculate depreciation using the straight-line, decreasing charge, and activity methods and recognize the effects of using each.

5. Explain the accounting issues for depletion of mineral resources.

6. Explain and apply the accounting procedures for partial periods and a

change in depreciation rate.

7. Explain the issues and apply the accounting standards for capital asset impairment under both IFRS and ASPE.

8. Explain and apply the accounting standards for long-lived assets that are

held for sale.

9. Account for derecognition of property, plant, and equipment.

10. Describe the types of disclosures required for property, plant, and equipment.

11. Analyze a company’s investments in assets.

12. Identify differences in accounting between ASPE and IFRS, and what

changes are expected in the near future.

13. Calculate capital cost allowance in straightforward situations (Appendix 11A).




Chapter Review

Depreciation Process

1. Depreciation, or amortization as it is also called (specifically in reference to intangible assets), is defined in accounting, is the rational and systematic allocation of the cost less residual value of an asset to income over those periods expected to benefit from its use. A substitute value, other than the cost of asset, could be used when the revaluation model is applied. Depreciation is the often-employed term used to reflect depreciation of tangible long lived assets, other than natural resources such as timber, oil, or mineral deposits (depletion). The cost allocation approach is justified because it is objective, whereas using fluctuations in market values of assets is difficult to determine.

2. To calculate depreciation, management and the accountant must establish

(a) the asset components to be depreciated separately, (b) the asset’s depreciable amount, (c) the period over which the asset will be depreciated, and (d) the pattern that best reflects how the asset’s economic benefits are used. Determination of these factors requires the use of estimates.

3. The fixed asset components to recognize separately are based on the

componentization policy developed by management. For instance, the policy should determine how to allocate costs of combined assets that have different components (such as building and land) or how to combine costs of smaller capital items into one if they have the same patterns of consumption.

4. The depreciable amount is the difference between an asset's cost (or

revalued amount if the revaluation model is used) and its residual value. Residual value is the estimated amount a company would receive today on disposal of the asset, less any related disposal costs, if the asset were at the same age and condition it is expected to be in at the end of its useful life. The salvage value is the estimate of the asset’s net realizable value at the end of its life, rather than its value at the end of its useful life to the entity. The salvage value is usually an insignificant amount. In practice, the residual value is most commonly used.

5. The deprecation period of an asset refers to the number of years that asset

is capable of economically providing the service it was purchased to perform. The service life should not be confused with its physical life. For example, a machine may no longer provide a useful service to an organization even




though it remains physically functional. Thus, the estimate of an asset's useful life is dependent upon both the economic factors and the physical factors related to its use. Economic factors are characterized by inadequacy, supersession, and obsolescence. Physical factors relate to wear and tear, decay, and casualties that prevent the asset from performing indefinitely It is important to also consider an asset’s legal life which may limit an asset’s useful life to an entity. For example, leasehold improvements do not provide benefits to an entity beyond the period of the lease term.

Depreciation Methods

6. The depreciation method selected for a particular asset should be

systematic and rational. In other words, the method selected should, to the extent possible, match the probable pattern of decline in an asset's benefits. Conceptually, the selection of a depreciation method should be determined on the basis of which method best meets the objectives of financial reporting in the particular circumstances though management sometimes appears to choose a method for the perceived economic consequences of the choice made. Other considerations that may influence the choice of a depreciation method include simplicity or elimination of some record keeping costs. The choice of method affects both the balance sheet and the income statement, so will affect various rations such rate of return on total assets, debt-to-total assets, and total asset turnover. The method will also affect contractual commitments based on ratios such as management compensation plans and debt covenants.

7. Depreciation methods may be classified as follows (not all of these

methods are covered in the text): a. Activity methods (units of production or use) b. Straight-line methods c. Decreasing charge (accelerated) methods:

i. Declining balance ii. Sum-of-the-years’-digits-method

d. Increasing charge methods e. Special depreciation methods:

i. Group and composite methods. ii. Hybrid or combination methods

This chapter focuses primarily on the straight-line method, the declining balance method, and the activity method.

8. Use of the straight-line method results in a uniform charge to depreciation

expense during each year of an asset's useful life and is considered a




function of the passage of time. This method is based upon the assumption that the decline in an asset's benefits is the same each year. Although the straight-line method is easy to use, it rests on the tenuous assumption that the asset's economic usefulness is constant from year to year.

9. The decreasing charge methods, often called accelerated depreciation or

diminishing balance methods, result in a higher depreciation charge during the early years of an asset's service life and lower charges in later years. This approach is justified on the basis that assets lose a greater amount of service potential in earlier years and thus depreciation should be higher.

10. The declining balance method is an often-used decreasing charge method.

This method uses a constant percentage (e.g., twice the straight-line rate called double-declining balance) applied to an asset's remaining book value each year. Residual value is ignored in the calculation of depreciation under the declining balance method, although depreciation ceases when the asset has been reduced to its residual value.

11. When the activity method (units of use or production, sometimes called a

variable charge approach) is used, depreciation is assumed to be a function of productivity rather than the passage of time. This method is appropriate for assets such as machinery or automobiles where depreciation can be based on units produced or kilometres driven (output measures). One problem associated with the use of this method concerns a before-the-fact estimation of the total output the asset will achieve during its useful life. For this reason, an input measure, such as budgeted machine hours, is an appropriate base. The activity method is particularly relevant for the extractive industry, such as gas and oil reserves. The depreciation of the cost of gas, oil and mining reserves is known as depletion and employs the units of production activity method.

Depletion

12. Depletion refers to the process of recording the consumption of natural

resources (wasting assets). The depletion base for natural resources includes acquisition cost, exploration costs, and intangible development costs, reduced by any residual value related to the land. The depreciation, or depletion expense, is a product cost, becoming a direct cost of the inventory of mineral or petroleum products produced during the period. Tangible assets used in extracting natural resources are normally set up in a separate account and depreciated individually.




13. Depletion is normally based on the number of units extracted during the period, which corresponds to the activity method discussed earlier. A major problem one faces when calculating depletion is estimating recoverable reserves.

14. Companies in the oil and gas industry may currently account for costs using

either the successful efforts approach or the full costing approach. Both successful efforts and full costing are historical cost approaches.

15. Companies that own a single extractive natural resource may gradually

distribute to shareholders their capital investment by paying a liquidating dividend, which is a dividend that exceeds the balance of the Retained Earnings account balance. The portion of the dividend that is a return of the shareholders’ original investment should be debited to Share Premium. In addition, the company must inform shareholders what portion of the dividend is a return of capital and what portion is a return on investment.

