ArnoldKyle IntermFinAcct Vol1 2017C PDF

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Intermediate Financial
Accounting
Volume 1
by Glenn Arnold & Suzanne Kyle
Edited by Athabasca University
VERSION 2017 – REVISION C
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a d v a n c i n g l e a r n i n g
Intermediate Financial Accounting

by Glenn Arnold & Suzanne Kyle
Edited by Athabasca University
Version 2017 — Revision C
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Table of Contents
Table of Contents iii
1 Review of Intro Financial Accounting 1
Chapter 1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Adjusting and Closing Entries . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Merchandising Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Inventory Costing Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4 Bank Reconciliations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.5 Receivables Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.6 Long-Lived Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.7 Current and Long-Term Liabilities . . . . . . . . . . . . . . . . . . . . . . . . 3
1.8 Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2 Why Accounting? 5
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Chapter Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1 Definition and Information Asymmetry . . . . . . . . . . . . . . . . . . . . . 7
iii
iv Table of Contents
2.2 Trade-Offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 How Are Standards Set? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.4 The Conceptual Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.4.1 The Objective of Financial Reporting . . . . . . . . . . . . . . . . . . 12
2.4.2 Qualitative Characteristics of Useful Information . . . . . . . . . . . 12
2.4.3 Elements of Financial Statements . . . . . . . . . . . . . . . . . . . 15
2.4.4 Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.4.5 Measurement Base . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.4.6 Capital Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.5 Challenges in Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . 22
2.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.7 IFRS/ASPE Key Differences . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3 Financial Reporting 35
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.1 Financial Reporting: Overview . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.2 Factors that Influence Financial Reports . . . . . . . . . . . . . . . . . . . . 38
3.2.1 Accounting Year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3.2.2 Changes in Accounting Estimates, Changes in Accounting Policy,

and Correction of Errors . . . . . . . . . . . . . . . . . . . . . . . . . 40
v
3.3 Financial Statements and Their Interrelationships . . . . . . . . . . . . . . . 43
3.3.1 Financial Statement Differences Between IFRS and ASPE . . . . . 47
3.4 Statement of Income and Comprehensive Income . . . . . . . . . . . . . . 47
3.5 Statement of Changes in Equity (IFRS) and Statement of Retained Earn-

ings (ASPE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.6 Analysis of Statement of Income and Statement of Changes in Equity . . . 60
3.7 IFRS and ASPE Applicable Standards . . . . . . . . . . . . . . . . . . . . . 62
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
4 Financial Reports – Statement of Financial Position and Statement of Cash

Flows 75
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.1 Financial Reports: Overview . . . . . . . . . . . . . . . . . . . . . . . . . . 78
4.2 Statement of Financial Position/Balance Sheet . . . . . . . . . . . . . . . . 80
4.2.1 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . 81
4.2.2 Factors Affecting the Statement of Financial Position/Balance Sheet

(SFP/BS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
4.3 Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
4.3.1 Preparing a Statement of Cash Flows . . . . . . . . . . . . . . . . . 100
4.3.2 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . 111
4.3.3 Interpreting the Statement of Cash Flows . . . . . . . . . . . . . . . 113
4.4 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

vi Table of Contents
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
5 Revenue 141
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
5.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
5.2 Revenue Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
5.2.1 Risks, Rewards, and Control . . . . . . . . . . . . . . . . . . . . . . 145
5.2.2 Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
5.2.3 Collectibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
5.2.4 Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
5.3 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
5.3.1 Bundled Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
5.3.2 Consignment Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
5.3.3 Instalment Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
5.3.4 Barter Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
5.3.5 Long-Term Construction Contracts . . . . . . . . . . . . . . . . . . . 153
5.4 Presentation and Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
5.5 IFRS 15: The New Standard . . . . . . . . . . . . . . . . . . . . . . . . . . 158
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

vii
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
6 Cash and Receivables 171
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
6.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
6.2 Cash and Cash Equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
6.2.1 Internal Control of Cash . . . . . . . . . . . . . . . . . . . . . . . . . 178
6.3 Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
6.3.1 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
6.3.2 Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
6.3.3 Derecognition and Sale of Receivables: Shortening the Credit-to-

Cash Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
6.3.4 Disclosures of Receivables . . . . . . . . . . . . . . . . . . . . . . . 219
6.4 Cash and Receivables: Analysis . . . . . . . . . . . . . . . . . . . . . . . . 221
6.6 Appendix A: Review of Internal Controls, Petty Cash, and Bank Reconcili-
ations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
7 Inventory 259

viii Table of Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
7.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
7.2 Initial Recognition and Measurement . . . . . . . . . . . . . . . . . . . . . . 262
7.3 Subsequent Recognition and Measurement . . . . . . . . . . . . . . . . . . 265
7.3.1 Inventory Accounting Systems . . . . . . . . . . . . . . . . . . . . . 265
7.3.2 Cost Flow Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . 266
7.3.3 The Problem of Overvaluation . . . . . . . . . . . . . . . . . . . . . 271
7.4 Presentation and Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
7.5 Inventory Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
7.6 Estimating Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
7.7 Inventory Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
8 Intercorporate Investments 289
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
8.1 Intercorporate Investments: Overview . . . . . . . . . . . . . . . . . . . . . 292
8.2 Non-Strategic Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
8.2.1 Held-For-Trading Investments (HFT); (ASPE – Short-Term Trading

Investments) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
ix
8.2.2 Available-for-Sale Investments (AFS); (IFRS only) . . . . . . . . . . 306
8.2.3 Held-To-Maturity Investments (HTM); (ASPE – All Other due to no

active market) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
8.3 Strategic Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
8.3.1 Investments in Associates (Significant Influence) . . . . . . . . . . . 325
8.3.2 Investments in Subsidiaries (Control) . . . . . . . . . . . . . . . . . . 328
8.3.3 Investments in Joint Arrangements . . . . . . . . . . . . . . . . . . . 329
8.4 Investments Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
8.5 Investments Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
9 Property, Plant, and Equipment 361
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
9.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
9.2 Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
9.3 Measurement at Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . 366
9.3.1 Self-Constructed Assets . . . . . . . . . . . . . . . . . . . . . . . . . 367
9.3.2 Borrowing Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
9.3.3 Asset Retirement Obligations . . . . . . . . . . . . . . . . . . . . . . 368
9.3.4 Lump Sum Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . 368

x Table of Contents
9.3.5 Nonmonetary Exchanges . . . . . . . . . . . . . . . . . . . . . . . . 369
9.3.6 Deferred Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
9.3.7 Government Grants . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
9.4 Measurement After Initial Recognition . . . . . . . . . . . . . . . . . . . . . 374
9.4.1 Cost Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
9.4.2 Revaluation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
9.4.3 Fair Value Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
9.5 Costs Incurred After Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . 378
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
10 Depreciation, Impairment, and Derecognition of Property, Plant, and Equip-

ment 391
Chapter 10 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
10.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394
10.2 Depreciation Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394
10.2.1 Depreciable Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . 394
10.2.2 Useful Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
10.2.3 Methods of Calculation . . . . . . . . . . . . . . . . . . . . . . . . . 396
10.2.4 Separate Components . . . . . . . . . . . . . . . . . . . . . . . . . . 399
10.2.5 Partial Period Calculations . . . . . . . . . . . . . . . . . . . . . . . 399

xi
10.2.6 Revision of Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . 400
10.3 Impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
10.3.1 Accounting for Impairment . . . . . . . . . . . . . . . . . . . . . . . . 401
10.3.2 Cash-Generating Units . . . . . . . . . . . . . . . . . . . . . . . . . 403
10.4 Derecognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
10.4.1 Held for Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
10.4.2 Other Derecognition Issues . . . . . . . . . . . . . . . . . . . . . . . 406
10.5 Presentation and Disclosure Requirements . . . . . . . . . . . . . . . . . . 407
10.7 Appendix A: ASPE Standards for Impairment . . . . . . . . . . . . . . . . . 408
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
11 Intangible Assets and Goodwill 421
Chapter 11 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . 421
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
11.1 Intangible Assets and Goodwill: Overview . . . . . . . . . . . . . . . . . . . 423
11.2 Intangible Assets: Initial Recognition and Measurement . . . . . . . . . . . 425
11.2.1 Purchased Intangible Assets . . . . . . . . . . . . . . . . . . . . . . 426
11.2.2 Internally Developed Intangible Assets . . . . . . . . . . . . . . . . . 427
11.2.3 Intangible Assets: Subsequent Measurement . . . . . . . . . . . . . 428

xii Table of Contents
11.2.4 Intangible Assets: Impairment and Derecognition . . . . . . . . . . . 430
11.3 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
11.3.1 Initial Recognition and Measurement . . . . . . . . . . . . . . . . . . 432
11.3.2 Subsequent Measurement of Goodwill . . . . . . . . . . . . . . . . . 435
11.4 Disclosures of Intangible Assets and Goodwill . . . . . . . . . . . . . . . . . 436
11.5 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
Solutions To Exercises 455
Chapter 2 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

Chapter 1
Review of Intro Financial Accounting
Chapter 1 Learning Objectives
LO 1: Complete Review Lab 1.1 to review adjusting entries.
LO 2: Complete Review Lab 1.2 to review merchandising transactions.
LO 3: Complete Review Lab 1.3 to review inventory costing methods.
LO 4: Complete Review Lab 1.4 to review bank reconciliations.
LO 5: Complete Review Lab 1.5 to review receivables transactions.
LO 6: Complete Review Lab 1.6 to review transactions related to long-lived assets.
LO 7: Complete Review Lab 1.7 to review current and long-term liabilities.
LO 8: Complete Review Lab 1.8 to review the statement of cash flows.
Introduction
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.
1
2 Review of Intro Financial Accounting
1.1 Adjusting and Closing Entries
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
1.2 Merchandising Transactions
related to merchandising transactions. If you require a ‘refresher’ on merchandising
transactions, refer to Chapter 5 of Introductory Financial Accounting.
1.3 Inventory Costing Methods
related to inventory costing methods. If you require a ‘refresher’ on inventory costing
methods, refer to Chapter 6 of Introductory Financial Accounting.
1.4 Bank Reconciliations
related to bank reconciliations. If you require a ‘refresher’ on bank reconciliations, refer to
Chapter 7 of Introductory Financial Accounting.

1.5. Receivables Transactions 3
1.5 Receivables Transactions
related to receivables transactions. If you require a ‘refresher’ on receivables transactions,
refer to Chapter 7 of Introductory Financial Accounting.
1.6 Long-Lived Assets
related to long-lived assets. If you require a ‘refresher’ on long-lived assets, refer to
Chapter 8 of Introductory Financial Accounting.
1.7 Current and Long-Term Liabilities
related to current and long-term liabilities. If you require a ‘refresher’ on current and long-
term liabillities, refer to Chapter 9 of Introductory Financial Accounting.
1.8 Statement of Cash Flows
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.

Chapter 2
Why Accounting?
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)
5
6 Why Accounting?
After completing this chapter, you should be able to:
LO 1: Identify the purpose of financial reporting.
LO 2: Describe the problem of information asymmetry, and discuss how this problem
can affect the production of financial information.
LO 3: Describe how accounting standards are set in Canada and identify the key entities
that are responsible for setting standards.
LO 4: Discuss the purpose of the conceptual framework, and identify the key compo-
nents of the framework.
LO 5: Describe the qualitative characteristics of accounting information.
LO 6: Identify the elements of financial statements.
LO 7: Discuss the criteria required for recognizing an element in financial statements.
LO 8: Identify different measurement bases that could be used, and discuss the strengths
and weaknesses of each base.
LO 9: Identify the alternative models of capital maintenance that could be applied.
LO 10: Discuss the relative strengths and weaknesses of rules-based and principles-
based accounting systems.
LO 11: Discuss the possible motivations for management bias of financial information.
LO 12: Discuss the need for ethical behaviour by accountants, and identify the key ele-
ments of the codes of conduct of the accounting profession.
Introduction
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 ac-
counting standards. We will also examine the accounting profession’s response to those
challenges, including the conceptual framework that currently shapes the development of
Chapter Organization 7
accounting standards. We will also discuss the role of ethical behaviour in the accounting
profession and the issues faced by practicing accountants.
Chapter Organization
1.0 Definition and

Information Asymmetry
The Objective of
Financial Reporting
2.0 Trade-offs
Qualitative
Characteristics
3.0 How are
Standards Set?
Elements of
Financial Statements
Why Accounting? 4.0 The Conceptual
Framework
Recognition
5.0 Challenges in
Financial Reporting
Measurement Base
6.0 Conclusion
Capital Maintenance
7.0 IFRS/ASPE
Key Differences
2.1 Definition and Information Asymmetry
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, and providing or settling loans and other forms of credit”
(International Accounting Standards Board, 2012). 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
8 Why Accounting?
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 selec-
tion 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.
2.2. Trade-Offs 9
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.
2.2 Trade-Offs
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, infor-
mation 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-
10 Why Accounting?
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.
2.3 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 Stan-
dards Oversight Council (AcSOC). The AcSOC was established in 2000 by the Canadian
Institute of Chartered Accountants (CICA) to oversee the standard setting process. Cur-
rently the AcSB receives funding, staff, and other resources from the Chartered Profes-
sional 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:

I. has issued, or is in the pr ocess 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
II. 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
2.4. The Conceptual Framework 11
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 125 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 Account-
ing 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.
2.4 The Conceptual Framework
According the CPA Canada Handbook, “the objective of a conceptual framework is to

facilitate the consistent and logical formulation of standards and provide a basis for the
use of judgment in resolving accounting issues” (CPA Canada, 2016). 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 have been working on a joint conceptual framework for several
years, and it is this framework that 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.
12 Why Accounting?
2.4.1 The Objective of Financial Reporting
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. The conceptual framework
then proceeds to discuss the qualitative characteristics of useful accounting information.
2.4.2 Qualitative Characteristics of Useful Information
The conceptual framework identifies fundamental and enhancing qualitative characteris-

tics 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, 2016, QC6). 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 condition or state of the item being reported. This does not mean, however,
that the representation must be 100 percent accurate. 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. Com-
pleteness 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 deprecia-
tion 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.
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
14 Why Accounting?
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 ob-
servers 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 state-
ments, 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 termi-
nology. 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 nonspecialist, 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 qual-
itative 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 ob-
tained 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.
2.4.3 Elements of Financial Statements
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 im-

portant 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
16 Why Accounting?
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 resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity” (CPA Canada, 2016,
4.4a). 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.
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 arising from past events, the set-
tlement of which is expected to result in an outflow from the entity of resources embodying
economic benefits” (CPA Canada, 2016, 4.4b). This definition can be visualized through
a time-continuum graphic:
Past EVENT Present OBLIGATION Future SETTLEMENT
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. 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.
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
18 Why Accounting?
other comprehensive income (IFRS only). However, other types of equity can arise on
certain types of transaction, such as contributed surplus, appropriated retained earnings,
and other reserves that may be allowed under local law. The purpose of all these subcat-
egories 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 economic benefits during the accounting period in

the form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants”
(CPA Canada, 2016, 4.25a). 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 con-
siders 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 economic benefits during the accounting period
in the form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants” (CPA
Canada, 2016, 4.25b). 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.
2.4.4 Recognition
Items are recognized in financial statements when the following criteria are present:
• The item meets the definition of an element.
• It is probable that any future economic benefit associated with the item will flow to
or from the entity.
• The item has a cost or value that can be measured with reliability (CPA Canada,
2016, 4.38).
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
reliable measurement, but the possible future impact of the event could still be of interest
to readers.
Determining the probability of future economic benefits often requires judgment, as future
events are not predictable with certainty. The accountant will need to consider not only
the element itself but also the characteristics of the entity’s environment and the quality of
the evidence available at the time. Although the conceptual framework does not formally
define the term probable, accountants usually interpret this to mean “more likely than
not.” As well, the reliability of measurement will also require the exercise of judgment, as
many accounting elements need to be estimated to be valued. These estimations can be
quite accurate when there are patterns of historical behaviour or other credible evidence
that supports the estimates. However, if the accountant does not have sufficient reliable
evidence to meet the measurement criterion, the element cannot be recognized.
2.4.5 Measurement Base
The conceptual framework also notes that once recognition is affirmed, the appropriate
measurement base needs to be considered. The following four measurement bases are
identified in the conceptual framework:
• Historical cost
• Current cost
• Realizable (settlement) value

20 Why Accounting?
• Present value
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 cost concept results in assets being reported at the amount that would
currently need to be paid to acquire a similar asset, while liabilities are reported at the
current, undiscounted amount of cash needed to settle the liability. 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.
Realizable (settlement) value attempts to value assets at the amount that could currently
be realized by selling the asset in an orderly fashion. Liabilities are measured at the undis-
counted amount of cash expected to be paid to settle the liabilities in the normal course
of business. Again, these measurements are felt to be more relevant than historical cost
information, as the information is current. However, this concept suffers from the same
reliability problems as current cost, as exit prices may not always be available for certain
types of assets. As well, some critics have pointed out that exit prices are not particularly
relevant if the company does not have any actual plans to dispose of the assets in the
near future.
Present value accounting attempts to get around this criticism by valuing assets at the
present value of future net-cash inflows related to those assets and liabilities at the
present value of future net-cash outflows. Thus, this is a more realistic valuation of
the asset’s value in use to the corporation. Quite often, this type of technique is used
for internal decision-making purposes, so it is thought that this information will also be
relevant to external readers. However, present-value calculations require a significant
amount of estimation regarding the quantum, timing, and probability of future cash flows
as well as the appropriate discount rate to use.
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 Con-
ceptual 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. Fair value is
defined as “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, 2016, IFRS 13.9). Depending on the nature of the item and the availability of
market information, the fair value may be determined easily or may require some degree
of estimation and judgment. In some cases, it may not be possible to determine the fair
value. 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 rec-
ommends 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.
2.4.6 Capital Maintenance
The last section of the conceptual framework deals with the concept of capital mainte-
nance. 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 mea-
surement 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 2014, so comparisons of capital over
longer periods become meaningless. One way to get around this problem is to apply a
22 Why Accounting?
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 informa-
tion 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 appropri-
ate capital maintenance model. Rather, the framework suggests that needs of financial-
statement users should be considered in determining the appropriate model.
2.5 Challenges in Financial Reporting
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 scan-
dals, 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 prac-
tices 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
2.5. Challenges in Financial Reporting 23
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 im-
proving 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 pro-
fessional 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
24 Why Accounting?
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 compen-
sated 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 main-
tained, 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.
2.5. Challenges in Financial Reporting 25
• 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 all of 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 asso-
ciated 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 pro-
fessional 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.
26 Why Accounting?
2.6 Conclusion
The accounting profession has seen tremendous transformation over the last forty years,
brought about by changes in technology, the sophistication of capital markets, the busi-
ness 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.
2.7 IFRS/ASPE Key Differences
Part II of the CPA Canada Handbook does not specifically refer to a conceptual frame-
work. 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:
Chapter Summary 27
IFRS ASPE
Two fundamental, qualitative characteris- Four principal qualitative characteristics
tics are relevance and faithful representa- are relevance, reliability, comparability,
tion. Comparability and understandabil- and understandability.
ity are considered enhancing qualitative
characteristics.
Timeliness is considered an enhancing Timeliness is included as a sub-element of
qualitative characteristic. relevance.
Verifiability is considered an enhancing Verifiability is a sub-element of reliability.
qualitative characteristic.
Faithful representation includes complete- Reliability includes representational faith-
ness, neutrality, and freedom from error. fulness, verifiability, neutrality, and conser-
vatism.
Gains are included in the element “in- Gains and losses are identified as sepa-
come,” and losses are included in the rate elements of financial statements.
element “expenses.”
Three types of capital maintenance con- Only a monetary measure of capital main-
cepts are identified, but no prescribed or tenance should be used, with no adjust-
preferred approach is indicated. ment for changes in purchasing power.
Chapter Summary
LO 1: Identify the purpose of financial reporting.
The purpose of financial reporting is to provide information that is useful for making deci-
sions 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
28 Why Accounting?
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 en-
vironment. 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 com-

posed 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
Chapter Summary 29
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: mone-

tary 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.
30 Why Accounting?
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.
Exercises 31
References
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-marke
t-flexibility
Exercises
EXERCISE 2–1
Describe the problem of information asymmetry and discuss the impact this problem has
on the work of accountants.
EXERCISE 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?
EXERCISE 2–3
What is the conceptual framework? Why does the accounting profession need this frame-
work?
EXERCISE 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?
EXERCISE 2–5
32 Why Accounting?
Describe the four enhancing qualitative characteristics and identify conflicts where possi-
ble trade-offs may occur in trying to maximize these characteristics.
EXERCISE 2–6
Identify which of the five financial statement elements applies to each item described
below:
a. A cash dividend is declared and paid to the shareholders.
b. Cash is used to purchase a machine that will be used in the production process over
the next five years.
c. Products are sold to customers on 30-days’ credit
d. Income taxes are calculated based on a company’s profit. The taxes will be paid
next year.
e. A customer makes a deposit on a special order that will not be manufactured until
next year.
f. A bill for electricity used in the current month is received but not payable until the
following month.
g. A shareholder invests money in a business in exchange for issued shares.
h. A shareholder invests money in a business by making a loan with commercial terms

to the business.
i. An insurance settlement is received for a fully depreciated asset that was destroyed
in a fire.
j. An allowance for doubtful accounts is established based on estimates of future

uncollectible accounts.
EXERCISE 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 ac-
counting treatment.
a. A publisher sells magazines on a two-year subscription. Customers are required to

pay the full amount at the commencement of the subscription.
Exercises 33
b. 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.
c. 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.
d. 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.
e. 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.
EXERCISE 2–8
Describe the four different measurement bases and discuss the relative strengths and
weaknesses of each base.
EXERCISE 2–9
What are some of the difficulties in trying to determine the best concept of capital main-
tenance to apply to the development of accounting standards?
EXERCISE 2–10
Discuss the relative merits and weaknesses of principles-based and rules-based account-
ing systems.
EXERCISE 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?
34 Why Accounting?
EXERCISE 2–12
You have just been appointed financial controller at Dril-Tex Inc., a manufacturer of spe-
cialized 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:
a. 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 conclu-
sion 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.
b. 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.
c. There are $50,000 worth of customer prepayments included in the Accounts Receiv-
able 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.
d. 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 com-
pany. We have capitalized the cost of his salary and benefits, as we are confident
he will soon be producing a breakthrough product for us.
e. 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, sup-

porting 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.
Chapter 3
Financial Reporting
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 light of 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.
The investigation was undertaken after the discovery of misclassifications in its

accounting records with regard to 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 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 is related 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)
35
36 Financial Reporting
LO 1: Describe the statement of income, the statement of comprehensive income, and

the statement of changes in equity and their role in accounting and business.
LO 2: Identify the factors that influence what is reported in the statement of income,
statement of comprehensive income, and the statement of changes in equity.
2.1 Explain the factors that influence the choice of accounting year-end.
2.2 Explain how changes in accounting estimates, changes due to correction of
accounting errors, and changes in accounting policy affect the income and
equity statements.
LO 3: Identify the core financial statements and explain how they interconnect together.
3.1 Explain the differences between IFRS and ASPE with regard to the income
and equity statements.
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.
LO 5: Describe the various formats used to report the changes in equity for IFRS and
ASPE companies, and identify the reporting requirements.
LO 6: Identify and describe the types of analysies techniques that can be used for
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 as 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.
1.0 Financial
Reporting: Overview
Accounting Year-End
2.0 Factors that Influence
Financial Reports Changes in Accounting
Estimates, Policy, and
Correction of Errors
3.0 Financial Statements, Differences Between

Interrelationships IFRS and ASPE
4.0 Statement of Income Statement Formats and

Financial Reporting and Comprehensive Income Reporting Requirements
5.0 Statement of Changes

in Equity(IFRS) and Statement Formats and
Statement of Retained Reporting Requirements
Earnings(ASPE)
6.0 Analysis of Income

Types of Analysis and
and Statement of
Segmented Reporting
Changes in Equity
7.0 IFRS and ASPE

Applicable Standards
3.1 Financial Reporting: Overview
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 the course
of 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 prescribe which financial data is to be specif-
ically identified and reported out of the many thousands of transactions making up the
accounting records. To comply with these standards, separate reporting of certain infor-
mation 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 two of the 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.
3.2 Factors that Influence Financial Reports
3.2.1 Accounting Year-end
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 close of the busiest part of the season when inventory
is at its lowest levels. This makes the physical count easier and less costly, with fewer
transactions to record before the books are closed. As well, staff are more available to
assist with the year-end process. Planning a fiscal year-end based on advantageous tax
consequences can be tricky, but essentially 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. Finally, businesses that are not incorpo-
rated (e.g., proprietorships and partnerships) tend to choose the calendar year-end so it
coincides with Canada Revenue Agency’s basis deemed for unincorporated businesses,
thereby making things much simpler from a tax perspective. Whatever fiscal year-end is
chosen, accounting standards require that the financial statements be reported on the
basis of accrual accounting. 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 final outcome regarding the 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
3.2. Factors that Influence Financial Reports 39
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 time period. For example, public companies in Canada
are required to produce quarterly financial statements. They provide information about
how the company has done to date. The accounting cycle has not yet been completed
at this interim time 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. 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. This is a period
of time in the new fiscal year when 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. The subsequent events time period may be
anywhere from a few days to several weeks, 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 account. If the total ending inventory amount from
the physical count is more or less than the carrying value in the accounting records,
an adjusting entry is required. 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, but very near to, the year-end date. 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. If the services were provided to the
purchaser just prior to the fiscal year-end and this invoice is not received until the
new fiscal year, the invoice will likely not be recorded until the new year. Every effort
is made by the purchaser to estimate and accrue any goods and services received
prior to year-end where the invoices have not yet been received, but this process is
not foolproof. Subsequent periods allow the purchasers a safety-net time period to
catch and record in the fiscal year just ended 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 dis-
closed in the notes to the financial statements for the year just ended. An example might
be where early in 2016 vandals damage some buildings and equipment. If the repair or
replacement costs are material, then these costs, though correctly paid and recorded in
2016, are to be disclosed in the notes to the 2015 year-end financial statements. This will
ensure that the company stakeholders have access to all the relevant information.
3.2.2 Changes in Accounting Estimates, Changes in Accounting

Policy, and Correction of Errors
Financial statements can be impacted by changes in accounting policies, changes in esti-

mates, and correction of errors. These were first introduced in the introductory accounting
course and will also be discussed in detail in a subsequent 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
pattern used to match use of the assets (depreciation) with revenues earned. Straight-
line, declining balance, or units-of-production depreciation methods are all examples
where changes in estimates can occur. Subsequent changes in the pattern of asset
use means a change in estimate. Other estimates involve uncollectible receivables, rev-
enue 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

3.2. Factors that Influence Financial Reports 41
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 classification, presentation, and measurement of financial assets and

liabilities under categories specified in the accounting standards such as invest-
ments classified as held-to-maturity (HTM), available-for-sale (AFS), or held-for-
trading (HFT). Details of these are discussed in the chapter on intercorporate in-
vestments, 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 used in the preparation of financial state-
ments
Management must consistently review its accounting policies to ensure they comply with
the latest pronouncements by IFRS or ASPE and that the adopted policies result in
presentation of the most relevant and reliable financial information for the stakeholders.
Accounting policies must be applied consistently to promote comparability between finan-

cial statements for different accounting periods. A change in accounting policy is only
allowed under two conditions:
1. as a result of changes in a primary source of GAAP
2. applied voluntarily by management to enhance the relevance and reliability of infor-

mation 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 general rule, changes in accounting policies must be applied retrospectively with

restatement to the financial statements. Retrospective application means that the com-
pany 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 in order to manage earn-
ings aggressively because the restatement is made to all prior years as well as to the
current year. If this were not the case, then the change made to a single year could
materially affect the statement of income for the current fiscal year.
As with the correction of an accounting error, 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 fol-

lowing 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 with regards to 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 imma-

terial.
• 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 such 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 period presented
• Where retrospective application is impracticable, the conditions that caused the

impracticality (CPA Canada, 2011).
3.3. Financial Statements and Their Interrelationships 43
Changes Due to Accounting Errors or Omissions
The accounting treatment for an error or omission is a retrospective adjustment with

restatement. Retrospective application means that the company deals with the error or
omission as though it had always been corrected. For example, an accounting error in
inventory originating in the current fiscal year is detected within the current fiscal year. The
accounting records are still open, so the inventory error correction is recorded as soon
as possible to the applicable accounts in the current year. Conversely, 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 adjusted, net of taxes, to the current year’s opening retained earnings
balance of the statement of changes in equity (IFRS) or the statement of retained earnings
(ASPE). This results in a restatement of opening retained earnings in the current year. If
the financial statements are comparative and include previous year’s data, then this data
is also restated to include the error correction. This will be discussed and illustrated later
in this chapter.
3.3 Financial Statements and Their Interrelationships
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 Ser-
vices Ltd., a large, privately-held company is presented below (assume Wellbourn applies
IFRS; for simplicity, comparative year data and reporting disclosures are not shown).
Wellbourn Services Ltd.

