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FINANCIAL ACCOUNTING IFRS MODULE

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FINANCIAL ACCOUNTING IFRS MODULE Powered By Docstoc
					      CMA Ontario
   Accelerated Program




FINANCIAL ACCOUNTING
         IFRS
      MODULE 1
Financial Accounting – Module 1



Table of Contents

1.       Financial Statements and the Conceptual Framework                             3

2.       The Statement of Cash Flow                                                   77

3.       Revenue Recognition                                                         110

4.       Cash                                                                        139

5.       Accounts Receivable                                                         147

6.       Notes Receivable/Payable                                                    163

7.       Inventory                                                                   187

8.       Capital Assets                                                              214

9.       Liabilities                                                                 278

10.      Shareholders’ Equity                                                        310

11.      Accounting for Pensions                                                     341

12.      Earnings per Share                                                          384

13.      Accounting for Leases                                                       405

14.      Accounting for NonProfit Organizations                                      437

15.      Financial Statement Analysis                                                475




Page 2                                                       CMA Ontario – September 2009
Financial Accounting – Module 1



1.       Financial Statements and the Conceptual Framework

The purpose of this section is to provide a high level review of the accounting cycle, the
preparation of financial statements and the conceptual framework. If you are reading this
before the course has started, we recommend that you spend as much time as you can
working in the Financial Accounting Primer that you received with the course materials.
In fact, we would recommend that you only spend time working with the primer until the
day the course starts.

Chapter 1 of the FA Primer should be read as a preamble to this chapter.


The Accounting Cycle

The accounting cycle describes the process whereby individual transactions get compiled
to eventually becoming financial statements. The cycle is as follows:
1.     Transaction: the company enters into a transaction, for example a sale on credit is
       made.
2.     Transaction analysis: the accountant analyzes the transaction in terms of which
       account has been impacted upon
3.     Journalization: the transaction gets recorded in a source journal. For example, the
       credit sale would likely get recorded in a sales journal. Other journals are:
       purchases journal, cash receipts journal, cash disbursements journal, payroll
       journal and the general journal. Note that this is by no means a comprehensive
       listing.
4.     Posting: the journals get posted to the general ledger. The general ledger shows
       the details of all transactions in the company’s accounts.
5.     Trial balance - the trial balance is a listing of all general account balances.
6.     Adjusting entries - analysis of the trial balance may require some entries to adjust
       the accounts before the financial statements are prepared.
7.     Financial Statement Preparation.
8.     Closing entries - once the financial statements have been prepared, all revenue
       and expense accounts are cleared out to zero and the residual amount (equal to net
       income) is closed out to retained earnings.




Page 3                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Example: Local Stationery Ltd. is a local store providing business supplies, furniture
and copy and fax services to local business and individuals. The trial balance as at
December 31, 20x5 is as follows:

                                                                   Debit             Credit
Cash                                                             $14,500
Accounts Receivable                                               74,000
Allowance for Doubtful Accounts                                                     $4,500
Inventory                                                        130,000
Note receivable, current                                          10,400
Prepaid insurance                                                  1,400
Land                                                              60,000
Building                                                         260,000
Equipment                                                         90,000
Accumulated amortization                                                            40,000
Accounts payable and accrued liabilities                                            25,000
Accrued wages payable                                                                2,800
Accrued income taxes payable                                                         3,600
Unearned revenue                                                                    15,000
Long-term debt                                                                     150,000
Common stock                                                                       250,000
Retained Earnings                                                                  149,400
                                                                $640,300          $640,300

The following is a schedule of cash receipts and disbursements for the year 20x6:

Cash receipts
 Cash sales                                                                        $450,000
 Collections on credit sales                                                        620,000
 Deposits received on furniture orders                                               50,000
 Sale of depreciable assets (note 1)                                                 20,000
 Receipt of note receivable (note 2)                                                 10,800
                                                                                  1,150,800


Note 1:         the assets sold had an original cost of $40,000 and accumulated
                amortization of $25,000.




Page 4                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Note 2:          the note was taken out on July 2, 20x5 for $10,000, is due on July 2, 20x6
                 and bears 8% annual interest.

Cash disbursements
 Purchase of inventory                                                             $650,000
 Wages and salaries                                                                 200,000
 Income tax installments paid                                                        25,000
 Operating expenses paid                                                            150,000
 Interest paid on long-term debt                                                     13,500
 Renewal of insurance policy                                                          7,200
 Long-term debt repaid (annual payment due every Dec 31)                             15,000
 Dividends paid                                                                      30,000
 Purchase of equipment                                                               50,000
                                                                                 $1,140,700

The T-accounts shown on pages 11-12 simulate the general ledger accounts.

The following three journal entries will record cash receipts and disbursements:

(1)      Cash                                                    $1,130,800
           Sales                                                                   $450,000
           Accounts Receivable                                                      620,000
           Unearned revenues                                                         50,000
           Note Receivable                                                           10,400
           Interest revenue                                                             400

(2)      Cash                                                         20,000
         Accumulated amortization                                     25,000
           Equipment                                                                 40,000
           Gain on sale of depreciable assets                                         5,000


(3)      Inventory                                                  650,000
         Wages and salaries                                         200,000
         Income tax expense                                          25,000
         Operating expenses                                         150,000
         Interest                                                    13,500
         Insurance expense                                            7,200
         Long-term debt                                              15,000
         Retained Earnings (dividends)                               30,000
         Equipment                                                   50,000
            Cash                                                                   1,140,700




Page 5                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


Other information:

You find out that $3,600 of accounts receivable were written off as uncollectible this
year.

(4)      Allowance for doubtful accounts                               3,600
           Accounts Receivable                                                         3,600

Accounts receivable at the end of the year total $98,000. After transaction #4, the
accounts receivable balance shows a $549,600 credit. This is because we credited the
account for collections but did not make an entry to record credit sales. Credit sales are:
$549,600 + 98,000 = $647,600.

(5)      Accounts Receivable                                         647,600
           Sales                                                                    647,600

Analysis of the accounts receivable indicate that the allowance for doubtful accounts
should be $5,700. After transaction # 4, the balance in the allowance for doubtful
accounts was a credit of $900. We need to increase this to $5,700 as follows:

(6)      Bad debt expense                                              4,800
           Allowance for doubtful accounts                                             4,800

An inventory count shows that there is $145,000 of inventory on hand at December 31,
20x6.

(7)      Cost of goods sold                                          635,000
           Inventory                                                                635,000

The company's insurance policy expires on May 31 of every year. On May 31, 20x6, the
company renewed it's insurance policy for 2 years. Consequently, the prepaid insurance
on December 31, 20x6 should be: $7,200 x 17/24 = $5,100. The current balance in the
account is $1,400, thus it needs to be increased by $5,100 - 1,400 = $3,700.

(8)      Prepaid insurance                                             3,700
           Insurance expense                                                           3,700

The annual amortization on the building and equipment has been calculated to be
$20,000.

(9)      Amortization expense                                         20,000
          Accumulated amortization                                                    20,000




Page 6                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


Accounts payable and accrued liabilities all relate to the purchase of inventory. The total
amount of accounts payable and accrued liabilities as at December 31, 20x6 is $35,000.

(10)     Cost of goods sold                                           10,000
           Accounts payable and accrued liabilities                                  10,000

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

(11)     Accrued wages payable                                         1,500
           Wages and salaries                                                         1,500

The balance in unearned revenues at December 31, 20x6 should be $10,000.

(12)     Unearned revenues                                            55,000
           Sales                                                                     55,000

Income taxes are 40% of net income before taxes. Net income before taxes is $122,700.
Income tax expense is $122,700 x 40% = $49,080 - 25,000 =

(13)     Income tax expense                                           24,080
           Accrued income taxes payable                                              24,080

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




Page 7                                                          CMA Ontario – September 2009
Financial Accounting – Module 1




ASSETS

              Cash                         Accounts Receivable          Allowance for Doubtful Accounts
Op        14,500 1,140,700   (3)   Op        74,000 620,000      (1)   (4)       3,600 4,500        Op
(1)    1,130,800                   (5)      647,600 3,600        (4)                   4,800        (6)
(2)       20,000
                                              98,000                                     5,700
         24,600
                                                Inventory                      Note Receivable
                                   Op        130,000 635,000     (7)   Op       10,400 10,400        (1)
                                   (3)       650,000

                                             145,000

             Land                                Building                     Prepaid Insurance
Op       60,000                    Op        260,000                   Op        1,400
                                                                       (8)       3,700

                                                                                 5,100

   Accumulated Amortization                    Equipment
(2)     25,000 40,000      Op      Op         90,000 40,000      (2)
               20,000      (9)     (3)        50,000

                  35,000                     100,000

LIABILITIES AND SHAREHOLDERS' EQUITY

Accounts Payable and Acc Liab.            Accrued Wages Payable           Accrued Inc Taxes Payable
               25,000      Op      (11)        1,500 2,800      Op                     3,600       Op
               10,000     (10)                                                         24,080    (13)
                                                       1,300
                  35,000                                                                 27,680

       Unearned Revenues                     Long-Term Debt
(12)     55,000 15,000       Op    (3)        15,000 150,000     Op
                50,000       (1)
                                                       135,000
                  10,000
                                             Common Stock                     Retained Earnings
                                                  250,000        Op    (3)     30,000 149,400        Op




Page 8                                                                 CMA Ontario – September 2009
Financial Accounting – Module 1




REVENUES

              Sales                          Interest Revenue              Gain on Disposal of Assets
                 450,000        (1)                   400         (1)                   5,000        (2)
                 647,600        (5)
                  55,000       (12)

                   1,152,600

EXPENSES

       Cost of Goods Sold                   Wages and Salaries                Operating Expenses
(7)     635,000                       (3)    200,000 1,500       (11)   (3)    150,000
(10)     10,000
                                             198,500
         645,000

             Interest                         Amortization                         Insurance
(3)       13,500                      (9)     20,000                    (3)       7,200 3,700        (8)

                                                                                  3,500


          Income Taxes                      Bad debt expense
(3)       25,000                      (6)     4,800
(13)      24,080

          49,080



From the balances in the t-accounts, we can now prepare a full set of financial statements.




Page 9                                                                  CMA Ontario – September 2009
Financial Accounting – Module 1


                                     Local Stationery Ltd.
                                       Income Statement
                            for the year ended December 31, 20x6

Sales                                                                          $1,152,600
Cost of goods sold                                                                645,000
Gross margin                                                                      507,600
Selling and general expenses                                                    (150,000)
Wages and salaries                                                              (198,500)
Depreciation expense                                                             (20,000)
Insurance expense                                                                 (3,500)
Bad debt expense                                                                  (4,800)
Interest revenue                                                                      400
Gain on disposal of assets                                                          5,000
Interest expense                                                                 (13,500)
Net income before taxes                                                           122,700
Income tax expense                                                                 49,080
Net income                                                                        $73,620


                                     Local Stationery Ltd.
                        Statement of Changes in Shareholders' Equity
                            for the year ended December 31, 20x6

                                                                Common           Retained
                                                                   Stock         Earnings
Balance, December 31, 20x5                                      $250,000         $149,400
Net income                                                                          73,620
Dividends                                                                         (30,000)
Balance, December 31, 20x6                                      $250,000         $193,020




Page 10                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


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


ASSETS

Noncurrent
  Land                                                                                $ 60,000
  Building                                                                             260,000
  Equipment                                                                            100,000
  Accumulated amortization                                                             -35,000
                                                                                       385,000

Current
  Cash                                                                                  24,600
  Accounts Receivable (net)                                                             92,300
  Inventory                                                                            145,000
  Prepaid insurance                                                                      5,100
                                                                                       267,000
                                                                                      $652,000

SHAREHOLDERS' EQUITY AND LIABILTIES

Shareholders' equity
  Common stock                                                                        $250,000
  Retained Earnings                                                                    193,020
                                                                                       443,020

Long-term debt                                                                         120,000

Current liabilities
  Accounts payable and accrued liabilities                                              35,000
  Accrued wages payable                                                                  1,300
  Accrued income taxes payable                                                          27,680
  Unearned revenues                                                                     10,000
  Current portion of long-term debt                                                     15,000
                                                                                        88,980
                                                                                      $652,000




Page 11                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


Financial Statements


Components of Financial Statements

IAS 1 states that a complete set of financial statements comprises of the following:
(a)    a statement of financial position as at the end of the period,
(b)    a statement of comprehensive income for the period,
(c)    a statement of changes in equity for the period,
(d)    a statement of cash flows for the period
(e)    a set of notes, which provide a summary of the entity's significant accounting
       policies along with other explanatory information

IAS 1 uses different terminology from what was used previously under both IAS's and
Canadian GAAP, for example a 'statement of financial position' is the equivalent of a
'balance sheet'. Nevertheless, an entity can continue to use financial statement titles other
than those used in IAS 1, as long as the titles are not misleading.

IAS 1.36 requires that financial statements be presented at least annually.

IAS 1.51 states that each financial statement and notes be clearly identified and
prominently displayed with the following information:
•      the name of the reporting entity,
•      whether the financial statements are for an individual entity or a group of entities,
•      the date of the end of the reporting period or the period covered by the set of
       financial statements,
•      the presentation currency, and
•      the level of rounding used in presenting amount.




Page 12                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


The Statement of Financial Position

The following is a schematic of a typical Statement of Financial Position:


                                                            Share Capital

                    Long-term Assets
                                                           Retained Earnings


                                                        Long-Term Liabilities



                                                         Current Liabilities
                      Current Assets


A Statement of Financial Position is essentially a listing of all assets of an accounting
entity (the left side). The right side of the balance sheet shows how these assets are
financed: through external creditor financing (liabilities) or though internal financing,
either through direct shareholder financing (share capital) or though growth (retained
earnings).

Note that the above 'inverted' statement of financial position is not required by IAS 1, so
companies can continue to use the traditional balance sheet format, i.e. current assets
followed by current liabilities. The inverted format however, is used by all European
entities that have adopted IFRS and is used in all examples in IAS 1.

Assets are segregated into current and long-term assets.

A current asset is defined as follows (IAS 1.66)
•      it is expected to be realized in, or is intended for sale or consumption in, the
       entity’s normal operating cycle
•      it is held primarily for the purpose of being traded
•      it is expected to be realized within 12 months, or
•      it is cash or a cash equivalent.

The operating cycle of a business is defined as the amount of time it takes to convert raw
materials into a final product and sold. For most businesses this is much less than one
year. Some businesses' operating cycle last longer than one year: tree farms, nuclear
submarine contractors, scotch whisky distillers, etc… For purposes of this course,
however, we can generally assume that current assets will be converted into cash or used
up in the business within one year.




Page 13                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


The most common current assets are: cash, short-term investments, accounts receivable,
inventory and prepaid expenses.

Non-current assets are defined by what they are not: they are not current assets.
Essentially, they are assets that will convert into cash or be used up in the business over
periods of longer than one year or the operating cycle of the business. The most common
long-term assets are: long-term investments, land, building, equipment, and intangible
assets (goodwill, patents and trademarks).

An entity should classify a liability as current when (IAS 1.69):
•      it expects to settle the liability in the entity's normal operating cycle,
•      it holds the liability primarily for the purpose of trading,
•      the liability is due to be settled within twelve months after the reporting period, or
•      the entity does not have an unconditional right to defer settlement of the liability
       for at least twelve months after the reporting period.

The most common current liabilities are: accounts payable, accrued liabilities and the
current portion of long-term debt.

Non-current liabilities, like non-current assets, are defined by what they are not: they are
not current liabilities. Generally non-current liabilities represent those liabilities that are
due to be paid in periods exceeding one year or the operating cycle of the business. The
most common long-term liabilities are: long-term debt and future income tax liabilities.

Shareholders' equity is typically made up of two components: share capital and retained
earnings. Share capital represents the amount that shareholders have invested in the
corporation directly. There are generally two types of share capital: common shares and
preferred shares.

Retained earnings represent the sum total of past earnings that have not been distributed
to shareholders by way of dividends.

IAS 1.54 requires that, as a minimum, the following be disclosed on the face of the
statement of financial position:
•      property, plant and equipment
•      investment property
•      intangible assets
•      financial assets
•      investments accounted for using the equity method
•      biological assets (i.e. cattle)
•      inventories
•      trade and other receivables
•      cash and cash equivalents
•      the total of assets classified as held for sale and assets included in disposal groups
       classified as held for sale
•      trade and other payables


Page 14                                                            CMA Ontario – September 2009
Financial Accounting – Module 1


•         provisions
•         financial liabilities
•         liabilities and assets for current tax (i.e. income taxes payable/receivable)
•         deferred tax liabilities and deferred tax assets
•         liabilities included in disposal groups classified as held for sale
•         noncontrolling interest, presented within equity
•         issued capital and reserves attributable to the parent's equity holders

Current/noncurrent classification - IAS 1.60 requires that current / non-current assets and
current / non-current liabilities be disclosed separately except when a presentation based
on liquidity would provide information that is reliable and more relevant. If that
exception applies, all assets and liabilities should be presented broadly in order of
liquidity. Financial institutions, for example, would be more likely to present their
statement of financial position on a liquidity basis. IAS 1 acknowledges that the current /
non-current classification is useful when an entity supplies goods or services within a
clearly identifiable operating cycle (IAS 1.62).

The following page provides a illustrative Statement of Financial Position (adapted from
IAS 1 - Implementation Guidance).




Page 15                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


XYZ Group
Statement of financial position
as at December 31, 20x7
(in thousands of currency units)

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



Page 16                                         CMA Ontario – September 2009
Financial Accounting – Module 1


The Statement of Comprehensive Income

IAS 1 requires firms to present all income and expenses recognized in a period in either
(1) a single statement of comprehensive income or (2) in two statements: a statement of
income ending with net income/loss and a statement beginning with the net income/loss
and displaying components of other comprehensive income.

Components of other comprehensive income will in introduced in Module 2 of this
course so you will not understand what these mean until we cover the next module. They
are illustrated here for purposes of form only.

As a minimum, the statement of comprehensive income shall include the following line
items (IAS 1.82, 83 and 84):

(a)       Revenue.

(b)       Finance costs (interest expense).

(c)       Share of profits and losses of associates and joint ventures accounted for using the
          equity method.

(d)       Tax expense.

(e)       A single amount comprising the total of-
          (i)    the post-tax profit or loss of discontinued operations; and
          (ii)   the post-tax gain or loss recognised on the measurement to fair value less
                 costs to sell or on the disposal of the assets or disposal group(s)
                 constituting the discontinued operation.

(f)       Profit or loss.

(g)       Each component of other comprehensive income classified by nature.

(h)       Share of other comprehensive income of associates and joint ventures accounted
          for using the equity method.

(i)       Total comprehensive income.

(j)       Allocations of profit or loss for the period:
          (i)    Profit or loss attributable to minority interest.
          (ii)   Profit or loss attributable to owners of the parent.

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



Page 17                                                            CMA Ontario – September 2009
Financial Accounting – Module 1




An entity may present items (a) to (f) and (j) above in a separate income statement.

The following is a illustration of a statement of comprehensive income in two parts
(adapted from IAS 1 - Implementation Guidance):

XYZ group
Income statement (classification of expenses by nature)
for the year ended December 31, 20x7
(in thousands of currency units)

                                                                     20x7               20x6
Revenue                                                           390,000         355,000
Other income                                                       20,667          11,300
Changes in inventories of finished goods and work in
  progress                                                      (115,100)        (107,900)
Work performed by the entity and capitalized                       16,000           15,000
Raw material and consumables used                                (96,000)         (92,000)
Employee benefits expense                                        (45,000)         (43,000)
Depreciation and amortization expense                            (19,000)         (17,000)
Impairment of property, plant and equipment                       (4,000)                -
Other expenses                                                    (6,000)          (5,500)
Finance costs                                                    (15,000)         (18,000)
Share of profit of associates                                      35,100           30,100
Profit before tax                                                 161,667         128,000
Income tax expense                                                (40,417)        (32,000)
Profit for the year from continuing operations                    121,250           96,000
Loss for the year from discontinued operations                          -         (30,500)
Profit for the year                                               121,250              65,500
Profit attributable to:
  Owners of the parent                                             97,000              52,400
  Minority interest                                                24,250              13,100
                                                                  121,250              65,500
Earnings per share (in currency units)
Basic and diluted                                                     0.46               0.30




Page 18                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


XYZ group
Statement of comprehensive income
for the year ended December 31, 20x7
(in thousands of currency units)

                                                                      20x7             20x6
Profit for the year                                                121,250           65,500
Other comprehensive income:
  Exchange differences on translating foreign operations             5,334          10,667
  Available-for-sale financial assets                             (24,000)          26,667
  Cash flow hedges                                                   (667)          (4,000)
  Gains on property revaluation                                        933            3,367
  Actuarial gains(losses) in defined benefit pension
    plans                                                             (667)           1,333
  Share of other comprehensive income of associates                     400           (700)
  Income tax relating to components of other
    comprehensive income                                             4,667          (9,334)
Other comprehensive income for the year, net of tax               (14,000)          28,000
Total comprehensive income for the year                            107,250           93,500
Total comprehensive income attributable to:
  Owners of the parent                                              85,800           74,800
  Minority interest                                                 21,450           18,700
                                                                   107,250           93,500

Note that an entity should not present any extraordinary items, either on the face of the
income statement or in the notes.

IAS 1.99 requires that expenses be presented in one of two forms on the statement of
income:
-        by nature of expense, i.e. depreciation, cost of materials, transport costs,
         employee benefits, advertising.
-        by function of expense: COGS, selling costs, distribution costs, administrative
         costs.
The choice ultimately depends on which method most fairly presents the elements of the
entity's performance and would likely be based on historical and industry factors and the
nature of the entity. The nature of expense method will require less analysis and be
simpler to use.

The income statement presented on the previous page was by nature of expense. The
same statement, but presented by function of expense is illustrated below.




Page 19                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


XYZ group
Income statement (classification of expenses by function)
for the year ended December 31, 20x7
(in thousands of currency units)

                                                                  20x7            20x6
Revenue                                                        390,000         355,000
Cost of sales                                                (245,000)       (230,000)
Gross profit                                                  145,000           125,000
Other income                                                    20,667           11,300
Distribution costs                                             (9,000)           (8,700)
Administrative expenses                                       (20,000)         (21,000)
Other expenses                                                 (2,100)           (1,200)
Finance costs                                                  (8,000)           (7,500)
Share of profit of associates                                   35,100           30,100
Profit before tax                                              161,667         128,000
Income tax expense                                            (40,417)         (32,000)
Profit for the year from continuing operations                121,250            96,000
Loss for the year from discontinued operations                      -          (30,500)
Profit for the year                                           121,250           65,500
Profit attributable to:
  Owners of the parent                                         97,000           52,400
  Minority interest                                            24,250           13,100
                                                              121,250           65,500
Earnings per share (in currency units)
Basic and diluted                                                 0.46             0.30




Page 20                                                     CMA Ontario – September 2009
Financial Accounting – Module 1


The Statement of Changes in Equity

The statement of changes in equity shows how each component of equity has changed
from the beginning of the year to the end of the year. A sample (simplified) statement is
as follows:

XYZ Company
Statement of Changes in Equity
For the year ended December 31, 20x6

                                                                                      Other
                            Preferred   Common     Contributed    Retained    Comprehensive
                              Shares     Shares       Surplus     Earnings          Income
Balance, Jan 1, 20x6        $200,000    $100,000     $155,000     $250,000         $75,000
Net income                                                         450,000
Increase in OCI                                                                        5,000
Issue of preferred           105,000
   shares
Purchase of                             (14,800)     (114,700)
   common shares
Stock Dividend                            95,850                   (95,850)
Cash Dividends
- Preferred                                                        (24,000)
- Common                                                           (46,860)
Balance, Dec 31, 20x6       $305,000    $181,050      $40,300     $533,290          $80,000




Page 21                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


The Conceptual Framework

A strong theoretical foundation is essential if accounting practice is to keep pace with a
changing business environment. Accountants are continuously faced with new situations
and business innovations that present accounting and reporting problems. These problems
must be dealt with in an organized and consistent manner. The conceptual framework
plays a vital role in the development of new standards and in the revision of previously
issued standards.

The Objective of Financial Statements

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

Underlying Assumptions

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




Page 22                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Qualitative Characteristics of Financial Statements

There are four principal qualitative characteristics of financial statements:

      Primary Characteristic                       Secondary Characteristics

1.    Understandability – financial
      statements must be readily
      understandable by users. Users are
      assumed to have a reasonable
      knowledge of business and economic
      activities and accounting and a
      willingness to study the information
      with reasonable diligence. Note that this
      does not preclude the inclusion of
      complex matters.

2.    Relevance – information is relevant          Materiality – information is material if
      when it influences the economic              its omission or misstatement could
      decisions of users by helping them           influence the economic decisions of
      evaluate past, present or future events      users taken on the basis of the financial
      (predictive value) or confirming, or         statements.
      correcting, their past evaluations
      (feedback value or confirmatory role).

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

                                                   Substance over form - it is necessary
                                                   that transactions are accounted for and
                                                   presented in accordance with their
                                                   substance and economic reality and not
                                                   merely their legal form.




Page 23                                                          CMA Ontario – September 2009
Financial Accounting – Module 1




      Primary Characteristic                   Secondary Characteristics

3.    Reliability (cont’d)                     Neutrality - financial statements are not
                                               neutral if, by the selection or presentation
                                               of information, they influence the making
                                               of a decision
                                               or judgment in order to achieve a
                                               predetermined result or outcome.

                                               Prudence – the inclusion of a degree of
                                               caution in the exercise of the judgments
                                               needed in making the estimates required
                                               under conditions of uncertainty, such that
                                               assets or income are not overstated and
                                               liabilities or expenses are not understated.
                                               Note that the exercise of prudence does
                                               not allow, for example, the creation of
                                               hidden reserves or excessive provisions,
                                               the deliberate understatement of assets
                                               or income, or the deliberate overstatement
                                               of liabilities or expenses, because the
                                               financial statements would not be neutral
                                               and, therefore, not have the quality of
                                               reliability.

                                               Completeness - the information in
                                               financial statements must be complete
                                               within the bounds of materiality and cost.
                                               An omission can cause information to be
                                               false or misleading and thus unreliable and
                                               deficient in terms of its relevance.

4.    Comparability - implies that
      accounting information is comparable
      with previous periods (interperiod
      comparability or consistency) and
      comparable to other firms operating in
      the same industry (interfirm
      comparability). Consistency implies
      that accounting principles are applied
      from period to period in the same
      manner. Users must be informed of
      the accounting policies used in the
      preparation of financial statements.



Page 24                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


The conceptual framework identifies three constraints on relevant and reliable
information:

1.        Timeliness - Management may need to balance the relative merits of timely
          reporting and the provision of reliable information. In achieving a balance
          between relevance and reliability, the overriding consideration is how best to
          satisfy the economic decision-making needs of users.

2.        Balance between benefit and cost - the benefits derived from information should
          exceed the cost of providing it.

3.        Balance between qualitative characteristics - generally the aim is to achieve an
          appropriate balance among the characteristics in order to meet the objective of
          financial statements.


The Elements of Financial Statements

An asset is defined as a resource controlled by the entity as a result of past events and
from which future economic benefits are expected to flow to the entity.

The future economic benefits embodied in an asset may flow to the entity in a
number of ways. For example, an asset may be:
(a)    used singly or in combination with other assets in the production of goods or
       services to be sold by the entity;
(b)    exchanged for other assets;
(c)    used to settle a liability; or
(d)    distributed to the owners of the entity.

A liability is defined as a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits.

The settlement of a present obligation usually involves the entity giving up resources
embodying economic benefits in order to satisfy the claim of the other party. Settlement
of a present obligation may occur in a number of ways, for example, by:
(a)     payment of cash;
(b)     transfer of other assets;
(c)     provision of services;
(d)     replacement of that obligation with another obligation; or
(e)     conversion of the obligation to equity.
An obligation may also be extinguished by other means, such as a creditor waiving or
forfeiting its rights.

Equity is defined as the residual interest in the assets of the entity after deducting all
its liabilities.


Page 25                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


Income is defined as increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants.

The definition of income encompasses both revenues and gains. Revenue arises in
the course of the ordinary activities of an entity and is referred to by a variety of
different names including sales, fees, interest, dividends, royalties and rent. Gains
represent other items that meet the definition of income and may, or may not, arise in the
course of the ordinary activities of an entity. Gains represent increases in economic
benefits and as such are no different in nature from revenue.

Expenses are defined as decreases in economic benefits during the accounting period
in the form of outflows or depletions of assets or incurrence’s of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants.

The definition of expenses encompasses losses as well as those expenses that arise in the
course of the ordinary activities of the entity. Expenses that arise in the course of the
ordinary activities of the entity include, for example, cost of sales, wages and
depreciation. They usually take the form of an outflow or depletion of assets such as cash
and cash equivalents, inventory, property, plant and equipment.

Capital maintenance adjustments - the revaluation or restatement of assets and
liabilities gives rise to increases or decreases in equity. While these increases or decreases
meet the definition of income and expenses, they are not included in the income
statement. Instead these items are included in equity as capital maintenance adjustments
or revaluation reserves.


Measurements of the Elements of Financial Statements

The current conceptual framework per section 1000 of the CICA handbook calls for one
measurement approach: historical cost. Although the most common basis is still historical
cost, there are four basis of measurement under IFRS:

•         Historical cost. Assets are recorded at the amount of cash or cash equivalents
          paid or the fair value of the consideration given to acquire them at the time of
          their acquisition. Liabilities are recorded at the amount of proceeds received in
          exchange for the obligation, or in some circumstances (for example, income
          taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy
          the liability in the normal course of business.

•         Current cost. Assets are carried at the amount of cash or cash equivalents
          that would have to be paid if the same or an equivalent asset was acquired
          currently. Liabilities are carried at the undiscounted amount of cash or cash
          equivalents that would be required to settle the obligation currently.



Page 26                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


•         Realizable (settlement) value. Assets are carried at the amount of cash or cash
          equivalents that could currently be obtained by selling the asset in an orderly
          disposal. Liabilities are carried at their settlement values; that is, the undiscounted
          amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in
          the normal course of business.

•         Present value. Assets are carried at the present discounted value of the future net
          cash inflows that the item is expected to generate in the normal course of
          business. Liabilities are carried at the present discounted value of the future net
          cash outflows that are expected to be required to settle the liabilities in the normal
          course of business.




Page 27                                                             CMA Ontario – September 2009
Financial Accounting – Module 1




Financial Statements and the Accounting Cycle
Problems with Solutions


Multiple Choice Questions

1.    Beach Company paid $3,480 on June 1, 20x8 for a two-year insurance policy and
      recorded the entire amount as Insurance Expense. The December 31, 20x8 adjusting
      entry is
      a.    Debit Insurance Expense and credit Prepaid Insurance, $1,015.
      b. Debit Insurance Expense and credit Prepaid Insurance, $2,465.
      c.    Debit Prepaid Insurance and credit Insurance Expense, $1,015.
      d. Debit Prepaid Insurance and credit Insurance Expense, $2,465.


2.    Karr Corporation received cash of $7,200 on August 1, 20x8 for one year's rent in
      advance and recorded the transaction with a credit to Rent Revenue. The December
      31, 20x8 adjusting entry is
      a.   Debit Rent Revenue and credit Unearned Rent, $3,000.
      b. Debit Rent Revenue and credit Unearned Rent, $4,200.
      c.   Debit Unearned Rent and credit Rent Revenue, $3,000.
      d. Debit Cash and credit Unearned Rent, $4,200.


3.    Which of the following best illustrates the accounting concept of prudence?
      a.  Use of the allowance method to recognize bad debt losses from credit sales
      b.  Use of the lower of cost or market approach in valuing inventories
      c.  Use of the same accounting method from one period to the next in calculating
          amortization expense
      d.  Utilization of a policy of deliberate understatement of asset values in order to
          present a conservative net income figure
      e.  Inclusion of a degree of caution when estimating the allowance for doubtful
          accounts.


4.    Baker Corp.'s liability account balances at June 30, 20x2 included a 10 percent note
      payable in the amount of $1,000,000. The note is dated October 1, 20x0 and is
      payable in three equal annual payments of $500,000 plus interest. The first interest
      and principal payment was made on October 1, 20x1. In Baker's June 30, 20x2
      balance sheet, what amount should be reported as accrued interest payable for this
      note?
      a.    $112,500
      b.    $75,000
      c.    $37,500
      d.    $25,000

Page 28                                                        CMA Ontario – September 2009
Financial Accounting – Module 1




5.    Financial information exhibits the characteristic of consistency when
      a.   expenses are reported as charges against revenue in the period in which they
           are paid.
      b.   accounting entities give accountable events the same accounting treatment
           from period to period.
      c.   extraordinary gains and losses are not included on the income statement.
      d.   accounting procedures are adopted which give a consistent rate of net income.


6.    Rice Co. was incorporated on January 1, 20x1, with $500,000 from the issuance of
      stock and borrowed funds of $75,000. During the first year of operations, net
      income was $25,000. On December 15, Rice paid a $2,000 cash dividend. No
      additional activities affected owners' equity in 20x1. At December 31, 20x1, Rice's
      liabilities had increased to $94,000. In Rice's December 31, 20x1, balance sheet,
      total assets should be reported at
      a.     $598,000
      b.     $600,000
      c.     $617,000
      d.     $692,000


7.    The purpose of recording prepaid expenses that are subsequently disclosed as
      current assets on the balance sheet is
      a.   to smooth income
      b.   to record payments made on invoices prior to the invoice due date
      c.   to allocate expenditures to the period in which they apply
      d.   to recognize current expenditures that will convert into cash within the next
           twelve months
      e.   to record payments for services to be received over a period of years




Page 29                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

The following list of accounts and their balances represents the unadjusted trial balance
of Guy Ltd. at December 31, 20x4.

                                                        Dr.           Cr.
Cash                                                 $ 188,220
Accounts Receivable                                    294,000
Allowance for Doubtful Accounts                                      $ 10,500
Merchandise Inventory                                  186,000
Prepaid Insurance                                        7,860
Investment in Dude Co. Bonds (10%)                     120,000
Land                                                    90,000
Building                                               372,000
Accumulated Depreciation-Building                                      37,200
Equipment                                              100,800
Accumulated Depreciation-Equipment                                     16,800
Patents                                                  79,800
Accounts Payable                                                     303,150
Bonds Payable (20-year; 8%)                                          630,000
Common Shares                                                        360,000
Retained Earnings                                                     67,080
Sales                                                                570,000
Rental Income                                                         32,400
Advertising Expense                                     67,500
Supplies Expense                                        32,400
Purchases                                              294,000
Purchase Discounts                                                      2,700
Office Salary Expense                                   52,500
Sales Salary Expense                                   108,000
Interest Expense                                        36,750

                                                    $2,029,830 $2,029,830

Additional information -

1. Actual advertising costs in Whassup Magazine amounted to $1,000 per month. The
   company has already paid for advertisements in Whassup Magazine for the first 6
   months of 20x5.
2. The company uses straight-line depreciation for its building. The building was
   purchased and occupied January 1, 20x2 with an estimated life of 20 years.
3. A portion of their building has been converted into a snack bar that has been rented to
   Snack Shack Corp. since July 1, 20x3 at a rate of $21,600 per year payable each July
   1st.




Page 30                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


4. Prepaid insurance contains the premium costs of two policies: Policy “Excel”, cost of
    $2,880, one-year term taken out on Sept. 1, 20x3; Policy “Access”, cost of $5,940,
    three-year term taken out on April 1,20x4.
5. One of the company's customers declared bankruptcy December 30, 20x4, and it has
    been definitely established that the $8,100 due from him will never be collected. This
    fact has not been recorded. In addition, Guy Ltd. estimates that 5% of the Accounts
    Receivable balance on December 31, 20x4 will become uncollectible.
6. The equipment was purchased January 1, 20x2 with an estimated life of 12 years. The
    company uses straight-line depreciation.
7. When the company purchased a competing firm on July 1, 20x2 it acquired a patent
    in the amount of $114,000, which is being amortized over its estimated life. (5 years)
8. On November 1, 20x4 Guy issued 315, $2,000 bonds at par value. Interest payments
    are made semiannually on April 30 and October 31. The interest expense shown in
    the trial balance does not relate to the bonds.
9. Office salaries are paid on the first and 16th of each month for the following half
    month. On December 31, 20x4, $1,800 was given as an advance to an office
    secretary. The transaction was recorded in Guy’s books, and the $1,800 was charged
    to Office Salary Expense.
10. On August 1, 20x4 Guy purchased 60, $2,000, 10% bonds maturing on August 31,
    20x9 at par value. Interest payment dates are July 31 and January 31.
11. The inventory on hand at December 31, 20x4 was $222,000 per a physical inventory
    count. Record the adjustment for inventory in the same entry that records the Cost of
    Goods Sold for the year.

Required -

(a)       Prepare adjusting and correcting entries for December 31, 20x4 using the
          information given.
(b)       Prepare an adjusted trial balance as at December 31, 20x4.
(c)       Prepare year-end financial statements for 20x4. (excluding Statement of Cash
          Flows)




Page 31                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2

Briar Place Construction was founded in January 20x0 by Tom Johnson and Ralph
Reinhart and specializes in home remodeling and repairs. Due to high real estate prices in
the local area, many residents have been repairing and remodeling their homes rather than
moving to larger or newer homes. As a consequence, Briar Place's business during the
first year was so successful that Johnson and Reinhart plan to expand their operations.

When Johnson approached the local bank for funds to finance the planned expansion, the
bank requested audited financial statements prepared on the accrual basis. At the time the
company was formed, cash planning was considered important to the successful
operation of the business so Reinhart and Johnson requested that their bookkeeping
service maintain the company's records on a cash basis. As a result of the bank's request,
Reinhart and Johnson hired Mary Anne Logan, an accountant, to convert the cash basis
financial statements to accrual basis financial statements.

From the company files and from discussions with Reinhart and Johnson, Logan has
gathered the following data concerning Briar Place's transactions during 20x0 and the
cash basis financial statements. In addition, the company's Statement of Financial
Position at January 1, 20x0, is presented below.

Summary of Cash Transactions for 20x0
Receipts:
    Cash sales                                                                  $116,000
    Collections from customers                                                    40,000
    Proceeds from one-year, 12% note received March 1, 20x0                       20,000
                                                                                $176,000

Disbursements:
   Payments on account for supplies                                              $40,400
   Wages paid to employees                                                        62,000
   Payments to the utility company                                                11,000
   Insurance premiums paid                                                         9,000
   Rent paid to landlord                                                          18,000
   Interest paid on September 1, 20x0, 12% note                                    1,200
                                                                                $141,600

•   Uncollected customers' bills totaled $34,900 at December 31, 20x0.

•   On March 1, 20x0, a supplier of Briar Place advanced the company $20,000 on a one-
    year, 12 percent note payable with semi-annual interest payments to be made on
    September 1, 20x0, and at maturity on March 1, 20x1.

•   Unpaid bills to suppliers totaled $5,600 at December 31, 20x0.

•   Supplies costing $4,000 were on hand at December 31, 20x0.

Page 32                                                        CMA Ontario – September 2009
Financial Accounting – Module 1




•   Wages owed to employees at December 31, 20x0, were $2,800.

•   The December utility bill of $975 was unpaid at December 31, 20x0.

•   The insurance premium was paid for a one-year liability and property damage policy
    effective February 1, 20x0.

•   The rent of $1,500 per month was paid to the landlord on the first of every month.

•   Logan recommends depreciating the company's construction equipment, purchased at
    the time the company was founded, over its useful life of ten years using straight-line
    depreciation. The equipment has no estimated residual value.

•   Logan has determined that Briar Place's effective tax rate is 40 percent. No taxes have
    been paid.

                                     Briar Place Construction
                                  Statement of Financial Position
                                         January 1, 20x0

Assets
    Cash                                                                         $ 24,800
    Supplies inventory                                                             12,000
    Equipment                                                                     110,000
                                                                                 $146,800


Liabilities and shareholders' equity
    Purchases payable                                                            $ 14,000
    Common stock                                                                  132.800
                                                                                 $146,800

Required -

Prepare Briar Place Construction's Income Statement for the year ended December 31,
20x0 and Statement of Financial Position as at December 31, 20x0.




Page 33                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

The unadjusted trial balance for Martina Company is presented for the year ended
December 31, 20x5, along with some additional information.

                                                                 Debits            Credits
Cash                                                          $ 104,690
Accounts Receivable                                             195,550
Allowance for doubtful accounts                                                    $ 2,950
Inventory                                                       289,776
Prepaid Expenses                                                 30,376
Land                                                            152,500
Building                                                        445,938
Accumulated Depreciation                                                           96,812
Equipment                                                       320,700
Accumulated Depreciation                                                        117,500
Intangible Assets                                                26,960
Accounts Payable                                                                162,876
Interest Payable                                                                 20,312
Taxes Payable                                                                    46,000
Bonds payable                                                                   481,500
Deferrred income taxes                                                           21,000
Common Stock                                                                    250,000
Retained Earnings                                                               107,758
Sales Revenue                                                                 3,329,440
Cost of Goods Sold                                            2,049,170
Amortization expense                                             85,000
Selling expense                                                 348,300
Administrative expense                                          451,188
Income tax expense                                               46,000
Interest Expense                                                 40,000
Dividends                                                        50,000
                                                             $4,636,148      $4,636,148




Page 34                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


Additional Information

Assume that all adjusting and correcting entries have been made except for the following
items:

1.        A sale in the amount of $9,100 and its related cost of goods sold was not recorded
          as of December 31, 20x5. Martina sells its inventory at a 40% markup on cost and
          uses a perpetual inventory system.

2.        Martina Company estimates bad debts to be equal to 0.25% of sales.

3.        On December 28, 20x5, a letter was received from a trustee in bankruptcy
          informing us that one of our customers has been released from bankruptcy and
          that we would not be receiving any money on the account owing. The amount
          owing from this client was $5,000 and is included in the accounts receivable
          balance at December 31, 20x5.

4.        As of December 31, no accrual for electricity expense had been made. An
          electricity bill for the warehouse for $5,000 was received January 15, 20x6, for
          electrical consumption from December 12, 20x5, through January 12, 20x6. The
          bill was paid on February 16, 20x6, and debited to administrative expenses at that
          time.

5.        Martina Company purchased equipment on July 1, 20x5, for $35,000 cash. This
          amount was debited to selling expenses. The equipment has an estimated useful
          life of ten years and a residual value of $10,000. The company uses the
          diminishing balance method of depreciation at a rate of 20%.

6.        Insurance was paid on January 31, 20x5, for $5,580 for the time
          period of January 31, 20x5, through January 31, 20x6. The full amount was
          debited to administrative expenses at the time it was paid.

7.        Wages for the time period of December 25, 20x5, through January 7, 20x6, were
          paid on January 15, 20x6, in the amount of $8,000.

8.        Total tax expense for 20x5 should be 34% of income before taxes.


Required -

a.        Prepare adjusting and correcting entries for the additional information.
b.        Prepare the following financial statements for the year ending December 31,
          20x5:
          i.     An income statement.
          ii.    A statement of changes in shareholders' equity.
          iii.   A statement of financial position.


Page 35                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 4

Heather Company Ltd. closes its books once a year, on December 31, but prepares
monthly financial statements by estimating month-end inventories. The company's trial
balance on January 31, 20x8 is presented below.

                                  HEATHER COMPANY LTD.
                                  Trial Balance January31, 20x8
Cash                                                                $ 11,000
Accounts Receivable                                                   23,000
Notes Receivable                                                       3,000
Allowance for Doubtful Accounts                                                         $ 720
Inventory, Jan. 1, 20x8                                               24,000
Furniture and Fixtures                                                30,000
Accumulated Depreciation of Furniture and Fixtures                                      7,500
Unexpired Insurance                                                      600
Supplies on Hand                                                       1,050
Accounts Payable                                                                       6,000
Notes Payable                                                                          5,000
Common Shares                                                                         20,000
Retained Earnings                                                                     27,005
Sales                                                                                130,000
Sales Returns and Allowances                                           1,500
Purchases                                                             80,000
Transportation-in                                                      2,000
Selling Expenses                                                      11,000
Administrative Expenses                                                9,000
Interest Revenue                                                                          125
Interest Expense                                                        200
                                                                   $196,350         $196,350

Required -

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


Page 36                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


(b)       Prepare a Statement of Financial Position, an income statement, and a statement
          of changes in Shareholders' Equity. Dividends of $3,000 were declared and paid
          on the common shares during the month.


Problem 5

Shriver Co. began business as a corporation on December 3, 20x0. The accounting for the
business since its inception has been done by Bill Miles. Miles' primary responsibilities
are in the purchasing area and his previous experience in accounting was limited. Sam
Cray, a qualified accountant, was hired to perform the company's accounting functions in
December of 20x2. The first task he was assigned was to review the accounting for the
company's first two years and to make any corrections that might be necessary to ensure
that the company's 20x1-20x2 financial statements were proper.

The preclosing trial balance as of November 30, 20x2, that is presented below includes
year-end adjustments that were prepared by Miles.

                                        Shriver Co.
                                  Preclosing Trial Balance
                                    November 30, 20x2
                                                                         Dr.            Cr.

Cash                                                                 $ 1,150
Accounts receivable                                                    9,350
Note receivable                                                        3,000
Inventory                                                             10,500
Land                                                                   8,000
Furniture and fixtures                                                20,000
Unexpired insurance                                                      600
Accounts payable                                                                   $ 4,950
Notes payable                                                                        5,000
Common shares                                                                       27,700
Retained earnings                                                                    8,950
Sales                                                                              103,800
Purchases                                                            78,750
Purchase returns                                                                        450
Selling expenses                                                     12,000
Administrative expenses                                               7,500
      Total                                                        $150,850       $150,850

Cray's review of the accounting records and other records uncovered the following
additional information.

1. Cheques totaling $2,350 had been written to vendors and recorded in the November
   20x2 cash disbursements journal but were still in the vault on December 7.

Page 37                                                         CMA Ontario – September 2009
Financial Accounting – Module 1




2. All receivables from 20x0-20x1 credit sales either had been collected or written off.
   The estimate for bad debts arising from 20x1-20x2 sales was $2,000, and the
   following entry was made to recognize this fact.

     Selling expense                                                2,000
             Accounts receivable                                                      2,000


3. The note receivable for $3,000 is from a customer. This three-month note is dated
   November 1, 20x2, and has an annual interest rate of 18 percent.

4. The physical inventory on November 30, 20x2, includes $9,900 of product on hand
   and $2,100 of inventory issued to Apex Co. on a consignment basis.

5. The furniture and fixtures were acquired on December 3, 20x0. These capital assets
   are being depreciated on a straight-line basis over a ten-year life with no residual
   value. The following adjusting entry was made by Miles in November 20x2 to
   recognize depreciation.

Selling expense                                                     2,000
Administrative expense                                                500
           Furniture and fixtures                                                     2,500

The same adjusting entry was made for the 20x0-20x1 fiscal year.

6. The company has one prepaid insurance policy. The policy covers a one-year period
   and was purchased for $1,200 on June 1, 20x2.

7. The notes payable were issued on November 1, 20x2, with an annual interest rate of
   12 percent. The principal and interest are payable on August 1, 20x3.

8. On November 20, 20x2, the Board of Directors declared a cash dividend of $2,500
   payable on December 14, 20x2. The dividend is payable to shareholders of record as
   of December 3, 20x2.

9. The tax return for the 20x1-20x2 fiscal year appears to be properly prepared and
   shows no tax liability.

Required -

a.        Prepare a Statement of Financial Position for the Shriver Co. as of November 30,
          20x2.
b.        Prepare a Statement of Income for the year ended November 30, 20x2.




Page 38                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 6

Mr. Chicken and Mr. Rib decided to go into business together and start a new restaurant.
On June 1, 20x0, Mr. Chicken and Mr. Rib each invested $50,000 cash in exchange for
shares in the company. After doing a feasibility study and some preparatory work, they
opened the restaurant for business on July 1, 20x0.

The following preparatory events took place in getting the new restaurant ready for the
grand opening:

•   An ideal location was found in a shopping mall. Mr. Chicken and Mr. Rib signed a
    lease for $3,000 per month starting July 1, 20x0.

•   Tables and chairs costing $25,000 were purchased on account. These assets were
    expected to last five years with zero residual value. The assets were delivered to the
    restaurant on July 1, 20x0.

•   Depreciation is calculated using the straight-line method.

•   As part of the promotion for the grand opening, beer mugs, purchased for $5 cash
    each, were given away to the first 100 customers.

•   During the month of July, $30,000 worth of food supplies (chicken and ribs) was
    purchased on account. Salad supplies costing $6,000 were purchased for cash on an
    "as required" basis.

•   Four cooks and eight waiters were hired. The cooks were paid a monthly salary of
    $2,000 each and the waiters were paid $1,000 each. The waiters also received
    gratuities from the customers at an average of $500 per month.

•   Advertising in the newspaper for the grand opening cost $1,500, utilities totaled
    $1,000 and janitorial services, $1,000. All of these costs were paid in cash.

In a rush to start up the restaurant, Mr. Chicken and Mr. Rib had neglected to hire an
accountant. They have approached you to handle their books. Additional information was
supplied by the owners:

•   In July, total accounts payable paid were $22,000.

•   On July 15, excess cash of $30,000 was invested in a money market fund as a
    temporary investment. The return is estimated at 8 percent per year. However, the
    interest will not be received until the fund is collapsed.

•   As of July 31, the owners had not drawn any money out of the business. It was
    estimated that each owner deserved a modest amount of $1,250 per month as
    management fees.


Page 39                                                          CMA Ontario – September 2009
Financial Accounting – Module 1




•   On July 31, a rough estimate of unsold chicken and rib supplies remaining on hand
    was $12,700.

•   Cash sales during July were $8,000. Sales to charge account customers, mainly
    business people in the mall, were $18,000.

The owners would like to find out how much money they have made or lost during the
month of July.

Required -

Prepare an income statement for July 20x0, and a Statement of Financial Position as of
July 31, 20x0. Show all supporting calculations and state your assumptions, if any.




Page 40                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 7

You have been given the following trial balances of the Sandmeyer Company. The trial
balance as of December 31, 20x0, was taken on a gross basis; that is, the totals of the
debits and of the credits in each of the ledger accounts, including any balance from the
postclosing trial balance as of June 30, 20x0, rather than the final balance, have been
included. You are advised that the company records disbursements for expense items
through liability accounts before making payment.

The books are not available. The trial balance is out of balance by $270, which is shown
as "unlocated difference." You are told that cash in bank of $28,044 has been verified.

                                  The Sandmeyer Company
                                       Trial Balances

ACCOUNT                                  JUNE 30, 20x0            DECEMBER 31, 20x0

Cash in bank                            $ 21,849                   $ 275,016     $ 246,972
Investments                               30,500                      40,712         5,000
Accounts receivable                       47,420                     301,425       248,979
Merchandise inventory                     55,542                     208,856       153,495
Office furniture and fixtures              8,663                      11,164           635
Accumulated depreciation                               $4,967            176         5,940
Notes payable                                          30,000         10,000        30,000
Accounts payable                                       15,879        211,658       233,986
Income taxes payable                                    7,350          5,658        11,050
Common shares                                          50,000                       50,000
Retained earnings                                      55,778         10,000        55,778
Sales                                                                    481       254,005
Cost of goods sold                                                   151,914
Salaries expense                                                      15,500
Other administrative expense                                          21,567
Selling expense                                                       25,348
Uncollectible accounts expense                                           665
Write-down of obsolete
   merchandise                                                         1,025
Gain on sale of investment                                                              168
Loss on sale of fixtures                                                 23
Interest expense                                                        850
Income tax expense                                                    3,700
Unallocated difference                                                  270
                                       $163,974      $163,974    $1,296,008     $1,296,008




Page 41                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Required -

Reconstruct the ledger accounts as they probably appear by recording the transactions for
the period in journal form and posting to the ledger accounts. You need not prepare
financial statements, but you should state where you think the error occurred in the books
and give reasons to support your conclusion.


Problem 8

The balances of the following accounts of ABC Travel Ltd. before and after the posting
of adjusting entries are:

                                      Preliminary         Adjusted
                                           Dr.        Cr.      Dr.          Cr.
Cash                                   $ 6,112 $           $ 6,112 $
Commissions receivable                   1,805               2,270
Allowance for doubtful accounts                       165                   210
Office supplies                            175                  55
Prepaid rent                               310                 155
Office equipment                           980                 980
Accumulated depreciation -
office equipment                                      196                   294
Accounts payable                                      366                   366
Note payable                                        3,000                 3,000
Income taxes payable                                  200                   200
Salaries payable                                                            290
Interest payable                                                            180
Capital                                             1,000                 1,000
Retained earnings                                     413                   413

Required -

Determine what adjusting entries were made and journalize these entries. Provide a
narrative to describe the purpose of each entry.




Page 42                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 9

Below are the account titles of a number of debit and credit accounts as they might
appear on the statement of financial position of the Saberhagen Corporation as of October
31, 20x1.

DEBITS

Cash in bank                                   Goodwill
Land                                           Inventory of finished goods
Inventory of operating parts and supplies      Inventory of work in process
Inventory of raw materials                     Deficit
Patents                                        Interest accrued on government
Cash and Canada Savings Bonds set                 securities
   aside for property additions                Notes receivable
Investment in subsidiary                       Petty cash fund

Accounts receivable                            Government securities
  Government contracts                         Treasury shares
  Regular                                      Unamortized bond discount
  Instalments, due in 20x1
  Instalments, due in 20x2-20x3

CREDITS

Accrued payroll                                Preferred shares dividend, payable 11/1/x1
Provision for renegotiation of                 Allowance for doubtful accounts
   government contracts                           receivable
Notes payable                                  Provision for federal income taxes
Accrued interest on bonds                      Customers' advances (on contracts to be
Accumulated depreciation                          completed in 20x2)
Accounts payable                               Appropriation for possible decline in
Accrued interest on notes payable                 value of raw materials inventory
8% first mortgage bonds to be redeemed         Premium on bonds redeemable in 20x1
   in 20x1 out of current assets               Officers' 20x1 bonus accrued
Share capital, preferred
9 1/2% first mortgage bonds due in 20x8

Required -

Select the current asset and current liability items from among these debits and credits. If
there appear to be certain borderline cases that you are unable to classify without further
information, give your reasons for making questionable classifications, if any.




Page 43                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 10

Mr. Janson, owner of Janson's Retail Hardware, states that he computes income on a cash
basis. At the end of each year he takes a physical inventory and computes the cost of all
merchandise on hand. To this amount he adds the ending balance of accounts receivable,
because he considers this to be a part of inventory on the cash basis. He deducts from this
total the ending balance of accounts payable for merchandise to arrive at what he calls
inventory (net).

The following information has been taken from Mr. Janson's cash-basis income
statements for the years indicated:

                                                         20x4            20x3           20x2
Cash received                                       $ 173,000      $ 159,000      $ 150,000
Cost of goods sold
     Inventory(net), Jan.1                            $ 8,000        $ 11,000        $ 3,000
     Total purchases                                  109,000         100,000         95,000
     Goods available for sale                         117,000         111,000         98,000
     Inventory(net), Dec. 31                           -1,000          -8,000        -11,000
       Cost of goods sold                             116,000        103,000          87,000
Gross margin                                         $ 57,000        $ 56,000       $ 63,000

Additional information is as follows for the years indicated:

                                                         20x4            20x3           20x2
Cash sales                                           $151,000       $147,000       $141,000
Credit sales                                           24,000         13,000         14,000
Accounts receivable, Dec. 31                            3,000          6,000          5,000
Accounts payable for merchandise, Dec. 31              33,000         19,000         12,000

Required -

1.        Without reference to the specific situation described above, discuss cash-basis and
          accrual accounting and indicate their conceptual merits.
2.        Is the gross margin for Janson's Retail Hardware being computed on a cash basis?
          Evaluate and explain the approach used with illustrative computations of the cash-
          basis gross margin for 20x3.
3.        Explain why the gross margin for Janson's Retail Hardware shows a decrease
          while sales and cash receipts are increasing.




Page 44                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 11

State whether you agree or disagree with the following and explain why. Consider each
statement independently.
a) Even though a division of a company is not incorporated separately, it is still a
    separate entity.
b) The financial statements of a company are neutral and free from bias.
c) Accounting reports are exact, as they are based on numbers and numbers are exact.
d) The historical cost principle allows us to arrive at objective numbers on financial
    statements.




Page 45                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


SOLUTIONS


Multiple Choice Questions

1.    d     The amount of prepaid insurance at December 31, 20x8 is: $3,480 / 24
            months x 17 months remaining = $2,465

2.    b     The amount of unearned rent at December 31, 20x8 is: $7,200 / 12 months x 7
            months = $4,200

3.    e

4.    b     $1,000,000 x 10% x 9/12 = $75,000

5.    b     Consistency is when the enterprise uses accounting principles that are
            consistent from one period to the next.

6.    c     $500,000 + 75,000 + 25,000 - 2,000 + (94,000 - 75,000) = $617,000

7.    c     Payments made for items (such as insurance premiums for the following year)
            which do not have a benefit until the following year are set up in prepaids and
            then expensed in the applicable year.




Page 46                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

1. Prepaid Advertising                              6,000
       Advertising Expense ($1,000 x 6 months)                     6,000

2. Depreciation Expense                            18,600
      Accumulated Depreciation – Building                         18,600
      ($372,000 / 20 years)

3. Rental Revenue                                  10,800
      Unearned Rental Revenue                                     10,800
      ($21,600 x 6/12)

4. Insurance Expense                                3,405
       Prepaid Insurance                                           3,405
       [($2,880 x 8/12) + ($5,940 / 3 x 9/12)]

5. Allowance for Doubtful Accounts                  8,100
       Accounts Receivable                                         8,100

   Bad Debt Expense                                11,895
       Allowance for Doubtful Accounts                            11,895
   Allowance for doubtful accounts should be:
       ($294,000 – 8,100) x 5% = 14,295
   Allowance for doubtful account balance before
   adjustment is: $10,500 – 8,100 = $2,400

    Bad debt expense= $14,295 – 2,400 = $11,895

6. Depreciation Expense                             8,400
       Accumulated Depreciation – Equipment                        8,400
       ($100,800 / 12 years)

7. Amortization Expense – Patent                   22,800
     Patent                                                       22,800
     ($114,000 / 5years)

8. Interest Expense                                 8,400
       Interest Payable                                            8,400
       ($630,000 x 0.08 x 2/12)

9. Prepaid Salaries                                 1,800
      Office Salary Expense                                        1,800




Page 47                                              CMA Ontario – September 2009
Financial Accounting – Module 1


10. Interest Receivable                                                   5,000
       Interest Revenue                                                                     5,000
       ($120,000 x 10% x 5/12)

11. Cost of Goods Sold                                                255,300
    Merchandise Inventory                                             222,000
    Purchase Discounts                                                  2,700
       Purchases                                                                        294,000
       Merchandise Inventory                                                            186,000


(b)
                                          Unadjusted             Adjustments          Adjusted Trial Balance
                                        Dr.         Cr.         Dr.        Cr.          Dr.           Cr.
Cash                                 $ 188,220                                        $188,220
Accounts Receivable                    294,000                              $8,100     285,900
Allowance for Doubtful Accounts                   $ 10,500      $8,100      11,895                   $14,295
Interest Receivable                                              5,000                   5,000
Merchandise Inventory                 186,000                  222,000     186,000     222,000
Prepaid Advertising                                              6,000                   6,000
Prepaid Insurance                        7,860                               3,405       4,455
Prepaid Salaries                                                 1,800                   1,800
Investment in Dude Co. Bonds (10%)    120,000                                          120,000
Land                                   90,000                                           90,000
Building                              372,000                                          372,000
Accumulated Depreciation-Building                    37,200                 18,600                    55,800
Equipment                             100,800                                          100,800
Accumulated Depreciation-Equipment                   16,800                  8,400                    25,200
Patent                                  79,800                              22,800      57,000
Accounts Payable                                   303,150                                           303,150
Interest Payable                                                             8,400                     8,400
Unearned Rental Income                                                      10,800                    10,800
Bonds Payable (20-year; 8%)                        630,000                                           630,000
Common Shares                                      360,000                                           360,000
Retained Earnings                                   67,080                                            67,080
Sales                                              570,000                                           570,000
Cost of Goods Sold                                             255,300                 255,300
Rental Income                                        32,400     10,800                                21,600
Interest Income                                                              5,000                     5,000
Advertising Expense                    67,500                                6,000      61,500
Supplies Expense                       32,400                                           32,400
Purchases                             294,000                              294,000
Purchase Discounts                                    2,700      2,700
Office Salary Expense                  52,500                                1,800      50,700
Sales Salary Expense                  108,000                                          108,000
Bad Debt Expense                                                11,895                  11,895
Insurance Expense                                                3,405                   3,405
Depreciation Expense                                            27,000                  27,000
Amortization Expense –Patent                                    22,800                  22,800
Interest Expense                        36,750                   8,400                  45,150
                                     $2,029,830   $2,029,830   $585,200    $585,200   $2,071,325   $2,071,325




Page 48                                                                    CMA Ontario – September 2009
Financial Accounting – Module 1


(c)
                                           Guy Ltd.
                                      Income Statement
                            For the year ended December 31, 20x4

Revenues
       Sales                                           570,000
       Less Cost of Goods Sold                        (255,300)
       Gross Margin                                    314,700
       Rental Income                                    21,600
       Interest Income                                   5,000
                Total Income                                       341,300
Expenses
       Advertising Expense                             61,500
       Supplies Expense                                32,400
       Office Salaries Expense                         50,700
       Sales Salaries Expense                         108,000
       Bad Debt Expense                                11,895
       Insurance Expense                                3,405
       Depreciation Expense                            27,000
       Amortization Expense                            22,800
       Interest Expense                                45,150
                Total Expenses                                     362,850

Net Loss                                                           (21,550)



                                           Guy Ltd.
                        Statement of Changes in Shareholders' Equity
                            For the year ended December 31 20x4

                                                                 Common           Retained
                                                                    Stock         Earnings
Balance, Jan 1, 20x4                                             $360,000          $67,080
Net loss                                                                          (21,550)
Balance, December 31, 20x4                                       $360,000          $45,530




Page 49                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


                                             Guy Ltd.
                                  Statement of Financial Position
                                      As at December 31 20x4

ASSETS

Long-Term Assets
Investment in Dude Co. Bonds                                                          $120,000
Land                                                                                    90,000
Building                                                                $372,000
Less: Accumulated Depreciation                                            55,800       316,200
Equipment                                                                100,800
Less: Accumulated Depreciation                                            25,200        75,600
Patent                                                                                  57,000
                                                                                       658,800

Current Assets
Cash                                                                                   188,220
Accounts Receivable (285,900 - 14,295)                                                 271,605
Interest Receivable                                                                      5,000
Merchandise Inventory                                                                  222,000
Prepaid Advertising                                                                      6,000
Prepaid Insurance                                                                        4,455
Prepaid Salaries                                                                         1,800
                                                                                       699,080
                                                                                    $1,357,880

SHAREHOLDERS’ EQUITY AND LIABILITIES

Shareholders’ Equity
Common Shares                                                                         $360,000
Retained Earnings                                                                       45,530
                                                                                       405,530

Long-Term Liability
Bonds Payable                                                                          630,000

Current Liabilities
Accounts Payable                                                                       303,150
Interest Payable                                                                         8,400
Unearned Rental Income                                                                  10,800
                                                                                       322,350
                                                                                    $1,357,880


Page 50                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2


                                    Briar Place Construction
                                       Income Statement
                             For the Year Ended December 31, 20x0

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




Page 51                                                                  CMA Ontario – September 2009
Financial Accounting – Module 1


                                     Briar Place Construction
                                  Statement of Financial Position
                                        December 31, 20x0

 ASSETS

 Fixed Assets
 Equipment                                                                 $110,000
 Less: Accumulated depreciation                                              11,000        99,000


 Current Assets
 Cash ($24,800 Beginning + 176,000 Cash Receipts - 141,600 Cash Disbursements)            $59,200
 Accounts receivable                                                                       34,900
 Supplies inventory                                                                         4,000
 Prepaid insurance (9,000 Paid - 8,250 Expense)                                               750
                                                                                           98,850

                                                                                         $197,850

 SHAREHOLDERS' EQUITY AND LIABILITIES

 Shareholders' equity
 Common stock                                                                             132,800
 Retained earnings                                                                         20,925
                                                                                          153,725

 Current Liabilities
 Accounts payable                                                                          $5,600
 Note payable                                                                              20,000
 Wages payable                                                                              2,800
 Utilities payable                                                                            975
 Interest payable (2,000 Expense - 1,200 Paid)                                                800
 Taxes payable                                                                             13,950
                                                                                           44,125

                                                                                         $197,850




Page 52                                                               CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

a.    1.    Accounts receivable                       $9,100
              Sales                                                 $9,100

            Cost of goods sold                         6,500
              Inventory                                               6,500
            $9,100 / 1.40 = $6,500

      2.    Bad debt expense                           8,346
              Allowance for doubtful accounts                         8,346
            ($3,329,440 + 9,100) x 0.25%

      3.    Allowance for doubtful accounts            5,000
              Accounts receivable                                     5,000

      4.    Administrative expense                     3,065
              Accounts payable                                        3,065
            $5,000 x 19/31

      5.    Equipment                                 35,000
              Selling expenses                                      35,000

            Amortization expense                       3,500
              Accumulated amortization                                3,500
            $35,000 x 20% x

      6.    Prepaid expenses                             465
              Administrative expenses                                   465
            $5,580 / 12

      7.    Selling expense                            4,000
              Accounts payable                                        4,000
            $8,000 x 7/14




Page 53                                         CMA Ontario – September 2009
Financial Accounting – Module 1




      8.    Income tax expense                                  81,478
              Income tax payable                                              81,478

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




Page 54                                                   CMA Ontario – September 2009
Financial Accounting – Module 1


Adjusted Trial Balance -

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




Page 55                                               CMA Ontario – September 2009
Financial Accounting – Module 1




b(i)      Martina Company
          Income Statement
          for the year ended December 31, 20x5

          Sales                                                          $3,338,540
          Cost of goods sold                                              2,055,670
          Gross margin                                                    1,282,870
          Depreciation expense                                             (88,500)
          Selling expense                                                 (317,300)
          Administration expense                                          (453,788)
          Bad debt expense                                                  (8,346)
          Interest expense                                                 (40,000)
          Net income before taxes                                           374,936
          Provision for income taxes                                        127,478
          Net income                                                       $247,458


b(ii)     Martina Company
          Statement of Changes in Shareholders' Equity
          for the year ended December 31, 20x5
                                                          Common           Retained
                                                             Stock         Earnings
          Balance, Jan 1, 20x5                            $250,000         $107,758
          Net income                                                         247,458
          Dividends                                                         (50,000)
          Balance, December 31, 20x5                      $250,000         $305,216




Page 56                                                  CMA Ontario – September 2009
Financial Accounting – Module 1




b(iii)    Martina Company
          Statement of Financial Position
          for the year ended December 31, 20x5

          ASSETS

          Noncurrent Assets
            Land                                                   $152,500
            Building                              $445,938
            Accumulated depreciation               (96,812)         349,126
            Equipment                               355,700
            Accumulated depreciation              (121,000)         234,700
            Intangible assets                                        26,960
                                                                    763,286
          Current Assets
            Cash                                                    104,690
            Accounts receivable                                     193,354
            Inventory                                               283,276
            Prepaid expenses                                         30,841
                                                                    612,161

                                                                 $1,375,447

          SHAREHOLDERS’ EQUITY AND LIABILITIES

          Shareholders’ Equity
            Common Stock                                           $250,000
            Retained Earnings                                       305,216
                                                                    555,216

          Long-term Liabilities
            Bonds payable                                           481,500
            Deferred income taxes                                    21,000
                                                                    502,500

          Current Liabilities
            Accounts payable                                        169,941
            Interest payable                                         20,312
            Taxes payable                                           127,478
                                                                    317,731

                                                                 $1,375,447


Page 57                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 4


1.   Bad debt expense                                      $514
       Allowance for Doubtful Accounts                                  $514
     ($130,000 - 1,500) x .4%

2.   Depreciation expense                                   250
       Accumulated depreciation                                           250
     $30,000 x 10% / 12

3.   Insurance expense                                       80
       Prepaid insurance                                                   80

4.   Supplies expense                                       210
       Supplies on hand                                                   210

5.   Office Salaries                                        500
       Salaries payable                                                   500

6.   Interest expense                                       200
        Interest payable                                                  200

7.   Interest revenue                                        75
        Unearned Interest Revenue                                          75

8.   Cost of goods sold (130,000 - 1,500) x 70%          89,950
       Inventory (plug)                                                7,950
       Purchases                                                      80,000
       Transportation-in                                               2,000




Page 58                                           CMA Ontario – September 2009
Financial Accounting – Module 1




Heather Company Ltd.
Income Statement
for the month ended January 31, 20x8

Sales (net)                                                      $128,500
Cost of goods sold                                                 89,950
Gross margin                                                       38,550
Selling expenses                                                  (11,000)
Administrative expenses ($9,000 + 500)                             (9,500)
Depreciation expense                                                 (250)
Bad debt expense                                                     (514)
Supplies expense                                                     (210)
Insurance expense                                                     (80)
Interest expense                                                     (400)
Interest income                                                         50
Net income                                                        $16,646



Heather Company Ltd.
Statement of changes in Shareholders' Equity
for the month ended January 31, 20x8
                                                Common           Retained
                                                  Shares         Earnings
Balance, Jan 1, 20x8                             $20,000          $30,005
Net income                                                          16,646
Dividends                                                          (3,000)
Balance, December 31, 20x8                       $20,000          $43,651




Page 59                                        CMA Ontario – September 2009
Financial Accounting – Module 1




Heather Company Ltd.
Statement of Financial Position as at January 31, 20x8

ASSETS

Noncurrent assets
  Furniture and fixtures                                                    $30,000
  Accumulated Depreciation                                                   (7,750)
                                                                              22,250
Current Assets
  Cash                                                                       11,000
  Accounts receivable                                                        21,766
  Note receivable                                                             3,000
  Inventory                                                                  16,050
  Supplies on hand                                                              840
  Unexpired insurance                                                           520
                                                                             53,176

                                                                            $75,426

SHAREHOLDERS' EQUITY & LIABILITIES

Shareholders' Equity
  Common Shares                                                              20,000
  Retained earnings                                                          43,651
                                                                             63,651
Current liabilities
  Accounts payable                                                           $6,000
  Notes payable                                                               5,000
  Salaries payable                                                              500
  Interest payable and unearned interest revenue                                275
                                                                             11,775
                                                                            $75,426




Page 60                                                  CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5

a.
                                            Shriver Co.
                                  Statement Of Financial Position
                                     As at November 30, 20x2

ASSETS

Fixed Assets
   Land                                                                                 $ 8,000
   Furniture and fixtures                                                                25,000
   Accumulated depreciation                                                             (5,000)
                                                                                         28,000

Current assets
  Cash ($1,150 + $2,350)                                                                 3,500
  Accounts receivable, net of allowance for doubtful accounts of $2,000                  9,350
  Note receivable                                                                        3,000
  Interest receivable ($3,000 x .18 x 1/12)                                                 45
  Inventory ($9,900 + $2,100)                                                           12,000
  Prepaid insurance                                                                        600
                                                                                        28,495

                                                                                       $56,495


SHAREHOLDERS' EQUITY AND LIABILITIES

Shareholders' Equity
  Common shares                                                                        $27,700
  Retained earnings ($8,950 Beginning R/E + 7,495 Net Income - 2,500 Dividends)         13,945
                                                                                        41,645

Current liabilities:
  Accounts payable ($4,950 + $2,350)                                                    $ 7,300
  Notes payable                                                                           5,000
  Interest payable ($5,000 x .12x 1/12)                                                      50
  Dividends payable                                                                       2,500
                                                                                         14,850

                                                                                       $56,495




Page 61                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


b.
                                   Shriver Co.
                              Statement of Income
                     For the year ended November 30, 20x2
Sales                                                                         $103,800
Cost of goods sold
  Beginning inventory                                             $10,500
  Purchases                                                        78,750
  Purchase returns                                                  (450)
  Ending inventory                                               (12,000)       76,800
Gross profit                                                                    27,000
Selling expenses                                                              (10,000)
Administration expense                                                         (7,000)
Depreciation expense                                                           (2,500)
Interest expense                                                                  (50)
Interest earned                                                                     45
Net income                                                                    $ 7,495




Page 62                                                     CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 6


Journal entries –

(a)   Cash                                          $100,000
        Capital Stock                                              $100,000

(b)   Rent expense                                     3,000
        Cash                                                           3,000

(c)   Tables and Chairs                               25,000
        Accounts payable                                             25,000

(d)   Depreciation expense (25,000 / 5 / 12)             417
        Accumulated depreciation                                         417

(e)   Advertising and promotion                          500
        Cash                                                             500

(f)   Food supplies                                   30,000
        Accounts payable                                             30,000

(g)   Food supplies                                    6,000
        Cash                                                           6,000

(h)   Salaries and wages                              16,000
        Cash                                                         16,000

(i)   Advertising and promotion                        1,500
      Utilities                                        1,000
      Janitorial                                       1,000
        Cash                                                           3,500

(j)   Accounts payable                                22,000
        Cash                                                         22,000

(k)   Temporary investment                            30,000
        Cash                                                         30,000

(l)   Interest receivable (30,000 x 8% x 1/24)           100
         Interest revenue                                                100




Page 63                                          CMA Ontario – September 2009
Financial Accounting – Module 1




(m) Salaries and wages                   2,500
      Salaries and wages payable                         2,500

(n)   Cost of food supplies             23,300
        Food Supplies                                  23,300

(o)   Cash                               8,000
      Accounts receivable               18,000
        Sales                                          26,000




Page 64                            CMA Ontario – September 2009
Financial Accounting – Module 1




ASSETS

         Cash                           Food Supplies                     Tables and Chairs
(a) 100,000 (b)         3,000     (f)   30,000 (n) 23,300         (c)       25,000
(o)   8,000 (e)           500     (g)    6,000
            (g)         6,000           12,700
            (h)        16,000
             (i)        3,500
             (j)       22,000     Accumulated Depreciation               Accounts Receivable
             (k)       30,000                 (d)      417        (o)       18,000
     27,000


  Temporary Investments               Interest Receivable
(k)  30,000                       (l)       100


LIABILITIES AND SHAREHOLDERS' EQUITY

    Accounts Payable              Salaries & Wages Payable                  Capital Stock
(j)  22,000 (c)   25,000                       (m)   2,500                         (a) 100,000
             (f)  30,000
                  33,000

REVENUES

Sales                             Interest Revenue
               (o)     26,000                   (l)         100


EXPENSES

   Cost of Food Supplies                    Rent                       Salaries and wages
 (n) 23,300                       (b)    3,000                    (h)    16,000
                                                                   (m)    2,500
                                                                         18,500

Advertising and Promotion                  Utilities                          Janitorial
(e)      500                      (i)    1,000                     (i)       1,000
(i)    1,500
       2,000

Depreciation Expense
(d)      417


Page 65                                                           CMA Ontario – September 2009
Financial Accounting – Module 1




                                        Chicken & Rib
                                      Income Statement
                             For the Month Ended, July 31, 20x0

Sales Revenue                                                                    $26,000
Cost of food supplies                                                             23,300
Gross Profit                                                                       2,700
Rent expense                                                                      (3,000)
Salaries and wages expense                                                       (18,500)
Advertising and promotion expense                                                 (2,000)
Utilities expense                                                                 (1,000)
Janitorial expense                                                                (1,000)
Depreciation expense                                                                (417)
Interest revenue                                                                      100
Net Loss and Deficit, July 31, 20x0                                            $(23,117)




Page 66                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




                                         Chicken & Rib
                                  Statement of Financial Position
                                        As at July 31, 20x0

Assets

Fixed Assets
  Table and Chairs                                                                     $25,000
  Less: Accumulated Depreciation                                                           417
                                                                                        24,583

Current Assets
  Cash                                                                                  27,000
  Temporary Investments                                                                 30,000
  Accounts Receivable                                                                   18,000
  Interest Receivable                                                                      100
  Food Supplies                                                                         12,700
                                                                                        87,800

                                                                                      $112,383


Shareholders' Equity and Liabilities

Shareholders' Equity
  Capital Stock                                                                         100,000
  Deficit                                                                              (23,117)
                                                                                         76,883

Current Liabilities
  Accounts Payable                                                                      33,000
  Wages Payable                                                                          2,500
                                                                                        35,500

                                                                                      $112,383




Page 67                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 7

NOTE: In each entry below, the account with an asterisk has been imputed from the
nature of the transaction.

a)    Investments ($40,712 - $30,500)                                  10,212
         *Cash                                                                      10,212
      To record purchase of investments.

b)    *Cash                                                             5,168
         Investments                                                                  5,000
         Gain on sale of investment                                                     168
      To record sale of investments.

c)    *Cash                                                          247,833
      Uncollectible accounts expense                                     665
      Sales                                                              481
         Accounts receivable                                                       248,979
      To record collection of accounts receivable,
      uncollectible accounts expense, and sales returns.

d)    Accounts receivable ($301,425 - $47,420)                       254,005
         Sales                                                                     254,005
      To record sales on account.

e)    Cost of goods sold                                             151,914
         *Inventory .                                                              151,914
      To record cost of goods sold.

f)    Writedown of obsolete merchandise                                 1,025
         *Inventory .                                                                 1,025
      To record obsolete merchandise.

g)    *Accounts payable                                                   556
         Inventory ($153,495 - $151,914 - $1,025)                                       556
      To record purchase returns, perpetual inventory method.

h)    Inventory ($208,856 - $55,542)                                 153,314
         *Accounts payable                                                         153,314
      To record purchases on account.

i)    Selling expense                                                  25,348
         *Accounts payable                                                          25,348
      To record selling expenses.