Other methods

16. Sometimes a company may choose something other than the common

ones discussed so far or may use the method required by the Canada Revenue Agency for simplicity’s sake. Capital Cost Allowance, or tax depreciation, is explained in more detail in the appendix.

Depreciation and Partial Periods

17. In general, depreciation should be based on the number of months an asset

is used during an accounting period. If a decreasing charge depreciation method is used for assets purchased during an accounting period, a slight modification is appropriate. When this situation occurs, determine depreciation expense for the full year and prorate the expense between the periods involved. This process continues throughout the service life of the asset.

Revision of Depreciation Rates

18. The estimates involved in the depreciation process are sometimes subject to

revision as a result of unanticipated occurrences. These estimates must be reviewed regularly and at least at each fiscal year end under IFRS. Such revisions are classified as changes in accounting estimates and should be handled in the current and prospective periods rather than changing previously reported results.




Depreciation Not a Source of Cash

19. Depreciation expense reduces net income for the accounting period in which it is recorded, even though a current cash outflow is not involved. However, depreciation should not be considered a source of funds. Cash is generated by revenues not by accounting procedures.

Impairments (Write-downs)

20. If an investment property is measured at fair value and its usefulness to

the company is significantly reduced, the remeasurement of the asset to fair value automatically recognizes the reduction and the loss is reflected in net income. However, this is not the case for assets measured under the cost or revaluation model. Assets measured under the cost or revaluation model are reported at cost or at fair value at the most recent revaluation date less accumulated depreciation. When the carrying value (cost less accumulated depreciation) exceeds its future economic benefits to the company it is considered to be impaired.

21. Recognition of the impairment loss can be accomplished by using different

models. One approach is the cost recovery impairment model that concludes that a long-lived asset is impaired only if an entity cannot recover the asset’s carrying amount from using the asset and eventually disposing of it. A second approach is the rational entity impairment model which assumes a company makes rational decisions in managing its long-term assets in that the company is likely to continue to use the asset if its use and later disposal generates a higher return than it would if it were currently disposed of.

The cost recovery model is used by ASPE and U.S. GAAP. The loss with this approach is charged to income and an Accumulated Impairment Losses account and once an asset has been written down in this way, no reversal is allowed even if the net recoverable amount increases.

22. The rational entity model is used by IFRS and the loss is recognized in net

income. However if the asset is accounted for under the revaluation model, the loss is charged first to comprehensive income to any revaluation surplus that exists for that asset and only the excess recognized in net income. A portion of the impairment loss may be reversed in the future, but not to an amount more than its carrying amount would have been if the impairment had not been recognized.




23. Under IFRS, the impairment test compares the asset’s recoverable amount with its carrying amount. If the carrying amount exceeds the recoverable amount, the difference is an impairment loss. If the recoverable amount is greater than the carrying amount there is no impairment.

a. The recoverable amount is the higher of fair value less cost to sell or value-in-use.

b. Fair value less cost to sell is the price that the asset could be sold for less costs of disposal.

c. Value-in-use is the present value of the cash flows expected from the future use and eventual sale of the asset. The appropriate discount rate is the company’s pretax borrowing rate.

d. If either the fair value less cost to sell or value-in-use is higher than the carrying value, there is no impairment.

e. If both the fair value less cost to sell and value-in-use are lower than the carrying amount, an impairment loss must be recorded.

24. The entry to record an impairment loss on a depreciable asset consists of a

debit to Loss on Impairment and a credit to either the asset account or the related accumulated depreciation account. The loss is reported in the “Other income and expense” section of the income statement. Depreciation for the subsequent periods, assuming straight-line depreciation, is calculated as follows:

Revised Book Value – Estimated Residual Value

Remaining Useful Life

= Annual Depreciation Charge

25. Under IFRS, if a review in a future period indicates that a depreciable asset in use is no longer impaired because the recoverable amount is higher than the carrying amount, the impairment loss may be reversed. The amount of the recovery of the loss is limited to the carrying value that would result if the impairment had not occurred. The entry to record the recovery consists of a debit to the accumulated depreciation account and a credit to Recovery of Impairment Loss. The recovery is reported in the “Other income and expense” section of the income statement.

26. When it is not possible to assess a single asset for impairment because it

generates cash flows only in combination with other assets, the company




should identify the smallest group of assets that can be identified that generate cash flows independently of the cash flows from other assets. This group is called a cash-generating unit (CGU).

Held for Sale and Derecognition of Assets

27. When a plant asset is derecognized, the accounting records should be relieved of the cost and accumulated depreciation associated with the asset. Depreciation should be recorded on the asset up to the date of derecognition, and any resulting gains or losses should be reported. Typically, derecognition occurs on the date of disposal but management may derecognize earlier if it is believed that no further economic benefits will be gained from the asset, either by use or disposal. Plant assets may be retired voluntarily or disposed of by sale, exchange, involuntary conversion, or abandonment. When a long-lived asset is to be disposed of by sale, it would first be classified as held for sale and then remeasured to its net realizable value, which is the lower of its carrying amount and fair value less cost to sell. Assets classified as held for sale are not depreciated during the period in which they are held.

28. When a company donates or contributes an asset, the gift is recorded as an

expense and is measured at the asset’s fair value with the difference between the fair value and carrying value being recorded as a gain or loss.

Presentation, Disclosure, and Analysis

29. The basis for valuing property, plant, equipment, and natural resources, which

is normally historical cost, should be disclosed in the financial statements along with any pledges, liens, and other commitments related to these assets. Normally, assets not used in a productive capacity (held for future use or as an investment) should be segregated from assets used in operations and classified as “Other Assets.” Financial statement disclosures related to depreciation include:

a. Depreciation expense for the period.

b. Balances of major classes of depreciable assets, by nature and function.

c. Accumulated depreciation, either by major classes of depreciable assets or in total.




d. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets.

30. Both publicly traded and privately held companies engaged in significant oil

and gas producing activities are required to disclose (a) the basic method of accounting for those costs incurred in oil and gas producing activities and (b) the manner of disposing of costs relating to oil and gas producing activities. Public companies must also disclose information about reserve quantities; capitalized costs; acquisition, exploration, and development activities; and a standardized measure of discounted future net cash flows related to proven oil and gas reserve quantities.