Statement of Income
for the year ended December 31, 2015
Revenues:
Sales $ 250,000
Services revenue 53,000
Total revenue $ 303,000
Operating expenses:
Cost of good sold 100,000
Rent expense 23,000
Salaries expense 65,000
Total operating expense 188,000
Income from continuing operations before tax 115,000
Income tax 34,500
Net income $ 80,500
Earnings per share $ 24

Statement of Comprehensive Income
Net income $80,500 to R/E
Other comprehensive income:
Items that may be reclassified subsequently to net income or loss:
Unrealized gains from AFS investments
(net of tax of $1,500) 3,500 to AOCI
Total comprehensive income $84,000

Statement of Changes in Equity
Accumulated Other
Common Contributed Retained Comprehensive
Shares Surplus Earnings Income Total
Balance, January 1 $200,000 $25,000 $75,000 $45,000 $345,000
Total comprehensive income:
Net income 80,500 80,500
Other Comprehensive Income 3,500 3,500
Total comprehensive income 80,500 3,500 84,000
Issuance of common shares 10,000 10,000
Dividends declared (50,000) (50,000)
Balance, December 31 $210,000 $25,000 $105,500 $48,500 $389,000
3.3. Financial Statements and Their Interrelationships 45

Statement of Financial Position
December 31, 2015
Assets Liabilities
Current assets Current liabilities
Cash $135,500 Accounts payable $ 77,500
Accounts receivable (net) 225,000 Accrued liabilities 225,000
Inventory 130,000 Total current liabilities 302,500
Total current assets 490,500 Bonds payable 160,000
Investments 100,000 Total liabilities 462,500
Property, plant, and equipment (net) 246,000 Equity
Intangible assets 15,000 Common shares 210,000
Total assets $851,500 Contributed surplus 25,000
Retained earnings 105,500
AOCI 48,500
Total equity 389,000
Liabilities and equity $851,500

Statement of Cash Flows
Cash flows from operating activities
Cash received from clients $ 50,000
Cash paid for supplies (25,000)
Cash paid to employees (51,200)
Net cash used by operating activities (26,200)
Cash flows from investing activities
Purchase of equipment (25,000)
Net cash used by investing activities (25,000)
Cash flows from financing activities
Dividends paid (50,000)
Issued bonds 160,000
Net cash received by financing activities 110,000
Net increase in cash 58,800
Cash balance, January 1 76,700
Cash balance, December 31 $ 135,500
Disclosure: Issuance of common shares for $10,000 was a non-cash transaction in

exchange for services rendered.
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 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.
Examples of OCI are foreign exchange gains or losses resulting from conversion of a
foreign subsidiary to its parent company’s functional currency for reporting purposes, or
any gains or losses for available for-sale investments resulting from changes in their fair
value while the investment is being held.
• Other comprehensive income (OCI) = certain gains or losses not already included
in net income
• Total comprehensive income = net income/loss +/- other comprehensive income

(OCI)
Within the statement of comprehensive income, the net income amount flows directly to
retained earnings, while any other comprehensive income (OCI) gain or loss flows directly
to the accumulated other comprehensive income (AOCI) account in the statement of
changes in equity. The AOCI account is a separate type of retained earnings account
that accumulates any items from OCI that have not been reported in net income and the
retained earnings account.
To summarize:
• Retained earnings accumulate net income/loss over time.
• AOCI accumulates other comprehensive income (OCI)/losses over time.
It should also be noted that IFRS companies can choose to keep the statement of in-
come 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 section 3.3.1, which follows.
The statement of changes in equity total column flows to the equity section of the state-
ment of financial position/balance sheet (SFP/BS). Finally, the statement of cash flows
(SCF) ending cash balance must be equal to the cash ending balance reported in the
SFP/BS, which completes the loop of interconnecting accounts and amounts.
Before continuing on with the income and changes in equity financial statements, some
differences in financial statements and their formats between IFRS and ASPE are now
discussed.
3.4. Statement of Income and Comprehensive Income 47
3.3.1 Financial Statement Differences Between IFRS and ASPE
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 in-
cluded
• a statement of financial position
• a statement of cash flows
• notes to the financial statements
For ASPE the statements are more simplified. ASPE requires the statement of income,
but only IFRS requires the comparative previous year amounts column as well as disclo-
sure of the earnings per share. 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 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).
3.4 Statement of Income and Comprehensive Income
As previously stated, net income is a measure of return on capital and, hence, of per-
formance. This means that investors and creditors can 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 – 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.
The statement of income and comprehensive income is based on accrual accounting, as

is the case with all the core financial statements. 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.
Quality of earnings – the amount of earnings attributable to sustainable ongoing core

business activities rather than to “artificial profits” created by the following:
• 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, result-
ing in potential misstatement
Lower quality earnings will include significant amounts of the items listed. If the quality
of earnings is low, then more risk is associated with inaccurate 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 publically 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, 2015.
Multiple-step format -
Minimum Line Item
typical sections and
Disclosures:
subtotals: Toulon Ltd.
Consolidated Statement of Income and Comprehensive Income Heading
Heading
In $000’s except per share amounts 2015 2014 Comparative years (IFRS)
Sales $6,260 $5,008 Revenue – separated into major

Gross profit section categories (IFRS & ASPE)
with subtotal Cost of goods sold 2,500 1,750 Inventory charged to expense
Gross profit 3,760 3,258 (IFRS & ASPE)
Operating expenses Employee benefits expense in-

cluding salaries and wages, pay-
Salaries and benefits expense 650 520 roll taxes, health care costs, and
post-retirement benefits (IFRS)
Depreciation expense 35 20 Depreciation and amortization

(IFRS & ASPE)
Travel and entertainment expense 150 120
Operating expenses Advertising expense 55 45
with subtotal
Freight-out expenses 10 8
The remaining expenses by na-
Supplies and postage expense 5 4 ture (IFRS)
Telephone and internet expense 15 12
Legal and professional expenses 8 6
Insurance expense 6 5
934 740
Income from operations 2,826 2,518
Other revenue and expense This section is for non-operating
Dividend revenue 3 3 items. Finance costs such as
interest income & expense, for-
Non-operationing Interest income from investments 2 2 eign exchange, gain/loss from
section with subtotal Gain from sale of trade investments 4 0 sale or impairment of assets and
Interest expense (2) (3) interest (IFRS & ASPE)
7 2
Income from continuing operations 2,833 2,520
before income tax Income tax expense on continu-
Income tax expense Income tax expense 850 680 ing operations (IFRS & ASPE)
Subtotal from
continuing operatings Income from continuing operations 1,983 1,840 Same as Income before discon-
Discontinued operations tinued operations (ASPE)
Loss from operation of discontinued division
(net of tax of $45,000) (105) 0 Discontinued operations, net-of-
Discontinued tax with tax amounts disclosed
Loss from disposal of division (IFRS & ASPE)
(net of tax of $18,000) (42) 0
(147) 0
Net income (profit or
Net income (note 1) 1,836 1,840 Net income (profit or loss)
loss)
Other comprehensive income:
Items that may be reclassified subsequently
to net income or loss: Other comprehensive income by
Comprehensive nature (IFRS)
Unrealized gain from available for sale investments
income (IFRS)
(net of tax of $6,000 for 2015 and $3,000
for 2014 respectively) 14 9
Total comprehensive income 1,850 1,849 Total comprehensive income
separated into attributable to
Non-controlling interests (minority interests) (11) (12)
parent and non-controlling
Attributable to the equity holders of Toulon $1,839 $1,837 interests (IFRS)
Earnings per share, attributable to

the equity holders of Toulon:
Basic EPS from continuing and
Basic earnings per share
discontinued operations (IFRS)
Earnings per share Continuing operations $ 16.32 $13.25
Basic and diluted EPS Discontinued operations (1.23) 0
(IFRS)
Diluted earnings per share
Continuing operations 12.86 13.75 Diluted EPS from continuing and
Discontinued operations (1.03) 0 discontinued operations (IFRS)
Note 1: Net income 1,836 1,840 Net income (profit or loss) sepa-
rated into attributable to the par-
Non-controlling interests (minority interests) (10) (11)
ent and non-controlling interests
Attributable to the equity holders of Toulon $1,826 $1,829 (IFRS & ASPE)
For Toulon, the consolidated statement of income and comprehensive income separates
the statement into individual sections, which includes a blend of mandatory reporting
requirements and minimum reporting items and subtotals:
Typical sections for the state- Minimum reporting require- Minimum reporting require-
ment of income and compre- ments for IFRS companies. ments for ASPE companies.
hensive income.
(A mix of line item reporting re- (Some of these can be either (Some of these can be either
quirements and optional report- reported on the face of the state- reported on the face of the state-
ing.) ment or in the notes to the finan- ment or in the notes to the finan-
cial statements.) cial statements.)
• revenue, sales and net sales, • revenue separated into income • revenue separated into income
COGS, and gross profit sources such as sales and sources such as sales and
revenue (for services, etc.) revenue (for services, etc.)
• inventory expensed • inventory expensed
• operating expenses by nature • amortization and depreciation • amortization and depreciation

(by function is optional)
• employee benefits such as • share-based compensation
salaries, wages, payroll taxes,
health care costs, and post-
retirement benefits
• all other operating expenses
by nature
Other non-operating revenues Other non-operating revenues Other non-operating revenues

and expenses such as: and expenses such as: and expenses such as:
• other revenues, expenses, • finance costs such as interest • income from investments sep-
gains and losses not incurred income and interest expense, arated into income from in-
in the normal course of income from associates vestment for non-consolidated
business subsidiaries, investments us-
• write-down of inventory
ing equity method, at cost or at
fair value
• impairment losses and rever-
sals of impairment losses on
PPE, intangible assets, and
goodwill
• exchange gains or losses
• gain or loss from asset dis-
posal 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)
• income tax expense • income tax expense (from con- • income tax expense (from con-
tinuing operations) tinuing operations)
• Income from continuing opera- • Income from continuing opera- • Income/loss before discontin-
tions subtotal tions subtotal ued operations subtotal (same
as income from continuing op-
erations IFRS)
• discontinued operations net of • discontinued operations, if any, • discontinued operations, if any,

tax with tax amounts disclosed net of tax with tax amounts net of tax with tax amounts
and subtotal disclosed and subtotal disclosed and subtotal
• net income (profit or loss) • net income (profit or loss) • net income
• other comprehensive income, • other comprehensive income, • N/A

if any if any
• total comprehensive income • total comprehensive income • N/A

(net income + OCI) (net income + OCI)
• basic and diluted earnings per • basic and diluted earnings per • not required
share by continuing and dis- share by continuing and dis-
continued operations continued operations
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 on-
going operations having a high predictive value separately, compared to non-operating or
unusual items having little predictive value. The following are examples of non-operating
revenue, expenses, gains, and losses for a typical company not normally involved in rental
properties or finance:
• rent revenue (e.g., for unused space)

• interest income (e.g., for investing idle cash)
• interest expense on debts payable
• gain or loss from the sale of assets
• foreign exchange gain or loss
These non-operating items are usually reported as separate line items in the non-operating
revenue and expenses section, but there is some flexibility regarding how these items can
be reported.
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, then 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
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 allo-
cation 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 perfor-
mance 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 (statement of income)
2. Discontinued operations gains or losses, and gain or loss from disposal of discon-
tinued operations (statement of income)
3. Each item reported in other comprehensive income (statement of comprehensive

income)
4. Each retrospective restatement for changes in accounting policy or correction of

prior period errors (statement of changes in equity or retained earnings statement),
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, 2015, allocates tax at a rate of 30% to the following:
• Income from continuing operations of $850,000 ($2,833,000 × 30%)
• Loss from discontinued operations of $45,000 ($150,000 × 30%)

• Loss from disposal of discontinued operations of $18,000 ($60,000 × 30%)
• Comprehensive income gain from available-for-sale investments of $6,000 ($20,000×

30%)
When reporting requirements are standardized, 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.
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. In order 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, then 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
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 first, the statement of income, ends
at net income (highlighted in yellow). A second statement, called the statement of
comprehensive income, would immediately follow the statement of income, beginning
with net income and include any other comprehensive income 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. This will be discussed again in the
chapter on intercorporate investments. How non-controlling interest is reported on the
statement of income and comprehensive income is the relevant point for this chapter.
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.
Earnings per Share
Basic earnings per share represent the amount of income attributable to each outstanding
common share, as shown in the calculation below:
Net income − preferred dividends

Basic earnings per share (EPS) =
Weighted average number of
common shares outstanding
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 publically-traded IFRS companies where shares are held by many investors.
For IFRS companies, basic earnings per share (excluding Other comprehensive income
(OCI) and non-controlling interests) are 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 struc-
ture consisting of common shares and perhaps non-convertible preferred shares or non-
convertible bonds. Reporting diluted earnings per share is also required when companies
hold financial instruments such as options or warrants, convertible bonds, or convertible
3.5. Statement of Changes in Equity (IFRS) and Statement of Retained Earnings (ASPE) 57
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.
3.5 Statement of Changes in Equity (IFRS) and

Statement of Retained Earnings (ASPE)
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, 2015.
Arctic Services Ltd.

Statement of Retained Earnings
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 reported, net of tax, with the tax amount disclosed. The retained
earnings 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:
General Journal
Date Account/Explanation PR Debit Credit
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Income tax payable . . . . . . . . . . . . . . . . . . . . . . 5,400
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 12,600
General Journal
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Income tax payable . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
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; 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, 2015.
Velton Ltd.
Accumulated Other
3.5. Statement of Changes in Equity (IFRS) and Statement of Retained Earnings (ASPE)
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 — AFS investments** 3,500 3,500
Total comprehensive income 125,000 3,500 128,500
Issuance of common shares 100,000 100,000
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
This statement is a reporting requirement for IFRS and is usually prepared in a worksheet-style format as shown above.
The equity portion of the SFP is shown below.
59
Velton Ltd.
Statement of Changes in Financial Position
Shareholders’ Equity Section
December 31, 2015
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/(defecit) 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 in-
sufficient to absorb these losses, then retained earnings would have a debit balance and
would be reported on the SFP as a deficit.
3.6 Analysis of Statement of Income and Statement of

Changes in Equity
Analysis of the financial statements is critical to decision making and to the assessment of
the overall financial state of a company. Financial statement analysis is an evaluative pro-
cess of determining the past, current, and projected performance of a company. Financial
statements report financial data; however, this information must be evaluated through the
process of analysis to become more useful to investors, shareholders, managers, and
other stakeholders. Several techniques are commonly used for financial statement anal-
ysis. 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 in-
come 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,
3.6. Analysis of Statement of Income and Statement of Changes in Equity 61
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 (net income divided by net sales 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. The next
intermediate accounting course will discuss segmented reporting in detail. 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 then
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 particular borderline,
or losing, component that produces parts may guarantee access to these critical parts
as 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 busi-
ness 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.
3.7 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 State-
ment, and Section 3475, Disposal of long-lived assets and discontinued operations
Chapter Summary
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 how well the company has performed 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 are studied in this chapter.
Chapter Summary 63
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 ex-
penses 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 or not to include them in the
financial statements or in the notes to the financial statements. Changes in accounting
estimates (prospective treatment), correcting accounting errors (retrospective treatment),
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 purpose of the statement of cash
flows is to reconcile cash and cash equivalent opening balances at the beginning of the
reporting period to the closing balances at the end of the period. This difference is 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 cycle. It provides a
snapshot at the end of the reporting period, such as month-end or year-end, which
identifies the company resources (assets) and the claims to these resources (liabilities).
The remaining balance represents the net assets that remain with the company’s owners,
who are the common shareholders. The ending balance of the statement of cash flow
reconciles to the cash and cash equivalent balances in the SFP/BS, and the statement of
changes in equity totals 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 prof-
itability. 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 considered to be 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.
There are typical formats used for these statements but there is flexibility in terms of
terminology and formatting. 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
Chapter Summary 65
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 all of the equity
accounts are identified, usually in a worksheet style with each account assigned to a col-
umn. 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 ex-
presses certain subtotals (gross profit) as a percentage of a total amount (sales), and
ratio analysis that highlights important relationships between data.
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/ArticleN
ews/story/gam/20140919/RBCDPENNWESTFINAL
Exercises
EXERCISE 3–1
The following information pertains to Inglewood Ltd. for the 2015 fiscal year ending De-
cember 31:
Gain on sale of held-for-trading 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 Available-for-sale investments (net of tax) 12,000
The company tax rate is 27%. The unrealized holding gain from Available-for-sale invest-
ments relates to investments that are not quoted in an active market and the gain has
been recorded to other comprehensive income (OCI).
Required:
a. Calculate income from continuing operations, net income, other comprehensive

income, and total comprehensive income.
b. How would your answers change in part (a) if the company followed ASPE?
EXERCISE 3–2
Wozzie Wiggits Ltd. produces and sells gaming software. In 2015, 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
Exercises 67
drop in cost of goods sold. This policy change was fully disclosed in the notes to the
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?
EXERCISE 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 cus-
tomer service. In 2015, 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?
EXERCISE 3–4
For the year ended December 31, 2015, Bunsheim Ltd. reported the following: sales rev-
enue $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, 2015, 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 2015. On December 15, 2015, the board of
directors declared a $45,000 dividend to its common shareholders payable on January
31, 2016. The company accounts for its investments in accordance with IAS 39 meaning
that any unrealized gains/losses on Available-for-sale investments are to be reported as
other comprehensive income (OCI). On January 4, 2016, the company discovered that
there was an understatement in travel expenses from 2014 of $80,000. The books for
2014 are closed.
Required
a. Prepare a statement of changes in equity including required disclosures. The en-

acted tax rate is 27% and has not changed for several years.
b. Prepare the same statement as in part (a) assuming that Bunsheim Ltd. follows
ASPE.
EXERCISE 3–5
For the year ended December 31, 2015, Patsy Inc. had income from continuing operations
of $1,500,000. During 2015, 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
2014 and $175,000 in 2015. Patsy also had an unrealized gain in its Available-for-sale
investments of $27,500 (net of tax). It accounts for its investments in accordance with IAS
39. Patsy had 50,000 outstanding common shares for the entire 2015 fiscal year and its
income tax rate is 30%.
Required:
a. Prepare a partial statement of comprehensive income with proper disclosures for

Patsy Inc. beginning with income from continuing operations. Patsy follows IFRS.
b. How would the statement in part (a) differ if Patsy followed ASPE?
EXERCISE 3–6
Below are the changes in account balances, except for retained earnings, for Desert Dorm
Ltd., for the 2015 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
Inventory 218,400
Investments – held for trading (46,500)
Intangible assets – patents 14,000
Unearned revenue 45,200
Retained earnings ??
Required: Calculate the net income for 2015, assuming that there were no entries in the
retained earnings account except for net income and a dividend declaration of $44,000,
which was paid in 2015. (Hint: using the accounting equation A = L + E to help solve this
question)
Exercises 69
EXERCISE 3–7
In 2015, Imogen Co. reported net income of $575,000, and declared and paid preferred
share dividends of $75,000. During 2015, the company had a weighted average of 66,000
common shares outstanding.
Required: Calculate the company’s basic earnings per share.
EXERCISE 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, 2015
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
Cost of goods sold 1,020,500
Dividends 58,500
Equipment 182,000
Error correction for understated cost of goods sold from 2014 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
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:
a. 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.
b. Prepare a combined single-step income statement and retained earnings by function

assuming ASPE.
EXERCISE 3–9
Below are adjusted accounts and balances for Ace Retailing Ltd. for the year ended
December 31, 2015:
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 held for trading 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, 2015 458,000
Selling and administrative expenses 245,000
Unrealized gain on Available-for-sale 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 2015, 400,000 common shares were outstanding with no shares activity for
2015.
3. Ace’s tax rate is 27%.
4. Ace follows IFRS and accounts for its investments in accordance with IAS 39 mean-
ing that any unrealized gains/losses are reported through net income.
Exercises 71
Required:
a. Prepare a multiple-step statement of income for the year ended December 31, 2015,
in good form reporting expenses by function.
b. Prepare a combined statement of income and comprehensive income in good form
reporting expenses by function.
c. 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?
d. Prepare a single-step statement of income in good form reporting expenses by
function.
e. 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.
EXERCISE 3–10
Vivando Ltd. follows IFRS and reported income from continuing operations before income
tax of $1,820,000 in 2015. The year-end is December 31, 2015, and the company
had 225,000 outstanding common shares throughout the 2015 fiscal year. Additional
transactions not considered in the $1,820,000 are listed below:
In 2015, 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 as a result of a lawsuit for a breached 2011 contract.
Before the decision, legal counsel was uncertain about the outcome of the suit and had
not established a receivable.
In 2015, 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
2015, 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.
EXERCISE 3–11
The following account balances were included in the adjusted trial balance of Spyder Inc.
at September 30, 2015. All accounts have normal balances:
Accumulated depreciation, office furniture 25,000

Accumulated depreciation, sales equipment 80,000
Accumulated Other Comprehensive Income 162,000
Depreciation expense, office furniture 10,150
Depreciation expense, sales equipment 6,972
Depreciation expense, understatement due to error – 2014 24,780
Dividend revenue 53,200
Dividends declared on common shares 12,600
Entertainment expense 20,748
Freight-out 40,502
Interest expense 25,200
Loss on disposal of discontinued operations – Aphfflek Division 49,000
Miscellaneous operating expenses (administrative) 6,601
Salaries and wages expense – office staff 78,764
Sales commissions expense 136,640
Sales discounts 21,000
Sales returns and allowances 87,220
Supplies expenses (administrative) 4,830
Telephone and Internet expense (administrative) 3,948
Telephone and Internet expense (sales) 12,642
The company follows IFRS and its income tax rate is 30%. On September 30, 2015, 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, 2014.
Exercises 73
Required:
a. Prepare a multiple-step income statement in good form with all required disclosures
by function and by nature for the year ending September 30, 2015.
b. Prepare a statement of changes in equity in good form with all required disclosures
for the year ended September 30, 2015.
c. Prepare a single-step income statement in good form with all required disclosures
by nature for the year ending September 30, 2015.
d. Assuming that Spyder also recorded unrealized gains for Available-for-sale invest-
ments through OCI of $25,000, prepare a statement of comprehensive income for
the company.
Chapter 4
Financial Reports – Statement of Financial Posi-
tion and Statement of Cash Flows
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 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 in its growth, causing a sharp drop
in the free cash flow levels compared to the SCF, net cash from operating section.
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.
75
76 Financial Reports – Statement of Financial Position and Statement of Cash Flows
So, which part of the CCC metric is Amazon leveraging the most? While it could be
good inventory management, it is not. It is actually 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 by 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)
After completing this chapter, you will gain the knowledge to:
LO 1: Describe the statement of financial position/balance sheet (SFP/BS) and the state-
ment of cash flows (SCF), and explain their role in accounting and business.
LO 2: Explain the purpose of the statement of financial position (SFP/BS).
2.1 Identify the various disclosure requirements for the SFP/BS and prepare a
SFP/BS in good form.
2.2 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.
LO 3: Explain the purpose of the statement of cash flows (SCF) and prepare a SCF in
good form.
3.1 Explain and describe an acceptable format for the SCF.

3.2 Describe and be able to prepare a SCF in good form with accounts analysis
as required, and interpret the results.
LO 4: Identify and describe the types of analysis techniques that can be used for the
SFP/BS and the SCF.
Introduction 77
Introduction
In Chapter 3 we discussed three of the core financial statements. This chapter will now
discuss the remaining two: the SFP/BS, and the statement of cash flows (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.
Disclosure
Requirements
Factors Affecting
the SFP/BS
Changes in
Estimates
1.0 Financial
Reports: Overview Accounting Errors
and Omissions
2.0 Statement
of Financial Changes in
Position/Balance Accounting Policy
Financial Reports Sheet (SFP/BS)
Statement of Financial
Position and Statement Contingencies
of Cash Flows and Guarantees
Subsequent
3.0 Statement of Events
Cash Flows (SCF)
Preparing a
Statement of
4.0 Analysis Cash Flows
Disclosure
Requirements
Interpreting the
Statement of
Cash Flows
4.1 Financial Reports: Overview
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 net-
work of financial information. The illustration in that chapter showed how the ending cash
position from the statement of cash flows (SCF) is also the ending cash balance amount
in the SFP/BS. So, this is the final link that completes the overall financial picture though
review of the core financial statements.
4.1. Financial Reports: Overview 79
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 balances link the two statements.

December 31, 2015
Assets Liabilities
Current assets Current liabilities
Cash $135,500 Accounts payable $ 77,500
Accounts receivable (net) 225,000 Accrued liabilities 225,000
Inventory 130,000 Total current liabilities 302,500
Total current assets 490,500 Bonds payable 160,000
Investments 100,000 Total liabilities 462,500
Property, plant, and equipment (net) 246,000 Equity
Intangible assets 15,000 Common shares 210,000
Total assets $851,500 Contributed surplus 25,000
AOCI 48,500
Total equity 389,000
Liabilities and equity $851,500

Cash received from clients $ 50,000
Cash paid for supplies (25,000)
Cash paid to employees (51,200)
Purchase of equipment (25,000)
Net cash used by investing activities (25,000)
Issued bonds 160,000
Net cash received by financing activities 110,000
Cash balance, January 1 76,700
Cash balance, December 31 $ 135,500
The statement of financial position (IFRS), or balance sheet (ASPE), 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 (share-
holders’ 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:
Assets = Liabilities + Equity
The key issues to consider with regard to the SFP/BS are the valuation and manage-
ment 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 identifies how the company utilized its cash inflows and
outflows over the reporting period and ends with its current cash and cash equivalents
position at the SFP/BS date. 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, then 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,
it may mean a downward spiral, with profits plummeting as a result. If cash sources are
originating mainly from financing activities, then the company is likely sourcing more cash
from debt or from issuing shares. Higher debt requires more cash to make the princi-
pal 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 the majority of 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 statement of cash flows will also be discussed in detail in this chapter. Note how
Wellbourn’s ending cash balance of $135,500 at December 31 flows to the SFP/BS and
is reported as the ending cash balance on that date. This is a critical relationship between
these two financial statements. 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 statement of financial position will now be discussed in detail.
4.2 Statement of Financial Position/Balance Sheet
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 a number of sources and are separated into current
4.2. Statement of Financial Position/Balance Sheet 81
and non-current (IFRS) or long-term (ASPE) categories and usually reported on the
basis shown in the table that follows. It is critically important to ensure that all items
reported within each classification meet the criteria for recognition and measurement prior
to their inclusion in the financial statement. The recognition and measurement criteria
are discussed in their respective chapters of this textbook as well as in the introductory
accounting course.
4.2.1 Disclosure Requirements
IFRS (IAS 1) and ASPE (section 1521) have disclosure requirements for SFP/BS. ASPE
and IFRS disclosure requirements 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 neces-
sary, so that the SFP/BS will be relevant and faithfully representative. Relevance
means that the information in the SFP/BS is capable of making 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 given.
• The SFP/BS is to report on assets and liabilities separately in many cases. The
schedule below lists many of the assets and liabilities that are to be separately
reported.
In addition to the line items above, any material classes of similar items are sep-
arately 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 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 liabilities in order of liquidity.
• Give the measurement basis used for each line item in the statement. Examples
would be whether the company applied fair value, fair value less costs to sell, cost,
amortized cost, net realizable value, lower of cost, and net realizable value 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 on any security that was
required for the loan.
• Cross-reference note disclosures to the related line items in the statement.
Below are the basic classifications with some of the more common reporting line items
and accounts. The focus is mainly IFRS for simplicity, but ASPE is substantially similar,
though some policy choices can be made in some instances. The required 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.
Basic Classifications of Report Line Items with Measurement Basis of Assets
Classification Report Line Items Includes Measurement Basis and

Other Required
Disclosures at Each
Reporting Date
Current assets – assets Cash and cash Currency, coin, bank Fair value, stated in
realized within one year equivalents accounts, petty cash, local currency
from the reporting date treasury bills maturing
or the operating cycle, within three months at
whichever is longer acquisition
Investments – trading Equity investments Usually at fair value
such as shares bought
for the purpose of
selling them within a
short time of their
purchase
Accounts receivable Trade receivables net of Net realizable value as
allowance for doubtful a surrogate measure of
account (AFDA) fair value
Related party Amounts owing by Carrying amount or
receivables related parties exchange amount
Notes receivable Notes receivable within Net realizable value
one year
Inventories Raw materials, Lower of cost and net
work-in-process, realizable value
finished goods held for (LCNRV) using FIFO,
sale, or goods held for weighted average cost
resale or specific identification
Supplies on hand Supplies that are Usually cost
expected to be realized
within one year

Other Required
Disclosures at Each
Reporting Date
Prepaid expenses Cash paid items where Usually cost
the expense is to be
incurred within one
year of the reporting
date
Assets held for sale Land, buildings, and If criteria met (ASPE),
equipment no longer lower of carrying less
used to generate costs to sell
income
Income taxes Income taxes
receivable receivable based on
current taxable loss
Deferred income tax Current portion of ASPE only
assets deferred income taxes
avoided/saved arising Under IFRS, all
from differences deferred tax is
between accounting non-current
income/loss and
taxable income/loss
Non-current/long – Investments Debt and equity HTM – cost, amortized
term assets investments such as cost
held to maturity (HTM),
available for sale AFS – fair value
(AFS), and bond through OCI (AFS is
sinking funds IFRS only)
Investments – equity Associate/Significant IFRS – equity method
method Influence for common
shares holdings ASPE – equity or cost
method
Joint-ventures and Equity investments for Partial or full
subsidiaries greater than 50% of the consolidation
investee company’s
outstanding shares
Investment property Land or building held Usually cost
as an investment
Biological assets Dairy cattle, pigs, IFRS – fair value less
sheep, farmed fish, costs to sell
trees for timber, trees
or vines for fruit ASPE – N/A
Property, plant, and Tangible assets used to Land – cost
equipment generate income such
as land, buildings, All else – amortized
machinery, equipment, cost
furniture
IFRS also allows fair
value (revaluation);
accumulated
depreciation disclosed
separately

Other Required
Disclosures at Each
Reporting Date
Intangible assets and Copyrights, customer Finite life and indefinite
goodwill lists, franchises, life – initially cost then
patents, trademarks, subsequently cost less
trade names, accumulated
purchased goodwill amortization (finite life
only) and accumulated
impairment losses
(both)
Accumulated
amortization disclosed
separately
Goodwill – excess of
purchase price over fair
values of net
identifiable assets and
tested annually for
impairment
Deferred income tax Non-current portion of IFRS and ASPE
assets deferred income taxes
avoided/saved arising
from differences
between accounting
income/loss and
taxable income/loss
Current liabilities – Bank indebtedness or Amounts owing to the Fair value stated in
obligations due within bank overdraft bank that cannot be local currency
one year from the offset by a same-bank
reporting date or the positive balance,
operating cycle, amount is payable on
whichever is longer demand
Accounts payable Suppliers’ invoices
owing for goods and
services
Notes and loans Notes and loans due
payable within one year
Accrued liabilities Adjusting entries for
various types of
expenses incurred but
not paid such as
salaries, benefits,
interest, property taxes,
payables
Unearned revenue Cash paid in advance
for goods and services
not yet provided to
customer

Other Required
Disclosures at Each
Reporting Date
Income taxes payable Income taxes payable
based on current
taxable income
Deferred income tax Current portion of ASPE only
liabilities deferred income taxes
expected to be owed
and arising from
differences between
accounting income/loss
and taxable
income/loss
Non-current/long-term Long-term debt payable Long-term mortgages, Each item is reported
liabilities bonds, notes, loans, separately
capital leases net of
current portions, Measurement basis
long-term construction varies – amortized
obligations 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 Employer pension The net defined benefit
benefits payable obligations for the liability/asset is
shortfall between the determined by
defined benefit deducting the fair value
obligation (DBO) and of the plan assets from
the plan assets both of the present value of the
which are held and defined benefit
reported through a obligation
separate trust
Deferred income tax Non-current portion of IFRS and ASPE

liabilities deferred income taxes
expected to be owed
arising from differences
between accounting
income/loss and
taxable income/loss

Other Required
Disclosures at Each
Reporting Date
Equity – a company’s Share capital Preferred shares and The exchanged value
net assets, which is common shares of (cost less any
equal to total assets various classes are transaction costs) of
minus total liabilities each separately issued shares
reported
Represents the The dividend amount,
ownership interest characteristics of
share, as well as
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
(Other examples are

discussed in the next
intermediate course)
Retained Undistributed
earnings/(deficit) accumulated net
income
If a negative number,
then it is labelled as a
“deficit”
Accumulated other Accumulated gains or IFRS only
comprehensive income losses reported in other
(AOCI) comprehensive income
(OCI) during the
current reporting period
that are closed to AOCI
at the end of that
reporting period
Non-controlling Minority interest An equity claim for the
interest/minority portion of a subsidiary
interest 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. Following 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 adjust-

ment for impairment
Accounts receivable and AFDA AFDA adjustments at each reporting date are the
basis for reporting at NRV
Related party receivables Adjusted for impairment
Notes receivable Adjusted for impairment
Inventory Adjusted for shrinkage, obsolescence, damage; re-

ported at LCNRV
Supplies/office supplies Adjusted for shrinkage, obsolescence, damage
Assets held for sale Adjusted for impairment
Investments Adjust to either fair value or for impairment, depend-

ing on classification of investment (refer to schedule
above for details)
Biological assets Adjust to fair values, therefore no subsequent adjust-

ment for impairment
Property, plant, and equipment Adjusted for impairment
Intangible assets Adjusted for impairment
Disclosures such as those listed 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 shown above is to be included in the notes to the financial statements along
with any other related disclosures. It is important that the SFP/BS clearly identify the
cross-reference between the line item in the statement and the relevant note disclosure.
Using parentheses tends to be more common for ASPE companies with simpler disclo-
sure 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 how line items and additional disclosures can be presented for a
company that follows ASPE. Recall that a classified SFP/BS separately reports groupings
of similar line items as either current or non-current (long-term) assets and liabilities.
ASPE Company Ltd.