Page 68                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


j)    Salaries expense                                            15,500
         *Accounts payable                                                     15,500
      To record salaries expense.

k)    Other administrative expense                                21,567
         *Accounts payable                                                     20,594
         Accumulated depreciation                                                 973
      To record other administrative expenses, including
      depreciation.

1)    Office furniture and fixtures ($11,164 - $8,663)             2,501
         *Accounts payable                                                       2,501
      To record purchase of furniture.

m)    Interest expense                                               850
         *Accounts payable                                                         850
      To record interest expense.

n)    Accounts payable ($211,658 - $556)                        211,102
         *Cash .                                                              211,102
      To record payments on account.

o)    *Cash                                                          436
      Accumulated depreciation                                       176
      Loss on sale of fixtures                                        23
         Fixtures                                                                  635
      To record sale of fixtures.

p)    Note payable                                                10,000
         *Cash                                                                 10,000
      To record payment on note.

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

r)    Income taxes payable                                         5,658
         *Cash                                                                   5,658
      To record payment of taxes.

s)    Retained earnings                                           10,000
         *Cash                                                                 10,000
      To record dividends.




Page 69                                                    CMA Ontario – September 2009
Financial Accounting – Module 1




           Cash*                              Investments               Accounts Receivable
                a) 10,212                             b) 5,000                    c) 248,979
Bal    21,849 n) 211,102          Bal        30,500                   Bal 47,420
 b)     5,168 p) 10,000            a)        10,212                    d) 254,005
 c)   247,833 r)    5,658                    40,712                       301,425
 o)       436 s) 10,000
      275,286     246,972               Uncollectible Accounts                  Inventory
                                                       Expense
*The total debits to cash               c) 665                                    e)        151,914
exceed the book total by                                                   55,542 f)          1,025
$270; therefore one of the                                             h) 153,314 g)            556
debits is smaller than                                                    208,856           153,495
shown here by the $270
which the books show as
"unlocated difference."

   Office Furniture and           Accumulated Depreciation             Loss on Sale of Fixtures
         Fixtures
                  o) 635                o)     176                      o)        23
  Bal 8,663                                          Bal     4,967
   l) 2,501                                           k)       973
      11,164                                                 5,940

     Note Payable                  Income Taxes Payable                  Income Tax Expense
  p) 10,000                          r) 5,658                           q) 3,700
             Bal 30,000                       Bal 7,350
                                               q) 3,700
                                                   11,050

      Gain on Sale of                           Sales                       Cost of Goods Sold
       Investments
                  b) 168             c)        481 d)      254,005      e) 151,914



  Writedown of Obsolete
       Merchandise                     Selling Expense                       Salaries Expense
  f) 1,025                          i) 25,348                          j)     15,500




Page 70                                                              CMA Ontario – September 2009
Financial Accounting – Module 1




  Other Administrative                Interest Expense                  Retained Earnings
        Expense
  k) 21,567                          m)     850                    s)    10,000
                                                                                  Bal 55,778


     Accounts Payable                     Share Capital
  g)     556
  n) 211,102          Bal                         Bal 50,000
                   15,879
             h) 153,314
              i)   25,348
              j)   15,500
              k)   20,594
               l)   2,501
             m)       850
     211,658      233,986


LOCATION OF ERROR: The posting of transactions as they appear to have occurred
leaves the cash account with total debits of $275,286 instead of $275,016 and with a
balance of $28,314. However, the company's cash balance of $28,044 has been verified.
The difference of $270 likely arises from the same error which caused the "unlocated
difference" of $270 in the trial balance.

The fact that $270 is evenly divisible by nine indicates the possibility of a transposition.
Since the $270 discrepancy in the cash account in the solution and the bookkeeper's cash
account appears on the debit side of the account the error should be found in one of the
entries which included debits to cash.

In examining the debits in the cash account we can presume that the opening balance of
$21,849 is correct since it was included in the opening trial balance which showed no
discrepancies. By looking at entries b and c we see that neither entry contains a figure
which could include a transposition error of $270 if we assume that there were no other
errors. Entry ‘o’, however, contains a credit of $635 to the office furniture & fixtures
account. This entry might well be where the $270 transposition error occurred.




Page 71                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


If the $635 credit to office furniture & fixtures had been correct, the entry for the sale
would have been:
           Cash                                                         436
           Accumulated depreciation                                     176
           Loss on sale of furniture & fixtures                          23
               Office furniture & fixtures                                                 635

Since this overstates cash by $270, the amount which was received, and which the
bookkeeper posted to the account, must have been $166 ($436 $270). The correct entry
would have been:
           Cash                                                     166
           Accumulated depreciation                                 176
           Loss on sale of furniture & fixtures                      23
               Office furniture & fixtures                                         365

It appears that the bookkeeper made a transposition error and posted a credit of $635
instead of $365 to office furniture & fixtures.




Page 72                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 8


1)    Commissions receivable                                            $465
             Commissions earned                                                     $465
      To accrue commissions earned

2)    Bad debt expense                                                     45
             Allowance for doubtful accounts                                           45
      To record estimated bad debts

3)    Office supplies expense                                             120
             Office supplies                                                          120
      To record the use of office supplies

4)    Rent expense                                                        155
             Prepaid rent                                                             155
      To recognize the expiration of prepaid rent

5)    Depreciation expense                                                 98
             Accumulated depreciation - office equipment                               98
      To record depreciation on office equipment for the period

6)    Salary expense                                                      290
             Salaries payable                                                         290
      To accrue unpaid salaries

7)    Interest expense                                                    180
              Interest payable                                                        180
      To accrue unpaid interest




Page 73                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 9


ACCOUNT TITLE                               ANALYSIS
Cash in bank                                Current asset if unrestricted

Inventory of operating parts and supplies   Current asset if expected to be used within
                                              longer of one year or operating cycle

Inventory of raw materials                  Current asset

Accounts receivable                         Current assets if collectible within longer of
                                              one year or operating cycle

Inventory of finished goods                 Current asset

Inventory of work in                        Current asset process

Interest accrued on government securities   Current asset

Notes receivable                            Same analysis as accounts receivable

Petty cash fund                             Current asset

Government securities                       Current asset unless expected to be held
                                              beyond longer of one year or operating
                                              cycle

Unamortized bond discount                   Contra account to current liability only if
                                              related bonds appropriately classified as
                                              current

Accrued payroll                             Current liability

Provision for renegotiation                 Current liability if expected to require use
   of government contracts                    of existing current assets

Notes payable                               Current liability if expected to be paid with
                                              existing current assets or through creation
                                              of another current liability

Accrued interest on bonds                   Current liability

Accounts payable                            Current liability

Accrued interest on notes payable           Current liability

Page 74                                                         CMA Ontario – September 2009
Financial Accounting – Module 1




8% first mortgage bonds                           Current liability

Preferred share dividend                          Current liability

Allowance for doubtful accounts                   Contra account to accounts receivable,
                                                     classified same as related receivables

Provision for federal income taxes                Current liability

Customers' advances                               Current liability

Premium on bonds redeemable in 20x1               Current liability if related bonds are
                                                    appropriately classified as current
                                                    liability

Officers' 20x1 bonus accrued                      Current liability



Problem 10

1.        Under cash-basis accounting, net income would be the net cash provided by
          operations. Revenue would be recognized when cash is received from other than
          investors and creditors r and expenses would be recognized when cash payments
          are made for reasons other than financing (including distributions to owners). This
          approach has very little conceptual merit because it fails to match expenses to
          revenues so as to satisfactorily measure operating performance during a period.

          In contrast, accrual accounting focuses on the transactions and events that affect
          the assets and liabilities of the accounting entity, and attempts to recognize and
          report those transactions and events in the accounting periods in which they
          occur. Revenues are recognized when they are earned and expenses are matched
          against revenues on the basis of: (a) cause and effect, (b) systematic and rational
          allocation, or (c) immediate recognition.

2.        Gross margin for Janson's Retail Hardware is not being calculated on a pure cash
          basis. Gross margin on a pure cash basis for 20x3 would be:

              Cash received:
                $147,000 Cash Sales + 13,000 Credit Sales - 1,000 Increase in AR    $159,000
              Cash payments for merchandise:
                Accounts payable, Jan 1, 20x3                            $ 12,000
                Purchases during 20x3                                     100,000
                                                                          112,000
              Less: Accounts payable, Dec 31, 20x3                       (19,000)    (93,000)

Page 75                                                                CMA Ontario – September 2009
Financial Accounting – Module 1


              Gross margin (net cash inflows)                                    $66,000


3.        Gross margin shows a decrease because it is being calculated incorrectly. When
          Mr. Janson adds the ending balance of accounts receivable to the cost of
          merchandise on hand in his determination of net inventory, he is improperly
          including the profit margin that is part of the accounts receivable. This results in
          an overstatement of net inventory at both the beginning and end of the accounting
          period.

          The major error in calculating gross margin occurs when Mr. Janson subtracts the
          accounts payable balance in arriving at the net inventory amounts. The increasing
          balance of accounts payable each year results in an increasing overstatement of
          cost of goods sold.


Problem 11

a) A division does not qualify as a separate entity for financial reporting purposes but
   only for internal control purposes. Financial statements are prepared on a company
   basis (entity concept).

b) Financial statements are neutral in the sense that they reflect certain facts about the
   company but they are not neutral in the way that these facts are selected and then
   shown. Financial statements may lack neutrality as many accounting methods may be
   available and only one is chosen to be used by the accountant.

c) Numbers are exact in the sense that they can be added together. But the process
   generating the numbers is not exact because often it is based on estimates and choices
   of methods. (Example - depreciation.)

d) The historical cost principle allows us to reduce disagreements as to how items
   should be recorded. Cost is more objective than, for example, market values, but it
   does not necessarily give us objective numbers as cost is more than just an invoice
   price in many situations.




Page 76                                                           CMA Ontario – September 2009
Financial Accounting – Module 1



2.        The Statement of Cash Flows

Re-consider the following schematic of the Statement of Financial Position:


                                                            Share Capital

                    Long-term Assets
                                                          Retained Earnings


                                                        Long-Term Liabilities



                                                         Current Liabilities
                      Current Assets




The purpose of the Cash Flow Statement is to report on sources and uses of cash over a
period of time as well as the net change in cash and cash equivalents. Reporting
information about the cash flows of a firm helps the users of the financial statements to
assess both the past performance of the entity in generating and controlling cash
resources and the entity’s probable future cash inflows, outflows, and net cash flows. The
major components of the cash flow statement are the cash flows resulting from the
operating, investing, and financing activities of the firm. For the purpose of the cash flow
statement, cash is defined as cash and cash equivalents. Cash equivalents include short-
term, highly liquid investments that can be readily converted into known amounts of
cash. Cash equivalents are shown net of bank overdrafts where overdrafts are part of the
cash management strategy of the firm.

Investing - all changes in noncurrent assets except those that flow through the income
statement (i.e. amortization expense); the latter are considered operating activities. The
only possible changes to noncurrent assets are:
• purchasing noncurrent assets - cash used for investing
• proceeds on sale of noncurrent assets - cash provided by investing
• equity income on long-term investments - deducted from net income in the operating
    section.

Financing - all changes in noncurrent liabilities and share capital are financing activities
except for those items flowing through the income statement.
• issue of long-term debt and share capital - cash provided by financing
• redemption of long-term debt and share capital - cash used by financing
• dividends paid (not just declared)




Page 77                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


The operating section of the Statement of Cash flow can be prepared using two formats.
These are the indirect or direct methods. Although both methods are acceptable under
IFRS, IAS 7.19 encourages entities to use the direct method. The direct method provides
information which may be useful in estimating future cash flows and which is not
available under the indirect method.

Cash Flow From Operations - Indirect method: we start with net income and adjust it for
non cash items: these are generally of two categories: (1) non cash revenue or expense
items and (2) any changes in non-cash working capital items. An indirect cash flow from
operations might look like this:

       Net income                                                       $12,000
       Adjust for items not requiring a cash outlay
         Depreciation                                                     2,000
         Gain on sale of depreciable assets                              -1,500
       Changes in noncash working capital items
         Increase in accounts receivable                                 -2,500
         Decrease in inventory                                              500
         Increase in accounts payable                                     1,500
         Decrease in income taxes payable                                  -600
       Cash flow from operations                                        $11,400

Cash Flow From Operations - Direct method: as opposed to taking net income and
adjusting it, we essentially go through each line on the income statement and convert all
items into cash. For example, if the sales were $124,000 for the year and assuming that
the accounts receivable increased $2,500, then the cash sales would be calculated as
$124,000 – 2,500 = $121,500.

If we continue the example used for the indirect method and we assume that the income
statement was as follows:

       Sales                                                          $124,000
       Cost of goods sold                                              (75,000)
       Operating expenses (all paid for in cash)                       (28,500)
       Amortization                                                      (2,000)
       Gain on sale of depreciable assets                                  1,500
       Net income before taxes                                            20,000
       Income tax expense (all current)                                    8,000
       Net income                                                       $12,000




Page 78                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


The direct approach to determining cash flow from operations would be as follows:

       Collections from customers ($124,000 Credit Sales
           – 2,500 Increase in Accounts Receivable)                        $121,500
       Payments to suppliers ($75,000 - 500 Decrease in Inventory           (73,000)
       - 1,500 Increase in Accounts Payable)
       Payments for operating expenses                                      (28,500)
       Payments made for Income taxes ($8,000 Income Tax Expense
           + 600 Decrease in Income Tax Payable)                             (8,600)
       Cash flow from operations                                            $11,400

Noncash Investing and Financing Activities – at times a corporation will enter into
noncash transactions. Examples of these could be the purchase of land by issuing new
shares as consideration or by taking out a mortgage; paying a stock dividend or
purchasing a company by issuing new shares. Since none of these transactions involve
cash, they do not belong on the Statement of Cash flows. Such transactions should be
disclosed elsewhere in the financial statements in a way that provides all the relevant
information about these investing and financing activities.

Specific required disclosures – regardless of whether the direct or indirect method is
used, the following two items need to be disclosed:
•       cash paid on interest, and
•       cash paid on taxes

A few more details…
•     a Statement of Cash Flows has to be prepared by all entities
•     cash includes cash and cash equivalents which are defined as short-term, highly
      liquid investments that are readily convertible to known amounts of cash and
      which are subject to an insignificant risk of changes in value.
•     short term bank loans: bank overdrafts may be included as a component of cash
      and cash equivalents when the bank balance fluctuates frequently from being
      positive to overdrawn; otherwise, bank overdrafts and short term demand loans
      are considered as cash flow from financing.
•     available for sale, held-for-trading and held to maturity investments are
      considered as part of cash flow from investing regardless of their classification as
      current or long-term assets.
•     cash flows from dividends received and paid can be classified as either operating,
      investing or financing cash flows as long as they are reported in a consistent
      manner.




Page 79                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


Example 1: Karington Ltd. has been manufacturing equipment for making pasta for the
past ten years. The company's comparative Statement of Financial Position as at March
31, 20x5, its fiscal year end, is as follows:

                                          Karington Ltd.
                                  Statement of Financial Position
                                       as at March 31, 20x5

ASSETS                                                                     20x5           20x4

Long-term Assets
Equipment                                                            1,175,000         881,250
Accumulated depreciation                                              (370,125)       (282,000)
Investment in Kolbe Ltd.                                               176,250               -
Patents                                                                129,250         141,000
                                                                     1,110,375         740,250

Current Assets
Cash                                                                   $82,250        $141,300
Accounts receivable                                                    282,000         312,550
Inventory                                                              458,250         352,500
Prepaid expenses                                                        23,500          18,500
                                                                       846,000         824,850

                                                                    $1,956,375      $1,565,100

LIABILITIES & SHAREHOLDERS' EQUITY                                        20x5            20x4

Shareholders' Equity
Capital stock                                                        1,408,100       1,233,750
Retained earnings                                                      189,900         141,000
                                                                     1,598,000       1,374,750
Long-term Liability
Notes Payable                                                         105,750

Current Liabilities
Bank overdraft                                                       $ 61,100        $ 47,000
Accounts payable                                                      105,925          59,250
Salaries payable                                                       32,900          37,600
Income taxes payable                                                   25,000          34,000
Deferred revenues                                                      10,000           8,000
Interest payable                                                        3,600           4,500
Dividends payable                                                      14,100               -
                                                                      252,625         190,350
                                                                    $1,956,375      $1,565,100


Page 80                                                             CMA Ontario – September 2009
Financial Accounting – Module 1




                                       Karington Ltd.
                                      Income Statement
                             for the year ended March 31, 20x5

Sales                                                                        $1,350,000
Cost of goods sold                                                              830,000
Gross margin                                                                    520,000
Salaries expense                                                              (220,000)
Selling and administrative expenses                                           (197,600)
Interest expense                                                               (12,400)
Gain on sale of equipment                                                        15,000
Net income before taxes                                                         105,000
Income tax expense                                                               42,000
Net income                                                                      $63,000


Additional Information:
• The investment in Kolbe Ltd. was financed by issuing a 10-year note for $105,750
   and providing the remainder in cash.
• Equipment with an original cost of $50,000 which was 70% depreciated was sold
   during the year.
• Depreciation expense in included in selling and administrative expenses
• Dividends of $14,100 were declared during the year.

Given the above information we can now construct the statement of cash flows as
follows.




Page 81                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


                                       Karington Ltd.
                                  Statement of Cash Flows
                             for the year ended March 31, 20x5

Cash Flow from Operations

Net income                                                                               $63,000
Adjust for noncash items
                                     1
  Depreciation and amortization                                                          134,875
  Gain on sale of equipment                                                             (15,000)

Changes in non-cash working capital items:
  Decrease in Accounts Receivable                                                          30,550
  Increase in Inventory                                                                (105,750)
  Increase in Prepaid Expenses                                                            (5,000)
  Increase in Accounts Payable                                                             46,675
  Decrease in Salaries Payable                                                            (4,700)
  Decrease in Income Taxes Payable                                                        (9,000)
  Increase in Deferred Revenues                                                             2,000
  Decrease in Interest Payable                                                              (900)
                                                                                         136,750

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

Cash Flow from Investing
  Investment in Kolbe Ltd. ($176,250 – 105,750)                                         (70,500)
  Proceeds on sale of equipment ($15,000 Gain
     + 15,000 NBV of Asset Sold)                                                          30,000
  Purchase of equipment2                                                               (343,750)
                                                                                       (384,250)

Decrease in cash and cash equivalents                                                   (73,150)
Cash and cash equivalents*, March 31, 20x4                                                94,300
Cash and cash equivalents, March 31, 20x5                                                $21,150

* Cash and cash equivalents include Cash net of the Bank Overdraft.
1
    Accumulated depreciation beginning                                                  $282,000
    Less accumulated depreciation on asset sold: $50,000 x 70%                           (35,000)
    Less accumulated depreciation, ending                                              (370,125)
    Depreciation expense on equipment                                                     123,125
    Add amortization on patent:
      $141,000 Patent – Opening Balance – 129,250 Patent – Ending Balance                 11,750
                                                                                        $134,875


Page 82                                                               CMA Ontario – September 2009
Financial Accounting – Module 1



2
     Equipment, end of year                                                                             $1,175,000
     Less equipment, beginning of year                                                                   (881,250)
     Net increase                                                                                          293,750
     Add cost of equipment sold                                                                             50,000
     Purchase of equipment                                                                                $343,750

If the direct method had been used, the cash flow from operations section would be as
follows:

Cash collected from customers ($1,350,000 Sales + 30,550 Decrease in A/R
    + 2,000 Increase in Deferred Revenues)                                                              $1,382,550
                                                COGS                Increase in Inventory
Cash paid to suppliers ($830,000                       + 105,750
               Increase in Accounts Payable
    - 46,675                                )                                                            (889,075)
                                                 Salaries Expense
Cash paid to employees ($220,000
    + 4,700 Decrease in Salaries Payable)                                                                (224,700)
                                                                                       S&A Expenses
Cash paid for Selling and Administrative Expenses ($197,600
    + 5,000 Increase in Prepaid Expenses – 134,875 Depreciation Expense)                                  (67,725)
Cash paid on interest ($12,400 Interest Expense + 900 Decrease in Interest Payable)                       (13,300)
Cash paid on taxes ($42,000 Income Tax Expense
    + 9,000 Decrease in Income Taxes Payable)                                                             (51,000)
                                                                                                          $136,750




Page 83                                                                                 CMA Ontario – September 2009
Financial Accounting – Module 1


Example 2 – the Statement of Cash Flow for Local Stationery Ltd. (example on page 4)
is as follows:

                                     Local Stationery Ltd.
                                    Statement of Cash Flow
                            for the year ended December 31, 20x6

Cash flow from operations
  Net income                                                                     $73,620
  Adjust for items not affecting cash flow
    Depreciation                                                                   20,000
    Gain on disposal of assets                                                    (5,000)
  Changes in non-cash working capital items
    Increase in accounts receivable                                              (22,800)
    Increase in inventory                                                        (15,000)
    Decrease in note receivable                                                    10,400
    Increase in prepaid insurance                                                 (3,700)
    Increase in accounts payable and accrued liabilities                           10,000
    Decrease in wages payable                                                     (1,500)
    Increase in accrued income taxes payable                                       24,080
    Decrease in unearned revenues                                                 (5,000)
                                                                                   85,100

Cash flow from investing
  Purchase of equipment                                                          (50,000)
  Sale of equipment                                                                20,000
                                                                                 (30,000)

Cash flow from financing
  Dividends                                                                      (30,000)
  Repayment of long-term debt                                                    (15,000)
                                                                                 (45,000)

Increase in cash                                                                  10,100
Cash, beginning of year                                                           14,500
Cash, end of year                                                                $24,600




Page 84                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


If the direct method had been used, the cash flow from operations section would be as
follows:

Cash collected from customers ($1,152,600 Sales - 22,800 Increase in A/R
    + 10,400 Decrease in Note Receivable - 5,000 Decrease in Deferred Revenues
    - 4,800 Bad Debt Expense*)                                                                             $1,130,400
Cash paid to suppliers ($645,000 COGS + 15,000 Increase in Inventory
    - 10,000 Increase in Accounts Payable)                                                                  (650,000)
Cash paid for Selling and Administrative Expenses                                                           (150,000)
                                                 Wages and Salaries Expense
Cash paid to employees ($198,500
    + 1,500 Decrease in Salaries Payable)                                                                   (200,000)
                                             Insurance Expense             Increase in Prepaid Insurance
Cash paid for insurance ($3,500                                  + 3,700                               )      (7,200)
Cash collected on interest                                                                                       400
Cash paid on interest                                                                                        (13,500)
                                      Income Tax Expense
Cash paid on taxes ($49,080
    - 24,080 Increase in Income Taxes Payable)                                                               (25,000)
                                                                                                             $85,100

*         the concept of how bad debt expense and the change in the allowance for doubtful accounts will
          be elaborated on when we cover Accounts Receivable.




Page 85                                                                                 CMA Ontario – September 2009
Financial Accounting – Module 1



Statement of Cash Flows
Problems with Solutions

Multiple Choice Questions

1.    Lance Corp.'s statement of cash flows for the year ended September 30, 20x2, was
      prepared using the indirect method and included the following:

      Net income                                                    $60,000
      Non-cash adjustments:
            Depreciation expense                                      9,000
            Increase in accounts receivable                          (5,000)
            Decrease in inventory                                    40,000
            Decrease in accounts payable                            (12,000)
      Net cash flows from operating activities                      $92,000

      Lance reported revenues from customers of $75,000 in its 20x2 income statement.
      What amount of cash did Lance receive from its customers during the year ended
      September 30, 20x2?
      a) $80,000
      b) $70,000
      c) $65,000
      d) $55,000


2.    On June 30, 20x4, D Ltd., a manufacturing company, sold a piece of land for its
      book value of $250,000. D Ltd. accepted $170,000 cash plus a mortgage in the
      amount of $80,000 in exchange for the land. How would D Ltd. report this on its
      December 31, 20x4, statement of cash flow?
      a) $250,000 inflow under the investing activities heading.
      b) $170,000 inflow under the investing activities heading.
      c)   $250,000 inflow under the investing and $80,000 outflow under the
           financing activities headings.
      d)    $170,000 inflow under the investing and $80,000 outflow under the
           financing activities headings.
      e)    $250,000 inflow and $80,000 outflow under the investing activities
           heading.




Page 86                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




3.    Consider the following information for a firm’s year ended December 31, 20x4:

                                                          January     December 31,
                                                           1, 20x4            20x4
                 Accounts receivable                     $340,000         $385,000
                 Prepaid Rent                              14,000            6,000
                 Unearned revenues                         36,000           54,000

                 Revenues                                    1,600,000

      Calculate the cash flow from customers for the year ended December 31, 20x4:
      a) $1,537,000
      b) $1,573,000
      c) $1,600,000
      d) $1,609,000
      e) $1,663,000


4.     Net cash flow from operating activities for 20x2 for Graham Corporation was
       $75,000. The following items are reported on the financial statements for 20x2:

                      Amortization expense                           $5,000
                      Cash dividends paid on common shares            3,000
                      Increase in accrued receivables                 6,000

       Based only on the information above, Graham's net income for 20x2 was:
       a) $64,000
       b) $66,000
       c) $74,000
       d) $76,000
       e) None of the above.


5.    The following information is available for Ace Company for 20x2:
                  Disbursements for purchases                   $500,000
                  Increase in trade accounts payable              50,000
                  Decrease in merchandise inventory               20,000
      Costs of goods sold for 20x2 was
      a) $570,000
      b) $530,000
      c) $470,000
      d) $430,000




Page 87                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




6.    On September 1, 20x3, Canary Co. sold used equipment for a cash amount equaling
      its carrying amount for both book and tax purposes. On September 15, 20x3,
      Canary replaced the equipment by paying cash and signing a note payable for new
      equipment. The cash paid for the new equipment exceeded the cash received for the
      old equipment. How should these equipment transactions be reported in Canary's
      2003 statement of cash flows?
      a) Cash outflow equal to the cash paid less the cash received
      b) Cash outflow equal to the cash paid and note payable less the cash received
      c) Cash inflow equal to the cash received and a cash outflow equal to the cash
             paid and note payable
      d) Cash inflow equal to the cash received and a cash outflow equal to the cash
             paid


Questions 7 through 9 are based on the following:

Flax Corp. uses the direct method to prepare its statement of cash flows. Flax's trial
balances at December 31, 20x1 and 20x0, are as follows:

                                        December 31
                                                  20x1                    20x0
Debits:
Cash                                              $35,000             $32,000
Accounts receivable                                33,000              30,000
Inventory                                          31,000              47,000
Property, plant, & equipment                      100,000              95,000
Unamortized bond discount                           4,500               5,000
Cost of goods sold                                250,000             380,000
Selling expenses                                  141,500             172,000
General and administrative expenses               137,000             151,300
Interest expense                                    4,300               2,600
Income tax expense                                 20,400              61,200
                                                 $756,700            $976,100
Credits:
Allowance for uncollectible accounts               $1,300               1,100
Accumulated depreciation                           16,500              15,000
Trade accounts payable                             25,000              17,500
Income taxes payable                               21,000              27,100
Future income taxes                                 5,300               4,600
8 % callable bonds payable                         45,000              20,000
Common stock                                       50,000              40,000
Additional paid-in capital                          9,100               7,500
Retained earnings                                  44,700              64,600
Sales                                             538,800             778,700
                                                 $756,700            $976,100

Page 88                                                         CMA Ontario – September 2009
Financial Accounting – Module 1




Flax purchased $5,000 in equipment during 20x1.

Flax allocated one-third of its depreciation expense to selling expenses and the remainder
to general and administrative expenses.

What amounts should Flax report in its statement of cash flows for the year ended
December 31, 20x1, for the following:

7.    Cash collected from customers?
      a) $541,800
      b) $541,600
      c) $536,000
      d) $535,800


8.    Cash paid for goods to be sold?
      a) $258,500
      b) $257,500
      c) $242,500
      d) $226,500


9.    Cash paid for interest?
      a) $4,800
      b) $4,300
      c) $3,800
      d) $1,700




Page 89                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

The income statement and comparative balance sheets of Harold Ltd. are shown below.

                                          Harold Ltd.
                                      Income Statement
                            for the year ended December 31, 20x2

          Sales                                                       $ 1,650,000
          Cost of goods sold                                          (1,236,000)
          Operating expenses                                            (197,000)
          Depreciation expense                                          (120,000)
          Interest expense                                               (25,000)
          Gain on sale of disposal of property, plant and equipment         6,000
          Income tax expense                                             (27,000)
          Net income                                                  $ 51,000




Page 90                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


                                             Harold Inc.
                                  Statement of Financial Position
                                      as at December 31, 20x2

                                                                         20x2             20x1
Noncurrent Assets
Property, plant and equipment                                        $850,000         $740,000
Accumulated depreciation                                             (426,000)       (356,000)
                                                                       424,000         384,000
Current assets
Cash                                                                  145,000           75,000
Accounts receivable                                                   226,000          202,000
Inventory                                                             305,000          336,000
Prepaid expenses                                                       14,000           35,000
                                                                      690,000          648,000
                                                                    $1,114,000     $ 1,032,000

Shareholders’ equity
Common shares                                                       $ 450,000       $ 400,000
Retained earnings                                                     177,000         156,000
                                                                      627,000         556,000
Long-term debt                                                        213,000          219,000

Current liabilities
Accounts payable                                                      225,000          206,000
Salaries payable                                                       14,000           20,000
Interest payable                                                       12,000           10,000
Income taxes payable                                                   13,000           16,000
Dividends payable                                                      10,000            5,000
                                                                      274,000          257,000
                                                                      487,000          476,000
                                                                    $1,114,000     $ 1,032,000

Additional information
During 20x4, property plant and equipment costing $100,000 was sold.

Required -

a.        Prepare a Statement of Cash Flows for Harold Inc. using the direct method.
b.        Prepare the Cash Flow from Operations section using the indirect method.




Page 91                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2

The records of Dumbledore Company provided the following data for the accounting
year ended December 31, 20x5:

                        Comparative Statements of Financial Position
                                    as at December 31

Assets                                                                  20x4          20x5
  Cash                                                               $30,000     $ 75,000
  Investment, short term (cash equivalent)                            10,000         8,000
  Accounts receivable                                                 56,000        86,000
  Inventory                                                           20,000        30,000
  Prepaid interest                                                         --        2,000
  Land                                                                60,000        25,000
  Machinery                                                           80,000        90,000
  Accumulated depreciation                                          (20,000)      (26,900)
  Other assets                                                        29,000        39,000
                                                                   $265,000      $328,100

Liabilities and Shareholders’ Equity
  Accounts payable                                                   39,000        54,000
  Salaries payable                                                    5,000         2,000
  Income taxes payable                                                2,000         8,000
  Bonds payable                                                      70,000        55,000
  Common shares                                                     100,000       130,000
  Preferred shares                                                   20,000        30,000
  Retained earnings                                                  29,000        49,100
                                                                   $265,000      $328,100

                                       Income Statement
                            for the year ended December 31, 20x5

           Sales revenue                                            $180,000
           Cost of goods sold                                        (90,000)
           Depreciation expense                                       (6,900)
           Salaries                                                  (33,900)
           Interest expense                                           (6,000)
           Remaining expenses                                         (4,000)
           Gain on sale of land                                        18,000
           Income tax expense                                        (12,100)
           Net income                                               $ 45,100




Page 92                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Analysis of selected accounts and transactions:

a.        Issued bonds payable for cash, $5,000.
b.        Sold land for $53,000 cash; book value, $35,000.
c.        Purchased machinery for cash, $10,000.
d.        Retired $20,000 bonds payable by issuing common shares; the common shares
          had a market value of $20,000.
e.        Acquired other assets by issuing preferred shares with a market value of $10,000.
f.        Statement of retained earnings:

                Balance, January 1, 20x5                      $29,000
                Net income for 20x5                            45,100
                Cash dividends                               (15,000)
                Stock dividend issued                        (10,000)
                Balance, December 31, 20x5                    $49,100

Required -

a.        Prepare the Statement of Cash Flows, indirect method.
b.        Prepare the operations section of the Statement of Cash Flows using the direct
          method of presentation.




Page 93                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

The Statement of Financial Positions of Sunrise Ski Company showed the following:
                                                              December December
                                                               31, 20x2      31, 20x1
Debits -
Cash                                                           $ 10,000      $ 12,000
Accounts receivable (net)                                        18,000        10,000
Inventory                                                        24,000        20,000
Long-term investments                                            10,000        24,000
Plant and equipment                                             104,000        60,000
                                                               $166,000      $126,000
Credits -
Accumulated depreciation                                       $ 14,000      $ 10,000
Accounts payable                                                 16,000        12,000
Notes payable-long-term                                          40,000        32,000
Share capital                                                    60,000        50,000
Retained earnings                                                36,000        22,000
                                                               $166,000      $126,000

The income statement for 20x2 appears below:

Sales                                                                             $320,000
Cost of sales                                                                    (200,000)
Expenses, including income taxes, paid in cash                                     (96,000)
Depreciation                                                                        (6,000)
Loss on disposal of plant and equipment                                             (4,000)
Gain on disposal of plant assets                                                      2,000
Net income                                                                        $ 16,000

Additional data concerning changes in the noncurrent accounts:
a) Cash dividends paid, $2,000.
b) Issue of common shares for cash, $10,000.
c) Plant and equipment disposed of during the year cost $6,000.

Required -

a.        Prepare a statement of cash flows for 20x2. Use the direct method.
b.        Calculate Cash flow from operations using the indirect method.




Page 94                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 4

TGA Corporation, a publicly-held company, develops and sells software application
programs. TGA's Statement of Income and Retained Earnings for the year ended
December 31. 20x1, and Comparative Statement of Financial Position for 20x0 and 20x1
are presented below.

                                  TGA Corporation
                     Statement of Income and Retained Earnings
                       For the Year Ended December 31, 20x1

Sales revenue                                                           $300,000
Cost of goods sold                                                       120,000
Gross profit                                                             180,000
Salaries expense                                                         (50,000)
Depreciation expense                                                       (6,000)
Loss on sale of equipment                                                  (2,500)
Interest expense                                                           (2,500)
Income before taxes                                                       119,000
Income tax expense                                                          48,000
Net income                                                                  71,000
Retained earnings, January 1, 20x1                                         87,000
Dividends                                                                 (8,000)
Retained earnings , December 31, 20x1                                   $150,000




Page 95                                                      CMA Ontario – September 2009
Financial Accounting – Module 1




                                   TGA Corporation
                        Comparative Statement of Financial Position
                           As of December 31, 20x1 and 20x0

                   Assets                    Dec 31, 20x1   Dec 31, 20x0          Change

Cash                                            $ 98,500       $ 86,000         $ 12,500
Accounts receivable, net                           50,000         30,000          20,000
Inventory                                          70,000         55,000          15,000
Land                                              200,000        200,000               -
Plant and equipment                                80,000         69,500          10,500
Accumulated depreciation                         (15,500)       (13,500)         (2,000)
   Total assets                                 $483,000       $427,000         $ 56,000



Liabilities & Shareholders' Equity
Accounts payable                                $ 15,000       $ 20,000         $ (5,000)
Salaries payable                                  10,000          7,000             3,000
Taxes payable                                      3,000         13,000         (10,000)
10% convertible bonds payable                          -        100,000        (100,000)
Common stock                                     305,000        200,000          105,000
Retained earnings                                150,000         87,000           63,000
  Total liabilities & shareholders' equity      $483,000       $427,000          $56,000


Additional Information

•   During the year, additional equipment was acquired by TGA for $20,000 cash. TGA
    also sold equipment costing $9,500, with a book value of $5,500, for $3,000 cash.
•   On March 30, 20x1, $100,000 of 10% convertible bonds, issued at face value with
    interest payment dates of June 30 and December 31, were converted into 2,000 shares
    of TGA Corporation common stock.
•   An additional $5,000 of common stock were issued for cash.

Required -

Using the direct method, prepare a Statement of Cash Flows for TGA Corporation for
the year ended December 31, 20x1.




Page 96                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5

Mr. Cumin, the president of Sage Ltd., presented you with the following Statement of
Financial Position and asked you to prepare a statement of cash flow.

                                       Sage Ltd.
                       Comparative Statement of Financial Position
                                  As at June 30, 20x5
                                                                20x5             20x4
                                         Assets

Long-Term Assets
   Government bonds held for expansion                          97,500           -
   Equipment                                                   602,550       420,550
   Accumulated depreciation                                   (270,400)     (241,800)
   Leasehold improvements                                       18,850        18,850
   Patents (net)                                                18,070        19,500
                                                              466,570        217,100

Current Assets
   Cash                                                       $ 94,250     $ 162,500
   Accounts receivable                                         164,450       177,450
   Allowance for doubtful accounts                              (9,100)      (11,050)
   Inventories                                                 313,950       313,950
                                                               563,550       642,850

                                                           $1,030,120       $859,950

                            Liabilities and Shareholders' Equity

Shareholders' Equity
   Preferred stock                                             58,500         65,000
   Common stock                                               325,000        325,000
   Retained earnings                                          274,300        174,200
                                                              657,800        564,200
Long-term Liabilities
   12% Bonds payable                                          162,500        195,000

Current Liabilities
   Accounts payable                                          $ 151,320     $ 68,250
   Cash dividends payable                                       26,000          -
   Current portion of bonds payable                             32,500       32,500
                                                               209,820       100,750

                                                           $1,030,120       $859,950

Page 97                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




At a meeting with the assistant controller, you learned that legal costs amounting to
$1,300 were incurred to defend a patent. A premium paid to retire preferred stock was
charged to retained earnings. Equipment with a book value of $39,650 was sold for
$31,200. Patent amortization amounted to $2,730. Equipment purchases amounted to
$250,900 and net income for the year was $126,750. Dividends in the amount of $26,000
were declared.

Required:

Prepare a statement of cash flows.


Problem 6

The Statement of Financial Positions for Carlos Ltd. as at December 31, 20x0 and 20x1,
and the income statement for the year ended December 31, 20x1 are presented below.

                                     CARLOS LTD.
                              Statement of Financial Positions
                                    December 31, 20x1

Assets                                                                 20x1            20x0
Cash                                                               $ 46,000        $ 40,000
Accounts receivable                                                 100,000          80,000
Inventory                                                            90,000          50,000
Buildings and equipment, net of accumulated amortization             82,000          80,000
                                                                  $ 318,000       $ 250,000
Liabilities and shareholders' equity
Accounts payable                                                   $ 20,000        $ 65,000
Taxes payable                                                         6,000           4,000
Interest payable                                                      1,000           2,000
Notes payable                                                        53,000          59,000
Common shares                                                       120,000         100,000
Retained earnings                                                   118,000          20,000
                                                                  $ 318,000        $250,000




Page 98                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


                                         CARLOS LTD.
                                        Income Statement
                                  year ended December 31, 20x1

Sales                                                                             $ 520,000
Expenses
  Cost of goods sold                                              $ 300,000
  Other expenses                                                     71,000
  Depreciation expense—building and equipment                         9,000
  Interest expense                                                    7,000
  Income tax expense                                                 35,000         422,000
Net income                                                                         $ 98,000

Other Information -

1.        Equipment costing $ 11,000 was purchased during the year.
2.        The company issued 800 shares for $20,000 cash.
3.        The note payable matures in 20x3.

Required -

a.        Prepare a cash flow statement for the year ended December 31, 20x1, using the
          direct method of presenting the cash flows from operations.
b.        Prepare the cash flow from operating activities using the indirect approach.




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Solutions

Multiple Choice Questions

1.    b     $75,000 - 5,000 Increase in A/R = $70,000

2.    b     Only the cash receipt would be shown on the statement of cash flows.

3.    b     $1,600,000 – 45,000 Increase in A/R + 18,000 Increase in Deferred Revenues
            = $1,573,000

4.    d     75,000 + 6,000 – 5,000 = $76,000


5.    a     Purchases = $500,000 + 50,000 = $550,000
            COGS = $550,000 + 20,000 = $570,000

6.    d

7.    c     $538,800 - $2,800 Increase in net receivables = $536,000

8.    d     Purchases = $250,000 - $16,000 decrease in inventory = $234,000
            Cash purchases = $234,000 - 7,500 Increase in trade payables = $226,500

9.    c     $4,300 Interest expense - $500 Amortization of discount on bonds payable




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Problem 1

a.     Harold Inc.
       Statement of Cash Flows
       For the year ended December 31, 20x2

       Cash flow from operations
         Cash collected from customers ($1,650,000 Sales
            – 24,000 Increase in Accounts Receivable)                                        $1,626,000
         Cash paid to suppliers ($1,236,000 – 31,000 Decrease in Inventory
           – 19,000 Increase in Accounts Payable)                                           (1,186,000)
         Cash paid for operating expenses ($197,000
           – 21,000 Decrease in Prepaid Expenses + 6,000 Decrease in Salaries Payable)        (182,000)
         Cash paid for interest ($25,000 – 2,000 Increase in Interest Expense)                 (23,000)
         Cash paid for income taxes ($27,000
           + 3,000 Decrease in Income Taxes Payable)                                           (30,000)
                                                                                                205,000

       Cash flow from investing
         Purchase of property, plant and equipment
           $110,000 Increase in PPE + 100,000 Cost of Equipment Sold                          (210,000)
         Proceeds on sale of PPE
           $50,000 NBV of PPE Sold* + 6,000 Gain on Sale                                         56,000
                                                                                              (154,000)

       Cash flow from financing
         Issue of common shares                                                                  50,000
         Repayment of long-term debt                                                            (6,000)
         Dividends Paid **                                                                     (25,000)
                                                                                                 19,000

       Increase in cash                                                                          70,000
       Cash, beginning of year                                                                   75,000
       Cash, end of year                                                                       $145,000

       * Accumulated Depreciation on PPE Sold =
           $120,000 Depreciation Expense - $70,000 Increase in Accumulated Depreciation

       ** Dividends Declared = $51,000 Net Income
            - 21,000 Increase in Retained earnings                                              $30,000
          Less Increase in Dividends Payable                                                     (5,000)
          Dividends paid                                                                        $25,000




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b.     Cash Flow from Operations - Indirect
           Net Income                                                                $51,000
           Adjust for non-cash items
             Depreciation                                                            120,000
             Gain on sale of disposal of property, plant and equipment                (6,000)
           Adjust for changes in non-cash working capital items
             Increase in Accounts Receivable                                         (24,000)
             Decrease in Inventory                                                     31,000
             Decrease in Prepaid Expenses                                              21,000
             Increase in Accounts Payable                                              19,000
             Decrease in Salaries Payable                                             (6,000)
             Increase in Interest Payable                                               2,000
             Decrease in Income Taxes Payable                                         (3,000)
                                                                                    $205,000




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Problem 2

a.
                              DUMBLEDORE CORPORATION
                                    Statement of Cash Flow
                            for the year ended December 31, 20x5

Cash Flow from Operations
  Net income                                                                     $45,100
  Adjust for non-cash items:
    Gain on sale of land                                                         (18,000)
    Depreciation                                                                    6,900
                                                                                   34,000
     Adjust for changes in working capital
       Increase in accounts receivable                                           (30,000)
       Increase in inventory                                                     (10,000)
       Increase in prepaid interest                                               (2,000)
       Increase in accounts payable                                                15,000
       Decrease in salaries payable                                               (3,000)
       Increase in taxes payable                                                    6,000
                                                                                   10,000
Cash Flow from Investing
  Proceeds on sale of land                                                         53,000
  Purchase of machinery                                                          (10,000)
                                                                                   43,000

Cash Flow From Financing
  Issue bonds                                                                       5,000
  Cash dividends                                                                 (15,000)
                                                                                 (10,000)

Net change in cash                                                                43,000
Cash and cash equivalents, beginning of year                                      40,000
Cash and cash equivalents, end of year                                           $83,000




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b.

Cash Flow from Operations - Direct
  Cash collected from customers ($180,000 Sales – 30,000 Increase in A/R)                $150,000
  Cash paid to Suppliers ($90,000 COGS + 10,000 Increase in Inventory
       – 15,000 Increase in Accounts Payable)                                             (85,000)
  Cash paid to employees ($33,900 Salary Expense + 3,000 Decrease in Salaries Payable)    (36,900)
  Cash paid for remaining expenses                                                         (4,000)
  Cash paid for interest (6,000 Interest Expense + 2,000 Increase in Prepaid Interest)     (8,000)
  Cash paid for Income taxes (12,100 Income Tax Expense
    – 6,000 Increase in Income Taxes Payable)                                              (6,100)
                                                                                            10,000




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Problem 3

a.
                                     Sunrise Ski Company
                                   Statement Of Cash Flows
                            for the year ended December 31, 20x2

Cash flows from operating activities
  Cash collections from customers ($320,000 - 8,000 Increase in A/R)                  $312,000
  Cash paid to suppliers ($200,000 COGS + 4,000 Increase in Inventory
    - 4,000 Increase in Accounts Payable)                                            (200,000)
  Other expenses paid in cash                                                         (96,000)
                                                                                        16,000
Cash flows from investing activities
  Proceeds on sale of plant and equipment (Note 1)                                        6,000
  Sale of long-term investments ($14,000 Decrease in Long-Term Investments
    - 4,000 Loss on disposal of investments)                                             10,000
  Purchase of equipment (Note 2)                                                       (50,000)
                                                                                       (34,000)
Cash flows from financing activities
  Issuance of common shares                                                              10,000
  Issue of notes payable                                                                  8,000
  Payment of dividends ($16,000 Net Income - 14,000 Increase in R/E)                    (2,000)
                                                                                         16,000

Net decrease in cash                                                                   (2,000)
Cash, January 1, 20x2                                                                   12,000
Cash, December 31, 20x2                                                               $ 10,000




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Note 1 - Proceeds on sale of plant and equipment
  Net book value of plant and equipment sold
     Cost                                                                                        $6,000
     Less Accumulated depreciation
       $6,000 Depreciation Expense - 4,000 Increase in Accumulated Depreciation                    2,000
                                                                                                   4,000
   Gain on disposal of plant and equipment                                                         2,000
   Proceeds                                                                                      $ 6,000

Note 2 - Purchase of equipment
  Increase in plant and equipment account                                                       $44,000
  Add cost of equipment sold                                                                      6,000
  Acquisitions during 20x2                                                                      $50,000


b. Cash Flow from Operations - Indirect

Net income                                                                                      $16,000
Adjust for non-Cash Items
  Depreciation                                                                                     6,000
  Loss on sale of long-term investments                                                            4,000
  Gain on disposal of fixed assets                                                               (2,000)
Adjust for changes in non-cash working capital accounts
  Increase in accounts receivable                                                                (8,000)
  Increase in inventory                                                                          (4,000)
  Increase in accounts payable                                                                     4,000
                                                                                                $16,000




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Problem 4

                                      TGA Corporation
                                  Statement of Cash Flows
                           For the Year Ended December 31, 20x1

Cash flow from operating activities:
       Cash collected from customers ($300,000 Sales - 20,000 Increase in A/R)          $280,000
       Cash paid to suppliers ($120,000 COGS + 15,000 Increase in Inventory
         + 5,000 Decrease in Accounts Payable)                                         (140,000)
       Cash paid to employees ($50,000 Salaries expense
         - 3,000 Increase in Salaries Payable)                                          (47,000)
       Cash paid for interest                                                            (2,500)
        Cash paid for taxes ($48,000 + 10,000 Decrease in Income Taxes Payable)         (58,000)
                                                                                          32,500

Cash flow from investing activities:
       Proceeds from sale of equipment                                                     3,000
       Purchase of additional equipment                                                 (20,000)
                                                                                        (17,000)

Cash flow from financing activities:
       Common stock issued for cash                                                         5,000
       Cash dividend paid                                                                 (8,000)
                                                                                          (3,000)

Net increase in cash                                                                      12,500
Cash balance, December 31, 20x0                                                           86,000
Cash balance, December 31, 20x1                                                          $98,500




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Problem 5

                                              Sage Ltd.
                                      Statement of Cash Flows
                                  for the year ended June 30, 20x5

Cash provided by operations
  Net income                                                                   $126,750
  Add back items not requiring a cash outlay
     Depreciation                                                                57,850     1
     Amortization of patent                                                       2,730
     Loss on sale of equipment ($39,650 - 31,200)                                 8,450
                                                                                195,780
      Decrease in accounts receivable (net)                                      11,050
      Increase in accounts payable                                               83,070
                                                                                289,900

Cash used by investing activities
  Purchase of government bonds                                                  (97,500)
  Purchase of equipment                                                        (250,900)
  Proceeds on sale of equipment                                                  31,200
  Patent defense costs                                                           (1,300)
                                                                               (318,500)

Cash used by financing activities
  Repayment of bonds                                                             (32,500)
  Redemption of preferred shares (6,500 + 650 2)                                  (7,150)
                                                                                 (39,650)

Decrease in cash                                                                (68,250)
Cash, beginning of year                                                         162,500
Cash, end of year                                                              $ 94,250


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

    Accumulated depreciation - beginning balance                               $241,800
    less accumulated depreciation on equipment sold:
       $68,900 - 39,650                                                         (29,250)
    less ending balance                                                        (270,400)
    = depreciation expense                                                    $ 57,850




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2   Retained earnings - Beginning of year                                      $174,200
    Net income                                                                  126,750
    Dividends                                                                   (26,000)
    Retained earnings - End of year                                            (274,300)
    Premium on retirement of preferred shares                                 $     650

Problem 6

Part (a)
                                         CARLOS LTD.
                                     Statement of Cash Flow
                                  year ended December 31, 20x1

Cash flows from operating activities
  Cash receipts from customers (520,000 - 20,000 Increase in AR)                       $500,000
  Cash payments for merchandise (300,000 + 40,000 Increase in Inventory
      + 45,000 Decrease in Accounts Payable)                                          (385,000)
  Cash payment for other expenses                                                      (71,000)
  Interest payments (7,000 + 1,000 Decrease in Interest Payable)                        (8,000)
  Income tax payments (35,000 - 2,000 Increase in Taxes Payable)                       (33,000)
                                                                                          3,000
Cash flows from investing activities
  Purchase of equipment (2,000 Increase in Buildings and Equipment
       + 9,000 Depreciation Expense)                                                    (11,000)

Cash flows from financing activities
  Payments for notes payable (53,000 - 59,000)                                           (6,000)
  Proceeds from common shares issued (120,000 - 100,000)                                  20,000
                                                                                          14,000

Net increase in cash                                                                      6,000
Cash, January 1, 20x1                                                                    40,000
Cash, December 31, 20x1                                                                $ 46,000

Part (b)

Cash flows from operating activities
  Net income                                                                            $98,000
  Add back depreciation which does not require a cash outlay                              9,000
  Changes in working capital items:
    Increase in accounts receivable                                                     (20,000)
    Increase in inventory                                                               (40,000)
    Decrease in accounts payable                                                        (45,000)
    Increase in taxes payable                                                               2,000
    Decrease in interest payable                                                          (1,000)
                                                                                         $ 3,000

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3.      Revenue Recognition

Revenue recognition under IFRS is governed by IAS 18 – Revenue and IAS 11 –
Construction Contracts.

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

Revenue is measured as the fair value of the consideration received or receivable (IAS
18.9). If the consideration is to be received over time and provides favorable financing
terms to the buyer, then the cash flows are discounted and the amount of revenue is
calculated based on the discounted value (IAS 18.11). The accounting for these
transactions will be discussed in section 6 of this Module.

Fair value is defined as the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm's length transaction (IAS 39.9).

Sale of Goods

Revenue from the sale of goods shall be recognized when all the following conditions
have been satisfied:
(a)    the entity has transferred to the buyer the significant risks and rewards of
       ownership of the goods;
(b)    the entity retains neither continuing managerial involvement to the degree usually
       associated with ownership nor effective control over the goods sold;
(c)    the amount of revenue can be measured reliably;
(d)    it is probable that the economic benefits associated with the transaction
       will flow to the entity; and
(e)    the costs incurred or to be incurred in respect of the transaction can be
       measured reliably (note that this item is also referred to as the matching
       principle). (IAS 18.14)

Note that in most cases, i.e. retail sales, the transfer of risks and rewards of ownership
will coincide with the transfer of the legal title or the passing of possession to the buyer.
In some cases, the timing of transfer of title and transfer of risks and rewards of
ownership may not coincide. For example, if the seller holds the legal title to the goods
until payment has been made, then you would still recognize revenue on the day the
buyer takes possession of the goods since the significant risk and rewards of ownership of
the goods has transferred to the buyer.




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If you retain significant risks of ownership, then the transaction is deemed to not be a sale
and revenues cannot be recognized. The standard provides the following examples where
this could be the case:
•       when the entity retains an obligation for unsatisfactory performance not covered
        by normal warranty provisions;
•       when the receipt of the revenue from a particular sale is contingent on the
        derivation of revenue by the buyer from its sale of the goods;
•       when the goods are shipped subject to installation and the installation is a
        significant part of the contract which has not yet been completed by the
        entity; and
•       when the buyer has the right to rescind the purchase for a reason specified in the
        sales contract and the entity is uncertain about the probability of return. (IAS
        18.16)
However, if you retain only insignificant risks of ownership, then the transaction is
deemed to be a sale and revenue is recognized.


Example: Green Time Landscaping Inc. (GTL), a residential and commercial landscaping
contractor, is completing its first year of operations. According to the terms of the bank
loan, the audited financial statements must be presented to the bank within 60 days of the
company's year-end. The company's year-end is November 30.

Jill Grasslands, the controller of GTL, is currently completing the year-end financial
statements and is considering alternative methods of recording the annual revenues. The
first year of operations was very successful partly due to the high quality of plant
materials (i.e., trees, shrubs, etc.) used and the one-year guarantee given to all customers.
In addition, the original contract stipulates that GTL must check all plant materials at six
months and one year to ensure they are growing as expected. GTL's terms of payment are
net 30 days after completion of the initial planting.

What factors should Jill Grasslands consider when selecting GTL's revenue recognition
policy? What policy should she adopt based on the facts provided?

Jill Grassland should consider the following factors when selecting a revenue recognition
policy for GTL:

1. Revenue is earned when the vendor has accomplished, or virtually completed,
   whatever it must do to be entitled to the revenue. GTL, as a landscaping business,
   must plant trees and shrubs and check that they are growing as expected throughout
   the following year. The major act of the contract is the planting of the trees and
   shrubs. The maintenance is considered minimal, but there is some uncertainty
   regarding the "success" of the plantings until the one year guarantee period has
   expired. All other significant risks and rewards can be considered to have been
   transferred to the customer once planting is completed.




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2. The amount of consideration to be received for goods and/or services must be
   reasonably assured before revenue can be recognized. GTL works on a contract basis
   with payment terms specified in the contract. It can be assumed that the amount of
   consideration for the goods and services are also stipulated in the contract. Since most
   major planting would have been completed by the end of October, the outstanding
   amounts should be small by the end of November (i.e., at year end). Any estimate
   required for uncollectible amounts should be made based on a review of outstanding
   receivables by the reporting deadline.

3. When a "right of return" such as a warranty or guarantee exists, the extent of the
   goods that can be expected to be returned will influence revenue recognition.
   Warranties and guarantees entail future costs that should be recognized in the
   accounts if they can be reasonably estimated.

    In the case of GTL, a one-year guarantee on the plants is stipulated in the contract
    with customers. Because this is GTL's first year of operations, there will be no past
    company experience to draw from in estimating the amount of plants that will have to
    be replaced during the guarantee period. GTL should look at industry practices in
    estimating the returns. Considering that GTL uses a high quality of plant, it may be
    reasonable to assume that returns/ replacements will not be great and that the expense
    warranty treatment of accounting for warranty (guarantee) costs would be
    appropriate.

Based on the above analysis, it is recommended that all revenue from all contracts that
were signed and completed during the year be recognized at year end and that an
allowance be made for estimated uncollectible accounts and for estimated cost of
replacing plants during the guarantee period.


In the appendix to IAS 18, some additional guidance is provided for some specific
transactions such as:

•       Bill and Hold Sales. These occur when the delivery of the goods is delayed at the
        customer's request but the customer accepts billing and takes title of the goods.
        Revenue can be recognized as long as the following criteria are met:
        -       it is probable that delivery will be made,
        -       the item is on hand, identified and ready for deliver to the buyer at the
                time the sale is recognized,
        -       the buyer specifically acknowledges the deferred delivery instructions, and
        -       the usual payment terms apply.

•       Goods subject to Installation and Inspection. Generally, revenue can be
        recognized when the goods have been installed and inspected, however if the
        installation is simple in nature or if inspection is performed only for purposes of
        determining the final contract price, then revenue can be recognized upon the
        buyer's acceptance of delivery.

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•       Consignment Sales. A consignment is an arrangement whereby the owner of the
        product (the consignee) provides the goods to the seller (the consignor) who then
        sells the goods on behalf of the consignee. The consignor does not purchase the
        goods, therefore these goods are not inventory of the consignor. Upon the sale, the
        consignor typically keeps a certain percentage of the sale as a commission and
        returns the remainder of the proceeds to the consignee. The revenue is recorded
        by the consignee and consignor only when the goods are sold to the ultimate
        consumer.

•       Lay away sales. These occur whenever delivery of the product takes place only
        when the buyer makes the final payment in a series of installments. Generally
        revenue is recorded when the last payment is made. However, if experience shows
        that most lay away sales are taken to term, revenue may be recognized when a
        significant deposit is received so long as the goods are on hand, identified and
        ready for deliver to the buyer.

•       Orders when payment, or partial payment, is received in advance of delivery.
        Recognize the cash received as deferred revenues and recognize revenues when
        the goods are delivered to the buyer.

•       Subscriptions to publications and similar items. If the items involved are of
        similar value, revenue is recognized on a straight-line basis. If not, revenue is
        recognized on the basis of the sales value of the items dispatched in relation to the
        total estimated sales value of all items covered by the subscription.

•       Installment Sales. Installment sales are sales whereby the customer pays the sales
        consideration in installments over time. The sales price is determined by
        discounting the cash flows. The mechanics of this process will be discussed in
        Section 6 of this module - Notes Receivable/Payable.

Rendering of Services

Service revenue is to be recognized on the percentage of completion basis if the
following conditions are present:
•      the amount of revenue can be measured reliably;
•      it is probable that the economic benefits associated with the transaction will flow
       to the entity;
•      the stage of completion of the transaction at the balance sheet date can be
       measured reliably; and
•      the costs incurred for the transaction and the costs to complete the transaction can
       be measured reliably. (IAS 18.20)

The last two items relate to long-term service contracts. The method referred to is called
the percentage of completion method and will be explained in more details later in this
section under 'Construction Contracts'.


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When the outcome of the transaction involving the rendering of services cannot be
estimated reliably, revenue shall be recognized only to the extent of the expenses
recognized that are recoverable. (IAS 18.26)

For example, say you sign a $500,000 three year contract to provide a service to one of
your clients. Because you cannot estimate the costs to complete the transaction at the end
of the first year, then the outcome of the transaction cannot be estimated reliably.
Assuming you incurred $75,000 of costs on this contract, then the amount of revenue you
could recognize in the first year is $75,000. As the outcome of the transaction cannot be
estimated reliably, no profit can be recognized. If you received $100,000 from your client
on this contract in the first year, you would then also record unearned revenues of
$25,000 on the Statement of Financial Position.

In the appendix to IAS 18, some additional guidance is provided for some specific
transactions:

•       Service fees included in the price of the product. If the selling price includes an
        identifiable amount that relates to servicing the product over a period of time, then
        that amount should be deferred and amortized over the time of the service
        contract.

•       Advertising Commissions. Recognize only when the related advertisement appears
        before the public. Production commissions are recognized in relation to the stage
        of completion of the project.

•       Insurance Agency Commissions. If no further work is required on behalf of the
        agent, the commission can be recognized as revenue on the
        commencement/renewal date of the policy. If further work is required, then the
        amount is deferred over the period which the work is performed.

•       Franchise Fees

        -       supplies of equipment and other tangible assets: recognize revenue when
                the items are delivered or title passes.

        -       supplies of initial and subsequent services: the typical franchise agreement
                calls for a franchise fee, usually to be paid up front but sometimes paid
                over a number of years. Over the life of the franchise, the franchisee
                usually agrees to pay a certain percentage of revenues to the franchisor.
                For example, a restaurant franchise agreement may ask the franchisee to
                pay $50,000 up front plus 6% of revenues - 4% royalty and 2% common
                advertising pool. In exchange for this, the franchisor agrees to support the
                franchisee on an ongoing basis. The issue is how to recognize the initial
                franchise fee of $50,000 as revenue. The franchisor needs to determine the



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                portion of the franchise fee that relates to continuing service and accrue
                this portion over the period of time the services are provided.

        -       continuing franchise fees - these are recognized as revenues as the services
                are provided



Interest, royalties and dividends

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

The bases for recognizing revenues are:
•      for interest – using the effective interest method,
•      for royalties – accrual basis in accordance with the substance of the relevant
       agreement, and
•      for dividends – when the right to receive payment is established (typically when
       the dividends have been declared). (IAS 18.30)

Disclosure

The accounting policies adopted for the recognition of revenue, including the methods
adopted to determine the stage of completion of transactions involving the rendering of
services have to be disclosed in the notes to the financial statements. (IAS 18.35a)

The following revenue items have to be separately disclosed:
•      the sale of goods,
•      the rendering of services,
•      interest,
•      royalties,
•      dividends. (IAS 18.35b)




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Construction Contracts (IAS 11)

Accounting for construction contracts requires the use of the percentage of completion
method. The completed contract method is no longer acceptable.

There are two types of contracts: fixed price and cost plus. The measures of the outcome
(i.e. revenue recognition criteria) vary depending whether we are dealing with a fixed
price or a cost plus contract.

In the case of a fixed price contract, the outcome of a construction contract can be
estimated reliably when all the following conditions are satisfied:
(a)     total contract revenue can be measured reliably;
(b)     it is probable that the economic benefits associated with the contract will
        flow to the entity;
(c)     both the contract costs to complete the contract and the stage of contract
        completion at the balance sheet date can be measured reliably; and
(d)     the contract costs attributable to the contract can be clearly identified and
        measured reliably so that actual contract costs incurred can be compared
        with prior estimates. (IAS 11.23)

In the case of a cost plus contract, the outcome of a construction contract can be
estimated reliably when all the following conditions are satisfied:
(a)     it is probable that the economic benefits associated with the contract will
        flow to the entity; and
(b)     the contract costs attributable to the contract, whether or not specifically
        reimbursable, can be clearly identified and measured reliably. (IAS 11.24)

When the outcome of a construction contract cannot be estimated reliably:
(a)   revenue shall be recognized only to the extent of contract costs incurred
      that it is probable will be recoverable; and
(b)   contract costs shall be recognized as an expense in the period in which they
      are incurred. (IAS 11.32)

During the early stages of a contract it is often the case that the outcome of the contract
cannot be estimated reliably. Nevertheless, it may be probable that the entity will recover
the contract costs incurred. Therefore, contract revenue is recognized only to the extent of
costs incurred that are expected to be recoverable. As the outcome of the contract cannot
be estimated reliably, no profit is recognized.




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Application of the Percentage of Completion Method

•       actual construction costs incurred are accumulated in a construction-in-progress
        (an inventory account);
•       accounts receivable is debited and a billings account is credited for progress
        billings; the billings account is a contra-account to the construction-in-progress
        account;
•       at year-end, the percentage of completion is determined:
             % Completion = Total costs incurred to date ÷ Total estimated project costs
•       the revenue to be recognized on the contract is the total contract revenue
        multiplied by the percentage of completion LESS any revenues recognized on the
        contract in previous years;
•       the costs to be recognized on the contract are equal to the costs incurred to date
        LESS any costs recognized on the contract in previous years;
•       any profit on the contract is debited to the construction-in-progress account;
•       at the end of the contract, the sum of the debits in the construction-in-progress
        account should equal to the sum of the credits in the billings account. Both are
        then removed from the accounts

When it is known that a loss will be incurred, the loss is considered to be a change in
accounting estimate and will be accrued in the period the loss becomes known.

Example: Assume that the Greenbank Construction Company was contracted to build a
roadway for a local municipality. The contract value is $6,000,000 and is expected to be
completed within three years. Data related to the contract are summarized as follows (all
amounts in '000s)

                                                     20x1             20x2             20x3
Costs incurred during the year                     $1,560           $2,340           $1,700
Expected additional costs to complete               3,640            1,600                -
Billings during the year                            1,400            3,000            1,600
Cash collections during the year                    1,200            2,500            1,900

At the end of year 20x1, the percentage of completion is:

        Costs incurred to date / Total expected project costs
        = $1,560 / ($1,560 + $3,640)
        = $1,560 / 5,200
        = 30%

The amounts of revenues and expenses that can be recognized on this project in 20x1 are
as follows:
          Revenues: $6,000 x 30%                                  $1,800
          Costs                                                     1,560
          Profit                                                     $240



Page 117                                                        CMA Ontario – September 2009
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Journal entries in 20x1 would be as follows:

Construction-in-progress                                           $1,560
  Cash, accounts payable, …                                                         $1,560

Accounts Receivable                                                 1,400
  Billings                                                                            1,400

Cash                                                                1,200
  Accounts Receivable                                                                 1,200

Cost of goods sold                                                  1,560
Construction-in-progress                                              240
  Revenues                                                                            1,800


At the end of year 20x2, the percentage of completion is:

        Costs incurred to date / Total expected project costs
        = ($1,560 + 2,340) / ($1,560 + $2,340 + $1,600)
        = $3,900 / 5,500
        = 71%

The amounts of revenues and expenses that can be recognized on this project in 20x2 are
as follows:
                                                         Less Amounts Amount to be
                                                            Previously recognized in
                                                           Recognized              20x2
Revenues: $6,000 x 71%                         $4,260           $1,800           $2,460
Cost of goods sold                              3,900            1,560            2,340
Profit                                           $360             $240             $120




Page 118                                                        CMA Ontario – September 2009
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Journal entries in 20x2 would be as follows:

Construction-in-progress                                         $2,340
  Cash, accounts payable, …                                                         $2,340

Accounts Receivable                                               3,000
  Billings                                                                           3,000

Cash                                                              2,500
  Accounts Receivable                                                                2,500

Cost of goods sold                                                2,340
Construction-in-progress                                            120
  Revenues                                                                           2,460

At the end of year 20x3, the percentage of completion is obviously 100% since the
project is complete.

The amounts of revenues and expenses that can be recognized on this project in 20x3 are
as follows:
                                                         Less Amounts Amount to be
                                                            Previously recognized in
                                                           Recognized              20x2
Revenues: $6,000 x 100%                        $6,000           $4,260           $1,740
Cost of goods sold                              5,600            3,900            1,700
Profit                                           $400             $360              $40


Journal entries in 20x3 would be as follows:

Construction-in-progress                                         $1,700
  Cash, accounts payable, …                                                         $1,700

Accounts Receivable                                               1,600
  Billings                                                                           1,600

Cash                                                              1,900
  Accounts Receivable                                                                1,900

Cost of goods sold                                                1,700
Construction-in-progress                                             40
  Revenues                                                                           1,740

The following T-accounts summarize the journal entries (entries to cash, accounts
payable, etc… have been ignored):


Page 119                                                      CMA Ontario – September 2009
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    Construction-in-Progress                  Billings                      Accounts Receivable
(x1)      1,560                                    1,400      (x1)   (x1)      1,400 1,200      (x1)
(x1)        240                                    3,000      (x2)   (x2)      3,000 2,500      (x2)
(x2)      2,340                                    1,600      (x3)   (x3)      1,600 1,900      (x3)
(x2)        120
(x3)      1,700                                   6,000       Bal    Bal         400
(x3)         40

Bal        6,000

            Revenue                      Cost of Goods Sold
                1,800      (x1)   (x1)      1,560
                2,460      (x2)   (x2)      2,340
                1,740      (x3)   (x3)      1,700

A few things to note:
•      at the end of 20x3, the debit in construction-in-progress is equal to the credit in
       the billings account. These two accounts are then closed out.
•      the $400 accounts receivable represents the billings not yet collected
•      the revenue and cost of goods sold accounts would get closed off to Retained
       Earnings at the end of each year


Losses on Long-Term Contracts

There are two types of losses that can occur on long-term contracts:

1.      The contract is profitable, but there is a loss in the current year. This happens
        when the income recognized in previous periods exceeds the income that should
        have been recognized to date. Such a loss should get recorded in the current
        period.

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




Page 120                                                             CMA Ontario – September 2009
Financial Accounting – Module 1



Problems with Solutions

Multiple Choice Questions

1.    Gow Constructors, Inc. has consistently used the percentage-of-completion method
      of recognizing income. In 20x5, Gow started work on an $18,000,000 construction
      contract that will be completed in 20x7. The following information was taken from
      Gow's 20x5 accounting records:
            Progress billings                               $6,600,000
            Costs incurred                                   5,400,000
            Collections                                      4,200,000
            Estimated costs to complete                     10,800,000

      What amount of gross profit should Gow have recognized in 20x5 on this contract?
      a) $1,400,000
      b) $1,200,000
      c) $ 900,000
      d) $ 600,000


2.    Carson Construction Co. uses the percentage-of-completion method. In 20x2,
      Carson began work on a contract for $1,650,000 and it was completed in 20x3.
      Data on the costs are:
                                                            Year Ended December 31
                                                                  20x2             20x3
                  Costs incurred                              $585,000        $420,000
                  Estimated costs to complete                  390,000                -
      For the years 20x2 and 20x3, Carson should recognize gross profit of

                        20x2             20x3
      a)                   $         $645,000
      b)            $387,000         $258,000
      c)            $405,000         $240,000
      d)            $405,000         $645,000




Page 121                                                     CMA Ontario – September 2009
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3.    The Gerard Construction Company entered into a long-term construction contract
      on January 2, 20x3 for a total contract price of $20,000,000. Project data for the
      first three years of the project are as follows:

                                                 20x3            20x4           20x5
           Costs incurred to date          $3,300,000      $7,800,000    $14,600,000
           Estimated costs to complete     14,700,000      11,700,000      6,900,000

      What amount of gain / loss will be recognized on this contract for the year ended
      December 31, 20x5?
      a) $818,605 Gain
      b) $0
      c) $1,300,000 Loss
      d) $1,500,000 Loss
      e) $1,700,000 Loss


4.     An independent automobile dealer acts as an agent for an automobile manufacturer
       on a non-consignment basis. The automobile manufacturer should normally
       recognize revenue when
       a) an order for an automobile is received from the dealer.
       b) an automobile comes off the assembly line.
       c) an automobile is shipped to the dealer.
       d) an automobile is picked up by the consumer from the dealer.
       e) payment is received from the dealer.


5.     Bella Construction Co. uses the percentage-of-completion method. In 20x1, Bella
       began work on a contract for $2,200,000; it was completed in 20x2. The following
       cost data pertain to this contract:

                                                             Year ended December 31
                                                                   20x1          20x2
           Costs incurred during the year                      $780,000      $560,000
           Estimated costs to complete at the of year           520,000             --

       The amount of gross profit to be recognized on the income statement for the year
       ended December 31, 20x2 is
       a) $320,000
       b) $344,000
       c) $360,000
       d) $860,000




Page 122                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

Newcastle Health and Racquet Club (NHRC), which operates eight clubs in the Calgary
metropolitan area, offers one-year memberships. The members may use any of the eight
facilities but must reserve racquetball court time and pay a separate fee before using the
court. As an incentive to new customers, NHRC advertised that any customers not
satisfied for any reason could receive a refund of the remaining portion of unused
membership fees. Membership fees are due at the beginning of the individual
membership period; however, customers are given the option of financing the
membership fee over the membership period at a 15 percent interest rate.

Some customers have expressed a desire to take only the regularly scheduled aerobic
classes without paying for a full membership. During the current fiscal year, NHRC
began selling coupon books for aerobic classes only to accommodate these customers.
Each book is dated and contains 50 coupons that may be redeemed for any regularly
scheduled aerobic class over a one-year period. After the one-year period, unused
coupons are no longer valid.

During 20x0, NHRC expanded into the health equipment market by purchasing a local
company that manufactures rowing machines and cross-country ski machines. These
machines are used in NHRC's facilities and are sold through the clubs and mail order
catalogs. Customers must make a 20 percent down payment when placing an equipment
order; delivery is 60-90 days after order placement. The machines are sold with a two-
year unconditional guarantee. Based on past experience, NHRC expects the costs to
repair machines under guarantee to be 4 percent of sales.

NHRC is in the process of preparing financial statements as of May 31, 20x6, the end of
its fiscal year. James Hogan, corporate controller, expressed concern over the company's
performance for the year and decided to review the preliminary financial statements
prepared by Barbara Sullens, NHRC's assistant controller. After reviewing the
statements, Hogan proposed that the following changes be reflected in the May 31, 20x6,
published financial statements.

•   Membership revenue should be recognized when the membership fee is collected.

•   Revenue from the coupon books should be recognized when the books are sold.

•   Down payments on equipment purchases and expenses associated with the guarantee
    on the rowing and cross-country machines should be recognized when paid.

Sullens indicated to Hogan that the proposed changes are not in accordance with
generally accepted accounting principles, but Hogan insisted that the changes be made.
Sullens believes that Hogan wants to manipulate income to forestall any potential
financial problems and increase his year-end bonus. At this point, Sullens is unsure what
action to take.



Page 123                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Required -

A. 1. Describe when Newcastle Health and Racquet Club (NHRC) should recognize
      revenue from membership fees, court rentals, and coupon book sales.
   2. Describe how NHRC should account for the down payments on equipment sales,
      explaining when this revenue should be recognized.
   3. Indicate when NHRC should recognize the expense associated with the guarantee
      of the rowing and cross-country machines.

B. Discuss why James Hogan's insistence that the financial statement changes be made
   is unethical.

C. Identify all of the specific steps Barbara Sullens should take to resolve the situation
   described above.


Problem 2

On April 1, 20x0, Butler, Inc., entered into a cost-plus-fixed-fee contract to construct an
electric generator for Dalton Corporation. At the contract date, Butler estimated that it
would take two years to complete the project, at a cost of $2 million. The fixed fee
stipulated in the contract is $300,000. Butler appropriately accounts for this contract
under the percentage-of completion method. During 20x0 Butler incurred costs of
$700,000 related to the project, and the estimated cost at December 31, 20x0, to complete
the contract is $1.4 million. Dalton was billed $500,000 under the contract and remitted
$300,000 to Butler.

Required -

1.      Prepare a schedule to compute the amount of gross profit to be recognized by
        Butler under the contract for the year ended December 31, 20x0. Show supporting
        computations in good form.
2.      Prepare Butler's journal entries for the above data.




Page 124                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

The Rushmore Company obtained a construction contract to build a highway. It was
estimated at the beginning of the contract that it would take 3 years to complete the
project at an expected cost of $50 million. The contract price was $60 million. The
project actually took 4 years to complete. The following information describes the status
of the job at the close of production each year:

                                        20x1          20x2          20x3          20x4          20x5
Actual Costs Incurred             $12,000,000   $18,160,000   $14,840,000   $10,000,000            $-
Estimated Costs to Complete        38,000,000    27,840,000    10,555,555             -             -
Collections on Contract            12,000,000    13,500,000    15,000,000    15,000,000     4,500,000
Billings on Contract               13,000,000    15,500,000    17,000,000    14,500,000             -

Required -

(a)     Using the percentage-of-completion method, calculate the estimated gross profit
        (loss) to be recognized in the years 20x1 to 20x4.
(b)     Prepare all journal entries for the years 20x1 to 20x5 relative to this contract.



Problem 4

On February 1, 20x1, Dandan Inc. obtained a contract to build an athletic stadium. The
stadium was to be built at a total cost of $5.4 million and was scheduled for completion
by September 1, 20x4. Contract price was $6.6 million. Below are the data pertaining to
the construction period.

                                                             20x1            20x2               20x3
Costs to date                                          $1,782,000      $3,850,000         $6,300,000
Estimated costs to complete                             3,618,000       2,650,000            900,000
Progress billings to date                               1,200,000       3,100,000          5,000,000
Cash collected to date                                  1,000,000       2,800,000          4,500,000

Required -

(a)     Using the percentage-of-completion method, calculate the estimated gross profit
        recognized in the years 20x1 to 20x3.
(b)     Prepare all journal entries for the years 20x1 to 20x3 relative to this contract.
(c)     Prepare a partial Statement of Financial Position for December 31, 20x2, showing
        the balances in the receivable and inventory accounts.




Page 125                                                               CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5

The board of directors of Jaworski Construction Company is meeting to choose between
the completed-contract method and the percentage-of-completion method of accounting
for long-term contracts in the company's financial statements. You have been engaged to
assist Jaworski's controller in the preparation of a presentation to be given at the board
meeting. The controller provides you with the following information:

a) Jaworski commenced doing business on January 1, 20x2.
b) Construction activities for the year ended December 31, 20x2, were as follows:

               TOTAL CONTRACT           BILLINGS THROUGH              CASH COLLECTIONS
PROJECT             PRICE                     12/31/x2                 THROUGH 12/31/x2
   A                    $ 520,000                    $ 350,000                   $310,000
   B                      670,000                      210,000                    210,000
   C                      475,000                      475,000                    395,000
   D                      200,000                       70,000                     50,000
   E                      460,000                      400,000                    400,000
                       $2,325,000                   $1,505,000                 $1,365,000

                           CONTRACT COSTS                  ESTIMATED
                         INCURRED THROUGH               ADDITIONAL COSTS
      PROJECT                  12/31/x2              TO COMPLETE CONTRACTS
         A                    $ 424,000                       $106,000
         B                      126,000                        504,000
         C                      315,000                             -0-
         D                      112,750                         92,250
         E                      370,000                         30,000
                             $1,347,750                       $732,250

c) Each contract is with a different customer.
d) Any work remaining to be done on the contracts is expected to be completed in 20x3.

Required -

(a)     Prepare a schedule by project, computing the amount of income (or loss) before
        selling, general, and administrative expenses for the year ended December 31,
        20x2, which would be reported under the percentage-of-completion method.




Page 126                                                       CMA Ontario – September 2009
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(b)     For each numbered space on the statement of financial position below, supply the
        correct balance (indicating DR or CR as appropriate). Disregard income taxes.

