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Earnings per share (EPS) measures the portion of a corporation’s profit allocated to each outstanding share of common stock. Many financial analysts believe that EPS is the single most important tool in assessing a stock’s market price. A high or increasing earnings per share can drive up a stock price. Conversely, falling earnings per share can lower a stock’s market price. EPS is also a component in calculating the price-to-earnings ratio (the market price of the stock divided by its earnings per share), which many investors find to be a key indicator of the value of a company’s stock.
CONCEPTS IN PRACTICE
Microsoft Earnings Announcements Exceeds Wall Street Targets
While a company’s board of directors makes the final approval of the reports, a key goal of each company is to look favorable to investors while providing financial statements that accurately reflect the financial condition of the company. Each quarter, public companies report EPS through a public announcement as one of the key measures of their profitability. These announcements are highly anticipated by investors and analysts. The suspense is heightened because analysts provide earnings estimates to the public prior to each announcement release. According to Matt Weinberger of Business Insider, the announcement by Microsoft of its first quarter 2018 EPS reported at \$0.95 per share, higher than analysts’ estimates of \$0.85 per share, caused the value of its stock to rise by more than 3% within hours of the announcement.17 While revenue was the other key metric in Microsoft’s earnings announcement, EPS carried more weight in the surge of the company’s market price.
Calculating Earnings per Share
Earnings per share is the profit a company earns for each of its outstanding common shares. Both the balance sheet and income statement are needed to calculate EPS. The balance sheet provides details on the preferred dividend rate, the total par value of the preferred stock, and the number of common shares outstanding. The income statement indicates the net income for the period. The formula to calculate basic earnings per share is:
By removing the preferred dividends from net income, the numerator represents the profit available to common shareholders. Because preferred dividends represent the amount of net income to be distributed to preferred shareholders, this portion of the income is obviously not available for common shareholders. While there are a number of variations of measuring a company’s profit used in the financial world, such as NOPAT (net operating profit after taxes) and EBITDA (earnings before interest, taxes, depreciation, and amortization), GAAP requires companies to calculate EPS based on a corporation’s net income, as this amount appears directly on a company’s income statement, which for public companies must be audited.
In the denominator, only common shares are used to determine earnings per share because EPS is a measure of earnings for each common share of stock. The denominator can fluctuate throughout the year as a company issues and buys back shares of its own stock. The weighted average number of shares is used on the denominator because of this fluctuation. To illustrate, assume that a corporation began the year with 600 shares of common stock outstanding and then on April 1 issued 1,000 more shares. During the period January 1 to March 31, the company had the original 600 shares outstanding. Once the new shares were issued, the company had the original 600 plus the new 1,000 shares, for a total of 1,600 shares for each of the next nine months—from April 1 to December 31. To determine the weighted average shares, apply these fractional weights to both of the stock amounts, as shown in Figure 14.15.
If the shares were not weighted, the calculation would not consider the time period during which the shares were outstanding.
To illustrate how EPS is calculated, assume Sanaron Company earns \$50,000 in net income during 2020. During the year, the company also declared a \$10,000 dividend on preferred stock and a \$14,000 dividend on common stock. The company had 5,000 common shares outstanding the entire year along with 2,000 preferred shares. Sanaron has generated \$8 of earnings (\$50,000 less the \$10,000 of preferred dividends) for each of the 5,000 common shares of stock it has outstanding.
Earnings per share=\$50,000−\$10,0005,000=\$8.00Earnings per share=\$50,000−\$10,0005,000=\$8.00
THINK IT THROUGH
When a company issued new shares of stock and buys other back as treasury stock, EPS can be manipulated because both of these transactions affect the number of shares of stock outstanding. What are ethical considerations involved in calculating EPS?
Measuring Performance with EPS
EPS is a key profitability measure that both current and potential common stockholders monitor. Its importance is accentuated by the fact that GAAP requires public companies to report EPS on the face of a company’s income statement. This is only ratio that requires such prominent reporting. If fact, public companies are required to report two different earnings per share amounts on their income statements—basic and diluted. We’ve illustrated the calculation of basic EPS. Diluted EPS, which is not demonstrated here, involves the consideration of all securities such as stocks and bonds that could potentially dilute, or reduce, the basic EPS.
LINK TO LEARNING
Where can you find EPS information on public companies? Check out the Yahoo Finance website and search for EPS data for your favorite corporation.
Common stock shares are normally purchased by investors to generate income through dividends or to sell at a profit in the future. Investors realize that inadequate EPS can result in poor or inconsistent dividend payments and fluctuating stock prices. As such, companies seek to produce EPS amounts that rise each period. However, an increase in EPS may not always reflect favorable performance, as there are multiple reasons that EPS may increase. One way EPS can increase is because of increased net income. On the other hand, it can also increase when a company buys back its own shares of stock. For example, assume that Ranadune Enterprises generated net income of \$15,000 in 2020. In addition, 20,000 shares of common stock and no preferred stock were outstanding throughout 2020. On January 1, 2020, the company buys back 2,500 shares of its common stock and holds them as treasury shares. Net income for 2020 stayed static at \$15,000. Just before the repurchasing of the stock, the company’s EPS is \$0.75 per share:
Earnings per share=\$15,00020,000shares=\$0.75pershareEarnings per share=\$15,00020,000shares=\$0.75pershare
The purchase of treasury stock in 2020 reduces the common shares outstanding to 17,500 because treasury shares are considered issued but not outstanding (20,000 − 2,500). EPS for 2020 is now \$0.86 per share even though earnings remains the same.
Earnings per share=\$15,00017,500shares=\$0.86per shareEarnings per share=\$15,00017,500shares=\$0.86per share
This increase in EPS occurred because the net income is now spread over fewer shares of stock. Similarly, EPS can decline even when a company’s net income increases if the number of shares increases at a higher degree than net income. Unfortunately, managers understand how the number of shares outstanding can affect EPS and are often in position to manipulate EPS by creating transactions that target a desired EPS number.
ETHICAL CONSIDERATIONS
Stock Buybacks Drive Up Earnings per Share: Ethical?
Public companies can increase their earnings per share by buying their own stock in the open market. The increase in earnings per share results because the number of shares is reduced by the purchase even though the earnings remain the same. With fewer shares and the same amount of earnings, the earnings per share increases without any change in overall profitability or operational efficiency. A Market Watch article attributing Goldman Sachs states, “S&P 500 companies will spend about \$780 billion on share buybacks in 2017, marking a 30% rise from 2016.”18 An article in Forbes provides some perspective by pointing out that buying back shares was legalized in 1982, but for the majority of the twentieth century, corporate buybacks of shares was considered illegal because “they were thought to be a form of stock market manipulation. . . . Buying back company stock can inflate a company’s share price and boost its earnings per share—metrics that often guide lucrative executive bonuses.”19 Is a corporation buying back its shares an ethical way in which to raise or maintain the price of a company’s shares?
Earnings per share is interpreted differently by different analysts. Some financial experts favor companies with higher EPS values. The reasoning is that a higher EPS is a reflection of strong earnings and therefore a good investment prospect. A more meaningful analysis occurs when EPS is tracked over a number of years, such as when presented in the comparative income statements for Cracker Barrel Old Country Store, Inc.’s respective year ends in 2017, 2016, and 2015 shown in Figure 14.16.20 Cracker Barrel’s basic EPS is labeled as “net income per share: basic.”
Most analysts believe that a consistent improvement in EPS year after year is the indication of continuous improvement in the earning power of a company. This is what is seen in Cracker Barrel’s EPS amounts over each of the three years reported, moving from \$6.85 to \$7.91 to \$8.40. However, it is important to remember that EPS is calculated on historical data, which is not always predictive of the future. In addition, when EPS is used to compare different companies, significant differences may exist. If companies are in the same industry, that comparison may be more valuable than if they are in different industries. Basically, EPS should be a tool used in decision-making, utilized alongside other analytic tools.
YOUR TURN
Would You Have Invested?
What if, in 1997, you invested \$5,000 in Amazon? Today, your investment would be worth nearly \$1 million. Potential investors viewing Amazon’s income statement in 1997 would have seen an EPS of a negative \$0.11. In other words, Amazon lost \$0.11 for each share of common stock outstanding. Would you have invested?
Solution
Answers will vary. A strong response would include the idea that a negative or small EPS reflects upon the past historical operations of a company. EPS does not predict the future. Investors in 1997 looked beyond Amazon’s profitability and saw its business model having strong future potential.
THINK IT THROUGH
Using Earnings per Share in Decision Making
As a valued employee, you have been awarded 10 shares of the company’s stock. Congratulations! How could you use earnings per share to help you decide whether to hold on to the stock or keep it for the future? | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/14%3A_Corporation_Accounting/14.05%3A_Discuss_the_Applicability_of_Earnings_per_Share_as_a_Method_to_Measure_Performance.txt |
14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
• The process of forming a corporation involves several steps, which result in a legal entity that can issue stock, enter into contracts, buy and sell assets, and borrow funds.
• The corporate form has several advantages, which include the ability to function as a separate legal entity, limited liability, transferable ownership, continuing existence, and ease of raising capital.
• The disadvantages of operating as a corporation include the costs of organization, regulation, and potential double taxation.
• There are a number of considerations when choosing whether to finance with debt or equity as a means to raise capital, including dilution of ownership, the repayment obligation, the cash obligation, budgeting reliability, cost savings, and the risk assessment by creditors.
• The Securities and Exchange Commission regulates large and small public corporations.
• There are key differences between public corporations that experience an IPO and private corporations.
• A corporation’s shares continue to be bought and sold by the public in the secondary market after an IPO.
• The process of marketing a company’s stock involves several steps.
• Capital stock consists of two classes of stock—common and preferred, each providing the company with the ability to attract capital from investors.
• Shares of stock are categorized as authorized, issued, and outstanding.
• Shares of stock are measured based on their market or par value. Some stock is no-par, which carries a stated value.
• A company’s primary class of stock issued is common stock, and each share represents a partial claim to ownership or a share of the company’s business. Common shareholders have four rights: right to vote, the right to share in corporate net income through dividends, the right to share in any distribution of assets upon liquidation, and a preemptive right.
• Preferred stock, by definition, has preferred characteristics, which are more advantageous to shareholders over common stock characteristics. These include dividend preferences such as cumulative and participating and a preference for asset distribution upon liquidation. These shares can also be callable or convertible.
14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
• The initial issuance of common stock reflects the sale of the first stock by a corporation.
• Common stock issued at par value for cash creates an additional paid-in capital account for the excess of the issue price over the par value.
• Stock issued in exchange for property or services is recorded at the fair market value of the stock or the asset or services received, whichever is more clearly determinable.
• Stock with a stated value is treated as if the stated value is a par value. The entire issue price of no-par stock with no stated value is credited to the capital stock account.
• Preferred stock issued at par or stated value creates an additional paid-in capital account for the excess of the issue price over the par value.
• A corporation reports a stock’s par or stated value, the number of shares authorized, issued, and outstanding, and if preferred, the dividend rate on the face of the balance sheet.
• Treasury stock is a corporation’s stock that the corporation purchased back. A company may buy back its stock for strategic purposes against competitors, to create demand, or to use for employee stock option plans.
• The acquisition of treasury stock creates a contra equity account, Treasury Stock, reported in the stockholders’ equity section of the balance sheet.
• When a corporation reissues its treasury stock at an amount above the cost, it generates a credit to the Additional Paid-in Capital from Treasury stock account.
• When a corporation reissues its treasury stock at an amount below cost, the Additional Paid-in Capital from Treasury stock account is reduced first, then any excess is debited to Retained Earnings.
14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
• Dividends are a distribution of corporate earnings, though some companies reinvest earnings rather than declare dividends.
• There are three dividend dates: date of declaration, date of record, and date of payment.
• Cash dividends are accounted for as a reduction of retained earnings and create a liability when declared.
• When dividends are declared and a company has only common stock issued, the reduction of retained earnings is the amount per share times the number of outstanding shares.
• A property dividend occurs when a company declares and distributes assets other than cash. They are recorded at the fair market value of the asset being distributed.
• A stock dividend is a distribution of shares of stock to existing shareholders in lieu of a cash dividend.
• A small stock dividend occurs when a stock dividend distribution is less than 25% of the total outstanding shares based on the outstanding shares prior to the dividend distribution. The entry requires a decrease to Retained Earnings for the market value of the shares to be distributed.
• A large stock dividend involves a distribution of stock to existing shareholders that is larger than 25% of the total outstanding shares just before the distribution. The journal entry requires a decrease to Retained Earnings and a credit to Stock Dividends Distributable for the par or stated value of the shares to be distributed.
• Some corporations employ stock splits to keep their stock price competitive in the market. A traditional stock split occurs when a company’s board of directors issues new shares to existing shareholders in place of the old shares by increasing the number of shares and reducing the par value of each share.
14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
• Owner’s equity reflects an owner’s investment value in a company.
• The three forms of business utilize different accounts and transactions relative to owners’ equity.
• Retained earnings is the primary component of a company’s earned capital. It generally consists of the cumulative net income minus any cumulative losses less dividends declared. A statement of retained earnings shows the changes in the retained earnings account during the period.
• Restricted retained earnings is the portion of a company’s earnings that has been designated for a particular purpose due to legal or contractual obligations.
• A company’s board of directors may designate a portion of a company’s retained earnings for a particular purpose such as future expansion, special projects, or as part of a company’s risk management plan. The amount designated is classified as appropriated retained earnings.
• The statement of stockholders’ equity provides the changes between the beginning and ending balances of each of the stockholders’ equity accounts, including retained earnings.
• Prior period adjustments are corrections of errors that occurred on previous periods’ financial statements. They are reported on a company’s statement of retained earnings as an adjustment to the beginning balance.
14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
• Earnings per share (EPS) measures the portion of a corporation’s profit allocated to each outstanding share of common stock.
• EPS is calculated by dividing the profit earned for common shareholders by the weighted average common shares of stock outstanding.
• Because EPS is a key profitability measure that both current and potential common stockholders monitor, it is important to understand how to interpret it.
Key Terms
accounting entity concept
concept indicating that the financial activity of an entity (corporation) must be kept separate from that of the owners
additional paid-in capital
account for recording excess of the proceeds received from the issuance of the stock over the stock’s par value
appropriated retained earnings
portion of a company’s retained earnings designated for a particular purpose such as future expansion, special projects, or as part of a company’s risk management plan
articles of incorporation
(also, charter) define the basic structure and purpose of a corporation and the amount of capital stock that can be issued or sold
authorized shares
maximum number of shares that a corporation can issue to investors; approved by state in which company is incorporated and specified in the corporate charter
brokers
buy and sell issues of stock on behalf of others
capital
cash and other assets owned by a company
cash dividend
corporate earnings that companies pass along to their shareholders in the form of cash payments
common stock
corporation’s primary class of stock issued, with each share representing a partial claim to ownership or a share of the company’s business
contributed capital
owner’s investment (cash and other assets) in the business, which typically comes in the form of common stock
corporation
legal business structure involving one or more individuals (owners) who are legally distinct (separate) from the business
date of declaration
date upon which a company’s board of directors votes and decides to give a cash dividend to all the company shareholders; the date on which the dividends become a legal liability
date of payment
date that cash dividends are paid to shareholders
date of record
date the list of dividend eligible shareholders is prepared; no journal entry is required
debt-to-equity ratio
measures the portion of debt used by a company relative to the amount of stockholders’ equity, calculated by dividing total debt by total equity
deficit in retained earnings
negative or debit balance
dividend smoothing
practice of paying dividends that are relatively equal period after period even when earnings fluctuate
double taxation
occurs when income is taxed to the corporation that earned the income, and then taxed again to stockholders when they receive a distribution of the corporation’s income as dividends
earned capital
capital earned by the corporation as part of business operations
earnings per share (EPS)
measurement of the portion of a corporation’s profit allocated to each outstanding share of common stock
ex dividend
status of stock sold between the record date and payment date during which the investor is not entitled to receive dividends
going concern assumption
absent any evidence to the contrary, assumption that a business will continue to operate in the indefinite future
incorporation
process of constituting a company into a legal entity
initial public offering (IPO)
when a company issues shares of its stock to the public for the first time
investment banker
financial professional who provides advice to companies wishing to issue new stock, then purchase the stock from the company issuing the stock and resell the securities to the public
issued shares
authorized shares that have been sold to shareholders
large stock dividend
stock dividend distribution that is larger than 25% of the total outstanding shares just before the distribution
market value of stock
price at which the stock of public companies trades on the stock market
no-par stock
stock issued with no par value assigned to it in a corporate charter
organization costs
costs of organizing the corporate entity that include attorney fees, promotion costs, and filing fees paid to the state
outstanding shares
shares that have been issues and are currently held by shareholders
owners’ equity
business owners’ share of the company
par value
value assigned to stock in the company’s charter and is typically set at a very small arbitrary amount; serves as legal capital
preemptive right
allows stockholders the option to maintain their ownership percentage when new shares of stock are issued by the company
preferred stock
type of stock that entitles the holder to unique preferences that are advantageous over common stock features
prior period adjustments
corrections of errors that occurred on previous periods’ financial statements
private corporation
corporation usually owned by a relatively small number of investors; shares are not traded publicly, and the ownership of the stock is restricted to only those allowed by the board of directors
property dividend
stock dividend distribution of assets other than cash
publicly traded company
company whose stock is traded (bought and sold) on an organized stock exchange
restatement
correction of financial statement amounts due to an accounting error in a prior period
restricted retained earnings
portion of a company’s earnings that has been designated for a particular purpose due to legal or contractual obligations
reverse stock split
issuance of new shares to existing shareholders in place of the old shares by decreasing the number of shares and increasing the par value of each share
secondary market
organized market where previously issued stocks and bonds can be traded after they are issued
Securities and Exchange Commission (SEC)
federal regulatory agency that regulates corporations with shares listed and traded on security exchanges through required periodic filings
small stock dividend
stock dividend distribution that is less than 25% of the total outstanding shares just before the distribution
special dividend
one-time extra distribution of corporate earnings to shareholders, usually stemming from a period of extraordinary earnings or special transaction, such as the sale of a company division
stated value
is an amount a board of director’s assigns to each share of a company’s stock; functions as the legal capital
statement of stockholders’ equity
provides the changes between the beginning and ending balances of each of the stockholders’ equity accounts during the period
stock discount
amount at which stock is issued below the par value of stock
stock dividend
dividend payment consisting of additional shares rather than cash
stock split
issuance of new shares to existing shareholders in place of the old shares by increasing the number of shares and reducing the par value of each share
stock trading
buying and selling of shares by investors and brokers
stockholder
owner of stock, or shares, in a business
treasury stock
company’s own shares that it has repurchased from investors | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/14%3A_Corporation_Accounting/14.06%3A_Summary.txt |
Multiple Choice
1.
LO 14.1Which of the following is not a characteristic that sets preferred stock apart from common stock?
1. voting rights
2. dividend payments
3. transferability
4. ownership
2.
LO 14.1Issued stock is defined as stock that ________.
1. is available for sale
2. that is held by the corporation
3. has been sold to investors
4. has no voting rights
3.
LO 14.1Your friend is considering incorporating and asks for advice. Which of the following is not a major concern?
1. colors for the logo
2. which state in which to incorporate
3. number of shares of stock to authorize
4. selection of the corporation name
4.
LO 14.1Par value of a stock refers to the ________.
1. issue price of a stock
2. value assigned by the incorporation documents
3. maximum selling price of a stock
4. dividend to be paid by the corporation
5.
LO 14.1Which of the following is not one of the five primary responsibilities of the Securities and Exchange Commission (the SEC)?
1. inform and protect investors
2. regulate securities law
3. facilitate capital formation
4. assure that dividends are paid by corporations
6.
LO 14.1When a C corporation has only one class of stock it is referred to as ________.
1. stated value stock
2. par value stock
3. common stock
4. preferred stock
7.
LO 14.1The number of shares that a corporation’s incorporation documents allows it to sell is referred to as ________.
1. issued stock
2. outstanding stock
3. common stock
4. authorized stock
8.
LO 14.2The total amount of cash and other assets received by a corporation from the stockholders in exchange for the shares is ________.
1. always equal to par value
2. referred to as retained earnings
3. always below its stated value
4. referred to as paid-in capital
9.
LO 14.2Stock can be issued for all except which of the following?
1. accounts payable
2. state income tax payments
3. property such as a delivery truck
4. services provided to the corporation such as legal fees
10.
LO 14.3A company issued 40 shares of \$1 par value common stock for \$5,000. The journal entry to record the transaction would include which of the following?
1. debit of \$4,000 to common stock
2. credit of \$20,000 to common stock
3. credit of \$40 to common stock
4. debit of \$20,000 to common stock
11.
LO 14.3A company issued 30 shares of \$.50 par value common stock for \$12,000. The credit to additional paid-in capital would be ________.
1. \$11,985
2. \$12,000
3. \$15
4. \$10,150
12.
LO 14.3A corporation issued 100 shares of \$100 par value preferred stock for \$150 per share. The resulting journal entry would include which of the following?
1. a credit to common stock
2. a credit to cash
3. a debit to paid-in capital in excess of preferred stock
4. a debit to cash
13.
LO 14.3The date the board of directors votes to declare and pay a cash dividend is called the:
1. date of stockholder’s meeting
2. date of payment
3. date of declaration
4. date of liquidation
14.
LO 14.3Which of the following is true of a stock dividend?
1. It is a liability.
2. The decision to issue a stock dividend resides with shareholders.
3. It does not affect total equity but transfers amounts between equity components.
4. It creates a cash reserve for shareholders.
15.
LO 14.4Stockholders’ equity consists of which of the following?
1. bonds payable
2. retained earnings and accounts receivable
3. retained earnings and paid-in capital
4. discounts and premiums on bond payable
16.
LO 14.4Retained earnings is accurately described by all except which of the following statements?
1. Retained earnings is the primary component of a company’s earned capital.
2. Dividends declared are added to retained earnings.
3. Net income is added to retained earnings.
4. Net losses are accumulated in the retained earnings account.
17.
LO 14.4If a company’s board of directors designates a portion of earnings for a particular purpose due to legal or contractual obligations, they are designated as ________.
1. retained earnings payable
2. appropriated retained earnings
3. cumulative retained earnings
4. restricted retained earnings
18.
LO 14.4Corrections of errors that occurred on a previous period’s financial statements are called ________.
1. restrictions
2. deficits
3. prior period adjustments
4. restatements
19.
LO 14.4Owner’s equity represents which of the following?
1. the amount of funding the company has from issuing bonds
2. the sum of the retained earnings and accounts receivable account balances
3. the total of retained earnings plus paid-in capital
4. the business owner’s/owners’ share of the company, also known as net worth or net assets
20.
LO 14.5Which of the following is a measurement of earnings that represents the profit before interest, taxes, depreciation and amortization are subtracted?
1. net income
2. retained earnings
3. EBITDA
4. EPS
21.
LO 14.5Which of the following measures the portion of a corporation’s profit allocated to each outstanding share of common stock?
1. retained earnings
2. EPS
3. EBITDA
4. NOPAT
22.
LO 14.5The measurement of earnings concept that consists of a company’s profit from operations after taxed are subtracted is ________.
1. ROI
2. EPS
3. EBITDA
4. NOPAT
23.
LO 14.5The correct formula for the calculation of earnings per share is ________.
1. (Net income + Preferred dividends) / Weighted average common shares outstanding
2. Net income / Weighted average common shares outstanding
3. (Net income – Preferred dividends) / Weighted average common shares outstanding
4. (Net income – Preferred dividends) / Treasury shares outstanding
24.
LO 14.5Most analysts believe which of the following is true about EPS?
1. Consistent improvement in EPS year after year is the indication of continuous improvement in the company’s earning power.
2. Consistent improvement in EPS year after year is the indication of continuous decline in the company’s earning power.
3. Consistent improvement in EPS year after year is the indication of fraud within the company.
4. Consistent improvement in EPS year after year is the indication that the company will never suffer a year of net loss rather than net income.
Questions
1.
LO 14.1Your corporation needs additional capital to fund an expansion. Discuss the advantages and disadvantages of raising capital through the issuance of stock. Would debt be a better option? Why or why not?
2.
LO 14.1How many shares of stock should your new corporation authorize? How did you arrive at your number?
3.
LO 14.1What factors should a new company consider in deciding in which state to incorporate?
4.
LO 14.1What are some of the reasons a business owner might choose the corporate form of business?
5.
LO 14.2Why would a company repurchase its own stock?
6.
LO 14.2The following data was reported by Saturday Corporation:
• Authorized shares: 30,000
• Issued shares: 25,000
• Treasury shares: 5,000
How many shares are outstanding?
7.
LO 14.2A corporation issues 6,000 shares of \$1 par value stock for a parcel of land valued at \$12,000. Prepare the journal entry to reflect this transaction.
8.
LO 14.2When corporations issue stock in exchange for professional services, what account(s) should be debited and what account(s) should be credited?
9.
LO 14.2A corporation issues 5,000 shares of \$1 par value stock for some equipment with a clearly determined value of \$10,000. Prepare the journal entry to reflect this transaction.
10.
LO 14.3On April 2, West Company declared a cash dividend of \$0.50 per share. There are 50,000 shares outstanding. What is the journal entry that should be recorded?
11.
LO 14.3Assuming the same facts as Exercise 14.10, what is the journal that should be recorded on May 5, the date of payment?
12.
LO 14.3When does a corporation incur a liability for a dividend?
13.
LO 14.3How does a stock split affect the balance sheet of a corporation?
14.
LO 14.4Your friend has questions about retained earnings and dividends. How do you explain to him that dividends are paid out of retained earnings?
15.
LO 14.4What does owners’ equity mean for the owner?
16.
LO 14.4What types of transactions reduce owner’s equity? What types of transactions reduce retained earnings? What do they have in common?
17.
LO 14.4Sometimes financial statements contain errors. What type of liabilities may need correction as a prior period adjustment?
18.
LO 14.4Retained earnings may be restricted or appropriated. Explain the difference between the two and give an example of when each may be used.
19.
LO 14.5Which financial statements do you need to calculate EPS?
20.
LO 14.5Where is EPS disclosed for publicly traded companies?
21.
LO 14.5Should investors rely on EPS as an investing tool? Why or why not?
22.
LO 14.5What information do you need to calculate the weighted average common shares outstanding?
23.
LO 14.5Which is the only ratio required to be reported on the face of a company’s financial statements? What are the two ways the ratio is required to be reported?
Exercise Set A
EA1.
LO 14.1You are an accountant working for a company that has recently decided to incorporate. The company has incurred \$4,300 for attorney’s fees, promotion costs, and filing fees with the state of incorporation as a part of organizing the corporate entity. What is the journal entry to record these costs on March 13, assuming they are paid in cash?
EA2.
LO 14.1What is the impact on stockholders’ equity when a company uses debt financing as a source of funding?
EA3.
LO 14.1What is the most obvious difference between debt and equity financing?
EA4.
LO 14.1How do creditors assess risk when lending funds to a company?
EA5.
LO 14.2Fortuna Company is authorized to issue 1,000,000 shares of \$1 par value common stock. In its first year, the company has the following transactions:
Jan. 31 Issued 40,000 shares at \$10 share
Jun. 10 Issued 100,000 shares in exchange for land with a clearly determined value of \$850,000
Aug. 3 Purchased 10,000 shares of treasury stock at \$9 per share
Journalize the transactions and calculate how many shares of stock are outstanding at August 3.
EA6.
LO 14.2James Incorporated is authorized to issue 5,000,000 shares of \$1 par value common stock. In its second year of business, the company has the following transactions:
Mar. 31 Issued 30,000 shares at \$10 share
Jul. 9 Issued 100,000 shares in exchange for a building with a clearly determined value of \$700,000
Aug. 30 Purchased 7,000 shares of treasury stock at \$9 per share
Journalize the transactions.
EA7.
LO 14.2McVie Corporation’s stock has a par value of \$2. The company has the following transactions during the year:
Feb. 28 Issued 300,000 shares at \$5 share
Jun. 7 Issued 90,000 shares in exchange for equipment with a clearly determined value of \$200,000
Sep. 19 Purchased 3,000 shares of treasury stock at \$7 per share
Journalize the transactions.
EA8.
LO 14.2Anslo Fabricating, Inc. is authorized to issue 10,000,000 shares of \$5 stated value common stock. During the year, the company has the following transactions:
Jan. 3 Issued 60,000 shares at \$10 share
Jun. 15 Issued 5,000 shares in exchange for office equipment with a clearly determined value of \$50,000
Aug. 16 Purchased 4,000 shares of treasury stock at \$20 per share
Journalize the transactions.
EA9.
LO 14.2St. Marie Company is authorized to issue 1,000,000 shares of \$5 par value preferred stock, and 5,000,000 shares of \$1 stated value common stock. During the year, the company has the following transactions:
Jan. 31 Issued 140,000 common shares at \$10 share
Jun. 10 Issued 160,000 preferred shares in exchange for land with a clearly determined value of \$850,000
Aug. 3 Issued 10,000 shares of common stock for \$9 per share
Journalize the transactions.
EA10.
LO 14.3Nutritious Pet Food Company’s board of directors declares a cash dividend of \$1.00 per common share on November 12. On this date, the company has issued 12,000 shares but 2,000 shares are held as treasury shares. What is the journal entry to record the declaration of this dividend?
EA11.
LO 14.3Nutritious Pet Food Company’s board of directors declares a cash dividend of \$1.00 per common share on November 12. On this date, the company has issued 12,000 shares but 2,000 shares are held as treasury shares. The company pays the dividend on December 14. What is the journal entry to record the payment of the dividend?
EA12.
LO 14.3Nutritious Pet Food Company’s board of directors declares a cash dividend of \$5,000 on June 30. At that time, there are 3,000 shares of \$5 par value 5% preferred stock outstanding and 7,000 shares of \$1 par value common stock outstanding (none held in treasury). What is the journal entry to record the declaration of the dividend?
EA13.
LO 14.3Nutritious Pet Food Company’s board of directors declares a small stock dividend (20%) on June 30 when the stock’s market value per share is \$30. At that time, there are 10,000 shares of \$1 par value common stock outstanding (none held in treasury). What is the journal entry to record the declaration of the dividend?
EA14.
LO 14.4Blanket Company has paid quarterly dividends every quarter for the past 15 years. Lately, slowing sales have created a cash crunch for the company. While the company still has positive retained earnings, the retained earnings balance is close to zero. Should the company borrow to continue to pay dividends? Why or why not?
EA15.
LO 14.4Farmington Corporation began the year with a retained earnings balance of \$20,000. The company paid a total of \$3,000 in dividends and earned a net income of \$60,000 this year. What is the ending retained earnings balance?
EA16.
LO 14.4Montana Incorporated began the year with a retained earnings balance of \$50,000. The company paid a total of \$5,000 in dividends and experienced a net loss of \$25,000 this year. What is the ending retained earnings balance?
EA17.
LO 14.4Jesse and Mason Fabricating, Inc. general ledger has the following account balances at the end of the year:
What is the total ending balance as reported on the company’s Statement of Stockholder’s Equity?
EA18.
LO 14.4Roxanne’s Delightful Candies, Inc. began the year with a retained earnings balance of \$45,000. The company had a great year and earned a net income of \$80,000. However, the company’s controller determined that it had made an error when calculating depreciation in the preceding year, resulting in an understated depreciation expense amount of \$2,000. What is the ending retained earnings balance?
EA19.
LO 14.5Jupiter Corporation earned net income of \$90,000 this year. The company began the year with 600 shares of common stock and issued 500 more on April 1. They issued \$5,000 in preferred dividends for the year. What is Jupiter Corporation’s weighted average number of shares for the year?
EA20.
LO 14.5Longmont Corporation earned net income of \$90,000 this year. The company began the year with 600 shares of common stock and issued 500 more on April 1. They issued \$5,000 in preferred dividends for the year. What is the numerator of the EPS calculation for Longmont?
EA21.
LO 14.5James Corporation earned net income of \$90,000 this year. The company began the year with 600 shares of common stock and issued 500 more on April 1. They issued \$5,000 in preferred dividends for the year. What is the EPS for the year for James (rounded to the nearest dollar)?
Exercise Set B
EB1.
LO 14.1Your high school friend started a business that has blossomed over the years, and she is considering incorporating so she can sell shares of stock and expand. She has asked you for help understanding the process she will need to undertake. How do you explain the process of incorporation to her?
EB2.
LO 14.1You are an accountant working for a manufacturing company that makes personal care products and has recently decided to incorporate. The company incurred a total of \$7,900 for attorney’s fees, promotion costs, and filing fees with the state of incorporation as a part of organizing the corporate entity. What is the journal entry to record these costs on February 28, assuming they are paid in cash?
EB3.
LO 14.1What is the impact on stockholders’ equity when a company uses equity financing as a source of funding?
EB4.
LO 14.1What is the biggest disadvantage to be considered when exploring the option of equity financing versus debt financing?
EB5.
LO 14.1Your high school friend started a business that has blossomed over the years, and he is considering incorporating so he can sell shares of stock and expand. He has asked you for help understanding the costs of incorporating. What are some of the costs that he will face as he organizes the corporation and begins to sell shares of stock?
EB6.
LO 14.2Spring Company is authorized to issue 500,000 shares of \$2 par value common stock. In its first year, the company has the following transactions:
Mar. 1 Issued 40,000 shares of stock at \$9.75 per share
Apr. 10 Issued 1,000 shares of stock for legal services valued at \$10,000.
Oct. 3 Purchased 1,000 shares of treasury stock at \$9 per share
Journalize the transactions and calculate how many shares of stock are outstanding at August 3.
EB7.
LO 14.2Silva Company is authorized to issue 5,000,000 shares of \$2 par value common stock. In its IPO, the company has the following transaction: Mar. 1, issued 500,000 shares of stock at \$15.75 per share for cash to investors. Journalize this transaction.
EB8.
LO 14.2Juniper Company is authorized to issue 5,000,000 shares of \$2 par value common stock. In conjunction with its incorporation process and the IPO, the company has the following transaction: Mar. 1, issued 4,000 shares of stock in exchange for equipment worth \$250,000. Journalize the transaction.
EB9.
LO 14.2Vishnu Company is authorized to issue 500,000 shares of \$2 par value common stock. In conjunction with its incorporation process and the IPO, the company has the following transaction: Apr. 10, issued 1,000 shares of stock for legal services valued at \$15,000. Journalize the transaction.
EB10.
LO 14.2Ammon Company is authorized to issue 500,000 shares of \$5 par value preferred stock. In its first year, the company has the following transaction: Mar. 1, issued 40,000 shares of preferred stock at \$20.50 per share. Journalize the transaction.
EB11.
LO 14.3Nutritious Pet Food Company’s board of directors declares a small stock dividend (20%) on June 30 when the stock’s market value per share is \$30. At that time, there are 10,000 shares of \$1 par value common stock outstanding (none held in treasury). What is the journal entry to record the stock dividend distribution on July 31?
EB12.
LO 14.3Nutritious Pet Food Company’s board of directors declares a large stock dividend (50%) on June 30 when the stock’s market value per share is \$30. At that time, there are 10,000 shares of \$1 par value common stock outstanding (none held in treasury). What is the journal entry to record the declaration of the dividend?
EB13.
LO 14.3Nutritious Pet Food Company’s board of directors declares a large stock dividend (50%) on June 30 when the stock’s market value per share is \$30. At that time, there are 10,000 shares of \$1 par value common stock outstanding (none held in treasury). What is the journal entry to record the stock dividend distribution on July 31?
EB14.
LO 14.3Nutritious Pet Food Company’s board of directors declares a 2-for-1 stock split on June 30 when the stock’s market value per share is \$30. At that time, there are 10,000 shares of \$1 par value common stock outstanding (none held in treasury). What is the new par value of the shares and how many shares are outstanding after the split?
EB15.
LO 14.3Nutritious Pet Food Company’s board of directors declares a 2-for-1 stock split on June 30 when the stock’s market value per share is \$30. At that time, there are 10,000 shares of \$1 par value common stock outstanding (none held in treasury). What is the new par value of the shares and how many shares are outstanding after the split? What is the total amount of equity before and after the split?
EB16.
LO 14.4Birmingham Company has been in business for five years. Last year, it experienced rapid growth and hired a new accountant to oversee the physical assets and record acquisitions and depreciation. This year, the controller discovered that the accounting records were not in order when the new accountant took over, and a \$3,000 depreciation entry was omitted resulting in depreciation expense being understated last year. How does the company make this type of correction and where is it reported?
EB17.
LO 14.4Chelsea Company is a sole proprietorship. Ashley, Incorporated is a corporation. Which company would report stockholder’s equity and retained earnings and not simply owner’s equity? Why? What is the difference between these accounts?
EB18.
LO 14.4Tart Restaurant Holdings, Incorporated began the year with a retained earnings balance of \$950,000. The company paid a total of \$14,000 in dividends and experienced a net loss of \$20,000 this year. What is the ending retained earnings balance?
EB19.
LO 14.4Josue Fabricating, Inc.’s accountant has the following information available to prepare the Statement of Stockholder’s Equity for the year just ended.
What is the total balance on the company’s Statement of Stockholder’s Equity? What is the amount of the contributed capital?
EB20.
LO 14.4Trumpet and Trombone Manufacturing, Inc. began the year with a retained earnings balance of \$545,000. The company had a great year and earned a net income of \$190,000 this year and paid dividends of \$14,000. Additionally, the company’s controller determined that it had made an error when calculating tax expense in the preceding year, resulting in an understated expense amount of \$22,000. What is the ending retained earnings balance?
EB21.
LO 14.5Brunleigh Corporation earned net income of \$200,000 this year. The company began the year with 10,000 shares of common stock and issued 5,000 more on April 1. They issued \$7,500 in preferred dividends for the year. What is Brunleigh Corporation’s weighted average number of shares for the year?
EB22.
LO 14.5Errol Corporation earned net income of \$200,000 this year. The company began the year with 10,000 shares of common stock and issued 5,000 more on April 1. They issued \$7,500 in preferred dividends for the year. What is the numerator of the EPS calculation for Errol?
EB23.
LO 14.5Bastion Corporation earned net income of \$200,000 this year. The company began the year with 10,000 shares of common stock and issued 5,000 more on April 1. They issued \$7,500 in preferred dividends for the year. What is the EPS for the year for Bastion?
Problem Set A
PA1.
LO 14.1You are a CPA who has been hired by DEF Company to assist with their initial public offering. Prepare a memo to the president of DEF outlining the steps you will take to launch the IPO.
PA2.
LO 14.1You are a CPA who has been hired by DEF Company to assist with their incorporation process. Prepare a memo to the president of DEF explaining the different statuses of shares of stock: authorized shares, issued shares, outstanding shares, and treasury shares.
PA3.
LO 14.1You are a CPA who has been hired by DEF Company to assist with their initial public offering. Prepare a memo to the president of DEF outlining the two most significant values, market value and par value, associated with stock.
PA4.
LO 14.2Wingra Corporation was organized in March. It is authorized to issue 500,000 shares of \$100 par value 8% preferred stock. It is also authorized to issue 750,000 shares of \$1 par value common stock. In its first year, the corporation has the following transactions:
Mar. 1 Issued 10,000 shares of preferred stock at \$115 per share
Mar. 2 Issued 120,000 shares of common stock at \$12.50 per share
Apr. 10 Issued 15,000 shares of common stock for equipment valued at \$196,000. The stock is currently trading at \$12 per share, and is a more reliable indicator of the value of the equipment.
Jun. 12 Issued 10,000 shares of common stock at \$15 per share
Aug. 5 Issued 1,000 shares of preferred stock at \$112 per share
Journalize the transactions.
PA5.
LO 14.2Copper Corporation was organized in May. It is authorized to issue 50,000,000 shares of \$200 par value 7% preferred stock. It is also authorized to issue 75,000,000 shares of \$5 par value common stock. In its first year, the corporation has the following transactions:
May 1 Issued 1,000 shares of preferred stock for cash at \$250 per share
May 23 Issued 2,000 shares of common stock at \$15.50 per share
Jun. 10 Issued 15,000 shares of common stock for equipment without a readily determinable value. The stock is currently trading at \$15 per share.
Journalize the transactions.
PA6.
LO 14.2EllaJane Corporation was organized several years ago and was authorized to issue 4,000,000 shares of \$50 par value 6% preferred stock. It is also authorized to issue 1,750,000 shares of \$1 par value common stock. In its fifth year, the corporation has the following transactions:
Mar. 1 Purchased 1,000 shares of its own common stock at \$11 per share
Apr. 10 Reissued 500 shares of its common stock held in the treasury for \$15 per share.
Jun. 12 Reissued 500 shares of common stock at \$9 per share
Journalize the transactions.
PA7.
LO 14.3Aggregate Mining Corporation was incorporated five years ago. It is authorized to issue 500,000 shares of \$100 par value 8% preferred stock. It is also authorized to issue 750,000 shares of \$1 par value common stock. It has issued only 50,000 of the common shares and none of the preferred shares. In its sixth year, the corporation has the following transactions:
Mar. 1 Declares a cash dividend of \$2 per share
Mar. 30 Pays the cash dividend
Jul. 10 Declares a 5% stock dividend when the stock is trading at \$15 per share
Aug. 5 Issues the stock dividend
Journalize these transactions.
PA8.
LO 14.3Aggregate Mining Corporation was incorporated five years ago. It is authorized to issue 500,000 shares of \$100 par value 8% preferred stock. It is also authorized to issue 750,000 shares of \$1 par value common stock. It has issued only 50,000 of the common shares and none of the preferred shares. In its seventh year, the corporation has the following transactions:
Mar. 1 Declares a cash dividend of \$5 per share
Mar. 30 Pays the cash dividend
Jul. 10 Declares a property dividend of 1/2 ton of limestone per share when the price of limestone is \$25 per ton
Journalize these transactions.
PA9.
LO 14.3Aggregate Mining Corporation was incorporated five years ago. It is authorized to issue 500,000 shares of \$100 par value 8% cumulative preferred stock. It is also authorized to issue 750,000 shares of \$6 par value common stock. It has issued 50,000 of the common shares and 1,000 of the cumulative preferred shares. The corporation has never declared a dividend and the preferred shares are one years in arrears. Aggregate Mining has the following transactions this year:
Mar. 1 Declares a cash dividend of \$20,000
Mar. 30 Pays the cash dividend
Jul. 10 Declares a 3-for-1 stock split of its common shares
Journalize these transactions. For the stock split, show the calculation for how many shares are outstanding after the split and the par value per share after the split
PA10.
LO 14.4The board of directors is interested in investing in a new technology. Appropriating existing retained earnings is a choice for funding the new technology. You are a consultant to the board. How would you explain this option to the board members so that they could make an educated decision?
PA11.
LO 14.4You are a consultant for several emerging, high-growth technology firms that were started locally and have been a part of a business incubator in your area. These firms start out as sole proprietorships but quickly realize the need for more capital and often incorporate. One of the common questions you are asked is about stockholder’s equity. Explain the characteristics and functions of the retained earnings account and how the account is different from contributed capital.
PA12.
LO 14.4You are the accountant for Kamal Fabricating, Inc. and you oversee the preparation of financial statements for the year just ended 6/30/2020. You have the following information from the company’s general ledger and other financial reports (all balances are end-of-year except for those noted otherwise:
Prepare the company’s Statement of Retained Earnings.
PA13.
LO 14.5You have some funds that you would like to invest. Do some internet research to find two publicly traded companies in the same industry and compare their earnings per share. Would the earnings per share reported by each company influence your decision in selecting which company to invest in?
PA14.
LO 14.5You are a consultant working with various companies that are considering incorporating and listing shares on a stock exchange. Explain the importance of the EPS calculation to financial analysts who follow companies on the stock exchanges.
Problem Set B
PB1.
LO 14.1You are the president of Duke Company and are leading the company through the process of incorporation. The next step is determining the type of stock the company should offer. You are relying on feedback from several key executives at Duke to help you assess the wisdom in this decision. Prepare a memo to your executive team outlining the differences between common stock and preferred stock. The memo should be complete enough to assist them with assessing differences and providing you with robust feedback.
PB2.
LO 14.1You are the president of Duke Company and are leading the company through the process of incorporation. The company has determined that common stock shares will be issued, but several key executives at Duke are not quite sure they understand the preemptive right feature associated with common shares. Prepare a memo to your executive team outlining the meaning of this right.
PB3.
LO 14.2Autumn Corporation was organized in August. It is authorized to issue 100,000 shares of \$100 par value 7% preferred stock. It is also authorized to issue 500,000 shares of \$5 par value common stock. During the year, the corporation had the following transactions:
Aug. 22 Issued 2,000 shares of preferred stock at \$105 per share
Sep. 3 Issued 80,000 shares of common stock at \$13.25 per share
Oct. 11 Issued 12,000 shares of common stock for land valued at \$156,000. The stock is currently trading at \$12 per share, and the stock’s trading value is a more accurate determinant of the land’s value.
Nov. 12 Issued 5,000 shares of common stock at \$15 per share
Dec. 5 Issued 1,000 shares of preferred stock at \$112 per share
Journalize the transactions.
PB4.
LO 14.2MacKenzie Mining Corporation is authorized to issue 50,000 shares of \$500 par value 7% preferred stock. It is also authorized to issue 5,000,000 shares of \$3 par value common stock. In its first year, the corporation has the following transactions:
May 1 Issued 3,000 shares of preferred stock for cash at \$750 per share
May 23 Issued 6,000 shares of common stock at \$12.50 per share
Jun. 10 Issued 5,000 shares of common stock for equipment without a readily determinable value. The stock is currently trading at \$11 per share
Journalize the transactions.
PB5.
LO 14.2Paydirt Limestone, Incorporated was organized several years ago and was authorized to issue 3,000,000 shares of \$40 par value 9% preferred stock. It is also authorized to issue 3,750,000 shares of \$2 par value common stock. In its fifth year, the corporation has the following transactions:
Mar. 1 Purchased 2,000 shares of its own common stock at \$15 per share
Apr. 10 Reissued 1,000 shares of its common stock held in the treasury for \$18 per share.
Jun. 12 Reissued 1,000 shares of common stock at \$12 per share
Journalize the transactions.
PB6.
LO 14.3Tent & Tarp Corporation is a manufacturer of outdoor camping equipment. The company was incorporated ten years ago. It is authorized to issue 50,000 shares of \$10 par value 5% preferred stock. It is also authorized to issue 500,000 shares of \$1 par value common stock. It has issued 5,000 common shares and none of the preferred shares. Tent & Tarp has the following transactions:
Mar. 1 Declares a cash dividend of \$3 per share
Mar. 30 Pays the cash dividend
Jul. 10 Declares a 35% stock dividend when the stock is trading at \$15 per share
Aug. 5 Issues the stock dividend
Journalize these transactions.
PB7.
LO 14.3Tent & Tarp Corporation is a manufacturer of outdoor camping equipment. The company was incorporated ten years ago. It is authorized to issue 50,000 shares of \$10 par value 5% preferred stock. It is also authorized to issue 500,000 shares of \$1 par value common stock. It has issued 5,000 common shares and none of the preferred shares. Tent & Tarp has the following transactions:
Mar. 1 Declares a cash dividend of \$5 per share
Mar. 30 Pays the cash dividend
Jul. 10 Declares a property dividend of one 6-person camping tent per share of stock when the price per tent is \$150.
Journalize these transactions.
PB8.
LO 14.3Tent & Tarp Corporation is a manufacturer of outdoor camping equipment. The company was incorporated ten years ago. It is authorized to issue 50,000 shares of \$10 par value 5% preferred stock. It is also authorized to issue 500,000 shares of \$1 par value common stock. It has issued 5,000 common shares and 2,000 of the preferred shares. The corporation has never declared a dividend and the preferred shares are one years in arrears. Tent & Tarp has the following transactions:
Mar. 1 Declares a cash dividend of \$10,000
Mar. 30 Pays the cash dividend
Jul. 10 Declares a 5-for-1 stock split of its common shares
Journalize these transactions. For the stock split, show the calculation for how many shares are outstanding after the split and the par value per share after the split
PB9.
LO 14.4You are a CPA working with sole proprietors. Several of your clients are considering incorporating because they need to expand and grow. One client is curious about how her financial reports will change. She’s heard that she may need to prepare a statement of retained earnings and a statement of stockholder’s equity. She’s confused about the difference between the two and what they report. How would you explain the characteristics and functions of the two types of statements?
PB10.
LO 14.4You are a consultant for several emerging, high growth technology firms that were started locally and have been a part of a business incubator in your area. These firms start out as sole proprietorships but quickly realize the need for more capital and often incorporate. One of the common questions you get is about stockholder’s equity. Explain the key ways the companies need to view retained earnings if they want to use it as a source of capital for future expansion and growth after incorporating.
PB11.
LO 14.4You are the accountant for Trumpet and Trombone Manufacturing, Inc. and you oversee the preparation of financial statements for the year just ended 6/30/2020. You have the following information from the company’s general ledger and other financial reports (all balances are end-of-year except for those noted otherwise):
Prepare the company’s Statement of Retained Earnings
PB12.
LO 14.5You have some funds that you would like to invest and you are relying heavily on the EPS calculation to help you make your decision. Initially you are baffled about why preferred dividends are subtracted in the numerator and why a weighted average is used in the denominator, so you do some research and reflection and come to understand why. Your friend is interested in hearing about your thought process. How would you explain to your friend why it’s important to subtract preferred dividends and to use weighted averages?
PB13.
LO 14.5You are a consultant working with various companies that are considering incorporating and listing shares on a stock exchange. One of your clients asks you about the various acronyms she has been hearing in conjunction with financial analysis. Explain the following acronyms and how they measure different things but may complement each other: EPS (earnings per share), EBITDA (earnings before interest, taxes, depreciation, and amortization), and NOPAT (net operating profit after taxes).
Thought Provokers
TP1.
LO 14.1Your bakery is incorporated and is looking for investors. Write a one paragraph story of why investors should buy stock in your company. What makes your bakery special?
TP2.
LO 14.1Do some research: why did Facebook choose to reincorporate in Delaware?
TP3.
LO 14.1Do some research: why is Comcast incorporated in Pennsylvania?
TP4.
LO 14.2On November 7, 2013, Twitter released its initial public offering (IPO) priced at \$26 per share. When the day ended, it was priced at \$44.90, reportedly making about 1600 people into millionaires in a single day.11 At the time it was considered a successful IPO. Four years later, Twitter is trading at around \$18 per share. Why do you think that occurred? IsTwitter profitable? How can you find out? If it is not profitable, why do investors continue to support it?
TP5.
LO 14.2Research online to find a company that bought back shares of its own stock (treasury stock) within the last 6–12 months. Why did it repurchase the shares? What happened to the company’s stock price immediately after the repurchase and in the months since then? Is there any reason to think the repurchase impacted the price?
TP6.
LO 14.3As a bakery business continues to grow, cash flow has become more of a concern. The board of directors would like to maintain the market share price, so a discussion ensues about issuing a stock dividend versus a cash dividend. As a newly appointed board member you listen to the conversation and need to cast your vote. Which do you vote for: stock dividend or cash dividend?
TP7.
LO 14.3Use the internet to find a company that declared a stock split within the last 1–2 years. Why did it declare the split? What happened to the company’s stock price immediately after the split and in the months since then? Is there any reason to think the split impacted the price?
TP8.
LO 14.4Use the internet to find a publicly held company’s annual report. Locate the section reporting Stockholder’s Equity. Assume that you work for a consulting firm that has recently taken on this firm as a client, and it is your job to brief your boss on the financial health of the company. Write a short memo noting what insights you gather by looking at the Stockholder’s Equity section of the financial reports.
TP9.
LO 14.4Use the internet to find a publicly held company’s annual report. Locate the section that comments on the Stockholder’s Equity section of the financial reports. What additional insights are you able to learn by looking further into the commentary? Is there anything that surprised you or that you think is missing and could help you if you were deciding whether to invest \$100,000 of your savings in this company’s stock? | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/14%3A_Corporation_Accounting/14.07%3A_Practice_Questions.txt |
As a recent graduate of a landscape architecture program, Ciara is ready to start her professional career. Dale, her friend from high school, has started a small lawn mowing and hardscape business and wants to expand his services. Ciara and Dale sit down and work out that if they combine their talents, they will be able to take advantage of a growing need in their local housing market. They agree to form a partnership, and together they decide what each person will contribute to the business. Ciara has committed to invest cash, and Dale will contribute assets he has acquired in his business. In addition to the assets that each will provide, Ciara will contribute her expertise in landscape design, while Dale will contribute his experience in property maintenance and stonework/wood design and construction.
They set out on their adventure, creating a partnership agreement and detailing the roles each will play in this newly created partnership. At first, business is great and they work well together. There is one problem: they have more business than they can handle, and they are getting requests for services they currently don’t provide. However, Ciara’s friend Remi is a pond installer. From speaking with Remi, she knows he is very dedicated and has a vast customer base. She realizes that if he joins the partnership, the company can handle all the business demand better. Therefore, Ciara and Dale decide to amend the partnership agreement and admit Remi as a new one-third partner.
15.01: Describe the Advantages and Disadvantages of Organizing as a Partnership
A partnership is legal business structure consisting of an association of two or more people who contribute money, property, or services to operate as co-owners of a business. When discussing partnerships as a form of business ownership, the term personcan refer to individuals, corporations, or even other partnerships. However, in this chapter, all the partners are individuals.
THINK IT THROUGH
Choosing a Partner
In some ways, a partnership is like a marriage; choosing a partner requires a great deal of thought. How do you know whether you and your potential partner or partners will be a good fit? A strong partnership agreement is one way to help settle future disagreements.
But before you get that far, it is really important to take a hard look at future partners. How do they deal with stressful situations? What skills and assets do they possess that you do not, and vice versa? What work ethic do they exemplify? Do they procrastinate? Are they planners? Do they get along with others? Do the two of you work well with each other?
All these questions and many more should be explored before choosing business partners. While you cannot predict the future or see all possible issues, doing your due diligence will help.
What other questions can you think of that would help you decide whether someone will be a good business partner for you?
Characteristics of a Partnership
Just like a corporation, a partnership is a legal entity. It can own property and can be held legally liable for its actions. It is a separate entity from its owners, the partners. Partnerships have several distinct characteristics that set them apart from other entity types. The most common characteristics of a partnership are the following:
• Formation by agreement. A partnership is formed by voluntary membership or association. The partners must have an agreement about who contributes assets or services, who performs what functions of the business, and how profits and losses and any additional compensation are shared. Ideally, this agreement should be in writing; however, if not, the Uniform Partnership Act or the Revised Uniform Partnership Act (RUPA) governs in areas of disagreement, depending on the state in which the partnership is located.
• Defined or limited life. Typically, the life term of the partnership is established by agreement. Unlike corporations, which have an unlimited life, partnerships end when a new partner is accepted or a partner leaves (and a new partnership may be created), or the partnership dissolves.
• Mutual agency. In a partnership, partners are considered agents of the entity. Mutual agency give each partner the ability to act as an agent for the partnership in dealing with outside entities such as vendors and lenders. The partnership is then bound by the actions of each partner acting within the scope of partnership activities.
• Unlimited liability. Due to mutual agency, any partner has the ability to incur debt for the partnership. Regardless of who negotiated the debt, each partner is liable to pay it if the debt was incurred to further partnership activities. There are exceptions to this, but only for partners who meet limited partnership standards (which you will learn about later in this chapter). If you are considered a general partner, you are liable for the business’s debt.
• Non-taxable income at partnership level. The net income of a partnership is not subject to federal taxation at the partnership level, despite the company’s being a separate legal entity from its partners. Instead, its income or loss is allocated among the partners based upon the partnership agreement and tax legislation, and the allocation is reported on each partner’s Tax Form K-1. The tax information on each partner’s K-1 is then incorporated into each partner’s individual tax return, and tax is paid at each individual partner’s relevant tax rate.
Income tax is levied on the partners regardless of how much of that taxable income is actually withdrawn by the partner in a given year. For example, assume that a partner earned \$20,000 in taxable income from a partnership in 2019 and withdrew \$25,000 as a draw. The partner’s taxable income from the partnership for the year is \$20,000. Draws are not considered taxable income. Instead, they are withdrawals from a partner’s capital account. However, the \$25,000 draw in this example reduces the partner’s capital account by \$25,000.
• Co-ownership of property. In a partnership, assets are jointly owned by all partners. If a dissolution occurs, each partner retains a claim on the total assets proportional to that partner’s equity in the organization. The rule presented herein does not apply to specific assets.
• Limited capital investment. Unlike a corporation, which is able to raise capital investments by issuing stock, partners do not have the ability to raise capital except by incurring additional debt or agreeing to contribute more of their personal assets. This limits the partnerships’ ability for rapid expansion.
• Participation in both income and loss. The net income or loss of the partnership is distributed as specified in the partnership agreement. If the arrangement is not specified in the partnership agreement, all partners participate equally in net income or losses.
IFRS CONNECTION
Partnerships and IFRS
You’ve learned how partnerships are formed, and you will soon learn how partnership capital and income can be allocated and what happens to the capital structure when a partner is added or subtracted. But how does a partnership account for normal day-to-day business transactions?
Partnership organizations can be very small, very large, or any size in between. What type of accounting rules do partnerships use to record their daily business activities? Partnerships can choose among various forms of accounting. The options broadly include using a cash basis, a tax basis, and a full accrual basis to track transactions. When choosing to use the full accrual basis of accounting, partnerships apply U.S. GAAP rules in their accounting processes. But you may be surprised to learn that some non-publicly traded partnerships in the United States can use IFRS, or a simpler form of IFRS known as IFRS for Small and Medium Sized Entities (SMEs). In 2008, the AICPA designated IFRS and IFRS for SMEs as acceptable sets of generally accepted accounting principles. However, it is up to each State Board of Accountancy to determine whether that state will allow the use of IFRS or IFRS for SMEs by non-public entities incorporated in that state.
Despite the use of size descriptors in the title, qualifying as a small- or medium-sized entity has nothing to do with size. A SME is any entity that publishes general purpose financial statements for public use but does not have public accountability. In other words, the entity is not publicly traded. In addition, the entity, even if it is a partnership, cannot act as a fiduciary; for example, it cannot be a bank or insurance company and use SME rules.
Why might a partnership want to use IFRS for SMEs? First, IFRS for SMEs contains fewer and simpler standards. IFRS for SMEs is only about 300 pages in length, whereas regular IFRS is over 2,500 pages long and U.S. GAAP is over 25,000 pages. Second, IFRS for SMEs is modified only every three years, whereas U.S. GAAP and IFRS are modified more frequently. This means entities using IFRS for SMEs don’t have to adjust their accounting systems and reporting to new standards as frequently. Finally, if a partnership transacts business with international businesses or hopes to attract international partners, seek capital from international sources, or be bought out by an international company, having its financial statements in IFRS form can make these transactions easier.
Advantages of Organizing as a Partnership
When it comes to choosing a legal structure or form for your business, the most common options are sole proprietorships, partnerships, and different forms of corporations, each with advantages and disadvantages. Partnerships have several advantages over other forms of business entities, as follows:
• Exemption from taxation at the partnership level. A significant advantage to forming a partnership is the exemption from taxation as a business entity. In other words, although the individual partners are taxed at the individual level, the partnership itself (as a business unit) is not subject to income tax. The tax characteristics of a partnership “flow through” to the individual partners.
• Ease and lower cost of formation. Most business regulations tend to be written for corporations, which is to be expected given the complexities of many such companies. Partnerships, on the other hand, are simpler and have to comply with fewer regulations. Also, without shareholders, partnerships have fewer reporting requirements. The partnership formation paperwork also tends to be less cumbersome than that for other entities in most states. Overall, partnerships are simple to form, alter, and terminate.
• Combined skills and financial resources. Combining business acumen and financial assets can give a partnership an advantage over sole proprietorships.
• Flexibility in managing and running the business. Partnerships are often simpler to manage and run than other business structures (except for most sole proprietorships), and they can offer more management flexibility as well if the partners generally agree on management issues. Since there is no board of directors overseeing operations, partnerships can be nimble and make speedy changes—again, as long as the partners agree.
• Easily changed business structure. It is a relatively easy process to convert a partnership to a corporation in the future. With no shareholders to consider, a partnership’s capital can be converted to shares of common stock.
• Informality. Unlike publicly traded corporations, partnerships do not need to prepare articles of incorporation, write bylaws, issue stock certificates to owners, document minutes or board meetings, pay incorporation fees to states, or file quarterly financial statements with the SEC. However, it is advised that partners create a written document detailing decision on issues such as profit sharing, dispute resolution procedures, partnership changes, and other terms that the partners might agree upon to prevent future complications.
YOUR TURN
All in the Family
Family partnerships are frequently utilized to allow family members to pool resources for investment purposes and to transfer assets in a tax-efficient manner. In what ways can you imagine using a family partnership?
Solution
Cash can be combined to purchase income-producing properties or other investments without having to sell assets, thus keeping costly investments all in the family. Through a family partnership, it becomes possible for those in high net worth tax brackets to transfer assets and wealth to younger generations in a way that reduces potential estate and gift taxes. For example, a family partnership can be formed by a grandparent who owns an apartment building. Children and grandchildren can be partners to share in profits of the building. As they earn the income from the building while living, this can be a very tax efficient way to transfer wealth.
Disadvantages of Organizing as a Partnership
While partnerships carry some clear advantages, there are also several disadvantages to consider. For example, due to unlimited liability, each partner in a general partnership is equally and personally liable for all the debts of the partnership. Following are some of the disadvantages of the partnership form of business organization:
• Difficulty of ownership transfer. Since a partnership dissolves when there is a change in ownership, it tends to be difficult to transfer ownership. It is a complicated process when a new partner is added or a partnership interest is sold, requiring asset valuation and negotiation of previously agreed upon partnership operating terms.
• Relative lack of regulation. You learned, for example, that a partnership’s informal agreement not need be in writing. But this could lead to legal disputes between partners and expose them to unlimited liability, something individuals in corporations do not need to worry about (they are liable only for the amount of their investment in the corporation’s stock).
• Taxation subject to individual’s tax rate. Individual partners often have other sources of income outside the partnership; this can make their allocated partnership income taxable at a higher rate than if the partnership were liable for the income taxes instead.
• Limited life. The partnership ends when a new partner is accepted into the partnership, a partner leaves, a partner dies, or the partnership dissolves. Therefore, most partnerships tend to have limited lives.
• Unlimited liability. Unlimited liability is the legal obligation of all general partners for the partnership’s debts regardless of which partner incurred them. This liability can extend to the partners’ personal assets.
• Mutual agency and partnership disagreements. Mutual agency is the right of all partners to represent the business and bind the partnership to contracts and agreements. This rule applies regardless of whether all the partners agree with the contract or agreement. Mutual agency could cause tension among the partners, since any of them can bind the partnership and make everyone liable as long as the action is taken in the interest of furthering the partnership.
• Limited ability to raise capital. A partnership is often limited in its ability to raise capital or additional funds, whether from the individual partners themselves or from a financial institution making a loan.
CONCEPTS IN PRACTICE
Sports Memorabilia Store
Farah and David decide to form a sports memorabilia retail partnership. They have known each other since business graduate school and have always worked well together on various projects. The business is doing well but cash flow is very tight. Farah takes several calls from vendors asking for payment. He believed David had been paying the bills. When he asks about this, David admits to embezzling from the partnership. What liability does Farah face as a result of the theft?
Table 15.1 summarizes some of the main advantages and disadvantages of the partnership form of business organization.
Advantages and Disadvantages of Forming a Partnership
Potential Advantages Potential Disadvantages
• No taxation at the partnership level
• Ease and lower cost of formation
• Combined skills and financial resources
• Flexibility in managing and running the business
• Easily changed business structure
• Informality
• Difficulty of ownership transfer
• Relative lack of oversight/regulation
• Number of partners needed
• Taxation subject to individual’s tax rate
• Limited life
• Unlimited liability
• Mutual agency and potential for partnership disagreements
• Limited ability to raise capital
Table15.1
Types of Partnerships
A general partnership is an association in which each partner is personally liable to the partnership’s creditors if the partnership has insufficient assets to pay its creditors. These partners are often referred to as general partners. A limited partnership (LP) is an association in which at least one partner is a general partner but the remaining partners can be limited partners, which means they are liable only for their own investment in the firm if the partnership cannot pay its creditors. Thus, their personal assets are not at risk.
Finally, the third type is a limited liability partnership (LLP), which provides all partners with limited personal liability against another partner’s obligations. Limited liability is a form of legal liability in which a partner’s obligation to creditors is limited to his or her capital contributions to the firm. These types of partnerships include “LLP” or partnership in their names and are usually formed by professional groups such as lawyers and accountants. Each partner is at risk however, for his or her own negligence and wrongdoing as well as the negligence and wrongdoing of those who are under the partners’ control or direction. Table 15.2summarizes the advantages and disadvantages of different types of partnerships.
Advantages and Disadvantages of Types of Partnerships
Type of partnership Advantages Disadvantages
General partnership Business is simple to form All partners have personal liability
Limited partnership (LP) Limited partners have limited liability General partners are personally liable
Limited liability partnership (LLP) Partners are protected from other partners’ malpractice Some partners remain personally liable
Table15.2
LINK TO LEARNING
Arthur Andersen was one of the “Big 5” accounting firms until it was implicated in the Enron scandal. Arthur Andersenhad been formed as an LLP. Read this CNN Money article about the Arthur Andersen case to see how courts can hold partners liable.
Dissolution of a Partnership
Dissolution occurs when a partner withdraws (due to illness or any other reason), a partner dies, a new partner is admitted, or the business declares bankruptcy. Whenever there is a change in partners for any reason, the partnership must be dissolved and a new agreement must be reached. This does not preclude the partnership from continuing business operations; it only changes the document underlying the business. In some cases, the new partnership may also require the revaluation of partnerships assets and, possibly, their sale. Ideally, the partnership agreement has been written to address dissolution. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/15%3A_Partnership_Accounting/15.00%3A_Prelude_to_Partnership_Accounting.txt |
The landscaping partnership is going well and has realized increases in the number of jobs performed as well as in the partnership’s earnings. At the end of the year, the partners meet to review the income and expenses. Once that has been done, they need to allocate the profit or loss based upon their agreement.
Allocation of Income and Loss
Just like sole proprietorships, partnerships make four entries to close the books at the end of the year. The entries for a partnership are:
1. Debit each revenue account and credit the income section account for total revenue.
2. Credit each expense account and debit the income section account for total expenses.
3. If the partnership had income, debit the income section for its balance and credit each partner’s capital account based on his or her share of the income. If the partnership realized a loss, credit the income section and debit each partner’s capital account based on his or her share of the loss.
4. Credit each partner’s drawing account and debit each partner’s capital account for the balance in that same partner’s drawing account.
The first two entries are the same as for a proprietorship. Both revenue and expense accounts are temporary accounts. The last two entries are different because there is more than one equity account and more than one drawing account. Capital accounts are equity accounts for each partner that track all activities, such as profit sharing, reductions due to distributions, and contributions by partners to the partnership. Capital accounts are permanent while drawing accounts must be zeroed out for each accounting period.
By December 31 at the end of the first year, the partnership realized net income of \$50,000. Since Dale and Ciara had agreed to a 50:50 split in their partnership agreement, each partner will record an increase to their capital accounts of \$25,000. The journal records the entries to allocate year end net income to the partner capital accounts.
Income Allocations
Not every partnership allocates profit and losses on an even basis. As you’ve learned, the partnership agreement should delineate how the partners will share net income and net losses. The partnership needs to find a methodology that is fair and will equitably reflect each partner’s service and financial commitment to the partnership. The following are examples of typical ways to allocate income:
1. A fixed ratio where income is allocated in the same way every period. The ratio can be expressed as a percentage (80% and 20%), a proportion (7:3) or a fraction (1/4, 3/4).
2. A ratio based on beginning-of-year capital balances, end-of-year capital balances, or an average capital balance during the year.
3. Partners may receive a guaranteed salary, and the remaining profit or loss is allocated on a fixed ratio.
4. Income can be allocated based on the proportion of interest in the capital account. If one partner has a capital account that equates to 75% of capital, that partner would take 75% of the income.
5. Some combination of all or some of the above methods.
A fixed ratio is the easiest approach because it is the most straightforward. As an example, assume that Jeffers and Singh are partners. Each contributed the same amount of capital. However, Jeffers works full time for the partnership and Singh works part time. As a result, the partners agree to a fixed ratio of 0.75:0.25 to share the net income.
Selecting a ratio based on capital balances may be the most logical basis when the capital investment is the most important factor to a partnership. These types of ratios are also appropriate when the partners hire managers to run the partnership in their place and do not take an active role in daily operations. The last three approaches on the list recognize differences among partners based upon factors such as time spent on the business or funds invested in it.
Salaries and interest paid to partners are considered expenses of the partnership and therefore deducted prior to income distribution. Partners are not considered employees or creditors of the partnership, but these transactions affect their capital accounts and the net income of the partnership.
Let’s return to the partnership with Dale and Ciara to see how income and salaries can affect the split of net income (Figure 15.3). Acorn Lawn & Hardscapes reports net income of \$68,000. The partnership agreement has defined an income sharing ratio, which provides for salaries of \$15,000 to Dale and \$10,000 to Ciara. They will share in the net income on a 50:50 basis. The calculation for income sharing between the partners is as follows:
Now, consider the same scenario for Acorn Lawn & Hardscapes, but instead of net income, they realize a net loss of \$32,000. The salaries for Dale and Ciara remain the same. Also, the distribution process for allocating a loss is the same as the allocation process for distributing a gain, as demonstrated above. The partners will share in the net loss on a 50:50 basis. The calculation for the sharing of the loss between the partners is shown in Figure 15.4
CONCEPTS IN PRACTICE
Spidell and Diaz: A Partnership
For several years, Theo Spidell has operated a consulting company as a sole proprietor. On January 1, 2017 he formed a partnership with Juanita Diaz called Insect Management.
The facts are as follows:
• Spidell was to transfer the cash, accounts receivable, furniture and equipment, and all the liabilities of the sole proprietorship in return for 60% of the partnership capital.
• The fair market value in the relevant accounts of the sole proprietorship at the close of business on December 31, 2016 are shown in Figure 15.5.
• In exchange for 40% of the partnership, Diaz will invest \$130,667 in cash.
• Each partner will be paid a salary – Spidell \$3,000 per month and Diaz \$2,000 per month.
• The partnership’s net income for 2016 was \$300,000. The partnership agreement dictates an income-sharing ratio.
• Assume that all allocations are 60% Spidell and 40% Diaz.
Record the following transactions as journal entries in the partnership’s records.
1. Receipt of assets and liabilities from Spidell
2. Investment of cash by Diaz
3. Profit or loss allocation including salary allowances and the closing balance in the Income Section account
THINK IT THROUGH
Sharing Profits and Losses in a Partnership
Michael Wingra has operated a very successful hair salon for the past 7 years. It is almost too successful because Michael does not have any free time. One of his best customers, Jesse Tyree, would like to get involved, and they have had several conversations about forming a partnership. They have asked you to provide some guidance about how to share in the profits and losses.
Michael plans to contribute the assets from his salon, which have been appraised at \$500,000.
Jesse will invest cash of \$300,000. Michael will work full time at the salon and Jesse will work part time. Assume the salon will earn a profit of \$120,000.
Instructions:
1. What division of profits would you recommend to Michael and Jesse?
2. Using your recommendation, prepare a schedule sharing the net income. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/15%3A_Partnership_Accounting/15.02%3A_Describe_How_a_Partnership_Is_Created_Including_the_Associated_Journal_Entries.txt |
So far we have demonstrated how to create a partnership, distribute the income or loss, and calculate income distributed at the end of the year after salaries have been paid. Acorn Lawn & Hardscapes has been doing well, but what if the opportunity arises to add another partner to handle more business? Or what happens if one partner wants to leave the partnership or sell his or her interest to someone else? This section will discuss those situations.
Admission of New Partner
There are two ways for a new partner to join a partnership. In both, a new partnership agreement should be drawn up because the existing partnership will come to an end.
1. The new partner can invest cash or other assets into an existing partnership while the current partners remain in the partnership.
2. The new partner can purchase all or part of the interest of a current partner, making payment directly to the partner and not to the partnership. If the new partner buys an existing partner’s entire interest, the existing partner leaves the partnership.
The new partner’s investment, share of ownership capital, and share of the net income or loss are all negotiated in the process of developing the new partnership agreement. Based on how a partner is admitted, oftentimes the admission can create a situation to be illustrated called a bonus to those in the partnership. A bonus is the difference between the value of a partner’s capital account and the cash payment made at the time of that partner’s or another partner’s withdrawal.
Admission of New Partner—No Bonus
Whenever a new partner is admitted to the partnership, a new capital account must be opened for him or her. This will allow the partnership to reflect the new members of the partnership.
The purchase of an existing partner’s ownership by a new partner is a personal transaction that involves the existing partner and the new partner without otherwise affecting the records of the partnership. Accounting for this method is very straightforward. The only changes that are recorded on the partnership’s books occur in the two partners’ capital accounts. The existing partner’s capital account is debited and, after being created, the new partner’s capital account is credited.
To illustrate, Dale decides to sell his interest in Acorn Lawn & Hardscapes to Remi. Since this is a personal transaction, the only entry Acorn needs to make is to record the transfer of partner interest from Dale to Remi on its books.
No other entry needs to be made. Note that the entry is a paper transfer—it is to move the balance in the capital account. The amount paid by Remi to Dale does not affect this entry.
If instead the new partner invests directly into the partnership, the change increases the assets of the partnership as well as the capital accounts. Suppose that, instead of buying Dale’s interest, Remi will join Dale and Ciara in the partnership. The following journal entry will be made to record the admission of Remi as a partner in Acorn Lawn & Hardscapes.
Admission of New Partner—Bonus to Old Partners
A bonus to the old partners can come about when the new partner’s investment in the partnership creates an inequity in the capital of the new partnership, such as when a new partner’s capital account is not proportionate to that of a previous partner. Because a change in ownership of a partnership produces a new partnership agreement, a bonus may be used to record the change in the ownership capital to prevent inequities among the partners.
A bonus to the old partner or partners increases (or credits) their capital balances. The amount of the increase depends on the income ratio before the new partner’s admission.
As an illustration, Remi is a skilled machine operator who will aid Acorn Lawn & Hardscapes in the building of larger projects. Assume the following information (Figure 15.6) for the partnership on the day Remi becomes a partner.
To allocate the \$10,000 bonus to the old partners, Dale and Ciara, make the following calculations:
Dale:(\$10,000×50%)Ciara:(\$10,000×50%)==\$5,000\$5,000Dale:(\$10,000×50%)=\$5,000Ciara:(\$10,000×50%)=\$5,000
The journal entry to record Remi’s admission to the partnership and the allocation of the bonus to Dale and Ciara is as shown.
Admission of New Partner—Bonus to New Partner
When the new partner’s investment may be less than his or her capital credit, a bonus to the new partner may be considered. Sometimes the partnership is more interested in the skills the new partner possesses than in any assets brought to the business. For instance, the new partner may have expertise in a particular field that would be beneficial to the partnership, or the new partner may be famous and can draw attention to the partnership as a result. This frequently happens with restaurants; many are named after sports celebrity partners. A bonus to a newly admitted partner can also occur when the book values of assets currently on the partnership’s books have a higher value than their fair market values.
A bonus to a new admitted partner decreases (or debits) the capital balances of the old partners. The amount of the decrease depends on the income ratio defined by the old partnership agreement in place before the new partner’s admission.
In our landscaping business example, suppose Remi receives a bonus based on his skills as a machine operator. Assume the following information (Figure 15.7) for the partnership on the day he becomes a partner.
To allocate the \$10,000 bonus that each of the old partners will contribute to the new partner, Remi, make the following calculations.
Dale:(\$10,000×50%)Ciara:(\$10,000×50%)==\$5,000\$5,000Dale:(\$10,000×50%)=\$5,000Ciara:(\$10,000×50%)=\$5,000
The journal entry to record Remi’s admission and the payment of his bonus in the partnership records is as follows:
Withdrawal of Partner
Now, let’s explore the opposite situation—when a partner withdraws from a partnership. Partners may withdraw by selling their equity in the business, through retirement, or upon death. The withdrawal of a partner, just like the admission of a new partner, dissolves the partnership, and a new agreement must be reached. As with a new partner, only the economic effect of the change in ownership is reflected on the books.
When existing partners buy out a retiring partner, the case is the opposite of admitting a new partner, but the transaction is similar. The existing partners use personal assets to acquire the withdrawing partner’s equity and, as a result, the partnership’s assets are not affected. The only effect in the partnership’s records is the change in capital accounts. For example, assume that, after much discussion, Dale is ready to retire. Each partner has capital account balances of \$60,000. Ciara and Remi agree to pay Dale \$30,000 each to close out his partnership account. To record the withdrawal of Dale from the partnership, the journal entry is as follows:
Note that there is no change to the net assets of Acorn Lawn & Hardscapes—only a change in the capital accounts. Ciara and Remi now have to create a new partnership agreement to reflect their new situation.
Partnership Buys Out Withdrawing Partner
When a partnership buys out a withdrawing partner, the terms of the buy-out should follow the partnership agreement. Using partnership assets to pay for a withdrawing partner is the opposite of having a new partner invest in the partnership. In accounting for the withdrawal by payment from partnership assets, the partnership should consider the difference, if any, between the agreed-upon buy-out dollar amount and the balance in the withdrawing partner’s capital account. That difference is a bonus to the retiring partner.
This situation occurs when:
1. The partnership’s fair market value of assets exceeds the book value.
2. Goodwill resulting from the partnership has not been accounted for.
3. The remaining partners urgently want the withdrawing partner to exit or want to show their appreciation of the partner’s contributions.
The partnership debits (or reduces) the bonus from the remaining partners’ capital balances on the basis of their income ratio at the time of the buy-out. To illustrate, Acorn Lawn & Hardscapes is appreciative of the hard work that Dale has put into its success and would like to pay him a bonus. Dale, Ciara, and Remi each have capital account balances of \$60,000 at the time of Dale’s retirement. Acorn Lawn & Hardscapes intends to pay Dale \$80,000 for his interest. Ciara and Remi will do this as follows:
1. Calculate the amount of the bonus. This is done by subtracting Dale’s capital account balance from the cash payment: (\$80,000 – \$60,000) = \$20,000.
2. Allocate the cost of the bonus to the remaining partners on the basis of their income ratio. This calculation comes to \$10,000 each for Ciara and Remi (\$20,000 × 50%).
The journal entry to record Dale’s retirement from the partnership and the bonus payment to reflect his withdrawal is as shown:
In some cases, the retiring partner may give a bonus to the remaining partners. This can happen when:
1. Recorded assets are overvalued.
2. The partnership is not performing well.
3. The partner urgently wants to leave the partnership
In these cases, the cash paid by the partnership to the retiring partner is less than the balance in his or her capital account. As a result, the other partners receive a bonus to their capital accounts based on the income-sharing ratio established prior to the withdrawal.
As an example, each of three partners of Acorn Lawn & Hardscapes has a capital balance of \$60,000. Dale has another opportunity and is eager to move on. He is willing to accept \$50,000 cash in order to retire. The difference between this cash amount and Dale’s capital account is a bonus to the remaining partners. The bonus will be allocated to Ciara and Remi based on the income ratio at the time of Dale’s departure.
The journal entry to record Dale’s withdrawal and the bonus to Ciara and Remi is as shown:
When a partner passes away, the partnership dissolves. Most partnership agreements have provisions for the surviving partners to continue operating the partnership. Typically, a valuation is performed at the date of death, and the remaining partners settle with the deceased partner’s estate either directly with cash or through distribution of the partnership’s assets. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/15%3A_Partnership_Accounting/15.04%3A_Prepare_Journal_Entries_to_Record_the_Admission_and_Withdrawal_of_a_Partner.txt |
Partnerships dissolve. Sometime the decision is made to close the business. Sometimes there is a bankruptcy. Partner negligence, retirement, death, poor cash flow, and change in business practices are just some of the reasons for closing down.
ETHICAL CONSIDERATIONS
Ethical Partnership Dissolution
In most dissolutions of a partnership, the business partners need to decide what will happen to the partnership itself. A partnership may be dissolved, but that may not end business operations. If the partnership’s business operations are to continue, the partnership must decide what to do with its customers or clients, particularly those primarily served by a partner leaving the business. An ethical partnership will notify its customers and clients of the change and whether and how the partnership is going to continue as a business under a new partnership agreement. Partners who are unable to agree on how to notify their customers and clients should look to the Uniform Partnership Act, Article 8, which outlines the general obligations and duties of partners when a partnership is dissolved.
A partner’s duties and obligation upon dissolution describe what the departing partner owes to the partnership and the other partners in duties of loyalty and care, which are the basic fiduciary duties of a partner prior to dissolution, as outlined in Section 409 of the Uniform Partnership Act. The one change upon dissolution is that “each partner’s duty not to compete ends when the partnership dissolves.” The Act states that “the dissolution of a partnership is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.”1 This may not terminate the partnership’s business operations, but the partner’s obligations under the dissolved partnership agreement will end, regardless of how the remaining partners create a new partnership.
The departure or removal of a partner or partners and the resulting creation of a new partnership may be tricky, because all original partners owe each other the duty of fairness and loyalty until the dissolution has been completed. All the partners, departing or otherwise, are required to behave in a fashion that does not hurt business operations and avoid putting their individual interests ahead of the interests of the soon-to-be-dissolved partnership. Once the partnership has been dissolved, the departing partners no longer have an obligation to their old business partners.
Fundamentals of Partnership Dissolution
The liquidation or dissolution process for partnerships is similar to the liquidation process for corporations. Over a period of time, the partnership’s non-cash assets are converted to cash, creditors are paid to the extent possible, and remaining funds, if any, are distributed to the partners. Partnership liquidations differ from corporate liquidations in some respects, however:
1. General partners, as you may recall, have unlimited liability. Any general partner may be asked to contribute additional funds to the partnership if its assets are insufficient to satisfy creditors’ claims.
2. If a general partner does not make good on his or her deficit capital balance, the remaining partners must absorb that deficit balance. Absorption of the partner’s deficit balance gives the absorbing partner legal recourse against the deficit partner.
Recording the Dissolution Process
As discussed above, the liquidation or dissolution of a partnership is synonymous with closing the business. This may occur due to mutual partner agreement to sell the business, the death of a partner, or bankruptcy. Before proceeding with liquidation, the partnership should complete the accounting cycle for its final operational period. This will require closing the books with only balance sheet accounts remaining. Once that process has been completed, four steps remain in the accounting for the liquidation, each requiring an accounting entry. They are:
• Step 1: Sell noncash assets for cash and recognize a gain or loss on realization. Realization is the sale of noncash assets for cash.
• Step 2: Allocate the gain or loss from realization to the partners based on their income ratios.
• Step 3: Pay partnership liabilities in cash.
• Step 4: Distribute any remaining cash to the partners on the basis of their capital balances.
These steps must be performed in sequence. Partnerships must pay creditors prior to distributing funds to partners. At liquidation, some partners may have a deficiency in their capital accounts, or a debit balance.
Let’s consider an example. Football Partnership is liquidated; its balance sheet after closing the books is shown in Figure 15.8.
The partners of Football Partnership agree to liquidate the partnership on the following terms:
1. All the partnership assets will be sold to Hockey Partnership for \$60,000 cash.
2. The partnership will satisfy the liabilities.
3. The income ratio will be 3:2:1 to partners Raven, Brown, and Eagle respectively. (Another way of saying this is 3/6:2/6:1/6.)
4. The remaining cash will be distributed to the partners based on their capital account basis.
The journal entry to record the sale of assets to Hockey Partnership (Step 1) is as shown:
The journal entry to allocate the gain on realization among the partners’ capital accounts in the income ratio of 3:2:1 to Raven, Brown, and Eagle, respectively (Step 2), is as shown:
The journal entry for Football Partnership to pay off the liabilities (Step 3) is as shown:
The journal entry to distribute the remaining cash to the partners based on their capital account basis (Step 4) is as shown: | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/15%3A_Partnership_Accounting/15.05%3A_Discuss_and_Record_Entries_for_the_Dissolution_of_a_Partnership.txt |
15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
• There are many advantages and disadvantages of partnership as a form of business entity and they should be carefully considered.
• The most significant advantage of partnerships is the exemption from tax at the business level. Partners are taxed on their share of the profit or loss at their individual tax rates.
• Mutual agency and unlimited liability should be weighed against the tax benefits of partnership.
• There are other entity forms that have many of the characteristics of standard partnerships. These other entity forms often share the legal liability protection of corporations, and the tax and personal benefits of a partnership.
15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
• Partners must consider several factors when developing their partnership agreement, such as the contributions and authority of each partner and a means to resolve disputes.
• Non-cash assets such as equipment and prepaid expenses should be recorded at current market values.
• Partners are sometimes given an ownership interest based on their expertise or experience instead of any contributed assets.
• Liabilities assumed by the partnership should be recorded at their current value.
15.3 Compute and Allocate Partners’ Share of Income and Loss
• There are several different approaches to sharing the income or loss of a partnership, including fixed ratios, capital account balances, and combinations of the two.
15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
• There are two different methods for admitting a new partner to a partnership—direct investment to the partnership (affects partnership assets) and transaction among partners (does not affect partnership assets).
• There are two different methods for a partner to withdraw from a partnership—direct payment from the partnership and direct payment from the partners.
15.5 Discuss and Record Entries for the Dissolution of a Partnership
• There are times, such as following bankruptcy, death, or retirement, when a partnership ceases operation.
• The following four accounting steps must be taken, in order, to dissolve a partnership: sell noncash assets; allocate any gain or loss on the sale based on the income-sharing ratio in the partnership agreement; pay off liabilities; distribute any remaining cash to partners based on their capital account balances.
Key Terms
bonus
difference between the value of a partner’s capital account and the cash payment made at the time of that partner’s or another partner’s withdrawal
capital account
equity account for each partner that tracks all activities such as profit sharing, reductions due to distributions, and contributions by partners to partnership
dissolution
closing down of a partnership for economic, personal, or other reasons that may be unique to the particular partnership
general partnership
partnership in which each partner is personally liable to the partnership’s creditors if the partnership has insufficient assets to pay its creditors
limited liability
form of legal liability in which a partner’s obligation to creditors is limited to his or her capital contributions to the firm
limited liability partnership (LLP)
partnership that provides all partners with limited personal liability against all other partners’ obligations
limited partnership (LP)
partnership in which at least one partner is a general partner but the remaining partners can be limited partners, which means they are liable only for their own investment in the firm if the partnership cannot pay its creditors; thus, their personal assets are not at risk
liquidation
(also, dissolution) process of selling off non-cash assets
mutual agency
ability of each partner to act as an agent of the partnership in dealing with persons outside the partnership
partner
individuals, corporations, and even other partnerships participating in a partnership entity
partnership
legal business structure consisting of an association of two or more people who contribute money, property, or services to operate as co-owners of a business
partnership agreement
document that details the partners’ role, the way profits and loss are shared, and the contributions each partner makes to the partnership
realization
the sale of noncash assets for cash
unlimited liability
form of legal liability in which general partners are liable for all business debts if the business cannot meet its liabilities. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/15%3A_Partnership_Accounting/15.06%3A_Summary.txt |
Multiple Choice
1.
LO 15.1A partnership ________.
1. has one owner
2. can issue stock
3. pays taxes on partnership income
4. can have more than one general partner
2.
LO 15.1Any assets invested by a particular partner in a partnership ________.
1. do not become a partnership asset but instead remain with the partner
2. can be used only by the investing partner
3. become the property of all the partners
4. are the basis for all profit sharing
3.
LO 15.1Which of the following is a disadvantage of the partnership form of organization?
1. limited life
2. no taxation at the partnership level
3. flexibility in business operations
4. combining of financial resources
4.
LO 15.1Mutual agency is defined as:
1. a mutual agreement
2. the right of all partners to represent the company’s normal business operations
3. a synonym for partnership
4. a partnership between two partnerships
5.
LO 15.2Chani contributes equipment to a partnership that she purchased 2 years ago for \$10,000. The current book value is \$7,500 and the market value is \$9,000. At what value should the partnership record the equipment?
1. \$10,000
2. \$9,000
3. \$7,500
4. none of the above
6.
LO 15.2Juan contributes marketable securities to a partnership. The book value of the securities is \$7,000 and they have a current market value of \$10,000. What amount should the partnership record in Juan’s Capital account due to this contribution?
1. \$10,000
2. \$7,000
3. \$3,000
4. none of the above
7.
LO 15.2Which one of the following would not be considered in the development of a partnership agreement?
1. profit and loss levels
2. processing disputes
3. stock options
4. asset contributions
8.
LO 15.3A well written partnership agreement should include each of the following except ________.
1. how to settle disputes
2. the name of the partnership
3. division of responsibilities
4. Partner’s individual tax rate
9.
LO 15.3What type of assets may a partner not contribute to a partnership?
1. accounts receivable
2. furniture
3. equipment
4. personal credit cards
10.
LO 15.3How does a newly formed partnership handle the contribution of previously depreciated assets?
1. continues the depreciation life as if the owner had not changed
2. starts over, using the contributed value as the new cost basis
3. shortens the useful life of the asset per the partnership agreement
4. does not depreciate the contributed asset
11.
LO 15.4Thandie and Marco are partners with capital balances of \$60,000. They share profits and losses at 50% each. Chris contributes \$30,000 to the partnership for a 1/3 share. What amount should the partnership record as a bonus to Chris?
1. \$20,000
2. \$15,000
3. \$10.500
4. \$5,000
12.
LO 15.4Thandie and Marco are partners with capital balances of \$60,000. They share profits and losses at 50%. Chris contributes \$30,000 to the partnership for a 1/3 share. What amount should Thandie’s capital balance in the partnership be?
1. \$60,000
2. \$50,000
3. \$45,000
4. \$30,000
13.
LO 15.4Thandie and Marco are partners with capital balances of \$60,000. They share profits and losses at 50%. Chris contributes \$90,000 to the partnership for a 1/3 share. What amount should the partnership record as an individual bonus to each of the old partners?