Balance Sheet
December 31, 2015
Assets
Current assets
Cash $ 250,000
Investments (Held for trading at fair value)
Accounts receivable $180,000
Allowance for doubful accounts (2,000) 178,000
Note receivable 15,000
Inventory (at lower of FIFO cost and NRV) 500,000
Prepaid expenses 15,000
Total current assets 958,000
Long term investments (Held to
maturity at amortized cost) 25,000
Property, plant and equipment
Land (at cost) 75,000
Building (at cost) $ 325,000
Accumulated depreciation (120,000) 205,000
Equipment (at cost) 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
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, 2024) 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, par
value, authorized, and outstanding shares must be disclosed on the face of the SFP/BS
when using parentheses.
Taking a closer look at this statement, ASPE Company reports that they possess $1,387,000
in total assets. The SFP/BS also reports the corresponding obligations against those
assets at that date totalling $464,000 owing to suppliers and other creditors.
On the topic of debt, reporting the current portion of long-term debt is mandatory and is
to be reported as a current liability. This topic was covered in the introductory accounting
course but it is worth reviewing. The current portion of the long-term debt is the amount
of principal that will be paid within one year after the SFP/BS date.
For example, on December 31, 2014, 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,
2014. Below is the payments schedule of the note using the effective interest method.
Payment Interest Principal Balance

Amount @ 2.75%
December 31, 2014 $391,473
December 31, 2015 $137,733 $10,766 $126,967 264,506
December 31, 2016 137,733 7,274 130,459 134,047
December 31, 2017 137,733 3,686 134,047 0
(rounded)
If the SFP/BS date is December 31, 2015, then 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 2015 reporting year as
previously explained. The amount owing as at December 31, 2015 is $264,506; therefore,
the long-term portion would be this amount minus the current portion of $130,459. Below
is how it would appear in the SFP/BS at December 31, 2015:
Current Liabilities
Current portion of long-term note payable $130,459
Long-term Liabilities
Note payable, 2%, three-year, due date Dec 31, 2017 $134,047
(balance owing Dec 31, 2015, of $264,506 − $130,459)
If the current portion of the long-term debt is not reported as a current liability, then
there will be a material presentation misstatement that would affect the assessment of
the company’s liquidity.
Total equity of $923,000 represents the remaining assets retained by the company in-
vestors. Ranking first are the preferred shares investors of $150,000. They are to be re-
ported above the common shares because they are senior to common shares in terms of
both dividend payouts and claims to resources if a company liquidates. The contributed
surplus for $15,000 identifies the additional equity from investor sources. Examples of
transactions resulting in recognizing contributed surplus include:
• stock options such as an employee stock option plan, or other share-based com-
pensation plan and issuance of convertible debentures
• for certain shares, 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 common shares, a paid-in capital subsection and
subtotal is also required for IFRS companies. Paid-in capital is the total amount “paid
in” by investors and therefore not obtained 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.
Some flexibility is allowed however. Some differences are noted below for illustrative
purposes.
• The statement can be prepared on a consolidated basis. This means that there are
subsidiaries included where the reporting company is the parent company. Sub-
sidiaries are investments in the capital stock of another company where the stock
purchased is between 50% and 100%. If the purchase was less than 100%, there
will be a non-controlling interest for the portion of the subsidiary owned by third-
party investors; therefore, the non-controlling interest balance is noted in the equity
section.
• 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 presented is comparative and includes the previous year (an IFRS
disclosure requirement).
• An accumulated other comprehensive income/loss (AOCI) is an equity account

used only by IFRS companies. Its purpose is similar to a retained earnings account.
For example, at the end of the year, net income from the income statement is
closed to retained earnings, while the OCI income/loss reported in the statement
of comprehensive income, discussed in the previous chapter, is closed to AOCI.
Recall that examples of OCI transactions would be the unrealized gains or losses
on investments accounted for through other comprehensive income (OCI) such as
available for sale (AFS) investments. Investments and AOCI will be covered in detail
in the chapter on intercorporate investments. For now, note that the position of the
AOCI on the SFP/BS is below the retained earnings account.
• The measurement basis for each asset and the interest rates, due dates, and secu-
rity information for each long-term liability can be included in the notes, rather than
in the face of the statement.
4.2.2 Factors Affecting the Statement of Financial Position/Balance

Sheet (SFP/BS)
The previous chapter explained that a thorough understanding of changes in accounting

estimates, policies, or the correction of errors is critical to the preparation of the financial
statements, including the SFP/BS. This information is repeated here from a SFP/BS
perspective.
Accounting Estimates, Changes in Accounting Policy, and Correction of Errors
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. Ex-
amples of changing estimates would be the useful life, residual value, or the depreciation
pattern used to match use of the assets (depreciation) with revenues earned. Straight-
line, declining balance, or units of production depreciation are all examples of methods
where changes in estimates can occur. Subsequent changes in the pattern of asset use
means a change in estimate. Other estimates involve uncollectible receivables, revenue
recognition for long-term contracts, 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 deals with the error or
omission as though it had always been corrected. For example, an accounting error in
inventory originating in the current fiscal year is detected within the current fiscal year, but
the accounting records are still open, so the inventory error correction is recorded as soon
as possible to the applicable accounts. Conversely, the error is treated retrospectively
if the accounting records are already closed when the inventory error is discovered.
This means that the cumulative amount due to the inventory error would be calculated
and adjusted, net of taxes, to the current year’s inventory balance and to the opening
retained earnings balance in the balance sheet, as well as to the statement of changes in
equity (IFRS) or the statement of retained earnings (ASPE). 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, then this data is also restated to include
the error correction.
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 classification, presentation, and measurement of financial assets and li-

abilities under categories specified in the accounting standards such as investments
classified as held to maturity (HTM), available for sale (AFS), or held for trading
(HFT). 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 used in the preparation of financial state-
ments.
Management must consistently review its accounting policies to ensure they comply with
the latest pronouncements by ASPE or IFRS and that the adopted policies result in
presentation of the most relevant and reliable financial information for the stakeholders.
Accounting policies must be applied consistently to promote comparability between finan-

cial statements for different accounting periods. A change in accounting policy is only
allowed under the following two conditions:
• as a result of 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 ex-
ceptions to this “relevance and reliability” rule to provide flexibility for changes from
one existing accounting standard to another.
As a general rule, changes in accounting policies must be applied retrospectively in

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 presented. Retrospective
application reduces the risk of changing policies in order 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, then the change made to a single year could materially affect the statement
of income for the current fiscal year.
As with an accounting error, 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).
Retrospective application of a change in accounting policy may be exempted in the fol-

lowing circumstances:
• A transitional provision of the changed standard allows the prospective application

of a new accounting policy. Specific transitional guidance of IFRS must be followed
in such circumstances.
• The application of a new accounting policy is with regard to 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 imma-

terial.
• 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 not be feasible or practical to reconstruct such 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.
Below are the required disclosures in the notes to the financial statements in which 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 period presented
• Where retrospective application is impracticable, the conditions that caused the

impracticality (Accounting-Simplified.com, n.d.)
Contingencies and Guarantees
In accounting, a contingency exists when a material future event, or circumstance, could

occur but cannot be predicted with certainty. IFRS (IAS 37.10) has the following definitions
with regard to 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 as a result of 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).
Start
Present obligation
No Possible No
as the result of an
obligation?
obligation event?
Yes Yes
No Yes
Probable outflow? Remote?
Yes
No
No (rare)
Reliable estimate?
Yes
Recognize and Disclouse contingent liability Do nothing

record as a provision in financial statement notes
Figure 4.1: Decision tree to determine if a potential obligation should be recog-

nized 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 to the flowchart above. A 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
course.
A guarantee is a type of contingent liability in that 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
Subsequent events 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.
There is a period of time after the year-end date when subsequent events may need to
be either recognized and recorded or disclosed in the notes. There is a period of time
in the new fiscal year where 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, 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 completed and officially published.
For example, a typical activity undertaken during this time period is the physical inventory
count that takes place as soon after the year-end date as possible. The total cost from
the physical count is compared to the ending balance in the inventory account. If the total
ending inventory amount from the physical count is more or less than the carrying value
in the accounting records, an adjusting entry is required. 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.
Any 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 the new (2015) fiscal year, vandals damage some buildings and equipment. If the repair
or replacement costs are significant, then these costs, though correctly paid and recorded
in 2015, are to be disclosed in the notes to the 2014 year-end financial statements. This
will ensure that the company stakeholders have access to all the relevant information.
4.3 Statement of Cash Flows
The final financial statement, the core statement, 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 cash equivalents and to enable users 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 discussed previously. 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 sections:
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. With the indirect method, the operating activities section begins
with net income/loss and continues with a series of adjustments for non-cash items from
the income statement followed by the changes in the current assets and current liabilities
accounts (except current portion of long-term debt and dividends payable) on a line item
basis. The total cash flows from the operating activities are the same for both methods.
As well, 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
course.
Below is a statement of cash flows that illustrates its linkages with the income statement
and SFP/BS.
4.3. Statement of Cash Flows 99
XYZ Company Ltd.

Linkage to other financial
Cash flows from operating activities statements:
Net income (loss) $$$ or ($$$)
Non-cash items (adjusted from net income)
Depreciation, depletion and amortization expenses + $$$
Losses (gains) from sale of non-current tangible assets $$$ or ($$$) line items from the income
Deferred income tax expense + $$$ statement
Impairment losses from inventory or receivables + $$$
Investment income from investment in associate ($$$)
Unrealized foreign exchange losses (gains) $$$ or ($$$)
Cash in (out) from operating working capital
Decrease (increase) in trading investments $$$ or ($$$)
Decrease (increase) in accounts receivable $$$ or ($$$)
Decrease (increase) in notes receivable $$$ or ($$$)
Decrease (increase) in inventory $$$ or ($$$)
Decrease (increase) in prepaid expenses $$$ or ($$$) changes in current assets
and current liabilities from the
Decrease (increase) in accounts payable $$$ or ($$$) balance sheet
Decrease (increase) in interest payable $$$ or ($$$)
Decrease (increase) in other liabilities $$$ or ($$$)
Decrease (increase) in income taxes payable $$$ or ($$$)
Decrease (increase) in unearned revenue $$$ or ($$$)
Net cash from operating activities
Sales proceeds or (purchase) of non-current investments $$$ or ($$$)
Sales proceeds or (purchase) of changes in non-current as-
property, plant, and equipment $$$ or ($$$) sets accounts
Sales proceeds or (purchase) of intangible assets $$$ or ($$$)
Net cash from investing activities $$$ or ($$$)
Additions to or (repayment) of long-term debt $$$ or ($$$) changes in non-current lia-
Proceeds from shares issuance $$$ or ($$$) bilities and equity accounts
Dividends paid ($$$) (share capital and dividends)
Net cash from financing activities $$$ or ($$$)
Net increase (decrease) in cash and cash equivalents $$$ or ($$$) sum of the 3 sections above
Cash and cash equivalents, January 1 $$$
reconciles the net change
Cash and cash equivalents, December 31 $$$ with opening and closing
cash and cash equivalent
balances from the balance
sheet
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. The
other two activities for investing and financing follow. Just as was done in the operating
activities section, any non-cash transactions occurring in the investing or financing
sections are not to be reported in a statement of cash flows but rather, in the notes
to the financial statements. 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.
4.3.1 Preparing a Statement of Cash Flows
Presented below is the SFP/BS and income statement for Watson Ltd.
Watson Ltd.
Balance Sheet
as at December 31, 2015
2015 2014
Assets
Current assets
Cash $ 307,500 $ 250,000
Investments (Held for trading at fair value) 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 (Held to maturity at 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
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, 2020) 246,000 280,000
Total liabilities 630,720 721,000
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 (O/S) 250,000 shares for 2015);
(2014: 200,000 shares issued and O/S) 862,500 680,300
Contributed surplus 18,450 18,450
1,065,450 883,250
1,149,860 933,250
Total liabilities and shareholders’ equity $1,780,580 $1,654,250
Watson Ltd.
Income Statement
Sales $3,500,000
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 equipment 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
1. The trading investment does not meet the criteria to be classified as a cash equiva-
lent 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, 2014.
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 is likely the most difficult statement to prepare. This is
because preparing the entries requires analyses of several accounts as well as differ-
entiating between cash inflows and cash outflows for each account change. 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 out any non-cash line items reported in the income statement to remove
them from the cash flow statement (i.e., depreciation, gain/loss on sale of assets).
4. Record the description and change amount 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 deter-
mine the reason for the change(s). Record the reason and 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. Ana-
lyze and determine the reason for the change(s). Record the reason and change
amount(s) as cash inflows or outflows.
7. Subtotal the three sections. Record the opening and closing cash and cash
equivalents, if any. Reconcile the opening balance + the subtotal from the three
sections to the closing balance to ensure the accounts balance correctly.
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 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.

Net income (loss)
Non-cash items (adjusted from net income):

Net cash from investing activities

Net cash from financing activities

Net increase (decrease) in cash
Cash, January 1
Cash, December 31
2. Record net income/(loss)

As illustrated in step 3 below.
3. Adjustments:
Watson Ltd.
Income Statement
Sales $3,500,000
Operating expenses
Salaries and benefits expense 800,000
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
Other revenue and expenses
Dividend income 3,000
Interest income from investments 2,000
Gain from sale of equipment 5,000
Interest expense (3,000)
7,000
Net income $ 77,000
Watson Ltd.

Net income (loss) $ 77,000
Gain from sale of equipment (5,000)
Enter the amount of the net income/(loss) as the first amount in the operating activi-
ties 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:

Calculate and record the change for each current asset and current liability (except
current portion of long-term notes payable, which is netted with its corresponding
long-term notes payable account) as shown below:
Watson Ltd. Accounting Equation:

for the year ended December 31, 2015 A = L + E MUST ALWAYS BALANCE!
Net income (loss) $ 77,000 Assets = Liabilities + Equity
Gain from sale of equipment (5,000) Cash + (all other) Assets = Liabilities + Equity
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 Cash + Assets = Liabilities + Equity
Increase in inventory (58,970)
Increase in prepaid expenses (3,450)
Increase in accounts payable 143,000 Cash + Assets = Liabilities + Equity
Decrease in interest payable (8,400)
Decrease in income taxes payable (5,880)
Decrease in unearned revenue (200,000) Cash + Assets = Liabilities + Equity
Net cash from operating activities (101,660)
Cash inflows to the company are reported as positive numbers, while cash outflows
are reported as negative numbers. How does one determine if the amount is a
positive or negative number? A simple tool 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, Assets = Liabilities +
Equity, must always remain in balance. This axiom can be applied when analysing
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:
A= L+E
Expanding the equation a bit:

Cash + accounts receivable + all other assets = Liabilities + Equity
If accounts receivable increases by $84,510, then this can be expressed as a black

up-arrow above the account in the equation:
Holding everything else in the equation constant except for cash, if accounts re-
ceivable increases, then its effect on the cash account must be a corresponding
decrease in order to keep the equation balanced:
If cash decreases, then it is a cash outflow, and the number must be negative as
shown in the statement above.
Conversely, when analysing liability or equity accounts, the same technique can be
used. For example, an increase in account payable (liability) of $143,000 will affect
the equation as follows:
Cash + all other assets = Liabilities + Equity
Again, holding everything else constant except for cash, if accounts payable in-
creases, then cash must also increase by a corresponding amount in order to keep
the equation in balance.
Cash + all other assets = Liabilities + Equity
If cash increases, then it is a cash inflow and the number must be positive as shown
in the statement above.
5. Non-current asset changes:

The next section is the investing activities section. The analysis of all the non-current
assets accounts must also take into account whether there have been any current
year purchases or disposals/sales (or both) as part of the analysis. The use of T-
accounts for this type of analysis provides a useful visual tool to help understand the
changes that occurred in the account.

Purchase of HTM investments (30,750) Cash + Assets = Liabilities + Equity
Sales proceeds from sale of building 55,000
Sales proceeds from sale of patent 14,300
Cash + Assets = Liabilities + Equity
Net cash from investing activities 38,550
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. Analysing 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:
General Journal
Investment (HTM) . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,750
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,750
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. Analysing 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:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000
Gain on sale of building . . . . . . . . . . . . . . . . . . 5,000
Buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Cash proceeds were therefore $55,000.

The sale of the patent is straightforward since there were no other sales or pur-
chases in the current year.
6. Non-current liabilities and equity changes:

Cash flows from financing activities Cash + Assets = Liabilities + Equity
Repayment of long-term note (19,000)
Proceeds from shares issuance 182,200
Net cash from financing activities 120,610 Cash + Assets = Liabilities + Equity
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. Ana-
lyzing 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:
General Journal
LT note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
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 retain earnings accounts are straightforward and the anal-
ysis 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:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182,200
Common shares . . . . . . . . . . . . . . . . . . . . . . . . . 182,200
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:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,590
Cash paid was therefore $42,590.
7. Subtotal and reconcile:

The three activities total a net increase in cash of $57,500. When added to the
opening cash balance of $250,000, the resulting total of $307,500 is equal to the
ending cash balance, December 31, 2015. This can be seen in the completed
statement below.
4.3.2 Disclosure Requirements
The next step in preparing the SCF, Step 8, involves the identification and preparation of
disclosures.
8. Required disclosures:
The statement of cash flows must disclose cash flows associated with interest paid
and received, dividends paid and received, and income taxes paid, as well as any
non-cash disclosures that may have occurred in the current year. These can be
disclosed in the notes or at the bottom of the statement, if not too lengthy. The cash
received for dividend income and interest income was taken directly from the income
statement since no accrual accounts exist on the SFP/BS for these items. Cash paid
for interest charges and income taxes are calculated on the basis of an analysis of
their respective liability accounts from the SFP/BS and expense accounts from the
income statement.
Following is the completed statement of cash flows, including disclosures, for Wat-
son Ltd., for the year ended December 31, 2015:
Watson Ltd.

Net income (loss) $ 77,000
Gain from sale of equipment (5,000)
Cash in (out) from operating working capital:

Increase in trading investments (2,000)
Decrease in notes receivable 3,550
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)
Purchase of HTM investments (30,750)
Sales proceeds from sale of building 55,000
Sales proceeds from sale of patent 14,300
Repayment of long-term note (19,000)
Proceeds from shares issuance 182,200

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
(60,000 + 33,000 − 54,120)
Cash paid for interest charges 11,400
(33,000 + 3,000 − 24,600)
Cash received for interest income 2,000
Cash received for dividend income 3,000
There were no non-cash transactions to disclose.

4.3.3 Interpreting the Statement of Cash Flows
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:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . 225,000
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 in held to maturity (HTM) securities (e.g., bonds). The sales proceeds
from the building may have been partially invested in the HTM 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 in an effort to
raise additional cash.
Looking at the financing activities it is clear that 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 the 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 (15,000 × $2) plus its share of the participating dividend. This leaves very little
dividend left over for the common shareholders. At some point, the common shareholder
investors will likely become concerned with receiving so little in dividends, along with the
dilution of their holdings 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. The $250,000 opening
balance was almost entirely due to the $225,000 unearned revenue received in advance,
but this is not an ongoing 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 fairly 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 then if
cash at the mid-year point were 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 in order 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.
4.4. Analysis 115
4.4 Analysis
Statement of Financial Position/Balance Sheet (SFP/BS)
The SFP/BS is made up of many line items, comprised of many general ledger ac-
counts, 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.
In reality, 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
analyse 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 state-
ments:
Ratio Formula Purpose
Liquidity ratios – ability to pay short term obligations
Current assets
Current ratio ability to pay short
Current liabilities
term debt
Cash*, marketable securities and net receivables

Quick ratio (or acid test ratio) ability to pay short
Current liabilities
term debt using
near-cash assets
* Cash includes cash equivalents, if any.
Activity ratios – ability to effectively use assets
Net sales
Accounts receivable turnover how quickly accounts receivable is
Average net accounts receivable
collected
365
In days average # of days to collect ac-
Accounts receivable turnover
counts receivable
Accounts receivable
Days’ sales uncollected × 365 average # of days that sales are
Net sales
uncollected (this can be compared
to the credit terms of the company)
Cost of goods sold

Inventory turnover how quickly inventory is sold
Average inventory
365
In days average number of days to sell in-
Inventory turnover
ventory
Ending inventory
Days’ sales in inventory × 365 average # of days for inventory to
Cost of Goods Sold
convert to sales
Net sales
Asset turnover the ability of assets to generate
Average total assets
sales
4.4. Analysis 117
Profitability ratios – ability to generate profits
Net income
Return on total assets × 100% overall profitability of assets
Average total assets
Return on common Net income − Preferred dividends

× 100% overall profitability of com-
shareholders’ equity Average common shareholders’ equity
mon shareholders’ invest-
(includes retained earnings/deficit)
ment
Net income − Preferred dividends

Earnings per share net income for each com-
Weighted average common
mon share
shares outstanding (WACS)
Cash dividends
Payout ratio × 100% percentage of earnings dis-
Net income
tributed as dividends
Coverage – ability to pay long-term obligations
Total liabilities
Debt ratio × 100% percentage of assets
Total assets
provided by creditors
Total equity
Equity ratio × 100% percentage of assets
Total assets
provided by investors

Cash debt coverage ratio × 100% the ability to pay debt
Average total liabilities
from net cash from op-
erating activities (state-
ment of cash flows)
Common shareholders’ equity

Book value per common share the amount per common
# of common shares outstanding
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 stan-
dards. 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, then a reasonable day’s sales uncollected
ratio would be 30 days × 1.3 = 39 days 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 benchmarks discussed 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, then 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, 2015, based on
the financial data presented in the previous section of this chapter. The calculations
below are provided as a high-level review. A more in-depth discussion is presented in the
introductory accounting course, and students are encouraged to review that material at
this time, if needed.
Ratio Formula Calculation Results
Current assets 1,314,880

Current ratio = 3.42 to 1 reasonable
current liabilities 384,720
Cash, marketable securities

and net receivables 307,500 + 12,000 + 249,510 + 18,450
Quick ratio (or reasonable
Current liabilities 384,720
acid test ratio) = 1.53 to 1
Activity ratios – ability to effectively use assets
Net sales 3,500,000

Accounts receivable turnover = 16.89 times / year reasonable
Average net accounts receivable ((249,510 + 165,000) ÷ 2)
365 365
In days = every 21 days reasonable
Accounts receivable turnover 16.89

Days’ sales uncollected × 365 × 365 = 26 days reasonable, given the typ-
Net sales 3,500,000
ical credit policy of net 30
days

Inventory turnover = 3.09 times this would be low, if the in-
Average inventory ((708,970 + 650,000) ÷ 2)
dustry standard is around
5 times
365 365
In days = every 118 days possibly too low if stan-
Inventory turnover 3.09
dard is 5 times or every 73
days
Ending inventory 708,970

Days’ sales in inventory × 365 × 365 = 123 days the total # of days to sell
Cost of Goods Sold 2,100,000
inventory and collect the
cash from accounts re-
ceivable is 123 + 26 = 149
days
Net sales 3,500,000
4.4. Analysis
Asset turnover = 2.04 depends on industry aver-
Average total assets ((1,780,580 + 1,654,250) ÷ 2)
age and company trends
119
120
Profitability ratios – ability to generate profits
Financial Reports – Statement of Financial Position and Statement of Cash Flows

Net income 77,000
Return on total × 100% = 4.48% depends on
Average total assets ((1,780,580 + 1,654,250) ÷ 2)
assets industry average
and company
trends
Net income − Preferred dividends (77,000 − 30,000)

Return on common × 100% = 5.48% depends on
Average common shareholders’ equity ((862,500 + 18,450 + 84,410 +
shareholders’ industry average
(includes retained earnings/deficit) 680,300 + 18,450 + 50,000) ÷ 2)
equity and company
trends
Net income − Preferred dividends (77,000 − 30,000)

Earnings per share = $20.89 per share depends on
Weighted average common 225,000
industry average
shares outstanding (WACS)
WACS (250,000 + 200,000) ÷ 2 = 225,000 and company
shares assuming that sale of the shares trends
occurred mid year
Cash dividends 42,590

Payout ratio × 100% × 100% = 55.3% depends on
Net income 77,000
industry average
and company
trends
Coverage – ability to pay long-term obligations

Debt ratio × 100% × 100% = 35.42% low
Total assets 1,780,580
1,149,860
= 64.58%
1,780,580
Total equity
Equity ratio × 100% OR high
Total assets
100% − 35.42% debt ratio
= 64.58%
Net cash provided by operating activities 101,660

Cash debt coverage × 100% = (15.04%) unfavourable due to
Average total liabilities ((630,720 + 721,000) ÷ 2)
ratio negative cashflow from
operating activities
Common shareholders’ equity (862,500 + 18,450 + 84,410)

Book value per = $3.86 depends on industry
# of shares outstanding 250,000
common share average and company
trends
4.4. Analysis
121
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.
As previously discussed, one of the most important aspects of the statement of cash
flows is the cash flow generated from the operating activities, since this reflects the
business’s day to day operations. 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. Conversely, the opposite was true for Watson Ltd. where it increased its
short-term debt (accounts payable), sold off a building, and issued 25% more common
shares.
Another critical aspect is the sustainability of positive cash flows from operating activi-
ties. 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.
Cash Flow Ratio
It is critical to monitor the trends regarding cash flows over time. Without benchmarks
such as historical trends or industry standards, ratio analysis is not as useful. 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:

Net cash flow from operating activities

Current cash debt coverage ability to pay short term debt
Average current liabilities
ratio from its day-to-day opera-
tions. A ratio of 1:1 is reason-
able.
Financial flexibility – ability to react to unexpected expenses and investment opportunities
Net cash flow from operating activities

Cash debt coverage ratio the ability to pay debt from net
Average total liabilities
cash from operating activities
(statement of cash flows)
Free Cash Flow Analyses
This is another way to assess a company’s cash flow liquidity. Free cash flow is the
remaining cash flow from the operating activities section after deducting cash spent on
Chapter Summary 123
capital expenditures such as purchasing property, plant, and equipment. Some compa-
nies also deduct cash paid dividends. The remaining cash flow represents cash available
in a company to do other things, such as expand its 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, 2015
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. Some companies include dividends in the calculation and others do not.
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 limited to
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.
Chapter Summary
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: A = L + E, 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 line item reported.
The statement of cash flows reports on how the company obtains and utilizes its cash
flows and reconciles with the opening and ending cash and cash equivalent balances. It
is separated into operating, investing, and financing activities. The combination of positive
and negative cash flows from within each activity can provide important information about
how the company is managing its cash flows. The ending cash flow for the statement of
cash flows is the same amount as the cash and cash equivalent ending balance in the
statement of financial position.
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. In order to be classified in this way, each line item being reported
must meet the criteria required. The statement has a number of 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 line items that meet the
standards for disclosure. Some of the more common required disclosures are listed,
including the measurement basis of each reporting line item such as cost, net realizable
value, fair value, and so on. The acceptable options regarding how to present the re-
quired disclosures include using parentheses or disclosing in the notes to the financial
statements.
A number of 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 both applied retroactively with restatement of
amounts for all reporting years included the statement. Descriptions of these are to be
included in the notes with detailed explanations. Other factors that can affect the SFP/BS
are contingencies and guarantees that may need to be recognized within the statement or
disclosed in the notes. Subsequent events can 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 com-
bines 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. Focussing on the indirect
method, the statement is presented in three distinct sections, which follow the basic
structure of the balance sheet classifications: operating activities (net income, current
assets, and liabilities), investing activities (non-current assets), and financing activities
Chapter Summary 125
(long-term debt and equity). The changes between the opening and closing balances
of the SFP/BS items are reported in the SCF as either cash inflows or cash outflows.
The three sections net to a single amount that, when combined with the cash and cash
equivalent opening balance, results in the same amount as the ending balance reported
on the SFP/BS.
The operating activities section begins with the net income/loss amount from the income
statement. Adjusting entries for non-cash items such as depreciation, depletion, amor-
tization, and gains/losses from sale/disposal of non-current assets are shown as adjust-
ments to net income in order to remove the effects of non-cash items. The remainder of
the operating activities section lists each current asset and current liability change from
opening to closing balances and reports as either cash flow in or out. Cash flow out is
prefixed by a minus sign. The investing activities are the change amounts between the
opening and closing balances for any non-current assets such as long-term investments,
property, plant, and equipment, as well as intangible assets. Each line item from the
non-current assets section of the SFP/BS is analyzed to determine if any non-current
assets were purchased or sold/disposed of during the year and the cash paid or received.
These amounts are reported as cash flows in or out. The financing section uses the
same method as the investing section for non-current liabilities and equity, such as any
long-term debt, issuance, or repurchase of shares for cash and dividends paid. These
amounts are reported as cash flows in or out. The three sections are netted to a single
amount and added to the cash and cash equivalent opening balance. The sum should
be the same amount as the ending cash and cash equivalent balance reported in the
SFP/BS. Required disclosures, in addition to the statement itself, include cash paid or
received for interest charges or income, cash dividends paid or received, and cash paid
for income taxes. Any non-cash transactions that occurred during the year are excluded
from the statement but disclosed at the bottom of the statement or in the notes.
An important section in the SCF is the operating activities section because it reports the
cash flows in or out resulting from daily operations and 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
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 that they
will continue into the future in a consistent way.
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.
The SFP/BS is made up of many different valuations and estimates, so it can only be
a starting point for further analysis. 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 in-
dustry standards exist. Ratios typically focus on a particular 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 can result from changes in
accounting policies or the application of different accounting estimates and methods by
competitors within the industry sector.
The statement of cash flows may report a positive net income, but that does not guarantee
a positive cash flow for the same period of time. Also, knowing which activity positive
cash flows originate from is critical analytical information for all stakeholders. At the end
of the day, operating activities must be able to sustain a positive cash flow if the firm is
to survive. There are some ratios that are useful to assess the operating activities cash
flow, but again, trends or industry standards are needed for the results to be informative.
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 furthering company strategies
such as 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.
References
Accounting-Simplified.com (n.d.). IAS 8 changes in accounting policy. Retrieved from htt

p://accounting-simplified.com/standard/ias-8/changes-in-accounting-policies.
html
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
/
Exercises 127
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/Artic
lePublication/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 htt
p://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.
Exercises
EXERCISE 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
EXERCISE 4–2
Below is a statement of financial position as at December 31, 2016, for Aztec Artworks
Ltd., prepared by the company bookkeeper:
Exercises 129
Aztec Artworks Ltd.

For the Year Ended December 31, 2016
Current assets
Cash (including a bank overdraft of $18,000) $ 225,000
Inventory (FIFO) 960,000
Investments (trading) 140,000

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
Patents (net) 21,000
Current liabilities
Accounts payable 450,000
Pension obligation 210,000
Rent payable 120,000
Long-term liabilities
Preferred shares 900,000
Additional information as at December 31, 2016:
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

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, 2016. 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 2025 and is accounted for using
amortized cost.
8. Patents were purchased by Aztec on January 1, 2014, 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, 2017. 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, 2020. 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 out-
standing. 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:
a. Prepare a corrected classified SFP/BS as at December 31, 2016, in good form, in-
cluding all required disclosures identified in Chapter 4. Adjust the account balances
as required based on the additional information presented.
Exercises 131
b. Calculate one liquidity ratio and one activity ratio and comment on the results. Use
ending balances in lieu of averages when calculating ratios.
EXERCISE 4–3
Below is the trial balance for Johnson Berthgate Corp. at December 31, 2016. Accounts
are listed in alphabetical order and all have normal balances.
Account Balance
Accrued liabilities 70,000
Accumulated depreciation, buildings 110,000
Accumulated depreciation, equipment 50,000
Administrative expenses 580,000
Bonds investment at amortized cost 190,000
Buildings 660,000
Cash 131,000
Commission payable 90,000
Correction of prior year’s error – a missed expense in 2015 (net of tax) 90,000
Equipment 390,000
Freight-out 11,000
Goodwill 30,000
Intangible assets, franchise (net) 115,000
Intangible assets, patents (net) 125,000
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 (due in 5 years) 587,559
Preferred shares 80,000
Prepaid advertising 6,000
Selling expenses 1,190,000
Unearned consulting fees 13,000
Unrealized gain on trading investments 40,000
Unusual gain 102,000
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 at fair value 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 2015.
The books are still open for 2016.
4. Patents and franchise were being amortized on a straight-line basis. Accumulated
amortization to December 31, 2016 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, 2000 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, 2019 and was signed
when market rates were 3.64%.
Below is the payment schedule:
Payment Amount Interest @ 3.64% Amortization Balance

December 31, 2014 $580,000
December 31, 2015 17,400 21,112 3,712 583,712
December 31, 2016 17,400 21,247 3,847 587,559
December 31, 2017 17,400 21,387 3.987 591,546
December 31, 2018 17,400 21,532 4,132 595,678
December 31, 2019 17,400 21,683 4,322* 600,000
* Rounded
8. During the year ended December 31, 2016, no dividends were declared and there
was no preferred or common share activity.
9. On December 31, 2016, the share structure was; common shares, unlimited autho-
rized, 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 invest-
ments in accordance with IAS 39.
Exercises 133
11. The income tax rate is 25%.
Required:
a. Prepare a classified statement of financial position as at December 31, 2016, in

good form, including all required disclosures identified in Chapter 4. Adjust the
account balances as required based on the additional information presented.
b. Calculate the company’s debt ratio and equity ratio and comment on the results.
c. 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 or not this change in the accounts will affect the assessment of
liquidity for this company. Round final ratio answers to the nearest 2 decimal places.
EXERCISE 4–4
Below is the trial balance in no particular order for Hughey Ltd. as at December 31, 2016:
Hughey Ltd.
Trial Balance
As at December 31, 2016
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 (OCI) 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
Bond payable 1,100,000
Common shares 2,500,000
Retained earnings 1,330,000
$8,530,000 $8,530,000
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 (OCI) have a fair value of $2,250,000.
3. The company purchased patents of $60,000 on January 1, 2010.
4. Bonds are 8%, 25-year and pay interest annually each January 1, and are due
December 31, 2025.
5. The 7%, notes payable represent bank loans that are secured by investments in
available for sale securities (OCI) with a carrying value of $800,000. Interest is paid
each December 31 and no principal is due until its maturity on April 30, 2017.
6. The capital structure for the common shares are # of authorized, 100,000 shares;
issued and outstanding, 80,000 shares.
Required:
a. Prepare a classified statement of financial position as at December 31, 2016, in

good form, including all required disclosures identified in Chapter 4.
b. Calculate the annual amortization for the patent.
c. Does this company follow IFRS or ASPE? Explain your answer.
EXERCISE 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 A = L + E to help determine if an amount is a positive or negative number.)
Exercises 135
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
EXERCISE 4–6
Below is the unclassified balance sheet for Carmel Corp. as at December 31, 2015:
Carmel Corp.
Balance Sheet
Cash $ 84,000 Accounts payable $ 146,000

Accounts receivable (net) 89,040 Mortgage payable 172,200
Investments – trading 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, 2016, 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 2016:
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 2016.
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, 2016, 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 2016 included principal of
$30,000 and interest of $35,000. For 2017, 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 2016, collections from customers were $980,000 and cash
payments to suppliers were $900,000.
9. Ignore income taxes for purposes of simplicity.
Required:
a. Prepare a classified SFP/BS in good form as at December 31, 2016. Identify which
required disclosures discussed in Chapter 4 were missed due to lack of information?
b. Prepare a statement of cash flows in good form with all required disclosures for the
year ended December 31, 2016. The company prepares this statement using the
indirect method.
Exercises 137
c. Calculate the company’s free cash flow and discuss the company’s cash flow pattern
including details about sources and uses of cash.
d. 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)?
EXERCISE 4–7
Below is the comparative balance sheet for Lambrinetta Industries Ltd.:
Lambrinetta Industries Ltd.

Balance Sheet
December 31
2016 2015
Assets:
Cash $ 32,300 $ 40,800
Accounts receivable 79,900 107,100
Investments – trading 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:
Current portion of long-term note 8,000 10,000
Long-term note payable 119,500 75,000
Common shares 130,900 81,600
Total liabilities and equity $ 564,400 $ 487,900
1. Net income for the year ended December 31, 2016 was $161,500.
2. Cash dividends were declared and paid during 2016.
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 2016.
4. The investments are reported at their fair value on the balance sheet date. During
2016, 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 2016, 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, 2016 in good form including all required disclosures identified in
Chapter 4. The company follows ASPE.
EXERCISE 4–8
Below is a comparative statement of financial position for Egglestone Vibe Inc. as at

December 31, 2016:
Egglestone Vibe Inc.