                                  Jaworski Construction Company
                                  Statement of Financial Position
                                     as at December 31, 20x2




Assets
  Cash                                                                                         $xx
  Accounts (contracts) receivable                                                                1
  Costs and estimated earnings in excess of billings on uncompleted contracts                    2
  Tangible capital assets, net                                                                  xx
  Other assets                                                                                  xx

                                                                                               $xx
Liabilities and shareholders' equity
   Accounts payable and accrued liabilities                                                    $xx
   Billings in excess of costs and estimated earnings on uncompleted contracts                   3
   Notes payable                                                                                xx
   Common shares                                                                                xx
   Retained earnings                                                                            xx

                                                                                               $xx




Page 127                                                        CMA Ontario – September 2009
Financial Accounting – Module 1



SOLUTIONS

Multiple Choice Questions

1.    d     Costs incurred                                              $ 5,400,000
            Estimated costs to complete                                  10,800,000
            Estimated total project costs                               $16,200,000

            Percentage complete $5,400,000 / 16,200,000                     33 1/3%

            Total project revenue                                       $18,000,000
            Estimated total project costs                                16,200,000
            Estimated total project gross profit                          1,800,000

            Amount to recognize in 20x5 - 33 1/3%                       $   600,000

2.    c     20x2 % of completion: $585,000 / (585,000 + 390,000) = 60%
              Gross profit to be recognized in 20x2:
                ($1,650,000 – 585,000 – 390,000) x 60% = $405,000
            20x3: Total profit = $1,650,000 – 585,000 – 420,000 = $645,000
              Gross profit to be recognized in 2003: $645,000 – 405,000 = $240,000

3.     e    Gross profit recognized to the end of 20x4:
              % completion = 7,800 / 19,500 = 40%
            $500,000 x 40% = $200,000
            Expected contract loss at end of 20x5 = $1,500,000
            Loss to be recognized in 20x5 - $1,500,000 + 200,000 = $1,700,000

4.     c

5.     a    2001 % Completion = 780 / (780 + 520) = 780 / 1,300 = 60%
            Gross profit recognized in 2001 = 2,200 – 1,300 = 900 x 60% = $540
            Gross profit recognized in 2002 = $2,200 – 1,340 – 540 = $320




Page 128                                                     CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

A. 1. NHRC should recognize revenue on the following bases.

        •   The membership fees, which are paid in advance and sold with a money-back
            guarantee, should be recognized as revenue over the life of the membership.
            Each month, NHRC earns one-twelfth of the revenue. This results in a liability
            for the unearned and potentially refundable portion of the fee. For those
            membership fees that are financed, interest is recognized as time passes at the
            rate of 15 percent per annum.

        •   Court rental fees should be recorded as revenue as the members use the courts.

        •   Revenue from the sale of coupon books should be recorded when the coupons
            are redeemed, i.e., when members attend aerobics classes. At year-end, an
            adjustment should be made to recognize the revenue from the unused coupons
            that have expired.

    2. Since NHRC has not provided any service when the down payment for equipment
       is received, the down payment should be treated as a current liability until
       delivery of the equipment is made.

    3. Since NHRC expects to incur costs under the guarantee and these costs can be
       estimated, an amount equal to 4 percent of the total revenue should be accrued in
       the accounting period in which the sale is recorded.

B. By insisting that the financial statement changes be made, James Hogan has violated
   the following ethical standards:

    •   Competence
        Hogan has an obligation (1) to perform his professional duties in accordance with
        relevant technical standards and (2) to prepare complete and clear reports after
        appropriate analyses of relevant and reliable information. Hogan's proposed
        changes to the financial statements are not in accordance with generally accepted
        accounting principles and, therefore, will not result in clear reports based on
        reliable information.




Page 129                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




    •   Confidentiality
        Hogan has an obligation to refrain from using or appearing to use confidential
        information acquired in the course of his work for unethical personal advantage.
        If Hogan is proposing the accounting changes to increase his year-end bonus, as
        Sullens believes, he has misused confidential information.

    •   Integrity
        By insisting on making the adjustments to the financial statements to cover up
        unfavorable information and increase his bonus, Hogan has (1) failed to avoid a
        conflict of interest, (2) prejudiced his ability to carry out his duties ethically, (3)
        subverted the attainment of the organization's legitimate and ethical objectives,
        (4) failed to communicate unfavorable as well as favorable information, and (5)
        engaged in an activity that discredits his profession.

    •   Objectivity
        Hogan's proposals do not communicate information fairly and objectively nor will
        they disclose all relevant information that could reasonably be expected to
        influence an intended user's understanding of the financial statements.

C. Barbara Sullens may wish to speak to Hogan again regarding the GAAP violations to
   ensure that she understands his position. In order to resolve the situation, Sullens
   should follow the policies established by NHRC for the resolution of ethical conflicts.
   If the company does not have such a policy or the policy does not resolve the conflict,
   Sullens should consider the following course of action:

    •   Since her immediate supervisor is involved in the situation, Sullens should take
        the issue to the next higher managerial level. Sullens need not inform Hogan of
        this step because of his involvement.

    •   If there is no resolution, Sullens should continue to present the problem to
        successively higher levels of internal review, i.e., audit committee, Board of
        Directors.

    •   Sullens should have a confidential discussion of her options with an objective
        advisor to obtain a clearer understanding of possible courses of action.

    •   After exhausting all levels of internal review without resolution, Sullens may have
        no other recourse than to resign her position. Upon doing so, she should submit an
        informative memorandum to an appropriate representative of the organization.

    •   Sullens should not communicate with individuals outside of the organization
        about this situation unless legally prescribed to do so.




Page 130                                                            CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2

1.      Estimated contract cost at completion ($700,000 + $1,400,000)            $ 2,100,000
        Fixed fee                                                                    300,000
        Total contract price                                                     $ 2,400,000
        Total estimated cost                                                     (2,100,000)
        Gross profit                                                               $ 300,000

        Percentage-of-completion ($700,000 / $2,100,000)                            33-1/3%
        Gross profit to be recognized ($300,000 x 33-1/3%)                         $ 100,000

2.      Construction-in-progress                                       700,000
           Miscellaneous credits                                                     700,000
        To record costs incurred.

        Accounts receivable                                            500,000
           Billings on contract                                                      500,000
        To record billings.

        Cash                                                           300,000
           Accounts receivable                                                       300,000
        To record collections.

        Construction-in-progress                                       100,000
           Construction income                                                       100,000
        To record construction income.

        Alternatively, the above entry could be recorded gross:

        Construction-in-progress                                       100,000
        Costs of construction revenue                                  700,000
          Construction revenue                                                       800,000




Page 131                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

(a)     20x1      % of completion = $12,000,000 / (12,000,000 + 38,000,000) = 24%
                  Expected total contract profit = $60,000,000 - 50,000,000 = $10,000,000
                  Profit recognized in 20x1 = $10,000,000 x 24% = $2,400,000

        20x2      % of completion = $30,160,000 / (30,160,000 + 27,840,000)
                    = $30,160,000 / 58,000,000 = 52%
                  Expected total contract profit = $60,000,000 - 58,000,000 = $2,000,000
                  Cumulative profit to be recognized to end of 20x2
                    = $2,000,000 x 52% = $1,040,000
                  Loss to be recognized in 20x2 = $1,040,000
                    - 2,400,000 Cumulative Profit to end of 20x2 = ($1,360,000)

        20x3      % of completion = $45,000,000 / (45,000,000 + 10,555,555)
                    = $45,000,000 / 55,555,555 = 81%
                  Expected total contract profit = $60,000,000 - 55,555,555 = $4,444,445
                  Cumulative profit to be recognized to end of 20x3
                    = $4,444,445 x 81% = $3,600,000
                  Profit to be recognized in 20x3 = $3,600,000
                    - 1,040,000 Cumulative Profit to end of 20x2 = $2,560,000

        20x4      % of completion = 100%
                  Actual total contract profit = $60,000,000 - 55,000,000 = $5,000,000
                  Profit to be recognized in 20x3 = $5,000,000
                    - 3,600,000 Cumulative Profit to end of 20x3 = $1,400,000

(b)     20x1      Construction in Process                    $12,000,000
                    Cash, Accounts Payable, …                                $12,000,000

                  Accounts Receivable                         13,000,000
                    Billings                                                   13,000,000

                  Cash                                        12,000,000
                    Accounts Receivable                                        12,000,000

                  Cost of construction                        12,000,000
                  Construction in Process                      2,400,000
                    Revenue                                                    14,400,000

                  Revenue = $60,000,000 x 24% = $14,400,000
                  Cost of construction = $50,000,000 x 24% = 12,000,000




Page 132                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




        20x2      Construction in Process                           18,160,000
                    Cash, Accounts Payable, …                                        18,160,000

                  Accounts Receivable                               15,500,000
                    Billings                                                         15,500,000

                  Cash                                              13,500,000
                    Accounts Receivable                                              13,500,000

                  Cost of construction                              18,160,000
                    Construction in Process                                           1,360,000
                    Revenue                                                          16,800,000

                  Revenue = $60,000,000 x 52%
                    = $31,200,000 - 14,400,000 Recognized in 20x1
                    = $16,800,000
                  Cost of construction = $58,000,000 x 52%
                    = $30,160,000- 12,000,000 Recognized in 20x1
                    = $18,160,000

        20x3      Construction in Process                           14,840,000
                    Cash, Accounts Payable, …                                        14,840,000

                  Accounts Receivable                               17,000,000
                    Billings                                                         17,000,000

                  Cash                                              15,000,000
                    Accounts Receivable                                             15,000,0000

                  Cost of construction                              14,840,000
                  Construction in Process                            2,560,000
                    Revenue                                                          17,400,000

                  Revenue = $60,000,000 x 81%
                    = $48,600,000 - 14,400,000 Recognized in 20x1 - 16,800,000 Recognized in 20x2
                    = $17,400,000
                  Cost of construction = $55,555,555 x 81%
                    = $45,000,000 - 12,000,000 Recognized in 20x1 - 18,160,000 Recognized in 20x2
                    = $14,840,000




Page 133                                                            CMA Ontario – September 2009
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        20x4      Construction in Process                        10,000,000
                    Cash, Accounts Payable, …                                     10,000,000

                  Accounts Receivable                            14,500,000
                    Billings                                                      14,500,000

                  Cash                                           15,000,000
                    Accounts Receivable                                          15,000,0000

                  Cost of construction                           10,000,000
                  Construction in Process                         1,400,000
                    Revenue                                                       11,400,000

                  Revenue = $60,000,000 - 14,400,000 Recognized in 20x1
                    - 16,800,000 Recognized in 20x2 - 17,400,000 Recognized in 20x3
                    = $11,400,000
                  Cost of construction = $55,000,000 - 12,000,000 Recognized in 20x1
                    - 18,160,000 Recognized in 20x2 - 14,840,000 Recognized in 20x2
                    = $10,000,000

        20x5      Cash                                            4,500,000
                    Accounts Receivable                                                4,500,000




Page 134                                                          CMA Ontario – September 2009
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Problem 4

(a)     20x1: % of completion: 1,782 / (1,782 + 3,618) = 33%
        Gross profit to recognize: $6,600 - 5,400 = 1,200 x 33% = $396

        20x2: % of completion: 3,850 / (3,850 + 2,650) = 59%
        Gross profit to recognize to date: $6,600 - 6,500 = 100 x 59% = $59
        Loss to recognize in 20x2: $396 - 59 = $337

        20x3: Expected contract loss of $600
        Loss to recognize in 20x3: $59 + 600 = $659

        % of completion = $6,300 / (6,300 + 900) = 87.5%

(b)     20x1      Construction in Process                      $1,782,000
                    Cash, Accounts Payable, …                                 $1,782,000

                  Accounts Receivable                           1,200,000
                    Billings                                                   1,200,000

                  Cash                                          1,000,000
                    Accounts Receivable                                        1,000,000

                  Cost of construction                          1,782,000
                  Construction in Process                         396,000
                    Revenue                                                    2,178,000

                  Revenue = $6,600,000 x 33% = $2,178,000
                  Cost of construction = $5,400,000 x 33% = 1,782,000

        20x2      Construction in Process                       2,068,000
                    Cash, Accounts Payable, …                                  2,068,000

                  Accounts Receivable                           1,900,000
                    Billings                                                   1,900,000

                  Cash                                          1,800,000
                    Accounts Receivable                                        1,800,000

                  Cost of construction                          1,716,000
                    Construction in Process                                      337,000
                    Revenue                                                    2,053,000




Page 135                                                      CMA Ontario – September 2009
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                  Revenue = $6,600,000 x 59% = 3,894,000 - 2,178,000 Recognized in 20x1
                    = 1,716,000
                  Cost of construction = $6,500,000 x 59%
                    = 3,835,000 - 1,782,000 Recognized in 20x1 = 2,053,000

        20x3      Construction in Process                          2,450,000
                    Cash, Accounts Payable, …                                      2,450,000

                  Accounts Receivable                              1,900,000
                    Billings                                                       1,900,000

                  Cash                                             1,700,000
                    Accounts Receivable                                            1,700,000

                  Cost of construction                             2,540,000
                    Construction in Process                                          659,000
                    Revenue                                                        1,881,000

                  Revenue = $6,600,000 x 87.5% = 5,775,000 - 2,178,000 Recognized in 20x1
                    - 1,716,000 Recognized in 20x2 = $1,881,000
                  Cost of construction = $1,881,000 + 659,000 Loss to be recognized in 20x2
                    = $2,540,000


(c)     Dandan Inc.
        Partial Statement of Financial Position
        As at December 31, 20x2
                                                          20x1           20x2           20x3
        Current Assets -

        Construction in progress
          Costs to date                            $1,782,000     $3,850,000     $6,300,000
          Profits/loss                                396,000         59,000       -600,000
          Less billings                            -1,200,000     -3,100,000     -5,000,000
                                                   $ 978,000      $ 809,000      $ 700,000

        Accounts receivable                          $200,000       $300,000       $500,000




Page 136                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5

(a)                                   Revenue to                    Income (Loss)
                                     be Reported           Costs            to be
             Project                (Schedule 1)        Incurred        Reported

                A                      $416,000         $424,000        $(10,000) *
                B                       134,000          126,000             8,000
                C                       475,000          315,000          160,000
                D                       110,000          112,750           (5,000) **
                E                       425,500          370,000            55,500
                                     $1,560,500       $1,347,750        $208,500

        *$520,000 - $530,000.
        **$200,000 - $205,000.

       Schedule 1
       Project

       A                          $424,000
                                             x $520,000 =                        $416,000
                                  $530,000

       B                          $126,000
                                             x $670,000 =                         134,000
                                  $630,000

       C                          $315,000
                                             x $475,000 =                         475,000
                                  $315,000

       D                          $112,750
                                             x $200,000 =                         110,000
                                  $205,000

       E                          $370,000
                                             x $460,000 =                         425,500
                                  $400,000
                                                                               $1,560,500




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(b)        1 - total billings of $1,505,000 less cash collections of $1,365,000 = $140,000
           2 - $127,250 - see Schedule 2
           3 - $76,000 - see Schedule 2


Schedule 2

                  Costs                              Costs and
              and Estimated        Related      Estimated Earnings in     Billings in Excess
Project        Earnings or         Billings       Excess of Billings     Estimated Earnings
                  Losses
       A        $414,000            $350,000          $ 64,000
       B         134,000             210,000                                  $76,000
       D         107,750              70,000            37,750
       E         425,500             400,000            25,500
              $1,081,250          $1,030,000          $127,250                $76,000




Page 138                                                         CMA Ontario – September 2009
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4.      Cash

Petty Cash

Most companies have a petty cash account for small-dollar purchases and transactions.
Imprest petty cash funds provide a means of paying for small expenditures and purchases
evidenced by vouchers or receipts. The size of the fund is limited to relatively small
amounts in relation to the size of the organization. The amount is determined by how
often the fund is to be replenished, the estimated number of transactions per period, and
the average expenditure. The fund is established with a fixed sum and periodically
replenished based upon an approved request by the person responsible for administering
the fund. The request to bring the fund back to its authorized cash balance is supported by
signed vouchers or receipts, which provide control.

As an example, assume that Rizzo Industries establishes a petty cash fund for $200 on
October 1, 20x8, and makes the following disbursements out of the fund during October:

           Supplies                                                $ 40
           Postage stamps                                            29
           Delivery charges                                         100
                                                                   $169

The journal entries to establish the fund and, subsequently, to replenish it are as follows:

Oct 1, 20x8       Petty Cash                                    $200
                    Cash                                                     $200

Oct 31, 20x8      Supplies expense                                 40
                  Postage expense                                  29
                  Delivery expense                                100
                    Cash                                                      169




Page 139                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Bank Statement Reconciliation

Each month a bank statement is typically sent to depositors of demand accounts. Upon its
receipt, a bank reconciliation of the differences (if any) between the cash balance as
shown by the bank and the cash balance reflected on the books of the organization should
be made. For most organizations the Cash account has more activity than any other
account, making the reconciliation process extremely important, since it helps maintain
control of cash.

The proper method of reconciliation is to bring both balances up to date, reflecting the
correct cash amount, a point at which the book balance and bank balance should be the
same. This method highlights the adjustments required to bring the book balance to the
true cash position at the date of reconciliation. The book balance also could be reconciled
to the bank balance or the bank to the books. Neither of these procedures, however, will
provide the correct cash balance at the financial statement date.

The following example illustrates a bank reconciliation in which both the bank balance
and the book balance are brought to the true cash-available position. To adjust the bank
balance, any cheques outstanding are deducted and deposits in transit added. Any errors
made by the bank also must be corrected. The most frequent adjustments to the book
balance are for bank service charges, interest earned on the account, errors made in the
books, and cheques returned by the bank as nonsufficient funds (NSF) checks. These are
customer cheques deposited in an account that have been returned to the depositor's bank
because they failed to clear the customer's bank. Note that any correction to the book
balance requires an adjusting entry to correct the Cash account. Any adjustments to the
bank balance will be made by the bank and do not require adjusting entries on the
company books.

Example : You have been asked to calculate the balance in the Cash account of Tender
Footsies Ltd. as at December 31, 20x4, and have been supplied with the following data:

A bank statement dated January 31, 20x5, was found with an opening balance on January
1, 20x5, of $12,000 and a closing balance of $15,598. The canceled cheques returned
totaled $18,227: $1,888 were dated November 20x5; $13,429, December 20x5; and
$2,910, January 20x5. All cheques issued prior to January 20x5 had been cashed by the
end of January 20x5. Deposits totaled $32,940 and included: a 30-day promissory note
due January 15, 20x5, for $200 plus $26 of interest; a deposit dated December 31, 20x4,
for $1,080 relating to accounts collected on that day; and a $500 credit to correct a bank
error which occurred in December 20x4. The bank statement also showed one debit,
dated January 2, 20x5, for $11,115 which represented the last payment of a bank loan
including $115 of interest, and another debit for $8 which represented January's bank
charges. None of these amounts had yet been entered in the books of Tender Footsies.




Page 140                                                        CMA Ontario – September 2009
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The bank reconciliation as at December 31, 20x4 would be as follows:

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




Page 141                                                    CMA Ontario – September 2009
Financial Accounting – Module 1



Problems with Solutions

Multiple Choice Questions

1.    In preparing its August 31, 20x5, bank reconciliation, Apex Corp. has available the
      following information:

            Balance per bank statement, Aug 31, 20x5                            $18,050
            Deposit in transit, Aug 31, 20x5                                      3,250
            Return of customer's check for insufficient funds, Aug 31, 20x5         600
            Outstanding cheques, Aug 31, 20x5                                     2,750
            Bank service charges for August                                         100

      At August 31, 1995, Apex's correct cash balance is
      a) $18,550
      b) $17,950
      c) $17,850
      d) $17,550


2.    Mork, Ltd. had the following bank reconciliation at July 31, 20x6:

              Balance per bank statement, July 31, 20x6                        $37,200
              Add: Deposit in Transit                                           10,300
              Less: Outstanding cheques                                       (12,600)
              Balance per books, July 31, 20x6                                 $34,900

      Data per bank for the month of August 20x6 was as follows:
             Deposits                                                         $47,700
             Disbursements                                                     49,700

      All reconciling items at July 31, 20x6 cleared the bank in August. Outstanding
      cheques at August 31, 20x6 totalled $5,000. There were no deposits in transit at
      August 31, 20x6. What is the cash balance per books at August 31, 20x6?
      a) $30,200
      b) $32,900
      c) $35,200
      d) $40,500




Page 142                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

In comparing the monthly bank statement for J.B. Enterprises with the cash ledger, the
following items were found to reconcile the difference:
1) Bank service charge of $8.
2) Cheque #0178 written in payment to a supplier for $175 was inadvertently recorded
    in the ledger at $157.
3) Three cheques written in the month had not yet cleared the bank. The total amount
    was $448.
4) The deposit made on the last day of the month for $2,650 was not included on the
    bank statement.
5) The bank collected a note for $980 which included $80 interest for J.B. Enterprises.
6) A cheque written by J.B. Holdings, a sister company, had been charged against this
    bank account in the amount of $320.
7) A customer cheque was returned N.S.F. with the bank statement. The cheque had
    been made out for $28. There was a $5 fee charged by the bank for this.

Required -

a) Prepare a journal entry to record each of the reconciling items where necessary in
   J.B.'s books. Also indicate where no entry is required.
b) If the cash ledger had an unadjusted ending balance of $6,161, what was the ending
   balance per the bank statement?
c) Briefly explain why it is necessary to do a bank reconciliation upon receipt of the
   bank statement.




Page 143                                                      CMA Ontario – September 2009
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Problem 2

The following information for the month of December 20x6, with respect to cash
activities, was gathered by Tressa Ltd.’s bookkeeper.

Cash balance per books, December 1                                                 $ 3,700
Cash received during December                                                       77,000
Cash payments made during December                                                  77,548
Cash balance per bank statement, December 31                                         6,300
Cheques outstanding, December 31                                                     5,300
Bank service charges for December                                                       52
Deposits in transit at December 31                                                   1,700
Cheque issued by Sparg Ltd. deducted from Tressa’s
  account in error by the bank                                                         580
A $1,200 cheque received from a customer on December 13 in payment
  of an account receivable was incorrectly recorded as                               1,020

Required

a.      Prepare the December 20x6 bank reconciliation for Tressa.
b.      Prepare any adjusting journal entries that would result from the December 20x6
        bank reconciliation.

Problem 3

The bank statement of Will’s Golf Shop indicated a balance of $15,670 at May 31, 20x3.
The bank balance did not include a deposit of $4,300 made by Will on May 31. Total
outstanding cheques as at May 31 totalled $7,650. In addition, the bank statement
revealed the following:

i)      the bank statement included a cheque in the amount of $500 written out by
        another local business – Jim the Undertaker,
ii)     service charges of $25 were charged by the bank,
iii)    cheque # 345 was recorded on the books in the amount of $4,546 was actually
        written out for $4,456. This cheque was for golf supplies. The correct amount of
        the invoice was $4,456.
iv)     a deposit made on May 26 included a cheque from a customer that was returned
        marked ‘Insufficient Funds’. The amount of the cheque was for $630. The bank
        charged a $10 fee for handling this returned cheque.

The May 31, 20x3 general ledger balance in the cash account was $13,395.

Required –

Prepare a bank reconciliation as at May 31 for Will’s Golf Shop and any adjusting entries
required.

Page 144                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


SOLUTIONS


Multiple Choice Questions

1.    a       Balance per statement                                                          $18,050
              Add deposit in transit                                                           3,250
              Less Outstanding cheques                                                        (2,750)
              Balance per books                                                              $18,550


2.    a       $34,900 + (47,700 - 10,300) - (49,700 - 12,600 + 5,000) = $30,200



Problem 1

a)
1.     Other expenses                                                               $8
           Cash                                                                                    $8

2.     Accounts payable                                                              18
           Cash                                                                                        18

3.     No entry required. These cheques have already been recorded.

4.     No entry required. This deposit has already been recorded.

5.     Cash                                                                         980
           Note receivable                                                                         900
           Interest revenue                                                                         80

6.     No entry required. Notify bank of error.

7.     Accounts receivable                                                           33
           Cash                                                                                        33

b.        Adjusted cash balance = $6,161 - 8 - 18 + 980 - 33 = $7,082
          Balance per bank = $7,082 + 448 Outstanding Cheques - 2,650 Outstanding deposits
                 - 320 Bank error = $4,560

c.        The bank reconciliation must be done for control purposes. Any errors made by
          the bank or the entity should be detected by this process. It also serves to identify
          any unrecorded transactions regarding cash. When these are identified, the records
          of the entity can be updated to the correct cash balance.


Page 145                                                                CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2

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

       Cash balance per bank, December 31                                        $6,300
       Add Sparg cheque deducted in error                                           580
       Add deposits in transit                                                    1,700
       Less outstanding cheques                                                 (5,300)
       Cash balance per books                                                    $3,280

b.     Cash                                                          $180
         Accounts receivable                                                      $180

       Bank service charges                                              52
         Cash                                                                        52


Problem 3

Adjusting Journal Entries -

Bank service charges                                              $25
  Cash                                                                              $25

Cash                                                                90
  Golf supplies                                                                      90
$4,546 – 4,456

Accounts receivable ($630 + 10)                                   640
  Cash                                                                              640

Revised bank balance = $13,395 – 25 + 90 – 640 = $12,820

Bank Reconciliation -
Balance per bank                                                               $15,670
Add: Bank error                                                                     500
      Deposits in transit                                                         4,300
Less: Outstanding cheques                                                       (7,650)
Balance per books                                                              $12,820


Page 146                                                    CMA Ontario – September 2009
Financial Accounting – Module 1



5.      Accounts Receivable

Accounts receivable arises whenever sales are made on account and our credit policy
allows customers a certain amount of time before payment is due. The recognition of
accounts receivable on the Statement of Financial Position derives from the revenue
recognition criteria developed in section 3. Once the revenue recognition criteria are
applied and it is deemed that we can record the revenue, the offsetting entry is typically
to accounts receivable.

Consequently, the only accounting issue dealt with in this section is that of the valuation
of accounts receivable - specifically, how to calculate the allowance for doubtful
accounts and bad debt expense. GAAP requires that accounts receivable be recorded at
the lower of cost or market. In the case of accounts receivable, we define market to be net
realizable value of the receivables (Accounts Receivable less the Allowance for Doubtful
Accounts).

There are two general theoretical approaches to the recording of bad debts: the direct
write-off approach and the allowance method. The direct write-off approach writes off
accounts receivable to bad debts when the probability of collecting an account becomes
low. There are two problems with this method: (1) it does not meet the lower of cost or
market criteria for the recording of accounts receivable in that receivables would be
recorded at their gross amount on the Statement of Financial Position and (2) it does not
meet the matching principle since accounts could get written off years after the sale was
recorded. Consequently, the direct write-off method is not acceptable under GAAP.

The allowance method is in accordance with GAAP and is the method we will use and
elaborate on. There are two distinct ways to apply the allowance method: the Statement
of Financial Position approach and the Income Statement approach.


Statement of Financial Position Approach

The Statement of Financial Position approach involves the estimation of the allowance
for doubtful accounts. Bad debt expense is the used as a residual account. Rework
sentence

The allowance for doubtful accounts can be generally estimated in one of three ways:
1.     by a review of individual accounts,
2.     as a percentage of accounts receivable,
3.     by aging the accounts receivable and taking a percentage for each category of
       receivables as potentially doubtful.




Page 147                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


During the year, any account that has been deemed uncollectible is written off against the
allowance for doubtful accounts: Allowance is already set up.

        Allowance for doubtful accounts                     XXX
              Accounts receivable                                   XXX

Any recoveries of accounts previously written off are first recovered by reversing the
above entry and then collected:

        Accounts receivable                                 XXX
              Allowance for doubtful accounts                       XXX

        Cash                                                XXX
                Accounts receivable                                 XXX

At period-end, the balance in the allowance for doubtful accounts is estimated. Any
corresponding entry is made to the bad debt expense account. Note that under this
method, it is possible for the bad debt expense account to have a credit balance.


Income Statement Approach

The income statement approach estimates the bad debt expense and uses the allowance
for doubtful accounts as a residual. This method is typically used by companies that offer
revolving credit to their customers (VISA, American Express…) and therefore cannot
properly age their accounts receivable. They will normally estimate bad debts as a
percentage of credit sales and credit the amount to the allowance for doubtful accounts.

The transactions to record the write-off and recovery of accounts is the same as for the
Statement of Financial Position approach.

Example 1: All of Tender Footsies sales are on credit. Sales for 20x4 totaled $934,800.
Included in the 20x4 sales were $10,000, representing the cost of goods which were sent
on consignment during the year. None of these goods had been sold by the end of 20x4.

The allowance for doubtful accounts had a balance of $4,540 on December 31, 20x3.
During 20x4, Tender Footsies wrote off $14,690 as uncollectible, but collected $3,300
which it had previously written off. The company follows the practice of allowing 2% of
net sales as uncollectible. Sales returns for 20x4 were $3,670.




Page 148                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


The Allowance for doubtful accounts at December 31, 20x4 is as follows:

       Balance, December 31, 20x3                                               $4,540
       Accounts written off as uncollectible                                   (14,690)
       Collection of account previously written off                              3,300
       Bad debt expense for the year:
              ($934,800 -10,000 - 3,670) x 2%                                   18,423
       Balance, December 31, 20x4                                              $11,573


Example 2: As an employee of Dunlop Company, you are provided with the following
information:

                                      Account Balances
                                      as at December 31

        Accounts receivable                                           $659,600 Dr.
        Allowance for doubtful accounts                                 13,000 Cr.

Sales on credit for the year amounted to $2,500,000. An aging schedule shows the
following totals:

                                          Number of Days Past Due
      Total
    Balance          Current             1-30          30-60           61-90             Over 90
   $659,600         $325,000         $177,000        $72,000         $65,000             $20,600

It is estimated that the following percentage of accounts receivable balances wil1 be
uncollectible:

                                                 Percentage
                        Number of                Estimated
                       Days Past Due            Uncollectible

                           Current                   2%
                             1-30                     4
                            31-60                    12
                            61-90                    25
                           Over 90                   50

It is assessed that 3 percent of all credit sales during the year will be uncollectible.




Page 149                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


Required:

a.      (1)     Assuming that Dunlop Company uses the aging analysis method,
                determine the balance required in the Allowance for Doubtful Accounts.

        (2)     Prepare a journal entry to adjust the balance in the Allowance for Doubtful
                Accounts.

b.      Assuming that Dunlop Company uses the percentage-of-credit-sales method
        instead of the aging method, calculate the required addition to the Allowance for
        Doubtful Accounts as of December 31 and prepare the required entry.

c.      Prepare the journal entry to write off the account of Titus Kanbee, who owes the
        company $1,200.

SOLUTION

Part (a)

Current: $325,000 x 2%                                  $6,500
1-30: $177,000 x 4%                                      7,080
31-60: $72,000 x 12%                                     8,640
61-90: $65,000 x 25%                                    16,250
Over 90: $20,600 x 50%                                  10,300
                                                       $48,770

Bad Debt Expense ($48,770 – 13,000)                                $35,770
  Allowance for Doubtful Accounts                                                   $35,770


Part (b)

Bad debt expense = $2,500,000 x 3% = $75,000

Bad Debt Expense                                                   $75,000
  Allowance for Doubtful Accounts                                                   $75,000


Part (c)

Allowance for Doubtful Accounts                                     $1,200
  Accounts Receivable                                                                $1,200




Page 150                                                         CMA Ontario – September 2009
Financial Accounting – Module 1



Problems with Solutions

Problem 1

Mr. N. Eedy, president of Scotland Corporation, approached Mr. P. L. Enty, manager of
Old Halifax Bank, for a loan. After reviewing the December 31, 20x0, financial
statements of Scotland Corporation, Mr. P. L. Enty asked for more information since a
few things bothered him: (a) Scotland Corporation has its accounts with Old Halifax
Bank and the balances of these accounts total the amount reported as cash on the
Statement of Financial Position. (b) The accounts receivable balance appears large
compared to the previous year.

Mr. P. L. Enty requested a copy of the bank reconciliation and an aging schedule of the
accounts receivable prior to making a decision as to whether or not the loan should be
granted.

The bank reconciliation has not been prepared. The total balances in the bank accounts
were reported as cash. However, Mr. N. Eedy provided the following data:

i)      Total balances in bank accounts                        $14,349.18
ii)     Outstanding cheques                                    $24,327.16
iii)    Outstanding deposits                                    $3,619.22
iv)     Bank charges for December                                  $57.02
v)      Adjusted cash balance per the November 30,
        20x0, bank reconciliation                               $2,027.03
vi)     The bank had collected a loan receivable for
        Scotland Corporation and deposited it in
        December                                                $2,000.00
vii)    An NSF cheque had been debited to the account
        by the bank                                               $150.00
viii)   There was an error in the books of Scotland
        Corporation. A receipt of cash had been credited
        rather than debited to the cash account                   $290.00




Page 151                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


Mr. N. Eedy provided you with the following aging schedule of accounts receivable:

                             Aged Accounts Receivable
                                Days Outstanding
                                December 31, 20x0

                  Total           0-30      31-60         61-90        Over 90

AB Ltd.            $14,360        $12,200                   $ 2,160
CD Ltd.             22,000         19,360                                 $2,640
EF Ltd.              6,900          3,600     $ 1,800         1,500
GH Ltd.             14,900          4,900       7,500         2,000           500
IJ Ltd.              2,050                                    2,050
Others              10,600          2,350       4,700         2,500         1,050

                   $70,810        $42,410    $14,000       $10,210        $4,190

Mr. Eedy apologized for the fact that the control account for accounts receivable on the
Statement of Financial Position shows $75,500. He assured you that his customers are
large well-known companies and that they are good credit risks.

Required -

Mr. P. L. Enty approaches you, as the assistant bank manager, and asks you to determine
whether or not the bank should loan $50,000 to Scotland Corporation for a period of 90
days. Include in your reply the current cash balance, your opinion of the accounts
receivable and your opinion of Scotland Corporation as a whole.




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Problem 2

The following are transactions affecting accounts receivable for the Jurdi Company
during the year ended December 31, 20x5:

Total Sales (all credit)                                                          $620,000

Cash collected on account (note that one half of customers took
advantage of the trade discount 2/10, net 30)                                      589,050

Accounts receivable written off                                                       5,450

Credit issued to customers for sales returns and allowances                         14,500

Recoveries of accounts receivable written off as uncollectible in prior
periods (not include in cash collected above)                                         3,400

The following balances were taken from the Balance Sheet dated December 31, 20x4:

Accounts receivable                                                                $96,400
Allowance for doubtful accounts                                                      9,700

The Jurdi Company estimated bad debts to be equal to 0.5% of credit sales net of sales
returns and allowances.

Required –

Calculate the Accounts Receivable and Allowance for Doubtful Accounts balance as at
December 31, 20x5.




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Problem 3

The Webster Company uses the aging method to estimate the allowance for doubtful
accounts. The following schedule of accounts receivable was prepared as at December
31, 20x6:

             Age                           Balance                   %
                                                          uncollectible
             0-30 days                    $674,000               0.5%
             31-60 days                    186,000               1.2%
             61-90 days                     65,400                10%
             91-120 days                    19,500                50%
             Over 120 Days                   7,800                75%
                                          $952,700

The balance in the allowance for doubtful accounts at the beginning of the year was
$31,150 (cr). The following transactions were recorded during the year:

       Accounts receivable written off                                    34,500

       Recoveries of accounts receivable written off as
       uncollectible in prior periods                                      2,300

Required –

Calculate the bad debt expense for the year 20x6.




Page 154                                                        CMA Ontario – September 2009
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Problem 4

The following information pertains to Bedford Company's accounts receivable for the
year ended December 31, 20x2:

Accounts receivable at January 1                                                $ 900,000
Credit sales for 20x2                                                           5,800,000
Allowance for doubtful accounts at January 1                                       55,000
Collections from 20x2 credit sales                                              4,900,000
Accounts written off August 31                                                     70,000
Previously written off accounts received September 20                               6,000

An aging analysis estimates uncollectible receivables at December 31, 20x2, to be
$80,000.

Required:

a.      Prepare all relevant journal entries.
b.      What is the accounts receivable balance at December 31?
c.      What effect did the accounts written off at August 31 have on the net realizable
        value of accounts receivable?


Problem 5

Any company that has a policy of extending credit when making sales must expect a
portion of these sales to become uncollectible. As a result, the company must recognize
bad debt expense either as a direct write-off or as an allowance.

Required -

a) Describe the difference between the direct write-off method and the allowance
   method of recognizing bad debts.

b) Are these methods in accordance with GAAP? Discuss the reasons, if any, why one
   of the above methods would be preferable to the other.




Page 155                                                       CMA Ontario – September 2009
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Problem 6

During the audit of accounts receivable, your client asks why the current year's income
statement reports bad debt expense when some accounts may become uncollectible next
year. He then said that he had read that financial statements should be based on
verifiable, objective evidence, and that it seemed to him to be much more objective to
wait until individual accounts receivable were actually determined to be uncollectible
before recording them as expenses.

Required -

1. Discuss the theoretical justification of the allowance method as contrasted with the
   direct write-off method of accounting for bad debts.

2. Describe the percentage-of-sales method and the aging method of estimating bad
   debts. Explain how well each method accomplishes the objectives of the allowance
   method of accounting for bad debts.

3. Of what merit is your client's contention that the allowance method lacks the
   objectivity of the direct writeoff method? Discuss in terms of accounting's
   measurement function.




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SOLUTIONS


Problem 1

Cash Balance

Bank Balance                                  $14,349.18
Less outstanding cheques                      (24,327.16)
Add outstanding deposits                         3,619.22

Book Balance - Overdraft                      $(6,358.76)

Other items: Bank charges, loan collection, NSF cheque, book error are already adjusted
by using the bank balance.

Accounts Receivable

The control account does not equal the subledger total. This is an indication of
unrecorded sales or errors.

Some customers may not be as good of a credit risk as the president believes. GH, for
example, and others owe amounts three months past due.

Since many accounts are past due, it is an indication that the credit department may not
be aggressive enough in its collection policies (or credit applications are not screened).
CD, as an example, owes amounts currently in addition to some old amounts. This is an
indication of errors or problems in the credit area.

Overall, an adjustment for doubtful accounts appears necessary to properly value the
accounts receivable.

Scotland Corporation

The system of internal control does not appear to be functioning properly. There is no
bank reconciliation and the control account does not balance to the accounts receivable
subledger. The net realizable value of the accounts receivable is much less than $70,810
and there is a bank overdraft on the books of Scotland Corporation.

Should the Bank Loan the $50,000?

Yes/No. Depends on arguments above.




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Problem 2

Accounts Receivable -
  Balance, January 1, 20x5                                                  $ 96,400
  Sales                                                                       620,000
  Collections ($297,500* x 2)                                              (595,000)
  Accounts written off                                                         (5,450)
  Credits issued to customers                                                (14,500)
  Balance, December 31, 20x5                                                $101,450

* Let X = one half of sales before cash discount
 X + 0.98X = $589,050
 1.98X = $589,050
 X = $297,500

Allowance for doubtful accounts -
  Balance, January 1, 20x5                                                     $9,700
  Accounts written off                                                        (5,450)
  Account recoveries                                                            3,400
  Bad debt expense: ($620,000 – 14,500 Sales Returns and Allowances)
     x 0.5%                                                                    3,027
  Balance, December 31, 20x5                                                 $10,677


Problem 3

Allowance for doubtful accounts, December 31, 20x6:
  $674,000 x 0.5%                                                             $3,370
   186,000 x 1.2%                                                              2,232
    65,400 x 10%                                                               6,540
    19,500 x 50%                                                               9,750
     7,800 x 75%                                                               5,850
                                                                             $27,742

Allowance for doubtful accounts, January 1, 20x6                             $31,150
Accounts written off                                                        (34,500)
Account recoveries                                                             2,300
Balance before adjustment for bad debt expense                              1,050 dr.
Allowance for doubtful accounts, December 31, 20x6                         27,742 cr.
Bad debt expense                                                          $28,792 dr.




Page 158                                                  CMA Ontario – September 2009
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Problem 4

Part (a)

Accounts Receivable                                                   $5,800,000
  Sales                                                                                  $5,800,000

Cash                                                                   4,900,000
  Accounts receivable                                                                     4,900,000

Allowance for doubtful accounts                                            70,000
  Accounts receivable                                                                         70,000

Accounts receivable                                                         6,000
  Allowance for doubtful accounts                                                              6,000

Cash                                                                        6,000
  Accounts receivable                                                                          6,000

Bad debt expense                                                           89,000
  Allowance for doubtful accounts                                                             89,000


Part (b)        900,000 Opening Balance + 5,800,000 Credit Sales - 4,900,000 Collections
                - 70,000 Write-Offs + 6,000 Recovery - 6,000 Collection on Recovery = $1,730,000

Part (c)        No effect (decreased both the accounts receivable and the allowance)




Page 159                                                               CMA Ontario – September 2009
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Problem 5

a)
Direct write-off:
i)     identify an uncollectible account
ii)    remove it from the accounts receivable
iii)   recognize bad debt expense

Allowance method:
i)    estimate bad debts expense by either % of sales or aging of accounts receivable at
      the end of a period
ii)   adjust the allowance for doubtful accounts
iii)  record the bad debt expense
iv)   when an uncollectible is identified, write it off against the allowance for doubtful
      accounts

In the direct write-off method, the net accounts receivable are reduced when an account is
written off; but in the allowance method, the net accounts receivable do not change.

In the allowance method, the expense is recognized in the same period as the sales; but in
the direct write-off method the expense may be recognized in a different period.

b)
Allowance method:
• matches sales in the period with possible bad debts
• achieves proper carrying value of the accounts receivable (because of the allowance
    for doubtful accounts)

Direct write-off:
Write-off and thus bad debt expense occurs in the period in which an account becomes
uncollectible and this is not necessarily the same period in which the sale was recorded;
therefore the expense and revenue may not be matched.

The allowance method is in accordance with GAAP but the direct write-off method may
also be if the bad debt expense is not material.




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Problem 6

1. The theoretical superiority of the allowance method over the direct write-off
   method of accounting for bad debts is twofold. First, because revenue is recognized
   at the point of sale on the assumption that the resulting receivables are valid liquid
   assets merely awaiting collection, periodic income will be overstated to the extent of
   any receivables that eventually become uncollectible.

    Second, accounts receivable on the Statement of Financial Position should be stated
    at their estimated net realizable value. The allowance method accomplishes this
    objective by deducting from gross receivables the allowance for doubtful accounts.

2. THE PERCENTAGE OF SALES METHOD: Under this method bad debt expense is
   debited and the allowance for uncollectible accounts is credited with a percentage of
   the current year's credit or total sales. The rate is determined by reference to the
   relationship between prior years' credit or total sales and actual bad debts arising
   therefrom.

    The percentage of sales method of providing for estimated uncollectible receivables is
    intended to record bad debt expense in the period in which the corresponding sales
    are recorded. Cumulatively significant errors in the experience rate may result in
    either an excessive or inadequate balance in the allowance account, however, this
    method may not accurately report accounts receivable at their estimated net realizable
    value. This result can be prevented by periodically reviewing and, if necessary,
    adjusting the balance in the allowance account. The materiality of any such
    adjustment would govern its treatment for reporting purposes.

    THE AGING METHOD: Under this method each year's debit to the expense account
    and credit to the valuation account is determined by an evaluation of the collectibility
    of open accounts receivable at the close of the year. An analysis of the accounts
    according to their due dates is the usual procedure. For each of the age categories
    established in the analysis, average percentage rates may be developed on the basis of
    past experience and applied to the accounts in the respective age categories. This
    method may also utilize individual analysis for some accounts, especially those that
    are considerably past due, in arriving at estimated uncollectible receivables. On the
    basis of the foregoing analysis the balance in the valuation account is then adjusted to
    the amount estimated to be uncollectible.

    This method of providing for uncollectible accounts is quite accurate for purposes of
    reporting accounts receivable at their estimated net realizable value in the Statement
    of Financial Position. From the standpoint of the income statement, however, the
    aging method may not match accurately bad debt expenses with the sales which
    caused them because the charge to bad debt expense is not based on sales.




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3. A major part of accounting is the measurement of financial data. Changes in value
   should be recognized as soon as they are measurable in objective terms in order that
   accounting may provide useful information on a periodic basis.

    Accountants have had to develop a philosophy regarding an acceptable degree of
    uncertainty in order to make their work useful. The accountant's term "objectivity"
    does not imply certainty. Estimates can be objective, though by definition they are not
    certain. To be considered objective, they must be based on evidence that is reliable
    and subject to verification by another competent investigator. This kind of criterion
    permits the preparation of meaningful periodic financial statements through such
    conventions as the sales method of revenue recognition and the allowance method of
    accounting for bad debts.

    The very existence of accounts receivable is based on the decision that a credit sale is
    an objective indication that revenue should be recognized. The alternative is to wait
    until the debt is paid in cash. If revenue is to be recognized and an asset recorded at
    the time of a credit sale, the need for fairness in the statements requires that both
    expenses and the asset should be adjusted for the estimated amounts of the asset that
    experience, which is subject to verification by competent investigators, indicates will
    not be collected.




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6.      Notes Receivable / Payable

A note receivable is usually created in one of the following two ways:
•      a customer with a current account receivable re-negotiates the terms of repayment
       by agreeing to pay the balance by a specified date. When this happens, the
       account balance should be removed from accounts receivable and set up as a note
       receivable:

        Dr. Notes Receivable                                             XXX
          Cr. Accounts Receivable                                                    XXX

•       a credit sale is made and the terms of repayment exceed the usual normal credit
        terms. For example, a furniture company makes a sale and agrees to delay the
        payment for 18 months. Such a receivable would be classified as a note
        receivable.

Whether a note receivable is classified as a current or long-term asset depends on the
terms of the note receivable. If at the Statement of Financial Position date, the note is due
within the next 12 months, then it is classified as current. Otherwise, it is classified as
long-term.

Notes receivable are usually interest bearing. If the amount of interest charged is equal to
the imputed interest rate (defined on the next page), the note gets recorded at its face
value and the interest gets recorded as it accrues.

Example 1: On January 2, 20x0 you sell equipment to one of your customers. The value
of the sale is $10,000 and you agree to take back a note receivable for two years. Interest
of 10% (equal to the imputed interest rate) is charged on the note and is payable on
December 31 of each year. The note is repayable on December 31, 20x1.

Given that the interest rate on the note is equal to market interest rates, the note would get
recorded as follows:

Jan 1, 20x0      Note Receivable                                      $10,000
                   Sales                                                             $10,000

The following journal entries will record the remaining transactions:

Dec 31, 20x0     Cash                                                  $1,000
                   Interest Revenue                                                   $1,000

Dec 31, 20x1     Cash                                                 $11,000
                   Note Receivable                                                   $10,000
                   Interest Revenue                                                    1,000




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The complication arises when the interest rate on the note receivable is less than the
imputed interest rate. In this case, the note receivable gets recorded at the sum of the
discounted cash flows to be received on the note receivable. The cash flows are
discounted at the imputed rate of interest.

The imputed rate of interest is the more clearly determinable of the following two rates:
(a)   the prevailing rate for a similar instrument of an issuer with a similar credit rating,
      or
(b)   a rate of interest that discounts the nominal amount of the instrument to the
      current cash sales price of the goods or services. (IAS 18.11)

Note that when establishing an imputed rate of interest for a note receivable, the imputed
interest rate in part (a) above is based on the credit rating of your customer. For a note
payable, it would be based on your own credit rating.

Example 2: Assume that in example 1, the seller of equipment agrees to only charge 4%
interest on the note.

                              N         I/Y         PV          PMT          FV
           Enter              2         10                       400        10000
           Compute                                  X=
                                                   8,959

The note would get recorded as follows:

Jan 1, 20x0      Note Receivable                                       $8,959
                   Sales                                                              $8,959

On December 31, 20x0, the interest revenue on the note will be equal to the carrying
value of the note times the market rate of interest: $8,959 x 10% = $896. The difference
between the interest revenue of $896 and the interest of $400 received increases the
carrying value of the note:

Dec 31, 20x0     Cash                                                    $400
                 Note receivable                                          496
                   Interest Revenue                                                        $896

On December 31, 20x1, the interest revenue on the note will be equal to the carrying
value of the note times the market rate of interest: ($8,959 +$ 496) = $9,455 x 10% =
$945. The difference between the interest revenue of $945 and the interest of $400
received increases the carrying value of the note:

Dec 31, 20x1     Cash                                                    $400
                 Note Receivable                                          545
                   Interest Revenue                                                        $945


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Note that the carrying value of the note is now: $9,455 + $545 = $10,000. The journal
entry to record the receipt of the principal amount of the note is as follows:

Dec 31, 20x1     Cash                                                $10,000
                   Note Receivable                                                  $10,000

To summarize, whenever you have a note receivable (or payable) whose interest rate is
less than the market interest rate, you first determine the cash flows that are expected
from the note receivable and then discount these cash flows at the market rate of interest.

Example 3: assuming the same information as for Example 2, but assume instead that the
best measure of the imputed interest rate is based on the cash price of the equipment sold
of $9,200.

The note would get recorded as follows:

Jan 1, 20x0      Note Receivable                                      $9,200
                   Sales                                                             $9,200

In order to calculate the interest revenue, we need to determine the imputed interest rate:

                              N        I/Y          PV         PMT          FV
           Enter              2                   -9,200        400        10000
           Compute                     I/Y =
                                      8.518%

On December 31, 20x0, the interest revenue on the note will be equal to the carrying
value of the note times the market rate of interest: $9,200 x 8.518% = $784. The
difference between the interest revenue of $896 and the interest of $400 received
increases the carrying value of the note:

Dec 31, 20x0     Cash                                                   $400
                 Note receivable                                         384
                   Interest Revenue                                                    $784

On December 31, 20x1, the interest revenue on the note will be equal to the carrying
value of the note times the market rate of interest: ($9,200 +$384) = $9,584 x 8.518% =
$816. The difference between the interest revenue of $945 and the interest of $400
received increases the carrying value of the note:

Dec 31, 20x1     Cash                                                   $400
                 Note Receivable                                         416
                   Interest Revenue                                                    $816




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Note that the carrying value of the note is now: $9,584 + $416 = $10,000. The journal
entry to record the receipt of the principal amount of the note is as follows:

Dec 31, 20x1     Cash                                               $10,000
                   Note Receivable                                                 $10,000


Appendix – Using your Financial Calculator

The format for solutions using a financial calculator used throughout this module and
other Accelerated Program modules is as follows:

                              N        I/Y         PV         PMT           FV
           Enter              5         6                                  1000
           Compute                                  X

In the above example, we are trying the calculate the present value of $1,000 to be
received in 5 years from now at an interest rate of 6%.

If you are using the Texas Instruments BA II Plus, you need to do the following:
-       set the calculator to accept one payment per year as follows:
                1       2ND N
        You only need to do this once.
-       clear the Time Value of Money memory as follows:
                2ND FV
        You should do this every time you do a time value of money calculation.
-       enter the numbers above in the TVM memory registers
-       to solve, press CPT and the TVM register you are attempting to solve for, in this
        case PV
-       the answer provided is -747.26. This means that if you were to invest $747.26
        today (money out of pocket and therefore the negative sign) and invest it for 5
        years at 6% compounded annually, the amount would grow to $1,000.

If you are using the Hewlett Packard 10BII, you need to do the following:
-       set the calculator to accept one payment per year as follows:
                 1      then Orange Button           then PMT
        You only need to do this once.
-       clear the Time Value of Money memory as follows:
                Orange Button                 C ALL
        You should do this every time you do a time value of money calculation.
-       enter the numbers above in the TVM memory registers
-       to solve, press the TVM register you are attempting to solve for, in this case PV
-       the answer provided is -747.26. This means that if you were to invest $747.26
        today (money out of pocket and therefore the negative sign) and invest it for 5
        years at 6% compounded annually, the amount would grow to $1,000.


Page 166                                                        CMA Ontario – September 2009
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Problems with Solutions

Problem 1 – Present Value Exercises

a.      You just came into some money - $50,000 and want to invest it for 12 years at
        6%. How much will you have in 12 years?
b.      You plan to deposit $5,000 in your RRSP each year for the next 30 years. The
        first payment will be in one year from now. How much will accumulate if i=7%?
c.      Continuation of part (b). It is now 30 years later and you have $472,303.93 in
        your RRSP account. You expect to live another 30 years - how much can you
        withdraw each year? Assume that the interest rate is still 7%.
d.      Continuation of part (b). It is now 30 years later, you are wondering what the
        purchasing power of $38,061.28 is compared to 30 years ago. You find out that
        the average inflation rate for the past 30 years was 2.5%.
e.      You need to purchase a vehicle costing $70,000. The dealership is offering you
        4.9% on a 5 year loan. What is your annual loan payment?
f.      Continuation of part (e). You purchased the car and have just made your 3rd loan
        payment. What is the balance of your loan?


Problem 2

The Low Quality Furniture Company allows you to purchase $5,000 of furniture on the
following terms:
i.     0% down, no interest for 2 years, full $5,000 to be repaid in 2 years
ii.    50% down, no interest for 3 years, balance of $2,500 to be repaid in 3 years
iii.   0% down, no interest for 5 years, required annual repayments of $1,000 at the end
       of each year for 5 years
iv.    0% down, annual interest repayments of 5% for 4 years, balance payable at the
       end of 4 years
v.     0% down, annual payments of $1,200 per year for 5 years.

Assuming a market interest rate of 8%, and assuming that each of the above situation is
independent, prepare all journal entries made by the store for each of the situations for all
years in question.




Page 167                                                         CMA Ontario – September 2009
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Problem 3

The Bertolo Corporation sold equipment with a list price of $50,000 to Chan Ltd. on the
following terms: $5,000 payable on December 31, 20x1 (the day the equipment was
delivered) and four payments of $11,250 payable on December 31 of each year starting
on December 31, 20x2. The cash price of the equipment is $43,106.

Required -

Prepare all journal entries for the Bertolo Corporation for the years ended December 31,
20x1 through to December 31, 20x3.



Problem 4

On December 31, 20x2, Kyle Corporation sold for $30,000 an old machine having an
original cost of $50,000 and a book value of $12,000. The terms of the sale were as
follows:

a) $10,000 down payment.
b) $10,000 payable on December 31 for each of the next two years.

The agreement of sale made no mention of interest; however, 10 percent would be a fair
rate for this type of transaction.

Required -

1. Prepare the entry to record the sale on December 31, 20x2.
2. Prepare the entry to record the receipt of $10,000 on December 31, 20x3 and on
   December 31, 20x4.




Page 168                                                      CMA Ontario – September 2009
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Problem 5

Linden, Inc., had the following long-term receivable account balances at December 31,
20x2:

Note receivable from sale of division                    $1,500,000
Note receivable from officer                                400,000

Transactions during 20x3 and other information relating to Linden's long-term
receivables were as follows:

a) The $1.5 million note receivable is dated May 1, 20x2, bears interest at 9 percent, and
   represents the balance of the consideration received from the sale of Linden's
   electronics division to Pitt Company.

    Principal payments of $500,000 plus appropriate interest are due on May 1, 20x3,
    20x4, and 20x5. The first principal and interest payment was made on May 1, 20x3.
    Collection of the note instalments is reasonably assured.

b) The $400,000 note receivable is dated December 31, 20x0, bears interest at 8 percent,
   and is due on December 31, 20x5. The note is due from Robert Finley, president of
   Linden, Inc., and is collateralized by 10,000 of Linden's common shares. Interest is
   payable annually on December 31 and all interest payments were paid on their due
   dates through December 31, 20x3. The quoted market price of Linden's common
   shares was $45 per share on December 31, 20x3.

c) On April 1, 20x3, Linden sold a patent to Bell Company in exchange for a $100,000
   noninterest-bearing note due on April 1, 20x5. There was no established exchange
   price for the patent, and the note had no ready market. The prevailing rate of interest
   for a note of this type at April 1, 20x3, was 15 percent. The patent had a carrying
   value of $40,000 at January 1, 20x3, and the amortization for the year ended
   December 31, 20x3, would have been $8,000. The collection of the note receivable
   from Bell is reasonably assured.

d) On July 1, 20x3, Linden sold a parcel of land to Carr Company for $200,000 under an
   instalment sale contract. Carr made a $60,000 cash down payment on July 1, 20x3,
   and signed a four-year, 16 percent note for the $140,000 balance. The equal annual
   payments of principal and interest on the note will be $50,000 payable on July 1,
   20x4, through July 1, 20x7. The land could have been sold at an established cash
   price of $200,000. The cost of the land to Linden was $150,000. Circumstances are
   such that the collection of the instalments on the note is reasonably assured.

Required -

1. Prepare the long-term receivables section of Linden's Statement of Financial Position
   at December 31, 20x3.


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2. Prepare a schedule showing the current portion of the long-term receivables and
   accrued interest receivable that would appear in Linden's Statement of Financial
   Position at December 31, 20x3.
3. Prepare a schedule showing interest revenue from the long-term receivables and gains
   recognized on sale of assets that would appear on Linden's income statement for the
   year ended December 31, 20x3.

Problem 6

On January 2, 20x1, the Harry Company acquired a truck with a list price of $500,000.
The Harry Company's incremental borrowing rate is 8%. Assume that the truck
manufacturer is offering Harry the following terms (each situation is independent). For
each of the terms, prepare the journal entries for the life of the note. Assume a December
31 year end.

a)      Harry Company has to make equal annual payments of principal and interest over
        five years. Payments are due on December 31 of every year. The interest rate
        charged is 10%.
b)      Harry Company pays the $500,000 in three years. No interest is charged on the
        note.
c)      Harry Company pays the $500,000 in three years. Interest of 3% is charged on the
        note payable on December 31 of every year.
d)      Harry Company pays $100,000 on the principal at the end of every year. No
        interest is charged.
e)      Harry Company pays $100,000 on the principal at the end of every year. Interest
        of 4% is charged on the balance.
f)      Harry Company has to make equal annual payments of principal and interest over
        five years. The interest rate charged is 4%.


Problem 7

Business transactions often involve the exchange of property, goods, or services for notes
or similar instruments that may stipulate no interest rate or an interest rate that varies
from prevailing rates.

Required -

1. When a note is received in exchange for property, goods, or services, what value
   should be placed on the note if it bears interest at a reasonable rate and is issued in a
   bargained transaction? If it bears no interest or is not issued in a bargained
   transaction? Explain.

2. If the recorded value of a note differs from the face value, how should the difference
   be accounted for? How should this difference be presented in the financial
   statements? Explain.


Page 170                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


SOLUTIONS


Problem 1

a.         N = 12, I = 6, PV = 50000, Solve for FV = 100,609.82

b.         N = 30, I = 7, PMT = 5000, Solve for FV = 472,303.93

c.         N = 30, I = 7, PV = 472303.93, Solve for PMT = 38,061.28

d.         N = 30, I = 2.5, FV = 38061.28, Solve for PV = 18,145.44

e.         N = 5, I = 4.9, PV = 70000, Solve for PMT = 16,123.57

f.         N = 2, I = 4.9, PMT = 16123.57, Solve for PV = 30,022.87


Problem 2

Part (i)

PV of note:

                              N          I/Y        PV         PMT            FV
            Enter             2           8                                  5000
            Compute                                 X=
                                                   4,287


Initial         Note receivable                                         $4,287
                  Sales                                                               $4,287

End Yr 1        Note Receivable                                            343
                  Interest revenue (4,287 x 8%)                                           343

End Yr 2        Note Receivable                                            370
                  Interest Revenue (4,287 + 343) x 8%                                     370

                Cash                                                     5,000
                  Note receivable                                                       5,000




Page 171                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Part (ii)

PV of note:

                              N        I/Y        PV         PMT         FV
            Enter             3         8                               2500
            Compute                               X=
                                                 1,985


Initial        Note receivable                                     $1,985
               Cash                                                 2,500
                 Sales                                                           $4,485

End Yr 1       Note Receivable                                        159
                 Interest revenue (1,985 x 8%)                                       159

End Yr 2       Note Receivable                                        172
                 Interest Revenue (1,985 + 159) x 8%                                 172

End Yr 3       Note Receivable                                        185
                 Interest Revenue (1,985 + 159 + 172) x 8%                           185

               Cash                                                 2,500
                 Note receivable                                                   2,500




Page 172                                                     CMA Ontario – September 2009
Financial Accounting – Module 1


Part (iii)

PV of note:

                              N       I/Y         PV          PMT         FV
           Enter              5        8                      1000
           Compute                                X=
                                                 3,993


Initial       Note receivable                                        $3,993
                Sales                                                             $3,993

End Yr 1      Cash                                                    1,000
                Note Receivable                                                       681
                Interest revenue (3,993 x 8%)                                         319

End Yr 2      Cash                                                    1,000
                Note Receivable                                                       735
                Interest revenue (3,993 - 681) = 3,312 x 8%                           265

End Yr 3      Cash                                                    1,000
                Note Receivable                                                       794
                Interest revenue (3,312 - 735) = 2,577 x 8%                           206

End Yr 4      Cash                                                    1,000
                Note Receivable                                                       857
                Interest revenue (2,577 - 794) = 1,783 x 8%                           143

End Yr 5      Cash                                                    1,000
                Note Receivable                                                       926
                Interest revenue (1,783 - 857) = 926 x 8%                              74




Page 173                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


Part (iv)

PV of note:

                              N        I/Y        PV           PMT         FV
            Enter             4         8                       250       5000
            Compute                               X=
                                                 4,503


Initial        Note receivable                                        $4,503
                 Sales                                                             $4,503

End Yr 1       Cash                                                     250
               Note Receivable                                          110
                 Interest revenue (4,503 x 8%)                                         360

End Yr 2       Cash                                                     250
               Note Receivable                                          119
                 Interest revenue (4,503 + 110) = 4,613 x 8%                           369

End Yr 3       Cash                                                     250
               Note Receivable                                          129
                 Interest revenue (4,613 + 119) = 4,732 x 8%                           379

End Yr 4       Cash                                                     250
                 Note Receivable                                        139
                 Interest revenue (4,732 + 129) = 4,861 x 8%                           389

               Cash                                                    5,000
                 Note Receivable                                                     5,000




Page 174                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Part (v)

PV of note:

                              N       I/Y         PV            PMT         FV
           Enter              5        8                        1200
           Compute                                X=
                                                 4,791


Initial       Note receivable                                          $4,791
                Sales                                                               $4,791

End Yr 1      Cash                                                      1,200
                Note Receivable                                                         817
                Interest revenue (4,791 x 8%)                                           383

End Yr 2      Cash                                                      1,200
                Note Receivable                                                         882
                Interest revenue (4,791 - 817) = 3,974 x 8%                             318

End Yr 3      Cash                                                      1,200
                Note Receivable                                                         953
                Interest revenue (3,974 - 882) = 3,092 x 8%                             247

End Yr 4      Cash                                                      1,200
                Note Receivable                                                       1,029
                Interest revenue (3,092 - 953) = 2,139 x 8%                             171

End Yr 5      Cash                                                      1,200
                Note Receivable                                                       1,111
                Interest revenue (2,139 - 1,029) = 1,110 x 8%                            89




Page 175                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

The first step is to determine the imputed interest rate. Note that the PV amount is equal
to the cash price of $43,106 less the initial deposit of $5,000.

                              N         I/Y         PV         PMT            FV
           Enter              4                   -38,106     11,250
           Compute                    X = 7%


Dec 31, 20x1      Note receivable                                      $38,106
                  Cash                                                   5,000
                    Sales                                                            $43,106

Dec 31, 20x2      Cash                                                  11,250
                    Note receivable                                                     8,583
                    Interest revenue ($38,106 x 7%)                                     2,667

Dec 31, 20x3      Cash                                                  11,250
                    Note receivable                                                     9,184
                    Interest revenue ($38,106 - 8,583) x 7%                             2,067


Problem 4

1.      Cash                                                              $10,000
        Note receivable*                                                   17,355
        Accumulated depreciation ($50,000 - $12,000)                       38,000
          Machine                                                                    $50,000
          Gain on sale of machine                                                     15,355

        * N=2, i=10, PMT=10000, solve for PV = 17,355

2.      Dec 31, 20x3       Cash                                            10,000
                             Interest revenue ($17,355 x 10%)                           1,736
                             Note receivable                                            8,264

        Dec 31, 20x4       Cash                                            10,000
                             Interest revenue ($17,355 - 8,264)
                              x 10%                                                       909
                             Note receivable                                            9,091




Page 176                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5

1.
Long-term receivables:
   9% note receivable from sale of division, due in annual
       installments of $500,000 to May 1, 20x5, less current
       portion                                                          $ 500,000 (1)
   8% note receivable from officer, due December 31, 20x5,
       collateralized by 10,000 shares of Linden, Inc.,
       common shares with a fair market value of $450,000                 400,000
   Non-interest-bearing note from sale of patent, net of
       15% imputed interest, due April 1, 20x5                             84,121 (2)
   Installment contract receivable, due in annual installments of
       $50,000 to July 1, 20x7, less current installment                  112,400 (3)
Total long-term receivables .                                          $1,096,521


2.
Current portion of long-term receivables:
   Note receivable from sale of division                                $ 500,000 (1)
   Installment contract receivable                                         27,600 (3)
Total current portion of long-term receivables                           $527,600
Accrued interest receivable:
   Note receivable from sale of division                                 $ 60,000 (4)
   Installment contract receivable                                         11,200 (5)
Total accrued interest receivable                                        $ 71,200

3.
Interest income:
   Note receivable from sale of division                                $ 105,000    (6)
   Note receivable from sale of patent                                      8,507    (2)
   Note receivable from officer                                            32,000    (7)
   Installment contract receivable from sale of land                       11,200    (5)
Total interest income                                                   $ 156,707
Gains on sale of assets:
   Patent                                                                $ 37,600 (8)
   Land                                                                    50,000 (9)
Total gains on sale of assets                                            $ 87,600
Total interest income and gains                                         $ 244,305




Page 177                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




        Explanations of amounts:

(1)     Long-term portion of 9% note receivable at Dec 31, 20x3:
        Face value                                                         $1,500,000
        Less installment received, May 1, 20x3                              (500,000)
        Balance, December 31, 20x3                                         $1,000,000
        Less installment due May 31, 20x4 (current portion)                 (500,000)
        Long-term portion, December 31, 20x3                                $ 500,000

(2)     Non-interest bearing note, net of imputed interest at
        December 31, 20x3:
        Discounted value of note: N = 2, I = 15, FV = 100000,
          solve for PV:                                                       $75,614
        Add: Interest earned to December 31, 20x3
           $75,615 x 15% x 9/12                                                 8,507
        Balance, December 31, 20x3                                           $ 84,121

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

(4)     Accrued interest--note receivable, sale of division, at
        December 31, 20x3:
          Interest accrued from May 1, 20x3 to Dec 31, 20x3:
               $1,000,000 x 9% x 8/12                                        $ 60,000

(5)     Accrued interest--installment contract at Dec 31, 20x3:
          Interest accrued from July 1, 20x3 to Dec 31, 20x3
              $140,000 x 16% x 1/2                                           $ 11,200

(6)     Interest income--note receivable, sale of division,
        Interest earned from Jan 1, 20x3 to Apr 30, 20x3
             $1,500,000 x 9% x 4/12                                          $ 45,000
        Interest earned from May 1, 20x3 to Dec 31, 20x3 (#4 above)            60,000
        Interest income                                                     $ 105,000

(7)     Interest income--note receivable from officer:
           400,000 x 8%                                                      $ 32,000



Page 178                                                          CMA Ontario – September 2009
Financial Accounting – Module 1




(8)     Gain on sale of patent:
          Selling price (part 2)                                      $ 75,600
          Less: Cost of patent (net):
          Carrying value Jan 1, 20x3                      $40,000
          Less: Amortization Jan 1, 20x3 to Apr 1, 20x3
                   $8,000 x 1/4                           (2,000)     (38,000)
                                                                      $ 37,600

(9)     Gain on sale of land:
          Selling price                                              $ 200,000
          Less cost                                                  (150,000)
                                                                      $ 50,000




Page 179                                                   CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 6


a)     Annual payment:
         N = 5, I = 10, PV = 500000, solve for PMT = $131,899

       Since the rate implied in the note is higher than the company's incremental
       borrowing rate, we do not discount the cash flows of the note at the incremental
       borrowing rate.

       Jan 2, 20x1         Equipment                              $500,000
                             Note payable                                        $500,000

       Dec 31, 20x1        Interest expense
                              ($500,000 x 10%)                       50,000
                           Note payable                              81,899
                              Cash                                                131,899

       Dec 31, 20x2        Interest expense
                              ($418,101* x 10%)                      41,810
                           Note payable                              90,089
                              Cash                                                131,899
                           * $500,000 - 81,899

       Dec 31, 20x3        Interest expense
                              ($328,012* x 10%)                      32,801
                           Note payable                              99,098
                              Cash                                                131,899
                           * $418,101 - 90,089

       Dec 31, 20x4        Interest expense
                              ($228,914* x 10%)                      22,891
                           Note payable                             109,008
                              Cash                                                131,899
                           * $328,012 - 99,098

       Dec 31, 20x5        Interest expense
                              ($119,906* x 10%)                   11,993**
                           Note payable                            119,906
                              Cash                                                131,899
                           * $228,914 – 109,008
                           ** difference due to rounding




Page 180                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




b)     PV of note:
         N = 3, I = 8, FV = 500000, Solve for PV = $396,916

       Jan 2, 20x1         Equipment                             $396,916
                             Note payable                                       $396,916

       Dec 31, 20x1        Interest expense
                              ($396,916 x 8%)                       31,753
                              Note payable                                        31,753

       Dec 31, 20x2        Interest expense
                              ($396,916 + 31,753)                   34,294
                               = $428,669 x 8%
                              Note payable                                        34,294

       Dec 31, 20x3        Interest expense
                              ($428,669 + 34,294) x 8%              37,037
                              Note payable                                        37,037

                           Note payable                           500,000
                             Cash                                                500,000




Page 181                                                      CMA Ontario – September 2009
Financial Accounting – Module 1




c)     PV of note : N = 3, I = 8, PMT = 15000, FV = 500000, Solve for PV = $435,573

       Jan 2, 20x1         Equipment                           $435,573
                             Note payable                                    $435,573

       Dec 31, 20x1        Interest expense
                              ($435,573 x 8%)                    34,846
                              Cash                                             15,000
                              Note payable                                     19,846

       Dec 31, 20x2        Interest expense
                              ($435,573 + 19,846)
                                = $455,419 x 8%                  36,434
                              Cash                                             15,000
                              Note payable                                     21,434

       Dec 31, 20x3        Interest expense
                              ($455,419 + 21,434)
                                = $476,853 x 8%                 38,147*
                              Cash                                             15,000
                              Note payable                                     23,147

                           Note payable                         500,000
                             Cash                                             500,000

* rounded to balance




Page 182                                                   CMA Ontario – September 2009
Financial Accounting – Module 1




d)     PV of note: N = 5, I = 8, PMT = 100000, Solve for PV = $399,271

       Jan 2, 20x1         Equipment                           $399,271
                             Note payable                                     $399,271

       Dec 31, 20x1        Interest expense
                              ($399,271 x 8%)                     31,942
                           Note payable                           68,058
                              Cash                                             100,000

       Dec 31, 20x2        Interest expense
                              ($399,271 - 68,058)
                               = $331,213 x 8%                    26,497
                           Note payable                           73,503
                              Cash                                             100,000

       Dec 31, 20x3        Interest expense
                              ($331,213 - 73,503)
                                = 257,710 x 8%                    20,617
                           Note payable                           79,383
                              Cash                                             100,000

       Dec 31, 20x4        Interest expense
                              ($257,710 - 79,383)
                               = $178,327 x 8%                    14,266
                           Note payable                           85,734
                              Cash                                             100,000

       Dec 31, 20x5        Interest expense
                              ($178,327 - 85,734)
                                = $92,593 x 8%                     7,407
                           Note payable                           92,593
                              Cash                                             100,000




Page 183                                                    CMA Ontario – September 2009
Financial Accounting – Module 1




e)     Interest in 20x1 = $500,000 x 4% = $20,000
         20x2 = $400,000 x 4% = $16,000
         20x3 = $300,000 x 4% = $12,000
         20x4 = $200,000 x 4% = $8,000
         20x5 = $100,000 x 4% = $4,000

       PV of note:
         20x1: N = 1, I = 8, FV = 20,000, Solve for PV =                      $18,518.52
         20x2: N = 2, I = 8, FV = 16,000, Solve for PV =                       13,717.42
         20x3: N = 3, I = 8, FV = 12,000, Solve for PV =                        9,525.99
         20x4: N = 4, I = 8, FV = 8,000, Solve for PV =                         5,880.24
         20x5: N = 5, I = 8, FV = 4,000, Solve for PV =                         2,722.33
         Principal annuity: N = 5, I = 8, PMT = 100,000, Solve for PV =       399,271.00
                                                                             $449,636.00

       Jan 2, 20x1         Equipment                             $449,636
                             Note payable                                       $449,636

       Dec 31, 20x1        Interest expense ($449,636 x 8%)         35,971
                           Note payable                             84,029
                              Cash                                               120,000

       Dec 31, 20x2        Interest expense
                              ($449,636 - 84,029)
                               = $365,607 x 8%                      29,249
                           Note payable                             86,751
                              Cash                                               116,000

       Dec 31, 20x3        Interest expense
                              ($365,607 - 86,751)
                              = $278,856 x 8%                       22,308
                           Note payable                             89,692
                              Cash                                               112,000

       Dec 31, 20x4        Interest expense
                              ($278,856 - 89,692)
                              = $189,164 x 8%                       15,133
                           Note payable                             92,867
                              Cash                                               108,000

       Dec 31, 20x5        Interest expense
                              ($189,164 - 92,867)                    7,703
                               = $96,297 x 8%
                           Note payable                             96,297
                              Cash                                               104,000

Page 184                                                      CMA Ontario – September 2009
Financial Accounting – Module 1




f)     Annual payment: N = 5, I = 4, PV = 500000, Solve for PMT = $112,314
       PV of note: N = 5, I = 8, PMT = 112314, Solve for PV = $448,437

       Jan 2, 20x1         Equipment                          $448,437
                             Note payable                                    $448,437

       Dec 31, 20x1        Interest expense
                              ($448,437 x 8%)                   35,875
                           Note payable                         76,439
                              Cash                                            112,314

       Dec 31, 20x2        Interest expense
                              ($448,437 – 76,439)
                                = $371,998 x 8%                 29,760
                           Note payable                         82,554
                              Cash                                            112,314

       Dec 31, 20x3        Interest expense
                              ($371,998 – 82,554)
                                = $289,444 x 8%                 23,156
                           Note payable                         89,158
                              Cash                                            112,314

       Dec 31, 20x4        Interest expense
                              ($289,444 – 89,158)
                                 = $200,286 x 8%                16,023
                           Note payable                         96,291
                              Cash                                            112,314

       Dec 31, 20x5        Interest expense
                              ($200,286 – 96,291)
                                 = $103,995 x 8%                 8,319
                           Note payable                        103,995
                              Cash                                            112,314




Page 185                                                  CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 7

1. A note received in exchange for property, goods, or services should be recorded at its
   present value, which is presumably the value of the property exchanged. In the case
   of a note bearing interest at a reasonable rate and issued in an arm's-length
   transaction, the face value of the note should be used, as explained below.

    A note received for property, goods, or services represents two elements, which may
    or may not be stipulated in the note: (a) the principal amount, equivalent to the cash
    exchange price of the property, goods, or services as established between the seller
    and the buyer and (b) an interest factor to compensate the seller over the life of the
    note for the use of funds he would have received in a cash transaction at the time of
    the exchange. Notes so exchanged are accordingly valued and accounted for at the
    present value of the consideration exchanged between the contracting parties at the
    date of the transaction in a manner similar to that followed for a cash transaction.

    When a note is exchanged for property, goods, or services in a bargained transaction
    entered into at arm's length, there is a presumption that the rate of interest stipulated
    by the parties to the transaction represents fair and adequate compensation to the
    seller for the use of the related funds. In these circumstances the note's present value
    is identical with its face value. Furthermore, where the rate of interest is reasonable
    and separately stated, the face value of the note is equal to the bargained exchange
    price for the property. When a note bears no interest (or has a stated interest rate that
    differs sharply from the prevailing rate and/or is not issued in an arm's-length
    transaction), the present value must be determined through consideration of the
    economic substance of the transaction.

    The note and the sales price of the property, goods, or services exchanged for the note
    should be recorded at the fair value of the property, goods, or services or at an amount
    that reasonably approximates the present value of the note, whichever is the more
    clearly determinable.

    That amount may or may not be the same as the face amount; any resulting discount
    or premium should be accounted for as an element of interest over the life of the note.

    In the absence of established exchange prices for the related property, goods, or
    services or evidence of the market value of the note, the present value of a note that
    stipulates no interest (or a rate of interest that differs sharply from the prevailing rate)
    should be determined by discounting all future payments on the note, using an
    imputed (implicit) rate of interest.

2. If the recorded value of a note differs from its face value, the difference is amortized
   as interest over the life of the note in such a way as to result in a constant rate of
   interest when applied to the amount outstanding at the beginning of any given period.
   This method is the "effective interest" method.



Page 186                                                           CMA Ontario – September 2009
Financial Accounting – Module 1



7.      Inventory

Inventory is defined as assets…
(a)    held for sale in the ordinary course of business;
(b)    in the process of production for such sale; or
(c)    in the form of materials or supplies to be consumed in the production process or
       in the rendering of services. (IAS 2.6)

Cost of Inventories

The cost of inventories is measured at the lower of cost and net realizable value (IAS
2.9).

Cost is defined as all costs of purchase, costs of conversion and other costs incurred in
bringing the inventories to their present location and condition (IAS 2.10).