1. \$10,000
2. \$7,000
3. \$3,000
4. \$20,000
14.
LO 15.4Thandie and Marco are partners with capital balances of \$60,000. They share profits and losses at 50%. Chris contributes \$60,000 to the partnership for a 1/3 share. What amount should the partnership record as an individual bonus to each of the old partners?
1. \$10,000
2. \$7,000
3. \$0
4. \$5,000
15.
LO 15.5When a partnership dissolves, the first step in the dissolution process is to ________.
1. allocate the gain or loss on sale based on income sharing ratio
2. pay off liabilities
3. sell noncash assets
4. divide the remaining cash among the partners
16.
LO 15.5When a partnership dissolves, the last step in the dissolution process is to ________.
1. allocate the gain or loss on sale based on income sharing ratio
2. pay off liabilities
3. sell noncash assets
4. divide the remaining cash among the partners
17.
LO 15.5Prior to proceeding with the liquidation, the partnership should ________.
1. prepare adjusting entries without closing
2. complete the accounting cycle for final operational period
3. prepare only closing entries
4. complete financial statements only
Questions
1.
LO 15.1Does a partnership pay income tax?
2.
LO 15.1Can a partner’s personal assets in a limited liability partnership be at risk?
3.
LO 15.2Can a partnership assume liabilities as part of one of the partner’s contributions?
4.
LO 15.2Does each partner have to contribute an equal amount of assets in order to split profit and losses?
5.
LO 15.3What types of bases for dividing partnership net income or net loss are available?
6.
LO 15.3Angela and Agatha are partners in Double A Partners. When they withdraw cash for personal use, how should that be recorded in the accounting records?
7.
LO 15.3On February 3, 2016 Sam Singh invested \$90,000 cash for a 1/3 interest in a newly formed partnership. Prepare the journal entry to record the transaction.
8.
LO 15.5Why do partnerships dissolve?
9.
LO 15.5What are the four steps involved in liquidating a partnership?
10.
LO 15.5When a partner withdraws from the firm, which accounts are affected?
11.
LO 15.5What is the first step in a partnership liquidation (termination and sale of assets)?
12.
LO 15.5When a partnership liquidates, do partners get paid first or do creditors get paid first?
13.
LO 15.5Coffee Partners decides to close due to the increased competition from the national chains. If after liquidating the noncash assets there is not enough cash to cover accounts payable, what happens?
Exercise Set A
EA1.
LO 15.2On May 1, 2017, BJ and Paige formed a partnership. Each contributed assets with the following agreed-upon valuations.
Prepare a separate journal entry to record each partner’s contributions.
EA2.
LO 15.3The partnership of Chase and Chloe shares profits and losses in a 70:30 ratio respectively after Chloe receives a \$10,000 salary. Prepare a schedule showing how the profit and loss should be divided, assuming the profit or loss for the year is:
1. \$ 30,000
2. \$ 6,000
3. (\$10,000)
EA3.
LO 15.4The partnership of Tasha and Bill shares profits and losses in a 50:50 ratio, and the partners have capital balances of \$45,000 each. Prepare a schedule showing how the bonus should be divided if Ashanti joins the partnership with a \$60,000 investment. The partner’s new agreement will share profit and loss in a 1:3 ratio.
EA4.
LO 15.5Cheese Partners has decided to close the store. At the date of closing, Cheese Partners had the following account balances:
A competitor agrees to buy the inventory and store fixtures for \$20,000. Prepare the journal entries detailing the liquidation, assuming that partners Colette and Swarma are sharing profits on a 50:50 basis:
Exercise Set B
EB1.
LO 15.4The partnership of Michelle, Amal, and Maureen has done well. The three partners have shared profits and losses in a 1:3 ratio, with capital balances of \$60,000 each. Maureen wants to retire and withdraw. Prepare a schedule showing how the cost should be divided if Amal and Michelle decide to pay Maureen \$70,000 for retirement of her capital account and the new agreement will share profits and losses 50:50.
Problem Set A
PA1.
LO 15.3The partnership of Tatum and Brook shares profits and losses in a 60:40 ratio respectively after Tatum receives a 10,000 salary and Brook receives a 15,000 salary. Prepare a schedule showing how the profit and loss should be divided, assuming the profit or loss for the year is:
1. \$40,000
2. \$25,000
3. (\$5,000)
In addition, show the resulting entries to each partner’s capital account. Tatum’s capital account balance is \$50,000 and Brook’s is \$60,000.
PA2.
LO 15.4Arun and Margot want to admit Tammy as a third partner for their partnership. Their capital balances prior to Tammy’s admission are \$50,000 each. Prepare a schedule showing how the bonus should be divided among the three, assuming the profit or loss agreement will be 1:3 once Tammy has been admitted and her contribution is:
1. \$20,000
2. \$80,000
3. \$50,000.
In addition, show the resulting journal entries to each of the three partners’ capital accounts.
PA3.
LO 15.5When a partnership is liquidated, any gains or losses realized by the sale of noncash assets are allocated to the partners based on their income sharing ratio. Why?
Problem Set B
PB1.
LO 15.3The partnership of Magda and Sue shares profits and losses in a 50:50 ratio after Mary receives a \$7,000 salary and Sue receives a \$6,500 salary. Prepare a schedule showing how the profit and loss should be divided, assuming the profit or loss for the year is:
1. \$10,000
2. \$5,000
3. (\$12,000)
In addition, show the resulting entries to each partner’s capital account.
PB2.
LO 15.4The partnership of Arun, Margot, and Tammy has been doing well. Arun wants to retire and move to another state for a once-in-a-lifetime opportunity. The partners’ capital balances prior to Arun’s retirement are \$60,000 each. Prepare a schedule showing how Arun’s withdrawal should be divided assuming his buyout is:
1. \$70,000
2. \$45,000
3. \$60,000.
In addition, show the resulting entries to the capital accounts of each of the three.
PB3.
LO 15.5Match each of the following descriptions with the appropriate term related to partnership accounting.
A. Each and every partner can enter into contracts on behalf of the partnership i. liquidation
B. The business ceases operations. ii. capital deficiency
C. How partners share in income and loss iii. admission of a new partner
D. Adding a new partner by contributing cash iv. mutual agency
E. A partner account with a debit balance v. income sharing ratio
Thought Provokers
TP1.
LO 15.1While sole proprietorships and corporations are the most popular forms of business organization, the limited liability company (LLC) is a close third. Limited liability companies are treated like partnerships in the majority of situations. Why do you think LLCs are gaining in popularity?
TP2.
LO 15.5A partnership is thriving. The three partners get along well; they complement each other’s skill sets and enjoy each other’s company. One of the partners, Melinda, begins to behave differently. She begins coming to work late or not at all. On several occasions she is spotted leaving the hotel next door in the afternoon. The other partners are concerned about the change in her behavior. They confront her and Melinda denies that anything is different. She points out that her work is still getting done and that she wants a little more flexibility in her hours. The other partners are not convinced and decide to terminate the partnership agreement. Can the other partners break the agreement? What considerations must the partners take into account? | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/15%3A_Partnership_Accounting/15.07%3A_Practice_Questions.txt |
Most financial accounting processes focus on the accrual basis of accounting, which reflects revenue earned, regardless of whether that revenue has been collected or not, and the related costs involved in producing that revenue, whether those costs have been paid or not. Yet the single-minded focus on accrued revenues and expenses, without consideration of the cash impact of these transactions, can jeopardize the ability of users of the financial statements to make well-informed decisions.
Some investors say that “cash is king,” meaning that they think a company’s cash flow is more important than its net income in determining investment opportunities. Companies go bankrupt because they run out of cash. Financial statement users should be able to develop a picture of how well a company’s net income generates cash and the sources and uses of a company’s cash. From the statement of cash flows, it becomes possible to reconcile income on the income statement to the cash actually generated during the same period. Having cash alone is not important, but the source and use of cash are also important, specifically where the cash is coming from. If the business is generating cash from operations (selling products and services), that is positive. If the company only has cash as it is taking out loans and selling assets, one must be careful in their analysis.
16.01: Explain the Purpose of the Statement of Cash Flows
The statement of cash flows is a financial statement listing the cash inflows and cash outflows for the business for a period of time. Cash flow represents the cash receipts and cash disbursements as a result of business activity. The statement of cash flows enables users of the financial statements to determine how well a company’s income generates cash and to predict the potential of a company to generate cash in the future.
Accrual accounting creates timing differences between income statement accounts and cash. A revenue transaction may be recorded in a different fiscal year than the year the cash related to that revenue is received. One purpose of the statement of cash flows is that users of the financial statements can see the amount of cash inflows and outflows during a year in addition to the amount of revenue and expense shown on the income statement. This is important because cash flows often differ significantly from accrual basis net income. For example, assume in 2019 that Amazon showed a loss of approximately \$720 million, yet Amazon’s cash balance increased by more than \$91 million. Much of the change can be explained by timing differences between income statement accounts and cash receipts and distributions.
A related use of the statement of cash flows is that it provides information about the quality of a company’s net income. A company that has records that show significantly less cash inflow on the statement of cash flows than the reported net income on the income statement could very well be reporting revenue for which cash will never be received from the customer or underreporting expenses.
A third use of the statement of cash flows is that it provides information about a company’s sources and uses of cash not related to the income statement. For example, assume in 2019 that Amazon spent \$287 million on purchasing fixed assets and almost \$370 million acquiring other businesses. This indicated to financial statement users that Amazon was expanding even as it was losing money. Investors must have thought that spending was good news as Amazon was able to raise more than \$1 billion in borrowings or stock issuances in 2019.
ETHICAL CONSIDERATIONS
Cash Flow Statement Reporting
US generally accepted accounting principles (GAAP) has codified how cash flow statements are to be presented to users of financial statements. This was codified in Topic 230: Statement of Cash Flows as part of US GAAP.1 Accountants in the United States should follow US GAAP. Accountants working internationally must report in accordance with International Accounting Standard (IAS) 7 Statement of Cash Flows.2 The ethical accountant understands the users of a company’s financial statement and properly prepares a Statement of Cash Flow. There is often more than one way that financial statements can be presented, such as US GAAP and International Financial Reporting Standards (IFRS). What if a company under US GAAP showed reporting issues on their financial statements and switched to IFRS where results looked better. Is this proper? Does this occur?
The statement of cash flows identifies the sources of cash as well as the uses of cash, for the period being reported, which leads the user of the financial statement to the period’s net cash flows, which is a method used to determine profitability by measuring the difference between an entity’s cash inflows and cash outflows. The statement answers the following two questions: What are the sources of cash (where does the cash come from)? What are the uses of cash (where does the cash go)? A positive net cash flow indicates an increase in cash during the reporting period, whereas a negative net cash flow indicates a decrease in cash during the reporting period. The statement of cash flows is also used as a predictive tool for external users of the financial statements, for estimated future cash flows, based on cash flow results in the past.
LINK TO LEARNING
This video from Khan Academy explains cash flows in a unique way.
Approaches to Preparing the Statement of Cash Flows
The statement of cash flows can be prepared using the indirect approach or the direct approach. The indirect method approach reconciles net income to cash flows by subtracting noncash expenses and adjusting for changes in current assets and liabilities, which reflects timing differences between accrual-based net income and cash flows. A noncash expense is an expense that reduces net income but is not associated with a cash flow; the most common example is depreciation expense. The direct methodlists net cash flows from revenue and expenses, whereby accrual basis revenue and expenses are converted to cash basis collections and payments. Because the vast majority of financial statements are presented using the indirect method, the indirect approach will be demonstrated within the chapter, and the direct method will be demonstrated in Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method.
LINK TO LEARNING
AccountingCoach is a great resource for many accounting topics, including cash flow issues.
Footnotes
• 1 Financial Accounting Standards Board (FASB). “Statement of Cash Flows (Topic 230) Classification of Certain Cash Receipts and Cash Payments.” An Amendment of the FASB Accounting Standards Codification. August 2016. https://asc.fasb.org/imageRoot/55/95454355.pdf
• 2 International Financial Reporting Standards (IFRS). “IAS 7 Statement of Cash Flows.” n.d. www.ifrs.org/issued-standard...of-cash-flows/ | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/16%3A_Statement_of_Cash_Flows/16.00%3A_Prelude_to_Statements_of_Cash_Flows.txt |
The statement of cash flows presents sources and uses of cash in three distinct categories: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Financial statement users are able to assess a company’s strategy and ability to generate a profit and stay in business by assessing how much a company relies on operating, investing, and financing activities to produce its cash flows.
THINK IT THROUGH
Classification of Cash Flows Makes a Difference
Assume you are the chief financial officer of T-Shirt Pros, a small business that makes custom-printed T-shirts. While reviewing the financial statements that were prepared by company accountants, you discover an error. During this period, the company had purchased a warehouse building, in exchange for a \$200,000 note payable. The company’s policy is to report noncash investing and financing activities in a separate statement, after the presentation of the statement of cash flows. This noncash investing and financing transaction was inadvertently included in both the financing section as a source of cash, and the investing section as a use of cash.
T-Shirt Pros’ statement of cash flows, as it was prepared by the company accountants, reported the following for the period, and had no other capital expenditures.
Because of the misplacement of the transaction, the calculation of free cash flow by outside analysts could be affected significantly. Free cash flow is calculated as cash flow from operating activities, reduced by capital expenditures, the value for which is normally obtained from the investing section of the statement of cash flows. As their manager, would you treat the accountants’ error as a harmless misclassification, or as a major blunder on their part? Explain.
Cash Flows from Operating Activities
Cash flows from operating activities arise from the activities a business uses to produce net income. For example, operating cash flows include cash sources from sales and cash used to purchase inventory and to pay for operating expenses such as salaries and utilities. Operating cash flows also include cash flows from interest and dividend revenue interest expense, and income tax.
Cash Flows from Investing Activities
Cash flows from investing activities are cash business transactions related to a business’ investments in long-term assets. They can usually be identified from changes in the Fixed Assets section of the long-term assets section of the balance sheet. Some examples of investing cash flows are payments for the purchase of land, buildings, equipment, and other investment assets and cash receipts from the sale of land, buildings, equipment, and other investment assets.
Cash Flows from Financing Activities
Cash flows from financing activities are cash transactions related to the business raising money from debt or stock, or repaying that debt. They can be identified from changes in long-term liabilities and equity. Examples of financing cash flows include cash proceeds from issuance of debt instruments such as notes or bonds payable, cash proceeds from issuance of capital stock, cash payments for dividend distributions, principal repayment or redemption of notes or bonds payable, or purchase of treasury stock. Cash flows related to changes in equity can be identified on the Statement of Stockholder’s Equity, and cash flows related to long-term liabilities can be identified by changes in long-term liabilities on the balance sheet.
CONCEPTS IN PRACTICE
Can a Negative Be Positive?
Investors do not always take a negative cash flow as a negative. For example, assume in 2018 Amazon showed a loss of \$124 billion and a net cash outflow of \$262 billion from investing activities. Yet during the same year, Amazon was able to raise a net \$254 billion through financing. Why would investors and lenders be willing to place money with Amazon? For one thing, despite having a net loss, Amazon produced \$31 billion cash from operating activities. Much of this was through delaying payment on inventories. Amazon’s accounts payable increased by \$78 billion, while its inventory increased by \$20 billion.
Another reason lenders and investors were willing to fund Amazon is that investing payments are often signs of a company growing. Assume that in 2018 Amazon paid almost \$50 billion to purchase fixed assets and to acquire other businesses; this is a signal of a company that is growing. Lenders and investors interpreted Amazon’s cash flows as evidence that Amazon would be able to produce positive net income in the future. In fact, Amazon had net income of \$19 billion in 2017. Furthermore, Amazon is still showing growth through its statement of cash flows; it spent about \$26 billion in fixed equipment and acquisitions. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/16%3A_Statement_of_Cash_Flows/16.02%3A_Differentiate_between_Operating_Investing_and_Financing_Activities.txt |
The statement of cash flows is prepared by following these steps:
Step 1: Determine Net Cash Flows from Operating Activities
Using the indirect method, operating net cash flow is calculated as follows:
• Begin with net income from the income statement.
• Add back noncash expenses, such as depreciation, amortization, and depletion.
• Remove the effect of gains and/or losses from disposal of long-term assets, as cash from the disposal of long-term assets is shown under investing cash flows.
• Adjust for changes in current assets and liabilities to remove accruals from operating activities.
Step 2: Determine Net Cash Flows from Investing Activities
Investing net cash flow includes cash received and cash paid relating to long-term assets.
Step 3: Present Net Cash Flows from Financing Activities
Financing net cash flow includes cash received and cash paid relating to long-term liabilities and equity.
Step 4: Reconcile Total Net Cash Flows to Change in Cash Balance during the Period
To reconcile beginning and ending cash balances:
• The net cash flows from the first three steps are combined to be total net cash flow.
• The beginning cash balance is presented from the prior year balance sheet.
• Total net cash flow added to the beginning cash balance equals the ending cash balance.
Step 5: Present Noncash Investing and Financing Transactions
Transactions that do not affect cash but do affect long-term assets, long-term debt, and/or equity are disclosed, either as a notation at the bottom of the statement of cash flow, or in the notes to the financial statements.
The remainder of this section demonstrates preparation of the statement of cash flows of the company whose financial statements are shown in Figure 16.2, Figure 16.3, and Figure 16.4.
Additional Information:
1. Propensity Company sold land with an original cost of \$10,000, for \$14,800 cash.
2. A new parcel of land was purchased for \$20,000, in exchange for a note payable.
3. Plant assets were purchased for \$40,000 cash.
4. Propensity declared and paid a \$440 cash dividend to shareholders.
5. Propensity issued common stock in exchange for \$45,000 cash.
Prepare the Operating Activities Section of the Statement of Cash Flows Using the Indirect Method
In the following sections, specific entries are explained to demonstrate the items that support the preparation of the operating activities section of the Statement of Cash Flows (Indirect Method) for the Propensity Company example financial statements.
• Begin with net income from the income statement.
• Add back noncash expenses, such as depreciation, amortization, and depletion.
• Reverse the effect of gains and/or losses from investing activities.
• Adjust for changes in current assets and liabilities, to reflect how those changes impact cash in a way that is different than is reported in net income.0
Start with Net Income
The operating activities cash flow is based on the company’s net income, with adjustments for items that affect cash differently than they affect net income. The net income on the Propensity Company income statement for December 31, 2018, is \$4,340. On Propensity’s statement of cash flows, this amount is shown in the Cash Flows from Operating Activities section as Net Income.
Add Back Noncash Expenses
Net income includes deductions for noncash expenses. To reconcile net income to cash flow from operating activities, these noncash items must be added back, because no cash was expended relating to that expense. The sole noncash expense on Propensity Company’s income statement, which must be added back, is the depreciation expense of \$14,400. On Propensity’s statement of cash flows, this amount is shown in the Cash Flows from Operating Activities section as an adjustment to reconcile net income to net cash flow from operating activities.
Reverse the Effect of Gains and/or Losses
Gains and/or losses on the disposal of long-term assets are included in the calculation of net income, but cash obtained from disposing of long-term assets is a cash flow from an investing activity. Because the disposition gain or loss is not related to normal operations, the adjustment needed to arrive at cash flow from operating activities is a reversal of any gains or losses that are included in the net income total. A gain is subtracted from net income and a loss is added to net income to reconcile to cash from operating activities. Propensity’s income statement for the year 2018 includes a gain on sale of land, in the amount of \$4,800, so a reversal is accomplished by subtracting the gain from net income. On Propensity’s statement of cash flows, this amount is shown in the Cash Flows from Operating Activities section as Gain on Sale of Plant Assets.
Adjust for Changes in Current Assets and Liabilities
Because the Balance Sheet and Income Statement reflect the accrual basis of accounting, whereas the statement of cash flows considers the incoming and outgoing cash transactions, there are continual differences between (1) cash collected and paid and (2) reported revenue and expense on these statements. Changes in the various current assets and liabilities can be determined from analysis of the company’s comparative balance sheet, which lists the current period and previous period balances for all assets and liabilities. The following four possibilities offer explanations of the type of difference that might arise, and demonstrate examples from Propensity Company’s statement of cash flows, which represent typical differences that arise relating to these current assets and liabilities.
Increase in Noncash Current Assets
Increases in current assets indicate a decrease in cash, because either (1) cash was paid to generate another current asset, such as inventory, or (2) revenue was accrued, but not yet collected, such as accounts receivable. In the first scenario, the use of cash to increase the current assets is not reflected in the net income reported on the income statement. In the second scenario, revenue is included in the net income on the income statement, but the cash has not been received by the end of the period. In both cases, current assets increased and net income was reported on the income statement greater than the actual net cash impact from the related operating activities. To reconcile net income to cash flow from operating activities, subtract increases in current assets.
Propensity Company had two instances of increases in current assets. One was an increase of \$700 in prepaid insurance, and the other was an increase of \$2,500 in inventory. In both cases, the increases can be explained as additional cash that was spent, but which was not reflected in the expenses reported on the income statement.
Decrease in Noncash Current Assets
Decreases in current assets indicate lower net income compared to cash flows from (1) prepaid assets and (2) accrued revenues. For decreases in prepaid assets, using up these assets shifts these costs that were recorded as assets over to current period expenses that then reduce net income for the period. Cash was paid to obtain the prepaid asset in a prior period. Thus, cash from operating activities must be increased to reflect the fact that these expenses reduced net income on the income statement, but cash was not paid this period. Secondarily, decreases in accrued revenue accounts indicates that cash was collected in the current period but was recorded as revenue on a previous period’s income statement. In both scenarios, the net income reported on the income statement was lower than the actual net cash effect of the transactions. To reconcile net income to cash flow from operating activities, add decreases in current assets.
Propensity Company had a decrease of \$4,500 in accounts receivable during the period, which normally results only when customers pay the balance, they owe the company at a faster rate than they charge new account balances. Thus, the decrease in receivable identifies that more cash was collected than was reported as revenue on the income statement. Thus, an addback is necessary to calculate the cash flow from operating activities.
Current Operating Liability Increase
Increases in current liabilities indicate an increase in cash, since these liabilities generally represent (1) expenses that have been accrued, but not yet paid, or (2) deferred revenues that have been collected, but not yet recorded as revenue. In the case of accrued expenses, costs have been reported as expenses on the income statement, whereas the deferred revenues would arise when cash was collected in advance, but the revenue was not yet earned, so the payment would not be reflected on the income statement. In both cases, these increases in current liabilities signify cash collections that exceed net income from related activities. To reconcile net income to cash flow from operating activities, add increases in current liabilities.
Propensity Company had an increase in the current operating liability for salaries payable, in the amount of \$400. The payable arises, or increases, when an expense is recorded but the balance due is not paid at that time. An increase in salaries payable therefore reflects the fact that salaries expenses on the income statement are greater than the cash outgo relating to that expense. This means that net cash flow from operating is greater than the reported net income, regarding this cost.
Current Operating Liability Decrease
Decreases in current liabilities indicate a decrease in cash relating to (1) accrued expenses, or (2) deferred revenues. In the first instance, cash would have been expended to accomplish a decrease in liabilities arising from accrued expenses, yet these cash payments would not be reflected in the net income on the income statement. In the second instance, a decrease in deferred revenue means that some revenue would have been reported on the income statement that was collected in a previous period. As a result, cash flows from operating activities must be decreased by any reduction in current liabilities, to account for (1) cash payments to creditors that are higher than the expense amounts on the income statement, or (2) amounts collected that are lower than the amounts reflected as income on the income statement. To reconcile net income to cash flow from operating activities, subtract decreases in current liabilities.
Propensity Company had a decrease of \$1,800 in the current operating liability for accounts payable. The fact that the payable decreased indicates that Propensity paid enough payments during the period to keep up with new charges, and also to pay down on amounts payable from previous periods. Therefore, the company had to have paid more in cash payments than the amounts shown as expense on the Income Statements, which means net cash flow from operating activities is lower than the related net income.
Analysis of Change in Cash
Although the net income reported on the income statement is an important tool for evaluating the success of the company’s efforts for the current period and their viability for future periods, the practical effectiveness of management is not adequately revealed by the net income alone. The net cash flows from operating activities adds this essential facet of information to the analysis, by illuminating whether the company’s operating cash sources were adequate to cover their operating cash uses. When combined with the cash flows produced by investing and financing activities, the operating activity cash flow indicates the feasibility of continuance and advancement of company plans.
Determining Net Cash Flow from Operating Activities (Indirect Method)
Net cash flow from operating activities is the net income of the company, adjusted to reflect the cash impact of operating activities. Positive net cash flow generally indicates adequate cash flow margins exist to provide continuity or ensure survival of the company. The magnitude of the net cash flow, if large, suggests a comfortable cash flow cushion, while a smaller net cash flow would signify an uneasy comfort cash flow zone. When a company’s net cash flow from operations reflects a substantial negative value, this indicates that the company’s operations are not supporting themselves and could be a warning sign of possible impending doom for the company. Alternatively, a small negative cash flow from operating might serve as an early warning that allows management to make needed corrections, to ensure that cash sources are increased to amounts in excess of cash uses, for future periods.
For Propensity Company, beginning with net income of \$4,340, and reflecting adjustments of \$9,500, delivers a net cash flow from operating activities of \$13,840.
YOUR TURN
Cash Flow from Operating Activities
Assume you own a specialty bakery that makes gourmet cupcakes. Excerpts from your company’s financial statements are shown.
How much cash flow from operating activities did your company generate?
Solution
THINK IT THROUGH
Explaining Changes in Cash Balance
Assume that you are the chief financial officer of a company that provides accounting services to small businesses. You are called upon by the board of directors to explain why your cash balance did not increase much from the beginning of 2018 until the end of 2018, since the company produced a reasonably strong profit for the year, with a net income of \$88,000. Further assume that there were no investing or financing transactions, and no depreciation expense for 2018. What is your response? Provide the calculations to back up your answer.
Prepare the Investing and Financing Activities Sections of the Statement of Cash Flows
Preparation of the investing and financing sections of the statement of cash flows is an identical process for both the direct and indirect methods, since only the technique used to arrive at net cash flow from operating activities is affected by the choice of the direct or indirect approach. The following sections discuss specifics regarding preparation of these two nonoperating sections, as well as notations about disclosure of long-term noncash investing and/or financing activities. Changes in the various long-term assets, long-term liabilities, and equity can be determined from analysis of the company’s comparative balance sheet, which lists the current period and previous period balances for all assets and liabilities.
Investing Activities
Cash flows from investing activities always relate to long-term asset transactions and may involve increases or decreases in cash relating to these transactions. The most common of these activities involve purchase or sale of property, plant, and equipment, but other activities, such as those involving investment assets and notes receivable, also represent cash flows from investing. Changes in long-term assets for the period can be identified in the Noncurrent Assets section of the company’s comparative balance sheet, combined with any related gain or loss that is included on the income statement.
In the Propensity Company example, the investing section included two transactions involving long-term assets, one of which increased cash, while the other one decreased cash, for a total net cash flow from investing of (\$25,200). Analysis of Propensity Company’s comparative balance sheet revealed changes in land and plant assets. Further investigation identified that the change in long-term assets arose from three transactions:
1. Investing activity: A tract of land that had an original cost of \$10,000 was sold for \$14,800.
2. Investing activity: Plant assets were purchased, for \$40,000 cash.
3. Noncash investing and financing activity: A new parcel of land was acquired, in exchange for a \$20,000 note payable.
Details relating to the treatment of each of these transactions are provided in the following sections.
Investing Activities Leading to an Increase in Cash
Increases in net cash flow from investing usually arise from the sale of long-term assets. The cash impact is the cash proceeds received from the transaction, which is not the same amount as the gain or loss that is reported on the income statement. Gain or loss is computed by subtracting the asset’s net book value from the cash proceeds. Net book value is the asset’s original cost, less any related accumulated depreciation. Propensity Company sold land, which was carried on the balance sheet at a net book value of \$10,000, representing the original purchase price of the land, in exchange for a cash payment of \$14,800. The data set explained these net book value and cash proceeds facts for Propensity Company. However, had these facts not been stipulated in the data set, the cash proceeds could have been determined by adding the reported \$4,800 gain on the sale to the \$10,000 net book value of the asset given up, to arrive at cash proceeds from the sale.
Investing Activities Leading to a Decrease in Cash
Decreases in net cash flow from investing normally occur when long-term assets are purchased using cash. For example, in the Propensity Company example, there was a decrease in cash for the period relating to a simple purchase of new plant assets, in the amount of \$40,000.
Financing Activities
Cash flows from financing activities always relate to either long-term debt or equity transactions and may involve increases or decreases in cash relating to these transactions. Stockholders’ equity transactions, like stock issuance, dividend payments, and treasury stock buybacks are very common financing activities. Debt transactions, such as issuance of bonds payable or notes payable, and the related principal payback of them, are also frequent financing events. Changes in long-term liabilities and equity for the period can be identified in the Noncurrent Liabilities section and the Stockholders’ Equity section of the company’s Comparative Balance Sheet, and in the retained earnings statement.
In the Propensity Company example, the financing section included three transactions. One long-term debt transaction decreased cash. Two transactions related to equity, one of which increased cash, while the other one decreased cash, for a total net cash flow from financing of \$34,560. Analysis of Propensity Company’s Comparative Balance Sheet revealed changes in notes payable and common stock, while the retained earnings statement indicated that dividends were distributed to stockholders. Further investigation identified that the change in long-term liabilities and equity arose from three transactions:
1. Financing activity: Principal payments of \$10,000 were paid on notes payable.
2. Financing activity: New shares of common stock were issued, in the amount of \$45,000.
3. Financing activity: Dividends of \$440 were paid to shareholders.
Specifics about each of these three transactions are provided in the following sections.
Financing Activities Leading to an Increase in Cash
Increases in net cash flow from financing usually arise when the company issues share of stock, bonds, or notes payable to raise capital for cash flow. Propensity Company had one example of an increase in cash flows, from the issuance of common stock.
Financing Activities Leading to a Decrease in Cash
Decreases in net cash flow from financing normally occur when (1) long-term liabilities, such as notes payable or bonds payable are repaid, (2) when the company reacquires some of its own stock (treasury stock), or (3) when the company pays dividends to shareholders. In the case of Propensity Company, the decreases in cash resulted from notes payable principal repayments and cash dividend payments.
Noncash Investing and Financing Activities
Sometimes transactions can be very important to the company, yet not involve any initial change to cash. Disclosure of these noncash investing and financing transactions can be included in the notes to the financial statements, or as a notation at the bottom of the statement of cash flows, after the entire statement has been completed. These noncash activities usually involve one of the following scenarios:
• exchanges of long-term assets for long-term liabilities or equity, or
• exchanges of long-term liabilities for equity.
Propensity Company had a noncash investing and financing activity, involving the purchase of land (investing activity) in exchange for a \$20,000 note payable (financing activity).
Summary of Investing and Financing Transactions on the Cash Flow Statement
Investing and financing transactions are critical activities of business, and they often represent significant amounts of company equity, either as sources or uses of cash. Common activities that must be reported as investing activities are purchases of land, equipment, stocks, and bonds, while financing activities normally relate to the company’s funding sources, namely, creditors and investors. These financing activities could include transactions such as borrowing or repaying notes payable, issuing or retiring bonds payable, or issuing stock or reacquiring treasury stock, to name a few instances.
YOUR TURN
Cash Flow from Investing Activities
Assume your specialty bakery makes gourmet cupcakes and has been operating out of rented facilities in the past. You owned a piece of land that you had planned to someday use to build a sales storefront. This year your company decided to sell the land and instead buy a building, resulting in the following transactions.
What are the cash flows from investing activities relating to these transactions?
Solution
Note: Interest earned on investments is an operating activity. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/16%3A_Statement_of_Cash_Flows/16.03%3A_Prepare_the_Statement_of_Cash_Flows_Using_the_Indirect_Method.txt |
In this section, we use the example of Virtual Co. to work through the entire process of preparing the company’s statement of cash flows using the indirect method. Virtual’s comparative balance sheet and income statement are provided as a base for the preparation of the statement of cash flows.
Review Problem: Preparing the Virtual Co. Statement of Cash Flows
Additional Information
The following additional information is provided:
1. Investments that originally cost \$30,000 were sold for \$47,500 cash.
2. Investments were purchased for \$50,000 cash.
3. Plant assets were purchased for \$66,000 cash.
4. Cash dividends were declared and paid to shareholders in the amount of \$8,000.
Directions:
Prepare the statement of cash flows (indirect method), for the year ended December 31, 2018.
16.05: Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
Cash flow ratio analysis allows financial statement users to see the company’s liquidity position from a clearer perspective. The ratios presented in this section focus on free cash flow, calculated as operating cash, reduced by expected capital expenditures and by cash dividends payments. The free cash flow value is thus an adaptation of cash flow from operating activities. The result obtained in the initial free cash flow calculation is then used to calculate the free cash flow to sales ratio, which is the ratio of free cash flow to sales revenue, and the free cash flow to assets ratio, which is the ratio of free cash flow to total assets. These three tools give indicators about the company’s flexibility and agility, which equates to their ability to seize opportunities in the future, as they arise.
ETHICAL CONSIDERATIONS
Cash Flow Analysis
Cash is required to pay the bills. All businesses need to have a clear picture of available cash so they can plan and pay their bills. The statement of cash flows allows investors direct insight into the actual activity on the company’s cash balances. Mark A. Siegel wrote in The CPA Journal that “as Wall Street analysts have lost faith in earnings-based metrics in the wake of Enron, WorldCom, and others, many have gravitated toward the cash flow statement. Companies are regularly evaluated on the basis of free cash flow yield and other measures of cash generation.”3 The operating cash flow ratio, and the cash flow margin ratio, and the other cash flow–related metrics discussed allow an investor and other users of the financial statements to analyze financial statement data to see a company’s ability to pay for current debt and assess its operational cash flow to function as a going concern.4 This helps investors and other users of the financial statements ensure the veracity of a company’s financial statements and its ability to pay its bills.
Free Cash Flow
Free cash flow calculations start with cash flows from operating activities, reduced by planned capital expenditures and planned cash dividend payments. In the example case demonstrated, free cash flow would be as follows:
Free cash flow calculation:
The absence of free cash flow is an indicator of severe liquidity concern for Propensity Company and could be an early indicator that the company may not be able to continue operations. This could also be a one-time occurrence, in a year where a large capital investment was planned, to be financed with resources from the company’s capital reserves from previous years’ profits. In such a case, the negative free cash flow would not be an issue of concern.
LINK TO LEARNING
This article by Investopedia presents information about how to use free cash flow to evaluate strengths of various businesses:
Cash Flows to Sales
The cash flows to sales ratio is computed by dividing free cash flow by sales revenue. In the Propensity Company case, free cash flow had a negative outcome, so the calculation would not be useful in this case.
Cash Flows to Assets
The cash flows to assets ratio is computed by dividing free cash flow by total assets. Again, when the free cash flow had a negative outcome, as it did in the Propensity Company example scenario, the calculation would not be useful
CONCEPTS IN PRACTICE
Lehman Brothers: Would You Have Invested?
Between 2005 and 2007, Lehman Brothers (an investment bank) increased its net income from \$3.1 billion to \$4.1 billion. It received nearly \$42 billion interest and dividends on its investments, a primary part of its business model, in 2007 alone. It also had \$7.2 billion available in cash at the end of 2007. Would you be interested in investing in Lehman Brothers? However, Lehman Brothers went bankrupt in September 2008; it was the biggest corporate bankruptcy in history. Could investors have known?
A clue would be its free cash ratio. Assuming that you would expect Lehman Brothers’ actual capital expenditures and dividend payments from 2007 be expected in 2008, Lehman’s free cash ratio would be calculated as, in millions:
Lehman Brothers invested heavily in securities created from subprime mortgages. When the subprime mortgage market collapsed in 2008, Lehman Brothers was not able to generate enough cash to stay in business. The large negative free cash flow gave warning that Lehman Brothers was a risky investment.
IFRS CONNECTION
Statement of Cash Flows
In every type of business across the globe, it is important to understand the business’s cash position. Analyzing cash inflows and outflows, current cash flow, and cash flow trends, and predicting future cash flows all importantly inform decision-making. The US Securities and Exchange Commission (SEC) requires the statement of cash flows as the mechanism that allows users to better assess a company’s cash position. US generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) set forth rules regarding the composition and presentation of the statement of cash flows.
• Method: Both GAAP and IFRS recommend and encourage the direct method of preparing the statement of cash flows but allow the indirect method. Under US GAAP, if the direct method is used, a reconciliation between net income and operating income must also be presented. This reconciliation is not required under IFRS.
• Presentation: The three categories—Cash Flows from Operating Activities, Cash Flows from Investing Activities, and Cash Flows from Financing Activities—are required under both US GAAP and IFRS. US GAAP requires the presentation of only one year of information, while IFRS requires two years of data.
• Categorizing Transactions: IFRS is more flexible in where to present certain cash flow transactions than is US GAAP. This flexibility occurs around interest, dividends, and taxes. As shown in Table 16.1, US GAAP is more rigid in reporting.
Comparing GAAP and IFRS
US GAAP IFRS
Interest paid Operating Operating or financing
Interest received Operating Operating or investing
Dividends paid Financing Operating or financing
Dividends received Operating Operating or investing
Taxes Operating Usually operating but option to dissect tax into operating and financing components
Table16.1
Understanding the impact of these potential differences is important. The statement of cash flows is used not only to evaluate from where a company receives and spends its cash, but also to predict future cash flows. The flexibility of these reporting items in the statement of cash flows can result in decreased comparability between similar companies using different reporting methods. For example, Free Cash Flow (Operating Cash Flows less Capital Expenditures), will have different results if interest and dividends are classified in sections other than operating activities.
Let’s consider an example: World-Wide Co. is headquartered in London and currently reports under US GAAP because it is traded on the New York Stock Exchange (NYSE). World-Wide is considering switching to reporting under IFRS to make the company more comparable to its competitors, since most of them use IFRS. World-Wide has the following information in the operating activities section of its most recent statement of cash flows.
World-Wide had \$1,000,000 in capital expenditures during the year, and they paid dividends of \$80,000 to shareholders.
Based on this information, World-Wide’s Free Cash Flow would be as follows:
or
\$2,500,000 − \$1,000,000 = \$1,500,000
If World-Wide switches to IFRS reporting, it has determined that its cash interest payments would be classified as financing activities because the payments are related to long-term debt. The interest received is from a short-term receivable and thus will remain classified as an operating activity, but the dividends received are from a long-term investment and will be reclassified to an investing activity. And, \$60,000 of the taxes have been identified as being associated with tax consequences of an investing opportunity and therefore will be reclassified as an investing activity. With these reclassifications, the free cash flow of World-Wide would be as follows:
FCF = (\$2,500,000 + \$200,000 − \$50,000 + \$60,000) − 1,000,000 = \$1,710,000
The take-away from this example is that the flexibility afforded by IFRS can have an impact on comparability between companies.
These, and other differences, between US GAAP and IFRS arise because of the more rules-based nature of the standards put forth by FASB versus the more principles-based rules set forth by IASB. The IASB, in creating IFRS standards, follows a substance-over-form viewpoint that allows firms more flexibility in assessing the intent of transactions. Anytime more judgement is allowed and/or utilized, there must be adequate disclosure to explain the chosen reporting methodology. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/16%3A_Statement_of_Cash_Flows/16.04%3A_Prepare_the_Completed_Statement_of_Cash_Flows_Using_the_Indirect_Method.txt |
As previously mentioned, the net cash flows for all sections of the statement of cash flows are identical when using the direct method or the indirect method. The difference is just in the way that net cash flows from operating activities are calculated and presented. The direct approach requires that each item of income and expense be converted from the accrual basis value to the cash basis value for that item. This is accomplished by adjusting the accrual amount for the revenue or expense by any related current operating asset or liability. Revenue and expense items that are not related to those current asset and liability accounts would not need an adjustment.
In the following section, we demonstrate the calculations needed to assess the component pieces of the operating section using the direct approach.
Cash Collected from Customers
Cash collected from customers is different from the sales revenue that is recorded on the accrual basis financial statements. To reconcile the amount of sales revenue reported on the income statement to the cash collected from sales, calculate the maximum amount of cash that could have been collected this period (potential cash collected) by combining (a) the amount that was due from customers on the first day of the period (beginning accounts receivable) and (b) total sales revenue recorded this period. If there were no outstanding accounts receivable balance at the end of the period, then one could reasonably assume that this total was collected in full during this period. Thus, the amount collected for sales can be determined by subtracting the ending accounts receivable balance from the total potential cash that could have been collected.
Cash Paid to Suppliers for Inventory
Cash paid for inventory is different from the cost of goods sold that is recorded on the accrual basis financial statements. To reconcile the amount of cost of goods sold reported on the income statement to the cash paid for inventory, it is necessary to perform two calculations. The first part of the calculation determines how much inventory was purchased, and the second part of the calculation determines how much of those purchases were paid for during the current period.
First, calculate the maximum amount of inventory that was available for sale this period by combining (a) the amount of inventory that was on hand on the last day of the period (ending inventory) and (b) total cost of goods sold recorded this period. If there were no inventory balance at the beginning of the period, then one could reasonably assume that this total was purchased entirely during the current period. Thus, the amount of inventory purchased this period can be determined by subtracting the beginning inventory balance from the total goods (inventory) available for sale.
Second, calculate the maximum amount of cash that could have been paid for inventory this period (total obligation to pay inventory costs) by combining (a) the amount that was due to suppliers on the first day of the period (beginning accounts payable) and (b) total inventory purchases this period, from the first inventory calculation. If there were no outstanding accounts payable balance at the end of the period, then one could reasonably assume that this total was paid in full during this current period. Thus, the amount paid for inventory can be determined by subtracting the ending accounts payable balance from the total obligation to pay inventory costs that could have been paid. The final number of the second calculation is the actual cash paid for inventory.
Cash Paid for Salaries
Cash paid for salaries is different from the salaries expense that is recorded on the accrual basis financial statements. To reconcile the amount of salaries expense reported on the income statement to the cash paid for salaries, calculate the maximum amount of cash that could have been paid for salaries this period (total obligation to pay salaries) by combining (a) the amount that was due to employees on the first day of the period (beginning salaries payable) and (b) total salaries expense recorded this period. If there were no outstanding salaries payable balance at the end of the period, then one could reasonably assume that this total was paid in full during this current period. Thus, the amount paid for salaries can be determined by subtracting the ending salaries payable balance from the total obligation to pay salaries that could have been paid.
Cash Paid for Insurance
Cash paid for insurance is different from the insurance expense that is recorded on the accrual basis financial statements. To reconcile the amount of insurance expense reported on the income statement to the cash paid for insurance premiums, calculate the maximum amount of cash that could have been paid for insurance this period (total insurance premiums expended) by combining (a) the amount of insurance premiums that were prepaid on the last day of the period (ending prepaid insurance) and (b) total insurance expense recorded this period. If there were no prepaid insurance balance at the beginning of the period, then one could reasonably assume that this total was paid entirely during the current period. Thus, the amount paid for insurance this period can be determined by subtracting the beginning prepaid insurance balance from the total insurance premiums that had been recorded as expended. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/16%3A_Statement_of_Cash_Flows/16.06%3A_Appendix-_Prepare_a_Completed_Statement_of_Cash_Flows_Using_the_Direct_Method.txt |
16.1 Explain the Purpose of the Statement of Cash Flows
• The statement of cash flows presents the sources and uses of cash.
• The statement of cash flows is used to predict future cash flows and to assess the quality of an entity’s earnings.
• There are two approaches utilized to prepare the statement of cash flow: the indirect method and the direct method.
16.2 Differentiate between Operating, Investing, and Financing Activities
• Transactions must be segregated into the three types of activities presented on the statement of cash flows: operating, investing, and financing.
• Operating cash flows arise from the normal operations of producing income, such as cash receipts from revenue and cash disbursements to pay for expenses.
• Investing cash flows arise from a company investing in or disposing of long-term assets.
• Financing cash flows arise from a company raising funds through debt or equity and repaying debt.
16.3 Prepare the Statement of Cash Flows Using the Indirect Method
• Preparing the operating section of statement of cash flows by the indirect method starts with net income from the income statement and adjusts for items that affect cash flows differently than they affect net income.
• Multiple levels of adjustments are required to reconcile accrual-based net income to cash flows from operating activities.
• The investing section of statement of cash flows relates to changes in long-term assets.
• The financing section of statement of cash flows relates to changes in long-term liabilities and changes in equity.
• Company activities that reflect changes in long-term assets, long-term liabilities, or equity, but have no cash impact, require special reporting treatment, as noncash investing and financing transactions.
16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
• Preparing the operating section of statement of cash flows by the indirect method starts with net income from the income statement and adjusts for items that affect cash flows differently than they affect net income.
• Multiple levels of adjustments are required to reconcile accrual-based net income to cash flows from operating activities.
• The investing section of the statement of cash flows relates to changes in long-term assets.
• The financing section of statement of cash flows relates to changes in long-term liabilities and changes in equity.
• Company activities that reflect changes in long-term assets, long-term liabilities, or equity, but have no cash impact, require special reporting treatment, as noncash investing and financing transactions.
16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
• Free cash flow relates to the amount of expected cash from operations which is left over after planned capital expenditures and dividends are paid.
• The cash flow to assets ratio correlates the company’s free cash flow to its total asset value.
• The cash flow to sales ratio considers free cash flow in relation to the company’s sales revenue.
16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
• This section included an example of a statement of cash flows, prepared under the direct method, using the continuing example for Propensity Company.
• The direct method of preparing the statement of cash flows is identical to the indirect method except for the cash flows from the operating section.
• To complete the cash flows from operating activities, the direct method directly shows the cash collected from customers from revenue activities and the cash spent on operations, rather than reconciling net income to cash flows from operating activities as done using the indirect method. Calculating the amounts directly collected from revenues and spent on expenditures involves calculating the cash effect of the accrual amounts reported on the income statement.
Key Terms
cash flow
cash receipts and cash disbursements as a result of business activity
direct method
approach used to determine net cash flows from operating activities, whereby accrual basis revenue and expenses are converted to cash basis collections and payments
financing activity
cash business transaction reported on the statement of cash flows that obtains or retires financing
free cash flow
operating cash, reduced by expected capital expenditures and by cash dividends payments
free cash flow to assets ratio
ratio of free cash flow to total assets
free cash flow to sales ratio
ratio of free cash flow to sales revenue
indirect method
approach used to determine net cash flows from operating activities, starting with net income and adjusting for items that impact new income but do not require outlay of cash
investing activity
cash business transaction reported on the statement of cash flows from the acquisition or disposal of a long-term asset
net cash flow
method used to determine profitability by measuring the difference between an entity’s cash inflows and cash outflows
noncash expense
expense that reduces net income but is not associated with a cash flow; most common example is depreciation expense
operating activity
cash business transaction reported on the statement of cash flows that relates to ongoing day-to-day operations
statement of cash flows
financial statement listing the cash inflows and cash outflows for the business for a period of time | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/16%3A_Statement_of_Cash_Flows/16.07%3A_Summary.txt |
Multiple Choice
1.
LO 16.1Which of the following statements is false?
1. Noncash activities should be reported in accrual basis financial statements.
2. Net cash flow from operating activities relates to normal business operations.
3. Net income usually equals net cash flow from operating activities.
4. The statement of cash flows is an essential part of the basic financial statements.
2.
LO 16.2Which of these transactions would not be part of the cash flows from the operating activities section of the statement of cash flows?
1. credit purchase of inventory
2. sales of product, for cash
3. cash paid for purchase of equipment
4. salary payments to employees
3.
LO 16.2Which is the proper order of the sections of the statement of cash flows?
1. financing, investing, operating
2. operating, investing, financing
3. investing, operating, financing
4. operating, financing, investing
4.
LO 16.2Which of these transactions would be part of the financing section?
1. inventory purchased for cash
2. sales of product, for cash
3. cash paid for purchase of equipment
4. dividend payments to shareholders, paid in cash
5.
LO 16.2Which of these transactions would be part of the operating section?
1. land purchased, with note payable
2. sales of product, for cash
3. cash paid for purchase of equipment
4. dividend payments to shareholders, paid in cash
6.
LO 16.2Which of these transactions would be part of the investing section?
1. land purchased, with note payable
2. sales of product, for cash
3. cash paid for purchase of equipment
4. dividend payments to shareholders, paid in cash
7.
LO 16.3What is the effect on cash when current noncash operating assets increase?
1. Cash increases by the same amount.
2. Cash decreases by the same amount.
3. Cash decreases by twice as much.
4. Cash does not change.
8.
LO 16.3What is the effect on cash when current liabilities increase?
1. Cash increases by the same amount.
2. Cash decreases by the same amount.
3. Cash decreases by twice as much.
4. Cash does not change.
9.
LO 16.3What is the effect on cash when current noncash operating assets decrease?
1. Cash increases by the same amount.
2. Cash decreases by the same amount.
3. Cash decreases by twice as much.
4. Cash does not change.
10.
LO 16.3What is the effect on cash when current liabilities decrease?
1. Cash increases by the same amount.
2. Cash decreases by the same amount.
3. Cash decreases by twice as much.
4. Cash does not change.
11.
LO 16.3Which of the following would trigger a subtraction in the indirect operating section?
1. gain on sale of investments
2. depreciation expense
3. decrease in accounts receivable
4. decrease in bonds payable
12.
LO 16.3Which of the following represents a source of cash in the investing section?
1. sale of investments
2. depreciation expense
3. decrease in accounts receivable
4. decrease in bonds payable
13.
LO 16.3Which of the following would be included in the financing section?
1. loss on sale of investments
2. depreciation expense
3. increase in notes receivable
4. decrease in notes payable
14.
LO 16.4If beginning cash equaled \$10,000 and ending cash equals \$19,000, which is true?
1. Operating cash flow 9,000; Investing cash flow (3,500); Financing cash flow (2,500)
2. Operating cash flow 4,500; Investing cash flow 9,000; Financing cash flow (4,500)
3. Operating cash flow 2,000; Investing cash flow (13,000); Financing cash flow 2,000
4. none of the above
15.
LO 16.5Which of the following is a stronger indicator of cash flow flexibility?
1. cash flow from operating activities
2. cash flow to sales ratio
3. free cash flow
4. all three indicate comparable degrees of flexibility
Questions
1.
LO 16.1What function does the statement of cash flows serve, as one of the four basic financial statements?
2.
LO 16.1Is it possible for a company to have significant net income in the same time period that net cash flows are negative? Explain.
3.
LO 16.2What categories of activities are reported on the statement of cash flows? Does it matter in what order these sections are presented?
4.
LO 16.2Describe three examples of operating activities, and identify whether each of them represents cash collected or cash spent.
5.
LO 16.2Describe three examples of investing activities, and identify whether each of them represents cash collected or cash spent.
6.
LO 16.2Describe three examples of financing activities, and identify whether each of them represents cash collected or cash spent.
7.
LO 16.3Explain the difference between the two methods used to prepare the operating section of the statement of cash flows. How do the results of these two approaches compare?
8.
LO 16.3Why is depreciation an addition in the operating section of the statement of cash flows, when prepared by the indirect method?
9.
LO 16.3When preparing the operating section of the statement of cash flows, using the indirect method, how must gains and losses be handled? Why?
10.
LO 16.3If a company reports a gain/(loss) from the sale of assets, as part of the net income on the income statement, and the net book value of those assets on the date of the sale is known, can the amount of the cash proceeds from the sale be determined? If so, how?
11.
LO 16.3Note payments reduce cash and are related to long-term debt. Do these facts automatically lead to their inclusion as elements of the financing section of the statement of cash flows? Explain.
12.
LO 16.4Is there any significance that can be attributed to whether net cash flows are generated from operating activities, versus investing and/or financing activities? Explain.
13.
LO 16.4Would there ever be activities that relate to operating, investing, or financing activities that would not be reported in their respective sections of the statement of cash flows? Explain. If a company had any such activities, how would they be reported in the financial statements, if at all?
14.
LO 16.5What insight does the calculation of free cash flow provide about the company’s cash flow position?
15.
LO 16.6Why is using the direct method to prepare the operating section of the statement of cash flows more challenging for accountants than preparing the balance sheet, income statement, and retained earnings statement?
Exercise Set A
EA1.
LO 16.1Provide journal entries to record each of the following transactions. For each, identify whether the transaction represents a source of cash (S), a use of cash (U), or neither (N).
1. Declared and paid to shareholders, a dividend of \$24,000.
2. Issued common stock at par value for \$12,000 cash.
3. Sold a tract of land that had cost \$10,000, for \$16,000.
4. Purchased a company truck, with a note payable of \$38,000.
5. Collected \$8,000 from customer accounts receivable.
EA2.
LO 16.2In which section of the statement of cash flows would each of the following transactions be included? For each, identify the appropriate section of the statement of cash flows as operating (O), investing (I), financing (F), or none (N). (Note: some transactions might involve two sections.)
1. paid advertising expense
2. paid dividends to shareholders
3. purchased business equipment
4. sold merchandise to customers
5. purchased plant assets
EA3.
LO 16.2In which section of the statement of cash flows would each of the following transactions be included? For each, identify the appropriate section of the statement of cash flows as operating (O), investing (I), financing (F), or none (N). (Note: some transactions might involve two sections.)
1. borrowed from the bank for business loan
2. declared dividends, to be paid next year
3. purchased treasury stock
4. purchased a two-year insurance policy
5. purchased plant assets
EA4.
LO 16.3Use the following information from Albuquerque Company’s financial statements to determine operating net cash flows (indirect method).
EA5.
LO 16.3What adjustment(s) should be made to reconcile net income to net cash flows from operating activities (indirect method) considering the following balances in current assets?
EA6.
LO 16.3Use the following information from Birch Company’s balance sheets to determine net cash flows from operating activities (indirect method), assuming net income for 2018 of \$122,000.
EA7.
LO 16.3Use the following information from Chocolate Company’s financial statements to determine operating net cash flows (indirect method).
EA8.
LO 16.3Use the following information from Denmark Company’s financial statements to determine operating net cash flows (indirect method).
EA9.
LO 16.3Use the following excerpts from Eagle Company’s financial records to determine net cash flows from financing activities.
EA10.
LO 16.3Use the following excerpts from Fruitcake Company’s financial records to determine net cash flows from investing activities.
EA11.
LO 16.3Use the following excerpts from Grenada Company’s financial records to determine net cash flows from operating activities and net cash flows from investing activities.
EA12.
LO 16.4Provide the missing piece of information for the following statement of cash flows puzzle.
EA13.
LO 16.4Provide the missing piece of information for the following statement of cash flows puzzle.
EA14.
LO 16.5Use the following excerpts from Kirsten Company’s Statement of Cash Flows and other financial records to determine the company’s free cash flow.
EA15.
LO 16.5Use the following excerpts from Franklin Company’s statement of cash flows and other financial records to determine the company’s free cash flow for 2018 and 2017.
EA16.
LO 16.5The following are excerpts from Hamburg Company’s statement of cash flows and other financial records.
Compute the following for the company:
1. free cash flow
2. cash flows to sales ratio
3. cash flows to assets ratio
EA17.
LO 16.6Use the following excerpts from Algona Company’s financial statements to determine cash received from customers in 2018.
EA18.
LO 16.6Use the following excerpts from Huckleberry Company’s financial statements to determine cash paid to suppliers for inventory in 2018.
Exercise Set B
EB1.
LO 16.1Provide journal entries to record each of the following transactions. For each, identify whether the transaction represents a source of cash (S), a use of cash (U), or neither (N).
1. Paid \$22,000 cash on bonds payable.
2. Collected \$12,600 cash for a note receivable.
3. Declared a dividend to shareholders for \$16,000, to be paid in the future.
4. Paid \$26,500 to suppliers for purchases on account.
5. Purchased treasury stock for \$18,000 cash.
EB2.
LO 16.2In which section of the statement of cash flows would each of the following transactions be included? For each, identify the appropriate section of the statement of cash flows as operating (O), investing (I), financing (F), or none (N). (Note: some transactions might involve two sections.)
1. collected accounts receivable from customers
2. issued common stock for cash
3. declared and paid dividends
4. paid accounts payable balance
5. sold a long-term asset for the same amount as purchased
EB3.
LO 16.2In which section of the statement of cash flows would each of the following transactions be included? For each, identify the appropriate section of the statement of cash flows as operating (O), investing (I), financing (F), or none (N). (Note: some transactions might involve two sections.)
1. purchased stock in Xerox Corporation
2. purchased office supplies
3. issued common stock
4. sold plant assets for cash
5. sold equipment for cash
EB4.
LO 16.3Use the following information from Hamlin Company’s financial statements to determine operating net cash flows (indirect method).
EB5.
LO 16.3What adjustment(s) should be made to reconcile net income to net cash flows from operating activities (indirect method) considering the following balances in current assets?
EB6.
LO 16.3Use the following excerpts from Indigo Company’s balance sheets to determine net cash flows from operating activities (indirect method), assuming net income for 2018 of \$225,000.
EB7.
LO 16.3Use the following information from Jumper Company’s financial statements to determine operating net cash flows (indirect method).
EB8.
LO 16.3Use the following information from Kentucky Company’s financial statements to determine operating net cash flows (indirect method).
EB9.
LO 16.3Use the following excerpts from Leopard Company’s financial records to determine net cash flows from investing activities.
EB10.
LO 16.3Use the following information from Manuscript Company’s financial records to determine net cash flows from financing activities.
EB11.
LO 16.3Use the following excerpts from Nutmeg Company’s financial records to determine net cash flows from operating activities and net cash flows from investing activities.
EB12.
LO 16.4Provide the missing piece of information for the following statement of cash flows puzzle.
EB13.
LO 16.4Provide the missing piece of information for the following statement of cash flows puzzle.
EB14.
LO 16.5Use the following excerpts from Indira Company’s Statement of Cash Flows and other financial records to determine the company’s free cash flow.
EB15.
LO 16.5Use the following excerpts from Bolognese Company’s statement of cash flows and other financial records to determine the company’s free cash flow for 2018 and 2017.
EB16.
LO 16.5The following shows excerpts from Camole Company’s statement of cash flows and other financial records.
Compute the following for the company:
1. free cash flow
2. cash flows to sales ratio
3. cash flows to assets ratio
EB17.
LO 16.6Use the following excerpts from Brownstone Company’s financial statements to determine cash received from customers in 2018.
EB18.
LO 16.6Use the following excerpts from Jasper Company’s financial statements to determine cash paid to suppliers for inventory in 2018.
Problem Set A
PA1.
LO 16.2Provide journal entries to record each of the following transactions. For each, also identify *the appropriate section of the statement of cash flows, and **whether the transaction represents a source of cash (S), a use of cash (U), or neither (N).
1. paid \$12,000 of accounts payable
2. collected \$6,000 from a customer
3. issued common stock at par for \$24,000 cash
4. paid \$6,000 cash dividend to shareholders
5. sold products to customers for \$15,000
6. paid current month’s utility bill, \$1,500
PA2.
LO 16.3Use the following information from Acorn Company’s financial statements to determine operating net cash flows (indirect method).
PA3.
LO 16.3Use the following information from Berlin Company’s financial statements to prepare the operating activities section of the statement of cash flows (indirect method) for the year 2018.
PA4.
LO 16.3Use the following information from Coconut Company’s financial statements to prepare the operating activities section of the statement of cash flows (indirect method) for the year 2018.
PA5.
LO 16.3Use the following information from Dubuque Company’s financial statements to prepare the operating activities section of the statement of cash flows (indirect method) for the year 2018.
PA6.
LO 16.3Use the following information from Eiffel Company’s financial statements to prepare the operating activities section of the statement of cash flows (indirect method) for the year 2018.
PA7.
LO 16.3Analysis of Forest Company’s accounts revealed the following activity for its Land account, with descriptions added for clarity of analysis. How would these two transactions be reported for cash flow purposes? Note the section of the statement of cash flow, if applicable, and if the transaction represents a cash source, cash use, or noncash transaction.
PA8.
LO 16.4Use the following excerpts from Zowleski Company’s financial information to prepare a statement of cash flows (indirect method) for the year 2018.
PA9.
LO 16.4Use the following excerpts from Yardley Company’s financial information to prepare a statement of cash flows (indirect method) for the year 2018.
PA10.
LO 16.4Use the following excerpts from Wickham Company’s financial information to prepare a statement of cash flows (indirect method) for the year 2018.
PA11.
LO 16.4Use the following excerpts from Tungsten Company’s financial information to prepare a statement of cash flows (indirect method) for the year 2018.
PA12.
LO 16.5The following shows excerpts from financial information relating to Aspen Company and Bergamot Company.
Compute the following for both companies. Compare your results.
1. free cash flow
2. cash flows to sales ratio
3. cash flows to assets ratio
PA13.
LO 16.6Use the following excerpts from Fromera Company’s financial information to prepare the operating section of the statement of cash flows (direct method) for the year 2018.
PA14.
LO 16.6Use the following excerpts from Victrolia Company’s financial information to prepare a statement of cash flows (direct method) for the year 2018.
PA15.
LO 16.6Use the following cash transactions relating to Lucknow Company to determine the cash flows from operating, using the direct method.
Problem Set B
PB1.
LO 16.2Provide journal entries to record each of the following transactions. For each, also identify: *the appropriate section of the statement of cash flows, and **whether the transaction represents a source of cash (S), a use of cash (U), or neither (N).
1. reacquired \$30,000 treasury stock
2. purchased inventory for \$20,000
3. issued common stock of \$40,000 at par
4. purchased land for \$25,000
5. collected \$22,000 from customers for accounts receivable
6. paid \$33,000 principal payment toward note payable to bank
PB2.
LO 16.3Use the following information from Grenada Company’s financial statements to prepare the operating activities section of the statement of cash flows (indirect method) for the year 2018.
PB3.
LO 16.3Use the following information from Honolulu Company’s financial statements to prepare the operating activities section of the statement of cash flows (indirect method) for the year 2018.
PB4.
LO 16.3Use the following information from Isthmus Company’s financial statements to prepare the operating activities section of the statement of cash flows (indirect method) for the year 2018.
PB5.
LO 16.3Use the following information from Juniper Company’s financial statements to prepare the operating activities section of the statement of cash flows (indirect method) for the year 2018.
PB6.
LO 16.3Use the following excerpts from Kayak Company’s financial information to prepare the operating section of the statement of cash flows (indirect method) for the year 2018.
PB7.
LO 16.3Analysis of Longmind Company’s accounts revealed the following activity for Equipment, with descriptions added for clarity of analysis. How would these two transactions be reported for cash flow purposes? Note the section of the statement of cash flow, if applicable, and if the transaction represents a cash source, cash use, or noncash transaction.
Equipment
Account balance, beginning of year \$ 88,000
• Purchase of equipment this year, for cash 29,500
• Purchase of equipment this year, with note payable 34,750
Account balance, end of year 152,250
PB8.
LO 16.4Use the following excerpts from Stern Company’s financial information to prepare a statement of cash flows (indirect method) for the year 2018.
PB9.
LO 16.4Use the following excerpts from Unigen Company’s financial information to prepare the operating section of the statement of cash flows (indirect method) for the year 2018.
PB10.
LO 16.4Use the following excerpts from Mountain Company’s financial information to prepare a statement of cash flows (indirect method) for the year 2018.
PB11.
LO 16.4Use the following excerpts from OpenAir Company’s financial information to prepare a statement of cash flows (indirect method) for the year 2018.
PB12.
LO 16.5The following shows excerpts from financial information relating to Stanwell Company and Thodes Company.
Compute the following for both companies. Compare your results.
1. free cash flow
2. cash flows to sales ratio
3. cash flows to assets ratio
PB13.
LO 16.6Use the following excerpts from Swansea Company’s financial information to prepare the operating section of the statement of cash flows (direct method) for the year 2018.
PB14.
LO 16.6Use the following excerpts from Swahilia Company’s financial information to prepare a statement of cash flows (direct method) for the year 2018.
PB15.
LO 16.6Use the following cash transactions relating to Warthoff Company to determine the cash flows from operating, using the direct method.
Thought Provokers
TP1.
LO 16.2Use the EDGAR (Electronic Data Gathering, Analysis, and Retrieval system) search tools on the US Securities and Exchange Commission website to locate the latest Form 10-K for a company you would like to analyze. Submit a short memo that provides the following information:
• the name and ticker symbol of the company you have chosen
• the following information from the company’s statement of cash flows:
1. amount of cash flows from operating activities
2. amount of cash flows from investing activities
3. amount of cash flows from financing activities
• the URL to the company’s Form 10-K to allow accurate verification of your answers
TP2.
LO 16.3Use a spreadsheet and the following financial information from Mineola Company’s financial statements to build a template that automatically calculates the net operating cash flow. It should be suitable for use in preparing the operating section of the statement of cash flows (indirect method) for the year 2018.
TP3.
LO 16.3Consider the dilemma you might someday face if you are the chief financial officer of a company that is struggling to maintain a positive cash flow, despite the fact that the company is reporting a substantial positive net income. Maybe the problem is so severe that there is often insufficient cash to pay ordinary business expenses, like utilities, salaries, and payments to suppliers. Assume that you have been asked to communicate to your board of directors about your company’s year, in retrospect, as well as your vision for the company’s future. Write a memo that expresses your insights about past experience and present prospects for the company. Note that the challenge of the assignment is to keep your integrity intact, while putting a positive spin on the situation, as much as is reasonably possible. How can you envision the situation turning into a success story?
TP4.
LO 16.4Use the EDGAR (Electronic Data Gathering, Analysis, and Retrieval system) search tools on the US Securities and Exchange Commission website to locate the latest Form 10-K for a company you would like to analyze. Pick a company and submit a short memo that provides the following information:
• The name and ticker symbol of the company you have chosen.
• A description of two items from the company’s statement of cash flows:
• One familiar item that you expected to be reported on the statement, based on what you’ve learned about cash flows
• One unfamiliar item that you did not expect to be on the statement, based on what you’ve learned about cash flows
• The URL to the company’s Form 10-K to allow accurate verification of your answers
TP5.
LO 16.5If you had \$100,000 available for investing, which of these companies would you choose to invest with? Support your answer with analysis of free cash flow, based on the data provided, and include in your decision whatever other reasoning you chose to utilize. | textbooks/biz/Accounting/Financial_Accounting_(OpenStax)/16%3A_Statement_of_Cash_Flows/16.08%3A_Practice_Questions.txt |
Learning Objectives
• Complete Review Lab 1.1 to review adjusting entries.
• Complete Review Lab 1.2 to review merchandising transactions.
• Complete Review Lab 1.3 to review inventory costing methods.
• Complete Review Lab 1.4 to review bank reconciliations.
• Complete Review Lab 1.5 to review receivables transactions.
• Complete Review Lab 1.6 to review transactions related to long-lived assets.
• Complete Review Lab 1.7 to review current and long-term liabilities.
• Complete Review Lab 1.8 to review the statement of cash flows.
To be successful in Intermediate Financial Accounting, it is imperative for a student to have a strong foundational knowledge of all Introductory Financial Accounting concepts. The purpose of Lesson 1 is to help a student identify any weaknesses in their Intro Accounting knowledge. Lesson 1 consists of a series of labs intended to help a student identify any knowledge gaps. If a weakness comes to light, the student is encouraged to go back to that concept in Intro Accounting and review in detail. It is the student's responsibility to ensure they come into Intermediate Financial Accounting with the appropriate pre-requisite knowledge.
Each section will provide a link to the open Introduction to Financial Accounting textbook by Dauderis and Annand. You may also access the textbook by visiting http://lifa1.lyryx.com/open_introfa/?LESSONS . You can either view the lessons online, or you will find a Download link on the left side that will let you download a PDF or order a printed copy of that textbook. If you used this textbook in your Introductory Financial Accounting course then you may already have a copy of the textbook.
01: Review of Intro Financial Accounting
In this section, you will complete the review labs to evaluate your pre-requisite knowledge related to adjusting and closing entries. If you require a 'refresher' on adjusting and/or closing entries, refer to Chapter 3 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch3
1.02: Merchandising Transactions
In this section, you will complete the review labs to evaluate your pre-requisite knowledge related to merchandising transactions. If you require a 'refresher' on merchandising transactions, refer to Chapter 5 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch5
1.03: Inventory Costing Methods
In this section, you will complete the review labs to evaluate your pre-requisite knowledge related to inventory costing methods. If you require a 'refresher' on inventory costing methods, refer to Chapter 6 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch6
1.04: Bank Reconciliations
In this section, you will complete the review labs to evaluate your pre-requisite knowledge related to bank reconciliations. If you require a 'refresher' on bank reconciliations, refer to Chapter 7 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch7
1.05: Receivables Transactions
In this section, you will complete the review labs to evaluate your pre-requisite knowledge related to receivables transactions. If you require a 'refresher' on receivables transactions, refer to Chapter 7 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch7
1.06: Long-Lived Assets
In this section, you will complete the review labs to evaluate your pre-requisite knowledge related to long-lived assets. If you require a 'refresher' on long-lived assets, refer to Chapter 8 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch8
1.07: Current and Long-Term Liabilities
In this section, you will complete the review labs to evaluate your pre-requisite knowledge related to current and long-term liabilities. If you require a 'refresher' on current and long-term liabilities, refer to Chapter 9 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch9
1.08: Statement of Cash Flows
In this section, you will complete the review labs to evaluate your pre-requisite knowledge related to the statement of cash flows. If you require a 'refresher' on the statement of cash flows, refer to Chapter 11 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch11 | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/01%3A_Review_of_Intro_Financial_Accounting/1.01%3A_Adjusting_and_Closing_Entries.txt |
It Was No Joke
Perhaps the timing was intentional. On April 2, 2009, the Financial Accounting Standards Board (FASB) in the United States voted to amend the accounting rules for financial instruments. In particular, the changes in the rules allowed banks and their auditors to apply "significant judgment" in the valuation of certain illiquid mortgage assets.
The issue arose directly as a result of the 2008 financial crisis. After the housing bubble of the early- to mid-2000s burst, resulting in the failure of several prominent financial institutions, many of the remaining banks were left with mortgage-backed securities that could not be sold. Existing accounting rules for financial instruments required those instruments be valued at the fair value, sometimes referred to as mark-to-market accounting. Unfortunately, many of these assets no longer had a market, and accountants were forced to report these assets at their "distressed" values.
The banking industry did not like this accounting treatment. Many industry lobbyists complained that a security that was backed by identifiable cash flows still had a value, even if it were currently unmarketable. They were concerned that reporting these distressed values in the financial statements would lower reported profits and further damage the already-weakened confidence in the banking sector. The banking industry lobbied lawmakers aggressively to put pressure on the FASB to change the rules. In the end, they succeeded, and the FASB made changes that allowed for alternative valuation techniques. The application of these techniques would result in higher profits than would have been reported under the old rules.
Although the banking industry was somewhat satisfied with this result, critics noted that the new rules gave the banks more latitude to report results that were less transparent and possibly less representative of economic reality. There is much at stake when financial results are reported, and accountants face pressures from parties both inside and outside the business to manipulate those results to achieve certain goals. Accountants need a solid foundation of rules and principles to rely on in making the judgments necessary when preparing financial statements. However, accounting standard setting can, at times, be a political process, and the practicing accountant needs to be aware that the profession's thoughtful principles may not always provide all the solutions.
(Source: Orol, 2009)
Learning Objectives
After completing this chapter, you should be able to:
1. Identify the purpose of financial reporting.
2. Describe the problem of information asymmetry, and discuss how this problem can affect the production of financial information.
3. Describe how accounting standards are set in Canada and identify the key entities that are responsible for setting standards.
4. Discuss the purpose of the conceptual framework, and identify the key components of the framework.
5. Describe the qualitative characteristics of accounting information.
6. Identify the elements of financial statements.
7. Discuss the criteria required for recognizing an element in financial statements.
8. Identify different measurement bases that could be used, and discuss the strengths and weaknesses of each base.
9. Identify the alternative models of capital maintenance that could be applied.
10. Discuss the relative strengths and weaknesses of rules-based and principles-based accounting systems.
11. Discuss the possible motivations for management bias of financial information.
12. Discuss the need for ethical behaviour by accountants, and identify the key elements of the codes of conduct of the accounting profession.
13. Explain the effects on the accounting profession of changes in information technology.
The profession and practice of accounting has seen tremendous changes since the turn of the new millennium. A series of accounting scandals in the early 2000s, followed by the tremendous upheaval in capital markets and the world economy that resulted from the 2008 meltdown of the financial services industry, has led many to question the purpose and value of accounting information. In this chapter, we will examine the nature and purpose of accounting information and the key challenges faced by those who create accounting standards. We will also examine the accounting profession's response to those challenges, including the conceptual framework that currently shapes the development of accounting standards. We will also discuss the role of ethical behaviour in the accounting profession and the issues faced by practicing accountants.
02: Why Accounting
The International Accounting Standards Board (IASB) has stated that the purpose of financial reporting is "to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, providing or settling loans and other forms of credit, or exercising rights to vote on, or otherwise influence, management's actions that affect the use of the entity's economic resources." (International Accounting Standards Board, 2019). The key elements of this definition are that information must be useful and that it must assist in the decision-making function. Although this primary definition identifies investors, lenders, and creditors as the user groups, the IASB does acknowledge that other users may also find financial statements useful. The IASB also acknowledges two key characteristics of the financial-reporting environment. First, most users, such as shareholders or lenders, do not have the ability to access information directly from the reporting entity. Thus, those users must rely on general-purpose financial statements as well as other sources to obtain the information. Second, management of the company has access to more information than the external users, as they can access internal, nonpublic sources from the company's records. These two conditions result in information asymmetry, which is a key concept in understanding the purpose and development of accounting standards.
Information asymmetry simply means that one individual has more information than another individual. This concept is very easy to understand and is obviously true in all kinds of interactions that occur in your life on a daily basis. When you enter the room to write an exam, you know how much sleep you had the night before and what you ate for breakfast, but your professor does not. This type of information advantage is not very useful to you, however, as your professor is interested only in what you write on your exam paper, not the conditions that led up to those responses. In other cases, however, it is possible that you could gain an information advantage that could be useful to your performance on the exam. In the broader perspective of financial accounting, we are concerned the implications and problems that may be caused by information asymmetry. To explore this concept further, we need to consider two different forms of information asymmetry: adverse selection and moral hazard.
Adverse selection occurs because employees and managers of a company have more knowledge of the company's operations than the general public and, more specifically, investors. Because these individuals know more about the company and its potential future profitability, they may be tempted to take advantage of this knowledge. For example, if a manager of a company knew that a contract had just been signed with a new customer that was going to significantly increase revenues in the following year, the manager may be tempted to purchase shares of the company on the open market before the contract is announced to the public. By doing so, the manager may benefit when the news of the contract is released and the price of the share rises. In this case, the manager has unfairly used his or her information advantage to gain a personal benefit, which can be considered adverse to the interests of other investors. Because investors are aware of this potential problem, they may lose confidence in the securities market. This could result in investors generally paying less for shares than may be warranted by the fundamental factors of the business. The investors would do this because they wouldn't completely trust the information they were receiving. If this lack of confidence became serious or widespread, it is possible that securities markets wouldn't function at all.
The field of financial accounting clearly has a role in trying to solve the adverse selection problem. By making sufficient, high-quality information available to investors in a timely manner, accountants can reduce the adverse effects of this form of information asymmetry. However, it is impossible to eliminate the problem completely, as insiders of a company will always receive the information first. The accounting profession must thus work toward cost-effective and reasonable (but imperfect) solutions to convey useful information to investors.
Moral hazard is a different type of problem caused by an information imbalance. Except for very small businesses, most companies operate under the principle of separation of ownership and management. Shareholders can be numerous and geographically diverse; it is impossible for them to be directly involved in the running of the business. To solve this problem, shareholders hire managers to act as stewards of their investment. One feature of corporate law is the presumption that managers will always work toward the best interests of the company. Shareholders assume this to be true, but they do not have a very effective method of directly observing manager behaviour. Managers know this; thus, there may be an incentive – or at least an opportunity – not to work as hard or as effectively as the shareholders would like. If the company's performance suffers because of poor manager effort, the manager can always blame outside factors or other economic conditions. In extreme cases, the manager may even be tempted to manipulate financial reports to cover up poor performance.
To give shareholders the ability to monitor manager performance, financial accounting must seek ways to provide financial performance measures. Many analytical techniques use financial accounting as a basis for the calculations. However, shareholders must have confidence not only in the accuracy of the information but also in the usefulness of the information for evaluation of management stewardship. Again, there is no perfect solution here, as the complexities and qualitative features of management activity can never be perfectly captured by numbers alone. Still, financial accounting information can help investors assess the quality of the managers they hire, which can potentially reduce the moral hazard problem. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/02%3A_Why_Accounting/2.01%3A_Definition_and_Information_Asymmetry.txt |
As suggested in the previous section, accounting can play a role in reducing both adverse selection and moral hazard. However, because these two problems relate to two different user needs (i.e., the need to predict future investment performance and the need to evaluate management stewardship), it is unlikely that accounting information will always be perfectly and simultaneously useful in alleviating these problems. For example, information about the current values of assets may help an investor better predict the future economic prospects of the company, particularly in the short term. However, current values may not reveal much about management stewardship, as managers have very little control over market conditions. Similarly, the depreciated historical cost of property, plant, and equipment assets can reveal something about management's decision-making processes regarding the purchase and use of these assets, but historical costs provide very little value in estimating future returns. Accounting standard setters recognize that any specific disclosure may not meet all users' needs, and as such, trade-offs are necessary in setting standards. Sometimes trade-offs between different user purposes are required, and sometimes the trade-off is simply a matter of evaluating the cost of producing the information compared with the benefit received. Because of these trade-offs, accounting information must be viewed as an imperfect solution to the problem of information asymmetry. Still, those who set accounting standards attempt to create the framework for the production of information that will be useful to all readers, in particular to the primary user groups of investors, lenders, and creditors.
2.03: How Are Standards Set
In Canada, the Accounting Standards Board (AcSB) sets accounting standards. The AcSB is an independent body whose members are appointed by the Accounting Standards Oversight Council (AcSOC). The AcSOC was established in 2000 by the Canadian Institute of Chartered Accountants (CICA) to oversee the standard setting process. Currently the AcSB receives funding, staff, and other resources from the Chartered Professional Accountants of Canada (CPA Canada).
Two distinct sets of accounting standards for profit-oriented enterprises exist in Canada: International Financial Reporting Standards (IFRS) for those entities that have public accountability and Accounting Standards for Private Enterprises (ASPE) for those entities that do not have public accountability.
The CPA Canada Handbook defines a publicly accountable enterprise as follows:
An entity, other than a not-for-profit organization, that:
1. has issued, or is in the process of issuing, debt or equity instruments that are, or will be, outstanding and traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); or
2. holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. (CPA Canada, 2016)
Entities included in the second category can include banks, credit unions, investment dealers, insurance companies, and other businesses that hold assets for clients. For most of the illustrative examples in this text, we will assume that publicly traded companies use IFRS and that private companies use ASPE. Note that companies that do not have public accountability may still elect to use IFRS if they like. They may choose to do this if they intend to become publicly traded in the future or have some other reporting relationship with a public company.
ASPE are formulated solely by the AcSB and are designed specifically for the needs of Canadian private companies. IFRS, on the other hand, are created by the IASB and are adopted by the AcSB. The AcSB is actively involved with the IASB in the development of IFRS, and most IFRS are adopted directly into the CPA Canada Handbook – Accounting. In some rare circumstances, however, the AcSB may determine that a particular IFRS does not adequately meet the reporting needs of Canadian businesses and may thus choose to "carve out" this particular section before including the standard in the CPA Canada Handbook.
The IASB was formed for the purpose of harmonizing international accounting standards. This concept makes sense, as the past few decades have seen increased international trade, improvement of technologies, and other factors that have made capital more mobile. Investors who want to make choices between companies in different countries need to have some confidence that they will be able to compare reported financial results. The IASB has attempted to provide this assurance, and the use of IFRS around the world continues to grow, with partial or full convergence now in more than 140 countries.
For Canadian accountants, it is important to note that the United States still has not converged its standards with IFRS. Canada has a significant amount of cross-border trade with the United States, and many Canadian companies are also listed on American stock exchanges. In the United States, accounting standards are set by the Financial Accounting Standards Board (FASB), although the actual legal authority for standard setting rests with the Securities and Exchange Commission (SEC). The FASB has indicated in the past that it wishes to work with IASB to find a way to converge its standards with the international model. However, the FASB's standards are quite detailed and prescriptive, which makes convergence difficult. As well, a number of political factors have prevented convergence from occurring. As this point, it is difficult to predict when or if the FASB will converge its standards with the IASB. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/02%3A_Why_Accounting/2.02%3A_Trade-Offs.txt |
According the CPA Canada Handbook, "the purpose of the Conceptual Framework is to:
1. assist the International Accounting Standards Board to develop IFRS Standards that are based on consistent concepts;
2. assist preparers to develop consistent accounting policies when no Standard applies to a particular transaction or other event, or when a Standard allows a choice of accounting policy; and
3. assist all parties to understand and interpret the Standards." (CPA Canada, 2019).
A solid, coherent framework of principles is important not only to standard setters who need to develop new principles in response to changes in the business environment but also to practicing accountants who may encounter unusual or unique types of business transactions on a daily basis.
The IASB and the FASB had been working on a joint conceptual framework for several years, but this project was replaced by an IASB-only project, which was completed in 2018. This framework is currently used in Canada for publicly accountable enterprises. The conceptual framework used for private enterprises is very similar in content, although the structure, terminology, and emphasis differ slightly. We will focus on the IASB framework, which is located in Part 1 of the CPA Canada Handbook.
2.04: The Conceptual Framework
The conceptual framework opens with a statement of the purpose of financial reporting, which was discussed previously in this chapter. Recall that the key components of this definition are that financial information must be useful for making decisions, primarily about investment or lending of resources to a business entity, or evaluation of management stewardship. The conceptual framework then proceeds to discuss the qualitative characteristics of useful accounting information.
2.4.02: Qualitative Characteristics of Useful Information
The conceptual framework identifies fundamental and enhancing qualitative characteristics of useful information.
The fundamental characteristics are
• relevance and
• faithful representation.
The enhancing characteristics are
• comparability,
• verifiability,
• timeliness, and
• understandability.
Fundamental Characteristics
Relevance means that information is "capable of making a difference in the decisions made by users" (CPA Canada, 2019, QC2.6). The definition is further refined to state that information is capable of influencing decisions if it has predictive value, confirmatory value, or both. Predictive value means that the information can be used to assist in the process of making predictions about future events, such as potential investment returns, credit defaults, and other decisions that financial-statement users need to make. Note that although the information may assist in these decisions, the information is not in itself a prediction or forecast. Rather, the information is the raw material used by the decision maker to make the prediction. Confirmatory value means that the information provides some feedback about previous decisions that were made. Quite often, the same information may be useful for prediction and feedback purposes, but in different time periods. An income statement may help an investor decide to invest in a company this year, and next year's income statement, when released, will provide feedback as to whether the investment decision was correct. The framework also mentions the concept of materiality. A piece of information is considered material if its omission would affect a user's decision. Materiality is a concept used frequently by both internal accountants and auditors in determining the need to make adjustments for errors identified. Clearly, an item that is not deemed to be material is not relevant, as it would not affect a user's decision.
Faithful representation means that the financial information presented represents the true economic substance or state of the item being reported. This does not mean, however, that the representation must be 100 percent accurate, as perfection is rarely attainable. The CPA Handbook indicates that for information to faithfully represent an economic phenomenon, it must be complete, neutral, and free from error.
Information is complete if there is sufficient disclosure for the reader to understand the underlying phenomenon or event. This means that many financial disclosures will require additional explanations that go beyond a mere reporting of the quantitative values. Completeness is the motivation behind many of the note disclosures contained in financial statements. Because financial-statement users are trying to make predictions about future events, more detail is often needed than simply the balance sheet or income-statement amount. For example, if an investor wanted to understand a manufacturing company's requirements for future replacement of property, plant, and equipment assets, detailed information about the remaining useful lives of the assets and related depreciation periods and methods would be needed. Similarly, if a creditor wanted to assess the possible future effect on cash flows of a lease agreement, detailed information about the term of the lease, the required payments, and possible renewal options would be needed.
The neutrality concept suggests that the information is not biased and does not favour one particular outcome or prediction over another. This can often be difficult to assess, as many judgments are required in some accounting measures. There are many motivations for managers and preparers of financial statements to bias or influence the reporting of certain results. These motivations will be discussed later in this chapter. The professional accountant's role is to ensure that these biases are understood and controlled so that the reported financial results are not misleading to readers. Neutrality can also be supported by the use of prudent judgment. "Prudence is the exercise of caution when making judgments under conditions of uncertainty" (CPA Canada, 2019, QC2.16). Prudence has historically been described as a cautious attitude that does not allow for the overstatement of assets or income, or an understatement of liabilities or expenses. However, the definition in the Conceptual Framework equally suggests that assets or income should not be understated and that liabilities or expenses should not be overstated. The Framework makes this explicit statement to suggest that asymmetry in standards is not necessary. However, there are examples of specific standards in IFRS that do have unbalanced requirements (i.e. have a requirement for more persuasive evidence when recognizing an income compared to an expense). These types of unbalanced standards are considered acceptable if they result in more relevant and faithfully representative information. The application of prudence obviously takes a high degree of skill and professional judgment. Prudence is not considered a qualitative characteristic on its own, but is rather, sound advice to the practicing accountant.
As noted previously, information that is free from errors is not a guarantee of certainty or 100 percent accuracy. Rather, this criterion suggests that the economic phenomenon is accurately described and the process at arriving at the reported amount has properly applied. There is still the possibility that a reported amount could be incorrect. For example, at the end of the fiscal year, many companies will make an allowance for doubtful accounts to reflect the possibility that some accounts receivable will not be collected. At the balance sheet date, there is no way to be 100 percent certain that the reported allowance is correct. Only the passage of time will reveal the truth about this estimate. However, we can still say that the allowance is free from error if we can determine that a logical and consistent process has been applied to determine the amount and that this process is adequately described in the financial statements. This way, readers are able to make their own assessments of the risks involved in collecting these future cash flows.
It should be noted that the presence of both of the fundamental characteristics is required for information to be useful. An error-free representation of an irrelevant phenomenon is not much use to financial-statement readers. Similarly, if a relevant measure cannot be described with any degree of accuracy, then users will not find this information very useful for predicting future cash flows.
Enhancing Characteristics
The conceptual framework describes four additional qualitative characteristics that should enhance the usefulness of information that is already determined to be relevant and faithfully represented. These characteristics are comparability, verifiability, timeliness, and understandability.
Comparability is the quality that allows readers to compare either results from one entity with another entity or results from the same entity from one year with another year. This quality is important because readers such as investors are interested in making decisions whether to purchase one company's shares over another's or to simply divest a share already held. One key component of the comparability quality is consistency. Consistency refers to the use of the same method to account for the same items, either within the same entity from one period to the next or across different entities for the same accounting period. Consistency in application of accounting principles can lead to comparability, but comparability is a broader concept than consistency. Also, comparability must not be confused with uniformity. Items that are fundamentally different in nature should be accounted for differently.
The verifiability quality suggests that two or more independent and knowledgeable observers could come to the same conclusion about the reported amount of a particular financial-statement item. This does not mean that the observers have to be in complete agreement with each other. In the case of an estimated amount on the financial statements, such as an allowance for doubtful accounts, it is possible that two auditors may agree that the amount should fall within a certain range, but each may have different opinion of which end of the range is more probable. If they agree on the range, however, we can still say the amount is verifiable. Verification may be performed by either directly observing the item, such as examining a purchase invoice issued by a vendor, or indirectly verifying the inputs and calculations of a model to determine the output, such as reviewing the assumptions and recalculating the amount of an allowance for doubtful accounts by using data from an aged trial balance of accounts receivable.
Timeliness is one of the simplest but most important concepts in accounting. Generally, information needs to be current to be useful. Investors and other users need to know the economic condition of the business at the present moment, not at some previous period. However, past information can still be useful for tracking trends and may be especially useful for evaluating management stewardship.
Understandability is the one characteristic that the accounting profession has often been accused of disregarding. It is generally assumed that readers of financial statements should have a reasonable understanding of business issues and basic accounting terminology. However, many business transactions are inherently complex, and the accountant faces a challenge in crafting the disclosures in such a way that they completely and concisely describe the economic nature of the item while still being comprehensible. Financial disclosures should be reviewed by non-specialist, knowledgeable readers to ensure the accountant has achieved the quality of understandability.
As mentioned previously, accountants are often faced with trade-offs in preparing financial disclosures. This is especially true when considering the application of the various qualitative characteristics. Sometimes, the need for timeliness may result less-than-optimal verifiability, as verification of some items may require the passage of time. As a result, the accountant is forced to make estimations in order to ensure the information is available within a reasonable time. As well, all information has a cost, and companies will carefully consider the cost of producing the information compared with the benefits that can be obtained from the information, such as improving relevance or faithful representation. These challenges point to the conclusion that accounting is an imperfect measurement system that requires judgment in both the preparation and interpretation of the information. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/02%3A_Why_Accounting/2.04%3A_The_Conceptual_Framework/2.4.01%3A_The_Objective_of_Financial_Reporting.txt |
The CPA Canada Handbook includes a section describing a number of essential financial-statement elements. This section is not intended to be an exhaustive list of each item that could appear on the financial statements. Rather, it describes broad categories of financial-statement elements and defines them using key concepts that identify the essential elements of each category. These broadly based definitions will require the accountant to use judgment in the determination of the nature and the specific treatment and disclosure of business transactions. However, the accountant's judgment can also help ensure that financial statements properly reflect the underlying economic nature of the transaction, not just the legal form that may have been designed to circumvent more specific rules.