31. Analysts evaluate assets relative to activity (turnover) and profitability. The

asset turnover ratio measures how efficiently a company used its assets to generate sales. The ratio divides net sales by average total assets. The resulting number is the sales dollars generated by each dollar invested in assets. The profit margin on sales ratio indicates the amount of profit generated by each dollar of sales. The ratio divides net income by net sales. The rate of return on assets ratio combines the asset turnover ratio and the profit margin on sales ratio. The ratio indicates the amount of profit generated for each dollar invested in assets. The ratio divides net income by average total assets.

IFRS and ASPE Comparison

32. With a few exceptions, ASPE is similar to IFRS, with the most significant difference being related to the IFRS requirement for using the impairment models. Text Illustration 11-23 summarizes the differences in chart form.

Capital Cost Allowance

33. The tax method of capital cost allowance establishes the maximum

depreciation that may be taken each year for tax purposes. Assets are categorized by asset classes, for which a maximum capital cost allowance is specified. One-half of this rate is applied to net additions to the class made during the tax year, while the full rate is applied to remaining un-depreciated capital cost. While some companies may be tempted to apply the CCA approach to determine depreciation for financial statement purposes (avoid two "sets of books") it must be recognized that the objectives of financial statement reporting are different from tax determination when choosing a depreciation method.




34. Accounting problems associated with the tax method of capital cost allowance determination include accounting for additions, retirements, and asset class elimination and are briefly examined.

35. In most non-English speaking nations, companies are not permitted to use one

depreciation method for financial statements and a different method for tax returns. The financial statements must conform to the tax return.




Lecture Outline

A. Depreciation: Procedures to indicate that the service potential of an asset has declined. Depreciation is the term frequently used to indicate depreciation of tangible long lived assets; amortization is commonly used for intangible assets; and depletion for natural resources. Depreciation and depletion are discussed in this chapter. Amortization of intangible assets is discussed in Chapter 12.

1. Depreciation is a process of cost allocation in a systematic and rational

manner over those periods expected to benefit from its use. A substitute value, other than the cost of asset, could be used when the revaluation model is applied.

2. Factors to be considered in the depreciation process:

a) the asset components to be depreciated separately

b) the asset’s depreciable amount

c) the period over which the asset will be depreciated

d) the pattern that best reflects how the asset’s economic benefits are used.

Determination of these factors requires the use of estimates.

3. Fixed asset components: Separate recognition based on the

componentization policy developed by management.

3. Depreciable Base: Function of original cost and residual (salvage) value.

4. Useful Life: Depends on various factors:

a. Physical factors such as wear and tear. b. Economic factors such as obsolescence c. An asset’s legal life.

B. Methods of Cost Apportionment.

1. Activity Methods: Assumes that depreciation is a function of use and

the life of the asset is expressed in terms of either the output it provides (e.g., units produced) or the input available (e.g., number of




hours it works). An estimate of units of output or service units is often difficult to make. This method is not appropriate when depreciation is a function of the passage of time instead of activity.

2. Straight-line Method: This method is widely used because of its

simplicity in charging a constant amount each period. It assumes the asset's economic usefulness is the same each year and that repair and maintenance are essentially the same each year.

3. Decreasing Charge Methods: Justified on the grounds that, since

the asset is more efficient in the earlier years, more depreciation should be charged in those years. Note that the CCA method allowed for tax purposes is a form of decreasing charge method (covered in Appendix). Specifically covered in this chapter is the:

Declining Balance Method. The declining balance rate remains constant and is applied to a declining book value. In this method, residual value is ignored in the calculation, but the asset may not be depreciated below residual value.

1. Selection of a depreciation method.

a. Ideally, the method that most fairly reflects net income should be

chosen (matching expense against benefits in a rational manner).

b. Practically, the method chosen may be the one that minimizes bookkeeping expenses or satisfies other purposes (e.g., impact on ratios or amounts that are important in contractual arrangements such as debt covenants and management compensation plans). Discuss appropriateness of these factors.

TEACHING TIP

Illustration 11-1 provides a graphical example of the effects of the different depreciation methods on carrying amount.

C. Depletion: Used for natural resources that are physically consumed over the period of use, such as petroleum and minerals.

1. Establishment of depletion base. The costs of natural resources are

divided into:




a. Acquisition costs.

b. Exploration costs. A successful efforts or full costs approach may be followed. Discuss the conceptual merits of these approaches.

c. Development costs. This includes both tangible equipments, not

included in the depletion base, and intangible development costs, which are included in the depletion base.

2. Write-off of Resource Cost. Normally the unit of production method is

used.

TEACHING TIP

Illustration 11-3 reflects the flow of asset costs to the income statement. Emphasize that depletion cost is recognized in the period that units are withdrawn. If units are not sold, depletion costs become a product cost and are inventoried.

3 Status of oil and gas industry. Both the successful efforts method and the full-cost method are acceptable in Canada.

4. Special problems in depletion accounting.

a. Estimating recoverable reserves.

b. Future removal and site restoration costs.

c. Liquidating dividends.

D. Special Depreciation Problems.

1. Partial Periods: Many methods are applied and are acceptable as

long as they are used consistently.

2. Depreciation and Replacement: Depreciation does not provide funds (cash) for replacements.

3. Revision of estimates: Estimates must be reviewed regularly and at

least at each fiscal year end under IFRS. Changes in estimates of




residual value or useful life are shown in current and prospective periods. They are treated as changes in estimates.

TEACHING TIP

Illustration 11-2 provides a graphical example of a revision in estimated residual value under the straight-line method.

E. Impairment of value (write-downs): If an investment property is measured at fair value and its usefulness to the company is significantly reduced, the remeasurement of the asset to fair value automatically recognizes the reduction and the loss is reflected in net income. Discuss:

Discuss the two models for measuring impairment losses

o the cost recovery impairment model - concludes that a long-lived asset is impaired only if an entity cannot recover the asset’s carrying amount from using the asset and eventually disposing of it § The cost recovery model is used by ASPE and

U.S. GAAP. The loss with this approach is charged to income and an Accumulated Impairment Losses account and once an asset has been written down in this way, no reversal is allowed even if the net recoverable amount increases.

o the rational entity impairment model - assumes a

company makes rational decisions in managing its long- term assets in that the company is likely to continue to use the asset if its use and later disposal generates a higher return than it would if it were currently disposed of. § The rational entity model is used by IFRS and the

loss is recognized in net income. However if the asset is accounted for under the revaluation model, the loss is charged first to comprehensive income to any revaluation surplus that exists for that asset and only the excess recognized in net income. A portion of the impairment loss may be reversed in the future, but not to an amount more than its carrying amount would have been if the impairment had not been recognized.