Costs of purchase would include the purchase price, import duties, transport, handling
and any other costs directly attributable to the purchase of inventory. Any trade discounts
or rebates should be deducted against the cost of inventory.

Costs of conversion refer to a manufacturing environment and will be explored in detail
in Segment 2 (on Management Accounting) of this program. The following are the
requirements for the financial reporting of any work-in-process or finished goods
manufactured inventories:
•      the allocation of fixed production overhead to inventory should be based on
       normal capacity,
•      normal capacity is defined as the production expected to be achieved over a
       number of periods under normal circumstances;
•      unallocated overhead is recognized as an expense in the period in which it is
       incurred; and
•      variable overhead is allocated to inventory on the basis of the actual use of
       production facilities.

Goods in transit - following the general rule that title to the merchandise is evidence of
ownership, any goods in transit belong to whomever has title or legal ownership. When
merchandise is in transit between buyer and seller, title or legal ownership is dependent
on the shipping terms between the buyer and seller. If the goods are shipped F.O.B.
shipping point, title passes to the buyer at the time the goods are loaded on the common
carrier. The buyer assumes the responsibilities of ownership, including freight charges,
insurance, and risk of loss or damage, and includes the merchandise in inventory. When
the terms of the sale are F.O.B. destination, title transfers to the buyer at the time the
goods are off-loaded to the buyer from the common carrier. In this case, the seller
assumes responsibility for the freight charge, insurance, and risk of loss, and includes the
merchandise as part of inventory until the buyer takes possession.




Page 187                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Perpetual vs. periodic inventory systems - A periodic inventory system records all
merchandise purchases in a purchases account and determines the inventory quantity and
value periodically (usually at the time of preparation of the financial statements) by
actual physical count. This system makes no attempt to maintain a current balance in the
inventory account.

In contrast, a perpetual inventory system does maintain a current balance in the inventory
account. Increases to the inventory account occur with each new purchase, while
decreases are made with each sale. Compared to the periodic system, the perpetual
system requires more record keeping, but it affords greater control over the inventory.

A periodic inventory system requires the use of several temporary accounts:

        Purchases – all inventory purchases are recorded in this account
        Purchase returns and allowance – any returns of merchandise to the supplier or
               any credits provided by the supplier for non-returned merchandise are
               credited to this account
        Purchase discounts – any purchase discounts taken on terms of payment
               (i.e. 2/10, n30) are credited to this account.
        Transportation-in – any freight costs paid for the acquisition of inventory are
               debited to this account.

At year-end, the inventory is counted, all of these accounts are closed off and cost of
goods sold is recorded.

Example – assume that a company using a periodic system has the following account
balances:

                                                               Dr.               Cr.
      Inventory (beginning of year)                      $ 655,000
      Purchases                                          3,540,000
      Purchase returns and allowances                                       $46,300
      Purchase discounts                                                      5,800
      Transportation-in                                      67,500

The year-end inventory count establishes the total cost of inventory at $768,000.

The journal entry to record cost of goods sold would be as follows:

      Cost of goods sold                                $3,442,400
      Inventory                                            113,000
      Purchase returns and allowances                       46,300
      Purchase discounts                                     5,800
        Purchases                                                       $3,540,000
        Transportation-in                                                   67,500



Page 188                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


In the above entry, cost of goods sold was calculated as a plug figure to balance the
journal entry. If you were to calculate cost of goods sold directly you would get the same
amount:

      Inventory, beginning of year                                        $655,000
      Purchases -
        Purchases                                      $3,540,000
        Transportation-in                                   67,500
        Purchase returns and allowances                  (46,300)
        Purchase discounts                                 (5,800)       3,555,400
      Less inventory, end of year                                        (768,000)
                                                                        $3,442,400

Inventory Valuation Methods

When inventory items are of high value and can be identified individually (for example,
by way of serial numbers), the specific identification method of inventory valuation has
to used. This method is quite simple and assigns the invoice price to each inventory item.

Note that specific identification is not appropriate when there are large numbers of
inventory items that are ordinarily interchangeable.

When the specific identification method is not used, then the cost of inventory is to be
assigned using one of two cost flow methods: FIFO or Weighted Average. IAS 2 requires
that the same method be used for all inventories having a similar nature and use. For
inventories with a different nature or use, different cost formulas can be used (IAS2.25).

Note that LIFO is no longer considered an acceptable method.

FIFO (First-in, First-out)

The FIFO method assumes that older goods get sold first. FIFO assigns the more recent
purchase price to the Statement of Financial Position inventory account; the older costs
go to the COGS account. It is convenient to use and produces an inventory asset value
close to current cost.

Weighted Average

The weighted average method of inventory is based on the assumption that all costs can
be aggregated and that the cost to be assigned to any particular unit should be the
weighted average of the costs of the units held during the accounting period. The
weighted average method assumes no particular flow of goods. Weighted average assigns
the available cost equally to the inventory asset and to cost of goods sold expense. It is
used for inventories that are a mixture of recent and older purchases and that are not
particularly perishable.


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Example: The Madison Company had the following inventory transactions for the month
of June 20x2:

Date                          Number of Units   Total Purchase cost         Balance (Units)
Opening Balance                         1,000              $11,000                   1,000
June 2                                  2,000               23,000                   3,000
June 5                                -1,400                                         1,600
June 12                                 1,500                18,000                  3,100
June 15                               -2,800                                           300
June 20                                 1,000                12,300                  1,300

Cost of goods available for sale -
  Opening Inventory                                                                $11,000
  Purchases: June 2                                               $23,000
     June 12                                                       18,000
     June 20                                                       12,300           53,300
                                                                                   $64,300

Calculations of cost of goods sold and final inventory values under all four methods of
accounting for inventory are as follows.

FIFO – Periodic

Ending inventory = 1,000 units from the June 20 purchase @ $12.30
Plus 300 units from the June 12 purchase @ $12.00
= $12,300 + 3,600
= $15,900

Cost of goods sold = $64,300 – 15,900 = $48,400


Weighted Average – Periodic

Weighted average cost per unit
= Cost of goods available for sale ÷ number of units available for sale
= $64,300 ÷ 5,500
= $11.69

Ending inventory = 1,300 units x $11.69 = $15,197

Cost of goods sold = $64,300 – 15,197 = $49,103




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FIFO - Perpetual

The ending inventory and Cost of Goods Sold for FIFO – Perpetual are identical as for
FIFO – Periodic. The following table is for illustration purposes only.

                        Number of Total Purchase                   Unit            Balance
Date                         Units              cost               Cost                 ($)
Opening Balance              1,000         $11,000               $11.00            $11,000
June 2                       2,000           23,000               11.50             34,000
June 5                      -1,000                                11.00             23,000
                              -400                                11.50             18,400
June 12                      1,500           18,000               12.00             36,400
June 15                     -1,600                                11.50             18,000
                            -1,200                                12.00              3,600
June 20                      1,000           12,300               12.30             15,900
Cost of goods sold = $64,300 – 15,900 = $48,400


Moving Weighted Average – Perpetual

                                                     Total
                     Number of Balance in         Purchase          Average        Balance
Date                      Units        Units           cost            Cost             ($)
Opening Balance           1,000        1,000       $11,000         $11.0000        $11,000
June 2                    2,000        3,000        23,000          11.3333         34,000
June 5                   -1,400        1,600                        11.3333         18,133
June 12                   1,500        3,100           18,000       11.6558         36,133
June 15                  -2,800          300                        11.6558          3,497
June 20                   1,000        1,300           12,300       12.1515         15,797
Cost of goods sold = $64,300 – 15,797 = $48,503




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Application of the Lower of Cost or Market Method

Market is defined as net realizable value. Net realizable value is the estimated selling
price in the ordinary course of business less the estimated costs of completion and the
estimated costs necessary to make the sale. The lower of cost or market rule is applied to
inventory on an item by item basis (IAS 2.29). Note that net realizable value is not the
same as fair value.

The standard allows for the reversal of a write-down in a subsequent period if the net
realizable value of the inventory increases, but not above the original cost (IAS 2.34).

Example: Assume that a company has 5 items of inventory whose cost and net realizable
value at year-end are as follows:

                                                Original         Net Realizable
           Item                                    Cost                  Value
           A                                    $30,000                $36,000
           B                                     56,000                 55,000
           C                                     12,000                 14,000
           D                                     32,000                 45,000
           E                                      4,000                  2,500

Inventory items B and E need to be written down to net realizable value as follows:

Periodic Inventory System: the values assigned to the ending inventory for items B and E
are $55,000 and $2,500.

Perpetual Inventory System: the following journal entry will be recorded:

    Cost of goods sold (or an Inventory loss account)                $3,500
      Inventory                                                                   $3,500


Estimating Inventories

Estimating Inventories – there are two approaches to estimate the values of ending
inventory: the gross profit and retail method.

The gross profit method uses historical estimates of gross profit as a percentage of sales
to estimate cost of goods sold. Once cost of goods sold has been estimated, we can
estimate the value of ending inventory. The gross-profit method is useful in situations
where a physical inventory is not practical, such as a fire loss or a suspected theft loss.
The gross-profit method is not acceptable for financial reporting purposes (except during
interim reporting periods), because it provides only an estimate of the inventory. A
physical count must be taken for annual financial reporting purposes.



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Example: you are given the following information for the first quarter ending March 31,
20x4:

           Beginning inventory                                           $80,000
           Purchases                                                   1,020,000
           Transportation-in                                              35,000
           Purchase returns and allowances                                18,000
           Sales                                                       1,500,000
           Historical gross profit margin                                   30%

The estimated cost of goods sold is $1,500,000 x (1 - 0.30) = $1,050,000

The cost of goods available for sale is:

           Beginning inventory                                     $   80,000
           + Purchases                                              1,020,000
           + Transportation-in                                         35,000
           - Purchase returns and allowances                         (18,000)
                                                                   $1,117,000

The estimate of ending inventory is $1,117,000 - 1,050,000 = $67,000.

Two major assumptions underlie the gross-profit method: (1) the rate of gross profit is
constant from one period to the next, and (2) the sales mix of products is constant from
one period to the next. The historical records of the company provide the information
necessary to use the gross profit method. The rate of gross profit is based on the weighted
average of the gross profit rates of all the individual products. This assumes that the gross
profit rates of the individual products are constant from one period to the next and that
the mix of products sold is constant from one year to the next. Finally, the gross profit
method assumes that if any changes in the gross profit rates or the product mix sold did
occur, the changes would offset each other with no resulting differences in the composite
gross profit rate. If any of these assumptions is violated, the gross profit method gives a
faulty estimate of the inventory value.

The retail inventory method is commonplace in the retail industry. As purchased
merchandise is received, it is displayed immediately for sale at the retail price. Most retail
concerns follow a consistent, observable pattern of markup on the cost of the
merchandise, thereby allowing the use of the retail method to estimate the cost of the
ending inventory.

The records required for the retail method include beginning inventory, purchases at cost
and retail, total sales, and any changes in selling price resulting from additional markups
and markdowns. A cost-to-retail ratio is calculated from these data and then applied to
the ending inventory at retail to estimate the ending inventory at cost.




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Note that for financial reporting purposes, the gross profit method can only be used for
interim reporting. It cannot be used to estimate the ending inventory at the end of a
company's fiscal year. The retail method, however, can be used to estimate the ending
inventory at the end of a company's fiscal year.


Disclosure Requirements

The following information must be disclosed with regards to inventories (IAS 2.36):
•      the accounting policies adopted in measuring inventories, including the cost
       formula used;
•      the total carrying amount of inventories and the carrying amount in classifications
       appropriate to the entity;
•      the carrying amount of inventories carried at fair value less costs to sell;
•      the amount of inventories recognized as an expense during the period;
•      the amount of any write-down of inventories recognized as an expense in the
       period;
•      the amount of any reversal of any write-down that is recognized as a reduction in
       the amount of inventories recognized as expense in the period;
•      the circumstances of events that led to the reversal of a write-down of inventories;
       and
•      the carrying amount of inventories pledged as security for liabilities.




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Problems with Solutions

Multiple Choice Questions

The Following Data Apply to Items 1-3

Addison Hardware began the month of November with 150 large brass switchplates on
hand at a cost of $4.00 each. These switchplates sell for $7.00 each. The following
schedule presents the sales and purchases of this item during the month of November.

                                  Purchases
                                    Date of   Quantity
Transaction                        Received   Unit Cost   Units Sold
November 5                                                   100
November 7                           200       $4.20
November 9                                                   150
November 11                          200        4.40
November 17                                                  220
November 22                          250        4.80
November 29                                                  100

1.    If Addison uses FIFO inventory pricing, the value of the inventory on November 30
      would be
      a) $936.
      b) $1,012.
      c) $1,046.
      d) $1,076.
      e) $1,104.


2.    If Addison uses perpetual moving average inventory pricing, the sale of 220 items
      on November 17 would be recorded at a unit cost of
      a) $4.00.
      b) $4.16.
      c) $4.20.
      d) $4.32.
      e) $4.40.


3.    If Addison uses weighted average inventory pricing (periodic), the gross profit for
      November would be
      a) $1,046.
      b) $1,482.
      c) $1,516.
      d) $1,548.
      e) $1,574.

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4.    Miller, Ltd. estimates the cost of its physical inventory at March 31 for use in an
      interim financial statement. The rate of markup on cost is 25%. The following
      account balances are available:

                  Inventory, March 1                        $220,000
                  Purchases                                  172,000
                  Purchase returns                             8,000
                  Sales during March                         350,000

      The estimate of the cost of inventory at March 31 would be
      a) $34,000
      b) $104,000
      c) $121,500
      d) $78,000



Problem 1

So Slow Ltd.’s record of transactions for the month of April was as follows:

                                          Purchases                                    Sales
April 1                                 600 @ $6.20
April 3                                                                       500 @ $10.00
April 4                                1,500 @ 6.00
April 8                                  800 @ 6.40
April 9                                                                      1,400 @ 10.00
April 11                                                                       600 @ 11.00
April 13                               1,200 @ 6.50
April 21                                 700 @ 6.60
April 23                                                                     1,200 @ 11.00
April 27                                                                       900 @ 12.00
April 29                                 500 @ 6.79

Required –

1.      Assuming that the periodic system is used, compute the inventory at April 30
        using (1) FIFO and (2) weighted-average cost.
2.      Assuming that the perpetual system is used, compute the inventory at April 30
        using (1) FIFO and (2) weighted-average cost.




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Problem 2

High Tech Manufacturing Company uses a special alloy called Moly in its manufacturing
process.

In 20x0, the beginning inventory and the purchases of Moly during the year were as
follows:
                                                 kg      Price/kg
January 1              Inventory             300            $11.50
April 12               Purchase              400             12.00
July 7                 Purchase              240             11.70
November 2             Purchase              320             12.30

At December 31, 20x0, a physical inventory count showed that 360 kg of Moly were still
in inventory.

Required -

a) Determine the dollar value of the December 31, 20x0, inventory using:
      i)     FIFO
      ii)    Weighted Average Costs.

b) Which inventory valuation method will produce the highest net income for 20x0?
   Explain.




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Problem 3

Manning Company Ltd. purchases and sells one product. Information regarding this
product for the first period of operations was as follows:

   Quantity                       Acquisition
  Purchased         Unit Cost        Cost
    2,000             $12             $24,000
    1,500              14              21,000
    1,800              15              27,000
    5,300                             $72,000

The Manning Company uses a periodic inventory system. Sales for the period were 5,000
units at $20 per unit. Assume that all sales took place at the end of the period at which
time the replacement cost of the product was $16.50 per unit.

Required

Compute the cost of goods sold expense and the ending inventory balance under the
FIFO assumption.


Problem 4

You are a member of the internal audit team performing the year end examination of the
inventory of Pilfer Limited, as of December 31, 20x0, and are confronted with the
following situations:

1. On December 30, Pilfer had completed and packed a special order for delivery to
   Steel Ltd. Pilfer had invoiced Steel on December 30, and had excluded the items in
   this special order from its December 31 inventory count. However, because of the
   unavailability of a courier during the holiday season, Pilfer did not ship the order until
   January 3, 20x1. The order had a cost of $600, and a selling price to Steel of $900.

2. During your observation, you noted several cartons being unloaded on January 2.
   These had been shipped FOB shipping point on December 20, and the invoice for
   $350 had been received and recorded at that time.

3. You noted that invoices totalling $450 from your customs broker for his fees relative
   to incoming merchandise had been charged to "Brokerage expense". One third of the
   current year's purchases were still in inventory at December 31.

4. It was noted that purchases later in the year were at generally much lower prices than
   those earlier in the year. Pilfer uses the weighted-average method of inventory
   valuation, which provided a recorded value of $32,000 for inventory; market value
   for inventory was $30,000 at December 31.

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Required -

a) As a member of the internal audit team, make a recommendation to your team leader
   as to what action should be taken, as a result of the above information. You should
   fully justify your recommended treatment in terms of normal accounting practice and
   accounting principles as they relate to these situations.
b) Prepare the necessary journal entries to correct or update the books of the Pilfer
   Company as at December 31, with respect to the four situations.


Problem 5

Port Debit Marina buys and sells new and used sailboats. At the end of the 20x0 season, a
B&B 27 built in 1979 was purchased for $20,000 and placed in inventory. The boat was
white with blue trim. At the beginning of the 20x1 season, the marina purchased another
B&B 27, also built in 1979, for $24,000 and placed it in inventory. This boat was white
but had green trim.

During the 20x1 season, 1979 B&B 27s are selling for $28,000. The white and blue boat
and the white and green boat are identical boats in similar condition except for the trim
colors. These colors are equally popular with sailors.

The marina uses the specific identification method to value inventory because boats are
usually different. The accountant for the marina is concerned about this. He wants to
change the method from specific identification to another "fairer" method to value
inventory of similar boats. He is considering FIFO or weighted average but feels that the
weighted-average method will be better to achieve his purpose, which is to make gross
profit the same for either B&B 27.

There are only three working days left in April, 20x1, and this month's sales have been
slow. The manager of Port Debit Marina wants to report as high a profit as possible for
April, 20x1. He receives a bonus based on income before income taxes. Because of this,
he wants the salesmen to concentrate on selling the white and blue sailboat rather than the
white and green one. It is expected that one B&B 27 will be sold before the month is
over.

Required -

Discuss the accountant's concerns and the manager's point of view. Is it to the advantage
of Port Debit Marina to use the weighted-average method to value inventory? Discuss.




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Problem 6

Sapphire Company lost the previous month's records. The current month's records show
the following:

Transportation-In                                   $ 1,800
Purchase Returns and Allowances                       2,100
Ending Inventory                                     32,300
Purchases                                            75,900
Cost of Goods Sold                                   72,500

Required -

i)      Calculate the current month's beginning inventory.
ii)     If the inventory at the end of the current year is overstated and the error is not
        caught during the following year, what is the effect on income for both years?
        Briefly explain.


Problem 7

The Simpson Company supplies you with the following information:

Freight-in                                                                 $ 3,000
Freight-out (selling expense)                                                2,000
Gross sales                                                                100,000
Merchandise inventory, Jan 1, 20x2                                          12,000
Merchandise inventory, Dec 31, 20x2                                         14,000
Purchases                                                                   72,000
Office supplies used                                                         7,000
Purchase discounts                                                           4,000
Purchase returns and allowances                                              6,000
Sales returns and allowances                                                10,000
Supplies inventory, Dec 31, 20x2                                             5,000

Required -

Calculate the cost of goods sold for Simpson Company. Make entries to (1) record cost
of goods sold and (2) close all temporary accounts to cost of goods sold. Simpson uses a
periodic inventory system.




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Problem 8

The Wicks Company was formed on January 1, 20x2. The following information is
available from Wicks' inventory records:

                                                                       UNIT
                                                           UNITS       COST
Beginning inventory, 1/1/x2                                   800       $ 9.00
Purchases
1/5/x2                                                        1,500        9.50
1/25/x2                                                       1,200       10.50
2/16/x2                                                         600       11.00
3/26/x2                                                         800       11.50

A physical inventory on March 31, 20x2, shows 1,600 units on hand.

Required:

Prepare schedules to calculate the ending inventory at March 31, 20x2, under each of the
following inventory methods (assume a periodic inventory system):

1. FIFO.
2. Weighted average.


Problem 9

D Ltd.'s December 31, 20x2, Statement of Financial Position reported inventory of
$55,000. There were 10,000 units of inventory on hand at December 31, 20x2. During
20x3, D Ltd. engaged in the following inventory transactions:

    Jan. 31         bought         6,000   units for      $ 27,000
    Feb. 20         sold           4,000   units for        32,000
    Mar. 30         sold           2,000   units for        16,500
    June 29         bought         6,000   units for        28,800
    Aug. 4          sold          12,000   units for      102,000
    Oct. 15         bought         9,000   units for        36,000

Calculate D Ltd.'s reported gross profit from the above inventory transactions assuming
that D Ltd. uses:
a) FIFO - Periodic
b) Weighted Average - Periodic
d) FIFO - Perpetual
d) Moving Weighted Average - Perpetual




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Problem 10

The Windsor Company has the following inventory transactions for item #A203 for the
month of August:

Date                                                 Units     Unit Cost
August       1        Balance                        1,000       $12.00
             5        Purchase                         200        12.20
             8        Sale                             600
             10       Sale                             400
             13       Purchase                         800           12.60
             17       Sale                             500
             21       Purchase                         800           13.00

Calculate Windor’s ending inventory from the above inventory transactions assuming
that Windsor uses:
a.     FIFO - Periodic
b.     Weighted Average - Periodic
c.     FIFO - Perpetual
d.     Moving Weighted Average – Perpetual


Problem 11

The Schmitt Corporation carries four items in inventory. The following data are available
at December 31, 20x5:

              Units        Cost   Replacement           Estimated       Selling        Normal
                                         Cost        Selling Price        Cost          Profit
A301          2,500      $11.00        $10.50              $12.00        $1.80          $4.00
A302          1,500       12.00         12.00                18.50        1.60           2.50
A303          4,500        5.00          4.00                 8.40        1.90           1.00
A304          2,400       14.00         15.00                15.00        2.40           3.50

Required –

Calculate the value of inventory and the journal entry (if any) to adjust the ending
inventory value.




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Problem 12

A fire destroyed the inventory of the Udit Company on October 16, 20x3. Data for the
20x2 fiscal year and for the year to data on 20x3 is as follows:

                                                     Year ended           Period ended
                                               December 31, 20x2       October 16, 20x3
Sales                                                $5,000,000             $3,600,000
Beginning inventory                                     840,000                850,000
Purchases                                             4,300,000              2,800,000
Ending inventory                                        850,000                    ????

Required –

Estimate the cost of the inventory destroyed on October 16, 20x3.




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SOLUTIONS


Multiple Choice Questions

1.    e     230 x $4.80 = 1,104

2.    d         50    @     4.00      200
               200    @     4.20      840
               250    @     4.16    1,040
              -150    @     4.16     -624
               100    @     4.16      416
               200    @     4.40      880
               300          4.32    1,296

3.    b     Cost of goods available for sale
            = (150 x 4.00) + (200 x 4.20) + (200 x 4.40) + (250 x 4.80) = $3,520
            Unit cost = $3,520 / 800 = $4.40
            Gross Profit = 570 units sold x (7.00 - 4.40) = $1,482


4.    b     Gross profit % = 25 / 125 = 20%
            Cost of goods sold = $350,000 x 80% = $280,000
            Ending inventory = $220,000 + 172,000 – 8,000 – 280,000 = $104,000




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Problem 1

a.    (1)   FIFO        500 x 6.79                             $3,395
                        200 x 6.60                              1,320
                                                               $4,715

      (2)   Sum of purchases = (600 x 6.20) + (1,500 x 6.00) + (800 x 6.40)
            + (1,200 x 6.50) + (700 x 6.60) + (500 x 6.79) = $33,655

            Average cost = 33,655 ÷ 5,300 = $6.35
            Inventory = $6.35 x 700 units = $4,445

b.    (1)   FIFO

                                  Change                   Unit    Change      Inventory
             Date                 in Units   Balance       Cost    In Cost       Balance
             Apr 1                     600       600       6.20      3,720         3,720
             Apr 3                    -500       100       6.20     -3,100           620
             Apr 4                  1,500      1,600       6.00       9,000        9,620
             Apr 8                    800      2,400       6.40       5,120       14,740
             Apr 9                   -100      2,300       6.20        -620       14,120
                                   -1,300      1,000       6.00      -7,800        6,320
             Apr 11                  -200        800       6.00      -1,200
                                     -400        400       6.40      -2,560        2,560
             Apr 13                 1,200      1,600       6.50       7,800       10,360
             Apr 21                   700      2,300       6.60       4,626       14,980
             Apr 23                  -400      1,900       6.40      -2,560
                                     -800      1,100       6.50      -5,200         7,220
             Apr 27                  -400        700       6.50      -2,600
                                     -500        200       6.60      -3,300         1,320
             Apr 29                   500        700       6.79       3,395         4,715




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      (2)   Moving Average

                                  Change                          Unit       Change      Inventory
             Date                 in Units      Balance           Cost       In Cost       Balance
             Apr 1                     600          600        6.20000         3,720         3,720
             Apr 3                    -500          100        6.20000        -3,100           620
             Apr 4                  1,500            1,600     6.01250          9,000        9,620
             Apr 8                    800            2,400     6.14167          5,120       14,740
             Apr 9                 -1,400            1,000     6.14167         -8,598        6,142
             Apr 11                  -600              400     6.14167         -3,685        2,457
             Apr 13                 1,200            1,600     6.41063          7,800       10,257
             Apr 21                   700            2,300     6.46826          4,620       14,877
             Apr 23                -1,200            1,100     6.46826         -7,762        7,115
             Apr 27                  -900              200     6.46826         -5,821        1,294
             Apr 29                   500              700     6.69857          3,395        4,689


Problem 2

a)
i)    FIFO Ending Inventory
      320 kg at 12.30 =                      $3,936
      40 kg at 11.70 =                          468
      360 kg                                 $4,404

ii)     Weighted Average Cost Ending Inventory

                                       kg                    Cost/kg
January 1          Inventory             300     x             $11.50    =         $3,450
April 12           Purchase              400     x              12.00    =          4,800
July 7             Purchase              240     x              11.70    =          2,808
November 2         Purchase              320     x              12.30    =          3,936
                                       1,260                                      $14,994

        $14,994/1,260 kg = $11.90/kg

        Ending Inventory: 360 kg x $11.90/kg = $4,284

b) Net Income = revenue - cost of goods sold

FIFO produces the highest ending inventory value which results in a lower cost of goods
sold and, therefore, the highest net income.




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Problem 3

a)
FIFO: cost of goods sold          = (2,000 x $12) + (1,500 x $14) + (1,500 x $15)
                                  = $67,500

Ending inventory = 300 x $15 = $4,500



Problem 4

a)      1)      This item is properly excluded from the inventory count, as it is a special
                order item that has been completed and segregated from inventory. The
                essential criteria of completion of the earnings process appears complete,
                so that revenue may be recognized, and it is normal accounting practice to
                recognize revenue for special orders in this manner. That is especially true
                in this case, as the only item which precluded delivery was the
                unavailability of a courier.

        2)      The terms of the sale are FOB shipping point, so risk transferred to Pilfer
                on December 20, and these items should be included in the ending
                inventory count. The purchase and related liability are correctly recorded
                in the year just ended.

        3)      The brokerage fees should be included as a part of the cost of inventory, as
                they are directly attributable to the acquisition of merchandise. They are
                included as a result of the cost principle, which specifies that inventories
                be valued at the "net laid-down cost." An appropriate portion should be
                charged to the cost of goods sold.

        4)      The company should recognize the decline in value as a charge against
                income in the period just ended.

b)      1)      No entry required.

        2)      No entry required, but these items should be included in the inventory
                count.

        3)
                Inventory                                               $150
                Cost of goods sold                                       300
                             Brokerage expense                                        $450



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        4)
                Unrealized loss on decline in market value of
                inventory                                            $2,000
                              Inventory                                             $2,000


Problem 5

Accountant's proposal

Specific identification may indicate different costs for similar items. This portrays reality
since the items' costs vary.

The method selected to determine costs should be the one which results in the fairest
matching of costs against revenues. However, changing methods frequently inhibits
comparability.

When specific identification is possible it has to be used unless the products are
interchangeable. In the case of sailboats, these normally would not be interchangeable.
Therefore, the use of the specific identification method should be used.

Weighted-average method can only be used if the items are all identical. Aside from the
color of the trim, this is the case for these boats. FIFO assumes that goods are sold on a
FIFO basis, which is not the case for boats.

Manager's point of view

Since his objectives are to maximize profit (i.e., his bonus), the manager's logic cannot be
faulted under the existing accounting scheme. He would want to use specific
identification if the white and blue sailboat is sold and weighted average if the white and
green sailboat is sold.

Is it to the advantage of Port Debit to use the weighted-average method?

Port Debit Marina is a going concern and therefore we must not only consider the profits
to be reported today but also those to be reported in the future.

Under the current system, when the marina sells the white and blue boat it will report
$8,000 profit. When the white and green boat is sold it will generate $4,000 profit. Based
on specific identification, the profit to be reported first will depend on which boat is sold
first.

There is no difference to the cash flows whichever inventory method is used (except that
the manager's bonus is higher this year and lower next).

Average cost would smooth out income. The desirability of this should be examined.

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The decision of which method to use should be based on sound accounting principles and
not on the manager's potential bonus.

From a control (and matching) point of view, Port Debit is probably better off with
specific identification.



Problem 6

i)     Purchases                                         75,900
       - Purchase Returns & Allowances                  (2,100)
       + Transportation-In                                1,800
       Cost of Gross Purchases                           75,600

       Cost of Goods Sold                               72,500
       + Ending Inventory                               32,300
       Cost of Goods Available for Sale                104,800
       - Cost of Gross Purchases                        75,600
       Beginning Inventory                              29,200


ii)    To overstate income this year and understate income next year.




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Problem 7

Cost of goods sold (a residual)                                  63,000
Inventory                                                         2,000
Purchase discounts                                                4,000
Purchase returns and allowances                                   6,000
   Purchases                                                                     72,000
   Freight in                                                                     3,000



Problem 8

1.     FIFO:

       Ending inventory by physical count = 1,600 units
       Purchased March 26              800 units @ $11.50 per unit =            $ 9,200
       Purchased February 16           600 units @ $11.00 per unit =              6,600
       Purchased January 25            200 units @ $10.50 per unit =              2,100
       FIFO ending inventory         1,600 units                   =            $17,900

2.                     WEIGHTED AVERAGE:
       Inventory, January 1        800 units       @ $ 9.00 per unit =          $ 7,200
       Purchase, January 5       1,500 units       @ $ 9.50 per unit =           14,250
       Purchase, January 25      1,200 units       @ $10.50 per unit =           12,600
       Purchase, February 16       600 units       @ $11.00 per unit =            6,600
       Purchase, March 26          800 units       @ $11.50 per unit =            9,200
                                 4,900 units                         =          $49,850

Total cost of goods available            49,850
                                    =           = $10.173
Total units of goods available            4,900

Weighted average ending inventory       = 1,600 units @ $10.173 per unit
                                        = $16,277




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Problem 9

a)      Ending inventory = 13,000 units
          9,000 x $4.00                                                             $36,000
          4,000 x $4.80                                                              19,200
                                                                                    $55,200

        Sales (32,000 + 16,500 + 102,000)                                          $150,500
        COS
          Opening inventory                                           55,000
          Purchases (27,000 + 28,800 + 36,000)                        91,800
          Ending inventory                                           -55,200         91,600
        Gross margin                                                                $58,900

b)      Average cost
         = Cost of goods available for sale ÷ Units available for sale
         = ($55,000 + 91,800) ÷ (10,000 + 6,000 + 6,000 + 9,000)
         = $146,800 ÷ 31,000
         = $4.735484

        Ending inventory = 13,000 units x $4.735484                                 $61,560

        Sales (32,000 + 16,500 + 102,000)                                          $150,500
        COS
          Opening inventory                                           55,000
          Purchases (27,000 + 28,800 + 36,000)                        91,800
          Ending inventory                                           -61,560         85,240
        Gross margin                                                                $65,260

c)      Same as for periodic system.

d)      Date                 Purchases       Sales      Balance            Cost    Cost/Unit
        Jan 1                                            10,000          55,000      5.5000
        Jan 31                    6,000                  16,000          82,000      5.1250
        Feb 20                               4,000       12,000          61,500      5.1250
        Mar 30                               2,000       10,000          51,250      5.1250
        Jun 29                    6,000                  16,000          80,050      5.0031
        Aug 4                               12,000        4,000          20,013      5.0031
        Oct 15                    9,000                  13,000          56,013      4.3087

        Sales (32,000 + 16,500 + 102,000)                                          $150,500
        COS
          Opening inventory                                               55,000
          Purchases (27,000 + 28,800 + 36,000)                            91,800
          Ending inventory                                               -56,013     90,787
        Gross margin                                                                $59,713

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Problem 10

a.    Ending inventory in units = 1,300 units

      (800 units x $13.00) + (500 units x $12.60) = $16,700

b.    Cost of goods available for sale
      = (1,000 x $12.00) + (200 x $12.20) + (800 x $12.60) + (800 x $13.00)
      = $12,000 + 2,440 + 10,080 + 10,400
      = $34,920

      Units available for sale = 1,000 + 200 + 800 + 800 = 2,800

      Average cost = $34,920 / 2,800 = $12.471

      Cost of ending inventory = 1,300 units x $12.471 = $16,212

c.                        Change                          Unit       Change       Inventory
      Date                in Units     Balance            Cost       In Cost        Balance
      August 1                           1,000           12.00                       12,000
      August 5                 200       1,200           12.20         2,440         14,440
      August 8                -600         600           12.00        -7,200          7,240
      August 10               -400         200           12.00        -4,800          2,440
      August 13                800       1,000           12.60        10,080         12,520
      August 17               -200         800           12.20        -2,440         10,080
                              -300         500           12.60        -3,780          6,300
      August 21                800       1,300           13.00        10,400         16,700

d.                        Change                         Unit        Change       Inventory
      Date                in Units     Balance          Cost*        In Cost        Balance
      August 1                           1,000          12.00                        12,000
      August 5                 200       1,200       12.03333          2,440         14,440
      August 8                -600         600       12.03333         -7,220          7,220
      August 10               -400         200       12.03333         -4,813          2,407
      August 13                800       1,000       12.48700         10,080         12,487
      August 17               -500         500       12.48700          6,243          6,244
      August 21                800       1,300       12.80308         10,400         16,644

*       the unit cost is recalculated each time a purchase is made, for example, the unit
        cost on August 5 is calculated by taking the inventory balance of $14,440 and
        dividing it by the unit balance of 1,200.




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Problem 11

Market is defined as Net Realizable Value = estimated selling price less selling costs.

                  Units       Unit Cost     Total Cost      Unit NRV           Total NRV
A301              2,500         $11.00        $27,500          $10.20            $25,500
A302              1,500          12.00         18,000           16.90              25,350
A303              4,500            5.00        22,500            6.50              29,250
A304              2,400          14.00         33,600           12.60              30,240

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

Unrealized loss on inventory                                   3,360
  Inventory (Unit A304)                                                       3,360


Problem 12

Cost of goods sold in 20x2 = $840,000 + 4,300,000 – 850,000 = $4,290,000
Cost of goods sold as a % of sale in 20x2 = $4,290,000 / 5,000,000 = 85.8%

Estimated cost of goods sold in 20x3 = $3,600,000 x 85.8% = $3,088,800
Estimated ending inventory => $850,000 + 2,800,000 – EI = $3,088,800
= $3,650,000 – 3,088,800 = $561,200




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8.      Capital Assets


Property, Plant and Equipment - General Recognition Principle

Property, plant and equipment are defined as tangible items that:
(a)    are held for use in the production or supply of goods and services, for rental to
       others, or for administrative purposes; and
(b)    are expected to be used during more than one period. (IAS16.6)

The general recognition principle applies to (i) the initial recognition of an asset, (ii)
when parts of that asset are replaced, and (iii) when costs are incurred relative to that
asset during its useful life. The standard does not distinguish between costs capitalized at
acquisition and costs capitalized post-acquisition. It specifies that the cost of an item of
property, plant and equipment as an asset if, and only if:
(a)     it is probable that future economic benefits associated with the item will flow to
        the entity, and
(b)     the cost of the item can be measured reliably. (IAS 16.7)

Assets acquired for safety or environmental reasons should be capitalized as property,
plant and equipment even though these do not meet the strict general recognition
principle. This is because these expenditures have to be incurred in order for the
productive assets to generate future benefits. (IAS 16.11)

Capital assets should be recorded at cost. Cost should be interpreted fairly broadly and is
meant to include all costs incurred in order to put the asset to productive use. For
example, this would include, in addition to the cost of acquiring the asset, freight,
installation costs, and testing of equipment.

There are three components of the initial cost of an asset:

(1) the purchase price – the amount of cash or cash equivalents paid or the fair value of
the other consideration given to acquire the asset. If the asset is acquired in exchange for
a note payable, the asset is recorded at the present value of the note. Purchases of groups
of assets are allocated to the assets based on their relative fair market values.

For example, say we purchase a building that comprises several pieces of equipment for
$1,000,000. If we obtain separate market values for the land, building and equipment, we
would break down the cost as follows:




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                                         Separate
                                          Market                 Allocation
                                            Value       %           of Cost
           Land                          $200,000     14.3%       $143,000
           Building                       900,000     64.3%        643,000
           Equipment                      300,000     21.4%        214,000
                                       $1,400,000 100.0%        $1,000,000


(2) directly attributable costs – these are defined as costs ‘necessary to bring the asset to
the location and condition necessary for it to be capable of operating in the manner
intended by management’ (IAS 16.20).

Examples of directly attributable costs (IAS 16.17):
•     costs of employee benefits arising from the construction or acquisition of the item
      of property, plant and equipment
•     costs of site preparation
•     initial delivery and handling costs
•     installation and assembly costs
•     costs of testing whether the asset is functioning properly
•     professional fees

Note the use of the words ‘necessary’ which implies that in order to be capitalized, that
these costs could not have been avoided. An additional cost that can be capitalized are
borrowing costs. This is discussed further in this section.

The following costs are specifically excluded (IAS 16.19 and 16.20):
•      costs of opening a new facility, such as an open house. These costs are incurred
       after the asset is capable of being used.
•      costs of introducing a new product or service, including costs of advertising and
       promotional activities.
•      administrative and other general overhead costs.
•      costs incurred while waiting for the asset to be used, but subsequent to the asset
       being capable of being used.
•      operating losses incurred in the initial stages of operating the asset.

(3) the initial estimate of the cost of dismantling, removal or restoration – this refers to
costs of dismantling, removing or restoring an asset, also known as decommissioning
costs. These costs are typically at the end of the useful life of the asset. The present value
of these costs are added to the cost of the asset and depreciated over the useful life of the
asset. The resulting asset retirement obligation is shown as a long-term liability. Interest
accrued on the asset retirement obligation over the life of the asset is expensed as a
finance cost on the income statement.



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Example: an oil refinery is purchased on December 31, 20x1 at a cost of $50 million cash
(allocated $10 million to land and $40 million to the refinery itself). The company has a
legal/constructive obligation1 to dismantle the site at the end of its 30 year useful life.
The best estimate of this cost is $10 million.

Assuming a discount rate of 5%, the present value of the asset retirement obligation is
$2,313,774:

                                 N             I/Y            PV            PMT             FV
           Enter                 30             5                                       10,000,000
           Compute                                           X=
                                                          2,313,774

The journal entry to record the purchase of the oil refinery would be as follows:

Dec 31, 20x1           Land                                                $10,000,000
                       Refinery                                             42,313,774
                         Cash                                                                  $50,000,000
                         Asset Retirement Obligation                                             2,313,774

Assuming the refinery has no residual value and that the company uses the straight line
method of depreciation, the journal entry to record depreciation expense at December 31,
20x2 would be as follows:

Dec 31, 20x2           Depreciation expense                                  $1,057,844
                         Accumulated Depreciation                                                $1,057,844
                       $42,313,774 / 30 years

The interest accrued on the asset retirement obligation would be recorded as follows:

Dec 31, 20x2           Interest expense                                        $115,689
                          Asset Retirement Obligation                                              $115,689
                       $2,313,774 x 5%

At December 31, 20x3, the following entries would be recorded:

Dec 31, 20x2           Depreciation expense                                  $1,057,844
                         Accumulated Depreciation                                                $1,057,844
                       $42,313,774 / 30 years

                       Interest expense                                          121,473
                          Asset Retirement Obligation                                               121,473
                       ($2,313,774 + 115,689) x 5%


1 The distinction between a legal and constructive obligation will be explained in the Liabilities section of
 this module.

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Assume now that, in 20x14, the estimate of the asset retirement obligation at the end of
the useful life of the refinery will be $16 million.

We first calculate the present value of the new estimate as at January 1, 20x14:

                              N         I/Y           PV       PMT            FV
           Enter              18         5                                15,000,000
           Compute                                  X=
                                                 6,232,810

The book value of the asset retirement obligation as at December 31, 20x13 is:

                              N         I/Y           PV       PMT            FV
           Enter              18         5                                10,000,000
           Compute                                  X=
                                                 4,155,207

The following entry would be recorded in 20x14 to increase the asset retirement
obligation:

20x14                Refinery                                   $2,077,603
                       Asset retirement obligation                               $2,077,603
                     $6,232,810 - 4,155,207

The net book value of the refinery at December 31, 20x13 is: $42,313,774 x 18/30 =
25,388,264. The journal entries to record depreciation expense on the refinery and
interest expense on the asset retirement obligation at December 31, 20x14 are as follows:

Dec 31, 20x14        Depreciation expense                       $1,525,882
                       Accumulated Depreciation                                  $1,525,882
                     ($25,388,264 + 2,077,603) / 18 years

                     Interest expense                              311,641
                        Asset Retirement Obligation                                 311,641
                     $6,232,810 x 5%

Note that the increase in the carrying value of the refinery is subject to the general
recognition principle in that it is probable that future economic benefits associated with
the item will flow to the entity (IFRIC 1.5).




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Component Approach

The standard requires a ‘component’ approach to asset recognition – i.e. significant parts
of an asset have to be recorded in separate accounts and depreciated separately. These are
generally parts that have a significant cost in relation to the total cost of the asset. For
example, an asset costing $100,000 may be made up of two distinct parts – Part A which
has a useful life of 10 years and Part B which has a useful life of 5 years. On the date of
acquisition, the cost of the asset would have to be split between the two parts and the two
parts would have to be depreciated separately. (IAS 16.9)

Note that the decision to breakdown an asset into components is based on managerial
judgment and materiality.

Example - on December 31, 20x1 a truck is purchased at a cost of $250,000. The
components of the truck are as follows:

                                                       Cost          Useful Life
       Truck Body                                  $150,000            20 years
       Engine                                        90,000            10 years
       Tires                                         10,000             5 years

Each of the three components would be recorded and depreciated separately.


Depreciation

There are generally speaking, three methods used to depreciate capital assets: units of
production, straight-line and the diminishing balance method.

The residual value of an asset is defined as the estimated amount that could be currently
obtained from disposal of the asset, after deducting the estimated costs of disposal, on the
assumption that the asset were already of the age and condition expected at the end of its
useful life (IAS 16.6).

Depreciation starts when an asset is available for use.


1.      Units of Production

Units of production method is used when the asset use (mileage, machine hours…) can
be measured. For example, if a machine has a useful life of 200,000 machine hours and it
is possible (and economically feasible) to measure these machine hours, then the units of
production method of depreciation may be used.




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Assume that the original cost of the asset was $150,000 and has a residual value of
$20,000. We would then depreciate $130,000 ($150,000 – 20,000) over the 200,000
machine hours: $130,000 ÷ 200,000 = $0.65 per machine hour.

If, in the first year, we used 24,000 machine hours, then the depreciation charge would
be: 24,000 x $0.65 = $15,600.

This method is not often used. The probable reason is that it requires that each piece of
equipment be metered and measured.

2.      Straight-line method

The straight-line method depreciates assets evenly over time. The depreciation expense is
the same year after year.

Continuing with the same example, if we assume that the useful life of the asset is 5
years, then the annual depreciation would be: $130,000 ÷ 5 years = $26,000.

3.      Diminishing Balance method

This method provides depreciation charges be higher in the first year and dropping off
afterwards.

Example: you purchase a piece of equipment costing $200,000 with a $20,000 residual
value and you decide to depreciate it at the rate of 20%, the following would be the
depreciation charges over the life of the asset:


                         Net Book Value                       Net Book Value
        Year                  Beginning       Depreciation            Ending
        1                      $200,000           $40,000           $160,000
        2                       160,000            32,000            128,000
        3                       128,000            25,600            102,400
        4                       102,400            20,480             81,920
        5                        81,920            16,384             65,536
        6                        65,536            13,108             52,428
        7                        52,428            10,586             41,942
        8                        41,942             8,388             33,554
        9                        33,554             6,711             26,843
        10                       26,843             5,369             21,474
        11                       21,474             1,474             20,000

Note that the depreciation expense in a given year is equal to the Net Book Value of the
asset times the depreciation rate. Also, the asset is depreciated down to its residual value
and no more. In the 11th year, the calculated depreciation would have been: $21,474 x
20% = 4,295. But this would have brought the net book value of the asset below its


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residual value. Therefore, the amount of depreciation taken in the 11th year was equal to
$1,474 which is just enough to bring the book value down to $20,000.

If you are required to determine the net book value of an asset at the end of the nth year,
you can do so by using the following formula:

        Net Book Value at end of nth year = Original cost x (1- depreciation rate)n

For example, the net book value at the end of the 10th year is:

        $200,000 (1 - .20)10
        = $200,000(.8)10
        = $21,474

Choice of Depreciation Methods

The choice of depreciation method is driven by the patters in which the asset's future
economic benefits are expected to be consumed by the entity (IAS 16.60) and has little to
do with the economic depreciation of the asset itself. A common misconception is that if
an asset depreciates at a greater amount in the early years of its useful life, then the
diminishing balance method must be used.

The choice depreciation method is based on the expected revenue stream to be generated
by the asset itself:
•       if an asset is expected to generate revenues evenly over the assets’ useful life,
        then the straight line method should be used,
•       if the asset is expected to generate higher revenues in the early years of the asset’s
        useful life, then the diminishing balance method should be used, and
•       if the asset is expected to generate revenues based in the asset’s use, then the units
        of production method should be used.

Both the depreciation method used and the residual values of assets have to be assessed
on an annual basis.


Self-Constructed Assets and Borrowing Costs

A self-constructed asset is one where the company uses its own equipment and labour to
produce the asset. The cost of the self-constructed asset should include all direct out-of
pocket costs and should also include appropriate cost allocations of joint costs consumed
by the construction of the asset. For example, if a construction company decides to pave
its company headquarters parking lot, it will put depreciable assets to use (trucks, paving
equipment). It would make sense that a reasonable amount of depreciation on this
equipment be capitalized to the cost of the parking lot. Note that the general recognition
criteria applies to self-constructed assets, i.e., the costs can be capitalized if, and only if:



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(a)     it is probable that future economic benefits associated with the item will flow to
        the entity, and
(b)     the cost of the item can be measured reliably.

The capitalization of borrowing costs is covered by IAS 23. The standard defines a
qualifying asset as ‘an asset that necessarily takes a substantial amount of time to get
ready for its intended use or sale’ (IAS 23.5). This includes intangible assets and
inventory, but excludes inventories that are routinely manufactured or otherwise
produced in large quantities or on a repetitive basis. Examples of these would include
items that take some time to manufacture but that are sold as standard items such as
residential housing, subway cars, aircraft, etc… (IAS 23.4).

Borrowing costs are defined as interest on short-term and long-term debt and includes
any amortization of discounts and premiums and finance charges on leases. The
capitalization rate is defined as the annual borrowing costs divided by the weighted
average debt that generated borrowing costs. The capitalization rate is applied to the
weighted average expenditures made on qualifying assets. The resulting amount is the
amount of borrowing costs to be capitalized to the asset. Note that the borrowing costs
capitalized can be on borrowings made for the direct purpose of financing the self-
constructed asset and/or can be on the firm's general borrowings. If the proceeds of an
asset-specific loan are invested to generate investment income, the proceeds of the
investment income reduce the borrowing costs capitalized.

Commencement of capitalization occurs when the earliest of all of the following three
conditions are met:
   (a) expenditures for the asset are being incurred;
   (b) borrowing costs are being incurred; and
   (c) activities that are necessary to prepare the asset for its intended use or sale are in
       progress. (IAS 23.17)

Cessation of capitalization occurs when substantially all the activities necessary to
prepare the qualifying asset for its intended use of sale are complete. (IAS 23.22)

Note that the capitalization of borrowing costs is mandatory.

Example: On March 1, 20x3, a company begins the construction of an asset. Construction
ended on October 31, 20x3. The company's year end coincides with the calendar year.
The following costs were incurred in the construction of the asset:

           Mar 1, 20x3                                 $200,000
           May 1, 20x3                                  100,000
           June 1, 20x3                                  50,000
           July 15, 20x3                                130,000
           Sep 1, 20x3                                  200,000
           Oct 1, 20x3                                  150,000



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The company's borrowings are as follows:
•     a $200,000, 7% one year note dated January 1, 20x3. This note relates
      specifically to the self-constructed asset.
•     bonds payable in the amount of $5,000,000. The annual interest on these bonds is
      8.5%.
•     other long-term debt in the amount of $2,000,000 bearing interest at 6%.

First, we calculate the average investment in the project:

                                          Costs Proportion of time                  Average
           Date                        Incurred to October 31, 20x3               Investment
           Mar 1, 20x3                 $180,000               8/12                  $120,000
           May 1, 20x3                  120,000               6/12                    60,000
           June 1, 20x3                  60,000               5/12                    25,000
           July 15, 20x3                150,000              3.5/12                   43,750
           Sep 1, 20x3                  240,000               2/12                    40,000
           Oct 1, 20x3                  150,000               1/12                    12,500
                                                                                    $301,250

Borrowing costs on specific borrowings are charged first to the asset, then we will
allocate general borrowings based on the weighted average borrowing rate of 7.8%:

        8.5% x ($5,000,000 / 7,000,000) + 6% x (2,000,000 / 7,000,000) = 7.8%

Borrowing costs to be capitalized:

           Asset specific note: $200,000 x 7%                         $14,000
           General borrowings: ($301,250 - 200,000) x 7.8%              7,898
                                                                      $21,898

Disclosure requirements - the entity must disclose (1) the amount of borrowing costs
capitalized and (2) the capitalization rate used to determine the amount if borrowing costs
eligible for capitalization.


The Revaluation Model

Companies can choose between two models for accounting for property, plant and
equipment: the cost model and the revaluation model. The revaluation model measures
the carrying amount of the assets at their fair value which is defined as ‘the amount for
which an asset could be exchanged between knowledgeable, willing parties in an arm’s
length transaction’. In most cases this would be equal to the market value of the asset.
However, when there is no active market for the assets in question, the use of surrogate
measures such as depreciated replacement cost or use of market indices can be used.



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The standard is silent on the nature of the frequency of revaluations. The only guideline
provided is that revaluations should be done in sufficient regularity such that the carrying
amount of the asset does not materially differ from fair value. The frequency of
revaluation should ultimately depend on the nature of the assets. If the assets are subject
to rapid obsolescence, then revaluations should occur more frequently.

The revaluation model is not applied to individual asset items but to classes of assets, i.e.
land, buildings, machinery, etc… For each asset class, management can choose between
the cost and revaluation model as long as these are applied consistently for all
components in the class. For example, it is possible to use the revaluation model for land
and buildings and the cost model for all other classes of assets.

The best way to describe the application of the revaluation model is by way of example.

Assume that Company X is formed on January 1, 20x1. The following assets are
purchased on this date:

           Land                    $500,000
           Building               1,500,000        Useful life = 40 years
                                                   Residual value = $300,000

Company X chooses to apply the revaluation model. Because the market for real estate is
relatively stable, the company chooses to revalue the assets every three years, i.e. the first
revaluation will be made in January 20x4, the second in January 20x7…

For years 20x1 – 20x3, the building will be depreciated at the rate of $30,000 per year.
The net book value of the building on January 1, 20x4 will be:
       $1,500,000 – (30,000 x 3 years) = $1,410,000

January 20x4 revaluation - The appraisals of the land and building in January 20x4 are
$600,000 for land and $1,460,000 for the building.

The increase in the value of land will be as follows:

       Land                                                       $100,000
         Revaluation Surplus (OCI)                                                  $100,000

The Revaluation Surplus account will be part of Other Comprehensive Income, which in
turn, is part of Shareholders’ Equity.

For the building, two approaches can be used:
   1.      restate proportionately with the change in the gross carrying amount of the
           asset so that the carrying amount of the asset after revaluation equals its
           revalued amount, or



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    2.       eliminate the accumulated depreciation balance against the gross carrying
             amount of the asset and the net amount is then restated to the fair value of the
             asset. (IAS 16.35)

Using the first approach, which we will label the Proportional Method, we first
recalculate the original cost and the accumulated depreciation on the building by
multiplying each by the revalued amount divided by the current net book value of the
assets, 1,460 / 1,410:

                                           Carrying                           Carrying
                                       amount before                       amount after
                                         revaluation                        revaluation
         Building                        $1,500,000 1,460 / 1,410           $1,553,191
         Accumulated Depreciation           (90,000) 1,460 / 1,410             (93,191)
                                          $1,410,000                          $1,460,000

The journal entry to record the revaluation of the building under the proportional method
will be:

         Building                                                  $53,191
           Accumulated Depreciation                                                    $3,191
           Revaluation Surplus (OCI)                                                   50,000

Under the second approach, which we will label the Gross Carrying Amount method, we
first eliminate the accumulated depreciation of the building against the building account,
and then increase the carrying amount of the building:

         Accumulated Depreciation                                  $90,000
           Building                                                                  $90,000

         Building                                                    50,000
           Revaluation Surplus (OCI)                                                   50,000

The depreciation expense for 20x4 through to 20x6 will be:

          ($1,460,000 – 300,000) / 37 = $31,351

January 20x7 revaluation - The appraisals of the land and building in January 20x7 are
$540,000 for land and $1,300,000 for the building.

The decrease in value of land will offset the previous revaluation surplus on land of
$100,000 reducing it to $40,000:


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       Revaluation Surplus (OCI)                                  $60,000
         Land                                                                      $60,000

The net book value of the building is $1,460,000 – ($31,351 x 3) = $1,365,947. We need
to decrease the carrying value of the building by $65,947 which exceeds the revaluation
surplus on the building of $50,000. In this situation, we would first apply the decrease in
value to the balance in the revaluation surplus and any excess would be an expense that
would flow to the income statement.

Using the proportional approach, the analysis would be as follows:

                                         Carrying                            Carrying
                                     amount before                        amount after
                                       revaluation                         revaluation
      Building                         $1,553,191       1,300,000 /        $1,478,204
                                                         1,365,947
      Accumulated Depreciation            (187,244)     1,300,000 /          (178,204)
                                                         1,365,947
                                         $1,365,947                         $1,300,000

The journal entry would be as follows:

       Accumulated Depreciation
         ($187,244- 178,204)                                       $9,040
       Revaluation Surplus (OCI)                                   50,000
       Loss on asset revaluation (I/S)                             15,947
         Building ($1,553,191 – 1,478,204)                                         $74,987


Under the Gross Carrying Amount Method, the journal entries would be as follows:

       Accumulated Depreciation ($31,351 x 3)                     $94,053
         Building                                                                  $94,053

       Revaluation Surplus (OCI)                                   50,000
       Loss on asset revaluation (I/S)                             15,947
         Building                                                                    65,947

Note that the new carrying value of the building under the Gross Carrying Amount
Method would be:



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       Carrying amount, net – January 1, 20x4                                   $1,460,000
       Less accumulated depreciation from 20x4 to 20x6:
          $31,351 x 3 years                                                        (94,053)
       Less revaluation reduction in January 20x6                                  (65,947)
       Gross value of building on January 1, 20x6                               $1,300,000

The depreciation expense for the years 20x6 through 20x8 will be:

        ($1,300,000 – 300,000) / 34 years remaining = $29,412


To summarize the accounting treatment for revaluations:

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

Disposition of the Revaluation Surplus Account

There are two ways to dispose of the Revaluation Surplus Account:
   1. when an asset is derecognized, any Revaluation Surplus relative to that asset
       should also be disposed of through Retained Earnings, and
   2. the standard also allows the option of transferring amounts from the Revaluation
       Surplus directly to Retained Earnings throughout the assets useful life as it is
       being depreciated. The amount of surplus transferred would be equal to the
       difference between depreciation based on the original cost, and the depreciation
       based on the revalued amount.




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Derecognition of Assets

When an asset is disposed of, the proceeds on disposal are compared to the net book
value of the asset. If the proceeds on disposal exceed the net book value of the asset, then
we record a gain on disposal. If the proceeds on disposal are less than the net book value
of the asset, we record a loss on disposal.

The carrying amount of an item of property, plant and equipment shall be derecognized:
(a)    on disposal; or
(b)    when no future economic benefits are expected from its use or disposal.
       (IAS 16.67)

For example, an asset with an original cost of $140,000 was purchased on January 2,
20x1 and is depreciated using the diminishing balance method at the rate of 30% per
year. On December 31, 20x6, the asset is sold for proceeds of $35,000.

The net book value of the asset on December 31, 20x6 is: $140,000 x .76 = $16,471. The
gain on sale of the depreciable asset is $35,000 – 16,471 = $18,529.

The journal entry to record the disposal of asset is:

Cash                                                               $35,000
Accumulated depreciation ($140,000 – 16,471)                       123,529
  Asset                                                                            $140,000
  Gain on sale of asset                                                              18,529

Note that when assets are traded in, the market value of the asset traded in becomes the
proceeds on disposal and not the trade-in value. The reason for this is that the trade-in
value often reflects a discount on the purchase price of the new asset purchased, which
should be recorded as such.

Example 2 - recall the example used when discussing the component approach: on
December 31, 20x1 a truck is purchased at a cost of $250,000. The components of the
truck are as follows:

                                                       Cost          Useful Life
       Truck Body                                  $150,000            20 years
       Engine                                        90,000            10 years
       Tires                                         10,000             5 years

Assume that on July 1, 20x10 the engine is replaced at a cost of $120,000. We would first
have to derecognize the old engine:

        Net book value of old engine:
               $90,000 x 1.5 years remaining /10 years useful life = $13,500



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The journal entry to record the derecognition of the old engine would be:

Accumulated depreciation ($90,000 – 13,500)                          $76,500
Loss on derecognition of engine                                       13,500
  Engine                                                                              $90,000

We would then record the acquisition of the new engine:

Engine                                                              $120,000
  Cash                                                                               $120,000


Exchanges of Assets

Nonmonetary asset exchanges are exchanges of one productive asset for another. The
cost of the asset received is measured at fair market value unless:
•       the exchange transaction lacks commercial substance, or
•       the fair value of neither the asset received differs nor the asset given up is reliably
        measurable.
If the asset received is not measured at fair value, its cost is measured at the carrying
amount of the asset given up (IAS 16.24).

The determination of commercial substance is based on the extent to which the entity's
future cash flows are expected to change as a result of the transaction. An exchange
transaction has commercial substance if:
•       the configuration (risk, timing and amount) of the cash flows of the asset received
        differs from the configuration of the cash flows of the asset transferred; or
•       the entity-specific value of the portion of the entity's operations affected by the
        transaction changes as a result of the exchange;
AND
•       the difference in the above two items is significant relative to the fair value of the
        assets exchanged.

Example - a hotel chain exchanges Hotel A for Hotel B from another hotel chain - they
receive $100,000 cash as a result of the transaction. The carrying and fair values of both
hotels is as follows:

                                            Carrying                     Fair
                                               Value                    Value
               Hotel A                    $1,200,000               $1,500,000
               Hotel B                       900,000                1,400,000




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Assuming no commercial substance, the journal entry to record this transaction is:

Property, plant and Equipment - Hotel B*                                    $1,100,000
Cash                                                                           100,000
  Property, plant and Equipment - Hotel A                                                        $1,200,000

* carrying value of $1,200,000 less cash received of $100,000

Assuming commercial substance, the journal entry to record this transaction is:

Property, plant and Equipment - Hotel B                                     $1,400,000
Cash                                                                           100,000
  Property, plant and Equipment - Hotel A                                                        $1,200,000
  Gain on sale of property, plant and equipment                                                     300,000


Impairment of Assets

Because IFRS is moving from a historical cost model to a fair value model of accounting,
there must be a control mechanism to prevent overvaluations of assets. The impairment
test performs this function. It applies to all assets2, regardless of how these are classified,
although in practice they apply mostly to property, plant and equipment and intangible
assets.

The purpose of the test is to ensure that assets are not carried at an amount that is greater
than their recoverable amount. The recoverable amount is defined as the greater of:
    (i)     the fair market value of the assets less costs to sell (FV), or
    (ii)    their value in use (VIU) – this is defined as the present value of cash flows
            expected from the future use and sale of the assets at the end of their useful
            lives.
Because the principle is the higher of the two, management may have to calculate both.
However, if one exceeds the carrying amount, then the other does not have to be
calculated.

One of the key concepts behind the impairment of asset test is that of the Cash
Generating Unit (CGU). A CGU is defined as the smallest identifiable group of assets
that together have cash inflows that are largely independent of the cash flows of another
asset, i.e. the part of a business that generates income and which is largely dependent of
other parts of a business. At a minimum, a company has as many CGU’s as they have
operating segments for the purposes of segment reporting. For example, Rogers
Communications Inc’s 2007 Annual Report3 shows that the company operates in three
segments: wireless, cable and media. At a minimum, Rogers would have three CGU’s.

2 With the exception of inventories, assets arising from construction contracts, deferred tax assets, assets
arising from employee benefits, financial assets, assets held for sale and investment properties carried at
fair value.
3 http://downloads.rogers.com/RCI_2007_Annual_Report.pdf, p.88


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However if one of the segments is made up of smaller identifiable businesses, then it
could potentially be broken down into separate CGU’s. Examples of typical CGU's are
single retain stores and factories. Note that a CGU can be a single asset.

Value-in-use starts with an approved cash flow forecast for the CGU. This forecast has to
be reasonable, supportable, reflect an expected outcome and should not exceed a period
of 5 years. A terminal value is also calculated representing the value of the CGU at the
end of the 5 years. These cash flows are then discounted at an appropriate risk-adjusted
discount rate to obtain their value-in-use.

Fair value of an asset is defined as the value that an external market participant would
place on the asset

Impairment tests do not have to be done on an annual basis, rather they only need to be
done if there is some indication that impairment has occurred. However, some assets
have to be tested for impairment annually (IAS 36.10):
•       intangible assets with indefinite useful lives,
•       intangible assets not yet available for use, and
•       goodwill acquired in a business combination (the specific requirements for the
        impairment test for goodwill will be discussed in Module 2 of the Accelerated
        Program).

The reason for requiring annual impairment tests for the above is due to the fact that their
values may be more uncertain than other assets. In addition, these assets are not
amortized on a regular basis.

The standards provide indicators of impairment and are classified as external and internal
sources (IAS 36.12):

External indicators:
•      indicators that the market value of the assets has decreased
•      significant changes in the external environment the firm operates in
•      changes in market interest rates
•      comparison of the market capitalization of the firm with the carrying value of its
       assets

Internal indicators:
•       obsolescence or physical damage to the assets
•       change in use of the assets
•       changes in the economic performance of the assets

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




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Assets held for Sale

Noncurrent assets held for sale need to be disclosed as such on the statement of financial
position, i.e. they need to be disclosed separately from other capital assets.

To qualify as held for sale, the following two criteria must be met:
•      they must be available for immediate sale in their existing condition and the sale
       must be highly probable (meaning there is an active plan to sell and the price is
       reasonable); and
•      the sale will occur within a year from the date the assets are classified as held for
       sale

A discontinued operations is defined as a subset of assets held for sale or disposed of
during the year and:
•      represents a separate major line of business or geographical area of operations,
•      is part of a single co-ordinated plan to dispose of a separate major line of business
       or geographical area of operations, or
•      is a subsidiary acquired exclusively with a view to resale

On the date an asset, disposal group or discontinued operation is classified as held for
sale, they are measured at the lower of carrying costs and fair market less costs to sell. If
the selling costs exceed one year, they must be discounted. Any losses on measurement
are classified as an impairment loss. If, at a subsequent balance sheet date, the re-
measurement of fair market value indicates a recovery, then such recovery can be
recorded as a gain, but only to the extent of previous losses. Assets held for sale are not
depreciated.

Discontinued operations are presented as a single amount comprising:
•      the post-tax profit or loss from discontinued operations, and
•      the post-tax gain or loss recognized on the measurement to fair value less costs to
       sell on the disposal of the assets or disposal group constituting the discontinued
       operations

This single amount needs to broken down further in the notes into…
•       the revenue, expenses and pre-tax profit of the discontinued operations;
•       the gain or loss recognized on the measurement to fair value less costs to sell or
        on the disposal of the assets
•       separately for each of the two items above, the related income tax expense.




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Disclosure Requirements - Property, Plant and Equipment

For each class of property, plant and equipment, the following have to be disclosed:
•      the measurement bases used for determining the gross carrying amount;
•      the depreciation methods used;
•      the useful lives or the depreciation rates used;
•      the gross carrying amount and the accumulated depreciation at the beginning and
       end of the period; and
•      a reconciliation of the carrying amount at the beginning and end of the period
       showing:
       -       additions;
       -       assets classified as held for sale or included as held for sale and other
               disposals;
       -       acquisitions through business combinations;
       -       increases or decreased resulting from revaluations and from impairment
               losses recognized or reversed in other comprehensive income;
       -       impairment losses recognized or reversed on the income statement;
       -       depreciation expense recognized during the period; and
       -       any other changes. (IAS 16.73)

If items of property, plant and equipment are stated at revalued amounts, the following
have to be disclosed:
•       the effective date of the revaluation;
•       whether an independent valuer was involved;
•       the methods and significant assumptions applied in estimating fair values;
•       the extent to which the fair values were determined directly bu reference to
        observable prices in an active market or recent market transactions on arm's
        length terms or were estimated using other valuation techniques;
•       for each class of property, plant and equipment, the carrying amount that would
        have been recognized had the assets been carried under the cost model; and
•       the revaluation surplus, indicating the change for the period and any restrictions
        on the distribution of the balance to shareholders.




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Intangible Assets

IAS 38 defines an intangible asset as an identifiable non-monetary asset without physical
substance. Intangible assets can be distinguished between those that are identifiable and
non-identifiable. Identifiable intangible assets are those whose existence can be clearly
identified such as patents, copyrights and franchises. Non-identifiable intangible assets
exist but cannot be associated with a particular asset. Goodwill is the best example of a
non-identifiable intangible asset.

A distinction can also be made between purchased and internally developed intangible
assets.

To be considered identifiable, an intangible asset must meet one of the following two
criteria:
-        the intangible asset is separable, i.e. is capable of being separated or divided from
         the entity and sold, transferred, licensed, rented or exchanged, either individually
         or together with a related contract, asset or liability; or
-        arises from contractual or other legal rights, regardless of whether those rights are
         transferable or separable from the entity or from other rights and obligations (IAS
         38.12)

The same recognition criteria applies for intangible assets as for any other asset; the cost
of an intangible asset can be recognized as an asset if, and only if:
(a)     it is probable that future economic benefits associated with the item will flow to
        the entity, and
(b)     the cost of the item can be measured reliably. (IAS 38.9)

The accounting for intangible assets is based on whether or not the intangible asset has a
useful life. Amortization of intangible assets:
•       intangible assets with a finite useful life should be amortized over the lessor of
        their useful lives or legal life (IAS 38.97)
•       intangible assets with an indefinite life are subject to an annual impairment test
        (IAS 38.109)

Examples of intangible assets:

1.      Patents: a legal right to the exclusive use of a process, design, product or plan and
        the right to permit others to use it under license, generally for 17 years.
2.      Trademark: a distinctive word or symbol. These have an unlimited life.
3.      Copyright: right to publish materials such as books, CDs, tapes, and computer
        programs. Life: person's life plus 50 years for an individual or 75 years for a
        company.
4.      Franchise: the right to operate under the name of the franchisor.
5.      Goodwill. The definition of this term and the accounting thereof is described in
        Lesson 9. Generally goodwill has an unlimited life.



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Internally developed intangible assets

Internally developed intangible assets such as research and development are accounted
for as follows: research expenditures are written off to the income statement whereas
development costs are to be capitalized if they meet the following six criteria:
(a)     the technical feasibility of completing the intangible asset so that it will be
        available for use or sale.
(b)     its intention to complete the intangible asset and use or sell it.
(c)     its ability to use or sell the intangible asset.
(d)     how the intangible asset will generate probable future economic benefits. Among
        other things, the entity can demonstrate the existence of a market for the output of
        the intangible asset or the intangible asset itself or, if it is to be used internally, the
        usefulness of the intangible asset.
(e)     the availability of adequate technical, financial and other resources to complete
        the development and to use or sell the intangible asset.
(f)     its ability to measure reliably the expenditure attributable to the intangible asset
        during its development. (IAS 38.57)

Research is defined as 'original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding'. Development is the
application of research findings or other knowledge to a plan or design for the production
of new or substantially improved materials, devises, products, processes, systems or
services before the start of commercial production or use. (IAS 38.8)

Revaluation Model

It is possible to use the revaluation model for intangibles whose value can be determined
in an active market. The accounting for revaluation of intangible assets is the same as for
property, plant and equipment.

Disclosure Requirements - Intangible Assets

The following must be disclosed for each class of intangible assets, distinguishing
between internally generated intangible assets and other intangible assets:
•      whether the useful lives are indefinite or finite, and if finite, the useful lives, the
       amortization rates and methods used;
•      the gross carrying amount and any accumulated amortization t the beginning and
       end of period;
•      the line item(s) of the statement of comprehensive income in which any
       amortization of intangible assets is included; and
•      a reconciliation of the carrying amount at the beginning and end of the period
       showing:
       -       additions, indicating separately those form internal development, those
               acquired separately and those acquired through business combinations;
       -       assets classified as held for sale or included as held for sale and other
               disposals;


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        -       increases or decreased resulting from revaluations and from impairment
                losses recognized or reversed in other comprehensive income;
        -       impairment losses recognized or reversed on the income statement;
        -       amortization expense recognized during the period; and
        -       any other changes. (IAS 16.73)

Depletion and Accounting for Natural Resources

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

Note that this method is essentially a variation of the units of production method.




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Capital Assets - Examples

Example 1: Tender Footsies owned the land they were on and the building they were in,
along with much machinery and equipment used both in the factory and in the office.
The land had cost $14,000, the building $89,000 and the machinery and equipment
$143,000. Since the company had been in operation for forty-five years, everything was
fully depreciated. But since all the assets had been well maintained, they could be used
for many years to come.

Tender Footsies acquired two new assets in 20x4. The first was an adjacent piece of
land, which was used to construct a warehouse; the other was a new state-of-the-art
packaging machine for the shipping department.

The land cost $115,000 and came with an old building which had to be demolished. The
materials obtained from the demolition were sold as scrap for $2,300. The following
additional costs were incurred and paid:

        Legal fees                                                                 $4,100
        Land transfer tax                                                           1,450
        Cost of company hired to demolish the old building                          2,770
        Cost of company hired to dig the hole for the foundation                   14,940
        Cost of constructing the warehouse                                        361,700
        Cost of changing the locks after master key was stolen                        210
        Cost of moving the goods to the new warehouse on July 1, 20x4               1,390

The warehouse was to last 50 years and has a residual value of $2,640. The company
used the straight-line method of depreciation for the building. The packaging machine
was purchased on October 1, 20x4, at a cost of $24,000 plus delivery of $800. The
company had to build a special base to hold the machine which cost $700. The machine
could package 50,000 boxes over its life span. It was used to package 100 boxes in 20x4
in its three months of use. It had no estimated residual value. The company uses the units
of production method for depreciating the packaging machine. Management believes that
the cost of the warehouse cannot be broken down into further components.




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Cost of new warehouse:
     Land -
            Land cost                                                          $115,000
            Legal fees                                                            4,100
            Land transfer tax                                                     1,450
            Proceeds on sale of scrap materials                                  (2,300)
            Cost to demolish old building                                         2,770
                                                                               $121,020
     Warehouse -
           Cost of foundation                                                  $ 14,940
           Construction cost                                                    361,700
                                                                               $376,640

Note: the cost of changing the locks and moving the goods should not be capitalized, but
rather, be expensed since they do not add value to the warehouse.

     Depreciation expense for the year -
           Depreciation base ($376,640 - 2,640)                                $374,000
           Years                                                                     50
           Annual depreciation expense                                            7,480
             20x4 Depreciation expense (1/2)                                   $   3,740

     Cost of packaging machine -
            Cost of machine                                                     $24,000
            Delivery cost                                                           800
            Cost of special base                                                    700
                                                                                $25,500

             Depreciation expense - $25,500 x 100/50,000                       $      51




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Example 2: Wilson Ltd. started a business on July 1, 20x3 and has a June 30 year end.
The following information was available on June 30, 20x5:

        •   on July 1, 20x3, a new office complex complete with new office equipment
            was purchased for $400,000. A municipal tax bill showed an assessed value
            of $100,000 for the land and $150,000 for the building. The fair market
            values of the land and building at that time were estimated to be $175,000 and
            $200,000 respectively. A quote from an office equipment store for equipment
            similar to that bought on July 1, 20x3, showed a price of $125,000. The
            residual value of the building was estimated to be $25,000 while that of the
            equipment was $7,000. Management believes that the cost of the building
            cannot be broken down into further components.

        •   also on July 1, 20x3, three identical display trucks were purchased for a total
            of $75,000. The trucks have a residual value of $5,000 each.

        •   on December 31, 20x4, Wilson Ltd. traded one of the display trucks plus
            $9,000 cash for a new truck. The new truck's residual value was estimated to
            be $2,000. The trade-in allowance was $15,000. The old truck could have
            been sold for $12,000.

        •   on March 31, 20x5, office equipment was sold for $1,000. The cost of this
            equipment had been properly recorded on July 1, 20x3, at $5,000. At that
            time, the expected residual value was $ 500 .

        •   also on March 31, 20x5, new office equipment was purchased for $24,000.
            This equipment has a residual value of $1,500 .

The following expenditures associated with the purchase of the new office equipment
were charged to expense:

    Installation fees                                                                $ 730
    Freight-in                                                                        1,050
    Purchase discount                                                                   650
    Repairs to machine for damage during installation                                   380
    Wages during testing                                                                490
    Testing supplies                                                                    150

        •   the company depreciates all of its assets using the 10% diminishing balance
            method

Land - July 1, 20x3, lump-sum acquisition (Note 1)                                 $140,000

Building - July 1, 20x3, lump-sum acquisition (Note 1)                             $160,000

Office Equipment


Page 238                                                         CMA Ontario – September 2009
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         July 1, 20x3, lump-sum acquisition (Note 1)                           $100,000
         Sale - March 31, 20x5                                                   (5,000)
         Purchase - March 31, 20x5
                 Cost                                             $24,000
                 Installation fee                                     730
                 Freight-in                                         1,050
                 Purchase discount                                  (650)
                 Wages - testing                                      490
                 Testing supplies                                     150        25,770
                                                                               $120,770

Trucks
         Purchase - July 1, 20x3                                                $75,000
         Sale of truck - December 31, 20x4                                      (25,000)
         Purchase of truck - December 31, 20x4 (9,000 + 12,000)                  21,000
                                                                                $71,000




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Depreciation expense / Accumulated Depreciation

                                       Office
                                     Building      Equip.         Trucks           Total
Y/E June 30, 20x4
      Depreciation (Note 2)          $16,000      $10,000         $7,500        $33,500

Y/E June 30, 20x5
      Disposals (Note 3)                             (838)        (3,625)        (4,463)
      Depreciation (Note 4)           14,400        9,532          6,675         30,607
                                     $30,400      $18,694        $10,550        $59,644


Loss or gain on disposal -

Equipment:
      Proceeds                                                                   $1,000
      Net book value
             Cost                                                 $5,000
             Accumulated
             Depreciation                                              (838)      4,162
      Loss on disposal                                                          $(3,162)


Truck:
         Proceeds (FMV)                                                         $12,000
         Net book value
                Cost                                             $25,000
                Accumulated                                       (3,625)        21,375
                Depreciation
         Loss on disposal                                                       $(9,375)

Notes

(1) Allocation of cost between properties
        Total fair market value:
                Land                                        $175,000                35%
                Building                                     200,000                40%
                Equipment                                    125,000                25%
                                                            $500,000              100%

         Allocation of total cost -
                Land: $400,000 x 35%                        $140,000
                Building: $400,000 x 40%                     160,000
                Equipment: $400,000 x 25%                    100,000
                                                            $400,000

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(2) Depreciation expense for the year ended June 30, 20x4:
               Building: $160,000 x 10%                                             $16,000
               Equipment: $100,000 x 10%                                             10,000
               Trucks: $75,000 x 10%                                                  7,500

(3) Accumulated Depreciation on disposals for the year ended June 30, 20x5:
             Equipment -
                    July 1, x3 - June 30, x4: $5,000 x 10%                           $ 500
                    July 1, x4 - March 31, x5: $4,500 x 10% x 9/12                     338
                                                                                     $ 838

                Truck -
                          July 1, x3 - June 30, x4: $25,000 x 10%                    $2,500
                          July 1, x4 - Dec 31, x4: 22,500 x 10% x 6/12                1,125
                                                                                     $3,625


(4) Depreciation expense for the year ended June 30, 20x5:
               Building: $160,000 - 16,000 = 144,000 x 10%                          $14,400

                Equipment:
                      July 1, x4 - Jun 30, x5: $95,000 - 9,500
                              = 85,500 x 10%                                        $ 8,550
                      July 1, x4- Mar 31, x5 (on equipment sold)                        338
                      Mar 31, x5 - June 30, x5 (on new equipment):
                              $25,770 x 10% x 3/12                                       644
                                                                                     $ 9,532




                Trucks -
                       July 1, x4 - Jun 30, x5: $50,000 - 5,000
                               = 45,000 x 10%                                       $ 4,500
                       July 1, x4 - Dec 31, x4 (on truck sold)                        1,125
                       Dec 31, x4 - June 30, x5 (on new truck):
                               $21,000 x 10% x 6/12                                    1,050
                                                                                     $ 6,675




Page 241                                                         CMA Ontario – September 2009
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Problems with Solutions

Multiple Choice Questions

1.      During 20x4, Yvo Corp. installed a production assembly line to manufacture
        furniture. In 20x5, Yvo purchased a new machine and rearranged the assembly
        line to install this machine. The rearrangement did not increase the estimated
        useful life of the assembly line, but it did result in significantly more efficient
        production. The following expenditures were incurred in connection with this
        project:
                  Machine                                                          $75,000
                  Labor to install machine                                           14,000
                  Parts added in rearranging the assembly line
                      to provide future benefits                                     40,000
                  Labor and overhead to rearrange the assembly line                  18,000

        What amount of the above expenditures should be capitalized in 20x5?
        a.     $147,000
        b.     $107,000
        c.     $ 89,000
        d.     $ 75,000


2.      Zahn Corp.'s comparative balance sheet at December 31, 20x5 and 20x4,
        reported accumulated depreciation balances of $800,000 and $600,000
        respectively. Property with a cost of $50,000 and a carrying amount of $40,000
        was the only property sold in 20x5. Depreciation charged to operations in 20x5
        was
        a.       $190,000
        b.       $200,000
        c.       $210,000
        d.       $220,000


3.    Weston Company purchased a tooling machine on January 3, 20x1 for $600,000.
      The machine was being amortized on the straight-line method over an estimated
      useful life of ten years, with no residual value. At the beginning of 20x8, the
      company paid $150,000 to overhaul the machine. As a result of this improvement,
      the company estimated that the useful life of the machine would be extended an
      additional five years (15 years total). What should be the amortization expense
      recorded for the machine in 20x8?
      a) $41,250
      b) $50,000
      c) $60,000
      d) $66,000

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4.    A company installed an assembly line costing $50,000 in 20x1. In 20x6, the
      company invested $100,000 to automate the line. The automation increased the
      market value and productive capacity of the assembly line but did not affect its
      useful life. Proper accounting for the cost of the automation should be to
      a) report it as an expense in 20x6.
      b) debit the accumulated depreciation account by $100,000.
      c) allocate it between the fixed asset and accumulated depreciation accounts.
      d) debit the fixed asset account by $100,000.
      e) none of the above.