An Underlying Assumption
Before commencing a detailed examination of elements of financial statements, it is important to understand the key assumption underlying the reporting process. It is normally assumed that companies are operating as a going concern. This means that the company is expected to continue operating into the foreseeable future and that there will be no need to liquidate significant portions of the business or otherwise materially scale back operations. This assumption is important, because a company that is not a going concern would likely need to apply a different method of accounting in order not to be misleading. If a company needed to liquidate equipment at a substantial discount due to bankruptcy or other financial distress, it would not be appropriate to carry those assets at depreciated cost. In situations of financial distress, the accountant needs to carefully consider the going-concern assumption in determining the correct accounting treatment.
Assets
An asset is the first financial-statement element that needs to be considered. In the simplest sense, an asset is something that a business owns. The CPA Canada Handbook defines an asset as "a present economic resource controlled by the entity as a result of past events" (CPA Canada, 2019, 4.3). The definition further states that an economic resource is a right that can produce economic benefits. The key point in this definition is that economic benefits are expected to be received at some point in the future as a result of holding the resource. The most obvious benefit is the future inflow of cash. This can be seen very clearly with an item such as inventory held by a retail store, as the store expects to sell the items in a short period of time to generate cash. However, an asset could also be a piece of equipment installed in a factory that reduces the consumption of electricity by production processes. Although this equipment will not directly generate a future cash inflow, it does reduce a future cash outflow. This is also considered an economic benefit. The use of the term "right" in the definition also suggests other types of relationships, such as the right to use a patented process or the right to receive a favourable amount under a derivative contract. Rights are often established by a legal contract or enacted legislation, but there are other ways that rights can be considered assets, even without legal form. It is also important to note that the right must be capable of producing benefits beyond those available to other parties. An artistic work that is legally available in the public domain cannot be considered an asset to an entity, since other parties can also equally access the work.
Many assets have a tangible, or physical, form. However, some assets, such as accounts receivable or a patent, have no physical form. In the case of an account receivable from a customer, the future benefit results from the legal right the company holds to enforce payment. For a patent, the future benefit results from the company's ability to sell its product while maintaining some protection from competitors. Cash in a bank account does not have physical form, but it can be used as a medium of exchange.
It should also be noted that, although we can generally think of assets as something we own, the actual legal title to the resource does not necessarily need to belong to the company for it to be considered an asset. A contract, such as a long-term lease that conveys benefits to the leasing party over a significant portion of the asset's useful life may be considered an asset in certain circumstances.
Liabilities
A liability is defined as "a present obligation of the entity to transfer an economic resource as a result of past events." (CPA Canada, 2019, 4.26). This definition can be visualized through a time-continuum graphic:
When we prepare a balance sheet, it represents the present moment, so the obligation gets reported as a liability. This obligation is often a legal obligation, as in the case when goods are purchased on account, resulting in an accounts payable entry, or when money is borrowed from a bank, resulting in a loan payable. As well, this legal obligation can exist even in the absence of a formal contract. A company still has to report wages payable for any work performed by an employee but not yet paid, even if that work was performed under the terms of an informal, casual labour agreement.
Liabilities can also result from common business practice or custom, even if there is no legally enforceable amount. If a retailer of mobile telephones agrees to replace one broken screen per customer, then the expected cost of these replacements should be reported as a liability, even if the damage resulted from the customer's neglect and there is no legal obligation to pay. This type of liability is referred to as a constructive obligation. As well, companies may record liabilities based on equitable principles. If a company significantly reduces its workforce, it may feel a moral obligation to provide career transition counselling to its laid-off employees, even though there is no legal obligation to do so. In general, an obligation is considered a duty or responsibility that an entity has no practical ability to avoid.
The settlement of the liability usually involves the future transfer of cash, but it can also be settled by transferring other assets. As well, liabilities are sometimes settled through the provision of services in the future. A health club that requires its members to pay for one year's fees in advance has an obligation to make the facilities available to its members for that time. Less common ways to settle liabilities include replacing the liability with a new liability and converting the liability into equity of the business. It should be noted that the determination of the value of the liability to be recorded sometimes requires significant judgment. An example of this would be the obligation under a pension plan to make future payments to retirees. We will discuss this estimation problem in more detail in later chapters dealing with liabilities.
Equity
Equity is the owners' residual interest in the business, representing the remaining amount of assets available after all liabilities have been settled. Although equity can be thought of as a balancing figure, it is usually subdivided into various categories when presented on the balance sheet. Many of these classifications are related to legal requirements regarding the ownership interest. The usual categories of equity include share capital, which can include common and preferred shares, retained earnings, and accumulated other comprehensive income (IFRS only). However, other types of equity can arise on certain types of transactions, such as contributed surplus, appropriated retained earnings, and other reserves that may be allowed under local law. The purpose of all these subcategories of equity is to give readers enough information to understand how and when the owners may be able to receive a distribution of their interests. For example, restrictions on retained earnings or levels of preferences on shares issued may constrain the future payment of dividends to common shareholders. A potential investor would want to know this before investing in the company.
It should also be noted that the company's reported equity does not represent its value, either in a real sense or in the market. The prices that shares trade at in the stock market represent the cumulative decisions of investors, based on all information that is available. Although financial statements form part of this total pool of information, there are so many other factors used by investors to value a company that it is unlikely that the market value of a company would equal the reported amount of equity on the balance sheet.
Income
Income is defined as "increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims." (CPA Canada, 2019, 4.68). Notice that the definition is based on presence of changes in assets or liabilities, rather than on the concept of something being earned. This represents the balance sheet approach used in the conceptual framework, which considers any measure of performance, such as profit, to simply be a representation of the change in balance sheet amounts. This perspective is quite different from some historical views adopted previously in various jurisdictions, which viewed the primary purpose of accounting to be the measurement of profit (an income-statement approach).
Income can include both revenues and gains. Revenues arise in the course of the normal activities of the business; gains arise from either the disposal of noncurrent assets (realized gains) or the revaluation of noncurrent assets (unrealized gains). Unrealized gains on certain types of assets are usually included in other comprehensive income, a concept that will be discussed in later chapters.
Expenses
Expenses are defined as "decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims." (CPA Canada, 2019, 4.69). Note that this definition is really just the inverse of the definition of income. Similarly, expenses can include those that are incurred in the regular operation of the business and those that result from losses. Again, losses can be either realized or unrealized, and the definition is the same it was for gains. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/02%3A_Why_Accounting/2.04%3A_The_Conceptual_Framework/2.4.03%3A_Elements_of_Financial_Statements.txt |
Items are recognized in financial statements when they meet the definition of a financial statement element. (CPA Canada, 2019, 5.6). However, the Conceptual Framework acknowledges that there may be circumstances when an item that meets the definition of an element is still not recognized, because doing so would not provide useful information. In referencing usefulness, the Framework is acknowledging the fundamental qualitative characteristics of relevance and faithful representation. If it is uncertain whether an asset or liability exists, or if the probability of an inflow or outflow of economic benefits is low, it is possible that recognition is not warranted, since the relevance of the information is questionable. Similarly, if the measurement uncertainty present in estimated amounts were too great, the element would not be faithfully represented, and accordingly, should not be recognized. It is also possible that if the costs of recognition outweigh the benefits to users of the financial statements, the item will not be recognized.
Recognition means the item is included directly in one of the financial statements and not simply disclosed in the notes. However, if an item does not meet the criteria for recognition, it may still be necessary to disclose details in the notes to the financial statements. A pending lawsuit judgment at the reporting date may not meet the criterion of measurement certainty, but the possible future impact of the event could still be of interest to readers.
2.4.05: Measurement Base
The Conceptual Framework also notes that once recognition is affirmed, the appropriate measurement base needs to be considered. The following measurement bases are identified in the conceptual framework:
• Historical cost
• Current value, which includes
• Fair value
• Value in use/fulfilment value, and
• Current cost
Historical cost is perhaps the most well-entrenched concept in accounting. This simply means that items are recorded at the actual amount of cash paid or received at the time of the original transaction. This concept has persisted in accounting thought for so long because of its relative reliability and verifiability. However, the concept is often criticized because historical cost information tends to lose relevance as time passes. This can be particularly true for long-lived assets, such as real estate.
The current value concept results in elements being reported at amounts that reflect current conditions at the measurement date. This measurement base tries to achieve greater relevance by using current information, but it may not always be possible to represent this information faithfully when active markets for the item do not exist. It may be very difficult to find the current cost of a unique or specialized asset that was purpose built for a company.
Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date (CPA Canada, 2019, 6.12). This amount can be easily determined when active markets exist. However, if there is no active market for the item in question, the fair value may still be estimated using a discounted cash flow technique. Obviously, the more assumptions required in deriving the fair value, the more measurement uncertainty will exist.
Value in use is also a discounted cash flow technique. It differs from fair value in that it uses entity specific assumptions, rather than market assumptions. In other words, the entity projects future cash flows based on the specific way it uses the asset in question, rather than cash flows based on market assumptions about the use of the asset. In many cases, fair value and value in use may result in the same valuation, but this is not necessarily true in all cases.
Current cost is the cost to acquire an equivalent asset at the measurement date. This cost will include any transaction costs to acquire the asset, and will take into consideration the age and condition of the asset, along with other factors. Current cost represents an entry value, while fair value and value in use represent exit values.
All of the measurement bases identified have both strengths and weaknesses in terms of their overall decision usefulness for readers. Thus, there are always trade-offs and compromises evident when accounting standards are set. It is not surprising, then, to see that current accounting standards are a hybrid, or conglomeration, of these different bases. Historical cost is still the most common base used, but many accounting standards for specific items will allow or require other bases as well.
It should be noted that the Conceptual Framework's discussion of measurement bases should be read in conjunction with IFRS 13 – Fair Value Measurement. While the Conceptual Framework provides a broad overview of possible measurement bases, IFRS 13 provides more specific guidance on how to determine fair value. Fair value is a concept that is applied to a number of different accounting transactions under IFRS. IFRS 13 suggests that valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs. The standard further applies a hierarchy to those inputs to assist the accountant in assessing the quality of the data used for valuation. Level 1 of the hierarchy represents unadjusted, quoted prices in active markets for identical assets or liabilities. Level 2 inputs are those that are directly or indirectly observable but do not meet the definition of Level 1. This could include quoted prices from inactive markets or quoted prices for similar (but not identical) assets. Level 3 inputs are those that are unobservable. In this case, valuation techniques that require the use of assumptions and calculations of future cash flows may be required. IFRS 13 recommends that Level 1 inputs should always be used where possible. Unfortunately, Level 1 inputs are often unavailable for many assets. The application of fair-value accounting as described in IFRS 13 will be discussed in more detail in subsequent chapters.
2.4.06: Capital Maintenance
The last section of the conceptual framework deals with the concept of capital maintenance. This is a broader economic concept that attempts to define the level of capital or operating capability that investors would want to maintain in a business. This is important for investors because they ultimately want to earn a return on their invested capital in order to achieve growth in their overall wealth. However, measuring this growth will depend on how capital is defined.
The conceptual framework identifies two broad approaches to this question. The measurement of the owners' wealth can be defined in terms of financial capital or in terms of physical capital.
Financial capital maintenance is measured simply by the changes in equity reported on the company's balance sheet. These changes can be measured either in terms of money invested or in terms of purchasing power. The monetary interpretation is consistent with the approach used in historical cost accounting, where wealth is measured in nominal units (dollars, euros, etc.). This is a simple and reasonable approach in the short term, but over longer periods, monetary values are less relevant due to inflation. A dollar in 1950 could purchase much more than it could in 2020, so comparisons of capital over longer periods become meaningless. One way to get around this problem is to apply a constant purchasing power model to capital maintenance. This attempts to apply a broad-based index, such as the Consumer Price Index, to equity in order to adjust for the effects of inflation. This should make financial results more comparable over time. However, it is very difficult to conclude that a broad-based index is representative of the actual level of inflation experienced by the company, as the company would be selling and purchasing goods that are different from those included in the index.
The concept of physical capital maintenance attempts to get around this problem by measuring productive capacity. If a company can maintain the same level of outputs year after year, then it can be said that capital is maintained, even if the nominal monetary amounts change. This approach essentially represents the rationale behind the current cost-measurement base. The difficulty in using this approach is that current cost information about each specific asset in the business would be prohibitively expensive to obtain. If, instead, the company tried to apply a general index of prices for its specific industry, it is unlikely that this index would accurately match the specific asset composition of the company.
The conceptual framework concludes that the framework will not prescribe or require a specific model because there are so many trade-offs required in determining the appropriate capital maintenance model. Rather, the framework suggests that needs of financial-statement users should be considered in determining the appropriate model. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/02%3A_Why_Accounting/2.04%3A_The_Conceptual_Framework/2.4.04%3A_Recognition.txt |
As noted in the introduction to this chapter, confidence in financial markets and the accounting profession were shaken in the early 2000s. A series of accounting scandals, perhaps most notably Enron Corporation's, resulted in questioning the role of the information providers and the need for further regulation. One response, indeed, to these problems was the introduction of further regulation. In the United States, the Sarbanes-Oxley Act (SOX) was introduced in 2002 to restore the confidence in financial markets that had been so badly shaken after the accounting scandals. This legislation tightened up auditor independence rules, introduced new levels of oversight, created additional penalties for company executives engaged in fraudulent reporting, and improved other disclosure requirements. There have been improvements observed in disclosure practices since the introduction of SOX, but these improvements have come with a cost. Some estimates have put the cost of SOX compliance at \$6 billion per year. This is significant, but in assessing this cost, it is also important to consider the benefits. The major benefit that results from legislation like SOX is the potential reduction of market failures. When scandals such as the one at Enron occur, the loss is borne not only by shareholders but also by employees, other companies, and the general public, who will feel the effect of any recession or economic slowing that results from reduced confidence in the markets. But although the nature of the benefit is clear, the quantification of it is not. It is very difficult to measure the reduction of market failures that has occurred due to legislation, because if the legislation worked, there would be nothing to measure.
It would be unrealistic to suggest that regulation could completely eliminate any problem as complex as information asymmetry. Although SOX did appear to be effective in improving financial practices and disclosures, it did not prevent the 2008 financial crisis and subsequent market meltdown. This is likely because the causes of this crisis were not primarily matters of accounting and reporting – rather, they were related to the regulation and practices of the investment-banking industry. So the argument can be made that further regulations are required. But the regulator faces the challenge to determine the appropriate amount of regulation. Too little regulation can allow fraudulent practices to continue, but too much can stifle business initiative and growth.
One response by the accounting profession to the need for the further regulation has been the development of IFRS. These standards were introduced at the time that financial crises were shaking the financial world in the early 2000s. IFRS are viewed as being more principles based relative to other standards, such as the United States' Generally Accepted Accounting Principles (GAAP), which has historically been more rules based. Principles-based standards present a series of basic concepts that can be used by professional accountants to make decisions about the appropriate accounting treatment of individual transactions. These concepts are often intentionally broad and often do not provide specific, detailed guidance to the accountant. Rules-based standards, on the other hand, are more prescriptive and detailed. These standards attempt to create a rule for any situation that may be encountered by the accountant. Accordingly, the body of knowledge is much larger, with much more specific detail regarding accounting treatments.
Principles-based standards are usually considered to have the advantage of being more flexible, as they allow for more interpretation and judgment by the accountant. This can be particularly useful when unusual or unique business transactions are presented to the accountant. However, this flexibility is one of the weaknesses of this approach. Some fear that giving too much freedom to the accountant to interpret the accounting standards may result in financial statements that are less comparable to those of other entities or that could be subject to increased earnings management or other manipulations.
Because rules-based systems have far greater detailed guidance, some have argued that this is better for the accountant, as the accountant can defend the treatment of a particular transaction by simply pointing to compliance with the rule. As well, it is thought that rules-based systems can also lead to greater comparability, as much of the format and content of disclosure are tightly prescribed. Unfortunately, overly detailed rules can still allow for a different type of misrepresentation called financial engineering. When an accounting treatment relies on specific and detailed rules, creative managers can simply invent a new type of transaction that works around the existing rules. They will argue that the rule does not specifically prohibit them from doing what they are doing, but the engineered transaction may, in fact, be violating the spirit of the rule. Interpretations that focus more on the form of the transaction than on the substance can lead to inappropriate and ultimately misleading accounting. As a practical matter, all systems of accounting regulation contain both broadly based principles and detailed rules. The challenge for accounting standard setters is to find the right balance of rules and principles.
It should be apparent that many of the problems faced by the accounting profession stem from the questionable application of ethical principles. As noted before, the broad purpose of accounting information is to reduce information asymmetry. Information asymmetry can never be eliminated, but if accountants can communicate sufficient, useful information, then the asymmetry can be mitigated. Although it is a normal business practice to try to take advantage of an information imbalance, if this is done in a misleading or deceitful way that unfairly disadvantages certain parties, confidence in capital markets will be damaged. The accountant, in trying to provide as much information as possible to clients, will face pressure from those vested interests that stand to gain from the information imbalance. The accountant may be asked to withhold or distort the information to achieve certain results. Often, these pressures are subtle and not presented as a clear-cut violation of accounting standards. Business transactions can be complex, and the application of accounting standards to those transactions can involve significant judgment, estimation, and uncertainty. The answer to an accounting question may not be clear, and certain interested parties may view this state as an opportunity to try to influence the accountant.
The management of a company often has a particular interest in trying to influence financial reports. Managers are given the task by the shareholders of managing the business in the most efficient and profitable way possible. Managers face great pressures in the task and will at times look at the financial reporting as one tool to be used to deal with these pressures. Managers may be motivated to influence or bias the reported financial results for a number of reasons, including the following:
• The presence of performance-based compensation: Managers may be rewarded in bonuses or stock options that are directly or indirectly influenced by financial results. The manager clearly has an incentive to make the results look positive.
• Evaluation of management stewardship: Even if the manager is not directly compensated based on results, the manager's value to the company will still be evaluated relative to the business's performance.
• Meeting market expectations: Financial markets expect results and can be very punitive when expected results are not achieved. In order to meet the market's expectations with respect to performance, the manager may feel pressure to "work the numbers."
• Conditions of contracts: Some contracts, such as a loan agreement with a bank, may stipulate that certain financial ratios be maintained. If the ratios are not maintained, then some punitive consequence will likely be applied, such as a penalty or additional interest charges. As the financial ratio is based on reported results, the manager has an incentive to ensure the results keep the company onside.
• Political pressures: Sometimes a company may face pressures that are not directly related to the interests of the investors or lenders. A large, profitable company that enjoys a certain level of oligopolistic power may face additional public scrutiny if profits are too high. Public-interest groups may feel that the company is taking advantage of its position of power, and they may demand political action, such as increased taxes or other sanctions against the company. In order to avoid this type of political heat, the managers may have an incentive to deliberately reduce or smooth income.
In these examples, it should be apparent that the accountant could play a key role in the achievement of management's objectives. The accountant must therefore always be aware of these motivations and apply sound judgment and ethical principles. But the application of ethics is not simply a matter of consulting an ethics handbook. An ethical sense is a personal characteristic that is inherent in each individual. It is very difficult to teach, as our personal ethics are formed long before we choose to become professional accountants. Ethical awareness and practice, however, is something for which the accounting profession has developed a significant framework.
All professional bodies contain codes of conduct for their members. In these codes, basic principles of ethical behaviour and discussions of how to deal with ethical conflicts are included. Some of the common principles that are included in these codes include the following:
• Integrity: The accountant should always act in an honest fashion and not be associated with any information that is false or misleading.
• Objectivity: The accountant should always be unbiased when applying judgment.
• Professional competence: The accountant should always maintain a level of professional knowledge that is current and sufficient for performing professional duties and should not engage in any work that is outside the scope of that accountant's knowledge.
• Confidentiality: The accountant must not share privileged client information with other parties and must not use that information for his or her own personal gain.
• Professional behaviour: The accountant should not engage in any activity that discredits the profession.
Dealing with ethical conflicts and external pressures from stakeholders can be difficult at times, and accountants are often advised to seek advice from other professionals or their own professional association when the need arises. Accountants play a key role in the operation of capital markets and are essential to the financing of a business. The external stakeholders of the business expect ethical and professional conduct from the accountants, and it is important the profession continues to earn and maintain this trust.
Another area which provides both challenges and opportunities to professional accountants is the increasing use of information technology to perform accounting and reporting functions. Technology has allowed for the automation of routine bookkeeping tasks, as well as the development more advanced functions such as data mining and strategic analysis. The increased use of cloud computing and mobile devices has provided platforms for instant access to information, which could enhance the qualitative characteristic of timeliness. Sophisticated big data applications could improve the relevance of accounting information by targeting the specific needs of the user. Technologies such as eXtensible Business Reporting Language (XBRL) have been designed to improve the comparability of information by providing a standardized platform for financial statement delivery. Computer assisted audit tools and techniques allow auditors to more precisely identify key areas of audit risk and to analyze larger sample sizes, which could lead to improvements in the reliability of information and the efficiency of the process. The emergence of blockchain technology may provide the biggest challenge and opportunity to the auditing profession. This type of decentralized, public ledger has the potential to allow for instant access and verification of transactions. Smart contract technology could use blockchain to automate and control many accounting and business processes. As blockchain has the potential to create unalterable, transparent accounting records, auditors will need to rethink the traditional, annual financial statement audit. Continuous auditing and verification of the structure of smart contracts may become the new role for audit professionals.
Recently, the growth of data analytics has begun to change the job of the accountant, and will likely continue to promote a profound alteration of the accounting and finance fields. The automation of routine and tedious tasks is only the beginning of the transformation of the role of financial professionals. Data analytics can be used to add value to an organization through descriptive, diagnostic, predictive, or prescriptive functions. The accountant of the future will need to be able to understand how to use both structured and unstructured data to solve business problems. Although accountants may not be experts in data analysis, they can provide valuable input and interpretation of the information created by data scientists. The accountant will need to work collaboratively with data scientists to ensure that the right questions are being asked, and the results are being deciphered in a meaningful way. Taking the results of data analysis and communicating them through data visualization techniques will provide value to the users of financial information.
Although technology provides professional accountants with opportunities to improve the value of the information provided, it also poses challenges. XBRL has experienced problems with data-tagging errors, which has reduced its effectiveness. Cloud computing and mobile devices have increased concerns about data security and economic disruption. Data mining strategies have led to ethical questions about the privacy of personal information. Real-time reporting of financial results faces concerns about data reliability, and more significantly, the alteration of manager behaviour (i.e., earnings management). Professional accountants need to be aware of these challenges as they adapt to rapidly changing technologies that have the potential to both benefit and damage the reputation of the profession. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/02%3A_Why_Accounting/2.05%3A_Challenges_and_Opportunities_in_Financial_Reporting.txt |
The accounting profession has seen tremendous transformation over the last forty years, brought about by changes in technology, the sophistication of capital markets, the business environment, and business practices. The profession has responded well to many of these changes, but it needs to continue to seek ways to maintain and improve its own relevance. At no time in history has so much information been so easily available to so many people. But how can people be assured that the information is both true and relevant? The accounting profession – if it is forward looking and responsive – has the ability to provide this assurance to information users, which will enhance the perceived value of accountants. There are many challenges to be faced by the profession, and some of these challenges will require solid research and reasoning and delicate political and negotiation skills. Because accounting is not a natural science, there are no "right" or "wrong" answers, but as long as the profession can come up with the "best" answers, it will continue to demonstrate its value.
2.07: IFRS ASPE Key Differences
Part II of the CPA Canada Handbook does not specifically refer to a conceptual framework. However, Section 1000–Financial Statement Concepts contains many of the same principles as identified in the IASB Conceptual Framework. Some of the key differences are identified below:
IFRS ASPE
Two fundamental, qualitative characteristics are relevance and faithful representation. Comparability and understandability are considered enhancing qualitative characteristics. Four principal qualitative characteristics are relevance, reliability, comparability, and understandability.
Timeliness is considered an enhancing qualitative characteristic. Timeliness is included as a sub-element of relevance.
Verifiability is considered an enhancing qualitative characteristic. Verifiability is a sub-element of reliability.
Faithful representation includes completeness, neutrality, and freedom from error. Reliability includes representational faithfulness, verifiability, neutrality, and conservatism. Prudence is a concept that supports neutrality.
Gains are included in the element "income," and losses are included in the element "expenses." Gains and losses are identified as separate elements of financial statements.
Three types of capital maintenance concepts are identified, but no prescribed or preferred approach is indicated. Only a monetary measure of capital maintenance should be used, with no adjustment for changes in purchasing power.
2.08: Chapter Summary
LO 1: Identify the purpose of financial reporting.
The purpose of financial reporting is to provide information that is useful for making decisions about providing resources to the business. The primary user groups are identified as present and potential investors, lenders, and other creditors, although other users will also find financial information useful for their purposes.
LO 2: Describe the problem of information asymmetry, and discuss how this problem can affect the production of financial information.
Information asymmetry simply means there is an imbalance of information between two parties in a business transaction. This imbalance can create problems in two forms: adverse selection and moral hazard. Adverse selection means that one party may try to gain a benefit over the other party by exploiting the information advantage. An example of this behaviour is insider trading. If insider trading is perceived by the market as being a pervasive problem, investors may lose confidence in the market, and security prices will drop. The accounting profession can alleviate this problem by increasing the amount of relevant and reliable information disclosed to the market, thus reducing the information advantage of insiders. Moral hazard occurs when managers shirk their duties because they know their efforts cannot be directly observed. In order to cover up shirking, managers may bias the presentation of financial results. The accounting profession can help alleviate this problem by ensuring financial-reporting standards create disclosures that are useful in evaluating management performance and are not easily manipulated by management.
LO 3: Describe how accounting standards are set in Canada, and identify the key entities that are responsible for setting standards.
Currently, accounting standards are set by the Accounting Standards Board (AcSB). This board applies two sets of standards: International Financial Reporting Standards (IFRS) and Accounting Standards for Private Enterprise (ASPE). IFRS are required for all publicly accountable entities, while private entities have the choice to use ASPE or IFRS. IFRS are developed by the International Accounting Standards Board (IASB) and then adopted by the AcSB. However, the AcSB can remove or alter certain sections of IFRS if it is believed that the accounting treatment does not reflect Canadian practice.
LO 4: Discuss the purpose of the conceptual framework, and identify the key components of the framework.
The conceptual framework provides a solid, theoretical foundation for standard setters when they have to develop new standards to respond to changes in the business environment. It also gives practicing accountants a basis and reference point to use when encountering new or unique business transactions. The key components of the framework describe the purpose of financial reporting, identify the qualitative characteristics of good accounting information and the elements of financial statements, and discuss the criteria for recognizing an item in financial statements, different possible measurement bases, and the framework's approach to capital maintenance.
LO 5: Describe the qualitative characteristics of accounting information.
The fundamental characteristics of accounting information are relevance (which is composed of both predictive and confirmatory characteristics) and faithful representation (which is composed of freedom from error, neutrality, and completeness). Relevance will also be affected by the concepts of materiality and the nature of the item. Enhancing qualitative characteristics are understandability, comparability, verifiability, and timeliness. Trying to meet the requirements of all the characteristics can sometimes result in trade-offs, and this must always be evaluated in the context of costs compared with potential benefits.
LO 6: Identify the elements of financial statements.
The elements of financial statements are assets, liabilities, equity, income, and expenses. The definition of each element contains references to the relationships between events and their time of occurrence, and each definition broadly describes the nature of the element. An underlying assumption in the preparation of financial statements is that the entity will continue as a going concern.
LO 7: Discuss the criteria required for recognizing an element in financial statements.
An element will be recognized in financial statements when it meets the definition of that element and can be measured reliably, and when it is probable that the future economic benefits attached to the element will flow to or from the entity.
LO 8: Identify different measurement bases that could be used, and discuss the strengths and weaknesses of each base.
The conceptual framework identifies four possible measurement bases: historical cost, current cost, realizable value, and present value. Historical cost forms the basis of much of current accounting practice, but other bases are used in circumstances where it is deemed appropriate. Each measurement base has certain advantages and disadvantages, and the choice of measurement base will often result in a trade-off in decision usefulness.
LO 9: Identify the alternative models of capital maintenance that could be applied.
The conceptual framework identifies three possible capital-maintenance models: monetary interpretation, constant purchasing power, and physical capital maintenance. Each model has certain advantages and disadvantages. Current accounting practice is built around the concept of monetary capital maintenance, but the conceptual framework does not identify one model as being preferred over the others.
LO 10: Discuss the relative strengths and weaknesses of rules-based and principles-based accounting systems.
Rules-based systems are seen as providing more detailed guidance to accountants, which could help accountants defend their work if challenged. As well, rules-based systems are thought to provide better comparability, as more consistent presentations will result. However, rules-based systems can also result in financial engineering, where transactions are designed specifically to circumvent the rules. Principles-based systems are seen as more flexible and more adaptive to new or unique circumstances. As well, principles-based systems can result in presentations that better reflect local or industry practices. Principles-based systems are criticized for being too flexible and allowing for too much judgment by the accountant. This could create the potential for management influence on the accountant's work.
LO 11: Discuss the possible motivations for management bias of financial information.
Management may be tempted to bias or otherwise influence the presentation of financial information because of compensation contracts that are based on financial results. As well, the manager will be concerned about meeting investor or analyst targets, meeting the conditions of loan covenants or other external agreements, achieving certain political or strategic objectives, and demonstrating sound stewardship over the company's assets. All of these motivations provide a temptation to the manager to influence the results reported in the financial statements.
LO 12: Discuss the need for ethical behaviour by accountants, and identify the key elements of the codes of conduct of the accounting profession.
As accountants control the preparation and presentation of financial information, they play a key role in determining the integrity of the information. Accountants will face pressures from management and other parties who may have an interest in the content and form of financial disclosures. Thus, accountants, need to practice their craft with an ethical mindset, but they must also have training in how to deal with ethical issues. All accounting bodies have codes of professional conduct that provide guidance to suggest that accountants always act with integrity, objectivity, and competence. As well, these codes usually specify that accountants should always maintain confidentiality and act in a professional manner. Accountants will often have to apply significant good judgment when dealing with ethical conflicts.
LO 13: Identify the effects on the accounting profession of changes in information technology.
Information technology has the potential to improve the relevance, reliability, timeliness, and comparability of information presented. It can allow accountants and auditors to provide more useful information and to more accurately identify risks. However, accountants also need to be aware that these technologies need to be managed carefully to minimize problems that could negatively affect the quality of information provided. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/02%3A_Why_Accounting/2.06%3A_Conclusion.txt |
CPA Canada. (2016). CPA Canada Handbook. Toronto, ON: CPA Canada.
International Accounting Standards Board. (2012). Objective, usefulness and limitations of general purpose. Conceptual Framework for Financial Reporting, OB2. London: IFRS.
Orol, R. D. (2009, April 2). FASB approves more mark-to-market flexibility. Marketwatch. Retrieved from http://www.marketwatch.com/story/fasb-approves-more-mark-market-flexibility
2.10: Exercises
2.1 Describe the problem of information asymmetry and discuss the impact this problem has on the work of accountants.
2.2 Discuss the reasons why Canada applies two different sets of accounting standards to profit-oriented companies. What are the benefits of having two sets of standards? What are the problems of maintaining two sets of standards?
2.3 What is the conceptual framework? Why does the accounting profession need this framework?
2.4 Describe the two fundamental qualitative characteristics of good accounting information. What problems do accountants face in trying to maximize these characteristics when producing accounting information?
2.5 Describe the four enhancing qualitative characteristics and identify conflicts where possible trade-offs may occur in trying to maximize these characteristics.
2.6 Identify which of the five financial statement elements applies to each item described below:
1. A cash dividend is declared and paid to the shareholders.
2. Cash is used to purchase a machine that will be used in the production process over the next five years.
3. Products are sold to customers on 30-days' credit
4. Income taxes are calculated based on a company's profit. The taxes will be paid next year.
5. A customer makes a deposit on a special order that will not be manufactured until next year.
6. A bill for electricity used in the current month is received but not payable until the following month.
7. A shareholder invests money in a business in exchange for issued shares.
8. A shareholder invests money in a business by making a loan with commercial terms to the business.
9. An insurance settlement is received for a fully depreciated asset that was destroyed in a fire.
10. An allowance for doubtful accounts is established based on estimates of future uncollectible accounts.
2.7 Consider the following independent situations. For each of the situations described, discuss how the recognition criteria should be applied and suggest the appropriate accounting treatment.
1. A publisher sells magazines on a two-year subscription. Customers are required to pay the full amount at the commencement of the subscription.
2. A company is being sued by a customer group for losses sustained due to a faulty product design. The company's lawyers feel the suit will likely succeed, but they cannot estimate the potential amount of damages that will be awarded.
3. A company has completed a large infrastructure construction project as part of an economic development partnership with a foreign government. The invoice for the work has been issued, but due to a recent change in government, there is some doubt about whether payment will actually be received.
4. A social media company has recorded an asset described as "Goodwill" and an offsetting amount in its equity section. The amount was determined by comparing the current trading value of the company's shares to the recorded value of the company's shares on the balance sheet.
5. A resource company is obligated by municipal regulations to clean up the site of an active drilling operation in 10 years' time when the resource has been fully extracted. The company is in its first year of operations and has no previous experience in cleaning up drilling sites.
2.8 Describe the four different measurement bases and discuss the relative strengths and weaknesses of each base.
2.9 What are some of the difficulties in trying to determine the best concept of capital maintenance to apply to the development of accounting standards?
2.10 Discuss the relative merits and weaknesses of principles-based and rules-based accounting systems.
2.11 What are some of the motivations that managers may have for attempting to influence or bias reported financial results? What should the accountant do to deal with these possible attempts to affect the perceptions of the company's results?
2.12 You have just been appointed financial controller at Dril-Tex Inc., a manufacturer of specialized equipment used by various manufacturers of consumer products on their own production lines. Your immediate supervisor, the vice-president finance, has indicated that he will be retiring in six months and that you could be in line for his position if you do a good job managing the preparation of the year-end financial statements. He has provided you with the following comments for your consideration during the preparation of these statements:
1. The company is currently being sued for breach-of-contract by one of our largest customers. This case has been ongoing for two years and will likely reach a conclusion next year. Our lawyers have now estimated that it is likely we will lose, and that the award will probably be in the range of \$250,000 to \$300,000. We have disclosed this previously in our notes, but have not accrued anything. Use the same treatment this year, as the case is not yet completed.
2. We have changed our inventory costing method this year from weighted-average to FIFO. This has resulted in an increase in net income of \$115,000. The new method should be identified in the accounting policy note.
3. There are \$50,000 worth of customer prepayments included in the Accounts Receivable sub-ledger. The customers have paid these amounts to guarantee their priority in our production cycle, but no work has yet been done on their special orders. We will just net these prepayments against the Accounts Receivable balance and report a single amount on the balance sheet.
4. This year we hired a director of research and development. He has not yet produced any viable products or processes, but he was a top performer at his previous company. We have capitalized the cost of his salary and benefits, as we are confident he will soon be producing a breakthrough product for us.
5. Our bank has put us on warning that our current ratio and debt-to-equity ratio are close to violation of the covenant conditions in our loan agreement. Violations will likely result in an increase in the interest rate the bank charges us. Keep this in mind as you prepare the year-end adjustments.
Comment on the accounting treatments proposed by the vice-president finance, supporting your discussion with any relevant components from the conceptual framework. Discuss the impact of item (e) on your work in preparing the year-end financial statements. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/02%3A_Why_Accounting/2.09%3A_References.txt |
Material Weaknesses Found in Financial Reporting Oversight
In 2014, Penn West Petroleum Ltd., a Calgary-based oil company, was tasked with restating more than two years of financial statements in response to an internal investigation that uncovered material weaknesses in its internal controls over financial reporting. The impact of the restatement was a reduction in cash flow by \$145 million and an increase in its operating costs by \$367 million–no small sums, to be sure!
The investigation was undertaken after the discovery of misclassifications in its accounting records regarding its capital spending, operating costs, and royalty payments. The investigation found that operating expenses were recorded to property, plant, and equipment, and significant amounts of operational expenses were reclassified to royalties' assets. The company claimed that these errors originated with some former employees who were no longer with the company. When news of the scandal reached investors' ears, fears escalated, resulting in large numbers of shares being sold off in the stock market. In the aftermath, investors launched \$400 million in class-action lawsuits in Canada and the U.S., alleging that the company and some of its former top executives were negligent in not ensuring that adequate internal controls regarding financial reporting were in place.
It is unknown whether the misclassifications were due to management bias, intended to deceive, or if they were due to human error and poor judgment. Either way, the financials prior to restatement were making the company look better than it was.
Penn West implemented new internal controls to ensure that this never happens again. A key component of the change relates to its journal entries, to ensure any transactions that are to be capitalized (versus being expensed) are done so only after passing a strict oversight process.
(Source: Jones, 2014)
Learning Objectives
After completing this chapter, you should be able to:
• Describe the statement of income, the statement of comprehensive income, and the statement of changes in equity and their roles in accounting and business.
• Identify the factors that influence what is reported in the statement of income, statement of comprehensive income, and the statement of changes in equity.
• Explain the factors that influence the choice of accounting year-end.
• Explain how changes in accounting estimates, changes due to correction of accounting errors, and changes in accounting policy affect the income and equity statements.
• Identify the core financial statements and explain how they interconnect together.
• Explain the differences between IFRS and ASPE regarding the income and equity statements.
• Describe the various formats used for the statement of income and the statement of comprehensive income, and identify the various reporting requirements for companies following IFRS and ASPE.
• Describe the various formats used to report the changes in equity for IFRS and ASPE companies, and identify the reporting requirements.
• Identify and describe the techniques used to analyze income and equity statements.
Introduction
Financial reports are the final product of a company's accounting processes. These reports, combined with thoughtful analysis, are intended to "tell the story" about the company's operations, its financial performance for the reporting period, and its current financial state (resources and obligations) including its cash position for that period. Is it good news or bad news for management, investors, and creditors who are the company's stakeholders? Did the company meet its financial goals and objectives for the fiscal year? The answers depend not only on the outcome of the actual operations reported in the financial statements, but also on their accuracy and reliability, as the opening story about Penn West explained. As discussed in Chapter 2, financial statements consist of a set of core reports that identify the company's resources (assets), claims to those resources (liabilities and investor's equity), and information about the changes in these resources and claims (performance). A key activity after the financial statements are prepared is to accurately analyze and evaluate the company's performance and determine if it met its objectives for the reporting period. This chapter will discuss financial statements that report net income, comprehensive income, and changes in equity and their ability to tell the story about the company's performance for the reporting period.
03: Financial Reports- Statement of Income Comprehensive Income and Changes in Equity
The accounting system is a data repository that tracks all the economic events that have occurred during an accounting cycle (period) and reports them in some meaningful way to the company stakeholders. For example, the statement of income is a report required by both IFRS and ASPE that measures the return on capital (assets) – it is the "how well did we do" statement. This statement shows how the company performed during its operations for a specific period of time (typically annually, monthly, or quarterly). Key elements of the income statement include various revenue, expenses, gains, and losses for continuing and discontinued operations. Combined, these numbers represent the company's net income or loss (profit or loss) for the reporting period. Comprehensive income (an IFRS-only requirement) begins with net income and reports certain gains and losses not reported in net income such as those arising from fair value re-measurements for certain investments. The statement of changes in equity identifies details about the changes in equity due to transactions affecting shareholders as owners and investors of the company.
The IFRS and ASPE accounting standards describe which financial data is to be specifically identified and reported, out of the many thousands of transactions making up the accounting records. To comply with these standards, separate reporting of certain information either within the body of the financial statements or within the notes to the financial statements is required. That said, there is some flexibility regarding the information to be reported. For example, the terminology and the style used to present the data within the financial statements are often left to management's discretion.
This chapter will discuss preparation of these core financial statements, identify the mandatory reporting requirements, and look at how these statements can be analyzed to assist in decision making by management, investors, and other stakeholders. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/03%3A_Financial_Reports-_Statement_of_Income_Comprehensive_Income_and_Changes_in_Equity/3.01%3A_Financial_Reporting-_Overview.txt |
Choosing the fiscal year-end date is a strategic activity that requires careful consideration because the decision made can result in operational and tax advantages. The year-end will likely be influenced most by the company's business cycle. For example, a retailer will likely choose a year-end at the end of its busiest season, when inventory is at its lowest levels. This makes the physical count easier and less costly, because there will be more staff available and fewer adjustments to make before the books are closed. Planning a fiscal year-end based on advantageous tax consequences can be tricky, but essentially it means choosing a year-end that results in some temporary differences between certain transactions accounted for in one fiscal year but not taxed until a subsequent fiscal year. Alternatively, businesses that are not incorporated (e.g., proprietorships and partnerships) may choose the calendar year-end to coincide with Canada Revenue Agency, for simplicity from a tax perspective. Whatever fiscal year-end is chosen, accounting standards require that the financial statements be accrual based. This relates back to the accounting principles of revenue recognition, in terms of when to record revenue, and the matching principle, to ensure that all expenses related to that revenue recorded are included. The statements are also the results of operations for a specified period of time (the periodicity principle), called the reporting period. This raises the issues of what, when, and how much detail to record for any transactions that occur near, at, or subsequent to the reporting period year-end date.
Financial statements are often done on an interim basis each year. Interim reports can be monthly, quarterly, or some other reporting period. For example, public companies in Canada are required to produce quarterly financial statements. The accounting cycle has not yet been completed, so the temporary revenue, expense, gains, and loss accounts are not closed, and several end-of-period adjusting entries are recorded in order to ensure that the accounting records are as complete as possible for the interim period being reported. The annual published financial statements usually cover a fiscal or calendar year (on rare occasions, an operating cycle, if longer than one year). After the release of the year-end financial statement, the temporary accounts are closed to retained earnings, and an updated post-closing trial balance for all the (permanent) balance sheet accounts is completed to commence the new fiscal year.
There is also a period of time after the year-end date when certain events or transactions detected in the new fiscal year may need to either be recorded and reported in the financial statements or disclosed in the notes to the financial statements. For this reason, the accounting records from the previous fiscal year are kept open to accrue any significant entries and adjustments found in the new year that pertain to the fiscal year just ended. This time period may be anywhere from a few days to several weeks or months, depending on the size of the company. The end of this time marks the point at which the temporary accounts for the old fiscal year are closed and the financial statements are completed and officially published.
The following are examples of these types of transactions.
• Inventory – the physical inventory count that takes place as soon after the year-end date as possible. The total amount from the physical count is compared to the ending balance in the inventory subledgers, and an adjusting entry recorded for the difference. Since the accounting standards state that inventory is to be valuated each reporting date at the lower of cost and net realizable value (LCNRV), a write-down of inventory due to shrinkage may be required.
• Invoices Received after Year-end – this relates to goods and services received from suppliers before the year-end date, but not yet recorded. For example, companies purchasing goods from a supplier close to the year-end date usually receive the goods with a packing slip that details the types and quantities of goods received as well as the total cost. Once the goods are received and verified, the entry to record the goods and recognize the accounts payable will occur with the packing slip and the company's own purchase order being the source documents for the accounting entry. Recording entries relating to purchasing services, on the other hand, can be tricky since there is no packing slip involved when purchasing services. If the supplier providing the services does not leave an invoice with the purchaser as soon as the services have been completed, it will be sent at some later date, usually sometime during the following month of the new fiscal year. Keeping the books open for a time after the year-end date allows the company extra time to catch and record any significant transactions that are discovered during the next fiscal year that might otherwise be missed.
Any significant subsequent event that occurs after the fiscal year-end should be disclosed in the notes to the financial statements for the year just ended. An example might be where early in 2021 vandals damage some buildings and equipment. If the repair or replacement costs are material, these costs, though correctly paid and recorded in 2021, should be disclosed in the financial statements of 2020 if not yet published. This will ensure that the company stakeholders have access to all the relevant information. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/03%3A_Financial_Reports-_Statement_of_Income_Comprehensive_Income_and_Changes_in_Equity/3.02%3A_Factors_that_Influence_Reports/3.2.01%3A_Accounting_Year-end.txt |
Financial statements can be impacted by changes in accounting policies, changes in estimates, and correction of errors. These were first introduced in the introductory accounting course and will also be discussed in detail in the next intermediate accounting course. However, it is worth including a review at this time because they can significantly affect the financial statements.
Changes in Accounting Estimates
Accounting is full of estimates that are based on the best information available at the time. As new information becomes available, estimates may need to be changed. Examples of changing estimates would be changing the useful life, residual value, or the depreciation method used to match use of the assets with revenues earned. Other estimates involve uncollectible receivables, revenue recognition for long-term contracts, asset impairment losses, and pension expense assumptions. Changes in accounting estimates are applied prospectively, meaning they are applied to the current fiscal year if the accounting records have not yet been closed and for all future years going forward.
Changes in Accounting Policy
The accounting treatment for a change in accounting policy is retrospective adjustment with restatement. Retrospective application means that the company deals with the error or omission as though it had always been corrected.
Examples of changes in accounting policies are:
• changes in valuation methods for inventory such as changing from FIFO to weighted average cost
• changes in classification, presentation, and measurement of financial assets and liabilities under categories specified in the accounting standards such as investments classified as fair value reported through net income (FVNI), amortized cost (AC), or fair value reported through OCI (FVOCI) (IFRS only). Details of these are discussed in the chapter on intercorporate investments, later in this text.
• changes in the basis of measurement of non-current assets such as historical cost and revaluation basis
• changes in the basis used for accruals in the preparation of financial statements
Management must consistently review its accounting policies to ensure they comply with the latest pronouncements by IFRS or ASPE and to ensure the most relevant and reliable financial information for the stakeholders. Accounting policies must also be applied consistently to promote comparability between financial statements for different accounting periods. For this reason, a change in accounting policy is only allowed under two conditions:
1. due to changes in a primary source of GAAP
2. applied voluntarily by management to enhance the relevance and reliability of information contained in the financial statements for IFRS. ASPE has some exceptions to this "relevance and reliability" rule to provide flexibility for changes from one existing accounting standard to another.
As a rule, changes in accounting policies must be applied retrospectively with restatement to the financial statements. Retrospective application means that the company implements the change in accounting policy as though it had always been applied. Consequently, the company will adjust all comparative amounts presented in the financial statements affected by the change in accounting policy for each prior period reported. Retrospective application reduces the risk of changing policies to manage earnings aggressively because the restatement is made to all prior years as well as to the current year. If this were not the case, the change made to a single year could materially affect the statement of income for the current fiscal year. A cumulative amount for the restatement is estimated and adjusted to the opening retained earnings balance of the current year, net of taxes, in the statement of changes in equity (IFRS) or the statement of retained earnings (ASPE). This will be discussed and illustrated later in this chapter.
Retrospective application of a change in accounting policy may be exempted in the following circumstances.
• A transitional provision of the changed standard allows the prospective application of a new accounting policy. Specific transitional guidance of IFRS or ASPE must be followed in such circumstances.
• The application of a new accounting policy regarding events, transactions, and circumstances that are substantially different from those that occurred in the past.
• The effect of the retrospective application of a change in accounting policy is immaterial.
• The retrospective application of a change in accounting policy is impracticable. This may be the case where a company has not collected sufficient data to enable an objective assessment of the effect of a change in accounting estimates and it would be unfeasible or impractical to reconstruct the data. Where impracticability impairs a company's ability to apply a change in accounting policy retrospectively from the earliest prior period presented, the new accounting policy must be applied prospectively from the beginning of the earliest period feasible, which may be the current period.
The following are the required disclosures in the notes to the financial statements when a change in accounting policy is implemented:
• Title of IFRS or ASPE standard
• Nature of change in accounting policy
• Reasons for change in accounting policy
• Amount of adjustments in current and prior periods presented
• Where retrospective application is impracticable, the conditions that caused the impracticality (CPA Canada, 2011).
Changes Due to Accounting Errors or Omissions
The accounting treatment for an error or omission is a retrospective adjustment with restatement. For example, an accounting error in inventory originating in the current fiscal year is detected within the current fiscal year while the accounting records are still open. The inventory error correction is recorded as soon as possible to the applicable accounts. However, if the accounting records are already closed when the inventory error is discovered, the error is treated retrospectively. This means that the cumulative amount due to the inventory error would be calculated and recorded, net of taxes, to the current year's opening retained earnings balance. If the financial statements are comparative and include previous year's data, this data is also restated to include the error correction. This will be discussed and illustrated later in this chapter. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/03%3A_Financial_Reports-_Statement_of_Income_Comprehensive_Income_and_Changes_in_Equity/3.02%3A_Factors_that_Influence_Reports/3.2.02%3A_Changes_in_Accountin.txt |
The core financial statements connect to complete an overall picture of the company's operations and its current financial state. It is important to understand how these reports connect; therefore, a review of some simplified financial statements for Wellbourn Services Ltd., a large, privately-held company is presented below (assume Wellbourn applies IFRS; for simplicity, comparative year data and reporting disclosures are not shown).
As can be seen from the flow of the numbers above, the net income from the statement of income becomes the opening amount for the statement of comprehensive income (a statement required for all IFRS reporting companies).
Comprehensive income starts with net income/loss and includes certain gains or losses called other comprehensive income (OCI) that are not already reported in net income. The most notable examples for purposes of this course are:
• unrealized gains or losses for investments classified as fair value through OCI (FVOCI), resulting from changes in their fair value while the investment is being held (Chapter 8)
• gains/losses resulting from the application of the revaluation method for property, plant and equipment, and intangibles (Chapter 9)
In the next intermediate accounting course, another OCI item is the remeasurement gains and losses regarding defined benefit pension plans.
To summarize:
IFRS companies must report:
• Other comprehensive income (OCI) = certain gains or losses not already included in net income, net of tax, with tax amount disclosed
• Total comprehensive income = net income/loss +/- other comprehensive income (OCI)
Returning to the Wellbourn financial statements, looking at the statement of comprehensive income, net income closes to retained earnings, while any other comprehensive income (OCI) gain or loss closes to accumulated other comprehensive income (AOCI) in the statement of changes in equity. The AOCI account is similar to a retained earnings account, except that AOCI only accumulates items from OCI.
To summarize:
• Retained earnings accumulate net income/loss over time. (ASPE and IFRS)
• AOCI accumulates other comprehensive income (OCI)/losses over time. (IFRS only)
It should also be noted that IFRS companies can choose to keep the statement of income separate from the statement of comprehensive income, or they can combine the two statements into one report called the statement of income and comprehensive income, which will be discussed in more detail in the next section.
Looking at the Wellbourn statement of changes in equity, note that the total column balances to the equity section of the statement of financial position/balance sheet (SFP/BS). The final link between all the financial statements is regarding the statement of cash flows (SCF), where the ending cash balance must be equal to the cash balance reported in the SFP/BS. This completes the loop of interconnecting accounts and amounts.
3.03: Financial Statements and their Interrelationships
The core financial statements shown above illustrate the types of statements required for IFRS companies. They are the following:
• a statement of income
• a statement of comprehensive income
• a worksheet-style statement of changes in equity with all the equity accounts included
• a statement of financial position
• a statement of cash flows
• notes to the financial statements
IFRS requires the comparative previous year amounts be reported as well as disclosure of the earnings per share. ASPE does not require these disclosures. IFRS requires the statement of comprehensive income (or a combined statement of income and comprehensive income), whereas ASPE only requires a statement of income because comprehensive income does not exist. The statement of changes in equity required by IFRS shown in the Wellbourn example above now becomes a more simplified statement of retained earnings for ASPE, where only the details for retained earnings are reported (though any changes in shareholder equity accounts must be disclosed in the notes to the financial statements). The remaining equity accounts such as common shares and contributed surplus are reported as ending balances directly in the balance sheet for ASPE (called the statement of financial position for IFRS companies). | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/03%3A_Financial_Reports-_Statement_of_Income_Comprehensive_Income_and_Changes_in_Equity/3.03%3A_Financial_Statements_and_their_Interrelationships/3.3.01%3A_F.txt |
As previously stated, net income is a measure of return on capital and, hence, of performance. This means that investors and creditors can often estimate the company's future earnings and profitability based on an evaluation of its past performance as reported in net income. Comparing a company's current performance with its past performance creates trends that can have a predictive, though not guaranteed, value about future earnings performance. Additionally, comparing a company's performance with industry standards helps to assess the risks of not achieving goals compared to competitor companies in the same industry sector.
As previously mentioned, all the core financial statements are based on accrual accounting. Accrual accounting, in turn, is based on a series of standards-based processes and estimates. Some of these estimates have more measurement uncertainty than others, and some estimates are inherently more conservative than others. This in turn affects the quality of earnings reported in an income statement.
Quality of earnings – the amount of earnings attributable to sustainable ongoing core business activities rather than to "artificial profits" arising from:
• differences in earnings due to applying the various accounting policy choices such as FIFO or weighted average cost for inventory valuation or straight-line, declining-balance, or units-of-production depreciation methods
• the use of estimates such as those for estimating bad debt or warranty provisions
• the presence of significant amounts of non-operating gains and losses compared to income from continuing operations
• the inclusion of unreliable items such as inappropriate contingent gains
• management bias and reported amounts not objectively determined
• differences due to IFRS or ASPE application of standards
• information that is not concise or clearly presented and is poorly understood, resulting in potential misstatement
Lower quality earnings will include significant amounts of the items listed. If the quality of earnings is low, more risk is associated with the financial statements, and investors and creditors will place less reliance on them.
Single-step and Multiple-step Statement of Income
Single-step, multiple-step, or any condensed formats used in a statement of income are not specified GAAP requirements. Companies can choose whichever format best suits their reporting needs. Smaller privately held companies tend to use the simpler single-step format, while publicly traded companies tend to use the multiple-step format. When condensed formats are used, they are supplemented by extensive disclosures in the notes to the financial statements and cross-referenced to the respective line items in the statement of income.
The Wellbourn Services Ltd. statement of income, shown earlier, is an example of a typical single-step income statement. For this type of statement, revenue and expenses are each reported in the two sections for continuing operations. Discontinued operations are separately reported below the continuing operations. The separate disclosure and format for the discontinued operations section is a reporting requirement and is discussed and illustrated below. The condensed or single-step formats make the statement simple to complete and keeps sensitive information out of the hands of competitive companies, but provides little in the way of analytical detail.
The multiple-step income statement format provides much more detail. Below is an example of a multiple-step statement of income for Toulon Ltd., an IFRS company, for the year ended December 31, 2020.
Other revenue and expenses section is to report non-operating transactions not due to typical daily business activities. For example, if a company sells retail goods, any interest expense incurred is a finance cost, and is not due to being in the retail business.
Toulon reported four non-operating items:
• Dividend revenue would be for dividends received from an investment in shares of another company
• Interest income from investments would likely be from an investment in bonds of another company
• Gain from the sale of trading investments would be for the profit made when the investment was sold. In this case, the investment is classified as fair value through net income (FVNI), which means any changes in the investment's fair value at each reporting date, or profit upon sale, are reported as a gain/loss in net income
• Interest expense would be any interest paid on amounts owed to various creditors. This is considered to be a financing expense and not an operating expense, unless the company is a finance company.
Other examples of non-operating items are listed below:
• write-down of inventory
• impairment losses and reversals of impairment losses on PPE, intangible assets, and goodwill
• foreign currency exchange gains or losses
• gain or loss from asset disposal or from long-lived assets reclassified as held for sale
• interest expense by current liabilities, long-term liabilities, and capital lease obligations
• unusual items (not typical and infrequent)
The multiple-step format with its section subtotals makes performance analysis and ratio calculations such as gross profit margins easier to complete and makes it easier to assess the company's future earnings potential. The multiple-step format also enables investors and creditors to evaluate company performance results from continuing and ongoing operations having a high predictive value compared to non-operating or unusual items having little predictive value.
Operating Expenses
Expenses from operations must be reported by their nature and, optionally, by function (IFRS). Expenses by nature relate to the type of expense or the source of expense such as salaries, insurance, advertising, travel and entertainment, supplies expense, depreciation and amortization, and utilities expense, to name a few. The statement for Toulon Ltd. is an example of reporting expenses by nature. Reporting expenses by nature is mandatory for IFRS companies; therefore, if the statement of income reports expenses by function, expenses by nature would also have to be reported either as a breakdown within each function in the statement of income itself or in the notes to the financial statements.
Expenses by function relate to how various expenses are incurred within the various departments and activities of a company. Expenses by function include activities such as the following:
• sales and marketing
• production
• office and administration
• research and development
Common costs such as utilities, supplies, insurance, and property tax expenses would have to be allocated between the various functions using a reasonable basis such as square footage or each department's proportional share of overall expenses. This allocation process can be cumbersome and will require more time, effort, and professional judgement.
The sum of all the revenues, expenses, gains, and losses to this point represents the income or loss from continuing operations. This is a key component used in performance analysis and will be discussed later in this chapter.
Income Tax Allocations
Intra-period tax allocation is the process of allocating income tax expense to various categories within the statement of income, comprehensive income, and retained earnings.
For example, income taxes are to be allocated to the following four categories:
1. Income from continuing operations before taxes
2. Discontinued operations, net of tax
3. Each item reported as other comprehensive income, net of tax
4. Each item regarding retrospective restatement for changes in accounting policy or correction of prior period errors reported in retained earnings, net of tax, which is also discussed later in this chapter
The purpose of these allocations is to make the information within the statements more informative and complete. For example, Toulon's statement of income for the year ending December 31, 2020, allocates 30% income tax as follows:
• Income from continuing operations of \$850,000 ()
• Loss from discontinued operations of \$45,000 ()
• Loss from disposal of discontinued operations of \$18,000 ()
• Comprehensive income gain from FVOCI investments of \$6,000 ()
All companies are required to report each of the categories above net of their tax effects. This makes analyses of operating results within the company itself and of its competitors more comparable and meaningful.
Note: if there is a net loss, the income tax reported on the income statement will be "income tax recovery" and shown as a negative (bracketed) amount.
Discontinued operations
Sometimes companies will sell or shut down certain business components or operations because the operating segment or component is no longer profitable, or they may wish to focus their resources on other business components. To be separately reportable as a discontinued operation in the statement of income, the business component being discontinued must have its own clearly distinguishable operations and cash flows, referred to as a cash-generating unit (CGU) for IFRS companies. Examples are a major business line or geographical area. If the discontinued operation has not yet been sold, there must be a formal plan in place to dispose of the component within one year and to report it as a discontinued operation.
The items reported in this section of the statement of income are to be separated into two reporting lines:
• Gains or losses in operations prior to disposal of the CGU, net of tax, with tax amount disclosed
• Gains or losses in operations on disposal of the CGU, net of tax, with the tax amounts disclosed
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Net Income and Comprehensive Income
Note that the statement for Toulon Ltd. combines net income and total comprehensive income. Two statements would be prepared for IFRS companies that prefer to separate net income from comprehensive income. The statement of income, ends at net income (highlighted in yellow). A second statement, called the statement of comprehensive income, would start with net income and include any other comprehensive income (OCI) items. The Wellbourn financial statement (shown in section 3.3 of this chapter) is an example of separating net income and total comprehensive income into two statements.
Another item that is important to disclose in the financial statements is the non-controlling interest (NCI) reported for net income and total comprehensive income. This is the portion of equity ownership in an associate (subsidiary) that is not attributable to the parent company (Toulon, in our example) that has a controlling interest (greater than 50% but less than 100% ownership) in the acquired company's net assets. Toulon must consolidate the associate's financial data with its own and report as a single entity to comply with IFRS standards. Consider that if a company purchases 80% of the net assets of another company, the remaining 20% must therefore be owned by outside investors. This 20% amount must be reported as the non-controlling interest to ensure that investors and creditors of the company holding 80% (parent) are adequately informed about the true value of the net assets owned by the parent company versus outside investors.
For ASPE companies using a multiple-step format, the statement of income would look virtually the same as the example for Toulon above and would include all the line items up to the net income amount (highlighted in yellow). As previously stated, comprehensive income is an IFRS concept only; it is not applicable to ASPE.
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Earnings per Share
Basic earnings per share represent the amount of income attributable to each outstanding common share, as shown in the calculation below:
The earnings per share amounts are not required for ASPE companies. This is because ownership of privately owned companies is often held by only a few investors, compared to publicly-traded IFRS companies where shares are held by many investors.
For IFRS companies, basic earnings per share excludes OCI and any non-controlling interests. EPS is to be reported on the face of the statement of income as follows:
• Basic and diluted EPS from continuing operations
• Basic and diluted EPS from discontinued operations, if any
The term basic earnings per share refers to IFRS companies with a simple capital structure consisting of common shares and perhaps non-convertible preferred shares or non-convertible bonds. Reporting diluted earnings per share is required when companies hold financial instruments such as options or warrants, convertible bonds, or convertible preferred shares, where the holders of these instruments can convert them into common shares at a future date. The impact of these types of financial instruments is the potential future dilution of common shares and the effect this could have on earnings per share to the common shareholders. Details about diluted earnings per share will be covered in the next intermediate accounting course.
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Recall that net income or loss is closed to retained earnings. For ASPE companies, there is no comprehensive income (OCI) and therefore no AOCI account in equity. With this simpler reporting requirement, ASPE companies report retained earnings in the balance sheet and detail any changes in retained earnings that took place during the reporting period in the statement of retained earnings. An example of a statement of retained earnings is that of Arctic Services Ltd., for the year ended December 31, 2020.
Arctic Services Ltd.
Statement of Retained Earnings
For the Year Ended December 31, 2020
Balance, January 1, as reported \$ 250,000
Cumulative effect on prior years of retrospective application
of changing inventory costing method from FIFO
to moving weighted average
(net of taxes for \$5,400) 12,600
Correction for an overstatement of net income from a prior period
due to an ending inventory error (net of \$3,000 tax recovery) (7,000)
Balance, January 1, as adjusted 255,600
Net income 80,500
336,100
Cash dividends declared \$ (75,000)
Stock dividends declared (60,000) (135,000)
Balance, December 31 \$ 201,100
As discussed at the beginning of this chapter, any error corrections from prior periods or allowable changes in accounting policies will result in a reporting requirement to restate the opening retained earnings balance for the current period. Each error and change in accounting policy item is separately reported, net of tax, with the tax amount disclosed. The retained earnings opening balance is restated and a detailed description is included in the notes to the financial statements. The journal entry for the two restatement items for Arctic Services would be:
The statement of retained earnings also includes any current period net income or loss followed by any cash or stock dividends declared by the board of directors. This detail provides important information to investors and creditors regarding the proportion of net income that is distributed to the shareholders through a dividend compared to the net income retained for future business purposes such as investment or expansion.
ASPE companies may choose to combine the statement of income and the statement of retained earnings. In this case, the statement of retained earnings is incorporated at the bottom of the statement of income, starting with net income as shown in a simple example below:
Net income \$\$\$
Retained earnings, January 1 \$\$\$
Dividends declared \$\$\$
Retained earnings, December 31 \$\$\$
For IFRS companies, net income is closed out to retained earnings, and other comprehensive income (OCI), if any, is closed out to accumulated other comprehensive income (AOCI). An example of how that works is illustrated in the Wellbourn financial statements included in section 3.3 of this chapter. Both retained earnings and AOCI are reported in the equity section of the statement of financial position (SFP) and the statement of changes in equity (IFRS).
For IFRS companies, each account from the equity section of the SFP is to be reported in the statement of changes in equity. The following is an example of the statement of changes in equity for an IFRS company, Velton Ltd., for the year ended December 31, 2020. Note how this statement is worksheet style, which discloses each retrospective adjustment net of tax, followed by a restatement of the equity account opening balances. Each equity account opening balance is then reconciled to its respective closing balance by reporting the changes that occurred during the year, such as the issuance/retirement of shares, net income, and dividends. The statement also must report total comprehensive income. Any non-controlling interest would also be reported (as a separate column), the same as was required and illustrated for Toulon Ltd.'s statement of income presented earlier.
Velton Ltd.
Statement of Changes in Equity
for the year ended December 31, 2020
Accumulated Other
Preferred Common Contributed Retained Comprehensive
Shares Shares Surplus Earnings Income Total
Balance, January 1 \$ 100,000 \$ 500,000 \$ 15,000 \$ 450,000 \$ 22,000 \$ 1,087,000
Cumulative effect on prior years of retrospective
application of changing inventory costing
method from FIFO to moving weighted average
(net of taxes for \$15,000) 35,000 35,000
Correction for an overstatement of net income from
a prior period due to an ending inventory error
(net of \$6,000 tax recovery) (20,000) (20,000)
Balance, January 1, as restated 100,000 500,000 15,000 465,000 22,000 1,102,000
Total comprehensive income:
Net income 125,000 125,000
Other Comprehensive Income –
unrealized gain — FVOCI investments** 3,500 3,500
Total comprehensive income 125,000 3,500 128,500
Issuance of common shares 100,000 100,000
Dividends declared (50,000) (50,000)
Balance, December 31 \$ 100,000 \$ 600,000 \$ 15,000 \$ 540,000 \$ 25,500 \$ 1,280,500
** net of related tax of \$800. May be reclassified subsequently to net income or loss
The equity portion of the SFP is shown below.
Velton Ltd.
Statement of Changes in Financial Position
Shareholders' Equity Section
December 31, 2020
Shareholder's equity
Paid-in capital:
Preferred shares, non-cumulative, 2,000 authorized;
1,000 issued and outstanding \$ 100,000
Common shares, unlimited authorized;
20,000 issued and outstanding 600,000
Contributed surplus 15,000
715,000
Retained earnings 540,000
Accumulated other comprehensive income 25,500
Total shareholders' equity \$ 1,280,500
If the company sustained net losses over several years and retained earnings were insufficient to absorb these losses, retained earnings would have a debit balance and would be reported on the SFP as a deficit.
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Financial statement analysis is an evaluative process of determining the past, current, and projected performance of a company. Financial statements report financial data; however, this information must be evaluated to be more useful to investors, shareholders, managers, and other stakeholders. Several techniques are commonly used for financial statement analysis. They were originally presented in the introductory accounting course. A summary review of these techniques follows.
Horizontal analysis compares two or more years of financial data in both dollar amounts and percentage form. An income statement and SFP/BS with comparative data from prior years are examples of where horizontal analysis is incorporated into the financial statements to enhance evaluation. Trends can emerge that are considered as either favourable or unfavourable in terms of company performance.
Vertical or common-size analysis occurs when each category of accounts on the income statement or SFP/BS is shown as a percentage of a total. For example, vertical analysis is used to evaluate the statement of income such as the percentage that gross profit is to sales or the percentages that operating expenses are to sales. Similarly, vertical analysis of the SFP/BS may be used to evaluate what percentage equity is to total assets. This ratio tells investors what proportion of the net assets is being retained by the company's investors compared to the company's creditors.
Ratio analysis calculates statistical relationships between data. Ratio analysis is used to evaluate various aspects of a company's financial performance such as its efficiency, liquidity, profitability, and solvency. Gross profit ratio (gross profit divided by net sales and/or revenue) and earnings per share (EPS) are examples of key ratios used to evaluate income and changes in equity. One of the most widely used ratios by investors to assess company performance is the price-earnings (P/E) ratio (market price per share divided by EPS). The P/E ratio is the most widely quoted measure that investors use as an indicator of future growth and of risk related to a company's earnings when establishing the market price of the shares. The trend of the various ratios over time is assessed to see if performance is improving or deteriorating. Ratios are also assessed across different companies in the same industry sector to see how they compare. Ratios are a key component to financial statement analysis.
Segmented Reporting
The statement of income can be segmented, or disaggregated, to enhance performance analysis. The statement can be segmented in various ways such as by geography or by type of product or service. As a point of interest, other segmented financial statements include the SFP/BS and the statement of cash flow covered in the next chapter.
For ASPE, there is currently no guidance regarding segmented reporting. For IFRS companies, a segment must meet several characteristics and quantitative thresholds to be a reportable segment for purposes of the published financial statements. Segmented reporting can set apart business components that have a strong financial performance from those that are weak or are negative "losing" performers. Management can use this information to make decisions about which components to keep and which components to discontinue as part of their overall business strategy. Keep in mind that not all business components that experience chronic losses should be automatically discontinued. There are strategic reasons for keeping a "losing" component. For example, retaining a borderline, or losing, segment that produces parts may guarantee access to these critical parts when needed for production of a much larger product to continue uninterrupted. If the parts manufacturing component is discontinued and disposed, this guaranteed access will no longer exist and production in the larger sense can quickly grind to a halt, affecting company sales and profits. Segmented reporting can also assist in forecasting future sales, profits, and cash flows, since different components within a company can have different gross margins, profitability, and risk.
There can be issues with segmented reporting. For example, accounting processes such as allocation of common costs and elimination of inter-segment sales can be challenging. A thorough knowledge of the business and the industry in which the company operates is essential when utilizing segmented reports; otherwise, investors may find segmentation meaningless or, at worst, draw incorrect conclusions about the performance of the business components. There can be reluctance to publish segmented information because of the risk that competitors, suppliers, government agencies, and unions can use this information to their advantage and to the detriment of the company.
3.07: IFRS and ASPE Applicable Standards
CPA Canada Handbook, Part 1 (IFRS) – IAS 1, Presentation of Financial Statements, IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, IFRS 5, non-current assets held for sale and discontinued operations
CPA Canada Handbook, Part 2, (ASPE) – Sections 1400 general standards of financial statement presentation, Section 1506, Accounting changes, Section 1520, Income Statement, and Section 3475, Disposal of long-lived assets and discontinued operations | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/03%3A_Financial_Reports-_Statement_of_Income_Comprehensive_Income_and_Changes_in_Equity/3.06%3A_Analysis_of_Statement_of_Income_and_Statement_of_Changes_in_E.txt |
LO 1: Describe statement of income, the statement of comprehensive income, and the statement of changes in equity, and their role in accounting and business.
The statement of income reports on company performance over the reporting period in terms of net income. The statement of comprehensive income is a concept only used by IFRS companies that reports on other gains and losses not already reported in net income. The statement of changes in equity (IFRS) reports on what changes took place in each of the equity accounts for the reporting period. For ASPE, this statement is a much simpler statement of retained earnings. Together, these statements enable the company stakeholders such as management, investors, and creditors to assess the financial health of the company and its ability to generate profits and repay debt. Each accounting standard (IFRS and ASPE) has minimum reporting requirements, which were discussed in this chapter.
LO 2: Identify the factors that influence what is reported in the statement of income, the statement of comprehensive income, and the statement of changes in equity.
The accounting standards require that all statements are reported on an accrual basis over a specific period of time (periodicity assumption) so that anything relevant to decision making is included (full disclosure principle). To ensure this, various adjusting entries are recorded to make certain that the accounting records are up to date, and an accounting fiscal year-end date is carefully chosen. Accrual entries include any revenues earned but not yet recorded, whether paid or not (revenue recognition principle), and any expenses where goods and services have been received but not yet recorded, whether paid or not (matching principle). Other adjusting entries include prepayment items (prepaid expenses and unearned revenues), the estimate for bad debt expense, depreciation and amortization of depreciable assets, unrealized gains and losses of certain assets, and any impairment or write-down entries, if required. Also considered are subsequent events that occur after the year-end date and whether to include them in the financial statements or in the notes to the financial statements. Changes in accounting estimates (prospective treatment with restatement), correcting accounting errors (retrospective treatment with restatement), and changes in accounting policy (retrospective treatment) can all affect the financial statements.
LO 3: Identify the core financial statements and explain how they interconnect together.
The core financial statements interconnect to complete an overall picture of a company's performance over the reporting period (income statement) as well as its current financial state (SFP/BS). Starting with performance, the net income from the statement of income becomes the first amount reported on the statement of comprehensive income. Added to that is other comprehensive income (OCI), which reports any gains or losses not already reported in net income (IFRS only). Net income and OCI each flow to the statement of changes in equity, which reports on all the items that have affected the equity accounts during the reporting period. Together, these three financial statements are used to assess the company performance for the reporting period. The statement of cash flows reconciles cash and cash equivalent opening balances at the beginning of the reporting period to the closing balances at the end of the period. These changes are broken down into sources of cash inflows and outflows. Cash inflows could be from customers, issuing debt, or issuing share capital, while cash outflows could be from payments to suppliers, to employees, the purchase of assets, the payment of debt, any retirement of share capital, or the payment of dividends. These activities are separated and reported into the operating, investing, and financing section. The net amount of change represents the total change between the opening cash and cash equivalent balance to the closing cash and cash equivalent balance. The SFP/BS completes the set of core financial statements. It provides a snapshot at the end of the reporting period, such as month-end or year-end, and identifies the company resources (assets) and the claims to these resources (liabilities). The remaining net assets belong to the various classes of shareholders. The ending cash and cash equivalent balance of the statement of cash flow must reconcile to the cash and cash equivalent balances in the SFP/BS, and the statement of changes in equity totals must reconcile to the SFP/BS equity section, so that all the statements fit together into a single reconciled network of financial information.
There are differences between IFRS and ASPE reporting standards. For APSE, the statement of income is quite similar but without the requirement for comparative years' data and earnings per share reporting. Comprehensive income is not a concept used by ASPE so there is no requirement for a statement of comprehensive income. ASPE companies report any changes in retained earnings through the statement of retained earnings, which is a much simpler statement that reports only the changes in the retained earnings account compared to the statement of changes in equity (IFRS), which reports the changes for all equity accounts.
LO 4: Describe the various formats used for the statement of income and the statement of comprehensive income, and identify the various reporting requirements for companies following IFRS and ASPE.
The purpose of the statement of income is to identify the revenues and expenses that comprise a company's net income. A comprehensive income statement, required by IFRS, identifies any gains and losses not already included in the statement of income. Together, these statements enable management, creditors, and investors to assess a company's financial performance for the reporting period. Comparing current with past performance, stakeholders can use these statements to predict future earnings and profitability. Since accounting is accrual-based, uncertainty exists in terms of the accuracy and reliability of the data used in the estimates. Net income (earnings) that can be attributable to sustainable ongoing core business activities are higher quality earnings than artificial numbers generated from applying accounting processes, determining various estimates, or gains and losses from non-operating business activities. The lower the quality of earnings, the less reliance will be placed on them by investors and creditors.
The statement of income can be a simple single-step or a more complex multiple-step format. Either one has its advantages and disadvantages. No matter which format is used, certain mandatory reporting requirements for both IFRS and ASPE exist, such as separate reporting for continuing operations and discontinued operations. To be reported as a discontinued operation, the business component must meet the definition of a cash-generating unit and a formal plan to dispose of the business component must exist. Companies can choose to report operating expenses by nature (type of expense) or by function (which department incurred the expense). However, if expenses by function is used, additional reporting of certain line items by nature is still required for both IFRS and ASPE companies such as inventory expensed, depreciation, amortization, finance costs, inventory write-downs, and income taxes to name a few. IFRS companies can choose to keep the statement of income separate from the statement of comprehensive income or combine them into a single statement: the statement of income and comprehensive income. For IFRS companies, the earnings per share are reporting requirements.
LO 5: Describe the various formats used to report the changes in equity for IFRS and ASPE companies, and identify the reporting requirements.
For ASPE companies the various sources of change occurring during the reporting period for retained earnings is reported, while for IFRS companies changes to each of the equity accounts is identified, usually in a worksheet style with each account assigned to a column. One important aspect to either statement is the retrospective reporting for changes in accounting policies or corrections of errors from prior periods. The opening balance for retained earnings is restated by the amount of the change or error, net of tax, with the tax amount disclosed. Other line items for these statements include net income or loss and dividends declared. For IFRS companies reporting will also include any changes to the share capital accounts and accumulated other comprehensive income (resulting from OCI items recorded in the reporting period).
LO 6: Identify and describe the types of analysis techniques that can be used for income and equity statements.
Analysis of the financial statements is critical to decision making and to properly assess the overall financial health of a company. Analysis transforms the data into meaningful information for management, investors, creditors, and other company stakeholders. By evaluating the financial data, trends can be identified which can be used to predict the company's future performance. Some techniques used on financial statements include horizontal analysis that compares data from multiple years, vertical analysis that expresses certain subtotals (gross profit) as a percentage of a total amount (sales), and ratio analysis that highlights important relationships between data.
3.09: References
CPA Canada. (2011). CPA Canada handbook, Part I, IAS 8.
Jones, J. (2014, September 19). Restated Penn West results reveal cut to cash flow. The Globe and Mail. Retrieved from https://secure.globeadvisor.com/servlet/ArticleNews/story/gam/20140919/RBCDPENNWESTFINAL | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/03%3A_Financial_Reports-_Statement_of_Income_Comprehensive_Income_and_Changes_in_Equity/3.08%3A_Chapter_Summary.txt |
3.1 The following information pertains to Inglewood Ltd. for the 2020 fiscal year ending December 31:
Gain on sale of FVNI investments (before tax): \$ 1,500
Loss from operation of discontinued division (net of tax) 2,500
Loss from disposal of discontinued division (net of tax) 3,500
Income from operations (before tax) 125,000
Unrealized holding gain of FVOCI investments (net of tax) 12,000
The company tax rate is 27%. The unrealized holding gain is from FVOCI investments where the gain has been recorded to other comprehensive income (OCI).
Required:
1. Calculate income from continuing operations, net income, other comprehensive income, and total comprehensive income.
2. How would your answers change in part (a) if the company followed ASPE?
3.2 Wozzie Wiggits Ltd. produces and sells gaming software. In 2020, Wozzie's net income exceeded analysts' expectations in the stock markets by 8%, suggesting an 8% increase from operations. Included in net income was a significant gain on sale of some unused assets. The company also changed their inventory pricing policy from FIFO which is currently being used in their industry sector to weighted average cost, causing a significant drop in cost of goods sold. This policy change was fully disclosed in the notes to the financial statements.
Required: Based solely on the information above, do you think that Wozzie's earnings are of high quality? Would you be willing to invest in this company based on the quality of earnings noted in the question?
3.3 Eastern Cycles Ltd. is a franchise that sells bicycles and cycling equipment to the public. It currently operates several corporate-owned retail stores in Ottawa that are not considered a separate major line of business. It also has several franchised stores in Alberta. The franchisees buy all of their products from Eastern Cycles and pay 5% of their monthly sales revenues to Eastern Cycles in return for corporate sponsored advertising, training, and support. Eastern Cycles continues to monitor each franchise to ensure quality customer service. In 2020, Eastern Cycles sold its corporate owned stores in Ottawa to a franchisee.
Required: Would the sale of the franchise meet the classification of a discontinued operation under IFRS or ASPE?
3.4 For the year ended December 31, 2020, Bunsheim Ltd. reported the following: sales revenue \$680,000; cost of sales \$425,750; operating expenses \$75,000; and unrealized gain on Available-for-sale investments \$25,000 (net of related tax of \$5,000). The company had balances as at January 1, 2020, as follows: common shares \$480,000; accumulated other comprehensive income \$177,000; and retained earnings \$50,000. The company did not issue any common shares during 2020. On December 15, 2020, the board of directors declared a \$45,000 dividend to its common shareholders payable on January 31, 2021. The company accounts for its investments in accordance with IFRS 9 meaning that any unrealized gains/losses on FVOCI investments are to be reported as other comprehensive income (OCI). On January 4, 2021, the company discovered that there was an understatement in travel expenses from 2019 of \$80,000. The books for 2019 are closed.
Required
1. Prepare a statement of changes in equity including required disclosures. The enacted tax rate is 27% and has not changed for several years.
2. Prepare the same statement as in part (a) assuming that Bunsheim Ltd. follows ASPE.
3.5 For the year ended December 31, 2020, Patsy Inc. had income from continuing operations of \$1,500,000. During 2020, it disposed of its Calgary division at a loss before taxes of \$125,000. Before the disposal, the division operated at a before-tax loss of \$150,000 in 2019 and \$175,000 in 2020. Patsy also had an unrealized gain in its Availablefor-sale investments (FVOCI) of \$27,500 (net of tax). It accounts for its investments in accordance with IFRS 9. Patsy had 50,000 outstanding common shares for the entire 2020 fiscal year and its income tax rate is 30%.
Required:
1. Prepare a partial statement of comprehensive income with proper disclosures for Patsy Inc. beginning with income from continuing operations. Patsy follows IFRS.
2. How would the statement in part (a) differ if Patsy followed ASPE?
3.6 Below are the changes in account balances, except for retained earnings, for Desert Dorm Ltd., for the 2020 fiscal year:
Account increase
(decrease)
Accounts payable \$ (23,400)
Accounts receivable (net) 15,800
Bonds payable 46,500
Cash 41,670
Common shares 87,000
Contributed surplus 18,600
Inventory 218,400
Investments – FVNI (46,500)
Intangible assets – patents 14,000
Unearned revenue 45,200
Retained earnings ??
Required: Calculate the net income for 2020, assuming there were no entries in the retained earnings account except for net income and a dividend declaration of \$44,000, which was paid in 2020. (Hint: using the accounting equation to help solve this question)
3.7 In 2020, Imogen Co. reported net income of \$575,000, and declared and paid preferred share dividends of \$75,000. During 2020, the company had a weighted average of 66,000 common shares outstanding.
Required: Calculate the company's basic earnings per share.
3.8 A list of selected accounts for Opi Co. is shown below. All accounts have normal balances. The income tax rate is 30%.
Opi Co.
For the year ended December 31, 2020
Accounts payable \$ 63,700
Accounts receivable 136,500
Accumulated depreciation – building 25,480
Accumulated depreciation – equipment 36,400
Administrative expenses 128,700
Allowance for doubtful accounts 6,500
Bond payable 130,000
Buildings 127,400
Cash 284,180
Common shares 390,000
Cost of goods sold 1,020,500
Dividends 58,500
Equipment 182,000
Error correction for understated cost of goods sold from 2019 13,500
Freight-out 26,000
Gain on disposal of discontinued operations – South Division 27,560
Gain on sale of land 39,000
Inventory 161,200
Land 91,000
Miscellaneous operating expenses 1,560
Notes payable 91,000
Notes receivable 143,000
Rent revenue 23,400
Retained earnings 338,000
Salaries and wages payable 23,500
Sales discounts 18,850
Sales returns and allowances 22,750
Sales revenue 1,820,000
Selling expenses 561,600
Required:
1. Prepare a single-step income statement with expenses by function and a separate statement of retained earnings assuming that Opi is a private company that follows ASPE.
2. Prepare a combined single-step income statement and retained earnings by function assuming ASPE.
3.9 Below are adjusted accounts and balances for Ace Retailing Ltd. for the year ended December 31, 2020:
Cost of goods sold 750,000
Dividends declared (common shares) 245,000
Dividends declared (preferred shares) 82,000
Gain on disposal of discontinued J division 115,000
Gain on sale of FVNI investments 45,000
Interest income 15,000
Loss on impairment of goodwill 12,000
Loss due to warehouse fire 175,000
Loss from operation of discontinued J division 285,000
Loss on disposal of unused equipment from F division 82,000
Retained earnings, January 1, 2020 458,000
Sales revenue 1,500,000
Selling and administrative expenses 245,000
Unrealized gain on FVOCI investments (OCI) 18,600
Additional information:
1. Ace decided to discontinue the J division operations. A formal plan to dispose of J division has been completed. There are no plans to dispose of F division at this time.
2. During 2020, 400,000 common shares were outstanding with no shares activity for 2020.
3. Ace's tax rate is 27%.
4. Ace follows IFRS and accounts for its investments in accordance with IFRS 9 meaning that any unrealized gains/losses for FVNI are reported through net income and FVOCI are reported in OCI.
Required:
1. Prepare a multiple-step statement of income for the year ended December 31, 2020, in good form reporting expenses by function.
2. Prepare a combined statement of income and comprehensive income in good form reporting expenses by function.
3. How would the answer in part (b) differ if a statement of comprehensive income were to be prepared without combining it with the statement of income?
4. Prepare a single-step statement of income in good form reporting expenses by function.
5. Explain what types of items are to be reported in other revenue and expenses as part of continuing operations, and provide examples for a retail business.
3.10 Vivando Ltd. follows IFRS and reported income from continuing operations before income tax of \$1,820,000 in 2020. The year-end is December 31, 2020, and the company had 225,000 outstanding common shares throughout the 2020 fiscal year. Additional transactions not considered in the \$1,820,000 are listed below:
In 2020, Vivando sold equipment of \$75,000. The equipment had originally cost \$92,000 and had accumulated depreciation to date of \$33,400. The gain or loss is considered ordinary.
The company discontinued operations of one of its subsidiaries, disposing of it during the current year at a total loss of \$180,600 before tax. Assume that this transaction meets the criteria for discontinued operations. The loss on operation of the discontinued subsidiary was \$68,000 before tax. The loss from disposal of the subsidiary was \$112,600 before tax.
The sum of \$180,200 was received because of a lawsuit for a breached 2016 contract. Before the decision, legal counsel was uncertain about the outcome of the suit and had not established a receivable.
In 2020, the company reviewed its accounts receivable and determined that \$125,600 of accounts receivable that had been carried for years appeared unlikely to be collected. No allowance for doubtful accounts was previously set up.
An internal audit discovered that amortization of intangible assets was understated by \$22,800 (net of tax) in a prior period. The amount was charged against retained earnings.
Required: Analyze the above information and prepare an income statement for the year 2020, starting with income from continuing operations before income tax (Hint: refer to the Toulon Ltd. example in Section 4 of this chapter). Calculate earnings per share as it should be shown on the face of the income statement. Assume a total effective tax rate of 25% on all items, unless otherwise indicated.
3.11 The following account balances were included in the adjusted trial balance of Spyder Inc. at September 30, 2020. All accounts have normal balances:
Accumulated depreciation, office furniture 25,000
Accumulated depreciation, sales equipment 80,000
Accumulated Other Comprehensive Income 162,000
Allowance for doubtful accounts 2,500
Cost of goods sold 1,500,478
Common shares 454,000
Depreciation expense, office furniture 10,150
Depreciation expense, sales equipment 6,972
Depreciation expense, understatement due to error – 2019 24,780
Dividend revenue 53,200
Dividends declared on common shares 12,600
Entertainment expense 20,748
Freight-out 40,502
Gain on sale of land 78,400
Interest expense 25,200
Loss on disposal of discontinued operations – Aphfflek Division 49,000
Miscellaneous operating expenses (administrative) 6,601
Retained earnings 215,600
Salaries and wages expense – office staff 78,764
Sales commissions expense 136,640
Sales discounts 21,000
Sales returns and allowances 87,220
Sales revenue 2,699,900
Supplies expenses (administrative) 4,830
Telephone and Internet expense (administrative) 3,948
Telephone and Internet expense (sales) 12,642
Additional information:
The company follows IFRS and its income tax rate is 30%. On September 30, 2020, the number of common shares outstanding was 124,000 and no changes to common shares during the fiscal year. The depreciation error was due to a missed month-end accrual entry at August 31, 2019.
Required:
1. Prepare a multiple-step income statement in good form with all required disclosures by function and by nature for the year ending September 30, 2020.
2. Prepare a statement of changes in equity in good form with all required disclosures for the year ended September 30, 2020.
3. Prepare a single-step income statement in good form with all required disclosures by nature for the year ending September 30, 2020, assuming this time that the dividends declared account listed in the trial balance are for preferred shares instead of common shares.
4. Assuming that Spyder also recorded unrealized gains for FVOCI investments through OCI of \$25,000, prepare a statement of comprehensive income for the company. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/03%3A_Financial_Reports-_Statement_of_Income_Comprehensive_Income_and_Changes_in_Equity/3.10%3A_Exercises.txt |
Amazon's Cash Flow Position
In 2014, Amazon reported its quarterly earnings for their year-to-date earnings release. Since the trend has been for their profits to slide downward in the recent past, initial speculation was that this was causing investor discontent resulting in decreasing stock prices. But was it?
Even though profits were on a downward trend, the earnings releases showed that the operating section of the statement of cash flow (SCF) was reporting some healthy net cash balances that were much higher than net income. This is often caused by net income including large amounts of non-cash depreciation expense.
Moreover, when looking at free cash flow, it could be seen that Amazon had been making huge amounts of investment purchases, causing a sharp drop in the free cash flow levels compared to the operating section of the SCF. However, even with these gigantic investment purchases, free cash flow continued to soar well above its net income counterpart by more than \$1 billion. What this tells investors is that there are timing differences between what is reported as net income on an accrual basis and reported as cash flows on strictly a cash basis.
The key to such cash flows success lies in the cash conversion cycle (CCC). This is a metric that measures how many days it takes for a company to pay it suppliers for its resale inventory purchases compared to how many days it takes to convert this inventory back into cash when it is sold and the customer pays their account. For example, if it takes 45 days to pay the supplier for resale inventory and only 40 days to sell and receive the cash from the customer, this creates a negative CCC of 5 days of access to additional cash flows. In industry, Costco and Walmart have been doing well at maintaining single-digit CCC's but Amazon tops the chart at an impressive negative 30.6 days in 2013. Apple also managed to achieve a negative CCC in 2013, making these two companies cash-generating giants in an often-risky high-tech world.
Amazon is using this internal access to additional cash to achieve significant levels of growth; from originally an online merchant of books to a wide variety of products and services, and, most recently, to video streaming. Simply put, Amazon can expand without borrowing from the bank, or from issuing more stock. This has landed Amazon's founder and CEO, Jeff Bezoz, an enviable spot in Harvard Business Review's list of best performing CEOs in the world.
So, which part of the CCC metric is Amazon leveraging the most? While it could be good inventory management, it is not. It is the length of time Amazon takes to pay its suppliers. In 2013, the company took a massive 95.8 days to pay its suppliers, a fact that suppliers may not be willing to accept forever.
Though it might have been too early to tell, some of the more recent earnings release figures for Amazon are starting to show the possibility that the CCC metric may be starting to increase. This shift might be a cause for concern for the investors. Moreover, this could be the real reason why Amazon's stock price was faltering in 2014 rather than because of the decreasing profits initially considered by many to be the culprit.
(Source: Fox, 2014)
Learning Objectives
After completing this chapter, should be able to:
1. Describe the statement of financial position/balance sheet (SFP/BS) and the statement of cash flows (SCF), and explain their role in accounting and business.
2. Explain the purpose of the SFP/BS.
1. Identify the various disclosure requirements for the SFP/BS and prepare a SFP/BS in good form.
2. Identify and describe the factors can affect the SFP/BS, such as changes in accounting estimates, changes in accounting policies, errors and omissions, contingencies and guarantees, and subsequent events.