December 31
2016 2015
Assets:
Cash $ 84,500 $ 37,700
Accounts receivable 113,100 76,700
Inventory 302,900 235,300
Investments – available for sale (OCI) 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:
Dividend payable 19,500 41,600
Notes payable 416,000 565,500
Common shares 322,500 162,500
Accumulated other comprehensive income 12,500 59,800
Total liabilities and equity $1,183,000 $1,265,900
1. Net income for the 2016 fiscal year was $24,700.
2. During 2016 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, 2016, notes payable of $160,000 were retired in exchange for the
issuance of common shares. On December 31, 2016, notes payable for $10,500
were issued for additional cash flow.
4. Available for sale investments (OCI) were purchased during 2016 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 2016.
Exercises 139
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 2016. Dividends
are reported under the financing section.
7. Goodwill impairment loss was recorded in 2016 to reflect a decrease in the recover-
able amount of goodwill.
Required:
a. 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.
b. Analyze and comment on the results reported in the statement.

Chapter 5
Revenue
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
where 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
141
142 Revenue
revenue recognition and some of the problems that companies like Tesco may face.
(Source: Marriage, 2014)
LO 1: Describe the criteria for recognizing revenue and determine if a company has
earned revenue in a business transaction.
LO 2: Discuss the problem of measurement uncertainty and alternative accounting treat-

ments for these situations.
LO 3: Prepare journal entries for a number of different types of sales transactions.
LO 4: Apply revenue recognition concepts to the determination of profit from long-term

construction contracts.
LO 5: Prepare journal entries for long-term construction contracts.
LO 6: Apply revenue recognition concepts to unprofitable long-term construction con-

tracts.
LO 7: Understand disclosure requirements for revenue-related accounts.
LO 8: Discuss the contract-based approach with revenue recognition, including a com-

parison of this approach with current practice.
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. Some-
times, 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 inves-
tigated 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.
Risks, Rewards,
1.0 Definition
and Control
Measurement
2.0 Revenue Recognition
Collectibility
Costs
Bundled Sales
Consignment Sales
3.0 Applications Instalment Sales

Revenue
Barter Transactions
4.0 Presentation
and Disclosure Long-term
Construction Contracts
5.0 IFRS 15: The

New Standard
6.0 IFRS/ASPE
Key Differences
5.1 Definition
IAS 18 defines revenue as “the gross inflow of economic benefits during the period
arising in the course of the ordinary activities of an entity when those inflows result in
144 Revenue
increases in equity, other than increases relating to contributions from equity participants”
(International Accounting Standards, 1993).
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, 2016, 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.
5.2 Revenue Recognition
There are two different perspectives on how to recognize revenues:
• The earnings approach
• The contract-based approach
The earnings approach is currently used in both ASPE and IFRS. This approach focuses
on the process of adding value to the final product or service that is delivered to the
customer. The contract-based approach is the subject of a new standard that was issued
in early 2014 but it is not yet effective. This standard focuses on the contractual rights and
obligations of the buyer and the seller and will be discussed in section 5.5.
IAS 18 distinguishes several different types of revenues, including the sale of goods and
the sale of services. For both of these categories, revenues should be recognized when
the following conditions are met:
a. The amount of revenue can be measured reliably.

5.2. Revenue Recognition 145
b. It is probable that the economic benefits associated with the transaction will flow to
the entity.
c. The costs incurred or to be incurred in respect of the transaction can be measured
reliably.
Note how these conditions are consistent with the recognition criteria of the Conceptual
Framework that we examined in Chapter 2.
For the sale of goods, two additional conditions are imposed:
a. The entity has transferred to the buyer the significant risks and rewards of ownership
of the goods.
b. The entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold.
For the sale of services, one additional condition is imposed:
c. The stage of completion of the transaction at the end of the reporting period can be
measured reliably.
Let’s examine these conditions in more detail.
5.2.1 Risks, Rewards, and Control
For many businesses, the question of the transfer of risks, rewards, and control is straight-
forward: it is determined by the completion of a critical event. 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. The reward in this transaction 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. An earnings process with such a critical event is often described as a
discrete earnings process.
Often, the question of when risks and rewards of ownership are transferred can be an-
swered by looking at possession of the goods and the presence of legal title. As long
146 Revenue
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 requires 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. Although Nortel’s actions appeared to be deliberate, they
point to the difficulties in determining transfer of risks and rewards of ownership.
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 a discrete earnings process, 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. IAS 18.20 requires the recognition
of revenue based on the stage of completion of the transaction, as long as that progress
can be measured reliably. This problem can become even more complicated when the
contract requires the vendor to provide both goods and services combined. In 2006, Nor-
tel 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. We will be
examining the issues surrounding recognition of revenue for long-term contracts later in
this chapter.
5.2.2 Measurement
The third criterion for revenue recognition states that revenue should be recognized only if
it can be measured reliably. Under IFRS, revenue should be measured at the fair value of
the consideration that is or will be received in the transaction, taking into account volume
rebates and trade discounts. If the sale results in cash paid in a short period of time, then
5.2. Revenue Recognition 147
the measurement is quite straightforward. However, measurement may become more

problematic if one of the following conditions is present in the transaction:
• The payment is received over a long period of time.
• The payment received is non-monetary (i.e., a barter transaction).
• Concessionary terms are present.
• The sale is a bundled sale of more than one good or service.
Let’s look at each of these situations.
For a long-term payment, IAS 18.11 states that when a sale results in a receivable that is
payable over a long period of time and bears no or low interest, the receivable should be
discounted to reflect the time value of money. The discount rate chosen should be either
the prevailing rate for similar notes receivable or the imputed rate that discounts the cash
flows to the current cash selling price of the goods sold. The choice will depend on which
of these rates is more reliably determinable. This approach will result in interest revenue
being recognized over the life of the receivable, representing the difference between the
discounted amount and the nominal amount actually received.
In the case of barter transactions, the transaction must first be identified as having com-
mercial substance or not. This criterion generally means that the transaction has a
legitimate business purpose and that the goods or services exchanged have different
characteristics. It is expected that after the exchange, the company will be in a different
position with respect to the timing, amount, or riskiness of future cash flows. If the
transaction does have commercial substance, then the transaction will be valued at the
fair value of the goods or services received, adjusted for any cash transferred. If fair value
is not determinable, the fair value of the product or service sold (adjusted for any cash
transferred) would be used. If the transaction does not have commercial substance (i.e.,
the goods and services exchanged are similar), then it would simply be treated as an
exchange of assets that maintains the current carrying values. That is to say, no revenue
or gain would be recognized on the exchange.
Concessionary terms are conditions in a contract that grant certain privileges to one party
that are more generous than would normally be expected for that kind of transaction.
Examples include larger-than-normal discounts, lenient credit policies and extended pay-
ment periods, generous return policies, additional services provided after the sale, bill-
and-hold transactions, and guarantees of resale or profit. In cases where concessionary
terms are present, the transaction must be analyzed carefully to determine not only if
recognition is warranted but also if the measurement basis is clearly determinable. For
example, if a company makes sales with overly generous return policies, is the full amount
of the sale the appropriate amount to report?
148 Revenue
For bundled sales, the problem becomes how to determine the value of each part of
the transaction. For example, mobile-telephone companies will often sell the phone at a
deeply discounted price as long as the customer signs a long-term contract. In this case,
the total value of contract must be allocated between the product (the telephone) and
service (access to airtime and data for the contract period). In order to record the revenue
for this transaction, the relative fair value method should be used. This technique
allocates the total contract price using the relative fair values of each component. The
residual value method could be used if there were difficulty ascertaining the fair values
of both components. Under this method, the fair value of the undelivered component
is subtracted from the total contract value. The remaining value is then allocated to the
delivered component. Once the contract price is allocated to the appropriate components,
revenue will be recognized following the recognition criteria previously discussed.
In general, when there are measurement problems as a result of any of the above situa-
tions, the choice would be to
a. not record the sale at all due to its immeasurability,
b. record the sale with an offsetting allowance that estimates the part of the sale for
which measurement problems exist, or
c. recognize revenue for services only to the extent that expenses are recoverable.
It is usually preferable to choose the second option, as long as the details of the transac-
tion are fully disclosed.
Another area where IFRS provides specific guidance relates to revenues earned from
interest, royalties, and dividends. A previous example discussed interest earned from a
long-term receivable, but there are other ways a company can generate interest revenue.
Whether an interest rate on a loan to another party is stated or not, the company should
recognize interest revenue using the effective interest method. This technique will be
discussed in later chapters. For royalties, revenue should be recognized on the accrual
basis in accordance with the substance of the relevant agreement. Dividend revenue
should be recognized when the shareholder’s right to receive the payment is established.
5.2.3 Collectibility
The fourth criterion for revenue recognition requires that there exist a reasonable prob-
ability that the benefits of the transaction flow to the vendor. This does not mean there
is absolute certainty regarding the collection of the account, but it does suggest there
is some basis for estimating any potentially uncollectible amounts. If collectibility is not
reasonably assured, then revenues cannot be recognized. This makes sense, as it is
5.3. Applications 149
unlikely that any true economic exchange has occurred. Any prudent business would not
agree to part with a valuable asset or service if there were no reasonable expectation of
getting paid. In cases like this, revenue could be recognized only when cash is actually
received by the vendor.
5.2.4 Costs
For revenue to be recognized, costs that are incurred or will be incurred need to be es-
timable. Without a reasonable basis for estimating costs, it is impossible to be certain that
the project will ultimately be profitable. It would be particularly inappropriate to recognize
revenue for a long-term project to provide a service, because any profits recognized now
may be absorbed by future expenses. To recognize revenue prematurely could provide
a misleading picture to financial-statement readers. In situations where future costs or
the outcome of a service project cannot be reasonably estimated, IFRS allows only
the recognition of revenues up to the amount of costs incurred that are expected to be
recovered. Under ASPE, no costs or revenues could be recognized until the contract was
complete. This technique, the completed-contract method, will be discussed further
later in this chapter.
5.3 Applications
Here are some examples that illustrate the principles of revenue recognition.
5.3.1 Bundled Sales
Telurama Inc. sells mobile telephones with two-year bundled airtime and data plans. The
fair value of the telephone is $600, and the fair value of the airtime and data plan is
$1,000. As the mobile telephone business is very competitive, Telurama is required to sell
the bundled package for $1,400. There are two possible ways Telurama can recognize
the revenue from this sale:
a. Relative fair value method

This is the preferred method, and it should be applied when the fair value of both
components can be determined. In this example, Telurama would recognize revenue
as follows:
150 Revenue
Component Calculation Allocation

Telephone [600 ÷ (600 + 1,000)] × 1,400 $ 525
Airtime and data [1,000 ÷ (600 + 1,000)] × 1,400 $ 875
Total $ 1,400
b. Residual value method

If the fair value of both components is not determinable, then this method should
be used. Here, the value of the undelivered component (the airtime and data)
is subtracted from the total contract value to arrive at the value of the delivered
component (the telephone). In this example, Telurama would recognize revenue as
follows:
Component Calculation Allocation

Telephone 1,400 − 1,000 $ 400
Airtime and data 1,400 − 400 $ 1,000
Total $ 1,400
In either case, revenue will be recorded based on the allocation calculated above. The
revenue for the delivered component will be recorded immediately when the telephone is
delivered 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 relative fair value
method would look like this:
General Journal
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . 1,400
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . 875
5.3.2 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. Thus, the risk and rewards of ownership have
not been transferred 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)
General Journal
Inventory on consignment . . . . . . . . . . . . . . . . . . . 12,000
Finished goods inventory . . . . . . . . . . . . . . . . 12,000
To segregate consignment goods.
Inventory on consignment . . . . . . . . . . . . . . . . . . . 550
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550
To record freight.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,350
Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Commission expense (15% × $23,000) . . . . . 3,450
Consignment revenue . . . . . . . . . . . . . . . . . . . 23,000
To record receipt of net sales.
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 6,275
Inventory on consignment. . . . . . . . . . . . . . . . 6,275
To record COGS: [(12,000 + 550) × 50%].
Magritte Merchandising Ltd. (consignee)
General Journal
Account receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
To record payment of advertising.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . 23,000
To record sales of consigned goods.
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . 1,200
Revenue from consignment sales . . . . . . . . 3,450
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,350
To record payment to consignor: 15% ×
$23,000 = $3,450.
152 Revenue
5.3.3 Instalment Sales
Sometimes in a competitive business environment, a company will deliver goods to a cus-

tomer but will then allow that customer to pay for the purchase with a series of payments
over time. In this case, there is a credit risk that some or all of the payments will not be
received. Credit risk is normally dealt with by simply recording the sale and then creating
an allowance for doubtful accounts. However, with an instalment sale, the extended
payment period may create such a high degree of risk that it would be inappropriate to
record the revenue at the time of delivery. Instead, it may be more appropriate to record
revenue only as cash is received.
Consider the following situation: BlastEm Systems Ltd. sells high-quality home-entertainment
systems. A premium system sells for $10,800. In order to promote sales, the company
lets customers pay for the purchase with 24 equal monthly payments. The cost to BlastEm
for the components of the system is $6,000. The journal entry to record the delivery of a
unit to a customer would look like this:
General Journal
Instalment accounts receivable . . . . . . . . . . . . . . 10,800
Deferred gross profit . . . . . . . . . . . . . . . . . . . . . 4,800
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
The deferred gross profit would be reported as a liability, and no revenue or profit is
reported at the time of delivery.
After one month, the customer makes the first instalment payment. Because this is a
long-term receivable, there is an interest component implicitly included in the transaction.
Assuming interest is calculated and reported separately, this would be the journal entry
for the payment:
General Journal
Cash (10,800 ÷ 24) . . . . . . . . . . . . . . . . . . . . . . . . . 450
Instalment accounts receivable . . . . . . . . . . 450
Deferred gross profit (4,800 × 1 ÷ 24) . . . . . . 200
Cost of goods sold (6,000 × 1 ÷ 24) . . . . . . . . 250
Sales revenue (10,800 × 1 ÷ 24) . . . . . . . . 450
If, at some future period, the customer defaults and does not make all the payments,
the outstanding account receivable and deferred gross profit balances would need to be
written off.
5.3.4 Barter Transactions
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:
General Journal
Utility expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Crude oil inventory . . . . . . . . . . . . . . . . . . . . . . . 7,000
In this case, the transaction is valued at the fair value of the goods received, unless this
value is not reliably determined, in which case the fair value of the goods given up would
be used.
5.3.5 Long-Term Construction Contracts
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. 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 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
154 Revenue
the project to determine the amount of revenue to recognize. 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, 2015,
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:
2015 2016 2017

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:
2015 2016 2017

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 2015 would look like this:
General Journal
Construction in progress . . . . . . . . . . . . . . . . . . . . 5,000,000
Materials, payables, cash, etc. . . . . . . . . . . . 5,000,000
To record construction costs.
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . 4,500,000
Billings on construction . . . . . . . . . . . . . . . . . . 4,500,000
To record billings.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . 4,200,000
To record collections.
Construction expenses . . . . . . . . . . . . . . . . . . . . . . 5,000,000
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,250,000
To recognize revenue.
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. If construction in
progress exceeds billings on construction, the net balance would be reported as recog-
nized 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 2017, once the contract is completed, an additional journal entry is required to close
the billings on construction and construction in progress accounts:
General Journal
Billings on construction . . . . . . . . . . . . . . . . . . . . . 25,000,000
Construction in progress . . . . . . . . . . . . . . . . . 25,000,000
To record completion.
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
156 Revenue
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. In this situation, a conservative approach should be applied, and the total
amount of the expected loss should be recorded in the current year. 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.
To illustrate this situation, consider our Salty Dog example again, with one change. As-
sume that in 2016, due to a worldwide iron shortage, the expected costs to complete the
project rise from $8,050,000 to $18,000,000. However, in 2017, 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:
2015 2016 2017

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
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 recon-
ciles with the total project revenue of $25,000,000 minus total project costs of $26,500,000.
Other Considerations
1
Note: The additional loss to recognize in 2016 represents the loss expected at this point on work not
yet completed (i.e., 60% × [25,000,000 − 30,000,000]). This additional loss gets reversed in 2017, because
there is no further work to complete once the project is finished. By recognizing this additional amount in
2016, the financial statements will show the total expected loss on the project at this point. In 2016, the
additional loss will be journalized by adding it to the total of the construction expenses account recognized.
5.4. Presentation and Disclosure 157
In some circumstances, it may be difficult to determine the outcome of the contract. This
may be due to uncertainties in estimating the total costs for the project or difficulties in
determining the project revenue. In circumstances where significant uncertainty exists, it
is inappropriate to recognize profit until the project is complete. In this case, IFRS requires
the application of the zero-profit method, which allows revenues to be recognized only in
an amount equal to costs incurred during the year that are expected to be recovered from
the customer. Thus, all profit will be deferred until the project is complete, at which time the
actual earned profit can be recognized. Under ASPE, the approach in this circumstance
would be to use the completed-contract method. This approach does not record any
revenue or expense until the year when the project is complete. ASPE also allows this
method to be used when performance under the contract is determined by a single act,
rather than by a continuous sequence of significant events.
5.4 Presentation and Disclosure
IAS 18 requires the disclosure of the accounting policies followed in determining the
recognition of revenue, along with methods used to determine the progress toward com-
pletion for service contracts. As well, IAS 18 requires the separate disclosure of significant
categories of revenue, including sales of goods, rendering of services, interest, royalties,
and dividends. Revenues earned from non-monetary exchanges must also be similarly
categorized.
With long-term construction contracts, which are covered by a separate standard (IAS 11),
there are some additional disclosure requirements. Along with disclosure of the amount
of contract revenue recognized, the policy chosen, and the methods used to determine
the percentage of completion, disclosure of the net amount owing to or from customers is
also required. This amount is determined by taking the total amount of costs incurred to
date, plus the amount of profit recognized (or minus the amount of loss recognized), less
the amounts billed to the client. This calculation could result in either a net debit or credit
balance. These balances are usually disclosed as current assets or current liabilities,
unless the length of the contract suggests it will take longer than one year to fully realize
the profits. Typically, the amount will be described as recognized revenues in excess
of billings or billings in excess of recognized revenues. Disclosure is also required
of any advances (amounts paid by the client prior to the commencement of work) and
retentions (billed amounts held back by the client to cover the completion of the contract
or the repair of any defects).
158 Revenue
5.5 IFRS 15: The New Standard
IFRS 15, Revenue from Contracts with Customers, was issued in May 2014. The standard
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 stan-
dard 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 new 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 obliga-
tions. 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.
Identify the Contract
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 ser-
vices. The contract must be one of commercial substance, and there must be reasonable
5.5. IFRS 15: The New Standard 159
expectation that the ultimate amount owing from the customer will be collected. This
collectibility criterion will prevent a situation where revenue is recognized and then a
provision is immediately made for an uncollectible account. Under the new rule, the
contract cannot be recognized until the collection is probable. If all of 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.
Identify the Performance Obligations
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.
Application of this criterion may result in more goods and services being bundled or
unbundled, compared with the current standard. This step may be particularly relevant to
software developers who offer their product bundled with a service component.
Determine the Transaction Price
The transaction price is the amount that the business expects to receive from the customer
once the performance obligation has been satisfied. In some cases, variable consider-
ation may be present in the contract. This may arise due to rebates, discounts, and
incentives, and it may also be dependent on future contingent events. The entity will need
to estimate these amounts, but the variable consideration can be recorded only if it is
highly probable that the amount will not be reversed in the future. This criterion may result
in revenue being recorded sooner than the current rules allow. For example, under current
rules, a company that sells a product with the right of return may not record revenue until
it is sold to the final customer. Under the new standard, revenue could be recognized to
the extent that the probability and amount of returns are estimable.
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 stand-alone selling price 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).

160 Revenue
The application of these approaches may result in the identification of performance obli-
gations that hadn’t previously been identified due to the lack of stand-alone prices. This
may be particularly relevant to companies selling software and related support services.
The standard also requires an assessment of the timing of the payments by the customer.
If there are significant time differences between the performance of the obligations and
the receipt of consideration from the customer, then part of the transaction price may need
to be allocated to a financing component.
Recognize Revenue
Revenue should be recognized when the performance obligation has been satisfied.
This is defined either by the transfer of control of an asset to the customer or by the
customer’s receipt and consumption of services or benefits provided by the contract.
The performance obligations can be satisfied either at a point in time or over time. The
specific tests applied to determine when to recognize revenue over time may be par-
ticularly relevant to the real estate development and aerospace industries. The timing
of revenue recognition may change significantly for some businesses, compared with
current practice. In particular, the sale of licenses for the use of intellectual property
may be recognized differently as new criteria are identified for these types of transactions.
This could be particularly relevant to businesses that sell software or license the use of
branding under franchise arrangements.
IFRS 15 also provides specific application guidance on a number of areas, including the
following:
• Sales with right of return
• Warranties
• Principal/agent considerations
• Repurchase agreements
• Bill-and-hold transactions
• Consignments
• Customer acceptance
• Customer options for additional goods and services
• Customers’ unexercised rights
• Non-refundable, upfront fees
• Disaggregation of revenue disclosures

5.5. IFRS 15: The New Standard 161
So how does the new standard differ from existing practice? In many cases, the treatment
under IFRS 15 will be exactly the same as required under the current standards. However,
IFRS 15 has introduced a significant amount of new disclosure requirements, including
detailed discussion of the judgments required in determining the recognition of revenue,
the disaggregation of revenue components, and identification of performance obligations.
These disclosures, both qualitative and quantitative, are intended to improve the reader’s
understanding of revenue recognition issues, as this is an area that in the past has
been subject to misrepresentation and vagueness. The standard also specifies that the
opening and closing balances reported on the balance sheet from these contracts should
be reported as a contract liability, a contract asset, or a receivable. The classification will
depend on the relationship between the entity’s performance and the customer’s payment.
One industry that has expressed concerns about the new standard is the telecommuni-
cation industry. Companies that offer mobile phones and airtime plans will often bundle
these products in a single contract. The requirement under IFRS 15 to value components
on the basis of their stand-alone prices may significantly affect the way telecommunication
companies report revenue. Some industry analysts have predicted that the new rules
will result in more revenue recognized up front (based on the value of the handset)
and less revenue recognized in the future. The industry has also expressed concerns
about the additional level of detail and estimation required to make these determinations,
stating that significant changes and investments in IT systems may be required to properly
track the information. A further concern of the industry relates to a specific section of
the new standard that requires the capitalization and amortization of direct, recoverable
costs incurred to obtain the contract. Current practice in this industry usually involves
simply expensing employee commissions at the time the contract is signed. Industry
representatives have also expressed concern about the requirement to segregate the
interest component of contracts, which may be particularly difficult for contracts with
commercial customers, who often have more complex terms and timelines. Some industry
representatives have suggested that the new accounting standard may affect how they
measure key performance indicators and how they design contracts with customers.
Other broader effects may include tax-planning adjustments, changes to remuneration

contracts with employees, changes in accounting procedures and internal controls, and
changes in methods for managing compliance with lender covenant arrangements. This
new standard has likely been the most significant change in accounting practice for many
businesses since the initial introduction of IFRS; it will have wide-reaching impacts for the
next several years.
162 Revenue
IFRS ASPE
The percentage-of-completion method Either the percentage-of-completion
should be used for long-term contracts, method or the completed-contract method
unless progress is not measurable, in can be used, depending on which
which case the zero-profit method should more accurately relates the revenues
be used. to the work accomplished. If progress
toward completion of the contract cannot
be measured, the completed contract
method must be used.
Barter transactions are measured at Barter transactions are measured at fair
fair value when the goods or services value when the transaction has commer-
exchanged are dissimilar. If the goods or cial substance. If there is no commercial
services exchanged are similar, then no substance, the asset acquired is mea-
revenue is recognized. sured at the carrying value of the asset
given up, adjusted for any cash considera-
NOTE: Although the concepts of dissimilar tion.
goods and services and commercial
substance are expressed differently, the
accounting result of barter transactions is
usually the same in IFRS and ASPE.
Specific guidance provided on determina- Payments received over time are dis-
tion of the appropriate discount rate for counted at the prevailing market rate.
payments received over time.
Disclosure requirements are more specific Disclosure requirements indicate only that
in describing the significant categories to major categories should be disclosed.
disclose.
IAS 18 specifies that revenue should be S3400 does not specify what measure-
measured at the fair value of consideration ment base to use to measure revenue.
received or receivable.
Chapter Summary
LO 1: Describe the criteria for recognizing revenue and determine if

a company has earned revenue in a business transaction.
Revenue from the sale of goods should be recognized when the seller has transferred
to the buyer the significant risks and rewards of ownership and does not retain any
Chapter Summary 163
control over the asset and when the amount of revenue is measurable, the collection
of the revenue is probable, and costs of the transaction are estimable. The transfer of
control may be more apparent when there is a discrete earnings process, but a continuous
earnings process can also exist. For long-term contracts, a rational method of recognizing
revenue will need to be applied, based on some method of measuring progress. Interest
revenue should be recognized using the effective interest method. Royalty revenue should
be recognized on the accrual basis in accordance with the substance of the relevant
agreement. Dividend revenue should be recognized when the shareholder’s right to
receive the payment has been established.
LO 2: Discuss the problem of measurement uncertainty and

alternative accounting treatments for these situations.
Measurement uncertainty can occur when payment is deferred, payment is made with
non-monetary assets, concessionary terms exist, or the sale consists of a bundle of goods
and services. The accounting treatment will depend on the nature of the measurement
problem. Where sales are bundled, a logical method of allocation will need to be applied.
Where the measurement uncertainty relates to future costs that are required to complete
the contract, it may be appropriate to recognize only revenue up to the amount of costs
incurred (IFRS) or not until the end of the contract (ASPE). Measurement uncertainty also
affects the assessment of collectibility, and it may appropriate to provide for uncollectible
amounts.
LO 3: Prepare journal entries for a number of different types of sales

transactions.
For bundled sales, the preferred method of allocating the proceeds is the relative fair-
value method. If fair values cannot be determined, the residual method can be used. The
amount related to the undelivered component will be recorded as unearned revenue until
such time that the revenue is unearned. 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 instalment sales, the gross profit on the sale should be deferred until the instalment
payment is received from the customer. Gross profit will be recognized in proportion to
the relative size of each instalment. For non-monetary exchanges of dissimilar assets,
the revenue should be recorded based on the fair value of the goods or services received,
unless this is not determinable, in which case the fair value of the goods or services given
up would be used.
164 Revenue
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 man-
ner 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-profit method
(IFRS) or the completed contract method (ASPE).
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.
LO 6: Apply revenue recognition concepts to unprofitable long-term

construction contracts.
When a construction contract is predicted to be unprofitable, 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: Understand disclosure requirements for revenue-related

accounts.
Accounting policies for revenue recognition must be disclosed, along with the basis for
measuring progress toward completion on long-term contracts, major categories of rev-
enues, and revenues earned from non-monetary exchanges. For long-term contracts,
more details about the method of measuring progress should be disclosed, along with the
net amount owing to or from customers of these contracts.
Exercises 165
LO 8: Discuss the contract-based approach to revenue recognition,

including a comparison of this approach with current practice.
IFRS 15 approaches revenue recognition from the perspective of the rights and obli-
gations present in a contract with a customer. The process of recognizing revenue
involves identifying the contract, identifying the performance obligations, determining the
transaction price, allocating the transaction price to the performance obligations, and then
recognizing revenue when the performance obligations are completed. Compared with
current practice, the new standard will result in more disclosure and more discussion
of the nature of the estimates required in determining the amount of revenue to record.
The new standard may also result in reallocations of revenue between years compared
with current practice. This may be true with companies that offer bundled sales and
other types of complex contracts. Some companies may also need to upgrade their
accounting systems and measurement metrics in order to capture data necessary to make
the determinations of revenue earned.
References
CPA Canada. (2016). Part II, Section 3400. In CPA Canada Handbook. Toronto, ON:
CPA Canada.
International Accounting Standards. (1993). IAS 18 – Revenue. Retrieved from http://

www.iasplus.com/en/standards/ias/ias18
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-0014
4feabdc0
Exercises
EXERCISE 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
166 Revenue
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.
EXERCISE 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 undeterminable and the
fair value of the airtime and data is as indicated.
EXERCISE 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 trans-
actions.
EXERCISE 5–4
Eames Fine Furniture sells high-quality furnishings utilizing special payment terms. Cus-
tomers are regularly allowed to purchase furniture and not make any payments for eight
months. Four equal payments must then be made in successive months, starting in the
ninth month after the purchase.
Assume that in January the company reported instalment sales totalling $350,000 and
the gross margin on these sales is 30%.
Required: Prepare journal entries to record the January sales and subsequent payments
using the instalment sales method.
EXERCISE 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 acces-
sories retailer. Mr. Ledger will compile the accounting records of DDI every month and
Exercises 167
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.
EXERCISE 5–6
Suarez Ltd. entered into a contract on January 1, 2015, 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 2016. Details of the project are as follows:
2015 2016
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:
a. Calculate the amount of gross profit to be recognized each year using the percentage-
b. Prepare all the required journal entries for both years.
EXERCISE 5–7
In 2016, 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:
2016 2017 2018

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
168 Revenue
Required:
b. Show how the details of this contract would be disclosed on the balance sheet and
income statement in 2017.
EXERCISE 5–8
On February 1, 2015, 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:
2015 2016 2017

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:
b. Prepare all the required journal entries for 2016.
EXERCISE 5–9
Take the same set of facts as described in the previous question, except assume that the
increase in material costs has created significant uncertainty for the contract.
Required:
Exercises 169
a. Using the zero-profit method (IFRS), determine the amount of revenue and expense
to report each year.
b. Using the completed-contract method (ASPE), determine the amount of revenue

and expense to report each year.
Chapter 6
Cash and Receivables
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 in
order for Apple’s money managers to 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.
171
172 Cash and Receivables
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)
LO 1: Describe cash and receivables, and explain their role in accounting and business.
LO 2: Describe cash and cash equivalents, and explain how they are measured and
reported.
2.1 Explain the purpose and key activities of internal control for cash.
LO 3: Describe receivables, identify the different types of receivables, explain their ac-
counting treatment, and prepare the relevant journal entries.
3.1 Describe accounts receivable, and explain how they are initially and subse-
quently measured and reported.
3.2 Describe notes receivables, and explain how they are initially and subse-
quently measured and reported.
3.3 Describe derecognition of receivables and the various strategies businesses

use to shorten the credit-to-cash cycle through sales of receivables or bor-
rowings secured by receivables.
3.4 Describe how receivables are disclosed on the balance sheet and in the
notes.
LO 4: Identify the different methods used to analyze cash and receivables.
LO 5: Explain the differences between IFRS and ASPE for recognition, measurement,
and reporting for cash and receivables.
Introduction 173
Introduction
As the opening story about Apple illustrates, actively managing cash and receivables has
important implications for businesses. The timeframe required to convert receivables to
cash is a cycle that calls for regular monitoring. This chapter addresses how management
uses financial reporting in order 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.
1.0 Cash and

Receivables: Overview
2.0 Cash and

Cash Equivalents Internal Control of Cash
Accounts Receivable
Notes Receivable
Cash and Receivables 3.0 Receivables
Derecognition and
Sales of Receivables
4.0 Cash and
Receivables: Analysis Disclosures of Receivables
5.0 IFRS/ASPE
Key Differences
A. Review of Internal
Controls, Petty Cash,
and Bank Reconciliations
6.1 Overview
Cash and receivables are financial assets. Specifically, cash, cash equivalents, ac-
counts 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 nonfinancial 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.
6.2 Cash and Cash Equivalents
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.
6.2. Cash and Cash Equivalents 175
Cash can be classified as a long-term asset if they are designated for particular 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 sav-

ings 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 ($85,000×$1.11). 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 ($85,000 ×($1.11 −$1.05)):
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100
Gain on foreign exchange . . . . . . . . . . . . . . . . 5,100
(US $85,000 × ($1.11 − $1.05))
Usually, this cash is included in current assets. However, if the cash flow out of the country
is restricted, then 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.
6.2. Cash and Cash Equivalents 177
Below is a partial balance sheet from Orange Inc. that shows cash and cash equivalents
as at December 31, 2015 along with the corresponding notes:
CONSOLIDATED BALANCE SHEETS