5.     Assume you are employed as the chief accountant for DrawPro Inc., a computer
       software company. The company was developing a new software program called
       Graphics Tool. At the end of the year, the director of research estimated that $1
       million was spent during the year for the Graphics Tool program. He asked you to
       reduce his expenses by capitalizing $1 million as research and development costs.
       Prior to capitalizing the research and development costs, which of the following
       questions would NOT be considered in ensuring that your statements would be in
       accordance with generally accepted accounting principles?
      a) Has the future market for Graphics Tool been clearly defined?
      b) Is the Graphics Tool program technology feasible?
      c) Are the costs related to research activities or development activities?
      d) Does management have the desire to launch the Graphics Tool program upon
            completion?
      e) All of the above questions would be considered.




Page 243                                                       CMA Ontario – September 2009
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Problem 1

The Flour Co. Ltd. wanted to build a new factory in Montreal. In June, 20x0, the
company purchased a block of land as a factory site for $190,000. Two small office
buildings were standing on the site. The buildings had a market value of $50,000
(included in the purchase price of $190,000).

The company paid $12,500 to demolish the old buildings. The bricks from the old
buildings were salvaged and sold for $1,400. Legal fees of $475 were paid for a land title
search. Property taxes in arrears of $1,500 were paid by Flour Co. Ltd.. Payment of
$20,000 was made to an engineering firm for drawing factory building plans. A
construction contractor agreed to build the factory on a fixed-fee basis. The contractor's
fixed fee charge for construction was $390,000. Special lighting was added to the
building for $10,000. The factory building was completed on October 31, 20x0. The
Flour Company's year end is December 31.

Required -

a.      Calculate the cost of the land and building.
b.      Assuming the factory building (and special lighting) has a 10 year life, compute
        the depreciation expense for both 20x0 and 20x1 on each of the following bases:
        i) straight-line
        ii) diminishing balance at 20%




Page 244                                                       CMA Ontario – September 2009
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Problem 2

Vesley Air Freight is a small freight forwarder operating out of Baltimore and serving the
Chesapeake Bay area. The company is in the process of preparing annual financial
statements for the fiscal year ended May 31, 20x1. Neal Kaiser, assistant controller, has
gathered the following data concerning accounts receivable and depreciable assets.

At May 31, 20x1, Vesley's Accounts Receivable were $525,000, and the Allowance for
Doubtful Accounts had a balance of $1,400. Kaiser prepared an aging report accounts
receivable at May 31, 20x1, and the schedule below summarizes the relevant information
from that aging report.

               Age                    Amount        Probability of Collection

    Under 30 days                      $420,000               97%
    31 - 90 days                         31,000                85
    91 – 150 days                        26,000                80
    Over 150 days                        48,000                70


To update its fleet, Vesley purchased three Colt airplanes and two Parker airplanes during
January 20x0 for $2,930,000. The airplanes were put into service on June 1, 20x0. The
details concerning cost, residual value, and the expected life of each of the airplanes are
given below. Vesley has decided to depreciate the airplanes using the straight-line
method of depreciation. On May 27, 20x1, one of the Colt airplanes (the N05110),
costing $610,500, was damaged beyond repair when it caught fire during a refueling
accident. The insurance proceeds amounted to $420,000. On May 30, 20x1, the company
purchased another Colt airplane for $593,200.

                     Identification                    Residual        Expected
    Airplane           Number             Cost          Value            Life

Colt                 N16313             $ 576,000       $ 94,050     9 years
Parker               N70224               563,800         55,600    11
Parker               N42326               562,500         55,950    11
Colt                 N05110               610,500         60,900    12
Colt                 N62199               617,200         60,800    13

                     Total             $2,930,000       $327,300




Page 245                                                           CMA Ontario – September 2009
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Required -

A.      1.      Calculate the proper balance in the Allowance for Doubtful Accounts
                using the percentage-of-receivable approach.
        2.      Prepare the entry to adjust the Allowance for Doubtful Accounts as of
                May 31, 20x1.

B.      1.      Prepare the journal entries to record the depreciation expense as at May
                31, 20x1.
        2.      Record the retirement of the Colt Airplane on May 27, 20x1 and the
                purchase of the new plane.


Problem 3

The Verdini Company made a lump-sum purchase of three pieces of machinery for
$120,000. At the time of acquisition, Verdini paid $5,000 to determine the appraised
value of the machinery. The appraisal disclosed the following values:

Machine 1                                           $70,000
Machine 2                                            52,000
Machine 3                                            23,000

Required -

Calculate the amount that Verdini should record in the accounts for each machine.




Page 246                                                        CMA Ontario – September 2009
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Problem 4

The Jurasni Company acquired a building on December 31, 20x1 at a total cost of
$1,500,000. The contractor provided the following breakdown of the major components
of the building:

                                                                                  Residual
Component                                          Cost      Useful Life            Value
Structure & frame                           $1,000,000       40 years            $100,000
Heating & AC System                            200,000       15 years                   0
Elevators (2)                                  225,000       20 years              25,000
Roof                                            75,000       25 years                   0

The company depreciates the structure & frame and roof using the straight line method.
The heating & AC system and elevators are depreciated using the diminishing balance
method at a rate of 15% and 10% respectively.

Required -

a.      Calculate the depreciation expense on the building's components for the year 20x2
        and 20x3.
b.      On June 30, 20x15 one of the two elevators is replaced at a cost of $150,000. The
        useful life of the new elevator is expected to be 20 years with a $20,000 residual
        value. The parts of the old elevator are sold for $10,000.
        i.      Prepare the journal entries to record these transactions.
        ii.     Calculate the depreciation expense on the elevators for the year 20x15.
c.      On January 2, 20x23, the roof is replaced at a cost of $120,000. The useful life of
        the new roof is 25 years. Prepare the journal entries for these transactions.




Page 247                                                       CMA Ontario – September 2009
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Problem 5 - Borrowing Costs

On January 1, 20x4, the Britton Corporation started the construction of a self-constructed
asset. Construction of the asset was completed on August 31, 20x4 and was put in
productive use on that date.

The following is a schedule of direct costs incurred in the construction of the asset:

           January 1, 20x4                             $30,000
           February 1, 20x4                             50,000
           April 1, 20x4                                75,000
           May 15, 20x4                                 40,000
           July 1, 20x4                                 60,000
           Aug 1, 20x4                                  45,000

The company's borrowings are as follows:
•     a $100,000, 6.5% one year note dated January 1, 20x4. This note relates
      specifically to the self-constructed asset. The note was repaid on August 31, 20x4.
•     bonds payable in the amount of $10,000,000. The annual interest on these bonds
      is 7.5%.
•     a bank loan payable in the amount of $15,000,000 bearing interest at 5%.

Required -

Calculate the cost of the asset at August 31, 20x4.




Page 248                                                         CMA Ontario – September 2009
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Problem 6

The following is the income statement for the Jen-Ward Company for the year ended
December 31, 20x7:

           Sales                                                        $9,500,000
           Cost of goods sold                                            6,000,000
           Gross margin                                                  3,500,000
           Operating expenses                                            2,000,000
           Net income before taxes                                       1,500,000
           Income taxes (@ 40%)                                            600,000
           Net income                                                   $9000,000

During December 20x7, the company’s board of directors passed a resolution to dispose
of one of the company’s three divisions. This division had revenues of $2,500,000, cost
of goods sold of $1,500,000 and operating expenses of $800,000. These amounts are
included in the above income statement.

The carrying value of the net assets of the division (net of current liabilities) was
$6,900,000. The fair market value of the net assets is estimated to be $6,200,000 and the
costs to sell the division are expected to be equal to 5% of the fair value of the net assets.
None of these have been taken into account in preparing the above income statement

Required –

Prepare an income statement for the Jen-Ward Company for the year ended December
31, 20x7.




Page 249                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 7

The controller for Murdock, Inc., has asked a member of the staff to review the repair and
maintenance expense account to determine if all of the charges are appropriate. The staff
member has reviewed this account and has identified the following ten transactions for
further scrutiny. All of these transactions are considered material in amount.

      DATE        AMOUNT                            DESCRIPTION

a)     1/3/x2        $10,000 Service contract on office equipment.
b)     3/7/x2         10,000 Initial design fee for proposed extension of office building.
      4/12/x2         18,500 New condenser for central air-conditioning unit located on
                                 the roof of office building.
d)    4/20/x2          7,000 Purchase of two executive chairs and desks.
e)    5/12/x2         40,850 Purchase of storm and screen windows and installation of
                                 same on all office windows.
f)    5/18/x2         38,450 Sealing of roof leaks over entire production plant.
g)    6/19/x2         28,740 Replacement of large door to production area.
h)     7/3/x2         11,740 Installation of automatic door-opening system on the above
                                 door to speed opening.
i)    9/14/x2         38,500 Purchase of overhead crane for the Assembly Department
                                 to speed up production,
j)   10/18/x2         11,000 Replacement of broken gear on machine in the Machining
                                 Department.

Required -

For each of the ten transactions identified by the controller's staff member, indicate
whether the transaction is properly charged to the repair and maintenance expense
account, and if not, indicate the appropriate account to which the transaction should be
charged. Explain your reasoning in each case.


Problem 8

Pinewood Corporation sells and erects shell houses-frame structures that are completely
finished on the outside but are unfinished on the inside except for flooring, partition
studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy
with tools and who have time to do the interior wiring, plumbing, wall completion and
finishing, and other work necessary to make the houses livable.

Pinewood buys shell houses from a manufacturer in unassembled packages consisting of
all lumber, roofing, doors, windows, and similar materials necessary to complete a shell
house. Upon commencing operations in a new area, Pinewood buys or leases land as a
site for its local warehouse, field office, and display houses. Sample display houses are
erected at a total cost of from $3,000 to $7,000, including the cost of the unassembled

Page 250                                                       CMA Ontario – September 2009
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packages. The chief element of cost of the display houses is the unassembled packages,
since erection is a short, low-cost operation. Old sample models are torn down or altered
into new models every three to seven years. Sample display houses have little residual
value because dismantling and moving costs amount to nearly as much as the cost of an
unassembled package.

Required -

Would it be preferable to depreciate the cost of display houses on the basis of (a) the
passage of time or (b) the number of shell houses sold? Explain.


Problem 9

On December 31, 20x5, Harwale Corporation had the following property, plant and
equipment on its balance sheet:

                                                    Accumulated      Net Carrying
                                           Cost     Depreciation           Value
           Buildings                  $900,000         $300,000          $600,000
           Equipment                   450,000          180,000           270,000

Harwale uses the revaluation model for its buildings and equipment and applies
revaluations using the gross carrying amount method. The revaluation surplus account
has a balance of $60,000 for the buildings and $0 for the equipment. The equipment
revaluation resulted in a charge to income of $20,000 in the year ended December 31,
20x2 – the last time the company revalued its assets.

An independent appraiser assessed the fair value of the buildings to be $700,000 and the
fair value of the equipment to be $300,000.

Required –

Prepare the journal entries at December 31, 20x5 to reflect the revaluation of the
buildings and equipment.




Page 251                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 10

The JZ Company acquired a building on January 2, 20x1 at a cost of $600,000. The
expected useful life of the building is 30 years with a residual value of $120,000. JZ uses
the revaluation model and applies revaluations using the gross carrying amount method.
The buildings’ appraisals are as follows:

    December 31, 20x1                                      $596,000
    December 31, 20x2                                       550,000
    December 31, 20x3                                       565,000

The building was sold on January 2, 20x4 for $560,000.

Required –

Prepare the journal entries for the years 20x1-20x4.


Problem 11

The Jerome Property Corporation’s capital asset policy is to use the revaluation model for
land and buildings and the historical cost model for equipment. The latest revaluation
occurred on December 31, 20x2. Jerome uses the Gross Carrying Amount method when
applying the revaluation model. Selected balance sheet data relating to the most current
fiscal year ending December 31, 20x2 is as follows:

        Long-Term Assets
          Land                                                            $1,200,000
          Buildings                                                        5,600,000
          Equipment                                           900,000
          Less accumulated depreciation                     (300,000)        600,000
                                                                          $7,400,000

        Shareholders’ Equity
          Revaluation Surplus – Land                                        $400,000
          Revaluation Surplus – Buildings                                    300,000

The buildings have a remaining useful life of 25 years. The equipment has a total useful
life of 10 years. The straight line method is used. Residual values are assumed to be zero.
The assets are revalued every two years. The appraisal results for the years ended
December 31, 20x4 and 20x6 are as follows:

                                                              Dec 31,        Dec 31,
                                                                 20x4           20x6
        Land                                               $1,000,000     $1,500,000
        Buildings                                           4,600,000      4,500,000

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There were no additions or disposals to the land, building and equipment accounts for the
years 20x3 to 20x6.

Required –

Prepare all journal entries for the years 20x3 to 20x6 for the Land, and Buildings
accounts.


Problem 12

On December 31, 20x1, certain accounts included in the capital assets section of the
Townsand Company's Statement of Financial Position had the following balances:

Land                                                            $500,000
Buildings                                                        900,000
Leasehold improvements                                           400,000
Machinery and equipment                                          500,000

During 20x2 the following transactions occurred:

a) Land site number 621 was acquired for $1 million. In addition, Townsand paid a
   $60,000 commission to a real estate agent. Costs of $15,000 were incurred to clear
   the land. During the course of clearing the land, timber and gravel were recovered and
   sold for $5,000.

b) A second tract of land (site number 622) with a building was acquired for $300,000.
   The closing statement indicated that the land's value was $200,000 and the building's
   value was $100,000. Shortly after acquisition, the building was demolished at a cost
   of $30,000. A new building was constructed for $150,000 plus the following costs:

     Excavation fees                                             $11,000
     Architectural design fees                                     8,000
     Building permit fee                                           1,000
     Imputed interest on funds used during construction            6,000

    The building was completed and occupied on September 30, 20x2.

c) A third tract of land (site number 623) was acquired for $600,000 and was put on the
   market for resale.

d) Extensive work was done to a building occupied by Townsand under a lease
   agreement that expires on December 31, 20x8. The total cost of the work was
   $125,000, which consisted of the following:



Page 253                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


                                                                      Estimated Useful
                         Work Done                            Cost       Life (years)

     Ceilings painted                                      $10,000             1
     Electrical work                                        35,000             10
     Extension to current work area constructed             80,000             30

     Total                                               $125,000

    The lessor paid one-half of the costs incurred in connection with the extension to the
    current working area.

e) During December 20x2 costs of $65,000 were incurred to improve leased office
   space. The related lease will terminate on December 31, 20x4, and is not expected to
   be renewed.

f) A group of new machines was purchased under a royalty agreement that provides for
   payment of royalties based on units of production for the machines. The invoice price
   of the machines was $75,000, freight costs were $2,000, unloading charges were
   $1,500, and royalty payments for 20x2 were $13,000.

Required -

Prepare a detailed analysis of the changes in each of the following Statement of Financial
Position accounts for 20x2:

1. Land.
2. Buildings.
3. Leasehold improvements.
4. Machinery and equipment.

Disregard the related accumulated depreciation accounts.




Page 254                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 13

Illini Technologies designs and manufactures aircraft parts and subsystems for several
large airplane manufacturers, and the company is known for its strong research and
development. Occasionally, Illini assigns patent rights to other companies and has also
acquired patent rights from outside companies.

The transactions listed below occurred during the current fiscal year ending December
31, 20x0. Illini has a policy of amortizing patent costs using the straight-line method,
calculated to the nearest month.

(1) On March 1, 20x0, Illini acquired a patent from Lucas Industries covering a new
    landing gear system for small, high performance jet aircraft. Lucas accepted a
    $75,000, 6% note due September 1, 20x0, in exchange for the patent. On September
    1, 20x0, Illini paid Lucas $77,250, the maturity value of the note. Illini believes that
    the patent will be technologically obsolete in six years.

(2) On July 1, 20x0, Illini received notification that a recent application for a patent was
    granted. Over the past three years, the company's Research and Development
    Department has expended $1.2 million on this project, including $485,000 spent
    during 20x0. The attorney's and filing fees for this patent totaled $104,800. Illini's
    engineers estimate that this patent has a useful life of ten years.

(3) In August 20x0, Illini was notified that an application for a patent covering a bonding
    process was denied. Illini's Research and Development Department expended
    $460,000 on this project. The attorney's and filing fees spent on this patent
    application totaled $34,950.

(4) During the first quarter of 20x0, Illini reevaluated the useful life of several patents.
    The engineering staff determined that three patents had no future value. The book
    value of these patents at the beginning of January 20x0 was $171,255. The
    engineering staff recommended that the useful life of another patent be reduced from
    four to two years. The book value of this patent at the beginning of January 20x0 was
    $40,700.

(5) During 20x0, Illini was successful as a plaintiff in a patent infringement suit. Legal
    costs incurred in this suit totaled $431,000. Of this amount, $380,000 had been
    expensed in prior years. The remaining $51,000 represents legal costs of this case
    incurred during 20x0.

(6) During January 20x0, Illini granted a license to Savey Company to manufacture a
    gear reduction unit for light aircraft engines. The manufacturing process is covered by
    one of Illini's patents. The licensing agreement calls for Savey to pay Illini a fee for
    each unit produced. Savey reported $103,260 as due under this agreement for the
    fiscal year ending December 31, 20x0.



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Required -

A. Describe how each of the six transactions would be presented on Illini Technologies'
   financial statements at December 31, 20x0, identifying the appropriate dollar amount
   where applicable. Footnote disclosure requirements should be ignored.

B. Describe the factors that should be considered when determining the useful life of a
   patent.


Problem 14

Company A and Company B are independent companies in a similar line of business.
They have each just purchased identical pick-up trucks for company use.

Company A purchased its truck for $13,000 cash.

Company B paid $9,000 cash and traded in a truck which it had bought three years ago
for $8,500. The older truck had been depreciated on a 30% diminishing balance basis.
This truck could have been sold for $4,500 had it not been traded in. Both trucks were
listed with the dealer at a selling price of $14,500.

Required -

a) Will the estimated lives of both trucks be the same for the purposes of computing
   depreciation? What information must be considered by the companies in estimating
   the useful lives of their trucks for depreciation purposes?
b) Should the companies use the same depreciation methods? Explain.
c) What is the acquisition cost of Company B's new truck? Explain.
d) Prepare the journal entry to record the purchase of the truck by Company B.




Page 256                                                      CMA Ontario – September 2009
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Problem 15

The Morash Company Ltd. purchased a commercial lot for $100,000. An old building on
the site was demolished at a cost of $8,000. Building stone from this old building was
sold for $1,500. Legal fees of $1,300 were incurred in connection with this acquisition,
and, in addition, land survey fees of $600 were paid in order to obtain preliminary
approval for the financing of the new construction. An engineering firm prepared factory
plans at a cost of $25,000. The contract price for the new building was $950,000.

During the construction, which lasted four months, a Morash foreman with an annual
salary of $24,000 acted exclusively as the liaison between the Morash Company and the
contractor, in order to supervise construction. Insurance premiums paid for the new
premises during construction totalled $600.

Required -

Determine the amount that should be debited to each of the land and building accounts
for this project. Show all calculations, and label the components of each of the asset
accounts.




Page 257                                                      CMA Ontario – September 2009
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Problem 16

During 20x6, the Alfaro Corporation purchased land with an existing building at a cost of
$860,000. The land was valued at $780,000 with the difference allocated to the building.
Alfaro demolished the existing building and began construction of a new office building
for its own use. The following represent costs incurred during the construction of the
building:

•       architect’s fees of $130,000
•       interest of $130,000 on construction financing taken on March 1, 20x6 and repaid
        on October 31, 20x6.
•       cost of $40,000 to demolish the existing building
•       proceeds on sale of materials from existing building = $8,000
•       costs to move from current building to new one = $106,000
•       payment of $15,000 of delinquent property taxes when the existing land and
        building were purchased
•       land survey fees of $6,000
•       cost to build new building = $1,200,000
•       liability insurance during construction = $5,000

The land and building were purchased on March 1, 20x6. Construction of the new
building started on April 1, 20x6 and was completed on October 31, 20x6.

Required –

a)      Calculate the cost of the land and building.
b)      Assume that the company moved into the new building on December 1, 20x6 and
        that the straight line method of depreciation is used. Calculate the depreciation
        expense on the building for the year ended December 31, 20x6. Assume a useful
        life of 50 years and a residual value of $200,000.




Page 258                                                       CMA Ontario – September 2009
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Problem 17

Lavoie Company's records show the following property acquisitions and disposals during
the first two years of operations:

                          Acquisition   Estimated                  Disposals
                             Cost of    Useful Life        Year of
Year                        Property     (years)        Acquisition                Amount
20x5                         $50,000        10
20x6                          20,000        10                  20x5         Cost - $7,000
                                                                         Proceeds - $4,000

The Lavoie Company’s capital asset policy is to depreciate assets for one-half year in the
year of acquisition and in its year of disposal.

Required -

1.      Compute depreciation expense for 20x5 and for 20x6 and the balances of the
        property and related accumulated depreciation accounts at the end of each year
        under the following depreciation methods. Show computations and round to the
        nearest dollar.
        a.      Straight-line method.
        b.      Diminishing balance method at a rate of 20%.
2.      Prepare the journal entry to record the disposal of property in 20x6 under the
        straight-line method.


Problem 18

The Linnay Company purchased a machine costing $500,000 on January 2, 20x1. The
expected useful life of the machine is 8 years and the residual value is expected to be
$100,000. The company uses the diminishing balance method of depreciation. The rate
used for machines is 25%. The Linnay Company has a December 31 year end.

Required –

Calculate the depreciation on the equipment in the year 20x6.




Page 259                                                        CMA Ontario – September 2009
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SOLUTIONS


Multiple Choice Questions

1.    a     All amounts provide future benefits and should therefore be capitalized.

2.    c     Accumulated depreciation, December 31, 20x4                             $600,000
            Accumulated depreciation on property sold: $50,000 - 40,000              -10,000
            Accumulated depreciation, December 31, 20x5                             -800,000
            Depreciation expense, 20x5                                              $210,000

3.    a     NBV at beginning of 20x8: $600,000 /10 x 3 = $180,000
            NBV with improvement = $180,000 + 150,000 = $330,000
            Amortization = $330,000 / 8 = $41,250

4.    d     The cost of an item of property, plant and equipment as an asset if, and only
            if:
            (a)     it is probable that future economic benefits associated with the item
                    will flow to the entity, and
            (b)     the cost of the item can be measured reliably
            All of the items meet the recognition principle and should be capitalized.

5.    e     Development costs (but not research costs) can be capitalized if certain
            criteria are met. All choices need to be met in order to capitalize internally
            generated intangible assets.




Page 260                                                         CMA Ontario – September 2009
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Problem 1

a.                                                                       Land           Building
        Purchase price of land                                       $190,000
        Cost to demolish existing buildings                             12,500
        Salvage                                                        (1,400)
        Land title search                                                  475
        Property taxes in arrears                                        1,500
        Factory building plans                                                       $20,000
        Construction costs                                                           390,000
        Special lighting                                                              10,000
                                                                     $203,075       $420,000

b.                                                    20x0                       20x1
        Depreciation of Building:

        i) Straight-line                       420,000 / 10 x 2/12          420,000 / 10
                                                    = 7,000                  = 42,000

        ii) Diminishing Balance               420,000 x 20% x 2/12        406,000 x 20%
                                                    = 14,000                 = 81,200




Page 261                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2

A.
1. The proper balance in Vesley Air Freight's Allowance for Doubtful Accounts using the
percentage-of-receivable approach is $36,850 as calculated below.

Vesley Air Freight
Allowance for Doubtful Accounts
                                      Percentage         Required Balance
Age                         Amount    Uncollectible        in Allowance
Under 30 days                $420,000      .03                     $12,600

31-90 days                        31,000     .15                       4,650

91-150 days                       26,000     .20                       5,200

Over 150 days                     48,000     .30                      14,400

     Required balance in Allowance                                   $36,850

2. The entry to adjust Allowance for Doubtful Accounts as of May 31, 20x1, is as
follows.

Bad Debt Expense                           $35,450
   Allowance for Doubtful Accounts                    $35,450
To adjust the Allowance for Doubtful Accounts as of May 31, 20x1, in accordance with
calculations below.

Balance required in Allowance                $36,850
Less current balance                           1,400
   Amount of adjustment                      $35,450

B.
1.

                              Residual     Depreciable    Expected          Annual
Airplane             Cost       Value             Cost        Life     Depreciation
Colt           $ 576,000      $ 94,050       $481,950      9 yrs.          $ 53,550
Parker           563,800        55,600        508,200       11               46,200
Parker           562,500       55, 950        506,550       11               46,050
Colt             610,500        60,900        549,600       12               45,800
Colt             617,200        60,800        556,400       13               42,800

                                                                           $234,400



Page 262                                                        CMA Ontario – September 2009
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Depreciation Expense                            $234,400
   Accumulated Depreciation                                    $234,400
To record the depreciation expense for the fiscal year ended May 31, 20x1, for Vesley
Air Freight.

2.
Cash                                           $420,000
Accumulated Depreciation                         45,800
Loss on disposal of fixed assets                144,700
   Fixed Assets – Airplanes                                   $610,500
To record retirement of damaged airplane, as of May 20x1.

Fixed Assets - Airplanes                        $593,200
   Cash                                                       $593,200
To record the acquisition of a new airplane as of May 20x1.


Problem 3

                                  Appraisal               Allocation of
                                    Values         %    Purchase Price
Machine 1                          $70,000    48.27%            60,345
Machine 2                           52,000    35.86%            44,828
Machine 3                           23,000    15.87%            19,827
                                  $145,000                    $125,000




Page 263                                                      CMA Ontario – September 2009
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Problem 4

a.    20x2 -
        Structure & Frame - ($1,000,000 - 100,000) / 40 years                      $22,500
        Heating & AC System - $200,000 x 15%                                        30,000
        Elevators: $225,000 x 10%                                                   22,500
        Roof: $75,000 / 25 years                                                     3,000
                                                                                   $78,000

      20x3 -
        Structure & Frame - ($1,000,000 - 100,000) / 40 years                      $22,500
        Heating & AC System - ($200,000 - 30,000) x 15%                             25,500
        Elevators: ($225,000 - 22,500) x 10%                                        20,250
        Roof: $75,000 / 25 years                                                     3,000
                                                                                   $71,250

b.    i.    Cost of elevator = $225,000 / 2 = $112,500
            Net book value of elevator at December 31, 20x14:
              $112,500 x (1 - 0.10)13 = $28,596
            Net book value of elevator at June 30, 20x15:
              $28,596 - (28,596 x 10% x ) = $27,166

            Cash                                                     $10,000
            Accumulated depreciation ($112,500 - 27,166)              85,334
            Loss on derecognition of asset                            17,166
              Elevator                                                            $112,500

            Elevator                                                 150,000
              Cash                                                                 150,000

      ii.   Depreciation expense to June 30, 20x15 on elevator derecognized:
              $28,596 x 10% x                                                       $1,430
            Depreciation expense from July 1 to Dec 31, 20x15:
              $150,000 x 10% x                                                        7,500
            Depreciation expense on other elevator:
              $112,500 x (1 - 0.10)13 x 10%                                          2,860
                                                                                   $11,790

c.    Net book value of original roof as at Dec 31, 20x22:
       $75,000 / 25 x 4 years remaining = $12,000

      Loss on derecognition of asset                                 $12,000
      Accumulated depreciation ($75,000 - 12,000)                     63,000
        Roof                                                                       $75,000


Page 264                                                        CMA Ontario – September 2009
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       Roof                                                          120,000
         Cash                                                                     120,000


Problem 5

The average investment in the project:

                                            Costs   Proportion of time           Average
Date                                     Incurred    to Aug 31, 20x4           Investment
January 1, 20x4                          $30,000           8/12                   $20,000
February 1, 20x4                          50,000           7/12                    29,167
April 1, 20x4                             75,000           5/12                    31,250
May 15, 20x4                              40,000          3.5/12                   11,667
July 1, 20x4                              60,000           2/12                    10,000
August 1, 20x4                            45,000           1/12                     3,750
                                                                                 $105,084

Borrowing costs on specific borrowings are charged first to the asset, then we will
allocate general borrowings based on the weighted average borrowing rate of 7.8%:

        7.5% x ($10,000,000 / 25,000,000) + 5% x (15,000,000 / 25,000,000) = 6%

Borrowing costs to be capitalized:

           Asset specific note: $100,000 x 8/12
             = 66,667 x 6.5%                                         $4,333
           General borrowings: ($105,084 - 66,667) x 6%               2,305
                                                                     $6,638




Page 265                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 6


Jen-Ward Company
Statement of Income
For the year ended December 31, 20x7

Sales ($9,500,000 - 2,500,000)                                             $7,000,000
Cost of goods sold ($6,000,000 – 1,500,000)                                 4,500,000
Gross margin                                                                2,500,000
Operating expenses ($2,000,000 – 800,000)                                   1,200,000
Net income before taxes                                                     1,300,000
Income taxes (40%)                                                            520,000
Net income before discontinued operations                                     780,000
Net loss from discontinued operations (note)                                  486,000
Net income                                                                   $294,000


Discontinued operations -
  Income from operations: $2,500,000 – 1,500,000 – 800,000                   $200,000
  Writedown to market value: $6,900,000 – (6,200,000 x 0.95)              (1,010,000)
                                                                              810,000
                                                                                x 0.6
                                                                           ($486,000)




Page 266                                                   CMA Ontario – September 2009
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Problem 7

a) If the service contract does not extend beyond the current period, it is properly
   included in repair and maintenance expense. If the service contract does extend
   beyond the current period, then the portion of the contract price related to future
   periods should be recorded as a prepaid expense and amortized to repair and
   maintenance expense over the periods benefited. In either case, the cost of the service
   contract should not be added to the cost of the assets to which the contracts apply,
   because the contracts do not enhance the future service potential of the assets.

b) The design fee should not be recorded as repair and maintenance expense. The fee is
   a capital expenditure which should be recorded as a part of the cost of the building
   addition. It is a necessary expenditure to provide future benefits from the building
   addition.

c) The cost of the new condenser should be capitalized and depreciated over its useful
   life. The old condenser should be derecognized.

d) The cost of the furniture should not be recorded as repair and maintenance expense.
   The desks and chairs have future service potential. Therefore, the cost is a capital
   expenditure and should be recorded as an asset, furniture and fixtures, and
   depreciated over the useful life of the furniture.

e) The cost of the storms and screens should not be recorded as repair and maintenance
   expense. The implication from the problem wording is that there were no storms and
   screens prior to this expenditure. Thus, the storms and screens constitute an
   improvement to the office building. Future service potential has been added to the
   building. The capital expenditure should be recorded as a part of the cost of the office
   building and depreciated over the remaining life of the building.

f) The cost of sealing the roof leaks is properly recorded as repair and maintenance
   expense. It is a revenue expenditure because it does not enhance the service potential
   of the plant. The expenditure merely enables the entity to obtain the originally
   anticipated service potential of the plant.

g) The cost of the new door should be capitalized and depreciated over its useful life.
   The old door should be derecognized.

h) The installation of the automatic door opening system constitutes an improvement,
   because it enhances the efficiency of the plant, thereby providing future service
   potential. Assuming the door opener will last beyond the current period, the cost
   should be capitalized and depreciated over its useful life.

i) The cost of the overhead crane should not be recorded as repair and maintenance
   expense. The crane enhances the service potential of the plant and therefore



Page 267                                                        CMA Ontario – September 2009
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    constitutes a capital expenditure. The cost should be capitalized and depreciated over
    the useful life of the crane.

j) The cost of the new gear should be capitalized and depreciated over its useful life.
   The old gear should be derecognized.


Problem 8

If all of the shell houses are to be sold at the same price, it may be appropriate to
depreciate the costs of the display houses on the basis of the number of shell houses sold.
This method would be similar to the units-of-production method of depreciation and
would result in proper matching of costs with revenues. The success of this method is
dependent upon accurate estimates of the number and selling price of shell houses to be
sold.

Depreciation based upon the passage of time may be preferable when the life of the
models can be estimated with a great deal more accuracy than can the number of units
which will be sold. If unit sales and selling prices are uniform over the life of the display
house, a satisfactory matching of costs and revenues may be achieved using this straight-
line procedure.


Problem 9

Accumulated Depreciation – Buildings                              $300,000
  Buildings                                                                         $300,000

Building                                                           100,000
  Revaluation Surplus (OCI)                                                          100,000

Accumulated Depreciation – Equipment                               180,000
  Equipment                                                                          180,000

Equipment                                                           30,000
  Revaluation Gain (I/S)                                                              20,000
  Revaluation Surplus (OCI)                                                           10,000




Page 268                                                         CMA Ontario – September 2009
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Problem 10

Jan 2, 20x1       Building                                             $600,000
                    Cash                                                             $600,000

Dec 31, 20x1      Depreciation expense                                    16,000
                    Accumulated depreciation                                           16,000
                  ($600,000 – 120,000) / 30

                  Accumulated depreciation                                16,000
                    Building                                                           16,000

                  Building                                                12,000
                    Revaluation Surplus (OCI)                                          12,000
                  Note: book value of building becomes
                  $596,000

Dec 31, 20x2      Depreciation expense                                    16,414
                    Accumulated depreciation                                           16,414
                  ($596,000 – 120,000) / 29

                  Accumulated depreciation                                16,414
                    Building                                                           16,414
                  Book value of building becomes: $596,000 –
                  16,414 = $579,586

                  Revaluation surplus (OCI)                               12,000
                  Revaluation loss (I/S)                                  17,586
                     Building                                                          29,586
                  This will bring the book value of the building
                  to: $579,586 – 29,586 = $550,000 (its
                  appraisal value)




Page 269                                                           CMA Ontario – September 2009
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Dec 31, 20x3      Depreciation expense                                15,357
                    Accumulated depreciation                                       15,357
                  ($550,000 – 120,000) / 28

                  Accumulated depreciation                            15,357
                    Building                                                       15,357
                  Book value of building becomes: $550,000 –
                  15,357 = $534,643

                  Building                                            30,357
                    Revaluation Gain* (I/S)                                        17,357
                    Revaluation Surplus (OCI)                                      13,000

Jan 2, 20x4       Cash                                              560,000
                  Revaluation Surplus (OCI)                          13,000
                  Loss on disposal of building                        5,000
                    Building                                                      565,000
                     Retained Earnings                                             13,000

* the credit to income is reduced by the amount of the deficit previously charged to
income as a lower depreciation charge for 20x1, 20x2 and 20x3: the total depreciation
expense for the years 20x1 - 20x3 was $16,000 + 16,414 + 15,357 = $47,771. This is
compared to the total depreciation charge had the historical cost model been used of
$48,000. Because the actual cumulative depreciation charge of $47,771 is lower than
what it would had been using the historical cost model, the credit to the income statement
is reduced by the difference: $17,586 - (48,000 - 47,771) = $17,357.




Page 270                                                       CMA Ontario – September 2009
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Problem 11

(a)     Land

Dec 31, 20x4       Revaluation Surplus - Land           $200,000
                     Land                                                $200,000

Dec 31, 20x5       Land                                  500,000
                     Revaluation Surplus – Land                           500,000

Buildings

Dec 31, 20x3       Depreciation expense                  224,000
                     Accumulated depreciation                             224,000
                   $5,600,000 / 25

Dec 31, 20x4       Depreciation expense                  224,000
                     Accumulated depreciation                             224,000

                   Accumulated depreciation              448,000
                     Buildings                                            448,000

                   Revaluation Surplus – Buildings       300,000
                   Revaluation Loss (I/S)                252,000
                     Buildings                                            552,000

Dec 31, 20x5       Depreciation expense                  200,000
                     Accumulated depreciation                             200,000
                   $4,600,000 / 23

Dec 31, 20x6       Depreciation expense                  200,000
                     Accumulated depreciation                             200,000

                   Accumulated depreciation              400,000
                     Buildings                                            400,000

                   Buildings                             300,000
                     Revaluation gain (I/S)                               252,000
                     Revaluation surplus – Buildings                       48,000




Page 271                                               CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 12

1.    LAND
      Beginning balance                                                            $500,000
      Add: Site number 621                                        $1,000,000
             Real estate commission (621)                             60,000
              Clearing costs (621)                                    15,000
              Site number (622)                                      300,000
              Demolition (622)                                        30,000      1,405,000a
      Deduct: Residual (621)                                                         (5,000)
      Ending balance                                                             $1,900,000
      a
        The cost of Site 623 is included as ‘Land held for sale’ because it is
      held for re-sale.

2.    BUILDINGS
      Beginning balance                                                           $ 900,000
      Add: Construction costs (site 622)                            $150,000
            Excavation fees (622)                                     11,000
            Architectural fees (622)                                   8,000
            Building permit (622)                                      1,000
             Interest (622)                                            6,000        176,000
      Ending balance                                                             $1,076,000

3.    LEASEHOLD IMPROVEMENTS
      Beginning balance                                                           $400,000
      Add: Electrical work (leased building)                        $35,000
              Extension to leased building ($80,000 x 50%)           40,000
              Improvements to leased offices                         65,000        140,000c
      Ending balance                                                              $540,000
      c
        The cost of painting the ceilings is a normal maintenance expenditure and thus
      must be expensed as incurred.

4.             MACHINERY AND EQUIPMENT
      Beginning balance                                                          $500,000
      Add: Cost of new machines                                     $75,000
              Freight on new machines                                  2,000
              Handling charges, new machines                           1,500       78,500d
      Ending balance                                                             $578,500
      d
        The royalty payments are not costs associated with getting the machines ready to
      use. They must be expensed as incurred.




Page 272                                                         CMA Ontario – September 2009
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Problem 13

A. The six transactions should be presented on Illini Technologies' December 31, 20x0,
   financial statements in the following manner.

(1) The patent for the landing gear system should appear on Illini's Statement of
    Financial Position at cost less ten months of amortization.

              Cost                                    $75,000
              Amortization
              ($75,000 / 6) x 10/12                    10,417
                 Book value                           $64,583

The Income Statement presentation for this patent should include $10,417 of amortization
expense and $2,250 of interest expense ($75,000 x .06 x 6/12).

(2) This patent should appear on the Statement of Financial Position at cost less six
    months of amortization.

              Cost                                  $104,800
              Amortization
              ($104,800 / 10) x 6/12                    5,240
                 Book value                           $99,560

        The Income Statement presentation for this patent should include $5,240 of
        amortization expense. All research and development costs should be expensed in
        the year in which they occur unless the criteria for capitalization of development
        costs have been met.

(3)     There should be no patent costs reflected on the company's Statement of Financial
        Position as the patent application was denied. The filing fees of $34,950 should be
        expensed on the current Income Statement.

(4)     The three patents determined to have no future value should no longer appear on
        the company's Statement of Financial Position. The Income Statement should
        include the write-off of $171,255 for these patents.

        The patent account on the Statement of Financial Position should include $20,350
        ($40,700 / 2) for the patent with the revised useful life. Patent amortization on the
        Income Statement should include $20,350 for this patent.

(5)     Since the lawsuit was successful, the legal fees of $51,000 should be capitalized
        and included on Illini's Statement of Financial Position. In general, the total costs
        expended to establish the validity of a patent can be capitalized; however, the
        previously expensed $380,000 should not be capitalized. The expensing was not


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         the result of an error but was a properly recorded estimate at the time, and
         changes in estimates must be accounted for prospectively.

(6)      The $103,260 reported by Savey Company should be reported as revenue on
         Illini's Income Statement and as License Fees Receivable on the company's
         Statement of Financial Position.

B. Factors that should be considered when determining the useful life of a patent include
   the following.

•     Consideration should be given to factors that may cause a patent to become
      economically ineffective, e.g., obsolescence due to changing technology.

•     The maximum life of a patent cannot exceed its legal life of 17 years.




Page 274                                                         CMA Ontario – September 2009
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Problem 14

a) The estimated lives of the trucks need not be the same for depreciation purposes. The
   depreciation process is one of allocating the cost of the asset to the periods of its use.
   The useful life to each company will depend upon the planned intensity of use,
   maintenance policy, and the retirement policy. There is no reason to believe that each
   company would be identical with respect to these considerations.

b) The methods by which each company chooses to allocate the cost of the assets might
   also be different. The allocation over the useful life should be reasonable and orderly.
   Depreciation seeks to measure realistically the expiration of the asset; i.e., the pattern
   of services consumed during the period. The problem is that this is not observable.
   Therefore, firms are free to select from among the methods allowed. Each will select
   what it feels is most appropriate for reporting purposes, and these need not be the
   same.

c) The asset should be recorded at the cash and/or cash equivalent given up to acquire it
   according to the cost principle. In this instance, cost will be cash plus the fair market
   value of the truck traded in.

     Cost = $9,000 + $4,500 = $13,500

d)
           Automotive equipment                         $13,500.00
           Accumulated depreciation                       5,584.50
                Automotive equipment                                     $8,500.00
                Cash                                                      9,000.00
                Gain on trade of equipment                                1,584.50




Problem 15

                                                                      Land         Building
Purchase of lot                                                   $100,000
Demolition                                                            8,000
Sale of building stone                                              (1,500)
Legal fees                                                            1,300
Land survey fees                                                        600
Factory plans                                                                     $ 25,000
Contract price                                                                     950,000
Foreman's salary ($24,000 x 4/12)                                                    8,000
Insurance                                                                              600
                                                                  $108,400        $983,600



Page 275                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 16

a)                                                     Land         Building
       Cost of land with existing building         $860,000
       Architect fees                                              $130,000
       Interest on construction financing                           130,000
       Cost to demolish the old building              40,000
       Proceeds on sale of materials                 (8,000)
       Payment of delinquent taxes                    15,000
       Land survey fees                                6,000
       Cost of new building                                       1,200,000
       Liability insurance during construction                        5,000
                                                   $913,000      $1,465,000

       The moving costs would be expensed.

b)     ($1,465,000 – 200,000) / 50 x 1/12                            $2,108




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Problem 17

1.    a.    20x5: $50,000 /10 x                                                     $2,500

            20x6: 20x5 Acquisitions: $43,000 / 10                                   $4,300
                                    $7,000 / 10 x                                      350
                  20x6 Acquisitions: $20,000 / 10 x                                  1,000
                                                                                    $5,650

      b.    20x5: $50,000 x 20% x                                                   $5,000

            20x6: 20x5 Acquisitions: $38,700* x 20%                                $7,740
                                    $6,300* x 20% x 1/2                               630
                  20x6 Acquisitions: $20,000 x 20% x 1/2                            2,000
                                                                                  $10,370

            *  Ending balance on $43,000 of assets acquired in 20x5 = $43,000 x .9 =
               $38,700 (i.e. the depreciation in the first year is 10%, the ending net book
               value of the asset is the acquisition cost times one minus the depreciation
               rate)
            ** $7,000 x .9 = $6,300

2.    Cash                                                           $4,000
      Accumulated amortization $350 x 2                                 700
      Loss on disposal of equipment                                   2,300
        Equipment                                                                   $7,000


Problem 18

Net book value of equipment at January 1, 20x6
= $500,000 x (1 - .25)5 = $118,652

Amortization in 20x6 = lesser of:
•     $118,652 x 25% = $29,663
•     $118,652 – 100,000 Salvage Value = $18,652
=>                                                                                $18,652




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9.      Liabilities

A liability is defined s a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits (IAS 37.10).


Current Liabilities

An entity should classify a liability as current when (IAS 1.69):
•      it expects to settle the liability in the entity's normal operating cycle,
•      it holds the liability primarily for the purpose of trading,
•      the liability is due to be settled within twelve months after the reporting period, or
•      the entity does not have an unconditional right to defer settlement of the liability
       for at least twelve months after the reporting period.


Accounts Payable and Accrued Liabilities

Accounts payable are those debts to suppliers that arise from the normal purchasing
activities of the company.

Accrued liabilities are typically not legally payable at the financial statement date but will
become payable later. For example, if the electrical utility takes meter readings on the
15th of every month, an estimate of electricity usage to the end of the fiscal period will
usually be made.

Other types of current liabilities include: provisions, notes payable (the accounting
thereof is similar to notes receivable), customer deposits, income taxes payable,
vacation/sick pay payable, and current portion of long-term debt.


Provisions

A provision is to be recognized as a liability when all of the following three criteria are
met:
•      the entity has a present obligation (legal or constructive) as a result of a past
       event;
•      it is probable that an outflow of resources embodying economic benefits will be
       required to settle the obligation; and
•      a reliable estimate can be made of the amount of the obligation (IAS 37.14).

If all of the above criteria are not met, then no recognition can take place. Provisions
differ from other liabilities such accounts payables and accrued liabilities because there is
uncertainty about the timing or amount of the future expenditure. Consequently,


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provisions should be reported separately from accounts payable and accrued liabilities
(IAS 37.11).

A past event is deemed to give rise to a present obligation ig, taking account of all
available evidence, it is more likely than not that a present obligation exists at the end of
the reporting period (IAS 37.15).

A legal obligation is an obligation that derives from:
•      a contract,
•      legislation, or
•      other operation of law (IAS 37.10).

A constructive obligation is an obligation that derives from an entity's actions where:
•      by an established pattern of past practice, published policies of a sufficiently
       specific current statement, the entity has indicated to other parties that it will
       accept certain responsibilities; and
•      as a result, the entity has created a valid expectation on the part of those other
       parties that it will discharge those responsibilities (IAS 37.10).

Examples of constructive obligations:
-     the entity announces that they will provide an additional one year warranty
      beyond the three year contractual warranty;
-     the right to return merchandise, although not legally required, is published as a
      policy on the firm's website; and
-     the entity publishes its environmental policy with goes beyond what is legally
      required of them.

A provision is measured as the best estimate of the expenditure required to settle the
present obligation at the end of the reporting period (IAS 37.36). If the range of outcomes
is discrete, i.e. if the provision involves several estimates, the obligation is estimated by
calculating the expected value. If the range of outcomes is continuous, and each point in
that range is as likely as any other, the mid-point of the range is used (IAS 37.39).

Example4: an entity in the oil industry causes contamination and operates in a country
where there is no environmental legislation. However, the entity has a widely published
environmental policy in which it undertakes to clean up all contamination that it causes
and has a record of honouring this published policy. The estimates for the costs of
cleaning up this contamination along with the associated probabilities are as follows:




4 this is an adaptation of Example 2B of Appendix C of IAS 37.


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                     Cost          Probability
                $400,000                 0.10
                 500,000                 0.30
                 600,000                 0.45
                 700,000                 0.09
                 800,000                 0.06

This is a provision because:
•       the entity has a constructive obligation to decontaminate the land; and
•       the outflow of resources is probable

The provision would be recorded at its expected value of $571,000.

        ($400,000 x 10%) + ($500,000 x 30%) + ($600,000 x 45%)
               + ($700,000 x 9%) + ($800,000 x 6%)
        = $571,000

If the range of possible outcomes ranges from $400,000 to $800,000 as a continuous
range (i.e. no estimate is better than the other), then we would accrue the mid-point, or
$600,000.

Of course, this assumes that the provision would need to be settled in the near future. If
the expenditures resulting from this provision are expected to be incurred in several years
from now and that the effect of time value of money is material, then the amount has to
be discounted (IAS 37.45). The discount rate to be used is the pre-tax rate that reflects
current market assessments of the time value of money and risks specific to the liability
(IAS 37.47).

Example: assume the same facts as in the previous example and that it is expected that
these expenditures will be incurred in 15 years. At a discount rate of 6%, the present
value of the provision is

                              N          I/Y        PV         PMT          FV
           Enter              15          6                               571,000
           Compute                                 X=
                                                 $238,258

If the difference between the undiscounted amount of $571,000 and the discounted
amount of $238,258 is material, then we have to accrue the discounted amount. The
provision would then be treated as decommissioning cost.

A provision can only be used for expenditures for which the provision was originally
recognized (IAS 37.61).

Specific examples of provisions are expense warranties and premiums.

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Expense Warranties

An expense warranty is an undertaking by a vendor to maintain and repair a product or
service. For example, a new car is usually sold with a warranty that contains some
distance limits. According to the revenue recognition criteria, the cost of the warranty
should be charged to the period in which the profit on the sale is recognized. Usually
much of the warranty work is done in accounting periods following the sale. Thus, the
estimated cost of the warranty is recorded in the year of sale through the following
journal entry:

Dr. Warranty expense
      Cr. Warranty Liability

When warranty work is actually done, it is charged against this liability account:

Dr. Warranty Liability
      Cr. Cash, Accounts Payable

Example: Company X provides a 3 year warranty on all of the products it sells. Sales for
the current year were $3,000,000 and it is estimated that the warranty expense is equal to
5% of sales. The warranty liability at the beginning of the year was $165,000 and actual
costs incurred to service warranties during the year amounted to $130,000.

The journal entry to record warranty expense is:

Warranty expense ($3,000,000 x 5%)                                 $150,000
 Warranty Liability                                                                  $150,000

The journal entry to record actual warranty costs incurred is:

Warranty Liability                                                  130,000
 Cash                                                                                 130,000

The warranty liability at the end of the year will be $165,000 Opening Balance + 150,000
Warranty Expense
                 – 130,000 Warranty Costs Incurred = $185,000.

Premiums

A premium liability arises when a company offers its customers redeemable coupons,
frequent flyer points or any program whereby the customer can receive something of
value in the future based on current purchases. Like warranties, the matching principle
requires that the premium expense accrued in a given year be properly matched to its
revenues. The accounting for premiums is very similar to that of warranties.




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Example – for every dollar of revenue, you give your customers one coupon. They can
then redeem 10,000 coupons to receive a gizmo that is valued at $50. You estimate that
only 60% of coupons will be redeemed. Your sales for the year amount to $5,600,000,
the opening balance in the premium liability was $15,000 and 4,800,000 coupons were
redeemed.

The journal entry to record the premium expense is:

Premium expense ($5,600,000 / 10,000 x $50 x 60%)                   $16,800
  Premium Liability                                                                   $16,800

The journal entry to record actual premium costs incurred is:

Premium Liability (4,800,000 / 10,000 x $50)                          24,000
  Cash                                                                                 24,000

The premium liability at the end of the year will be $15,000 Opening Balance + 16,800 Premium
Expense
        – 24,000 Premium Rewards Incurred = $7,800.

Note that the premium expense is not shown as part of expenses on the Statement if
Income, but as a reduction of sales (IFRIC 13).


Disclosure Requirements - Provisions

For each class of provision, the following has to be disclosed:
•      the carrying amount at the beginning and end of the period;
•      additional provisions made in the period, including increases to existing
       provisions;
•      amounts used (i.e. incurred and charged against the provision) during the period;
•      unused amounts reversed during the period;
•      the increase during the period on the discounted amount arising from the passage
       of time and the effect of any change in the discount rate;
•      a brief description of the nature of the obligation and the expected timing of any
       resulting outflows of economic benefits;
•      an indication of the uncertainties about the amount and timing of those outflows;
       and
•      the amount of the any expected reimbursement, stating the amount of any asset
       that has been recognized for that expected reimbursement (IAS 37.84:85).




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Sales Warranties

In addition to providing warranties that come with products, some manufacturers/retailers
often sell extended warranties. The accounting for the expense warranty (the one that
comes with the product) was explained above. The accounting for the sales warranty is as
follows:
•       on date of sale, the sale warranty is recorded as unearned revenue:

                dr. Cash
                       Cr. Unearned sales warranty revenue

•       as the sales warranty period progresses, the sales warranty is earned:

                dr. Unearned sales warranty revenue
                       cr. Sales warranty revenue

•       as expenses are incurred under the sales warranty, they are simply charged to
        expense:

                dr. Sales warranty expense
                        cr. Cash or Accounts Payable

Note that we accrue the sales warranty revenue over the life of the sales warranty.
However, unlike expense warranties, warranty expense is not accrued but expensed as
incurred.

Example – assume that you sell a product that comes with a one year warranty. In
addition, you provide your customers an optional two year extended warranty. The
product sells for $1,000, you estimate that the warranty costs will equal to 2% of sales on
average. The extended warranty costs the customer $120.

The journal entries to record the sale of product and extended warranty on January 2,
20x2 are as follows. Assume a calendar year end and that the product is returned for
repairs on September 15, 20x2 at a cost of $30 and on July 23, 20x4 at a cost of $160.

Jan 2, 20x2      Cash ($1,000 + 120)                                   $1,120
                   Sales                                                            $1,000
                   Unearned sales warranty revenues                                    120

                 Warranty expense ($1,000 x 2%)                            20
                  Warranty liability                                                     20

Sep 15, 20x2     Warranty liability                                        30
                  Cash                                                                   30




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Dec 31, 20x3     Unearned sales warranty revenues                             60
                   Sales warranty revenues                                                    60
                 (Note that the accrual could be on a monthly
                 basis)

Jul 23, 20x4     Sales warranty expense                                     160
                   Cash                                                                    160

Dec 31, 20x4     Unearned sales warranty revenues                             60
                   Sales warranty revenues                                                    60


Contingent Liabilities and Contingent Assets

A contingent liability is defined as:
•      a possible obligation that arises from past events and whose existence will be
       confirmed only by the occurrence or non-occurrence of one of more uncertain
       future events not wholly within the control of the entity; or
•      a present obligation that arises from past events but is not recognized because:
       -       it is not probable that an outflow of resources embodying economic
               benefits will be required to settle the obligation; or
       -       the amount of the obligation cannot be measured with sufficient reliability
               (IAS 37.10).

Contingent liabilities are not recognized (IAS 37.27). Unless the possibility of any
outflow in settlement is remote, an entity shall disclose for each class of contingent
liability a brief description of the nature of the contingent liability and, where practicable,
•        an estimate of the financial effect;
•        an indication of the uncertainties relating to the amount or timing of any outflow;
         and
•        the possibility of any reimbursement.

Appendix A of the standard provides the following table which outlines the key
differences between provisions and contingent liabilities:

There is a present                There is a possible            There is a possible
obligation that probably          obligation or a present        obligation or a present
requires an outflow of            obligation that may, but       obligation where the
resources.                        probably will not, require     likelihood of an outflow of
                                  an outflow of resources.       resources is remote.
A provision is recognized.        No provision is recognized.    No provision is recognized.
Disclosures are required for      Disclosures are required for   No disclosure is required.
the provision.                    the contingent liability.



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Contingent Assets

A contingent asset arises from an unplanned or other unexpected event that gives rise to
the possibility of an inflow of economic benefit to the entity. For example, a claim that an
entity is pursuing through the legal system, where the outcome is uncertain.

Contingent assets cannot be recognized since this may result in the recognition of income
that may never be realized (IAS 37.31 and 37.33). If an inflow of economic benefit is
probable, contingent assets must be disclosed in the notes to the financial statements (IAS
37.34).


Accounting for Bonds Payable

A bond is a legal document giving evidence of a contractual obligation by a company,
starting at a time referred to as the inception date, to

(i)     redeem the bond for a stated amount (the face amount or par value) at some stated
        time in the future called the maturity date and
(ii)    make periodic interest payments during the term of the bond.

These interest payments are normally stated as a percentage of the face amount, and this
percentage is termed the coupon rate (or stated rate). The length of time between the
inception and maturity dates is known as the term of the bond. Bonds may be secured by
the pledge of specific assets of the company, such as land and buildings, in which case
they are referred to as mortgage bonds. If there is no pledge of specific assets but rather a
general charge against all assets, the bonds are referred to as debentures.

The legal terms of the bond are very important because the sums borrowed are often very
large (e.g., $25 million). Moreover, as any given issue is often widely held, renegotiation
of the terms is usually expensive and difficult. The terms of the bond issue are set out in a
trust indenture, which is a legal agreement between the issuing company and a trust
company acting on behalf of the bondholders. The trust company is referred to as the
bond trustee. It is the bond trustee's duty to see that the issuing company lives up to the
terms of the trust indenture and to take whatever steps are necessary to protect the
bondholders (ie., seize the assets given as security for the bond issue).

Here is an example of a straightforward bond issue. On July 1, 20x1, Gamma
Corporation issued bonds with a face value of $500,000 and a coupon rate of 10%. The
bonds pay interest semi-annually on January 1 and July 1 and are due in five years. If the
bonds were sold for their face amount, they would be selling at par value; if less than
their face amount, they would be selling at a discount; and if more than their face value,
they would be selling at a premium.




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Assume that the going market interest rate for similar bonds on July 1, 20x1 is 8%.
Because the Gamma bonds pay a higher amount of interest, investors will be willing to
pay more for these bonds and will purchase them at a premium. The bonds will sell for
the discounted value of the bond's cash flow. The cash flows are discounted at the market
rate of interest. Note also that because the interest is paid semi-annually, that we are
dealing with semi-annual amortization.

The value of the bond issue will be as follows:

                              N        I/Y          PV        PMT            FV
           Enter              10        4                     25000        500000
           Compute                                  X=
                                                  540,554

The journal entry to record the issuance of these bonds is as follows:

July 1, 20x1      Cash                                              $540,554
                    Bonds payable                                                   $540,554

On January 1, 20x2, the first interest payment is made to bondholders of $25,000
($500,000 x 10% x 1/2). However, because the firm is effectively paying 8% interest on
these bonds (the market rate), the interest expense will be lower than $25,000. The
difference will be handled through the amortization of the premium on bonds payable
($540,554 Proceeds – 500,000 Face Value = $40,554). This premium will be amortized and
reduce the balance of the bonds payable to $500,000 by the end of the bond term.
The method used to account for the amortization of the discount or premium on bonds is
called the effective interest method. The journal entry to record the interest payments is
as follows:

Jan 1, 20x2       Bonds payable                                          $3,378
                  Interest expense (540,554 x 4%)                        21,622
                     Cash                                                             25,000

Note that the amount of interest expense is calculated directly and that the amount of the
premium on bonds payable is imputed as Cash - Interest expense. The interest expense is
calculated as the carrying value of the bond times the market rate of interest.

The journal entry to record the interest payment of July 1, 20x2 would be as follows:

Jul 1, 20x2       Bonds                                                  $3,513
                  Interest expense (540,554 - 3,378) x 4%                21,487
                     Cash                                                             25,000

If we now assume that the going rate of interest at the time of issue is 14%, then the
bonds would sell at a discount since investors want to be compensated for the fact that the
bonds are paying a coupon rate of only 10%.


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The value of each $1,000 bond will be as follows:

                              N         I/Y         PV         PMT           FV
           Enter              10         7                     25000       500000
           Compute                                  X=
                                                  429,764

The journal entry to record the issuance of the bonds would be as follows:

July 1, 20x1      Cash                                               $429,764
                    Bonds payable                                                   $429,764

The journal entry to record the first interest payment if the straight-line method of
amortization is used is as follows:

Jan 1, 20x2       Interest expense                                     $32,024
                     Bonds payable ($70,236 ÷ 10)                                        7,024
                     Cash                                                               25,000

Note that the interest expense is higher because the firm is effectively paying 14%
interest even though they are paying coupon payments of 10% of the face value.

The journal entry to record the first two interest payments if the effective interest method
of amortization is used is as follows:

Jan 1, 20x2     Interest expense (429,764 x 7%)                        $30,083
                   Bonds payable                                                         5,083
                   Cash                                                                 25,000

Jul 1, 20x2     Interest expense (429,764 + 5,083) x 7%                $30,439
                   Bonds payable                                                         5,439
                   Cash                                                                 25,000

Accounting for bonds can be summarized as follows:

1.      On date of issue, we calculate the present value of the bonds by discounting the
        coupon payments and face value at the yield to maturity (market interest rate). If
        the resulting amount is less than the face value of the bonds, then the bonds have
        issued at a discount. If the resulting amount is higher than the face value of the
        bonds, then the bonds have issued at a premium. The journal entry to record the
        bond issue is as follows:

               Cash                                          XXX
                 Bonds Payable                                        XXX



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2.      On coupon payment dates, we record the interest expense using the effective
        interest method. The interest expense is equal to the book value of the bonds
        payable times the yield to maturity. Since bonds pay coupons semi-annually, the
        yield to maturity rate must be divided by two. The difference between the interest
        expense and the coupon paid is equal to the amortization of the bond premium or
        discount and gets recorded directly to the Bonds Payable Account.

        If the bonds were issued at a discount, the journal entry would be as follows:

              Interest expense                                XXX
                 Bonds Payable                                        XXX
                 Cash                                                 XXX

        If the bonds were issued at a premium, the journal entry would be as follows:

              Interest expense                                XXX
              Bonds Payable                                   XXX
                 Cash                                                 XXX

3.      If the coupon payment date does not coincide with the company’s year-end, then
        interest on the bond issue must be accrued at year end.

        The accrued interest = book value of bonds payable x YTM x prorata for time
        since last coupon payment date

        The journal entry would be as follows (note that this journal entry would be
        reversed at the beginning of the next period):

              Interest expense                                XXX
                 Interest Payable                                     XXX

4.      If the bonds are redeemed before the maturity date of the bonds, we must first
        calculate the book value of the bonds and then remove these from the books. Any
        difference between the cash paid to retire the bonds and the book value of the
        bonds retired gets debited/credited to loss/gain on redemption of bonds payable.

        If the bonds are retired at a loss, the journal entry would be as follows:

              Bonds Payable                                   XXX
              Loss on retirement of Bonds Payable             XXX
                Cash                                                  XXX




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Example: In order to finance a major expansion program, Aughey Ltd. issued bonds
dated May 31, 20x5, on July 2, 20x5, with a face amount of $3,000,000 and a coupon rate
of 10%. Interest is payable on November 30 and May 31. The bonds were issued to
yield 12% plus accrued interest and mature in twelve years. Aughey Ltd. uses the
effective interest rate method.

Assume that the company retires $900,000 face amount of the bonds on September 30,
20x8, at 97 plus accrued interest. The fiscal year end of Aughey Ltd. is December 31.

The proceeds received on the bond issue will equal to:

        1.      The present value of the bond issue:

                              N        I/Y         PV         PMT         FV
           Enter              24        6                    150000     3000000
           Compute                                 X=
                                                2,623,489

        2.      The accrued coupon payments received by bondholders:
                       = $3,000,000 x 10% x 1/12 = $25,000

The journal entry to record the bond issue on July 2, 20x5 will be:

Jul 2, 20x5       Cash                                          $2,648,489
                    Interest expense                                              $25,000
                    Bonds payable                                               2,623,489




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The journal entries for 20x5 to May 31, 20x6 and the journal entry to record the
retirement of the bonds on September 30, 20x8 will be:

Nov 30, 20x5      Interest expense ($2,623,489 x 6%)             $157,409
                     Bonds payable                                                   7,409
                     Cash                                                          150,000

Dec 31, 20x5      Interest expense                                  26,309
                     Interest payable                                               26,309
                  ($2,623,489 + 7,409) x 6% x 1/6
                  = $2,630,898 x 6% x 1/6

Jan 1, 20x6       Interest payable                                  26,309
                     Interest expense                                               26,309

May 31, 20x6      Interest expense ($2,630,898 x 6%)              157,854
                     Bonds payable                                                   7,854
                     Cash                                                          150,000

In order to prepare the journal entry for the bond redemption on September 30, 20x8, we
need to calculate the book value of the bonds payable at May 31, 20x8 (the most recent
interest payment date).

Book value of bonds payable = the present value of the remaining cash flows at the
original yield to maturity

                              N         I/Y         PV         PMT        FV
           Enter              18         6                    150000    3000000
           Compute                                X=
                                               2,675,172

The first thing we need to do is accrue interest expense on these bonds to September 30,
20x8:

Sep 30, 20x8      Interest expense ($2,675,172 x 6% x 4/6)        107,007
                     Bonds payable                                                   7,007
                     Interest payable ($150,000 x 4/6)                             100,000

This brings the book value of the bonds payable at: $2,675,172 + 7,007 = $2,682,179

We will have to pay the bondholders 4 months coupon:
      $900,000 x 5% x 4/6 = $30,000

Sep 30, 20x8     Interest payable                                   30,000
                    Cash                                                            30,000
The entry to record the redemption of the bonds payable is:


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Sep 30, 20x8      Bonds payable ($2,682,179 x 900/3,000)            804,654
                  Loss on redemption of bonds payable                68,346
                    Cash ($900,000 x .97)                                           873,000


Bond Issue Costs

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


Events after the reporting period

Events after the reporting period are events arising between the end of the reporting
period and the date the financial statements are authorized to be issued.

There are two types of subsequent events:
•      adjusting events after the reporting period - those which provide further evidence
       of conditions which existed at the financial statement date - these will result in an
       adjustment to the financial statements, and
•      non-adjusting events after the reporting period - those which are indicative of
       conditions which arose subsequent to the financial statement date that do not
       provide further evidence of conditions which existed at the financial statement
       date - if material, these have to be disclosed in the notes to the financial
       statements (IAS 10.3)

Examples of adjusting events after the reporting period:
•     institution of bankruptcy proceedings against a debtor - you may have to revise
      the allowance for doubtful accounts;
•     a long-term investment in which you hold a significant influence announces its
      worst annual results since inception - you may have to determine whether a write-
      down is required;
•     a court case confirms the existence of a previously recorded provision or a
      previously disclosed contingent liability.

Examples of non-adjusting events after the reporting period:
•     an event such as a fire or flood which results in a loss;
•     purchase of a business;
•     commencement of litigation where the cause of action arose subsequent to the
      date of the financial statements;
•     changes in foreign currency exchange rates;
•     the issue of capital stock or long term debt.

Financial statements should be adjusted when events occurring between the date of the
financial statements and the date the financial statements are authorized to be issued since


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these provide additional evidence relating to conditions that existed at the date of the
financial statements (IAS 10.8).

Disclosure Requirements

If non-adjusting events after the reporting period are material, non-disclosure could
influence the economic decisions that users make on the basis of the financial statements.
Accordingly, an entity shall disclose the following for each material category of non-
adjusting event after the reporting period:
•       the nature of the event, and
•       an estimate of its financial effect, or a statement that such an estimate cannot be
        made (IAS 10.21).




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Problems with Solutions

Multiple Choice Questions

1.      Robb Company requires advance payments with special orders from customers or
        machinery constructed to their specifications. Information for 20x5 is as follows:

                Customer advances - balance December 31, 20x4                   $295,000
                Advances received with orders in 20x5                            460,000
                Advances applied to orders shipped in 20x5                       410,000
                Advances applicable to orders cancelled in 20x5                  125,000

        At December 31, 20x5, what amount should Robb report as a current liability for
        customer deposits?
        a.    $0.
        b.    $220,000.
        c.    $345,000.
        d.    $370,000.

2.      Cobb Company sells appliance service contracts to repair appliances for a two
        year period. Cobb's past experience is that, of the total amount spent for repairs on
        service contracts, 40% is incurred evenly (per month) during the first contract
        year and 60%, evenly during the second contract year. Receipts from service
        contract sales for the two years ended December 31, 20x5, are $500,000 in 20x4
        and $600,000 in 20X5. Receipts from contracts are credited to unearned service
        contract revenue. Assume that all contract sales are made evenly (per month) the
        during the year. What amount should Cobb report as unearned service contract
        revenue at December 31, 20x5?
        a.      $360,000.
        b.      $470,000.
        c.      $480,000.
        d.      $630,000.




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3.      Farr Company sells its products in expensive, reusable containers. The customer
        is charged a deposit for each container delivered and receives a refund for each
        container returned within two years after the year of delivery. Farr accounts for
        the cash received for containers not returned within the time limit as a sale at the
        deposit amount when the time limit expires. Information for 20x5 is as follows:

        Containers held by customers at December 31, 20x4, from deliveries in:

            20x3                                                    $ 75,000
            20x4                                                     215,000
                                                                    $290,000

        Containers delivered in 20x5                                $390,000

        Containers returned in 20x5, from deliveries in:
           20x3                                               $ 45,000 (Eligible for refund)
           20x4                                                      125,000
           20x5                                                      143,000
                                                                    $313,000

        What amount should Farr report as a liability for returnable containers at
        December 31, 20x5?
        a.    $247,000.
        b.    $322,000.
        c.    $337,000.
        d.    $367,000.


4.    Bonds due in 5 years were sold at $104,158 on January 1 to yield an effective
      interest rate of 7% compounded semiannually. Face value of the bonds is $100,000
      and the annual coupon rate is 8%. Cash interest is paid semiannually. What is the
      interest expense for the first 6-month period using the effective interest method?
      a.    $3,500.
      b. $3,646.
      c.    $3,584.
      d. $4,166.
      e.    $4,416.




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5.    The 10% bonds payable of Issac Company had a net carrying amount of $760,000
      on January 2, 20x3. The bonds, which had a face value of $800,000, were issued at
      a discount to yield 12%. The amortization of the bond discount was recorded under
      the effective interest method. Interest was paid on January 1 and July 1 of each
      year. On July 2, 20x3, several years before their maturity, Issac retired the bonds at
      102. The interest payment on July 1, 20x2 was made as scheduled. What is the loss
      that Issac should record on the early retirement of the bonds on July 2, 20x3?
      Ignore taxes.
      a) $16,000
      b) $50,400
      c) $44,800
      d) $56,000


6.    Which of the following situations would NOT require disclosure in the notes to the
      financial statements of Company A?
      a) Company A is being sued by an employee for wrongful dismissal and is
            unsure as to whether it will lose. If Company A does lose, the most likely loss
            will be $400,000, a material amount. No amount has been accrued.
      b) Company A changed its inventory valuation method from FIFO to average
            cost.
      c) There is a high probability that a lawsuit launched by Company A against a
            competitor for breach of copyright will be successful, resulting in significant
            proceeds.
      d) Company A is being sued by a former customer for $40,000 relating to some
            deficient work. Company A is sure that it will lose and has therefore accrued a
            liability of $40,000.
      e) Company A recently determined that it under-remitted payroll taxes in a
            previous fiscal year. Although the under-remittance has been accrued,
            Company A is unsure as to whether the maximum amount of $100,000 of
            penalties will be charged.




Page 295                                                        CMA Ontario – September 2009
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7.    On November 5, 20x1, a Dunn Corp. truck was in an accident with an auto driven
      by Bell. Dunn received notice on January 12, 20x2, of a lawsuit for $700,000
      damages for personal injuries suffered by Bell. Dunn Corp.'s counsel believes it is
      probable that Bell will be awarded an estimated amount in the range between
      $200,000 and $450,000, and that $300,000 is a better estimate of potential liability
      than any other amount. Dunn's accounting year ends on December 31, and the 20x1
      financial statements were issued on March 2, 20x2. What amount of provision
      should Dunn accrue at December 31, 20x1?
      a) $0
      b) $200,000
      c) $300,000
      d) $450,000


8.    On March 1, 20x5, Cain Corp. issued at 103 plus accrued interest, two hundred of
      its 9%, $1,000 bonds. The bonds are dated January 1, 20x5, and mature on January
      1, 20x15. Interest is payable semiannually on January 1 and July 1. Cain paid bond
      issue costs of $10,000. Cain should realize net cash receipts from the bond issuance
      of :
      a) $216,000
      b) $209,000
      c) $206,000
      d) $199,000




Page 296                                                       CMA Ontario – September 2009
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Problem 1

Early in 20x0, Draeger Incorporated decided to retool its automotive engine plant to
produce a newly designed 24-valve, six-cylinder automotive engine. This engine is
capable of attaining a high gas mileage rating with low emissions. The advance notices in
several national automotive magazines were very favorable.

In order to finance the retooling, Draeger issued $200 million of 8% registered
debentures due in ten years June 30. Interest is payable semi-annually on December 31
and June 30. As a result of the favorable notices in the automotive magazines, the
noncallable bonds were sold to yield 7%. The issue was sold through underwriters on
July 1, 20x0.

The company's fiscal year ends December 31.

Required -

a. Prepare the journal entries for Draeger Incorporated to record the issuance of the
   bonds on July 1, 20x0.
b. Prepare the journal entries for Draeger Incorporated to reflect the bond issuance on
   the financial statements dated December 31,20x0.


Problem 2

Alpha Corporation sold $400,000 of 8% (payable semi-annually on June 30 and
December 31), three-year bonds. The bonds were dated and sold on January 1, 20x2, at
an effective interest rate of 10%. The accounting period for the company ends on 31
December.

Required –

1.      Compute the price of the bonds.
2.      Prepare a debt amortization schedule for the life of the bonds (use the effective
        interest method and round to the nearest dollar).
3.      Prepare entries for Alpha through December 31, 20x2.
4.      Show how Alpha would report the bonds on its Statement of Financial Position at
        December 31, 20x2.
5.      What would be reported on the income statement for the year ended December
        31, 20x2?




Page 297                                                       CMA Ontario – September 2009
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Problem 3

On April 1, 20x0, Hanson Industries Ltd. issued ten year bonds with a face value of
$5,000,000. The proceeds of the issue were $5,159,133. The bonds have a stated interest
rate of 10%, payable semi-annually at October 1 and April 1. Hanson Industries has a
December 31 year end.

Required -

a) Prepare all of the journal entries necessary from April 1, 20x0 to April 1, 20x1.
b) Assume that one-half of the bonds were retired on April 1, 20x4 at 102. Prepare the
   journal entry to record the retirement of the bonds.


Problem 4

On January 1 20x0, the Nolan Trust Ltd. issued for $519,641 five-year, 12% bonds that
have a maturity value of $500,000 and pay interest semi-annually on June 30 and
December 31 of each year. The yield to maturity on that date was 5.1%. A call price of
105 exists on these bonds.

Required -

a) What does the issue price of the bonds tell you about the market interest rate on
   January 1, 20x0? Explain your answer.
b) If the bonds are called by Nolan Trust Ltd. at any time during their life, would you
   expect a gain or a loss to be realized upon the early retirement? Explain your answer.
c) What is the interest expense as reported on the income statement for the year ended
   December 31, 20x0? Show your calculations.
d) Present the liability for these bonds as it would be reported on the Statement of
   Financial Position as at December 31, 20x0.




Page 298                                                       CMA Ontario – September 2009
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Problem 5

Maston Company is a manufacturer of toys. During the year, the following situations
arose:

Situation 1: A safety hazard related to one of Maston's toy products was discovered. It is
considered likely that liabilities have been incurred. A reasonable estimate of the amount
of loss can be made on the basis of past experience.

Situation 2: One of Maston's small warehouses is located on the bank of a river and can
no longer be insured against flood losses. No flood losses have occurred since the date
when the insurance became unavailable.

Required -

1. How should Maston report the safety hazard? Why?
2. How should Maston report the uninsurable flood risk? Why?


Problem 6

The following two independent sets of facts relate to the possible accrual of a loss
contingency or its possible disclosure by other means.

Situation 1: A company offers a one-year warranty for the product that it manufactures.
A history of warranty claims has been compiled and the likely amount of claims related
to sales for a given period can be determined.

Situation 2: A company has adopted a policy of recording self-insurance for any possible
losses resulting from injury to others by its vehicles. The premium for an insurance
policy for the same risk from an independent insurance company would have an annual
cost of $2,000. During the period covered by the financial statements, there were no
accidents involving the company's vehicles which resulted in injury to others.

Required -

For each of the two independent sets of facts above, discuss the accrual or type of
disclosure necessary (if any) and the reason why such disclosure is appropriate.




Page 299                                                        CMA Ontario – September 2009
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Problem 7

In May 20x2 the Dennon Company became involved in litigation. As a result, it is likely
that Dennon will have to pay $1.3 million. In July 20x2 a competitor commenced a suit
against Dennon alleging violation of antitrust laws and seeking damages of $2.2 million.
Dennon denies the allegations, and the likelihood that Dennon will have to pay any
damages is remote. In September 20x2 Blane County brought action against Dennon for
$1.8 million for polluting Bass Lake. It is possible that the county's suit will be
successful, but the amount of damages Dennon will have to pay is not reasonably
determinable.