3. Explain the purpose of the statement of cash flows (SCF) and prepare a SCF in good form.
1. Explain and describe an acceptable format for the SCF.
2. Describe and prepare a SCF in good form with accounts analysis as required, and interpret the results.
4. Identify and describe the types of analysis techniques that can be used for the SFP/BS and the SCF.
Introduction
In Chapter 3 we discussed three of the core financial statements. This chapter will now discuss the remaining two, which are the SFP/BS, and the SCF. Both of these statements are critical tools used to assess a company's financial position and its current cash resources, as explained in the opening story about Amazon. Cash is one of the most critical assets to success as will be discussed in a subsequent chapter on cash and receivables. How an investor knows when to invest in a company and how a creditor knows when to extend credit to a company is the topic of this chapter.
NOTE: IFRS refers to the balance sheet as the statement of financial position (SFP) and ASPE continues to use the term balance sheet (BS). To simplify the terminology, this chapter will refer to this statement as the SFP/BS, unless specific reference to either one is necessary.
04: Financial Reports Statement of Financial Position and Statement of Cash Flows
As discussed previously, investors and creditors assess a company's overall financial health by using published financial statements. Recall that the previous chapter about financial reporting illustrated how the core financial statements link into a cohesive network of financial information. The illustration in that chapter showed how the ending cash balance from the statement of cash flows (SCF) is also the ending cash balance in the SFP/BS. This is the final link that completes the connection of the core financial statements.
For example, in the SFP/BS for Wellbourn Services Ltd. at December 31 (which we saw also in the previous chapter) note how the cash ending balance links the two statements.
The SFP/BS provides information about a company's resources (assets) at a specific point in time and whether these resources are financed mainly by debt (current and long-term liabilities) or equity (shareholders' equity). In other words, the SFP/BS provides the information needed to assess a company's liquidity and solvency. Combined, these represent a company's financial flexibility.
Recall the basic accounting equation:
The key issues to consider regarding the SFP/BS are the valuation and management of resources (assets) and the recognition and timing of debt obligations (liabilities). Reporting the results within the SFP/BS creates a critical reporting tool to assess a company's overall financial health.
The statement of cash flows, discussed later in this chapter, identifies how the company utilized its cash inflows and outflows over the reporting period. Since the SCF separates cash flows into those resulting from operating activities versus investing and financing activities, investors and creditors can quickly see where the main sources of cash originate. If cash sources are originating more from investing activities than from operations, this means that the company is likely selling off some of its assets to cover its obligations. This may be appropriate if these assets are idle and no longer contributing towards generating profit, but otherwise, selling off useful assets could trigger a downward spiral, with profits plummeting as a result. If cash sources are originating mainly from financing activities, the company is likely sourcing its cash from debt or from issuing shares. Higher debt requires more cash to make the principal and interest payments, and more shares means that existing investors' ownership is becoming diluted. Either scenario will be cause for concern for both investors and creditors. Even if most of the cash sources are mainly from operating activities, a large difference between net income and the total cash from operating activities is a warning sign that investors and creditors should be digging deeper.
The bottom line after reviewing the two statements is: if debt is high and cash balances are low, the greater the risk of failure.
The SFP/BS will now be discussed in detail. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/04%3A_Financial_Reports__Statement_of_Financial_Position_and_Statement_of_Cash_Flows/4.01%3A_Financial_Reports-_Overview.txt |
The purpose of the SFP/BS is to report the assets of a company and the composition of the claims against those assets by creditors and investors at a specific point in time. Assets and liabilities come from several sources and are usually separated into current and non-current (IFRS) or long-term (ASPE) categories.
4.02: Statement of Financial Position Balance Sheet
IFRS (IAS 1) and ASPE (section 1521) identify the disclosure requirements for SFP/BS, which are quite similar. Listed below are summary points for some of the more commonly required disclosures for both standards:
• The application of the standards is required, with additional disclosures when necessary, so that the SFP/BS will be relevant and faithfully representative. Relevance means that the information in the SFP/BS can make a difference in decision-making. Faithfully representative means that the statement is complete, neutral, and free from errors.
• Any material uncertainties about a company's ability to continue as a going concern are to be disclosed.
• Company name, name of the financial statement, and date must be provided.
• The SFP/BS is to report assets and liabilities separately in many cases. The schedule below lists many of the more common assets and liabilities that are to be separately reported.
In addition, any material classes of similar items are to be separately disclosed in either the statement or in the notes to the financial statements (e.g., items of property, plant, and equipment, types of inventories, or classes of equity share capital).
• When preparing the SFP/BS, assets are not to be netted with liabilities. This does not apply to contra accounts.
• Assets and liabilities are to be separated into current and non-current (long-term). Some companies further report assets in order of their liquidity.
• The measurement basis used for each line item in the statement is to be disclosed. Examples would be whether the company applied fair value, fair value less costs to sell, cost, amortized cost, net realizable value, or lower of cost and net realizable value (LCNRV) when preparing the statement.
• Due dates and interest rates for any financial instruments payable such as loans, notes, mortgages, and bonds payable, as well as details about any security required for the loan are to be disclosed.
• Cross-reference note disclosures to the related line items in the statement.
Below are the basic classifications for some of the more common reporting line items and accounts. The focus is mainly IFRS for simplicity, though ASPE is substantially similar. The required supplemental disclosures below focus on the measurement basis of the various assets, the due dates, interest rates, and security conditions for non-current liabilities; and the structure for each class of share capital in shareholders' equity when preparing a SFP/BS. These will be discussed in more detail in the chapters that follow in the next intermediate accounting course.
SFP/BS – Classifications and Reporting Requirements
Classification Report Line Items Includes Measurement Basis and
Other Required
Disclosures at Each
Reporting Date
Current assets – assets realized within one year from the reporting date or the operating cycle, whichever is longer Cash and cash equivalents (unrestricted) Currency, coin, bank accounts, petty cash, treasury bills maturing within three months at acquisition Fair value, stated in local currency. Restricted cash and compensating balances are reported separately as a current or long-term asset, as appropriate.
Investments – trading Equity investments such as shares purchased to sell within a short time Usually fair value
Accounts receivable Trade receivables net of allowance for doubtful account (AFDA) Net realizable value as a fair value measure
Related party receivables Amounts owing by related parties Carrying amount or exchange amount
Notes receivable Notes receivable within one year Net realizable value
Inventories Raw materials, work-in-process, finished goods held for sale, or goods held for resale Lower of cost and net realizable value (LCNRV) using FIFO, weighted average cost or specific identification
Supplies on hand Supplies that are expected to be consumed within one year Usually invoice cost
Prepaid expenses Cash paid items where the expense is to be incurred within one year of the reporting date Usually invoice cost
Assets held for sale Land, buildings, and equipment no longer used to generate income If criteria met (ASPE), lower of carrying less costs to sell
Income taxes receivable Income taxes receivable based on current taxable loss Based on tax rate
Deferred income tax assets Current portion of deferred income taxes avoided/saved arising from differences between accounting income/loss and taxable income/loss ASPE only
Under IFRS, all deferred tax is non-current
Non-current / long-term assets Investments – non-strategic Debt and equity investments such as held to maturity to collect principal and interest (AC), fair value through OCI to collect principal and interest and to sell (FVOCI), and FVNI for all else AC – cost, amortized cost
FVOCI – fair value through OCI (IFRS only)
FVNI – fair value through net income - debt or equity investments not classified as FVOCI (IFRS), or equity investments in active markets (ASPE)
Investments – strategic Associate/Significant Influence equity investments in shares IFRS – equity method
ASPE – equity method, cost method, or FVNI
Joint-ventures and subsidiaries Equity investments of greater than 50% of the investee company's outstanding shares Partial or full consolidation
Investment property Land or building held as an investment Usually fair value
Biological assets Dairy cattle, pigs, sheep, farmed fish, trees for timber, trees or vines for fruit IFRS – fair value less costs to sell
ASPE – N/A
Property, plant, and equipment Tangible assets used to generate income such as land, buildings, machinery, equipment, furniture Land – cost
All else – amortized cost
IFRS also allows fair value (revaluation); accumulated depreciation disclosed separately
Intangible assets Copyrights, customer lists, franchises, patents, trademarks, trade names Finite life and indefinite life – initially cost, and subsequently cost less accumulated amortization (finite life only) net of accumulated impairment losses (both)
Accumulated amortization disclosed separately
Goodwill Purchased goodwill Goodwill – excess of purchase price over fair values of net identifiable assets and tested annually for impairment
Deferred income tax assets Non-current portion of deferred income taxes avoided/saved arising from differences between accounting income/loss and taxable income/loss IFRS and ASPE
Current liabilities – obligations due within one year from the reporting date or the operating cycle, whichever is longer Bank indebtedness or bank overdraft Amounts owing to the bank that cannot be offset by a same-bank positive balance, amount, and is payable on demand Fair value or contract amount stated in local currency
Accounts payable Trade payables, such as suppliers' invoices owing for goods and services received Invoice cost, net of realized discounts
Notes and loans payable Notes and loans due within one year Also includes principal portion of long-term debt obligation due within one year of the reporting date
Accrued liabilities Adjusting entries for various types of expenses incurred but not paid such as salaries, benefits, interest, property taxes, non-trade payables Invoice or contract cost
Unearned revenue Cash received in advance for goods and services not yet provided to customer Consideration amount received
Income taxes payable Income taxes payable based on current taxable income Based on taxable income at the current tax rate
Deferred income tax liabilities Current portion of deferred income taxes expected to be owed and arising from differences between accounting income/loss and taxable income/loss ASPE only
Non-current/long-term liabilities Long-term debt payable Long-term mortgages, bonds, notes, loans, capital leases net of current portions, long-term construction obligations Each item is reported separately
Measurement basis varies – amortized cost, fair value, discounted present value, estimated construction obligation, and so on
Reporting requirements include the amortization period, due date, interest rate and security conditions
Employee pension benefits payable Employer pension obligations for the shortfall between the defined benefit obligation (DBO) and the plan assets both of which are held and reported through a separate trust The net defined benefit liability/asset is determined by deducting the fair value of the plan assets from the present value of the defined benefit obligation
Deferred income tax liabilities Non-current portion of deferred income taxes expected to be owed arising from differences between accounting income/loss and taxable income/loss IFRS and ASPE
Equity – a company's net assets, which is equal to total assets minus total liabilities
Represents the ownership interest
Share capital Preferred shares and common shares of various classes are each separately reported The exchanged value (transaction price less any transaction costs) of issued shares
The dividend amount, characteristics of each share class, as well as the number of shares authorized, issued, and outstanding for each class of share
Contributed surplus Gains from certain shares transactions, donated assets by a shareholder, redemption or conversion of shares
Retained earnings/(deficit) Undistributed accumulated net income
If a negative number, label as a "deficit"
Accumulated other comprehensive income (AOCI) Accumulated gains or losses reported in other comprehensive income (OCI) each reporting period that are closed to AOCI at the end of that reporting period IFRS only
Non-controlling interest/minority interest Minority interest An equity claim for the portion of a subsidiary corporation's net assets that are not owned by the parent corporation (third-party investors)
Note that in addition to the measurement basis identified for each asset category in the chart above, many assets' valuations can be subsequently adjusted, depending on the circumstances. Below are examples of some of the common valuation adjustments made to various asset accounts that will be discussed in later chapters.
Cash and cash equivalents Foreign exchange adjustments for foreign currencies
Investments – trading Adjust to fair values, therefore no subsequent adjustment for impairment
Accounts receivable and AFDA AFDA adjustments at each reporting date are the basis for reporting accounts receivable at NRV
Related party receivables Adjust for impairment
Notes receivable Adjust for impairment
Inventory Adjust for cost of goods sold, shrinkage, obsolescence, damage; reported at lower of cost and net realizable value (LCNRV)
Supplies/office supplies Adjust for usage, shrinkage, obsolescence, damage
Assets held for sale Adjust to fair values, therefore no subsequent adjustment for impairment
Investments Adjust to either fair value or for impairment, depending on classification of investment (refer to classification schedule above for details)
Biological assets Adjust to fair values, therefore no subsequent adjustment for impairment
Property, plant, and equipment Adjust for impairment
Intangible assets Adjust for impairment
Disclosures such as those listed in the classification schedule above may be presented in parentheses beside the line item within the body of the SFP/BS, if the disclosure is not lengthy. Otherwise, the disclosure is to be included in the notes to the financial statements and cross-referenced to the corresponding line item in the SFP/BS.
Using parentheses tends to be more common for ASPE companies with simpler disclosure requirements. IFRS companies and larger ASPE companies extensively use the cross-referencing method because of the more complex and lengthy notes disclosures required.
Below is an example of a Statement if Financial Position. Recall that a classified SFP/BS reports groupings of similar line items together as either current or non-current (long-term) assets and liabilities.
ABC Company Ltd.
Statement of Financial Position
December 31, 2020
Assets
Current assets
Cash \$ 250,000
Investments (fair value)
Accounts receivable \$ 180,000
Allowance for doubtful accounts (2,000) 178,000
Note receivable (NRV) 15,000
Inventory (at lower of FIFO cost and NRV) 500,000
Prepaid expenses 15,000
Total current assets 958,000
Long term investments (fair value 25,000
Property, plant and equipment
Land 75,000
Building \$ 325,000
Accumulated depreciation (120,000) 205,000
Equipment 100,000
Accumulated depreciation (66,000) 34,000 314,000
Intangible assets (net of accumulated
amortization for \$25,000) 55,000
Goodwill 35,000
Total assets \$ 1,387,000
Liabilities and Shareholders' Equity
Current liabilities
Accounts payable \$ 75,000
Accrued interest payable 15,000
Accrued other liabilities 5,000
Income taxes payable 44,000
Unearned revenue 125,000
Total current liabilities \$ 264,000
Long-term bonds payable (20-year
5% bonds, due June 20, 2029) 200,000
Total liabilities 464,000
Shareholders' equity
Paid in capital
Preferred, (\$2, cumulative, participating
– authorized, 30,000 shares; issued
and outstanding, 15,000 shares) \$ 150,000
Common (authorized, 400,000 shares;
issued and outstanding 250,000 shares) 750,000
Contributed surplus 15,000 915,000
Retained earnings 8,000 923,000
Total liabilities and shareholders' equity \$ 1,387,000
Note that the measurement basis disclosures are in parenthesis for any assets where a measurement other than cost is possible. Also note the interest rate and due date parenthetical disclosure for the long-term liability. In the equity section, the class, authorized, and outstanding shares are disclosed.
Taking a closer look at this statement, ASPE Company reports \$1,387,000 in total assets and \$464,000 in corresponding obligations against those assets owing to suppliers and other creditors.
On the topic of debt reporting, the current portion of long-term debt is a reported as a current liability. The current portion of the long-term debt is the amount of principal that will be paid within one year of the SFP/BS date.
For example, on December 31, 2019, ASPE Company signed a three-year, 2%, note. Payments of \$137,733 are payable each December 31. If the market rate was 2.75%, the present value of the note would be \$391,473 at the time of signing on December 31, 2019. Below is the payments schedule of the note using the effective interest method.
If the SFP/BS date is December 31, 2020, the current portion of the long-term debt to report as a current liability would be \$130,459 from the note payable payments schedule above. Note that this amount comes from the year following the 2020 reporting year to correspond with the principal amount owing within one year of the current reporting date (December 31, 2020). The total amount owing as at December 31, 2020 is \$264,506; therefore, the long-term portion of \$134,047 would be the amount owing net of the current portion of \$130,459. Below is how it would be reported in the SFP/BS at December 31, 2020:
Current Liabilities
Current portion of long-term note payable \$130,459
Long-term Liabilities
Note payable, 2%, three-year, due date Dec 31, 2022 \$134,047
(balance owing Dec 31, 2020, of )
If the current portion of the long-term debt is not reported as a current liability, there will be a material reporting misstatement that would affect the assessment of the company's liquidity and solvency.
Total equity of \$923,000 represents the remaining assets financed by the company shareholders. Ranking first are the preferred shareholders capital investors of \$150,000. They are usually reported before the common shares because they are senior to common shares in terms of both dividend payouts and claims to resources if a company liquidates. However, this is not a reporting requirement. The contributed surplus of \$15,000 is additional paid-in capital from shareholders. Examples of transactions that recognize contributed surplus include:
• stock options such as an employee stock option plan, or other share-based compensation plan and issuance of convertible debentures
• for certain share re-purchase transactions where the purchase proceeds are lower than the assigned value of the shares
• donated assets by shareholders
• defaulted shares subscriptions
• certain related party transactions (ASPE)
If there are more line items than simply common shares, a paid-in capital subtotal is also required for IFRS companies. Paid-in capital is the total amount "paid in" by shareholders and therefore not resulting from ongoing operations. It is comprised of all classes of share capital plus contributed surplus, if any. Finally, the retained earnings line item is the total net income accumulated by the company since its inception that has not been distributed in dividends to the shareholders.
Below are other reporting requirements:
• The statement can be prepared on a consolidated basis. This means that there are subsidiaries included where the reporting company is the parent company. Subsidiaries are investments in the shares of another company where the shares purchased are greater than 50%. In this case, there will be a line item called "non-controlling interest" that must be included for the portion of the subsidiary owned by other third-party investors.
• The presentation currency is stated as Canadian dollars and the level of rounding can be to the nearest thousand dollars or million dollars, depending on the size of the company.
• The financial data is to include the previous year (an IFRS disclosure requirement).
• An accumulated other comprehensive income/loss (AOCI) is an equity account used only by IFRS companies to accumulate items reported in OCI in the statement of comprehensive income. AOCI. Recall from the previous chapter that an example of an OCI transaction would be the unrealized gains or losses from fair value adjustments while holding certain FVOCI investments. FVOCI investments and AOCI will be covered in detail later in this course. For now, note the position of the AOCI account in the equity section.
A video is available on the Lyryx web site. Click Here to view the video. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/04%3A_Financial_Reports__Statement_of_Financial_Position_and_Statement_of_Cash_Flows/4.02%3A_Statement_of_Financial_Position_Balance_Sheet/4.2.01%3A_Disclosu.txt |
Accounting Estimates, Changes in Accounting Policy, and Correction of Errors
These were discussed in the previous chapter, but a summary of the pertinent information in this chapter is warranted because of their impact on the SFP/BS.
Financial statements can be affected by changes in accounting estimates, changes due to accounting errors or omissions, and changes in accounting policies. These were first introduced in the introductory accounting course and will also be discussed in detail in the next intermediate accounting course. However, it is worth including a review at this time because of the potentially significant effect on the financial statements.
Changes in Accounting Estimates
Accounting is full of estimates that are based on the best information available at the time. As new information becomes available, estimates may need to be changed. Examples of changing estimates would be the useful life, residual value, or the depreciation pattern used to match the use of assets with revenues earned. Other changes in estimates involve uncollectible receivables, asset impairment losses, and pension assumptions that could affect the accrued pension asset/liability account in the SFP/BS. Changes in accounting estimates are applied prospectively, meaning they are applied to the current fiscal year if the accounting records have not yet been closed and for all future years going forward.
Changes Due to Accounting Errors or Omissions
The accounting treatment for an error or omission is a retrospective adjustment with restatement. Retrospective adjustment means that the company reports treat the error or omission as though it had always been corrected. If an accounting error in inventory originating in the current fiscal year is detected before the current year's books are closed, the inventory error correction is easily recorded to the current fiscal year accounts. If the accounting records are already closed when the inventory error is discovered, the error is adjusted to the inventory account and to retained earnings, net of taxes. This results in a restatement of inventory and retained earnings in the current year. If the financial statements are comparative and include previous year's data, this data is also restated to include the error correction from the previous year.
Changes in Accounting Policy
The accounting treatment for a change in accounting policy is retrospective adjustment with restatement.
Examples of changes in accounting policies are:
• Changes in valuation methods for inventory such as changing from FIFO to weighted average cost.
• Changes in financial assets and liabilities such as FVNI, FVOCI and AC investments or certain lease obligations. Details of these are discussed in the chapter on intercorporate investments, later in this text.
• Changes in the basis of measurement of non-current assets such as historical cost and revaluation.
• Changes in the basis used for accruals in the preparation of financial statements.
Accounting policies must be applied consistently to promote comparability between financial statements for different accounting periods. A change in accounting policy is only allowed under the following two conditions:
• due to changes in a primary source of GAAP
• may be applied voluntarily by management to enhance the relevance and reliability of information contained in the financial statements for IFRS. [ASPE has some exceptions to this "relevance and reliability" rule to provide flexibility for changes from one existing accounting standard to another.]
Changes in accounting policies are applied retrospectively in the financial statements. As with accounting errors, retrospective application means that the company implements the change in accounting policy as though it had always been applied. Consequently, the company will adjust all comparative amounts presented in the financial statements affected by the change in accounting policy for each prior period presented. Retrospective application reduces the risk of changing policies to manage earnings aggressively because the restatement is made to all prior years as well as the current year. If this were not the case, the change made to a single year could materially affect the statement of income for the current fiscal year. A cumulative amount for the restatement is estimated and adjusted to the affected asset or liability in the SFP/BS and to the opening retained earnings balance of the current year, net of taxes, in the statement of changes in equity (IFRS) or the statement of retained earnings (ASPE).
Contingencies, Provisions and Guarantees
In accounting, a contingency (ASPE) or provision (IFRS) exists when a material future event, or circumstance, could occur but cannot be predicted with certainty. IFRS (IAS 37.10) has the following definitions regarding the various types of contingencies in accounting (IFRS, 2015).
Key definitions [IAS 37.10]
Provision: a liability of uncertain timing or amount.
Liability:
• present obligation resulting from past events
• settlement is expected to result in an outflow of resources (payment)
Contingent liability:
• a possible obligation depending on whether some uncertain future event occurs, or
• a present obligation but payment is not probable, or the amount cannot be measured reliably
Contingent asset:
• a possible asset that arises from past events, and
• whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
IAS 37 explains that a contingent liability is to be disclosed in the financial statement notes. Figure 4.1 is a decision tree that identifies the various decision points when determining if a potential obligation should be recognized and recorded, because it meets the definition of a liability; added only to the notes, because it meets the definition of a contingent liability; or omitted altogether because it fails to meet any of the relevant criteria (Friedrich, Friedrich, & Spector, 2009).
Figure 4.1 Decision tree to determine if a potential obligation should be recognized and recorded (Friedrich, Friedrich, & Spector, 2009)
IAS 37 also states that a contingent asset is not to be recorded until it is actually realized but can be included in the notes if it is probable that an inflow of economic benefits will occur (IFRS, 2012). If a note disclosure is made, management must take care not to mislead the reader regarding its potential realization; if the potential asset is not probable, it must not be disclosed.
ASPE is similar, but the provision is usually interpreted as "more likely than not" whereas a contingent liability is one that is "likely."
Contingencies will be discussed further in the chapter on liabilities in the next intermediate accounting course.
A guarantee is a type of contingent liability because it is a promise to take responsibility for another company's financial obligation if that company is unable to do so. An example might be a parent company that guarantees part or all of a bond issuance to investors by its subsidiary company. Guarantees are not recognized and recorded because they are not probable, so they are to be disclosed in the notes. This will enable investors and creditors to assess the potential impact of the guarantee and the risk associated with it.
Subsequent Events
There is a period of time after the year-end date when economic events apparent in the new year may need to be either reported in the financial statements for the year just ended or disclosed in the notes prior to their release.
If this subsequent event is significant and relates to business operations prior to the reporting date, it is to be included in the financial statements prior to release. These would include adjusting entries such as inventory write-downs due to shrinkage, recording additional accounts payable for late arriving invoices from suppliers or correction of errors or omissions found when reconciling the general ledger accounts as part of the year-end process.
If a subsequent event is significant but relates to operations occurring after the reporting period, it is to be included in the notes. An example might be where early in the new fiscal year, there is a flood causing serious damage to buildings and equipment, if the repair or replacement costs are significant and perhaps uninsured, these costs, though correctly paid and recorded in the new year, are to be disclosed in the notes to the financial statements for the year-end just ended. This will ensure that the company stakeholders will be aware of all the information about risks that could detrimentally affect company operations. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/04%3A_Financial_Reports__Statement_of_Financial_Position_and_Statement_of_Cash_Flows/4.02%3A_Statement_of_Financial_Position_Balance_Sheet/4.2.02%3A_Factors_.txt |
The last core final financial statement to discuss is the statement of cash flows. The purpose of this statement is to provide a means to assess the enterprise's capacity to generate cash and to enable stakeholders to compare cash flows of different entities (CPA Canada, 2016). This statement is an integral part of the financial statements for two reasons. First, this statement helps readers to understand where these cash flows in (out) originated during the current year, to assess a company's liquidity, solvency, and financial flexibility. Second, these historic cash flows in (out) can be used to predict future company performance.
The statement of cash flows can be prepared using two methods: the direct method and the indirect method. Both methods organize cash flows into three activities: operating, investing, and financing activities. The direct method reports cash flows from operating activities into categories such as cash from customers, cash to suppliers, and cash to employees. The indirect method reports cash flows from operating activities starting with net income/loss adjusted for any non-cash items, followed by the changes in each of the working capital accounts (i.e., current assets and current liabilities accounts). The total cash flows from the operating activities are the same for both methods. The investing and financing activities are prepared the same way under both methods.
This course will explain how to prepare the statement of cash flows using the indirect method. The direct method will be discussed in a subsequent intermediate accounting course.
Below is a statement of cash flows that illustrates the overall format and its connections with the income statement and SFP/BS.
Note that interest and dividends paid can also be reported in the operating activities section.
For the indirect method, the sum of the non-cash adjustments and changes to current assets and liabilities represents the total cash flow in (out) from operating activities. Any non-cash transactions relating to the investing or financing activities are excluded from the SCF but are disclosed in the notes. An example would be an exchange of property, plant, or equipment for common shares or a long-term note payable. The final section of the statement reconciles the net change from the three sections with the opening and closing cash and cash equivalents balances.
4.03: Statement of Cash Flows (SCF)
Presented below is the SFP/BS and income statement for Watson Ltd.
Watson Ltd.
Balance Sheet
As at December 31, 2020
2020 2019
Assets
Current assets
Cash \$ 307,500 \$ 250,000
Investments (trading, at fair value through net income) 12,000 10,000
Accounts receivable (net) 249,510 165,000
Notes receivable 18,450 22,000
Inventory (at lower of FIFO cost and NRV) 708,970 650,000
Prepaid insurance expenses 18,450 15,000
Total current assets 1,314,880 1,112,000
Long term investments (at amortized cost) 30,750 0
Property, plant, and equipment
Land 92,250 92,250
Building (net) 232,000 325,000
324,250 417,250
Intangible assets (net) 110,700 125,000
Total assets \$ 1,780,580 \$ 1,654,250
Liabilities and Shareholders' Equity
Current liabilities
Accounts payable \$ 221,000 \$ 78,000
Accrued interest payable 24,600 33,000
Income taxes payable 54,120 60,000
Unearned revenue 25,000 225,000
Current portion of long-term notes payable 60,000 45,000
Total current liabilities 384,720 441,000
Long-term notes payable (due June 30, 2025) 246,000 280,000
Total liabilities 630,720 721,000
Shareholders' equity
Paid in capital
Preferred, (\$2, cumulative, participating – authorized
issued and outstanding, 15,000 shares) 184,500 184,500
Common (authorized, 400,000 shares; issued and
outstanding (2020: 250,000 shares);
(2019: 200,000 shares) 862,500 680,300
Contributed surplus 18,450 18,450
1,065,450 883,250
Retained earnings 84,410 50,000
1,149,860 933,250
Total liabilities and shareholders' equity \$ 1,780,580 \$ 1,654,250
Watson Ltd.
Income Statement
For the Year Ended December 31, 2020
Sales \$ 3,500,000
Cost of goods sold 2,100,000
Gross profit 1,400,000
Operating expenses
Salaries and benefits expense 800,000
Depreciation expense 43,000
Travel and entertainment expense 134,000
Advertising expense 35,000
Freight-out expenses 50,000
Supplies and postage expense 12,000
Telephone and internet expense 125,000
Legal and professional expenses 48,000
Insurance expense 50,000
1,297,000
Income from operations 103,000
Other revenue and expenses
Dividend income 3,000
Interest income from investments 2,000
Gain from sale of building 5,000
Interest expense (3,000)
7,000
Income from continuing operations before income tax 110,000
Income tax expense 33,000
Net income \$ 77,000
Additional information:
1. The trading investment does not meet the criteria to be classified as a cash equivalent and no purchases or sales took place in the current year.
2. An examination of the intangible assets sub-ledger revealed that a patent had been sold in the current year. The intangible assets have an indefinite life.
3. No long-term investments were sold during the year.
4. No buildings or patents were purchased during the year.
5. Most of the unearned revenues occurred on December 31, 2019.
6. There were no other additions to the long-term note payable during the year.
7. Common shares were sold for cash. No other transactions occurred during the year.
8. Cash dividends were declared and paid.
The statement of cash flows can be challenging to prepare. This is because preparing the entries requires analyses of the accounts as well as an understanding of the types of transactions that affect each account. Preparing a statement of cash flows is made much easier if specific steps in a sequence are followed. Below is a summary of those steps.
1. Complete the statement headings.
2. Record the net income/loss in the operating activities section.
3. Adjust for any non-cash line items reported in the income statement to restate net income/loss from an accrual to a cash basis (i.e., depreciation expense, amortization expense and any non-cash gains or losses).
4. Record the description and change amount as cash inflows or outflows for each current asset and current liability (working capital accounts) except for the "current portion of long-term debt" line item, since it is not a working capital account. Subtotal the operating activities section.
5. In the investment activities section, using T-accounts or other techniques, determine the change for each non-current (long-term) asset account. Analyze and determine the reasons for the change. Record a description and the change amount(s) as cash inflows or outflows.
6. In the financing activities section, add back to long-term debt any current portion identified in the SFP/BS for both years, if any. Using T-accounts or other techniques, determine the change for each non-current liability and equity account. Analyze and determine the reason for the change(s). Record a description and the change amount(s) as cash inflows or outflows.
7. Subtotal the three sections and record as the net change in cash. Record the opening and closing cash and cash equivalents balances. Sum the opening balance, the new change in cash subtotal, and the closing balance. This should to reconcile with the ending cash and cash equivalent balances from the SFP/BS.
8. Complete any required disclosures.
To summarize the steps above into a few key words and phrases to remember:
Headings
Record net income/(loss)
Adjust out non-cash income statement items
Current assets and current liabilities changes
Non-current asset accounts changes
Non-current (long-term) liabilities and equity accounts changes
Subtotal and reconcile
Disclosures
Applying the Steps:
1. Headings:
Watson Ltd.
Statement of Cash Flows
For the Year Ended December 31, 2020
Cash flows from operating activities
Net income (loss)
Non-cash items (adjusted from net income):
Net cash from operating activities
Cash flows from investing activities
Net cash from investing activities
Cash flows from financing activities
Net cash from financing activities
Net increase (decrease) in cash
Cash, January 1
Cash, December 31
2. Record net income/(loss)
3. Adjustments:
Enter the amount of the net income/(loss) as the first amount in the operating activities section. Next, review the income statement and select the non-cash items. Look for items such as depreciation, depletion, amortization, and gain/loss on sale/disposal of assets. In this case, there are two non-cash items to adjust. Record them as adjustments to net income in the statement of cash flows.
4. Current assets and liabilities:
Cash inflows are reported as positive numbers, while cash outflows are reported as negative numbers. To determine if the amount is a positive or negative number, a simple method is to use the accounting equation to determine whether cash is increasing as a positive number or decreasing as a negative number.
Recall that the accounting equation, , must always remain in balance. This concept can be applied when analyzing the various accounts and recording the changes. For example, accounts receivable has increased from \$165,000 to \$249,510 for a total change of \$84,510. Using the accounting equation, this can be expressed as:
Expanding the equation a bit:
If accounts receivable increases by \$84,510, this can be expressed as a black up-arrow above the account in the equation:
If accounts receivable increases, its effect on the cash account must be a corresponding decrease to keep the equation balanced:
If cash decreases, it is a cash outflow, and the number must be negative (bracketed) as shown in the statement above.
The same technique can be used when analyzing liability or equity accounts. For example, an increase in account payable (liability) of \$143,000 will affect the equation as follows:
If accounts payable increases, cash must also increase by a corresponding amount in order to keep the equation in balance.
If cash increases, it is a cash inflow and the number must be positive (no brackets) as shown in the statement above.
5. Non-current asset changes:
There are four non-current asset accounts: long-term investments, land, buildings, and intangible assets. The land account had no change so there were no purchases or sales of land. Analyzing the investment account results in the following cash flows:
Long-term investment
?? = purchase of investment
30,750
Since the additional information presented above stated that there were no sales of long-term investments during the year, the entry would have been for a purchase:
Cash paid for the investment was therefore \$30,750.
Analysis of the buildings account is a bit more complex because of the effects of the contra account for accumulated depreciation. In this case, the building account and its contra account must be merged since the SFP/BS reports only the net carrying amount. Analyzing the buildings account results in the following cash flows:
Building (net of accum. depr.)
325,000
43,000 current year accum. depr.
?? = sale of building
232,000
Building (net of accum. depr.)
325,000
43,000
50,000 = X
232,000
Since there was a gain from the sale of buildings, the entry would have been:
Cash proceeds were therefore \$55,000.
The sale of the patent is straightforward since there were no other sales or purchases in the current year.
6. Non-current liabilities and equity changes:
There are five long-term liability and equity accounts: long-term notes payable, preferred shares, common shares, contributed surplus, and retained earnings. The preferred shares and contributed surplus accounts had no changes to report. Analyzing the long-term note payable account results in the following cash flows:
Long-term note payable
280,000
45,000
?? = repayment
246,000
60,000
Since there were no other transactions stated in the additional information above, the entry would have been:
Cash paid was therefore \$19,000.
Note how the current portion of long-term debt has been included in the analysis of the long-term note payable. The current portion line item is a reporting requirement regarding the principal amount owing one year after the reporting date, but it is not actually a working capital account, so it is omitted from the operating section and included with its corresponding long-term liability account in the financing activities section as shown above.
The common shares and retained earnings accounts are straightforward and the analysis of each are shown below.
Common shares
680,300
?? = share issuance
862,500
Since there were no other transactions stated in the additional information above, the entry would have been:
Cash received was therefore \$182,200.
Retained earnings
50,000
77,000 net income
?? = dividends paid
84,410
The additional information stated that cash dividends were declared and paid, so the entry would have been:
Cash paid was therefore \$42,590.
7. Subtotal and reconcile:
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Step 8 involves the identification and preparation of disclosures.
1. Required disclosures:
Following is the completed statement of cash flows, including disclosures, for Watson Ltd., for the year ended December 31, 2020:
Watson Ltd.
Statement of Cash Flows
For the Year Ended December 31, 2020
Cash flows from operating activities
Net income (loss) \$ 77,000
Non-cash items (adjusted from net income):
Depreciation expense 43,000
Gain from sale of equipment (5,000)
Cash in (out) from operating working capital:
Increase in trading investments (2,000)
Increase in accounts receivable (84,510)
Decrease in notes receivable 3,550
Increase in inventory (58,970)
Increase in prepaid expenses (3,450)
Increase in accounts payable 143,000
Decrease in interest payable (8,400)
Decrease in income taxes payable (5,880)
Decrease in unearned revenue (200,000)
Net cash from operating activities (101,660)
Cash flows from investing activities
Purchase of AC investments (30,750)
Sales proceeds from sale of building 55,000
Sales proceeds from sale of patent 14,300
Net cash from investing activities 38,550
Cash flows from financing activities
Repayment of long-term note (19,000)
Proceeds from shares issuance 182,200
Dividends paid (42,590)
Net cash from financing activities 120,610
Net increase (decrease) in cash 57,500
Cash, January 1 250,000
Cash, December 31 \$ 307,500
Disclosures:
Cash paid for income taxes \$ 38,880
()
Cash paid for interest charges 11,400
()
Cash received for interest income 2,000
Cash received for dividend income 3,000
[There were no non-cash transactions to disclose.]
4.3.03: Interpreting the Sta
The cash balance shows an increase of \$57,500 from the previous year. Without looking deeper into the reasons why, a hasty conclusion could be drawn that all is well with Watson Ltd. However, there is trouble ahead for this company. For example, the operating activities section, which represents the reason for being in business, is in a negative cash flow position. The profit that a company earns is expected to result in positive cash flows, and this positive cash flow should be reflected in the operating activities section. In this case, it does not, since there is a negative cash flow of \$101,660 from operating activities. Why?
For Watson, both the accounts receivable and inventory have increased, resulting in a net decrease in cash of \$143,480. An increase in accounts receivable may mean that sales have occurred, but the collections are not keeping pace with the sales on account. An increase in inventory may be because there have not been enough sales in the current year to cycle the inventory from a current asset to sales/profit and ultimately into cash. The risk of holding large amounts of inventory is the increased possibility that inventory will become obsolete or damaged and unsellable.
In this case, an additional reason for decreased net cash from operating activities is due to a decrease in unearned revenue. This is an interesting issue that needs to be explained more fully. Recall that unearned revenue is cash received from customers in advance of earning the revenue. In this case, the cash would have been reported as a positive cash flow in the operating activities section in the previous reporting period when the cash was actually received. At that time, the cash generated from operating activities would have increased by the amount of the cash received for the unearned revenue. The entry upon receipt of the cash would have been:
When the company provides the goods and services to the customer, the net income reported at the top of the operating section will reflect that portion of the unearned revenue that is now earned. However, it did not obtain actual cash for this revenue in this reporting period because the cash was already received in the prior reporting period. Keep in mind that unearned revenue is not normally an obligation that must be paid in cash to the customer. Once the goods and services are provided to the customer, the obligation ceases.
Looking at the investing activities, there was a sale of a building and a purchase of a long-term investment. The sales proceeds from the building may have been partially invested in the investment to make a return on the cash proceeds until it can be used for its intended purpose in the future. Again, more analysis is necessary to confirm whether this is the case. The sale of the patent also generated a positive cash flow. There was no gain on sale of the patent reported in the income statement, so the sales proceeds did not exceed its carrying value at the time it was sold. Hopefully, the patent sale was not the result of a panic sale to raise additional cash.
Looking at the financing activities the majority of cash inflows for this reporting period resulted from the issuance of additional common shares of \$182,200. This represents an increase in the share capital of greater than 25%. Increased shares will have a negative impact on the earnings per share and possibly its market price as well, which may send warning signals to investors. The shareholders were also paid dividends of \$42,590, but this amount only barely covers the preferred shareholders dividend of \$30,000 () plus its share of the participating dividend. This leaves very little dividend left over for the common shareholders. At some point, the common shareholders will likely become concerned with receiving so little in dividends, along with the dilution of their shareholdings due to the large issuance of additional shares.
When looking at the opening and closing cash balances for Watson, these seem like sizeable balances, but what matters is where the cash came from and whether those sources are sustainable. The \$250,000 opening balance was almost entirely due to the \$225,000 unearned revenue received in advance, but this is likely not a sustainable source. The ending cash balance of \$307,500 is due to the issuance of additional share capital of \$182,200 (possibly a one-time transaction) and an increase in accounts payable of \$143,000 that must be paid soon. Consider that during the year, the cash from the unearned revenues was being consumed and the issuance of the additional capital had not yet occurred. It would be no surprise, if cash at the mid-year point was insufficient to cover even the short-term liabilities, hence the increase in accounts payable and ultimately the issuance of additional capital shares.
Watson is currently unable to generate positive cash flows from its operating activities. The unearned revenue of \$225,000 at the start of the year added some needed cash early on, but this reserve was depleted by the end of the reporting year. In the meantime, without a significant change in how the company manages its inventory and receivables, Watson may continue to experience a shortage of cash from its operating activities. To compensate, it may continue to sell off assets, issue more shares, or incur more long-term debt to obtain needed cash. In any case, these sources will dry up eventually when investors are no longer willing to invest, creditors are no longer willing to loan cash, and no assets worth selling remain. This current negative cash position from operating activities for Watson Ltd. is unsustainable and must be turned around quickly for the company to remain a going concern.
Not all companies who report profits are financially stable. This is because profits do not translate on a one-to-one basis with cash. Watson reported a \$77,000 net income (profit), but it is currently experiencing significant negative cash flows from its operating activities.
If sufficient cash is generated from operating activities, the company will not have to increase its debt, issue shares, or sell off useful assets to pay their bills. For Watson Ltd., it increased its short-term debt (accounts payable), sold off a building, and issued 25% more common shares.
Perhaps Watson's negative cash flow from operating activities will turn itself around in the next reporting period. This would be the company's best hope. For other companies who experience positive cash flows from operations, they must also ensure that this is sustainable and can be repeated consistently in the future. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/04%3A_Financial_Reports__Statement_of_Financial_Position_and_Statement_of_Cash_Flows/4.03%3A_Statement_of_Cash_Flows_%28SCF%29/4.3.02%3A_Disclosure_Requireme.txt |
Statement of Financial Position/Balance Sheet (SFP/BS)
The SFP/BS is made up of many line items, comprised of many general ledger accounts, using different measurement bases (historical cost, fair value, and other valuation methods previously discussed in this chapter), and with significant adjusting entries for accruals and application of the company's accounting policies. For this reason, the SFP/BS does not present a clear-cut, definitive report of a company's exact financial state. Its purpose is to provide an overview as a starting point for further analysis. Some types of analysis typically undertaken by management are discussed below.
Comparative SFP/BS
Arranging previous reporting data beside the current data is a useful tool with which to analyze trends. Some companies also include the percentage change for each line item to allow certain changes in amounts to become highly visible. This enables analysts to narrow down possible areas of poor performance where further investigation will be undertaken to determine the reasons why.
Ratio Analyses
Ratio analysis is simply where relationships between selected financial data (presented in the numerator and denominator of the formula) provide key information about a company. Ratios from current year financial statements may be more useful when they are used to compare with benchmark ratios. Examples of benchmark ratios are ratios from other companies, ratios from the industry sector the company operates in, or historical and future ratio targets set by management as part of the company's strategic plan.
Care must be taken when interpreting ratios, because companies within an industry sector may use different accounting policies that will affect the comparison of ratios. In the end, ratios are based on current and past performance and are merely indicators. Further investigation is needed to gather more business intelligence about the reasons why certain variances are occurring.
Below are some common ratios used to analyze the SFP/BS and SCF financial statements:
Ratio Formula Purpose
Liquidity ratios – ability to pay short term obligations
Current ratio ability to pay short term debt
Quick ratio (or acid test ratio) ability to pay short term debt using near-cash assets
* Cash includes cash equivalents, if any.
Ratio Formula Purpose
Activity ratios – ability to effectively use assets
Accounts receivable turnover how quickly accounts receivable is collected
In days average # of days to collect accounts receivable
Days' sales uncollected average # of days that sales are uncollected (this can be compared to the credit terms of the company)
Inventory turnover how quickly inventory is sold
In days average number of days to sell inventory
Days' sales in inventory average # of days for inventory to convert to sales
Asset turnover the ability of assets to generate sales
Ratio Formula Purpose
Profitability ratios – ability to generate profits
Return on total assets overall profitability of assets
Return on common shareholders' equity overall profitability of common shareholders' investment
Earnings per share net income for each common share
Payout ratio percentage of earnings distributed as dividends
Ratio Formula Purpose
Coverage – ability to pay long-term obligations
Debt ratio percentage of assets provided by creditors
Equity ratio percentage of assets provided by investors
Cash debt coverage ratio the ability to pay debt from net cash from operating activities (statement of cash flows)
Book value per common share the amount per common share if company liquidated at reported amounts.
Many of the ratios identified above will be illustrated throughout the remaining chapters of this course.
Note that ratios are not particularly meaningful without historical trends or industry standards. Some general benchmarks signifying a reasonably healthy financial state are:
Current ratio 2:1
Quick ratio 1:1
Days' sales uncollected 1.3 times the credit policy in days
For example, if the credit policy were 30 days, a reasonable day's sales uncollected ratio would be that a sale would remain uncollected.
Inventory turnover 5 times per year (or in days, every 365 5 = 73 days)
Again, it is important to understand that the general benchmarks identified above are guidelines only. Industry standard ratios are superior in every way, if available, since ratios are only as good as what they are being compared to (the benchmark). If the comparative ratio is not accurate for that industry, the analysis will be meaningless. (This is often referred to as "garbage in; garbage out.") As a result, management can make incorrect decisions on that basis, seriously impairing a company's potential future performance and sustainability.
Below are the ratio calculations for Watson Ltd. as at December 31, 2020, based on the financial data presented in the previous section of this chapter. The material in this chapter is intended as a high-level review. In-depth discussions are included in the introductory accounting course, and students are encouraged to review that material at this time, if needed.
Ratio Formula Calculation Results
Liquidity ratios – ability to pay short term obligations
Current ratio reasonable
Quick ratio (or acid test ratio)
reasonable
Ratio Formula Calculation Results
Activity ratios – ability to effectively use assets
Accounts receivable turnover reasonable
In days reasonable
Days' sales uncollected days reasonable, given the typical credit policy of net 30 days
Inventory turnover times this would be low, if the industry standard is around 5 times
In days possibly too low if standard is 5 times or every 73 days
Days' sales in inventory days the total # of days to sell inventory and collect the cash from accounts receivable is 123 + 26 = 149 days
Asset turnover depends on industry average and company trends
Ratio Formula Calculation Results
Profitability ratios – ability to generate profits
Return on total assets depends on industry average and company trends
Return on common shareholders' equity
depends on industry average and company trends
Earnings per share per share
WACS shares assuming that sale of the shares occurred mid year
depends on industry average and company trends
Payout ratio depends on industry average and company trends
Ratio Formula Calculation Results
Coverage – ability to pay long-term obligations
Debt ratio low
Equity ratio
OR
high
Cash debt coverage ratio unfavourable due to negative cashflow from operating activities
Book value per common share depends on industry average and company trends and assumes no preferred shares dividends are in arrears
Cash Flow Ratio
It is critical to monitor the trends regarding cash flows over time. If trends are tracked, ratio analyses can be a powerful tool to evaluate a company's cash flows. Below are some of the cash flow ratios currently used in business:
Ratio Formula Purpose
Liquidity ratios – ability to pay short term obligations:
Current cash debt coverage ratio ability to pay short term debt from its day-to-day operations. A ratio of 1:1 is reasonable.
Financial flexibility – ability to react to unexpected expenses and investment opportunities:
Cash debt coverage ratio the ability to pay debt from net cash from operating activities (statement of cash flows)
Free Cash Flow Analyses
Free cash flow is the remaining cash flow from the operating activities section after deducting cash spent on capital expenditures such as purchasing property, plant, and equipment. Some companies also deduct cash paid dividends. The remaining cash flow represents cash available to do other things, such as expand operations, pay off long-term debt, or reduce the number of outstanding shares. Below is the calculation using the data from Watson Ltd. statement of cash flows:
Watson Ltd.
Free Cash Flow
December 31, 2020
Cash flow provided by operating activities \$ (101,660)
Less capital expenditures 0
Dividends \$ (42,590)
Free cash flow \$ (144,250)
It is no surprise that Watson has no free cash flow and no financial flexibility, since its operating activities are in a negative position. Note that the dividend deduction in the free cash flow calculation is optional, since dividends can be waived at management's discretion. In Watson's case, it met its current year dividend cash requirements by selling more common shares to raise additional cash. The capital expenditures should be for those relating to daily operations that are intended to sustain ongoing operations. For this reason, capital expenditures purchased as investments are usually excluded from the free cash flow analysis. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/04%3A_Financial_Reports__Statement_of_Financial_Position_and_Statement_of_Cash_Flows/4.04%3A_Analysis.txt |
LO 1: Describe the statement of financial position/balance sheet (SFP/BS) and the statement of cash flows (SCF), and explain their role in accounting and business.
The statement of financial position (IFRS) also known as the balance sheet (ASPE) reports on what resources the company has (assets) at a specific point in time and what claims to those resources exist (liabilities and equity). The statement provides a way to assess a company's liquidity and solvency – both together creating a picture of the company's financial flexibility. The structure of the SFP/BS follows the basic accounting equation: , where assets are presented first, followed by liabilities and equity, which together equal the total assets. Key issues are the recognition and valuation used for each account reported.
The statement of cash flows reports on how the company obtains and utilizes its cash flows and reconciles with the cash balance reported in the SFP/BS. It is separated into operating, investing, and financing activities. The combination of positive and negative cash flows from each activity can provide important information about how the company manages its cash flows.
LO 2: Explain the purpose of the SFP/BS and prepare a SFP/BS in good form.
The classified SFP/BS separates the assets and liabilities into current and non-current (long-term) subsections based on meeting certain criteria. The statement has many disclosure requirements that ensure it is faithfully representative, that the business continues as a going concern, and that revenue and expenses are grouped into appropriate classifications that meet the standards for disclosure. Some of the more common required disclosures are listed, including the measurement basis of each account, such as cost, net realizable value, fair value, and so on. The acceptable options regarding how to present the required disclosures include using parentheses in the body of the statement or disclosing in the notes to the financial statements.
Several factors influence what is reported in the SFP/BS. Included are changes in accounting estimates that are applied prospectively and changes due to errors or omissions or accounting policy that are applied retroactively with restatement. Descriptions of these are to be included in the notes with detailed explanations. Other factors that can affect the SFP/BS are provisions, contingencies and guarantees that may need to be recognized within the statement or disclosed in the notes. Certain subsequent events will also affect what is reported in the SFP/BS.
LO 3: Explain the purpose of the statement of cash flows and prepare a SCF in good form.
The statement of cash flows (SCF) provides the means to assess the business's capacity to generate cash and to determine where the cash flows come from. The statement combines with the SFP/BS to evaluate a company's liquidity and solvency; when combined, these represent a company's financial flexibility. This information can be used to predict the future financial position and cash flows of the company based on past events. The SCF can be prepared using either the direct or indirect method. Regarding the indirect method, the statement is presented in three distinct sections, which follow the basic structure of the balance sheet classifications: operating activities (current assets, and current liabilities), investing activities (non-current assets), and financing activities (long-term debt and equity). The changes between the opening and closing balances of the SFP/BS accounts are reported in the SCF as either cash inflows or cash outflows. The three sections net to a single net cash change amount that, when combined with the cash and cash equivalent opening balances, results in the same amount as the ending balances reported in the SFP/BS.
An important section in the SCF is the operating activities section because it reports the cash flows resulting from daily operations which is the reason why the company is in business. If cash flows are negative in this section, management must determine if this is due to a temporary condition or if fundamental changes are needed to better manage activities such as the collections of accounts receivables or levels of unsold inventory. If a company is in a negative cash flow position from operating activities, it will usually either increase its debt by borrowing, increase its equity by issuing more shares, or sell off some of its assets. If these activities are undertaken, they will be detected as cash inflows from either the investing or financing sections. None of these three options are ideal and can be done in the short run, but they cannot be sustained in the long run. Even positive cash flows from operating activities must be evaluated to determine if they are sustainable and will continue into the future.
LO 4: Identify and describe the types of analysis techniques that can be used for the statement of financial position/balance sheet and the statement of cash flows.
Several analytical techniques can be applied when reviewing the SFP/BS. For example, comparative years' data can be presented to help identify trends. Using a percentage for each line item will help highlight items that may possess unusual characteristics for further analysis. Ratio analysis is the most often used technique but is of limited value if no benchmarks such as historical ratios or industry standards exist. Ratios typically focus on an aspect of a company such as liquidity, profitability, effectiveness of assets used, and ability to service short- and long-term debts. Care must be taken when interpreting the results of ratio analysis, and management must be aware that differences in ratios from competitors' financial statements can result from changes in accounting policies or the application of different accounting estimates and methods.
Another technique called free cash flow analysis calculates the remaining cash flow from the operating activities section after deducting cash spent on capital expenditures such as purchasing property, plant, and equipment. Some companies also deduct cash paid as dividends. The cash flow remaining is available to use for expansion, repayment of long-term debt, or down-sizing shareholdings to improve the share price, reduce the amount of dividends to pay, and to attract investors.
4.06: References
Accounting-Simplified.com (n.d.). IAS 8 changes in accounting policy. Retrieved from http://accounting-simplified.com/standard/ias-8/changes-in-accounting-policies.html
CPA Canada. (2016). CPA Canada Handbook. Toronto, ON: CPA Canada.
Fox, J. (2014, October 20). At Amazon it's all about cash flow. Harvard Business Review. Retrieved from http://blogs.hbr.org/2014/10/at-amazon-its-all-about-cash-flow/
Friedrich, B., Friedrich, L., & Spector, S. (2009). International accounting standard 37 (IAS 37), provisions, contingent liabilities and contingent assets. Professional Development Network. Retrieved from https://www.cga-pdnet.org/Non_VerifiableProducts/ArticlePublication/IFRS_E/IAS_37.pdf
IFRS. (January, 2012). IAS 37 Provisions, Contingent Liabilities and Contingent Assets, IFRS 2012, IAS 37, para. 31–35. (2012, Jan.). [Technical summary]. Retrieved from http://www.ifrs.org/IFRSs/IFRS-technical-summaries/Documents/IAS37-English.pdf
IFRS. (2015). International Financial Reporting Standards 2014: IAS 37 provisions, contingent liabilities and contingent assets. London, UK: IFRS Foundation Publications Department. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/04%3A_Financial_Reports__Statement_of_Financial_Position_and_Statement_of_Cash_Flows/4.05%3A_Chapter_Summary.txt |
4.1 Using the classification codes identified in brackets below, identify where each of the accounts below would be classified:
Current assets (CA) Non-current liabilities (NCL)
Long-term investments (LI) Share Capital (Cap)
Property, plant, and equipment (PPE) Contributed surplus (CS)
Intangible assets (IA) Retained earnings (RE)
Accumulated other comprehensive income (AOCI) Current liabilities (CL)
Account name Classification
Preferred shares
Franchise agreement
Salaries and wages payable
Accounts payable
Buildings (net)
Investment – Held for Trading
Current portion of long-term debt
Allowance for doubtful accounts
Accounts receivable
Bond payable (maturing in 10 years)
Notes payable (due next year)
Office supplies
Mortgage payable (maturing next year)
Land
Bond sinking fund
Inventory
Prepaid insurance
Income tax payable
Cumulative unrealized gain or loss from an OCI investment
Investment in associate
Unearned subscriptions revenue
Advances to suppliers
Unearned rent revenue
Copyrights
Petty cash
Foreign currency bank account or cash
4.2 Below is a statement of financial position as at December 31, 2021, for Aztec Artworks Ltd., prepared by the company bookkeeper:
Aztec Artworks Ltd.
Statement of Financial Position
For the Year Ended December 31, 2021
Current assets
Cash (including a bank overdraft of \$18,000) \$ 225,000
Accounts receivable (net) 285,000
Inventory (FIFO) 960,000
Investments (trading) 140,000
Property, plant, and equipment
Construction work in progress 220,000
Building (net) 1,500,000
Equipment (net) 380,000
Land 420,000
Intangible assets
Goodwill 190,000
Investment in bonds 200,000
Prepaid expenses 30,000
Patents (net) 21,000
Current liabilities
Accounts payable 450,000
Notes payable 300,000
Pension obligation 210,000
Rent payable 120,000
Long-term liabilities
Bonds payable 800,000
Shareholders' equity
Common shares 700,000
Preferred shares 900,000
Contributed surplus 430,000
Retained earnings 501,000
Accumulated other comprehensive income 160,000
Additional information as at December 31, 2021:
1. Cash is made up of petty cash of \$3,000, a bond sinking fund of \$100,000, and a bank overdraft of \$18,000 held at a different bank than the bank account where the cash balance is currently on deposit.
2. Accounts receivable balance of \$285,000 includes:
Credit balances to be cleared in 90 days 35,000
Allowance for doubtful accounts 12,000
The company considers the credit balance to be significant.
3. Inventory ending balance does not include inventory costing \$20,000 shipped out on consignment on December 30, 2021. The company uses FIFO cost formula and a perpetual inventory system.
The net realizable value of the inventory at year-end is:
Inventory, December 31 \$ 960,000
Inventory on consignment 25,000
4. Investments are held for trading purposes. Their fair value at year-end is \$135,000.
5. The accumulated depreciation account balance for buildings is \$450,000 and \$120,000 for equipment. The construction work-in-progress represents the costs to date on a new building in the process of construction. The land where the building is being constructed was purchased of \$220,000. The remaining land is being held for investment purposes.
6. Goodwill of \$190,000 was included in the accounts when management decided that their product development team has added significant value to the company.
7. The investment in bonds is being held to maturity in 2030, and is accounted for using amortized cost.
8. Patents were purchased by Aztec on January 1, 2019, at a cost of \$30,000. They are being amortized on a straight-line basis over 10 years.
9. Income tax payable of \$80,000 was accrued on December 31 and included in the accounts payable balance.
10. The notes payable are due June 30, 2022. The principal is not due until then.
11. The pension obligation is considered by the auditors to be a long-term liability.
12. The 20-year bonds payable bear interest at 5% and are due August 31, 2025. The bonds' annual interest was paid on December 31. The company established the bond sinking fund that is included in the cash balance.
13. For common shares, 900,000 are authorized and 700,000 are issued and outstanding. The preferred shares are \$2, non-cumulative, participating shares. Fifty thousand are authorized and 20,000 are issued and outstanding.
14. Net sales for the year are \$3,000,000 and gross profit is 40%.
Required:
1. Prepare a corrected classified SFP/BS as at December 31, 2021, in good form, including all required disclosures identified in Chapter 4. Adjust the account balances as required based on the additional information presented.
2. Calculate one liquidity ratio and one activity ratio and comment on the results. Use ending balances in lieu of averages when calculating ratios.
4.3 Below is the trial balance for Johnson Berthgate Corp. at December 31, 2021. Accounts are listed in alphabetical order and all have normal balances.
Account Balance
Accounts payable \$ 350,000
Accounts receivable 330,000
Accrued liabilities 70,000
Accumulated depreciation, buildings 110,000
Accumulated depreciation, equipment 50,000
Accumulated other comprehensive income 55,000
Administrative expenses 580,000
Allowance for doubtful accounts 15,000
Bonds investment at amortized cost 190,000
Bonds payable 655,684
Buildings 660,000
Cash 131,000
Commission payable 90,000
Common shares 520,000
Correction of prior year's error – a missed expense in 2020 (net of tax) 90,000
Cost of goods sold 3,050,000
Equipment 390,000
Freight-out 11,000
Goodwill 30,000
Income tax expense 8,500
Intangible assets, franchise (net) 115,000
Intangible assets, patents (net) 125,000
Interest expense 135,000
Inventory 440,000
Investment (available for sale) 180,000
Investment (trading) 100,000
Land 170,000
Notes payable (due in 6 months) 60,000
Notes payable 571,875
Preferred shares 80,000
Prepaid advertising 6,000
Retained earnings 290,941
Sales revenue 4,858,000
Selling expenses 1,190,000
Unearned consulting fees 13,000
Unrealized gain on trading investments 40,000
Unusual gain 102,000
Additional information as at December 31, 2021:
1. Inventory has a net realizable value of \$430,000. The weighted average cost method of inventory valuation was used.
2. Trading investments are securities held for trading purposes and have a fair value of \$120,000. Investments in bonds are being held to maturity at amortized cost with interest payments each December 31. Investments in other securities are classified as available for sale (FVOCI) and any gains or losses will be recognized through other comprehensive income (OCI). These have a fair value of \$180,000 at the reporting date.
3. Correction of the prior period error relates to a missed travel expense from 2020. The books are still open for 2021.
4. Patents and franchise were being amortized on a straight-line basis. Accumulated amortization to December 31, 2021 is \$80,000 for patents and \$45,000 for the franchise.
5. Goodwill was recognized at the time of the purchase as the excess of the cash paid purchase price over the net identifiable assets.
6. The bonds were issued at face value on December 31, 2005 and are 5%, 20 year, with interest payable annually each December 31.
7. The 3%, 5-year note payable will be repaid by December 31, 2024 and was signed when market rates were 3.5%.
Below is the payment schedule:
Payment Amount Interest @ 3.5% Amortization Balance
December 31, 2019 \$566,906
December 31, 2020 17,400 19,842 2,442 569,348
December 31, 2021 17,400 19,927 2,527 571,875
December 31, 2022 17,400 20,016 2,616 574,491
December 31, 2023 17,400 20,107 2,707 577,198
December 31, 2024 17,400 20,202 2,802 580,000
8. During the year ended December 31, 2021, no dividends were declared and there was no preferred or common share activity.
9. On December 31, 2021, the share structure was; common shares, unlimited authorized, 260,000 shares issued and outstanding. \$3 preferred shares, non-cumulative, 1,200 authorized, 800 shares issued and outstanding.
10. The company prepares financial statements in accordance with IFRS and investments in accordance with IFRS 9.
11. The income tax rate is 25%.
Required:
1. Prepare a classified statement of financial position as at December 31, 2021, in good form, including all required disclosures identified in Chapter 4. Adjust the account balances as required based on the additional information presented.
2. Calculate the company's debt ratio and equity ratio and comment on the results.
3. Assume now that accounts receivable is made up of the following:
Accounts with debit balances \$ 580,000
Accounts with credit balances (250,000)
Discuss whether this change in the accounts will affect the liquidity of this company. Round final ratio answers to the nearest 2 decimal places.
4.4 Below is the trial balance in no particular order for Hughey Ltd. as at December 31, 2021:
Hughey Ltd.
Trial Balance
As at December 31, 2021
Debits Credits
Cash \$ 250,000
Accounts receivable 1,015,000
Allowance for doubtful accounts \$ 55,000
Prepaid rent 40,000
Inventory 1,300,000
Investments – available for sale (FVOCI) 2,100,000
Land 530,000
Building 770,000
Patents (net) 25,000
Equipment 2,500,000
Accumulated depreciation, equipment 1,200,000
Accumulated depreciation, building 300,000
Accounts payable 900,000
Accrued liabilities 300,000
Notes payable 600,000
Bond payable 1,100,000
Common shares 2,500,000
Accumulated other comprehensive income 245,000
Retained earnings 1,330,000
\$ 8,530,000 \$ 8,530,000
Additional information as at December 31, 2021:
1. The inventory has a net realizable value of \$1,350,000. The company uses FIFO method of inventory valuation.
2. Investments in available for sale securities (FVOCI) have a fair value of \$2,250,000.
3. The company purchased patents of \$60,000 on January 1, 2015.
4. Bonds are 8%, 25-year and pay interest annually each January 1, and are due December 31, 2030.
5. The 7%, notes payable represent bank loans that are secured by investments in available for sale securities (FVOCI) with a carrying value of \$800,000. Interest is paid each December 31 and no principal is due until its maturity on April 30, 2022.
6. The capital structure for the common shares are # of authorized, 100,000 shares; issued and outstanding, 80,000 shares.
Required:
1. Prepare a classified statement of financial position as at December 31, 2021, in good form, including all required disclosures identified in Chapter 4.
2. Calculate the annual amortization for the patent.
3. Does this company follow IFRS or ASPE? Explain your answer.
4.5 Below is a list of independent transactions. For each transaction, identify which section of the statement of cash flows it is to be reported and indicate if it is a cash in-flow (a positive number) or cash out-flow (negative number). (Hint: recall the use of the accounting equation to help determine if an amount is a positive or negative number.)
Description Section Amount
Issue of bonds payable of \$500 cash
Sale of land and building of \$60,000 cash
Retirement of bonds payable of \$20,000 cash
Current portion of long-term debt changed from \$56,000 to \$50,000
Repurchase of company's own shares of \$120,000 cash
Issuance of common shares of \$80,000 cash
Payment of cash dividend of \$25,000 recorded to retained earnings
Purchase of land of \$60,000 cash and a \$100,000 note
Cash dividends received from a trading investment of \$5,000
Interest income received in cash from an investment of \$2,000
Interest and finance charges paid of \$15,000
Purchase of equipment for \$32,000
Increase in accounts receivable of \$75,000
Decrease in a short-term note payable of \$10,000
Increase in income taxes payable of \$3,000
Purchase of equipment in exchange for a \$14,000 long-term note
4.6 Below is the unclassified balance sheet for Carmel Corp. as at December 31, 2020:
Carmel Corp.
Balance Sheet
As at December 31, 2020
Cash \$ 84,000 Accounts payable \$ 146,000
Accounts receivable (net) 89,040 Mortgage payable 172,200
Investments – trading (FVNI) 134,400 Common shares 400,000
Buildings (net) 340,200 Retained earnings 297,440
Equipment (net) 168,000 \$ 1,015,640
Land 200,000
\$ 1,015,640
The net income for the year ended December 31, 2021, was broken down as follows:
Revenues \$ 1,000,000
Gain 2,200
Total revenue 1,002,200
Expenses
Operating expenses 809,200
Interest expenses 35,000
Depreciation expense – building 28,000
Depreciation expense – equipment 20,000
Loss 5,000
897,200
Net income \$ 105,000
The following events occurred during 2021:
1. Investments in traded securities are short-term securities and the entire portfolio was sold for cash at a gain of \$2,200. No new investments were purchased in 2021.
2. A building with a carrying value of \$225,000 was sold for cash at a loss of \$5,000.
3. The cash proceeds from the sale of the building were used to purchase additional land for investment purposes.
4. On December 31, 2021, specialized equipment was purchased in exchange for issuing an additional \$50,000 in common shares.
5. An additional \$20,000 in common shares were issued and sold for cash.
6. Dividends of \$8,000 were declared and paid in cash to the shareholders.
7. The cash payments for the mortgage payable during 2021 included principal of \$30,000 and interest of \$35,000. For 2022, the cash payments will consist of \$32,000 for the principal portion and \$33,000 for the interest.
8. All sales to customers and purchases from suppliers for operating expenses were on account. During 2021, collections from customers were \$980,000 and cash payments to suppliers were \$900,000.
9. Ignore income taxes for purposes of simplicity.
Required:
1. Prepare a classified SFP/BS in good form as at December 31, 2021. Identify which required disclosures discussed in Chapter 4 were missed due to lack of information?
2. Prepare a statement of cash flows in good form with all required disclosures for the year ended December 31, 2021. The company prepares this statement using the indirect method.
3. Calculate the company's free cash flow and discuss the company's cash flow pattern including details about sources and uses of cash.
4. How can the information from the SFP/BS and statement of cash flows be beneficial to the company stakeholders (e.g., creditors, investors, management and others)?
4.7 Below is the comparative balance sheet for Lambrinetta Industries Ltd.:
Lambrinetta Industries Ltd.
Balance Sheet
December 31
2021 2020
Assets:
Cash \$ 32,300 \$ 40,800
Accounts receivable 79,900 107,100
Investments – trading (FVNI) 88,400 81,600
Land 86,700 49,300
Plant assets 425,000 345,100
Accumulated depreciation – plant assets (147,900) (136,000)
Total assets \$ 564,400 \$ 487,900
Liabilities and Equity:
Accounts payable \$ 18,700 \$ 6,800
Current portion of long-term note 8,000 10,000
Long-term note payable 119,500 75,000
Common shares 130,900 81,600
Retained earnings 287,300 314,500
Total liabilities and equity \$ 564,400 \$ 487,900
Additional information:
1. Net income for the year ended December 31, 2021 was \$161,500.
2. Cash dividends were declared and paid during 2021.
3. Plant assets with an original cost of \$51,000 and with accumulated depreciation of \$13,600 were sold for proceeds equal to book value during 2021.
4. The investments are reported at their fair value on the balance sheet date. During 2021, investments with a cost of \$12,000 were purchased. No other investment transactions occurred during the year. Fair value adjustments are reported directly on the income statement.
5. In 2021, land was acquired through the issuance of common shares. The balance of the common shares issued were for cash.
Required: Using the indirect method, prepare the statement of cash flows for the year ended December 31, 2021 in good form including all required disclosures identified in Chapter 4. The company follows ASPE.
4.8 Below is a comparative statement of financial position for Egglestone Vibe Inc. as at December 31, 2021:
Egglestone Vibe Inc.
Statement of Financial Position
December 31
2021 2020
Assets:
Cash \$ 84,500 \$ 37,700
Accounts receivable 113,100 76,700
Inventory 302,900 235,300
Investments – available for sale (FVOCI) 81,900 109,200
Land 84,500 133,900
Plant assets 507,000 560,000
Accumulated depreciation – plant assets (152,100) (111,800)
Goodwill 161,200 224,900
Total assets \$ 1,183,000 \$ 1,265,900
Liabilities and Equity:
Accounts payable \$ 38,100 \$ 66,300
Dividend payable 19,500 41,600
Notes payable 416,000 565,500
Common shares 322,500 162,500
Retained earnings 374,400 370,200
Accumulated other comprehensive income 12,500 59,800
Total liabilities and equity \$ 1,183,000 \$ 1,265,900
Additional information:
1. Net income for the 2021 fiscal year was \$24,700.
2. During 2021 land was purchased for expansion purposes. Six months later, another section of land with a carrying value of \$111,800 was sold for \$150,000 cash.
3. On June 15, 2021, notes payable of \$160,000 were retired in exchange for the issuance of common shares. On December 31, 2021, notes payable for \$10,500 were issued for additional cash flow.
4. Available for sale investments (FVOCI) were purchased during 2021 for \$20,000 cash. By year-end, the fair value of this portfolio dropped to \$81,900. No investments from this portfolio were sold in 2021.
5. At year-end, plant assets originally costing \$53,000 were sold for \$27,300, since they were no longer contributing to profits. At the date of the sale, the accumulated depreciation for the asset sold was \$15,600.
6. Cash dividends were declared and a portion of those were paid in 2021. Dividends are reported under the financing section.
7. Goodwill impairment loss was recorded in 2021 to reflect a decrease in the recoverable amount of goodwill.
Required:
1. Prepare a statement of cash flows in good form, including all required disclosures identified in Chapter 4. The company uses the indirect method to prepare the statement.
2. Analyze and comment on the results reported in the statement. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/04%3A_Financial_Reports__Statement_of_Financial_Position_and_Statement_of_Cash_Flows/4.07%3A_Exercises.txt |
Trouble at Tesco
On November 9, 2014, it was reported that several legal firms were considering launching a class action suit against British grocery giant Tesco PLC. The claims were related to revelations made by the company in September that its profits for the first half of the year were overstated by £ 263 million. In October, the United Kingdom's Serious Fraud Office announced that it was launching its own investigation into the accounting practices at Tesco. This followed the company's suspension of eight senior executives along with the resignation of the CEO.
The issue at Tesco stemmed primarily from a misstatement of a revenue category described as "commercial income." Although the company's primary business is selling groceries to consumers, it also earns a significant amount from suppliers. Manufacturers and suppliers understand that in a grocery store, the location of the product on the shelves can have a significant effect on the level of sales generated. Many of these suppliers will offer rebates or other payments to Tesco in exchange for preferential placement of their products on the shelves. These rebates will often be calculated on a sliding scale, increasing as the level of sales increases.
In Tesco's interim financial statements, many of these rebates would need to be estimated, as the sales level for the entire year would not yet be known. Tesco's auditor, PwC, indicated in its 2014 audit report that the determination of commercial income was an area of audit risk due to the judgment required and possibility of manipulation. Tesco had been experiencing decreasing market share in 2014, and this may have provided an incentive for some degree of earnings management. Some analysts suggested that Tesco might have booked promotional rebates based on historic results rather than current activity.
Problems with revenue recognition have been a source of many accounting errors and frauds over the years. Given the complex nature of some types of business transactions and contracts, the criteria for recognition of revenue may not always be clear. When significant levels of judgment are required to determine the point at which revenue should be recognized, the opportunity for misstatement grows. Given that many of the complex issues surrounding revenue recognition are not always well understood by financial-statement readers, managers may sometimes give in to the temptation to "work" the numbers a little bit.
This chapter will explore some of the issues and judgments required with respect to revenue recognition and some of the problems that companies like Tesco may face.
(Source: Marriage, 2014)
Learning Objectives
After completing this chapter, you should be able to:
• Describe the criteria for recognizing revenue and determine if a company has earned revenue in a business transaction.
• Discuss the problem of measurement uncertainty and alternative accounting treatments for these situations.
• Prepare journal entries for a number of different types of sales transactions.
• Apply revenue recognition concepts to the determination of profit from long-term construction contracts.
• Prepare journal entries for long-term construction contracts.
• Apply revenue recognition concepts to unprofitable long-term construction contracts.
• Describe presentation and disclosure requirements for revenue-related accounts.
• Discuss the earnings approach to revenue recognition and compare it to current IFRS requirements.
Introduction
Revenue is the essence of any business. Without revenue, a business cannot exist. The basic concept of revenue is well understood by business people, but complex and important accounting issues complicate the recognition and reporting of revenue. Sometimes, the complexity of these issues can lead to erroneous or inappropriate recognition of revenue. In 2007, Nortel Networks Corporation paid a \$35 million settlement in response to a Securities and Exchange Commission (SEC) investigation into its reporting practices. Although several problems were identified, one of the specific issues that the SEC investigated was Nortel's earlier accounting for bill-and-hold transactions. In a separate matter, Nortel was also required to restate its financial statements due to errors in the timing of revenue recognition for bundled sales contracts. In this chapter, we will examine these issues and determine the appropriate accounting treatment for revenues.
05: Revenue
IFRS 15 defines revenue as "participants income arising in the course of an entity's ordinary activities." 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 an increase in equity, other than those relating to contributions from equity participants." (CPA Canada, 2017, IFRS 15 Appendix A).
ASPE defines revenue as "the inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise, normally from the sale of goods, the rendering of services, and the use by others of enterprise resources yielding interest, royalties and dividends" (CPA Canada, 2017, 3400.03a).
Both definitions refer to the ordinary activities of the entity, which suggests that gains made from incidental activities, such as the sale of surplus assets, cannot be defined as revenue. However, these gains are still considered income, as the Conceptual Framework includes revenue and gains as part of its definition of income. Revenue is realized when goods or services are converted to cash. The point when cash is realized is usually easy to identify. In a grocery store, when a customer pays for his or her purchase with cash, the revenue is realized at that moment. In a wholesale business, when goods are sold on credit, the revenue is not realized until the account receivable is collected and cash is deposited in the bank. However, in this case, the revenue would have been recognized at some earlier point when the account receivable was created. In accounting, the point at which revenue should be recognized is not always so simple to determine. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.01%3A_Definition.txt |
There are two different perspectives on how to recognize revenues:
• The contract-based approach
• The earnings approach
The contract-based approach is the subject of IFRS 15 – Revenue from Contracts with Customers. This standard focuses on the contractual rights and obligations of the buyer and the seller. The earnings approach is currently used in ASPE. This approach focuses on the process of adding value to the final product or service that is delivered to the customer, and will be discussed in Section 5.5.
IFRS 15, issued in 2014, is effective for fiscal years beginning on or after January 1, 2018, although early adoption is allowed. The length of this transition period reflects the anticipated effect this standard may have on business results and business processes. This standard was a joint project between IASB and FASB, as both standard-setting bodies were interested in creating more consistency in the application of revenue-recognition principles. The nature and complexity of this standard and the resulting process meant that development time was lengthy. The project was first added to the IASB agenda in 2002, and the first discussion paper was produced in 2008.
The standard applies to all contractual relationships with customers except for leases, financial instruments, insurance contracts, and those transactions covered by standards that deal with subsidiaries, joint arrangements, joint ventures, and associates. The standard also doesn't apply to non-monetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers. The new standard replaces several existing standards, including IAS 11, IAS 18, IFRIC 13, IFRIC 15, IFRIC 18, and SIC-31.
The standard takes the approach that the essence of the relationship between a business, and its customers can be characterized as one of contractual rights and obligations. To determine the correct accounting treatment for these transactions, the standard applies a five-step model:
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
The standard provides a significant amount of detail in the application of these steps. We will focus on some of the key elements of each component of the model.
5.02: Revenue Recognition
The contract must be approved by both parties and must clearly identify both the goods and services that will be transferred and the price to be paid for these goods and services. The contract must be one of commercial substance, and there must be reasonable expectation that the ultimate amount owing from the customer will be collected. This collectability criterion will prevent a situation where revenue is recognized and then a provision is immediately made for an uncollectible account. Under this criterion, the contract cannot be recognized until the collection is probable. If these conditions are not present, the contract can be continually reassessed to see if its status changes. The standard also applies guidance on how to deal with contract modifications. Depending on the circumstances, the modifications may be treated as either a change to the existing contract or as a completely new contract. A new contract would exist if the scope of the contract increases due to the addition of distinct goods or services, and the price of the contract increases by an amount that reflects the entity's stand-alone selling prices of the additional goods or services.
The contract will not exist if each party to the contract has the unilateral, enforceable right to terminate a wholly unperformed contract without compensating the other party. A contract would be considered wholly unperformed if the entity has not yet transferred any of the promised goods or services to the customer, and the entity has not received any consideration or entitlement to consideration. In this situation, there is clearly no revenue to recognize as there has not been any exchange under the contract. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.02%3A_Revenue_Recognition/5.2.01%3A_Identify_the_Contract.txt |
This is a critical step, as the performance obligations will determine when revenue is recognized. The standard requires that the promised performance obligation be identified either as distinct goods and services or as a series of distinct goods and services that are substantially the same and that have the same pattern of transfer to the customer. A performance obligation exists only if there is a transfer of goods or services to a customer. This limitation in the definition means that internal administrative tasks required to manage a contract are not, in themselves, performance obligations.
During the development and implementation of IFRS 15, there was a great deal of discussion around the concept of distinct goods or services. The definition of "distinct" in this context contains two criteria: the customer can benefit from the good or service either on its own or together with other resources that are already available to the customer, and the contract contains a separately identifiable promise to transfer the good or service. It is important to note that both of these criteria must be satisfied to meet the definition of "distinct." For some contracts, the satisfaction of the second criteria may require some analysis. The standard provides further clarification by specifying the following indicators of a combined good or service (i.e., a single performance obligation):
• Significant services in integrating the goods or services with other goods or services are provided in the contract.
• The goods or services provided significantly modify or customize other goods or services provided in the contract.
• The goods or services are highly interdependent.
The standard provides further detailed examples to illustrate these concepts. A common, simple example can also illustrate the idea of "distinct". Consider a customer who wishes to build a brick wall. There are two ways this could be done. The customer could arrange with a local building supply warehouse to deliver all the required materials (bricks, mortar, tools, etc.) The company could then arrange a separate contract with a local mason to build the wall. In this case, there are two separate contracts. In the first contract, the performance obligation is satisfied when the materials are delivered to the building site. The performance obligation in the second contract will be satisfied when the mason completes construction of the wall.
Now consider a different scenario: the company hires a local contractor to build the wall. The contractor purchases all the materials and arranges to have them delivered to the building site. Although these materials could meet the first criteria (i.e., the customer could benefit from them), the second criteria is not met. The contractor has made a promise for a single good: the completed wall. The contractor is going to provide significant services in integrating the goods (assembling the bricks with the mortar), the service modifies the goods, and the goods and services are interdependent (the skilled labour of the contractor is required to assemble the raw materials). In this case, the delivery of the materials to the building site does not satisfy a performance obligation. The performance obligation is not satisfied until the wall is completed.
To provide further clarity on the nature of performance obligations, the standard provides the following examples of goods and services:
• Sale of goods produced by the entity
• Resale of goods purchased by the entity
• Resale of rights to goods or services purchased by the entity
• Performing a contractually agreed upon task
• Providing a service of standing ready to provide goods or services
• Providing a service of arranging for another party the transfer of goods or services
• Granting rights to goods or services to be provided in the future that the customer can resell
• Constructing, manufacturing, or developing an asset on behalf of a customer
• Granting licenses
• Granting options to purchase additional goods or services
(CPA Handbook – Accounting, IFRS 15.26)
In some of the examples above, it is apparent that the entity would be acting as an agent for the benefit of a principal. In determining whether an agency relationship exists, the key factor to consider is control. If the entity controls the good or service before it is transferred to the customer, then the entity is a principal. If the entity does not control the good or service, the entity would be considered an agent. The main concern from an accounting perspective in these situations is the amount of revenue to recognize. For a principal, the gross amount of consideration expected from the transaction is considered revenue. For an agent, only the fee or commission earned from the transfer of goods or services is reported as revenue. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.02%3A_Revenue_Recognition/5.2.02%3A_Identify_the_Performance_Obligations.txt |
The standard defines the transaction price as the amount of the consideration the entity expects to be entitled in exchange for transferring promised goods or services, excluding amounts collected on behalf of third parties. This consideration may be fixed or variable in nature. As well, there may be an implied financing component present in the consideration. Also, there are certain contracts that may require the payment of non-cash consideration.
Variable consideration can occur when discounts, rebates, refunds, credits, price concessions, or other incentives or penalties exist. When variable consideration is present in a contract, the amount should be estimated using either the expected value (the sum of probability-weighted amounts from a range of possible amounts) or the most likely amount (usually more appropriate when the range contains only a few choices). Variable consideration can be included in the transaction price only if it is highly probable that a significant reversal in the amount cumulative revenue recognized will not occur in the future. The standard does not define what is meant by "highly probable", but it does provide a list of factors to consider when making this assessment. These situations require professional judgment and analysis of both quantitative and qualitative factors.
In some contracts, the entity may be providing significant financing services, even if these are not explicitly stated in the contract. A simple example would be goods sold which require payment in two years' time. Although the contract may not state an interest rate, there is clearly a financing component present. The selling entity needs to account for the time value of money in determining the portion of the sale that relates to the goods and the portion that relates to the financing provided. In determining if a significant financing component exists, the entity should consider the difference between the consideration and the cash selling price of the goods or services, the length of time between the transfer of control and the customer's payment, and prevailing interest rates in the relevant market. The discount rate used should reflect the rate that would be arrived at if the entity and the customer had engaged in a separate financing contract. This rate should reflect current market conditions, as well as the customer's credit rating, collateral offered, and any other relevant factors. As a practical expedient, the standard allows entities to ignore the financing component if the time from delivery of goods or services to receipt of payment is expected to be one year or less.
When a contract allows non-cash consideration to be paid by a customer, that consideration should be measured at its fair value. In some cases, it may not be possible to determine the fair value of the consideration received. In these cases, the entity should use the stand-alone selling prices of the promised goods or services to determine the transaction price.
5.2.04: Allocate the Transaction Price to the Performance Obligations
Where multiple performance obligations are included in a single-price contract, the price should be allocated based on the relative proportions of the stand-alone selling prices of each component at the contract inception date. Where the stand-alone selling prices cannot be determined, other suitable estimation methods include
• the adjusted market assessment approach,
• the expected cost plus a margin approach, and
• the residual approach (permissible only in limited circumstances).
The application of these approaches may result in the identification of performance obligations that hadn't previously been identified due to the lack of stand-alone prices. If the customer receives a discount from purchasing a bundle of goods or services, this discount would normally be allocated in a proportional manner to the different performance obligations. The standard does, however, allow for discounts to be allocated in a disproportional manner if certain criteria are met. When variable consideration is present in a contract, the standard allows the variable component to be allocated to specific performance obligations if certain criteria are met. Otherwise, the variable consideration would be allocated in a proportional manner, similar to other consideration. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.02%3A_Revenue_Recognition/5.2.03%3A_Determine_the_Transaction_Price.txt |
Revenue should be recognized when the performance obligation has been satisfied. This occurs when the entity has transferred control of an asset to the customer. In this context, an asset includes either goods or services. A service is considered an asset because the customer obtains a benefit from its use, even if only briefly. The performance obligations can be satisfied either at a point in time or over time.
The standard defines control as the ability to direct the use of, and obtain substantially all of the benefits from the asset. (CPA Canada Handbook – Accounting, IFRS 15.33). Benefits are described as future cash flows, and can take the form of either inflows or reductions of outflows. Thus, cash flows can include not only the revenue derived directly from selling the asset, but also savings from using the asset to enhance other assets, or even the settlement of liabilities with the asset.
Many common business transactions result in performance obligations being satisfied at a point in time. This point could also be described as the critical event. For example, when you buy groceries at your local convenience store, the critical event occurs when you exchange cash for possession of the goods. Once you leave the store with the groceries, revenue has been earned by the store. The proprietor no longer has any responsibility for or control over the goods. Other factors that can be considered when determining if control of an asset has been transferred include the transfer of legal title, the transfer of physical possession, the acceptance by the customer of the asset, the entity's entitlement to payment by the customer, and the transfer of significant risks and rewards of ownership. In the example of groceries purchased, the reward is the realization of the cash received from the sale. Prior to the sale, the risk to the vendor is that the food products may pass their sell-by date or may not be saleable due to changes in consumer tastes. Once you have purchased the goods, you are accepting responsibility for consuming the product prior to the sell-by date. Thus, the rewards have been transferred to the seller and the risks have been transferred to the buyer.
Often, the question of control can be answered by looking at a number of the factors identified above. As long as a company possesses the goods and still holds the title to the goods, there is both a risk (i.e., goods could be damaged, stolen, or destroyed) and a reward (i.e., goods can pledged or sold) available to the vendor. Sometimes, a vendor may transfer legal title to the customer but still maintain physical possession of the goods. In late 2000, Nortel Networks Corporation recorded approximately \$1 billion of revenue using bill-and-hold transactions. These transactions were recorded as sales, but the company maintained possession of the goods until some later date when the customer requested delivery. In order to promote these types of sales, the company offered several different incentives to its customers. To report these types of transactions, US GAAP required that several conditions be met, including the conditions that the transaction must be requested by the customer and serve some legitimate business purpose. Nortel's actions violated these two conditions, and as such, the company was later required to restate revenues for the fourth quarter by over \$1 billion.
The selling of services can create further accounting problems, as there is no longer the obvious transfer of a physical product to indicate completion of the earnings process. When you get a haircut, the service will be completed when you are satisfied with the cut and the barber enters the sale into the cash register. This can still be described as revenue earned at a point in time, as the completion of the haircut can be seen to be a critical event. However, some activities can take longer to complete, and they can even extend over several accounting periods. When a company agrees to provide a service over a period of time that crosses several fiscal years, the problem is to determine in which accounting periods to recognize the revenue. IFRS 15 requires one of three criteria be met to recognize revenue over time:
• The customer simultaneously receives and consumes benefits as the entity performs;
• The entity's performance creates or enhances an asset that the customer controls; or
• The entity's performance does not create an asset with an alternative use to the entity and entity has an enforceable right to payment
(CPA Canada Handbook – Accounting, IFRS 15.35)
When recognizing revenue for a performance obligation that is satisfied over time, it is essential that the entity have a reliable method for measuring progress. These methods should be based on either inputs or outputs. If the entity cannot reasonably measure its progress towards satisfaction of the performance obligation, then revenue should not be recognized. In some cases, although reliable measures of progress are not available, there is still a reasonable expectation that costs incurred will be recovered. In this instance, revenue would be recognized equal to the costs incurred. This is referred to as the zero-margin method. Revenue recognition for long term contracts will be discussed further in Section 5.3.
Accounting for revenue over time can create further problems when both goods and services are delivered. For example, in 2006, Nortel Networks was required to restate its financial statements due to improper accounting of several "multiple element arrangements." Nortel was engaged in many different types of long-term contracts with customers where installation, network planning, engineering, hardware, software, upgrades, and customer-support features were all included in the contract price. The accounting for these contracts was complicated, and the restatement was required because certain undelivered products and services were not considered separate accounting units, as no fair value could be determined for them.
5.2.06: Contract Costs
IFRS 15 also provides guidance on how to account for costs incurred to obtain and fulfill a contract. When obtaining a contract, any incremental costs incurred should be capitalized as an asset and amortized over the life of the contract. These costs only include those direct costs that would not have been incurred if the contract had not been obtained. A common example would be commissions paid to sales staff. As a practical expedient, the standard allows the costs to be expensed immediately for contracts terms of one year or less. This particular section of the standard has generated some debate, particularly in the telecommunications sector. Common practice in this industry usually involves expensing employee commissions at the time the contract is signed. Some industry representatives have expressed concern that the requirement to capitalize contract costs, along with other aspects of the standard, will result in significant changes and investments in IT systems to properly track the information.
For costs incurred to fulfill a contract, the standard requires capitalization only if the costs relate directly to the contract, the costs generate or enhance resources that will be used to satisfy the performance obligations, and the costs are expected to be recovered. These conditions will generally prevent the capitalization of general and administrative costs that are not explicitly chargeable under a contract or the cost of wasted resources that are not reflected in the price of the contract. However, overhead costs such as project management, supervision, insurance, and depreciation may be eligible for capitalization if they relate directly to the contract. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.02%3A_Revenue_Recognition/5.2.05%3A_Recognize_Revenue_When_%28or_as%29_the_Entity_Satisfies_a_Performance_Obligation.txt |
IFRS 15 provides fourteen sections of application guidance which elaborate on certain aspects of the standard as they relate to specific situations. As well, the standard provides sixty-three illustrative examples for further clarity. In this section, we will examine some of the examples and guidance.