F. Other Issues a) Derecognition and Held for Sale Assets

a. Derecogntion of Asset: Depreciation should be recorded on the asset up to the date of derecognition, and any resulting gains or losses should be reported. Plant assets may be retired voluntarily or disposed of by sale, exchange, involuntary conversion, or abandonment.

b. Held for Sale Assets: When a long-lived asset is to be disposed of by sale, it is first classified as held for sale and then remeasured to its net realizable value, which is the lower of its carrying amount and fair value less cost to sell. Assets classified as held for sale are not depreciated during the period in which they are held.

c. Donated asset – the gift is recorded as an expense and is measured at the asset’s fair value with the difference between the fair value and carrying value being recorded as a gain or loss.

b) Presentation & Disclosure – based on needs of users and is very

extensive under IFRS, less so under ASPE.

c) Analysis – long lived assets are significant – discuss the use of asset turnover and rate of return on assets in assessing the efficiency of asset use and return on investment .

G. IFRS and ASPE Comparison

With a few exceptions, ASPE is similar to IFRS, with the most significant difference being related to the IFRS requirement for using the impairment models. Text Illustration 11-23 summarizes the differences in chart form.

H. Capital Cost Allowance Method—Appendix 11A

a) The capital cost allowance (CCA) method is required for income tax

purposes in Canada, regardless of which method is used for financial reporting purposes. The mechanics of this method are similar to the declining balance method. The Income Tax Act specifies the rate to be used for an asset class and CCA is calculated separately for each assets class.

b) When the disposal of an asset results in the elimination of an asset

class, the following may result:




i. A recapture of capital cost allowance, with or without a capital gain.

ii. A terminal loss, with or without a capital gain. This occurs only when the last asset in the class is disposed of, and an undepreciated capital cost balance still exists in the class after deducting the appropriate amount on the disposal of the asset.

iii. In most non-English-speaking nations, companies are not permitted to use one depreciation method for financial statements and a different method for tax returns. The financial statements must conform to the tax return.




ILLUSTRATION 11-1

Possible Benefit Patterns for Assets

Pattern (1): assets that provide roughly the same level of benefits in each year of their life. For these assets, a straight-line method is rational because it results in a constant depreciation expense each period. Example: warehouse

Pattern (2): assets that provide a decreased level of benefits in each year of their life. For these assets, a decreasing benefit pattern should be used because depreciation expense will decline each year. Example: airplane

Pattern (3): assets that provide a fluctuating level of benefits in each year of their life. For these assets, a fluctuating benefit pattern should be used because depreciation will vary from period to period. Example: the use of a truck

Pattern (4): assets that provide an increased level of benefits in each year of their life. For these assets, an increasing benefit pattern should be used because their benefits increase as they age. This pattern is seldom applicable as very few assets provide more service potential or generate higher value cash flows as they age.




ILLUSTRATION 11-2

Change of estimates: straight-line method

Original cost $10,000

$1050/year

Original schedule = $900/year

Revised schedule =

Original estimate of residual value = $1,000 Revised estimate of residual value = $100 0 4 years

Time

End of useful life = 10 years

Original cost = $10,000 Estimated useful life = 10 years Initial estimate of residual value = $1,000 Depreciation per year = $900 Revised estimate of residual value = $100 Time of change: During the fifth year (i.e., have taken four years depreciation)

$1,00(09$40)0$1000 Revised depreciation = $6,3$01,0p0e5r year 0

6 6




Gets

ILLUSTRATION 11-3

Flow of asset cost

Over time

ASSETS (Balance Sheet Debits)

EXPENSES (Income Statement Debits)

INVENTORY

PROPERTY, PLANT, & EQUIPMENT

NATURAL RESOURCES

INVENTORY OF PROCESSED RESOURCES

INTANGIBLE ASSETS

Gets Sold

Wears Out

Extracted and

Processed

Gets Sold

Benefits Expire

COST OF

GOODS SOLD

DEPRECIATION EXPENSE

DEPLETION EXPENSE

COST OF GOODS SOLD RESOURCES

DEPRECIATION EXPENSE




LEGAL NOTICE







CHAPTER 12

INTANGIBLE ASSETS AND GOODWILL


Business Combinations Section 1582 IFRS 3

Goodwill and Intangible Assets Section 3064 IAS 38

Impairment of Long-Lived Assets Section 3063 IAS 36

Non-monetary transactions/Exchange of Assets

Section 3831 IAS 38




LEARNING OBJECTIVES

1. Understand the importance of intangible assets and goodwill from a business perspective.

2. Define and describe the characteristics of intangible assets.

3. Identify and apply the recognition and measurement requirements for

purchased intangible assets.

4. Identify and apply the recognition and measurement requirements for internally developed intangible assets.

5. Explain how intangibles are accounted for after initial recognition.

6. Identify and explain the accounting for specific types of intangible assets.

7. Explain and account for impairments of limited-life and indefinite-life

intangible assets.

8. Explain the concept of goodwill and how it is measured and accounted for after acquisition.

9. Identify the types of disclosure requirements for intangible assets and

goodwill and explain the issues in analyzing these assets.

10. Identify differences in accounting between ASPE and IFRS

11. Explain and apply basic approaches to valuing goodwill (Appendix 12A).




CHAPTER REVIEW

1. Chapter 12 discusses the identification, measurement, and impairment of intangible assets and goodwill. Intangible assets are generally recognized only when it is acquired in a purchase and sale transaction and are measured at their cost and adjusted downward to reflect their future benefit to the entity as of the end of each fiscal period.

Intangible Asset Issues

2. The characteristics of intangible assets are: (1) they are identifiable, (2) they lack physical existence, and (3) they are not monetary assets.

a. Identifiability – An asset is identifiable if it has at least one of the

following characteristics: it results from contractual or other legal rights, or it is separable—it can be separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either by itself or in combination with another contract, identifiable asset, or liability.

b. Non-physical existence – value comes from the rights and privileges

granted to the company that uses them.

c. Non-monetary – As identified above, intangible assets are characterized by a non physical existence. Bank deposits, accounts receivable, and long-term investments also lack physical substance, and they are not classified as intangible assets, but as financial instruments. However the value of these assets comes from the right or claim to receive fixed or determinable amounts of money in the future, whereas intangible assets do not have these rights or claims.

3. Intangible assets:

provide economic benefits over a period of years are normally classified as long term assets include patents, copyrights, franchises or licensing agreements, trademarks, trade names, secret formulas, computer software, technological knowledge, prepayments, and some development costs.