Required -

1. What amount, if any, should be accrued in 20x2?
2. Draft the disclosures, if any, that should appear in Dennon Company's 20x2 financial
   statements as the result of the litigation in 20x2.


Problem 8

On January 1, 20x4, H. Ltd. issued 10% bonds, maturing in ten years, with a face value
of $200,000 at a price to yield 8% compounded semi-annually. The bonds pay interest
semi-annually. H. Ltd. uses the effective interest rate method to account for bond
discounts and premiums. What amount of bond interest expense will H. Ltd. report on its
fiscal year ended December 31, 20x4, financial statements?


Problem 9

The Canadian Chocolate Company (CCC) is a manufacturer of chocolate candy products.
Earlier this year, one of CCC's subsidiaries was the victim of an extortion attempt. The
extortionists demanded $24 million from the company. When CCC refused to comply,
the extortionists carried out the threat to poison "Treat" bars in three large cities,
apparently chosen at random. As a result, six people died and 12 others became seriously
ill. The company responded by removing every "Treat" bar from the shelves of all
retailers and destroying the stock. The company also introduced a tamper-proof wrapper
for new stock and hired a public relations firm to undertake a special campaign to rebuild
consumer confidence in the bar.

All costs were transferred to the head office to allow for one consolidated insurance
claim. The company has estimated that the total cost resulting from the poisoning is about
$25 million: $2 million for the new wrapping machinery, $8 million for the products
destroyed, $2 million for the public relations firm, and $14 million for profits lost through
reduced product sales. CCC does not want to include the insurance settlement in income
in the current year but wants to defer and amortize the amount over a five-year term (on
the same basis as the costs of machinery and equipment are depreciated).


Page 300                                                         CMA Ontario – September 2009
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Legal proceedings have been commenced against CCC and its subsidiaries by the estates
of the deceased parties and by those who became ill. They are suing for $450 million.

Required -

How should CCC reflect the above facts in the current year-end financial statements?
Provide calculations where possible.


Problem 10

Foster Music Emporium carries a wide variety of musical instruments, sound
reproduction equipment, recorded music, and sheet music. As a sales promotion
technique, Foster uses warranties to attract customers. Musical instruments and sound
equipment are sold with a one year warranty for replacement of parts and labour. The
estimated warranty cost, based on experience, is 1.5 percent of sales. Sales for these items
were $5.4 million in 20x2. Foster uses the accrual method to account for the warranty
costs for financial reporting purposes. The balance in the account related to warranties on
January 1, 20x2, was as shown below.

Estimated liability from warranties                   $63,000

Replacement parts and labour for warranty work totalled $80,000 during 20x2.

Required -

Foster Music Emporium is preparing its financial statements for the year ended
December 31, 20x2. Determine the amount that will be shown on the 20x2 financial
statements for the following:

a) Warranty expense.
b) Estimated liability from warranties.




Page 301                                                        CMA Ontario – September 2009
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SOLUTIONS


Multiple Choice Questions

1.    b

2     d     The outstanding contracts at Dec 31, 20x5:
            20x4: $500,000 x 60% x 1/2 = $150,000
            20x5: $600,000 x 40% x 1/2 = $120,000
                   600,000 x 60% = $360,000
            Total = $630,000

3.    c     $290,000 + 390,000 - 313,000 - 30,000 = $337,000

4.    b     The interest expense for the first 6 months that the bonds are outstanding is
            calculated as (7% x $104,158) x .5 = $3,646.

5.    b     Book value of bonds on July 2, 20x3 =
              $760,000 + [(760,000 x 6%) – (800,000 x 5%)]
              $760,000 + (45,600 – 40,000)
              $765,600
            Cost to retire bond issue = $800,000 x 1.02 = $816,000
            Loss on retirement = $816,000 – 765,600 = $50,400

6.    d     No disclosure is necessary since no further exposure exists in addition to the
            amount accrued. Choices a), b), c) and e) all describe situations where
            disclosure in the notes would be required.

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

8.    d.    Bond: 200 bonds x $1,000 x 1.03                                       $206,000
            Accrued interest: $200,000 x 9% x 2/12 months                            3,000
            Bond issue costs                                                       -10,000
            Net cash proceeds on bond issue                                       $199,000




Page 302                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

a.      The journal entries to record Draeger Incorporated's issuance of bonds and
        payment of related costs at July 1, 20x0 are presented below.

        The proceeds on the bond issue:

                              N       I/Y          PV         PMT            FV
           Enter              20      3.5                    8000000      200000000
           Compute                                X=
                                              214,212,403


        Cash                                              $214,212,403
          Bonds payable                                                     $214,212,403
        To record bond issuance at July 1, 20x0.


b.      The journal entries to record Draeger Incorporated's bond issuance on the
        financial statements dated December 31, 20x0 are presented below.

        Interest expense ($214,212,403 x 3.5%)            $7,497,434
        Bonds payable                                        502,566
           Cash                                                                $8,000,000
        To record interest and premium at December 31, 20x0.




Page 303                                                       CMA Ontario – September 2009
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Problem 2

1.
                              N        I/Y           PV        PMT            FV
           Enter              6         5                      16000        400000
           Compute                                  X=
                                                  $379,697

2.                                                              Discount
           Time      Date             Interest               Amortization           Balance
           0         Jan 1, x2                                                     $379,697
           1         Jun 30, x2                   18,985            2,985           382,682
           2         Dec 31, x2                   19,134            3,134           385,816
           3         Jun 30, x3                   19,290            3,290           389,106
           4         Dec 31, x3                   19,455            3,455           392,561
           5         Jun 30, x4                   19,628            3,628           396,189
           6         Dec 31, x4                  19,811*            3,811           400,000

        * rounded to balance

3.      Jan 1, x2        Cash                                           379,697
                           Bonds Payable                                            379,697

        Jun 30, x2       Interest expense                                18,985
                            Bonds payable                                             2,985
                            Cash                                                     16,000

        Dec 31, x2       Interest expense                                19,134
                            Bonds payable                                             3,134
                            Cash                                                     16,000

4.      Bonds payable                                                              $385,816

5.      Interest expense (18,985 + 19,134)                                          $38,119




Page 304                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

a)      First, we have to calculate the YTM on the bonds:

                              N         I/Y        PV         PMT           FV
           Enter              20                5,159,133   -250,000    -5,000,000
           Compute                    4.75%

       Apr 1, 20x0        Cash                                $5,159,133
                            Bonds payable                                     $5,159,133

       Oct 1, 20x0        Interest expense
                             ($5,159,133 x 4.75%)               $245,059
                          Bonds payable                            4,941
                             Cash                                                250,000

       Dec 31, 20x0       Interest expense
                             ($5,159,133 - 4,941) x 4.75%
                                x 3/6                            122,412
                             Interest payable                                    122,412

       Apr 1, 20x1        Interest expense                       122,412
                          Bonds payable                            5,176
                          Interest payable                       122,412
                             Cash                                                250,000


b) Book value of bonds payable at April 1, 20x4:

                              N        I/Y          PV       PMT           FV
           Enter              12       4.75                 250,000     5,000,000
           Compute                              5,112,369


           Bonds payable ($5,112,369 x 50%)                    $2,556,185
             Gain on retirement of bonds                                        $ 6,185
             Cash ($2,500,000 x 1.02)                                          2,550,000




Page 305                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 4

a) Since the bonds were issued at a premium (i.e., the proceeds exceeded the face value),
   this indicates that the market interest rate at January 1, 20x0 must be less than the
   12% offered by the bond issue. Otherwise, investors would not be willing to pay more
   than the face value for this investment.

b) If the bonds are called by Nolan Trust Ltd., the company will have to pay the call
   price of 105. The bonds were issued at 104 ($520,000 / $500,000) . The four percent
   premium will be amortized over the life of the bonds. The bonds at face value plus
   the unamortized premium represent the carrying value of the bonds. At any time the
   call price would exceed the carrying value of the bonds in this case; therefore, there
   would be a loss on retirement realized by Nolan Trust Ltd.

c) 1st half of the year: $519,641 x 2.55%                                                 $13,251
   2nd half of the year: $519,641
      - (15,000 Coupon Pmt - 13,251 Interest Exp - 1st Half) x 2.55%
      = $517,892 x 2.55%                                                                   13,206
                                                                                          $26,457

d) Bonds payable [$517,892 - (15,000 Coupon Pmt - 13,251 Interest Exp - 2nd Half)]       $516,098




Page 306                                                               CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5

1. Maston should report the estimated loss from the safety hazard as an expense in the
   income statement and a provision in the Statement of Financial Position because both
   of the following conditions were met:
   • the entity has a present obligation (legal or constructive) as a result of a past
       event;
   • it is probable that an outflow of resources embodying economic benefits will be
       required to settle the obligation; and
   • a reliable estimate can be made of the amount of the obligation (IAS 37.14).

2. Maston should not report the estimated loss from the uninsurable flood risk as an
   expense in the income statement or as provision in the Statement of Financial
   Position because no losses have occurred since the warehouse has 'been uninsured.
   Furthermore, disclosure of the uninsurable risk in the notes to the financial statements
   is not required because no losses have occurred since the warehouse has been
   uninsured. Disclosure in the notes to the financial statements is, however, desirable to
   alert the reader to the exposure created by the lack of insurance.


Problem 6

SITUATION 1. When a company sells a product subject to a warranty, it is likely that
there will be expenses incurred in future accounting periods relating to revenues
recognized in the current period. As such, a liability has been incurred to honour the
warranty at the same date as the recognition of the revenue and a provision should be
taken for the warranty liability. Based on prior experience or technical analysis, the
occurrence of warranty claims can be reasonably estimated and a likely dollar estimate of
the liability can be made.

SITUATION 2. The fact that a company chooses to self-insure the contingency of injury
to others caused by its vehicles is not basis enough to accrue a provision that has not
occurred at the date of the financial statements. An accrual or "reserve" cannot be made
for the amount of insurance premium that would have been paid had a policy been
obtained to insure the company against this particular risk. A provision may only be
accrued if prior to the date of the financial statements a specific event has occurred that
will impair an asset or create a liability and an amount related to that specific occurrence
can be reasonably estimated. The fact that the company is self-insuring this risk should be
disclosed by means of a note to alert the financial statement reader to the exposure
created by the lack of insurance.




Page 307                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 7

1. An amount of $1,300,000 should be accrued as a provision on the first lawsuit since:
   • Dennon has a present obligation as a result of a past event;
   • it is probable that an outflow of resources embodying economic benefits will be
      required to settle the obligation; and
   • a reliable estimate can be made of the amount of the obligation.

    The $2.2 million dollar lawsuit does not qualify as a contingent liability since the
    likelihood of paying damages is remote. No disclosure is necessary.

    The $1.8 million dollar lawsuit qualifies as a contingent liability since it is possible
    for the lawsuit to be successful. Disclosure of the contingency is required.

2. NOTE - LOSS CONTINGENCY: In September of 20x2, Blane County filed suit
   against Dennon Company for polluting Bass Lake. Blane County is requesting
   $1,800,000 from Dennon. It is likely that Blane County will be successful, but the
   amount of damages Dennon will have to pay is not reasonably determinable.


Problem 8

Issue Price –

                              N         I/Y          PV          PMT            FV
           Enter              20         4                       10000        200000
           Compute                                 X=
                                                 $227,181

Bond Interest:
Period 1 = $227,181 x 4% =                                    $ 9,087
Period 2 = [$227,181 - ($10,000 - $9,087)] x 4%
    = $226,268 x 4% =                                            9,051
                                                              $18,138




Page 308                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 9

The net book value of the equipment taken out of service, the cost of the destroyed
products, and the public relations cost do not represent future benefits so they should not
be capitalized and amortized over time. CCC should recognize them as an expense on the
Statement of Income.

CCC should accrue a provision with respect to the lawsuits if a loss is likely and if an
amount can be reasonably estimated. If not, then the company needs to assess if the
outcome of the lawsuit is possible and if so, then the lawsuit is a contingent liability and
the details of the litigation should be disclosed by way of note.


Problem 10

a)      Sales of musical instruments and sound equipment                          $5,400,000
        Estimated warranty cost                                                       x .015
        Warranty expense for 20x2                                                    $81,000

b)      Estimated liability from warranties--January 1, 20x2                          $63,000
        20x2 Warranty expense (Requirement a)                                          81,000
                                                                                    $144,000
        Actual warranty costs during 20x2                                            (80,000)
        Estimated liability from warranties--December 31,20x2                         $64,000




Page 309                                                         CMA Ontario – September 2009
Financial Accounting – Module 1



10.     Shareholders’ Equity

Historically, companies had common shareholders, or those entitled to elect the board of
directors, and preferred shareholders, who were entitled to receive a dividend of a stated
minimum amount before any dividends were paid to common shareholders. The voting
rights of preferred shareholders were usually minimal or nil unless they failed to receive a
dividend, at which time their voting rights increased according to the terms under which
the shares were issued. In effect, the preferred shareholders had to play a more passive
role, but their dividend and rights on the winding-up of the company were better
protected.

This simple distinction between common and preferred shareholders has been blurred
over time, as companies have developed classes of common shareholders with differing
rights between them. The Canada Business Corporations Act (CBCA) now makes no
distinction between common and preferred shares, but allows for different classes whose
rights, privileges, restrictions, and conditions must be set out in the articles of
incorporation of the company. However, at least one of the classes of shares must contain
(i) the right to vote at all meetings of that class of shareholder and (ii) the right to
dividends and distribution of assets when the company is wound up. These are the
traditional rights of common shareholders. Thus, in effect the act requires that at least one
class of shares must have the minimum attributes of common shares. For convenience we
will refer to this class of shares as common shares.

Apart from disclosure requirements (which were discussed in Chapter 1 of this Module),
Share Based Payments and Stock Option Grants to Employees (discussed later in this
chapter), there are no IFRS's dealing with accounting for shareholders' equity items.
Therefore, the discussion in this section are based on pre-IFRS Canadian GAAP.

A typical shareholders' equity section of a statement of financial position could look as
follows:

No Name Company Ltd.
Partial Statement of Financial Position
As at December 31, 20x6

Shareholders' Equity
  Common Shares, 1,000,000 shares issued and outstanding                        $26,000,000
  Preferred Shares, $5, cumulative, 250,000 shares issued and
    outstanding                                                                  12,000,000
  Contributed Surplus                                                             3,000,000
  Retained Earnings                                                               9,500,000
  Accumulated Other Comprehensive Income                                          (750,000)
                                                                                $49,750,000




Page 310                                                         CMA Ontario – September 2009
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Common Shares

Common shares typically have the following features:
•    they provide the right to vote at annual meetings,
•    upon liquidation of the company, any cash remaining after all obligations have
     been settled revert back to common shareholders, and
•    they are a perpetuity, meaning they never become due.

The corporation is under no obligation to provide a financial return to common
shareholders, that is, any dividend declarations are at the sole discretion of the company’s
board of directors. Dividends become a liability of the corporation only when the board
of directors declares them.

Note that the IFRS standards refer to common shares as 'ordinary shares'. This is because
some countries do not use common share terminology. These lesson notes will refer to
these shares as common shares.

Preferred Shares

Preferred shares have the following characteristics:
•      they are generally non-voting shares,
•      they carry a stated dividend per share,
•      like common shares, they are a perpetuity, and
•      they have preference on liquidation.

Like common shares, the corporation is under no obligation to provide a financial return
to preferred shareholders, that is, any dividend declarations are at the sole discretion of
the company’s board of directors. Dividends become a liability of the corporation only
when the board of directors declares them. However, in most cases preferred shares are
cumulative. This means that if dividends are missed, any preferred dividends in arrears
must be paid before any dividends can be paid to common shareholders.

Example – Assume the shareholders' equity as outlined on the previous page. The
preferred share dividends were last paid on December 31, 20x3. It is now December 1,
20x6 and management wants to pay a dividend of $8 per common shares.

First, the preferred dividends in arrears for 20x4 and 20x5 will have to be paid:
         250,000 shares x $5.00 x 2 years = $2,500,000
Next, the preferred dividends for the year 20x6 must be paid:
         250,000 shares x $5.00 x 1 year = $1,250,000
Finally, the dividend to common shareholders can be paid:
         1,000,000 shares x $8 = $8,000,000
The total dividend to be declared will be: $2,500,000 + 1,250,000 + 8,000,000
         = $11,750,000




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Contributed Surplus

Contributed Surplus arises when…
•      shares are repurchased at an amount less than the average amount of cash that was
       raised when they were issued (see the Issuance, Reacquisition and Retirement of
       Shares section of this chapter); and
•      when a share based payment plan is put in place (discussed later in this chapter),
       and
•      when subscribed shares are defaulted.


Retained Earnings

Retained earnings represents the accumulated earnings of the corporation net of any
dividends paid. Any premiums paid on retirement of shares are also charged to retained
earnings.

The statement of retained earnings is as follows:

       Retained earnings, beginning of year                               $ XXX
       Premium on redemption of shares                                     -XXX
       Net income (loss) for the year                                     ±XXX
       Dividends                                                           -XXX
       Retained earnings, end of year                                     $ XXX


Accumulated Other Comprehensive Income

At its fundamental level, accumulated other comprehensive income consists of unrealized
gains or losses that do not flow to net income but get placed in accumulated other
comprehensive income until realized, at which time they flow from accumulated other
comprehensive income to net income. These include:
•       the funded status on a pension plan (discussed in Chapter 11 of this Module);
•       unrealized gains or losses on investments in available-for-sale securities
        (discussed in Chapter 1 of Module 2);
•       unrealized gains or losses on cash flow hedges (discussed in Chapter 6 and 8 of
        Module 2); and
•       unrealized gains and losses on the translation of the financial statements of
        foreign subsidiaries when the functional currency is the Canadian dollar
        (discussed in Chapter 7 of Module 2).




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Differences between classes of shares

Current Canadian GAAP requires that the following types of differences between classes
of shares be disclosed:

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

2.      Redemption, call, and retraction privileges: certain classes of shares may be
        issued on the condition that they can be redeemed at the option of either the
        shareholder or the company (depending on the terms of issue). If redeemable at
        the option of the shareholder, they are often called redeemable shares5. If
        redeemable at the option of the company, they are usually referred to as
        retractable preferred shares or callable preferred shares.

3.      Voting privileges: The voting privileges set out in the articles of incorporation
        may eliminate or restrict the right of certain classes of shares to vote to elect
        directors, thus keeping the bulk of the power to influence company affairs in the
        hands of the common shareholders. However, in certain circumstances, the shares
        with restricted voting rights may have these restrictions changed to increase their
        voting power. Typically, this happens when dividends have not been paid on these
        shares for a period of time, such as two years.

4.      Conversion privileges: The articles of incorporation may provide that holders of a
        particular class of share have the privilege of converting their shares into shares of
        another class. Typically, this would be the right to convert shares with a fixed
        annual dividend into common shares or to convert voting (but non-marketable)
        shares into non-voting (but marketable) shares




5       In some circumstances, retractable preferred shares which are redeemable at the option of the
        shareholders could be classified as financial liabilities. This will be discussed in more depth in
        Chapter 8 of Module 2.

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Issuance, Reacquisition and Retirement of Shares

Issuance of Shares

A company may issue shares for cash or non-cash consideration. When issuing shares for
cash consideration, the journal entry to reflect the issuance of shares is quite simple:

Dr. Cash
       Cr. Common Stock (or Preferred Stock)

When shares are issued for non-cash consideration, the fair value of the asset(s) or
service acquired in exchange for the shares must be determined. The assets/services are
recorded at their fair market value of the goods or services received at the date they are
received with the corresponding entry to common stock. If the fair value of the goods or
services cannot be determined, then the value shall be determined by reference to the fair
value of the equity instruments granted. (IFRS 2.10)

Dr. Asset(s) or Expense (service)
       Cr. Common Stock (or Preferred Stock)

Issue Costs

Corporations generally contract with underwriters who sell or issue stock to investors. A
percentage of the proceeds from issuing stock is normally retained as a fee by the
underwriters. Other costs associated with a stock issue include legal fees, registration fees
with the Securities Commission, accounting fees and printing costs. These direct costs of
issuing stock are deducted from the proceeds of the stock issuance and the net proceeds
are credited to the Capital Stock account. Indirect costs such as management time spent
on the stock issue are expensed.

Issuance of Shares by way of Subscription

At times, companies may conduct a share issue on a subscription basis. Generally, this is
done when a small company goes public for the first time or when shares are offered to
employees. For example, a company issues, on a subscription basis, 1,000,000 shares of
its stock at $30 per share. The terms of the contract require that a down payment of 20%
be made at the time the contract is signed with the balance payable in 90 days.

On the date the contracts are signed, the following entries will be made:

Share Subscriptions Receivable (1,000,000 x $30)              $30,000,000
  Common Stock Subscribed                                                       $30,000,000

Cash (1,000,000 x $6)                                            6,000,000
  Share Subscriptions Receivable                                                  6,000,000



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The Common Shares Subscribed account will become part of Shareholders' Equity. The
Share Subscriptions Receivable account can be disclosed in one of two ways: as a current
asset or as a reduction of shareholders' equity. I believe it is best shown as a reduction of
shareholders' equity because current assets are generally used for operating purposes,
which share subscriptions receivable are not.

On the date the final payment is received, the following entries are made - the first entry
records the final receipt of cash; the second entry records the issuance of common stock.

Cash (1,000,000 x $24)                                          24,000,000
  Share Subscriptions Receivable                                                 24,000,000

Common Stock Subscribed                                         30,000,000
  Common Stock                                                                   30,000,000

The above entries assume that 100% of the final payments were received. Generally,
some subscribers will default on their final payment. How we account for defaults
depends on whether the down payment is refundable. If we assume that 95% of the shares
are fully paid and that the down payment is fully refundable, then the journal entries
would be as follows:

Cash (950,000 x $24)                                            22,800,000
  Share Subscriptions Receivable                                                 22,800,000

Common Shares Subscribed (50,000 x $30)                          1,500,000
  Share Subscriptions Receivable (50,000 x $24)                                   1,200,000
  Cash (50,000 x $6)                                                                300,000

Common Stock Subscribed (950,000 x $30)                         28,500,000
  Common Stock                                                                   28,500,000

If the down payment is not refundable, then we would credit Contributed Surplus instead
of Cash in the second entry above.




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Reacquisition and Retirement of Shares

When a company reacquires its own shares, it has to cancel them and effectively retire
the shares. The journal entry will comprise of the following:
•       a debit to common shares in an amount equal to the number of shares retired
        times the average book value per common share, and
•       a credit to cash in the amount of the net cost to retire the shares.

A debit or credit will be required to balance the entry:
•      if a credit is required, then the we credit Contributed Surplus,
•      if a debit is required, then we first debit Contributed Surplus to the extent it was
       created by a similar transaction in the past, if there is not enough Contributed
       Surplus, then we debit the remaining amount directly to Retained Earnings.

For example, assume that a company has 1,000,000 common shares issued with a book
value of $2,750,000 on January 1, 20x2. On March 16, 20x2 the company issues an
additional 200,000 shares for a total of $750,000. On June 22, 20x2, the company
repurchases 50,000 of these shares at a price of $2.80, the journal entry to record the
repurchase of the shares would be as follows:

Common shares (50,000 x $2.9167)                                  $145,835
  Contributed Surplus                                                                 $5,835
  Cash (50,000 x $2.80)                                                              140,000

* Average book value per share = ($2,750,000 + 750,000) / (1,000,000 + 200,000)
 = $2.9167

If, on August 31, 20x2, the company repurchased 30,000 shares at a price of $3.30, the
journal entry would be as follows:

Common shares (30,000 x $2.9167)                                   $87,501
Contributed Surplus                                                  5,835
Retained earnings                                                    5,664
  Cash (30,000 x $3.30)                                                               99,000


Accounting for Stock Splits and Stock Dividends

A stock dividend is a dividend paid in any class of shares of the company's own shares to
holders of the same class of shares. Usually it is paid to common shareholders in common
shares. The shareholders' proportionate share in the equity of the company has not
changed after the dividend. They are essentially in the same position as before - they
simply have more share certificates to represent the same interest in the company.
Nevertheless, it is common to capitalize a portion of the retained earnings which is
thought to represent the value of the new shares that have been issued, thus reducing the
retained earnings available for cash dividends.

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The Canada Business Corporations Act requires that shares must be issued for their fair
market value. Thus the issue of such shares would increase the stated capital and decrease
the retained earnings correspondingly.

Darren Inc declared a stock dividend of ten common share for each 100 common shares
held (10% stock dividend). There were 400,000 shares outstanding before the declaration
of the dividend, and their market value at the time the dividend was declared was $15
each. The entry at the time the dividend was declared would be as follows:

Retained Earnings (40,000 x $15)                                  $600,000
  Common Stock                                                                     $600,000

Note that we are implicitly assuming that the share price of $15 is the share price after the
stock dividend is announced. Since a stock dividend does not increase the value of the
firm, the share price will go down once a stock dividend is announced.

For example, if the $15 was the share price before the stock dividend was announced,
then the share price after the stock dividend would be equal to the value of the firm's
equity divided by the number of shares outstanding after the stock dividend:

        Value of the firm's equity = 400,000 shares x $15 = $6,000,000
        Share price after the stock dividend = $6,000,000 ÷ 440,000 shares = $13.64

If this was the case, we would have capitalized the retained earnings at a share price of
$13.64 and not $15.00.

A stock dividend should be distinguished from a stock split, which is an increase in the
number of existing shares outstanding. A share split is often used to decrease the price at
which the company's shares are traded on the stock market, often with the intention of
increasing their appeal to a wider group of small investors. Under a stock split there is no
increase in the common shares of the firm, only an increase in the number of shares
outstanding. No journal entries are required to record a stock split.




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Stock Option Grants to Employees (IFRS 2)

When a company provides stock options to executives and employees as part of their
compensation package, we must measure and accrue the compensation expense arising
out of the stock option grant. In order to do so, we need to know three things:

1.      The market value of the stock options on the date of grant. This can be calculated
        by using an accepted stock option pricing model such as the Black-Scholes or the
        binomial option pricing models.

2.      The vesting period for which it is expected the executives will provide services.
        This is usually the period in which the options cannot be exercised. For example,
        if stock options are issued on January 1, 20x3 and are exercisable anytime after
        January 1, 20x6, then the vesting period is the period Jan 1, 20x3 to Dec 31, 20x5.

3.      An estimate as to what percentage of the stock options will vest.

The market value of the stock options are accrued over the vesting period as follows:

dr. Compensation Expense
       cr. Contributed Surplus - Unexpired Stock Options

If the vesting period exceeds the current year, then the total market value of the options
on the date of grant is accrued over the vesting period. At the end of each of the year of
the vesting period, the compensation expense is calculated as follows:

        Total cumulative value of the stock options earned to the end of the period times
               the estimated percentage of stock options that will vest.
        Less the cumulative compensation expense recorded on this stock option plan to
               as of the end of the previous fiscal period.

For example, assuming the options are granted on January 1, 20x3, the vesting period is
20x3-20x5, the total market value of the options is $300,000, and in 20x3 management
estimates that 85% of the options will vest, then the compensation expense for 20x3
would be: $300,000 x 1/3 x 85% = $85,000. At the end of 20x4, assume that
management revises their estimate and believes that 90% of the options will vest, then the
compensation expense for 20x4 would be:

      Cumulative value of the stock options earned for the period
        20x3 - 20x4: $300,000 x 2/3 x 90%                                   $180,000
      Less cumulative compensation expense to the end of 20x3                 85,000
      Compensation expense - 20x4                                           $ 95,000

If, by the end of 20x5, 92% of the stock options actually vested, then the compensation
expense for 20x5 would be calculated as follows:


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      Cumulative value of the stock options earned for the period
        20x3 - 20x5: $300,000 x 100% x 92%                                  $276,000
      Less cumulative compensation expense to the end of 20x4:
         $85,000 + 95,000                                                     180,000
      Compensation expense - 20x5                                            $ 96,000

After the vesting period, but during the exercise period, one of two events will occur with
regards to the options:

1.      They will be exercised, in which case we record the issuance of the stock as
        follows:

        dr.     Cash
        dr.     Contributed Surplus - Unexpired Stock Options
                cr.    Common Stock

        The credit to common stock is simply the sum of the cash received on the exercise
        of the options plus the prorata amount of contributed surplus created by these
        stock options. Note that the market value of the shares on the date of exercise has
        absolutely no impact on the above entry.

2.      The options will expire due to the holders of the options letting the options expire.
        The journal entry to record expired stock options is as follows:

        dr.     Contributed Surplus - Unexpired Stock Options
                cr.    Contributed Surplus - Expired Stock Options

Example: on January 2, 20x2 the Solomons Company issued 140,000 stock options to
their executive team and senior managers. The market price of the company's stock on
January 2, 20x2 was $16. The exercise or strike price of the options was also $16. The
employment contract stated that the executives had to provide services to Solomons
Company for the period January 1, 20x2 to December 31, 20x4. The stock options were
exercisable in the fiscal year ended December 31, 20x5. The Black-Scholes model puts
the market value at $2.25 per option. At the end of 20x2, management estimates that 95%
of the stock options will vest. At the end of 20x3, this estimate was revised to 90%. At
December 31, 20x4 the actual number of options that vested amounted to 120,000.

During 20x5, 90,000 of the options were exercised when the stock price was $28 per
share. The remaining 30,000 options expired at December 31, 20x5.

The total value of the options on the date of grant is: 140,000 x $2.25 = $315,000.

Dec 31, 20x2        Compensation expense
                      ($315,000 x 1/3 x 95%)                          $99,750
                      Contributed Surplus
                         – Unexpired Stock Options                                  $99,750

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The compensation expense for the 20x3 is calculated as follows:

       Cumulative value of the stock options earned for the period
         20x2 - 20x3: $315,000 x 2/3 x 90%                                 $189,000
       Less cumulative compensation expense to the end of 20x2               99,750
       Compensation expense - 20x3                                         $ 89,250


Dec 31, 20x3        Compensation expense                               89,250
                      Contributed Surplus                                          89,250
                        – Unexpired Stock Options

The compensation expense for the 20x4 is calculated as follows:

       Cumulative value of the stock options earned for the period
         20x2 - 20x4: 120,000 options vested x $2.25                       $270,000
       Less cumulative compensation expense to the end of 20x3:
         $99,750 + 89,250                                                   189,000
       Compensation expense - 20x4                                         $ 81,000

Dec 31, 20x4        Compensation expense                               81,000
                      Contributed Surplus                                          81,000
                        – Unexpired Stock Options

In 20x5, we record the conversion of 90,000 options. Note that the stock market price at
that date is not relevant to this transaction.

20x5                Cash (90,000 x $16)                              1,440,000
                    Contributed Surplus
                      – Unexpired Stock Options
                           (90,000 x $2.25)                           202,500
                      Common stock                                               1,642500

Finally, on December 31, 20x5 we record the expiration of the remaining 30,000 stock
options:

Dec 31, 20x5        Contributed Surplus
                       – Unexpired Stock Options                       67,500
                      Contributed Surplus                                          67,500
                    30,000 x $2.25




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Problems with Solutions

Multiple Choice Questions


1.    How would the declaration of a 15 % stock dividend by a corporation affect
      each of the following?
                                           Total
                       Retained earnings   Shareholders' equity

        a.              No effect            No effect
        b.              No effect            Decrease
        c.              Decrease             No effect
        d.              Decrease             Decrease


Use the following information for questions 2-3:

Gott Co. was organized on January 1, 20x2, with 300,000 no par value common shares
authorized. During 20x2, Gott had the following shares transactions:

           Jan 4      Issued 120,000 shares at $10 per share.
           Mar 8      Issued 40,000 shares at $11 per share.
           May 17     Purchased 15,000 shares at $12 per share and cancelled them.
           Jul 6      Issued 30,000 shares at $13 per share.
           Aug 27     Issued 10,000 shares at $14 per share.

2.    The total amount in the share capital account at December 31, 20x2 is
      a) $2,170,000
      b) $2,016,250
      c) $2,007,250
      d) $1,990,000


3.    The total amount of contributed surplus at December 31, 20x2 is
      a) $-0-
      b) $26,250
      c) $153,750
      d) $180,000




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4.    Renn Corporation was organized on January 1, 20x2, with an authorization of
      400,000 no par value common shares. During 20x2, the corporation had the
      following capital transactions:

                January 5          issued 150,000 shares @ $10 per share
                April 6            issued 50,000 shares @ $12 per share
                June 8             issued 50,000 shares @ $14 per share
                July 28            purchased 20,000 shares @ $11 per share and
                                   cancelled them
                December 31        issued 20,000 shares @ $18 per share

      What is the total amount of contributed surplus as of December 31, 20x2?
      a) $0
      b) $4,000
      c) $20,000
      d) $220,000




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Problem 1

The following is the Shareholders' Equity section of Parsely Industry Ltd.'s Statement of
Financial Position at its fiscal year end, September 30.

                                                                   20x1          20x0
Common Shares, 1,000 shares outstanding
  at end of 20x0                                              $ 105,880      $105,000
Preferred Shares                                                 10,000        10,000
Contributed Surplus                                               5,040             -
Retained Earnings                                               199,500       177,300
Total Shareholders' Equity                                     $320,420      $292,300

The company's net income for 20x1 was $30,300. On January 2, 20x1, Parsely Industry
Ltd. re-acquired and cancelled 120 of its common shares at $63 per share.

Required -

Prepare journal entries to record all the transactions affecting shareholders' equity during
the 20x1 fiscal year.


Problem 2

The shareholders' equity section of Parsley Ltd. at September 30, 20x0, was as follows:

Common stock, 40,000 shares issued and outstanding                                 $800,000
Retained earnings                                                                   480,000
Total shareholders' equity                                                       $1,280,000

Additional Information:

•   On October 1, 20x0, the corporation declared and issued 4,000 shares as a dividend.
    The market value of the capital stock was $30 per share on October 2, 20x0. (after
    market adjustment to the stock dividend news)
•   Parsley Ltd. reacquired and cancelled 3,000 of its own shares for $24 per share on
    October 31, 20x0.
•   A cash dividend of $2.50 per share was declared on December 31, 20x0, to
    shareholders of record on this date. The dividend was to be paid out on February 1,
    20x1.




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Required

a)      i)     Prepare a journal entry to record the stock dividend.
        ii)    Explain what effect, if any, the stock dividend had on the shareholders'
               equity section of the Statement of Financial Position and on the individual
               shareholders of Parsley Ltd.
b)      i)     Prepare a journal entry to record the cash dividend.
        ii)    What effect, if any, would the cash dividend have on the company's
               financial statements, assuming that Parsley Ltd.'s year end is December
               31? Explain.
c)      Prepare a journal entry to record the reacquisition and cancellation of the
        corporation's own stock.


Problem 3

The shareholders' equity section of Kolbe Co. Ltd. as at May 31, 20x0, was as follows:

              Common shares, no par value; authorized 20,000
                   shares, issued and outstanding 5,000 shares       $ 60,000
              Retained earnings                                        60,000
                                                                     $120,000

On May 1, 20x1, when the fair market value of common shares was $15, a 10% stock
dividend was declared (assume that the price is before stock market reaction to the stock
dividend). Shares will be issued on May 31, the company's year end. Kolbe Co. Ltd.
sustained a loss for 20x1 in the amount of $10,000.

Required -

i)      Prepare the journal entry for the declaration of the dividend.
ii)     Prepare the shareholders' equity section as it would appear on a Statement of
        Financial Position prepared at May 31, 20x1. (Show all computations.)




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Problem 4

At the beginning of 20x2, the shareholders' equity section of Barnes Incorporated was as
follows:

           $5 cumulative preferred shares,
              authorized 15,000 shares,
              issued and outstanding 5,000 shares                        $500,000
           Common shares, no par value; issued and
              outstanding, 175,000 shares                                  700,000
           Retained earnings                                             1,000,000
                                                                        $2,200,000

The preferred shares did not receive dividends in either 20x1 or 20x0. They are
redeemable at $105. The company is subject to a 50% tax rate.

The following affected shareholders' equity during 20x2:

1) The company purchased a building in exchange for 5,000 preferred shares. The
   preferred shares were trading at $115. The fair value of the building on the date of
   purchase was $600,000.
2) Paid dividends of $1 per share to common shareholders.
3) Net income for the year was $750,000.

Required -

Prepare all the necessary journal entries for the above transactions.


Problem 5

The J-Mo Corporation offered 1,000,000 common shares at $70 on a subscription basis
on June 30, 20x5. The terms of the contract stipulated that a downpayment equal to 35%
of the subscription price had to be made when the subscription contract was signed. The
balance was due on September 30, 20x5. By July 5, 20x5 all of the shares were
subscribed.

Required –

1.      Record the all transactions assuming that the subscribers all paid the final
        payment on the shares and that all of the shares were issued.
2.      Record all of the transactions on the assumption that 90% of subscribers paid the
        final balance and that the contract requires the company to reimburse the deposits
        on un-issued shares.




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3.      Record all of the transactions on the assumption that 90% of subscribers paid the
        final balance and that the contract does not require the company to reimburse the
        deposits on un-issued shares.


Problem 6

The Shlee Company was formed on July 1, 20x0. It was authorized to issue 200,000
shares and 50,000, $.60, and cumulative and nonparticipating preferred shares. Shlee
Company's fiscal year ends June 30.

The following information relates to the shareholders' equity accounts of Shlee Company:

COMMON SHARES

Before the 20x2-20x3 fiscal year, Shlee Company had 105,000 outstanding common
shares issued as follows:

a) 95,000 shares were issued for cash on July 1, 20x0, at $20 per share.

b) On July 24, 20x0, 5,000 shares were exchanged for a plot of land that cost the seller
   $70,000 in 19x4 and had an estimated fair market value of $102,000 on July 24,
   20x0.

c) 5,000 shares were issued on March 1, 20x2; the shares had been subscribed for $32
   per share of October 31, 20x1.

d) During the 20x2-20x3 fiscal year, the following common share transactions took
   place:

     October 1, 20x2
     Subscriptions were received for 10,000 shares at $40 per share. Cash of $80,000 was
     received in full payment for 2,000 shares and stock certificates were issued. The
     remaining subscriptions for 8,000 shares were to be paid in full by 9/30/x3, at which
     time the certificates were to be issued.

     November 30, 20x2
     Shlee purchased and cancelled 2,000 of its own shares on the open market at $38 per
     share.

     December 15, 20x2
     Shlee declared a 2 percent stock dividend for shareholders of record on 1/15/x3, to be
     issued on 1/31/x3. Shlee was having a liquidity problem and could not afford a cash
     dividend at the time. Shlee's common shares were selling at $43 per share on
     December 16 after they adjusted for the announcement of the stock dividend. (Stock



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    dividends are not distributed on subscribed shares until the subscriptions are fully
    paid.)

PREFERRED SHARES

e) Shlee issued 30,000 preferred shares at $15 per share on July 1, 20x1.


CASH DIVIDENDS

f) Shlee has followed a schedule of declaring cash dividends in December and June,
   with payment being made to shareholders of record in the following month. The cash
   dividends that have been declared through June 30, 20x3, are shown below.


                                                  Common              Preferred
       Declaration                                 Shares              Shares
         Date                                    (per share)         (per share)

      January 15, 20x1                              $0.10                  -
      June 15, 20x2                                  0.10               $0.30
      December 15, 20x2                                -                 0.30

No cash dividends were declared in June 20x3 because of Shlee's liquidity problems.

RETAINED EARNINGS

g) As of June 30, 20x2, Shlee's retained earnings account had a balance of $370,000. For
   the fiscal year ended June 30, 20x3, Shlee reported net income of $20,000.

h) In March 20x2, Shlee received a term loan from the National Bank. The bank requires
   Shlee to establish a sinking fund and restrict retained earnings in an amount equal to
   the sinking fund deposit. The annual sinking fund payment of $40,000 is due on April
   30 each year; the first payment was made on schedule on April 30, 20x3.

Required -

Prepare the shareholders' equity section of the Statement of Financial Position, including
appropriate notes, for Shlee Company as of June 30, 20x3.




Page 327                                                        CMA Ontario – September 2009
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Problem 7

Howard Corporation is a publicly owned company whose shares are traded on the TSE.
At December 31, 20x4, Howard had unlimited shares of common shares authorized, of
which 15,000,000 shares were issued. The shareholders' equity accounts at December 31,
20x4, had the following balances:

              Common shares (15,000,000 shares)                     $230,000,000
              Retained earnings                                       50,000,000

During 20x5, Howard had the following transactions:

a.      On February 1, a distribution of 2,000,000 common shares was completed. The
        shares were sold for $18 per share.
b.      On February 15, Howard issued, at $110 per share, 100,000 of no-par value, $8,
        cumulative preferred shares.
c.      On March 1, Howard reacquired and retired 20,000 common shares for $14.50
        per share.
d.      On March 15, Howard reacquired and retired 10,000 common shares for $20
        per share.
e.      On March 31, Howard declared a semi-annual cash dividend on common shares
        of $0.10 per share, payable on April 30, 20x5, to shareholders of record on April
        10, 20x5. (Record the dividend declaration and payment.)
f.      On April 15, 18,000 common shares were reacquired and retired for $17.50 per
        share.
g.      On May 31, when the market price of the common was $23 per share, Howard
        declared a 5% stock dividend distributable on July 1, 20x5, to common
        shareholders of record on June 1, 20x5. On June 1, immediately after the
        announcement of the stock dividend, the market price of the common dropped to
        $20.
h.      On September 30, Howard declared a semi-annual cash dividend on common
        shares of $0.10 per share and the yearly dividend on preferred shares, both
        payable on October 30, 20x5, to shareholders of record on October 10, 20x5.
        (Record the dividend declaration and payment.)

Required:

Prepare journal entries to record the various transactions. Round per share amounts to
two decimal places.




Page 328                                                       CMA Ontario – September 2009
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Problem 8

On January 3, 20x4 the Bailey Company granted 200,000 stock options to its executives.
The exercise price of the options is $25 and was equal to the stock price on that date. An
option pricing model puts the total value of these stock options at $125,000. The options
are exercisable during the fiscal period ending December 31, 20x6 on the condition that
the executives are still in the employ of Bailey Company as of December 31, 20x5. The
Bailey Company estimates that 80% of the stock options will vest at December 31, 20x4.
The actual number of options that vested on December 31, 20x5 was 175,000.

During the year 20x6, 160,000 options were exercised and the remaining 15,000 options
expired.

Required –

Prepare the journal entries for the years 20x4 through to 20x6



Problem 9

50 executives are given a stock option grant of 1,000 options each on January 2, 20x4.
The vesting period is 4 years and the market value of each option is estimated to be $20.
It is estimated that 75% of the options will vest. At the end of 20x5 (the second year),
management estimates that 80% of the executives will remain. This estimate still holds
for the year ended December 31, 20x6. At the end of 20x7, there are 41 executives left.

Required -

Calculate compensation expense for the years 20x4 - 20x7.




Page 329                                                         CMA Ontario – September 2009
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Problem 10

At December 31, 20x1, the shareholders' equity of the Page Golf Club Company totalled
$3,707,500. The balances of various accounts at that date were as follows:

$4 preferred shares (10,000 shares authorized, 5,000 shares issued)          $ 507,500
Common shares (100,000 shares authorized, 50,000 shares issued)                750,000
Retained earnings (unappropriated)                                           2,450,000

The following transactions occurred during 20x2:

MARCH 20        The regular semi-annual preferred dividend was declared, payable April 1.

APRIL 1         Payment of previously declared dividend.

JUNE 15         The regular semi-annual common dividend of 40 cents per share was
                declared, payable July 10.

JULY 10         Payment of the previously declared dividend.

SEP 20          Regular semi-annual preferred dividend was declared, payable October 1.

OCT 1           Payment of previously declared dividend.

DEC 15          The regular semi-annual dividend of 40 cents per common share was
                declared payable January 10. In addition, a 10 percent stock dividend
                (5,000 shares) was declared to common shareholders of record as of
                December 20, to be issued January 20. The market price of the shares was
                $20 per share (which is the amount that should be transferred from
                retained earnings to contributed capital).

Required -

1. Prepare all journal entries necessary to reflect the above transactions during 20x2.
2. Prepare a statement of shareholders' equity at December 31, 20x2, assuming net
   income for 20x2 amounted to $165,000.
3. Prepare a statement of changes in shareholders' equity for the year ended December
   31, 20x2.




Page 330                                                       CMA Ontario – September 2009
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     SOLUTIONS


Multiple Choice Questions

1.    c

2.    b      (120,000 x 10) + (40,000 x 11)                                        $1,640,000
             15,000 x $10.25 (1,640,000 / 160,000)                                   -153,750
             (30,000 x $13) + (10,000 x $14)                                          530,000
                                                                                   $2,016,250

3.    a      15,000 x (12.00 – 10.25) = $26,250 debit to retained earnings, No Contributed
             Surplus.

4.    b      Book value per share = [(150,000 x $10) + (50,000 x $12) + (50,000 x $14)]
             ÷ 250,000 = $11.20
             Increase in contributed surplus = 20,000 shares x ($11.20 – 11.00)
             = $4,000


Problem 1

Common Shares ($105,000 / 1,000) x 120                $12,600
  Cash (120 x $63)                                                         7,560
  Contributed Surplus                                                      5,040

Retained Earnings1                                       8,100
   Dividends Payable                                                       8,100

Cash                                                   13,480
  Common Shares2                                                         13,480

1.        $30,300 Net Income – 22,200 Increase in retained earnings = $8,100
2.        $105,880 - $105,000 = $880 net Increase in common Stock + 12,600 Common
          Stock repurchases = $13,480.




Page 331                                                         CMA Ontario – September 2009
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Problem 2

a)      i)      Oct. 1, 20x0
                 Retained earnings (4,000 shares x $30)                120,000
                    Common stock                                                    120,000

        ii)     Total shareholders' equity is unchanged since the stock dividend causes no
                change in the assets or liabilities of Parsley Ltd. That is, the shareholders
                did not receive anything they did not have before. The only change the
                stock dividend resulted in was to alter the components of shareholders'
                equity to recognize the capitalization of retained earnings equivalent to the
                market value of the shares resulting from the dividend. The number of
                shares held by each shareholder increased but each shareholder's
                percentage of ownership in Parsley Ltd. was unchanged.

b)      i)      Dec. 31, 20x0
                 Retained Earnings                                      102,500
                   Dividends payable                                                    102,500

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

        ii)     The cash dividend created an obligation (liability) for Parsley Ltd, to pay
                cash to its shareholders of record on December 31, 20x0. It' a current
                liability because it is payable within one year of that date. The company's
                Statement of Financial Position dated December 31, 20x0, would be
                affected to the extent of an increase in current liabilities and a decrease in
                retained earnings.

c)      i)
              Oct. 31, 20x0
              Common Stock ($920,000 / 44,000) x 3,000                  62,728
              Retained Earnings                                          9,272
               Cash (3,000 x $24)                                                      72,000




Page 332                                                          CMA Ontario – September 2009
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Problem 3

PART A

i)    Retained Earnings                                               $6,820
         Stock Dividend Distributable                                               $6,820
      Theoretical market price after adjustment to stock
      dividend news = $15 /1.1 = $13.64
      5,000 shares x 10% x $13.64 = $6,820

ii)   Common shares authorized 20,000 shares, issued and
       outstanding 5,500 shares                                                    $66,820
      Retained Earnings                                                             43,180
                                                                                  $110,000

PART B

i)    Building                                        600,000
       Preferred Shares                                              600,000

      Retained Earnings (note)                        275,000
       Cash                                                          275,000

      Calculation of total dividend declaration -
        Dividends Preferred – Arrears: (5,000 x 5) x 2                             $50,000
          Current year: 10,000 x 5                                                  50,000
        Common (175,000 x $1)                                                      175,000
                                                                                  $275,000




Page 333                                                        CMA Ontario – September 2009
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Problem 5

1.     Jul 5, 20x5        Share subscriptions receivable       $70,000,000
                             Common shares subscribed                          $70,000,000
                          1,000,000 shares x $70

                          Cash ($70,000,000 x 35%)              24,500,000
                            Share subscriptions receivable                      24,500,000

       Sep 30, 20x5       Cash ($70,000,000 x 65%)              45,500,000
                            Share subscriptions receivable                      45,500,000

                          Common shares subscribed              70,000,000
                            Common shares                                       70,000,000

2.     July 5, 20x5       Same as in part (1).

       Sep 30, 20x5       Cash ($70,000,000 x 90% x 65%)        40,950,000
                            Share subscriptions receivable                      40,950,000

                          Common stock subscribed                 7,000,000
                            Cash ($24,500,000 x 10%)                              2,450,000
                            Subscription receivable                               4,550,000

                          Common stock subscribed               63,000,000
                            Common Stock                                        63,000,000

3.     All entries are the same with one exception. In the second journal entry in part (2),
       we would credit Contributed Surplus and not Cash.




Page 334                                                        CMA Ontario – September 2009
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Problem 6

                                      Shlee Company
                                  SHAREHOLDERS' EQUITY
                                      JUNE 30, 20x3

Share capital:
   $.60 Preferred shares, no par, cumulative and
      nonparticipating, 50,000 shares authorized, 30,000
      shares issued and outstanding—Note A                                   $ 450,000
   Common shares, no par, 200,000 shares authorized,
      107,100 shares issued and outstanding                  $ 2,290,400a
   Common shares subscribed, 8,000 shares                        320,000
         Total common shares issued and subscribed                           2,610,400
Retained earnings:
   Appropriated--Note B                                        $ 40,000
   Unappropriated                                               216,600b       256,600
         Total shareholders' equity                                         $3,317,000

NOTE A: Shlee Company is in arrears on the preferred shares in the amount of $9,000.

NOTE B: Shlee Company is required to appropriate retained earnings in an amount that
is equal to the sinking fund deposit that is to be accumulated to retire a term loan.
a
 Outstanding prior to current year (105,000)                                $ 2,162,000
Subscribed shares fully paid (2,000 x $40)                                       80,000
Shares cancelled [($2,242,000 / 107,000) x 2,000)                              (41,900)
2% stock dividend [.02(107,000 - 2,000) x $43]                                   90,300
                                                                            $ 2,290,400


b
 Beginning                                                                   $ 370,000
Net Income                                                                       20,000
Appropriation                                                                 (40,000)
Stock dividend (2,100 x$43)                                                   (90,300)
Preferred dividend ($.30 x 30,000)                                              (9,000)
Common share retirement in excess of carrying value
   ($76,000 - $41,900)                                                         (34,100)
                                                                              $216,600




Page 335                                                    CMA Ontario – September 2009
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Problem 7


Feb 1      Cash                                        $36,000,000
             Common Shares                                            $36,000,000

Feb 15     Cash                                         11,000,000
             Preferred shares                                           11,000,000

Mar 1      Common shares (20,000 x 15.65*)                313,000
              Contributed Surplus (20,000 x 1.15)                           23,000
              Cash (20,000 x 14.50)                                        290,000
           * 266,000,000 / 17,000,000 = $15.65

Mar 15     Common shares (10,000 x 15.65)                 156,500
           Contributed Surplus                             23,000
           Retained earnings                               20,500
             Cash (10,000 x 20)                                            200,000

Mar 31     Retained earnings (16,970,000 x .10)          1,697,000
             Dividends Payable                                           1,697,000

Apr 30     Dividends Payable                             1,697,000
             Cash                                                        1,697,000

Apr 15     Common shares (18,000 x 15.65)                 281,700
           Retained earnings                               33,300
             Cash (18,000 x $17.50)                                        315,000

May 31     Retained Earnings (16,952,000 x 5% x $20)    16,952,000
             Stock dividend distributable                               16,952,000

           Stock dividend distributable                 16,952,000
             Common stock                                               16,952,000

Sep 30     Retained Earnings *                           2,579,960
              Dividends payable                                          2,579,960
           * (17,799,600 x .1) + (100,000 x 8)

           Dividends payable                             2,579,960
             Cash                                                        2,579,960




Page 336                                                CMA Ontario – September 2009
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Problem 8

Dec 31, 20x4        Compensation expense
                      ($125,000 x 1/2 x 80%)                          $50,000
                      Contributed Surplus
                         – Unexpired Stock Options                                $50,000

The compensation expense for the 20x5 is calculated as follows:

       Cumulative value of the stock options earned for the period
         20x4 - 20x5: $125,000 x 100% x 175,000 / 200,000                  $109,375
       Less cumulative compensation expense to the end of 20x4               50,000
       Compensation expense - 20x5                                         $ 59,375


Dec 31, 20x5        Compensation expense                               59,375
                      Contributed Surplus
                        – Unexpired Stock Options                                  59,375

20x6                Cash (160,000 x $25)                             4,000,000
                    Contributed Surplus
                      – Unexpired Stock Options
                           ($109,375 x 160,000 / 175,000)             100,000
                      Common stock                                               4,100,000

Dec 31, 20x5        Contributed Surplus
                      – Unexpired Stock Options                         9,375
                      Contributed Surplus                                             9,375




Page 337                                                       CMA Ontario – September 2009
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Problem 9

20x4         50,000 options x $20 x 75% x                                      $187,500

20x5         Cumulative compensation expense to end of 20x5:
               50,000 options x $20 x 80% x 2/4                                $400,000
             Less 20x4 compensation expense                                     187,500
                                                                               $212,500

20x6         Cumulative compensation expense to end of 20x6:
               50,000 options x $20 x 80% x 3/4                                $600,000
             Less cumulative compensation expense to end of 20x5:
               $187,500 + 212,500                                               400,000
                                                                               $200,000

20x7         Total cumulative compensation expense to the end of 20x7:
               1,000 shares x 41 executives x $20                              $820,000
             Less cumulative compensation expense to end of 20x6:
               $187,500 + 212,500 + 200,000                                     600,000
                                                                               $220,000




Page 338                                                     CMA Ontario – September 2009
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Problem 10

1.
March 20     Retained earnings (or dividends--preferred)                10,000
                Dividends payable                                                  10,000
             (5,000 x $4 x 1/2)

April 1      Dividends payable                                          10,000
                Cash                                                               10,000

June 15      Retained earnings (or dividends--common)                   20,000
                Dividends payable                                                  20,000
             ($.40 x 50,000 shares)

July 10      Dividends payable                                          20,000
                Cash                                                               20,000

Sept. 20     Retained earnings (or dividends--preferred)                10,000
                Dividends payable                                                  10,000
             (5,000 x $4 x 1/2)

Oct. 1       Dividends payable                                          10,000
                Cash                                                               10,000

Dec. 15      Retained earnings (or dividends--common)                   20,000
                Dividends payable                                                  20,000
             ($.40 x 50,000 shares)

             Retained earnings ($20 x 5,000 shares)                    100,000
                Stock dividends distributable ($20x 5,000)                        100,000




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2.
                                  Page Golf Club Company
                              Statement of Shareholders' Equity
                                   as at December 31, 20x2
Preferred shares                                                                    $ 507,500
Common shares                                                                         750,000
Common share dividend distributable                                                   100,000
   Total contributed capital                                                        1,357,500
Retained earnings                                                                   2,455,000
                                                                                   $3,812,500

3.
                                   Page Golf Club Company
                        Statement of Changes in Shareholders' Equity
                            for the year ended December 31, 20x2

                                                         Common
                                                            Share
                                  Preferred   Common     Dividend       Retained
                                    Shares     Shares     Distrib.      Earnings         Total
Balance, January 1, 20x2          $507,500    $750,000        $ -     $2,450,000   $3,707,500
Net income for the year
 ended December 31, 20x2                                                165,000       165,000
Cash dividends declared
  and paid                                                              (60,000)      (60,000)
Stock dividend declared                                   100,000      (100,000)             -
Balance, December 31, 20x2        $507,500    $750,000   $100,000     $2,455,000   $3,812,500




Page 340                                                          CMA Ontario – September 2009
Financial Accounting – Module 1



11.     Accounting for Pensions

Accounting for Pension Plans is covered by IAS 19 - Employee Benefit. As its title
would suggest, this standard covers the accounting issues broadly related to employee
benefits. Employee benefits are defined as all forms of consideration given by an entity in
exchange for service rendered by employees (IAS19.7). These include…
•       short-term employee benefits such as social security contributions, short-term
        compensated absences, non-monetary benefits, and profit-sharing and bonus plans
•       post-employment benefits (defined benefit and defined contribution pension
        plans).

This chapter will focus on post-employment benefits.

A pension plan is any arrangement (contractual or otherwise) by which a program is
established to provide retirement income to employees.

There are two basic types of pension plans. The first type is a defined benefit pension
plan. This type specifies either the benefits to be received by employees after retirement
or the method for determining those benefits. Benefits are typically determined by the
number of years of service and by the employee's earnings during those years of service.
For example, the standard benefit formula used by public service pension plans is as
follows - retirement income is based on the following formula: 2% x the average five best
years of salary x number of years of service to a maximum of 35 years. An employee
with 32 years of service whose average five best years of salary is $120,000 would be
eligible for a pension equal to $120,000 x 2% x 32 = $76,800.

The second type is a defined contribution pension plan. This is one in which the
employer's contributions are fixed, usually as a percentage of compensation, and
allocated to specific individuals. Pension benefits are a direct function of accumulated
contributions of the employer, employee, and earnings from investing those
contributions.

For the accountant, a defined contribution pension plan presents few problems. The
pension plan agreement provides a formula to be used in determining the employer's
contributions. Since these contributions represent the employer's only obligation to the
plan, there is usually no issues in determining the employer's annual cost – the pension
expense is usually equal to the contributions made to the employee’s pension plan by the
employer.

Defined benefit pension plans are considerably more complex. The future benefits to be
obtained by retirees under the pension plan is influenced by such things as the future rates
of return, mortality rates, early retirements/termination of employment prior to retirement
and future salary levels. Calculations of the plan's cost are based on actuarial estimates.

When creating a pension plan, the employer must examine the level of economic risk that
the firm will assume. For a defined contribution pension plan, the employer contributes

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the amount that was determined in the pension plan agreement. This is the employer's
only obligation. In other words, the employer assumes no risk for the accumulation of
the pension plan funds. It is the employee who assumes this risk as well as the risk of
what the prevailing economic conditions will be like at the time of retirement (as this
affects the amounts to be paid out as benefits).

The reverse is true for a defined benefit pension plan. The employer assumes the risk for
the benefits that are paid out to employees and these are not known with certainty until
paid. As stated previously, a number of things influence the total amount to be paid out as
benefits and these are all based on estimates. Therefore, there is risk inherent with this
type of plan. Also, the employer assumes the risk of the accumulation of the fund's assets
and its investments. It is the employer who must make up any shortfall caused by a
deficiency in the expected returns of the fund's investments.

This chapter will therefore focus on the accounting for defined benefit pension plans.

Pension Expense

For defined benefit pension plans, the pension expense for a period potentially includes
the following five items:

1)      Current service cost
2)      Interest accrued on the defined benefit obligation
3)      Expected return on plan assets
4)      Amortization of plan amendments / past service cost
5)      Amortization of actuarial gains or losses

Each of these items is now briefly discussed individually:

1) Current service cost
Current service cost is the increase in the present value of a defined benefit obligation
resulting from employee service in the current period (IAS 19.7). The accountant has no
involvement in the determination of this amount. It is calculated by the actuary and
provided to the accounting staff for inclusion in the determination of pension expense for
financial statement purposes.

2) Interest accrued on the defined benefit obligation
The present value of the defined benefit obligation (DBO) is the present value of
expected future payments required to settle the obligation resulting from employee
service in the current and future periods (IAS 19.7). Because the defined benefit
obligation is a discounted value, we must accrue interest on an annual basis. Each period
the interest on the DBO increases the pension expense for financial statement purposes.
The interest rate used in this calculation is based on management’s best estimate of an
appropriate rate. This interest cost is generally provided by the actuary.




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3) Expected return on plan assets
In order to provide for pension benefits that must be paid to employees in the future, the
employer usually makes regular payments or contributions to an asset pool. This pool of
funds is managed by a trustee and is invested in a number of different investment
vehicles such that the pool of assets will grow to meet the future pension obligation. The
expected return on the pension fund assets in the period, reduces the pension expense for
the corresponding period.

At this point let's look at a simple example incorporating these three components of
pension expense.
Example 1 - The following information relates to the defined benefit pension plan of
Milkweed Company for the year ended December 31, 20x6:

                                                                                          $
January 1, 20x6 balances          - Defined benefit obligation                    2,400,000
                                  - Pension Plan Assets                           2,300,000
                                  - Pension Account on Statement of
                                      Financial Position                         100,000 cr.
Current service cost                                                                190,000
Pension benefit payments                                                            100,000
Employer contributions                                                              300,000
Interest on Pension Obligation                                                      192,000
Interest on Pension Fund Assets (expected and actual)                               265,000

It's helpful to analyze the Defined benefit obligation and Pension Plan Assets, then use
that information to determine the pension expense for the period.

                                                  Pension                          Accrued
                                                     Plan                           Benefit
                                                   Assets                        Obligation
Opening balance                                $2,300,000                        $2,400,000
Current service cost                                                                190,000
Contributions to plan assets                      300,000
Benefits paid                                    (100,000)                         (100,000)
Expected return on plan assets                    265,000
Accrued interest on Accrued
  Benefit Obligation                                                                192,000
Closing balance                                $2,765,000                        $2,682,000

Pension expense:
  Current service cost                                            $190,000
  Interest on Accrued Pension Obligation                           192,000
  Expected return on plan assets                                  (265,000)
Total                                                             $117,000



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The journal entry to record the pension expense for the period, and the funding for the
period is:

    Pension expense                                        $117,000
    Pension account                                         183,000
           Cash                                                            300,000

The balance in the pension account represents the funded status of the pension plan at the
end of the year. At the beginning of the year the balance of the DBO was greater than the
Pension Fund Assets, indicating the pension plan was underfunded. The value of the
pension assets was not sufficient to relinquish the defined benefit obligation. By year end
the situation is reversed and the balance of the Pension Fund Assets exceeds the Defined
benefit obligation. This situation indicates the plan is overfunded. The value of the asset
pool exceeds the expected liability. The funded status of the pension plan at this point is
reflected on the Statement of Financial Position in the account called the pension account.
In this example the opening balance in this account is a credit of $100,000, indicating the
plan is underfunded. The account changes by a debit of $183,000 during the year
resulting in a closing debit balance of $83,000. The plan is overfunded at year end by
$83,000, the difference between the Pension Fund Assets balance of $2,765,000 and the
Defined benefit obligation balance of $2,682,000.

As note on interest accrual

In most pension textbook situations, for simplicity, it is assumed that the current service
cost, benefits paid to pension plan participants and contributions to the pension plan
assets are made at the end of the year. Consequently, we calculate the accrued interest on
the defined benefit obligation based on the opening balance. Similarly, the expected
return on the plan assets is based on the opening pension plan asset balance.

If you are told, for example, that the contributions to the pension plan assets were made
halfway through the year, then in addition to the expected return on the opening balance,
you would have to include an expected return on the contribution made by accruing
interest for one-half of the year.

Now let's look at the more complex adjustments to pension expense.

4) Amortization of plan amendments/past service costs
When a defined benefit pension plan is introduced or amended, employee services
provided prior to the introduction/amendment of the plan often qualify for future pension
benefits. These employee services are referred to as past service costs. These past
service costs also often arise on the amendment of the pension plan. The past service
costs are amortized on a straight line basis over the average period until the past service
costs become vested. This amortization increases pension expense for the period. The
rationale for this treatment is that the employer expects to receive future benefits from
this employee group and therefore is willing to allow the prior years' service to qualify
for pension benefits. The total lump sum of past service costs increases the balance in the


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DBO. If the past service cost vest immediately, they are recognized as an expense
immediately.

5) Actuarial Gains and losses
Actuarial gains and losses are changes in the value of the defined benefit obligation and
the pension plan assets resulting from:
i)     experience different from that assumed; and/or
ii)    changes in actuarial assumptions.

With respect to the Pension Plan Assets, experience gains and losses arise when the
expected return generated by the pension fund assets is different than the actual return
generated. An experience gain is generated when the actual return exceeds the expected
return. An experience loss is generated when the actual return falls short of the expected
return.

The expected Defined benefit obligation balance at year end differs from the actual year
end balance when the actuarial assumptions change. The actuary will audit the pension
plan every so often and will calculate what the defined benefit obligation balance should
be. This is compared with the amount of defined benefit obligation that was calculated.
Any difference is an actuarial revaluation and will either increase or reduce the DBO.

Actuarial gains and losses are amortized only if, in the aggregate, they exceed 10% of the
greater of:
i)      the defined benefit obligation at the beginning of the year, or
ii)     the fair value of the pension fund assets at the beginning of the year.

This is referred to as the corridor test.

When amortization is required, the minimum amortization should be that excess divided
by the estimated average remaining service life of the employees under the plan.

Example 2 - Assume that a firm initiated a pension plan on January 1, 20x1, and the
actuary arrived at a current service cost of $200,000 per year by using a 10% discount
rate. Now assume, however, that the firm will recognize past service costs of $500,000.
This represents the present value of the company's past service costs at the date of the
plan initiation. Assume also that the firm will fund current service costs by making a
payment of $200,000 per year to the pension plan trustee.

The terms of the new pension plan require that the firm fund, in addition to the full
current service cost, the past service costs in three annual installments of $201,058
beginning December 31, 20x1. The past service costs vest in three years and therefore
will be amortized to pension expense over three years.

The annual amount of amortization of past service cost is simply:
      $500,000 / 3 = $166,667.



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Funding of the current service costs and past service costs occurs at the end of the year.
Let's begin by analyzing the Pension Plan Assets and Pension Obligation.

                                                                   Pension        Accrued
                                                                      Plan          Benefit
                                                                    Assets       Obligation
20x1
Opening balance                                                                    $500,000
Accrued Interest                                                                     50,000
Current service cost                                                                200,000
Contributions - current                                           $200,000
               - past                                              201,058
Closing Balance                                                   $401,058         $750,000

20x2
Opening balance                                                   $401,058       $ 750,000
Expected return / Accrued interest                                  40,106          75,000
Current service cost                                                               200,000
Contributions - current                                            200,000
               - past                                              201,058
Closing balance                                                   $842,222       $1,025,000

20x3
Opening balance                                                  $ 842,222       $1,025,000
Expected return / Accrued interest                                  84,222          102,500
Current service cost                                                                200,000
Contributions - current                                            200,000
               - past                                              201,058
Closing balance                                                  $1,327,502      $1,327,500

The pension expense for each year is as follows:

                                                      20x1             20x2            20x3
Current service cost                              $200,000        $200,000          200,000
Accrued interest on pension obligation              50,000           75,000         102,500
Expected return on plan assets                                      (40,106)        (84,222)
Amortization of past service costs                 166,667         166,667          166,667
                                                   416,667         401,561          384,945

Journal entries for the first three years would be as follows:

20x1       Pension expense                                       $416,667
                 Pension account                                                    $15,609
                 Cash ($201,058 + 200,000)                                          401,058


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20x2       Pension expense                                      $401,561
                 Pension account                                                     $ 503
                 Cash ($201,058 + 200,000)                                          401,058

20x3    Pension expense                                         $384,945
        Pension account                                           16,113
               Cash ($201,058 + 200,000)                                           $401,058

Note that at the end of 20x1 the Defined benefit obligation exceeds the Pension Fund
Assets by $348,942 ($750,000 - 401,058), which indicates the pension plan is
underfunded. In simple situations, this underfunded amount would be reflected in the
pension account on the Statement of Financial Position. In this case, at the end of 20x1
the pension account has a credit balance of $15,609. The difference between these two
amounts ($348,942 - 15,609 = $333,333) is due to the balance of unrecognized past
service costs ($500,000 - 166,667 = $333,333). The past service costs increase the
balance in the defined benefit obligation as soon as the past employee service qualifies
for pension benefits. These costs are recognized in the financial statements to pension
expense over the period of time these benefits vest.

It's also important to note that at the end of 20x3 the balance in the pension account is
zero. This result is consistent with the fully funded status of the plan, where the defined
benefit obligation is equal to the Pension Fund Assets, and the full recognition for
accounting purposes of the past service costs.

Example 3 - Refer to Example 2. Assume that at the end of 20x1 the actual balance in the
Pension Fund Assets was $420,000, and the Pension Obligation at year-end was
determined to be $765,000. Assume that the estimated average remaining service life
(EARSL) of the employee group is 3 years. Now let's determine pension expense. We
start by looking at the Pension Plan Assets and the Pension Obligation.

20x1                                   Pension                Defined
                                          Plan                 benefit
                                        Assets              obligation

Year-end balance as calculated        $401,058               $750,000

Actual balance at year-end             420,000                765,000

Experience gain                        $18,942     gain
Actuarial revaluation                                         $15,000 loss

The net gain is $3,942.

The pension expense for 20x1 will be the same as previously calculated. The
amortization of the net actuarial gain (if any) will begin in 20x2 and would decrease


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pension expense. To determine whether or not we need to amortize the actuarial gain, we
must compare it to the corridor:

      10% of pension obligation as at the beginning of 20x2:
        $765,000 x 10%                                                             $76,500
      10% of the pension fund assets as at the beginning of 20x2:
        $420,000 x 10%                                                             $42,000

Since our actuarial gain of $3,942 is less than $76,500, we do not need to amortize it.

Reconcilation of the Funded Status

At any point in time, there will be a difference between the funded status of the plan and
the pension account on the Statement of Financial Position. The funded status is defined
as the difference between the defined benefit obligation and the plan assets. The funded
status represents the true economic liability (or asset) of the firm vis a vis the pension
plan. For example, if the balance in the defined benefit obligation is $20,000,000 and the
balance in the pension assets is $16,000,00, then the funded status is a liability of
$4,000,000. If the pension account shows a balance of $1,000,000 cr., then we have an
unrecorded liability of $3,000,000.

The unrecorded liability at any point in time will always equal the sum of:
•      any unamortized plan amendments, and
•      any unamortized actuarial gains and losses (actuarial revaluations and/or
       experience gains and losses).


Pension accounting and future income taxes

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


Actuarial Gains and Losses - Additional Options

Until now, we have assumed that the entity applies the corridor test to the accumulated
actuarial gains and losses and amortized only if the corridor is exceeded. Although it is
expected that the majority of entities will do just that, IAS 19 allows for two additional
options:

1.      the entity may adopt any systematic method that results in faster recognition of
        actuarial gains and losses, provided that the same basis is applied to both gains
        and losses and the basis is applied consistently from period to period (IAS 19.93).



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2.      the entity may adopt a policy of recognizing actuarial gains and losses in the
        period in which they occur in other comprehensive income providing it does so
        for all of its defined benefit plans and all of its actuarial gains and losses (IAS
        19.93A). If the entity chooses this option, then the corridor test still has to be done
        and any amortization required gets transferred from other comprehensive income
        directly to retained earnings (IAS 19.93C).

Summary of Calculations

Defined benefit obligation
       Balance, beginning of year
       + Accrued interest
       + Current service cost
       - Benefits paid to retirees
       ± Actuarial revaluation
       ± New plan amendment
       = Balance, end of year

Plan Assets
       Balance, beginning of year
       + Expected return
       + Contributions to plan
       - Benefits paid to retirees
       ± Experience gains/losses
       = Balance, end of year

Pension Expense
       Current service cost
       + Accrued interest on DBO
       - Expected return on plan assets
       ± Amortization of plan amendments / past service costs
       ± Amortization of actuarial gains/losses, per corridor test




Page 349                                                          CMA Ontario – September 2009
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Comprehensive example

You are provided with the following data for the Tarrant Company pension plan. The
company has a fiscal year coinciding with the calendar year.

Balances as at January, 1, 20x5:
  Defined benefit obligation                                                   $26,000,000
  Plan Assets                                                                   19,500,000
  Pension account balance                                                        2,000,000 cr.
  Unamortized plan amendment (the plan amendment was made on
    January 2, 20x3 and is being amortized over a total of 12 years
    to full vesting)                                                              1,600,000

Data for the year ended December 31, 20x5:
  Current service cost                                                          $3,000,000
  Benefits paid to retirees                                                      1,800,000
  Actual return on plan assets                                                   2,200,000
  Contributions made to pension plan                                             4,000,000

The interest rate used for both the defined benefit obligation and the plan assets is 7%.
The actuary audited the defined benefit obligation at December 31, 20x5 and calculated
the balance to be $30,400,000. The expected remaining service live of the employees at
January 1, 20x5 is 8 years.


The first thing we want to do is reconcile the funded status at the beginning of the year.
This will tell us if we need to take into account any unrecognized actuarial gains and
losses at that time.

Funded status ($26,000,000 – 19,500,000)                                         $6,500,000
Less balance in pension account                                                   2,000,000
Unrecognized liability                                                            4,500,000
Less Unamortized plan amendment                                                   1,600,000
Unamortized actuarial losses, January 1, 20x5                                    $2,900,000




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The corridor test shows that we have to amortize some of these actuarial losses:

Unamortized actuarial losses, January 1, 20x5                                   $2,900,000
Corridor: $26,000,000 x 10%                                                      2,600,000
Excess                                                                            $300,000

Amortization: $300,000 / 8 years                                                   $37,500

The pension expense is calculated as follows:
  Current service cost                                                          $3,000,000
  Accrued interest on DBO: $26,000,000 x 7%                                       1,820,000
  Expected return on plan assets: $19,500,000 x 7%                              (1,365,000)
  Amortization of plan amendment: $1,600,000 / 10 years remaining                   160,000
  Amortization of actuarial losses                                                   37,500
                                                                                $3,652,500

The journal entry to record pension expense will be as follows:

  Pension expense                                              $3,652,500
  Pension account                                                 347,500
    Cash                                                                        $4,000,000

The balance in the pension account at the end of the year will be:
  $2,000,000 cr + 347,500 dr. = $1,652,500 cr.

In order to reconcile the funded status at the end of the year, we must calculate the ending
balances of both the defined benefit obligation and plan assets.

Defined benefit obligation
  Balance, beginning of year                                                   $26,000,000
  Accrued interest                                                               1,820,000
  Current service cost                                                           3,000,000
  Benefits paid to retirees                                                     (1,800,000)
  Actuarial revaluation                                                          1,380,000
  Balance, end of year                                                         $30,400,000

Plan assets
  Balance, beginning of year                                                   $19,500,000
  Expected return                                                                1,365,000
  Contributions                                                                  4,000,000
  Benefits paid to retirees                                                     (1,800,000)
  Experience gain: $2,200,000 – 1,365,000                                          835,000
  Balance, end of year                                                         $23,900,000




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Reconciliation of funded status as at December 31, 20x5:

Funded status: $30,400,000 – 23,900,000                                     $6,500,000
Less balance in pension account                                              1,652,500
Unrecognized liability                                                      $4,847,500

Accounted for:
  Unamortized plan amendment: $1,600,000 – 160,000 Amortization             $1,440,000
  Unamortized actuarial losses
    Balance, beginning of year                         $2,900,000
    Actuarial revaluation                                1,380,000
    Experience gain                                      (835,000)
    Amortization of actuarial losses                      (37,500)           3,407,500
                                                                            $4,847,500




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Problems with Solution

Multiple Choice Questions

1.      Defined contribution plans and defined benefit plans are two common types of
        pension plans. Choose the correct statement concerning these plans.
        a.     The required annual contribution to the plan is determined by formula or
               contract in a defined contribution plan.
        b.     Both plans provide the same retirement benefits.
        c.     The retirement benefit is usually determinable well before retirement in a
               defined contribution plan.
        d.     In both types of plans, pension expense is generally the amount funded
               during the year.


2.      Which of the following is never one of the five continuing components of pension
        expense (or part of a component)?
        a.     Amortization of excess actuarial gain or loss.
        b.     Expected return on plan assets.
        c.     Amount paid to the pension trustee for current service during the period.
        d.     Growth (interest cost) in accrued pension obligation since the beginning of
               the period.


3.      The following information for Gamez Enterprises is given below:

           Plan assets (at fair value), Dec 31, 20x8                           $2,476,000
           Accrued Pension Obligation, Dec 31, 20x8                             2,760,000
           Unrecognized past service costs, Dec 31, 20x8                          410,000
           Unrecognized actuarial gains (net), Dec 31, 20x8                     (210,000)
           Pension Account (on balance sheet) Jan 1, 20x8                       48,000 cr.
           Pension expense for 20x8                                               360,000
           Contributions to plan assets during 20x8                               324,000

        What is the amount that Gamez Enterprises should report as Pension Account as
        of December 31, 20x8?
        a.     $84,000 cr.
        b.     $120,000 cr.
        c.     $72,000 cr.
        d.     $12,000 cr.




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The following information relates to questions 4 - 5:

On January 1, 20x8, Moore Co. has the following balances:

      Accrued pension obligation                                                $2,800,000
      Fair value of plan assets                                                  2,500,000

The current interest rate is 10%. Other data related to the pension plan for 20x8 are:

      Current service cost                                                        $160,000
      Amortization of unrecognized prior service costs                              37,000
      Contribution to plan assets                                                  180,000
      Benefits paid                                                                150,000
      Actual return on plan assets                                                 176,000
      Amortization of unrecognized net gain                                         12,000

4.      The balance of the defined benefit obligation at December 31, 20x8 is
        a.     $3,048,000
        b.     $3,060,000
        c.     $3,085,000
        d.     $3,090,000

5.      The fair value of plan assets at December 31, 20x8 is
        a.     $2,354,000.
        b.     $2,526,000.
        c.     $2,706,000.
        d.     $2,856,000.