5.03: Applications
Telurama Inc. sells mobile telephones with two-year bundled airtime and data plans. The stand-alone selling price of the telephone is \$600. The the airtime and data plan does not have an observable stand-alone selling price, but Telurama has used the adjusted market assessment approach to estimate the stand-alone selling price as \$1,000. As the mobile telephone business is very competitive, Telurama is required to sell the bundled package for \$1,400. Telurama has determined that the discount should be allocated proportionally to the two performance obligations. In this case, the revenue would be recognized as follows:
Component Calculation Allocation
Telephone \$ 525
Airtime and data \$ 875
Total \$ 1,400
If the airtime and data plan was sold to different customer groups for a broad range of different prices, Telurama could use the residual approach instead, as the stand-alone selling price for this performance obligation would not be observable. With this approach, the value of the observable stand-alone selling price (the telephone) is subtracted from the total contract value to arrive at the value of the unobservable stand-alone selling price (the airtime and data plan). In this example, Telurama would recognize revenue as follows:
Component Calculation Allocation
Telephone stand-alone price \$ 600
Airtime and data \$ 800
Total \$ 1,400
In either case, revenue will be recorded based on the allocation calculated above. The revenue for the telephone will be recorded immediately upon delivery to the customer, and the remaining amount relating to the airtime and data will be reported as unearned revenue that will be recognized over the term of the contract. The journal entry at the time of sale to record this transaction using the first example would look like this:
5.3.02: Consignment Sales
Sometimes a retailer may not want to take the risk of purchasing a product for resale. The retailer may not want to tie up working capital or may think the product is too speculative or risky. In these cases, a consignment arrangement may be appropriate. Under this type of arrangement, the manufacturer of the product (the consignor) will ship the goods to the retailer (the consignee), but the manufacturer will retain legal title to the product. The consignee agrees to take care of the product and make efforts to the sell the product, but no guarantee of performance is made. As well, the agreement will likely require the return of the goods to the consignor after a specified period, if the goods are not sold. Thus, the performance obligation has not been satisfied when the goods are transferred to the consignee, and the consignor cannot recognize revenue at this point. The goods will, thus, remain on the consignor's books as inventory until the consignee sells them. When the consignee actually sells the product, an obligation is now created to reimburse the consignor the amount of the sales proceeds, less any commissions and expenses that are agreed to in the contract for the consignment arrangement. At the time of sale, the consignor can recognize the revenue from the product, and the consignee can recognize the commission revenue.
Assume the following facts: Dali Printmaking Inc. produces fine-art posters. Dali ships 3,000 posters to Magritte Merchandising Ltd. on a consignment basis. The total cost of the posters is \$12,000, and Dali pays \$550 in shipping costs. Magritte pays \$1,200 for advertising costs that will be reimbursed by Dali. During the year, Magritte sells one-half of the posters for \$23,000. Magritte informs Dali of this and pays the amount owing. Magritte's commission is 15 percent of the sales price. The accounting for this type of transaction looks like this:
Dali Printmaking Inc. (consignor)
Magritte Merchandising Ltd. (consignee)
5.3.03: Sales With Right of Return
It is a common practice in the retail sector to allow customers to return products for various reasons, within a certain period of time. When the product is returned, the customer may receive a full refund, a credit to be applied against future purchases, or a replacement product. The accounting issue for the company is whether the full amount of revenue should be recognized at the time of sale, given that a certain number of returns may be expected. The general approach used here is to record revenue only in the amount of consideration expected to be received. In other words, the company needs to make an estimate at the time of sale of the amount of returns expected, and then exclude this amount from reported revenue. This amount should be reported as a refund liability. As well, the company should report an asset equal to the expected amount of product to be returned. The asset would be adjusted against the cost of goods sold in the period of sale. At the end of every accounting period, the estimates used to arrive at the refund liability and asset should be reviewed and adjusted where necessary. It is expected that most companies should be able to make reasonable estimates of these amounts, using historical, industry, technical, or other data.
Consider the following example. Wyeth Mart sells high quality paintbrushes for use in fine art applications. Each brush costs the company \$15 and sells for \$25. Wyeth Mart offers a full refund for any unused product that is returned within 30 days of purchase, and the company expects that these returned products can resold for a profit. The company has reviewed historical sales data and estimated that 2% of products sold will be returned for a refund. During the month of May, 1,000 paintbrushes are sold for cash. The journal entries in May would be:
In June, if 20 brushes are returned, the journal entry will be:
If the amount returned differs from estimated amount, the refund liability and refund asset will need to be adjusted once the return period expires. This is an ongoing process, as most companies will continue to make new sales during the period. As a practical matter, many companies will only review the balances of the refund liability and refund asset account at the annual reporting date. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.03%3A_Applications/5.3.01%3A_Bundled_Sales.txt |
There are times when a customer may purchase goods from a company, but not take physical possession of the goods until a later date. Customers may have legitimate reasons for doing this, including a lack of warehouse space, delays in their own productions processes, or the need to secure a supply of a scarce product. When the selling entity is considering whether to recognize revenue on these types of contracts, it needs to consider if control of the goods has been transferred to the customer. Aside from the normal criteria that are used to evaluate control, an additional three conditions must be satisfied in bill-and-hold transactions:
• The reason for the bill-and-hold transaction must be substantive;
• The product must be identified separately;
• The entity must not have the ability to use or resell the product to another customer.
(CPA Canada Handbook – Accounting, IFRS 15.B81)
Consider the following example. Koenig Ltd. processes rare-earth elements used in certain technological applications. One of these elements forms a critical component of a customer's product. The customer has requested Koenig Ltd. set aside a one-year supply of the element to ensure that its production process is not interrupted. The customer's factory is in close proximity to Koenig's warehouse, and transportation between the two locations is easily facilitated. The customer agrees to pay for the entire one-year supply, as well as a monthly rental fee to cover Koenig's cost of storing the product in its warehouse. The entire payment of \$500,000, representing the cost of the element and 12 months of rent, is received on December 29, 2022. Koenig has separately identified and segregated the product in its warehouse, and the contract with the customer specifies that product cannot be sold to another customer. The fair value of the warehouse rental service being provided is \$800 per month.
In this case, the revenue from the sale of the product can be recognized on December 29, 2022 because the reason for the bill-and-hold transaction is substantive (the customer requested it), the product has been identified separately, and the contract specifies that the product cannot be resold. Assuming the transaction price has been determined using the fair value of the product and rental service, revenue will be recognized as follows:
Revenue related to rental service () = \$9,600
Revenue related to product () = \$490,400
Thus, on December 29, 2022, Koenig will recognize revenue of \$490,400 and report unearned revenue of \$9,600. The \$9,600 will be recognized as revenue at the rate of \$800 per month over the next year. If the holding period were longer than one year, Koenig would also need to consider the presence of a financing component in the transaction price.
5.3.05: Barter Transactions
When a customer and an entity agree that payment for goods or services can be made using non-cash consideration, the non-cash consideration received should be reported at its fair value. Assume that an oil-and-gas company wishes to trade a quantity of crude oil for natural gas that is used to power the refinery where the oil is processed. The natural gas will be consumed and will not be held in inventory. As these two products have different uses for the company, this transaction has commercial substance. Assume that the fair value of the natural gas received is \$10,000, and the cost of the crude oil traded is \$7,000. The journal entry for this transaction would be as follows: | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.03%3A_Applications/5.3.04%3A_Bill-and-Hold_Arrangements.txt |
Many large construction projects can take several years to complete. With these types of projects, a significant amount of professional judgment is required to determine when to recognize revenue. An obvious approach may be to simply wait until the completion of the project before recognizing revenue. However, this approach would not properly reflect the periodic activities of the business. Although contracts of this nature are usually complex, they do usually establish the right of the contractor to bill for work that is completed throughout the project and result in a transfer of control to the customer. Because the contractor is adding economic value to the product, while at the same time establishing a legal right to collect money for work performed, it is appropriate to recognize revenue on a periodic basis throughout the life of the project. This method of recognizing revenue and related costs is referred to as the percentage-of-completion method.
The most difficult part of applying this method is determining the proportion of revenue to recognize at the end of each accounting period. Both inputs (labour, materials, etc.) and outputs (square footage of a building completed, sections of a bridge, etc.) can be used, but judgment must be applied to determine which approach results in the most accurate measurement of progress on the project. One of the problems with output methods is that the measure may not accurately represent the entity's progress toward satisfying the performance obligation. With input methods, the problem may be that the input measured does not directly correlate to the transfer of control of goods or services to the customer. A common approach that is used by many construction companies is called the cost-to-cost basis. This approach uses the dollar value of inputs as the measurement of progress. More precisely, the proportion of costs incurred to date to the current estimate of total project costs is multiplied by the total expected revenue on the project to determine the amount of revenue to recognize. When this method is used, it is assumed that costs incurred do correlate to the transfer of control of goods and services to the customer and that these costs are a reasonable representation of the entity's progress toward satisfying the performance obligation. This approach is illustrated in more detail in the examples below.
Example 1: Profitable Contract
Salty Dog Marine Services Ltd. commenced a \$25 million contract on January 1, 2020, to construct an ocean-going freighter. The company expects the project will take three years to complete. The total estimated costs for the project are \$20 million. Assume the following data for the completion of this project:
2020 2021 2022
Costs to date 5,000,000 12,000,000 20,100,000
Estimated costs to complete project 15,000,000 8,050,000
Progress billings during the year 4,500,000 7,000,000 13,500,000
Cash collected during the year 4,200,000 6,800,000 14,000,000
The amount of revenue and gross profit recognized on this contract would be calculated as follows:
2020 2021 2022
Costs to date (A) 5,000,000 12,000,000 20,100,000
Estimated costs to complete project 15,000,000 8,050,000 0
Total estimated project costs (B) 20,000,000 20,050,000 20,100,000
Percent complete (C = A B) 25.00% 59.85% 100.00%
Total contract price (D) 25,000,000 25,000,000 25,000,000
Revenue to date (C D) 6,250,000 14,962,500 25,000,000
Less previously recognized revenue (6,250,000) (14,962,500)
Revenue to recognize in the year 6,250,000 8,712,500 10,037,500
Costs incurred the year 5,000,000 7,000,000 8,100,000
Gross profit for the year 1,250,000 1,712,500 1,937,500
Note that the costs incurred in the year are simply the difference between the current year's costs to date and the previous year's costs to date. The total amount of gross profit recognized over the three-year contract is \$4,900,000, which represents the difference between the contract revenue of \$25 million and the total project costs of \$20.1 million. It is not uncommon for the total project costs to differ from the original estimate. Adjustments to estimated project costs are always captured in the current year only. It is assumed that estimates are based on the best information at the time they are made, so it would be inappropriate to adjust previously recognized profit.
The journal entries to record these transactions in 2020 would look like this:
Construction in progress is a balance sheet account that represents accumulated costs to date on a project plus any recognized profit. Billings on construction is also a balance sheet account; it represents total amounts billed to the customer. These two accounts are normally presented on a net basis on the balance sheet, and may sometimes be described as Contract Asset/Liability. If construction in progress exceeds billings on construction, the net balance would be reported as recognized revenues in excess of billings. This asset would be reported as either current or noncurrent, depending on the length of the contract. If billings on construction exceeds construction in progress, the net balance would be reported as billings in excess of recognized revenues. This liability would also be either current or noncurrent. On the income statement, the company would report the revenues and construction expenses, with the difference being reported as gross profit.
In 2022, once the contract is completed, an additional journal entry is required to close the billings on construction and construction in progress accounts:
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A video is available on the Lyryx web site. Click Here to view the video.
Example 2: Unprofitable Contract
Although it would be ideal if contract costs could always be accurately estimated, most often this is not the case. Unexpected difficulties can occur during the construction process, or costs can rise due to uncontrollable economic factors. Whatever the reason, it is quite likely that the actual total costs on the project will differ from the original estimates. If costs rise during an accounting period, this situation is treated as a change in estimate, as it is presumed that the original estimates were based on the best information available at the time. A change in estimate is always applied on a prospective basis, which means the current period is adjusted for the net effect of the change, and future periods will be accounted for using the new information. There is no need to restate the prior periods when there is a change in estimate. If the revised estimate of costs will still result in the contract earning an overall profit, the only effect of increased cost estimates will be to reverse any previously overaccrued profits into the current year. This may result in a loss for the current year, but the project will still report a total profit over its lifespan.
Sometimes, however, cost estimates may increase so much that the total project becomes unprofitable. That is, the total revised project costs may exceed the total revenue on the project. This situation is referred to as an onerous contract, which results in a liability. When the unavoidable costs of fulfilling a contract exceed the economic benefits to be derived from the contract, a conservative approach should be applied, and the total amount of the expected loss should be recorded in the current year. In determining the unavoidable costs on the contract, the entity should consider the least costly option available, even if this means cancelling the contract and paying a penalty. This treatment is required because it is important to alert financial-statement readers of the potential total loss, regardless of the stage of completion, so that they are not misled about the realizable value of assets or income. Onerous contracts will be discussed in a later chapter.
To illustrate this situation, consider our Salty Dog example again, with one change. Assume that in 2021, due to a worldwide iron shortage, the expected costs to complete the project rise from \$8,050,000 to \$18,000,000. However, in 2022, it turns out that the drastic rise in iron prices was only temporary, and the final tally of costs at the end of the project is \$26,500,000. The profit on the project would be calculated as follows:
2020 2021 2022
Costs to date (A) 5,000,000 12,000,000 26,500,000
Estimated costs to complete project 15,000,000 18,000,000 0
Total estimated project costs (B) 20,000,000 30,000,000 26,500,000
Percent complete (C = A B) 25.00% 40.00% 100.00%
Total contract price (D) 25,000,000 25,000,000 25,000,000
Revenue to date (C D) 6,250,000 10,000,000 25,000,000
Less previously recognized revenue 0 (6,250,000) (10,000,000)
Revenue to recognize for the year 6,250,000 3,750,000 15,000,000
Costs incurred for the year 5,000,000 7,000,000 14,500,000
Gross profit (loss) for the year 1,250,000 (3,250,000) 500,000
Additional loss to recognize1 (3,000,000) 3,000,000
Gross profit (loss) for the year (6,250,000) 3,500,000
Notice that the total loss recognized over the life of the project is \$1,500,000, which reconciles with the total project revenue of \$25,000,000 minus total project costs of \$26,500,000.
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Other Considerations
There may be cases where input costs include the purchase of a single, significant asset. The entity may be required to install the asset as part of the contract, but may not have anything to do with the construction of the asset itself. In this case, the use input costs may be a misleading way to measure progress toward satisfaction of the performance obligation, as the entity does not contribute to the construction of the asset.
Consider the following example. Rohe Construction Ltd. signs a contract with a customer to install a distillation tower in an oil refinery. Rohe Construction Ltd. purchases the distillation tower from a supplier for \$3,000,000 and delivers it to the work site on November 20, 2022. At this time, the customer obtains control of the tower. The company estimates that it will take six months to install the distillation tower, and that the total project costs, excluding the tower, will be \$1,200,000. The total value of the contract is \$5,000,000.
The company has determined that using total input costs would be a misleading way to represent its progress toward satisfying the performance obligation. Instead, it will recognize revenue from the distillation tower itself using the zero-margin method, and revenue from the installation services using the percentage-of-completion method. Assume that by December 31, 2022, the company has incurred \$300,000 of costs, excluding the purchase of the tower. Revenue would be recognized as follows:
Tower Installation Total
Revenue 3,000,000 500,000 3,500,000
Cost of goods sold 3,000,000 300,000 3,300,000
Gross profit 0 200,000 200,000
NOTE: Installation revenue is calculated as
Using this approach, the total profit recorded to date of \$200,000 represents 25% of the total expected project profit of \$800,000 (). This makes sense, as the company has incurred 25% of the total expected costs, excluding the tower itself. The company doesn't recognize profit from the tower itself, as the tower's delivery does not represent satisfaction of the company's performance obligation to install the tower.
The zero-margin method can also be applied in situations where it is difficult to measure the outcome of a performance obligation. This could occur, for example, in the early stages of a long-term construction contract where significant progress cannot yet be measured. If the entity believes that costs incurred will ultimately be recoverable under the contract, then the zero-margin method can be applied, and the company will recognize revenue equal to the costs incurred. Once the entity determines that progress is now reliably measurable, it can then start applying the percentage-of-completion method. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.03%3A_Applications/5.3.06%3A_Long-Term_Construction_Contracts.txt |
IFRS 15 requires the presentation of contract assets or liabilities on the balance sheet once performance of the contract occurs. Contract assets or liabilities should be reported separately from receivables under the contract. Receivables are defined as unconditional rights to consideration. The standard allows for alternate terminology in describing the contract asset/liability, as long is it is clearly distinguishable from the receivable.
The standard has fairly extensive quantitative and qualitative disclosure requirements for contracts with customers. These requirements were designed to address a deficiency in previous standards regarding the level of detail disclosed for revenue transactions. The disclosures provide information about the contracts themselves, the judgments applied in accounting for the contracts, and any assets recognized by creating or fulfilling the contract. Some of the key disclosures include:
• Revenue and impairment losses from contracts with customers
• Sufficient disaggregation of revenue categories to depict how the nature, amount, timing, and uncertainty of revenue amounts are affected by economic factors
• A reconciliation of opening and closing contract asset/liability balances, including an explanation of how satisfaction of performance obligations relates to the timing of customer payments
• A detailed description of performance obligations
• Details of transaction prices allocated to unsatisfied performance obligations
• Details of judgments applied in determining the performance obligations and the allocation of transaction prices to those obligations
• Explanations of methods used to determine the timing of satisfaction of performance obligations over time
• Details of methods, inputs, and assumptions used to determine and allocate transaction prices
• Details of assets recognized from costs to obtain or fulfill a contract
• The application of any practical expedient allowed under the standard
5.05: The Earnings Approach
ASPE uses a different approach to revenue recognition. This approach, often referred to as the earnings approach, focuses on how an entity adds value during the completion of a business transaction. While IFRS focuses on the balance sheet (contract assets and liabilities), ASPE focuses more on the processes the entity undertakes to earn revenue. In this sense, it can be thought of as income statement approach to revenue.
With the earnings approach, revenue is recognized when four conditions are met:
• The seller has transferred the significant risks and rewards of ownership to the buyer
• The seller maintains no continuing managerial involvement or control over the goods
• Reasonable assurance exists regarding the measurement of consideration to be received and the extent to which goods can be returned
• Collection of the consideration is reasonably assured
(CPA Canada Handbook – Accounting, ASPE 3400.04 and .05)
Although conceptually this approach appears quite different from the IFRS five-step approach, the results will often be the same when applying the two methods to the same circumstances. The transfer of risks and rewards of ownership under ASPE will often coincide with the satisfaction of a performance obligation under IFRS. There are, however, some situations where the results will be different under the two approaches.
One area where IFRS and ASPE differ is in the treatment of long term contracts. ASPE allows for either the percentage-of-completion method or the completed contract method to be used. The choice between methods is based on the accountant's professional judgment as to which method better relates the revenue to the work accomplished. The completed contract method would usually be used when a company is unable to make reasonable estimates of progress or performance of the contract consists of a single act. Under the completed contract method, no revenues or expenses are recognized until the contract is completed. This means the income statement will not reveal any information about the company's progress on the contract, as all costs and billings will simply be accumulated in balance sheet accounts. In the year the contract is completed, all revenue and expenses are recognized. Although this method avoids the problem of estimation error, it does not provide useful information in the interim periods before project completion.
5.06: IFRS ASPE Key Differences
IFRS ASPE
Revenue is recognized by applying the five-step process. The focus is on performance obligations and contract assets and liabilities. Revenue is recognized using the earnings approach. The focus is on the transfer of risks and rewards of ownership.
The percentage-of-completion method should be used for long-term contracts, unless progress is not measurable, in which case the zero-margin method should be used. Either the percentage-of-completion method or the completed-contract method can be used, depending on which more accurately relates the revenues to the work accomplished. The completed contract method should only be used if progress toward completion of the contract cannot be measured or if performance consists of a single act.
Barter transactions are measured at fair value. Barter transactions are measured at fair value when the transaction has commercial substance. If there is no commercial substance, the asset acquired is measured at the carrying value of the asset given up, adjusted for any cash consideration.
Specific guidance provided on determination of the appropriate discount rate for payments received over time. Payments received over time are discounted at the prevailing market rate.
Disclosure requirements are more specific and detailed. Disclosure requirements are less detailed and indicate only that accounting policies and major categories should be disclosed. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.04%3A_Presentation_and_Disclosure.txt |
LO 1: Describe the criteria for recognizing revenue and determine if a company has earned revenue in a business transaction.
Under IFRS, revenue is recognized using a five-step process: 1) identify the contract, 2) identify the performance obligations, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations, and 5) recognize revenue when a performance obligation is satisfied. Performance obligations must relate to distinct goods or services. Performance obligations can be satisfied over time or at a point in time. The amount of revenue to be recognized from a performance obligation will depend on whether the entity is acting as a principal or an agent. Incremental costs incurred to obtain or fulfill a contract should be capitalized and amortized over the life of the contract. For long-term contracts, a rational method of recognizing revenue will need to be applied, based on some method of measuring progress.
LO 2: Discuss the problem of measurement uncertainty and alternative accounting treatments for these situations.
Measurement uncertainty can occur when the contract includes variable consideration, an implied financing component, non-cash consideration, or a discount on a bundle of goods and services. The accounting treatment will depend on the nature of the measurement problem. Where sales are bundled, the consideration will normally be allocated based on the relative stand-alone selling prices of each component. Variable consideration should be measured at the expected value or most likely amount. Interest, even if not explicitly stated in the contract, should be identified as a separate performance obligation, unless the contract period is less than one year. Non-cash consideration should be reported at its fair value.
LO 3: Prepare journal entries for a number of different types of sales transactions.
For bundled sales, consideration should be allocated proportionally, based on the stand-alone selling price of each component. The residual value approach would only be appropriate if the stand-alone selling price of a component was not determinable. For consignment sales, inventory first needs to be reclassified. Revenue from consignment sales should not be recorded until the consignee actually sells the goods to a third party. Costs of the transaction also need to be recorded. For sales with a right of return, an accrual of the estimated amount of the refund liability needs to be recorded, along with an estimate of the amount of refund assets expected to be received from customers. For bill-and-hold arrangements, revenue should only be recognized if control has been transferred to the customer. Additional criteria will need to be evaluated in making this determination. For non-monetary exchanges, revenue should be recorded based on the fair value of the goods or services received.
LO 4: Apply revenue recognition concepts to the determination of profit from long-term construction contracts.
For a long-term construction contract, profits should be recognized in some rational manner over the life of the project. To do this, reliable estimates of progress are required. Input or output measures may be used. Many construction companies prefer to use the cost-to-cost method, which measures progress in terms of the dollar value of inputs. If progress cannot be reliably measured, then profits should be reported using the zero-margin method.
LO 5: Prepare journal entries for long-term construction contracts.
Costs are accumulated a construction-in-progress account. When profit is estimated at the end of the year using the percentage-of-completion method, the revenue and related expense will be recorded, with the net profit being added to the construction-in-progress account. Also, journal entries will record billings to customers and collections of those billings. At the end of the construction contract, the construction-in-progress account will be zeroed out against the billings account. The terms "contract asset" and "contract liability" may also be used in place of the construction-in-progress and billings accounts.
LO 6: Apply revenue recognition concepts to unprofitable long-term construction contracts.
When a construction contract is predicted to be unprofitable, resulting in an onerous contract, the entire projected loss on the contract needs to be recognized immediately. Once the project is completed, this amount will be adjusted so that the actual amount of the project loss is reported. This approach results in inconsistent amounts of profit being reported in each year of the project, but the total profit will be correct over the life of the project.
LO 7: Describe presentation and disclosure requirements for revenue-related accounts.
Contract assets and liabilities should be presented separately from contract receivables on the balance sheet. IFRS 15 contains detailed qualitative and quantitative disclosure requirements, including disaggregation of revenue categories, descriptions and reconciliations of performance obligations, and discussions of methods and judgements applied in determining revenue.
LO 8: Discuss the earnings approach to revenue recognition, and compare it to current IFRS requirements.
The earnings approach is used in ASPE and includes four criteria for revenue recognition: 1) the seller has transferred the risks and rewards of ownership to the buyer, 2) the seller does not maintain any continuing managerial involvement or control over the goods, 3) there is reasonable assurance regarding measurement of the consideration to be received and the amount of goods that may be returned, and 4) collection of consideration is reasonable assured. In many instances, the earnings approach will arrive at similar results as the contract based approach of IFRS 15. In some cases, however, the results may be different. With long-term construction contracts, the earnings approach allows for the completed contract method to be used if there is no reasonable way to estimate progress or performance of the contract consists of a single act.
5.08: References
CPA Canada. (2017). Part II, Section 3400. In CPA Canada Handbook. Toronto, ON: CPA Canada.
CPA Canada. (2017). Part I, Section IFRS 15. In CPA Canada Handbook. Toronto, ON: CPA Canada.
Marriage, M. (2014, November 9). US law firms line up investors to sue Tesco. Financial Times. Retrieved from https://next.ft.com/content/4ff7ce62-669f-11e4-91ab-00144feabdc0 | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.07%3A_Chapter_Summary.txt |
5.1 PhreeWire Phones offers a number of plans to its mobile telephone customers. For example, a customer can receive a free phone when signing a 3-year contract for airtime and data that requires a monthly payment of \$80. Alternately, the customer could pay \$300 for the telephone when signing a 2-year contract requiring monthly payments of \$100.
Required: Determine the amount of revenue to be recognized each year under the two different scenarios. Assume that the fair value of the telephone is \$500 and the fair value of the airtime and data is \$600 per year.
5.2 Refer to the previous question.
Required: Determine the amount of revenue to be recognized each year under the two different scenarios. Assume that the fair value of the telephone is indeterminable and the fair value of the airtime and data is as indicated.
5.3 Art Attack Ltd. ships merchandise on consignment to The Print Haus, a retailer of fine art prints. The cost of the merchandise is \$58,000, and Art Attack pays the freight cost of \$2,200 to ship the goods to the retailer. At the end of the accounting period, The Print Haus notifies Art Attack Ltd. that 80% of the merchandise has been sold for \$79,000. The Print Haus retains a 10% commission as well as \$3,400, which represent advertising costs it paid, and remits the balance owing to Art Attack Ltd.
Required: Complete the journal entries required by each company for the above transactions.
5.4 Eames Fine Furniture sells high quality, roll-top desks. The company allows customers to return products for a full refund within 90 days of purchase. The desks sell for \$3,000 and cost the company \$2,000 to manufacture. The company expects that any returned desks can be resold for a profit. The company has reviewed historical financial data and determined that 0.5% of all desks sold are returned for a refund. During the month of January, the company sold 800 desks.
Required:
1. Prepare all the required journal entries to record the January sales.
2. Assume one desk was actually returned by the end of January. Prepare the journal entry required to record the return and describe the appropriate accounting treatment of any further returns.
5.5 Frank Ledger, a non-designated accountant, has agreed to provide twelve months of bookkeeping services to Digital Dreams Inc. (DDI), a computer equipment and accessories retailer. Mr. Ledger will compile the accounting records of DDI every month and provide an unaudited financial statement. Mr. Ledger has agreed not to invoice DDI during the year, and DDI has agreed to provide Mr. Ledger with a free computer system. The computer would normally sell for \$3,000. Mr. Ledger has indicated that he would typically charge approximately \$250/month for similar bookkeeping services, although the actual amount invoiced per month would depend on the volume of transactions and a number of other factors.
Required: Assume the contract described above is signed on October 1 and Mr. Ledger's fiscal year end is December 31. Prepare all the required journal entries for Mr. Ledger between these two dates.
5.6 Suarez Ltd. entered into a contract on January 1, 2020, to construct a small soccer stadium for a local team. The total fixed price for the contract is \$35 million. The job was completed in December 2021. Details of the project are as follows:
2020 2021
Costs incurred in the period \$20,000,000 \$11,000,000
Estimated costs to complete the project 10,000,000 -
Customer billings in the period 18,000,000 17,000,000
Cash collected in the period 17,000,000 15,000,000
Required:
1. Calculate the amount of gross profit to be recognized each year using the percentage-of-completion method.
2. Prepare all the required journal entries for both years.
5.7 In 2021, Gerrard Enterprises Inc. was contracted to build an apartment building for \$5.2 million. The project was expected to take three years and Gerrard estimated the costs to be \$4.3 million. Actual results from the project are as follows:
2021 2022 2023
Accumulated costs to date \$1,100,000 \$3,400,000 \$4,500,000
Estimated costs to complete the project 3,200,000 1,000,000 -
Customer billings to date 1,500,000 3,300,000 5,200,000
Cash collected to date 1,000,000 3,000,000 5,200,000
Required:
1. Calculate the amount of gross profit to be recognized each year using the percentage-of-completion method.
2. Show how the details of this contract would be disclosed on the balance sheet and income statement in 2022.
5.8 On February 1, 2020, Sterling Structures Ltd. signed a \$3.5 million contract to construct an office and warehouse for a small wholesale company. The project was originally expected to be completed in two years, but difficulties in hiring a sufficient pool of skilled workers extended the completion date by an extra year. As well, significant increases in the price of steel in the second year resulted in cost overruns on the project. Sterling was able to negotiate a partial recovery of these costs, and the total contract value was adjusted to \$3.8 million in the second year. Additional information from the project is as follows:
2020 2021 2022
Total contract value \$3,500,000 \$3,800,000 \$3,800,000
Accumulated costs to date 800,000 2,400,000 3,900,000
Estimated costs to complete the project 2,100,000 1,600,000 -
Customer billings to date 1,000,000 2,100,000 3,800,000
Cash collected to date 1,000,000 2,000,000 3,800,000
Required:
1. Calculate the amount of gross profit to be recognized each year using the percentage-of-completion method.
2. Prepare all the required journal entries for 2021.
5.9 Take the same set of facts as described in the previous question, except assume that there is no reasonable way to estimate progress on the contract.
Required:
1. Using the zero-margin method (IFRS), determine the amount of revenue and expense to report each year.
2. Using the completed-contract method (ASPE), determine the amount of revenue and expense to report each year. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/05%3A_Revenue/5.09%3A_Exercises.txt |
Cash Overflows for Apple
In 2013, Apple advised their shareholders that it sold 34M iPhones, up 90% from the same quarter last year, and up 150% from the year before. Along with the increased sales came increased profits (almost double) and increased cash in the bank; about US\$ 9.9B in cash flow from operations for a total cash holding of about US\$ 100B.
Until that point, Apple was reluctant to pay out dividends to its shareholders as most high-tech companies need large amounts of cash to expand their existing markets and for research and development costs to find new markets. In 2013, Tim Cook, CEO of Apple Inc., convinced Apple's board of directors that it was time to start paying out some periodic cash dividends to its investors; US\$ 3.05 per share. Dividend payouts, along with some shares repurchases, totalled about US\$ 7.8B paid to investors in the third quarter of 2013. Since Apple is a multinational corporation operating globally, some of this cash stockpile was in foreign funds. This strategy avoids paying the 35% US tax on foreign earnings repatriation. In all, about two-thirds of its cash holdings are in foreign currencies. Even though this cash is not available for dividends, this does not seem to bother Apple, since the company seems to have more than enough US cash for dividends payments and other return of capital. Even so, all this currency, especially foreign currency, is creating a new problem.
At this rate of continued growth, many analysts are predicting a continued piling up of foreign and US cash. The issue then becomes; what to do with all this cash, especially the massive two-thirds portion of foreign cash? It has become a conundrum—to manage all this cash, Apple has had to open about two hundred different bank accounts across different banks to monitor and track cash locations and spending, as well as to track and manage liquidity across the organization on a day-to-day basis.
The risk to their gigantic cash pile sitting in bank accounts is that it may be earning simple interest instead of better rates from investing in higher yielding instruments such as money market funds. For a cash-rich company such as Apple, a centralized cash management system is crucial; it will provide information quickly and efficiently so that Apple's money managers can make critical (and timely) investment decisions. Another benefit of a centralized cash repository is reduced risk of fraudulent access to cash, since cash invested in money market funds and similar alternatives is less accessible than cash sitting in a bank account, or many bank accounts as is the case with Apple.
In Apple's case, a centralized cash treasury will add value by reducing the percentage of idle cash through streamlining bank accounts and by allowing cash managers to focus on ensuring the right levels of cash with the remainder invested in instruments with better returns.
While some may consider too much cash in too many bank accounts to be an enviable position, it is still a risk that could lead to cash opportunities lost or worse, cash leaking away in inappropriate hands if left unexamined.
(Source: Apple Inc., 2013)
Learning Objectives
After completing this chapter, you should be able to:
• Describe cash and receivables, and explain their role in accounting and business.
• Describe cash and cash equivalents, and explain how they are measured and reported.
1. Explain the purpose and key activities of internal control for cash.
• Describe receivables, identify the different types of receivables, explain their accounting treatment, and prepare the relevant journal entries.
1. Describe accounts receivable, and explain how they are initially and subsequently measured and reported.
2. Describe notes receivables, and explain how they are initially and subsequently measured and reported.
3. Describe derecognition of receivables and the various strategies businesses use to shorten the credit-to-cash cycle through sales of receivables or borrowings secured by receivables.
4. Describe how receivables are disclosed on the balance sheet and in the notes.
• Identify the different methods used to analyze cash and receivables.
• Explain the differences between IFRS and ASPE for recognition, measurement, and reporting for cash and receivables.
Introduction
As the opening story about Apple illustrates, actively managing cash and receivables has important implications for businesses. The time frame required to convert receivables to cash is a cycle that calls for regular monitoring. This chapter addresses how management uses financial reporting to regularly assess both the credit-to-cash cycle and its overall cash position in terms of liquidity (the availability of liquid assets to pay short-term obligations as they come due) or solvency (the ability to meet all maturing obligations as they come due). This chapter will focus on cash, cash equivalents, accounts receivable, and notes (loans) receivable. Each of these will be discussed in terms of their use in business: their recognition, measurement, reporting, and analysis.
06: Cash and Receivables
Cash and receivables are financial assets. Specifically, cash, cash equivalents, accounts receivable, and notes receivable are all considered to be financial assets because they are either:
• Cash
• A contractual right to receive cash or another financial asset, from another entity (such as accounts and notes receivable).
A financial asset derives its value because of a contractual right, or a claim for a determinable amount. The physical paper that cash or receivables are printed on has no value by itself. Their real value is based on what they represent. For example, financial assets such as cash include foreign currencies because their value in Canadian dollars is determinable by applying the current exchange rate. Receivables result from the sale of goods and services on credit or through lendings, for which the amount has been fixed or known (determinable) at the time of the transaction. In contrast, the cash value is not known in advance for non-financial assets such as inventories and fixed assets because their cash value will depend on future market conditions.
Cash and receivables are also monetary assets because they represent a claim to cash where the amount is fixed by contract. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.01%3A_Overview.txt |
Recognition, Measurement, and Disclosure
Cash is the most liquid of the financial assets and is the standard medium of exchange for most business transactions.
Cash is usually classified as a current asset and includes unrestricted:
• Coins and currency, including petty cash funds
• Bank accounts funds and deposits
• Negotiable instruments such as money orders, certified cheques, cashiers' cheques, personal cheques, bank drafts, and money market funds with chequing privileges.
Cash can be classified as a long-term asset if they are designated for specific purposes such as a plant expansion project, or a long-term debt retirement, or as collateral.
Petty cash funds are classified as cash because these funds are used to meet current operating expenses and to pay current liabilities as they come due. Even though petty cash has been set aside for a particular purpose, its balance is not material, so it is included in the cash balance in the financial statements.
Excluded from cash are:
• Post-dated cheques from customers and IOUs (informal letters of a promise to pay a debt), which are classified as receivables
• Travel advances granted to employees, which are classified as either receivables or prepaid expenses
• Postage stamps on hand, which are classified as either office supplies (asset) or prepaid expenses (asset)
Restricted Cash and Compensating Balances
Restricted cash and compensating balances are reported separately from regular cash if the amount is material. Any legally restricted cash balances are to be separately disclosed and reported as either a current asset or a long-term asset, depending on the length of time the cash is restricted and whether the restricted cash offsets a current or a long-term liability. In practice, many companies do not segregate restricted cash but disclose the restrictions through note disclosures.
A compensating balance is a minimum cash balance in a company's chequing or savings account as support for a loan borrowed from a bank (or other lending institution). By requiring a compensating balance, the bank can use the restricted funds that must remain on deposit to invest elsewhere resulting in a better rate of return to the bank than the stated interest rate (also called a face rate) of the loan itself.
Foreign Currencies
Many companies have bank accounts in other countries, especially if they are doing a lot of business in those countries. A company's foreign currency is reported in Canadian dollars at the exchange rate at the date of the balance sheet.
For example, if a company had cash holdings of US \$85,000 during the year at a time when the exchange rate was US \$1.00 = Cdn \$1.05, at the end of the year when the exchange rate had changed to US \$1.00 = Cdn \$1.11, the US cash balance would be reported on the balance sheet in Canadian funds as \$94,350 (). Since the original transaction would have been recorded at Cdn \$1.05, the adjusting entry would be for the difference in exchange rates since that time, or \$5,100 ():
Usually, this cash is included in current assets. However, if the cash flow out of the country is restricted, the cash is treated in the accounts as restricted and reported separately.
Bank Overdrafts
Bank overdrafts (a negative bank balance) can be netted and reported with cash on the balance sheet if the overdraft is repayable on demand and there are other positive bank balances in the same bank for which the bank has legal right of access to settle the overdraft. Otherwise, bank overdrafts are to be reported separately as a current liability.
Cash Equivalents
Cash equivalents are short-term, highly liquid assets that can readily be converted into known amounts of cash and with little risk of price fluctuations. An example of a short-term cash equivalent asset would be one that matures in three months or less from the acquisition date. They may be considered as "near-cash," but are not treated as cash because they can include a penalty to convert back to cash before they mature. Examples are treasury bills (T-bills), money market funds, short-term notes receivable, and guaranteed investment certificates (GICs). For companies using ASPE, equities investments are usually not reported as cash equivalents. For IFRS, preferred shares that are acquired within three months of their specified redemption date can be included as cash equivalents.
Disclosures of Cash and Cash Equivalents
Cash equivalents can be reported at their fair value, together with cash on the balance sheet. Fair value will be their cost at acquisition plus accrued interest to the date of the balance sheet.
Below is a partial balance sheet from Orange Inc. that shows cash and cash equivalents as at December 31, 2020 along with the corresponding notes:
CONSOLIDATED BALANCE SHEETS
(in millions)
December 31 December 31
2020 2019
ASSETS:
Current assets:
Cash and cash equivalents \$ 18,050 \$ 12,652
Short-term marketable securities 36,800 27,000
Financial Instruments
Cash Equivalents and Marketable Securities
All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents and are combined and reported with Cash. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the designations at each balance sheet date. For example, the Company classifies its marketable debt securities as either short term or long term based on each instrument's underlying contractual maturity date. If they have maturities of 12 months or less, they are classified as short term. Marketable debt securities with maturities greater than 12 months are classified as long term. The Company classifies its marketable equity securities, including mutual funds, as either short term or long term based on the nature of each security and its availability for use in current operations. The Company's marketable debt and equity securities are carried at fair value, with the unrealized gains and losses, reported either as net income or, net of taxes, as a component of shareholders' equity (IFRS 9). The cost of securities sold is based on the specific identification model. This will be discussed in more detail in Chapter 8, Investments.
Effective cash management includes strong internal controls and a strategy to invest any excess cash into short-term instruments that will provide a reasonable return in interest income but still be quickly convertible back into cash, if required.
Summary of Cash, Cash Equivalents, and Other Negotiable Instruments
Asset Classification Description and Examples
Cash (current asset) Unrestricted: coins, currency, foreign currencies, petty cash, bank funds, money orders, cheques, and bank drafts
Cash equivalent (current asset) Short-term commercial paper, maturing three months or less at acquisition, such as T-bills, money market funds, short-term notes receivable, GICs
Cash (long-term asset) Cash funding set aside for plant expansion, or long-term debt retirement, or collateral
Cash (current or long-term asset) Separate reporting for legally restricted cash and compensating bank balances
Receivables (current or long-term asset) Post-dated cheques, IOUs, travel advances
Office supplies inventory (current asset) Postage on hand
Bank indebtedness (current liability) Bank overdraft accounts not offset by same bank positive balances
6.02: Cash and Cash Equivalents
A key part of effective cash management is the internal control of cash. This topic was introduced in the introductory accounting course. Below are some highlights regarding internal control.
The purpose of effective financial controls is to:
• Protect assets
• Ensure reliable recognition, measurement, and reporting
• Promote efficient operations
• Encourage compliance with company policies and practices
The control of cash includes implementing internal controls over:
• The physical custody of cash on hand, including adequate levels of authority required for all cash-based transactions and activities
• The separation of duties regarding cash
• Maintaining adequate cash records, including petty cash and the preparation of regular bank reconciliations.
Controlling the physical custody of cash plays a key role in effective cash management. In the opening story, Apple consolidated its bank accounts to a more manageable number, converted its idle cash into less accessible commercial paper that earned interest, and implemented a robust financial reporting system that would provide reliable and timely information about its cash position.
Refer to 6.6 Appendix A: for a review of internal controls, petty cash, and bank reconciliations taken from an introductory financial accounting textbook. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.02%3A_Cash_and_Cash_Equivalents/6.2.01%3A_Internal_Control_of_Cash.txt |
Receivables are asset accounts applicable to all amounts owing, unsettled transactions, or other monetary obligations owed to a company by its credit customers or debtors. These are contractual rights that have future benefits such as future cash flows to the company. These accounts can be classified as either a current asset, if the company expects them to be realized within one year or as a long-term asset, if longer than one year.
Typical receivable-related categories include:
• Accounts (trade) receivable—amounts owed by customers for goods or services sold by a company on credit in the normal course of business. The transaction document is typically called an invoice.
• Notes receivable—more formal, unconditional written promises to pay a specified amount of money on a specified future date or on demand. The transaction document is usually referred to as a promissory note.
• Non-trade receivable—arise from any number of other sources such as income tax refunds, GST/HST taxes receivable, amounts due from the sale of assets, insurance claims, advances to employees, amounts due from officers, and dividends receivable. These are generally classified and reported as separate items in the balance sheet or in a note that is cross-referenced to the balance sheet statement.
The illustration below shows a portion of the balance sheet for cash and cash equivalents and various receivables on the financial statements:
Consolidated Balance Sheet
As of December 31, 2020 and 2019
(In millions of dollars except share amounts)
2020 2019
ASSETS
Cash and cash equivalents 3,500 4,200
Marketable securities 1,500 1,400
Receivables from affiliates 30 60
Trade accounts and notes receivables (net) 3,800 3,800
Financing receivables (net) 25,500 22,200
Financing receivables, securitized (net) 4,200 3,200
Other receivables 1,000 1,500
Operating leases receivables (net) 3,000 2,500
Receivables Management
It is important to consider carefully how to manage and control accounts receivable balances. If credit policies are too restrictive, potential sales could be lost to competitors. If credit policies are too flexible, more sales to higher risk customers may occur, resulting in more uncollectible accounts. The bottom line is that receivables management is about finding the right level of receivables to maintain when implementing the company's credit policies.
As part of a credit assessment process, companies will initially assess the individual creditworthiness of new customers and grant them a credit limit consistent with the level of assessed credit risk. After the initial assessment, a customer's payment history will affect whether their credit limit will change or be revoked.
To lessen the risk of uncollectible accounts and improve cash flows, some companies will adopt a policy that offers:
• Cash discounts to encourage cash sales
• Sales discounts to encourage faster payments of amounts owing on credit
• Late payment interest charges for any overdue accounts
Other management strategies can be implemented to shorten the receivables to cash cycle. In addition to the discounts or late payment fees listed above, small- and medium-sized companies may decide to sell their accounts receivable to financial intermediaries (factors). This will convert the receivables into cash more quickly than if they waited for customers to pay. Larger companies may rely on another way of selling receivables, called securitization. This will be discussed later in this chapter.
Receivables management involves developing sound business practices for overall monitoring as well as early detection of potential uncollectible accounts. Key activities include:
• Regular analysis of aged accounts receivable
• Regularly scheduled assessments and follow up on overdue accounts
6.03: Receivables
Recognition and Measurement of Accounts Receivable
Accounts receivable result from credit sales in the normal course of business (called trade receivables) that are expected to be collected within one year. For this reason, they are classified as current receivables on the balance sheet and initially measured at the time of the credit sale at their net realizable value (NRV). Net realizable value (NRV) is the amount expected to be received from the customer. IFRS and ASPE standards both allow NRV to approximate the fair value, since the interest component is immaterial when determining the present value of cash flows for short-term accounts receivable. In subsequent accounting periods, accounts receivable are to be measured at their amortized cost which is the same as cost, since there is no present value interest component to recognize. For long-term notes and loans receivable that have an interest component, the asset's carrying amount is measured at amortized cost which will be described later in this chapter.
The valuation of the account receivable is also affected by:
• Trade and sales discounts
• Sales returns and allowances
Trade Discounts
Manufacturers and wholesalers publish catalogues with inventory and sales prices to assist purchasers with their purchases. Catalogues are expensive to publish, so this is only done from time to time. Sellers often offer trade discounts to customers to adjust the sales prices of items listed in the catalogue. This can be an incentive to purchase larger quantities, as a benefit of being a preferred customer or because costs to produce the items for sale have changed.
Since the catalogue, or list, price is not intended to reflect the actual selling price, the seller records the net amount after the trade discount is applied. For example, if a plumbing manufacturer has a catalogue or list price of \$1000 for a bathtub and sells it to a plumbing retailer for list price less a 20% trade discount, the sale and corresponding account receivable recorded by the manufacturer is \$800 per bathtub.
Sales Discounts
Sales discounts can be part of the credit terms for customers and are offered to encourage faster payment of the account. The credit term 1.5/10, n/30 means there is a 1.5% discount if the invoice is paid within ten days with the total amount owed due in thirty days.
Companies purchasing goods and services that do not take advantage of the sales discounts are usually not using their cash as effectively as they could. For example, a purchaser who fails to take the 1.5% reduction offered for payment within ten days for an account due in thirty days is equivalent to missing a stated annual interest rate return on their cash for 27.38% (). For this reason, companies usually pay within the discount period unless their available cash is insufficient to take advantage of the opportunity.
IFRS 15.53 – the term variable consideration, discussed in Chapter 5, Revenue, would also include sales discounts because it is uncertain how many customers will actually take the sales discount. For this reason, IFRS states that an estimate of "highly probable" sales discounts expected to be taken by customers, needs to be determined and included at the time of the sale. Given the high rate of return identified in the preceding paragraph, recording the estimate immediately upon sale is conceptually sound and is consistent with the net method described below. The standard suggests using either the expected value (a weighted average of probabilities), or the "most likely amount" to estimate sales discounts, perhaps based on past history.
To illustrate the net method, assume that Cramer Plumbing sells fifty bathtubs to a reseller for \$800 each, for a total sale of \$40,000, with credit terms of 1.5/10, n/30. Using the net method, Cramer expects that the sales discount will be taken by the purchaser; therefore, Cramer Plumbing will record the following entry:
Note the reduction due to the sales discount is immediately recorded upon the sale. This results in the accounts receivable being valued at its net realizable value and based on Cramer's "more likely than not" estimate of sales discounts expected to be taken, which is consistent with IFRS 15.53.
If \$10,000 of the account receivable is collected from the reseller within the ten-day discount period (for a cash amount of \$9,850), the entry would be:
The entry for collection of the remaining amount owing for \$30,000 after the discount period is:
As can be seen above, the net method records and values the accounts receivable at its lowest, or net realizable value of \$39,400, or gross sales for \$40,000 less the 1.5% discount.
The gross method is much easier and ASPE can choose either method. For the gross method, sales are recorded at the gross amount with no discount taken. If the customer pays within the discount period, the applicable discount taken is recorded to a sales discounts account. Any payments made after the discount period are simply the cash amount collected and no calculation for the sales discounts forfeited is required.
Using the same example, assume that Cramer Plumbing sells fifty bathtubs for \$800 each, with credit terms of 1.5/10, n/30. Using the gross method, the entry for the sale is:
The entry on collection of \$10,000 within the ten-day discount period is:
The entry on collection of the remaining \$30,000 after the discount period is:
Note how the accounts receivable would not be reported at its net realizable value with this method. If discounts are significant, this would overstate accounts receivable and sales in the financial statements. For this reason, if the gross method is used and it is expected that significant cash discounts are likely to be taken by customers in the fiscal year, an asset valuation account and an adjusting entry is required to ensure that accounts receivable, net of the valuation account, will reflect its net realizable value.
At year-end, assume that \$6 million of Cramer's accounts receivable all have terms of 1.5/10, n/30, and management expects that 60% of these accounts will be collected within the discount period, which it deems to be significant. The unadjusted balance in the allowance for sales discounts account (a contra account to accounts receivable) is \$3,000 credit balance. The year-end adjusting entry to update the accounts receivable allowance account with the estimated sales discounts would be:
Throughout the following year, the allowance account can be directly debited each time customers take the discounts and is adjusted up or down at the end of each reporting period.
A video is available on the Lyryx web site. Click Here to view the video.
Sales Returns and Allowances
Many ASPE companies have policies that allow for the return of goods under certain circumstances and will refund all or a partial amount of the returned item's cost.
Assuming that returns for this company are insignificant, the entry for a \$1,000 sales return on account (with a cost \$800) returned to inventory, for a company using a perpetual inventory system, would be:
Sales allowances are reductions in the selling price for goods sold to customers, perhaps due to damaged goods that the customer is willing to keep if the sales price is reduced sufficiently.
For example, if a sales allowance of \$2,000 is granted due to damaged goods that the customer chose to keep, the entry, assuming sales allowances for this company are insignificant, would be:
As was done with sales discounts, sales returns and allowances should be recognized in the period of the sale to avoid overstating accounts receivable and sales. Sales returns and allowances are therefore estimated and adjusted at the end of each reporting period. If the amount of returns and allowances is not material a year-end adjusting entry is not required and the entries shown above would be sufficient, provided that it is handled consistently from year to year. If returns and allowances are significant, an allowance for sales returns and allowances account, which is an asset valuation account contra to accounts receivable, is used to record the estimates.
For example, management estimates the total sales returns and allowances to be \$51,500, which it deems to be significant. If the company follows ASPE, and the unadjusted balance in the allowance for sales returns and allowances account is \$5,000 credit balance, the year-end adjusting entry would be:
Note how another contra account, the sales returns and allowances account, is used to record the debit entry for the previous two journal entries above. Its purpose is to track returns and allowances transactions separately, as opposed to directly recording them as a debit to sales. If amounts in this contra account become too high, it could indicate to management the possibility of future sales lost due to unsatisfied customers.
During the reporting period, the allowance for sales returns and allowances asset valuation account can be directly debited each time customers are granted returns or allowances. This asset valuation account will subsequently be adjusted up or down at the end of each reporting period.
Sales with right of return under IFRS has been discussed in Section 5.3, Sales With Right of Return, where a detailed example is presented.
Estimating Allowance for Uncollectible Accounts
When accounts receivables exist, some amounts of uncollectible receivables are inevitable due to credit risk. This risk is the likelihood of loss due to customers not paying their amounts owing. If the uncollectible amounts are both likely and can be estimated, an amount for uncollectible accounts must be estimated and recognized in the accounts to ensure that accounts receivable and net income are not overstated over the lifetime of the accounts receivable (IFRS 9; lifetime expected credit losses). The allowance account, called the allowance for doubtful accounts (AFDA), is an asset valuation account (contra account to accounts receivable), which is used the same way as the Allowance for Sales Discounts discussed earlier.
Many companies set their credit policies to allow for a certain percentage of uncollectible accounts. This is to ensure that the credit policy is not too restrictive or liberal, as explained in the opening paragraph of the Receivables Management section of this chapter.
Measuring uncollectible amounts at the end of each reporting period involves estimates that can be calculated using several methods:
• Percentage of accounts receivable method
• Accounts receivable aging method
• Credit sales method
• Mix of methods
The first three methods were covered in the introductory accounting course. Below is a review of these methods. The mix of methods is perhaps a more realistic view of how companies estimate bad debt expense over a reporting period.
For each method above, management estimates a percentage that will represent the likelihood of collectability. The estimated total amount of uncollectible accounts is calculated and usually recorded to the AFDA allowance account, with the offsetting entry to bad debt expense. The net amount for accounts receivable and its contra account, the AFDA, reflects the net realizable value of the accounts receivable at the reporting date.
Percentage of Accounts Receivable Method
For this method, the accounts receivable closing balance is multiplied by the percentage that management estimates is uncollectible. This method is based on the premise that some portion of accounts receivable will be uncollectible, and management uses reasonably available and supportable information (IFRS 9) regarding past experiences, current economic conditions, and expected future conditions as a guide to the percentage used. For this reason, the estimated amount of uncollectible accounts is to be equal to the adjusted ending balance of the AFDA. The adjusting entry amount must therefore be the amount required that results in that ending balance of the AFDA.
For example, assume that accounts receivable and the AFDA ending balances were \$200,000 debit and \$2,500 credit balances respectively at December 31, and the uncollectible accounts is estimated to be 4% of accounts receivable. This means that the AFDA adjusted ending balance is estimated to be the amount equal to 4% of \$200,000, or \$8,000. The adjusting entry to achieve the correct AFDA adjusted ending balance of \$8,000 would be:
The AFDA ending balance after the adjusting entry would correctly be \$8,000
().
Sometimes the AFDA ending balance can be in a temporary debit balance due to a write-off of an uncollectible account during the period. If this is the case, care must be taken to make the correct calculations for the adjusting entry. For the example above, if the unadjusted AFDA balance was a \$300 debit balance, then the adjusting entry for uncollectible accounts would be:
The AFDA ending balance after the adjusting entry would correctly be \$8,000 ().
Notice that the AFDA ending balance of \$8,000 is the same for both examples when applying the percentage of accounts receivable method. This is because the calculation is intended to be an estimate of the AFDA ending balance, so the adjustment amount is whatever is required to result in that ending balance.
Accounts Receivable Aging Method
Typically, the older the uncollected account, the more likely it is to be uncollectible. Following this premise, the accounts receivable are grouped into categories based on the length of time they have been outstanding.
Just as was done for the percentage of accounts receivable method above, companies will use past experience to estimate the percentage of their outstanding receivables that will become uncollectible for each aged group, such as the four aging groups identified in the schedule below. The sum of all the estimated uncollectible amounts by group represents the total estimated uncollectible accounts. Just like the percentage of accounts receivable method previously discussed, the estimated amount of uncollectible accounts using this method is to be equal to the ending balance of the AFDA account. The adjusting entry amount must therefore be whatever amount is required to result in this ending balance.
Aging schedules are also a good indicator of which accounts may need additional attention by management, due to their higher credit risk group, such as the length of time the account has been outstanding or overdue.
Below is an example of an accounts receivable aging schedule:
Taylor and Company
Aging Schedule
As at December 31, 2020
Customer Balance Under 61–90 91–120 Over 120
Dec 31, 2020 60 days days days days
Abigail Holdings \$3,500 \$1,500 \$2,000
Beaver Industries Inc. 45,000 25,000 8,500 \$6,500 \$5,000
Cambridge Instruments Co. 18,000 18,000
Dereck Station Ltd. 25,000 25,000
Falling Gate Repair 6,840 6,840
Gladstone Walkways Corp. 26,000 26,000
Tremsol Cladding Inc. 15,000 10,000 4,000 1,000
Warbling Water Pond Installations 6,480 1,480 5,000
\$186,480 \$124,050 \$22,300 \$22,130 \$18,000
Percent estimated uncollectible 5% 10% 15% 35%
Total Allowance for uncollectible
accounts ending balance \$18,053 \$6,203 \$2,230 \$3,320 \$6,300
The analysis above indicates that Taylor and Company expects to receive \$186,480 less \$18,053, or \$168,427 net cash receipts from the December 31 amounts owed. The \$168,427 represents the company's estimated net realizable value of its accounts receivable and this amount would be reported as the net accounts receivable in the balance sheet as at December 31.
Assuming the data above for Taylor and Company and an unadjusted AFDA credit balance as at December 31 of \$2,500, the adjusting entry for uncollectible accounts would be:
As was illustrated for the percentage of accounts receivable method above, the calculation of the adjusting entry amount must consider whether the unadjusted AFDA balance is a debit or credit amount.
Credit Sales Method
This is the easiest method to apply. The amount of credit sales (or total sales, if credit sales are not determinable) is multiplied by the percentage that management estimates is uncollectible. Factors to consider when determining the percentage amount to use will be trends resulting from amounts of uncollectible accounts in proportion to credit sales experienced in the past. The resulting amount is credited to the AFDA account and debited to bad debt expense.
Note that for this method, the previous balance in the AFDA account is not taken into consideration. This is because the credit sales method is intended to calculate the bad debt expense that will be reported in the income statement. This is a fast and simple way to estimate bad debt expense because the amount of sales (or preferably credit sales) is known and readily available. This method also illustrates proper matching of expenses with revenues earned over that reporting period.
For example, if credit sales were \$325,000 at the end of the period and the uncollectible accounts was estimated to be 3% of credit sales, the entry would be:
Mix of Methods
Often companies will use the percentage of credit sales method to adjust the net accounts receivables for interim (monthly) financial reporting purposes because it is easy to apply. At the end of the year, either the percentage of accounts receivable or aging accounts receivable method is used for purposes of preparing the year-end financial statements so that the AFDA account is adjusted accordingly, and reported on the balance sheet.
Below is a partial balance sheet for Taylor and Company using the data from the Accounts Receivable Aging Method section above:
Taylor and Company
Balance Sheet
December 31, 2020
Current assets:
Accounts receivable \$ 186,480
Less: Allowance for doubtful accounts 18,053
\$ 168,427
To summarize, the \$186,480 represents the total amount of trade accounts receivables owing from all the credit customers at the reporting date of December 31, 2020. The \$18,053 represents the estimated amount of uncollectible accounts calculated using the allowance method, the percentage of sales method, or a mix of methods. The \$168,427 represents the net realizable value (NRV) of the receivable at the reporting date.
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Write-offs and Collections
Write-off of an Actual Uncollectible Account
Management may deem that a customer's account is uncollectible and may wish to remove the account balance from accounts receivable with the offsetting entry to the allowance for doubtful accounts. For example, using the data for Taylor and Company shown under the accounts receivable aging method, assume that management wishes to remove the account for Cambridge Instruments Co. of \$18,000 because it remains unpaid despite efforts to collect the account. The entry to remove the account from the accounting records is:
Because the AFDA is a contra account to accounts receivable, and both have been reduced by identical amounts, there is no effect on the net accounts receivable (NRV) on the balance sheet. This treatment and entry makes sense because the estimate for uncollectible accounts adjusting entry (with a debit to bad debt expense) had already been done using one of the allowance methods discussed earlier. The purpose of the write-off entry is to simply remove the account from the accounting records.
Collection of a Previously Written-off Account
Even though management at Taylor and Company thinks that the collection of the \$18,000 account has become unlikely, this does not mean that the company will make no further efforts to collect the amount outstanding from the purchaser. During the tough economic times in 2009 and onward, many companies were in such financial distress that they were simply unable to pay their amounts owing. Many of their accounts had to be written-off by suppliers during that time as companies struggled to survive the crisis. Some of these companies recovered through good management, and cash flows returned. It is important for these companies to rebuild their relationships with suppliers they had previously not paid. So, it is not uncommon for these companies, after recovery, to make efforts to pay bills that the supplier had previously written-off.
As a result, a supplier may be fortunate enough to receive some or all of a previously written-off account from a customer. When this happens, a two-step process accounts for the payment:
1. Reinstate the account receivable amount being paid by reversing the previous write-off entry for an amount equal to the payment now received.
2. Record the cash received as a collection of the accounts receivable amount reinstated in the first entry.
If Cambridge Instruments Co. pays \$5,000 cash and indicates that this is all that the company can pay of the original \$18,000, the entry would be:
Step 1: Reinstate the account receivable upon receipt of cash (reversing a portion of the write-off entry):
Step 2: Record the receipt of cash on account from Cambridge Instruments:
Summary of Transactions and Adjusting Entries
An understanding of the relationships between the accounts receivable and the AFDA accounts and the types of transactions that affect them are important for sound accounts analysis. Below is an overview of some of the types of transactions that affect these accounts:
Transaction or Adjusting Entry: Accounts Allowance for
Receivable Doubtful Accounts
Debit Credit Debit Credit
Opening balance, assuming accounts have
normal balances 1) \$\$ 1) \$\$
Sale on account 2) \$\$ 2)
Cash receipts 3) \$\$ 3)
Customer account written-off 4) \$\$ 4) \$\$
Reinstatement of account previously
written-off 5) \$\$ 5) \$\$
Subtotal
End of period adjustment for uncollectible
accounts (debit to bad debt expense) 6) 6) \$\$
Closing balance, end of period \$\$ \$\$
Direct Write-off of Uncollectible Accounts
Some smaller companies may only have a few credit sales transactions and small accounts receivable balances. These companies usually use the simpler direct write-off method because the amount of uncollectible accounts is deemed to be immaterial. This means that when a specific customer account is determined to be uncollectible, the account receivable for that customer account is written-off with the debit entry recorded to bad debt expense as shown in the following entry:
If the uncollectible account written-off is subsequently collected at some later date, the entry would be:
If the uncollectible amounts were material, it would not be appropriate to use the direct write-off method, for many reasons:
• Without an estimate for uncollectible accounts, net account receivables would be reported at an amount higher than their net realizable value.
• The write-off of the uncollectible account will likely occur in a different year than the sale, which will create over- and under-statements of net income over the affected years resulting in non-compliance of the matching principle.
• Direct write-off creates an opportunity to manipulate asset amounts and net income. For example, management might delay a direct write-off to keep net income high artificially if this will favourably affect a bonus payment.
This section of the chapter is intended to be a summary overview of the methods and entries used to estimate and write-off uncollectible accounts originally covered in detail in the introductory accounting course. Students may wish to review those learning concepts from that course. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.03%3A_Receivables/6.3.01%3A_Accounts_Receivable.txt |
Recognition and Measurement of Notes Receivable
A note receivable is an unconditional written promise to pay a specific sum of money on demand or on a defined future date and is supported by a formal written promissory note. For this reason, notes are negotiable instruments the same as cheques and bank drafts.
Notes receivable can arise due to loans, advances to employees, or from higher-risk customers who need to extend the payment period of an outstanding account receivable. Notes can also be used for sales of property, plant, and equipment or for exchanges of long-term assets. Notes arising from loans usually identify collateral security in the form of assets of the borrower that the lender can seize if the note is not paid at the maturity date.
Notes may be referred to as interest-bearing or non-interest-bearing:
• Interest-bearing notes have a stated rate of interest that is payable in addition to the face value of the note.
• Notes with stated rates below the market rates or zero- or non-interest-bearing notes may or may not have a stated rate of interest. This is usually done to encourage sales. However, there is always an interest component embedded in the note, and that amount will be equal to the difference between the amount that was borrowed and the amount that will be repaid.
Notes may also be classified as short-term (current) assets or long-term assets on the balance sheet:
• Current assets: short-term notes that become due within the next twelve months (or within the business's operating cycle if greater than twelve months);
• Long-term assets: notes are notes with due dates greater than one year.
Cash payments can be interest-only with the principal portion payable at the end or a mix of interest and principal throughout the term of the note.
Notes receivable are initially recognized at the fair value on the date that the note is legally executed (usually upon signing). Subsequent valuation is measured at amortized cost.
Transaction Costs
It is common for notes to incur transactions costs, especially if the note receivable is acquired using a broker, who will charge a commission for their services. For a company using either ASPE or IFRS, the transaction costs associated with financial assets such as notes receivable that are carried at amortized cost are to be capitalized which means that the costs are to be added to the asset's fair value of the note at acquisition and subsequently included with any discount or premium and amortized over the term of the note.
Short-Term Notes Receivable
When notes receivable have terms of less than one year, accounting for short-term notes is relatively straight forward as discussed below.
Calculating the Maturity Date
Knowing the correct maturity date will have an impact on when to record the entry for the note and how to calculate the correct interest amount throughout the note's life. For example, to calculate the maturity date of a ninety-day note dated March 14, 2020:
For example, assume that on March 14, 2020, Ripple Stream Co. accepted a ninety-day, 8% note of \$5,000 in exchange for extending the payment period of an outstanding account receivable of the same value. Ripple's entry to record the acceptance of the note that will replace the accounts receivable is:
The entry for payment of the note ninety days at maturity on June 12 would be:
In the example above, if financial statements are prepared during the time that the note receivable is outstanding, interest will be accrued to the reporting date of the balance sheet. For example, if Ripple's year-end were April 30, the entry to accrue interest from March 14 to April 30 would be:
When the cash payment occurs at maturity on June 12, the entry would be:
The interest calculation will differ slightly had the note been stated in months instead of days. For example, assume that on January 1, Ripple Stream accepted a three-month (instead of a ninety-day), 8%, note in exchange for the outstanding accounts receivable. If Ripple's year-end was March 31, the interest accrual would be:
Note the difference in the interest calculation between the ninety-day and the three-month notes recorded above. The interest amounts differ slightly between the two calculations because the ninety-day note uses a 90/365 ratio (or 24.6575% for a total amount of \$98.63) while the three-month note uses a 3/12 ratio (or 25% for a total of \$100.00).
Receivables, Interest, and the Time Value of Money
All financial assets are to be measured initially at their fair value which is calculated as the present value amount of future cash receipts. But what is present value? It is a discounted cash flow concept, which is explained next.
It is common knowledge that money deposited in a savings account will earn interest, or money borrowed from a bank will accrue interest payable to the bank. The present value of a note receivable is therefore the amount that you would need to deposit today, at a given rate of interest, which will result in a specified future amount at maturity. The cash flow is discounted to a lesser sum that eliminates the interest component—hence the term discounted cash flow. The future amount can be a single payment at the date of maturity or a series of payments over future time periods or some combination of both. Put into context for receivables, if a company must wait until a future date to receive the payment for its receivable, the receivable's face value at maturity will not be an exact measure of its fair value on the date the note is legally executed because of the embedded interest component.
For example, assume that a company makes a sale on account for \$5,000 and receives a \$5,000, six-month note receivable in exchange. The face value of the note is therefore \$5,000. If the market rate of interest is 9%, or its value without the interest component, is \$4,780.79 and not \$5,000. The \$4,780.79 is the amount that if deposited today at an interest rate of 9% would equal \$5,000 at the end of six months. Using an equation, the note can be expressed as:
(0 PMT, .75% I/Y, 6 N, 5000 FV)
Where I/Y is interest of .75% each month (9%/12 months) for six months.
N is for interest compounded each month for six months.
FV is the payment at the end of six months' time (future value) of \$5,000.
To summarize, the discounted amount of \$4,780.79 is the fair value of the \$5,000 note at the time of the sale, and the additional amount received after the sale of \$219.21 () is interest income earned over the term of the note (six months). However, for any receivables due in less than one year, this interest income component is usually insignificant. For this reason, both IFRS and ASPE allow net realizable value (the net amount expected to be received in cash) to approximate the fair value for short-term notes receivables that mature within one year. So, in the example above, the \$5,000 face value of the six-month note will be equivalent to the fair value and will be the amount reported, net of any estimated uncollectability (i.e. net realizable value), on the balance sheet until payment is received. However, for notes with maturity dates greater than one year, fair values are to be determined at their discounted cash flow or present value, which will be discussed next.
Long-Term Notes Receivable
The difference between a short-term note and a long-term note is the length of time to maturity. As the length of time to maturity of the note increases, the interest component becomes increasingly more significant. As a result, any notes receivable that are greater than one year to maturity are classified as long-term notes and require the use of present values to estimate their fair value at the time of issuance. After issuance, long-term notes receivable are measured at amortized cost. Determining present values requires an analysis of cash flows using interest rates and time lines, as illustrated next.
Present Values and Time Lines
The following timelines will illustrate how present value using discounted cash flows works. Below are three different scenarios:
1. Assume that on January 1, Maxwell lends some money in exchange for a \$5,000, five-year note, payable as a lump-sum at the end of five years. The market rate of interest is 5%. Maxwell's year-end is December 31. The first step is to identify the amount(s) and timing of all the cash flows as illustrated below on the timeline. The amount of money that Maxwell would be willing to lend the borrower using the present value calculation of the cash flows would be \$3,917.63 as follows:
In this case, Maxwell will be willing to lend \$3,917.63 today in exchange for a payment of \$5,000 at the end of five years at an interest rate of 5% per annum. The entry for the note receivable at the date of issuance would be:
2. Now assume that on January 1, Maxwell lends an amount of money in exchange for a \$5,000, five-year note. The market rate of interest is 5%. The repayment of the note is payments of \$1,000 at the end of each year for the next five years (present value of an ordinary annuity). The amount of money that Maxwell would be willing to lend the borrower using the present value calculation of the cash flows would be \$4,329.48 as follows:
The entry for the note receivable would be:
Note that Maxwell is willing to lend more money (\$4,329.48 compared to \$3,917.63) to the borrower in this example. Another way of looking at it is that the interest component embedded in the note is less for this example. This makes sense because the principal amount of the note is being reduced over its five-year life because of the yearly payments of \$1,000.
3. How would the amount of the loan and the entries above differ if Maxwell received five equal payments of \$1,000 at the beginning of each year (present value of an annuity due) instead of at the end of each year as shown in scenario 2 above? The amount of money that Maxwell would be willing to lend using the present value calculation of the cash flows would be \$4,545.95 as follows:
The entry for the note receivable would be:
Again, the interest component will be less because a payment is paid immediately upon execution of the note, which causes the principal amount to be reduced sooner than a payment made at the end of each year.
Below is a comparison of the three scenarios:
Scenario 1 Scenario 2 Scenario 3
Single payment Five payments of Five payments of
at maturity \$1,000 at the end \$1,000 at the beginning
of each month of each month
Face value of the note \$5,000 \$5,000 \$5,000
Less: present value of the note 3,918 4,329 4,546
Interest component \$1,082 \$671 \$454
Note that the interest component decreases for each of the scenarios even though the total cash repaid is \$5,000 in each case. This is due to the timing of the cash flows as discussed earlier. In scenario 1, the principal is not reduced until maturity and interest would accrue over the full five years of the note. For scenario 2, the principal is being reduced on an annual basis, but the payment is not made until the end of each year. For scenario 3, there is an immediate reduction of principal due to the first payment of \$1,000 upon issuance of the note. The remaining four payments are made at the beginning instead of at the end of each year. This results in a reduction in the principal amount owing upon which the interest is calculated.
This is the same concept as a mortgage owing for a house, where it is commonly stated by financial advisors that a mortgage payment split and paid every half-month instead of a single payment once per month will result in a significant reduction in interest costs over the term of the mortgage. The bottom line is: If there is less principal amount owing at any time over the life of a note, there will be less interest charged.
Present Values with Unknown Variables
As is the case with any algebraic equation, if all variables except one are known, the final unknown variable can be determined. For present value calculations, if any four of the five variables in the following equation
PV = (PMT, I/Y, N, FV)
are known, the fifth "unknown" variable amount can be determined using a business calculator or an Excel net present value function. For example, if the interest rate (I/Y) is not known, it can be derived if all the other variables in the equation are known. This will be illustrated when non-interest-bearing long-term notes receivable are discussed later in this chapter.
Present Values when Stated Interest Rates are Different than Effective (Market) Interest Rates
Differences between the stated interest rate (or face rate) and the effective (or market) rate at the time a note is issued can have accounting consequences as follows:
• If the stated interest rate of the note (which is the interest rate that the note pays) is 10% at a time when the effective interest rate (also called the market rate, or yield) is 10% for notes with similar characteristics and risk, the note is initially recognized as:
face value = fair value = present value of the note
This makes intuitive sense since the stated rate of 10% is equal to the market rate of 10%.
• If the stated interest rate is 10% and the market rate is 11%, the stated rate is lower than the market rate and the note is trading at a discount.
• If the stated interest rate is 10% and the market rate is 9%, the stated rate is higher than the market rate and the note is trading at a premium.
The premium or discount amount is to be amortized over the term of the note. Below are the acceptable methods to amortize discounts or premiums:
• If a company follows IFRS, the effective interest method of amortization is required (discussed in the next section).
• If a company follows ASPE, the amortization method is not specified, so either straight-line amortization or the effective interest method is appropriate as an accounting policy choice.
Long-Term Notes, Subsequent Measurement
Under IFRS and ASPE, long-term notes receivable that are held for their cash flows of principal and interest are subsequently accounted for at amortized cost, which is calculated as:
• Amount recognized when initially acquired (present value) including any transaction costs such as commissions or fees
• Plus interest and minus any principal collections/receipts. Payments can also be blended interest and principal.
• Plus amortization of discount or minus amortization of premium
• Minus write-downs for impairment, if applicable
Below are some examples with journal entries involving various stated rates compared to market rates.
1. Notes Issued at Face Value
Assume that on January 1, Carpe Diem Ltd. lends \$10,000 to Fascination Co. in exchange for a \$10,000, three-year note bearing interest at 10% payable annually at the end of each year (ordinary annuity). The market rate of interest for a note of similar risk is also 10%. The note's present value is calculated as:
Face value of the note \$ 10,000
Present value of the note principal and interest:
PV = (1000 PMT, 10 I/Y, 3 N, 10000 FV) 10,000
Difference \$ 0
In this case, the note's face value and present value (fair value) are the same (\$10,000) because the effective (market) and stated interest rates are the same. Carpe Diem's entry on the date of issuance is:
If Carpe Diem's year-end was December 31, the interest income recognized each year would be:
2. Stated Rate Lower than Market Rate: A Discount
Assume that Anchor Ltd. makes a loan to Sizzle Corp. in exchange for a \$10,000, three-year note bearing interest at 10% payable annually. The market rate of interest for a note of similar risk is 12%. Recall that the stated rate of 10% determines the amount of the cash received for interest; however, the present value uses the effective (market) rate to discount all cash flows to determine the amount to record as the note's value at the time of issuance. The note's present value is calculated as:
Face value of the note \$ 10,000
Present value of the note principal and interest:
PV = (1000 PMT, 12 I/Y, 3 N, 10000 FV) 9,520
Difference \$ 480
As shown above, the note's market rate (12%) is higher than the stated rate (10%), so the note is issued at a discount.
Anchor's entry to record the issuance of the note receivable:
Even though the face value of the note is \$10,000, the amount of money lent to Sizzle would only be \$9,520, which is net of the discount amount and is the difference between the stated and market interest rates discussed earlier. In return, Anchor will receive an annual cash payment of \$1,000 for three years plus a lump sum payment of \$10,000 at the end of the third year, when the note matures. The total cash payments received will be \$13,000 over the term of the note, and the interest component of the note would be:
Cash received \$13,000
Present value (fair value) 9,520
Interest income component 3,480 (over the three-year life)
As mentioned earlier, if Anchor used IFRS the \$480 discount amount would be amortized using the effective interest method. If Anchor used ASPE, there would be a choice between the effective interest method and the straight-line method.
Below is a schedule that calculates the cash received, interest income, discount amortization, and the carrying amount (book value) of the note at the end of each year using the effective interest method:
\$10,000 Note Receivable Payment and Amortization Schedule
Effective Interest Method
Stated rate of 10% and market rate of 12%
Cash Interest Amortized Carrying
Received Income @12% Discount Amount
Date of issue \$9,520
End of year 1 \$1,000 \$1,142* \$142 9,662
End of year 2 1,000 1,159 159 9,821
End of year 3 1,000 1,179 179 10,000
End of year 3 final payment 10,000 - - 0
\$13,000 \$3,480 \$480
*
The total discount \$480 amortized in the schedule is equal to the difference between the face value of the note of \$10,000 and the present value of the note principal and interest of \$9,250. The amortized discount is added to the note's carrying value each year, thereby increasing its carrying amount until it reaches its maturity value of \$10,000. As a result, the carrying amount at the end of each period is always equal to the present value of the note's remaining cash flows discounted at the 12% market rate. This is consistent with the accounting standards for the subsequent measurement of long-term notes receivable at amortized cost.
If Anchor's year-end was the same date as the note's interest collected, at the end of year 1 using the schedule above, Anchor's entry would be:
Alternatively, if Anchor used ASPE the straight-line method of amortizing the discount is simple to apply. The total discount of \$480 is amortized over the three-year term of the note in equal amounts. The annual amortization of the discount is \$160 (\$480 3 years) for each of the three years as shown in the following entry:
Comparing the three years' entries for both the effective interest and straight-line methods shows the following pattern for the discount amortization of the note receivable:
Effective Interest Straight-Line
End of year 1 \$142 \$160
End of year 2 159 160
End of year 3 179 160
\$480 \$480
The amortization of the discount using the effective interest method results in increasing amounts of interest income that will be recorded in the adjusting entry (decreasing amounts of interest income for amortizing a premium) compared to the equal amounts of interest income using the straight-line method. The straight-line method is easier to apply but its shortcoming is that the interest rate (yield) for the note is not held constant at the 12% market rate as is the case when the effective interest method is used. This is because the amortization of the discount is in equal amounts and does not take into consideration what the carrying amount of the note was at any given period of time. At the end of year 3, the notes receivable balance is \$10,000 for both methods, so the same entry is recorded for the receipt of the cash.
3. Stated Rate More than Market Rate: A Premium
Had the note's stated rate of 10% been greater than a market rate of 9%, the present value would be greater than the face value of the note due to the premium. The same types of calculations and entries as shown in the previous illustration regarding a discount would be used. Note that the premium amortized each year would decrease the carrying amount of the note at the end of each year until it reaches its face value amount of \$10,000.
\$10,000 Note Receivable Payment and Amortization Schedule
Effective Interest Method
Stated rate of 10% and market rate of 9%
Cash Interest Amortized Carrying
Received Income @9% Premium Amount
Date of issue \$10,253
End of year 1 \$1,000 \$923* \$77 10,176
End of year 2 1,000 916 84 10,091
End of year 3 1,000 908 92 10,000
End of year 3 final payment 10,000 - - 0
\$13,000 \$2,747 \$253
*
Anchor's entry on the note's issuance date is for the present value amount (fair value):
If the company's year-end was the same date as the note's interest collected, at the end of year 1 using the schedule above, the entry would be:
The entry when paid at maturity would be:
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4. Zero-Interest Bearing Notes
Some companies will issue zero-interest-bearing notes as a sales incentive. The notes do not state an interest rate but the term "zero-interest" is inaccurate because financial instruments always include an interest component that is equal to the difference between the cash lent and the higher amount of cash repaid at maturity. Even though the interest rate is not stated, the implied interest rate can be derived because the cash values lent and received are both known. In most cases, the transaction between the issuer and acquirer of the note is at arm's length, so the implicit interest rate would be a reasonable estimate of the market rate.
Assume that on January 1, Eclipse Corp. received a five-year, \$10,000 zero-interest bearing note. The amount of cash lent to the issuer (which is equal to the present value) is \$7,835 (rounded). Eclipse's year-end is December 31. Looking at the cash flows and the time line:
Notice that the sign for the \$7,835 PV is preceded by the +/- symbol, meaning that the PV amount is to have the opposite symbol to the \$10,000 FV amount, shown as a positive value. This is because the FV is the cash received at maturity or cash inflow (positive value), while the PV is the cash lent or a cash outflow (opposite or negative value). Many business calculators require the use of a +/- sign for one value and no sign (or a positive value) for the other to calculate imputed interest rates correctly. Consult your calculator manual for further instructions regarding zero-interest note calculations.
The implied interest rate is calculated to be 5% and the note's interest component (rounded) is \$2,165 (), which is the difference between the cash lent and the higher amount of cash repaid at maturity. Below is the schedule for the interest and amortization calculations using the effective interest method.
Non-Interest-Bearing Note Receivable Payment and Amortization Schedule
Effective Interest Method
Cash Interest Amortized Carrying
Received Income @5% Discount Amount
Date of issue \$7,835.26
End of year 1 \$0 \$391.76* \$391.76 8,227.02
End of year 2 0 411.35 411.35 8,638.37
End of year 3 0 431.92 431.92 9,070.29
End of year 4 0 453.51 453.51 9,523.81
End of year 5 0 476.19 476.19 10,000.00
End of year 5 payment 10,000 0
\$2,164.74 \$2,164.74
*
The entry for the note receivable when issued would be:
At Eclipse's year-end of December 31, the interest income at the end of the first year using the effective interest method would be:
At maturity when the cash interest is received, the entry would be:
If Eclipse used ASPE instead of IFRS, the entry using straight-line method for amortizing the discount is calculated as the total discount of \$2,164.74, amortized over the five-year term of the note resulting in equal amounts each year. Therefore, the annual amortization is \$432.95 () each year is recorded as:
5. Notes Receivable in Exchange for Property, Goods, or Services
When property, goods, or services are exchanged for a note, and the market rate and the timing and amounts of cash received are all known, the present value of the note can be determined. For example, assume that on May 1, Hudson Inc. receives a \$200,000, five-year note in exchange for land originally costing \$120,000. The market rate for a note with similar characteristics and risks is 8%. The present value is calculated as follows:
PV = (0 PMT, 8 I/Y, 5 N, 200000 FV)
PV = \$136,117
The entry upon issuance of the note and sale of the land would be:
However, if the market rate is not known, either of following two approaches can be used to determine the fair value of the note:
1. Determine the fair value of the property, goods, or services given up. As was discussed for zero-interest bearing notes where the interest rate was not known, the implicit interest rate can still be derived because the cash amount lent, and the timing and amount of the cash flows received from the issuer are both known. In this case the amount lent is the fair value of the property, goods, or services given up. Once the interest is calculated, the effective interest method can be applied.1
I/Y = (+/-31750 PV, 0 PMT, 3 N, 40000 FV)
I/Y = 8%; the interest income component is \$8,250 over three years ()
The entry upon issuance of the note would be:
2. Determine an imputed interest rate. An imputed interest rate is an estimated interest rate used for a note with comparable terms, conditions, and risks between an independent borrower and lender.
On June 1, Edmunds Co. receives a \$30,000, three-year note in exchange for some swampland. The land has a historic cost of \$5,000 but neither the market rate nor the fair value of the land can be determined. In this case, a market rate must be imputed and used to determine the note's present value. The rate will be estimated based on interest rates currently in effect for companies with similar characteristics and credit risk as the company issuing the note. For IFRS companies, the "evaluation hierarchy" identified in IFRS 13 Fair Value Measurement would be used to determine the fair value of the land and the imputed interest rate. In this case, the imputed rate is determined to be 7%. The present value is calculated as follows:
PV = (7 I/Y, 3 N, 30000 FV)
PV = \$24,489
The entry upon issuance of the note would be:
Loans to employees
In cases where there are non-interest-bearing long-term loans to company employees, the fair value is determined by using the market rate for loans with similar characteristics, and the present value is calculated on that basis. The amount loaned to the employee invariably will be higher than the present value using the market rate because the loan is intended as a reward or incentive. This difference would be deemed as additional compensation and recorded as Compensation expense.
Impairment of notes receivable
Just as was the case with accounts receivable, there is a possibility that the holder of the note receivable will not be able to collect some or all of the amounts owing. If this happens, the receivable is considered impaired. When the investment in a note receivable becomes impaired for any reason, the receivable is re-measured at the present value of the currently expected cash flows at the loan's original effective interest rate.
The impairment amount is recorded as a debit to bad debt expense and as a credit either to an allowance for uncollectible notes account (a contra account to notes receivable) or directly as a reduction to the asset account. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.03%3A_Receivables/6.3.02%3A_Notes_Receivable.txt |
Derecognition is the removal of a previously recognized receivable from the company's balance sheet. In the normal course of business, receivables arise from credit sales and, once paid, are removed (derecognized) from the books. However, this takes valuable time and resources to turn receivables into cash. As someone once said, "turnover is vanity, profit is sanity, but cash is king"2. Simply put, a business can report all the profits possible, but profits do not mean cash resources. Sound cash flow management has always been important but, since the economic downturn in 2008, it has become the key to survival for many struggling businesses. As a result, companies are always looking for ways to shorten the credit-to-cash cycle to maximize their cash resources. Two such ways are secured borrowings and sales of receivables, discussed next.
Secured Borrowings
Companies often use receivables as collateral for a loan or a bank line of credit. The receivables are pledged as security for the loan, but the control and collection often remain with the company, so the receivables are left on the company's books. The company records the proceeds of the loan received from the finance company as a liability with the loan interest and any other finance charges recorded as expenses. If a company defaults on its loan, the finance company can seize the secured receivables and directly collect the cash from the receivables as payment against the defaulted loan. This will be illustrated in the section on factoring, below.
Sales of Receivables
What is the accounting treatment if a company's receivables are transferred (sold) to a third party (factor)? Certain industry sectors, such as auto dealerships and almost all small- and medium-sized businesses selling high-cost goods (e.g., gym equipment retailers) make extensive use of third-party financing arrangements with their customers to speed up the credit-to-cash cycle. Whether a receivable is transferred to a factor (sale) or held as security for a loan (borrowing) depends on the criteria set out in IFRS and ASPE which are discussed next.
Conditions for Treatment as a Sale
For accounting purposes, the receivables should be derecognized as a sale when they meet the following criteria:
IFRS—substantially all of the risks and rewards have been transferred to the factor. The evidence for this is that the contractual rights to receive the cash flows have been transferred (or the company continues to collect and forward all the cash it collects without delay) to the factor. As well, the company cannot sell or pledge any of these receivables to any third parties other than to the factor.
ASPEcontrol of the receivables has been surrendered by the transferor. This is evidenced when the following three conditions are all met:
1. The transferred assets have been isolated from the transferor.
2. The factor has obtained the right to pledge or to sell the transferred assets.
3. The transferor does not maintain effective control of the transferred assets through a repurchase agreement.
If the conditions for either IFRS or ASPE are not met, the receivables remain in the accounts and the transaction is treated as a secured borrowing (recorded as a liability) with the receivables as security for the loan. The accounting treatment regarding the sale of receivables using either standard is a complex topic; the discussion in this section is intended as a basic overview.
Below are some different examples of sales of receivables; such as factoring and securitization.
Factoring
Factoring is when individual accounts receivable are sold or transferred to a recipient or factor, usually a financial institution, in exchange for cash minus a fee called a discount. The seller does not usually have any subsequent involvement with the receivable and the factor collects directly from the customer. (Companies selling fitness equipment exclusively use this method for all their credit sales to customers.)
The downside to this strategy is that factoring is expensive. Factors typically charge a 2% to 3% fee when they buy the right to collect payments from customers. A 2% discount for an invoice due in thirty days is the equivalent of a substantial 25% a year, and 3% is over 36% per year compared to the much lower interest rates charged by banks and finance companies. Most companies are better off borrowing from their bank, if it is possible to do so.
However, factors will often advance funds when more traditional banks will not. Even with only a prospective order in hand from a customer, a business can turn to a factor to see if it will assume or share the risk of the receivable. Without the factoring arrangement, the business must take time to secure and collect the receivable; the factor offers a reduction in additional effort and aggravation that may be worth the price of the fee paid to the factor.
There are risks associated with factoring receivables. Companies that intend to sell their receivables to a factor need to check out the bank and customer references of any factor. There have been cases where a factor has gone out of business, still owing the company substantial amounts of money held back in reserve from receivables already paid up.
Factoring versus Borrowing: A Comparison
The difference between factoring and borrowing can be significant for a company that wants to sell some or all of its receivables. Consider the following example:
Assume that on June 1, Cromwell Co. has \$100,000 accounts receivable it wants to sell to a factor that charges 10% as a financing fee. Below is the transaction recorded as a sale of receivables compared to a secured note payable arrangement, starting with some opening balances:
Cromwell Co. Balance Sheet – Opening Balances
Cash \$ 10,000
Accounts receivable 150,000
Property, plant, and equipment 200,000
Total assets \$ 360,000
Accounts payable \$ 70,000
Note payable 0
Equity 290,000
Total liabilities and equity \$ 360,000
Debt-to-total assets ratio 19%
Below is the balance sheet after the transaction:
Cromwell Co. Balance Sheet – Sale of Receivables
Cash \$ 100,000
Accounts receivable 50,000
Property, plant, and equipment 200,000
Total assets \$ 350,000
Accounts payable \$ 70,000
Note payable 0
Equity 280,000
Total liabilities and equity \$ 350,000
Debt-to-total assets ratio 20%
Cromwell Co. Balance Sheet – Note Payable
Cash \$ 100,000
Accounts receivable 150,000
Property, plant, and equipment 200,000
Total assets \$ 450,000
Accounts payable \$ 70,000
Note payable 90,000
Equity 290,000
Total liabilities and equity \$ 450,000
Debt-to-total assets ratio 36%
Note that the entry for a sale is straightforward with the receivables of \$100,000 derecognized from the accounts and a decrease in retained earnings due to the loss reported in net income. However, for a secured borrowing, a note payable of \$90,000 is added to the accounts as a liability, and the accounts receivable of \$100,000 remains in the accounts as security for the note payable. Referring to the journal entry above, in both cases cash flow increased by \$90,000, but for the secured borrowing, there is added debt of \$90,000, affecting Cromwell's debt ratio and negatively impacting any restrictive covenants Cromwell might have with other creditors. After the transaction, the debt-to-total assets ratio for Cromwell is 20% if the accounts receivable transaction meets the criteria for a sale. The debt ratio worsens to 36% if the transaction does not meet the criteria for a sale and is treated as a secured borrowing. This impact could motivate managers to choose a sale for their receivables to shorten the credit-to-cash cycle, rather than the borrowing alternative.
Sales without Recourse
For sales without recourse, all the risks and rewards (IFRS) as well as the control (ASPE) have been transferred to the factor, and the company no longer has any involvement.
For example, assume that on August 1, Ashton Industries Ltd. factors \$200,000 of accounts receivable with Savoy Trust Co., the factor, on a without-recourse basis. All the risks, rewards, and control are transferred to the finance company, which charges an 8% fee and withholds a further 4% of the accounts receivables for estimated returns and allowances. The entry for Ashton is:
The accounting treatment will be the same for IFRS and ASPE since both sets of conditions (risks and rewards and control) have been met. If no returns and allowances are given to customers owing the receivables, Ashton will recoup the \$8,000 from the factor. In turn, Savoy's net income will be the \$16,000 revenue reduced by any uncollectible receivables, since it now has assumed the risks/rewards and control of these receivables.
Sales with Recourse
In this case, Ashton guarantees payment to Savoy for any uncollectible receivables (recourse obligation). Under IFRS, the guarantee means that the risks and rewards have not been transferred to the factor, and the accounting treatment would be as a secured borrowing as illustrated above in Cromwell—Note Payable. Under ASPE, if all three conditions for treatment as a sale as described previously are met, the transaction can be treated as a sale.