(in millions)
December 31 December 31
2015 2014
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. The Company’s marketable debt and equity securities
have been classified and accounted for as available-for-sale. Management determines
the appropriate classification of its investments at the time of purchase and reevaluates
the designations at each balance sheet date. The Company classifies its marketable
debt securities as either short term or long term based on each instrument’s underlying
contractual maturity date. Marketable debt securities with maturities of 12 months or
less are classified as short term and 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,
net of taxes, reported as a component of shareholders’ equity. The cost of securities sold
is based on the specific identification model.
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 cur-
rencies, 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 expan-
sion, 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 ad-
vances
Office supplies inventory (current asset) Postage on hand
Bank indebtedness (current liability) Bank overdraft accounts not offset by
same bank positive balances
6.2.1 Internal Control of Cash
A key part of effective cash management is the internal control of cash. This topic was
introduced in the introductory accounting prerequisite 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 re-
quired for all cash-based transactions and activities
• The separation of duties with regard to cash
• Maintaining adequate cash records, including petty cash and the preparation of
regular bank reconciliations.
6.3. Receivables 179
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 reconcilia-
tions taken from an introductory financial accounting textbook.
6.3 Receivables
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 docu-
ment is usually referred to as a promissory note.
• Nontrade 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 receiv-
able. 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, 2015 and 2014
(In millions of dollars except share amounts)
2015 2014
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 bal-
ances. 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 uncollectable 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 or not 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 covered later in this chapter.
Receivables management involves developing sound business practices for overall moni-
toring 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
6.3.1 Accounts Receivable
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 sub-
sequent 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 as a
way 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 dis-
counts 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% (365 days ÷20 days ×1.5%). For this reason, companies usually
pay within the discount period unless their available cash is insufficient to take advantage
of the opportunity.
In order to value accounts receivable from sales at their net realizable value, sales trans-
actions should be recorded at their lowest cash price after deducting any applicable sales
discount (the net method). This may be conceptually sound, but it is rarely used in
practice because it requires more bookkeeping to track and record any sales discounts
forfeited (given up) if the customer does not pay within the discount period.
To illustrate, assume that Cramer Plumbing purchased fifty bathtubs from a manufacturer
for $800 each, for a total sale of $40,000, with credit terms of 1.5/10, n/30. Using the net
method, it is assumed at the time of the sale that the sales discount will be taken by the
purchaser; therefore the manufacturer will record the entry for the sale as:
General Journal
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,400
($800 × 50 units × 98.5)
Note that the reduction due to the discount is immediately recorded upon the sale. This
results in the accounts receivable being valued at its net realizable value. Since this is the
case, no asset valuation adjusting entry is needed at the end of the accounting period to
revalue accounts receivable to its lowest net realizable value.
If $10,000 of the account receivable is collected from Cramer within the ten-day discount
period, the entry would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,850
($10,000 × 1.5%)
The entry for collection of the remaining amount owing for $30,000 after the discount
period is:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Sales discounts forfeited . . . . . . . . . . . . . . . . . 450
For Sales discount forfeited: ($30,000 ×
1.5%)
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. This is theoretically consistent with the accounting standards and no asset
valuation adjusting entry is required. This is not the case when using the gross method
which is discussed next.
For the gross method, sales are recorded at the gross amount with no discount taken.
If the customer pays within the discount period, then 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. However, if it is expected that significant cash discounts are to be taken in the
fiscal year, then an asset valuation adjusting entry is required under the gross method
so that the valuation for accounts receivable, net of the valuation account, will reflect its net
realizable value. As long as the asset valuation adjusting entry is made to the allowance
account at the end of the reporting period under the gross method, the income statement
and balance sheet results will be the same under either method. If the discount is material
and the adjusting entry is not recorded, accounts receivable and sales revenue would be
overstated.
Using the same example, assume that Cramer Plumbing purchased fifty bathtubs from a
manufacturer for $800 each, with credit terms of 1.5/10, n/30. Using the gross method,
the entry for the sale is:
General Journal
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
($800 × 50 units)
The entry on collection of $10,000 within the ten-day discount period is:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,850
Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
For Sales discounts (a contra sales revenue
account): ($10,000 × 1.5%)
The entry on collection of $30,000 after the discount period is:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
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.
The year-end adjusting entry to update the accounts receivable allowance account with
the estimated sales discounts would be:
General Journal
Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,000
Allowance for sales discounts . . . . . . . . . . . . 51,000
(($6,000,000 × 1.5% × 60%) − $3,000).
(Allowance for sales discounts is a contra
accounts receivable account)
Throughout the following year, the sales discounts account can be directly debited each
time customers take the discounts. The allowance account can be adjusted up or down
at the end of each reporting period.
Sales Returns and Allowances
The sales returns and allowances account is a contra sales revenue account. Its
purpose is to track these transactions separately for monitoring purposes as opposed
to directly netting them with sales. For example, if amounts in this contra account be-
come too high, it could indicate to management the possibility of future sales lost due to
unsatisfied customers.
Sales returns refer to goods that customers return to the seller after a sale. This can
happen for many reasons such as receiving an incorrect or defective item. Many compa-
nies have policies that allow for the return of goods under certain circumstances and will
refund all or a partial amount of the item cost. Assuming that the goods are returned to
inventory, the entry for a $1,000 sales return on account (with a cost $800) for a company
using a perpetual inventory system would be:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
COGS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Sales returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
(Sales returns is a contra sales revenue
account)
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.
For example, if a sales allowance of $2,000 is granted due to damaged goods that the
customer chose to keep, the entry for the allowance would be:
General Journal
Sales returns and allowances . . . . . . . . . . . . . . . 2,000
Accounts receivable or cash . . . . . . . . . . . . . 2,000
(Sales returns and allowances is a contra
sales revenue account)
As was done with sales discounts, sales returns and allowances should be recognized
in the period of the sale to avoid distorting the current period’s income statement. To
accomplish this, sales returns and allowances are estimated and adjusted to the sales
returns and allowances account at the end of each reporting period. If the amount of
returns and allowances is not material then the year-end adjusting entry is not required
provided that the items are handled consistently from year to year.
For example, management estimates the total sales returns and allowances to be $51,500,
which it deems to be significant. If the unadjusted balance in the allowance for sales
returns and allowances account is $5,000, the year-end adjusting entry would be:
General Journal
Allowance for sales returns and al- 46,500
lowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
($51,500 − $5,000) (Sales returns and al-
lowances is a contra sales revenue account
and Allowance for sales returns and al-
lowances is a contra accounts receivable
account)
Throughout the following year, the sales returns and allowances account can be directly
debited each time customers are granted returns or allowances. The allowance account
can be adjusted up or down at the end of each reporting period.
Estimating Allowance for Uncollectible Accounts
When accounts receivables exist, some amount of uncollectible receivables is inevitable

due to credit risk. This risk is the likelihood of loss due to customers not paying their
bills. If the uncollectible amounts are both likely and can be estimated, an amount for
uncollectible accounts must be determined and recognized in the accounts to ensure
that accounts receivable and net income are not overstated. The allowance account,
called the allowance for doubtful accounts (AFDA), is an asset valuation account (contra
account to accounts receivable) and is used similarly to the two allowance accounts for
sales discounts and sales returns and allowances discussed earlier in this chapter.
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 ex-
plained 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 a number of methods:
• Percentage of accounts receivable method
• Accounts receivable aging method
• Credit sales method
• Mix of methods
For each method above, management estimates a percentage that will represent the
likelihood of uncollectibility. The estimated total amount of uncollectible accounts is then
calculated and recorded either directly to accounts receivable or to the AFDA allowance
account, with the offsetting entry to bad debt expense. The net amount for accounts
receivable and the AFDA is intended to reflect 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 past
experiences and current economic 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 un-
collectible 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:
General Journal
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500
Allowance for doubtful accounts . . . . . . . . . . 5,500
(($200,000 × 4%) − $2,500)
The AFDA ending balance after the adjusting entry would correctly be $8,000
($2,500 unadjusted balance + $5,500 adjusting entry).
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, then 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, then the adjusting entry for uncollectible
accounts would be:
General Journal
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 8,300
(($200,000 × 4%) + 300)
The AFDA ending balance after the adjusting entry would correctly be $8,000 ($300 debit+
$8,300 credit).
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 attain that ending balance.
Accounts Receivable Aging Method
Usually the older the uncollected account, the more likely it is to be uncollectible. For this
method, the accounts receivable are grouped into categories based on length of time they
have been outstanding.
Just as was done for the percentage of accounts receivable method above, companies will
use their 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 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 achieve this ending balance.
Aging schedules are also a good indicator of which accounts may be in need of addi-
tional attention. This may be because they are part of a 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
Customer Balance Under 61–90 91–120 Over 120
Dec 31, 2015 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 therefore 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 balance as
at December 31 of $2,500, the adjusting entry for uncollectible accounts would be:
General Journal
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 15,553
($18,053 − $2,500)
As was illustrated for the percentage of accounts receivable method above, the calculation
of the adjusting entry amount must take into account 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 directly calculate
the bad debt expense by using a percentage of credit sales. The bad debt estimate does
not attempt to relate to accounts receivable in any way but rather as an amount to be
reported in the income statement as bad debt expense based on credit sales. 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:
General Journal
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 9,750
($325,000 × 3%) (Allowance for doubtful
accounts is a contra accounts receivable
account)
Mix of Methods
Sometimes 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
method is used for purposes of preparing the year-end financial statements so that the
AFDA account is adjusted accordingly.
This is how it works. If the trend between the previous year’s credit sales and the uncol-
lectible accounts is fairly stable, then the resulting percentage can be used to estimate
the uncollectible accounts at the end of each month throughout the fiscal year.
At the end of the fiscal year, management analyzes the year-end receivables either by
estimating a percentage of accounts receivable or by aging, and estimates the adjusted
AFDA balance. If required, a year-end adjusting entry is recorded to the AFDA to bring it
back into alignment.
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, 2015
Current assets:
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, 2015. 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.
Write-offs and Collections
Write-off of an Actual Uncollectible Account
Management may deem a particular customer account as 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:
General Journal
Allowance for doubtful accounts . . . . . . . . . . . . . 18,000
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 on the
balance sheet. This treatment and entry makes sense because the estimate for uncol-
lectible 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 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 bills. 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 rein-
stated in the first entry.
Assuming that Cambridge Instruments Co. pays $5,000 cash and indicates that this is all
that the company is able to 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):
General Journal
Step 2: Record the receipt of cash on account from Cambridge Instruments:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
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) $$
Closing balance, end of period $$ $$
Direct Write-off of Uncollectible Accounts
Some smaller companies may only have a few credit sales transactions and small ac-
counts receivable balances. These companies usually use the simpler direct write-off
method because the amount of uncollectible accounts is deemed to be immaterial. This
means that when a specific customer account is determined to be uncollectible, the
account receivable for that customer account is written-off with the debit entry recorded
to bad debt expense as shown in the following entry:
General Journal
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . $$
Accounts receivable, S. Smith. . . . . . . . . . . . $$
If the uncollectible account written-off is subsequently collected at some later date, the
entry would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $$
Bad debt expense or uncollectible amount $$
recovered, S. Smith (Income statement) . . . . .
If the uncollectible amounts were material, then it would not be appropriate to use the
direct write-off method, for a number of reasons as follows:
• 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. You may wish to review those learning concepts from
that course.
6.3.2 Notes Receivable
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. The typical note receivable requires payment of a specified face amount, also
called principal, and interest, paid as a single lump sum at maturity, a series of payments,
or a combination of both.
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 with regard to sales of property, plant, and equipment or for ex-
changes 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 a term of less than one year, then 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 on 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, 2015:
Total days in March 31
Minus date of note 14
Days in March 17
Days in April 30
Days in May 31
Days in June to equal 90 days 12 Maturity date is June 12, 2015
Period of note 90
For example, assume that on March 14, 2015, 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:
General Journal
Mar 14 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
The entry for payment of the note ninety days at maturity on June 12 would be:
General Journal
Jun 12 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,098.63
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . 5,000.00
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 98.63
For Interest income: ($5,000×.08×90÷365)
In the example above, if financial statements are prepared during the period of time that
the note receivable is outstanding, then interest will be accrued to the reporting date of the
balance sheet. For example, if Ripple’s year-end were April 30, then the entry to accrue
interest from March 14 to April 30 would be:
General Journal
Apr 30 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 51.51
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 51.51
($5,000 × .08 × 47 ÷ 365) (Mar 31 − 14 =
17 days + Apr = 30 days)
When the cash payment occurs at maturity on June 12, the entry would be:
General Journal
Jun 12 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,098.63
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . 51.51
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . 5,000.00
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 47.12
For Interset income: (($5,000 × .08 × 90 ÷
365) − $51.51)
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:
General Journal
Mar 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 100.00
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 100.00
($5,000 × .08 × 3 ÷ 12)
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, then the receivable’s face value at maturity will not be an exact measure
of its fair value today (transaction date) 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%, the note’s present 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
($5,000.00 − $4,780.79) is interest income earned over the term of the note (six months).
However, in reality, this interest income is usually insignificant compared to a company’s
overall net income for any receivables due in less than one year. 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 on the balance sheet until it
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:
N = years 0 1 2 3 4 5
$5,000
Present Value (PV) = $3,917.63
PV = (0 PMT, 5 I/Y, 5 N, 5000 FV)

where I/Y is interest
N is # of periods
FV is future value
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:
General Journal
Jan 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,917.63
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,917.63
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:
N = years 0 1 2 3 4 5
$1,000 $1,000 $1,000 $1,000 $1,000

$1000
(1.05)1
= $952.38
$1000
(1.05)2
= $907.03
$1000
(1.05)3
= $863.84
$1000
(1.05)4
= $822.70
$1000
(1.05)5 = $783.53
Present Value of an = $4,329.48

Ordinary Annuity
PV = (1000 PMT, 5 I/Y, 5 N, 0 FV)

where PMT is the payment amount
I/Y is the interest
N is the # of periods
FV is the single payment at maturity.
The entry for the note receivable would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,329.48
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. This is the same concept as a mortgage
owing for a house, where it is commonly expressed 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.
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:
N = years 0 1 2 3 4 5
$1,000 $1,000 $1,000 $1,000 $1,000

$1000
(1.05)0
= $1000.00
$1000
(1.05)1
= $952.38
$1000
(1.05)2
= $907.03
$1000
(1.05)3
= $863.84
$1000
(1.05)4
= $822.70
Present Value of an = $4,545.95

Annuity Due
PV = (1000 P/AD, 5 I/Y, 5 N, 0 FV)

where P/AD is the payment at the beginning of the period
I/Y is interest
N is # of periods
FV is a single payment at maturity.
The entry for the note receivable would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,545.95
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.
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 calculated (derived). So, 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 actually
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%, then the stated rate is
lower than the market rate and the note is trading at a discount.
If stated rate lower than market Present value lower Difference is a discount
• If the stated interest rate is 10% and the market rate is 9%, then the stated rate is
higher than the market rate and the note is trading at a premium.
If stated rate higher than market Present value higher Difference is 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, then 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 ac-
counting 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:
Interest = $10,000 × 10% = $1,000 PMT
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:
General Journal
Jan 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
If Carpe Diem’s year-end was December 31, the interest income recognized each year
would be:
General Journal
Dec 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
(10,000 × 10%)
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:
Interest = $10,000 × 10% = $1,000 PMT
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:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,520
Even though the face value of the note is $10,000, the amount of money lent to Sizzle
would only be $9,520, which takes into account the discount amount due to 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 amorti-
zation, 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% Premium 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
* $9,520 × 12% = $1,142
Note that the total discount amortized of $480 in the schedule is equal to the discount
originally calculated as the difference between the face value of the note and the present
value of the note principal and interest. Also, the amortization amount calculated each
year is added to the note’s carrying value, 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.
Assuming that 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:
General Journal
End of year 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Note receivable (discount amortized amount) 142
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,142
For Interest income: (9,520 × 12%)
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:
General Journal
End of year 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Note receivable (discount amortized amount) 160
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,160
Comparing the three years’ entries for both the effective interest and straight-line methods
shows the following pattern for amortization over 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 increas-
ing 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.
However, 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.
General Journal
End of year 3 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
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%, then 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 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

Stated rate of 10% and market rate of 9%
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
* $10,253 × 9% = $923
Anchor’s entry on the note’s issuance date is for the present value amount (fair value):
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,253
Assuming that 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:
General Journal
End of year 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Note receivable (premium amortized 77
amount) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 923
For Interest income: (10,253 × 9%)
The entry when paid at maturity would be:

General Journal
End of year 3 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
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 the notes
actually do 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:
N = years 0 1 2 3 4 5
$10,000
Present Value (PV) = ($7,835)
Interest
I/Y = (+/- 7835 PV, 0 PMT, 5 N, 10000 FV)

where I/Y is interest
PV is the amount of cash lent
N is # of periods
FV is the future cash received
Interest = 5% (rounded), or $2,165
Note 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 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 ($10,000−$7,835), 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 Schedulee

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
* $7,835.26 × 5% = $391.76
The entry for the note receivable when issued would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,835.26
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:
General Journal
Dec 31 Note receivable (discount amortized amount) 391.76
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 391.76
(7,835.26 × 5%)
At maturity when the cash interest is received, the entry would be:
General Journal
End of year 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
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 ($2,164.74 ÷ 5 years) each year is recorded as:
General Journal
End of year 1 Note receivable (discount amortized amount) 432.95
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 432.95
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:
General Journal
May 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,117
Gain on sale of land . . . . . . . . . . . . . . . . . . . . . 16,117
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
However, if the market rate is not known, either of following two approaches can be used
to determine the fair value of the note:
a. 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
1
Source: http://www.iasplus.com/en/standards/ifrs/ifrs13 IFRS 13 Fair Value Measurement
applies to IFRSs that require or permit fair value measurements or disclosures and provides a single
IFRS framework for measuring fair value and requires disclosures about fair value measurement. The
Standard defines fair value on the basis of an “exit price” notion and uses a “fair value hierarchy,” which
For example, on June 1, Mayflower Consulting Ltd. receives a $40,000, three-year

note in exchange for some land. The market rate cannot be accurately determined
due to credit risks regarding the issuer. The land cost and fair value is $31,750. The
interest rate is calculated as follows:
I/Y = (+/-31750 PV, 0 PMT, 3 N, 40000 FV)
I/Y = 8%; the interest income component is $8,250 over three years ($40,000 −
$31,750)
The entry upon issuance of the note would be:
General Journal
Jun 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,750
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,750
b. 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 then 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:
General Journal
Jun 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,489
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Loans to employees
results in a market-based, rather than entity-specific, measurement. IFRS 13 was originally issued in May
2011 and applies to annual periods beginning on or after 1 January 2013 and is beyond the scope of this
course. For simplicity, the fair value of the property, goods or services given up as explained in the chapter
material assumes that IFRS 13 assumptions and hierarchy to determine fair values have been appropriately
considered.
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 considered to be additional
compensation and recognized as a debit to 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
(IAS 39.63; 2003).
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.
6.3.3 Derecognition and Sale of Receivables: Shortening the

Credit-to-Cash Cycle
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
remains with the company, so the receivables are left on the company’s books. The
2
“Cash is king” is a catch phrase for “cash is most important.” While a firm can generate a profit, if it
cannot be converted to cash fast enough to pay the liabilities as they are due, then the company runs the
risk of failing.
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 pass all of 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.
ASPE—control of the receivables has been surrendered by the transferor. This is

evidenced when the following three conditions are all met:
a. The transferred assets have been isolated from the transferor.

b. The factor has obtained the right to pledge or to sell the transferred assets.
c. 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, then the receivables remain in
the accounts and the transaction is treated as a secured borrowing (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 secu-
ritization, which is a larger and more complex version.
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
so 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 invoices. 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. 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
making the sale 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
Property, plant, and equipment 200,000
Total assets $360,000

Note payable 0
Equity 290,000
Total liabilities and equity $360,000
Debt-to-total assets ratio 19%
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Loss on sale of receivables . . . . . . . . . . . . . . . . . 10,000
Cromwell Co. – Sale of Receivables. Loss on
sale: ($100,000 × 10%)
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Discount on note payable**. . . . . . . . . . . . . . . . . . 10,000
Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Cromwell Co. – Note Payable. **Discount
shown separately from notes payable for
comparability. Discount will be amortized to
interest expense over the term of the note.
Below is the balance sheet after the transaction:

Cromwell Co. Balance Sheet – Sale of Receivables
Cash $100,000

Note payable 0
Equity 280,000

Cromwell Co. Balance Sheet – Note Payable

Cash $100,000

Note payable 90,000
Equity 290,000
Note that the entry for a sale is straightforward with the receivables of $100,000 derec-
ognized 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 ac-
counts 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:
General Journal
Aug 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176,000
Due from factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
For Due from factor: ($200,000 × 4%), for
Loss on sale of receivables: ($200,000 × 8%)
The accounting treatment will be the same for IFRS and ASPE since both sets of con-
ditions (risks and rewards and control) have been met. If no returns and allowances
are given to customers owing the receivables, then 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 (re-
course 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, then the transaction
can be treated as a sale.
Continuing with the example for Ashton, assume that the receivables are sold with re-
course, 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 obliga-
tion has a fair value of $5,000. The entry for Ashton, including the estimated recourse
obligation is:
General Journal
Aug 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176,000
Due from factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Recourse liability . . . . . . . . . . . . . . . . . . . . . . . . 5,000
For Due from factor: ($200,000 × 4%), for
Loss on sale of receivables: ($16,000 +
$5,000)
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, then 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.
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 re-

course, 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 port-
folio assets. Once purchased, the originating company (seller) derecognizes the receiv-
ables 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 tradable 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. In essence,
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 al-
located 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 ex-
pectation 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
subprime 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).
6.3.4 Disclosures of Receivables
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 reconcili-
ation 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 meth-
ods 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 trans-
fers 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 transac-
tions 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 liabili-
ties.
• 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).
6.4. Cash and Receivables: Analysis 221
6.4 Cash and Receivables: Analysis
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 is discussed
elsewhere in this textbook if you need a review.
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 an increasing
sense of concern and vigilance, especially if they drop into the oldest time bucket.
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 perhaps only for particular 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, the majority of all invoices are billed at
the end of the month. If you run the aging report 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 approximately match 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. You can plot the outstanding
accounts receivable balance at the end of each month for the past year, and use it 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
a period of time. If there is a strong recurring trend in this percentage, management may
want to take action. As was discussed earlier, if the percentage of bad debt is increasing,
management may want to authorize tighter credit terms to customers. Conversely, if the
bad debt percentage is extremely low, management may elect to loosen credit terms in
order 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 con-
verted into cash
• Days’ sales uncollected, which measures the number of days that receivables re-
main 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,
2016 2015
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
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,
2016 2015
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:
Cash & cash equivalents + short-term investments + current receivables

Quick Ratio =
Current liabilities
Calculation:
2016 2015
$50,414+$210,664+$4,631 $120,139+$171,605+$7,531
Quick Ratio = $586,216
= .45 $463,372
= .65
As of December 31, 2016, 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 considered to be a reasonable measure of liquidity, then 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 2016, the quick ratio using the shorter
calculation would be:
$574,989 − $104,326
Quick raio = = .80
$586,216
It is clear from the comparative calculations that .80 is significantly higher than the previ-
ously 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, then the
quickness attribute of this ratio becomes a point of concern. 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, then
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 result-
ing from comparison to other factors. Using Best Coffee and Donuts data, we calculate
the following:
Formula:
Net credit sales (or net sales, if unavailable)

A/R turnover =
Average net accounts receivable
Calculation for 2016:
$3,255,533
A/R turnover =
($210,664 + 171,605) ÷ 2
= 17.03 times or every 21.43 days on average (365/17.03 = 21.43)
If the industry standard or the company credit policy is n/30 days, then 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 out-
standing.
Formula:
6.5. IFRS/ASPE Key Differences 227

Accounts receivable (net)
Days’ sales uncollected = × 365
Net sales
Calculation for 2016:

$210,664
Days’ sales uncollected = × 365 = 23.62 days
$3,255,533
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), then 23.62 days compared to the benchmark of forty days (30 days × 1.33)
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 then add trend analysis to see if
these problems have been changing over time.
Item ASPE IFRS

Cash equivalents Equity investments are ex- Preferred shares can be
cluded from this classifica- included if there is a spec-
tion. ified redemption date and
are acquired close to their
maturity date.
Accounts Initially measured at net Same as ASPE
receivable—initial realizable value (net of
measurement trade discounts and sales
discounts, returns and al-
lowances) in lieu of fair
value given their short-term
nature (there is no signifi-
cant interest component).
Accounts Cost in lieu of amortized Same as ASPE

receivable—subsequent cost since there is no
measurement significant interest compo-
nent.
Accounts Impairment is determined Same as ASPE
receivable—impairment by estimating uncollectible
accounts using either ac-
counts receivable or credit
sales as the basis. Direct
write-off of uncollectible ac-
counts directly to bad debt
expense is only used under
limited circumstances.
Short-term notes In lieu of fair value, mea- Same as ASPE
receivable—initial and sured at NRV:
subsequent
measurement
face value plus stated
rate of interest for interest-
bearing notes and face
value which includes inter-
est for non-interest-bearing
notes.
Long-term notes At fair value: Same as ASPE
receivable—initial Interest bearing: Present
measurement 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 Measured at amortized Measured at amortized
receivable—subsequent cost using either the cost using the effective
measurement straight-line method or the interest rate method for
effective interest method interest, discounts, or
for interest, discounts, or premiums.
premiums.
Long-term notes S 3856.17 – if impaired, the If impaired, the receiv-

receivable—impairment receivable is re-measured able is remeasured at the
at the present value of present value of the ex-
the expected cash flows at pected cash flows at the
the current market interest loan’s original effective in-
rate. terest rate.
Long-term notes Capitalized at acquisition Same as ASPE
receivable—transaction and added to discount or
costs premium to be amortized
over life of note.
Derecognition of When the entity has given When substantially all of
receivables up the control of the re- the risks and rewards
ceivables by meeting all have been transferred:
three conditions:
• The contractual rights to
• The transferred assets receive the cash flows
are isolated in the books. is transferred or collected
and immediately passed
• The company does not on to the recipient.
have a repurchase agree-
ment. • The company cannot sell
or pledge any of these
• The receiver (factor) has receivables to any third
the right to pledge or sell parties other than to the
the assets. factor.
Derecognition of If all three conditions met, If condition met, then treat

receivables—sale then treat as a sale, other- as a sale, otherwise as a
without recourse wise as a secured borrow- secured borrowing.
ing.
Derecognition of If all three conditions met, Treat as a secured borrow-
receivables—sale with then treat as a sale, other- ing.
recourse wise as a secured borrow-
ing.
Disclosure of receivables Are to provide information Are to provide information

about: about:
• the significance of finan- • the significance of finan-

cial instruments cial instruments
• the nature and extent of • the nature and extent of

risks arising from finan- risks arising from finan-
cial instruments cial instruments
Less disclosure require- More information required

ments than IFRS. than ASPE, including
a reconciliation of any
changes in the allowance
account and extensive
disclosures regarding
securitization transactions.
Analysis of receivables Three financial tools: Same as ASPE
• An accounts receivable
aging report
• Trendline analysis
• Ratio analysis
6.6 Appendix A: Review of Internal Controls, Petty

Cash, and Bank Reconciliations
Internal Control
Assets are the lifeblood of a company. As such, they 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 recordkeeping, pro-
duces 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 recordkeeping functions and control of assets, and em-
ployees’ work is checked by others. The use of electronic recordkeeping systems does
not decrease the need for good internal controls.
6.6. Appendix A: Review of Internal Controls, Petty Cash, and Bank Reconciliations 231
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 cir-
cumvent internal control systems for personal gain. Sometimes, employees cooperate in
order 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 a particular type of asset 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 trans-
mitted 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
afterward, 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 disburse-
ments). 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 respon-
sible 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 prepared for the amount of the fund. 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 then issued to reimburse the petty cash
fund. At any given time, the petty cash amount should consist of cash and supporting
receipts, all totalling the petty cash fund amount. To demonstrate the management of a
petty cash fund, assume that a $200 cheque is issued for the purpose of establishing a
petty cash fund.
The journal entry is:
General Journal
Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
To establish the $200 petty cash fund.
Petty Cash is a current asset account. When reporting Cash on the financial statements,
the balances in Petty Cash and Cash are added together and reported 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.
General Journal
Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Postage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Office Supplies Expense3 . . . . . . . . . . . . . . . . . . . 55
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
To reimburse the petty cash fund.
The petty cash receipts should be cancelled at the time of reimbursement in order 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:
General Journal
Postage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Office Supplies Expense . . . . . . . . . . . . . . . . . . . . 55
Cash Over/Short Expense . . . . . . . . . . . . . . . . . . 2
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
To reimburse the petty cash fund and ac-
count for the $2.00 shortage.
Notice that 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:
3
An expense is debited instead of Office Supplies, an asset, because the need to purchase supplies
through petty cash assumes the immediate use of the items.
General Journal
Postage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Office Supplies Expense . . . . . . . . . . . . . . . . . . . . 55
Cash Over/Short Expense . . . . . . . . . . . . . . . 4
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
To reimburse the petty cash fund and ac-
count for the $4.00 overage.
Again, notice that 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.
General Journal
Postage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Petty Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
To reimburse the petty cash fund and reduce
it by $75.
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 pro-
vides 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 particular company usually differs from
the bank cash balance of that company. 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 recon-
ciliation 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 a number of 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 as a result 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 as a result 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 rec-
onciling 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 actually $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 as a result 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.
Cash Acct. No. 101

Date Description Debit Credit DR/CR Balance
2015
Mar. 31 Balance DR 20673 -

Apr. 30 April cash receipts 9482 - DR 30155 -
30 April cash payments 8226 - DR 21929 -
Remember, ‘DR’ (debit) denotes a

positive cash balance in the far right-
hand column of the general ledger.
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.
PER COMPANY RECORDS PER BANK RECORDS
Outstanding cheques
at March 31:
Step 1a: March 31
Cheque No. Amount outstanding cheques
580 $4,051 x are compared with
599 196 x cheques cashed to
see if any are still
600 7x outstanding at April
30. Cleared items are
marked with an ‘x’.
Cheques written
during month of April:
Cheque No. Amount
Step 1b: Cheques The BDCC bank statement for the
601 $ 24 x written are compared month of April is as follows:
602 1,720 x with the cleared
603 230 x cheques on the bank
statement to identify
604 200 x which ones have Second Chartered Bank
605 2,220 x not cleared the bank Bank Statement
(outstanding cheques).
606 287 Cleared items are for Big Dog Carworks Corp.
607 1,364 marked with an ‘x’. For the Month Ended April 30, 2015
608 100
609 40 Deposits/ Balance
Step 2: Other charges
610 1,520 made by the bank are Cheques/Charges/Debits Credits 24,927
611 124 x identified (SC=service 4,051 x 1,570 22,446
612 397 x charge; NSF=not 196 x 24 x 230 x 390 22,386
sufficient funds).
$8,226 200 x 22,186
124 x 397 x 7x 21,658
2,220 x 180 NSF 5,000 24,258
Deposits made for 1,720 x 31 1,522 24,029
the month of April: 6 SC 24,023
Date Amount
April 5 $1,570 x
10 390 x Step 3: Deposits Step 5: Remaining items are identified and
23 5,000 x made by the company resolved with the bank.
are compared with
28 1,522 x deposits on the bank
30 1,000 statement to determine
outstanding deposits at Step 4: Outstanding deposits from March 31
$9,482 are compared with the bank statement to see
April 30. Cleared items
are marked with an ‘x’. if they are still outstanding at April 30. (There
were no outstanding deposits at March 31.)
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,
2015:
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:
a. 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.
b. 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.
a. 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.
b. An examination of the April 30 bank statement shows that the bank had also de-
ducted 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.
Big Dog Carworks Corp.