4. Recognition and measurement: Similar to property, plant, and equipment, intangible assets are recognized when it is probable that the entity will receive the expected future economic benefits, and the asset’s cost can be measured reliably. Cost is the appropriate basis for recording purchased intangible assets. Again like property, plant, and equipment, cost includes acquisition price and all other expenditures necessary in making the asset ready for its intended use. When intangibles are acquired for consideration other than cash, the cost of the intangible is the fair market value of the consideration given or the intangible asset, whichever is more clearly evident.

5. Prepayments are recognized as an asset only when an entity pays for

goods before their delivery.

6. Costs incurred internally to create intangible assets are generally expensed as incurred. This is due to the uncertainty of the future benefits to be derived from the specific expenditure. IFRS requires that costs for internally generated intangible assets can be capitalized when certain criteria are met. Because of the uncertainty of whether an asset should be recognized, two phases are considered:

a. Research Phase – expensed as incurred.

b. Development Phase – an entity capitalizes development costs only

when the future benefits are reasonably certain - must meet six criteria: i. Technical feasibility of completing the intangible asset; ii. The entity’s intention to complete it for use or sale; iii. The entity’s ability to use or sell it; iv. Availability of technical, financial, and other resources needed to

complete it, and to use or sell it; v. The way in which the future economic benefits will be received;

including the existence of a market for the asset if it will be sold, or its usefulness to the entity if it will be used internally; and

vi. The ability to reliably measure the costs associated with and attributed to the intangible asset during its development.

7. When all six criteria are met, direct costs attributable to create, produce,

and prepare the intangible asset to operate in the way intended by management are accumulated and capitalized.




8. Recognition and Measurement after Acquisition – most after acquisition costs are expensed. After initial recognition, the cost model (CM) and revaluation model (RM) are used to measure intangible assets. The CM is the most widely used and the only one allowed under ASPE. IFRS allows both, but the revaluation model can only be used if the asset has a fair value determined in an active market, so its use is limited. Accounting under these two models is the same for intangible assets as it is for property, plant, and equipment.

9. The accounting standards prior to 2001 required that all intangibles be

amortized over their useful life, not exceeding 40 years. In 2001, the CICA Accounting Standards Board replaced the “one size fits all” approach to the treatment of intangibles subsequent to acquisition. This approach takes into consideration the differing nature of the particular intangible. Only intangibles that have a determinable or limited life are amortized.

10. Specifically identifiable (cost of creating the intangible can be identified)

may have a determinable or limited life. Thus, their cost less residual value should be amortized over the period the asset is expected to generate future economic benefits, using either the cost model or revaluation model. Due to uncertainties, residual value is generally assumed to be zero, unless there is an observable market for the asset, and it is expected to exist at the end of its useful life. IFRS requires companies to assess the estimated residual values and useful lives of intangible assets least annually. Companies must also evaluate intangibles annually for impairment. If there is an indication of impairment, an impairment test is performed.

11. Factors considered in determining useful life are:

a. The expected use of the asset or of a related group of assets(s) by the

entity; b. Any legal or regulatory provisions that may limit the useful life; c. Any legal or regulatory provisions that enable renewal or extension of

useful life; d. The effects of obsolescence, competition, and other economic factors; e. The level of maintenance expenditure required to obtain the expected

level of cash flows from the asset.




12. Intangibles are often classified into one of five major categories (excluding goodwill):

a. Marketing-related intangible assets are those assets primarily used

in the marketing or promotion of products or services. Examples are trademarks or trade names, newspaper masthead, Internet domain names, and noncompetition agreements. Trademarks are a common form of a marketing-related intangible. A trademark or trade name is a word, phrase, or symbol that distinguishes or identifies a particular enterprise or product. If a trademark or trade name is purchased, its capitalized cost is the purchase price and other direct costs of acquisition. If a trademark or trade name is developed by the enterprise itself, the capitalized cost includes only legal fees, registration fees, design costs, consulting fees and other expenditures directly related to securing it (excluding research costs, which must be expensed). Trademark registrations in Canada last for 15 years, and are renewable at a reasonable cost. Although the legal life of such assets may be unlimited, in practice they may only provide benefits to the enterprise over a finite period. Trademarks can, however, be determined to provide benefits to an enterprise indefinitely. In this case, the intangible asset is not amortized.

b. Customer-related intangible assets occur as a result of interactions

with outside parties. Examples are customer lists, order or production backlogs, and both contractual and non-contractual customer relationships.

c. Artistic-related intangible assets involve ownership rights to plays,

literary and musical works, paintings, sculptures, photography, etc. These rights are protected by copyrights. A copyright is a federally granted right that authors and other artists have in their creations. A copyright is granted for the life of the creator, plus 50 years. During this time, the owner or heirs have the exclusive right to reproduce and sell an artistic or published work. Generally, the copyright’s useful life is less than its legal life. The costs of the copyright (acquisition and successfully depending the copyright) should be allocated to the years in which the benefits are expected to be received. The difficulty in determining the benefit period for a copyright generally encourages companies to amortize these costs over a fairly short period of time.




d. Contract-related intangible assets represent the value of rights that arise from contractual agreements. Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts. A franchise is a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products or services, to use certain trademarks or trade names, or to perform certain functions, usually within a designated geographical area. A license or permit is the arrangement commonly entered into by a governmental body and a business enterprise that uses public property. Franchises and licenses can have limited or indefinite lives. The cost of a franchise (or license) with a limited life should be amortized as operating expense over the life of the franchise; whereas those with an indefinite life should be carried at cost and not amortized. A second type of contract-related intangibles is a leasehold. Leasehold is a contractual right for the use of specific property for a specified period of time. If rent is paid in advance, the amount is most appropriately included in the current or other asset category (e.g., prepaid expenses).

Improvements made to leased property normally revert to the lessor at the end of the lease. Thus, the cost of leasehold improvements should be capitalized by the lessee, and amortized over the life of the lease or the useful life of the improvement, whichever is shorter. Leasehold improvements are generally classified as tangible assets, although some accountants classify them as intangible assets.

e. Technology-related intangible assets relate to innovations or

technological advances. Examples are patented technology and trade secrets. A patent gives the holder exclusive right to use, manufacture, and sell a product or a process for a period of 20 years without interference or infringement by others. Amortization is recorded over its useful life, which is often shorter than its legal life. Any legal costs incurred to secue a patent or to successfully defend a patent suit may be capitalized; however, research and development costs related to the development of a product, process, or idea that is subsequently patented must be expensed as incurred, except for development costs when all of the six criteria listed above are satisfied.