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Problem 1

Mullen Company, a manufacturer of photographic equipment, is in the process of
preparing year-end financial statements. Susan Thawley was recently hired as assistant
controller of Mullen, and her first responsibility is to prepare the annual pension accrual.
Mullen established a noncontributory, defined benefit pension plan covering its 190
employees at the beginning of the fiscal year ended May 31, 20x0. At that time, the prior
service cost for the existing employee group was $11,300, and the average time to full
vesting of past service costs was 20 years. Mullen's corporate controller, Roger Kaplan,
has provided Thawley with last year's workpapers and copies of the annual reports from
the actuary and the fund trustee for Mullen. The following additional data is available:

        Average remaining service life, May 31, 20x3                      16 years
        Benefits paid                                                      $ 1,778
        Contributions to plan assets                                       $ 3,680
        Expected return on plan assets                                        10%
        Fair value of plan assets, May 31, 20x2                           $32,650
        Fair value of plan assets, May 31, 20x3                           $39,500
        Current service cost                                               $ 2,430
        Defined benefit obligation, May 31, 20x2                          $43,800
        Interest rate used for accrued pension obligation                      8%

There were no unamortized actuarial gains and losses at May 31, 20x2.

Required -

a) Calculate the Defined benefit obligation, Plan Assets for the year ended May 31,
   20x3. Also calculate the pension expense for the year. Reconcile the funded status.
b) 1. Explain why pension gains and losses are not recognized on the income statement
      in the period in which they arise.
   2. Briefly describe how pension gains and losses are recognized.




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Problem 2

The Chisnall Corporation Ltd began a pension fund in the year 20x3, effective January 1,
20x4. Terms of the pension plan follow:

•       the discount rate on plan assets is 6%
•       employees will receive partial credit for past service. The defined benefit
        obligation, valued by the actuary using a discount rate of 6%, is $216,000 as of
        January 1, 20x4.
•       past service cost will be funded over 15 years. The initial payment, on January1,
        20x4 is $20,000. After that, another $20,000 will be added to the December 31
        current service funding amount, including the December 31, 20x4 payment. The
        amount of past service funding will be reviewed every five years to ensure its
        adequacy.
•       the average number of years to full vesting of past service costs at January 1, 20x4
        was 20 years.
•       the current service cost will be fully funded each December 31, plus or minus any
        actuarial or experience gains related to the defined benefit obligation (i.e.
        actuarial revaluations). Experience gains and losses related to the difference
        between actual and expected earnings on fund assets will not affect plan funding
        in the short-run, as they are expected to offset over time.

        Data for 20x4 and 20x5 -
                                                                      20x4            20x5
        Current service cost                                       $51,000         $57,000
        Funding amount, January 1, 20x4                             20,000              —
        Funding amount, December 31                                     ??              ??
        Actual return on fund assets                                 1,000           6,800
        Increase in actuarial liability at year-end due
          to an actuarial revaluation                                    —          16,000
        Expected Average Remaining Service Life for all
          employees                                               26 years         25 years

Required:

Prepare journal entries to record pension expense and funding for 20x4 and 20x5. Also
prepare a reconciliation of funding status to the pension account as it would appear on the
Statement of Financial Position.




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Financial Accounting – Module 1


Problem 3

Bufflehead Ltd. has a noncontributory pension plan which was instituted on January 1,
20x0. the current data as at December 31, 20x1 are as follows:

•    Actuary’s discount rate                                                    10%
•    Anticipated earnings on plan assets                                         8%
•    Defined benefit obligation, January 1, 20x1                           658,000
•    Pension Account balance on Statement of Financial Position
                  at Jan 1, 20x1                                             5,000 cr.
•    Pension plan assets at fair value, January 1, 20x1                   $245,000
•    Current service cost – 20x1                                           148,000
•    Contributions to pension fund by Bufflehead, Ltd. in 20x1              95,000
•    Unamortized past service cost, January 1, 20x1                        420,000
         (this is being amortized at the rate of $26,250 per year)
•    Pension benefits paid to retirees during 20x1                         174,000
•    Pension plan assets at fair value, December 31, 20x1                  261,000
•    Defined benefit obligation, December 31, 20x1
         (per actuarial estimate)                                          710,000
•    Estimated remaining service life of employees,
         as at January 1, 20x0                                                   17 years

Assume all payments to and from the plan are made at the end of the year.

Required –

a.   Calculate:
     i.       defined benefit obligation
     ii.      plan assets
     iii.     pension expense
b.   Prepare the journal entry required to record the pension plan for 20x1.
c.   Reconcile the funded status of the plan with the pension account that would appear
          on the Statement of Financial Position as at December 31, 20x1.




Page 357                                                        CMA Ontario – September 2009
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Problem 4

Patti Company has a defined benefit pension plan. The following is partial information
related to the plan:

Defined benefit obligation, January 1, 20x0                                $ 32,000
Actuarial losses, January 1, 20x0                                          $ 15,000
Pension Plan Assets, January 1, 20x0                                       $ 30,000

Expected return on plan assets                                             10%
Discount rate                                                              11 %
Average remaining service time, January 1, 20x0                            30 years

Current service cost for 20x0                                              $ 2,000
Benefit payments to retired employees for 20x0                             $ 4,000
Contributions to the pension fund for 20x0                                 $ 3,000
Actual return on plan assets for 20x0                                      $ 4,000


Required

a.      Compute the defined benefit obligation as at December 31, 20x0.
b.      Compute the pension plan assets as at December 31, 20x0.
c.      Compute the pension expense for the year 20x0.
d.      Prepare the reconciliation of funded status as at December 31, 20x0.




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Problem 5

As controller of Tumeric Ltd., you have been asked by the president to attend a
subcommittee meeting as an observer on December 30, 20x5. Those present included the
president, treasurer, and vice-president of sales.

President       As we decided at our last annual meeting, the company adopted a pension
                plan for its employees starting on January 1, 20x5. You were all present
                yesterday at the office of Hoskins Ltd., the actuarial firm handling the plan
                for us. Do you have any questions?
Treasurer:      What is it going to cost us?
President:      Hoskins determined that the value of past service benefits at January 1,
                20x5, was $883,212.
Treasurer:      What I meant was, since Hoskins recommended that we cover the past
                service costs by making annual deposits of $266,660 at the end of each
                year for 4 years at an expected return of 8% per annum, what will be the
                annual expense for 20x6 and 20x7?
President:      At the moment, I don't know. We do know, however, that the pension cost
                for current service will be $225,000 for 20x5. This is estimated to increase
                annually by $5,000, and will be fully funded at the end of each year. As
                far as I understand, we can amortize the past service costs independently
                from the funding period. The expected average time to full vesting of the
                past service costs is 6 years. The accruals for service, and all necessary
                payments will be made at year-end.
Treasurer:      What I want to know is, what effect would all this have on the journal
                entries for 20x5 through to 20x7?
President:      I'm not sure.
VP Sales:       Don't forget that Hoskins estimated an annual benefit payment of $25,000,
                to be made at the end of each year.
Treasurer:      What effect would there be, if any, if on December 31, 20x6, the pension
                fund earned $15,000 more than expected?
President:      I'm afraid we'll have to address these questions ourselves. It's getting late,
                and if there are no further questions, I'd like to adjourn today's meeting.

Required:

Answer the queries raised by the subcommittee. Also, reconcile the defined benefit
obligation and plan assets to the Statement of Financial Position account. Assume an
interest rate of 8% on both the defined benefit obligation and the plan assets. The
estimated average remaining service life is 10 years for all years.




Page 359                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 6

This problem is a continuation of the Do-Re-Mi problem taken up in class. It assumes
you have completed the in-class problem.

Assume the following additional data:

                                                         20x4            20x5          20x6

Current service cost                                 $120,000       $134,000       $165,000

Interest rate on accrued benefits and fund assets          8%              7%            7%

Actual return on plan assets                          120,000          10,000        50,000

Annual funding payments to trustee                           -        300,000       600,000

Benefits paid to retirees                              45,000          65,000        90,000

Changes in actuarial assumptions establishes a
December 31 benefit obligation of                   $1,400,000                   $2,000,000

EARSL                                                 13 years       14 years       12 years

On January 2, 20x5, the company amended the pension plan formula – this caused an
increase in the Defined benefit obligation of $252,000. The number of years to full
vesting was 14 years.




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Financial Accounting – Module 1


Problem 7

The Harold Corporation operates a defined benefit plan for its employees. Data relative to
the plan for the year 20x8 is as follows:

Data relative to balances at January 1, 20x8:
  Defined benefit obligation                                                   $5,600,000
  Plan assets                                                                   6,700,000
  Pension account balance                                                      800,000 dr.
  Unamortized past service cost arising from a plan amendment
     made on January 1, 20x1 (amortized at the rate of $75,000 per
     year)                                                                        500,000

Current service cost                                                              260,000
Benefits paid to employees                                                        210,000
Contributions to pension assets
  January 2, 20x8                                                                  60,000
  July 2, 20x8                                                                     80,000
  December 31, 20x8                                                               150,000
Actual return on pension assets                                                   450,000
Discount rate used for Defined benefit obligation and Pension Assets                  6%

The actuary estimates that the defined benefit obligation as at December 31, 20x8 is
$6,500,000.

The estimated average service life of the employees as at January 1, 20x8 is 10 years.

Required –

Reconcile the opening balance of the Defined benefit obligation and Plan assets to their
ending balances. Calculate pension expense for the year 20x8 and reconcile the funded
status at December 31, 20x8.




Page 361                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 8

The following information is given DBOut a defined benefit plan. The present value of
the obligation and the fair market value of the plan assets at January 1, 20x1 were both
$1,000. The net cumulative unrecognized actuarial gains at that date were $140.

                                                         20x1           20x2          20x3
Discount rate                                          10.0%           9.0%           8.0%
Expected rate of return on plan assets                 12.0%          11.1%          10.3%
Current service cost                                      130            140            150
Benefits paid                                             150            180            190
Contributions paid                                         90            100            110
Present value of obligation at December 31              1,141          1,197          1,295
Fair value of plan assets at December 31                1,092          1,109          1,093
Expected average remaining service lives of                10             10               10
employees (years)

In 20x2, the plan was amended to provide additional benefits. The present value at
January 1, 20x2 of the additional benefits for employee service before January 1, 20x3
was $50 for vested benefits and $30 for non-vested benefits. As at January 1, 20x3, it was
estimated that the average period until the non-vested benefits would become vested was
three years.

Required –

Calculate pension expense for the years 20x1 - 20x3 and reconcile the funded status at
the end of each of these years. (Adapted from IAS 19 Appendix A)




Page 362                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 9

As Controller of Barns Ltd. you were presented with the pension plan information shown
below. The company's plan commenced in 20x0 when past service costs (PSC) were
estimated to be $566,000. The estimated remaining service life of the employees at that
time was 15 years. Assume that there will be no payments to retirees during this period.

                                  Past Service Costs
                                                                       Cash
                   Current                 PSC                      Payment          Pension
                    Service        Amortization            Net       To Plan         Account
      Year             Cost            Amount          Interest      Trustee          - debit
      20x0         $49,000             $37,733         $56,600      $165,259         $21,926
      20x1           49,000             37,733          50,634       165,259          49,818
      20x2           49,000             37,733          44,072       165,259          84,272
      20x3           49,000             37,733          36,853       165,259         125,945
      20x4           49,000             37,733          28,912       165,259         175,559
      20x5           49,000             37,733          20,178       165,259         233,907
      20x6           49,000             37,733          10,570       165,265         301,869
      20x7           49,000             37,733               0        49,000         264,136
      20x8           49,000             37,733               0        49,000         226,403
      20x9           49,000             37,733               0        49,000         188,670
     20x10           49,000             37,733               0        49,000         150,937
     20x11           49,000             37,733               0        49,000         113,204
     20x12           49,000             37,733               0        49,000          75,471
     20x13           49,000             37,733               0        49,000          37,738
     20x14           49,000             37,733               0        49,000               0

Required -

a)      What is the interest rate used in the above schedule? Justify your answer.
b)      What does the net interest amount represent? Show how it is calculated for the
        year 20x1.
c)      Calculate the Defined benefit obligation and the Plan Asset balances at the end of
        20x2 and reconcile the funded status to the Pension Account.
d)      At the end of 20x7, how would the amount $264,136 be disclosed on the financial
        statements and what does this amount represent?
e)      Show how the annual amount for the amortization of past service costs was
        calculated.
f)      Show how the annual cash payments were determined.
g)      Prepare the necessary journal entry with respect to the pension plan for the year
        20x3.
h)      Prepare the necessary journal entry with respect to the pension plan for the year
        20x9.




Page 363                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 10

On January 2, 20x0, Mount Royal adopted a defined benefit pension plan. At the time of
adoption, the past service cost amounted to $883,212. This amount is being funded over
15 years, at the beginning of each year, in an equal amount per year of $95,544. The
management of Mount Royal, using their best estimates, determined the long-run interest
rate to be 8%. The expected return on plan assets is also 8%. Of the total past service
costs of $883,212, $400,000 vest immediately and the remainder vest in 5 years.

The current service cost, determined using the projected benefits method prorated on
services, is funded in full at the beginning of each year. Other information is as follows:

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

Mount Royal has a December 31 year-end.

Required -

Prepare required journal entries for 20x0 and 20x1 to record pensions in Mount Royal's
books. Reconcile the funded status for both years.




Page 364                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Solutions

Multiple Choice Questions

1.    a

2.    c

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

4.    d     Pension Obligation, beginning balance                                $2,800,000
            Interest @ 10%                                                          280,000
            Current service cost                                                    160,000
            Benefits paid                                                          -150,000
            Pension Obligation, ending balance                                   $3,090,000

5.    c     Plan assets, beginning of year                                       $2,500,000
            Contributions                                                           180,000
            Benefits paid                                                          -150,000
            Actual return                                                           176,000
                                                                                 $2,706,000




Page 365                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

a)
      Defined benefit obligation
      Balance, beginning of year                                               $43,800
      Accrued interest @ 8%                                                      3,504
      CSC                                                                        2,430
      Benefits paid                                                             -1,778
      Balance, end of year                                                     $47,956

      Pension Plan Assets
      Balance, beginning of year                                               $32,650
      Expected return @ 10%                                                      3,265
      Contributions                                                              3,680
      Benefits paid                                                             -1,778
      Experience gain                                                            1,683
      Balance, end of year                                                     $39,500

      Pension Expense
      CSC                                                                       $2,430
      Accrued interest on DBO                                                    3,504
      Expected return on Plan Assets                                            -3,265
      Amortization of Past Service Costs
        $11,300 / 20                                                               565
                                                                                $3,234

      Journal Entry -
      Pension expense                                              $3,234
      Pension account                                                 446
          Cash                                                                  $3,680

      Pension Account balance, May 31, 20x3
      Funded Status at beginning of year: $43,800 - 32,650                     $11,150
      Less unamortized PSC: $11,300 x 17/20                                      9,605
      Pension account balance, May 31, 20x2, credit                              1,545
      Less 20x3 journal entry                                                      446
      Pension account balance, May 31, 20x3, credit                             $1,099




Page 366                                                     CMA Ontario – September 2009
Financial Accounting – Module 1




        Reconciliation to funded status -
        DBO                                                                        $47,956
        Plan assets                                                                 39,500
        Funded Status                                                                8,456
        Less Pension Account                                                         1,099
        Unrecognized liability                                                      $7,357

        Reconciles to:
          Unamortized Past Service Cost: $11,300 x 16/20                            $9,040
          Experience Gain                                                           -1,683
                                                                                    $7,357


b) 1.    Pension gains and losses result from changes in the value of the accrued benefit
         obligation or the fair value of the plan assets. The volatility of these gains and
         losses may reflect an unavoidable inability to predict compensation levels, length
         of employee service, mortality, retirement ages, and other relevant events
         accurately for a period, or several periods. Therefore, fully recognizing the gains
         or losses on the income statement may result in volatility that does not reflect
         actual changes in the funded state of the plan in that period.

    2. In order to decrease the volatility of reporting pension gains and losses, these
       gains and losses are accumulated from year to year in a "memo" or "off-Statement
       of Financial Position" account. When the unrecognized balance in this account
       (gain or loss) exceeds 10 percent of the greater of the defined benefit obligation or
       the market-related value of the plan assets, the "corridor approach" is used to
       amortize the accumulated balance. The excess balance, the amount outside the
       corridor, must be amortized using any systematic method as long as it is not less
       than the amount computed using the straight-line method over the average
       remaining service life of all active employees.




Page 367                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2

                                                           20x4             20x5
Defined benefit obligation
  Beginning balance                                    $216,000         $279,960
  Interest @ 6%                                          12,960           16,798
  Current service cost                                   51,000           57,000
  Actuarial revaluation                                       -           16,000
                                                       $279,960         $369,758

Pension Assets
  Beginning Balance                                          $0          $92,000
  Funding payment - beginning of year                    20,000
  Expected Return @ 6%                                    1,200             5,520
  Funding payment - end of year
     (51,000 + 20,000) | (57,000 + 20,000 + 16,000)      71,000           93,000
  Experience gain (loss)                                   -200            1,280
                                                        $92,000         $191,800

Corridor Test
 Unrecognized gains/losses
     Experience gain (loss)                                    -             -200

  Corridor: 10% of opening PO                            21,600           27,996

Pension Expense
  Current service cost                                  $51,000          $57,000
  Interest on Defined benefit obligation                 12,960           16,798
  Expected Return on Pension Assets                      -1,200           -5,520
  Amortization of Past Service Costs (216,000 / 20)      10,800           10,800
                                                        $73,560          $79,078

Journal Entries -

20x4: Pension expense                                    73,560
      Pension Account                                    17,440
        Cash                                                              91,000

20x5: Pension expense                                    79,078
      Pension Account                                    13,922
        Cash                                                              93,000




Page 368                                              CMA Ontario – September 2009
Financial Accounting – Module 1




                                                                     20x4           20x5

Reconciliation
  Defined benefit obligation                                   $279,960         $369,758
  Plan Assets                                                    92,000          191,800
  Funded Status                                                 187,960          177,958
  Add Pension Account                                            17,440           31,362
  Unrecognized liability                                       $205,400         $209,320

Accounted for:
  Unamortized past service cost                                $205,200         $194,400
  Experience (gain) loss                                            200           -1,080
  Actuarial revaluation                                                           16,000
                                                               $205,400         $209,320


Problem 3

Before you start, it is always wise to do a reconciliation of the opening balances to
determine if there are any unrecognized amounts outstanding at the beginning of the year.

     Funded status at beginning of year
       $658,000 - 245,000                                              $413,000
     Less pension account balance                                         5,000
     Unrecorded liability                                              $408,000

     Reconciles to
      Unamortized past service cost                                    $420,000
      Unrecognized amounts (gains)*                                     (12,000)
                                                                       $408,000

     * this number, although not given, was imputed from the data.

a.
     Defined benefit obligation
       Beginning balance                                                $658,000
       Interest @ 10%                                                     65,800
       Current service cost                                              148,000
       Benefits paid                                                   (174,000)
       Actuarial revaluation                                              12,200
       Ending balance                                                   $710,000




Page 369                                                      CMA Ontario – September 2009
Financial Accounting – Module 1




     Pension Assets
       Beginning balance                                              $245,000
       Expected Return @ 8%                                             19,600
       Employer contributions                                           95,000
       Benefits paid                                                 (174,000)
       Experience gain                                                  75,400
       Ending balance                                                 $261,000

     Corridor Test -
       Corridor: $658,000 x 10%                                        $65,800
       Unrecognized amounts (gains)                                     12,000
          No amortization necessary.

     Pension Expense
      Current service cost                                           $148,000
      Interest on defined benefit obligation                            65,800
      Expected return plan assets                                     (19,600)
      Amortization of past service cost                                 26,250
                                                                     $220,450

b.   Pension expense                                     $220,450
         Cash                                                           $95,000
         Pension Account                                                125,450

     Balance in pension account at end of year = $5,000 + 125,450 = $130,450

c.
     Funded status at end of year
       $710,000 - 261,000                                            $449,000
     Less pension account balance                                     130,450
     Unrecorded liability                                            $318,550

     Reconciles to
      Unamortized past service cost                                  $393,750
      Unrecognized amounts
        $12,000 Op Gain - 12,200 Actuarial Revaluation
           + 75,400 Experience Gain                                   (75,200)
                                                                     $318,550




Page 370                                                     CMA Ontario – September 2009
Financial Accounting – Module 1




Problem 4


a.    Balance, beginning                                                          $32,000
      Interest: $32,000 x 11%                                                       3,520
      Current service cost                                                          2,000
      Benefit payments                                                             (4,000)
                                                                                  $33,520

b.    Balance, beginning                                                          $30,000
      Expected return: $30,000 x 10%                                                3,000
      Experience gain                                                               1,000
      Contributions                                                                 3,000
      Benefit payments                                                             (4,000)
                                                                                  $33,000

c.    Corridor Test -
        Corridor: $32,000 x 10%                                                    $3,200
        Unrecognized amounts                                                       15,000
        Excess                                                                     11,800
           Divide by EARSL                                                            / 30
           Amortization required                                                     $393

      Current service cost                                                         $2,000
      Accrued interest on pension obligation                                        3,520
      Expected return on plan assets                                               (3,000)
      Amortization of unrecognized amounts per corridor test                          393
      Pension expense, 20x0                                                        $2,913

      Journal entry -
        Pension expense                                                 $2,913
        Pension asset                                                       87
           Cash                                                                     $3,000


d.    First we must calculate the balance in the pension account:
        Balance at the beginning of year =
            Funded Status at beginning of year ($32,000 - 30,000)                  $ 2,000
            Less unrecognized amounts                                               15,000
            Pension account (asset) at beginning of year                            13,000
        Increase during year                                                            87
                                                                                   $13,087



Page 371                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




        Reconciliation -
        Funded Status: $33,520 - 33,000                                                             $520
        Add pension account                                                                       13,087
        Unrecorded liability                                                                     $13,607

        Unrecognized amounts:
          $15,000 Balance Beginning of year - 1,000 Experience Gain - 393 Amortization           $13,607


Problem 5


                                                               20x5              20x6           20x7
Defined benefit obligation
   Opening balance                                     $ 883,212          $1,153,869     $1,451,179
   Interest @ 8%                                           70,657             92,310        116,094
   Current Service Cost                                   225,000            230,000        235,000
   Benefit Payment                                        (25,000)           (25,000)       (25,000)
   Ending Balance                                      $1,153,869         $1,451,179     $1,777,273

Plan Assets
   Opening balance                                     $   -              $ 466,660      $ 990,653
   Funding on Past Service Cost                          266,660            266,660         266,660
   Funding on Current Service Cost                       225,000            230,000         235,000
   Benefit payments                                      (25,000)           (25,000)        (25,000)
   Expected return on plan assets                            -               37,333          79,252
   Experience gain                                           -               15,000             -
   Ending Balance                                      $ 466,660          $ 990,653      $1,546,565

Corridor Test –
   Corridor = 10% of Opening DBO                           $88,321          $115,357       $145,118
   Actuarial gains/losses                                                     15,000         15,000

    No amortization necessary

Pension Expense
   Current Service Cost                                $ 225,000          $ 230,000      $ 235,000
   Interest on PBO                                        70,657             92,310        116,094
   Expected return on plan assets                            -              (37,333)       (79,252)
   Amortization of PSC 1                                 147,202            147,202        147,202
                                                       $ 442,859          $ 432,179      $ 419,044

    1     $883,212 / 6 = $147,202



Page 372                                                                     CMA Ontario – September 2009
Financial Accounting – Module 1


Journal entries:

20x5        Pension expense                 $442,859
            Pension Account                   48,801
               Cash ($266,660 + $225,000)                  $491,660

20x6        Pension expense                 $432,179
            Pension Account                   64,481
               Cash ($266,660 + $230,000)                  $496,660

20x7        Pension expense                 $419,044
            Pension Account                   82,616
               Cash ($266,660 + $235,000)                  $501,660

Reconciliation -
                                                    20x5              20x6               20x7
Defined benefit obligation                    $1,153,869        $1,451,179         $1,777,273
Plan Assets                                      466,660           990,653          1,546,565
Funded Status                                    687,209           460,526            230,708
Add Pension Account (asset)                       48,801           113,282            195,898
Unrecognized liability                          $736,010          $573,808           $426,606

Accounted for:
  Unamortized PSC                              $736,010           $588,808           $441,606
  Experience gain                                                  -15,000            -15,000
                                               $736,010           $573,808           $426,606




Page 373                                                   CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 6

                                                       20x4           20x5          20x6
Defined benefit obligation
  Balance, beginning of year                      $1,053,000 $1,400,000 $1,836,640
  Plan amendment                                                252,000
  Accrued interest @ 8% | 7% | 7%                     84,240    115,640    128,565
  Current service cost                               120,000    134,000    165,000
  Benefits paid to retirees                         (45,000)   (65,000)   (90,000)
  Actuarial revaluation gain/loss                    187,760              (40,205)
                                                  $1,400,000 $1,836,640 $2,000,000

Pension Plan Assets
  Balance, beginning of year                       $458,000       $533,000  $778,000
  Expected return @ 8% | 7% | 7%                      36,640         37,310     54,460
  Contributions                                            -        300,000   600,000
  Benefits paid to retirees                         (45,000)       (65,000)  (90,000)
  Experience gain/loss                                83,360       (27,310)    (4,460)
                                                   $533,000       $778,000 $1,338,000

Corridor test -
  10% of the greater of the opening plan assets
     or defined benefit obligation                 $105,300       $140,000      $183,664
  Unrecognized amounts at beginning of year          55,367        159,767       185,665
  Excess                                                  -         19,767         2,001
  EARSL                                                   -             14            12
  Amortization required                                   -         $1,412          $167

Pension expense
  Current service cost                               120,000        134,000       165,000
  Accrued interest on pension obligation              84,240        115,640       128,565
  Expected return on plan assets                    (36,640)       (37,310)      (54,460)
  Amortization of plan amendment - initial            44,000         44,000        44,000
     - 20x5 amendment                                                18,000        18,000
  Amortization of unrecognized amounts                    -           1,412           167
                                                   $211,600       $275,742      $301,272




Page 374                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


Journal entries –

20x4       Pension expense                                $211,600
             Pension Account                                               $211,600

20x5       Pension expense                                 275,742
           Pension account                                  24,258
             Cash                                                           300,000

20x6       Pension expense                                 301,272
           Pension account                                 298,728
             Cash                                                           600,000

Balance in Pension Account –

                                                 Dr.             Cr.       Balance
Jan 1, 20x4                                                              $11,633 cr.
Dec 31, 20x4                                                211,600      223,233 cr.
Dec 31, 20x5                                  24,258                     198,975 cr.
Dec 31, 20x6                                 298,728                      99,753 dr.


Reconciliation -
  Funded status                               $867,000   $1,058,640        $662,000
  Pension liability (asset)                  (223,233)    (198,975)          99,753
  Difference                                  $643,767     $859,665        $761,753

  Accounted for -
    Unrecognized amounts
      Experience gains/losses                  (6,660)        20,650          25,110
      Actuarial revaluation                   166,460       166,460         126,255
      Less amortization to date                   (33)       (1,445)         (1,612)
                                              159,767       185,665         149,753
       Unamortized plan amendment – intial    484,000       440,000         396,000
         - 20x5 amendment                                   234,000         216,000
                                             $643,767      $859,665        $761,753




Page 375                                                 CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 7


Reconciliation of Funded Status, Jan 1, 20x8
  Defined benefit obligation                                             $5,600,000
  Plan assets                                                             6,700,000
    Funded status (asset)                                                 1,100,000
  Less pension account                                                      800,000
  Unrecorded asset                                                          300,000
  Unamortized past service cost (liability)                                 500,000
  Actuarial gain                                                           $800,000

Corridor Test
  Corridor: $6,700,000 x 10%                                               $670,000
  Actuarial gain                                                            800,000
  Excess                                                                    130,000
  Average remaining service life                                            10 years
  Amortization of actuarial gain                                            $13,000

Defined benefit obligation
  Balance, Jan 1                                                         $5,600,000
  Accrued interest                                                          336,000
  Current service cost                                                      260,000
  Benefits paid                                                           (210,000)
  Actuarial revaluation                                                     514,000
                                                                         $6,500,000

Pension Assets
  Balance, Jan 1                                                         $6,700,000
  Expected return:
    On Opening Balance + Jan 2 Contribution: $6,760,000 x 6%                405,600
    On July 2 contribution: $80,000 x 6% x                                    2,400
  Contributions                                                             290,000
  Benefits paid                                                           (210,000)
  Experience gain                                                            42,000
                                                                          7,230,000

Pension expense
  Current service cost                                                     $260,000
  Interest on defined benefit obligation                                     336,000
  Expected return on plan assets                                          (408,000)
  Amortization of past service costs                                          75,000
  Amortization of actuarial gains per corridor test                         (13,000)
                                                                           $250,000


Page 376                                                 CMA Ontario – September 2009
Financial Accounting – Module 1




Journal entry to record pension expense -

Pension expense                                                  $250,000
Pension account                                                    40,000
  Cash                                                                            $290,000

Balance in pension account at December 31, 20x8:
  $800,000 dr + 40,000 dr. = $840,000 dr.

Reconciliation of Funded Status – December 31, 20x8 -
  Defined benefit obligation                                                    $6,500,000
  Plan assets                                                                    7,230,000
    Funded status (asset)                                                          730,000
  Less pension account                                                             840,000
  Unrecorded liability                                                            $110,000

Accounted for…
  Unamortized past service cost ($500,000 – 75,000)                               $425,000
  Actuarial gains ($800,000 Beginning – 13,000 Amortization
    - 514,000 Actuarial Revaluation + 42,000 Experience Gain)                    (315,000)
                                                                                  $110,000




Page 377                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 8


                                                   20x1            20x2          20x3
Defined benefit obligation
  Balance, beginning of year                      $1,000         $1,141        $1,197
  Accrued interest                                   100            103            96
  Current service cost                               130            140           150
  Benefits paid to retirees                        (150)          (180)         (190)
  Plan amendment – vested                                            50
                    - nonvested                                      30
  Actuarial revaluation gain/loss                     61           (87)            42
                                                  $1,141         $1,197        $1,295

Pension Plan Assets
  Balance, beginning of year                      $1,000         $1,092        $1,109
  Expected return                                    120            121           114
  Contributions                                       90            100           110
  Benefits paid to retirees                        (150)          (180)         (190)
  Experience gain/loss                                32           (24)          (50)
                                                  $1,092         $1,109        $1,093

Corridor test -
  10% of the greater of the opening plan assets
     or defined benefit obligation                 $100            $114          $120
  Unrecognized amounts at beginning of year         140             107           170
  Excess                                             40               -            50
  Expected average remaining working lives of
    employees                                        10                             10
  Amortization required                              $4                 -           $5

Pension expense
  Current service cost                              $130            $140          $150
  Accrued interest on pension obligation             100             103            96
  Expected return on plan assets                   (120)           (121)         (114)
  Plan amendment – non-vested benefits                                10            10
  Plan amendment – vested benefits                                    50
  Net actuarial gain recognized in year              (4)                           (5)
                                                   $106            $182          $137




Page 378                                                   CMA Ontario – September 2009
Financial Accounting – Module 1


Journal Entries –

20x1       Pension expense                     $106
             Pension liability                                   16
             Cash                                                90

20x2       Pension expense                      182
             Pension liability                                   82
             Cash                                               100

20x3       Pension expense                      137
             Pension liability                                   27
             Cash                                               110

Pension Liability Account -

Balance, January 1, 20x1                                   $140 cr.
December 31, 20x1                             16 cr.        156 cr.
December 31, 20x2                             82 cr.        238 cr.
December 31, 20x3                             27 cr.        265 cr.



Reconciliation -
  Funded status
    Defined benefit obligation      $1,141      $1,197      $1,295
    Pension assets                   1,092       1,109       1,093
                                        49          88         202
  Less pension liability               156         238         265
  Difference                          $107        $150         $63

  Accounted for -
    Unrecognized amounts
      Balance, beginning of year       140         107          170
      Experience gains/losses         (61)          87         (42)
      Actuarial revaluation             32        (24)         (50)
      Less amortization to date         (4)                      (5)
                                       107          170          73
       Unamortized plan amendment                  (20)        (10)
                                     $107         $150          $63




Page 379                                CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 9

a)      The interest rate used is 10%. The opening balance of the Defined benefit
        obligation is $566,000 and the opening balance of the Pension Plan Assets is zero.
        Therefore, the net interest amount for the year 20x0 will be the interest accrued on
        the DBO only: $566,000 x 10% = $56,600

b)      The net interest amount is equal to the difference between the accrued interest on
        the DBO and the expected return on the plan assets. The following schedule
        calculates the amount for 20x1:

                                                                      DBO       Plan Assets
        Balance, Jan 1, 20x0                                       $566,000             $0
        Accrued Interest / Expected Return                           56,600               0
        CSC / Funding                                                49,000        165,259
        Balance, Jan 1, 20x1                                        671,600        165,259
        Accrued Interest / Expected Return (10%)                     67,160         16,526

        The net amount is calculated as: $67,160 - 16,526 = $50,634

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

                                                                      DBO       Plan Assets
        Balance, Jan 1, 20x1                                       $671,600       $165,259
        Accrued Interest / Expected Return                           67,160         16,526
        CSC / Funding                                                49,000        165,259
        Balance, Jan 1, 20x2                                        787,760        347,044
        Accrued Interest / Expected Return                           78,776         34,704
        CSC / Funding                                                49,000        165,259
        Balance, December 31, 20x2                                 $915,536       $547,007

        Funded Status ($915,536 - 547,007)                                        $368,529
        Add Pension Account (asset)                                                 84,272
        Unrecognized liability                                                    $452,801

        Unamortized Past Service Cost                                             $452,801
          $566,000 - (37,733 x 3 years)

d)      The amount, $264,136, would appear on the Statement of Financial Position as
        "Prepaid Pension Costs" or "Deferred Pension Expense", a non-current asset.

e)      $566,000 / 15 years = $37,733




Page 380                                                        CMA Ontario – September 2009
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f)      N=7
        I = 10
        PV = 566,000 (the Past Service Cost)
        Solve for PMT = $116,229

        Total funding amount = $116,259 + 49,000 CSC = 165,259

g)      20x3
           Pension Expense*                                           123,586
           Pension Account                                             41,673
              Cash                                                                    165,259

        * 49,000 CSC+ 36,853 Net Interest + 37,733 Amort PSC

h)      20x9
           Pension Expense (2)                                          86,733
             Pension Account                                                           37,733
              Cash                                                                     49,000

        * 49,000 CSC+ 0 Net Interest + 37,733 Amort PSC = 86,733




Page 381                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 10

                                                       20x0            20x1
Defined benefit obligation
Balance, beginning of year                          $883,212     $1,200,000
Accrued interest @ 8%                                 70,657         96,000
CSC                                                  225,720        254,700
Actuarial revaluation (loss)                          20,411          9,300
Balance, end of year                              $1,200,000     $1,560,000

Pension Plan Assets
Balance, beginning of year                               $0        $355,000
Funding at beginning of year: $95,544 + CSC         321,264         350,244
Expected return @ 8%                                 25,701          56,420
Experience gain (loss)                                8,035         -11,664
Balance, end of year                               $355,000        $750,000

Corridor Test
Corridor ($883,212 x 10% | $1,200,000 x 10%)        $88,321        $120,000
Unrecognized amounts at beginning of year                 0
  ($20,411 – 8,035)                                                 $12,376
No amortization necessary.

Pension Expense
CSC                                                $225,720        $254,700
Accrued interest on DBO                              70,657          96,000
Expected return on Plan Assets                      -25,701         -56,420
Amortization of Past Service Costs
  Fully vested                                      400,000
  Amortization of remainder: $483,212 / 5 years      96,642          96,642
                                                   $767,318        $390,922

Journal Entries -
20x0       Pension expense                         $767,318
             Pension account                                        446,054
             Cash                                                  $321,264

20x1       Pension expense                          390,054
             Pension account                                         40,678
             Cash                                                   350,244




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                                                        20x0            20x1
Reconciliation to Funded Status -

DBO                                                $1,200,000     $1,560,000
Plan assets                                           355,000        750,000
Funded Status                                         845,000        810,000
Less Pension Account                                  446,054        486,732
Unrecognized liability                               $398,946       $323,268

Reconciles to:
Unamortized Past Service Cost -
  $483,212 - 96,642 | $483,212 - 96,642 - 96,642    $386,540        $289,928
Unrecognized amounts
  $20,411 – 8,035                                     12,376
  $12,376 + 9,300 + 11,664                                            33,340
                                                    $398,946        $323,268




Page 383                                                CMA Ontario – September 2009
Financial Accounting – Module 1



12.     Earnings Per Share

Earnings per share data have to be disclosed by entities (i) whose shares are traded in a
public market, or (ii) that files, or is in the process of filing, its financial statements with a
securities commission or other regulatory organization for the purpose of issuing shares
in a public market (IAS 33.2).

Two earnings per share numbers have to be disclosed: basic earnings per share and
diluted earnings per share. This chapter discuses the details on how to calculate each of
these EPS numbers.

If income from continuing operations is calculated, then earning per share numbers have
to be presented for both profit and loss attributed to common shareholders and on profit
or loss from continuing operations attributable to those common shareholders (IAS 33.9).


Basic Earnings Per Share

Basic earnings per share is calculated as follows:

                     Net income available to common shareholders
        Weighted average number of common shares outstanding during the period

The numerator of the computation is equal to net income less dividends declared on non-
cumulative preferred shares and annual dividend entitlements on cumulative preferred
shares, whether or not declared (IAS 33.14)

The denominator of the computation is an amount representing the weighted average
number of common shares outstanding during the period.

Note that common shares issued, during the year or after the year-end but prior to the
issuance of the annual report, in connection with a common stock dividend or stock split
are considered to have been issued at the beginning of the accounting period (or at the
time of issue, in the case of common stock issued during the year). Stock dividends and
stock splits do not change the proportionate ownership of the shareholders. However,
shareholders will be assessing the value of their investment in terms of the number of
shares currently owned. To avoid misleading shareholders into thinking their investment
is worth more than it really is, the stock dividends and stock splits are considered
outstanding for the entire period (IAS 33.26). If a stock split and stock dividend is
declared during the year, this is applied retrospectively to previous fiscal years. For
example, if a 2:1 split is declared in the year ended December 31, 20x4, then the EPS for
previous years are recalculated on the assumption that the stock split done at that time.




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Example 1: The long-term liabilities and stockholders' equity section of Thompson Ltd.
at January 1, 20x3, was as follows:

Long-Term Liabilities

8% convertible bonds, each $1,000 bond convertible into 50 common               $4,000,000
shares, interest payable June 30 and December 31

Shareholders' Equity

4% non-cumulative series A preferred shares, $100 par value,                    $2,000,000
outstanding 20,000 shares

5% cumulative convertible series B preferred shares, $100 par value,             5,000,000
convertible into 2 common shares, outstanding 50,000 shares

Common Stock - no par value, 400,000 shares outstanding (Note 1)                 6,000,000

Retained Earnings                                                                3,000,000
                                                                                16,000,000
                                                                              $20,000,000

At January 1, 20x3, there were stock options outstanding enabling the option holders to
acquire 100,000 common shares at $60 per share. Information for 20x3:
1) Net income was $2,410,0000.
2) On July 1, all the 8% convertible bonds were converted. The company had no
    interest obligation on these bonds in the month of July.
3) Dividends were declared and paid on the A and B preferred shares respectively.
4) The company is subject to a 40% tax rate.
5) The average share price during the year 20x3 was $80.

We start by determining net income available to common shareholders:
  Net income                                                                   $2,410,000
  Less: preferred dividend entitlements
          A - 20,000 x 4                                                          (80,000)
          B - 50,000 x 5                                                         (250,000)
  Net income available to common shareholders                                  $2,080,000

Weighted average number of common shares outstanding:
 Shares outstanding at January 1                                                  400,000
                                                Half-Year
 Conversion of bonds on July 1: 200,000* x 6/12           =                       100,000
 * (4,000,000/ 1,000 x 50)                                                        500,000

Basic E.P.S = $2,080,000 / 500,000 = $4.16


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Diluted earnings per share

Companies with complex capital structures have various securities outstanding which can
potentially be converted into common shares at the option of the holder. These securities
include convertible debt, convertible preferred shares, common share warrants and stock
options. The exercise of any of these securities would reduce the ownership percentage
of the existing common shareholders.

Diluted earnings per share indicates what basic earnings per share would have been if the
potentially dilutive securities outstanding at the end of the year had been converted at the
later of the beginning of the year or the date of issue of the convertible security. The
objective is to report the most pessimistic earnings per share figure so it is necessary to
rank the potentially dilutive items (IAS 33.41).

The steps in the calculation of diluted earnings per share are (IAS 33.44):

(1) Individually analyze each outstanding convertible security to determine its impact on
    basic earnings per share. The denominator in the analysis is the additional common
    shares due to the conversion of the particular item. The numerator is the additional
    amount of after-tax income available assuming the item was converted. This
    additional income is generally one of the following two items:
    (a) the amount of dividends applicable to convertible preferred shares for the period.
    (b) the amount of interest expensed for the period, net of income taxes, on convertible
        debt.

(2) Compare the individual earnings per share figures with basic EPS to determine which
    items are dilutive (decrease earnings per share), and which are anti-dilutive (increase
    earnings per share). The anti-dilutive securities are excluded from the calculation, as
    we are trying to determine the lowest possible earnings per share figure assuming all
    convertible items were converted.

(3) Rank the dilutive items from most dilutive to least dilutive.

(4) Individually add the dilutive items to the basic EPS beginning with the most dilutive.
    Calculate the new earnings per share figure after each dilutive item is added.
    Continue to add dilutive items as long as the earnings per share figure decreases. The
    lowest earnings per share figure is the fully-dilutive earnings per share.

If conversion rights associated with convertible debt, shares, warrants and options do not
become effective for a period of at least ten years from the date of the Statement of
Financial Position, these items may be ignored in calculating fully diluted earnings per
share.

Impact on conversion of warrants and options: the exercise of options and warrants is
assumed at the beginning of the period and common shares are assumed to be used. The
proceeds from the exercise are then assumed to be used to purchase common shares at the


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average market price for the period. The difference between the number of shares
assumed issued and the number of shares assumed purchased are included in the
denominator of the fully diluted earnings per share computation (IAS 33.45). Stock
options that are in the money (i.e. when the exercise price is greater than the average
market price of the stock) are always dilutive. If they are out of the money (i.e. when the
exercise price is less than the average market price of the stock), then they would be
antidilutive and would not be included in the diluted EPS calculations.

For example, a company has 20,000 options outstanding exercisable at $67.50 per share.
The average market price per common share during the year was $90. The assumed
exercise of these options would generate $67.50 x 20,000 = $1,350,000 which is an
amount sufficient to acquire 15,000 shares ($1,350,000 / $90). Thus, 5,000 incremental
shares (20,000 – 15,000) are added to the denominator in computing fully diluted
earnings per shares




Page 387                                                        CMA Ontario – September 2009
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Example 2: Refer to the Thompson Ltd. data in Example 1.

We first analyze the dilutive effect of each convertible item:

a) Convertible bonds - impact on EPS had the bonds been converted on January 1 instead
   of July 1:
      Impact on numerator: $4,000,000 x 8% x 6/12 x 0.6 = $96,000
      Impact on denominator: 4,000 bonds x 50 shares x 6/12 = 100,000
      Incremental impact: $96,000 / 100,000 = $0.96
         => Dilutive since it is lower than Basic EPS of $4.16

b) Convertible B preferred shares
     Impact on numerator: $5,000,000 x .05 = $250,000
     Impact on denominator: 50,000 x 2 = 100,000
     Incremental impact: $250,000 / 100,000 = $2.50
        => Dilutive since it is lower than Basic EPS of $4.16

c) Stock options
     Proceeds on assumed conversion = 100,000 x $60         $6,000,000
     These could be used to purchase $6,000,000 / $80 = 75,000 shares
     Increase in denominator = 100,000 – 75,000 = 25,000 shares

The order of entry into the diluted EPS calculation is as follows:
1 - Stock options      2 - Convertible Bonds          3 - Convertible Preferred Shares

                                               Income             Shares                 EPS
Basic EPS                                    2,080,000           500,000              $4.16
Stock options                                         -            25,000
                                             2,080,000           525,000              $3.96
Convertible bonds                               96,000           100,000
                                             2,176,000           625,000                 3.48
Preferred shares                               250,000           100,000
Diluted EPS                                  2,426,000           725,000              $3.35




Page 388                                                         CMA Ontario – September 2009
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Example 3 – Assume the following information for the Skyview Inc.:
-     Skyview has income available to common shareholders of $10,000,000 for the
      year 20x6 (i.e. preferred dividends were already deducted in arriving at this
      amount)
-     2,000,000 weighted average common shares were outstanding for the year 20x6
-     the average market price of common shares was $75 during the year 20x6
-     Skyview has the following potential convertible instruments outstanding during
      the year:
-     options to purchase 100,000 common shares at $60 each
-     800,000 convertible preferred shares entitled to a cumulative dividend of $8 per
      share. Each preferred share is convertible into two common shares.
-     5% convertible debentures with a principal amount of $100,000,000 (issued at
      par). Each $1,000 debenture is convertible into 20 common shares.
-     the tax rate was 40% for 20x6

Determination of earnings per incremental share:

                                                              Increase in     Earnings per
                                             Increase in       number of       incremental
                                                 Income    common shares             share
Options (1)                                            -          20,000
Convertible preferred shares (2)             $6,400,000        1,600,000              $4.00
5% convertible debentures (3)                 3,000,000        2,000,000               1.50

(1) 100,000 options x $60 = $6,000,000 / $75 = 80,000; 100,000 – 80,000 = 20,000
(2) Income: 800,000 shares x $8 = $6,400,000; shares = 800,000 x 2
(3) Income: $100,000,000 x 5% x .6 = $3,000,000
    Shares: $100,000,000 / 1000 x 20 = 2,000,000

Order of entry: options first; convertible debentures second and preferred shares last.

Computation of diluted earnings per share:

                                                Income              Shares             EPS
As reported                                $10,000,000           2,000,000            $5.00
Options                                                             20,000
                                            10,000,000           2,020,000                4.95
5% convertible debentures                    3,000,000           2,000,000
                                            13,000,000           4,020,000                3.23
Convertible preferred shares                 6,400,000           1,600,000
                                           $19,400,000           5,620,000            $3.45

Diluted earnings per share is therefore $3.23 since the convertible preferred shares are
anti-dilutive.



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Example 4 - Net Loss Situation

The Loser Corporation's net loss for the year ending December 31, 20x4 was $1,500,000.
The weighted average number of shares for the year was calculated as 1,000,000. The
company has convertible, cumulative preferred shares outstanding. There are 100,000
shares outstanding with an annual dividend rate per share of $2.00. The conversion ratio
is 2 common shares for one preferred share.

The company also has $10,000,000 of 6% convertible bonds outstanding. The conversion
ratio is 20 common shares for each $1,000 bond. The company’s tax rate is 35%.

The basic EPS would be calculated as follows:

        [($1,500,000) - 200,000] / 1,000,000
        = (1,700,000) / 1,000,000
        = ($1.70)

Note that the inclusion of the preferred shares in the diluted EPS calculations would
cause EPS to be equal to: ($1,500,000) / 1,200,000 = ($1.25). Because this causes the loss
per share to decrease, the preferred shares are antidilutive.

The inclusion of the bonds would cause EPS to become:

        ($1,500,000) + 390,000 / (1,000,000 + 200,000)
        = ($1,110,000) / 1,300,000
        = ($0.85)

Again antidutive. The point of this example is that when the company is in a loss
situation, the inclusion or ordinarily dilutive convertible instruments will cause the loss
per share to reduce and become antidilutive.




Page 390                                                         CMA Ontario – September 2009
Financial Accounting – Module 1



Problems with Solutions

Multiple Choice Questions

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


2.      Timp, Inc. had the following common stock balances and transactions during
        20x5:

        January 1, x5     Common stock outstanding                             30,000
        February 1, x5    Issued a 10% common stock dividend                    3,000
        March 1, x5       Issued common stock                                   9,000
        July 1, x5        Issued common stock                                   8,000
        Dec 31, x5         Common stock outstanding                            50,000

        What was Timp's 20x5 weighted average shares outstanding?
        a.    40,000
        b.    44,250
        c.    44,500
        d.    46,000




Page 391                                                       CMA Ontario – September 2009
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3.      On June 30, 20x4, Lomond, Inc. issued twenty, $10,000, 7% bonds at par. Each
        bond was convertible into 200 shares of common stock. On January 1, 20x5,
        10,000 shares of common stock were outstanding. The bondholders converted all
        the bonds on July 1, 20x5. The following amounts were reported in Lomond's
        income statement for the year ended December 31, 20x5:

                Revenues                                      $977,000
                Operating expenses                             920,000
                Interest on bonds                                7,000
                Income before income tax                        50,000
                Income tax at 30%                               15,000
                Net income                                    $ 35,000

        What amount should Lomond report as its 20x5 basic earnings per share?
        a.    $2.50
        b.    $2.86
        c.    $2.92
        d.    $3.50


4.    Dextar Corporation had 300,000 common shares outstanding at December 31,
      20x1. On April 1, 20x2 an additional 120,000 common shares were issued. On June
      1, 20x2 a 10% stock dividend was declared. In addition, it had 90,000 stock options
      outstanding, which had been granted to certain executives, and which gave them the
      right to purchase Dextar's shares at an option price of $37 per share. The average
      market price of Dextar's common shares for 20x2 was $50. What is the number of
      shares that should be used in calculating diluted earnings per share for the year
      ended December 31, 20x2?
      a) 420,000
      b) 449,000
      c) 466,600
      d) 454,740


5.    On January 2, 20x2, Starr Co. issued at par $10,000 of 6% bonds convertible in
      total into 1,000 of Starr's common shares. No bonds were converted during 20x2.
      Throughout 20x2, Starr had 1,000 shares of common shares outstanding. Starr's
      20x2 net income was $6,000. Starr's income tax rate is 30%.

      No potentially dilutive securities other than the convertible bonds were outstanding
      during 20x2. Starr's diluted earnings per share for 20x2 would be (rounded to the
      nearest penny)
      a) $3.00.
      b) $3.21
      c) $3.30
      d) $6.42

Page 392                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

The December 31, 20x2 Statement of Financial Position of Davis Company included the
following items:
•      4,000 9% convertible bonds outstanding. The 20-year bonds mature December 31,
       20x5. Each $1,000 bond is convertible into 30 common shares.
•      270,000 convertible, cumulative, preferred shares. These preferred shares have an
       annual dividend of $2.00 per share and each preferred share can be exchanged for 3
       common shares.
•      1,500,000 common shares issued and outstanding.
•      125,000 Series 1 share options outstanding with an exercise price of $45.
•      100,000 Series 2 share options outstanding with an exercise price of $60.

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

Required -
a)    Compute basic and diluted earnings per common share for 20x2. Show your
      calculations.
b)    Assume that on Nov 31, 20x2, Davis issued a 10% stock dividend to common
      shareholders. Calculate the weighted average number of common shares for
      purposes of calculation of basic earnings per share.




Page 393                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2

The following data is available for the Culum Company for it’s 20x4 fiscal year.

•       Net income for the year ended December 31, 20x4 amounted to $1,650,000.

•       the Culum company had 1,500,000 common shares outstanding at January 1,
        20x4.

•       The following share issues took place:
               March 31               100,000 shares @ $15.67 per share
               November 1             200,000 shares @ $17.60 per share

•       On May 18, the company declared a 10% stock dividend.

•       the Company has $1,000,000 of convertible, cumulative preferred shares
        outstanding. These shares pay a dividend of 6%. The last time a preferred share
        dividend was paid was on December 31, 20x1. Each $1,000 par value preferred
        share converts into 120 common shares

•       the company also has $3,000,000 of convertible bonds outstanding. These bonds
        were issued at par when the market interest rates were 7%. The bonds pay interest
        semi-annually. Each $1,000 bond is convertible into 50 common shares.

•       there are 60,000 stock options outstanding that expire on July 16, 20x8. The
        holder of the stock options can purchase a share of stock for $7.50.

•       the average market price of the shares for 20x4 was $16.00.

•       the tax rate is 40%.

Required –

Compute the basic and diluted earnings per share.




Page 394                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

Marion Tess, controller, at Norris Pharmaceutical Industries, a public company, is
currently preparing the calculation for basic and fully diluted earnings per share and the
related disclosure for Norris' external financial statements. Below is selected financial
information for the fiscal year ended June 30, 20x2.


Norris Pharmaceutical Industries
Selected Statement of
Financial Position Information
June 30, 20x2

Long-term debt
      Notes payable, 10%                                                 $ 1,000,000
      7% convertible bonds payable                                         5,000,000
      10% bonds payable                                                    6,000,000
         Total long-term debt                                           $12,000,000

Shareholders' equity
Preferred stock, 8.5% cumulative,
       $50 par value, 100,000 shares
       authorized, 25,000 shares issued
       and outstanding                                                   $ 1,250,000
Common stock, $1 par, 10,000,000
       shares authorized. 1,000,000 shares
       issued and outstanding                                             1,000,000
Additional paid-in capital                                                4,000,000
Retained earnings                                                         6,000,000
       Total shareholders' equity                                       $12,250,000

The following transactions have also occurred at Norris.

•   Options were granted in 20x0 to purchase 100,000 shares at $15 per share. Although
    no options were exercised during 20x2, the average price per common share during
    fiscal year 20x2 was $20 per share, while the market price on June 30, 20x2, was $25
    per common share.

•   Each bond was issued at face value. The 7% convertible debenture will convert into
    common stock at 50 shares per $1,000 bond. They are exercisable after five years.

•   The 8.5% preferred stock was issued in 20x0.

•   There are no preferred dividends in arrears; however, preferred dividends were not
    declared in fiscal year 20x2.


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Financial Accounting – Module 1


•    The 1,000,000 shares of common stock were outstanding for the entire 20x2 fiscal
     year.

•    Net income for fiscal year 20x2 was $1,500,000, and the average income tax rate is
     40%.

Required -

a. For the fiscal year ended June 30, 20x2, calculate Norris Pharmaceutical Industries'
   1. basic earnings per share.
   2. diluted earnings per share.

b. Describe the appropriate disclosure required for earnings per share for Norris
   Pharmaceutical Industries for the fiscal year ended June 30, 20x2.


Problem 4

Perfume Inc. had the following securities outstanding at January 1, 1998:

Preferred shares, $6.00, no par value, cumulative convertible shares;
   authorized 500,000 shares; outstanding 200,000 shares                     $ 15,000,000

Common shares, no par value; authorized 2,000,000 shares;
  outstanding 1,050,000 shares                                               $ 10,500,000

The preferred shares are convertible into common shares on a one-for-one basis and pay
dividends February 28 and August 31. During 1998, Perfume reported net income of
$14,400,000 and had the following transactions:

June 30                 450,000 common shares (market value $5,400,000) were issued
                        to acquire a competitor.
September 30            90,000 common shares were purchased for $13.00 each and
                        retired.

The tax rate for 1998 was 40% and the pretax internal rate of return was 12%.

Required

a.      Compute basic earnings per share for 1998.
b.      Compute diluted earnings per share for 1998.




Page 396                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5

Ruby Company was incorporated on January 1, 20x0, with the following authorized
capital structure:

        100,000 non-cumulative no par value preferred shares, which pay a $6 dividend,
        and 1,000,000 no par value common shares.

In January 20x0, 500,000 common shares were sold for $1 per share, and 10,000 non-
cumulative preferred shares were sold for $90 each.

On September 30, 20x1, an additional 200,000 common shares were issued at $1 each.
Net income after taxes for 20x0 and 20x1 was $75,000 and $88,000 respectively. No
dividends were declared.

Required -

a)      Calculate the earnings per share for 20x0 and 20x1.
b)      Calculate the earnings per share assuming the preferred shares are cumulative.


Problem 6

Spray, Inc., had 4 million common shares outstanding on December 31, 20x1. An
additional 1 million common shares were issued on April 1, 20x2, and 500,000 more
shares were issued on July 1, 20x2. On October 1, 20x2, Spray issued 10,000, $1,000
face value, 7 percent convertible bonds. Each bond is convertible into 40 common shares.
No bonds were converted into common shares in 20x2.

Required -

What is the number of shares to be used in calculating basic EPS and fully diluted EPS,
respectively? Assume that the convertible bonds are dilutive.




Page 397                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 7

Davis, Inc., earned $700,000 after taxes in 20x2. Davis began 20x2 with 200,000
common shares outstanding. On May 1, 30,000 new shares were issued and on October
31, 10,000 shares were acquired as treasury shares. On December 1 Davis split its
common shares 2 for 1.

In addition to common shares, Davis had 50,000 $100 par, 8 percent cumulative
nonconvertible preferred shares outstanding during all of 20x2.

Required -

Calculate Davis' EPS for 20x2. Provide a schedule showing determination of the
weighted average number of common shares used in the EPS calculation.




Page 398                                                    CMA Ontario – September 2009
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SOLUTIONS


Multiple Choice Questions


1.    b     ($330,000 – 60,000) / 300,000 = $0.90

2.    c     Opening balance                                                       30,000
            Feb 1 Stock Dividend - 3,000 x 12/12                                   3,000
            Mar 1 Issue - 9,000 x 10/12                                            7,500
            Jul 1 Issue - 8,000 x 6/12                                             4,000
                                                                                 $44,500

3.    c     Weighted average number of common shares:
             Outstanding at beginning of year                                     10,000
             July 1 conversion: 200 x 20 x 6/12                                    2,000
                                                                                  12,000

            Basic earnings per share = $35,000 / 12,000                             $2.92

4.    d     Free shares = 90,000 – (90,000 x 37 / 50) = 23,400 x 1.1 = 25,740
            Weighted average number of CS =
              Opening balance                                                    300,000
              April 1 issue: 120,000 x 9/12                                       90,000
              June 1 stock dividend: 390,000 x 10%                                39,000
                                                                                 429,000

            Increase in denominator = 429,000 + 25,740 = 454,740

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

            Increase in numerator $10,000 x 6% x .7 = $420
            Increase in denominator = 1,000
            Incremental impact = $420/1,000 = $0.42 => Dilutive

            Diluted-EPS = ($6,000 + 420) / (1,000 + 1,000) = $3.21




Page 399                                                      CMA Ontario – September 2009
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Problem 1

a)      Weighted Average # of Common Shares –

        Common Shares outstanding at beginning of year
          1,500,000 – 150,000                                                        1,350,000
        June 1 Issue: 150,000 x 7/12                                                    87,500
                                                                                     1,437,500

        Basic EPS = ($4,000,000 – 540,000) / 1,437,500 = $2.41

        Effect of Dilution:

           Convertible bonds:
             Increase in numerator: $4,000,000 x 9% x .6 = $216,000
             Increase in denominator: 4,000 x 30 = 120,000
             Incremental impact = $216,000 / 120,000 = $1.80

           Preferred Shares: $540,000 / 810,000 = $0.67

           Series 1 share options:
             Free shares = 125,000 - 125,000 x $45 / 50 = 125,000 – 112,500 = 12,500

           Series 2 share options are out of the money and therefore antidilutive.

                                                Numerator Denominator                    EPS
        Basic EPS                               $3,460,000  1,437,500                   $2.41
        Series 1 share options                                 12,500
                                                $3,460,000  1,450,000                     2.39
        Preferred shares                           540,000    810,000
        Diluted EPS                             $4,000,000  2,260,000                   $1.77

        Convertible bonds are not included since they would have an antidilutive effect.

b)      Common Shares outstanding at beginning of year
          (1,500,000 / 1.1) – 150,000                                                1,213,636
        June 1 Issue: 150,000 x 7/12                                                    87,500
        Nov 31 Stock Dividend: 1,213,636 x 10%                                         121,364
          87,500 x 10%                                                                   8,750
                                                                                     1,431,250




Page 400                                                        CMA Ontario – September 2009
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Problem 2


Basic EPS Calculations -

Weighted average number of common shares -
 Shares outstanding at beginning of year                                         1,500,000
 March 31 issue: 100,000 x 9/12                                                     75,000
 May 18 stock dividend – 1,575,000 x 10%                                           157,500
 November 1 issue: 200,000 x 2/12                                                   33,333
                                                                                 1,765,833

Basic EPS = (1,650,000 – 60,000) / 1,765,833
  = 1,590,000 / 1,765,833 = 0.90

Diluted EPS Calculations -

Impact of preferred shares: 60,000 / (1,000,000 / 1,000 x 120 x 1.1)
  = 60,000 / 132,000 = $0.45

Impact of convertible bonds:
  = ($3,000,000 x 7% x .6) / (3,000,000 / 1,000 x 50 x 1.1)
  = $126,000 / 165,000
  = $0.76

Impact of options: [60,000 – (60,000 x $7.50 / 16)] x 1.1
= (60,000 – 28,125) x 1.1
= 35,063

Order of entry: options, preferred shares, bonds

                                             Numerator        Denominator         EPS
Basic EPS                                    $1,590,000         1,765,833        $0.90
Options                                                            35,063
                                              1,590,000         1,800,896         0.88
Preferred shares                                 60,000           132,000
                                              1,650,000         1,932,896         0.85
Convertible bonds                               126,000           165,000
Diluted EPS                                  $1,776,000         2,097,896        $0.85




Page 401                                                        CMA Ontario – September 2009
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Problem 3

a.      Basic EPS = $1,500,000 - 106,2501 / 1,000,000
        =      $1,393,750 / 1,000,000
        =      $1.39
        1
            25,000 shares x $50 x 8.5%

        Fully Diluted EPS:

        Incremental impact of the exercise of options:

                 Number of shares assumed purchased:
                        100,000 x $15 = $1,500,000 / $20 = 75,000
                 Increase in shares (free shares): 100,000 – 75,000 = 25,000

        Incremental impact of the exercise of bonds:

                 Increase in income = $5,000,000 x 7% x .6 = $210,000
                 Increase in shares = $5,000,000/1,000 x 50 = 250,000
                 Incremental impact = $0.84

                                                   Numerator Denominator               EPS
        Basic EPS                                  $1,393,750  1,000,000              $1.39
        Options                                                   25,000
                                                   $1,393,750  1,025,000              $1.36
        Convertible Bonds                             210,000    250,000
                                                    1,603,750  1,275,000              $1.26

b.      Norris Pharmaceutical Industries should disclose both basic earnings per share
        and fully diluted earnings per share on the face of the income Statement for all
        periods presented.




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Problem 4

a.         Weighted average number of common shares
            Shares outstanding at the beginning of the year                    1,050,000
            June 30 Issue: 450,000 x 1/2                                         225,000
            September 30 retirement: 90,000 x 3/12                               -22,500
                                                                               1,252,500

           Basic EPS = (14,400,000 - 1,200,000) ÷ 1,252,500                       $10.54

b.         Diluted EPS: 14,400,000 ÷ (1,252,500 + 200,000)                          $9.91



Problem 5

a)                                                                  20x1            20x0
        Weighted Average number of common shares -
          Balance, beginning of year                             500,000         500,000
          Issue: 200,000 x 3/12                                   50,000
                                                                 550,000         500,000

        Basic EPS: $75,000 / 500,000                                                $0.15
          $88,000 / 550,000                                         $0.16

b)      Basic EPS: ($75,000 - 60,000) / 500,000                                     $0.03
          ($88,000 - 60,000) / 550,000                              $0.05




Page 403                                                      CMA Ontario – September 2009
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Problem 6

Weighted Average Number of Shares - Basic EPS:
 Balance, beginning of year                                                 4,000,000
 April 1, 20x2: 1,000,000 x 9/12                                              750,000
 July 1, 20x2: 500,000 x 6/12                                                 250,000
                                                                            5,000,000

Weighted Average Number of Shares – Diluted EPS:

Basic EPS Weighted Average number of shares                                 5,000,000
Add: shares assumed on conversion (400,000 x 3/12)                            100,000
Number of shares to be used for fully diluted EPS                           5,100,000


Problem 7

Weighted Average Number of Shares - Basic EPS:
 Balance, beginning of year                                                   200,000
 May 1, 20x2: 30,000 x 8/12                                                    20,000
 October 31, 20x2: 10,000 x 2/12                                               -1,667
 December 1 Stock Split:
    (200,000 + 20,000 - 1,667) x 2                                            218,333
                                                                              436,666

Basic EPS = [$700,000 - (50,000 x $100 x 8%)] / 436,666 = $0.69




Page 404                                                   CMA Ontario – September 2009
Financial Accounting – Module 1



13.     Accounting for Leases

A lease is a contract between a lessor, the owner of the property involved, and the lessee,
the person or entity wishing to use that property in exchange for a certain number of cash
payments.

Prior to 1979, accounting for leases was based simply on the legal form of the
transaction. The existence of a leasing agreement ensured that a leasing transaction would
be regarded as a non-capital transaction (i.e. the asset and the lease liability were kept off
the Statement of Financial Position), regardless of whether in substance, the arrangement
amounted to an outright sale of the asset by the lessor and purchase of the asset by the
lessee. This helped to make leasing a popular alternative to outright purchase. If a
company chose to lease a piece of equipment, its debt-to-equity ratio would generally be
lower than if the asset was purchased on credit.

Starting in 1979, the accounting for leases became a function of the economic substance
of the transaction rather than the form. In essence, it stated that when a leasing
arrangement results in a transfer to the lessee of virtually all of the risks and benefits
associated with ownership of the asset then the arrangement should be treated as a capital
transaction - the sale of an asset by the lessor and the purchase of an asset by the lessee.

A finance lease is defined as a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset. Title may or may not eventually be transferred. (IAS
17.4)

An operating lease is defined as a lease other than a finance lease (IAS 17.4).

Classification of leases

IAS 17.10 provides the following guidance when classifying a lease. The following
situations, individually or in combination, would normally lease to a lease being
classified as a finance lease:
(a)     the lease transfers ownership of the asset to the lessee by the end of the lease
        term;
(b)     the lessee has the option to purchase the asset at a price that is expected to be
        substantially lower than the fair value at the date the option becomes exercisable
        for it to be reasonably certain, at the inception of the lease, that the option will be
        exercised (often referred to as a bargain purchase option);
(c)     the lease term is for the major part of the economic life of the asset even if title is
        not transferred;
(d)     at the inception of the lease the present value of the minimum lease payments
        amounts to at least substantially all of the fair value of the leased asset; and
(e)     the leased assets are of such a specialized nature that only the lessee can use them
        without major modification.



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Clearly, if situations (a) or (b) were to occur, the lease would be considered a finance
lease since title to the asset is expected to pass.

Under previous Canadian GAAP, the numerical criteria for item (c) was that if the lease
term was 75% or more of the economic life of the asset, then the lease was deemed to be
a finance lease. The numerical criteria for item (d) was that if the present value of the
minimum lease payments was 90% of more of the fair value of the asset, then the lease
was deemed to be a finance lease. Although, these numerical criteria do not apply under
IFRS, they will likely be used as guidelines for some time to come.

The minimum lease payments are equal to the payments over the lease term that the
lessee is or can be required to make (excludes contingent rent, costs for services and taxes
to be paid by and reimbursed to the lessor6) together with:
• any amounts guaranteed by the lessee such as a guaranteed residual value, or
• a bargain purchase option.

IAS 17.12 makes it clear that if there are other features that the lease does not transfer
substantially all risks and rewards incidental to ownership, the lease can be classified as
an operating lease. Ultimately, the classification of a lease as a finance lease is subject to
managerial judgment.

At the commencement of the lease term, the lessee recognizes finance leases as assets
and liabilities in the statement of financial position at amounts equal to the fair value of
the leased property or, if lower, the present value of the minimum lease payments, each
determined at the inception of the lease. The discount rate to be used is the interest rate
implicit in the lease, if this is practicable to determine; if not, the lessee's incremental
borrowing rate shall be used. (IAS 17.20).


Depreciation Expense on Leased Assets

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


Accounting for bargain purchase options and residual values

With a bargain purchase option (BPO), the lessee obtains legal title to the leased asset at
the end of the lease term and has use of the asset for its entire economic life. Both the
lessee and the lessor include the BPO as part of the minimum lease payments (MLP).

Guaranteed and unguaranteed residual value can only exist when the leased property
returns to the lessor at the end of the lease term. The lessee would completely disregard

6 These are referred to as executory costs.


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the unguaranteed residual value (URV) in his/her MLP and depreciation computations.
The lessor on the other hand, would treat the URV as part of the calculation of the lease
payment. The lessor is in effect charging less than he would otherwise because he/she is
expecting the leased property to be of some additional value after the lease term has
expired.

Both the lessee and lessor would regard any guaranteed residual value (GRV) as part of
the MLP because, at the end of the lease term the lessee would expect the leased property
to have a value equal to the GRV, he/she would depreciate on that basis. An amount
equal to the GRV should still be in his/her leased property and liability accounts at the
end of the lease term. The lessor would have an outstanding receivable in the amount of
the GRV until the lessee discharged his/her liability.

The following example will include coverage of bargain purchase options and guaranteed
and unguaranteed residual values.

Example 1A: Sampson Ltd. leases equipment to Bowie Ltd. on January 1, 20x0, for five
years. The following information pertains to the lease agreement:

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




Page 407                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Classification of lease contract by Bowie Ltd.:

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

2.     The lessee has the option to purchase the asset        Yes. Bowie Ltd. can acquire the
       at a price that is expected to be substantially        equipment for $3,000 at the end
       lower than the fair value at the date the option       of the lease term when its
       becomes exercisable for it to be reasonably            estimated fair market value is
       certain, at the inception of the lease, that the       $8,000.
       option will be exercised.

3.     The lease term is for the major part of the            No. The lease term of 5 years is
       economic life of the asset even if title is not        about 63% of the equipment' s
       transferred.                                           economic life of 8 years.

4.     At the inception of the lease the present value        Yes - the present value of the
       of the minimum lease payments amounts to at            minimum lease payments is equal
       least substantially all of the fair value of the       to 100% of the fair value of the
       leased asset.                                          asset. See schedule below.

5.     The leased assets are of such a specialized            Unknown.
       nature that only the lessee can use them
       without major modification.

The present value of annual lease payments and bargain purchase option – set your
financial calculator to assume that the cash flows occur at the beginning of the year
(BGN mode). Once you have completed the calculation, set it back to normal mode.

           [BGN]              N          I/Y             PV         PMT          FV
           Enter              5           8                         9600        3000
           Compute                                   X=
                                                   $43,438

Conclusion: due to the existence of the bargain purchase option, this is a finance lease.




Page 408                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


The interest expense and liability reduction schedule is as follows:

                                                                 Principal
Date                              Payment         Interest       Reduction          Balance
Jan 2, 20x0                                                                         $43,438
Jan 2, 20x0                        $9,600               -          $9,600            33,838
Dec 31, 20x0                        9,600           2,707           6,893            26,945
Dec 31, 20x1                        9,600           2,156           7,444            19,501
Dec 31, 20x2                        9,600           1,560           8,040            11,461
Dec 31, 20x3                        9,600             917           8,683             2,778
Dec 31, 20x4                        3,000             222           2,778                 0

Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows:

Jan 1, 20x0      Equipment under finance lease                         $43,438
                   Obligation under finance lease                                   $43,438

                 Executory costs                                           400
                 Obligation under finance lease                          9,600
                   Cash                                                              10,000

Dec 31, 20x0     Prepaid executory costs                                   400
                 Interest expense                                        2,707
                 Obligation under finance lease                          6,893
                    Cash                                                             10,000

                 Depreciation expense                                    5,305
                   Accumulated depreciation                                            5,305
                 ($43,438 - 1,000) / 8

Jan 1, 20x1      Executory Costs                                             400
                   Prepaid Executory Costs                                               400

Dec 31, 20x1     Prepaid executory costs                                   400
                 Interest expense                                        2,156
                 Obligation under finance lease                          7,444
                    Cash                                                             10,000

                 Depreciation expense                                    5,305
                   Accumulated depreciation                                            5,305
                 ($43,438 - 1,000) / 8




Page 409                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


The December 31, 20x4, journal entries follow:

Interest expense                                                            222
Obligation under finance lease                                            2,778
   Cash                                                                                 3,000

Equipment                                                               43,438
  Equipment under finance lease                                                      43,438


Example 1B - Assume the same facts as in Example 1A, with the following exception:
there is no option to purchase the asset at the end of the 5th year. The equipment reverts
back to the lessor at the end of the 5th year. The lessee guarantees the residual value of
the asset ($8,000). Annual lease payments are $9,211 (including the $400 executory
costs).

Classification of lease contract by Bowie Ltd.:

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

2.     The lessee has the option to purchase the asset No.
       at a price that is expected to be substantially
       lower than the fair value at the date the option
       becomes exercisable for it to be reasonably
       certain, at the inception of the lease, that the
       option will be exercised.

3.     The lease term is for the major part of the        No. The lease term of 5 years is
       economic life of the asset even if title is not    about 63% of the equipment' s
       transferred.                                       economic life of 8 years.

4.     At the inception of the lease the present value    Yes - the present value of the
       of the minimum lease payments amounts to at        minimum lease payments is equal
       least substantially all of the fair value of the   to 100% of the fair value of the
       leased asset.                                      asset. See schedule below.

5.     The leased assets are of such a specialized        Unknown.
       nature that only the lessee can use them
       without major modification.

The present value of annual lease payments and bargain purchase option – set your
financial calculator to assume that the cash flows occur at the beginning of the year
(BGN mode). Once you have completed the calculation, set it back to normal mode.



Page 410                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


           [BGN]              N        I/Y          PV         PMT            FV
           Enter              5         8                      8,811         8,000
           Compute                                  X=
                                                  $43,438

Conclusion: due to the existence of the bargain purchase option, this is a finance lease.

The interest expense and liability reduction schedule is as follows:
                                                                 Principal
Date                         Payment            Interest         Reduction           Balance
Jan 2, 20x0                                                                          $43,438
Jan 2, 20x0                    $8,811                  -           $8,811             34,627
Dec 31, 20x0                     8,811            2,770              6,041            28,586
Dec 31, 20x1                     8,811            2,287              6,524            22,062
Dec 31, 20x2                     8,811            1,765              7,046            15,016
Dec 31, 20x3                     8,811            1,201              7,610             7,406
Dec 31, 20x4                          -             594                                8,000

Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows:

Jan 1, 20x0      Equipment under finance lease                         $43,438
                   Obligation under finance lease                                    $43,438

                 Executory costs                                           400
                 Obligation under finance lease                          8,811
                   Cash                                                                9,211

Dec 31, 20x0     Prepaid executory costs                                   400
                 Interest expense                                        2,770
                 Obligation under finance lease                          6,041
                    Cash                                                               9,241

                 Depreciation expense                                    7,088
                   Accumulated depreciation                                            7,088
                 ($43,438 - 8,000) / 5

Jan 1, 20x1      Executory Costs                                             400
                   Prepaid Executory Costs                                               400

Dec 31, 20x1     Prepaid executory costs                                   400
                 Interest expense                                        2,287
                 Obligation under finance lease                          6,524
                    Cash                                                               9,241

                 Depreciation expense                                    7,088
                   Accumulated depreciation                                            7,088


Page 411                                                         CMA Ontario – September 2009
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The December 31, 20x4, journal entries follow:

Interest expense                                                           594
   Obligation under finance lease                                                       594

Accumulated depreciation                                                35,438
Obligation under finance lease                                           8,000
  Equipment under finance lease                                                      43,438

If the appraisal value of the equipment works out to less than $8,000, then the lessee will
have to make up the difference. This difference will simply be expensed at the time it is
known.

The differences between example 1A (Bargain Purchase Option) and example 1B
(guaranteed residual value) can be summarized as follows:
•      in example 1B, the asset reverts back to the lessor at the end of the lease term,
•      the guaranteed residual value is included as part of the minimum lease payments,
•      the asset is depreciated over 5 years down to its residual value of $8,000
•      at the end of the lease term, just before the asset reverts to the lessor, the lessee
       has an net asset balance of $8,000 and an obligation under capital lease of $8,000.
       These net out against the other when the asset is removed from the books.




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Example 1C - Assume the same facts as in Example 1A, with the following exception:
there is no option to purchase the asset at the end of the 5th year. The equipment reverts
back to the lessor at the end of the 5th year. The lessee does not guarantee the residual
value of the asset ($8,000). Annual lease payments are $9,211 (including the $400
executory costs).

Classification of lease contract by Bowie Ltd.:

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

2.     The lessee has the option to purchase the asset No.
       at a price that is expected to be substantially
       lower than the fair value at the date the option
       becomes exercisable for it to be reasonably
       certain, at the inception of the lease, that the
       option will be exercised.

3.     The lease term is for the major part of the            No. The lease term of 5 years is
       economic life of the asset even if title is not        about 63% of the equipment' s
       transferred.                                           economic life of 8 years.

4.     At the inception of the lease the present value        Yes - the present value of the
       of the minimum lease payments amounts to at            minimum lease payments is equal
       least substantially all of the fair value of the       to 87% of the fair value of the
       leased asset.                                          asset. See schedule below.


5.     The leased assets are of such a specialized            Unknown.
       nature that only the lessee can use them
       without major modification.

The present value of annual lease payments and bargain purchase option – set your
financial calculator to assume that the cash flows occur at the beginning of the year
(BGN mode). Once you have completed the calculation, set it back to normal mode.

           [BGN]              N          I/Y             PV         PMT          FV
           Enter              5           8                         8,811
           Compute                                   X=
                                                   $37,994

Conclusion: the most likely conclusion would be that this lease is an operating lease,
given that the lease term is 63% of the economic life and that the present value of the
minimum lease payments is equal to 87% of the fair value of the asset. The classification
of this lease would be based on managerial judgment and may consider other factors.


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Two solutions will be presented: the first assuming that the lease classification is a
finance lease and the second on the assumption that it is an operating lease.

Finance Lease Assumption -

Per IAS 17.20, the lease would be recorded as an asset and liability of $37,994.