Bank Reconciliation
At April 30, 2015
Book balance at Apr. 30 $21,929 Bank statement balance at Apr. 30 $24,023

Add: Outstanding deposit 1,000
Cheque deducted in error 31
25,054
Less: Bank charges $6 Less: Outstanding cheques
NSF Cheque – J. Donne 180 186 Cheque No. Amount
606 $ 287
607 1,364
608 100
609 40
610 1,520 3,311
Adjusted book balance at Apr. 30 $21,743 Adjusted bank balance at Apr. 30 $21,743
These balances must agree.
Reconciling items in this section require Reconciling items in this section do

journal entries to be made in the general not require journal entries because
journal to correct the unreconciled Cash the outstanding deposits and cheques
balance of $21,929 in the general ledger should clear the bank next month, in
to the reconciled balance of $21,743. May. Additionally, the other reconciling
items (e.g., the $31 cheque deducted in
error) must be reported to the bank so it
can make the necessary corrections to
Big Dog’s account in the next month.
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.
Book balance at Apr. 30 $21,929 Bank Service Charges Expense . . . . . . . . . . . . . 6

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
To record service charges from April 30 bank
Less: Bank charges $6 reconciliation.
NSF Cheque – J. Donne 180 186
Accounts Receivable – J. Donne . . . . . . . . . . . . 180
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
To record NSF cheque from April 30 bank reconciliation.
Adjusted book balance at Apr. 30 $21,743
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 illus-
trated in Figure 6.4.
Bank Service Charges Expense . . . . . . . . . . . . . . . . . . . 6

Accounts Receivable – J. Donne. . . . . . . . . . . . . . . . . . . 180
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
To record reconciling items from April 30 bank reconciliation.
Cash Acct. No. 101

Date Description Debit Credit DR/CR Balance
2015
Mar. 31 Balance DR 20673 -

Apr. 30 April cash receipts 9482 - DR 30155 -
30 April cash payments 8226 - DR 21929 -
30 Bank charge expense 6- DR 21923 -
30 NSF cheque 180 - DR 21743 -
This adjusted cash balance now

agrees with the bank reconciliation.
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.
Chapter Summary
LO 1: Describe cash and receivables, and explain their role in

accounting and business.
Companies usually have significant amounts of accounts receivable and the timeframe
and effort required to convert receivables to cash is a cycle that calls for regular mon-
itoring 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 signif-
icant 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).
Chapter Summary 245
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, which is defined as their
present value (a discounted cash flows concept). Subsequently they are measured at
amortized cost. Categories include trade (accounts) receivable, notes receivable, and
nontrade 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 re-
porting 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 in reality 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 employ-
ees, 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 receiv-
ables 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, amor-
tized 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 regarded 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.
References 247
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 analysed 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.
References
Apple Inc. (2013). Annual report for the fiscal year ended September 28, 2013. Re-
trieved from http://files.shareholder.com/downloads/AAPL/3038213857x0x701402/a
406ad58-6bde-4190-96a1-4cc2d0d67986/AAPL_FY13_10K_10.30.13.pdf
IFRS. (2015). International Financial Reporting Standards 2014. London, UK: IFRS
Foundation Publications Department.
International Accounting Standards. (2003). IAS 39—Financial instruments: Recognition

and measurement. Retrieved from http://www.iasplus.com/en/standards/ias/ias39
Jobst, A. (2008). What is securitization? Finance & Development, 45(3), 48–49. Re-
trieved from http://www.imf.org/external/pubs/ft/fandd/2008/09/basics.htm
Exercises
EXERCISE 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.
a. Chequing account balance $600,000
b. Short-term (60-day) treasury bills $22,000
c. Cash advance received from a customer $2,670
d. Cash advance of $5,000 to company executive, payable on demand
e. Refundable deposit of $13,000 paid to developer to guarantee performance on a

construction contract
f. Cash restricted for future plant expansion $545,000
g. Certificate of deposit $575,000, maturing in nine months
h. Utility deposit paid to utility company $500
i. Cash advance to subsidiary $100,000
j. Post-dated cheque from customer $30,000
k. Cash restricted to maintain compensating balance requirement $115,000, consid-

ered to be significant
l. Certified cheque from customer $13,000
m. Postage stamps on hand $1,115
n. Savings account balance $545,000 and overdraft in special chequing account at

same bank as normal chequing account $25,000
o. Cash held in non-current bond sinking fund $150,000
p. Petty cash fund $1,200
q. Cash on hand $13,000
r. Money-market balance at mutual fund with chequing privileges $75,400
s. NSF cheque received from the bank for a customer $8,000

Exercises 249
EXERCISE 6–2
Below is financial information for Overachiever Ltd. The company’s year-end is December
31.
i. 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.
ii. The company must maintain a minimum cash balance of $175,000 with First Royal
Bank in order to retain its overdraft privileges.
iii. A separate cash fund for $2 million is restricted for the retirement of long-term debt.
iv. There are five cash floats for retail operation cash registers for $250 each.
v. Currency and coin on hand amount to $15,000.
vi. The petty cash fund has $1,500.
vii. The company has received a cheque dated January 18, 2015, in the amount of
$12,500 from a customer for an amount owing as at December 31.
viii. The company has received a cheque dated January 12, 2015, 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, 2015.
ix. 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 ex-
pense reports after they travel.
x. An employee owes $2,300 that was borrowed from the company and will be withheld
from his salary in January 2015.
xi. The company has invested $2.5 million in money market funds (with chequing privi-
leges) maturing in 2 months at the Commercial Bank of British Columbia.
xii. The company has a 180-day treasury bill for $50,000. It was purchased on Novem-
ber 22.
xiii. The company has a 60-day treasury bill for $18,000. It was purchased on December
15.
xiv. The company holds commercial paper for $1.56 million from Ace Furniture Co.,
which is due in 145 days.
xv. 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, 2015.
Required:
a. Prepare a partial statement of financial position (balance sheet) as at December 31,

2015, reporting any cash balances.
b. For any items not reported in (a) above, indicate the proper way to disclose them.
EXERCISE 6–3
Amy Glitters Ltd. provides you with the following information about its accounts receivable
at December 31, 2015:
Due from customers, of which $30,000 has been pledged as security for a bank loan $275,000
Instalment accounts due after December 31, 2016 50,000
Advances to employees 2,500
Advances to a related party (originated in 2010) 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.
EXERCISE 6–4
From July 1 to August 30, 2015, 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.
Exercises 251
Required:
a. Prepare the entries for Busy Beaver Computers Ltd., assuming the gross method is
used to record sales and cash discounts.
b. 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.
EXERCISE 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:
a. Estimate the ending accounts receivable that should appear in the ledger. Calculate
any shortages, if any. Assume that all sales are made on account.
b. What controls can be put in place to prevent theft?
EXERCISE 6–6
The trial balance before adjustment of Cyncrewd Inc. shows the following balances:
Dr. Cr.
Allowance for doubtful accounts (AFDA) 2,340
Credit sales 375,000
Sales returns 35,000
Required:
a. 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 follow-
ing 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.
b. What could account for the unadjusted debit balance in the AFDA account for $2,340?
EXERCISE 6–7
At January 1, 2015, the credit balance of Reimer Corp.’s allowance for doubtful accounts
was $575,000. During 2015, the bad debt expense entry was based on a percentage
of net credit sales. Net sales for 2015 were $16 million, of which 75% were on account.
Based on the information available at the time, the 2015 bad debt expense was estimated
to be 1% of net credit sales. During 2015, uncollectible receivables amounting to $40,000
were written off against the allowance for doubtful accounts. The company has estimated
that at December 31, 2015, based on a review of the aged accounts receivable, the
allowance for doubtful accounts would be properly measured at $500,000.
Required:
a. Prepare a schedule calculating the balance in Reimer Corp.’s allowance for doubtful
accounts at December 31, 2015. Prepare any necessary journal entry at year-end
to adjust the allowance for doubtful accounts to the required balance.
b. If accounts receivable balance at December 31 was $50,950,000, prepare a partial

classified balance sheet at December 31, 2015 for Reimer. What is the net accounts
receivable balance intended to measure?
c. Under what conditions is using the direct write-off method justified?

Exercises 253
EXERCISE 6–8
On May 1, 2015, 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:
a. Prepare Effix’s entries for the note, the interest entries over the five years and the
collection of the note at maturity.
b. Using present value calculations prove that the note yields 8%.
c. Prepare a partial classified balance sheet as at December 31, 2016. 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, 2019?
d. 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, 2015?
EXERCISE 6–9
Below are three unrelated scenarios:
i. 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.
ii. 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%.
iii. On July 1, a one-year 10% note for $115,000 was accepted in exchange for an
unpaid accounts receivable $104,545 from a higher-risk customer. The customer’s
borrowing interest rate at that time was 10%.
Required:
a. Prepare the entries to recognize the notes payable and accrued interest, if any. The
year-end is December 31.
b. 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.
EXERCISE 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:
a. 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.
b. Prepare the interest entry for the first year assuming that Harrison follows ASPE and
uses the straight-line method for interest.
EXERCISE 6–11
On July 1, 2015, 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, 2015. 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:
a. Assuming the transaction does not qualify as a sale, prepare the July 1, 2015 journal
entry for Helim Ltd.
b. Prepare the journal entry for Helim’s collection of $750,000 of the accounts receiv-
able during the period July 1 to September 30, 2015.
c. On July 1, 2015, Helim paid Central Bank the entire amount that was due on the
loan.
d. Explain the differences between IFRS and ASPE regarding the sale of receivables
compared to a secured borrowing.
Exercises 255
e. Explain if management would prefer the transaction to be reported as a sale of

receivables or a secured borrowing and why.
EXERCISE 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.
EXERCISE 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, 2015. Holistic Financing as-
sesses 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:
a. Assuming that the conditions for a sale are met, prepare the journal entry on Febru-
ary 1, 2015, for Jertain to record the sale of receivables, assuming the recourse
obligation has a fair value of $10,000.
b. What effect will the factoring of receivables have on calculating the accounts receiv-
able turnover for Jertain?
EXERCISE 6–14
On July 1, 2015, 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 promis-
sory 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, 2015, 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:
a. Prepare the journal entries to record the three notes receivable for Brew It Again Ale
Co. for 2015 fiscal year.
b. 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.
c. From Brew It Again Ale’s perspective, what are the advantages of an instalment note
compared with a non-interest-bearing note?
EXERCISE 6–15
The following information below relates to Corvid Company for 2015:
• 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 2015 were $12,500. The AFDA account ending balance for
2015 needed no further adjustment for estimated uncollectible accounts at year-end.
Required:
a. Calculate Corvid Company’s accounts receivable turnover ratio for the year. How
old is the average receivable?
b. Use the turnover ratio calculated in part (a) to analyze Corvid Company’s liquidity.
The turnover ratio last year was 5.85.
EXERCISE 6–16
Exercises 257
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:
a. Prepare the journal entries for both companies.
b. 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.
EXERCISE 6–17
Opal Co. Ltd. transfers $400,000 of its accounts receivable to an independent trust in a
securitization transaction on July 11, 2015, 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, 2015, for Opal Co. Ltd. to record the
securitization of the receivables, assuming it follows ASPE.
Chapter 7
Inventory
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)
259
260 Inventory
LO 1: Define inventory and identify those characteristics that distinguish it from other
assets.
LO 2: Identify the types of costs that should be included in inventory.
LO 3: Identify accounting issues and treatments applied to inventory subsequent to its

purchase.
3.1 Describe the differences between periodic and perpetual inventory systems.
3.2 Identify the appropriate criteria for selection of a cost flow formula and apply
different cost flow formulas to inventory transactions.
3.3 Determine when inventories are overvalued and apply the lower of cost and
net realizable value rule to write-down those inventories.
LO 4: Describe the presentation and disclosure requirements for inventories under both
IFRS and ASPE.
LO 5: Identify the effects of inventory errors on both the balance sheet and income
statement and prepare appropriate adjustments to correct the errors.
LO 6: Calculate estimated inventory amounts using the gross profit method.
LO 7: Calculate gross profit margin and inventory turnover period and evaluate the sig-
nificance of these results with respect to the profitability and efficiency of the
business’s operations.
LO 8: 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.
1.0 Definition
2.0 Intial Recognition Inventory

and Measurement Accounting Systems
3.0 Subsequent
Recognition and Cost Flow Assumptions
Measurement
The Problem of
4.0 Presentation
Overvaluation
and Disclosure
Inventory
5.0 Inventory Errors
6.0 Estimating Inventory
7.0 Inventory Analysis
8.0 IFRS/ASPE
Key Differences
7.1 Definition
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
262 Inventory
by the business. The definition also recognizes that for manufacturing businesses, inven-
tory 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 var-
ious 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.
7.2 Initial Recognition and Measurement
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?

7.2. Initial Recognition and Measurement 263
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 inven-
tories. 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
264 Inventory
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 nonproduction 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.
7.3. Subsequent Recognition and Measurement 265
7.3 Subsequent Recognition and Measurement
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.
7.3.1 Inventory Accounting Systems
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 tech-
nologies 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 pe-
riod, 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.
266 Inventory
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.
7.3.2 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 inven-
tory 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.
Weighted Average Cost
This technique can be applied to either periodic or perpetual inventory systems by calcu-
lating the weighted 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 11 Sale 150 units
May 25 Sale 375 units
May 31 Ending inventory 325 units
Inventory and cost of goods sold would be calculated as follows:
Date Purchase Sale Balance Moving Balance of

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
1
The moving average after each transaction is calculated as the total inventory balance divided by the
total number of units remaining. The calculation of cost of goods sold and ending balances are out slightly
due to rounding differences.
268 Inventory
The total cost of goods sold for the period is ($467.50 + $1,193.30) = $1,660.80, 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.
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
($450.00 + $1,176.25) 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.
270 Inventory
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 as-
sumptions 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.
7.3.3 The Problem of Overvaluation
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:
General Journal
Loss due to decline in inventory value . . . . . . . 200
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
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. How-
ever, 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
272 Inventory
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.
7.4 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.
7.5. Inventory Errors 273
7.5 Inventory Errors
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, 2014, 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, 2015, would have also been
understated, which would have resulted in an understatement of cost of goods sold
for 2015. Thus, over a two-year period, net income would have been understated by
$7,000 in 2014 and overstated by $7,000 in 2015. 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, 2014, 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 2014 books, it would have been corrected as
follows:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . 7,000
274 Inventory
If the error was not discovered until after the 2014 books were closed, it would have been
corrected as follows:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . 7,000
After 2015, as noted above, the error would have corrected itself, so no adjustment would
be required. However, the 2014 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 Decem-
ber 31, 2014, 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 2015,
the vendor may have issued a replacement invoice when they realized PartsPeople hadn’t
paid for the shipment. When PartsPeople recorded the invoice in 2015, 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 2014 (and before a replacement invoice is issued by the vendor), it would have
been corrected as follows:
General Journal
If the error was not discovered until after the 2014 books were closed, it would have been
corrected as follows:
General Journal
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, 2014. 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
7.6. Estimating Inventory 275
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 under-
statement of year-end inventory. The net effect of the two errors is a $900 − $500 = $400
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 2014, the entry to correct them would be as follows:
General Journal
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
If the errors were not discovered until after the 2014 books were closed, they would have
been corrected as follows:
General Journal
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
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.
7.6 Estimating Inventory
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
276 Inventory
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 rela-
tionships 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, 2014, 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, 2014, was reported at a cost of $250,000, which was verified
by a count. As well, assume that between January 1 and May 17, 2014, 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 (25% × $1,200,000) $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 tech-
nique. 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
2014, 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
7.7. Inventory Analysis 277
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.
7.7 Inventory Analysis
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:
Gross profit
Gross profit margin = × 100
Sales revenue
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):
278 Inventory
Year Ended Year Ended

December 31, 2016 December 31, 2015
Sales $ 136,200 $ 140,100
Cost of sales 123,400 125,300
Gross profit $ 12,800 $ 14,800
Sales declined slightly in 2016 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 2016 = 9.40%

Gross profit margin 2015 = 10.56%
Although the gross profit margin dropped by only 1.16 percent between years, this rep-
resents 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, man-
agement 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:
Average inventories held

Inventory turnover period = × 365
Cost of sales
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): 2016–$7,860, 2015–$7,700, 2014–$7,360.
Using the formula above, we can determine the following inventory turnover periods:
2016: 23.01 days

2015: 21.94 days
(Note that the average inventories amount was calculated as the simple average of open-
ing 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.
IFRS ASPE
Biological assets that produce a har- No specific standard exists for biological
vestable product are accounted for under assets or agricultural produce.
the provisions of IAS 41.
Disclosures regarding categories of in- Disclosures regarding categories of inven-
ventories and accounting policies are tories and accounting policies used are
required. As well, further disclosures required.
regarding qualitative reasons for write-
downs are required.
Chapter Summary
280 Inventory
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 sys-
tems.
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.
Chapter Summary 281
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 appro-
priate with inventory items whose characteristics uniquely differentiate them from other
inventory units. For homogenous 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 com-

pany 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. Account-
ing 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
282 Inventory
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 understand-
ing 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 prod-
ucts 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 inven-
tory turnover period can identify problems with the efficiency movement of inventories,
Exercises 283
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.
References
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/De
sktop/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.iasp

lus.com/en/standards/ias
Exercises
EXERCISE 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

284 Inventory
• 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
EXERCISE 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
EXERCISE 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:
a. If the company produces 105,000 units in a year, how much total fixed overhead
should be allocated to the inventory produced?
b. If the company produces 30,000 units in a year, how much total fixed overhead
Exercises 285
c. If the company produces 160,000 units in a year, how much total fixed overhead
EXERCISE 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 $560
Sale, May 15 15
Sale, May 25 23
Closing inventory, May 31 42
Required: Segura Ltd. uses a perpetual inventory system. Using the FIFO cost flow
assumption, calculate the cost of goods sold for the month of May and inventory balance
on May 31.
EXERCISE 7–5
Refer to the information in the previous question.
Required: Assume that Segura Ltd. uses the moving average cost flow assumption
instead. Calculate the cost of goods sold for the month of May and the inventory balance
on May 31.
EXERCISE 7–6
The following chart for Severn Ltd. details the cost and selling price of the company’s
inventory:
286 Inventory
Description Category Cost ($) Selling

Price ($)
Brake pad #1 Brake pads 159 140
Total brake pads 334 320
Soft tire Tires 325 337

Hard tire Tires 312 303
Total tires 637 640
Required:
a. 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.
b. 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.
EXERCISE 7–7
Hawthorne Inc. identified the following inventory errors in 2015.
a. Goods were in transit from a vendor on December 31, 2015. The invoice cost was
$82,000 and the goods were shipped FOB shipping point on December 27, 2015.
The goods will be sold in 2016 for $135,000. The goods were not included in the
inventory count.
b. On January 6, 2016, a freight bill for $6,000 was received. The bill relates to
merchandise purchased in December 2015 and two-thirds of this merchandise was
still in inventory on December 31, 2015. The freight charges were not included in
either the inventory account or accounts payable on December 31, 2015.
c. Goods shipped to a customer FOB destination on December 29, 2015, were in
transit on December 31, 2015, and had a cost of $27,000. When notified that the
customer had received the goods on January 3, 2016, Hawthorne’s bookkeeper
issued a sales invoice for $42,000. These goods were not included in the inventory
count.
d. Excluded from inventory was a box labeled “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.
Exercises 287
Required: Determine the effect of each of the above errors on both the balance sheet ac-
counts at December 31, 2015, and the reported net income for the year ended December
31, 2015 and complete the table below.
Item Inventory A/R A/P Net Income

A
B
C
D
Total
EXERCISE 7–8
Refer to the information provided in the previous question.
Required:
a. Assume the books are still open for 2015. Provide any required adjusting journal
entries to correct the errors.
b. How would the adjustments change if the books are now closed for 2015?
EXERCISE 7–9
Wormold Industries suffered a fire in its warehouse on March 4, 2016. 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, 2016, to March 4, 2016, accounting records showed the
following:
Purchases $650,000
Purchase returns 16,000
Sales revenue 955,000
The inventory balance on January 1, 2016, was $275,000, and the company has histori-
cally earned a gross profit percentage of 35%.
Required: Use the gross profit method to determine the cost of inventory damaged by
the fire.
288 Inventory
EXERCISE 7–10
Bollen Custom Automobile Mfg. reported the following results (all amounts are in millions
USD):
2015 2014
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 2013 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.
Chapter 8
Intercorporate Investments
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.
289
290 Intercorporate Investments
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 sim-
plify the terminology, this chapter will refer to this statement as the historically
generic term balance sheet.
Chapter 8 Learning Objectives 291
LO 1: Describe intercorporate investments and their role in accounting and business.
LO 2: Identify and describe the three types of non-strategic investments.
2.1 Held-for-trading (HFT) classification and accounting treatment.

2.2 Available-for-sale (AFS) classification and accounting treatment.
2.3 Held-to-maturity (HTM) classification and accounting treatment.
LO 3: Identify and describe the three types of strategic investments.
3.1 Investments in associates classification and accounting treatment.

3.2 Investments in subsidiaries classification and accounting treatment.
3.3 Investments in joint arrangements general overview.
LO 4: Explain disclosures requirements for intercorporate investments.
LO 5: Identify the issues for stakeholders regarding investment analyses of performance.
LO 6: 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 subse-
quently), reported, and analyzed. Canada has two IFRS standards in effect: the current
IAS 39 and the proposed IFRS 9, which is currently optional. Add the ASPE standard to
the mix, and together this creates yet more complexity to an already complex area. The
purpose of this chapter is to present the information about intercorporate investments in
a clear and concise manner.
1.0 Intercorporate
Investments: Overview Held-for-Trading (HFT)
2.0 Non-Strategic Available-for-Sale (AFS)

Investments
Held-to-Maturity (HTM)
Intercorporate
Investments
Associate (Significant
Influence)
Subsidiary
3.0 Strategic Investments
(Control)
4.0 Disclosures Joint Arrangements
5.0 Analysis
6.0 IFRS/ASPE
Key Differences
8.1 Intercorporate Investments: Overview
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 institu-
tions 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, perhaps as a hedge against
8.1. Intercorporate Investments: Overview 293
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 investment
revenue. These are all examples of non-strategic investments where the prime reason
for investing is to increase company revenues 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 board of directors’ investing, financing and operating decisions and hence the
operations of the investee company. Strategies to purchase shares of a manufacturer,
wholesaler, or customer company can strengthen relationships, thereby guaranteeing a
source of raw materials or increased 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 signifi-
cant 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? These are all relevant accounting issues that will be examined in this
chapter.
The accounting standards also have their own issues. As mentioned in the opening
paragraph, IFRS currently has the existing standard, IAS 39, and a proposed replacement
standard, IFRS 9. The latest implementation date for IFRS 9 to replace IAS 39 has been
delayed until January 1, 2018, but companies can choose to adopt IFRS 9 early (IFRS,
(2011). In other words, Canada currently has ASPE plus two IFRS standards—so three
in total. It is not surprising that accounting for investments has become so complex!
As a point of interest, below is a brief comparison between IAS 39 and the proposed IFRS
9.
Note: The chapter material and the end-of-chapter questions will focus on IAS 39 and
ASPE, since these are the two standards that are currently mandatory at the time of this
writing.
Non-Strategic Investments
Summary of significant changes from IAS 39 to the proposed IFRS 9
Description IAS 39 (currently in use) IFRS 9 (proposed for 2018 but is
currently an option)
Classification basis Rules based: driven by the trad- Principles-based: driven by the
ing intent for each financial as- nature of the investment such
set by management as its cash flow characteristics
and the business model in which
an asset is held
Classification categories: three Held-for-trading (HFT), Fair value through profit and loss
categories for each standard Available-for-sale (AFS), Held- (FV-PL), fair value through OCI
to-maturity (HTM) (FV-OCI), amortized cost (AC)
Available-for-sale/FV-OCI classi- Can be for debt or equity For equity instruments. Once
fication instruments. Unrealized the designation is made, it
gains/losses in fair value is irrevocable. Unrealized
reported through OCI. When gains/losses in fair value are
sold, realized gains/losses reported through OCI. When
reclassified and reported sold, realized gains/losses are
through net income reclassified from OCI to retained
earnings with no recycling
through net income
Impairment Has multiple impairment models Has one impairment model
(Source: IFRS, 2014)
Investments are financial assets. Chapter 6: Cash and Receivables, defines financial
assets to include those that have contractual rights to receive cash or other financial
assets from another party. Examples of intercorporate investments (investments in other
companies) include the purchase of 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 will report these purchases as
investment assets, while the company whose bonds or shares were purchased 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
included in the investment asset except for Held-for-trading (HFT) or Subsidiary (Control)
investments where they are expensed as incurred.
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 (IAS 39) and ASPE.
Classification
of Investments
Non-Strategic Strategic Investments

Investments (voting shares)
Equity Instruments
(less than 20% Debt Instruments
ownership)
***IFRS ONLY ***IFRS ONLY Associate

Held-For- Held-For- Held-To- Subsidiary Joint Operation
Available-For- Available-For- (Significant
Trading (HFT)* Trading (HFT) Maturity (HTM) (Control) (Joint Control)
Sale (AFS) - no Sale (AFS) - no Influence)
- to trade over - to trade over - to hold 50% - 100% various %
specific trading specific trading 20% - 50%
the short term the short term until maturity ownership ownership
intention intention ownership
*includes most derivatives
Note that investments can either be a strategic acquisition of voting shares of another
company in order to influence company’s operating, investing, or financing decisions or
non-strategic in order to earn a return on otherwise idle or under-utilized cash. Within
these two broad categories are six classifications: held-for-trading (HFT), available-for-
sale (AFS), held-to-maturity (HTM), significant Influence, subsidiary, and joint arrange-
ment. The terms HFT, AFS, and HTM are IFRS terms. ASPE uses a more generic
description for its two categories (AFS is only for IFRS companies). For simplicity, this
chapter will use the terms HFT and HTM interchangeably for both standards.
Both standards have identified some percentage of ownership reference points as guide-
lines 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. So, it is clear that these
investments are acquired mainly for the investment return of interest income, dividend
income, and capital appreciation of the investment itself. Share purchases of between
20% and 50% indicate that the investor will likely have significant influence over the
investee company. This acquisition may have been done in order to enhance existing
relationships with suppliers or customers or to guarantee a ready supply of goods from
manufacturers. These percentages are IFRS guidelines and are not immutable or 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 bonded 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 (IAS 39) and ASPE (Sec. 3856) as of February
2015. Note the differences between the accounting standards. For example, ASPE
has two classifications for its non-strategic investments and three classifications for its
strategic investments classifications; IFRS has three classifications in each category.
Focussing on types of instruments, ASPE debt investments such as bonds are accounted
for using amortized cost, whereas for IFRS companies, debt investments can be classified
as HFT, AFS, or HTM, depending on management intent.
Not all categories are commonly used. For example, for both standards, there are cir-
cumstances where the fair value for certain equities purchased is undeterminable. In this
case, for shares without a quoted market price, the cost method would be used. But
IAS 39 goes on to clarify that this would be rare because in all likelihood, a fair value for
unquoted shares is normally possible. For this reason, the balance of the chapter will
categorize equities for IFRS companies as the more common HFT or AFS classifications
debt as HFT, AFS, or HTM.
ASPE IFRS
Nature of investment as either
Classification Trading intention of the investment
debt, equity or derivative1
basis
Classification Accounting Classification Accounting
Treatment Treatment
Non-strategic Investments
Short-term Fair value through Held-for-trading Fair value through
trading net income (HFT): debt, net income
Investments: equities or
equities trading in derivatives
an active market, traded over short
debt or most term
derivatives under
the fair value
option
(classification
irrevocable, once
made)
Available-for- Fair value through
sale (AFS): debt Other
or equities with Comprehensive
no specific trading Income (OCI)
intentions
Equities at cost
All other equities Held-to-maturity Amortized cost
and debt and debt at (HTM): debt
amortized cost held-to-maturity
Strategic Investments – must be voting shares
Significant Choice of equity Associate: Equity method
Influence: method, cost or equities acquired
equities fair value through to influence
net income if company
active market decisions
exists
Subsidiary: Choice of Control: equities Consolidation
equities consolidation, acquired for
equity, cost, or control of
quoted amount if company
active market
exists
Joint Proportionate Joint Proportionate
Arrangement: consolidation, Arrangement: consolidation or
equities equity, or cost equities equity depending
depending upon upon the nature of
the nature of the the joint
joint arrangement arrangement and
and arrangement arrangement
terms terms
1
A derivative is a financial instrument whose value changes according to a specified variable such as a
stock price or interest rate. It requires little or no initial investment and it is settled at a future date.
The accounting entries to acquire and hold investments using fair value, amortized cost,
and cost models are similar for IFRS and ASPE. For this reason and for simplicity, this
chapter uses the IFRS terms HFT, AFS, HTM interchangeably to describe the three classi-
fications for either ASPE or IFRS non-strategic investments. Where there are differences
such as the choice of either straight-line or effective interest rate methods for ASPE or for
impairment evaluation and measurement for certain investments, these will be separately
identified for IFRS and ASPE.
Below are details for each of the six classification categories identified for IFRS above
(five categories for ASPE) with details about how they are measured and reported.
8.2 Non-Strategic Investments
8.2.1 Held-For-Trading Investments (HFT); (ASPE – Short-Term

Trading Investments)
Investments in debt, equity, and derivatives are reported at their fair value at each bal-
ance sheet date with fair value changes recorded in net income. Transactions costs are
expensed as incurred. Any gain (loss) upon sale of the investment is recorded in net
income. HFT investments are reported as a current asset.
These investments are acquired for the purpose of selling in the short term in order to
make short-term profits. Derivatives such as stock options, swaps, futures, and forwards
are also included in this classification because of their higher risk nature which motivates
companies to hold them for only short periods of time. Any debt, equity, or derivative can
be classified as HFT as long as management’s intent is to trade them in the short term
in order to make a profit. For this reason, reporting at fair value is a relevant measure for
this classification and useful for financial statement stakeholders.
Market (fair) values can go up or down while HFT investments are being held until they are
sold. Since they have not yet been sold, these increases and decreases are referred to
as unrealized gains and losses and are reported in net income. Once a sale occurs,
the gain or loss will be realized and reported in the income statement as a gain (loss)
from the sale of the investment. In order to preserve the original cost of the investment,
companies may choose to use a valuation allowance instead of directly changing the
asset carrying value. This is an option for any of the categories discussed in this chapter
and will be illustrated in more detail below.
8.2. Non-Strategic Investments 299
Impairment
Investments are reported at fair value at each reporting date, so no separate impairment
evaluations and entries are required.
The accounting for HFT equity investments such as shares is usually more straight-
forward compared to debt investments such as bonds. Examples of investments in shares
and in debt are illustrated below.
HFT Investments in Shares
Assume that the following equity transactions occurred for Lornelund Ltd. in 2015:
Lornelund Ltd. – Non-Strategic Equity Investments

Dates # of Price per Total
in 2015 Transaction Detail Shares Share Amount
June 1 Purchased Symec Org. shares for $150 per share (transaction 1,000 $150.00 $150,000
costs were an additional $1.25 per share)
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 2016
Jan 10 Sold Symec shares 500 165.70 82,850
The journal entries for the HFT investments are recorded below:
General Journal
Jun 1 2015 HFT investments – Symec shares . . . . . . . . . . . 150,000
Transactions fees expense . . . . . . . . . . . . . . . . . . 1,250
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151,250
Aug 15 2015 HFT investments – Hemiota shares . . . . . . . . . 210,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000
Nov 30 2015 Cash (or Dividend receivable if declared but 6,100

not paid) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . 6,100
Dec 31 2015 HFT investments – Symec shares . . . . . . . . . . . 15,000

Unrealized gain (loss) on HFT invest- 15,000
ments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
($165 − $150) × 1,000
Dec 31 2015 Unrealized gain (loss) on HFT investments . . 5,000

HFT investments – Hemiota shares . . . . . . 5,000
($82 − 84) × 2,500
Jan 10 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,850

HFT investments – Symec shares . . . . . . . . 82,500
Gain (loss) on sale of HFT investments . . 350
For cash amount: ($165.70×500 shares), for
share value: ($165 × 500 shares)
Note that the transactions fees are expensed for HFT 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 HFT 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 HFT investments. The HFT
investment account would appear in the balance sheet as shown below.
Lornelund Ltd.
Balance Sheet
December 31, 2015
Current assets:
HFT investments (at fair value) * $370,000
*($150,000 + 210,000 + 15,000 − 5,000)

As previously mentioned, instead of recording the changes in fair value directly to the
HFT investment account as shown above, companies will often record the changes to a
valuation allowance as a contra account to the HFT 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 used for buildings or equipment.
How they differ is that the HFT investment valuation account can either have a debit or
credit balance, whereas the accumulated depreciation account will have a credit balance.
If a valuation allowance contra account were used, the balance sheet would appear as
follows:
Lornelund Ltd.
Balance Sheet
December 31, 2015
Current assets:
HFT investments (at cost)* $360,000
Valuation allowance for fair value adjustments** $ 10,000
$370,000
* ($150,000 + 210,000)
**($15,000 − 5,000)
Valuation allowance accounts can be used for fair value changes for any investments
accounted for using fair values such as HFT and available-for-sale (AFS) investments.
For HFT investments, recall that there are no separate entries for impairments since fair
values are already being reported.
HFT Investments in Debt
HFT investments can also be bonds, if market fair values are determinable. On January
1, 2015, 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 $521,326.2
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.
2
$521,326 is the present value of the bond’s future cash flows. Since the bond interest is being paid
twice per year, the number of payments is 10 payments (5 years × 2 payments per year) until the bond
matures. The market interest rate is 6% or 3% for each semi-annual interest payment. At maturity, $500,000
principal amount of the bond is payable to the bondholder/investor. The present value can be calculated
using a financial calculator as follows: PV = 17,500 P/A, 3 I/Y, 10 N, 500,000 FV). For a review of present
value techniques, refer to Chapter 6: Cash and Receivables.
Effective Interest Method for 7% Bonds (market/yield rate 6%)

Cash Received Interest Income Amortized Premium
@ 3.5% stated rate @ 3% market rate (decreases
Date for 6 months for 6 months carrying value) Carrying Value
Jan 1, 2015 $521,326
Jul 1 17,500 15,640 1,860 519,466
Jan 1, 2016 17,500 15,584 1,916 517,550
Jul 1 17,500 15,527 1,973 515,577
Jan 1, 2017 17,500 15,467 2,033 513,544
Jul 1 17,500 15,406 2,094 511,450
Jan 1, 2018 17,500 15,344 2,156 509,294
Jul 1 17,500 15,279 2,221 507,073
Jan 1, 2019 17,500 15,212 2,288 504,785
Jul 1 17,500 15,144 2,356 502,429
Jan 1, 2020 17,500 15,073 2,429* 500,000
*rounded
Osterline’s journal entries from January 1, 2015 to July 1, 2016 are

shown below.
General Journal
Jan 1 2015 HFT investments – Waterland bonds . . . . . . . . 521,326
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521,326
Jul 1 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

HFT investments – Waterland bonds . . . . . 1,860
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 15,640
For cash: ($500,000 × 7% × 6 ÷ 12), for
Interest income: ($521,326 × 3%)
Dec 31 2015 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 15,584
For Interest receivable: ($500,000 × 7% ×
6 ÷ 12), for Interest income: (($521,326 −
1,860) × 3%)
Dec 31 2015 Unrealized gain (loss) on HFT investments . . 7,550