Continuing with the example for Ashton, assume that the receivables are sold with recourse, the company uses ASPE, and that all three conditions have been met. In addition to the 8% fee and 4% withholding allowance, Savoy estimates that the recourse obligation has a fair value of \$5,000. The entry for Ashton, including the estimated recourse obligation is:
You will see that the recourse liability to Savoy results in an increase in the loss on sale of receivables by the recourse liability amount of \$5,000. If there were no uncollectible receivables, Ashton will eliminate the recourse liability amount and decrease the loss. Savoy's net income will be the finance fee of \$16,000 with no reductions in revenue due to uncollectible accounts, since these are being guaranteed and assumed by Ashton.
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Securitization
Securitization is a financing transaction that gives companies an alternative way to raise funds other than by issuing debt, such as a corporate bond or note. The process is extremely complex and the description below is a simplified version.
The receivables are sold to a holding company called a Special Purpose Entity (SPE), which is sponsored by a financial intermediary. This is similar to factoring without recourse, but is done on a much larger scale. This sale of receivables and their removal from the accounting records by the company holding the receivables is an example of off-balance sheet accounting. In its most basic form, the securitization process involves two steps:
Step 1: A company (the asset originator) with receivables (e.g., auto loans, credit card debt), identifies the receivables (assets) it wants to sell and remove from its balance sheet. The company divides these into bundles, called tranches, each containing a group of receivables with similar credit risks. Some bundles will contain the lowest risk receivables (senior tranches) while other bundles will have the highest risk receivables (junior tranches).
The company sells this portfolio of receivable bundles to a special purpose entity (SPE) that was created by a financial intermediary specifically to purchase these types of portfolio assets. Once purchased, the originating company (seller) derecognizes the receivables and the SPE accounts for the portfolio assets in its own accounting records. In many cases, the company that originally sold the portfolio of receivables to the SPE continues to service the receivables in the portfolio, collects payments from the original borrowers and passes them on—less a servicing fee—directly to the SPE. In other cases, the originating company is no longer involved and the SPE engages a bank or financial intermediary to collect the receivables as a collecting agent.
Step 2: The SPE (issuing agent) finances the purchase of the receivables portfolio from the originating company by issuing tradeable interest-bearing securities that are secured or backed by the receivables portfolio it now holds in its own accounting records as stated in Step 1—hence the name asset-backed securities (ABS). These interest-bearing ABS securities are sold to capital market investors who receive fixed or floating rate payments from the SPE, funded by the cash flows generated by the portfolio collections. To summarize, securitization represents an alternative and diversified source of financing based on the transfer of credit risk (and possibly also interest rate and currency risk) from the originating company and ultimately to the capital market investors.
The Downside of Securitization
Securitization is inherently complex, yet it has grown exponentially. The resulting highly competitive securitization markets with multiple securitizers (financial institutions and SPEs), increase the risk that underwriting standards for the asset-backed securities could decline and cause sharp drops in the bundled or tranched securities' market values. This is because both the investment return (principal and interest repayment) and losses are allocated among the various bundles according to their level of risk. The least risky bundles, for example, have first call on the income generated by the underlying receivables assets, while the riskiest bundles have last claim on that income, but receive the highest return.
Typically, investors with securities linked to the lowest-risk bundles would have little expectation of portfolio losses. However, because investors often finance their investment purchase by borrowing, they are very sensitive to changes in underlying receivables assets' quality. This sensitivity was the initial source of the problems experienced in the sub-prime mortgage market (derivatives) meltdown in 2008. At that time, repayment issues surfaced in the riskiest bundles due to the weakened underwriting standards, and lack of confidence spread to investors holding even the lowest risk bundles, which caused panic among investors and a flight into safer assets, resulting in a fire sale of securitized debt of the SPEs.
In the future, securitized products are likely to become simpler. After years of posting virtually no capital reserves against high-risk securitized debt, SPEs will soon be faced with regulatory changes that will require higher capital charges and more comprehensive valuations. Reviving securitization transactions and restoring investor confidence might also require SPEs to retain an interest in the performance of securitized assets at each level of risk (Jobst, 2008). | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.03%3A_Receivables/6.3.03%3A_Derecognition_and_Sale_of_Receivables-_Shortening_the_Credit-to-Cash_Cycle.txt |
The standards for receivables reporting and disclosures have been in a constant state of change. IFRS 7 (IFRS, 2015) and IAS 1 (IAS, 2003) include significant disclosure requirements that provide information based on significance and the nature and extent of risks.
The Significance of Financial Instruments
IFRS 7 and IAS 1 specify the separate reporting categories based on significance such as the following:
• Trade accounts, amounts owing from related parties, prepayments, tax refunds, and other significant amounts
• Current amounts from non-current amounts
• Any impaired balances and amount of any allowance for credit risk and a reconciliation of the changes in the allowance account during the accounting period
• Disclosure on the income statement of the amounts of interest income, impairment losses, and any reversals associated with impairment losses
• Net losses on sales of receivables (IFRS, 2015, 7.20 a, iv).
For each receivables category above, the following disclosures are required:
• The carrying amounts such as amortized cost/cost and fair values (including methods used to estimate fair value) with details of any amounts reclassified from one category to another or changes in fair values
• Carrying amount and terms and conditions regarding financial assets pledged as collateral or any financial assets held as collateral
• An indication of the amounts and, where practicable, the maturity dates of accounts with a maturity of more than one year
• For IFRS, extensive disclosures of major terms regarding the securitization or transfers of receivables, whether these have been derecognized in their entirety or not. Some of these disclosures include the characteristics of the securitization, the fair value measurements and methods used and cash flows, as well as the nature of the servicing requirements and associated risks.
The Nature and Extent of Risks Arising from Financial Instruments
Stakeholders, such as investors and creditors, want to know about the various transactions that hold risks. Basic types of risks and related disclosures are:
• Credit risk—the risk that one party to a financial instrument will default on its debt obligation. Disclosures include an analysis of the age of financial assets that are past due as at the end of the reporting period but not impaired and an analysis of financial assets that are individually determined to be impaired as at the end of the reporting period, including the factors the entity considered in determining that they are impaired (IFRS 2015, 7.37 a, b).
• Liquidity risk—the risk that an entity will have difficulties in paying its financial liabilities.
• Market risk—the risk that the fair value or cash flows of a receivable will fluctuate due to changes in market prices which are affected by interest rate risk, currency risk, and other price risks. Disclosures include a sensitivity analysis for each type of market risk to which the entity is exposed at the end of the reporting period, showing how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at that date (IFRS 2015, 7.40 a).
In addition, information about company policies for managing risk, including quantitative and qualitative data, is to be disclosed. ASPE disclosure requirements are much the same as IFRS, though perhaps requiring slightly less information about risk exposures and fair values than IFRS (CPA Canada, 2016, Part II, Section 3856.38–42). | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.03%3A_Receivables/6.3.04%3A_Disclosures_of_Receivables.txt |
The most common analytical tool regarding cash is the statement of cash flows. This statement reveals how a company spends its money (cash outflows) and where the money comes from (cash inflows). It is well known that a company's profitability, as shown by its net income, is an important performance evaluator. Although accrual accounting provides a basis for matching revenues and expenses, this system does not actually reflect the amount of cash that the company has received from its profits. This can be a crucial distinction as discussed earlier in this chapter. The statement of cash flows was discussed in Chapter 4.
For receivables analysis, three key financial tools are:
• An accounts receivable aging report
• Trendline analysis
• Ratio analysis
Accounts Receivable Aging Report
One of the easiest methods for analyzing the state of a company's accounts receivable is to print an accounts receivable aging report, which is a standard report available in any accounting software package. As was discussed earlier in this chapter, this report divides the age of the accounts receivable into various groups according to the amount of time uncollected. Any invoices uncollected for greater than 30 days are cause for increased vigilance, especially if they drop into the oldest time grouping.
There are several issues to be aware of when analyzing accounts receivables based on an aging report.
Individual credit terms—Management may have authorized unusually long credit terms to specific customers, or for specific types of invoices. If so, these items may appear to be severely overdue for payment when they are, in fact, not yet due for payment at all.
Distance from billing date—In many companies, most of the invoices are billed at the end of the month. If an aging report is run a few days later as part of the month-end analysis, it will likely still show outstanding accounts receivable from one month ago for which payment is about to arrive, as well as the full amount of all the receivables that were just billed a few days ago. In total, it appears that receivables are in a bad state. However, if you were to run the report just prior to the month-end billing activities, there would be far fewer accounts receivable in the report, and there may appear to be very little cash coming from uncollected receivables.
Time grouping size—The groupings should approximate the duration regarding the company's credit terms. For example, if credit terms are just ten days and the first time grouping spans 30 days, nearly all invoices will appear to be current.
Trendline Analysis
Another accounts receivable analysis tool is the trendline. If the outstanding accounts receivable balance at the end of each month for the past year is graphed, it can be used to predict the amount of receivables that should be outstanding in the near future. This is a particularly valuable tool when sales are seasonal, since you can apply seasonal variability to estimates of future sales levels.
Trendline analysis is also useful for comparing the percentage of bad debts to sales over time. If there is a strong recurring trend in this percentage, management will likely take action. As was discussed earlier, if the percentage of bad debt is increasing, management will likely authorize tighter credit terms to customers. Conversely, if the bad debt percentage is extremely low, management may elect to loosen credit terms to expand sales to somewhat more risky customers. Their philosophy will be that not all customers in the riskier categories will default on paying their debts to suppliers so there should be a net benefit from increasing sales. The bottom line is that the credit terms need to strike a balance between the two opposites. Trendline analysis is a particularly useful tool when you run the bad debt percentage analysis for individual customers, since it can spotlight problems that may indicate the possible bankruptcy of a customer.
There are two issues to be aware of when you use trendline analysis:
• Change in credit policy. If management has authorized a change in the credit policy, it can lead to sudden changes in accounts receivable or bad debt levels.
• Change in products or business lines. If a company adds to or deletes from its mix of products or business lines, it may cause profound changes in the trend of accounts receivable.
An interesting analysis related to accounts receivable is a trendline of the proportion of customer sales that are paid at the time of sale, noting the payment type used. Changes in a company's selling procedures and policies may shift sales toward or away from up-front payments, which therefore has an impact on the amount and characteristics of accounts receivable.
Ratio Analysis
A third type of accounts receivable analysis is ratio analysis. Ratios, on their own, do not really tell the whole story. Ratios compared to a benchmark, such as an industry sector or previous period trends will be more meaningful. Some of the more common ratios that include cash and accounts receivable are:
• Quick or acid-test ratio, which measures immediate debt-paying ability
• Accounts receivable turnover, which measures how quickly the receivables are converted into cash
• Days' sales uncollected, which measures the number of days that receivables remain uncollected
These are examples of liquidity ratios which measure a company's ability to pay its debts as they come due. Below is selected financial data for Best Coffee and Donuts:
Best Coffee and Donuts Inc.
Excerpts from the Consolidated Balance sheet
(in thousands of Canadian dollars)
(Unaudited)
As at
December 29, December 30,
2021 2020
Current assets
Cash and cash equivalents \$ 50,414 \$ 120,139
Restricted cash and cash equivalents 155,006 150,574
Accounts receivable, net (includes royalties
and franchise fees receivable) 210,664 171,605
Notes receivable, net 4,631 7,531
Deferred income taxes 10,165 7,142
Inventories and other, net 104,326 107,000
Advertising fund restricted assets 39,783 45,337
Total current assets \$ 574,989 \$ 609,328
Current liabilities
Accounts payable \$ 204,514 \$ 169,762
Accrued liabilities 274,008 227,739
Deferred income taxes - 197
Advertising fund liabilities 59,912 44,893
Short-term borrowings 30,000 -
Current portion of long-term obligations 17,782 20,781
Total current liabilities \$ 586,216 \$ 463,372
Best Coffee and Donuts Inc.
Excerpts from the Consolidated Statement of Operations
(in thousands of Canadian dollars, except share and per share data)
(Unaudited)
Year ended
December 29, December 30,
2021 2020
REVENUES
Sales \$ 2,265,884 \$ 2,225,659
Franchise revenues
Rents and royalties 821,221 780,992
Franchise fees 168,428 113,853
989,649 894,845
TOTAL REVENUES \$ 3,255,533 \$ 3,120,504
Quick ratio
The quick or acid-test ratio, measures only the most liquid current assets available to cover its current liabilities. The quick ratio is more conservative than the current ratio which includes all current assets and current liabilities because it excludes inventory and any other current assets that are not highly liquid.
Formula:
Calculation:
2021 2020
Quick Ratio = = .45 = .65
As of December 31, 2021, with amounts expressed in thousands, Best Coffee and Donuts' quick current assets amounted to \$265,709, while current liabilities amounted to \$586,216. The resulting ratio produced is .45. This means that there is \$.45 of the most liquid current assets available for each \$1.00 of current liabilities. If a quick ratio of greater than \$1.00 is a reasonable measure of liquidity, this means that Best Coffee and Donuts' ability to cover its current liabilities as they mature is at risk. Moreover, this ratio has weakened compared to the previous year of .65 or \$.65 for each \$1.00 in current liabilities.
Variations
In practice, some presentations of the quick ratio calculate quick assets (the formula's numerator) as simply the total current assets minus the inventory account. This is quicker and easier to calculate. By excluding a relatively less-liquid account such as inventory, it is thought that the remaining current assets will be of the more-liquid variety.
Using Best Coffee and Donuts as an example, for 2021, the quick ratio using the shorter calculation would be:
It is clear from the comparative calculations that .80 is significantly higher than the previously calculated .45 ratio. Restricted cash, prepaid expenses, and deferred income taxes do not pass the test of truly liquid assets. Thus, using the shorter calculation artificially overstates Best Coffee and Donuts more-liquid current assets and inflates its quick ratio. For this reason, it is not advisable to rely on this abbreviated version of the quick ratio.
Another type of analysis is to compare the quick ratio with its corresponding current ratio. If the current ratio is significantly higher, it is a clear indication that the company's current assets are dependent on inventory and other "less than liquid" current assets, such as legally restricted cash balances.
Even though the quick ratio is a more conservative measure of liquidity than the current ratio, they both share the same problems regarding the time it takes to convert accounts receivables to cash in that they assume a liquidation of accounts receivable as the basis for measuring liquidity. In truth, a company must focus on the time it takes to convert its working capital assets to cash—that is the true measure of liquidity. This is the credit-to-cash cycle emphasized throughout this chapter. So, if a company's accounts receivable, has a much longer conversion time than a typical credit policy of thirty days, the quickness attribute of this ratio becomes a focal point. For this reason, investors and creditors need to be aware that relying solely on the current and quick ratios as indicators of a company's liquidity can be misleading. The "quickness" attribute will be discussed next.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures the number of times per year on average that it takes to collect a company's receivables. When using this ratio for analysis, the following issues must be considered:
• Credit sales, rather than all sales, would be the better measure to use for the numerator, but this information can be more difficult to obtain by third parties such as prospective investors and creditors, so total sales are often used in practice.
• Typically, average receivables outstanding are usually calculated from the beginning and ending balances. However, if a business has significant seasonal cycles, calculating a series of turnover averages throughout the fiscal year, such as semi-annually or quarterly, will likely provide better results.
• Companies can choose to sell their receivables making comparability with other companies not suitable.
• Net accounts receivable includes the allowance for doubtful accounts (AFDA), so the choice of what method and rates to use when estimating uncollectible accounts can vary significantly between companies, resulting in invalid comparisons.
The key consideration is to ensure comparability and consistency when interpreting ratio analysis, since ratios are used to determine favourable or unfavourable trends resulting from comparison to other factors. Using Best Coffee and Donuts data, we calculate the following:
Formula:
Calculation for 2021:
If the industry standard or the company credit policy is n/30 days, an accounts receivable turnover of every twenty-one days on average would be a favourable outcome compared to the thirty-day due date set by the company's credit policy. Aging schedules would provide further information about the quality of specific receivables and would highlight any customer accounts that were overdue and requiring immediate attention.
Days' sales uncollected
This ratio estimates how many days it takes to collect on the current receivables outstanding.
Formula:
Calculation for 2021:
Note that the average receivables are not used in this calculation. This means that the ratio measures the collectability of the current accounts receivables instead of the average accounts receivable. If a guideline for this ratio is that it should not exceed 1.33 times its credit period when no discount is offered (or the discount period if a discount is offered), 23.62 days compared to the benchmark of forty days () means that the ratio is favourable.
The best way to analyze accounts receivable is to use all three techniques. The accounts receivable collection period can be used to get a general idea of the ability of a company to collect its accounts receivable, add an analysis of the aging report to determine exactly which invoices are causing collection problems, and add trend analysis to see if these problems have been changing over time. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.04%3A_Cash_and_Receivables-_Analysis.txt |
Item ASPE IFRS
Cash equivalents Equity investments are excluded from this classification. Preferred shares can be included if there is a specified redemption date and are acquired close to their maturity date.
Accounts receivable—initial measurement Initially measured at net realizable value (net of trade discounts and sales discounts, returns and allowances) in lieu of fair value given their short-term nature (there is no significant interest component). Same as ASPE
Accounts receivable—subsequent measurement Cost in lieu of amortized cost since there is no significant interest component. Same as ASPE
Accounts receivable—impairment Impairment is determined by estimating uncollectible accounts using either accounts receivable or credit sales as the basis. Direct write-off of uncollectible accounts directly to bad debt expense is only used under limited circumstances. Same as ASPE
Short-term notes receivable—initial and subsequent measurement In lieu of fair value, measured at NRV: Same as ASPE
face value plus stated rate of interest for interest-bearing notes and face value which includes interest for non-interest-bearing notes.
Long-term notes At fair value: Same as ASPE
receivable—initial measurement Interest bearing: Present value of the expected cash flows discounted at the market rate of interest.
Non-interest bearing: Present value of the expected cash flows discounted at the market rate of interest. The interest component is the difference between the proceeds (the present value set by the lender) and the repayment amount.
Long-term notes receivable—subsequent measurement Measured at amortized cost using either the straight-line method or the effective interest method for interest, discounts, or premiums. Measured at amortized cost using the effective interest rate method for interest, discounts, or premiums.
Long-term notes receivable—impairment If impaired, the receivable is re-measured at the present value of the expected cash flows at the current market interest rate. If impaired, the receivable is remeasured at the present value of the expected cash flows at the loan's original effective interest rate.
Long-term notes receivable—transaction costs Capitalized at acquisition and added to discount or premium to be amortized over life of note. Same as ASPE
Derecognition of receivables When the entity has given up the control of the receivables by meeting all three conditions:
• The transferred assets are isolated in the books.
• The company does not have a repurchase agreement.
• The receiver (factor) has the right to pledge or sell the assets.
When substantially all of the risks and rewards have been transferred:
• The contractual rights to receive the cash flows is transferred or collected and immediately passed on to the recipient.
• The company cannot sell or pledge any of these receivables to any third parties other than to the factor.
Derecognition of receivables—sale without recourse If all three conditions met, treat as a sale, otherwise as a secured borrowing. If condition met, treat as a sale, otherwise as a secured borrowing.
Derecognition of receivables—sale with recourse If all three conditions met, treat as a sale, otherwise as a secured borrowing. Treat as a secured borrowing.
Disclosure of receivables Are to provide information about:
• the significance of financial instruments
• the nature and extent of risks arising from financial instruments
Less disclosure requirements than IFRS.
Are to provide information about:
• the significance of financial instruments
• the nature and extent of risks arising from financial instruments
More information required than ASPE, including a reconciliation of any changes in the allowance account and extensive disclosures regarding securitization transactions.
Analysis of receivables Three financial tools:
• An accounts receivable aging report
• Trendline analysis
• Ratio analysis
Same as ASPE | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.05%3A_IFRS_ASPE_Key_Differences.txt |
Internal Control
Assets are the lifeblood of a company and must be protected. This duty falls to managers of a company. The policies and procedures implemented by management to protect assets are collectively referred to as internal controls. An effective internal control program not only protects assets, but also aids in accurate record-keeping, produces financial statement information in a timely manner, ensures compliance with laws and regulations, and promotes efficient operations. Effective internal control procedures ensure that adequate records are maintained, transactions are authorized, duties among employees are divided between record-keeping functions and control of assets, and employees' work is checked by others. The use of electronic recordkeeping systems does not decrease the need for good internal controls.
The effectiveness of internal controls is limited by human error and fraud. Human error can occur because of negligence or mistakes. Fraud is the intentional decision to circumvent internal control systems for personal gain. Sometimes, employees cooperate with each other to avoid internal controls. This collusion is often difficult to detect, but fortunately, it is not a common occurrence when adequate controls are in place.
Internal controls take many forms. Some are broadly based, like mandatory employee drug testing, video surveillance, and scrutiny of company email systems. Others are specific to an asset type or process. For instance, internal controls need to be applied to a company's accounting system to ensure that transactions are processed efficiently and correctly to produce reliable records in a timely manner. Procedures should be documented to promote good recordkeeping, and employees need to be trained in the application of internal control procedures.
Financial statements prepared according to generally accepted accounting principles are useful not only to external users in evaluating the financial performance and financial position of the company, but also for internal decision making. There are various internal control mechanisms that aid in the production of timely and useful financial information. For instance, using a chart of accounts is necessary to ensure transactions are recorded in the appropriate account. As an example, expenses are classified and recorded in applicable expense accounts, then summarized and evaluated against those of a prior year.
The design of accounting records and documents is another important means to provide financial information. Financial data is entered and summarized in records and transmitted by documents. A good system of internal control requires that these records and documents be prepared at the time a transaction takes place or as soon as possible afterwards, since they become less credible and the possibility of error increases with the passage of time. The documents should also be consecutively pre-numbered, to indicate whether there may be missing documents.
Internal control also promotes the protection of assets. Cash is particularly vulnerable to misuse. A good system of internal control for cash should provide adequate procedures for protecting cash receipts and cash payments (commonly referred to as cash disbursements). Procedures to achieve control over cash vary from company to company and depend upon such variables as company size, number of employees, and cash sources. However, effective cash control generally requires the following:
• Separation of duties: People responsible for handling cash should not be responsible for maintaining cash records. By separating the custodial and record-keeping duties, theft of cash is less likely.
• Same-day deposits: All cash receipts should be deposited daily in the company's bank account. This prevents theft and personal use of the money before deposit.
• Payments made using non-cash means: Cheques or electronic funds transfer (EFT) provide a separate external record to verify cash disbursements. For example, many businesses pay their employees using electronic funds transfer because it is more secure and efficient than using cash or even cheques.
Two forms of internal control over cash will be discussed in this chapter: the use of a petty cash account and the preparation of bank reconciliations.
Petty Cash
The payment of small amounts by cheque may be inconvenient and costly. For example, using cash to pay for postage on an incoming package might be less than the total processing cost of a cheque. A small amount of cash kept on hand to pay for small, infrequent expenses is referred to as a petty cash fund.
Establishing and Reimbursing the Petty Cash Fund
To set up the petty cash fund, a cheque is issued for the amount needed. The custodian of the fund cashes the cheque and places the coins and currency in a locked box. Responsibility for the petty cash fund should be delegated to only one person, who should be held accountable for its contents. Cash payments are made by this petty cash custodian out of the fund as required when supported by receipts. When the amount of cash has been reduced to a pre-determined level, the receipts are compiled and submitted for entry into the accounting system. A cheque is issued to reimburse the petty cash fund. At any given time, the petty cash amount should consist of cash and supporting receipts, that total to the petty cash fund amount. To demonstrate the management of a petty cash fund, assume that a \$200 cheque is issued to establish a petty cash fund.
The journal entry is:
Petty Cash is a current asset account and is reported with Cash as one amount.
Assume the petty cash custodian has receipts totalling \$190 and \$10 in coin and currency remaining in the petty cash box. The receipts consist of the following: delivery charges \$100, \$35 for postage, and office supplies of \$55. The petty cash custodian submits the receipts to the accountant who records the following entry and issues a cheque for \$190.
The petty cash receipts should be cancelled at the time of reimbursement to prevent their reuse for duplicate reimbursements. The petty cash custodian cashes the \$190 cheque. The \$190 plus the \$10 of coin and currency in the locked box immediately prior to reimbursement equals the \$200 total required in the petty cash fund.
Sometimes, the receipts plus the coin and currency in the petty cash locked box do not equal the required petty cash balance. To demonstrate, assume the same information above except that the coin and currency remaining in the petty cash locked box was \$8. This amount plus the receipts for \$190 equals \$198 and not \$200, indicating a shortage in the petty cash box. The entry at the time of reimbursement reflects the shortage and is recorded as:
The \$192 credit to Cash plus the \$8 of coin and currency remaining in the petty cash box immediately prior to reimbursement equals the \$200 required total in the petty cash fund.
Assume, instead, that the coin and currency in the petty cash locked box was \$14. This amount plus the receipts for \$190 equals \$204 and not \$200, indicating an overage in the petty cash box. The entry at the time of reimbursement reflects the overage and is recorded as:
The \$186 credit to Cash plus the \$14 of coin and currency remaining in the petty cash box immediately prior to reimbursement equals the \$200 required total in the petty cash fund.
What happens if the petty cash custodian finds that the fund is rarely used? In such a case, the size of the fund should be decreased to reduce the risk of theft. To demonstrate, assume the petty cash custodian has receipts totalling \$110 and \$90 in coin and currency remaining in the petty cash box. The receipts consist of the following: delivery charges \$80 and postage \$30. The petty cash custodian submits the receipts to the accountant and requests that the petty cash fund be reduced by \$75. The following entry is recorded and a cheque for \$35 is issued.
The \$35 credit to Cash plus the \$90 of coin and currency remaining in the petty cash box immediately prior to reimbursement equals the \$125 new balance in the petty cash fund (\$200 original balance less the \$75 reduction).
In cases when the size of the petty cash fund is too small, the petty cash custodian could request an increase in the size of the petty cash fund at the time of reimbursement. Care should be taken to ensure that the size of the petty cash fund is not so large as to become a potential theft issue. Additionally, if a petty cash fund is too large, it may be an indicator that transactions that should be paid by cheque are not being processed in accordance with company policy. Remember that the purpose of the petty cash fund is to pay for infrequent expenses; day-to-day items should not go through petty cash.
Cash Collections and Payments
The widespread use of banks facilitates cash transactions between entities and provides a safeguard for the cash assets being exchanged. This involvement of banks as intermediaries between entities has accounting implications. At any point in time, the cash balance in the accounting records of a company usually differs from the bank cash balance. The difference is usually because some cash transactions recorded in the accounting records have not yet been recorded by the bank and, conversely, some cash transactions recorded by the bank have not yet been recorded in the company's accounting records.
The use of a bank reconciliation is one method of internal control over cash. The reconciliation process brings into agreement the company's accounting records for cash and the bank statement issued by the company's bank. A bank reconciliation explains the difference between the balances reported by the company and by the bank on a given date.
A bank reconciliation proves the accuracy of both the company's and the bank's records, and reveals any errors made by either party. The bank reconciliation is a tool that can help detect attempts at theft and manipulation of records. The preparation of a bank reconciliation is discussed in the following section.
The Bank Reconciliation Process
The bank reconciliation is a report prepared by a company at a point in time. It identifies discrepancies between the cash balance reported on the bank statement and the cash balance reported in a business's Cash account in the general ledger, more commonly referred to as the books. These discrepancies are known as reconciling items and are added or subtracted to either the book balance or bank balance of cash. Each of the reconciling items is added or subtracted to the business's cash balance. The business's cash balance will change as a result of the reconciling items. The cash balance prior to reconciliation is called the unreconciled cash balance. The balance after adding and subtracting the reconciling items is called the reconciled cash balance. The following is a list of potential reconciling items and their impact on the bank reconciliation.
Book reconciling items Bank reconciling items
Collection of notes receivable (added) Outstanding deposits (added)
NSF cheques (subtracted) Outstanding cheques (subtracted)
Bank charges (subtracted)
Book errors (added or subtracted, Bank errors (added or subtracted,
depending on the nature of the error depending on the nature of the error)
Book Reconciling Items
The collection of notes receivable may be made by a bank on behalf of the company. These collections are often unknown to the company until they appear as an addition on the bank statement, and so cause the general ledger cash account to be understated. As a result, the collection of a notes receivable is added to the unreconciled book balance of cash on the bank reconciliation.
Cheques returned to the bank because there were not sufficient funds (NSF) to cover them appear on the bank statement as a reduction of cash. The company must then request that the customer pay the amount again. As a result, the general ledger cash account is overstated by the amount of the NSF cheque. NSF cheques must therefore be subtracted from the unreconciled book balance of cash on the bank reconciliation to reconcile cash.
Cheques received by a company and deposited into its bank account may be returned by the customer's bank for many reasons (e.g., the cheque was issued too long ago, known as a stale-dated cheque, an unsigned or illegible cheque, or the cheque shows the wrong account number). Returned cheques cause the general ledger cash account to be overstated. These cheques are therefore subtracted on the bank statement, and must be deducted from the unreconciled book balance of cash on the bank reconciliation.
Bank service charges are deducted from the customer's bank account. Since the service charges have not yet been recorded by the company, the general ledger cash account is overstated. Therefore, service charges are subtracted from the unreconciled book balance of cash on the bank reconciliation.
A business may incorrectly record journal entries involving cash. For instance, a deposit or cheque may be recorded for the wrong amount in the company records. These errors are often detected when amounts recorded by the company are compared to the bank statement. Depending on the nature of the error, it will be either added to or subtracted from the unreconciled book balance of cash on the bank reconciliation. For example, if the company recorded a cheque as \$520 when the correct amount of the cheque was \$250, the \$270 difference would be added to the unreconciled book balance of cash on the bank reconciliation. Why? Because the cash balance reported on the books is understated by \$270 because of the error. As another example, if the company recorded a deposit as \$520 when the correct amount of the deposit was \$250, the \$270 difference would be subtracted from the unreconciled book balance of cash on the bank reconciliation. Why? Because the cash balance reported on the books is overstated by \$270 because of the error. Each error requires careful analysis to determine whether it will be added or subtracted in the unreconciled book balance of cash on the bank reconciliation.
Bank Reconciling Items
Cash receipts are recorded as an increase of cash in the company's accounting records when they are received. These cash receipts are deposited by the company into its bank. The bank records an increase in cash only when these amounts are actually deposited with the bank. Since not all cash receipts recorded by the company will have been recorded by the bank when the bank statement is prepared, there will be outstanding deposits, also known as deposits in transit. Outstanding deposits cause the bank statement cash balance to be understated. Therefore, outstanding deposits are a reconciling item that must be added to the unreconciled bank balance of cash on the bank reconciliation.
On the date that a cheque is prepared by a company, it is recorded as a reduction of cash in a company's books. A bank statement will not record a cash reduction until a cheque is presented and accepted for payment (or clears the bank). Cheques that are recorded in the company's books but are not paid out of its bank account when the bank statement is prepared are referred to as outstanding cheques. Outstanding cheques mean that the bank statement cash balance is overstated. Therefore, outstanding cheques are a reconciling item that must be subtracted from the unreconciled bank balance of cash on the bank reconciliation.
Bank errors sometimes occur and are not revealed until the transactions on the bank statement are compared to the company's accounting records. When an error is identified, the company notifies the bank to have it corrected. Depending on the nature of the error, it is either added to or subtracted from the unreconciled bank balance of cash on the bank reconciliation. For example, if the bank cleared a cheque as \$520 that was correctly written for \$250, the \$270 difference would be added to the unreconciled bank balance of cash on the bank reconciliation. Why? Because the cash balance reported on the bank statement is understated by \$270 as a result of this error. As another example, if the bank recorded a deposit as \$520 when the correct amount was \$250, the \$270 difference would be subtracted from the unreconciled bank balance of cash on the bank reconciliation. Why? Because the cash balance reported on the bank statement is overstated by \$270 because of this specific error. Each error must be carefully analyzed to determine how it will be treated on the bank reconciliation.
Illustrative Problem—Bank Reconciliation
Assume that a bank reconciliation is prepared by Big Dog Carworks Corp. (BDCC) at April 30. At this date, the Cash account in the general ledger shows a balance of \$21,929 and includes the cash receipts and payments shown in Figure 6.1.
Figure 6.1 Big Dog's General Ledger 'Cash' Account at April 30
Extracts from BDCC's accounting records are reproduced with the bank statement for April in Figure 6.2.
Figure 6.2 The Bank Reconciliation Process
For each entry in BDCC's general ledger Cash account, there should be a matching entry on its bank statement. Items in the general ledger Cash account but not on the bank statement must be reported as a reconciling item on the bank reconciliation. For each entry on the bank statement, there should be a matching entry in BDCC's general ledger Cash account. Items on the bank statement but not in the general ledger Cash account must be reported as a reconciling item on the bank reconciliation.
There are nine steps to follow in preparing a bank reconciliation for BDCC at April 30, 2020:
Step 1
Identify the ending general ledger cash balance (\$21,929 from Figure 6.1) and list it on the bank reconciliation as the book balance on April 30 as shown in Figure 6.3. This represents the unreconciled book balance.
Step 2
Identify the ending cash balance on the bank statement (\$24,023 from Figure 6.2) and list it on the bank reconciliation as the bank statement balance on April 30 as shown in Figure 6.3. This represents the unreconciled bank balance.
Step 3
Cheques written that have cleared the bank are returned with the bank statement. These cheques are said to be cancelled because, once cleared, the bank marks them to prevent them from being used again. Cancelled cheques are compared to the company's list of cash payments. Outstanding cheques are identified using two steps:
1. Any outstanding cheques listed on the BDCC's March 31 bank reconciliation are compared to the cheques listed on the April 30 bank statement.
For BDCC, all of the March outstanding cheques (nos. 580, 599, and 600) were paid by the bank in April. Therefore, there are no reconciling items to include in the April 30 bank reconciliation. If one of the March outstanding cheques had not been paid by the bank in April, it would be subtracted as an outstanding cheque from the unreconciled bank balance on the bank reconciliation.
2. The cash payments listed in BDCC's accounting records are compared to the cheques on the bank statement. This comparison indicates that the following cheques are outstanding.
Cheque No. Amount
606 \$ 287
607 1,364
608 100
609 40
610 1,520
Outstanding cheques must be deducted from the bank statement's unreconciled ending cash balance of \$24,023 as shown in Figure 6.3.
Step 4
Other payments made by the bank are identified on the bank statement and subtracted from the unreconciled book balance on the bank reconciliation.
1. An examination of the April bank statement shows that the bank had deducted the NSF cheque of John Donne for \$180. This is deducted from the unreconciled book balance on the bank reconciliation as shown in Figure 6.3.
2. An examination of the April 30 bank statement shows that the bank had also deducted a service charge of \$6 during April. This amount is deducted from the unreconciled book balance on the bank reconciliation as shown in Figure 6.3.
Step 5
Last month's bank reconciliation is reviewed for outstanding deposits at March 31. There were no outstanding deposits at March 31. If there had been, the amount would have been added to the unreconciled bank balance on the bank reconciliation.
Step 6
The deposits shown on the bank statement are compared with the amounts recorded in the company records. This comparison indicates that the April 30 cash receipt amounting to \$1,000 was deposited but it is not included in the bank statement. The outstanding deposit is added to the unreconciled bank balance on the bank reconciliation as shown in Figure 6.3.
Step 7
Any errors in the company's records or in the bank statement must be identified and reported on the bank reconciliation.
An examination of the April bank statement shows that the bank deducted a cheque issued by another company for \$31 from the BDCC bank account in error. Assume that when notified, the bank indicated it would make a correction in May's bank statement.
The cheque deducted in error must be added to the bank statement balance on the bank reconciliation as shown in Figure 6.3.
Step 8
Total both sides of the bank reconciliation. The result must be that the book balance and the bank statement balance are equal or reconciled. These balances represent the adjusted balance.
The bank reconciliation in Figure 6.3 is the result of completing the preceding eight steps.
Figure 6.3 BDCC's April Bank Reconciliation
Step 9
For the adjusted balance calculated in the bank reconciliation to appear in the accounting records, an adjusting entry(s) must be prepared.
The adjusting entry(s) is based on the reconciling item(s) used to calculate the adjusted book balance. The book balance side of BDCC's April 30 bank reconciliation is copied to the left below to clarify the source of the following April 30 adjustments.
It is common practice to use one compound entry to record the adjustments resulting from a bank reconciliation as shown below for BDCC.
Once the adjustment is posted, the Cash general ledger account is up to date, as illustrated in Figure 6.4.
Figure 6.4 Updated Cash Account in the General Ledger
Note that the balance of \$21,743 in the general ledger Cash account is the same as the adjusted book balance of \$21,743 on the bank reconciliation. Big Dog does not make any adjusting entries for the reconciling items on the bank side of the bank reconciliation since these will eventually clear the bank and appear on a later bank statement. Bank errors will be corrected by the bank. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.06%3A_Appendix_A-_Review_of_Internal_Controls_Petty_Cash_and_Bank_Reconciliations.txt |
LO 1: Describe cash and receivables, and explain their role in accounting and business.
Companies usually have significant amounts of accounts receivable and the time frame and effort required to convert receivables to cash is a cycle that calls for regular monitoring for which financial reporting plays a significant role. Cash and receivables are financial assets defined as cash or a contractual right to receive cash or another financial asset from another entity. Cash and receivables are also monetary assets because they represent a claim to cash where the amount is fixed by contract.
Cash and receivables need to be kept in balance for the company to be financially stable. Too many accounts receivable may mean a substandard credit policy, resulting in significant uncollectible accounts. Too few accounts receivable could be an indication that the company's credit policy is too restrictive, resulting in missed sales opportunities. Effective cash management is essential to ensure that any surplus cash is invested appropriately to maximize interest income and to minimize any bank loans and other borrowings.
LO 2: Describe cash and cash equivalents, and explain how they are measured and reported.
Cash is the most liquid asset and if unrestricted is usually classified as a current asset. Cash consists of coins, currency, bank accounts and petty cash funds, and negotiable instruments such as money orders, cheques, and bank drafts. Temporary same-bank overdrafts are usually netted with the current cash balance. Foreign currencies are reported in Canadian dollars as at the balance sheet date. Cash balances set aside for long-term purposes, such as a plant expansion project or long-term debt retirement, are classified long-term assets. Legally restricted or compensating balances are reported separately as current or non-current assets depending on the classification of the account it is supporting.
Cash equivalents are short-term, highly liquid assets with maturities no longer than three months (or ninety days) at acquisition that can be converted into known amounts of cash. Cash equivalents are usually combined with cash and reported in a single cash and cash equivalents account on the balance sheet. Examples are treasury bills, money market funds, short-term notes receivable, and guaranteed investment certificates (GICs).
LO 3: Describe receivables, identify the different types of receivables, explain their accounting treatment, and prepare the relevant journal entries.
Receivables are claims held against customers and debtors that are contractual rights with a legal claim to receive cash or other financial assets. They can be classified as current or long-term and are initially reported at their fair value. Subsequently they are measured at amortized cost. Categories include trade (accounts) receivable, notes receivable, and non-trade receivables.
Accounts receivable are usually collected within one year, so the interest component is not significant. Measurement in lieu of fair value is net realizable value. This is equivalent to the transaction value on the date the credit sale initially occurred and adjusted by any trade or sales discounts, sales returns, and allowances. Subsequent measurement is at cost (in lieu of amortized cost, since there is no interest component to amortize). Accounts receivable are affected by credit risk which may result in impairment of the accounts thereby reducing their net realizable value. This requires estimating an amount for uncollectible accounts that can be recorded to a valuation account called an allowance for doubtful accounts (AFDA). The AFDA is a contra account to accounts receivable and the net of the two accounts is intended to reflect the accounts receivable's net realizable value. The calculations to estimate uncollectible accounts will be completed at each reporting date using either a percentage of accounts receivable, percentages applied to the accounts receivable aging report, a percentage of credit sales, or a mix of these methods. Whenever an actual account is deemed uncollectible, it is written-off by removing it from the accounts receivables and AFDA accounts.
Notes receivable are a written promise to pay a specific sum of money on demand or on a defined future date. Payments can be a single lump sum at maturity, a series of payments, or a combination of both. Notes may be referred to as interest bearing or non-interest-bearing, even though there is always an interest component that must be recognized. For interest-bearing notes, the interest paid is equal to the stated interest rate on the note. For non-interest-bearing notes, the interest paid is the difference between the amount lent (proceeds) and the (higher) amount paid at maturity. Notes may be classified as short-term (less than twelve months) or long-term. Notes are initially measured at their fair value including transaction fees on the date that the note is legally executed. For short-term notes, since the effects of the discounted cash flows are insignificant, the net realizable value is used to approximate fair value. For long-term notes, fair value is equal to the present value of the expected future cash flows discounted by the market rate at the time of note issuance. After issuance, long-term notes receivable are measured at amortized cost, which allocates the interest income and discount or premium, if any, over the term of the note. For ASPE, either the effective interest rate method or the straight-line method can be used for amortization purposes. For IFRS, the effective interest rate method is to be used.
Non-trade receivables are amounts due for item such as income tax refunds, GST/HST receivable, amounts due from the sale of assets, insurance claims, advances to employees, amounts due from officers of the company, or dividends receivable.
To shorten the cycle of receivables to cash, companies can arrange for a borrowing (loan) from a financial institution (using the receivables as collateral) or as a sale of the receivables to another entity for cash. Sales can be either factoring or securitization. Factoring involves a financial intermediary (factor), such as a finance company that purchases the receivables and collects from the customers. Securitization is more complex; it involves a special purpose entity or vehicle (SPV) set up by a financial institution that purchases the receivables from the transferor using proceeds obtained from selling debt instruments to investors. These debt instruments are secured by the receivables received from the transferor. Companies selling receivables may or may not have continuing involvement regarding the transferred receivables. The issue becomes whether the transfer should be treated as a secured borrowing or a sale. For IFRS, receivables are treated as a sale if the risks and rewards have substantially been transferred. This is evidenced by the contractual rights to cash flows being transferred or the company continues to collect but immediately passes the proceeds on to the entity that purchased the receivables. As well, the company cannot sell or pledge the receivables to any other party. For ASPE, the focus is on control of the receivables. Three conditions must be met for control to occur and for receivables to be treated as a sale.
IFRS disclosures of receivables involve levels of significance and the nature and extent of the risks arising from them and how these risks are managed. Separate reporting is required for:
• trade accounts receivable from non-trade accounts
• current accounts receivable from non-current
• disclosures of any impairments or reversals of impairments
• details regarding any allowance accounts.
Other disclosures require details about the carrying amounts such as fair values, amortized costs or costs where applicable, and methods used for estimating uncollectible accounts. For long-term receivables, the amounts and maturity dates are to be disclosed. Information about any assets pledged or held as collateral is to be disclosed. Extensive disclosures are required for any securitization or transfers of receivables. Various types of risks such as credit, liquidity and market risks are to be disclosed. Companies following ASPE require less disclosure than IFRS companies.
LO 4: Identify the different methods used to analyze cash and receivables.
Cash and receivables are analyzed using various techniques to determine the levels of risk for uncollectible accounts as well as the company's overall liquidity or solvency. The statement of cash flows provides information about the sources and uses of cash. Receivables can be analyzed using accounts receivable aging reports, trendline analysis, and various ratio analyses such as quick and current ratios, accounts receivable turnover ratios, and days' sales uncollected.
LO 5: Explain the differences between IFRS and ASPE for recognition, measurement, and reporting for cash and receivables.
For the most part, the IFRS and ASPE standards are similar. The differences between IFRS and ASPE arise regarding: 1) what is recognized as cash equivalents; 2) the method used to amortize interest, premiums, or discounts for long-term receivables; 3) the criteria needed for treatment as either a sale of receivables or as a secured borrowing; and 4) both the nature and extent of disclosing requirements for cash and receivables on the balance sheet.
6.08: References
Apple Inc. (2013). Annual report for the fiscal year ended September 28, 2013. Retrieved from http://files.shareholder.com/downloads/AAPL/3038213857x0x701402/a406ad58-6bde-4190-96a1-4cc2d0d67986/AAPL_FY13_10K_10.30.13.pdf
CPA Canada. (2016). CPA Canada Handbook. Toronto, ON: CPA Canada.
IFRS. (2015). International Financial Reporting Standards 2014. London, UK: IFRS Foundation Publications Department.
International Accounting Standards. (2017). IFRS 9–Financial Instruments. Retrieved from http://www.iasplus.com/en/standards/ifrs/ifrs9
Jobst, A. (2008). What is securitization? Finance & Development, 45(3), 48–49. Retrieved from http://www.imf.org/external/pubs/ft/fandd/2008/09/basics.htm | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.07%3A_Chapter_Summary.txt |
6.1 Below is a list of various items. For each item, determine the amount that should be reported as cash or cash equivalent. For all other items, identify the proper disclosure.
1. Chequing account balance \$600,000
2. Short-term (60-day) treasury bills \$22,000
3. Cash advance received from a customer \$2,670
4. Cash advance of \$5,000 to company executive, payable on demand
5. Refundable deposit of \$13,000 paid to developer to guarantee performance on a construction contract
6. Cash restricted for future plant expansion \$545,000
7. Certificate of deposit \$575,000, maturing in nine months
8. Utility deposit paid to utility company \$500
9. Cash advance to subsidiary \$100,000
10. Post-dated cheque from customer \$30,000
11. Cash restricted to maintain compensating balance requirement \$115,000, considered to be significant
12. Certified cheque from customer \$13,000
13. Postage stamps on hand \$1,115
14. Savings account balance \$545,000 and overdraft in special chequing account at same bank as normal chequing account \$25,000
15. Cash held in non-current bond sinking fund \$150,000
16. Petty cash fund \$1,200
17. Cash on hand \$13,000
18. Money-market balance at mutual fund with chequing privileges \$75,400
19. NSF cheque received from the bank for a customer \$8,000
6.2 Below is financial information for Overachiever Ltd. The company's year-end is December 31.
1. A commercial savings account with \$575,000 and a commercial chequing account with \$450,000 are held at First Royal Bank. There is also a bank overdraft of \$150,000 in a chequing account at the Lemon Bank. It is the only account held at the Lemon Bank.
2. The company must maintain a minimum cash balance of \$175,000 with First Royal Bank in order to retain its overdraft privileges.
3. A separate cash fund for \$2 million is restricted for the retirement of long-term debt.
4. There are five cash floats for retail operation cash registers for \$250 each.
5. Currency and coin on hand amount to \$15,000.
6. The petty cash fund has \$1,500.
7. The company has received a cheque dated January 18, 2021, in the amount of \$12,500 from a customer for an amount owing as at December 31.
8. The company has received a cheque dated January 12, 2021, in the amount of \$1,800 from a customer as payment in advance for an order placed on December 27. Goods will be delivered FOB destination on January 20, 2021.
9. There are cash advances for \$15,000 paid for executive travel to occur in the first quarter of next year. These travel advances will be recovered from the travel expense reports after they travel.
10. An employee owes \$2,300 that was borrowed from the company and will be withheld from his salary in January 2021.
11. The company has invested \$2.5 million in money market funds (with chequing privileges) maturing in 2 months at the Commercial Bank of British Columbia.
12. The company has a 180-day treasury bill for \$50,000. It was purchased on November 22.
13. The company has a 60-day treasury bill for \$18,000. It was purchased on December 15.
14. The company holds commercial paper for \$1.56 million from Ace Furniture Co., which is due in 145 days.
15. The company acquired 1,000 shares of Highland Ltd. for \$3 per share on July 31 and is holding them for trading. The shares are still on hand as at December 31 have a fair value of \$4.06 per share on December 31, 2020.
Required:
1. Prepare a partial statement of financial position (balance sheet) as at December 31, 2020, reporting any cash balances.
2. For any items not reported in (a) above, indicate the proper way to disclose them.
6.3 Amy Glitters Ltd. provides you with the following information about its accounts receivable at December 31, 2020:
Due from customers, of which \$30,000 has been pledged as security for a bank loan \$ 275,000
Instalment accounts due after December 31, 2021 50,000
Advances to employees 2,500
Advances to a related party (originated in 2015) 30,000
Overpayments made to a supplier 6,000
Required: Prepare a partial classified balance sheet at December 31, which is their year-end. Make the required disclosures in parentheses after the line item account.
6.4 From July 1 to August 30, 2020, Busy Beaver Ltd. completed the following transactions:
On July 1, Busy Beaver sold 40 computers at a unit price of \$3,000 to Heintoch Corp., terms 1/15, n/30. Average cost for these computers was \$1,500. Busy Beaver also paid the freight costs of \$3,200 cash. On July 5, Heintoch Corp. returned for full credit three damaged computers from the July 1 shipment. These were not returned to inventory. Heintoch agreed to pay the \$240 freight cost to return the computers to Busy Beaver. On July 10, Busy Beaver received payment from Heintoch for the full amount owed from the July transactions. On July 14, Busy Beaver purchased 50 computers on account from Correl Computers Ltd. for \$1,500 per unit plus freight for \$4,000. On July 17, Busy Beaver sold \$224,000 in computers and peripherals to Perkins Store, terms 1.5/10, n/30. Cost for these computers was \$112,000. On July 26, Perkins Store paid Busy Beaver for half of its July purchases. On August 30, Perkins Store paid Busy Beaver for the remaining half of its July purchases. Busy Beaver uses the perpetual inventory system.
Required:
1. Prepare the entries for Busy Beaver Computers Ltd., assuming the gross method is used to record sales and sales discounts.
2. Assume that Heintoch has access to a bank line of credit facility at a rate of 8%. Is it a good idea to pay within the discount period? Explain your answer using data from the question.
3. Prepare the entries for July and August, assuming Busy Beaver is an IFRS company that uses the net method to record sales and sales discounts. Also assume that on August 30 year-end, Busy Beaver estimates sales returns and allowances to be \$44,000 for the year just ended, which it considers to be significant. The unadjusted balance of its refund liability account prior to the July and August transactions was \$23,000 credit.
6.5 The following information is available for Inverness Ltd.'s second year in business:
• Opening merchandise inventory is \$35,000.
• Goods are marked to sell at 35% above cost.
• Merchandise purchased totalled \$600,000.
• Collections from customers are \$420,000.
• Ending merchandise inventory is \$225,000.
• Opening accounts receivable balance is \$0.
• Ending accounts receivable balance is \$85,000.
Required:
1. Estimate the ending accounts receivable that should appear in the ledger. Calculate any shortages, if any. Assume that all sales are made on account.
2. What controls can be put in place to prevent theft?
6.6 The trial balance before adjustment of Cyncrewd Inc. shows the following balances:
Dr. Cr.
Accounts receivable \$ 225,000
Allowance for doubtful accounts (AFDA) 2,340
Credit sales 375,000
Sales returns 35,000
Required:
1. Give the entry for bad debt expense for the current year assuming:
• The allowance should be 4% of gross accounts receivable.
• Historical records indicate that based on accounts receivable aging the following statistics apply:
Balance Percentage Estimated
to be Uncollectible
0–30 days outstanding \$141,000 1%
31–60 days outstanding 53,500 3%
61–90 days outstanding 10,500 8%
Over 90 days outstanding 20,000 14%
• Allowance for doubtful accounts is \$2,340, but it is a credit balance, and the allowance should be 2% of gross accounts receivable.
2. What could account for the unadjusted debit balance in the AFDA account for \$2,340?
6.7 At January 1, 2020, the credit balance of Reimer Corp.'s allowance for doubtful accounts was \$575,000. During 2020, the bad debt expense entry was based on a percentage of net credit sales. Net sales for 2020 were \$16 million, of which 75% were on account. Based on the information available at the time, the 2020 bad debt expense was estimated to be 1% of net credit sales. During 2020, uncollectible receivables amounting to \$40,000 were written off against the allowance for doubtful accounts. The company has estimated that at December 31, 2020, based on a review of the aged accounts receivable, the allowance for doubtful accounts would be properly measured at \$500,000.
Required:
1. Prepare a schedule calculating the balance in Reimer Corp.'s allowance for doubtful accounts at December 31, 2020. Prepare any necessary journal entry at year-end to adjust the allowance for doubtful accounts to the required balance.
2. If accounts receivable balance at December 31 was \$50,950,000, prepare a partial classified balance sheet at December 31, 2020 for Reimer. What is the net accounts receivable balance intended to measure?
3. Under what conditions is using the direct write-off method justified?
6.8 On May 1, 2020, Effix Ltd. provided services to Harper Inc. in exchange for Harper's \$336,000, five-year, zero-interest-bearing note. The implied interest is 8%. Effix's year-end is December 31.
Required:
1. Prepare Effix's entries for the note, the interest entries over the five years and the collection of the note at maturity.
2. Using present value calculations prove that the note yields 8%.
3. Prepare a partial classified balance sheet as at December 31, 2021. What would be the unamortized discount/premium, if any? How would the classification of the note receivable differ on the partial classified balance sheet as at December 31, 2024?
4. If an appropriate market rate of interest for the note receivable is not known, how should the transaction be valued and recorded on December 31, 2020?
6.9 Below are three unrelated scenarios:
1. On July 1, a one-year note for \$120,000 was accepted in exchange for an unpaid accounts receivable for \$120,000. Interest for 5% would be payable at maturity.
2. On July 1, a one-year non-interest-bearing note for \$110,250 was accepted in exchange for an unpaid accounts receivable for \$105,000. The market rate of interest at that time was 5%.
3. On July 1, a one-year 10% note for \$115,000 was accepted in exchange for unpaid accounts receivable \$104,545 from a higher-risk customer. The customer's borrowing interest rate at that time was 10%.
Required:
1. Prepare the entries to recognize the notes payable and accrued interest, if any. The year-end is December 31.
2. Assume that for item (iii) above, the borrower faces financial difficulties and can only pay 75% of the note's maturity amount. After a thorough analysis, the creditor determines that the 25% remaining is uncollectible. Prepare the entry for the note at maturity.
6.10 On January 1, Harrison Corp. sold used vehicles with a cost of \$78,000 and a carrying amount of \$12,600 to Aberdeen Ltd. in exchange for a \$18,000, four-year non-interest-bearing note receivable. The market rate of interest for a note of similar risk is 7.5%. Harrison follows IFRS and has a year-end of December 31.
Required:
1. Prepare the entries to record the sale of equipment in exchange for the note, the interest for the first year, and the collection of the note at maturity.
2. Prepare the interest entry for the first year assuming that Harrison follows ASPE and uses the straight-line method for interest.
6.11 On July 1, 2020, Helim Ltd. assigns \$800,000 of its accounts receivable to Central Bank of Tasmania as collateral for a \$500,000 loan that is due October 1, 2020. The assignment agreement calls for Helim to continue to collect the receivables. Central Bank assesses a finance fee of 3.5% of the accounts receivable, and interest on the loan is 7.5%, a realistic rate for a note of this type and risk.
Required:
1. Assuming the transaction does not qualify as a sale, prepare the July 1, 2020 journal entry for Helim Ltd.
2. Prepare the journal entry for Helim's collection of \$750,000 of the accounts receivable during the period July 1 to September 30, 2020.
3. On October 1, 2020, Helim paid Central Bank the entire amount that was due on the loan.
4. Explain the differences between IFRS and ASPE regarding the sale of receivables compared to a secured borrowing.
5. Explain if management would prefer the transaction to be reported as a sale of receivables or a secured borrowing and why.
6.12 Browing Sales Ltd. sells \$1,450,000 of receivables with a fair value of \$1,500,000 to Finnish Trust in a securitization transaction that meets the criteria for a sale. Browing receives the full fair value of the receivables and agrees to continue to service them. The fair value of the service liability component is estimated as \$250,000.
Required: Prepare the journal entry for Browing to record the sale.
6.13 Jertain Corporation factors \$800,000 of accounts receivable with Holistic Financing Inc. on a with recourse basis. Holistic Financing will collect the receivables. The receivable records are transferred to Holistic Financing on February 1, 2020. Holistic Financing assesses a finance charge of 2.5% of the amount of accounts receivable and also reserves an amount equal to 4% of accounts receivable to cover probable adjustments. Jertain prepares financial statements under ASPE and has a year-end of December 31.
Required:
1. Assuming that the conditions for a sale are met, prepare the journal entry on February 1, 2020, for Jertain to record the sale of receivables, assuming the recourse obligation has a fair value of \$10,000.
2. What effect will the factoring of receivables have on calculating the accounts receivable turnover for Jertain?
6.14 On July 1, 2020, Brew It Again Ale Co. sold excess land in exchange for a three-year, non-interest-bearing promissory note in the face amount of \$530,000. The land's carrying value is \$250,000.
On September 1, Brew It Again Ale rendered services in exchange for a six-year promissory note having a face value of \$500,000. Interest at a rate of 3% is payable annually.
For both transactions, the customers are able to borrow money at 11% interest. Brew It Again Ale's cost of capital is 7.4%.
On October 1, 2020, Brew It Again Ale agreed to accept an instalment note from one if its customers, in partial settlement of accounts receivable that were overdue. The note calls for five equal payments of \$12,000, including the principal and interest due, on the anniversary of the note. The implied interest rate on this note is 12%.
Required:
1. Prepare the journal entries to record the three notes receivable for Brew It Again Ale Co. for 2020 fiscal year.
2. Prepare an effective-interest amortization table for the instalment note obtained in partial collection of accounts receivable. Brew It Again Ale's year-end is December 31. Prepare the year-end journal entry and the first cash payment entries for the first year.
3. From Brew It Again Ale's perspective, what are the advantages of an instalment note compared with a non-interest-bearing note?
6.15 The following information below relates to Corvid Company for 2020:
• The beginning of the year net Accounts Receivable balance was \$123,000.
• Net sales for the year were \$1,865,000. Credit sales were 54.8% of the total sales and no cash discounts are offered.
• Collections on accounts receivable during the year were \$863,260, and uncollectible accounts written off in 2020 were \$12,500. The AFDA account ending balance for 2020 needed no further adjustment for estimated uncollectible accounts at year-end.
Required:
1. Calculate Corvid Company's accounts receivable turnover ratio for the year. How old is the average receivable?
2. Use the turnover ratio calculated in part (a) to analyze Corvid Company's liquidity. The turnover ratio last year was 5.85.
6.16 Jersey Shores Ltd. sold \$1,250,000 of accounts receivable to Fast Factors Inc. on a without recourse basis. The transaction meets the criteria for a sale, and no asset or liability components of the receivables are retained by Jersey Shores. Fast Factors charges a 3.5% finance fee and retains another 5% of the total accounts receivable for estimated returns and allowances.
Required:
1. Prepare the journal entries for both companies.
2. Assume instead, that Jersey Shores follows ASPE and sells the accounts receivable with recourse. The recourse obligation has a fair value of \$7,400. Prepare the journal entries for the sale by Jersey Shores.
6.17 Opal Co. Ltd. transfers \$400,000 of its accounts receivable to an independent trust in a securitization transaction on July 11, 2020, receiving 95% of the receivables balance as proceeds. Opal will continue to manage the customer accounts, including their collection. Opal estimates this obligation has a fair value of \$14,000. In addition, the agreement includes a recourse provision with an estimated value of \$12,000. The transaction is to be recorded as a sale.
Required: Prepare the journal entry on July 11, 2020, for Opal Co. Ltd. to record the securitization of the receivables, assuming it follows ASPE. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/06%3A_Cash_and_Receivables/6.09%3A_Exercises.txt |
Too Much Inventory
BlackBerry Ltd. faced a rough week in late September 2013. Within a seven-day period, the company not only announced a potential buyer for the company but also reported a quarterly loss of close to a billion dollars. The loss was generated primarily by write-down of BlackBerry 10 handsets (BB 10), the company's new flagship product. Prior to this result, the company had been struggling to keep up with other smartphone competitors, and sales of the new phone had not met expectations. As a result of the news reported during this week, the company's share price fell over 20 percent on the market.
When the company reported its annual financial results for the year ended March 1, 2014, the gross profit on hardware sales was actually negative. In fact, it was – \$2.5 billion. How can a company report a negative gross profit? In BlackBerry's case, a further write-down of the BB 10 handset occurred in the third quarter, resulting in total write-downs for the year of approximately \$2.4 billion. As described in the company's Management Discussion and Analysis of Financial Condition report, evaluations of inventory require an assessment of future demand assumptions (BlackBerry Ltd., 2014). Sales of the new BlackBerry product were significantly lower than expected, resulting in a large number of unsold handsets. As the goal of financial reporting is to portray the economic truth of a company, BlackBerry Ltd. had no choice but to accept the reality that their inventory of BB 10 phones could not be sold for the amount reported on the balance sheet. The company described the causes of the write-down as these: the maturing smartphone market, very intense competition, and uncertainty created by the company's strategic review process.
Regardless of the causes, it was clear that this massive write-down had a profound effect on BlackBerry Ltd.'s financial results and share price. Although the write-down was a symptom of other deeper problems in the company, it is clear that management of inventory levels can be a significant issue for many businesses. For the accountant, understanding the importance of the reported inventory amount is paramount, and critically analyzing the valuation assumptions is essential to fair reporting of inventory balances.
(Sources: BlackBerry Ltd., 2014; Damouni, Kim & Leske, 2013)
Learning Objectives
After completing this chapter, you should be able to:
• Define inventory and identify those characteristics that distinguish it from other assets.
• Identify the types of costs that should be included in inventory.
• Identify accounting issues and treatments applied to inventory subsequent to its purchase.
• Describe the differences between periodic and perpetual inventory systems.
• Identify the appropriate criteria for selection of a cost flow formula and apply different cost flow formulas to inventory transactions.
• Determine when inventories are overvalued and apply the lower of cost and net realizable value rule to write-down those inventories.
• Describe the presentation and disclosure requirements for inventories under both IFRS and ASPE.
• Identify the effects of inventory errors on both the balance sheet and income statement and prepare appropriate adjustments to correct the errors.
• Calculate estimated inventory amounts using the gross profit method.
• Calculate gross profit margin and inventory turnover period and evaluate the significance of these results with respect to the profitability and efficiency of the business's operations.
• Identify differences in accounting for inventories between ASPE and IFRS.
Introduction
The nature of economic activity has been evolving rapidly over the last two decades. The knowledge economy is becoming an increasingly significant component of the world's gross domestic product. But even in the wired world of services and data, there is always a need for physical products. The concept of retail business may be changing through the development of online shopping, but consumers still expect to receive their goods eventually. This chapter will deal with some accounting issues surrounding the acquisition, production, and sale of inventory items, and it will discuss some of the problems that can arise when errors are made in the recording of inventory items.
07: Inventory
IFRS defines inventories as assets that are:
• held for sale in the ordinary course of business,
• in the process of production for such sale, and
• in the form of materials or supplies to be consumed in the production process or in the rendering of services (International Accounting Standards, n.d., 2.6).
The key feature of inventory is that it is held for sale in the normal course of business, which differentiates it from other tangible assets, such as property, plant, and equipment, that are only sold only when their productive capacity is exhausted or no longer required by the business. The definition also recognizes that for manufacturing businesses, inventory can take various forms throughout the production process. Raw materials, work in process, and finished goods are all considered inventory. For many businesses, inventory can represent a significant asset. In 2013, Bombardier Inc., a manufacturer of airplanes and trains, reported total inventory of \$8.2 billion, which represented over 28 percent of the company's total assets. In the same year, Loblaw Companies Ltd., a grocery retailer, reported total inventory of over \$2 billion.
It is not surprising that, given its significance, inventory can also be the source of various types of accounting problems. In 2014, BlackBerry had to write off approximately \$2.4 billion of its inventory due to slow sales resulting from competitive pressures. In a more troubling series of events, inventories of DHB Industries Inc., a manufacturer of body armour for the military and police, were overstated by approximately \$47 million in 2004. The accounting errors included the falsification of amounts included in work in process, and raw materials and a failure to write off significant amounts of obsolete raw materials. These accounting errors led to a Securities and Exchange Commission (SEC) investigation and penalties. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/07%3A_Inventory/7.01%3A_Definition.txt |
An obvious question that arises when considering inventory is, what costs should be included? In answering this question, IFRS has provided some general guidance: the cost of inventories shall include all costs of purchase, costs of conversion, and "other costs incurred in bringing the inventories to their present location and condition" (International Accounting Standards, n.d., 2.10).
Costs of Purchase
Purchase costs include not only the direct purchase price of the goods but also the costs to transport the goods to the company's premises and any nonrecoverable taxes or import duties paid on the purchase. As well, any discounts or rebates earned on the purchase should be deducted from the cost of the inventory.
One issue that often needs to be considered when determining inventory costs at the end of an accounting period is the matter of goods in transit. Goods may be shipped by a seller before the end of an accounting period but are not received until after the end of the purchaser's accounting period. The question of who owns the goods while they are in transit obviously needs to be addressed. More specifically, three issues arise from this question:
1. Who pays for the shipping costs?
2. Who is responsible for the loss if goods are damaged in transit?
3. When should the transfer of ownership be recorded in the accounting records?
To answer these questions, the legal term free on board (FOB) needs to be understood. When goods are shipped by a seller, the invoice will usually indicate that the goods are shipped either FOB shipping or FOB destination. If the goods are FOB shipping, the purchaser is assuming legal title as soon as the goods leave the seller's warehouse. This means the purchaser is responsible for shipping costs as well as for any damage that occurs in transit. As well, the purchaser should record these goods in his or her inventory accounts as soon as they are shipped, even if they don't arrive until after the end of the accounting period. If the goods are FOB destination, the purchaser is not assuming ownership of the goods until they are received. This means that the seller would be responsible for shipping costs and any damage that occurs in transit. As well, the purchaser should not include these goods in his or her inventory until they are actually received. Likewise, the seller would still include the goods in his or her inventory until they are actually delivered to the purchaser. Accountants and auditors pay close attention to the FOB terms of purchases and sales near the fiscal period end, as these terms can affect the accurate recording of the inventory amount on the balance sheet.
Costs of Conversion
Another more complex issue arises in the determination of the cost of manufactured inventories. As noted above, IAS 2-10 requires the inclusion of costs to convert inventories into their current form. For a manufacturing company, this means that inventories will include raw materials, work in progress, and finished goods. For raw materials, the cost is fairly easy to determine. However, for work in progress and finished goods, the determination of which costs to include becomes more complicated. Although labour and variable overhead costs, such as utilities consumed by operating factory machines, are fairly easy to associate directly with the production of a product, the treatment of other fixed overhead costs is not as clear. It can be argued that costs such as factory rent should not be included in the inventory cost because this cost will not vary with the level of production. However, it can also be argued that without the payment of rent, the production process could not occur. For management accounting purposes, a variety of methods are used to account for overhead costs. For financial accounting purposes, however, it is clear that all conversion costs need to be included in inventory. Thus, the financial accountant will need to determine the best way to allocate fixed overhead costs. In normal circumstances, the fixed overhead costs are simply allocated to each unit of inventory produced in an accounting period. However, if production levels are significantly higher or lower than normal levels, then the accountant needs to apply some judgment to the situation. If fixed overhead costs are applied to very low levels of production, the result would be inventory that is carried at a value that may be higher than its realizable value. For this reason, fixed overhead costs should be allocated to low production volumes using the rate calculated on normal production levels, with unallocated overhead being expensed in the period. This is done to avoid reporting misleadingly high inventory levels. On the other hand, if abnormally high production occurs, the fixed overhead costs are allocated using the actual production level. This would result in lower per-unit costs for the inventory produced. This situation could result in higher profits, as presumably some of the excess production would be held in inventory at the end of the year. A manager may be tempted to increase production strictly for the purpose of increasing current earnings. Although this does not violate any accounting standard, the accountant should be careful in this situation, as there may be a risk of obsolete inventory as a result of the overproduction, or there may be other forms of income-maximizing earnings management occurring.
Other Costs
IAS 2–15 indicates that other costs can be included in inventory only to the extent "they are incurred in bringing the inventories to their present location and condition." The standard provides examples such as certain non-production overhead costs or product-design costs for specific customers. Clearly, the accountant would need to exercise judgment in allocating these kinds of costs to inventory. The standard also clearly defines some costs that should not be included in inventories but rather expensed in the current period. These costs include the following:
• Abnormal amounts of wasted materials, labour, or other production costs
• Storage costs, unless those costs are necessary in the production process before a further production stage
• Administrative overheads that do not contribute to bringing inventories to their present location and condition
• Selling costs
As well, IAS 23–Borrowing Costs describes some limited and specific circumstances when interest costs can be included in inventory. IAS 2-19 also discusses inventory of a service provider. An example of this would be a professional services firm, such as an accounting practice. These types of firms will often track work in progress on their balance sheets. These accounts should include only direct costs (which would primarily consist of direct and supervisory labour) and attributable overheads. These costs should not include the costs of any administrative or sales personnel or other non-attributable overheads, nor should they include any mark-ups on costs that might be included in standard charge rates for customers. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/07%3A_Inventory/7.02%3A_Initial_Recognition_and_Measurement.txt |
Once the initial inventory amounts have been determined and recorded, a number of subsequent accounting decisions need to be made. These decisions can be summarized in the following questions:
• What type of inventory accounting system should be used?
• What cost flow assumption should be applied?
• What method can be applied to ensure reported inventories are not overvalued?
We will examine each of these issues in the following sections.
7.03: Subsequent Recognition and Measurement
A merchandising business can typically be engaged in thousands or millions of inventory transactions each year. As well, inventory can comprise a significant proportion of a merchandising company's total assets. It is thus important for merchandising businesses to have robust and accurate systems in place for gathering data on inventory transactions. The use of various technologies, such as computers, bar codes, and RFIDs, has simplified the complex task of gathering inventory transaction information. The use of such technologies has allowed most businesses to implement perpetual inventory systems as their data-collection method. A perpetual inventory system is one that tracks all inventory additions and subtractions (purchases and sales) directly in the accounting records. Thus, at any point in time, the company can produce an accurate income statement and balance sheet that will display the amount of the cost of goods sold for the period and inventory balance at the end of the period. This type of system provides more timely information to managers, which can lead to better decision processes.
A periodic inventory system, on the other hand, does not track purchases and sales of inventory items directly in the accounting records. Rather, purchases are tracked through a separate purchases account, and the cost of goods sold is not recorded at all at the time of sale. The cost of goods sold can be determined only at the end of the accounting period, when a physical inventory count is taken, and the ending inventory is then reconciled with the opening inventory. This type of system is less useful for management purposes, as profitability can be determined only at the end of the accounting period. As well, the balance sheet would not reflect the appropriate inventory balance until the period-end reconciliation is performed. Periodic inventory systems may be appropriate for a small business where accounting resources are limited, but improvements in technology have resulted in many businesses switching to perpetual inventory systems.
Note that although a perpetual inventory system does result in an instantaneous update of inventory accounts, physical inventory counts are still required under this system. There are many situations, such as product spoilage or theft, that are not captured by perpetual inventory systems, so it is important that companies employing these systems still physically verify the goods at least once per year.
7.3.02: Cost Flow Assumptions
The issue of cost flow assumptions can become particularly important when prices of inventory inputs are changing. Consider a merchandising company that purchases inventory items on a continuous basis in order to fill customer orders. At any given point during the accounting period, the goods available for sale may consist of identical items that were purchased at different times for different costs. The question the accountant must answer is, which costs should be allocated to the current cost of goods sold and which costs should continue to be held in inventory? To answer this question, the accountant can choose from three possible methods:
• Specific identification
• Weighted average cost
• First in, first out
Specific Identification
This technique is theoretically the most correct way to allocate costs. Each unit that is sold is specifically identified, and the cost for that unit is allocated to cost of goods sold. This method would thus achieve the perfect matching of costs to the revenue generated. There are, however, some disadvantages to this method. First, unless items are easy to physically segregate, it may difficult to identify which items were actually sold. As well, although physical segregation may be possible, this method could be expensive to implement, as a great deal of record keeping is required. The second disadvantage of this method is its susceptibility to earnings-management techniques. If a manager wanted to manipulate the current period net income, he or she could do this very easily using this method by simply choosing which items to sell and which to retain in inventory. Lower cost items could be shipped to customers, which would result in lower cost of goods sold, higher profits, and higher inventory values on the statement of financial position. Because of this potential problem, this technique should be applied only in situations where inventory items are not normally interchangeable with each other. An example of this would be the inventory held by a car dealership. Each item would have a separate serial number and could not be substituted for another item.
Average Cost
This technique can be applied to either periodic or perpetual inventory systems by calculating the average of all goods available for sale and then allocating the average to both the quantity of goods sold and the quantity of goods retained in inventory. When this technique is applied to a perpetual inventory system, it is usually referred to as a moving average cost. An example of a moving average cost calculation is as follows:
The following transactions occurred in the month of May for PartsPeople Inc.
May 1 Opening inventory 300 units @ \$3.00
May 3 Purchase 100 units @ \$3.20
May 7 Purchase 200 units @ \$3.25
May 11 Sale 150 units
May 22 Purchase 250 units @ \$3.30
May 25 Sale 375 units
May 31 Ending inventory 325 units
Inventory and cost of goods sold would be calculated as follows:
Date Purchase Cost of Balance Moving Balance of
Goods Sold Average1 Units
May 1 300 \$3.00 = \$3.0000 300
\$900.00
May 3 100 (300 \$3.00) + \$3.0500 400
\$3.20 (100 \$3.20) =
\$1,220.00
May 7 200 (300 \$3.00) + \$3.1167 600
\$3.25 (100 \$3.20) +
(200 \$3.25) =
\$1,870.00
May 11 150 \$3.1167 450 \$3.1167 = \$3.1167 450
= \$467.50 \$1,402.50
May 22 250 (450 \$3.1167) + \$3.1821 700
\$3.30 (250 \$3.30) =
\$2,227.50
May 25 375 \$3.1821 325 \$3.1821 = \$3.1821 325
= \$1,193.30 \$1,034.20
The total cost of goods sold for the period is , and the ending inventory balance is \$1,034.20. Under this approach, the average inventory cost is recalculated after each purchase, and this revised average cost is then used to determine the cost of goods sold when a sale is made. After a sale is made, the revised average cost becomes the new base amount for further inventory transactions until the next purchase occurs, and a new average is determined.
This method is often used due to its simplicity and reliability. It is very difficult for managers to manipulate income with this method, as the effects of rising or falling prices will be averaged over both the goods sold and the goods remaining on the balance sheet. As well, for goods that are similar and interchangeable, this method may most closely represent the actual physical flow of those goods.
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First in, First out (FIFO)
Another cost-flow choice companies can use is referred to as the first in, first out method, usually abbreviated as FIFO. This method allocates the oldest costs to goods sold first, with newer costs remaining in the inventory balance. Assume the same set of facts for PartsPeople Inc. used in the previous example. Under FIFO, each time a sale occurs, the oldest items are removed from inventory first. The calculation of costs and inventory amounts would be done as follows:
Date Purchase Sale Balance Balance of
Units
May 1 300 \$3.00 = 300
\$900.00
May 3 100 \$3.20 (300 \$3.00) + 400
(100 \$3.20) =
\$1,220.00
May 7 200 \$3.25 (300 \$3.00) + 600
(100 \$3.20) +
(200 \$3.25) =
\$1,870.00
May 11 150 \$3.00 = (150 \$3.00) + 450
\$450.00 (100 \$3.20) +
(200 \$3.25) =
\$1,420.00
May 22 250 \$3.30 (150 \$3.00) + 700
(100 \$3.20) +
(200 \$3.25) +
(250 \$3.30) =
\$2,245.00
May 25 (150 \$3.00) + (75 \$3.25) + 325
(100 \$3.20) + (250 \$3.30) =
(125 \$3.25) = \$1,068.75
\$1,176.25
In this case, the total ending inventory balance of \$1,068.75 is higher than the balance calculated under the moving average cost system. This makes sense, as FIFO inventory balances represent the most recent purchases, and in this scenario, input costs were rising throughout the month. This feature of FIFO is considered one of its strengths, as the method results in balance-sheet amounts that more closely represent the current replacement cost of the inventory. Also note that the total cost of goods sold of \$1,626.25 is lower than moving average amount. This also makes sense, as older costs, which are lower in this case, are being expensed first. This characteristic of FIFO is also one of its major drawbacks. The method of expensing older costs first means that proper matching is not being achieved, as current revenues are being matched to older costs. This method thus represents a trade-off common in accounting standards. A more relevant balance sheet results in a less relevant income statement. Moving average, on the other hand, averages out the differences between the balance sheet and income statement, resulting in some loss of relevance for both statements. As both methods are acceptable under IFRS and ASPE, management would have to decide which statement is more important to the end users and then choose a policy accordingly.
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How to Choose?
When making an inventory cost flow assumption, what factors do managers need to consider? Generally, the cost flow assumption should attempt to reflect the actual physical flow of goods as much as possible. For example, a grocery retailer selling perishable merchandise may want to use FIFO, as it is common practice to place the oldest items at the front of the rack to encourage their sale first. Alternatively, consider a hardware store that sells bulk nails that are scooped from a bin. There is no way to identify the individual items specifically, and it is likely that over time, customers scooping out nails would mix together items stocked at different times. Weighted average costing would make the most sense in this case, as this would likely represent the real movement of the product. For a company selling heavy equipment, specific identification would likely make the most sense, as each item would be unique with its own serial number, and these items can be easily tracked.
A further consideration would be the effects on the income statement and balance sheet. FIFO results in the inventory reported on the balance being reported at more current costs. As there is an increasing emphasis in standard setting on valuation concepts, this approach would result in the most useful information for determining the value of the company. If profitability is more important to a financial-statement reader, then weighted average cost would be more useful, as more current costs would be averaged into income.
Income taxes may also be a consideration when choosing a cost flow formula. This motivation must be considered carefully, however, as income will be affected in opposite ways, depending on whether input prices are rising or falling. As well, although taxes could be reduced in any given year through the cost flow assumption made, this is only a temporary effect, as all inventory will eventually be expensed through cost of goods sold.
Whatever method is chosen, it should be applied on a consistent basis. It would be inappropriate for a company to change cost flow assumptions year to year, simply to achieve a certain result in net income. Once the cost flow assumption is determined, it should be applied the same way each year, unless there has been a significant change in circumstances that warrants a change. A company may use different cost flow assumptions for different major inventory classes, but these choices should still be applied consistently.
As a historical note, a further cost flow assumption, last in, first out (LIFO), was once available for use. This method took the most recent purchases and allocated them to the cost of the goods sold first. LIFO is now not allowed in Canada under IFRS or ASPE, but it is still used in the United States. Although this method resulted in the most precise matching on the income statement, tax authorities criticized it as way to reduce taxes during periods of inflation. As well, it was more easily manipulated by management and did not result in accurate valuations on the balance sheet. Canadian companies that are allowed to report under US GAAP may still use this method, but it is not allowed for tax purposes in Canada. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/07%3A_Inventory/7.03%3A_Subsequent_Recognition_and_Measurement/7.3.01%3A_Inventory_Accounting_Systems.txt |
Overvaluation can occur when inventory is reported at a higher value than the ultimate amount that can be recovered. This happens with changes in market conditions or consumer tastes, or it happens for other reasons. If a particular product loses favour with the market and must be severely discounted or even disposed of, it would not be appropriate to continue to carry that item on the balance sheet at its cost when that cost is not recoverable. To avoid this problem, the lower of cost and net realizable value (LCNRV) needs to be applied. Under this approach, inventory values are reduced to their recoverable amounts in order to ensure that current assets are not stated at an amount greater than the ultimate amount of cash that will be realized from their sale. This also results in recording an expense equal to the loss in value of the asset, which achieves the effect of matching the cost to the period in which the loss actually occurs. For example, if an inventory item has a reported cost of \$1,000 but a net realizable value of only \$800, the company should record the following journal entry:
Most companies will simply report the loss as part of the cost of goods sold account on the income statement. Separate disclosure may be appropriate, however, if the amount is considered material or unusual in nature.
What Is Net Realizable Value?
When determining the loss in inventory value, it is important to have a clear understanding of the concept of net realizable value (NRV). Net realizable value is an estimate based on the expected selling price of the goods in the ordinary course of business, less any estimated costs required to complete and sell the goods. It thus represents the net cash flow that will ultimately be generated by the sale of the product. Because the net realizable value is an estimate, it can be affected by management estimation bias and by changes in economic circumstances. As a result, write-downs of inventories need to be reviewed carefully and frequently by accountants to ensure the reported amounts are reasonable.
How Is the Lower of Cost and Net Realizable Test Applied?
In general, the lower of cost and net realizable test should be applied to the most detailed level possible. This would normally be considered to be individual inventory items. However, in some situations, it may be appropriate to group inventory items together and apply the test at the group level. This would be appropriate only when items relate to the same product line, have similar end uses, are produced and marketed in the same geographic area, and cannot be segregated from other items in the product line in a reasonable or cost-effective way. If grouping is appropriate, the amount of inventory write-downs will be less than if the test is applied on an individual-item basis. This occurs because grouping allows for some offsetting of over- and undervalued items.
Biological Assets
One interesting exception to the lower of cost and net realizable value rule is accounting for biological assets. Although ASPE does not specifically address these types of assets, IFRS does present a separate standard: IAS 41 Agriculture. This standard covers raising and harvesting living plants and animals. The biological assets are considered the original source of the commercial activity, such as the fruit tree that produces apples, the sheep that produces wool, or the dairy cow that produces milk. The detailed accounting for these specialized assets goes beyond the scope of this course. Generally, the product of the biological asset would fall under the normal rules for inventory accounting, but the biological asset itself is accounted for at its fair value, less selling costs. This means that every year, the value of the biological-asset must be determined, and an adjustment to the assets carrying value must be made. This adjustment would result in an unrealized gain or loss. As the inventory is produced, it is transferred from the biological-asset account to an inventory account at its fair value less selling costs at the point of harvest. This value now becomes the inventory's cost. When inventory is sold, the sale amount is transferred from the unrealized account to realized revenue.
Conceptually, these types of assets are similar in nature to a capital asset, but they are also different in that they grow and obtain value independent of the inventory they produce. This unique nature is the reason IFRS presents a separate standard for the accounting and disclosure of biological assets.
7.04: Presentation and Disclosure
Inventories are required to be disclosed as a separate item on the company's balance sheet. As well, significant categories of inventories should be disclosed, such as raw materials, work in process, and finished goods. As with any significant balance sheet item, the company's accounting policies for measuring and reporting inventories, including its chosen cost formula, should be disclosed. The company should also disclose the amount of inventories recognized as an expense during the period. This would normally be disclosed as cost of goods sold, but there may be other material amounts that could be disclosed separately, such as write-downs due to obsolescence and subsequent reversals of those write-downs. As well, under IFRS, additional details of the write-downs need to be disclosed, such as qualitative reasons for the write-downs or subsequent reversal. If the inventory has been pledged as collateral for any outstanding debt, this fact needs to be disclosed, along with the amount pledged. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/07%3A_Inventory/7.03%3A_Subsequent_Recognition_and_Measurement/7.3.03%3A_The_Problem_of_Overvaluation.txt |
Given the volume of inventory transactions that occur in a merchandising or manufacturing business and the portable nature of many inventory items, it is inevitable that errors in accounting for those items will occur. It is important to understand how inventory errors affect the reported net income and financial position of the company, as these errors could be material and could affect users' interpretations of financial results. To understand the effects of inventory errors, it is useful to review the formula for determining the cost of goods sold:
Opening inventory
+ Purchases
= Goods available for sale
– Ending inventory
= Cost of goods sold
As the ending inventory for one accounting period becomes the opening inventory for the next period, it is easy to see how an inventory error can affect two accounting periods. Let's look at a few examples to determine the effects of different types of inventory errors.
Example 1: Using our previous company, assume PartsPeople missed counting a box of rotors during the year-end inventory count on December 31, 2019, because the box was hidden in a storage room. Further assume that the cost of these rotors was \$7,000 and that the invoice for the purchase was correctly recorded. How would this error have affected the financial statements? If we consider the cost of goods sold formula above, we can see that understating ending inventory would have overstated the cost of goods sold, as the ending inventory is subtracted in the formula. As well, consider the following year. The opening inventory on January 1, 2020, would have also been understated, which would have resulted in an understatement of cost of goods sold for 2020. Thus, over a two-year period, net income would have been understated by \$7,000 in 2019 and overstated by \$7,000 in 2020. At the end of two years, the error would have corrected itself, and the total income reported for those two years would be correct. However, the allocation of income between the two years was incorrect, and the company's balance sheet at December 31, 2019, would have been incorrect. This could be significant if, for example, PartsPeople had a bank loan with a covenant condition that required maintenance of certain ratios, such as debt to equity or current ratios. If the error were discovered prior to the closing of the 2019 books, it would have been corrected as follows:
If the error was not discovered until after the 2019 books were closed, it would have been corrected as follows:
After 2020, as noted above, the error would have corrected itself, so no adjustment would be required. However, the 2019 financial statements used for comparative purposes in future years would have to be restated to reflect the correct amounts of inventory and cost of goods sold.
Example 2: Suppose instead that PartsPeople correctly counted its inventory on December 31, 2019, but missed recording an invoice to purchase a \$4,000 shipment of brake pads, because the invoice fell behind a desk in the accounting office. Again, using our cost of goods sold formula, we can see that an understatement of purchases will result in an understatement of the cost of goods sold. As the ending inventory balance was counted correctly, one may think that this problem was isolated to this year only. However, in 2020, the vendor may have issued a replacement invoice when they realized PartsPeople hadn't paid for the shipment. When PartsPeople recorded the invoice in 2020, the purchases for that year would have been overstated, which means the cost of goods sold was also overstated. Again, the error corrected itself over two years, but the allocation of income between the two years was incorrect. If the error was discovered before the books were closed for 2019 (and before a replacement invoice is issued by the vendor), it would have been corrected as follows:
If the error was not discovered until after the 2019 books were closed, it would have been corrected as follows:
Example 3: This time, let's consider the effect of two errors. Assume PartsPeople sold goods to a customer with terms FOB shipping on December 29, 2019. The company correctly recorded this as a sale on December 29, but due to a data-processing error, the goods, with a cost of \$900, were not removed from inventory. Further, assume that a supplier sent a shipment to PartsPeople on December 29, also with the terms FOB shipping, and the cost of these goods was \$500. These goods were not received until January 4 of the following year, but due to poor cut-off procedures at PartsPeople, these goods were not included in the year-end inventory balance.
In this situation, we have two different errors that create opposing effects on the income statement and balance sheet. The goods sold to the customer should not have been included in inventory, resulting in an overstatement of year-end inventory. The goods shipped by the supplier should have been included in inventory, resulting in an understatement of year-end inventory. The net effect of the two errors is a overstatement of ending inventory. This will result in an understatement of the cost of goods sold and thus an overstatement of net income. If these errors were discovered before the books were closed in 2019, the entry to correct them would be as follows:
If the errors were not discovered until after the 2019 books were closed, they would have been corrected as follows:
These three illustrations are just a small sample of the many kinds of inventory errors that can occur. In evaluating the effect of inventory errors, it is important to have a clear understanding of the nature of the error and its impact on the cost of goods sold formula. It is also important to consider the effect of the error on subsequent years. Although immediate correction of errors is preferable, most inventory errors will correct themselves over a two-year period. However, even if an error corrects itself, there may still be a need to restate comparative financial-statement information.
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Although a business will normally take an inventory count at least once per year to verify the perpetual inventory records, there may be circumstances where an inventory count is either impractical or impossible. For example, when a company prepares interim unaudited financial statements, it may be too costly to conduct an inventory count, as operations would have to cease during the count, and staff would need to be reallocated to this purpose. Or, in the case where a disaster strikes, such as a warehouse fire, inventory may be destroyed, making a count impossible. In these situations, the company may choose to use an estimation method to determine the inventory. The estimated balance can be used for the interim financial statements or for making an insurance claim in the case of a disaster. Several methods can be used to estimate inventory. We will focus on the gross profit method.
This method attempts to estimate the inventory balance at a point in time using past relationships between the cost of goods sold and sales and then applying the cost of goods sold formula to determine the ending inventory balance. Consider the following scenario for PartsPeople. On May 17, 2019, a fire caused by faulty electrical wiring completely destroyed one of the company's warehouses and all of the contents. Fortunately, this loss was covered by the company's insurance policy, but in order to make a claim, the company needed a credible estimate of the amount of inventory destroyed. Assume that the inventory on January 1, 2019, was reported at a cost of \$250,000, which was verified by a count. As well, assume that between January 1 and May 17, 2019, the cost of all inventory purchases was \$820,000, and sales for this period were reported at \$1,200,000. Based on analysis of the previous year's results, the company knows that its gross profit percentage is 25 percent. Based on this information, the company could have estimated the cost of the destroyed inventory as follows:
Inventory on January 1 \$250,000
Purchases \$820,000
Goods available for sale \$1,070,000
Sales \$1,200,000
Less gross profit () \$300,000
Estimated cost of goods sold \$900,000
Estimated inventory on May 17 \$170,000
PartsPeople could have used this information to make a claim in the amount of \$170,000 for inventory damaged in the fire. There are some obvious limitations in using this technique. First, the gross profit percentage used here was based on the previous year's results. If the company had made changes to its pricing or purchasing strategies in 2019, the percentage would need to have been adjusted. Second, a single gross profit percentage has been used for all inventory items. It is quite likely that individual inventory items would have different amounts of gross profit built into their pricing, depending on consumer demand, purchasing dynamics, and so on. This blanket rate is based on an average of all inventory items, but depending on the product mix of both sales and purchases during the intervening period, this rate may not be appropriate.
Because this technique provides only an estimate, it should not be used for annual financial reporting purposes. In the circumstances noted above, however, it can be useful, but the calculated amount should be compared with the perpetual inventory records to determine the reasonableness of the estimate. Management should consider the suitability of the single gross profit percentage and consider any adjustments that may be appropriate.
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As mentioned previously, inventory can be a significant asset for many businesses, as it represents profit-generating potential. Buying or producing goods at a certain price and then selling them for a higher price is the essence of the retail, wholesale and manufacturing sectors. Obviously, efficient management of these inventories is essential for the success of the business. A company needs to control the cost of inventories in order to maintain its profit margins. As well, companies need to ensure that inventories move through the system quickly. Inventories sitting in a warehouse, unsold, are not producing profits or cash flow for the company. While the items sit in the warehouse, the company will incur costs: the cost of the warehouse space itself and the cost of funds required to finance the inventory. Obviously, to minimize these costs, it is important to sell the inventory as quickly as possible, while maintaining the desired margin.