Impairment and Derecognition

13. As with tangible capital assets, the pattern of recognizing amortization expense should be consistent with the way the enterprise benefits from the asset’s use. Limited-life intangibles are evaluated for impairment. An impairment loss is recognized if the intangible’s carrying amount is not recoverable and/or its carrying amount exceeds its fair value.

14. Identifiable intangibles generate specifically identifiable cash flow

streams, singly or in combination with other assets. Examples include a contractual right to lease space at favourable rates or a customer list. Goodwill and other intangibles, on the other hand, do not generate identifiable cash flow streams on their own, are not separable from the rest of the entity, and control over future benefits does not result from a contractual or legal right.

15. For accounting purposes, identifiable intangible assets are recognized

separately from goodwill if control over the future economic benefits is obtained through contractual or other legal rights or if the asset can be separated or divided and sold, transferred, licensed, rented, or exchanged. Intangibles acquired in a business combination that do not meet either of these two conditions become part of the residual goodwill.

16. Limited Life Intangibles:

The same impairment models and standards that apply to long-lived

tangible assets also apply to limited-life intangibles. ASPE requires that limited-life intangibles be tested for

impairment whenever events and circumstances indicate the carrying value may not be recoverable.

IFRS requires this assessment at the end of each reporting period. The asset is formally tested by applying the appropriate impairment model – the cost recovery impairment model (ASPE) or rational entity impairment model (IFRS). Reversal of the impairment loss is limited and only applicable under the rational entity impairment model.




17. Indefinite-Life Intangibles:

Under ASPE, they are tested for impairment whenever events and circumstances indicate the carrying value may not be recoverable, in which case the fair value test is applied. This impairment test differs from the one used for limited-life intangibles in that there is no recoverability test. The indefinite-life intangible’s carrying amount is compared directly with its fair value and written down where fair value is lower. The recoverability test does not apply to indefinite-life intangibles, as it would be impossible to measure the future cash flows objectively.

Under IFRS, the only difference in testing from limited life intangibles is that the testing must be done at least annually regardless of whether impairment appears to exist.

18. Derecognition

An intangible asset is derecognized when it is disposed of or is no longer expected to generate future economic benefits and the gain or loss recognized in income.

Goodwill

19. Goodwill generated internally should not be capitalized in the accounts, because of the complexity in measuring the components of goodwill and in associating any costs with future benefits. Goodwill is recorded only when an entire business is purchased, because goodwill cannot be separated from the business as a whole. Goodwill is measured in a business purchase by computing the difference between the fair value of the net assets purchased and their bargained-for price.

20. A bargain purchase, often called negative goodwill, arises when the fair

value of the net assets acquired is higher than the purchase price of the assets. When negative goodwill exists, the excess is recognized as a gain only when all variables, values, and measurement procedures have been reassessed.




21. The standard setters in both Canada and the U.S. have concluded that most goodwill has value that is maintained, similar to identifiable intangibles with an indefinite life. Therefore goodwill should not be amortized under any circumstances. If IFRS is being followed, goodwill is assigned to a cash generating unit (CGU) and if ASPE is being followed, goodwill is assigned to a reporting unit. The carrying amount of this goodwill is reduced when it is found to be impaired or is associated with assets to be sold or disposed of.

Impairment of Goodwill

22. Because of the significance of purchased goodwill, it is important to stipulate when impairment tests should be carried out.

IFRS requires that an assessment of the estimated value of goodwill

be done on an annual basis or on an interim basis if circumstances indicate the CGU may be impaired.

ASPE requires this assessment when events or changes in circumstances indicate impairment. A goodwill impairment reversal is not allowed under either IFRS or ASPE.

23. A) Under ASPE, the impairment test compares the carrying amount of the

reporting unit with its fair value. The impairment test for goodwill is a two-step process:

a. Compare the fair value of the reporting unit with its carrying

amount, including goodwill. If the fair value exceeds the carrying amount, goodwill is considered not to be impaired. If not proceed to step b.

b. Calculate the implied current fair value of goodwill, and compare

this fair value with the carrying amount. If fair value is less than carrying amount, then an impairment has occurred.

The loss is allocated to goodwill as a goodwill impairment loss (note that impairment test for other assets in the group is done before the goodwill impairment test)




B) Under IFRS the process is similar, only the comparison looks at the recoverable amount of the CGU and its carrying value to determine impairment. Under IFRS, a goodwill impairment loss is recorded if the test shows that the carrying amount of the CGU including goodwill is greater than the recoverable amount. (Recoverable amount is the higher of value in used and fair value less costs to sell). The impairment loss is allocated first to goodwill, then remainder to other assets on a relative carrying amount (proportionate amount).

Under both ASPE and IFRS a goodwill impairment reversal is not allowed.

24. Presentation, Disclosure, and Analysis

As with other disclosure requirements, ASPE is limited because users can assess additional information available to them. Under IFRS, disclosure needs to be sufficient to allow users to assess the changes in the different classes of intangible assets, how the changes came about, the use of fair value measurements, and impairment calculations.

25. Analysis must consider disclosures and other financial reports provided

regarding intangible assets that do not appear on the statement of financial position because they are subject to measurement uncertainty or because they don’t meet the criteria to be capitalized (such as knowledge assets or intellectual property).

26. On the statement of financial position, goodwill is the only intangible

requiring separate, single line item disclosure. All other intangibles should be aggregated and reported as a separate line item on the statement of financial position. For intangibles subject to amortization, disclosure is required of the amortization methods and rates used, as well as the amount of amortization expense charges to income for the period.

27. Impairment losses associated with intangibles do not require separate line

disclosure on the income statement, but a description of each impaired asset and details related to the amount of the loss must be disclosed.




Comparison of IFRS and ASPE

28. Refer to Text Illustration 12-16 for a comparison of the differences and similarities in accounting for intangible assets and goodwill under IFRS and ASPE.

Appendix 13A—Excess Earnings Approach to Valuing Goodwill

29. The excess earnings approach calculates difference between the annual normalized earnings of the company and the annual average earnings if it was to generate a rate of return similar to that of a firm in the same industry. The excess earnings amount is then discounted to estimate the value of goodwill.




LECTURE OUTLINE

This chapter can be covered in one or two class sessions. As students have likely been introduced to intangibles in previous accounting classes, additional emphasis should be placed on the most recent developments in accounting for intangibles.

A. Nature of Intangible Assets: Characterized by a lack of physical exis-

tence and a high degree of uncertainty concerning future benefits.