($521,326 − 1,860 − 1,916 − 510,000)
General Journal
Jan 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . 17,500
Jul 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 15,527
For Cash: ($500,000 × 7% × 6 ÷ 12),
for Interest income: (($521,326 − 1,860 −
1,916) × 3%)
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 HFT investment (asset) 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 HFT shares example.
The July 1, 2015, 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 HFT 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
in order 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 ($521,326 − 1,860 − 1,916)
and the fair value on that date of $510,000. Since the fair value is less than the
carrying value, this HFT investment (or a valuation allowance) is reduced to its fair
value by $7,550 ($517,550 − 510,000). 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, 2016, 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, 2016, 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, 2016 is shown below.
General Journal
Jul 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000
Gain on sale of HFT bonds . . . . . . . . . . . . . . 26,973
HFT Investment – Waterland bonds . . . . . . 508,027
For cash: ($500,000 × 1.07), for HFT Invest-
ment: ($510,000 − 1,973)
Recall from the journal entries above that on December 31, 2015, the investment had
been reduced to its fair value of $510,000. On July 1, 2016, the interest entry included
amortization of the premium for $1,973, resulting in a carrying value as at July 1, 2016 of
$508,027. The market price point for selling the investment was 107 resulting in a gain of
$26,973.
As a point of interest, 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. Unlike those companies following IFRS,
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.
ASPE companies can choose to use straight-line amortization of the bond premium in-
stead of the effective interest method. If straight-line was used, the amount recorded to
the investment account would be $2,133 ($21,326 ÷ 5 years × 6 ÷ 12) at each interest
date until the investment is sold.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500
HFT Investment – Waterland bonds . . . . . . 2,133
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 15,367
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.
Investments in Foreign Currencies
Investments may be priced in foreign currencies, which must be converted into Canadian
currency for recording and reporting purposes. All classifications of investments in foreign
currencies require this accounting treatment. Illustrated below are the accounting entries
for a HFT investment priced in a foreign currency.
HFT 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 in bonds at par. In Canadian dollars the amount
would be $51,500. The entry to record the purchase would be:
General Journal
HFT Investment – bonds . . . . . . . . . . . . . . . . . . . . 51,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,500
(US $50,000 × 1.03)
At year-end, the fair value for 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 (US $49,000 ×1.05) 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:
General Journal
Unrealized loss on HFT investments . . . . . . . . 1,050
Foreign exchange gain. . . . . . . . . . . . . . . . . . . 1,000
HFT Investment – bonds . . . . . . . . . . . . . . . . . 50
For Unrealized loss: ((US $50,000 − 49,000)
× 1.05), for Foreign exchange gain: (US
$50,000 × (1.05 − 1.03)), for HFT investment:
($51,500 − 51,450)
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:
General Journal
Unrealized loss on HFT investments . . . . . . . . 50
HFT Investment – shares . . . . . . . . . . . . . . . . 50
($51,500 − 51,450)
8.2.2 Available-for-Sale Investments (AFS); (IFRS only)
AFS 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 the
HFT investments (also a fair value concept), transaction costs are usually added to the
carrying amount of the AFS investment. AFS investments are reported as long-term
assets unless it is expected they will be sold within twelve months or the normal operating
cycle.
The available-for-sale investments category exists only for IFRS companies. Manage-
ment considers these as available-for-sale, but with no specific intention to actively trade
them. As a result, AFS is a catch-all category for equity or debt investments (excluding
derivatives) not otherwise specified as HFT or HTM. Since these investments are for sale,
fair value measurement at each reporting date is appropriate with the change recorded
to the investment asset account (or a valuation account). The unrealized holding gain
(loss) is reported in OCI rather than in net income. When the investments are sold,
any gains (losses) resulting from the sale are reported in net income and any unrealized
gain (loss) for that investment is transferred from OCI to net income at that time. Recall
from the chapter on Statement of Income and Statement of Changes in Equity, that OCI
is not included in net income, but rather, it is reported in a separate statement called the
Statement of Comprehensive Income. This means that any unrealized gains (losses) from
holding AFS investments will bypass the statement of net income until the investment is
sold or impaired as will now be discussed. You are encouraged to review the material
regarding the topic of OCI.
Impairment of Investments
For IFRS companies using the AFS category, fair value measurements are required if
there is an indication of impairment of the investment. An impairment is when an event
occurs that triggers a loss in value in between reporting dates; an evaluation must be
undertaken to determine if impairment has indeed occurred. If it has, the impairment is
calculated as the difference between the carrying value at the time of the impairment and
the impaired investment’s fair value (which is the same as the present value of impaired
cash flows using the current interest rate). The carrying value of the investment (or
a valuation account) is reduced to the impaired fair value and the impairment loss is
“recycled” through OCI to net income. As well, any OCI gains (losses) relating to this
investment recorded to OCI are to be reclassified as realized to net income due to the
impairment. Impairment losses can be reversed for debt investments only, but the
recovery amount cannot result in a carrying value balance greater than if there had been
no impairment.
There is more than one way to record an impairment on an AFS investment. For example,
if an investment with an unrealized gain of $15,000 were to become impaired by $5,000

due to a triggering event, the accounting treatment would be:
Method 1 Method 2
AFS Investment (or allowance account) . . . . . . . . . . . . . . . . . . . . . 15,000 15,000
Unrealized gain in AFS investment (OCI) . . . . . . . . . . . . . . . . . . 15,000 15,000
To record the fair value gain in AFS investment.
Loss due to impairment of AFS investment (NI) . . . . . . . . . . . . . . 5,000

Unrealized impairment loss in AFS investment (OCI) . . . . . . . . 5,000
AFS Investment (or allowance account) . . . . . . . . . . . . . . . . . . . 5,000 5,000
To record the impairment loss either to OCI or directly to NI.
Loss due to impairment of AFS investment (OCI) . . . . . . . . . . . . 10,000 15,000

Gain due to impairment of AFS investment (NI) . . . . . . . . . . . 10,000 15,000
Reclassify the related OCI for AFS investment to net income.
For OCI: (15,000 − 5,000)
For method 1, the loss due to impairment of $5,000 is recorded first to OCI. This reduces
the OCI credit from $15,000 to $10,000, which is then reclassified from OCI to net income
(NI). For method 2, the $5,000 loss due to impairment is recorded directly to net income
(NI). The $15,000 previous gain is then reclassified from OCI to net income (NI). Either
method yields the same net result in all the accounts.
Impairment losses can be reversed for debt investments only, but the recovery amount
cannot result in a carrying value balance greater than if there had been no impairment.
For example, assume that the carrying value for an investment in Amherst Ltd. bonds
is $224,000 and that that Amherst experiences prolonged cash flow problems. The net
present value of the impaired expected cash flows for the bonds is determined to be
$200,000. The impairment amount would be $24,000 ($224,000 − $200,000). After three
years, profitability returns to Amherst and the value of the bonds make a full recovery.
If the carrying value at the end of three years was $190,000, had the impairment not
occurred, then the $190,000 is the maximum value that can be reported as the carrying
value for the investment asset. The recovery adjustment amount will limited by this
constraint. This is a good example of where a valuation allowance account to record
impairments separately would preserve the amortized cost without impairment making
the calculation of any potential impairment recovery amount easier.
AFS Investments in Shares
The similarities and differences between HFT and AFS investments journal entries will be
examined next. Using the same example for Lornelund Ltd. used in the HFT investments
above, a comparison between the entries required for HFT and AFS is shown below.
Recall that to qualify, these shares will be actively traded for the HFT category and for
sale with no specific intention for AFS category. The transactions are repeated below but
now include a loss event to trigger an impairment evaluation.
Lornelund Ltd. – Non-Strategic Equity Investments

Dates # of Price per Total
in 2015 Transaction Detail Shares Share Amount
June 1 Purchased Symec Org. shares for $150 per share (transaction 1,000 $150.00 $150,000
costs were an additional $1.25 per share)
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 2016
Jan 10 Sold Symec shares 500 165.70 82,850
Jan 23 A prolonged downturn in the industry sector results in a 2,500 $72 180,000
triggered event loss in the value of the Hemoita shares
investment. The fair value of the impaired shares was
determined to be $180,000.
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 HFT TO AFS

Held-for-trading Available-for-sale
(HFT) (AFS)
2015
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 6,100 6,100
paid) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,100 6,100
Dec 31 Investments – Symec shares . . . . . . . . . . . . . . . . . . . . 15,000 13,750

Unrealized gain (loss) on HFT investments (NI) 15,000
Unrealized gain (loss) on AFS investments 13,750
(OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(HFT: $165,000 − 150,000, AFS: $165,000 −
151,250)
NOTE – Both HFT and AFS shares carrying values for

Symec are $165,000.
Dec 31 Unrealized gain (loss) on HFT investments (NI) . . 5,000

Unrealized gain (loss) on AFS investments (OCI) 5,000

Investments – Hemiota shares . . . . . . . . . . . . . . . . 5,000 5,000
For Investments: (2,500 × ($84 − $82))
NOTE – Both HFT and AFS shares carrying values for

Hemiota are $82 per share × 2,500 = $205,000
2016
Jan 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,850 82,850
Investments – Symec shares . . . . . . . . . . . . . . . . . . 82,500 82,500
Gain (loss) on sale of investments . . . . . . . . . . . . . 350 350
For Cash: ($165.70 × 500 shares), For Invest-
ments: ($165 × 500 shares)
Jan 10 OCI – removal of unrealized gain (loss) due to sale 6,875

Gain on sale of investments . . . . . . . . . . . . . . . . . . . ** 6,875
(($165,000 − 151,250) × 50%)
Jan 23 Loss on impairment AFS investments (OCI) . . . . . 25,000

Investments – Hemiota shares . . . . . . . . . . . . . . . . 25,000
To record the impairment charge. ((2,500×$82)−
$180,000))
Loss on impairment AFS investments (NI) . . . . . . . 30,000
Loss on impairment AFS investments (OCI) . . . 30,000
To reclassify the OCI for impaired shares to net
income. (For NI: ($5,000 + 25,000), for OCI:
($210,000 − 180,000)
Dec 31 Investments – Symec shares . . . . . . . . . . . . . . . . . . . . 650 650

Unrealized gain (loss) on HFT investments (NI) 650
Unrealized gain (loss) on AFS investments 650
(OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
For Investments: (500 × ($165.70 − 167.00))
Dec 31 Unrealized gain (loss) on HFT investments (NI) . . 17,500

Investments – Hemiota shares . . . . . . . . . . . . . . . . 17,500
For Investments: ($205,000 − (2,500 × $75))
Investments – Hemiota shares . . . . . . . . . . . . . . . . . . . 7,500

Unrealized gain (loss) on AFS investments 7,500
(OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
For Investments: ($180,000 − (2,500 × $75))
Lornelund Ltd.
Investment Accounts
2015 and 2016
HFT AFS
Symec Symec
150,000 151,250
15,000 13,750
2015: 165,000 2015: 165,000
82,500 82,500
650 650
2016: 83,150 2016: 83,150
Hemiota Hemiota
210,000 210,000
5,000 5,000
2015: 205,000 2015: 205,000
25,000
17,500 7,500
2016: 187,500 2016: 187,500
Net Income Net Income

1,250 6,100 6,100
15,000
5,000
2015: 14,850 2015: 6,100
350 350
650 6,875
17,500 30,000
2016: 16,500 2016: 22,775
Total loss over Total loss over

two years 1,650 two years 16,675
OCI
13,750
5,000
2015: 8,750
6,875
25,000
30,000
650
7,500
2016: 6,275
Note that for HFT investments, the adjustment to fair values will be on the next reporting
date as noted in the journal entries on December 31. So, the timing and amounts of the
fair value changes will differ between the HFT compared to the AFS investments.
Note also that the transactions fees are expensed for HFT investments but are added
to the carrying value for AFS investments. At December 31 year-end, Lornelund makes
two end-of-period adjusting entries to record the latest fair values changes for each in-
vestment. The fair value for Symec shares increased from $150 to $165 per share
resulting in an increase in the investment value by $15,000 and $13,750 for HFT and
AFS categories respectively. These amounts are different due to the transaction costs
originally recorded to the investment asset of the AFS 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 HFT and AFS investments. Since this was not due
to a specific event loss that would trigger an impairment evaluation, the decrease in fair
value for Hemiota’s shares is recorded to OCI as a normal fair value adjustment.
The investment account and AOCI would appear in the December 31, 2015 balance sheet
and the income statement as shown below. Assume that income tax expense for the
unrealized gain is $2,625 for 2015 and $1,880 for 2016.
Lornelund Ltd.
Balance Sheet
December 31, 2015
Current assets: HFT AFS
HFT investments (at fair value)* $370,000
Long-term assets:
Long-term investment (at fair value) $370,000
Equity:
Accumulated other comprehensive income ** $ 6,125
*HFT ($150,000 + 210,000 + 15,000 − 5,000); AFS ($151,250 + 210,000 + 13,750 − 5,000)
**AOCI ($13,750 − 5,000) less taxes for $2,625
There is no difference in the ending balances of the investment asset accounts under the
HFT and AFS methods on December 31, 2015, because both are reported at fair value at
each reporting date. Even though the transaction costs were initially capitalized under the
AFS method, the year-end fair value adjustment entry for both HFT and AFS investments
resulted in equalizing the investments balances.
Lornelund Ltd.
Income Statement and Comprehensive Income Statement (partial)
HFT AFS
Dividend income $ 6,100 $ 6,100
Unrealized gain ($15,000 – 5,000) 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 AFS investments $ 8,750
Less taxes (2,625) 6,125
At this point, the unrealized gains from holding the HFT investments ($10,000) is signifi-
cantly higher compared to the AFS investments ($8,750 before taxes) due to the different
accounting treatments.
On January 23, a loss event resulted in triggering an impairment evaluation and an impair-
ment charge of $25,000 ($205,000 carrying value − $180,000 fair value at impairment).
Note that method 1 is used where the $25,000 adjustment is initially recorded to OCI,
followed by a second entry reclassifying the total cumulative OCI amount for Hemiota
shares of $30,000 ($5,000 unrealized holding loss + $25,000 impairment loss) from OCI
to net income. When there is an impairment charge, any amounts in OCI for the impaired
investment becomes realized and reported in net income. The only remaining amounts
in OCI as of this date will be for the Symec shares. For the HFT method, fair values are
adjusted at each reporting date, so there is no separate evaluation or impairment entry
on January 23.
At December 31, 2016 year-end, the fair values are once again adjusted for both Symec
and Hemiota investments. Even though the share price for Hemiota’s shares improved
from $72 to $75, recall that impairment losses for AFS equity investments cannot be
reversed, so the unrealized gain of $7,500 is recorded to OCI as is normally the case.
Below is a partial balance sheet and income statement reporting the investment at De-
cember 31, 2016.
Lornelund Ltd.
Balance Sheet
December 31, 2016
Current assets: HFT AFS
HFT investments (at fair value)* $270,650
Long-term assets:
Long-term investment (at fair value) $270,650
Equity:
Accumulated other comprehensive income ** $ 10,520
*HFT ($370,000 − 82,500 + 650 − 17,500); AFS ($370,000 − 82,500 − 25,000 + 650 + 7,500)
**AOCI ($6,125 gain + 4,395 gain)
Lornelund Ltd.
Income Statement and Comprehensive Income Statement (partial)
HFT AFS
Gain on sale of shares $ 350 $ 7,225*
Unrealized loss (16,850)**
Loss on impairment (30,000)
Net loss $ 16,500 $ 22,775

Items that may be reclassified
subsequently to net income or loss:
Unrealized gain from AFS investments $6,275***
Less taxes (1,880) 4,395
Total comprehensive loss $ 18,380
* ($350 + 6,875)
** ($350 + 650 − 17,500)
*** ($30,000 + 650 + 7,500 − 6,875 − 25,000)
For the HFT category, the net loss over two years was $1,650 ($14,850 net income −
$16,500 net loss); the net loss over two years for the AFS category was $16,675
($6,100 net income − $22,775 net loss) with a $10,520 credit in AOCI that is yet to be
realized until the Hemiota and remaining Symec shares are sold.
As can be seen from the illustrations above, there are significant differences in net income
due to the accounting treatments between HFT and AFS investments. Care must be
taken to ensure that these differences are taken into account when analyzing investment
portfolio performance. These differences may also be motivation for managers to reclas-
sify investments to manipulate income or investment asset balances. To minimize this
possibility, reclassifications are limited in IFRS and ASPE as will be discussed later in the
chapter.
AFS Investments in Debt
AFS investments for IFRS companies can also be bonds under the current IFRS standard,
IAS 39, though this classification will be limited to equities only, once IFRS 9 replaces IAS
39 in 2018. In the meantime, as was explained previously for the AFS shares example,
unrealized gains (losses) are recorded to OCI for AFS investments compared to net
income for HFT investments.
Use the same example as for HFT investments in bonds discussed above, where Oster-
line Ltd. purchased 7%, 5-year bonds with a face value of $500,000. On July 1, 2016, just
after receiving the interest, Osterline sells the bonds at the market rate of 107. Osterline’s
journal entries from Jan 1, 2015 to July 1, 2016 using AFS classification are shown below.
Osterline Ltd.
COMPARISON OF HFT TO AFS
Held-for-trading Available-for-sale
(HFT) (AFS)
2015
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: ($500,000 × 7% × 6 ÷ 12), for Interest
income: ($521,326 × 3%)
Dec 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,584 15,584
For Interest receivable: ($500,000 × 7% × 6 ÷ 12),
for Interest income: (($521,326 − 1,860) × 3%)
Dec 31 Unrealized loss on HFT investment (NI) . . . . . . . . . . 7,550

Unrealized gain (loss) on investments (OCI) . . . . . 7,550
For NI: ($521,326 − 1,860 − 1,916 − 510,000)
2016
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,527 15,527
For Cash: ($500,000 × 7% × 6 ÷ 12), for Interest

income: (($521,326 − 1,860 − 1,916) × 3%)
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000 535,000

Gain on sale of Waterland bonds . . . . . . . . . . . . . . 26,973 26,973
For Cash: ($500,000 × 1.07), for Investments:
($510,000 − 1,973)
Jul 1 Loss on sale of investment . . . . . . . . . . . . . . . . . . . . . . 7,550

OCI – removal of unrealized loss due to sale . . 7,550
($521,326 − 1,860 − 1,916 − 510,000)
Osterline
Investment Accounts
2015 and 2016
HFT AFS
Waterland Waterland
521,326 521,326
1,860 1,860
1,916 1,916
7,550 7,550
2015: 510,000 2015: 510,000
1,973 1,973
508,027 508,027
2016: - - 2016: - -
Net Income Net Income

15,640 15,640
15,584 15,584
7,550
2015: 23,674 2015: 31,224
15,527 15,527
26,973 26,973
7,550
2016: 42,500 2016: 34,950
Total gain over Total gain over

two years 66,174 two years 66,174
OCI
7,550
2015: 7,550
7,550
2016: - 7,550
Note the similarities and differences between the HFT and AFS classifications for bonds.
On December 31, there were two adjusting entries as before. The first entry was for the
interest income that has accrued since the last interest payment on July 1, and the second
adjusting entry is for the change in fair values. As was the case for the HFT 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 HFT, the
unrealized gain/loss is reported in net income, whereas for AFS, the unrealized gain/loss
is reported as Other Comprehensive Income and accumulated in the AOCI account (an
equity account) until the investment is sold. Once sold, any AOCI amounts that relate to
the sale of investments are now considered to be realized and are reclassified from AOCI
to net income.
Note that net income of $31,224 for the AFS investment is larger than the net income of
$23,674 under the HFT bonds. This makes intuitive sense since the earlier unrealized
loss of $7,550 for the AFS investment accumulated in the AOCI account until it was sold,
creating a delay in the full loss amount until the sale date.
Calculating impairment losses is done the same way for both AFS equity and debt se-
curities. It is the difference between the carrying value and the impaired fair value. Im-
pairment losses for AFS debt investments can be reversed (but limited as was discussed
previously), unlike AFS equity investment impairments, which cannot be reversed.
8.2.3 Held-To-Maturity Investments (HTM); (ASPE – All Other due to

no active market)
IFRS investments in debt securities such as bonds are reported at their amortized cost at
each balance sheet date. For ASPE companies, debt or equity investments are reported
at amortized cost and cost respectively (unless there’s an active market in equities then
ASPE companies can elect to report at fair value). Transactions costs are added to the
investment (asset) account. HTM 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.
For IFRS companies, 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 a HTM 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 AFS the more appropriate classification for unquoted
equities. 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 HFT investments, shares or bonds may be purchased as
HTM investments for other reasons, such as to strengthen relationships with a supplier or
an important customer.
To summarize the initial and subsequent measurements used for HTM investments:
• Initial purchase is at cost (purchase price) which is also fair value on the purchase
date. Unlike HFT investments, transaction fees are added to the investment (asset)
account. This is because HTM are cost-based investments, so any fees paid to
acquire the asset are to be capitalized similar to property, plant, and equipment,
which are also cost-based purchases. If the investment involves an exchange of
assets, then the investment is initially measured as the fair value for the asset given
up (or the fair value of the asset acquired, if it is more reliable).
• 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. For ASPE companies, they can choose between amortization
using the effective interest rate method or the straight-line method.
• If the investment is impaired, determine the impairment amount by reducing the

investment carrying value to the impaired value. For IFRS, it is the present value of
impaired future cash flows at the original interest rate. For ASPE it 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). Both standards allow
for reversals of impairment.
• Report the investment at its carrying value at each reporting date, net of any impair-
ment. Valuation accounts can be used.
• 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 or loss prior to its removal from the books.
The difference between the carrying value and the net sales proceeds is reported
as a gain or loss on sale (including full or partial recovery of a previous impairment,
if applicable) and reported in net income.
HTM Investments in Debt
In the previous sections discussing HFT and AFS investments, Osterline purchased Wa-
terland bonds on the January 1, 2015, the interest payment date. Assume now that Os-
terline classified this as a HTM investment. The entries would be the same as illustrated
earlier for the HFT category, except to exclude any fair value adjustments.
General Journal
Jan 1 2015 HTM investments – Waterland bonds . . . . . . . . 521,326
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521,326
Jul 1 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

HTM investments – Waterland bonds . . . . 1,860
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 15,640
For Cash: ($500,000 × 7% × 6 ÷ 12), for
Interest income: ($521,326 × 3%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 15,584
6 ÷ 12), for Interest income: (($521,326 −
1,860) × 3%)
Jan 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Jul 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 15,527
For Cash: ($500,000 × 7% × 6 ÷ 12),
for Interest income: (($521,326 − 1,860 −
1,916) × 3%)
Jul 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000

Gain on sale of Waterland bonds . . . . . . . . 19,423
For Cash: ($500,000 × 1.07), for HTM
investments: ($521,326 − 1,860 − 1,916 −
1,973)
Note that the entry to the investment account for the sale of Waterland bonds for the HFT
or AFS methods shown earlier is $508,027 compared to HTM method above for $515,577.
The reason for this difference is due to the fair value adjustment for $7,550 for the HFT
and AFS methods (both fair-value based) but not done for HTM method which is based
on amortized cost.
HTM 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 a HTM investment in bonds that is purchased
between interest payment dates.
On March 1, 2015, 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 ($685,843 ÷ $700,000)
on March 1, 2015. On December 31, 2015 year-end, the fair value of the bond at year-end
is $710,000. Trimliner follows IFRS and intends to hold the investment to maturity (HTM
classification).
Note that the purchase date of March 1 falls in between interest payments on January 1
and July 1. The business practise 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.
$21,000 × 2 ÷ 6 = $7,000
2 months 4 months
0
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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, 2015 and the first interest payment on July 1, 2015, 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.
General Journal
Mar 1 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
HTM investment – Zimmermann bonds . . . . . . 685,843
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 692,843
For Interest receivable: ($700,000×6%×2÷
12)
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

HTM investment – Zimmermann bonds . . . . . . 814
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 14,814
For Cash: ($700,000 × 6% × 6 ÷ 12), for
Interest income: ($685,843 × 6.48% × 4 ÷ 12)
The net interest income recorded by Trimliner is $14,814 on July 1 ($685,843 × 3.24% ×
4 ÷ 6), 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 HTM bonds, there are no entries to adjust the HTM investment to fair
value at year-end. The fair value information of $710,000 on December 31, 2015,
that was provided in the question data is not relevant for HTM investments.
General Journal
HTM investments – Zimmermann bonds . . . . 1,248
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 22,248
12), for Interest income: (($685,843 + 814) ×
6.48% × 6 ÷ 12)
Jan 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Jul 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

HTM investments – Zimmermann bonds . . . . 1,288
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 22,288
For Interest income: (($685,843 + 814 +
1,248) × 6.48% × 6 ÷ 12)
When the bonds mature at the end of five years, the entry to record the proceeds of the
sale is shown below.
General Journal
Jan 1 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000
HTM investment – Zimmermann bonds . . 700,000
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 ($700,000 − 685,843) will be amortized over five years.
The amortization amount for the July 1 entry would be for four months or $944 ($14,157 ÷
5 years × 4 ÷ 12). After that, the amortization will be for every six months or $1,416
($14,157 ÷ 5 × 6 ÷ 12).
HTM Impairment
To recap, HFT investments are based on fair value at each reporting date, so there is no
separate impairment evaluation or measurement. AFS investments are also reported at
fair value but could incur a separate impairment charge if a loss event triggers the need
for an impairment evaluation. For HTM investments, impairment evaluations are done if
a loss event occurs as a trigger. However, the impairment measurements are different for
IFRS compared to ASPE, and will now be discussed.
Since HTM investments are measured at amortized cost (IFRS and ASPE) for bonds
and cost (ASPE) 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 HTM investments for IFRS
and ASPE companies are measured:
• IFRS—reduce the investment carrying value to the present value of impaired esti-
mated future cash flows, discounted using the original effective interest rate.
• 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.
In both cases, the loss is reported in net income and the investment (or valuation al-
lowance) is reduced accordingly. These impairments may be reversed for both IFRS
and ASPE, though the reversal is limited, as has been previously explained in the AFS
Investments – impairment section.
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:
Present value of impaired cash flows using the current market rate $190,000
Net realizable value either through sale or by exercising
the investor’s rights to sell any collateral 185,000
Present value of impaired cash flows using the original effective
interest rate 180,000
For companies following IFRS, the entry for the HTM investment in bonds would be:
General Journal
Loss on impairment of HTM investments . . . . 20,000
HTM Investment – Forsythe bonds . . . . . . . 20,000
Using original effective interest rate:
($200,000 − 180,000)
For companies following ASPE, the entry for the HTM investment in bonds would be:
General Journal
Loss on impairment of HTM investments . . . . 10,000
HTM Investment – Forsythe bonds . . . . . . . 10,000
Present value using higher of the current in-
terest rate of $190,000 and the net realizable
value of $185,000: ($200,000 − 190,000)
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 HFT, AFS, and HTM methods. It is easy
to see how this might lead to manipulation of net income or asset values by management.
To minimize this possibility, IFRS restricts reclassifications in or out of HFT investments.
Also, IFRS restricts reclassifications out of HTM to AFS to prevent manipulation of the
balance sheet. For ASPE companies, the fair value after initial designation is irrevocable.
For example, management could reclassify any investments with profits from HTM to AFS
and leave the investments with losses in HTM. This would result in all unrealized losses
being recorded in net income, while any unrealized profits would bypass net income since
AFS records unrealized holding gains/loss to OCI until the investment is sold. This might
be done to avoid taxes. To prevent manipulation of net income, if a reclassification from
HTM to AFS before maturity occurs, then all remaining HTM investments must also be
reclassified to AFS and no further reclassifications to HTM are allowed for two subsequent
fiscal years.
8.3 Strategic Investments
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.
Strategic Investments
(voting shares)
Subsidiary
Associate
(Control) Joint Arrangements
(Significant Influence)
50% - 100% various % ownership
20% - 50% ownership
ownership
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 invest-
ments (HFT, AFS, and HTM) 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 signif-
icant 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.
8.3. Strategic Investments 325
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 (IFRS 11) 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.
With regard to strategic investments—why would an investor want to influence or control

another company? If the investee company has resources that would enhance the oper-
ations 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.
8.3.1 Investments in Associates (Significant Influence)
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 method 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 intercompany 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, 2015, 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 is able to 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:
Total 25% Note

Amount paid by Tilton for 25% shares of Beaton $455,000 1
Book value of Beaton’s net assets on January 1, 2015 $1,500,000 375,000
Excess of the amount paid from the net book value 80,000
Fair value allocation of excess paid for net 240,000 60,000 4
depreciable assets
Remaining life of Beaton’s depreciable assets as 10 years
at January 1, 2015
Unexplained excess assumed to be goodwill 20,000
Dividends declared and paid on December 31, 2015 150,000 37,500 2
Net income for the year ended December 31, 2015 250,000 62,500 3
Below are the entries recorded to Tilton’s books that relate to its investment in Beaton:
8.3. Strategic Investments 327
General Journal
Jan 1 2015 Investment in associate – Beaton shares . . . . 455,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455,000
Note 1: Purchase of 25% of Beaton’s com-
mon shares
Dec 31 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,500

Investment in associate – Beaton shares . 37,500
Note 2: 25% share of dividends received
Dec 31 2015 Investment in associate – Beaton shares . . . . 62,500

Investment income (loss) . . . . . . . . . . . . . . . . 62,500
Note 3: 25% share of net income for 2015
Dec 31 2015 Investment income (loss) . . . . . . . . . . . . . . . . . . . . 6,000

Note 4: Amount of excess price paid for net
depreciable assets amortized over 10 years.
($60,000 ÷ 10 years)
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 unexplainable, so it will be treated as unrecorded goodwill. Goodwill is discussed in
detail in Chapter 11: Intangible Assets and Goodwill; you are encouraged to review that
material, if necessary. 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 De-
cember 31, 2015.
Tilton Co.
Balance Sheet
December 31, 2015
Long-term investment:
Investment in associates (equity method)* $474,000
*($455,000 − 37,500 + 62,500 − 6,000)
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 ($460,000 −
474,000) is recorded as a reduction to the investment (or valuation account) and to net
income (loss).
General Journal
Loss due to impairment . . . . . . . . . . . . . . . . . . . . . 14,000
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 repre-
sents 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.
8.3.2 Investments in Subsidiaries (Control)
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 con-
solidation, 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
8.4. Investments Disclosures 329
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
8.3.3 Investments in Joint Arrangements
As previously stated in the overview of strategic investments, joint arrangements (IFRS

11) is another type of strategic investment that involves a contractual arrangement be-
tween 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. There are two types of
joint arrangements:
• Joint operations—investor has direct rights to assets and (unlimited) liability obliga-
tions 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 obliga-
tions) 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.
8.4 Investments Disclosures
Reporting disclosures were addressed under each accounting method above. To sum-
marize, 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, then 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. Also similar between IFRS and ASPE standards are 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., HFT, HTM, AFS, Significant Influence, Sub-
sidiary, Joint arrangements)
• the carrying value of investments with details about their respective fair values,
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 with regard to market risk, liquidity risk, and credit risk, as well as the
policies in place to manage risks
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.
8.5 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 sepa-
rate the assets, liabilities, and income components of the investment portfolios from the
company’s core operations in order 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 will
be demonstrated 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 informa-
tion and a thorough understanding of the various accounting treatments will reduce the
possibility that management will make suboptimal business investment decisions due to
misinterpretation of analysis results.
There is no doubt that accounting for investments is a complex task, given the presence of
three accounting standards (IFRS 9 is optional until 2018) that have identified six separate
categories for IFRS and five for ASPE as shown in the Classifications and Accounting
Treatments section at the beginning of this chapter. Add to this mix the differences in
accounting for equity versus debt investments (with their respective impairment measure-
ments) within each category and the complexity increases even more.
To assist with the learning process, we offer two illustrations below. The first is a “de-
cision map” for various holdings of shares investments for IFRS and ASPE, identifying
which accounting treatment to use in each circumstance. The second illustration is a
numeric example of a non-strategic equity investment, to compare the accounting entries
among the three main categories for IFRS and ASPE. This is followed by another numeric
example of a debt investment with the same comparison.
Below is a decision map for the various equity investment categories:

Corporate
Std Description Planning Purpose Treatment
IFRS If voting shares Strategic Control Full consolidation
ownership is
greater than 50%
If voting shares Strategic Associate Equity method
ownership is
between 20%
and 50%
If equity Non-strategic Held-for-trading Fair value – net
investment is (HFT) income
less than 20%
If equity Non-strategic For sale but no Fair value – OCI
investment is specific intention
less than 20% (AFS)
ASPE If voting shares Strategic Subsidiary Choice of

ownership is consolidation,
greater than 50% equity method, or
cost method
If voting shares Strategic Significant Choice of equity
ownership is influence method or cost
between 20% method, or fair
and 50% value (if market
exists) – net
income
If equity Non-strategic Short-term Fair value – net
investment is trading income
less than 20%
and has an active
market
If equity Non-strategic All other equities Cost
investment is
less than 20%
and has no active
market
The numerical example below compares the accounting entries among the three main
categories for IFRS and ASPE over the life cycle of an equity investment.
Non-Strategic Investment: less than 20% of voting common shares or other equity
instruments
# of Price per
Date Description shares Share Total
Jan 1, 2014 Purchase shares 500 $10 $5,000
Jan 1, 2014 Transaction costs 100
Jun 30, 2014 Dividend declared and received 500 $1.20 600
Dec 31, 2014 Year-end market price 500 $9 4,500
Apr 30, 2015 Triggered loss event – present value @ original effective 3,800
interest rate
Triggered loss event – present value @ current interest 500 $8 4,000
rate
Triggered loss event – Fair value 4,000
Triggered loss event – NRV through sale of investment 4,100
or sale of collateral
Jun 30, 2015 Immediately after impairment, 50% of shares are sold 250 $11 2,750
334
INVESTMENTS IN SHARES
Investment intention or nature Trading in an active market No specific ASPE – no
selling intention active market
Exclusions ASPE N/A (not IFRS N/A
an ASPE category) (for debt only)
Accounting treatment while holding investment Fair Value – Net Income Fair Value – OCI Cost
ASPE – Short-
IFRS – HFT Term Trading IFRS – AFS ASPE
Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Jan 1, 2014 Investment – shares . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,000 5,000 5,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,000 5,000 5,000
Jan 1, 2014 Investment – shares . . . . . . . . . . . . . . . . . . . . . . . . . . 100 100