To analyze inventory, we will look at two types of ratios: gross profit margin and inventory turnover period.
Gross Profit Margin
Gross profit represents the difference between sales revenue and cost of sales. This is an essential measurement in determining the profitability of a business, as it represents the profit generated by the primary business activity of selling goods, before considering any other expenses. To facilitate comparisons between different sales volumes, the gross profit margin is calculated as follows:
By expressing this relationship as a percentage, one can make comparisons between different companies or different accounting periods for the same company. This is a type of common size analysis that helps the reader discern relationships and trends that may indicate something about the company's profitability. Consider the following example from the financial statements of a large automobile manufacturer (in \$ millions):
Year Ended Year Ended
December 31, 2021 December 31, 2020
Sales \$ 136,200 \$ 140,100
Cost of sales 123,400 125,300
Gross profit \$ 12,800 \$ 14,800
Sales declined slightly in 2021 compared with the previous year, as did gross profit. By calculating the gross profit margin, we can get a better idea of the meaning of these results:
Gross profit margin 2021 = 9.40%
Gross profit margin 2020 = 10.56%
Although the gross profit margin dropped by only 1.16 percent between years, this represents lost profits of approximately \$1.5 billion on this scale of revenues. Management would obviously be motivated to find ways to control these margins to prevent further declines, whether through adjusting sales prices or controlling costs better.
Inventory Turnover Period
Aside from the profitability of the business's core activities as calculated above, management is also interested in the efficiency of carrying out those activities. One way to measure the efficiency of inventory movements to calculate the inventory turnover period:
This ratio will help us understand how quickly the company moves inventory through the various business processes that eventually result in a sale. For a manufacturing company, this process begins with the receipt of raw materials and ends when the finished goods are finally sold. Once again, consider the reported inventory levels of the automobile manufacturer (in \$ millions): 2021–\$7,860, 2020–\$7,700, 2019–\$7,360.
Using the formula above, we can determine the following inventory turnover periods:
2021: 23.01 days
2020: 21.94 days
(Note that the average inventories amount was calculated as the simple average of opening and closing inventories. For businesses with seasonal or other unusual patterns of sales, more sophisticated calculations of the average inventories may be required.)
In this example, the inventory turnover period increased by slightly more than one day during the current year. This may not seem significant, but it does indicate that inventories are being held for a longer time, which will increase the company's costs. Line managers are very motivated to find ways to reduce the turnover period through more efficient purchasing practices, better production techniques, and more effective sales promotions.
It should be noted that the absolute values of the ratios we have calculated are not particularly useful on their own. Like all ratios, a comparison or benchmark is needed for comparison. Most companies will start by comparing the ratio with the previous year to see if improvements have occurred in the current year. Many managers will also compare with a budgeted or target amount, as this will provide feedback on the actions they have taken. It may also be useful to compare with industry standards or competitor data, as this indicates something of the company's competitive position. Ratio analysis does not provide answers to questions, but it does help managers and other financial statement users to identify areas where performance is improving or declining.
7.08: IFRS ASPE Key Differences
IFRS ASPE
Biological assets that produce a harvestable product are accounted for under the provisions of IAS 41. No specific standard exists for biological assets or agricultural produce.
Disclosures regarding categories of inventories and accounting policies are required. As well, further disclosures regarding qualitative reasons for write-downs are required. Disclosures regarding categories of inventories and accounting policies used are required. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/07%3A_Inventory/7.07%3A_Inventory_Analysis.txt |
LO 1 Define inventory, and identify those characteristics that distinguish it from other assets.
Inventories can be a significant asset for many businesses. The key feature of inventory is that it is held for sale in the normal course of business, which distinguishes it from financial instruments and long-lived assets, such as property, plant, and equipment.
LO 2: Identify the types of costs that should be included in inventory.
Recognition of the initial cost of purchase should include transportation, discounts, and other nonrecoverable taxes and fees that need to be paid to transport the goods to the place of business. FOB terms of purchase need to be considered when applying cut-off procedures at the end of the accounting period. This is important for determining when the responsibility for the inventory passes from the seller to the buyer. For manufacturers, conversion costs must also be included in inventory. For direct materials and labour, this allocation is fairly straightforward. However certain issues with overhead allocations can occur with low or high production levels. With abnormally low production levels, overheads should be allocated at the rate used for normal production levels. With abnormally high production levels, overheads should be allocated using the actual level of production. Other costs required to bring the inventory to the place of business and get into a saleable condition may also be included. The accountant will need to exercise judgment when considering other costs to include.
LO 3: Identify accounting issues and treatments applied to inventory subsequent to its purchase.
LO 3.1: Describe the differences between periodic and perpetual inventory systems.
Perpetual inventory systems are those that instantly update accounting records for sales and purchases of goods. These types of systems are commonly used today and are facilitated by advances in computer and other technologies. Periodic inventory systems do not allow for the real-time updating of accounting records. Rather, these systems require a periodic inventory count (at least annually) that is then used to derive the cost of goods sold. These types of systems are less useful for management purposes. Even under a perpetual inventory system, annual inventory counts are still required to detect spoilage, theft, or other unaccounted inventory changes.
LO 3.2: Identify the appropriate criteria for selection of a cost flow formula, and apply different cost flow formulas to inventory transactions.
The cost flow formula determines how to allocate inventory costs between the income statement and the balance sheet. Although specific identification of individual inventory items is the most precise way to allocate these costs, this method would only be appropriate with inventory items whose characteristics uniquely differentiate them from other inventory units. For homogeneous inventory products, weighted average or first in, first out (FIFO) are appropriate choices. Weighted average (or moving average, when used with a perpetual inventory system) recalculates the average cost of the inventory every time a new purchase is made. This revised cost is used to determine the cost of goods sold. With FIFO, the oldest inventory items are assumed to be sold first. Each method has certain advantages and disadvantages, and each has a different effect on the balance sheet and income statement. The choice of method will depend on the actual physical movement of goods, financial reporting objectives, tax considerations, and other factors. Whatever method is chosen, it should be applied consistently.
LO 3.3: Determine when inventories are overvalued, and apply the lower of cost and net realizable value rule to write-down those inventories.
When economic circumstances change, such as a shift in consumer preferences, a company may find itself holding inventory that cannot be sold for its carrying value. In this case, the inventory should be written-down to its net realizable value (selling price less estimated costs required to complete and sell the goods) in order to ensure the balance sheet is not reporting a current asset at a value greater than the amount of cash that can be realized from its sale. Generally, this technique should be applied on an individual-item basis, but in certain cases where a group of products all belong to one product line, are produced and marketed in one geographic area, have similar end uses, or are difficult to segregate, it may be appropriate to apply the test on a grouped basis. Judgment is required in applying this technique, as net realizable values are estimates that may not be easy to verify.
One unique application of fair value inventory accounting relates to biological assets. These are assets that are living plants or animals used to produce an agricultural product. Under IFRS these assets are adjusted to their fair value, less selling costs, each year. This can result in increases as well as decreases in value.
LO 4: Describe the presentation and disclosure requirements for inventories under both IFRS and ASPE.
Inventory should be described separately on the balance sheet, with separate disclosure of major categories such as raw materials, work in process, and finished goods. Accounting policies used should also be disclosed, as well as the amount of any inventory that has been pledged as collateral for any liability. The amount of inventory expensed during the period should be disclosed as cost of goods sold on the income statement, but other categories, if material, could be disclosed separately, such as significant write-downs or reversals of write-downs.
LO 5: Identify the effects of inventory errors on both the balance sheet and income statement, and prepare appropriate adjustments to correct the errors.
Due to the nature and relative volume of inventory transactions, material errors in financial reporting can occur. To correct these errors, the accountant must have a firm understanding of the cost of goods sold formula and its effects on both the current and subsequent years. If inventory errors are discovered after the closing of the books, an adjustment to retained earnings may be required. If an error is not discovered until two years after its occurrence, it is quite likely that the error has corrected itself. In this case, no adjusting entry would be required, but restatement of prior-year comparative results would still be necessary.
LO 6: Calculate estimated inventory amounts using the gross profit method.
The gross profit method can be useful for estimating inventory amounts when a physical count is impractical or impossible. This could be the case when for interim reporting periods or when the inventory is destroyed in a disaster. The technique uses past gross profit percentages and applies it to purchases and sales during the period to estimate the amount of inventory on hand. The method is not appropriate for annual financial reporting purposes, as the estimate could be subject to error as a result of using past gross profit percentages that are not representative of current margins or are not representative of the current product mix. Considerable judgment and care should be applied when using this method.
LO 7: Calculate gross profit margin and inventory turnover period, and evaluate the significance of these results with respect to the profitability and efficiency of the business's operations.
Managers are concerned about the profitability of the company's core business of buying and selling products. Managers are also concerned with the efficiency with which products are moved through the production and sales process. Calculating gross profit margin can identify trends in the profitability of the company's core operations. Calculating inventory turnover period can identify problems with the efficiency movement of inventories, including raw materials, work in progress, and finished goods. Ratio calculations need to be compared with some type of benchmark to be meaningful.
LO 8: Identify differences in accounting for inventories between ASPE and IFRS.
Inventory accounting standards under IFRS and ASPE are substantially the same. The primary difference relates to biological assets. IFRS has a complete set of standards (IAS 41) for these types of assets, whereas ASPE does not separately identify this category. As well, IFRS requires certain additional disclosures that ASPE does not, including a description of qualitative reasons for inventory write-ups and write-downs. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/07%3A_Inventory/7.09%3A_Chapter_Summary.txt |
BlackBerry Ltd. (2014). 1.3 Management's discussion and analysis of financial condition and results of operations for the fiscal year ended March 1, 2014. In Blackberry Ltd. Annual Report. Retrieved from http://us.blackberry.com/content/dam/bbCompany/Desktop/Global/PDF/Investors/Documents/2014/Q4_FY14_Filing.pdf
Damouni, N., Kim, S., & Leske, N. (2013, October 4). Cisco, Google, SAP discussing BlackBerry bids.Reuters.com. Retrieved from
http://www.reuters.com/article/us-blackberry-buyers-idUSBRE99400220131005
International Accounting Standards. (n.d.). In IAS Plus. Retrieved from http://www.iasplus.com/en/standards/ias
7.11: Exercises
7.1 Identify which of the following costs of a product manufacturer would be included in inventories:
• Salaries of assembly line workers
• Raw materials
• Salary of factory foreman
• Heating cost for the factory
• Miscellaneous supplies used in production process
• Salary of the CEO
• Costs to ship raw materials from the supplier to the factory
• Electricity cost for the factory
• Salaries of the sales team
• Depreciation of factory machines
• Property taxes on factory building
• Discounts for early payment of raw material purchases
• Salaries of the factory's janitorial staff
7.2 Complete the following table by identifying whether the seller (S) or the purchaser (P) is the appropriate response for each cell.
FOB Shipping FOB Destination
Owns the goods while in transit
Is responsible for the loss if goods are damaged in transit
Pays for the shipping costs
7.3 Hasselbacher Industries Ltd. has fixed production overhead costs of \$150,000. In a normal year, the company produces 100,000 units of product, which results in a fixed overhead allocation of \$1.50 per unit.
Required:
1. If the company produces 105,000 units in a year, how much total fixed overhead should be allocated to the inventory produced?
2. If the company produces 30,000 units in a year, how much total fixed overhead should be allocated to the inventory produced?
3. If the company produces 160,000 units in a year, how much total fixed overhead should be allocated to the inventory produced?
7.4 Segura Ltd. operates a small retail store that sells guitars and other musical accessories. During the month of May, the following transactions occurred:
Number of Units Cost per unit
Opening inventory, May 1 8 \$550
Purchase, May 5 50 \$560
Purchase, May 8 10 \$575
Sale, May 15 15
Purchase, May 22 12 \$572
Sale, May 25 23
Closing inventory, May 31 42
Required: Segura Ltd. uses a perpetual inventory system. Using the FIFO cost flow assumption, calculate the cost of goods sold for the month of May and inventory balance on May 31.
7.5 Refer to the information in the previous question.
Required: Assume that Segura Ltd. uses the moving average cost flow assumption instead. Calculate the cost of goods sold for the month of May and the inventory balance on May 31.
7.6 The following chart for Severn Ltd. details the cost and selling price of the company's inventory:
Description Category Cost (\$) Selling
Price (\$)
Brake pad #1 Brake pads 159 140
Brake pad #2 Brake pads 175 180
Total brake pads 334 320
Soft tire Tires 325 337
Hard tire Tires 312 303
Total tires 637 640
Required:
1. Assume that grouping of inventory items is not appropriate in this case. Apply the lower of cost and net realizable value test and provide the required adjusting journal entry.
2. Assume that grouping of inventory items is appropriate in this case. Apply the lower of cost and net realizable value test and provide the required adjusting journal entry.
7.7 Hawthorne Inc. identified the following inventory errors in 2020.
1. Goods were in transit from a vendor on December 31, 2020. The invoice cost was \$82,000 and the goods were shipped FOB shipping point on December 27, 2020. The goods will be sold in 2021 for \$135,000. The goods were not included in the inventory count.
2. On January 6, 2021, a freight bill for \$6,000 was received. The bill relates to merchandise purchased in December 2020 and two-thirds of this merchandise was still in inventory on December 31, 2020. The freight charges were not included in either the inventory account or accounts payable on December 31, 2020.
3. Goods shipped to a customer FOB destination on December 29, 2020, were in transit on December 31, 2020, and had a cost of \$27,000. When notified that the customer had received the goods on January 3, 2021, Hawthorne's bookkeeper issued a sales invoice for \$42,000. These goods were not included in the inventory count.
4. Excluded from inventory was a box labelled "Return for Credit." The cost of this merchandise was \$2,000 and the sale price to a customer had been \$3,500. No entry had been made to record this return and none of the returned merchandise seemed damaged.
Required: Determine the effect of each of the above errors on both the balance sheet accounts at December 31, 2020, and the reported net income for the year ended December 31, 2020 and complete the table below.
Item Inventory A/R A/P Net Income
A
B
C
D
Total
7.8 Refer to the information provided in the previous question.
Required:
1. Assume the books are still open for 2020. Provide any required adjusting journal entries to correct the errors.
2. How would the adjustments change if the books are now closed for 2020?
7.9 Wormold Industries suffered a fire in its warehouse on March 4, 2021. The warehouse was full of finished goods, and after reviewing the damage, management determined that inventory, with a retail selling price of \$90,000, was not damaged by the fire.
For the period from January 1, 2021, to March 4, 2021, accounting records showed the following:
Purchases \$ 650,000
Purchase returns 16,000
Sales revenue 955,000
The inventory balance on January 1, 2021, was \$275,000, and the company has historically earned a gross profit percentage of 35%.
Required: Use the gross profit method to determine the cost of inventory damaged by the fire.
7.10 Bollen Custom Automobile Mfg. reported the following results (all amounts are in millions USD):
2020 2019
Sales 20,222 13,972
Cost of sales 17,164 11,141
Gross profit 3,058 2,831
Inventories at year end 2,982 1,564
Inventories at the end of 2018 were \$1,239.
Required: Using the data above, analyze the profitability and efficiency of the company with respect to its core business activities. Provide any points for further investigation that your analysis reveals. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/07%3A_Inventory/7.10%3A_References.txt |
An Acquisition Debacle for Hewlett Packard
In 2011, Hewlett-Packard (HP) purchased approximately 87% of the share capital (213 million shares) of Autonomy Corporation plc. for US \$11.1 billion cash. The purpose of this acquisition was to ensure that HP took the lead in the quickly growing enterprise information management sector. Autonomy's products and solutions complemented HP's existing enterprise offerings and strengthened the company's data analytics, cloud, industry, and workflow management capabilities, so the acquisition made sense from a strategic point of view.
Autonomy HP was to operate as a separate business unit. Dr. Mike Lynch, founder and CEO of Autonomy, would continue to lead Autonomy HP's business and report to HP's Chief Executive Meg Whitman (Hewlett Packard, 2011).
However, trouble quickly brewed and in 2012, accounting "anomalies" were uncovered by HP, giving rise to a massive impairment write-down of the Autonomy HP unit to the tune of an \$8.8 billion impairment charge. Compared to the original \$11.1 billion purchase price, the impairment represented a whopping 79% drop in the investment's value, a mere one year later.
HP alleged that the owners of Autonomy misrepresented their company's financial position due to what HP referred to as serious accounting improprieties. To make matters worse, all this came at a bad time for HP, given that its fourth quarter financial results were already down 20% in hardware sales and 12% in laptop/desktop sales (Souppouris, 2012).
The question remained; how was it possible to lose 79% of Autonomy HP unit value in less than one year? HP claims to have discovered all kinds of accounting irregularities which were denied by Autonomy's founder and CEO, Mike Lynch. HP claimed that it would have paid half the purchase price, had it known what it later discovered about Autonomy's true profitability and growth.
Consider that software companies like Autonomy do not have much value in hard assets, so the impairment did not relate to a revaluation of assets. Also, Autonomy did not have much in the way of outstanding invoices, so there was no large non-payment of amounts owed to trigger the drop in value and subsequent impairment write-down.
So the impairment charge more likely reflected a reassessment by HP of the future cash flows originally estimated, based on the financials, to be much less than anticipated. This is backed up by Chief Executive Meg Whitman's assertion that Autonomy's real operating profit margin was closer to 30%, and not its reported 40 to 45%.
Whitman accused Autonomy of recording both long-term deals and sales through resellers as fully realized sales. Consider that the booking of revenue is not clear-cut in the software industry because of the differing accounting rules. For example, if Autonomy recorded an extra \$20 million of future sales now, without recording the associated additional cost of goods sold, the gross profit percentage would exponentially increase, perhaps by as much as 10 to 15%.
HP also stated that the actual losses of Autonomy's loss-prone hardware division were misclassified as "sales and marketing expenses" in the operating expenses section rather than as cost of goods sold in the gross profit section. Since sales figures were reported as steeply increasing, this would create a more favourable overall growth rate. Since growth is another factor in business valuations, this exponential effect could also have affected the purchase price HP thought it was willing to pay.
Companies can also increase reported net income by inappropriately classifying certain current expenses as investments (assets), which are thereafter amortized over several years. Some analysts suspected that Autonomy misclassified some of its research costs in this way. Moreover, some of Autonomy's growth was generated from acquisitions of other businesses. Takeovers can, for example, give a more favourable impression of growth rates, if pre-acquisition sales are understated. In this light, apparently, some analysts questioned Autonomy's acquisition accounting.
With all the factors discussed above, it is possible that HP could allege and demonstrate that inappropriate reporting and valuation errors led to a discrepancy the size of which it purports. Autonomy HP unit CEO, Mike Lynch, denies all charges of reporting impropriety or error. He said that Autonomy followed international accounting rules.
Until HP's accusations are fully investigated, it will be impossible for stakeholders and others to know what really happened.
(Source: Webb, 2012)
[Note: IFRS refers to the balance sheet as the statement of financial position (SFP) and ASPE continues to use the historically-used term balance sheet (BS). To simplify the terminology, this chapter will refer to this statement as the historically generic term balance sheet.
Learning Objectives
After completing this chapter, you should be able to:
• Describe intercorporate investments and their role in accounting and business.
• Identify and describe the three types of non-strategic investments.
• Fair value through net income (FVNI) classification and accounting treatment.
• Fair value through OCI (FVOCI) classification and accounting treatment.
• Amortized Cost (AC) classification and accounting treatment.
• Identify and describe the three types of strategic investments.
• Investments in associates classification and accounting treatment.
• Investments in subsidiaries classification and accounting treatment.
• Investments in joint arrangements general overview.
• Explain disclosures requirements for intercorporate investments.
• Identify the issues for stakeholders regarding investment analyses of performance.
• Discuss the similarities and differences between IFRS and ASPE for the three non-strategic investment classifications.
Introduction
Intercorporate investments arise when companies invest in other companies' securities as the Hewlett Packard shares acquisition cover story illustrates. This chapter will focus on explaining how these investments are classified, measured (both initially and subsequently), reported, and analyzed. Canada currently has two IFRS standards in effect: IFRS 9, which was effective January 1, 2018 and ASPE. The purpose of this chapter is to identify the various classifications and accounting treatments permitted by either standard for investments in other companies' debt and equity securities.
08: Intercorporate Investments
There are many reasons why companies invest in bonds, shares, and securities of other companies. It is well-known that banks, insurance companies, and other financial institutions hold large portfolios of investments (financed by deposits and fees their customers paid to the banks) to increase their interest income. But it may also be the best way for companies in non-financial industry sectors to utilize excess cash and to strengthen relationships with other companies. If the investments can earn a higher return compared to idle cash sitting in a bank account, then it may be in a company's best interests to invest. The returns from these investments will be in the form of interest income, dividend income, or an appreciation in the value of the investment itself, such as the market price of a share.
In some cases, investments are a part of a portfolio of actively managed short-term investments undertaken in the normal course of business, to offset other financial risks such as foreign exchange fluctuations. Other portfolios may be for longer-term investments such as bonds that will increase the company's interest income. These are examples of non-strategic investments where the prime reason for investing is to increase company income using cash not required for normal business operations.
Alternatively, companies may undertake strategic investments where the prime reason is to enhance a company's operations. If the percentage of voting shares held as an investment is large enough, the investing company can exercise its right to influence or control the investee company's investing, financing and operating decisions. Strategies to purchase shares of a manufacturer, wholesaler, or customer company can strengthen those relationships, perhaps to guarantee a source of raw materials or increase market share for sales. In some cases, it can be part of a strategy to take over a competitor because it would enhance business operations and profits to do so. Intercorporate investments do have risks as the opening story explains. Hewlett Packard's acquisition of a controlling interest in the voting shares of Autonomy Corp. is an example of where a strategic investment, which was to improve HP's operations and profit, does not always work out as originally intended.
The many different reasons why companies invest in other companies creates significant accounting and disclosure challenges for standard setters. For example, how are investments to be classified and reported in order to provide relevant information about the investments to the stakeholders? What is the best measurement—cost or fair value? How should investments be reported if the investment's value were to suddenly decline in the market place? Are there differences in the accounting treatments and reporting requirements between IFRS and ASPE? These are all relevant accounting issues that will be examined in this chapter.
What are Investments?
Investments are financial assets. Chapter 6: Cash and Receivables, defines financial assets as those that have contractual rights to receive cash or other financial assets from another party. Examples of intercorporate investments include the purchase of another company's debt instruments (such as bonds or convertible debt) or equity instruments (such as common shares, preferred shares, options, rights, and warrants). The company purchasing the investment (investor) will report these purchases as investment assets, while the company whose bonds or shares were purchased (investee) will report these as liabilities or equity respectively. For this reason, intercorporate investments are financial instruments because the financial asset reported by one company gives rise to a financial liability or equity instrument in another company.
Initial Measurement
The initial measurement for investments is relatively straightforward. All investments are initially measured at fair value which is the acquisition price that would normally be agreed to between unrelated parties. Any transactions costs such as fees and commissions are either expensed or included in the investment asset except valuation which will be explained later in the chapter.
Subsequent Measurement
There is no single subsequent measurement for all investments for IFRS and ASPE. Below is a summary of the various classification alternatives for the two current standards for IFRS 9 and ASPE.
As stated above, investments can either be a strategic acquisition of voting shares of another company in order to influence the investee company's operating, investing, financing decisions, or a non-strategic financing decision in order to earn a return on otherwise idle or under-utilized cash. Within these two broad categories are six classifications: fair value through net income (FVNI), fair value through OCI (FVOCI), amortized cost (AC), significant influence, subsidiary, and joint arrangement.
Both IFRS and ASPE identify some percentage of ownership reference points as guidelines to help determine in which category to classify an investment. For example, any investment in shares where the ownership is less than 20% would be considered a non-strategic investment. It is highly unlikely that this level of ownership would result in having any influence on a company's decisions or operations. These investments are acquired mainly for the investment return of interest income, dividend income, and capital appreciation resulting from a change in fair values of the investment itself, depending on the company's investment business model. For share purchases of between 20% and 50%, the investor will more likely have a significant influence over the investee company as previously explained. These percentages are not cast in stone. Classifications of investments do not always have to adhere to these ranges where it can be shown that another classification is a better measure of the true economic substance of the investment. For example, an investment of 30% of the shares of a company may not have any significant influence if the remaining 70% is held by very few other investors who are tightly connected together. The circumstances for each investment must be considered when determining the classification of an investment purchase.
A share investment of 50% or greater will result in the investor having control over the company's decisions and policies because the majority of the shares are held by the investing company. The investee company will be regarded as a subsidiary of the investor company. This was the case in the cover story where Hewlett Packard purchased the majority of the outstanding shares of Autonomy Corporation in order to enhance HP's operations.
Classifications and Accounting Treatments
Below is a classification summary for IFRS 9 and ASPE (Sec. 3856). Note the differences between the accounting standards. ASPE has two classifications for its non-strategic investments and IFRS has three classifications. The table below summarizes the classification criteria for ASPE and IFRS:
ASPE IFRS
Classification basis Type of investment as either debt or equity, and if there is an active market Management intent and investment business model is to hold and collect interest and dividends only, or to also sell/trade in order to realize changes in value of the investment
Description Classification Description Classification
Non-strategic Investments
Short-term trading Investments: equities trading in an active market Fair value through net income (FVNI) Equities, debt or non-hedged derivatives (i.e., options, warrants) where intent is to sell/trade to realize changes in value of the investment Fair value through net income (FVNI)
Equities1 and debt where intent is to collect cash flows of interest or dividends, AND to sell, to realize changes in value of the investment. Fair value through Other Comprehensive Income (FVOCI) with recycling (debt) or no recycling (equities)
All other equities and debt Equities at cost and debt at amortized cost (AC) Debt where intent is to collect contractual cash flows of principal and interest and to hold investment until maturity Amortized cost (AC)
Strategic Investments – must be voting shares
Significant Influence: equities Choice of equity method, cost or fair value through net income if active market exists Associate: equities acquired to influence company decisions Equity method
Subsidiary: equities Choice of consolidation, equity, cost, or quoted amount if active market exists Control: equities acquired for control of company Consolidation
Joint Arrangement: equities Proportionate consolidation, equity, or cost depending upon the nature of the joint arrangement and arrangement terms Joint Arrangement: equities Proportionate consolidation or equity depending upon the nature of the joint arrangement and arrangement terms
Under IFRS 9, investments are divided into separate portfolios according to the way they are managed. For non-strategic investments these classifications are based on "held to collect solely principal and interest cash flows (AC)", "held to collect solely principal and interest cash flows AND to sell (FVOCI)", and "all else (FVNI)". That is not to say that investments classified as AC can never be sold, but sales in this classification would be incidental and made in response to some sort of change in the investment, such as an increase in investment risk. FVOCI considers that sales are an integral part of portfolio management where active buying and selling are typical activities in order to collect cash flows while investing is held, AND to realize increases in fair values through selling. Both ASPE and IFRS allows companies to classify an investment as FVNI only at acquisition. For IFRS this FVNI election is only to eliminate or significantly reduce an accounting mismatch arising from a measurement or recognition inconsistency for investments that would otherwise be classified as AC or FVOCI.
Differences in the ASPE standard, such as the choice of either straight-line or effective interest rate methods or impairment evaluation and measurement of certain investments, will be separately identified throughout the chapter. Companies that follow IFRS can choose to record interest, dividends, and fair value adjustments to a single "investment income or loss" account or they can keep these separated in their own accounts. ASPE requires that interest, dividends, and fair value adjustments each be reported separately. Since IFRS companies still need to know the interest expense from any dividends received for tax purposes, this chapter separates interest and dividends for both IFRS and ASPE companies, as this is appropriate for both standards and for simplicity and consistency.
Below are the classification categories with details about how they are measured and reported. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.01%3A_Intercorporate_Investments-_Overview.txt |
Types of Investments Accounting Treatment
Debt (bonds) Interest and dividends through net income as earned/declared.
Equities2 (shares) Remeasure investment to fair value at each reporting date or upon sale, with gains/losses through net income. Can be recorded directly to investment or through an asset valuation account.
Investments in debt and equity, including derivatives, are reported at their fair value at each balance sheet date with fair value changes reported in net income. Transactions costs are expensed as incurred. Any gain (loss) upon sale of the investment is reported in net income. FVNI investments are reported as a current asset if they meet the conditions of a current asset, such as; a cash equivalent, are held for trading purposes, or are expected to mature or be sold within 12 months of the balance sheet/SFP reporting date or the normal operating cycle. Otherwise, they are a long-term asset.
Market (fair) values can go up or down while FVNI investments are being held. These increases and decreases are referred to as unrealized gains and losses and are reported in net income. Once a sale occurs, the investment can either be remeasured to its fair value as an unrealized gain/loss followed by the receipt of cash, or the gain or loss will be recorded as realized and reported through net income as a gain (loss) from the sale of the investment. Either treatment is acceptable for FVNI classification, because the unrealized and realized gains/losses are reported the same way in the income statement. For this reason, treatment as either an unrealized or realized gain/loss upon sales can become blurred.
In order to preserve the original cost of the investment, companies may choose to use an asset valuation allowance account instead of directly changing the asset carrying value. This is an option for any of the FVNI, FVOCI, and AC classification discussed in this chapter and will be illustrated in more detail below.
Impairment
Investments are reported at fair value at each reporting date, so no separate impairment evaluations and entries are required.
FVNI Investments in Shares
The accounting for FVNI equity investments such as shares is usually more straight-forward compared to debt investments such as bonds.
Assume that the following equity transactions occurred for Lornelund Ltd. in 2020:
Lornelund Ltd. – Non-Strategic Equity Investments
Dates # of Price per Total
in 2020 Transaction Detail Shares Share Amount
June 1 Purchased Symec Org. shares for \$150 per share (transaction costs were an additional \$1.25 per share) 1,000 \$150.00 \$150,000
Aug 15 Purchased Hemiota Ltd. shares 2,500 84.00 210,000
Nov 30 Dividends for Symec declared and received 1,000 6.10 6,100
Dec 31 Market price for Symec shares at year-end 165.00
Dec 31 Market price for Hemiota shares at year-end 82.00
Dates
in 2021
Jan 10 Sold Symec shares 500 165.70 82,850
The journal entries for the FVNI investments are recorded below:
Note that the transaction fees are expensed for FVNI investments. This makes intuitive sense since the shares are being purchased at their fair market value and this represents the maximum amount that can be reported on the investor company's balance sheet. At December 31 year-end, Lornelund makes two adjusting entries to record the latest fair values changes for each FVNI investment. The fair value for Symec shares increased from \$150 to \$165 per share, resulting in an overall increase in the investment value by \$15,000 (from \$150,000 to \$165,000). Conversely, the fair value for Hemiota shares decreased from \$84 to \$82 per share, resulting in a decrease in the investment value of \$5,000 (from \$210,000 to \$205,000). In both cases, the gains and losses will be reported in the income statement as unrealized gains (losses) on FVNI investments. The FVNI investment account would appear in the balance sheet as shown below.
Lornelund Ltd.
Balance Sheet
December 31, 2020
Current assets:
FVNI investments (at fair value) * \$ 370,000
*()
As previously mentioned, instead of recording the changes in fair value directly to the FVNI investment account as shown above, companies will often record the changes to a valuation allowance as a contra account to the FVNI investment account (asset). This separates and preserves the original cost information from the fair value changes in much the same way as the accumulated depreciation account for buildings or equipment. If a valuation allowance contra account was used, the balance sheet would appear as follows:
Lornelund Ltd.
Balance Sheet
December 31, 2020
Current assets:
FVNI investments (at cost)* \$ 360,000
Valuation allowance for fair value adjustments** \$ 10,000
\$ 370,000
* ()
**()
On January 10, 2021, the Symec shares were sold at \$165.70 per share. As previously explained, the shares can be remeasured to fair value prior to recording the sales proceeds, or the entry can skip that step and record the sales proceeds with the gain/loss as realized from sale of the investment. The entry above chose the latter, simpler alternative.
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FVNI Investments in Debt
FVNI investments can also be bonds, if market fair values are determinable. On January 1, 2020, Osterline Ltd. purchases 7%, 5-year bonds of Waterland Inc. with a face value of \$500,000. Interest is payable on July 1 and January 1. The market rate for a bond with similar characteristics and risks is 6%. The bond sells for \$521,326.3
On December 31, the fair value of the bonds at year-end is \$510,000. Osterline follows IFRS. The interest is calculated using the effective interest method as shown below.
The bond was initially valued and recorded at its purchase price (fair value) of \$521,326. Note that this is higher than the face value of \$500,000. This is referred to as purchasing at a premium, which is amortized to the FVNI investment account over the life of the bond using the effective interest method. This method was also discussed in Chapter 6: Cash and Receivables; review that material again, if necessary. There were no transaction costs, but these would have been expensed as incurred just as was done in the previous FVNI shares example.
The July 1, 2020, entry was for interest income based on the market rate (or yield) for 3% (6% annually for six months), while the cash paid by Waterland on that date of \$17,500 was based on the stated or face rate for 3.5% (7% annually for six months). The \$1,860 difference was the amount of premium to be amortized to the FVNI investment account on that date. On Dec 31, there were two adjusting entries:
• The first entry was for the interest income that has accrued since the last interest payment on July 1. This interest entry must be done before the fair value adjustment to ensure that the carrying value is up to date.
• The second adjusting entry is for the fair value adjustment which is the difference between the investment's carrying value of \$517,550 () and the fair value on that date of \$510,000. Since the fair value is less than the carrying value, this FVNI investment (or a valuation allowance) is reduced to its fair value by \$7,550 (). The investment carrying amount after the adjustment is now equal to the fair value of \$510,000.
It is important to note that the July 1, 2021, interest income of \$15,527 calculated after the fair value adjustment had been recorded continues to be based on the amounts calculated in the original effective interest schedule. The interest rate calculations will continue to use the original effective interest rate schedule amounts throughout the bond's life, without any consideration for the changes in fair value.
On July 1, 2021, just after receiving the interest, Osterline sells the bonds at the market rate of 107. The entry for the sale of the bonds on July 1, 2021 is shown below.
Recall from the journal entries above that on December 31, 2020, the investment had been reduced to its fair value of \$510,000. On July 1, 2021, the interest entry included amortization of the premium for \$1,973, resulting in a carrying value as at July 1, 2021 of \$508,027. The market price for selling the investment was 107 resulting in a gain of \$26,973. Note that this entry skipped the remeasure to fair value as an unrealized holding gain and recorded the sale entry as simply a gain on sale. Either method is acceptable.
ASPE companies can choose to use straight-line amortization of the bond premium instead of the effective interest method. If straight-line was used, the amount recorded to the investment account would be \$2,133 () at each interest date until the investment is sold.
Again, note that no separate impairment evaluations or entries are recorded since the debt investment is already adjusted to its current fair value at each reporting date.
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Investments in Foreign Currencies
Investments may be priced in foreign currencies, which must be converted into Canadian currency for recording and reporting purposes. Illustrated below are the accounting entries for a FVNI investment priced in a foreign currency.
FVNI investments purchased in foreign currencies are converted into Canadian currency using the exchange rates at the time of the purchase. Also, depending on the accounting standard and the circumstances of the investment, the fair value adjusting entry may have to separately record the foreign exchange gain (loss) from the fair value adjustment amount.
For example, assume that the US dollar is worth \$1.03 Canadian at the time of an investment purchase for US \$50,000 bonds at par. In Canadian dollars, the amount would be \$51,500. The entry to record the purchase would be:
At year-end, the fair value of the bonds is US \$49,000 and the exchange rate at that time is 1.05. In Canadian dollars the amount would be \$51,450 () compared to the original purchase price in Canadian dollars of \$51,500, an overall net loss of \$50.
The entry to record the fair value adjustment separately from the exchange gain/loss would be:
Note that the exchange rate increased from 1.03 to 1.05 for the US \$50,000 investment amount. This increase in the exchange rate resulted in a gain of Cdn \$1,000 which was recorded separately from the fair value adjustment loss of Cdn \$1,050.
If there was no requirement to separate the exchange gain from the fair value adjusting entry, the adjusting entry would be: | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.02%3A_Non-Strategic_Investments/8.2.01%3A_Fair_Value_Through_Net_Income_%28FVNI%29.txt |
Types of Investments Accounting Treatment
• Debt (bonds)
• Interest and dividends through net income as earned/declared.
• Debt (bonds)
• Equities (shares) by special irrevocable election only at acquisition
• Remeasure investment to fair value at each reporting date through OCI. Can be recorded directly to investment or through an asset valuation account.
• Upon sale, remeasure investment sold to its fair value with gains/losses through OCI.
• Reclassify the OCI for the debt investment sold to net income (FVOCI with recycling), and to retained earnings for equities investments (FVOCI without recycling).
Looking at the table above, one cannot help but notice how the FVOCI debt investments are recycled through net income when sold in contrast to the FVOCI equities investments which are not recycled, and are reclassified to retained earnings instead, bypassing net income altogether. Originally, the FVOCI classification was without recycling for both debt and equity. This was done to lessen the instances of "earnings management" which is the manipulation of earnings due to bias. By timing the most opportune time to sell, a company could suddenly boost net income resulting from the reclassification of OCI from AOCI to net income of the unrealized gains dating back to when the investment was purchased. However, it appears that an exception has now been made to allow FVOCI debt investments to recycle through net income. FVOCI investments in equities continue to be classified as FVOCI without recycling.
FVOCI debt and equity investments are reported at their fair value at each balance sheet date with fair value changes recorded in Other Comprehensive Income (OCI). Unlike FVNI investments, transaction costs are usually added to the carrying amount of the FVOCI investment, and are usually reported as long-term assets unless it is expected they will be sold within twelve months or the normal operating cycle.
The fair value measurement at each reporting date is recorded to the investment asset account (or an asset valuation account). The unrealized holding gain (loss) is recorded to unrealized gain (loss) OCI and reported in OCI (net-of-tax). When the investments are sold, a remeasure to fair value can precede the entry for the sales proceeds, or alternatively, any gains (losses) resulting from the sale are reported in net income as a realized gain (loss) on sale of investment.
This is the point where FVOCI investments in debt differ from FVOCI investments in equity.
For FVOCI, debt investment sold:
• any unrealized gain (loss) in AOCI at the time of the sale is reclassified from AOCI to net income (with recycling).
For FVOCI, equity investment sold:
• any unrealized gain (loss) in AOCI at the time of the sale is reclassified from AOCI to retained earnings (without recycling).
Recall from the chapter on Statement of Income and Statement of Changes in Equity, that OCI is not included in net income, and is reported in a separate statement called the Statement of Comprehensive Income. This means that any unrealized gains (losses) from holding FVOCI investments will not be reported as net income until the debt investment is sold or impaired as will now be discussed. Students are encouraged to review the material regarding the topic of OCI.
Impairment of Investments with no recycling (Equity)
For FVOCI in equity investments, there is no need for impairment tests because equities are continually re-measured to their fair value based on the readily available market prices and these changes in value are not reported in net income, so impairment testing is not done. For FVOCI investments in debt, impairments will be discussed in detail in the FVOCI with recycling (debt) section later in this chapter.
FVOCI (without recycling) – Investments in Shares
The similarities and differences between FVNI and FVOCI investments journal entries will be examined next, since both apply fair value remeasurements, but differ in how these are recorded and reported. Using the same example for Lornelund Ltd. used in the FVNI investments above, a comparison between the entries required for FVNI and FVOCI is shown below. The transactions are repeated below but now include another fair value change at the end of 2021.
Lornelund Ltd. – Non-Strategic Equity Investments
Dates # of Price per Total
in 2020 Transaction Detail Shares Share Amount
June 1 Purchased Symec Org. shares for \$150 per share (transaction costs were an additional \$1.25 per share) 1,000 \$150.00 \$150,000
Aug 15 Purchased Hemiota Ltd. shares 2,500 84.00 210,000
Nov 30 Dividends for Symec declared and received 1,000 6.10 6,100
Dec 31 Market price for Symec shares at year-end 165.00
Dec 31 Market price for Hemiota shares at year-end 82.00
Dates
in 2021
Jan 10 Sold Symec shares 500 165.70 82,850
Dec 31 Market price for Symec shares at year-end \$167.00
Dec 31 Market price for Hemiota shares at year-end \$75.00
COMPARISON OF FVNI TO FVOCI (without recycling)
(FVNI) (FVOCI)
2020
June 1 Investments – Symec shares 150,000 151,250
Transactions fees expense 1,250
Cash 151,250 151,250
Aug 15 Investments – Hemiota shares 210,000 210,000
Cash 210,000 210,000
Nov 30 Cash (or dividend receivable if declared but not paid) 6,100 6,100
Dividend income 6,100 6,100
Dec 31 Investments – Symec shares 15,000 13,750
Unrealized gain (loss) on FVNI investments (NI) 15,000
()
Unrealized gain (loss) on FVOCI investments (OCI) 13,750
()
NOTE – Both FVNI and FVOCI shares carrying values for Symec are .
Dec 31 Unrealized gain (loss) on FVNI investments (NI) 5,000
(()
Unrealized gain (loss) on FVOCI investments (OCI) 5,000
Investments – Hemiota shares 5,000 5,000
NOTE – Both FVNI and FVOCI shares carrying values for Hemiota are \$82 per share 2,500 = \$205,000
2021
Jan 10 Cash 82,850 82,850
Investments – Symec shares 82,500 82,500
Gain (loss) on sale of investments (NI) 350
Gain (loss) on sale of investments (OCI) 350
For Cash: (), For Investments: ()
Jan 10 AOCI 7,050
Retained earnings 7,050
()
To reclassify unrealized gains from AOCI to retained earnings for 500 Symec shares sold.
Dec 31 Investments – Symec shares 1,000 1,000
Unrealized gain (loss) on FVNI investments (NI) 1,000
Unrealized gain (loss) on FVOCI investments (OCI) 1,000
()
Dec 31 Unrealized gain (loss) on FVNI investments (NI) 17,500
Investments – Hemiota shares 17,500
()
Unrealized gain (loss) on FVOCI investments (OCI) 17,500
FVOCI Investments – Hemiota shares 17,500
Note that the transaction fees are expensed for FVNI investments but are added to the carrying value for FVOCI investments. At December 31 year-end, Lornelund makes two end-of-period adjusting entries to record the latest fair values changes for each investment. The fair value for Symec shares increased FVOCI \$150 to \$165 per share resulting in an increase in the investment value by \$15,000 and \$13,750 for FVNI and FVOCI categories respectively. These amounts are different due to the transaction costs originally recorded to the investment asset of the FVOCI investment. The fair value for Hemiota shares decreased from \$84 to \$82 per share resulting in a decrease in the investment value of \$5,000 for both FVNI and FVOCI investments.
Ignoring taxes for simplicity, below are the financial statements for 2020 under FVNI and FVOCI:
Lornelund Ltd.
Balance Sheet
December 31, 2020
Current assets: FVNI FVOCI
FVNI investments (at fair value)* \$ 370,000
Long-term assets:
Long-term investment (at fair value) \$ 370,000
Equity:
Accumulated other comprehensive income ** \$ 8,750
* FVNI (); FVOCI ()
** AOCI ()
There is no difference in the ending balances of the investment asset accounts under the FVNI and FVOCI methods on December 31, 2020, because both are reported at fair value at each reporting date. Even though the transaction costs were initially capitalized under the FVOCI method, the year-end fair value adjustment entry for both FVNI and FVOCI investments resulted in equalizing the investments balances.
Lornelund Ltd.
Income Statement and Comprehensive Income Statement (partial)
For the Year Ended December 31, 2020
FVNI FVOCI
Dividend income \$ 6,100 \$ 6,100
Unrealized gain () 10,000
Transaction fees expense (1,250)
Net income \$ 14,850 \$ 6,100
Other Comprehensive Income:
Items that may be reclassified
subsequently to net income or loss:
Unrealized gain from FVOCI investments ()
\$ 8,750
Total comprehensive income \$ 14,850 \$ 14,850
At December 31, 2021 year-end, 50% of the Symec shares have been sold in January and the fair values are once again adjusted for both Symec and Hemiota investments at year-end.
Below is a partial balance sheet and income statement reporting the investment at December 31, 2021.
Lornelund Ltd.
Balance Sheet
December 31, 2021
Current assets: FVNI FVOCI
FVNI investments (at fair value)* \$ 271,000
Long-term assets:
Long-term investment (at fair value) \$ 271,000
Equity:
Retained earnings \$ 7,050
Accumulated other comprehensive income/loss ** (14,500)
* FVNI (); FVOCI ()
** AOCI ()
Lornelund Ltd.
Income Statement and Comprehensive Income Statement (partial)
For the Year Ended December 31, 2021
FVNI FVOCI
Gain on sale of shares \$ 350 \$
Unrealized loss (17,500)
Net income/(loss) \$ (16,150)
Other Comprehensive Income:
Items that may be reclassified
subsequently to net income or loss:
Unrealized gain/loss from FVOCI investments \$ (16,150)*
Total comprehensive income/(loss) \$ (16,150) \$ (16,150)
* ()
As can be seen from the illustrations above, there are significant differences in net income, due to the accounting treatments between FVNI and FVOCI investments. This could lead to earnings management, if care is not taken to ensure that these differences are considered solely for the purpose of managing net income to get higher bonuses, or fall under the radar regarding any restrictive covenants (for example, net income minimum thresholds set by creditors as performance targets). These differences also have to be taken into account when analyzing investment portfolio performance.
FVOCI (with recycling) – Investments in Debt
FVOCI investments for IFRS companies can also be debt, such as bonds. FVOCI shares (no recycling) reports dividends in net income and unrealized gains in OCI until sold, at which time the OCI corresponding to the shares sold are reclassified from OCI/AOCI to retained earnings. FVOCI debt (with recycling) reports interest in net income and unrealized gains in OCI until sold. As the "with recycling" name suggests, when the debt securities are sold, the corresponding OCI is recycled through net income.
Using the same example as for FVNI investments in bonds discussed earlier, where Osterline Ltd. purchased 7%, 5-year Waterland bonds with a face value of \$500,000. On July 1, 2021, just after receiving the interest, Osterline sells the bonds at the market rate of 107. Osterline's journal entries from Jan 1, 2020 to July 1, 2021 classified as FVNI are repeated below and compared with debt investments classified as FVOCI.
Osterline Ltd.
COMPARISON OF FVNI TO FVOCI debt (with recycling)
(FVNI) (FVOCI)
2020
Jan 1 Investments – Waterland bonds 521,326 521,326
Cash 521,326 521,326
Jul 1 Cash 17,500 17,500
Investments – Waterland bonds 1,860 1,860
Interest income 15,640 15,640
For Cash: (), for Interest income: ()
Dec 31 Interest receivable 17,500 17,500
Investments – Waterland bonds 1,916 1,916
Interest income 15,584 15,584
For Interest receivable: (), for Interest income: ()
Dec 31 Unrealized loss on FVNI investment (NI) 7,550
Unrealized gain (loss) on investments (OCI) 7,550
Investments – Waterland bonds 7,550 7,550
For NI: ()
2021
Jan 1 Cash 17,500 17,500
Interest receivable 17,500 17,500
Jul 1 Cash 17,500 17,500
Investments – Waterland bonds 1,973 1,973
Interest income 15,527 15,527
For Cash: (), for Interest income: ()
Jul 1 Cash 535,000 535,000
Gain on sale of Waterland bonds 26,973
Gain on sale of Waterland bonds (OCI) 26,973
Investments – Waterland bonds 508,027 508,027
For Cash: (), for Investments: ()
Jul 1 OCI – removal of gain due to sale 19,473
Gain from sale of investment (NI) 19,473
()
Note the similarities in accounting treatment between the FVNI and FVOCI classifications for bonds. As was the case for the FVNI investment in shares, the investment is adjusted to fair value at the reporting date. The difference between the two methods is the account used for the fair value adjustment. For FVNI, the unrealized gain/loss is reported in net income, whereas for FVOCI, the unrealized gain/loss is reported as Other Comprehensive Income which is closed at each year-end to the AOCI account (an equity account), until the investment is sold. Once sold, any unrealized gains/losses that relate to the sale of this investment are now realized and are transferred from OCI to net income. This is referred to as "with recycling" (through net income). Recall that FVOCI in equities do not recycle through net income. It is for this reason that FVOCI investments in debt with recycling must be evaluated for impairment which is discussed next.
Also note the order of the entries upon sale. The July 1 sales is comprised of two entries above. The first entry is a combined entry that records the cash proceeds, removal of the investment sold and any realized gain/loss through OCI. This is the same as the method used for FVOCI equities. The second entry is a transfer of the OCI related to the sale from OCI to net income. For FVOCI equities this entry is a reclassification from OCI to retained earnings. This is an important distinction regarding the accounting treatment for the FVOCI investments.
Because the entire investment was sold, the net income differed in the first and second year between FVNI and FVOCI with recycling, but over two years, the net income was the same for both. If only part of the investment been sold, the differences would be similar to the example regarding FVOCI equities, with regard to balances in the OCI/AOCI account compared to FVNI where all the gains/losses are reported through net income.
Impairment of Investments – FVOCI with recycling (Debt)
For FVOCI in debt investments, an evaluation is done starting at its acquisition date. Under IFRS 9, impairment evaluation and measurement is based on expected losses, and must now reflect the basic principles below:
• An unbiased evaluation over a range of probability-based possible outcomes
• Estimated revised cash flows are discounted to reflect time value of money
• The evaluation and measurements are based on data from past, current and estimated future economic conditions, using reasonable and supportable information without undue cost or effort at the reporting date
The last point suggests that a company does not need to identify every possible scenario when risks are low, and companies are encouraged to use modelling techniques to simplify evaluations and impairment measurements of large low-risk portfolios.
Essentially how it works is that for each investment at acquisition, various potential default scenarios (where the debt owing is not paid when due) are identified. Expected future cash flows are estimated for each scenario, which is multiplied by its probability of occurring. These probability-based cash flows are summed, and the total is deemed as the expected credit loss (ECL) for that investment. This is a separate evaluation and measurement of impairment losses than fluctuations in the market.
These estimated cash flows can either be based on scenarios and probabilities of default over the investment's next 12 months (12-month ECL) from acquisition, if risk of default is low, or over the investment's lifetime (Lifetime ECL), if risk of default is higher. IFRS 9 identifies three approaches for receivables and investments:
• Credit adjusted approach – for investments that are impaired at acquisition, such as deeply discounted investments from high risk investee companies. This approach will apply only rarely. Evidence of high risk could be due to significant financial difficulties or potential bankruptcy, a history of defaults, a history of concessions granted by creditors on previous debt, or economic downturns in the investee company's industry sector. This approach uses the cumulative change in Lifetime ECL.
• Simplified approach – this approach is intended specifically for trade receivables, IFRS 15 contract assets and lease receivables where the financial instrument does not contain a significant interest component. It is based on Lifetime ECL
• General approach – this approach applies to all other financial instruments not covered in the first two approaches. It is based on a 12-month ECL unless the credit risk increases significantly.
If the credit risk is high at the investment's acquisition, the credit adjusted approach with Lifetime ECL will apply, otherwise the general approach would be used with the shorter 12-month ECL. The end-result is that every investment will have an ECL amount associated with it. These risk-based cash flows are discounted using the historic interest rate at acquisition, and compared to the carrying value of the debt investment at the evaluation date. The carrying value of the investment (or an asset valuation account) is reduced by the loss amount and recorded to net income. Below is a schedule that illustrates a simple ECL calculation:
Investment in Bonds – Emil Ltd. Investee
Expected Credit Loss Calculation
Scenario 1 Scenario 2 Scenario 3 Total
Estimated future cash flows at
acquisition assuming no risk of
default, discounted @ effective
interest rate \$ 500,000 \$ 500,000 \$ 500,000
Future cash flows if default
occurs, discounted @ historic
effective rate at acquisition 450,000 400,000 350,000
Cash flow shortage 50,000 100,000 150,000
Probability of default 2.0% 1.5% 0.5%
Expected Credit Loss (ECL) \$ 1,000 \$ 1,500 \$ 1,750 \$ 4,250
Management can include as many default scenarios as is appropriate. In this case, there are three scenarios where management has identified potential defaults for this investment. If at the first reporting date after acquisition the fair value of the investment is \$480,000, the entry to record the fair value change would be:
The unrealized loss of \$15,750 is to adjust for changes in the market fluctuations that is not due to an impairment, so it is recorded to OCI. The loss on impairment resulting from the ECL calculation must be reported through net income. Compared to the previous accounting standard (IAS 39), this results in an earlier recognition of an impairment loss because it is recorded at the first reporting period after the investment acquisition. This clearly could create more volatility in the income statement.
After the initial recognition, the ECL is adjusted up or down, through net income at each reporting date as the probabilities of default change. Once the investment is collected, the ECL will be reduced to zero and impairment recoveries will be reported through net income. If default risk increases due to adverse changes in business conditions, not only will the estimated cash flow shortages and probabilities increase, the increased credit risk could result in a change from the simpler 12-month ECL to the Lifetime ECL if risk becomes too high. If a default does occur, the ECL amount will equal the actual cash flow shortage. In IFRS 9, there is a presumption that credit/default risk significantly increases if contractual payments from the investee are more than 30 days past due.
To summarize, assessing credit risk is only required for amortized cost and FVOCI debt (with recycling). FVNI and FVOCI equities do not need to be evaluated for impairment because they are always remeasured to fair value each reporting date. Evaluating and measuring impairments requires considerable judgement and companies are encouraged to establish an accounting policy regarding factors to consider when determining if increases in credit risk (ECL) is to be deemed as significant or not. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.02%3A_Non-Strategic_Investments/8.2.02%3A_Fair_Value_Through_OCI_Investments_%28FVOCI%29_%28IFRS_only%29.txt |
For ASPE companies, either debt or equities that are not traded in an active market are reported at amortized cost or cost respectively. Unlike investments acquired for short-term profit such as FVNI investments, shares or bonds may be purchased as AC investments for other reasons, such as to strengthen relationships with a supplier or an important customer.
For IFRS companies, if the investment business model is to acquire investments to collect the contractual cash flows of principal and interest, and there is no intention to sell, investments in debt securities such as bonds are reported at their amortized cost at each balance sheet date. Management intent is to hold these investments until maturity, so debt instruments are included in this category. Equity investments have no set maturity dates, therefore they are not classified as an AC investment. Even if equities such as shares are not part of a quoted market system, IFRS states that fair values are still normally determinable, making FVOCI equities (without recycling) the more appropriate classification for unquoted equities.
Transactions costs are added to the investment (asset) account. AC investments are reported as long-term assets unless they are expected to mature within twelve months of the balance sheet date or the normal operating cycle.
To summarize the initial and subsequent measurements used for AC investments:
• Initial purchase is at cost (purchase price) which is also fair value on the purchase date. Unlike FVNI investments, transaction fees are added to the investment (asset) account. This is because AC investments are cost-based investments, so any fees paid to acquire the asset are to be capitalized like property, plant, and equipment, which are also cost-based purchases.
• Bond interest and share dividends declared are reported in net income as realized. Any premium or discount is amortized to the investment asset using the effective interest rate method (IFRS). For ASPE companies, they can choose between the effective interest rate method and the straight-line method.
• If the investment is impaired, determine the impairment amount. For ASPE the impairment amount is the higher of: a) the present value of impaired future cash flows at the current market interest rate, and b) net realizable value through sale (or sale of collateral). ASPE allows for reversals of impairment. For IFRS, refer to the Impairment section above in the FVOCI debt (with recycling).
• Report the investment at its carrying value at each reporting date, net of any impairment. As asset valuation account can be used instead of recording the impairment loss directly to the investment account.
• When the investment is sold, remove the related accounts from the books. For debt instruments, ensure that any interest, amortization or possible impairment recovery is updated before calculating the gain/loss on sale prior to its removal from the books. The difference between the carrying value and the net sales proceeds is reported as a gain/loss on sale (including full or partial recovery of a previous impairment, if applicable) and reported in net income.
AC Investments in Debt
In the previous sections discussing FVNI and FVOCI investments, Osterline purchased Waterland bonds on the January 1, 2020, the interest payment date. Assume now that Osterline classified this as an AC investment. The entries would be the same as illustrated earlier for the FVNI category, except to exclude any fair value adjustments.
Note that the entry to the investment account for the sale of Waterland bonds for the FVNI or FVOCI methods shown earlier is \$508,027 compared to AC method above for \$515,577. The reason for this difference is due to the fair value adjustment for \$7,550 for the FVNI and FVOCI methods (both fair-value based) but not done for AC method which is based on amortized cost.
AC Investments in Bonds – Between Interest Dates
What if the debt investment is purchased in between interest payment dates? Below is an example of the accounting treatment for an AC investment in bonds that is purchased between interest payment dates.
On March 1, 2020, Trimliner Co. purchases 6%, 5-year bonds of Zimmermann Inc. with a face value of \$700,000. Interest is payable on January 1 and July 1. The market rate for a bond with similar characteristics and risks is 6.48%. The bond is purchased for \$685,843 cash. Stated another way, the bond is purchased at 98 () on March 1, 2020. On December 31, 2020 year-end, the fair value of the bond at year-end is \$710,000. Trimliner follows IFRS and intends to hold the investment to collect the contractual cash flows of principal and interest and to hold until maturity (AC classification).
Note that the purchase date of March 1 falls in between interest payments on January 1 and July 1. The business practice regarding bond interest payments is for the bond issuer to pay the full six months interest to the bond holder throughout the life of the bond. This creates a much simpler bond interest payment process for the bond issuer, but it creates an issue for the purchaser since they are only entitled to the interest from the purchase date to the next interest date, or four months in this case, as illustrated below.
This issue is easily resolved. The purchaser includes in the cash paid any interest that has accrued between the last interest payment date on January 1 and the purchase date on March 1, or two months. In other words, the purchaser adds to the cash payment any interest that they are not entitled to receive. Later, when they receive the full six months of interest on July 1 for \$21,000, the net amount received will be for the four-month period that was earned, which was from the purchase date on March 1 to the next interest payment on July 1 as shown above.
In this example, the purchase price of \$685,843 is lower than the face value of \$700,000, so the bonds are purchased at a discount.
The entry to record the investment for Trimliner, including the interest adjustment on March 1, 2020 and the first interest payment on July 1, 2020, is shown below. Note that the discount is also amortized from the date of the purchase of bonds to the end of the interest period.
The net interest income recorded by Trimliner is \$14,814 on July 1 (), which represents the four months interest earned from the March 1 purchase date to the first interest payment date on July 1. The interest receivable is now eliminated.
Note that for AC bonds, there are no entries to adjust the AC investment to fair value at year-end. The fair value information of \$710,000 on December 31, 2020, that was provided in the question data is not relevant for AC investments.
When the bonds mature at the end of five years, the entry to record the proceeds of the sale is shown below.
As previously stated, ASPE companies can choose to use either the effective interest or the straight-line method to amortize premiums or discounts. If straight-line method is used, the discount for \$14,157 () will be amortized over five years. The amortization amount for the July 1 entry would be for four months or \$944 (). After that, the amortization will be for every six months or \$1,416 ().
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AC Impairment
For IFRS companies, the process to evaluate and measure impairments was already discussed in FVOCI debt (with recycling). The accounting treatment for impairments (IFRS) is the same for both FVOCI debt with recycling and AC.
This section will now discuss impairment for ASPE companies with AC investments.
Since AC investments are measured at amortized cost for bonds and cost for shares, there is always the possibility of an impairment loss since fair values are not used. For this reason, investments should be assessed at the end of each reporting period to see if there has been a loss event. Investment assets should be evaluated on both an individual investment and portfolio (grouped) investment basis to minimize any possibilities of hidden impairments within a portfolio of investments with similar risks. Below are details regarding how impairments for AC investments are measured:
ASPE—reduce the investment carrying value to the higher of:
• the present value of impaired future cash flows using the current market interest rate and
• the net realizable value either through sale or by exercising the entity's rights to sell any collateral.
The loss is reported in net income and the investment (or an asset valuation allowance) is reduced accordingly. These impairments may be reversed.
For example, assume that Vairon Ltd. purchased an investment in Forsythe Ltd. bonds for \$200,000 at par value on January 1 and intends to hold them until maturity. The bonds pay interest on December 31 of each year. At year-end, Forsythe experiences cash flow problems that are considered by the investor as a loss event that triggers an impairment evaluation. The following cash flows are identified:
Changes in Classifications
Changes in management's intention to sell or hold to maturity can result in a change in classification. However, earlier in this chapter some significant impacts in net income and investment asset values were illustrated between FVNI, FVOCI, and AC methods. It is easy to see how this might lead to manipulation of net income or asset values by management. To minimize this possibility, for ASPE, no reclassification is permitted unless there's a change in the company's business model, which happens very rarely. For IFRS, there is the fair value option discussed earlier for FVOCI equities, which is irrevocable. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.02%3A_Non-Strategic_Investments/8.2.03%3A_Amortized_Cost_Investments_%28AC%29.txt |
In the previous categories, investments in other companies' debt or shares were acquired in order to make a return on idle cash. Investing in other companies can also be for strategic purposes, such as to acquire the power to influence the board of directors and company policies, or to take over control of the company outright. This is done by acquiring various amounts of another company's voting common shares. The degree of ownership (number of votes) defines the level of influence.
Guidelines have been developed to help determine the classification of the investment based on the degree of influence. For example, the previous three categories of investments (FVNI, FVOCI, and AC) each assumed that the investor's ownership in shares were less than 20%, therefore having no influence on the investee company.
For ownership in shares greater than 20% but less than 50%, it is assumed that significant influence exists. IFRS calls this category investment in associates. However, if an investing company owns between 20% and 50% of another company's shares, significant influence is by no means assured and can be refuted, if there is evidence to the contrary. For example, if an investor acquires 40% of the outstanding common shares of a company but the remaining 60% of the shares are held by one other investor, then significant influence will not exist. A general assumption is that the greater the number of investors, the more likely that investment holdings of greater than 20% will result in significant influence.
If an investor holds greater than 50% of the common shares, then it has the majority of the votes at the board of directors' meetings, thereby having control of the investee company's operations, decisions and policies.
Joint arrangements is another type of strategic investment that involves the contractually-agreed sharing of control by two or more investors. There are two types of joint arrangements, namely; joint operations and joint ventures. A joint operation exists if the investor has rights to the assets and unlimited liability obligations of the joint entity and a joint venture exists if the investor has rights to net assets (assets and limited liability obligations of the joint entity.
Regarding strategic investments—why would an investor want to influence or control another company? If the investee company has resources that would enhance the operations of the investor, then acquiring sufficient voting shares to significantly influence or control the investee's board of directors would be a prime motivator to do so. Acquiring an interest in another company could secure a guaranteed source of materials and products, open up new markets, or broaden existing ones for the investor company. It could also expand an investor company's range of products and services available for sale as was the case with Hewlett Packard's acquisition of 87% of Autonomy Corporation's shares resulting in control of the company.
The accounting treatments for these classifications are complex and will be covered in more detail in the advanced accounting courses. The rest of this chapter will focus on an introduction to the three strategic investment classifications.
8.03: Strategic Investments
For IFRS, investments between 20% and 50% of the voting shares in another company are reported using the equity method. For ASPE companies, management can choose the equity method, the fair value through net income method (if this investment is traded in an active market), or the cost method if no market exists. Transactions costs are expensed for the equity and fair value methods and added to the investment (asset) account for the cost method. Investments in associates are reported as long-term investments and income from associates is to be separately disclosed.
This chapter has already discussed the fair value and cost models, so the focus will now be on the equity method.
The equity method initially records the shares at the cost of acquiring them which is also fair value. Subsequent measurement of the investment account includes recording the proportionate share of the investee's:
• net income (loss) adjusted for any inter-company transactions
• dividends
• amortization of any fair value difference in the investee's capital assets
• impairments, if any
• proceeds of sale
The equity method is often referred to as the one-line consolidation because all the related transactions are recorded as increases or decreases in a single investment asset account. For example, if the investee company reported net income, this would result in a proportionate increase in the investor's investment (asset) due to the added profit. Conversely, a net loss reported or dividend received would be recorded as a proportionate decrease in the investment. Any amortization of fair value adjustments from the date of purchase or impairment would also be recorded as a decrease in the investment account. Below is an example of how the investment is accounted for using the equity method.
On January 1, 2020, Tilton Co. purchased 25% of the 100,000 outstanding common shares of Beaton Ltd. for \$455,000. Beaton currently is one of Tilton's suppliers of manufactured goods. The outstanding shares are widely held, so with this purchase, Tilton can exercise significant influence over Beaton. This investment solidified the relationship between Tilton and will guarantee a steady supply of goods needed by Tilton for its customers. The following financial information relates to Beaton:
Below are the entries recorded to Tilton's books that relate to its investment in Beaton:
On December 31, Tilton recorded its 25% share of dividends received, net income (loss), and amortization of Beaton's net depreciable assets. But what about the \$80,000 excess paid for the investment? The excess of \$60,000 relates to Beaton's net depreciation assets, so this portion of the excess is amortized over ten years. The remaining \$20,000 is inexplicable, so it will be treated as unrecorded goodwill. Goodwill is discussed in detail in Chapter 11: Intangible Assets and Goodwill. Since there is unrecorded goodwill, an intangible asset, Tilton must evaluate its investment each reporting date to determine if there has been any impairment in the investment's value.
Below is a partial balance sheet and income statement reporting the investment at December 31, 2020.
Tilton Co.
Balance Sheet
December 31, 2020
Long-term investment:
Investment in associates (equity method)* \$ 474,000
*()
For IFRS, investments in this classification are assessed each balance sheet date for possible impairment. If it was determined that the investment's recoverable amount—being the higher of its value in use (the present value of expected cash flows from holding the investment, discounted at the current market rate) and fair value less costs to sell, both of which are discounted cash flow concepts—was \$460,000, then the carrying value is more than the recoverable amount and an impairment loss of \$14,000 () is recorded as a reduction to the investment (or valuation account) and to net income (loss).
For ASPE, impairment evaluation and measurement is the same as IFRS except "fair value" does not include netting the costs to sell.
Since there is \$20,000 of unrecorded goodwill, the \$14,000 impairment charge represents a loss in an intangible asset and is therefore not reversible. If there had been no unrecorded goodwill, any subsequent impairment charge would be reversible, but limited and the recovery amount could not result in a carrying value balance greater than if there had been no impairment. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.03%3A_Strategic_Investments/8.3.01%3A_Investments_in_Associates_%28Significant_Influence%29.txt |
For IFRS, investments greater than 50% of the voting shares in another company are reported using the consolidation method. For ASPE companies, there is a choice of consolidation, equity, or cost methods. Transactions costs are expensed for the consolidation and equity methods and added to the investment (asset) account for the cost method.
For IFRS companies, the investor is referred to as the parent, and the investee as the subsidiary, and it is reasonable to treat the two companies as one economic unit and prepare a consolidated set of financial reports for the combined entity. This means that the investment account is eliminated and 100% of each asset and liability of the subsidiary is reported within the parent company's balance sheet on a line-by-line basis. For example, the accounts receivable ending balance for the subsidiary would be added to the accounts receivable balance of the parent and reported as a single amount on the consolidated balance sheet. This would be done for all of the subsidiary's assets and liabilities sheet accounts. As well, 100% of each of the subsidiary's revenues, expenses, gains, and losses accounts would be included with those of the parent company and reported in the consolidated income statement.
Since 100% of all the net assets and net income (loss) is being reported by the parent, any percentage of ownership held by outside investors, referred to as the minority interest, must also be reported in the financial statements. This is reported as a single line in the balance sheet and the income statement as non-controlling interest. For example, in the cover story, Hewlett Packard purchased a majority of the voting shares of Autonomy Corp. The remaining percentage would be the minority interest shareholders who did not sell their shares to Hewlett Packard and continue to be investors of Autonomy Corp. This non-controlling interest would be reported as a single line in the balance sheet and the income statement. Earlier chapters regarding the income statement and statement of financial position both illustrate how the non-controlling interest is presented in these financial statements.
8.3.03: Investments in Joint Arrangements
As previously stated in the overview of strategic investments, joint arrangements is another type of strategic investment for both IFRS and ASPE that involves a contractual arrangement between two or more investors regarding control of a joint entity. Control in this case means that the investors must together agree on the decision-making. For IFRS, there are two types of joint arrangements:
• Joint operations—investor has direct rights to assets and (unlimited) liability obligations of the joint entity, such as a partnership where liability can be unlimited. Each investor would include in their financial statements the assets, liabilities, revenue, and expenses that they have a direct interest in. In other words, it is a form of proportionate consolidation where the investor's proportionate share of the assets, liabilities, revenue and expense accounts from the joint entity are added to the investor's existing accounts.
• Joint ventures—investor has rights to net assets (assets and (limited) liability obligations) of the joint entity, such as the case involving corporations with limited liability. The equity method is used for this type of investment which is the method illustrated for investments in associates above. In this case, the joint entity is shown on a net basis in an investment account on the statement of financial position.
The ASPE standards are very similar, though the terms are a bit different, namely, jointly controlled operations, jointly controlled assets, and jointly controlled enterprises. ASPE companies can make a policy choice to use proportionate consolidation, equity, or cost to account for their joint entity investments. Once chosen, the method must be applied to all investments of this nature. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.03%3A_Strategic_Investments/8.3.02%3A_Investments_in_Subsidiaries_%28Control%29.txt |
Reporting disclosures were addressed under each accounting method above. To summarize, investments will be reported as either current or long-term assets on the same basis as other assets. If the investment is expected to be sold within twelve months of the balance sheet date (or its operating cycle), is held for trading purposes, or is a cash equivalent, it will be reported as a current asset. All other investments will be reported as long-term assets. Both IFRS and ASPE companies are similar regarding this classification. IFRS and ASPE standards are also similar regarding the disclosure objectives for investments for the following reasons:
• to ensure that information is available to assess the level of significance of the overall financial position and performance of the investments
• to understand the nature and extent of risks arising from the investments
• to know how these risks are managed
Examples of disclosure details are:
• separation of investments by type (i.e., FVNI, AC, FVOCI, Significant Influence, Subsidiary, Joint arrangements)
• the carrying value of investments with details about their respective fair values including valuation techniques, interest income, unrealized and realized gains (losses), impairments and reversals of impairments, and reclassifications
• information from the legal documents including maturity dates, interest rates, and collateral
• information regarding market risk, liquidity risk, and credit risk, as well as the policies in place to manage risks
• IFRS for impaired assets must disclose the basis for the ECL and changes in ECL as well as a breakdown and reconciliation of the reporting year's adjustments of any impairment allowance accounts
Since investments are also financial instruments, the disclosure requirements identified in Chapter 6: Cash and Receivables apply to intercorporate investments as well. Refer to that chapter for more details.
8.05: Investments Analysis
Access to the information contained in financial statements and required disclosures is vital to sound investment analysis. This information will assist management to separate the assets, liabilities, and income components of the investment portfolios from the company's core operations to accurately assess performance of the company and of the investment itself. As well, creditors and potential investors will have to keep in mind the impact that certain accounting treatments would have on existing financial data. The equity method was referred to earlier as the one-line consolidation method for a reason: some of the key data using this method is not separately identifiable. As well, the accounting treatment chosen could affect the amounts and timing of net income and assets balances reported by the investor company. Some of these differences are identified in the chapter highlights below. Decisions regarding when to purchase or sell are in part determined by analysis of the investee company's operating results, earnings prospects, and earnings ratios. For this reason, care must be taken to clearly be aware of any obscured data and to understand the differences in data created by the choice of accounting treatments for each investment portfolio. Proper access to information and a thorough understanding of the various accounting treatments will reduce the possibility that management will make sub-optimal business investment decisions due to misinterpretation of analysis results.
8.06: IFRS ASPE Key Differences
There is no doubt that accounting for investments is complex, given the presence of two accounting standards that have identified eight separate categories for IFRS and ASPE as shown in the Classifications chart at the beginning of this chapter.
Below is a decision map for the various equity investment categories:
Corporate
Std Description Planning Purpose Treatment
IFRS If voting shares ownership is greater than 50% Strategic Control Full consolidation
If voting shares ownership is between 20% and 50% Strategic Associate Equity method
If equity investment is less than 20% Non-strategic For trading purposes (FVNI) FVNI – fair value – net income
If equity investment is less than 20% Non-strategic To collect dividends and also to sell (FVOCI) Fair value – OCI without recycling (equities)
ASPE If voting shares ownership is greater than 50% Strategic Subsidiary Choice of consolidation, equity method, or cost method
If voting shares ownership is between 20% and 50% Strategic Significant influence Choice of equity method or cost method, or fair value (if market exists) – net income
If equity investment is less than 20% and has an active market Non-strategic Short-term trading FVNI – fair value – net income
If equity investment is less than 20% and has no active market Non-strategic All other equities Cost | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.04%3A_Investments_Disclosures.txt |
LO 1: Describe intercorporate investments and their role in accounting and business.
Non-strategic intercorporate investments exist when companies invest in other companies' equity (shares or derivatives) or debt (bonds or convertible debt) to earn a better return on their idle cash. These returns will take the form of interest income, dividend income, or capital appreciation of the security itself.
Strategic intercorporate investments are voting shares purchased by the investor company to enhance its own operations. The goal is to either influence the investee's board of directors (share holdings 20% or greater) or to take control over the company (share holdings 50% or greater). This is undertaken in order to guarantee a source of scarce materials or services or to increase sales and hence profit. There are also joint arrangements where two or more investors, through a contractual agreement, control a joint entity.
Intercorporate investments are financial assets because the investor's contractual rights to receive cash or other assets of the investee company result in a financial liability or equity instrument of the investee. They are reported as either current or long-term investments depending on the investments business model and if management intends to hold and collect interest and dividends or to realize changes in their value through selling them.
For all investments, the initial measurement is the acquisition price (which is equal to the fair value) in Canadian funds. For equity investments this would likely be the market price and for debt investments such as bonds, it would be the future cash flows discounted using the market interest rate (net present value). Subsequent measurement will depend on the category of the investment. For non-strategic investments, IFRS has three categories: a) FVNI for trading and measured at fair value through net income; b) AC to hold and collect cash flows and measured at amortized cost; and c) FVOCI to collect cash flows and to sell, measured at fair value through OCI with recycling (debt) or without recycling (equities). ASPE has two categories: a) investments for trading purposes (FVNI); and b) all other investments at cost or amortized cost. Strategic investments have three categories: a) holdings of 20% or greater (associate or significant influence) which uses the equity method (IFRS); b) holdings of 50% or greater (subsidiary or control) which uses consolidation (IFRS); and c) joint arrangements made up of various percentages, using the equity method for joint ventures or a form of proportionate consolidation for joint operations. ASPE allows some other choices of methods for its strategic investments and permits straight-line amortization of its debt instruments. The ownership percentages are guidelines only and there can be exceptions to these.
LO 2: Identify and describe the three types of non-strategic investments.
Held-for-trading (FVNI) investments in debt, equity, or derivatives are held for short periods of time. For ASPE companies, these are for equities trading in an active market, debt, or most derivatives under the fair value option (classification irrevocable, once made). FVNI investments are reported as current assets at fair value through net income at each balance sheet date. Transaction costs are expensed. Gains (losses) upon sale are reported in net income. Since they are reported at fair value, no separate impairment tests or charges are required. Investor companies often use an asset valuation allowance account (contra account to the investment asset) to record changes in fair value to preserve the original cost information for the investment. For debt instruments such as bonds, any amortization is calculated using the effective interest method for IFRS. ASPE companies can also elect to use straight-line method for its amortization.
FVOCI investments in debt or equity are for sale, but also for the purpose of collecting the cash flows of interest and dividends. This classification is only available for IFRS companies. They are reported as long-term assets (until within twelve months of the intention to sell them) at fair value through OCI at each balance sheet date until sold. Transactions costs are capitalized. For FVOCI investments in debt, gains/losses upon sale are transferred from OCI to net income. For FVOCI investments in equities, gains/losses upon sale are reclassified from AOCI to retained earnings. Impairment evaluations begin as soon as the investment is acquired and estimated costs regarding potential defaults (expected credit losses or ECL) are calculated and reported at the first reporting date after acquisition. The ECL is adjusted up or down depending on if credit risk increasing or decreasing.
For IFRS, AC investments in debt are reported at amortized cost at each balance sheet date. ASPE companies can also classify equity securities not traded in an active market to this category at cost. Transaction costs are capitalized. AC investments are reported at their carrying value as long-term assets, unless they are expected to mature within twelve months of the balance sheet date. Interest earned on investments in debt (bonds), and dividends earned on equity securities measured at cost, are reported in net income. Any bond premium or discount amortization is calculated using the effective interest rate method for IFRS companies. ASPE can choose to use either the effective interest or the straight-line method. For ASPE, if a loss event occurs, any impairment is calculated as the difference between the carrying value and the present value of the impaired cash flows using the current market rate. Any gain (loss) due to impairment or upon sale is reported in net income. An asset valuation allowance can be used for either standard and any of the classifications.
For IFRS, impairment evaluations for AC investments are the same process as for FVOCI debt. To summarize, impairment evaluations begin as soon as the AC investment is acquired and estimated costs regarding potential defaults (expected credit losses or ECL) are calculated and reported at the first reporting date after acquisition. The ECL is adjusted up or down depending on if credit risk increasing or decreasing.
LO 3: Identify an describe the three types of strategic investments.
Investments in the voting shares of an investee company are undertaken to influence or take over control of the board of directors. The degree of ownership defines the level of influence and the classification.
Associate (Significant Influence) investments of 20% or greater voting shares are reported using the equity method for IFRS. For ASPE, management can choose the equity method, the fair value method through net income if traded in an active market, or the cost method if no market exists. Transaction costs are expensed for the equity and fair value methods and added to the investment (asset) account for the cost method. Investments in associates are reported as long-term investments and income from associates is to be separately disclosed on the income statement. The equity method is based on a reflection of ownership in the investee company. Dividends received are treated as a return of some of the investment asset and are recorded as a reduction in the value of the investment. Conversely, the investor company's share of an associate's reported net income is added to the value of the investment. Included in the journal entries are also any excess amount paid that is attributable to the investee's net identifiable assets amortized over the remaining life of the assets. Any remaining excess is usually attributable to unrecorded goodwill. Any impairment charge other than those attributed to unrecorded goodwill is recoverable, but limited.
Investments in subsidiaries (Control) for greater than 50% of the voting shares in another company are reported using the consolidation method for IFRS. For ASPE companies, there is a choice of consolidation, equity, or cost methods. Transaction costs are expensed for the consolidation and equity methods and added to the investment (asset) account for the cost method. Consolidation involves the elimination of the investment account, and 100% of each asset and liability of the subsidiary is incorporated on a line-by-line basis with the assets and liabilities of the parent company's balance sheet. As well, 100% of the revenues, expenses, gains, and losses are also incorporated on a line-by-line basis in the parent company's consolidated statement of income. If the parent company owns less than 100%, then a minority interest held by other shareholders exists. This is reported as a single line called non-controlling interest in the parent company's consolidated balance sheet and consolidated income statement.
The investments in joint arrangements classification is used when there are multiple investors each having direct rights to the assets and obligations of the joint arrangement. The degrees of ownership can be varying percentages, and are reported in each investor company using the proportionate consolidation method for IFRS. For ASPE companies, there is a choice of using proportionate consolidation, equity, or cost. The mechanics of the proportionate consolidation method are similar to the consolidation method discussed above.
LO 4: Explain disclosures requirements for intercorporate investments.
The various classifications and accounting treatments can significantly impact the asset values and net income of investor companies. Accounting methods in this chapter can obscure some of the key data and stakeholders may have difficulty distinguishing between performance of the investor's core operations and those of its investments. Investment decisions to buy or sell are based on this information so it is critical to be aware of any obscured data that could influence these decisions.
LO 5: Identify the issues for stakeholders regarding investment analyses of performance.
Analyzing the performance of a company's portfolio of intercorporate investments is a critical process. The most significant hurdle to good investment management is to ensure that the information used to assess performance is clearly understood by those performing the analysis and interpreting the results, since some of the critical data can be obscured by the choice of accounting treatment. Investments have three potential accounting categories for both non-strategic (FVNI, FVOCI, AC) and strategic (associate, control, joint arrangements) investments. As well, accounting treatments can also vary between debt instruments and equity securities within a specific classification, making comparisons with other benchmark data (e.g., historic or industry ratios) difficult, and hence performance assessment challenging as well. The result is that both net income and investment accounts balances can differ widely at each reporting date depending on the category classification chosen to account for the investment(s).
LO 6: Discuss the similarities and differences between IFRS and ASPE for the three non-strategic investment classifications.
A decision map assists in determining the proper treatment for various types of investment decisions.
8.08: References
Hewlett Packard. (2011, October 3). HP acquires control of Autonomy Corporation plc [press release]. Retrieved from http://www8.hp.com/us/en/hp-news/press-release.html?id=1373462#.V5omfPkrJph
IFRS. (2011, December 16). IFRS 9 mandatory effective date and disclosures. Retrieved from http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/IFRS-9-Mandatory-effective-date-and-disclosures/Pages/IFRS-9-Mandatory-effective-date-and-disclosures.aspx
IFRS. (2014). IFRS 9 financial instruments (replacement of IAS 39). Retrieved from http://www.ifrs.org/current-projects/iasb-projects/financial-instruments-a-replacement-of-ias-39-financial-instruments-recognitio/Pages/financial-instruments-replacement-of-ias-39.aspx
Souppouris, A. (2012, November 20). HP reports \$8.8 billion 'impairment charge' due to allegedly fraudulent Autonomy accounting. The Verge. Retrieved from http://www.theverge.com/2012/11/20/3670386/hp-q3-2012-financial-results-autonomy-fraud-allegation
Webb, Q. (2012, December 10). Did HP just lost \$5 billion through bad accounting? Slate.com. Retrieved from http://www.slate.com/blogs/breakingviews/2012/12/10/how_did_hp_lose_five_billion_dollars_through_bad_accounting.html | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.07%3A_Chapter_Summary.txt |
8.1 On January 1, Maverick Co. purchased 500 common shares of Western Ltd. for \$50,000 plus a 1% commission of the transaction. On September 30, Western declared and paid a cash dividend of \$2.25 per share. At year-end, the fair value of the shares was \$108 per share. In early March of the following year, Maverick sold the shares for \$57,000 less a 1% commission. The shares are not publicly traded, so Maverick will account for them using the cost method. Maverick follows ASPE.
Required:
1. Describe the type of investment and how it would be reported.
2. Prepare the journal entry for the purchase, the dividends received, and the sale, and any year-end adjustments, if required.
3. Assume now that Maverick follows IFRS and the investment in shares is accounted for as FVNI investment. Prepare the journal entry for the purchase, the dividends received, any year-end adjusting entries and the sale.
4. How would your answer to part (c) change if Maverick follows ASPE and the shares are traded on an active market?
8.2 On January 1, 2020, Smythe Corp. invested in a 10-year, \$25,000 face value 4% bond, paying \$25,523 in cash. Interest is paid annually, every January 1. On January 3, 2028, Smythe sold all of the bonds for 101. Smythe's year-end is December 31 and the company follows IFRS. At the time of purchase, Smythe intended to collect the contractual cash flows of interest and principle, and to hold the bonds to maturity.
Required:
1. What is the effective interest rate for this bond, rounded to the nearest whole dollar? (Hint: this involves a net present value calculation as discussed in Chapter 6: Cash and Receivables.)
2. What is the amount of the bond premium or discount? Indicate if it is a premium or a discount.
3. Record all relevant entries for 2020, the January entry for 2021, and the entry for the sale in 2028, if Smythe classifies the investment as an AC investment. Round amounts to the nearest whole dollar.
4. What is the total interest income and net cash flows for Smythe over the life of the bond? What accounts for the difference between these two amounts?
5. Assume now that Smythe follows ASPE. How would the entries in part (c) differ? Use numbers to support your answer.
8.3 On January 2, Terrace Co. purchased \$100,000 of 10-year, 4% bonds from Inverness Ltd. for \$88,580 cash. The effective interest yield for this transaction is 5.5%. The bonds pay interest on January 1 and July 1. Terrace's business model is to hold and collect the contractual cash flows of interest and principal until maturity. The company follows IFRS and their year-end is December 31.
Required:
1. What is the discount or premium, if any, for this investment? Explain why a premium or discount could occur when purchasing bonds.
2. Record the bond purchase, the first two interest payments, and any year-end adjusting entries, rounding amounts to the nearest whole dollar.
3. Record the entries from part (b), assuming now that Terrace follows ASPE and has chosen the alternative method to account for the premium or discount, if any.
8.4 On January 2, Bekinder Ltd. purchased \$100,000 of 10-year, 4% bonds from Colum Ltd. for \$88,580 cash. The effective interest yield for this transaction is 5.5%. The bonds pay interest on January 1 and July 1. Terrace follows IFRS and classifies this investment as AC. Their year-end is September 30.
Required: Record the first two interest payments and any adjusting entries, rounding amounts to the nearest whole dollar.
8.5 On March 1, Imperial Mark Co. purchased 5% bonds with a face value of \$20,000 for trading purposes. The bonds were priced in the trading markets at 101 to yield 4.87%, at the time of the purchase, and pay interest annually each July 1. At year-end on December 31, the bonds had a fair value of \$21,000. Imperial Mark follows IFRS.
Required:
1. What classification would Imperial Mark use to report this investment?
2. Prepare the journal entries for the bond purchase, the first interest payment, and any year-end adjusting entries required. Round amounts to the nearest whole dollar.
3. Assume now that Imperial Mark follows ASPE. How would Imperial Mark classify and report this investment? Prepare the journal entries from part (b) using the ASPE classification and the alternate method to amortize the premium. Assume that bond investment matures in ten years.
8.6 Halberton Corp. purchased 1,000 common shares of Xenolt Ltd., a publicly traded company, for \$52,800. During the year Xenolt paid cash dividends of \$2.50 per share. At year-end, due to a temporary downturn in the market, the shares had a market value of \$50 per share. Halberton's business model is to collect the dividend cash flows for now, and sell this investment if/when the share price reaches 54,000. Halberton follows IFRS and has elected to classify this investment as FVOCI equities, with recycling to best fit with their intentions to sell, but at a later date.
Required:
1. How would Halberton report this investment?
2. Prepare Halberton's journal entries for the investment purchase, the dividend, and any year-end adjusting entries. Is the drop in market price due to an investment impairment?
3. Prepare the sale entry if Halberton sells the investment one week into the next fiscal year for \$54,200 cash.
4. How would the answer for part (a) change if Halberton followed ASPE?
8.7 The following are various transactions that relate to the investment portfolio for Zeus Corp., a publicly traded corporation. The portfolio is made up of debt and equity instruments all purchased in the current year and accounted for as investments for trading (FVNI). The investee's year-end is December 31.
1. On February 1, the company purchased Xtra Corp. 12% bonds, with a par value of \$500,000, at 106.5 plus accrued interest to yield 10%. Interest is payable April 1 and October 1.
2. On April 1, semi-annual interest was received on the Xtra bonds.
3. On July 1, 9% bonds of Vericon Ltd. were purchased. These bonds, with a par value of \$200,000, were purchased at 101 plus accrued interest to yield 8.5%. Interest dates are June 1 and December 1.
4. On August 12, 3,000 shares of Bretin ACT Corp. were acquired at a cost of \$59 per share. A 1% commission was paid.
5. On September 1, Xtra Corp. bonds with a par value of \$100,000 were sold at 104 plus accrued interest.
6. On September 28, a dividend of \$0.50 per share was received on the Bretin ACT Corp. bonds.
7. On October 1, semi-annual interest was received on the remaining Xtra Corp. bonds.
8. On December 1, semi-annual interest was received on the Vericon Ltd. bonds.
9. On December 28, a dividend of \$0.52 per share was received on the Bretin ACT Corp. shares.
10. On December 31, the following fair values were determined: Xtra Corp. 101.75; Vericon Ltd. bonds 97; and Bretin ACT Corp. shares \$60.50.
Required: Prepare the journal entries for each of the items (a) to (j) above. The company wishes to record interest income separately from other investment gains and losses.
8.8 On January 1, 2020, Verex Co. purchased 10% of Optimal Instrument's 140,000 shares for \$135,000 plus \$1,750 in brokerage fees. Management accounted for this investment as a FVOCI. In October, Optimal declared a \$1.10 cash dividend. On December 31, which is Verex's year-end, the market value of the shares was \$9.80 per share. On February 1, 2021, Verex sold 50% of the investment for \$12 per share less brokerage fees of \$580.
Required:
1. Does Verex follow ASPE or IFRS, and why?
2. Record all the relevant journal entries for Verex for this investment from purchase to sale.
8.9 At December 31, 2020, the following information is reported for Jackson Enterprises Co.:
Net income \$ 250,000
Investments in FVOCI – carrying value 320,000
Investments in FVOCI – fair value 350,000
Accumulated Other Comprehensive Income, Jan 1, 2020 15,000
Required: Calculate the Other Comprehensive Income (OCI) and total comprehensive income for the year ending December 31, 2020, and the December 31, 2020 ending balance for the Accumulated Other Comprehensive Income (AOCI). Ignore income taxes.
8.10 On January 2, 2020, Bellevue Holdings Ltd. purchased 5%, 10-year bonds with a face value of \$200,000 at par. This investment is accounted for at amortized cost. On January 4, 2021, the investee company was experiencing financial difficulties. As a result, Bellevue evaluated the investment and determined the following:
• The present value of the cash flows using the current market rate was \$195,000
• The present value of the cash flows using the original effective interest rate was \$190,000
By June 30, 2021, the investee recovered from the financial difficulties and was no longer considered impaired.
Required: Record all the impairment related transactions in 2020 and 2021 assuming Bellevue uses ASPE.
8.11 On December 31, 2020, Camille Co. provided the following information as at December 31, 2020 about its investment accounts that it acquired for trading purposes:
Carrying Amount Fair Value
ABC Ltd. shares \$15,000 \$17,500
Warbler Corp. shares 24,300 22,500
Shickter Ltd. Shares 75,000 80,200
During 2021, Warbler Corp. shares were sold for \$23,000 and 50% of the Shickter shares were sold for \$42,000. At the end of 2021, the fair value of ABC shares was \$19,200 and Shickter Ltd. was \$41,000. Camille follows IFRS.