1. Intangibles may be categorized by these characteristics:

a. Identifiability (must be separately identifiable or result from contractual or other legal rights);

b. Non physical existence

c. Non-monetary

2. Intangible assets:

provide economic benefits over a period of years are normally classified as long term assets include patents, copyrights, franchises or licensing agreements, trademarks, trade names, secret formulas, computer software, technological knowledge, prepayments, and some development costs. Often classified into 5 major categories (excluding goodwill):

o Marketing-related intangible assets (such as trademarks) o Customer-related intangible assets (such as customer lists) o Artistic-related intangible assets (such as copyrights) o Contract-related intangible assets (such as franchises or

licenses) o Technology-related intangible assets (such as patents)




B. Recognition and Measurement:

At Acquisition:

1. Intangible assets are recognized when it is probable that the entity will receive the expected future economic benefits, and the asset’s cost can be measured reliably. Initially, intangibles should be recorded at cost, which includes all expenditures necessary to make the intangible asset ready for its intended use. When intangibles are acquired for consideration other than cash, the cost of the intangible is the fair market value of the consideration given or the intangible asset, whichever is more clearly evident.

2. Borrowing costs can be capitalized if directly attributable to the asset

and incurred during the acquisition, construction, or development stage. Prepayments are recognized as an asset only when an entity pays for goods before their delivery.

3. Costs incurred internally to create intangible assets are generally

expensed as incurred due to the uncertainty of the future benefits to be derived from the expenditures. Exception: IFRS allows costs for internally generated assets to be capitalized when certain criteria are met – two phases are then considered:

a. Research phase – generally expensed b. Development phase – capitalized when future benefits are

reasonably certain – 6 criteria must be met, including: i. Technical feasibility of completing the intangible asset ii. The entity’s intention to complete it for use or sale iii. The entity’s ability to use or sell it iv. Availability of technical, financial, and other resources

needed to complete it, and to use or sell it v. The way in which the future economic benefits will be

received; including the existence of a market for the asset if it will be sold, or its usefulness to the entity if it will be used internally

vi. The ability to reliably measure the costs associated with and attributed to the intangible asset during its development




Amortization

4. Specifically identifiable (cost of creating the intangible can be identified) may have a determinable or limited life. Thus, their cost less residual value should be amortized over the period the asset is expected to generate future economic benefits, using either the cost model or revaluation model. Due to uncertainties, residual value is generally assumed to be zero, unless there is an observable market for the asset, and it is expected to exist at the end of its useful life. Factors to consider in determining useful economic life can include:

a. The expected use of the asset or of a related group of assets(s)

by the entity;

b. Any legal or regulatory provisions that may limit the useful life;

c. Any legal or regulatory provision that enable renewal or extension of useful life;

d. The effects of obsolescence, competition, and other economic factors; and

e. The level of maintenance expenditure required to obtain the expected level of cash flows from the asset.

TEACHING TIP

Illustration 12-1 is provided as a summary of the process of evaluating intangibles after acquisition.

5. After Acquisition Measurement: In general, most after acquisition costs are expensed. Two models are used to measure intangibles after acquisition – the cost model (CM) and the revaluation model (RM). The CM is the most widely used and the only one allowed under ASPE. IFRS allows both, but the revaluation model can only be used if the asset has a fair value in an active market, so its use is limited. Accounting under these two models is the same for intangible assets with both limited and unlimited lives except for unlimited lives, the amortization amount would be 0.




TEACHING TIP

Illustrati on 12 -2 p ro vide s a comparis on of the cost method and the re valuat ion method – this is a lso Il lus tratio n 12 -3 in the t ext .

C. Impairment

1. Both limited-life intangibles and unlimited life intangibles are evaluated for impairment. An impairment loss is recognized if the intangible’s carrying amount exceeds its fair value (cost recovery impairment model used for ASPE) or its carrying amount is less than its recoverable amount (rational entity impairment model used for IFRS).

2. Limited-life intangibles:

Timing of impairment testing:

i. whenever events and circumstances indicate the carrying value may not be recoverable (ASPE), or

ii. at the end of each reporting period (IFRS). Method of applying the test: The asset is formally tested by applying the appropriate impairment model

i. the cost recovery impairment model (ASPE), or ii. rational entity impairment model (IFRS).

1. Reversal of the impairment loss is limited and only applicable under the rational entity model.

2. Recoverability test: applicable under ASPE only (under the cost recovery impairment model).

3. Indefinite-Life Intangibles:

a. Under ASPE, they are tested for impairment whenever events

and circumstances indicate the carrying value may not be recoverable, but the fair value test is applied. This impairment test differs from the one used for limited-life intangibles in that there is no recoverability test. The indefinite-life intangible’s carrying amount is compared directly with its fair value and written down where fair value is lower. The recoverability test does not apply




to indefinite-life intangibles, as it would be impossible to measure the future cash flows objectively.

b. Under IFRS the only difference compared to testing for limited-life intangibles is that the testing must be done at least annually regardless of whether impairment appears to exist.

T E A C H I N G T I P

Illustrati on 12 -3 pro vide s a comparison of the cost reco very model and the rational entit y impairment model – this is also Illustrati on 12 -5 in the te xt.

4. Derecognition

An intangible asset is derecognized when it is disposed of or is no longer expected to generate future economic benefits and the gain or loss recognized in income.

D. Goodwill: The most complex and controversial asset presented in financial statements.

1. Goodwill is only recorded when an entire business entity is

purchased, because goodwill is a "going concern" valuation and cannot be separated from the business as a whole.

2. Recording goodwill:

a. Goodwill is recorded as the excess of the purchase price of an

acquired business over the fair market value of the identifiable net assets acquired.

b. A bargain purchase, often called negative goodwill, arises when the fair value of the net assets acquired is higher than the purchase price of the assets. When negative goodwill exists, the excess is recognized as a gain only when all variables, values, and measurement procedures have been reassessed.




TEACHING TIP

Illustration 12-4 provides a numerical example of recording goodwill at acquisition.

3. If IFRS is being followed, goodwill is assigned to a cash generating unit (CGU) and if ASPE is being followed, goodwill is assigned to a reporting unit. The carrying amount of this goodwill is reduced when it is found to be impaired or is associated with assets to be sold or disposed of.

4. Because of the significance of purchased goodwill, it is important to

stipulate when impairment tests should be carried out. IFRS requires that an assessment of the estimated value of goodwill be done on an annual basis or on an interim basis if circumstances indicate the CGU may be impaired. ASPE requires this assessment when events or changes in circumstances indicate impairment. A goodwill impairment reversal is not allowed under either IFRS or ASPE.