The interest expense and liability reduction schedule is as follows:

                                                                 Principal
Date                              Payment         Interest       Reduction           Balance
Jan 2, 20x0                                                                          $37,994
Jan 2, 20x0                        $8,811               -           $8,811            29,183
Dec 31, 20x0                        8,811           2,335            6,476            22,707
Dec 31, 20x1                        8,811           1,817            6,994            15,712
Dec 31, 20x2                        8,811           1,257            7,554             8,158
Dec 31, 20x3                        8,811             653            8,158                 0

Bowie Ltd.'s journal entries for 20x0 and 20x1 are as follows:

Jan 1, 20x0      Equipment under finance lease                          $37,994
                   Obligation under finance lease                                    $37,994

                 Executory costs                                            400
                 Obligation under finance lease                           8,811
                   Cash                                                                  9,211


Dec 31, 20x0     Prepaid executory costs                                    400
                 Interest expense                                         2,335
                 Obligation under finance lease                           6,476
                    Cash                                                                 9,211

                 Depreciation expense                                     7,599
                   Accumulated depreciation                                              7,599
                 $37,994 / 5

Jan 1, 20x1      Executory Costs                                             400
                   Prepaid Executory Costs                                                400

Dec 31, 20x1     Prepaid executory costs                                    400
                 Interest expense                                         1,817
                 Obligation under finance lease                           6,994
                    Cash                                                                 9,211



Page 414                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


                 Depreciation expense                                       7,599
                   Accumulated depreciation                                               7,599


The differences between example 1B (guaranteed residual value) and 1C (unguaranteed
residual value) can be summarized as follows:
•      the unguaranteed residual value is included as part of the minimum lease
       payments,
•      the lessor will likely include the residual value as part of the calculation of the
       lease payment,
•      the asset is depreciated over 5 years down to zero.


Operating Lease Assumption

Jan 1, 20x0      Prepaid lease payment                                      9,211
                   Cash                                                                   9,211

Dec 31, 20x0     Lease expense                                              9,211
                   Prepaid lease payment                                                  9,211

Jan 1, 20x1      Prepaid lease payment                                      9,211
                   Cash                                                                   9,211

Dec 31, 20x0     Lease expense                                              9,211
                   Prepaid lease payment                                                  9,211



Leases of Land and Buildings

A characteristic of land is that it normally has an indefinite economic life. If title is not
expected to pass to the lessee by the end of the lease term, the lessee normally does not
receive substantially all of the risks and rewards incidental to ownership, in which case
the lease of land will be an operating lease (IAS 17.14). An exception to this is if the
value of the land relative to the total value of the lease is immaterial, in which case the
land can be combined with the value of the building (IAS 17.17).

This means that a lease for both land and building would have to be considered separately
for purpose of lease classification. The minimum lease payments would be allocated to
land and building elements based on the relative fair values of the leasehold interests in
the land element and buildings element of the lease at the inception of the lease. If the
lease payments cannot be allocated reliably between these two elements, the entire lease
is classified as a finance lease. (IAS 17.16)




Page 415                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


Lessor Accounting

The criteria for determining whether or not a lease is a finance lease are the same as those
used by the lessee. Fundamentally, lessor accounting is a mirror image of lessee
accounting, in that:
•      the lessor recognizes a receivable at an amount equal to the net investment in the
       lease (IAS 17.36); and
•      the lessor recognizes finance income based on a pattern reflecting a constant
       periodic rate of return on the lessor's net investment in the finance lease (IAS
       17.39).

Note that, unlike previous Canadian GAAP, IAS 17 does not distinguish between a
sales-type and direct financing lease for lessor accounting.

The lessor will calculate the lease payments as follows:
-      they will want to recover the initial cost or fair value of the asset being leased, and
-      they will consider the bargain purchase option, the guaranteed or unguaranteed
       residual values as a future cash inflow.

Example - the fair value of the asset leased is $400,000. The lease term is 6 years and
there is a bargain purchase option to purchase the asset at the end of the lease term of
$20,000. Assuming that the first payment is due at the signing of the lease agreement and
that the lessor requires a 7% return, the lease payment will be $75,815.33:

        [BGN]      N=6           I/Y = 7%              PV = -400,000          FV = 20,000
        Compute PMT = $75,815.33

Sale and Leaseback transactions

A sale and leaseback transaction involves the sale of property with the seller concurrently
leasing the same property back to the seller. The same criteria outlined above are used to
determine whether the lease is classified as an operating or finance lease.

One feature of sale and leaseback transactions is that the lessee may show a gain or loss
on sale of the property to the lessor. If the sale and leaseback transaction results in a
finance lease, any gain or loss on the transaction shall be deferred and amortized over the
lease term (IAS 17.59).

If the sale and leaseback transaction results in an operating lease, and it is clear that the
transaction is established at fair value, any gain or loss shall be recognized immediately.
If the sales price is below fair value, any gain or loss are recognized immediately except
that, if the loss is compensated for by future lease payments at below market price, it
shall be deferred and amortized in proportion to the lease payments over the period for
which the asset is expected to be used. If the sales price is above fair value, the excess
over fair value shall be deferred and amortized over the period for which the asset is
expected to be used. (IAS 17.61)


Page 416                                                          CMA Ontario – September 2009
Financial Accounting – Module 1



Problems with Solutions

Multiple Choice Questions

1.      On December 30, 20x1, Rafferty Corp. leased equipment under a finance lease.
        Annual lease payments of $20,000 are due December 31 for 10 years. The
        equipment's useful life is 10 years, and the interest rate implicit in the lease is
        10%. The finance lease obligation was recorded on December 30, 20x1, at
        $135,000, and the first lease payment was made on that date. What amount
        should Rafferty include in current liabilities for this capital lease in its December
        31, 20x1, balance sheet?
        a.      $ 6,500
        b.      $ 8,500
        c.      $11,500
        d.      $20,000


2.      On December 29, 20x1, Action Corp. signed a 7-year capital lease for an airplane
        to transport its sports team around the country. The airplane's fair value was
        $841,500. Action made the first annual lease payment of $153,000 on December
        29, 20x1. Action's incremental borrowing rate was 12 %, and the interest rate
        implicit in the lease, which was known by Action, was 9%.

        What amount should Action report as capital lease liability in its December 31,
        20x1, balance sheet?
        a.      $841,500
        b.      $780,300
        c.      $688,500
        d.      $627,300


3.      Hammer Company leased equipment from the King Company on July 1, 20x8, for
        an eight-year period expiring June 30, 20x16. Equal annual payments under the
        lease are $400,000 and are due on July 1 of each year. The first payment was
        made on July 1, 20x8. The rate of interest contemplated by Hammer and King is
        8%. The cash selling price of the equipment is $2,482,500 and the cost of the
        equipment on King's accounting records was $2.2 million. Assuming that the
        lease is appropriately recorded as a sale for accounting purposes by King, what is
        the amount of profit on the sale and the interest income that King would record
        for the year ended December 31, 20x8?
        a.      $0 and $0.
        b.      $0 and $83,300.
        c.      $282,500 and $83,300.
        d.      $282,500 and $99,300.


Page 417                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

JKL Company manufactures and distributes heavy equipment. One of its popular lathes
costs $67,500 to make and sells for $100,000. On January 1, 20x8, MNO agrees to lease
a lathe for 4 years from JKL. The lathe is expected to have a useful life of 6 years and no
residual value at that time. However, it is expected to have a residual value of $9,000 at
the end of the lease at which time MNO has the option to purchase it for $3,000. The first
payment is due on January 1, 20x8. The rate implicit in the lease, known to MNO, is 12%
while MNO's incremental borrowing rate is 14%.

Required

a.         Compute the lease payment.
b.         Prepare all 20x8 journal entries for MNO.
c.         Prepare all January 1, 20x8, journal entries for JKL.


Problem 2

The McGrath Corporation entered into a 5 year lease agreement for equipment on
December 31, 20x3. Data relative to this transaction is as follows:

             Fair value of equipment                                     $250,000
             Economic life of equipment                                   10 years
             Residual value at end of economic life                        20,000

For each of the independent situations below, prepare all journal entries relative to this
lease for the year 20x4 and 20x5.

     (a)      The rate implicit in the lease is 8%. The lease agreement includes an option to
              purchase the equipment at the end of the lease term for $10,000. The fair
              value of the equipment at the end of the lease term is estimated to be $60,000.
     (b)      The rate implicit in the lease is 8%. The lease agreement requires McGrath to
              return the equipment at the end of the lease term and to guarantee the residual
              value of $60,000.
     (c)      The rate implicit in the lease is 8%. The lease agreement requires McGrath to
              return the equipment at the end of the lease term. The residual value of
              $60,000 was considered in calculating the lease payments by the lessor but is
              unguaranteed.
     (d)      The rate implicit in the lease is not known, nor is the fair value of the
              equipment. The lease term is for 8 years. McGrath’s incremental borrowing
              rate is 7% and the annual lease payment is $42,000.




Page 418                                                           CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

On January 3, 20x5, Thermotech Inc. leased a specialized piece of diagnostic equipment
to Eastview Medical Clinic. Details are as follows:

Cost to manufacture to Thermotech                                                  $ 80,000
Normal sales price                                                                 $100,000
Lease term                                                                           8 years
Economic Life                                                                       10 years
Residual value at the end of the lease term                                         $20,000
Residual value at end of useful life                                                   $ 500
Lease payment (1st payment payable January 3, 20x5)                                 $16,881
Purchase option (exercisable at end of year 8)                                       $ 2,000
Incremental borrowing rate of Eastview                                                  12%
Rate implicit in the lease                                                              10%

Assume that Thermotech has reasonable assurance that Eastview will make the remaining
lease payments. All costs of operating the leased equipment are borne by Eastview.
Assume that subsequent payments are due on December 31st of every year.

Required.

Prepare the journal entries and disclosure for Thermotech Inc. and Eastview Medical
Clinic for 20x5 and 20x6. Assume that both companies have a December 31 year-end.


Problem 4

The Johnson Company leased equipment from the Ike Company on October 1, 20x2. For
accounting purposes the lease is appropriately recorded as a finance lease. The lease is
for an eight-year period that expires September 30, 20x10. Equal annual payments under
the lease are $600,000 and are due on October 1 of each year. The first payment was
made on October 1, 20x2. The cost of the equipment on Ike's accounting records was $3
million. The equipment has an estimated useful life of eight years with no residual value
expected. Johnson uses straight-line depreciation. The implicit rate of interest in the lease
is 10 percent.

Required -

1. What expense should Johnson record for the year ended December 31, 20x2?
2. What income or loss before income taxes should Ike record for the year ended
   December 31, 20x2?




Page 419                                                         CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5

At the beginning of 20x2, Agudelo entered into a 20-year, non-cancellable, long-term
lease agreement for a truck terminal that had been constructed on Agudelo’s land. The
terminal has a useful life of 40 years, and Agudelo can acquire title to the facility at the
end of the lease term by paying the lessor $1. The annual lease payments over the lease
term, payable at the beginning of the year, are as follows:

     First 10 years                                                $1,000,000 per year
     Second 10 years                                                  300,000 per year

Agudelo also must make annual payments to the lessor of $75,000 for property taxes and
$125,000 for insurance. The implicit rate in the lease (known to Agudelo) was 6%. On
January 1, 20x2, Agudelo made the first payment of $1.2 million to the lessor.

Required –

a.      Discuss how Agudelo should classify the truck terminal lease.
b.      Prepare all necessary entries for Agudelo for the year 20x2.


Problem 6

On December 31, 20x3, Cooray Inc. sold a building with a net book value of $1,800,000
to Gardner Industries for $1,757,346. Cooray immediately entered into a leasing
agreement whereby Cooray would lease the building back for an annual payment of
$260,000. The term of the lease is 10 years, the expected remaining useful life of the
building. The first annual lease payment is to be made immediately, and future payments
will be made on December 31 of each succeeding year. Gardner’s implicit interest rate is
10%. The building has a residual value of $0 and the Cooray Company amortizes its
buildings using the straight-line method.

Required -

1.      Prepare the journal entries that should be made by Cooray on December 31, 20x3,
        relating to this sale and leaseback transaction.
2.      Prepare the journal entries that should be made by Cooray for the year ended
        December 31, 20x4, relating to this sale and leaseback transaction.




Page 420                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 7

On November 1, 20x0, the president of Pepper Ltd. summoned you, the controller, to an
emergency meeting of the officers of the company.

President:            I'm sorry I had to call this meeting on short notice but we have a
                      problem. The bank has turned down our loan request for $600,000.

V.P. Production:      Is that the $600,000 for my equipment?

President:            Yes.

V.P. Production:      I thought that might happen, so I took the liberty of contacting White
                      Star Leasing. They are prepared to offer us the same equipment on a
                      lease basis for seven years, the same period that we had requested for
                      the bank loan.

Treasurer:            Why did the bank turn us down?

President:            I don't really know. We were willing to pay 14% and that's high.

V.P. Production:      We don't need the bank loan. White Star's lease will carry only a 10%
                      interest rate and the bottom line is we won't have to show anything
                      concerning the lease on our financial statements.

President:            I would want to see all calculations and explanations supporting your
                      statement. I'm sure the lease would have to appear on the Statement
                      of Financial Position.

Treasurer:            What will this lease cost?

V.P. Production:      The annual payments will be $98,595, due on January 1st of each
                      year.

Treasurer:            Who will own the equipment at the end of the lease term?

V.P. Production:      White Star retains ownership.

President:            Can we add an option-to-purchase clause?

V.P. Production:      I asked that, but White Star said it's not their policy. Who cares
                      anyway? I know the equipment is supposed to have a useful life of
                      ten years, but I don't think it will be in any great shape after seven.

Treasurer:            You said that the installments start January 1, 20x1. When does the
                      lease term begin?


Page 421                                                           CMA Ontario – September 2009
Financial Accounting – Module 1




V.P. Production:      That same day.

Treasurer:            I don't understand why the leasing company can charge us only 10%
                      when the bank won't give us the loan at 14%.

President:            Before we adjourn today, there is one other thing to consider. In
                      terms of the effects on our income statement and Statement of
                      Financial Position, would the lease or the bank loan be better?

The following day the president presented you with a copy of the minutes of the meeting
and asked you to write a report addressing the questions and concerns raised at the
meeting.

Required -

As the controller of Pepper Ltd., write the report to the president.


Problem 8

Aaron, Inc., was incorporated in 20x1 to operate as a computer software service firm with
a fiscal year ending August 31. Aaron's primary product is a sophisticated on-line
inventory control system; its customers pay a fixed fee plus a charge for using the system.

Aaron has leased a large, BIG-I computer system from the manufacturer. The lease calls
for an annual rental payment of $700,000 for the 12 year lease term. The estimated useful
life of the computer is 15 years. The computer is installed on August 31.

Each scheduled annual payment includes $120,000 for full-service maintenance on the
computer to be performed by the manufacturer. All rentals are payable on August 1 of
each year beginning with August 31, 20x2. The lease is noncancellable for its 12-year
term, and it is secured only by the manufacturer's chattel lien on the BIG-1 system. On
any anniversary date of the lease after August 20x7, Aaron can purchase the BIG-1
system from the manufacturer at the then current fair market value of the computer.

This lease is to be accounted for as a finance lease by Aaron, and it will be depreciated by
the straight-line method with no expected residual value. Borrowed funds for this type of
transaction would cost Aaron 10 percent per year.

Required -

a.      Why is the lease a finance lease to Aaron?
b.      Prepare all entries Aaron should have made in its accounting records from August
        31, 20x2 and August 31, 20x3.



Page 422                                                         CMA Ontario – September 2009
Financial Accounting – Module 1



Solutions

Multiple Choice Questions

1.    b     Lease payment, Dec 31, 20x2                                      $20,000
            Interest: ($135,000 - 20,000) x 10%                               11,500
            Principal reduction = current portion                             $8,500

2.    c     $841,500 - 153,000                                              $688,500

3.    c     Profit: $2,482,500 - 2,200,000                                  $282,500
            Interest: ($2,482,500 - 400,000) x 8% x 1/2                       83,300




Page 423                                                  CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

a.      Calculation of lease payments -

           [BGN]              N          I/Y        PV           PMT          FV
           Enter              4          12       -100000                    3000
           Compute                                                X=
                                                                $28,835

b.      Lease is a finance lease due to the presence of bargain purchase option.

        Jan 1, x8        Asset under finance lease                   $100,000
                           Lease liability (100,000 - 28,836)                        $71,165
                           Cash                                                       28,835

        Dec 31, x8       Interest expense (71,165 x 12%)                  8,540
                            Interest payable                                            8,540

        Dec 31, x8       Depreciation expense                          16,667
                           Accumulated Depreciation                                   16,667
                         (100,000 ÷ 6)

c.      Jan 1, x8        Lease receivable                             $71,165
                         Cash                                          28,835
                           Revenue                                                  $100,000

                         Cost of sales                                 67,500
                           Inventory                                                  67,500

        Dec 31, x8       Interest receivable                              8,540
                            Interest revenue                                            8,540




Page 424                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2


(a)   This is a finance lease due to the presence of the bargain purchase option. It is
      assumed that the lessee will exercise the bargain purchase option and keep the asset
      for its economic life.

      Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -10,000
      Solve for PMT = $56,398

      Dec 31, 20x3        Equipment under Finance Lease            $250,000
                            Cash                                                  $56,398
                            Lease Obligation                                      193,602

      Dec 31, 20x4        Interest expense ($193,602 x 8%)            15,488
                          Lease obligation                            40,910
                             Cash                                                  56,398

                          Depreciation expense                        23,000
                            Accumulated depreciation                               23,000
                          ($250,000 – 20,000) / 10

      Dec 31, 20x5        Interest expense
                             ($193,602 – 40,910) x 8%                 12,215
                          Lease obligation                            44,183
                             Cash                                                  56,398

                          Depreciation expense                        23,000
                            Accumulated depreciation                               23,000




Page 425                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




(b)   This is a finance lease since the existence of the guaranteed residual value makes
      the present value of the minimum lease payments equal the fair value of the
      equipment.

      Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -60,000
      Solve for PMT = $48,506

      Dec 31, 20x3        Equipment under Financel Lease            $250,000
                            Cash                                                  $48,506
                            Lease Obligation                                      201,494

      Dec 31, 20x4        Interest expense ($201,494 x 8%)            16,120
                          Lease obligation                            32,386
                             Cash                                                   48,506

                          Depreciation expense                        38,000
                            Accumulated depreciation                                38,000
                          ($250,000 – 60,000) / 5

      Dec 31, 20x5        Interest expense
                             ($201,494 – 32,386) x 8%                 13,529
                          Lease obligation                            34,977
                             Cash                                                   48,506

                          Depreciation expense                        38,000
                            Accumulated depreciation                                38,000




Page 426                                                       CMA Ontario – September 2009
Financial Accounting – Module 1




(c)   Lease Payment: [BGN] N = 5, I = 8, PV = 250,000, FV = -60,000
      Solve for PMT = $48,506

      Present value of lease payments: N = 5, I = 8, PMT = 48,506
      Solve for PV = 209,164
      PV as a % of the fair value of equipment = $209,164 / 250,000 = 84%

      Lease term as a % of economic life = 5/10 = 50%

      This lease should be classified as an operating lease since it does not transfer the
      rights, rewards and risks of ownership to McGrath.


      Dec 31, 20x3        Prepaid rent                                 $48,506
                            Cash                                                     $48,506

      Dec 31, 20x4        Rent expense                                  48,506
                            Cash                                                      48,506

      Dec 31, 20x5        Rent expense                                  48,506
                            Cash                                                      48,506




Page 427                                                         CMA Ontario – September 2009
Financial Accounting – Module 1




(d)   PV of minimum lease payments: [BGN] N = 8, I = 7, PMT = 42,000
      Solve for PV = $268,350

      This one is a little trickier. The lease term is 80% of the economic life of the asset
      which is an indicator of a finance lease, however we cannot compare the present
      value of the minimum lease payments to the fair value of the equipment since the
      latter is unknown. It would be up to managerial judgment to determine whether the
      present value of the minimum lease payments covers a substantial portion of the
      fair value of the equipment. The fact that the lease term covers 80% of the
      economic life of the asset is significant and therefore, we will classify this lease as a
      finance lease.

      Dec 31, 20x3        Equipment under Finance Lease                $268,350
                            Cash                                                      $42,000
                            Lease Obligation                                          226,350

      Dec 31, 20x4        Interest expense ($226,350 x 7%)               15,844
                          Lease obligation                               26,156
                             Cash                                                      42,000

                          Depreciation expense                           33,544
                            Accumulated depreciation                                   33,544
                          $268,350 / 8

      Dec 31, 20x5        Interest expense
                             ($226,350 – 26,156) x 7%                    14,014
                          Lease obligation                               27,986
                             Cash                                                      42,000

                          Depreciation expense                           33,544
                            Accumulated depreciation                                   33,544




Page 428                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 3

Lease Classification

Criteria                                                      Assessment

1.     The lease transfers ownership of the asset to          No
       the lessee by the end of the lease term.

2.     The lessee has the option to purchase the asset Yes. Purchase option is $2,000
       at a price that is expected to be substantially  when equipment is estimated to
       lower than the fair value at the date the option have a residual value of $20,000
       becomes exercisable for it to be reasonably
       certain, at the inception of the lease, that the
       option will be exercised.

3.     The lease term is for the major part of the            Yes. The lease term is about 80%
       economic life of the asset even if title is not        of the equipment' s economic life.
       transferred.

4.     At the inception of the lease the present value        Yes. The present value of the
       of the minimum lease payments amounts to at            minimum lease payments is equal
       least substantially all of the fair value of the       to 100% of the fair value of the
       leased asset.                                          property. See schedule below.


5.     The leased assets are of such a specialized            Unknown.
       nature that only the lessee can use them
       without major modification.


           [BGN]              N         I/Y              PV          PMT           FV
           Enter              8         10                           16881        2000
           Compute                                   X=
                                                   $99,998

        Therefore, lease is a finance lease from the lessee's point of view




Page 429                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


Journal Entries - Lessee

Jan 1, 20x5      Asset Under Finance Lease                   $100,000
                   Cash                                                       $16,881
                   Finance Lease Obligation                                    83,119

Dec 31, 20x5     Interest Expense (83,119 x 10%)                 8,312
                 Finance Lease Obligation                        8,569
                    Cash                                                       16,881

                 Depreciation expense                            9,950
                   Accumulated depreciation                                      9,950
                 (100,000 - 500 ) ÷ 10 years

Dec 31, 20x6     Interest Expense (83,119 - 8,569) x 10%         7,455
                 Finance Lease Obligation                        9,426
                    Cash                                                       16,881

                 Depreciation entry same as for 20x5


Journal Entries - Lessor

Jan 1, 20x5      Lease receivable                             $83,119
                 Cash                                          16,881
                   Sales                                                     $100,000

                 Cost of goods sold                            80,000
                   Finished Goods Inventory                                    80,000

Dec 31, 20x5     Cash                                          16,881
                   Lease Receivable                                              8,569
                   Interest Revenue                                              8,312

Dec 31, 20x6     Cash                                          16,881
                   Lease Receivable                                              9,426
                   Interest Revenue                                              7,455




Page 430                                                   CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 4

1.   Depreciation [$3,521,040 (Schedule 1) / 8 x 3/12]                          $110,033
     Interest expense (Schedule 2)                                                73,026
                                                                                $183,059

2.   Profit on sale:
        Sales price (Schedule 1)                                             $3,521,051
        Cost of equipment                                                    (3,000,000)
                                                                               $521,051
     Finance income (Schedule 2)                                                  73,026
                                                                               $594,066

     Schedule 1 –

                [BGN]              N       I/Y           PV        PMT          FV
                Enter              8        10                    600000
                Compute                               X=
                                                   $3,521,051

     Schedule 2
                                 Calculation of Interest
     Purchase price of equipment                                              $3,521,051
     Payment made on October 1, 20x2                                           (600,000)
                                                                              $2,921,051
     Interest rate                                                                x 10%
     Interest expense (October 1, 20x2 to October 1, 20x3)                      $292,105
     Interest expense applicable to 20x2 (3/12 months)                            x 25%
                                                                                 $73,026




Page 431                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 5


a.     Criteria                                               Assessment

1.     The lease transfers ownership of the asset to          No
       the lessee by the end of the lease term.

2.     The lessee has the option to purchase the asset Yes.
       at a price that is expected to be substantially
       lower than the fair value at the date the option
       becomes exercisable for it to be reasonably
       certain, at the inception of the lease, that the
       option will be exercised.

3.     The lease term is for the major part of the            No. The lease term is about 75%
       economic life of the asset even if title is not        of the equipment' s economic life.
       transferred.

4.     At the inception of the lease the present value        Unknown since we do not know
       of the minimum lease payments amounts to at            the FMV of the property
       least substantially all of the fair value of the
       leased asset.


5.     The leased assets are of such a specialized            Unknown.
       nature that only the lessee can use them
       without major modification.

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

b.      PV of the first 10 years of payments:

           [BGN]              N         I/Y              PV          PMT          FV
           Enter              10         6                          1000000
           Compute                                   X=
                                                  $7,801,692

        PV of the last 10 years of payments (remember to take your calculator off the
        BEGIN mode:

                              N         I/Y          PV             PMT          FV
           Enter              10         6                         300000
           Compute                                  X=
                                                 $2,208,026



Page 432                                                             CMA Ontario – September 2009
Financial Accounting – Module 1


        This is a present value at t=9, so we need to bring it back to t=0:

                              N         I/Y          PV           PMT           FV
           Enter              9          6                                    2208026
           Compute                                  X=
                                                 $1,306,927

        Total PV of minimum lease payments: $7,801,692 + 1,306,927 = $9,108,619

     Jan 1, x2    Terminal under finance lease                    $9,108,619
                     Lease liability                                              $9,108,619

     Jan 1, x2    Lease liability                                  1,000,000
                  Property taxes (or prepaid)                         75,000
                  Insurance (or prepaid)                             125,000
                      Cash                                                        $1,200,000

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

     Dec 31, x2 Depreciation expense                                 227,715
                   Accumulated depreciation                                         227,715
                $9,108,619 / 40 years


Problem 6

1.     Dec 31, 20x3       Building under Finance Lease             $1,757,346
                          Deferred loss on sale-leaseback              42,654
                            Building                                              $1,800,000

                          Cash ($1,757,346 – 260,000)               1,497,346
                            Lease obligation                                       1,497,346

2.     Dec 31, 20x4       Interest expense ($1,497,346 x 10%)         149,735
                          Lease obligation                            110,265
                             Cash                                                   260,000

                          Depreciation expense                        175,735
                            Accumulated depreciation                                175,735
                          $1,757,346 / 10

                          Depreciation expense                           4,265
                            Deferred loss on sale-leaseback                             4,265
                          $42,654 / 10

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Problem 7

                                    Report to the President

Date:            November 2, 20x0

From:            CMA Student, Controller

Regarding:       Issues raised at the meeting of November 1, 20x0

Whether or not the lease must be shown on the Statement of Financial Position depends
on the kind of lease it is deemed to be. A lease must be capitalized based on managerial
judgment based on the following criteria; otherwise, it may be accounted for as an
operating lease.

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

2.      The lessee has the option to purchase the asset No.
        at a price that is expected to be substantially
        lower than the fair value at the date the option
        becomes exercisable for it to be reasonably
        certain, at the inception of the lease, that the
        option will be exercised.

3.      The lease term is for the major part of the            No. The lease term of 7 years is
        economic life of the asset even if title is not        equal to 70% of the equipment' s
        transferred.                                           economic life of 10 years.

4.      At the inception of the lease the present value        Yes - the present value of the
        of the minimum lease payments amounts to at            minimum lease payments is equal
        least substantially all of the fair value of the       to 88% of the fair value of the
        leased asset.                                          asset. See schedule below.


5.      The leased assets are of such a specialized            Unknown.
        nature that only the lessee can use them
        without major modification.


                              N           I/Y             PV        PMT           FV
           Enter              7           10                        98595
           Compute                                    X=
                                                    $528,002



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The lease is therefore an operating lease and requires only the following journal entry
annually:

Lease rental expense                     $98,595
       Cash                                               $98,595

Since the lease is not a finance lease, neither the assets nor the liabilities of Pepper Ltd.
are affected. It should be noted that had the company been able to secure the bank loan to
buy the equipment, both long-term assets and liabilities would increase by $600,000. This
would place the company in a more leveraged financial position than it is in at the
moment which will have a detrimental effect on the company's ability to incur additional
debt financing.

Pepper Ltd. received the relatively low 10% rate of interest from White Star because the
financing terms of the lease may have been sufficient to provide an adequate profit to the
lessor.

From an earnings point of view, the following shows that the lease option would be the
more favorable of the two options discussed:


                                                            Operating Lease          Bank Loan
Expected before interest and lease installment
   (assumed)                                                     $4,680,000           $4,680,000
Depreciation expense ($600,000/10)                                                      (60,000)
Interest expense ($600,000 x .14)                                                       (84,000)
Lease rental cost                                                  ( 98,595)
Earnings before taxes                                             $4,581405           $4,536,000

Conclusion -

The above shows that Pepper Ltd. need not be concerned that the bank turned down its
loan request. The lease option would afford a cleaner Statement of Financial Position
presentation notwithstanding the fact that a long-term liability exists, assuming that the
lease is an irrevocable one. In addition, the lease option would help to improve the
company's cash flow situation.




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Problem 8

a.     Criteria                                           Assessment

1.     The lease transfers ownership of the asset to      No
       the lessee by the end of the lease term.

2.     The lessee has the option to purchase the asset No.
       at a price that is expected to be substantially
       lower than the fair value at the date the option
       becomes exercisable for it to be reasonably
       certain, at the inception of the lease, that the
       option will be exercised.

3.     The lease term is for the major part of the        Yes. The lease term is about 80%
       economic life of the asset even if title is not    of the equipment' s economic life.
       transferred.

4.     At the inception of the lease the present value    Unknown since we do not know
       of the minimum lease payments amounts to at        the FMV of the property.
       least substantially all of the fair value of the
       leased asset.


5.     The leased assets are of such a specialized        Unknown.
       nature that only the lessee can use them
       without major modification.

        Lease is a finance lease since the lease term is 80% of the equipment's economic
        life.

b.    [BGN] N = 12, I = 10, PMT = $700,000 -120,000 = $580,000
      PV = $4,347,135

      Aug 31, x2      Computer under finance lease                 $4,347,135
                      Prepaid maintenance                             120,000
                        Cash                                                       $700,000
                        Lease obligation                                          3,767,135

      Aug 31, x3       Maintenance expense                             120,000
                       Interest expense ($3,767,135 x 10%)             376,714
                       Lease obligation                                203,286
                          Cash                                                      780,000

                       Depreciation expense ($4,347,135 / 12)          362,261
                         Accumulated depreciation                                   362,261


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14.       Accounting for Non-Profit Organizations

Note that there are no IFRS standards covering accounting for non-profit organizations.
The material in this chapter is based on current CICA handbook pronouncements.


Differences and similarities of not-for-profit organizations with business enterprises.

The following table summarizes the major differences:

Factors                 Business Enterprises            Not-for-Profit Enterprises

Ownership               Private or share ownership      No specific individual ownership
                        that is transferable.           and therefore no transferable
                                                        ownership interests.

Organization            Profit Maximization (an over    Usually some form of service
Objectives              simplification)                 function. In many not-for-profit
                                                        organizations, the objectives are
                                                        specific and tend to make the
                                                        organizations less flexible than
                                                        businesses.

Board of Directors      Elected by shareholders.        Usually the board is elected by
                                                        members. In cases where there is
                                                        a large amount of government
                                                        financing, a certain percentage of
                                                        the board may be appointed by the
                                                        specific government. If an
                                                        organization has a closed
                                                        membership, the board can
                                                        basically elect itself and is self-
                                                        perpetuating. The make-up of the
                                                        board impacts on user needs and
                                                        therefore the type of financial
                                                        reporting required.

Major Source of         Equity and debt. In an          Fees, grants, donations.
Funds                   ongoing sense, the
                        organization funds itself.




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Cost Control and        The profit motive provides a     Since there is no bottom line, and
General                 measurement of the effective-    the provision of some specific
Expenditures            ness of cost controls.           service will probably seem to
                                                         require more funds than are
                                                         available, cost control and
                                                         expenditure control are very
                                                         serious issues in accounting for
                                                         not-for-profit organizations. The
                                                         analysis of what is needed and
                                                         how efficiently and effectively
                                                         funds are used is extremely
                                                         subjective.

Need to segregate       Not generally an issue.          Not-for-profit organizations may
funds                   Usually this can be done by      have a number of restrictions on
                        management discretion.           sources of funds and therefore
                        Certain government grants        need to account for various funds
                        may require funds to be used     individually.
                        for specific purposes;
                        therefore, these funds need to
                        be tracked separately.


A brief summary of the above table can be stated in two words: profit and nonprofit. The
profit objective has led to widely held transferable ownership. It makes the operations of
the organization flexible in that resources can be moved from one industry to another as
long as the move has profit potential. Profit, the basic measurement of success, has a
built-in incentive to make expenditures that will generate revenue and has, relatively
speaking, automatic cost control. Nonprofit organizations are usually set up for specific
purposes and, although ownership cannot be transferred, members tend to perpetuate the
organization because of their interest in the specific purpose - e.g., Church, Art Gallery,
etc. Except for fee-for-service organizations, revenues are not generated by resource
expenditures - expenditures are limited by revenues and measurement of success, or what
is optimal, tends to be difficult. Because sources of funds often have restrictions,
accounting records need to be segregated by type of fund.

Both business and not-for-profit organizations should be run effectively and efficiently.
Both have goals or objectives; both wish to be productive in the sense of achieving these
goals with a minimum of input. The measurement issue involved is a relatively easy one
for business organizations - net income is the success indicator. Measuring the success
of not-for-profit organizations has varying degrees of difficulty depending on the nature
of the organization. Fee-for-service organizations are very similar to business
organizations. Service organizations which depend almost exclusively on grants and
donations are on the opposite end of the continuum.



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Objectives of financial reporting

The basic objective of financial reporting for both business and not-for-profit
organizations is to provide information that is useful for decision making. Who are the
users of these statements? The following table lists some of the users for business and
not-for-profit organizations, and from the list, it is apparent that there is a strong overlap
in users and the types of information they would require.

The types of information are:

a)      performance evaluation
b)      stewardship
c)      cash flow predictions

        Business Users                                 Not-for-Profit Users

        managers                                       managers
        shareholders                                   members/directors
        creditors                                      creditors
        employees                                      employees
        investors in general                           donors
        governments                                    governments
        general public                                 general public

The relative importance of each type of information would depend on the nature of the
organization. Not-for-profit organizations have tended to stress the stewardship function
because members/donors are concerned with how the money has been spent and because
it involves relatively easier measurements. However, this may not provide the most
useful information.

Given similar user groups, the same principles of relevance, materiality, etc. should apply
to reporting of business and not-for-profit organizations.

The following table summarizes how financial statements relate to required information
for both business and not-for-profit organizations.




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Type of Information           Business Organizations     Not-for-Profit Organizations

Performance Evaluation        Income statements; profit Statements don't really measure
                              can be compared to other this; they can show a deficit or
                              firms in the same industry. surplus but generating income
                                                          dollars is not the primary
                                                          function.

Stewardship                   Income statement,          Statements can show if the
                              Statement of Financial     organization stayed within
                              Position, etc.             budget and can report on the use
                                                         and segregation of funds.
                                                         Basically, this is seen by many
                                                         users and preparers as the
                                                         primary function of statements
                                                         for the not-for-profit
                                                         organizations and explains the
                                                         lack of allocations.

Cash Flow                     Statements and external    Statements can indicate the
                              assessments.               sources of funds and the
                                                         organization's expenditures, but
                                                         external factors which predict
                                                         future sources and liquidity are
                                                         of major importance.


Non-profit Organizations defined

A non-profit organization is defined as an entity, normally without transferable
ownership interests, organized and operated exclusively for social, educational,
professional, religious, health, charitable or any other not-for-profit purpose. A non-
profit's members and contributors do not receive any financial return directly from the
organization.

Therefore, there are three essential characteristics to a non-profit organization:
-      no transferable ownership interest,
-      they are operated exclusively for non-profit purposes, and
-      resource providers do not stand to benefit because of their status as resource
       providers.

This definition is important, because the accounting requirements for non-profit
organizations will not apply if the organization has not met all of the criteria.




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The statements normally required for financial reporting are:

        Statement of Financial Position (in the for-profit world: Statement of Financial
        Position)
        Statement of Operations (in the for-profit world: income statement)
        Statement of Cash Flows
        Statement of Changes in Net Assets (in the for-profit world: statement of changes
               in Retained Earnings)

All revenues and expenditures should be shown at their gross amounts. For example, a
charitable organization that conducts a weekly bingo often pays out all prizes and
expenses of running the bingo out of receipts and deposits and discloses the remainder as
net bingo revenues. Such an organization would have to disclose the gross bingo receipts
and related expenses.

The notes to the financial statements have to provide a clear and concise description of
the non-profit's purpose, its intended community of service, its status under income tax
legislation and its legal form.


Fund Accounting

In a simple not-for-profit organization, there might be a single service function and a
single source of funds. Accounting for such an organization would be fairly
straightforward. The organization would simply keep track of a single set of expenditures
to relate to its source of funds. However, many not-for-profit organizations have various
sources and uses of funds which require separate tracking because of restrictions - donors
specify uses, or there are legal requirements; or simply because specific funds are raised
for specific purposes and stewardship requires tracking these particular sources and uses.

A brief review of common types of funds and their purposes follows:

        Operating funds - sources and uses of funds to conduct the organization's day-to-
        day functions.

        Self-sustaining funds - sources and uses of a revenue-generating activity in an
        organization such as the sale of prints in an art gallery.

        Special funds - sources and uses of funds for a special project or event such as a
        benefit concert given by a local symphony or a survey carried on by a health
        service organization to assess local needs.

        Trust funds - accounting for funds held for other organizations or groups; the
        benefit does not go to the holding organization itself, but is a service provided to
        others.



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        Endowed funds - these funds are provided mainly so that only the investment
        income from them is available to the organization. Such funds may be established
        to provide scholarships or operating funds to a museum.

        Capital funds - as the name implies, these funds are segregated for asset purchase
        or improvement.

Each type of fund requires its own record keeping and its own statements. This results in
some rather complex accounting statements, but serves to meet the stewardship
requirements of nonprofit organizations. It should be noted that a Statement of Financial
Position must be prepared for each segregated fund. Many of the items contained on the
fund Statement of Financial Position are similar to those found on a Statement of
Financial Position for a business enterprise. The major difference between not-for-profit
Statement of Financial Positions and the business enterprise Statement of Financial
Position is in the equity section. The ‘equity’ section of a nonprofit business Statement
of Financial Position is called Net assets and must disclose the following:

1) restricted balances - those which cannot be expended because of legal or contractual
   conditions.
2) unappropriated - the amounts available for future operations.

If fund accounting is used, a brief description of the purpose of each fund reported should
be provided in the notes to the financial statements.


Accounting for Contributions

There are three types of contributions:

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

•       endowment contributions: these are a special type of restricted contribution. The
        assets endowed are usually held as investments and cannot be used by the
        organization. Only the income generated by the investments can be used. Again,
        the reporting of contributions depends on which of the two methods of accounting
        for contributions the organization uses.

•       unrestricted contributions: these contributions were received with 'no strings
        attached'. The organization is free to use these funds as they see fit. Unrestricted
        contributions are recognized as revenue immediately, regardless of which method
        the organization uses to account for contributions.



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The two methods of accounting referred to above are (1) the deferral method and (2) the
restricted fund method.
- if the organization uses fund accounting to show restrictions, then it should use the
    restricted fund method,
- if the organization uses fund accounting to show activities, then it should use the
    deferral method
- if the organization does not use fund accounting, then it should use the deferral
    method.

An organization using fund accounting to show restrictions would normally have a
general fund and one or more restricted funds - each restricted fund showing the receipt
of restricted funds as revenues and the related allowable expenses. For example, assume
the Canadian Heart Institute, a national clinic for people with severe heart problems,
operates two programs: the regular clinical program where doctors treat patients and a
research program. Sources of funding are as follows:
-       unrestricted government contributions for the treatment program
-       unrestricted government contributions for the research program
-       restricted contributions received from various sources for the research program
-       endowment funds

If the Canadian Heart Institute does not use fund accounting, then it must follow the
deferral method of accounting for these contributions.

If the Canadian Heart Institute uses fund accounting, then the choice of method to
account for contributions will depend on how funds are structured. If funds are structured
according to activities: Clinic Fund, Research Fund and Endowment Fund, then it would
still use the deferral method. Note that the Research Fund receives both restricted and
unrestricted contributions, consequently the restricted fund method does not apply to the
Research Fund.

If the Institute's funds were organized on the basis of restrictions: a general fund where
all clinical work and research funded by unrestricted funds, a research fund showing only
restricted revenues and related expenditures, and an endowment fund. In this case, the
restricted fund method would apply.




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The following schematic summarizes the above discussion:


                             Fund Accounting
                             Currently Used?




            Yes                                      No



      Objective of
     Fund Accounting?




        Show                       Show
       Restrictions               Activities



       Restricted                                  Deferral
      Fund Method                                  Method




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Deferral Method

The majority of non-profit organizations will likely adopt the deferral method. The
following describes the accounting treatment of different types of contributions under the
deferral method:

Type of Contribution         Accounting Treatment

Endowment                    Direct increases in net assets. The contribution by-passes the
Contributions                statement of operations and essentially increases assets
                             (investments - restricted) and increases net assets - restricted.

Restricted                   This is the non-profit equivalent of deferred revenues. These
Contributions for            contributions are set up as deferred contributions when
expenses of future           received. As expenditures are made against these funds, an
periods                      equivalent amount of revenue is recognized in the statement of
                             operations.

Restricted                   These are deferred and amortized on the same basis as the
Contributions for the        amortization of the related capital asset. For example, if we
purchase of capital          receive a $100,000 contribution for the purchase of a building
assets                       which will get amortized over 40 years, then the contribution
                             will also get deferred and amortized over 40 years. The net
                             effect is that the amortization of the contribution offsets the
                             related amortization expense.

                             If the contribution is received for an asset that does not
                             amortize, then it is recorded as a direct increase in net assets.

Any restricted contributions for expenses in the current period and unrestricted
contributions should be recognized in the current period.

Disclosure requirements are as follows:
•      deferred contributions should be presented in the liabilities section of the
       Statement of Financial Position
•      the nature and amount of changes in deferred contribution balances should be
       disclosed (likely as a note to the financial statements)


Restricted Fund Method

Generally, all revenues reported in a restricted fund should be externally restricted. An
external restriction is one imposed by the funder. All unrestricted funds should be
reported in the General Fund.




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Endowment contributions should be recognized as revenue of the endowment fund in the
current period. Note that any revenues generated by the endowment fund are recorded as
revenues of the general fund since these are usually unrestricted. If revenues are restricted
for a specific purpose, they should be recorded as revenues of the appropriate restricted
fund.

Restricted contributions are recorded as revenues of the period in the related restricted
fund. However, restricted contributions for which no corresponding restricted fund is
presented should be recognized in the general fund in accordance with the deferral
method.

Contributions Receivable

Not-for-profit organizations which rely on donations as a source of revenues often
receive pledges from donators. The United Way is such an organization. Their fund
raising campaign is in the fall of each year and serves to finance the following calendar
year. Most of the donation revenue received by the United Way is by means of payroll
deductions. Employees will pledge a certain amount to be deducted from their pay
cheques in the upcoming year; for example, you might pledge to give $20 every pay. If
you get paid every two weeks, such a pledge amounts to $520. When preparing its
financial statements at December 31, the United Way will include these pledges as
pledges receivable on their Statement of Financial Position.

However, pledges have one important difference with ordinary accounts receivable.
Pledges are not legally enforceable. Therefore, if you decide to not fulfill your promise,
the not-for-profit organization to which you made the pledge has no recourse against you.
The reason for this lies in contract law: for a claim to be legally enforceable, good
consideration must have occurred. In this case, there has been no good consideration
since there has been no exchange between the parties.

Is it possible to record an asset we do not own? The answer is yes. If you refer to the
definition of an asset you will note that an asset is defined as ‘economic resources
controlled by an entity’. Thus, it is not necessary to have legal ownership of an asset.
Another example of this are capital leases where the ownership of the asset lies with the
lessor.

Consequently, a contribution receivable should be recognized as an asset when it meets
the following criteria:
-       the amount can be reasonably estimated, and
-       ultimate collection is reasonably assured.

Note that these are simply the same revenue recognition criteria that apply to any
organization. Also, as for any organization, an allowance for uncollectible contributions
should be set up.




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The amount recognized as assets and the amount recognized as revenues need to be
disclosed.

Capital Assets

In the past, there were three principal accounting methods allowed:

1.      Expense immediately
2.      Capitalize and depreciate
3.      Capitalize but do not depreciate.

Expensing immediately was the most common method used; the main reason for its
popularity relates to the nature of the revenue used to acquire the assets. Not-for-profit
organizations often receive capital grants which are given for the purpose of purchasing
specific assets - the capital grant is shown in income with the corresponding asset shown
as an expense. If the organization were to capitalize and depreciate the asset, then
recognition of the revenue in the period of acquisition without the offsetting expenditure
would make it appear that the organization has a substantial surplus and, in future
periods, the depreciation would put the organization in an operating deficit position.

Sometimes capital grants are given only for major assets (buildings) while smaller
acquisitions (furniture & fixtures) must be financed through the operating grants - in that
case, different accounting policies might be used for the two types of assets due to the
differing relationship to revenues. For example, you could capitalize and depreciate
those capital items financed as part of normal ongoing operations and expense those
capital items financed through capital grants.

There are two side effects of expensing capital assets. First, the Statement of Financial
Position does not disclose the existence of, or investment in, capital assets, and second,
future operations bear no part of the cost of the capital assets.

The first problem is often solved by creating a capital fund whereby capital assets are
shown on the Statement of Financial Position and an offsetting amount called the capital
fund balance is shown on the liabilities and surplus side of the Statement of Financial
Position.

Capitalization without depreciation is only appropriate when the assets do not decline in
value or in usefulness; i.e. collections of art galleries and museums.

Only not-for-profit organizations whose average gross revenues for the last two years are
under $500,000 have the above options available to them. All others must depreciate
assets over their useful lives.




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Donated Goods & Services and Capital Assets

The issue can be summarized as follows. Not-for-profit organizations often receive
goods and services. Should these goods and services received be recognized in the
financial statements of the not-for-profit organization? A simple example will put this
issue to light.

Assume a not-for-profit organization has an audit done for free. The substance of the
transaction is that the auditors are donating their time (which has value) to the
organization. One way to do this would be for the not-for-profit organization to pay for
this service and then have the auditor remit a donation to the organization of the same
amount. Such a transaction would have the effect of increasing donation revenues and
audit expense by the same amount. However, when the audit is done for free, there is no
exchange of cheques and the transaction may never make it to the financial statements.
The basic issue, however, is that there is absolutely no difference between the two
transactions. Therefore, why should the accounting for these transactions be different.

The recognition criteria set out by the CICA handbook becomes one of (1) whether or not
a value can be put on these goods or services and (2) whether or not the organization
would otherwise have to pay for these goods or services.

In all cases, criteria 1 must be met if these transactions are to be recorded in the financial
records. In the case of donated fixed assets, if criteria 1 is met, then the asset must be
recorded. In the case of donated materials and services (non capital), the organization
may choose to record these, so long as criteria 2 is met.

        Donated property, plant and equipment should be recorded at fair value when
        fair value can be reasonably estimated.

        The nature and amount of donated property, plant and equipment received in the
        period and recorded in the financial statements should be disclosed.

        An organization may choose to record the value of donated materials and
        services, but should do so only when a fair value can be reasonably estimated and
        when the materials and services are normally purchased by the organization and
        would be paid for if not donated. When donated materials and services are
        recorded, fair value should be used as the basis of measurement.

        The policy followed in accounting for donated materials and services should be
        disclosed.

        The nature and amount of donated materials and services received in the period
        and recorded in the financial statements should be disclosed.7


7 CICA Handbook, 4230.04 to .08


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When donated goods or services are assigned a value and recorded by the organization,
the credit to revenues offsets the debit to expenditures and there is no impact in the net
operating results - however, the absolute values of the revenues and expenses are
affected, and it is possible that management performance could be evaluated differently.


Encumbrance System

An encumbrance system results from the need to control expenditures and/or keep track
of financial commitments. Basically, it is a built-in device to record transactions at the
decision/commitment stage rather than when an actual transaction occurs. In a business
organization, you would record the purchase of inventory when the goods are in your
possession, not when ordered. In an encumbrance system, an entry is made at the time of
the order. The result of such a system is that the records clearly show what funds are
available - or encumbered. Given the fact that nonprofit organizations have limited
sources of funds, the system provides a cost control function.




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Problems with Solutions

Multiple Choice Questions


1.    George Rogers takes a 6-month leave of absence from his job to work full-time for
      an NPO. George's employer continues paying his salary. Rogers fills the position of
      finance director because the incumbent is on paid sick leave during this period. This
      position normally pays $38,000 per year. How should Roger's contribution be
      recorded (assuming that the NPO chooses to record the contribution)?
      a) As revenue of $19,000 and expense of $19,000
      b) As revenue of $19,000
      c) As deferred revenue of $19,000
      d) No entry should be recorded


2.    In 20x9, Mercy Clinic, a not-for-profit health care facility, received an unrestricted
      bequest of common stock with a fair market value of $50,000 in accordance with
      the will of a deceased benefactor. The testator had paid $20,000 for the stock in
      20x0. The clinic should record the bequest as
      a) Unrestricted revenue of $20,000
      b) Unrestricted revenue of $50,000
      c) Endowment revenue of $50,000
      d) Deferred revenue of $50,000


3.    The Smythe family lost its possessions in a fire. On December 23, 20x4, an
      anonymous benefactor sent money to the Aylmer Benevolent Society, an NPO, to
      purchase furniture for the Smythe family. During January 20x5, Aylmer purchased
      this furniture for the Smythe family. How should Aylmer report the receipt of this
      money in its 20x4 financial statements? Assume the deferred method is used.

      a)    As an unrestricted contribution
      b)    As a restricted contribution
      c)    As a deferred contribution
      d)    As a liability




Page 450                                                         CMA Ontario – September 2009
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The following information applies to questions 4 and 5 although each question should be
considered independently.

First Harvest (FH) collects food for distribution to people in need. During November
1998, its first month of operations, the organization collected a substantial amount of
food and also $26,000 in cash from a very wealthy donor. The donor specified that the
money was to be used to pay down a loan that the organization had with the local bank.
The loan had been taken out to buy land, on which the organization plans to build a
warehouse facility. A warehouse is needed since, although the organization does not plan
to keep a lot of food in stock, sorting and distribution facilities are crucial. FH has also
received $100,000, which according to the donor is to be deposited, with any income
earned to be used as FH sees fit.

4.    In which of the following ways should the food donation and the $26,000 be
      reflected in the financial statements. Assume that fair market values are available
      and that FH uses the deferral method and does not maintain separate funds.

            Food donations                  $26, 000 cash donation
      a)    Deferred revenues               Deferred revenues
      b)    Deferred revenues               Increase in net assets
      c)    Revenues                        Increase in net assets
      d)    Revenues                        Deferred revenues


5.    In which of the following ways should the $100,000 contribution be accounted for
      under the following revenue recognition methods?

            Deferral method                     Restricted fund method
      a)    Direct increase in net assets       Revenue of the endowment fund
      b)    Direct increase in net assets       Revenue of the general fund
      c)    Revenue                             Revenue of the endowment fund
      d)    Revenue                             Revenue of the general fund


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


Page 451                                                        CMA Ontario – September 2009
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7.    Jubilee Home Care is a not-for-profit organization. It uses the deferral method of
      accounting for contributions. Which of the following contributions should be
      reported as deferred revenue?
      a) Restricted contributions for expenses of one or more future periods
      b) Restricted contributions for the purchase of capital assets that will not be
            amortized
      c) Restricted contributions for setting up an endowment fund
      d) Unrestricted contributions


8.    On January 1, 20x2, NP, a not-for-profit organization, received a $650,000
      contribution from a wealthy benefactor. The contribution was to be used to build a
      subsidized housing complex on vacant land that NP had owned for several years.
      Construction was to begin in the summer of 20x3. Any interest earned on the
      $650,000 was to be used for the same purchase. NP uses restricted fund
      accounting, and it has established a separate fund for the housing complex. How
      should the contribution and related earned interest be treated under GAAP?
      a) In 20x2, the contribution should be shown as a deferred contribution in the
            restricted fund, and earned interest should be recognized as revenue.
      b) In 20x2, both the contribution and earned interest should be shown as deferred
            revenue in the restricted fund.
      c) In 20x2, both the contribution and earned interest should be immediately
            recognized as revenue in the restricted fund.
      d) The amount of contribution recognized as revenue should be equal to any
            eligible expenses incurred (such as maintenance expense or amortization).
            Therefore, revenue recognition will commence in 20x3.


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


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10.   A not-for-profit seniors’ home is preparing its year-end financial statements. Which
      of the following should be included in the current assets section of the balance
      sheet?
      a) A bank savings account with a balance of $52,000 representing a restricted
            capital fund for an expansion project to take place in two years.
      b) A $20,000 grant application for a project that has been completed. There is a
            20% likelihood of the grant application being accepted; however, at the time of
            preparing the financial statements, no word on the grant’s status has been
            received.
      c) Inventory totalling $80,000 representing gift items held on consignment. When
            the items are sold, the seniors’ home receives 20% of the revenue to aid in the
            expansion of one of the wings of the building.
      d) Cash held in trust in a bank account for the residents of the seniors’ home.
      e) None of the above.




Page 453                                                       CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

City Youth Services (CYS) is a not-for-profit organization established to provide
counselling and other services to children under the age of 18. It concentrates on troubled
teenagers who are typically referred to CYS by the courts, police, and hospitals. In years
past, the majority of the operating budget of CYS has been funded by the Provincial
Government; increasingly, however, CYS is turning to private donors for support.

Two years ago, CYS engaged in a major funding drive in order to raise funds for a group
home for troubled teenagers. The drive was a success; $110,000 was raised during 20x0
and a mortgage of $90,000 was negotiated so that CYS was able to purchase a house for
$200,000 in January 20x1. Since then, CYS continued its fund raising activities and was
able to raise $125,000 in donations in 20x1. The funds raised annually for the group
home are used to employ several in-house social workers on an hourly basis and pay the
operating expenses of the home.

CYS has continued to operate in separate rented premises and employs 12 social workers
to provide counselling. Increasingly, time spent by the regular social workers has
involved overload group home work that cannot be handled by in-house social workers.
As a result of the increase in group home related work, and the resulting increase in the
payroll costs of regular CYS social workers, CYS is currently running a deficit in its
operating fund. Fund raising for the counselling activities, which is separate from fund
raising for the group home, has been insufficient to offset the operating deficit. A major
fund raising drive to secure donations for CYS and the group home is planned for 20x2.

Twenty volunteers from the community have assisted the social workers in the group
home and in the regular counselling services. Two of these volunteers have also assisted
with clerical duties in the office.

You are Mary Jones, CMA, a friend of the Executive Director of CYS, James Smith. You
attend a meeting of the Board of Directors of CYS, where Smith says the following: "As
you know, Mary, our needs for private donations are greater than ever, especially with
government funding freezes. The trouble with private donations is that we are competing
with so many other worthwhile causes. Some of the people we approach for donations
have complained about a lack of information regarding where we spent past donations,
our current financial position, and our effectiveness in achieving the purposes for which
we receive money. Accordingly, we have decided to provide all donors in 20x2 with a
copy of our 20x1 annual report. Since you are an accounting expert, perhaps you could
advise us on ways in which we might improve our annual report to enhance the
information value for donors." He then gave you the statement of operations and the
Statement of Financial Position of CYS (see attached).




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Financial Accounting – Module 1


Required:

As Mary Jones, comment on ways in which the reporting of CYS might be improved to
enhance the informational value for donors.



                                     City Youth Services
                                  Statement of Operations
                           For the year ended December 31, 20x1

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




Page 455                                                    CMA Ontario – September 2009
Financial Accounting – Module 1




                                  City Youth Services
                            Statement of Financial Position
                               As at December 31, 20x1
Assets
           Cash                                                             $ 6,000
           Donor pledges                                                     10,000
                                                                            $16,000

Liabilities
          Accounts payable                                                   $ 3,000
          Mortgage                                                            90,000
                                                                              93,000

Net Assets
         Operating fund                                                     (22,000)
         Capital fund                                                       (55,000)
                                                                             $16,000


Additional Information:
1. Included in office expenses in the Operating Fund are outlays of $6,000 for two
   typewriters, a personal computer, and a used photocopier. CYS charges capital
   expenditures to the current period.
2. CYS maintains one bank account into which it deposits donations for both CYS and
   the group home.




Page 456                                                      CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 2

Lark Opera Company (LOC) was formed and registered as a charity under the Provincial
Charities Act. The original idea to form the association was from Marcia Braun. She has
been LOC's artistic director and general manager, as well as a board member, since
LOC's inception. Marcia owns and operates a singing school that trains students for the
opera. Ninety percent of the performers in LOC's productions are her students and the
others are professional performers. LOC is recognized in the artistic community for the
high quality of its productions.

The City of Lark has a population of 550,000 and is a suburb of the metropolis of Oriole
which is the location of the well established National Opera. The City of Lark has many
opera fans who patronize the National Opera.

As a registered charity, LOC has several sources of funds, as follows:

•     Grants from the City of Lark
•     Bingo
•     Donations
•     Box office ticket sales
•     Advertising.

For every LOC production, the City of Lark grants an amount equal to revenue from
ticket sales. Before every major production, the city advances funds based on projected
ticket sales. Once the production is finished, the funding amount is to be adjusted to equal
actual revenue from ticket sales.

ED Corporation (EDC), the major donor to LOC, makes donations for specific opera
productions. Recently, EDC has expressed concern that it has not seen any financial
statements and is questioning the possible use of its donations for activities not related to
the specified opera productions.

LOC has a volunteer board of eight directors. All are members of the local arts
community with little business experience. The banking and accounting functions for
LOC are performed by various members of the board. Marcia Braun and Vince George,
the treasurer, are authorized to sign cheques against LOC's main operating bank account.
Only one of their signatures is required on a cheque. A separate bank account is
maintained by another board member, Lou Smith, for LOC's fund raising bingo
operations.

Under the Provincial Charities Act, audited financial statements must be prepared
annually. The last audited statements available are for 20x4. During 20x5 and 20x6, LOC
has put on four productions and the financial impact of these productions is unclear. The
last auditor moved to Europe and the board has not yet appointed a new auditor.




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Once the board approves a new production, a rough estimate of revenue from ticket sales
is made and submitted to the City of Lark, which uses the information to determine its
advance funding. The advance funds received from the city are deposited to the main
operating bank account and are not segregated for the production. Further, no budget is
drawn up, nor is a forecast of expenses made. Cash is drawn out of the main operating
account as and when needed during the production.

As the artistic director, Marcia Braun has total control of who is hired to provide the
various services required to produce the opera (i.e., choreographer, vocal trainer,
orchestra, etc.). She also negotiates the terms of payment to these people.
As the general manager, Marcia Braun developed a system of segregated duties that she
felt would ensure internal control. Financial information (i.e., invoices, cheques and bank
statements) is placed in the hands of different people. All invoices are sent to Vince
George who approves and pays them, and then keeps them in a file in his home.
Payments to performers are usually made by Marcia Braun. Anne Warne, another
member of the board, makes all deposits to the main operating account and the bankbook
is in her care. The bank sends the canceled cheques together with bank statements to
Anne Warne.

Since 20x5, LOC has run a bingo as a major source of funds. Lou Smith, a board
member, runs all aspects of the bingo, including all banking. His only help is casual labor
needed on bingo nights. These workers are paid cash from the bingo revenues before
deposits are made to the bingo bank account. Each month, Lou transfers money from the
bingo bank account to LOC's main operating bank account. In the past, other board
members have offered to help Lou, but he has rejected all such offers.

The city recently indicated that no further funds will be granted in the future unless
audited financial statements are made available and the future viability of LOC is
demonstrated. In June 20x7, at the request of the board, the city appointed René Laberge,
CMA, from the municipality's program review division to help LOC's board of directors
produce financial statements in accordance with generally accepted accounting principles
and conduct an assessment of the viability of LOC.

After an initial review, René Laberge made the following observations:

1.    There appear to be no accounting records for the bingo operations. Except for
      answering a few questions over the phone, Lou Smith was unavailable to meet with
      Rene and unable to provide any records.

2.    At times, payments have been made with no supporting invoices and some
      duplicate payments have been made.

3.    Attendance at LOC's productions has been dropping despite good reviews of the
      productions. An initial survey of opera lovers in the City of Lark indicated that
      95% of them patronized the National Opera's productions in Oriole, but only 25%
      of them patronized LOC's productions. Fifty percent of those surveyed were not


Page 458                                                        CMA Ontario – September 2009
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      even aware of the existence of LOC. Of those who attended productions by both,
      most commented that LOC's ticket prices averaged one-quarter the ticket prices of
      the National Opera Company's productions.

4.    A detailed review of the financial account balances prepared by the treasurer for
      20x5 and 20x6 (see Exhibit 1) revealed a number of additional observations (see
      Exhibit 2).

A special board meeting has been called to review Rene Laberge's report.

Required:

As René Laberge, prepare the requested report for Lark Opera Company's board of
directors. The report should include a comparative statement of financial position and
statement of operations for 20x5 and 20x6, as well as recommendations regarding
nonfinancial and management control issues.

                                        Exhibit 1

                                  Lark Opera Company
                                   Balance of Accounts
                                   As at December 31

                                                     20x6                   20x5
Accounts payable                                     $ 53,100                   $ 38,200
Accounts receivable                          $ 2,000                     $0
Advertising expense                            4,000                   6,000
Advertising revenue                                     3,000                      4,000
Bank overdraft                                         16,000                     12,000
Bingo revenue (net)                                    63,000                     59,000
Computer equipment                             2,500                        0
Donations revenue                                      27,000                      30,000
Grants from the city                                   25,000                      25,000
Interest expense                               2,600                   2,400
Marcia Braun's salary                         48,000                  48,000
Net assets (liabilities) - beginning balance 50,000                   39,000
Office expense                                10,000                  12,000
Prepaids                                           0                     200
Production costs                              76,500                  75,600
Suspense                                       5,000                       0
Ticket sales                                           13,500                  15,000
Totals                                      $200,600 $200,600       $183,200 $183,200




Page 459                                                       CMA Ontario – September 2009
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                                       Exhibit 2
                     Additional Observations Made by Rene Laberge

1.    Since its inception, LOC has run fund-raising campaigns for which pledges are
      usually recorded only when the cash is received. In the 20x6 fund-raising campaign,
      $6,500 of pledges were made. Of these pledges, $3,000 have been received to date
      and recorded as donations. Past experience has shown that about 75% of the
      remaining pledges will be received, but this has not been recognized in the
      accounting records.

2.    LOC purchased a computer in January 20x6 for Marcia Braun's use in planning
      opera productions. The cost of the computer has been capitalized, but no
      depreciation has been recorded. The computer is expected to have a five-year useful
      life.

3.    In 20x5, a $5,400 payment was made to a professional singer for a production held
      in 20x5. The National Opera had made this particular singer available to LOC for
      the production and a payment for this singer had already been made to the National
      Opera. These payments were both recorded as production costs in 20x5. No
      attempt has been made to recover this overpayment or adjust the accounting
      records.

4.    Grants from the city have not been adjusted to match actual ticket sales.

5.    In 20x6, a donation of props and costumes for the latest production was received
      from a private donor. A tax receipt of $5,000 was issued for this donation and
      $5,000 was recorded as donations revenue. Since there was no invoice submitted by
      the donor, no expense was recorded. Instead, a suspense asset account was debited
      for $5,000.

6.    The donations revenue recorded for 20x6 includes a $9,000 donation from EDC.
      According to EDC, this donation was to be used specifically for a production
      planned for 20x8.

7.    Bingo revenues represent the amounts that Lou Smith transfers monthly to LOC's
      general operating bank account. These monthly transfers are made after the casual
      workers hired to help at the bingos are paid in cash. Lou has not been able to
      provide a reconciliation of the bingo account, but has confirmed that the amounts
      reported in the bingo revenue account for 20x5 and 20x6 were the actual amounts
      transferred to LOC's operating bank account. He also confirmed that there were no
      outstanding accounts payable for the bingo operation at the end of the two years.
      The bank confirmed that the December 31 bank balances in the bingo account were
      $4,000 for 20x5 and $8,500 for 20x6.

8.    Included in the 20x6 production costs is a $17,000 advance paid to performers who
      will appear in a 20x7 opera production.


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Financial Accounting – Module 1



SOLUTIONS


Multiple Choice Questions

1.    a

2.    b

3.    c

4.    c

5.    a

6.    a

7.    a

8.    c

9.    e     According to section 4400.17 of the CICA Handbook, transfers between
            funds do not result in increases or decreases in the economic resources of the
            organization as a whole and therefore are reported in the statement of changes
            in net assets rather than in the statement of operations. Choices a), b), c) and
            d) all are in accordance with generally accepted accounting principles.

10.   e     Choice a) is a restricted fund that can only be used for a specific project to
            take place in two years; therefore, it is not liquid. The project costs in choice
            b) must be expensed in the year because the grant is not guaranteed and
            cannot be recorded as a receivable. For choice c), the seniors’ home does not
            have ownership of the gift items; therefore, they cannot be recorded as assets.
            For choice d), the account is held in trust and is therefore not accessible to the
            seniors’ home. Therefore, choice e) is the correct answer.




Page 461                                                          CMA Ontario – September 2009
Financial Accounting – Module 1


Problem 1

MEMORANDUM

TO:                 James Smith
                    Executive Director of CYS
FROM:               Mary Jones
SUBJECT:            Reporting of City Youth Services

There are several groups of potential users of the annual report of CYS, but you have
asked me to comment on how the reporting might be improved to enhance the
information value for donors. The following issues will be discussed with respect to
donors specifically.

Program Effectiveness
Donors are especially interested in seeing what their donations will accomplish. A
brochure, or notes to the financial statements, should include a description of the
objectives of CYS, the number of children who have been counselled or helped in other
ways, the number of social workers and volunteers, and a description of the services that
they typically perform, a description of the home purchased, the number of children in
the home and their average length of stay, what happens to them after they leave the
home, etc.

Financial Statements
The financial statements, including notes, should provide information to enable donors to
assess the stewardship of management. The current statement of operations and the
statement of financial position (balance sheet) of CYS may be misleading. The following
discussion and suggestions may enhance the information value.

Notes to the Financial Statements
The notes to the financial statements should provide a clear description of the not-for-
profit organization's purpose, the community it intends to serve, its status under income
tax legislation, and its legal form.

Net Assets
"Net Assets" is the terminology in the emerging not-for-profit accounting literature that
replaces the term "surplus" in describing a not-for-profit organization's equity on its
statement of financial position.

Net assets should be presented for each fund. Net assets that represent investments in
capital assets are not available for general use by the not-for-profit organization and
should be distinguished on the statement of financial position. For this reason, the use of
a "Net assets invested in capital assets" account is recommended.




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Revenue Recognition
There are two alternative methods for accounting for contributions under GAAP for not-
for-profit organizations: the deferral method and the restricted fund method.

The restricted fund method is a specialized type of fund accounting that presents details
of financial statement elements by fund. Restricted contributions (those contributions that
are "earmarked" by the contributors for a specific purpose) would be recorded as revenue
in the corresponding restricted fund in the period that they were received or receivable.

The deferral method relates restricted contributions to the expenses that they are intended
to finance. Restricted revenue that pertains to expenses of future periods is deferred and
recognized as revenue in the period in which the related expenses are incurred. The
deferral method can be used with either a fund accounting or "corporate" style of
financial statement presentation.

Statement of Cash Flow
A statement of cash flow should be presented along with the statement of financial
position, the statement of revenue and expenditures, and the statement of changes in net
assets.

Fund Accounting
It should be noted that fund accounting involves an accounting segregation of funds and
not necessarily a physical segregation of funds. From the perspective of internal control
and to aid the board in understanding fund accounting, it may be appropriate to have
separate bank accounts for the operating fund and the group home fund.

City Youth Services should provide a brief description in the notes to the financial
statements as to the purpose of each fund.

The statement of financial position should indicate if any of the assets are restricted. The
statement of operations should present a total that includes all funds reported. In other
words, total revenues, expenditures, and the total excess or deficiency for the period
should be reported in the statement of operations (i.e., the statement of revenue and
expenditures). This assumes that the deferral method is the appropriate method of
accounting for contributions received by CYS.

Segregation of Funds
At present, there is a lack of clear segregation between the operating fund and the capital
fund. Some of the social worker payroll costs charged to the operating fund should have
been charged to the capital fund, since the costs relate to group home activities and are
the major reason why the operating fund is showing a deficit. All of the financial
activities related to running the group home should be segregated in the statement of
operations so that donors to either CYS or the group home can get a clear picture of
money spent on group home activities. This segregation will likely show that revenues
are covering expenses for the regular operations of CYS. The segregation of funds would



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Financial Accounting – Module 1


be facilitated by the use of separate bank accounts. Service charges and interest revenue
or deductions would then be allocated accurately.

The name of the capital fund should be changed to the group home fund to better reflect
its use. A separate capital fund could be set up for future projects.

Donor Pledges
A pledge is a non-enforceable promise to contribute cash or some other asset or economic
benefit to a not-for-profit organization. Because of the nature of pledges, it is likely that
less than 100% of the pledges will ultimately be collected. In order for CYS to recognize
pledges as revenue in the current year's financial statement, CYS needs to demonstrate
that the pledges can be reasonably estimated and that their ultimate collection is
reasonably assured. Alternatively, contributions would not be recognized until they were
collected.

Donated Services
The service of the volunteers could be credited to revenue offset by a debit to expenses.
This would only be appropriate where the services provided are used in the course of
CYS's operations and would otherwise have been purchased. However, because of the
difficulty of estimating the value, I would recommend simply describing the donated
services in the annual report.

Comparative Statements
Comparative information for 20x0 should be provided to enhance the assessment of
trends and also to emphasize the success of the fund raising drive for the group home.

Budgets
The donors would likely be interested in seeing a comparison of actual revenues and
expenses to those budgeted for the year, along with the budget for next year. It should not
be necessary to use budgetary accounts or an encumbrance system, however. It would be
best to keep the accounting system as uncomplicated as possible, especially because
volunteers are required in the office.

Capital Assets
The expensing of the home has produced a large deficit in the capital fund. This treatment
does not charge any of the cost to future periods that will benefit from the expenditure.
Also, the investment is not shown on the CYS statement of financial position. GAAP
recommends that not-for-profit organizations with annual gross revenues of $500,000 or
greater should capitalize and amortize capital assets.

Average revenues of City Youth Services appear to exceed $500,000; therefore, CYS
should capitalize its purchases of both the home and the office equipment and amortize
these assets over their useful lives. This amortization must be recognized as an expense in
City Youth Services' statement of operations. The choice of fund to which the
amortization expense is charged would be based on providing the most meaningful
information to the user. Showing it as an expense of the operating fund emphasizes that it


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Financial Accounting – Module 1


is a cost of delivery. Showing it as an expense of the capital fund or group home fund
presents all revenues and expenses associated with the group home in a single fund.

Mortgage Payments
If the mortgage payments included a repayment of principal, then the mortgage liability
on the statement of financial position should be reduced. In accounting for the mortgage
payments, CYS should expense the interest portion and debit the principal repayment
directly to the mortgage liability.

Conclusion
The above recommendations should assist you to provide the most useful information to
prospective donors. If you have any questions, please do not hesitate to call me.




Page 465                                                       CMA Ontario – September 2009
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Problem 2

A. Financial Statements

1.    Pledges receivable

      •     GAAP allows pledges to be shown on the balance sheet as pledges receivable
            provided that (i) reasonable assurance of collection exists and (ii) the amount
            can be reasonably estimated

      •     LOC has enough past history to estimate collectibility

      •     recommend that pledges receivable be recorded at their net realizable value
            of: $3,500 x 75% = $2,626

            dr. Pledged receivable
                cr. Donation revenues

      •     the amount of pledges recorded as revenue will have to be disclosed in the
            notes to the financial statements


2.    Computer Equipment

      •     GAAP requires that NPO’s whose average revenues are in excess of $500,000
            capitalize and depreciate capital assets. Those NPO’s whose average revenues
            are less than $500,000 have three options:
            I. capitalize and depreciate
            ii. expense in the year of purchase, or
            iii. capitalize and do not depreciate.

      •     given the small size of this organization, I would recommend that they
            expense the computer equipment - no accounting adjustment required




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Financial Accounting – Module 1


3.    Duplicate Payment

      •     the duplicate payment should be treated as a recoverable amount

      •     however, if the National Opera forces LOC to recover the payment from the
            singer, collectibility may prove to be a problem - consideration should be then
                given to the need to set up an allowance against this amount

      •     dr. Accounts receivable                              $5,400
                 cr. Production costs (20x5)                                     $5,400


4.    Donation of Props and Costumes

      •     assuming the props and costumes are good for one production only, then we
            are dealing with donated materials and services (as opposed to a capital item)

      •     GAAP allows NPO’s the option of recording donated materials and services if
                 two criteria are met:
            (i) a monetary value can be ascribed to the donated goods or services, and
            (ii) the donated goods or services would have been purchased if not donated

      •     the two criteria are met in this case. Therefore, I recommend that the value of
            the donated props and costumes be recorded since it would show the true cost
            of producing the specific opera

            dr. Production costs                                 $5,000
                  cr. Suspense account                                           $5,000


5.    Matching of City grant against ticket sales

      •     20x5: $25,000 - 15,000 = $10,000 due to city
      •     20x6: $25,000 - 13,500 = $11,500 due to city

            dr. Grants from the City (20x5)                     $10,000
            dr. Grants from the City (20x6)                     $11,500
                  cr. Payable to City                                          $21,500




Page 467                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


6.    Donation revenue from EDC

      •     the $9,000 donation should be removed from current revenues and set up as a
            deferred contribution since it relates to a future production

            dr. Donations revenues                               $9,000
                 cr. Deferred Contributions                                     $9,000


7.    Bingo Revenues

      •     GAAP requires that such revenues be reported using the gross method. That
            is, the gross revenues must be reported separately from the expenses.

      •     given that no accounting records were kept, we will be unable to do this
            year. However, it is recommended that starting this year, detailed records be
            kept of revenues and expenditures

      •     the Bingo revenues need to be adjusted for the changes in the bingo bank
            account and the bingo bank account needs to be brought on LAC’s Statement
            of Financial Position:

            dr.   Cash                                            8,500
                  cr. Bingo revenues (20x5)                                       4,000
                  cr. Bingo revenues (20x6)                                       4,500

8.    Prepaid Production costs

      •     the $17,000 should be set up as a prepaid Production Cost since the payment
            relates to a future period




Page 468                                                        CMA Ontario – September 2009
Financial Accounting – Module 1


Revised Financial Statements:


                                   Lark Opera Company
                                  Statement of Operations
                           for the year ended December 31, 20x6

                                                                  20x6             20x5
Revenues
 Ticket sales                                                $13,500            $15,000
 Grant from City                                              13,500             15,000
 Donations (27,000 + 2,625 Pledges
    - 9,000 Deferred Contribution from EDC)                   20,625             30,000
 Bingo - net (63,000 + 4,500 | 59,000 + 4,000)                67,500             63,000
 Advertising                                                   3,000              4,000
                                                             118,125            127,000

Expenses
  Advertising                                                  4,000               6,000
  Computer equipment                                           2,500
  Interest                                                     2,600              2,400
  Salary                                                      48,000             48,000
  Office                                                      10,000             12,000
  Production costs (76,500 - 17,000 Prepaid Production
Costs
        + 5,000 Donation of Props and Costumes)
      (75,600 - 5,400 Duplicate Payment)                      64,500             70,200
                                                             131,600            138,600

Excess of revenues over expenses                            (13,475)           (11,600)
Net Assets - beginning                                      (50,600)           (39,000)
Net Assets - end                                           $(64,075)          $(50,600)




Page 469                                                     CMA Ontario – September 2009
Financial Accounting – Module 1


                                      Lark Opera Company
                                  Statement of Financial Position
                                     as at December 31, 20x6

                                                                       20x6               20x5
ASSETS

Current
 Cash                                                                $8,500             $4,000
 Accounts receivable (2,000 + 2,625 + 5,400)                         10,025              5,400
 Prepaid production costs                                            17,000                200
                                                                    $35,525             $9,600

LIABILITIES AND NET ASSETS

Current
 Bank overdraft                                                     $16,000            $12,000
 Due to city                                                         21,500             10,000
 Accounts payable                                                    53,100             38,200
 Deferred contribution                                                9,000                  0
                                                                     99,600             60,200

Net Assets                                                          (64,075)           (50,600)

                                                                    $35,525             $9,600




Page 470                                                            CMA Ontario – September 2009
Financial Accounting – Module 1



B.    Internal Controls

•     most of the problems of LOC rise from the fact that the internal controls
      implemented by Marcia Braun were not working as anticipated. For example, there
      is no indication that bank reconciliations were done after Anne Warne collected the
      bank statements. Both Marcia Braun and Vince George, who approve payments and
      write cheques, have authority to sign the cheques they prepare without the other's
      approval. This and the fact that payments were made without supporting backup
      caused duplicate payments to be made.

•     a contributing factor to LOC's problems was the fact that financial information was
      not being prepared for the board of directors on a timely basis. No financial
      statements have been prepared since 20x4; therefore, it is assumed that no financial
      information has been presented to the board in two years.

•     it is difficult to have any separation of duties because of the shortage of people but,
      as a start, the following can be done:
      1. Ideally, whoever writes and prepares the cheques should not have signing
             authority. At least there should be a requirement that each cheque be signed
             by two officers of LOC who have cheque signing authority.
      2. All payments should be supported by approved supporting invoices.
      3. All bank statements, deposit books and invoices should be in one centralized
             place.
      4. Bank reconciliations should be done every month, independent of those
             handling the banking.
      5. Budgeted financial statements, using accrual accounting, should be produced
             and given to the board regularly (e.g., quarterly).
      6. An auditor should be appointed immediately.
      7. The bingo operation should be considered part of LOC's operation. Details of
             the bingo operation's expenses and revenues should