Required:
1. Prepare the adjusting entry for December 31, 2020, if any.
2. Prepare the entry for the Warbler and Shickter sales.
3. Prepare the adjusting entry for December 31, 2021, if any.
4. How would the entries in parts (a), (b), and (c) differ if Camille accounted followed ASPE?
8.12 On September 30, 2019, FacePlant Inc. purchased a \$225,000 face-value bond for par plus accrued interest. The bond pays interest each October 31 at 4%. Management's investment business model is to hold for trading purposes. On December 31, 2019, the company year-end, the fair value published for bonds of similar characteristics and risk was 102.6. On March 1, 2020, FacePlant sold the bonds for 102.8 plus accrued interest. FacePlant follows IFRS.
Required:
1. Prepare all the related journal entries for this investment. The company wants to report interest income separately from other gains and losses.
2. Prepare a partial classified balance sheet and income statement for FacePlant, as at December 31, 2019.
3. How would the answer to parts (a) and (b) change if FacePlant followed ASPE?
4. What kinds of returns did this investment generate? (Hint: Consider all sources, such as interest income and gain/loss on sale of the investment.)
8.13 Bremblay Ltd. owns corporate bonds that it accounts for using the amortized cost model. As at December 31, 2020, after an impairment review was triggered, the bonds have the following financial data:
Par value \$ 500,000
Amortized cost 422,000
Discounted cash flow at the current market rate 400,000
Discounted cash flows at the original historic rate 390,000
Bond, net realizable value 395,000
The company does not use a valuation account.
Required:
1. Prepare all relevant entries related to the impairment assuming the company follows ASPE. Is this reversible?
2. Prepare all relevant entries related to the impairment assuming that the company follows ASPE but uses an asset valuation allowance account.
8.14 On January 1, 2020, Helsinky Co. paid cash to acquire 8% bonds of Britanica Corp. with a maturity value of \$250,000, to mature January 1, 2028. The bonds provide a 9% yield and pay interest each December 31. Helsinky purchased these bonds as part of its trading portfolio and accounts for the bonds as FVNI investments. On December 31, 2020, the bonds had a fair value of \$240,000. Helsinky follows ASPE and has a December 31 year-end.
During 2021, the industry sector that Britanica operates in experienced some difficult times due to the drop in international market prices for oil and gas. As a result, by December 31, 2021, their debt was downgraded to the market price of 87.3. By December 31, 2022, the bond had a market price of 92.3. In 2023, conditions improved measurably, resulting in the bonds having a fair value on December 31, 2023 of 99.3.
Required:
1. Prepare all of the relevant entries for 2020, 2021, 2022 and 2023, including any adjusting entries as required. Round entry amounts to the nearest whole dollar.
2. If Helsinky had accounted for the investment at amortized cost, identify and describe the impairment model that the company would have used.
8.15 On January 1, 2014, Billings Ltd. purchased 2,500 shares of Outlander Holdings for \$87,500. During the time that this investment has been held by Billings, the economy and the investee company Outlander have experienced many good and bad times. In 2020, Outlander stated that it was experiencing a reduction in profits but was trying to get things to improve.
Required:
1. Assume that Billings applies the cost method to this investment because there is no active market for Outlander shares. In 2019, Billings had a general sense that the value of its investment in Outlander had probably dropped by about 8.6% to \$80,000. This was not enough to trigger an impairment evaluation as it was still uncertain. By 2020, seeing no improvement, Billings' management completed an evaluation of the investment and estimated that the discounted cash flows from this investment was now \$50,000.
Prepare the entries for 2019 and 2020, assuming that Billings follows ASPE.
2. Next, assume that Billings classifies the investment as a FVNI. By the end of 2019, the price of Outlander shares had fallen from \$34.00 the previous year to \$32.00. By 2020, the price had dropped to a 52-week low of \$25.00 per share.
Prepare the entries for 2019 and 2020, assuming that Billings follows ASPE.
3. Finally, assume that Billings follows IFRS and had purchased the shares of Outlander because Billings wanted to collect the dividends and sell them to realize the change in the shares' valuation. For this reason, Billings classified the investment as a FVOCI investment. How might the accounting treatment change due to a change to IFRS and FVOCI?
8.16 On January 1, 2020, Sandar Ltd. purchased 32% of Yarder Co.'s 50,000 outstanding common shares at a price of \$25 per share. This price is based on Yarder's net assets. On June 30, Yarder declared and paid a cash dividend of \$60,000. On December 31, 2020, Yarder reported net income of \$120,000 for the year. At this time, the shares had a fair value of \$23. Sandar's year-end is December 31 and follows ASPE.
Required:
1. Assuming that Sandar does not have any significant influence over Yarder, prepare all the 2020 entries relating to this investment using the FVNI classification.
2. Prepare all the 2020 entries relating to this investment if it was classified as cost due to no active markets.
3. Prepare all the 2020 entries relating to this investment assuming that Sandar has significant influence over Yarder. Sandar uses the equity method of accounting.
8.17 The following T-account shows various transactions using the equity method. This investment of \$290,000 is made up of 30% of the outstanding shares of another company who had a carrying amount of \$900,000. The excess of the purchase price over the investment amount is attributable to capital assets in excess of the carrying values with the remainder allocated to goodwill. The investor company has significant influence over the investee company. Dividends for 15% of the investee's net income are paid out in cash annually. The investee's net assets have a remaining useful life of 10 years. The investor company follows IFRS.
Investment in Investee Company
\$290,000
60,000
9,000
1,500
Required:
1. What was the investee's total net income for the year?
2. What was the investee's total dividend payout for the year?
3. What is the investor's share of net income?
4. How much was the investor's annual depreciation of the excess payment for capital assets?
5. How much of the excess payment would be assigned to goodwill?
6. How much are the investor's share of dividends for the year?
8.18 On January 1, 2019, Dologan Enterprises Ltd. purchased 30% of the common shares of Twitterbug Inc. for \$380,000. These shares are not traded in any active markets. The carrying value of Twitterbug's net assets at the time of the shares purchase was \$1.2 million. Any excess of the purchase cost over the investment is attributable to unrecorded intangibles with a 10-year life.
During 2019, the following summary operations for Twitterbug occurred:
Net income and Total comprehensive income \$ 50,000
Dividends paid 25,000
Investment fair value 400,000
During 2020, the following summary operations for Twitterbug occurred:
Net loss and Total comprehensive loss \$ 15,000
Dividends paid 0
Investment fair value 360,000
Investment recoverable amount 370,000
Required:
1. Prepare all the relevant entries for 2019 and 2020 assuming no significant influence. Assume that Dologan follows IFRS and accounts for the investment as a FVNI.
2. How is the comprehensive income affected in 2019 and 2020 in part (a)?
3. Prepare all the relevant entries for 2019 and 2020 assuming that Dologan can exercise significant influence. Assume that Dologan follows IFRS.
4. Calculate the carrying value of the investment as at December 31, 2020 assuming Dologan can exercise significant influence and follows IFRS.
5. How would your answer to part (c) be different if Twitterbug's statement of comprehensive income included a loss from discontinued operations of \$15,000 (net of tax) for 2019?
8.19 On January 1, 2020, Chacha Holdings Ltd., a privately-held corporation that follows ASPE, purchased 35% of the common shares of Eugene Corp. for \$600,000. With this purchase, Chacha now has significant influence over Eugene, who is a supplier of materials for Chacha's production processes. Below is some information about the investee at the date the shares were purchased:
Carrying value of assets subject to amortization \$ 900,000
Carrying value of assets not subject to amortization
(10 years useful life remaining, on a straight-line basis) 780,000
Fair value of the assets subject to amortization 1,050,000
Liabilities 225,000
Required: Prepare all relevant entries for the investment based on the information provided above. Subsequently, the investee reported net income of \$225,000 and dividends paid of \$100,000. Assume that any excess of payment that is unexplained is attributed to goodwill.
8.20 Below are details for several independent investments:
1. Preferred shares were purchased from a publicly traded company because of their favourable dividend payout history. They are for sale, but management has no specific intention to sell at this time.
2. On February 1, 2020, 10% or 1,400 shares of the total outstanding shares were purchased from another company that is a privately-held corporation. Management intends to acquire 30% of the total outstanding shares.
3. The company has an investment in 10-year bonds which will mature in 5 more years. Management's intention was to hold them until maturity but the company is short of cash, so a possibility exists that they may be sold in 2020, though that is not certain at this point.
4. Common shares of a supplier company were purchased to strengthen their relationship. Management intends to hold this investment into the future.
5. On January 1, 2020, a 4% bond that will mature in 6 years was purchased at market price of 92. When the price point reaches 103, management intends to sell the investment.
6. Bonds that mature in 10 years were purchased with monies set aside for a new building purchase expected to occur in 10 years. The bonds will be sold once they mature.
7. On March 1, 2020, bonds maturing in 2021 were purchased.
Required:
1. What classification would each investment item be if the investor company follows APSE? How are impairments treated from an accounting perspective?
2. What classification would each investment item be if the investor company follows IFRS?
8.21 On January 1, 2020, Amev Ltd., an IFRS company, acquires a 3%, 5-year, bond at par for \$1,150,000, which it intends to hold and collect the contractual cash flows of principal and interest. At year-end, management has determined that there is no significant increase in credit risk, but there is a 1% chance that the company will not collect 15% of the bond face value in the next 12 months.
Required: Determine the investment's classification and prepare the year-end journal entry. What is the carrying value of the bond?
8.22 Referring to the data in Exercise 8–21, assume now that management estimates that there has been a significant increase in the credit risk and there is now a 6% chance that the Amev will not collect 50% of the bond face value over its life.
Required: Prepare the year-end entry and determine the carrying value of the investment. What else has changed since the previous ECL valuation?
8.23 Referring to the data in Exercise 8–21, prepare the year-end entry assuming that Amev classifies the investment as FVOCI and the fair value of the bond at year-end was 99.5, assuming the probabilities have not changed and there has been no significant change in credit risk. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/08%3A_Intercorporate_Investments/8.09%3A_Exercises.txt |
Winter in Hawaii!
In July 2014, WestJet Airlines Ltd. (WestJet) announced that it planned to purchase four Boeing 767-300ERW aircraft to continue and enhance its service from Alberta to Hawaii. These flights had previously been offered through an arrangement with another airline. This represented a significant investment by the company, as each Boeing 767 sells for approximately \$191 million. The company had previously announced in March 2014 that it had placed an order for an additional five Bombardier Q400 NextGen aircraft. Aside from these orders, the company had also taken delivery of five other Q400 NextGen aircraft and two Boeing 737NG 800s in the first half of 2014. The company's total fleet of aircraft in mid-2014 was 120 units, but the company indicated that it planned to expand the fleet to approximately 200 units by 2027.
Clearly, aircraft equipment is a significant asset for an airline. In WestJet's case, the total carrying value of all its property and equipment at June 30, 2014 was approximately \$2.7 billion. This represented approximately 66% of the company's total asset base. The bulk of the company's investment in equipment was comprised of aircraft (\$1.9 billion) and deposits on aircraft (\$0.5 billion). For any financial statement reader or decision maker, it is important to gain a clear understanding of the nature of this significant asset class in WestJet.
WestJet reports that their aircraft equipment is actually comprised of several components. These components include the aircraft itself—the engine, airframe, and landing gear components—and the live satellite television equipment. Each component is depreciated over different periods of time, ranging from five to twenty years. In addition to the aircraft equipment, the company depreciates other property and equipment, such spare engines, ground property, buildings, and leasehold improvements over periods ranging from three to forty years. It is evident that understanding the nature and identification of components is an important accounting function in a company like WestJet.
In the company's accounting policy note, it is stated that the identification of components is based on management's judgment of what constitutes a significant cost in relation to the total cost of an asset. As well, it states that management considers the patterns of consumption and useful lives of the assets when identifying reportable components. The accounting policy note further states that most overhaul expenditures are capitalized and depreciated.
As WestJet continues to expand its fleet into new types of aircraft, it will be important for management to consider their accounting policies carefully with respect to their property and equipment. With such a significant investment in non-current assets, accounting decisions regarding the identification of asset components can have a profound effect on reported income. A sound understanding of the criteria and principles behind capitalization of property, plant, and equipment assets is essential to understanding WestJet.
(Sources: Barterm, 2014; Westjet, 2014)
Learning Objectives
After completing this chapter, you should be able to:
• Describe the characteristics of property, plant, and equipment assets that distinguish them from other assets.
• Identify the criteria for recognizing property, plant, and equipment assets.
• Determine the costs to include in the measurement of property, plant, and equipment at acquisition.
• Determine the cost of a property, plant, and equipment asset when the asset is acquired through a lump-sum purchase, a deferred payment, or a non-monetary exchange.
• Identify the effect of government grants in determining the cost of a property, plant, and equipment asset.
• Determine the cost of a self-constructed asset, including treatment of related interest charges.
• Identify the accounting treatment for asset retirement obligation.
• Apply the cost model.
• Apply the revaluation model.
• Apply the fair value model.
• Explain and apply the accounting treatment for post-acquisition costs related to property, plant, and equipment assets.
• Identify key differences between IFRS and ASPE.
Introduction
The rapid development of information technology in recent decades has highlighted the importance of intellectual capital. The future of commerce, we are told, lies in the development of ideas, processes, and brands. Yet, even with this change in focus from a traditional manufacturing economy, the importance of the physical assets of a business cannot be ignored. Even companies like Facebook and Google still need computers to run their applications, desks and chairs for staff to sit in, or buildings to house their operations. And even as the knowledge economy grows, there continues to be an increasing variety of consumer products being manufactured and sold. All of this activity requires capacity, and this capacity is provided by the property, plant, and equipment of a business.
09: Property Plant and Equipment
The computers, furniture, buildings, land, factory equipment, and so forth that a business owns are called its hard assets, also sometimes referred to as fixed assets or capital assets. But the term that is consistently used in the IFRS publications is property, plant, and equipment (PPE).
According to IAS 16.6, under IFRS property, plant, and equipment are the tangible items that are:
• held for use in the production or supply of goods or services, for rental to others, or for administrative purposes
• expected to be used during more than one period (IAS, 2003a)
A key element of the definition is that the item be tangible. This means that it must have a physical substance; therefore, it does not include items of an intangible nature, such as a copyright. The intended use of the asset is also important, as it is expected that it be used for some productive purpose and not simply resold to a customer. This distinction of intent is important. An automobile held by a car dealership would be considered inventory, as the dealership intended to resell it; whereas, an automobile owned by a rental company would be considered PPE, as the intended use is earning revenue from rentals. The definition also suggests that the asset should be useful to the business for more than one accounting period. Although this means that a tangible, productive asset with a useful life of two years would be considered PPE, many PPE items have lives much longer than this. A property that includes land and a manufacturing facility could be useful to a business for thirty or forty years, or even longer. The long-term, productive assets of a business are sometimes referred to as bricks and mortar, suggesting something of the relatively permanent nature of these assets. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.01%3A_Definition.txt |
According to IAS 16.7, a PPE item should be recognized when:
• It is probable that future economic benefits associated with the item will flow to the entity.
• The item's cost can be measured reliably (IAS 2003a).
Notice that these conditions are similar to our basic definition of an asset. Also notice that the definition is phrased in terms of economic benefits, rather than of the item itself. This means that some expenditures not directly incurred to purchase the asset, but necessary nonetheless to guarantee the continued productive use of the asset, may still be included in the asset's cost. For example, safety equipment mandated by legislation may not provide direct revenue to the business, but is necessary in order to continue operating the equipment legally. Thus, these costs should be capitalized as part of the asset's cost, and if significant, may even be identified as a separate component of the asset.
The definition of PPE does not contain any guidance on how to define an individual element of PPE. This means that the accountant will need to apply professional judgment to determine the segregation of various PPE components. If we consider a large, complex piece of equipment such as an airplane, the need for proper component accounting becomes clear. An airplane contains several major elements: the fuselage, the engines, and the interior fixtures (seats, galley, and so on). As indicated in the opening story about WestJet, each of these elements may have a significantly different useful life, and may require maintenance and replacement at different intervals. Because we need to depreciate assets based on their useful lives, and because we need to consider the accounting treatment of subsequent expenditures, it is important to define the separate components of a PPE item properly at the time of recognition. Accountants will usually consider the value of the component relative to the whole asset, along with the useful life and other qualitative and practical factors when making these determinations.
IAS 16 also indicates that spare parts, stand-by equipment, and servicing equipment should be recognized as property, plant, and equipment if they meet the definition. If they don't meet the definition, then it is more appropriate to classify these items as inventory. This is an area where materiality and the accountant's professional judgment will come into play, as the capitalization of these items may not always be practical.
9.3.01: Self-Constructed Assets
PPE assets are initially measured at their cost, which is the cash or fair value of other assets given to acquire the asset. A few key inclusions and exclusions need to be considered in this definition.
Any cost required to purchase the asset and bring it to its location of operation should be capitalized. As well, any further costs required to prepare the asset for its intended use should also be capitalized. The following is a list of some of the costs that should be included in the capitalized amount:
• Purchase price, including all non-recoverable tax and duties, net of discounts
• Delivery and handling
• Direct employee labour costs to construct or acquire the asset
• Site preparation
• Other installation costs
• Net material and labour costs required to test the asset for proper functionality
• Professional fees directly attributable to the purchase
• Estimates of decommissioning and site restoration costs
Costs that should not be included in the initial capitalized amount include:
• Initial operating losses
• Training costs for employees
• Costs of opening a new facility
• Costs of introducing a new product or service
• Costs of reorganization and operation at a new location
• Administration and general overhead costs
• Other revenue or expenses that are incidental to the development of the PPE
9.03: Measurement at Recognition
When a company chooses to build its own PPE, further accounting problems may arise. Without a transaction with an external party, the cost of the asset may not be clear. Although the direct materials and labour needed to construct the asset are usually easy to identify, the costs of overheads and other indirect elements may be more difficult to apply. The general rule to apply here is that only costs directly attributable to the construction of the asset should be capitalized. This means that any allocation of general overheads or other indirect costs is not appropriate. As well, any internal profits or abnormal costs, such as material wastage, are excluded from the capitalized amount. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.02%3A_Recognition.txt |
One particular problem that arises when a company constructs its own PPE is how to treat any interest incurred during the construction phase. IAS 23 (IAS, 2007) requires that any interest that is directly attributable to the construction of a qualifying asset be capitalized. A qualifying asset is any asset that takes a substantial amount of time to be prepared for its intended use. This definition could thus include inventories as well as PPE, although the standard does not require capitalization of interest for inventory items that are produced in large quantities on a regular basis.
If a PPE asset is qualified under this definition, then a further question arises as to how much interest should be capitalized. The general rule is that any interest that could have been avoided by not constructing the asset should be capitalized. If the company has obtained specific financing for the project, then the direct interest costs should be easy to identify. However, note that any interest revenue earned on excess funds that are invested during the construction process should be deducted from the total amount capitalized.
If the project is financed from general borrowings and not a specific loan, identification of the capitalized interest is more complicated. The general approach here is to apply a weighted average cost of borrowing to the total project cost and capitalize this amount. Some judgment will be required to determine this weighted average cost in large, complex organizations.
Interest capitalization should commence when the company first incurs expenditures for the asset, first incurs borrowing costs, and first undertakes activities necessary to prepare the asset for its intended use. Interest capitalization should cease once substantially all of the activities necessary to get the asset ready for its intended use are complete. Interest capitalization should also be stopped if active development of the project is suspended for an extended period of time.
Many aspects of the accounting standards for interest capitalization require professional judgment, and accountants will need to be careful in applying this standard.
9.3.03: Asset Retirement Obligations
For certain types of PPE assets, the company may have an obligation to dismantle, clean up, or restore the site of the asset once its useful life has been consumed. An example would be a drilling site for an oil exploration company. Once the well has finished extracting the oil from the reserve, local authorities may require the company to remove the asset and restore the site to a natural state. Even if there is no legal requirement to do so, the company may still have created an expectation that it will do so through its own policies and previous conduct. This type of non-legally binding commitment is referred to as a constructive obligation. Where these types of legal and constructive obligations exist, the company is required to report a liability on the balance sheet equal to the present value of these future costs, with the offsetting debit being record as part of the capital cost of the asset. This topic will be covered in more detail in Chapter 10, but for now, just be aware that this type of cost will be capitalized as part of the PPE asset cost.
9.3.04: Lump Sum Purchases
There are instances where a business may purchase a group of PPE assets for a single price. This is referred to as a lump sum, or basket, purchase. When this occurs, the accounting issue is how to allocate the purchase price to the individual components purchased. The normal practice is to allocate the purchase price based on the relative fair value of each component. Of course, this requires that information about the assets' fair values be available and reliable. Often, insurance appraisals, property tax assessments, depreciated replacement costs, and other appraisals can be used. The reliability and suitability of the source used will be a matter of judgment on the part of the accountant.
Consider the following example. A company purchases land and building together for a total price of \$850,000. The most recent property tax assessment from the local government indicated that the building's assessed value was \$600,000 and the land's assessed value was \$150,000. The total purchase price of the components would be allocated as follows:
Land = \$170,000
Building = \$680,000
Total = \$850,000 | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.03%3A_Measurement_at_Recognition/9.3.02%3A_Borrowing_Costs.txt |
When PPE assets are acquired through payments other than cash, the question that arises is how to value the transaction. Two particular types of transactions can occur: 1) a company can acquire a PPE asset by issuing its own shares, or 2) a company can acquire a PPE asset by exchanging it with another asset the company currently owns.
Asset Acquired by Issuing Shares
When a company issues its own shares to acquire an asset, the transaction should be recorded at the fair value of the asset acquired. IFRS presumes that this fair value should normally be obtainable. This makes sense, as it unlikely that a company would acquire an asset without having a reasonable estimate of its value. If the fair value of the asset acquired is not determinable, then the asset should be reported at the fair value of the shares given up. This value is relatively easy to determine for an actively traded public company. In cases where neither the value of the asset nor the value of the shares can be reliably determined, the asset could not be recorded.
Asset Acquired in Exchange for Other Assets
When assets are acquired though exchange with other non-monetary assets or a combination of monetary and non-monetary assets, the asset acquired should be valued at the fair value of the assets given up. If this value cannot be reliably determined, then the fair value of the asset received should be used. Notice how this differs from the rule for share-based payments. The presumption is that the fair values of assets are generally more reliable than the fair values of shares.
The implication of this general rule is that when non-monetary assets are exchanged, there will likely be a gain or loss recorded on the transaction, as fair values and carrying values are usually not the same. The recognition of a gain or loss suggests that the earnings process is complete for this asset. This seems reasonable, as each company involved in the transaction would normally expect to receive some economic benefit from the exchange.
There are two instances, however, where the general rule does not apply. These two situations occur when:
• The fair values of both assets are not reliably measurable.
• The transaction lacks commercial substance.
Although it is an unusual situation, it is possible that the fair value of neither asset can be reliably determined. In this case, the asset acquired would be recorded at the book value of the asset given up. This means that no gain or loss would be recorded on the transaction.
A more likely situation occurs when the transaction lacks commercial substance. This means that after the exchange of the assets, the company's economic position has not been altered significantly. This condition can usually be determined by considering the future cash flows resulting from the exchange. If the business is not expected to realize any difference in the amount, timing, or risk of future cash flows, either directly or indirectly, then there is no real change in its economic position. In this case, it would be unreasonable to recognize a gain, as there has been no completion of the earnings process. This type of situation could occur, for example, when two companies want to change their strategic directions, so they swap similar assets that may be located in different markets. There may be no significant difference in cash flows, but the assets received by each company are more suitable to their long-term plans. In this case, the asset acquired is reported at the carrying value of the asset given up.
One instance where accountants need to be careful occurs when an asset exchange lacks commercial substance and the carrying amount of the asset given up is greater than the fair value of the asset acquired. If we apply the principle for non-commercial exchanges by recording the asset acquired at the carrying value of the asset given up, the result will be an asset reported at an amount greater than its fair value. This result would create a misleading statement of financial position, so in this case, the asset acquired should be reported at its fair value, even though there is no commercial substance. This will result in a loss on the exchange.
Consider the following illustrations of asset exchanges.
Commercial Substance
ComLink Ltd. decides to change its manufacturing process in order to accommodate a new product that will be introduced next year. They have decided to trade a factory machine that is no longer used in their production for a new machine that will be used to make the new product. The machine that is being disposed of had an original cost of \$78,000 and accumulated depreciation of \$60,000. The fair value of the old machine at the time of exchange was \$22,000. The new machine being obtained has a list price of \$61,000. After a period of negotiation, the seller finally agreed to sell the new machine to ComLink Ltd. for cash of \$33,000 plus the trade-in of the old machine. As the new machine will be used to manufacture a new product for the company, and the old machine was essentially obsolete, we can reasonably conclude that this transaction has commercial substance. In this case, the journal entry to record the exchange will be:
Note that the new machine is reported at the fair value of the assets given up in the exchange (). Also note that the gain on the disposal is equal to the fair value of the old machine (\$22,000) less the carrying value of the machine at disposal ().
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No Commercial Substance
Assume that ComLink Ltd. has a delivery truck that it purchased one year ago for \$32,000. Depreciation of \$5,000 has been recorded to date on this asset. The company decides to trade this for a new delivery truck in a different colour. The new truck has the same functionality and expected life as the old truck. The only difference is the colour, which the company feels ties in better with its corporate branding efforts. No identifiable cash flows can be associated with the effect of this branding. The fair value of the old truck at the time of the trade was \$28,000. The seller of the new truck agrees to take the old truck in trade, but requires ComLink Ltd. to pay an additional \$5,000 in cash. In this instance, because there is no discernible effect on future cash flows, we would reasonably conclude that the transaction lacks commercial substance. The journal entry to record this transaction would be:
Note that the new truck is reported at the book value of the assets given up (). Also note that the implied fair value of the new truck () is not reported, and no gain on the transaction is realized.
If the same exchange occurred, but we were able to ascertain that the fair value of the asset acquired was only \$30,000, it would be inappropriate to record the new asset at a value of \$32,000, as this would exceed the fair value. The journal entry would thus be:
Note that the new truck is recorded at the lesser of its fair value and the book value of the asset given up. This results in a loss on the transaction, even though the transaction lacks commercial substance.
A video is available on the Lyryx web site. Click Here to view the video. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.03%3A_Measurement_at_Recognition/9.3.05%3A_Non-monetary_Exchanges.txt |
When a PPE asset is purchased through the use of long-term financing arrangements, the asset should initially be recorded at the present value of the obligation. This technique essentially removes the interest component from the ultimate payment, resulting in a recorded amount that should be equivalent to the fair value of the asset. (Note, however, that interest on self-constructed assets, covered in IAS 23 and discussed previously in this chapter, is included in the cost of the asset.) Normally, the present value would be discounted using the interest rate stated in the loan agreement. However, some contracts may not state an interest rate or may use an unreasonably low interest rate. In these cases, we need to estimate an interest rate that would be charged by arm's length parties in similar circumstances. This rate would be based on current market conditions, the credit-worthiness of the customer, and other relevant factors.
Consider the following example. ComLink Ltd. purchases a new machine for its factory. The supplier agrees to terms that allow ComLink Ltd. to pay for the asset in four annual instalments of \$7,500 each, to be paid at the end of each year. ComLink Ltd. issues a \$30,000, non-interest bearing note to the supplier. The market rate of interest for similar arrangements between arm's length parties is 8%. ComLink Ltd. will record the initial purchase of the asset as follows:
The capitalized amount of \$24,841 represents the present value of an ordinary annuity of \$7,500 for four years at an interest rate of 8%. The difference between the capitalized amount and the total payments of \$30,000 represents the amount of interest expense that will be recognized over the term of the note.
9.3.07: Government Grants
Governments will at times create programs that provide direct assistance to businesses. These programs may be designed to create employment in a certain geographic area, to develop research and economic growth in a certain industry sector, or other reasons that promote the policies of the government. When governments provide direct grants to businesses, there are a number of accounting issues that need to be considered.
IAS 20 states that government grants should be "recognized in profit or loss on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate" (IAS 20-12, IAS, 1983). This type of accounting is referred to as the income approach to government grants, and is considered the appropriate treatment because the contribution is coming from an entity other than the owner of the business.
If the grant is received in respect of current operating expenses, then the accounting is quite straightforward. The grant would either be reported as other income on the statement of profit or loss, or the grant would be offset against the expenses for which the grant is intended to compensate. When the grant is received to assist in the purchase of PPE assets, the accounting is slightly more complicated. In this case, the company can defer the grant income, reporting it as a liability, and then recognize the income on a systematic basis over the useful life of the asset. Alternately, the company could simply use the grant funds received to offset the initial cost of the asset. In this method, the grant is implicitly recognized through the reduced depreciation charge over the life of the asset.
Consider the following example. ComLink Ltd. purchases a new factory machine for \$100,000. This machine will help the company manufacture a new, energy-saving product. The company receives a government grant of \$20,000 to help offset the cost of the machine. The machine is expected to have a five-year useful life with no residual value. The accounting entries for this machine would look like this:
Deferral Method Offset Method
Debit Credit Debit Credit
Machine 100,000 80,000
Deferred grant 20,000 -
Cash 80,00 80,000
Purchase of machine.
Depreciation expense 20,000 16,000
Accumulated depreciation 20,000 16,000
Deferred grant 4,000 -
Grant income 4,000 -
First year depreciation and revenue recognition.
For Depreciation expense, deferral method: (); offset method: ()
For Deferred grant: ()
The net effect on income of either method is the same. The difference is only in the presentation of the grant amount. Under the deferral method, the deferred grant amount presented on the balance sheet as a liability would need to be segregated between current and non-current portions.
Companies may choose either method to account for grant income. However, significant note disclosures of the terms and accounting methods used for grants are required to ensure comparability of financial statements. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.03%3A_Measurement_at_Recognition/9.3.06%3A_Deferred_Payments.txt |
Once a PPE asset has been recognized and recorded, there are three choices in IFRS of how to deal with the asset in subsequent accounting periods. The asset may be accounted for using the cost model, the revaluation model, or the fair value model. Each of these models treats subsequent changes in the value of the asset differently. When a model is chosen, it must be applied consistently to all the assets in a particular class.
9.04: Measurement After Initial Recognition
The cost model is considered the more established or traditional method of accounting for PPE assets. This model measures the asset after its acquisition at its cost, less any accumulated depreciation or accumulated impairment losses. The model, thus, does not attempt to adjust the asset to its current value, except in the case of impairment. This means that changes in the value of the asset are not recognized in income until that value is actually realized through the sale of the asset. This model is widely used and is very easy to understand and apply. Depreciation and impairment will be discussed in a later chapter.
9.4.02: Revaluation Model
IFRS allows an alternative method for subsequent reporting of PPE assets. The revaluation model attempts to capture changes in an asset's value over its life. An essential condition of using this model is that the fair value of an asset be available and reliable at the reporting date. Fair values can often be determined through the use of qualified appraisers or other professionals who understand how to interpret market conditions. If appraisals are not available, other valuation techniques may be used to estimate the value. However, in some cases reliable fair values will not be available, so the model cannot be used.
The standard does not require that revaluations be performed at each reporting date, but it does require that the reported value not be materially different from the current fair value at the reporting date. If the property, plant, and equipment asset is expected to have volatile and significant changes in value, then annual revaluations are required. If the asset is only subject to insignificant changes in fair value each year, then revaluations every three to five years are recommended. The costs of obtaining valuation data or appraisals are likely one reason this method is not used by many companies. There is an additional cost in obtaining the reliable fair values, which many companies would compare to the marginal benefit of adjusting the PPE amounts on the balance sheet. In many cases, the fair values and depreciated costs of PPE assets would not be significantly different, so the model would not be applied. For some types of assets such as real estate, however, the revaluation model may provide significantly different results than the cost model. In these instances, the use of the revaluation model has a stronger justification.
In applying the revaluation model, adjustments are made to the PPE asset value by either adjusting the cost and accumulated depreciation proportionally, or by eliminating the accumulated depreciation and adjusting the asset cost to the new value. The second approach is simpler to apply, and will be used in the illustrations below.
When adjusting the value of the PPE asset, the obvious question is how to treat the offsetting side of the journal entry. The answer is to use an account called Revaluation Surplus, which is reported as part of other comprehensive income. However, there are some complicating factors in using this account.
If the adjustment increases the reported value, then report as part of revaluation surplus. If the adjustment decreases the reported value, then first reduce any existing revaluation surplus for that asset to zero, and record the remaining reduction as an expense in profit or loss. This expense may be reversed in future periods, if the value once again rises.
Consider the following example to illustrate this model. ComLink Ltd. purchases a factory building on January 1, 2019, for \$500,000. The building is expected to have a useful life of twenty years with no residual value. The company uses the revaluation model for this class of asset and will obtain current valuations every two years. The journal entries for the first two years would be:
On December 31, 2020, an appraisal on the building is conducted and its fair value is determined to be \$490,000. The following adjustment, which eliminates accumulated depreciation and adjusts the asset's cost to its new value, will be required:
The cost of the building is now \$490,000 and the accumulated depreciation is \$nil. Because the building has now been revalued, we need to revise the depreciation calculation. Assuming no change in the remaining useful life of the asset, the new depreciation rate will be \$490,000 18 years = \$27,222. The journal entries for the next two years will be:
On December 31, 2022, the building is again appraised, and this time the fair value is determined to be \$390,000. The following journal entries will be required:
The revaluation loss of \$5,556 will be reported on the income statement in the current year. In future years, if the value of the building increases again, a revaluation gain can be reported on the income statement up to this amount. Any further increases will once again increase the Revaluation Surplus account.
The Revaluation Surplus (OCI) account itself can be dealt with in two ways. It can simply continue to be reported as part of accumulated other comprehensive income for the life of the asset. Once the asset is disposed of, the balance of the account is transferred from Accumulated Other Comprehensive Income directly to retained earnings. Another option is to make an annual transfer from the revaluation surplus account to retained earnings. The amount that can be transferred is limited to the difference between the depreciation expense that is actually recorded (using the revalued carrying amount) and the amount that would have been recorded had the cost model been used instead.
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9.4.03: Fair Value Model
The fair value model is a specialized type of optional accounting treatment that may be applied to only one type of asset: investment properties. IAS 40 (IAS, 2003b) considers investment properties to be land or buildings that are held primarily for the purpose of earning rental income or capital appreciation, are not used for production or administrative purposes of the business, and are not held for resale in the ordinary course of business. This definition suggests that the asset will earn cash flows that are largely independent of the regular operations of the business, which is why a different accounting standard can be applied. The fair value model requires adjustment of the carrying value of the investment property to its fair value every reporting period. As well, no depreciation is recorded for investment properties under the fair value model. The key feature that differentiates this model from the revaluation model is that gains and losses in value with investment properties are reported directly on the income statement, rather than using a Revaluation Surplus (OCI) account. This can be illustrated with the following example.
ComLink Ltd. purchases a vacant piece of land that it feels will appreciate in value over the next ten years as a result of suburban expansion. The land is initially purchased for \$5 million on January 1, 2019. The company has classified this land as an investment property and has chosen to use the fair value model. The appraised values of the land over the next three years are:
Appraisal Date Appraised Value
December 31, 2019 \$5,200,000
December 31, 2020 \$4,600,000
December 31, 2021 \$4,850,000
The adjustments will be recorded each year as follows:
It should be noted that this model is optional for reporting purposes. A company may choose to use the cost model for its investment properties. However, if the fair value model is chosen, all investment properties must be reported this way. As well, there are significant disclosure requirements under this model. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.04%3A_Measurement_After_Initial_Recognition/9.4.01%3A_Cost_Model.txt |
Costs to operate and maintain a PPE asset are rarely ever captured completely by the initial purchase price. After a PPE asset is acquired, it is quite likely that there will be additional costs incurred over time to maintain or improve the asset. The essential accounting question that needs to be answered here is whether these costs should be recognized immediately as an expense, or whether they should be capitalized and depreciated in future periods. IAS 16 indicates that costs incurred in the day-to-day servicing of a PPE asset should not be capitalized, as they do not meet the recognition criteria (i.e., they do not provide future economic benefits). The types of costs discussed in the standard include labour, consumables, and small parts. Immediately expensing these types of costs recognizes the fact that normal repair and maintenance activities do not significantly extend the useful life of an asset, nor do they improve the function of the asset. Rather, they simply maintain the existing capacity. As such, they should be recognized as period costs.
Sometimes, a major component of a PPE asset may require periodic replacement. For example, the motor of a transport truck may need replacement after operating for a certain number of hours. Or, a restaurant may choose to knock down its existing walls to reconfigure and redecorate the space to create a fresher image. If the business managers think these changes create the potential for future economic benefits, then capitalization would be appropriate.
When these types of items are capitalized, they are actually replacing an existing component of a PPE asset. In these cases, the old component needs to be removed from the carrying value of the asset before the new addition is capitalized. This procedure is required, even if the part being replaced was not actually recorded as a separate component. If this is the case, the standard allows for a reasonable estimate to be made of the asset's carrying value.
Consider the following example. LeCorre, a Michelin-starred restaurant, has recently decided to update its image through a complete renovation of the dining room. This process involved tearing out all the existing fixtures and relocating several walls. None of the fixtures or walls were reported as separate components, as they were merely included as part of the original building cost when it was purchased five years ago. The building has been depreciated on a straight-line basis over an estimated useful life of thirty years. The total cost of the renovation was \$87,000, and the company received an additional \$2,000 from the sale of the old fixtures. It was also determined that construction costs in this area have increased by approximately 30% over the last five years.
The journal entries to record this renovation will be separated into two parts: the disposal of the old assets and the purchase of the new assets.
1. Disposal of old assets
If we assume that the old fixtures and decorations are of a similar quality as the new ones, then the construction cost of the new renovations can be used to estimate the cost of the assets that have been removed. With an increase in construction costs of 30% over five years, the original cost can be estimated to be . If the asset has been depreciated for five years, then the accumulated depreciation would be . The loss on disposal equals the difference between the calculated, net carrying value and the proceeds received.
2. Purchase of the new assets
If the management of LeCorre believes that these types of interior renovations will continue in the future at similar intervals, it should record the cost as a separate component, as the useful life would clearly differ from the building itself.
Note that if the original renovations had already been recorded as a separate component, the journal entries would take the same form, but there would be no need to estimate the cost and book value of the original assets, as they would be evident from the accounting records.
9.06: IFRS ASPE Key Differences
IFRS ASPE
Component accounting is required. An item of PPE is defined by the economic benefits that are derived from it, not the physical nature of the item. Significant and separable component parts should be recorded as individual assets where practicable. In practice, this definition has led to less components being reported under ASPE than IFRS.
Any revenue and expense incurred prior to the PPE asset being ready to use is taken to profit or loss, as this is considered incidental to the construction of the asset. Any revenue or expense from using an item of PPE prior to its substantial completion is included in the asset's cost. Expenses are added to the asset cost while revenues are deducted from the asset cost.
Borrowing costs directly attributable to PPE acquisition, construction, or development must be capitalized. Directly attributable Interest costs may be capitalized if this is the company's chosen accounting policy.
The cost of legal and constructive obligations for asset retirement must be capitalized. Only legal obligations for asset retirement need to be capitalized.
PPE items can be accounted for using the cost or the revaluation models. Only the cost model may be used for PPE.
Investment properties can be accounted for using the cost or fair value models. No separate standard for investment properties. They fall under the same general rule (i.e., the cost model) as other types of PPE.
IAS 16.19 (IAS, 2003a) prohibits the inclusion of general overhead costs in the capital cost of a property, plant, and equipment asset. S 3061.08 allows directly attributable overhead costs to be included in the capital cost of self-constructed property, plant, and equipment assets.
The general capitalization criterion requires the presence of future economic benefits flowing to the entity. However, IAS 16.20 (IAS, 2003a) prohibits the capitalization of redeployment, relocation, or reorganization costs. This excludes the capitalization of some of the items that could be classified as betterments under ASPE. S 3061.14 allows for the capitalization of betterments. Betterments are costs incurred to improve the service capacity, extend the useful life, improve the quantity or quality of output, or reduce the operating costs of a property, plant, and equipment asset. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.05%3A_Costs_Incurred_After_Acquisition.txt |
LO 1: Describe the characteristics of property, plant, and equipment assets that distinguish them from other assets.
PPE assets are tangible items that are held for use in the production or supply of goods and services, for rental to others, or for administrative purposes. It is presumed that they are expected to be used for more than one period. The distinguishing features are in their nature (they are tangible) and in their use (production, rather than resale).
LO 2: Identify the criteria for recognizing property, plant, and equipment assets.
PPE assets should be recognized when it is probable that future economic benefits associated with the item will flow to the entity and the item's cost can be measured reliably. As the definition of PPE does not identify what specific, physical element should be measured, it is important for accountants to apply good judgment in identifying the specific components of an asset that need to be reported separately.
LO 3: Determine the costs to include in the measurement of property, plant, and equipment at acquisition.
PPE costs should include any cost required to purchase the asset and bring it to its intended location of use. As well, any further costs incurred to prepare the asset for its intended use should also be capitalized.
LO 4: Determine the cost of a property, plant, and equipment asset when the asset is acquired through a lump-sum purchase, a deferred payment, or a non-monetary exchange.
When an asset is acquired through a lump-sum exchange, the purchase price should be allocated based on the relative fair value of each asset acquired. When an asset is acquired through a deferred payment, the asset cost should be recorded at the present value of the future payments, discounted at either the interest rate implicit in the contract, or at a reasonable market rate if the contract does not include a reasonable interest rate. When a PPE asset is obtained through the issuance of the company's own shares, the asset should be recorded at its fair value. When a PPE asset is obtained by exchange with another, non-monetary asset of the company, the new asset should be reported at the fair value of the assets given up. However, if the fair values are not reliably measurable, or if the transaction lacks commercial substance, then the new asset should be recorded at the carrying value of the assets given up. The only exception to this occurs when a transaction lacks commercial substance, but the fair value of the asset acquired is less than the carrying value of the asset given up. In this case, the transaction should be reported at the fair value of the asset acquired, in order to avoid overstating the value of the new asset.
LO 5: Identify the effect of government grants in determining the cost of a property, plant, and equipment asset.
IAS 20 says that, "Government grants [should be recognized] in profit or loss on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate." In the case of grants received to assist in the purchase of PPE assets, the grant can either be deducted from the initial cost of the asset, which will reduce future depreciation, or the grant can be deferred and amortized into income on the same basis as the asset's depreciation. The net effect on income of these two methods will be exactly the same.
LO 6: Determine the cost of a self-constructed asset, including treatment of related interest charges.
For self-constructed assets reported under IFRS, only direct costs, and not overheads, should be allocated to the PPE asset. When borrowing is incurred to construct an asset over a substantial amount of time, any interest that is directly attributable to the construction should be included in the asset cost.
LO 7: Identify the accounting treatment for asset retirement obligation.
When the company has a legal or constructive obligation to dismantle, clean up, or restore the asset site at the end of its useful life, the present value of those asset retirement costs should be included in the capital cost of the asset.
LO 8: Apply the cost model.
Under this model, PPE assets are reported at their acquisition cost, less any accumulated depreciation. No attempt is made to adjust the value to reflect current market conditions.
LO 9: Apply the revaluation model.
Under this model, PPE assets may be adjusted to their fair values on a periodic basis, assuming the fair values are both available and reliable. Increases in value are credited to the other comprehensive income account titled revaluation surplus. If the increase reverses a previous decrease that was expensed, the increase should be reported as part of profit or loss. Decreases in value are applied to first reduce any existing revaluation surplus, and then reported as expense, if any balance remains. Adjustments to the asset value can be made either by eliminating the accumulated depreciation and adjusting the asset cost, or by adjusting the asset cost and accumulated depreciation proportionally.
LO 10: Apply the fair value model.
This model can only be used for investment properties, which are land and buildings held primarily for the purpose of earning rental income or capital appreciation. With this model, the carrying value of the investment property is adjusted to its fair value every reporting period. Any gains and losses resulting from the revaluation are reported directly in profit or loss. As well, no depreciation is reported on investment properties under this model.
LO 11: Explain and apply the accounting treatment for post-acquisition costs related to property, plant, and equipment assets.
Costs incurred after acquisition can either be expensed immediately or added to the carrying value of the PPE asset. Costs incurred for the normal, day-to-day maintenance of PPE asset are usually expensed, as these costs do not add to the service life or capacity of the asset. Costs that improve the asset by increasing future economic benefits, either by extending the useful life or improving the efficiency of operation, are usually capitalized. When a significant component of the asset is replaced, the cost and accumulated depreciation of the old asset should be removed and the cost of the new asset should be capitalized.
LO 12: Identify key differences between IFRS and ASPE.
The concept of component accounting is not as explicitly articulated in ASPE. ASPE requires revenues or expenses incurred prior to asset completion to be included in the asset cost, whereas IFRS takes these items to profit or loss. IFRS requires capitalization of borrowing costs, whereas ASPE leaves the choice to management. ASPE only requires capitalization of legal obligations for asset retirement, whereas IFRS also includes constructive obligations as well. ASPE does not allow the use of the revaluation model or the fair value model.
9.08: References
Bartrem, R. (2014, July 29). Adding four 767-300ERW aircraft to the WestJet fleet [Westjet Web log message]. Retrieved from http://blog.westjet.com/adding-boeing-767-300-aircraft-fleet/
International Accounting Standards. (1983). IAS 20–Accounting for government grants and disclosure of government assistance. Retrieved from http://www.iasplus.com/en/standards/ias/ias20
International Accounting Standards. (2003a). IAS 16–Property, plant and equipment. Retrieved from http://www.iasplus.com/en/standards/ias/ias16
International Accounting Standards. (2003b). IAS 40–Investment property. Retrieved from http://www.iasplus.com/en/standards/ias/ias40
International Accounting Standards. (2007). IAS 23–Borrowing costs. Retrieved from http://www.iasplus.com/en/standards/ias/ias23
WestJet. (2014). Management's discussion and analysis of financial results for the three and six months ended June 30, 2014. Retrieved from http://www.westjet.com/pdf/investorMedia/financialReports/WestJet-Second-Quarter-Report-2014.pdf | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.07%3A_Chapter_Summary.txt |
9.1 Dixon Ltd. has recently purchased a piece of specialized manufacturing equipment. The following costs were incurred when this equipment was installed in the company's factory facilities in 2020.
Cash price paid, net of \$1,600 discount, including \$3,900 of recoverable tax \$ 82,300
Freight cost to ship equipment to factory 3,300
Direct employee wages to install equipment 5,600
External specialist technician needed to complete final installation 4,100
Repair costs during the first year of operations 1,700
Materials consumed in the testing process 2,200
Direct employee wages to test equipment 1,300
Costs of training employees to use the equipment 1,400
Overhead costs charged to the machine 5,300
Legal fees to draft the equipment purchase contract 2,400
Government grant received on purchase of the equipment (8,000)
Insurance costs during first year of operations 900
Required: Determine the total cost of the equipment purchased. If an item is not capitalized, describe how it would be reported.
9.2 Argyris Mining Inc. completed construction of a new silver mine in 2020. The cost of direct materials for the construction was \$2,200,000 and direct labour was \$1,600,000. In addition, the company allocated \$250,000 of general overhead costs to the project. To finance the project, the company obtained a loan of \$3,000,000 from its bank. The loan funds were drawn on February 1, 2020, and the mine was completed on November 1, 2020. The interest rate on the loan was 8% p.a. During construction, excess funds from the loan were invested and earned interest income of \$30,000. The remainder of the funds needed for construction was drawn from internal cash reserves in the company. The company has also publicly made a commitment to clean up the site of the mine when the extraction operation is complete. It is estimated that the mining of this particular seam will be completed in ten years, at which time restoration costs of \$100,000 will be incurred. The appropriate discount rate for this type of expenditure is 10%.
Required: Determine the cost of the silver mine to be capitalized in 2020.
9.3 Cheng Manufacturing Ltd. recently purchased a group of assets from a bankrupt company during a liquidation auction. The total proceeds paid for the assets were \$220,000 and included a specialized lathe, a robotic assembly machine, a laser guided cutting machine, and a delivery truck. To make the bid at the auction, the company hired a qualified equipment appraiser who provided the following estimates of the fair value of the assets, based on their conditions, productive capacities, and intended uses:
Specialized lathe \$ 30,000
Robotic assembly machine \$ 90,000
Laser guided cutting machine \$ 110,000
Delivery truck \$ 20,000
Required: Determine the cost of each asset to be capitalized on Cheng Manufacturing Ltd.'s books.
9.4 Prabhu Industries Ltd. recently exchanged a piece of manufacturing equipment for another piece of equipment owned by Zhang Inc. Prabhu Industries was required to pay an amount of cash to finalize the exchange. The following information is obtained regarding the exchange:
Prabhu Zhang
Equipment, at cost 25,000 21,000
Accumulated depreciation 10,000 8,000
Fair value of equipment 17,000 19,000
Cash paid 2,000
Required:
1. Prepare the journal entries required by each company to record the exchange, assuming the exchange is considered to have commercial substance.
2. Repeat part (a) assuming the exchange does not have commercial substance.
3. Repeat part (b) assuming the accumulated depreciation recorded by Prabhu is only \$5,000 instead of \$10,000.
9.5 Lo-Dun Inc. is a publicly traded financial services company. The company recently acquired two assets in the following transactions:
Transaction 1: Lo-Dun acquired a new computer system to assist with its programmed trading activities. The computer system had a list price of \$85,000, but the salesperson indicated that the price could likely be negotiated down to \$80,000. After further negotiation, the company acquired the asset by issuing 15,000 of its own common shares. At the time of the transaction, the shares were actively trading at \$5.25 per share.
Transaction 2: Lo-Dun acquired new office furniture by making a down payment of \$5,000 and issuing a non-interest bearing note with a face amount of \$45,000. The note is due in one year. The market rate of interest for similar transactions is 9%.
Required: Prepare the journal entries for Lo-Dun Inc. to record the transactions. Provide a rationale for the amount recorded for each item.
9.6 Pei Properties recently purchased a vacant office condo where it plans to operate an employment-training centre. The total purchase price of the condo was \$625,000 with an expected useful life of 30 years with no residual value. The local government in this municipality was very interested in this project, providing a grant of \$90,000 for the purchase of the condo. The only condition of the grant was that the employment-training centre be operated for a period of at least five years. Pei Properties believes that this target can be achieved with the business plan it has prepared.
Required:
1. Prepare the journal entry to record the purchase of the condo, assuming the company uses the deferral method to record the government grant.
2. Repeat part (a) assuming the company uses the offset method to record the government grant.
3. Determine the annual effect on the income statement for each of the above methods.
9.7 Finucane Manufacturing Inc. owns a large factory building that it purchased in 2016. At the time of purchase, the company decided to apply the revaluation model to the property; the first revaluation occurred on December 31, 2018. On January 1, 2019, the recorded cost of the building was \$1,200,000, and the accumulated depreciation was nil, as the company applies the revaluation model by eliminating accumulated depreciation. The balance in the revaluation surplus account on January 1, 2019, was \$150,000. As well, the company decided on this date to obtain annual appraisals of the property in order to revalue it at every reporting period. The appraised values obtained over the next three years were as follows:
Date Appraised Value
December 31, 2019 \$1,250,000
December 31, 2020 \$1,000,000
December 31, 2021 \$1,150,000
Required: Prepare all the required journal entries for this property for the years ended December 31, 2019 to 2021. Assume that the building is depreciated on a straight-line basis over 30 years with no residual value. Also assume that the company does not make annual transfers from the revaluation surplus account to retained earnings.
9.8 Kappi Capital Inc. holds a number of investment properties that it accounts for under IAS 40 using the fair value method. The company purchased a new rental property on January 1, 2020, for \$1,500,000. The appraised value on December 31, 2020, was \$1,450,000 and the appraised value on December 31, 2021, was \$1,625,000.
Required: Prepare the adjusting journal entries for this property on December 31, 2020, and December 31, 2021.
9.9 Sun Systems Ltd. operates a manufacturing facility where specialized electronic components are assembled for use in consumer products. The facility was purchased in 2014 for a cost of \$800,000, excluding the land component. At the time of purchase, it was believed that the building would have a useful life of 40 years with no residual value. The company follows the policy of recording a full year of depreciation in the year of an asset's acquisition and no depreciation in the year of an asset's disposal. During 2020, the following transactions with respect to the building occurred:
• Regular repairs to exterior stucco and mechanical systems were incurred at a total cost of \$32,000.
• In the middle of the year, the existing boiler system failed and required replacement. The replacement cost of the new unit was \$125,000. Management considers this to be a major component of the building, but had not separately recorded the cost of the original boiler, as it was included in the building purchase price. It is estimated inflation has increased the cost of these types of units by 15% since 2014.
• The entire building was repainted at a cost of \$15,000 during the year. This did not extend the useful life of the building, but improved its overall appearance.
• A major structural repair to the foundation was undertaken during the year. This repair cost \$87,000 and was expected to extend the useful life of the building by ten years over the original estimate.
• A small fire in the staff kitchen caused damage that cost \$5,000 to repair.
Required: Prepare the journal entries to record the transactions that occurred in 2020. Assume all transactions were settled in cash. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/09%3A_Property_Plant_and_Equipment/9.09%3A_Exercises.txt |
The Limping Kangaroo
The year 2014 was tough for Qantas Airways Ltd. On August 28, the iconic Australian airline announced that it would be reporting a net loss of AUD \$2,843 million for the year ended June 30, 2014. The most significant components included in this loss were two asset-impairment charges: AUD \$387 million for impairment of specific assets and AUD \$2.6 billion for impairment of the Qantas International cash-generating unit. The CEO, in his annual report to shareholders, indicated that these write-downs were "required by accounting standards." The chairman of the board of directors indicated in his report that the year was "challenging" and "unsatisfactory" but made no mention of the asset write-downs. These non-cash, asset-impairment charges, which were charged primarily to the aircraft and engines category, clearly had a significant impact on the company's financial results. The impairment of the cash-generating unit, in particular, was almost solely responsible for the company's net loss.
This asset-impairment charge arose as part of a restructuring plan within the business. The company assessed the value in use of a particular group of assets, Qantas International, and determined that the current carrying value of these assets was overstated. The value in use was determined by projecting future cash flows for this asset group and then discounting these cash flows at a 10.5 percent interest rate. In projecting the cash flows, assumptions were made about the growth rate of future revenues, fuel charges, currency exchange rates, and many other factors.
The annual report explained that the impairment loss resulted from a situation where wide-body aircraft were purchased at a time when the Australian dollar was weaker than the US dollar. Although this may explain why the initial recorded value of these assets was higher, it obscures reasons behind the current decline in the value in use.
Clearly, the economic benefits to be derived from these assets were no longer justified by the initial purchase price. Companies purchase property, plant, and equipment assets with the expectation of realizing economic benefits at least equal to the price paid. Accounting standards need to be able to allocate these capital costs in a rational way so that they are reflected in the accounting periods where the economic benefits are created. When these estimates of benefit consumption are incorrect, write-downs such as those experienced by Qantas are necessary. The CEO was correct in stating that accounting standards require this treatment. (Qantas, 2014).
In this chapter, we will examine the details of the accounting treatment of the use and consumption of property, plant, and equipment assets.
Learning Objectives
After completing this chapter, you should be able to:
• Identify the purpose of depreciation, and discuss the elements that are required to calculate depreciation.
• Calculate depreciation using straight-line, diminishing-balance, and units-of-production methods.
• Discuss the reasons for separate component accounting and the accounting problems that may arise from this approach.
• Calculate depreciation when partial periods or changes in estimates are required.
• Discuss indicators of impairment and calculate the amount of impairment.
• Identify the criteria required to classify an asset as held for sale.
• Prepare journal entries for assets held for sale.
• Discuss other derecognition issues.
• Identify the presentation and disclosure requirements for property, plant, and equipment.
• Identify key differences between IFRS and ASPE.
Introduction
As we saw in the previous chapter, companies invest significant amounts of capital in property, plant, and equipment (PPE) assets. The purpose of these investments is to gain productive capacity that will further the goals of the business. The success of these investments in PPE will be evaluated based on the productive capacity attained relative to the costs incurred. We have already learned how to determine the costs to record for PPE assets. In this chapter, we will examine how to record the use of PPE assets and how to deal with the eventual disposal of these assets.
10: Depreciation Impairment and Derecognition of Property Plant and Equipment
IAS 16.50 indicates that the depreciable amount of an asset should be allocated on a systematic basis over its useful life. This description captures one of the key elements of depreciation concept: it is an allocation of the asset's cost.
Many people often associate the idea of depreciation with a decline in value of the asset. Although it is possible that the depreciation calculated approximates the loss in value of the asset as it is used, there is no guarantee that this will be true. It is important to appreciate that the purpose of accounting depreciation is to match the initial cost of the PPE asset to the periods that benefit from its use. Depreciation does not provide an estimate of the change in an asset's fair value. Rather, it simply provides a way to allocate asset costs to the correct accounting periods.
The description above also identifies three key concepts:
• The depreciable amount
• The useful life of the asset
• The basis (method) used to calculate depreciation.
A further requirement of the standard is that significant components be depreciated separately. We will deal with each of these elements separately. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/10%3A_Depreciation_Impairment_and_Derecognition_of_Property_Plant_and_Equipment/10.01%3A_Definition.txt |
The first element that needs to be determined for a depreciation calculation is the depreciable amount. It represents the cost that will be allocated to future periods through the depreciation process. This amount is determined by taking the asset's cost and deducting the residual value. (Note: if the company uses the revaluation method, the cost is replaced by the revalued amount in this calculation.) The residual value is the estimated net amount that the company would be able to sell the asset for at the end of its useful life, based on current conditions. Thus, the estimate does not try to anticipate future changes in market or economic conditions; it merely considers the nature of the asset itself. The residual value is, of course, an estimate and is thus subject to possible error. As a result, IFRS requires an annual review of residual amounts used in depreciation calculations. If the residual amount needs to be changed, it should be accounted for prospectively as a change in estimate. Many assets will have a residual value of zero or close to zero, and this amount will thus be ignored in the calculation. If the revised residual value were to exceed the carrying value of the asset, then depreciation would cease until the residual value dropped back below the carrying value.
10.2.02: Useful Life
The useful life of an asset is determined by its utility to the company. This means that estimates need to be made about how long the company plans to use the asset. For certain types of assets, companies may have a policy of timed replacement, even if the asset is still functioning. This means the useful life may be less than the physical life of the asset. IFRS (International Accounting Standards, n.d., 16.56) identifies the following factors that need to be considered in determining useful life to the company:
• The expected usage of the asset, as assessed by reference to the asset's expected capacity or physical output.
• The expected physical wear and tear, which depends on operational factors, such as the number of shifts for which the asset is to be used, the repair and maintenance program, and the care and maintenance of the asset while idle.
• The technical or commercial obsolescence of the asset arising from changes or improvements in production or from a change in the market demand for the product or service output of the asset. Expected future reductions in the selling price of an item that was produced using an asset could indicate the expectation of technical or commercial obsolescence of the asset, which, in turn, might reflect a reduction of the future economic benefits embodied in the asset.
• The legal or similar limits on the use of the asset, such as the expiry dates of related leases.
It should be apparent that a substantial amount of judgment is required in determining the useful life of an asset. Although management may have significant experience in working with these assets, the estimation process can still result in errors. The process of annual review and estimation changes for useful lives is the same as described above, in 10.2: Depreciable Amount, for residual values.
Another question that needs to addressed when determining the useful life of an asset is when to start and stop depreciating it. Depreciation of the asset should commence when the asset is available for use. This means that the asset is in place and ready for productive function, even if it is not actually being used yet. Depreciation should stop at the earlier date when the asset is either reclassified as held for sale or derecognized. These situations will be covered later in the chapter. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/10%3A_Depreciation_Impairment_and_Derecognition_of_Property_Plant_and_Equipment/10.02%3A_Depreciation_Calculations/10.2.01%3A_Depreciable_Amount.txt |
The IFRS requirement of allocation of cost on a systematic basis is a deliberately vague description of the techniques used to calculate depreciation. Companies are given the freedom to choose the method used, as long as the method makes sense in relation to the consumption of future economic benefits realized by use of the asset. The standard does identify three broad techniques that can be used: straight line, diminishing balance, and units of production. However, other techniques could be justified if they provide a more systematic and reasonable allocation of cost. The standard also indicates that depreciation methods based on revenue should not be used, as revenue may be affected by factors, such as inflation, that are not directly related to the consumption of economic benefits.
Straight-Line Method
This is the simplest and most commonly used depreciation method. This method simply allocates cost in equal proportions to the time periods of an asset's useful life. The formula to determine the depreciation charge is as follows:
For example, consider an automated packaging machine purchased for \$100,000 that is used in a factory. It is estimated that this machine will have a useful life of ten years and will have a residual value of \$5,000. The calculation of the annual depreciation charge is as follows:
The benefit of this method is its simplicity for both the preparer and reader of the financial statement. No special knowledge is required to understand the logic of the calculation. As well, the method is appropriate if we assume that economic benefits are delivered in roughly equal proportions over the life of the asset. However, there are arguments that are contrary to this assumption. For certain assets, it may be reasonable to assume that the economic benefits decline with the age of the asset, as there is more downtime due to repairs or other operational inefficiencies that result from age. If these inefficiencies are significant, then the straight-line method may not be the most appropriate method.
Diminishing-Balance Method
The diminishing-balance method results in more depreciation in the early years of an asset's life and less depreciation in later years. The justification for this method is that an asset will offer its greatest service potential when it is relatively new. Once an asset ages and starts to require more repairs, it will be less productive to the business. This reasoning is quite consistent with the experience many companies have with assets that have mechanical components. This method will also result in an overall expense to the company that is fairly consistent over the life of the asset. In early years, depreciation charges are high, but repairs are low; in later years, this situation will reverse.
A number of different calculations can be used when applying the diminishing-balance method. The common feature of all the methods is that a constant percentage is applied to the closing net book value of the asset each year to determine the depreciation charge. The percentage that is used can be derived in a number of ways. The most accurate way would be to apply a formula to determine the exact percentage needed to depreciate the asset down to its residual value. Although this can be done, this approach is not often used, because it requires a more complex calculation. A simpler, more commonly used approach is to simply use a multiple based on the asset's useful life. For example, a technique referred to as double-declining balance would convert the useful life to a percentage and multiply the result by two. In our previous example, the calculation would be as follows:
Depreciation would thus be calculated as follows:
Year Book Value, Rate Depreciation Accumulated Book Value,
Opening Expense Depreciation Closing
1 100,000 20% 20,000 20,000 80,000
2 80,000 20% 16,000 36,000 64,000
3 64,000 20% 12,800 48,800 51,200
4 51,200 20% 10,240 59,040 40,960
5 40,960 20% 8.192 67,232 32,768
6 32,768 20% 6,554 73,786 26,214
7 26,214 20% 5,243 79,029 20,971
8 20,971 20% 4,194 83,223 16,777
9 16,777 20% 3,355 86,578 13,422
10 13,422 20% 8,422* 95,000 5,000
*Note: In the final year, depreciation does not equal the calculated amount of net book value multiplied by depreciation percentage (). In the final year, the asset needs to be depreciated down to its residual value. The double-declining balance method will not result in precisely the right amount of depreciation being taken over the asset's useful life. This means that the final year's depreciation will need to be adjusted to bring the net book value to the residual value. Depending on the useful life of the asset, this final-year depreciation amount may by higher or lower than the amount calculated by simply applying the percentage. Because depreciation is an estimate based on a number of assumptions, this type of adjustment in the final year is considered appropriate.
Also note that in the calculations above, unlike other methods, the residual value is not deducted when determining the depreciation expense each year. The residual value is considered only when adjusting the final year's depreciation expense.
Units-of-Production Method
This method is the most theoretically supportable method for certain types of assets. The method charges depreciation on the basis of some measure of activity related to the asset. The measures are often output based, such as units produced. They can also be input based, such as machine hours used. Although output-based measures are the most accurate way to reflect the consumption of economic benefits, input-based measures are also commonly used. The benefit of this method is that it clearly links the actual usage of the asset to the expense being charged, rather than simply reflect the passage of time. Returning to our example, if the machine were expected to be able to package 1,000,000 boxes before requiring replacement, our depreciation rate would be calculated as follows:
Thus, if in a given year, the machine actually processed 102,000 boxes, the depreciation charge for that year would be as follows:
In years of high production, depreciation will increase; in years of low production, depreciation will decrease. This is a reasonable result, as the costs are being matched to the benefits being generated. However, this method is appropriate only where measures of usage are meaningful. In some cases, assets cannot be easily measured by their use. An office building that houses the corporate headquarters cannot be easily defined in terms of productive capacity. For this type of asset, a time-based measure would make more sense. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/10%3A_Depreciation_Impairment_and_Derecognition_of_Property_Plant_and_Equipment/10.02%3A_Depreciation_Calculations/10.2.03%3A_Methods_of_Calculation.txt |
As noted in Chapter 9, IFRS requires PPE assets be segregated into significant components. One of the reasons for doing this is that a significant component of the asset may have a different useful life than other parts of the asset. An airplane's engine does not have the same useful life as the fuselage. It makes sense to segregate these components and charge depreciation separately, as this will provide a more accurate picture of the consumption of economic benefits from the use of the asset.
The process of determining what comprises a component requires some judgment from managers. A reasonable approach would be to first determine what constitutes a significant component of the whole and then determine which components have similar characteristics and patterns of use. Practical considerations, the availability of information, and cost versus benefit analyses (related to accounting costs) may all be relevant in determining how finely the components are defined. The goal is to create information that is meaningful for decision-making purposes without being overly burdensome to the company.
10.2.05: Partial Period Calculations
In the year of acquisition or disposal of a PPE asset, an additional calculation complication arises—namely, how to deal with depreciation for only part of a year. If the units-of-production method is being used, this isn't really a problem, as the depreciation will be based on the actual production in the partial period. However, for time-based methods, like straight line or diminishing balance, an adjustment to the calculation will be required.
Because accounting standards do not specify how to deal with this problem, companies have adopted a number of different practices. Although depreciation could be prorated on a daily basis, it is more usual to see companies prorate the calculation based on the nearest whole month that the asset was being used in the accounting period. Some companies will charge a full year of depreciation in the year of acquisition and none in the year of disposal, while other companies will reverse this pattern. Some companies charge half the normal rate in the years of acquisition and disposal. Whatever method is used, the total amount of depreciation charged over the life of the asset will be the same. As long as the method is applied consistently, there shouldn't be material differences in the reported results.
10.2.06: Revision of Depreciation
As noted previously, many elements of the depreciation calculation are based on estimates. IFRS requires that these estimates be reviewed on an annual basis for their reasonableness. If it turns out that the original estimate is no longer appropriate, how should the depreciation calculation be revised? The treatment of estimate changes requires prospective adjustment, which means that current and future periods are adjusted for the effect of the change. No adjustments should be made to depreciation amounts reported in prior periods. The reasoning behind this treatment is that estimates, by their nature, are subject to inaccuracies. As well, conditions may change; the asset may be used in a different fashion than originally intended, or the asset may lose function quicker or slower than originally anticipated. As long as the original estimate was reasonable in relation to the information available at the time, there is no need to adjust prior periods once conditions change.
Consider our original example of straight-line depreciation. The initial calculation resulted in an annual depreciation charge of \$9,500. After two years of use, the company's management noticed that the asset's condition was deteriorating quicker than expected. The useful life of the asset was revised to seven years, and the residual value was reduced to \$2,000. The revision to the depreciation charge would be calculated as follows:
Thus, the calculation would be as follows:
The company would begin charging this amount in the third year and would not revise the previous depreciation that was recorded. This technique is also applied if the company changes its method of depreciation, because it believes the new method better reflects the pattern of use or benefits derived from the asset, or if improvements are made to the asset that add to its capital cost. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/10%3A_Depreciation_Impairment_and_Derecognition_of_Property_Plant_and_Equipment/10.02%3A_Depreciation_Calculations/10.2.04%3A_Separate_Components.txt |
For a variety of reasons, a PPE asset may sometimes become fully or partially obsolete to the business. If the value of the asset declines below its carrying value, the accounting question is whether this decline in value should be recorded or not. For current assets such as inventory, these types of declines in value are recorded so that a financial-statement reader is not misled into thinking the current asset will generate more cash than is actually realizable. This treatment is reasonable for a current asset, but should the same approach be used for PPE assets?
Impairment of PPE asset values can result from many different circumstances. IAS 36 discusses the following possible signs of impairment:
External indicators
• include observable indications of decline in value;
• include technological, market, economic, or legal changes that affect the asset or entity;
• include increases in interest rates that reduce the discounted value in use of the asset; and
• mean that the carrying value of the entity's net assets is greater than its market capitalization.
Internal indicators
• include obsolescence or physical damage;
• include significant changes in how the asset is used, such as excess capacity or plans for early disposal of the asset; and
• mean that economic performance of asset is worse than expected, including the cash needed to acquire and/or operate and maintain the asset.
These factors and other information will need to be considered carefully when reviewing for impairment; judgment will need to be applied. The company should assess whether there is any indication of asset impairment on an annual basis. If there is evidence of impairment, then the company will need to determine the amount of the impairment and account for this condition.
10.03: Impairment
There is an assumption in the IFRS standards that an entity will act in a rational manner. This means that if selling the asset rather using it can generate more economic benefit, it would make sense to do so. To determine impairment, we need to compare the carrying value of the asset with its recoverable amount.
The recoverable amount of an asset is defined as the greater of the asset's value in use and its fair value, less costs of disposal. The asset's value in use is calculated as the present value of all future cash flows related to the asset, assuming that it continues to be used. The fair value less costs of disposal refers to the actual net amount that the asset could be sold for based on current market conditions.
Consider the following example. During the annual review of asset impairment conditions, a company's management team decides that there is evidence of impairment of a particular asset. This asset is recorded on the books with a cost of \$30,000 and accumulated depreciation of \$10,000. Management estimates and discounts future cash flows related to the asset and determines the value in use to be \$15,000. The company also seeks the advice of an equipment appraiser who indicates that the asset would likely sell at an auction for \$14,000, less a 10 percent commission.
The recoverable amount of the asset is \$15,000, as this value in use is greater than the fair value less costs of disposal (). The carrying value is \$20,000 (). As the recoverable amount is less than the carrying value, the asset is impaired. The following journal entry must be recorded to account for this condition:
Although a separate accumulated impairment loss account has been credited here, it is common in practice to simply credit accumulated depreciation. The net result of these two approaches will be exactly the same. Also note that if the asset were accounted for using the revaluation method, the impairment loss would first reduce any existing revaluation surplus (OCI), with the remaining loss being charged to the income statement.
If, in the future, the recoverable amount increases so that the asset is no longer impaired, the accumulated impairment loss can be reversed. However, the impairment loss can be reversed only to the extent that the new carrying value does not exceed the depreciated carrying value that would have existed had the impairment never occurred. Also note that in subsequent years, depreciation calculations will be based on the revised carrying value.
A different method is used to determine impairment under ASPE. This method is described in 10.7 Appendix A. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/10%3A_Depreciation_Impairment_and_Derecognition_of_Property_Plant_and_Equipment/10.03%3A_Impairment/10.3.01%3A_Accounting_for_Impairment.txt |
The usual situation when applying an impairment test would be to make the assessments on an asset-by-asset basis. However, in some circumstances, it may be impossible to determine the impairment of an individual asset. Some assets may have a value in use only when used in combination with other assets. Consider, for example, a petrochemical-processing plant. The plant is engineered with many customized components that work together to process and produce a final product. If any part of the plant were removed, the process could not be completed. In this case, the cash flows derived from the use of the group of assets are considered a single economic event. The cash flows from an individual asset component within the group cannot be determined separately. In these cases, IAS 36 allows the impairment test to be performed at the level of the cash-generating unit, rather than at the individual asset level.
IAS 36 defines a cash-generating unit as "the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets" (International Accounting Standards, n.d., 36.68). The definition of cash-generating units should be applied consistently from year to year. Obviously, significant judgment is required in making these determinations.
The impairment test is applied the same way to cash-generating units as with individual assets. The only difference is that any resulting impairment loss is allocated on a pro-rata basis to the individual assets within the cash-generating unit, based on the relative carrying amounts of those assets within the group. However, in this process, no individual asset should be reduced below the greater of its recoverable amount or zero.
Consider the following example. A petrochemical-processing plant is composed of a number of different assets, including the following:
Cost (\$) Accumulated Carrying
Depreciation (\$) Amount (\$)
Pumps, tanks, and drums 390,000 210,000 180,000
Reactors 1,100,000 650,000 450,000
Pipes and fittings 275,000 155,000 120,000
Distillation column 850,000 465,000 385,000
2,615,000 1,480,000 1,135,000
Management considers this plant to be a cash-generating unit. Due to recent declines in commodity prices, management believes the plant may be impaired. After some investigation, management determines that the distillation column could be sold for net proceeds of \$435,000. All the other assets, however, are integrated into the plant structure and could not be sold separately. As well, due to local regulations, the plant cannot be sold in its entirety. Management has projected that by operating the plant for the next three years, cash flows of \$1,200,000 could be generated. The present value of these cash flows is \$950,000.
Impairment here is determined by comparing the carrying amount of \$1,135,000 with the recoverable amount of \$950,000. The value in use is the appropriate measure here, as the fair value less costs to sell of \$435,000 is lower. In this case, there is an impairment of \$185,000 (). None of the impairment should be allocated to the distillation column, as the carrying value of \$385,000 is already less than the recoverable amount of \$435,000. For the remaining components, we cannot determine the recoverable amount, so the impairment loss will be allocated to these assets on a pro-rata basis.
Carrying Proportion Impairment
Amount (\$) Loss (\$)
Pumps, tanks, and drums 180,000 180/750 44,400
Reactors 450,000 450/750 111,000
Pipes and fittings 120,000 120/750 29,600
750,000 185,000
The journal entry would record separate accumulated-impairment loss amounts for each of the above components.
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At some point in a PPE asset's life, it will be sold, disposed, abandoned, or otherwise removed from use. The accounting treatment for these events will depend on the timing and nature of the transactions.
10.04: Derecognition
When management first makes the decision to sell a noncurrent asset rather than continue to use it in operations, it should be reclassified as an asset that is held for sale. This is a class of current assets that is disclosed separately from other assets. For an asset to be classified as held for sale, the following conditions must be met:
• The asset must be available for immediate sale in its present condition, subject only to terms that are usual and customary for sales of such assets.
• The sale must be highly probable.
• Management must be committed to a plan to sell the asset.
• There must be the initiation of an active program to locate a buyer and complete the plan.
• The asking price must be reasonable in relation to the asset's current fair value.
• The sale should be expected within one year of the decision, unless circumstances beyond the entity's control delay the sale.
• It is unlikely that the plan will be withdrawn.
There are a number of accounting issues with held-for-sale assets. First, the asset needs to be revalued to the lower of its carrying value, or its fair value, less costs to sell. Because the company expects to sell these assets in a short period of time, it is reasonable to report them at an amount that is no greater than the amount of cash that can be realized from their sale. Second, assets that are held for sale are no longer depreciated. This is reasonable, as these assets by definition are available for immediate sale. This means that they are no longer being used for productive purposes, so depreciating them would not be appropriate.
The result of the revaluation described above means that an impairment loss will occur if the expected proceeds (fair value less costs to sell) are less than the carrying value. This loss will be reported in the year that management makes the decision to sell the asset, even if the asset is not actually sold by the year-end. The impairment loss will be reported in a manner consistent with other impairment losses, as described in IAS 36. When the asset is actually sold, the difference between the actual proceeds and the amount expected will be treated as a gain or loss in that year, not as an increase or reversal of the previous impairment loss.
If, at the time of classification as held for sale, the expected proceeds are greater than the carrying amount, this gain will not be reported until the asset is actually sold. This gain will simply be reported as a gain consistent with the treatment of other gains.
Consider this example. A company purchases an asset for \$100,000 in 2015 and decides in late 2020 to sell the asset immediately. The accumulated depreciation at the time the decision is made is \$40,000. Management estimates that the asset can be sold for \$50,000, less disposal costs of \$2,000. In 2020, when the decision to sell the asset is made, the following journal entry will be required.
In 2021, the asset is actually sold for net proceeds of \$49,000. The journal entry to record this transaction is as follows:
Now, if in 2020, the amount management estimates the sales proceeds to be \$65,000 instead of \$50,000, less costs to sell of \$2,000, the journal entry would be as follows:
Note that we do not report the asset held for sale at its estimated realizable value (), as this is greater than the carrying value. When the sale occurs in 2021, the following journal entry would be required:
As a practical matter, many companies may not immediately reclassify the asset as held for sale, as they expect to sell it within the same accounting period, or they do not meet the strict criteria for classification. If this occurs, then the disposal journal entry will simply remove the carrying value of the asset, report the net proceeds received, and report a gain or loss on disposal. This gain or loss will be reported on the income statement, but gains cannot be classified as revenues.
10.4.02: Other Derecognition Issues
There are times when assets may be disposed of in ways other than by direct sale. For example, an asset can be expropriated by a government agency that has the authority to do so, with compensation being paid. Insurance proceeds may be received for an asset destroyed in a fire. These types of transactions would be recorded much as a simple sale would be, with a resulting gain or loss (the difference between the compensation received and the carrying value of the assets) being reported on the income statement.
In other instances, a company may choose to simply abandon or scrap an asset for no proceeds. If this occurs, the asset should be derecognized, and a loss equal to the carrying value of the asset at the time of abandonment should be recognized.
A less common situation may occur when a business agrees to donate an asset to some other entity. For example, a land-development company may donate a piece of land to a municipality for use as a recreational space. The company may believe that this will help develop a positive business relationship with the municipality and its citizens. With this type of transaction, the fair value of the property needs to be determined. The disposal will then be recorded at this value, which will result in expense being recorded equal to this fair value. The carrying value of the asset will also be derecognized, which will result in a gain or loss if the carrying value differs from the fair value.
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IAS 16 details a number of required disclosures for property, plant, and equipment assets. Some of these disclosures are as follows:
• The measurement bases used
• Depreciation methods used
• Useful life or depreciation rates used
• A reconciliation of the gross carrying amount and accumulated depreciation at the beginning of the period to the amount at the end of the period, including
• details of revaluations and impairment losses, including an indication of whether an independent appraiser was used;
• details of additions and disposals, including assets held for sale;
• the depreciation charged during the year; and
• the effect on PPE of exchange rate differences
• Restrictions on the use of the assets pledged as security for liabilities
• Commitments to purchase assets
• Any compensation received from third parties when assets are impaired or abandoned
• Details of the effects of changes in estimates.
The scope and scale of these disclosure requirements reflect the fact that property, plant, and equipment assets are often a significant portion of a company's total asset base. As well, they reflect the variety of different methods and estimates required in accounting for PPE assets. The significant disclosures should help readers better understand how a company uses its assets to generate returns.
10.06: IFRS ASPE Key Differences
IFRS ASPE
The depreciable amount is calculated using the asset's residual value. The depreciable amount is calculated using the lesser of salvage value or residual value. Salvage value is the estimated value of the asset at the end of its physical life, rather than its useful life.
The term used is depreciation. The term used is amortization.
Cost, revaluation, and fair-value models can be used. Only the cost model is allowed.
Assessment for indications of impairment should occur at least annually. Impairment is tested only when circumstances indicate impairment may exist.
A one-step process to determine impairment, based on comparing recoverable amount with carrying amount, is used. Recoverable amount is the greater of value in use or fair value less costs to sell. A two-step process is used. Impairment is tested first by comparing carrying value with undiscounted cash flows. If impaired, the loss is determined by subtracting the fair value from the carrying amount. See 10.7 Appendix A for details.
Impairment loss can be reversed when estimates change. However, amount of reversal may be limited. Impairment loss cannot be reversed.
Assets that meet the criteria of held for sale are classified as current. Assets held for sale can be classified as current only if the asset is sold before financial statements are completed.
More extensive disclosure requirements must be met. Fewer disclosure requirements must be met.
10.07: Appendix A- ASPE Standards for Impairment
Under ASPE 3063, a different set of standards is applied to the issue of PPE impairment. The basic premise underlying these principles is that an asset is impaired if its carrying value cannot be recovered. Unlike IFRS, which requires annual impairment testing, the ASPE standard requires only impairment testing when events or changes in circumstances indicate that impairment may be present. Some of the possible indicators of an asset's impairment include the following:
• A significant decrease in its market price
• A significant adverse change in the extent or manner in which it is being used or in its physical condition
• A significant adverse change in legal factors or in the business climate that could affect its value, including an adverse action or assessment by a regulator
• An accumulation of costs significantly in excess of the amount originally expected for its acquisition or construction
• A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with its use
• A current expectation that, more likely than not, it will be sold or otherwise disposed of significantly before the end of its previously estimated useful life ("more likely than not" means a level of likelihood that is more than 50 percent) (CPA Canada, 2016, 3063.10).
The accountant will need to apply judgment in assessing these criteria. Other factors could be present that could indicate impairment.
Once the determination is made that impairment may be present, the accountant must follow a two-step process:
1. Determine if the asset is, in fact, impaired.
2. Calculate and record the impairment loss.
Step 1 involves the application of a recoverability test. This test is applied by comparing the predicted, undiscounted future cash flows from the asset's use and ultimate disposal with the carrying value of the asset. If the undiscounted future cash flows are less than the asset's carrying value, the asset is impaired. The calculation of the predicted, undiscounted cash flows will be based primarily on the company's own assessment of the possible uses of the asset. However, the accountant will need to apply diligence in assessing the reasonableness of these cash flow assumptions.
Step 2 involves a different calculation to then determine the impairment loss. The impairment loss is the difference between the asset's carrying value and its fair value. The fair value is defined as "the amount of the consideration that would be agreed upon in an arm's length transaction between knowledgeable, willing parties who are under no compulsion to act" (CPA Canada, 2016 3063.03b). Note that, unlike the IFRS calculation, disposal costs are not considered. The fair value should always be less than the undiscounted cash flows, as any knowledgeable party would discount the cash flows when determining an appropriate value. The best evidence of fair value would be obtained from transactions conducted in active markets. However, for some types of assets, active market data may not be available. In these cases, other techniques and evidence will be required to determine the fair value.
The application of this standard can be best illustrated with an example. Consider a company that believes a particular asset may be impaired, based on its current physical condition. Management has estimated the future undiscounted cash flows from the use and eventual sale of this asset to be \$125,000. Recent market sales of similar assets have indicated a fair value of \$90,000. The asset is carried on the books at a cost of \$200,000 less accumulated depreciation of \$85,000. In applying step 1, the recoverability test, management will compare the undiscounted cash flows (\$125,000) with the carrying value (\$115,000). In this case, because the undiscounted cash flows exceed the carrying value, no impairment is present, and no further action is required.
If, however, the future, undiscounted cash flows were \$110,000 instead of \$125,000, the result would be different:
Step 1: Future undiscounted cash flows \$ 110,000
Carrying value \$ 115,000
Difference \$ (5,000)
Because this result is less than zero, the asset is impaired. The impairment loss must then be calculated.
Step 2: Fair value \$ 90,000
Carrying value \$ 115,000
Impairment loss \$ (25,000)
This loss would be recorded as follows:
Although a separate accumulated impairment loss account has been credited here, it is common in practice to simply credit accumulated depreciation. The net result of these two approaches will be the same.
The new carrying value for the asset after the impairment loss is recorded becomes the new cost base for the asset. This result has two effects. First, the asset's depreciation rate will need to be recalculated to take into account the new cost base and any other changes that may be relevant. Second, any subsequent change in circumstances that results in the asset no longer being impaired cannot be recorded. Future impairment reversals are not allowed, because we are creating a new cost base for the asset.
One conceptual problem with this approach is that the carrying value of the asset may not always reflect the underlying economic value to the company. By not testing for impairment every year, it is possible that an asset that is becoming impaired incrementally may not be properly adjusted until the impairment is quite severe. Once the impairment is recorded, the inability to reverse this amount if future circumstances improve means the asset's economic potential is not properly reflected on the balance sheet. Although there are problems with this approach, it can be argued that annual impairment testing for all assets is a time-consuming and costly exercise. Thus, the standard results in a trade-off between theoretical and practical considerations. This is considered a reasonable trade-off for private enterprises, as they usually have a much smaller group of potential financial-statement readers, as well as fewer resources available to dedicate to accounting and reporting matters. | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/10%3A_Depreciation_Impairment_and_Derecognition_of_Property_Plant_and_Equipment/10.05%3A_Presentation_and_Disclosure_Requirements.txt |
LO 1: Identify the purpose of depreciation, and discuss the elements that are required to calculate depreciation.
Depreciation is a systematic allocation of an asset's cost to the accounting periods in which the benefits of the asset are consumed. Depreciation is not an attempt to revalue the asset. To calculate depreciation, one needs to determine the depreciable amount, the useful life, and method of calculation. The depreciable amount is the cost less the residual value. The useful life of an asset will not necessarily be the same as the physical life of the asset. The method should systematically allocate the cost in a manner that reflects the consumption of economic benefits. Significant judgment will be required when applying these three elements.
LO 2: Calculate depreciation using straight-line, diminishing-balance, and units-of-production methods.
Straight-line depreciation assumes that benefits are derived from the asset in equal proportions over the asset's life. The calculation divides the depreciable amount by the useful life and then allocates this equal charge over the life of the asset. The diminishing-balance approach assumes that greater benefits are derived earlier in an asset's life. This approach charges a constant percentage of the asset's carrying value each year to depreciation. The units-of-production method charges varying amounts of depreciation based on the asset's activity. Using output measures is more theoretically correct, but input measures may also be used. The calculation requires dividing the depreciable amount by the expected amount of productive output over the asset's life and then applying the resulting rate to the actual production in the reporting period.
LO 3: Discuss the reasons for separate component accounting and the accounting problems that may arise from this approach.
Component accounting is required because significant asset components may have different useful lives and different economic consumption patterns. By recording components separately, accountants are able to create more meaningful depreciation calculations. Problems that arise in this approach include the inability to measure component costs accurately, the judgment required in identifying significant components, and the additional accounting costs in maintaining component records.
LO 4: Calculate depreciation when partial periods or changes in estimates are required.
The depreciation charge in the period in which an asset is purchased or sold will need to be prorated based on time, except when using the units-of-production method. This proration can be calculated a number of ways but should be consistent from period to period. When changes in estimates regarding useful life, residual value, or pattern of consumption (method) are determined, these changes should be treated prospectively. The new estimate is applied to the current carrying amount, resulting a new depreciation charge for current and future periods. No adjustments are made to past period-depreciation charges.
LO 5: Discuss indicators of impairment and calculate the amount of impairment.
Impairment is indicated when external factors related to the environment in which the business operates or internal factors related to the asset itself indicate that the carrying value may not be ultimately realized. External factors include observable indications of loss of value; technological, market, or legal changes; increases in interest rates; and declines in market capitalization. Internal factors include physical damage, changes in the use of the asset, and declining productivity of the asset. Impairment is calculated as the difference between the carrying amount and the recoverable amount. The recoverable amount is the greater of the value in use or fair value, less costs of disposal. Impairment tests may sometimes be applied to cash-generating units if the effects on individual assets cannot be determined.
LO 6: Identify the criteria required to classify an asset as held for sale.
For an asset to be classified as held for sale, a number of conditions must be present. The asset must be available for immediate sale, and the sale must be highly probable. Management must be committed to the sale and must have an active program to locate a buyer. The asking price must be reasonable in relation to the market. The sale should be expected within one year, and it should be unlikely that the plan will be withdrawn.
LO 7: Prepare journal entries for assets held for sale.
When an asset is classified as held for sale, it must be revalued to the lower of its carrying value or fair value less costs to sell. As well, depreciation of the asset will cease once it is classified as held for sale. This treatment means that either no change in value will occur, or an impairment loss will be reported in the year when the classification occurs. When the asset is subsequently sold in a future period, the resulting gain or loss is not treated as an impairment loss or reversal.
LO 8: Discuss other derecognition issues.
If an asset is expropriated or otherwise disposed, and proceeds are received, this transaction is treated the same as any other asset disposal, with the resulting gain or loss being reported on the income statement. If an asset is simply abandoned or scrapped, then that asset needs to be derecognized, and a loss will be reported equal to the carrying value of the asset. When an asset is donated, the asset needs to be derecognized, and an expense is recognized equal to the fair value of the asset. This means a gain or loss will likely result on this transaction.
LO 9 Identify the presentation and disclosure requirements for property, plant, and equipment.
IFRS requires a significant amount of disclosure regarding PPE assets. Some of these disclosures include details of methods and assumptions that are used in depreciation calculations, the measurement base used, reconciliation of changes during the period, restrictions on and commitments for assets, details of any revaluations, details of changes in estimates, and other factors.
LO 10: Identify key differences between IFRS and ASPE.
IFRS and ASPE share many similarities in the treatment of PPE assets. Some differences include the absence of fair value and revaluation methods under ASPE, a different test and criteria for impairment, different classification rules for held-for-sale assets, different methods of determining the depreciable amount, and greater disclosure requirements under IFRS.
10.09: References
CPA Canada. (2006) CPA Canada Handbook. Toronto, ON: CPA Canada.
International Accounting Standards (n.d.). In IAS Plus. Retrieved from http://www.iasplus.com/en/standards/ias
Qantas. (2014). Qantas Airways and its controlled entities: Preliminary final report for the financial year ended 30 June 2014. Retrieved from http://www.qantas.com.au/infodetail/about/investors/preliminaryFinalReport14.pdf | textbooks/biz/Accounting/Intermediate_Financial_Accounting_1__(Arnold_and_Kyle)/10%3A_Depreciation_Impairment_and_Derecognition_of_Property_Plant_and_Equipment/10.08%3A_Chapter_Summary.txt |
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