5. Under IFRS, a goodwill impairment test compares the carrying amount

of the CGU with its recoverable amount. Under ASPE, the impairment test compares the carrying amount of the reporting unit with its fair value. The impairment test for goodwill is a two-step process:

a. Compare the fair value of the reporting unit with its carrying

amount, including goodwill. If the fair value exceeds the carrying amount, goodwill is considered not to be impaired. If not proceed to step b.

b. Calculate the implied current fair value of goodwill, and compare this fair value with the carrying amount. If fair value is less than carrying amount, then an impairment has occurred.

Under IFRS the process is similar, only the comparison looks at the recoverable amount of the CGU and its fair value to determine impairment.




6. The entry to record an impairment of goodwill is:

Loss on impairment of goodwill XXX Accumulated impairment losses—goodwill XXX

E. Presentation, Disclosure, Analysis, and Comparison of IFRS and ASPE

1. Presentation, Disclosure, and Analysis As with other disclosure requirements, ASPE is limited because users can assess additional information available to them. Under IFRS, disclosure needs to be sufficient to allow users to assess the changes in the different classes of intangible assets, how the changes came about, the use of fair value measurements, and impairment calculations.

2. Analysis must consider disclosures and other financial reports

provided regarding intangible assets that do not appear on the balance sheet because they are subject to measurement uncertainty or because they don’t meet the criteria to be capitalized (such as knowledge assets or intellectual property).

3. On the statement of financial position, goodwill is the only intangible

requiring separate, single line item disclosure. All other intangibles should be aggregated and reported as a separate line item on the balance sheet. For intangibles subject to amortization, disclosure is required of the amortization methods and rates used, as well as the amount of amortization expense charges to income for the period.

4. Refer to Text Illustration 12-16 in the text for a comparison of the

differences and similarities in accounting for intangible assets and goodwill under IFRS and ASPE.




F. Appendix 12-A discusses the excess earnings power approach and other methods of valuing goodwill.

1. Valuing goodwill:

a. The expected earnings in excess of anticipated normal earnings are often used as an aid in determining the purchase price for a business including an amount for goodwill.

b. The difference between what the firm earns and what is normal in the industry is referred to as excess earnings power.

c. Excess earnings power is attributed to the existence of unidentifiable values (goodwill) that enable an enterprise to have increased earnings.

d. Excess earnings power approach. Problems relate to:

i. Determination of a normal rate of return, ii. Determination of future earnings, iii. Determination of an appropriate discount rate, iv. Determination of the appropriate period.

TEACHING TIP

Use Illustration 12-5 to demonstrate the calculation of a value for goodwill and a purchase price for an acquisition using the excess earnings power approach. The example uses the same problem information as Illustration 12-4.




ILLUSTRATION 12-1

VALUATION OF INTANGIBLE ASSETS AFTER ACQUISITION

IDENTIFIABLE INTANGIBLES

Identifiable AND

Not a financial instrument AND

No physical existence

NO YES

Limited Life Indefinite Life

Expense

Amortize over useful life

Do not

amortize

Test for impairment using the appropriate model.




Illustration 12-2




ILLUSTRATION 12-3




ILLUSTRATION 12-4

RECORDING GOODWILL: VALUATION AT ACQUISITION

EXAMPLE: Global Corporation purchased the net assets of Local Company for $300,000 on December 31, 2014. The statement of financial position of Local Company just prior to acquisition is listed below along with an appraisal of the fair values of its identifiable net assets.

FINANCIAL Local Company POSITION STATEMENT OF FINANCIAL POSITION AND FAIR December 31, 2014 VALUES

Fair Increase Asset Values (Decrease)

Cash $ 15,000 $ 15,000 -0-

Receivables

10,000

10,000

-0-

Inventories (FIFO)

50,000

70,000

20,000

Prop., plant & equip

80,000

130,000

50,000

Total assets

$155,000

$225,000

Current liabilities

$ 25,000

$ 25,000

EQUITIES/ NET ASSETS

$130,000

$200,000





ANALYSIS

PURCHASE FAIR VALUE OF BOOK VALUE OF PRICE (COST) IDENTIFIABLE IDENTIFIABLE

NET ASSETS NET ASSETS $300,000 $ 200,000 $ 130,000

$ 100,000 $ 70,000

GOODWILL REVALUATIONS

December 31, 2014

ACQUISITION Cash 15,000

JOURNAL Receivables 10,000 ENTRY Inventories 70,000 Property, Plant & Equipment 130,000 Goodwill 100,000 Current Liabilities 25,000 Cash 300,000




ILLUSTRATION 12-5

DETERMINATION OF GOODWILL AND PURCHASE PRICE

Step 1: Determine adjusted average net earnings of the firm. Adjust for accounting changes, extraordinary items, and other such items.

Step 2: Determine normal earnings. Multiply the industry average rate of

return times the fair value of the identifiable net assets of the firm.

Step 3: Determine excess earnings. This is the average earnings from Step 1 less the normal earnings from Step 2.

Step 4: Value goodwill. This can be done by using an appropriate discount

rate and choosing the number of periods for which the excess earnings will be maintained. It could be treated as perpetuity. Alternatively, the number of year's method could be used.

Step 5: Determine purchase price. This will be the sum of the value of

goodwill and the fair value of identifiable net assets of the firm.

Apply the 5 steps above to the numerical example given in Illustration 12-4. Emphasize to the students that the Global Corporation would employ an analysis similar to the 5 steps below in order to arrive at an approximate purchase price to be used in the negotiations for the acquisition of Local Company.

Step 1: Determine the average net earnings of Local Company.

Historical earnings: 2010 $21,000 2011 30,000 2012 19,000 2013 55,000

2014 50,000

Total earnings (5 years) $175,000 5 years = $ 35,000 Average Net Earnings




Step 2: Determine normal earnings.

Normal average earnings = 10% (Obtained from industry sources) Rate for industry Industry Average Rate or Return × Fair value of Identifiable Net Assets 10% $ 200,000 = $ 20,000 Normal Earnings

Step 3: Determine excess earnings.

Average net earnings from Step 1 less normal earnings from Step 2.

$ 35,000 – $ 20,000 = $ 15,000 Excess Earnings

Step 4: Value goodwill.

Appropriate discount rate in perpetuity for Global Corporation = 15%.

Divide excess earnings by discount rate.

$ 15,000 = $ 100,000 Value for Goodwill 15%

Step 5: Determine purchase price.

The sum of value for goodwill plus the fair value of identifiable net assets.

$ 100,000 + $ 200,000 = $ 300,000 Purchase price.




ILLUSTRATION 12-5




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