Transaction costs expense (NI) . . . . . . . . . . . . . . . 100 100
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 100 100 100
Jun 30, 2014 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 600 600 600

Dividend income (NI) . . . . . . . . . . . . . . . . . . . . . . . 600 600 600 600
Dec 31, 2014 Unrealized loss on shares investment (OCI) . . . 600

Unrealized loss on shares investment (NI) . . . . 500 500 -
Investment – shares . . . . . . . . . . . . . . . . . . . . . . . . 500* 500* 600** -
(carrying value – fair value)
*($5,000 − $4,500)
**($5,100 − $4,500)
Apr 30, 2015 Loss on impairment of shares (OCI) . . . . . . . . . . 500

Apr 30, 2015 Loss on impairment of shares (NI) . . . . . . . . . . . . - - 1,000
Investment – shares . . . . . . . . . . . . . . . . . . . . . . . . - - 500* 1,000**
*(carrying value – fair value) ($4,500 − $4,000) Reversible (limited)
**(carrying value – higher of [present value @
current interest rate and NRV through sale])
($5,100 − higher of [$4,000 and $4,100])
To record impairment charge.
ASPE – Short-
IFRS – HFT Term Trading IFRS – AFS ASPE
Loss on impairment of shares (NI) . . . . . . . . . . . . 1,100

Loss on impairment of shares (OCI) 1.100
($600 + 500)
Transfer the OCI balance for impaired Not reversible
investment to net income.
Jun 30, 2015 Investment – shares . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Impairment recovery (NI) . . . . . . . . . . . . . . . . . . . 1,000
Sold 50% of shares at $11 market price which Not reversible
triggers an impairment recovery back to the
carrying value prior to impairment for $5,100
for the entire investment. Recovery amount
(4,100 − 5,100) = $1,000
Jun 30, 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,750 2,750 2,750 2,750

Investment – shares . . . . . . . . . . . . . . . . . . . . . . . . 2,250 2,250 2,000 2,550
Gain (loss) on sale of shares (NI) . . . . . . . . . . . 500* 500* 750 200**
(carrying value – net sales proceeds)
*($4,500 × 50% − 2,750)
8.6. IFRS/ASPE Key Differences

** [$2,750 sales price −
($5,100 recovered carrying value × 50%)] =
$200 sales proceeds amount in excess of the
carrying value
335
336
T-Account Details
Trading – fair value NI AFS – fair Cost
value OCI
IFRS ASPE IFRS ASPE
Investment Investment Investment Investment
Jan 1, 2014 Purchase $5,000 $5,000 $5,000 $5,000
Jan 1, 2014 Transaction costs 100 100
Dec 31, 2014 Year-end adjustment to fair value 500 500 600 -
Balance 4,500 4,500 4,500 5,100
Apr 30, 2015 Loss event triggering an impairment charge - - - - 500 1,000
Balance 4,000 4,100
Jun 30, 2015 Impairment recovery 1,000
Sell 50% 2,250 2,250 2,000 2,550
Jun 30, 2015 Balance $2,250 $2,250 $2,000 $2,550
Partial Balance Sheet as at June 30, 2015

Trading – fair value NI AFS – fair Cost
value OCI
IFRS ASPE IFRS ASPE
Current assets:
Investment in shares (fair value – net income) $2,250 $2,250
Long-term assets:
Investment in shares (fair value – OCI) $2,000
Investment in shares (cost) $2,550
Equity
Retained earnings increase due to net income changes $500 $500 $250 $800
Accumulated other comprehensive income $0
For equity investments, ASPE has two choices: trade, if an active market exists (fair
value), or all else (cost). IFRS also has two choices; intention to actively trade (fair
value), or AFS (fair value catch-all account). The example above included an impairment
triggering event and a sale with the price high enough to result in the recovery of the
impairment. For AFS investments, the April 30 impairment of $500 also triggered a
reclassification of the $600 fair value loss, initially recorded to OCI, to now be realized
in net income. This resulted in an overall loss to net income of $1,100. Recall that
impairments are not reversible for IFRS – AFS equity investments.
For the ASPE cost method, no fair value adjustment was recorded at year-end. The
impairment measurement was calculated using different parameters than IFRS – AFS.
Accordingly, the impairment charge is $1,000 and is reversible up to the original carrying
value had no impairment occurred. On June 30, 50% of the shares are sold for $11.
The increased sale price of $11 means that the 500 shares now have a value of $5,500
(500 × $11) which resulted in a recovery of the previous $1,000 impairment charge. The
recovery cannot exceed the original carrying amount for $5,100, so the amount is limited
to $1,000 impairment recovery adjustment. This leaves a gain from sale of the shares of
$200 ($2,750 − $2,550 recovered carrying value).
For IFRS, AFS investments reported the lowest effect in retained earnings due to net
income realization over the life of the investment compared to HFT. For ASPE, the in-
vestment asset account is greater for the cost method shares compared to the fair value
method shares, and the income effect as seen in the retained earnings change is also
lower. With these kinds of differences on the financial statement accounts for the various
methods, management could be motivated to adopt aggressive accounting policies to
manipulate either the asset balances or net income. For example, IFRS companies
could reclassify HFT investments to AFS to decrease the net income over the life of the
investment and save on income taxes. Similarly, ASPE companies might be tempted
to reclassify investments from cost to fair value to reduce income taxes. Alternatively,
IFRS companies might want to reclassify investments to HFT to increase asset values if
there were restrictive covenants on the company’s financial arrangements. As a result,
IFRS restricts reclassifications in or out of HFT investments and ASPE prohibits any
reclassifications from fair value, once designation is made.
Below is a comparison between IFRS and ASPE and the three categories over the life
cycle of a debt investment.
Non-Strategic Debt Investment:

Date Description Total

Jan 1, 2014 Purchase bonds – 5%, 5 year, $5,000 face value with interest annually each $4,900
Dec 31 @ 98 ($5,000 × .98)
Jan 1, 2014 Transaction costs 80
Dec 31, 2014 Interest income received ($5,000 × 5%) 250

Dec 31, 2014 Year-end market price 4,800
Apr 30, 2015 Triggered loss event – present value @ original effective interest rate 4,750
Triggered loss event – present value @ current interest rates 4,700
Triggered loss event – Fair value 4,700
Triggered loss event – NRV through sale of investment or sale of collateral 4,850
Jun 30, 2015 Sell 50% of bonds @ 104 ($5,000 × 50% × 1.04) 2,600
Effective Interest Method for 5% Bonds (market or yield for 5.47%)

Cash Received Amortized Discount
@ 5% stated rate Interest Income (increases Carrying
annually @ 5.47% market rate* carrying value) Value
Jan 1, 2014 $4,900
Dec 31, 2014 250 268 18 4,918
Dec 31, 2015 250 269 19 4,937
Dec 31, 2016 250 270 20 4,957
Dec 31, 2017 250 271 21 4,978
Dec 31, 2018 250 272 22 5,000
* Effective interest rate:

I/Y = (4900 PV, 250 P/A, 5 N, 5000 FV)
I/Y = 5.467941207 or 5.47% (rounded)
INVESTMENTS IN DEBT (BONDS)
Investment intention or nature Trading in No specific Hold until maturity
an active market selling intention
Exclusions ASPE N/A (this is ASPE N/A (not
an equity-only category) an ASPE category)
Accounting treatment while Fair Value – Fair Value – Amortized Cost
holding investment Net Income OCI
ASPE – all
IFRS – HFT IFRS – AFS IFRS – HTM debt investments
Jan 1, 2014 Investment – bonds . . . . . . . . . . . . . . . 4,900 4,900 4,900 4,900
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,900 4,900 4,900 4,900
Jan 1, 2014 Investment – bonds . . . . . . . . . . . . . . . 80 80 80

Transaction costs expense (NI) . . . . 80
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 80 80 80
Dec 31, 2014 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 250 250 250

Investment – bonds . . . . . . . . . . . . . . . 18 18 18 18*
Interest income (NI) . . . . . . . . . . . . . 268 268 268 268
* ASPE companies can choose to
amortize bond premiums and
discounts using the straight-line

method over the life of the bond
Dec 31, 2014 Unrealized loss on bonds 198

investment (OCI) . . . . . . . . . . . . . . . . . .
Unrealized loss on bonds 118 - -
investment (NI) . . . . . . . . . . . . . . . . . . . .
Investment – bonds . . . . . . . . . . . . . 118* 198** - -
(Carrying value – fair value)
*($4,918 − $4,800)
**($4,998 − $4,800)
Apr 30, 2015 Loss on impairment of bonds (OCI) 100
339
340
ASPE – all
Loss on impairment of bonds (NI) . - 248 148
Investment – bonds (allowance - 100* 248** 148***
account) . . . . . . . . . . . . . . . . . . . . . . . . . .
*(Carrying value – impaired fair Reversible (limited) Reversible (limited) Reversible (limited)
value)
($4,800 − $4,700)
**(Carrying value – present value
using original effective interest
rate)
($4,998 − $4,750)
***(Carrying value – higher of
[present value @ current interest
rate and NRV through sale])
($4,998 −
higher of [$4,700 and $4,850])
Loss on impairment of bonds (NI) . 298

Loss on impairment of bonds 298
(OCI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
To transfer OCI for impaired asset
to net income. (198 + 100)
Jun 30, 2015 Investment – bonds (allowance 100 248 148

account) . . . . . . . . . . . . . . . . . . . . . . . . . .
Impairment recovery . . . . . . . . . . . . 100 248 148
Sold 50% of bonds for $2,600
which triggers an impairment
recovery back to the carrying value
prior to impairment. Allowance
account for impairment was
reversed.
Jun 30, 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600 2,600 2,600 2,600

ASPE – all
Investment – bonds . . . . . . . . . . . . . 2,400 2,400 2,499 2,499
Gain (loss) on sale of bonds 200 200 101 101
(plug) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
T-Account Details
IFRS Investment IFRS Investment IFRS Investment ASPE Investment
Jan 1, 2014 Purchase $4,900 $4,900 $4,900 $4,900
Jan 1, 2014 Transaction costs 80 80 80
Jun 30, 2014 Amortized discount 18 18 18 18
Dec 31, 2014 Year-end adjustment to fair value 118 198 - -
Balance 4,800 4,800 4,998 4,998
Jun 30, 2015 Sell 50% 2,400 2,400 2,499 2,499
Jun 30, 2015 Balance $2,400 $2,400 $2,499 $2,499

Investment contra account for impairment
Allowance Allowance Allowance Allowance
Apr 30, 2015 Loss event triggering an evaluation with impairment - - $100 $248 $148
charge
Jun 30, 2015 Impairment recovery - - 100 248 148
Jun 30, 2015 Balance - - $0 $0 $0
341
342
Partial Balance Sheet as at June 30, 2015
HFT AFS Hold to maturity
(fair value) (amortized cost)
IFRS IFRS IFRS ASPE
Current assets:
Investment in bonds (fair value – net income) $2,400
Long-term assets:
Investment in bonds (fair value – OCI) $2,400
Investment in bonds (amortized cost) $2,499 $2,499
Equity
Retained earnings increase due to net income changes $270 $270 $369 $369
Accumulated other comprehensive income $0
Chapter Summary 343
For debt investments, ASPE has only one choice: amortized cost, so there are no reclas-
sification issues. IFRS has three choices: trade (fair value), hold to maturity (amortized
cost), or AFS (fair value catch-all account).
In the debt investments example above, allowance accounts record investment changes
due to impairments. This can be useful because it preserves the amortized carrying
value, making calculations easier in the event that an impairment recovery event occurs.
For the AFS investment, impairment reversals are allowed. They are also allowed for any
investments using the amortized cost method (IFRS – HTM and ASPE amortized cost).
The sale for 50% of the bonds for sales proceeds greater than the impaired carrying
values means that there was an impairment recovery. Since the selling price for $2,600
exceeded the carrying value before the impairment, the full impairment amount could be
recovered.
Note the differences between the retained earnings due to net income effect over the
life of the bonds as well as the differences in the investment carrying value. Again,
reclassification to manipulate net income or the asset value could be a temptation. For this
reason, IFRS generally restricts reclassifications in or out of HFT investments to prevent
manipulation of net income. Also, IFRS restricts reclassifications out of HTM to AFS to
prevent manipulation of the balance sheet.
In the shares and bonds examples above, it has been demonstrated that the differences
arising from the various accounting treatments are significant. The accounting standards
have done much to lessen the possibility that management will manipulate net income or
investment asset balances by arbitrary reclassifications. It is also important to understand
that if investment fair values were significantly different, if there were no impairments or
if returns for dividends or interest were higher or lower than the examples above, then
the comparisons between categories might yield completely different results. There is
still the risk of misinterpreting investment performance analysis and making suboptimal
investment decisions as a result. A thorough understanding of the impact that each
method has on investments as well as regular investment analysis is critical to sound
investment portfolio management.
Chapter Summary
LO 1: Describe intercorporate investments and their role in

Non-strategic intercorporate investments exist when companies invest in other compa-

nies’ equity (shares or derivatives) or debt (bonds or convertible debt) in order 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 com-
pany in order 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.
Canada currently has three standards in effect (two IFRS and one ASPE), making classi-
fication, measurement, and reporting a complex task.
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 how long management intends to hold 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 cate-
gories: a) investments that are held for trading purposes (HFT) measured at fair value
through net income; b) held-to-maturity (HTM) measured at amortized cost; and c) for
sale but no specific intention (AFS) measured at fair value through OCI. ASPE has two
categories: a) investments for trading purposes (fair value); 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.
For IFRS companies, management’s intention to sell or hold is the basis for which clas-
sification to use. For ASPE, it is the nature of the investment (debt, equity, or derivative)
that is the basis for the classification.
Chapter Summary 345
Held-for-trading (HFT) 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).
HFT 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 a 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.
Available-for-sale (AFS) investments in debt or equity are for sale, but with no specific
intention about how long they will be held. 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. Transactions
costs are capitalized. Gains (losses) upon sale are reported in net income with any
unrealized amounts in OCI for the investment sold reclassified to net income as realized.
For AFS investments, if an event occurs triggering a loss in value in between reporting
dates, then an evaluation must be undertaken to determine if impairment has occurred.
If it has, the impairment amount is the difference between the carrying value at the time
of the impairment and the impaired investment’s fair value of impaired cash flows using
the current market rate. The carrying value of the investment is reduced to the impaired
value and the impairment loss is recycled through OCI to net income. Any OCI gains
(losses) for the impaired investment is reclassified from OCI to net income as “realized”
due to the impairment. Impairment losses can be reversed for debt investments only, but
the recovery amount cannot result in a carrying value balance greater than if there had
been no impairment. A valuation allowance can be used.
Held-to-maturity (HTM) investments in debt (IFRS) 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. HTM investments
are reported at their carrying value as long-term assets, unless they are expected to
mature or be sold within twelve months of the balance sheet date. Interest earned on
investments in debt (bonds), or dividends earned on equity securities measured at cost,
is 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. If a loss event occurs, any impairment
is calculated as the differences between the carrying value and the present value of the
impaired cash flows using the original interest rate for IFRS. For ASPE, the impairment
is 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. A valuation allowance can be used.
The three classifications can result is significantly different asset values and net income.
This may result in a temptation to manipulate either the asset value or net income by
reclassifying at certain points in the investment’s life. Both IFRS and ASPE standards
have prescriptive guidelines for reclassifying between classifications.
LO 3: Identify an describe the three types of strategic investments.
Investments in the voting shares of an investee company are undertaken in order 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 re-
ported 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 considered to be
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,
Chapter Summary 347
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 en-
sure 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 (HFT, AVS, HTM) and strategic (associate,
control, joint arrangements) investments. As well, accounting treatments can also vary
between debt instruments and equity securities within a particular accounting category,
making comparisons with other benchmark data (e.g., historic or industry ratios) difficult,
and hence performance assessment challenging as well. The end result is that both
net income and investment accounts balances can differ widely at each reporting date
depending on the category designation to account for the investment(s).
LO 6: Discuss the similarities and differences between IFRS and

ASPE for the three non-strategic investment classifications.
The illustrations in this section of Chapter 8 pulled together all the pieces of information
into a more coherent whole. The first illustration, a decision map, assists in determining
the proper treatment for various types of investment decisions. The second illustration
compares four different accounting treatments (two for IFRS and two for ASPE) regarding
equity securities as an investment. The third illustration does the same thing for debt
instruments. In these illustrated scenarios, the schedule shows all the journal entries over
a typical “buy-hold-sell” life-cycle of an investment. The schedule clarifies which entries
recorded are the same among the various categories and which entries recorded are
different. T-accounts are presented as a visual aid to see the flow of the numbers over
all the transactions. Finally, the investment account and the total income accumulated in
retained earnings give a sense of the differences in ending balances and why potential
reporting bias might be an issue.
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.h
tml?id=1373462#.V5omfPkrJph
IFRS. (2011, December 16). IFRS 9 mandatory effective date and disclosures. Re-
trieved from http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Inst
ruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/IFRS-9-Mand
atory-effective-date-and-disclosures/Pages/IFRS-9-Mandatory-effective-date-a
nd-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-replac
ement-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.theve
rge.com/2012/11/20/3670386/hp-q3-2012-financial-results-autonomy-fraud-alleg
ation
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/h
ow_did_hp_lose_five_billion_dollars_through_bad_accounting.html
Exercises
EXERCISE 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
Exercises 349
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 publically traded so Maverick will account for them
using the cost method. Maverick follows ASPE.
Required:
a. What type of accounting treatment is this investment?
b. Prepare the journal entry for the purchase, the dividends received, and the sale. Are
any year-end adjustments required?
c. Assume now that Maverick follows IFRS and the investment in shares is accounted
for as a non-strategic, held-for-trading (HFT) investment. Prepare the journal entry
for the purchase, the dividends received, any year-end adjusting entries and the
sale.
d. How would your answer to part (c) change if Maverick follows ASPE and the shares
are traded on an active market?
EXERCISE 8–2
On January 1, 2015, 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, 2023,
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 hold the bonds to maturity.
Required:
a. 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.)
b. What is the amount of the bond premium or discount? Indicate if it is a premium or

a discount.
c. Record all relevant entries for 2015, the January entry for 2016, and the entry for the
sale in 2023, assuming that Smythe classifies the investment as a held-to-maturity
(HTM) investment. Round amounts to the nearest whole dollar.
d. 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?
e. Assume now that Smythe follows ASPE. How would the entries in part (c) differ?
Use numbers to support your answer.
EXERCISE 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 intends to hold this investment until maturity.
The company follows IFRS and their year-end is December 31.
Required:
a. What is the discount or premium, if any, for this investment? Explain why a premium
or discount could occur when purchasing bonds.
b. Record the bond purchase, the first two interest payments, and any year-end ad-
justing entries, rounding amounts to the nearest whole dollar.
c. 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.
EXERCISE 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 their year-end is September
30.
Required: Record the first two interest payments and any adjusting entries, rounding
amounts to the nearest whole dollar.
EXERCISE 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:
Exercises 351
a. What classification would Imperial Mark use to report this investment?

b. 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.
c. 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.
EXERCISE 8–6
Halberton Corp. purchased 1,000 common shares of Xenolt Ltd., a publically 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 has no specific intention as to when it will sell the shares.
Halberton follows IFRS.
Required:
a. How would Halberton classify and report this investment?

b. Prepare Halberton’s journal entries for the investment purchase, the dividend, and
any year-end adjusting entries.
c. Prepare the sale entry if Halberton sells the investment one week into the next fiscal
year for $54,200 cash.
d. How would the answer for part (a) change if Halberton followed ASPE?
EXERCISE 8–7
The following are various transactions that relate to the investment portfolio for Zeus
Corp., a publically traded corporation. The portfolio is made up of debt and equity in-
struments all purchased in the current year and accounted for as held-for-trading (HFT).
The investee’s year-end is December 31.
a. 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.
b. On April 1, semi-annual interest was received on the Xtra bonds.

c. 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.
d. On August 12, 3,000 shares of Bretin ACT Corp. were acquired at a cost of $59 per
share. A 1% commission was paid.
e. On September 1, Xtra Corp. bonds with a par value of $100,000 were sold at 104
plus accrued interest.
f. On September 28, a dividend of $0.50 per share was received on the Bretin ACT
Corp. bonds.
g. On October 1, semi-annual interest was received on the remaining Xtra Corp. bonds.
h. On December 1, semi-annual interest was received on the Vericon Ltd. bonds.
i. On December 28, a dividend of $0.52 per share was received on the Bretin ACT
Corp. shares.
j. 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.
EXERCISE 8–8
On January 1, 2015, 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 an AFS. 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,
2016, Verex sold 50% of the investment for $12 per share less brokerage fees of $580.
Required:
a. Does Verex follow ASPE or IFRS, and why?
b. Record all the relevant journal entries for Verex for this investment from purchase to
sale.
EXERCISE 8–9
Exercises 353
At December 31, 2015, the following information is reported for Jackson Enterprises Co.:
Net income $250,000

Investments in AFS – carrying value 320,000
Investments in AFS – fair value 350,000
Accumulated Other Comprehensive Income, Jan 1, 2015 15,000
Required: Calculate the Other Comprehensive Income (OCI) and total comprehensive
income for the year ending December 31, 2015, and the December 31, 2015 ending
balance for the Accumulated Other Comprehensive Income (AOCI).
EXERCISE 8–10
On January 2, 2015, 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, 2016, 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, 2016, the investee recovered from the financial difficulties and was no longer
considered impaired.
Required:
a. Record all the impairment related transactions in 2015 and 2016 assuming Bellevue
uses ASPE.
b. Record all the impairment related transactions in 2015 and 2016 assuming Bellevue
uses IFRS (IAS 39).
c. How would the answer to part (b) change, had the investment been in equities such
as shares?
EXERCISE 8–11
On December 31, 2015, Camille Co. provided the following information as at December
31, 2015 about its investment accounts held-for-trading:
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 2016, Warbler Corp. shares were sold for $23,000 and 50% of the Shickter shares
were sold for $42,000. At the end of 2016, the fair value of ABC shares was $19,200 and
Shickter Ltd. was $41,000. Camille follows IFRS.
Required:
a. Prepare the adjusting entry for December 31, 2015, if any.
b. Prepare the entry for the Warbler and Shickter sales.
c. Prepare the adjusting entry for December 31, 2016, if any.
d. How would the entries in parts (a), (b), and (c) differ if Camille accounted followed
ASPE?
EXERCISE 8–12
On September 30, 2014, 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
intent is to hold for trading purposes. On December 31, 2014, the company year-end, the
fair value published for bonds of similar characteristics and risk was 102.6. On March 1,
2015, FacePlant sold the bonds for 102.8 plus accrued interest. FacePlant follows IFRS.
Required:
a. Prepare all the related journal entries for this investment. The company wants to
report interest income separately from other gains and losses.
b. Prepare a partial classified balance sheet and income statement for FacePlant, as
at December 31, 2014.
c. How would the answer to parts (a) and (b) change if FacePlant followed ASPE?
d. What kinds of returns did this investment generate? (Hint: Consider all sources,
such as interest income and gain/loss on sale of the investment.)
Exercises 355
EXERCISE 8–13
Bremblay Ltd. owns corporate bonds that it accounts for using the amortized cost model.
As at December 31, 2015, 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
The company does not use a valuation account.
Required:
a. Prepare all relevant entries related to the impairment assuming the company follows
ASPE. Is this reversible?
b. Prepare all relevant entries related to the impairment assuming the company follows
IFRS. Is this reversible?
c. Prepare all relevant entries related to the impairment assuming that the company
follows ASPE but uses a valuation account.
EXERCISE 8–14
On January 1, 2015, Helsinky Co. paid $236,163 for 8% bonds of Britanica Corp. with a
maturity value of $250,000, to mature January 1, 2023. 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 held-for-trading (HFT) investments. On December
31, 2015, the bonds had a fair value of $240,000. Helsinky follows IFRS and has a
December 31 year-end.
During 2016, the industry sector that Britanica operates in experienced some difficult
times due to the drop in prices for oil and gas. As a result, by December 31, 2016,
their debt was downgraded to the price-point of 87.3. By December 31, 2017, the price-
point for the bond had a market price of 92.3. In 2018, conditions improved measurably
resulting in the bonds to have a fair value on December 31, 2018 of 99.3.
Required:
a. Prepare all of the relevant entries for 2015, 2016, 2017 and 2018, including any
adjusting entries as required. Round entry amounts to the nearest whole dollar.
b. If Helsinky had accounted for the investment at amortized cost, identify and describe
the impairment model that the company would have used if they had followed IFRS
or ASPE.
EXERCISE 8–15
On January 1, 2009, 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
2015, Outlander stated that it was experiencing a reduction in profits but was trying to get
things to improve.
Required:
a. Assume that Billings applies the cost method to this investment because there is
no active market for Outlander shares. In 2014, 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 quite
speculative. By 2015, 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 2014 and 2015, assuming that Billings follows IFRS, IAS 39.
Prepare the entries for 2014 and 2015, assuming that Billings follows ASPE.
b. Next, assume that Billings classifies the investment as a held-for-trading (HFT)
because Outlander is a publically traded company. By the end of 2014, the price
of Outlander shares had fallen from $34.00 the previous year to $32.00. By 2015,
the price had dropped to a 52-week low of $25.00 per share.
Prepare the entries for 2014 and 2015, assuming that Billings follows ASPE.
c. Finally, assume that Billings had purchased the shares of Outlander because Out-
lander is an important customer and Billings wanted to secure a steady source of
sales from them. For this reason, Billings classifies the investment as an available-
for-sale (AFS) investment. In 2014, Billings had determined that the value of its
investment in Outlander was $80,000. By 2015, 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.
Exercises 357
EXERCISE 8–16
On January 1, 2015, 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,
2015, 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:
a. Assuming that Sandar does not have any significant influence over Yarder, prepare
all the 2015 entries relating to this investment using the held-for-trading (HFT) clas-
sification and the cost classification.
b. Prepare all the 2015 entries relating to this investment assuming that Sandar has
significant influence over Yarder. Sandar uses the equity method of accounting.
EXERCISE 8–17
The following T-account shows various transactions using the equity method. This invest-
ment 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:
a. What was the investee’s total net income for the year?
b. What was the investee’s total dividend payout for the year?
c. What is the investor’s share of net income?
d. How much was the investor’s annual depreciation of the excess payment for capital
assets?
e. How much of the excess payment would be assigned to goodwill?
f. How much are the investor’s share of dividends for the year?
EXERCISE 8–18
On January 1, 2014, 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 2014, 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 2015, 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:
a. Prepare all the relevant entries for 2014 and 2015 assuming no significant influence.
Assume that Dologan follows IFRS and accounts for the investment as a held-for-
trading (HFT).
b. How is the comprehensive income affected in 2014 and 2015 in part (a)?
c. Prepare all the relevant entries for 2014 and 2015 assuming that Dologan can
exercise significant influence. Assume that Dologan follows IFRS.
d. Calculate the carrying value of the investment as at December 31, 2015 assuming
Dologan can exercise significant influence and follows IFRS.
Exercises 359
e. How would your answer to part (c) be different if Twitterbug’s statement of compre-
hensive income included a loss from discontinued operations of $15,000 (net of tax)
for 2014?
EXERCISE 8–19
On January 1, 2015, 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:
Assets subject to amortization $ 900,000

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
Net income reported 225,000
Dividends paid 100,000
Required: Prepare all relevant entries for the investment based on the information pro-
vided above. Assume that any excess of payment that is unexplained is attributed to
goodwill.
EXERCISE 8–20
Below are details for several independent investments:
i. Preferred shares were purchased from a publically traded company because of

their favourable dividend payout history. They are for sale, but management has
no specific intention to sell at this time.
ii. On February 1, 2015, 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.
iii. 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 2015, though that is not certain
at this point.
iv. Common shares of a supplier company were purchased to strengthen their relation-
ship. Management intends to hold this investment into the future.
v. On January 1, 2015, a 4% bond that will mature in 6 years was purchased at market
at a spot rate of 92. When the price point reaches 103, management intends to sell
the investment.
vi. 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.
vii. On March 1, 2015, bonds maturing in 2016 were purchased.
Required:
a. What classification would each investment item be if the investor company follows
APSE?
b. What classification would each investment item be if the investor company follows
IFRS (IAS 39)?
Chapter 9
Property, Plant, and Equipment
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.
361
362 Property, Plant, and Equipment
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)
LO 1: Describe the characteristics of property, plant, and equipment assets that distin-
guish them from other assets.
LO 2: Identify the criteria for recognizing property, plant, and equipment assets.
LO 3: Determine the costs to include in the measurement of property, plant, and equip-
ment at acquisition.
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.
LO 5: Identify the effect of government grants in determining the cost of a property, plant,
and equipment asset.
LO 6: Determine the cost of a self-constructed asset, including treatment of related

interest charges.
LO 7: Identify the accounting treatment for asset retirement obligation.
LO 8: Apply the cost model.
LO 9: Apply the revaluation model.
LO 10: Apply the fair value model.
LO 11: Explain and apply the accounting treatment for post-acquisition costs related to
property, plant, and equipment assets.
LO 12: Identify key differences between IFRS and ASPE.

Introduction 363
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 de-
velopment 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.
Self-Constructed Assets
1.0 Definition
Borrowing Costs
2.0 Recognition Asset Retirement

Obligations
3.0 Measurement
Lump Sum Purchases
at Recognition
Nonmonetary Exchanges
Property, plant,
and equipment
Deferred Payments
Government Grants
Cost Model
4.0 Measurement After

Initial Recognition Revaluation Model
Fair Value Model

5.0 Costs Incurred
After Acquisition
6.0 IFRS/ASPE
Key Differences
9.1 Definition
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:
9.2. Recognition 365
• 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.
9.2 Recognition
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 Measurement at Recognition
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
9.3. Measurement at Recognition 367
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
9.3.1 Self-Constructed Assets
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.
9.3.2 Borrowing Costs
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.
9.3.3 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.
9.3.4 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:
150,000×850,000
Land (150,000+600,000) = $170,000
600,000×850,000
Building = $680,000
(150,000+600,000)
Total = $850,000
9.3.5 Nonmonetary Exchanges
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 com-
bination 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 unreason-
able 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:
General Journal
New machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000
Accumulated depreciation – old machine . . . . 60,000
Old machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000
Gain on disposal of machine . . . . . . . . . . . . . 4,000
For New machine: ($22,000 + $33,000)
Note that the new machine is reported at the fair value of the assets given up in the
exchange ($33,000 cash + $22,000 machine). 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 ($78,000 − $60,000 = $18,000).
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:
General Journal
New truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Accumulated depreciation – old truck . . . . . . . . 5,000
Old truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
For New truck: ($27,000 + $5,000)
Note that the new truck is reported at the book value of the assets given up ($5,000 cash+
($32,000 −$5,000) = $27,000 truck). Also note that the implied fair value of the new truck
($28,000 + $5,000 = $33,000) 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:
General Journal
New truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Accumulated depreciation – old truck . . . . . . . . 5,000
Old truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Loss on disposal of truck . . . . . . . . . . . . . . . . . . . . 2,000
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.
9.3.6 Deferred Payments
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:
General Journal
Factory machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,841
Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,841
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.
9.3.7 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 sys-
tematic 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 prod-
uct. 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: ($100,000 ÷
5 years = $20,000); offset method: ($80,000 ÷ 5 years =
$16,000)
For Deferred grant: ($20,000 ÷ 5 years = $4,000)
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.
9.4 Measurement After Initial Recognition
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.
9.4.1 Cost Model
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
9.4. Measurement After Initial Recognition 375
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.
9.4.2 Revaluation Model
IFRS allows an alternative method for subsequent reporting of PPE assets. The reval-
uation 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, 2014, 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:
General Journal
Jan 1 2014 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Dec 31 2014 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . 25,000

Accumulated depreciation . . . . . . . . . . . . . . . 25,000
(($500,000 − 0) ÷ 20 years)

On December 31, 2015, 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:
General Journal
Dec 31 2015 Accumulated depreciation . . . . . . . . . . . . . . . . . . . 50,000
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
($25,000 × 2 years)
Dec 31 2015 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Revaluation surplus (OCI) . . . . . . . . . . . . . . . 40,000
(($490,000 − ($500,000 − $50,000))
The cost of the building is now $490,000 and the accumulated depreciation is $nil. Be-
cause 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:
General Journal
9.4. Measurement After Initial Recognition 377
On December 31, 2017, the building is again appraised, and this time the fair value is
determined to be $390,000. The following journal entries will be required:
General Journal
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,444
Dec 31 2017 Revaluation surplus (OCI) . . . . . . . . . . . . . . . . . . . 40,000

Revaluation loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,556
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,556
For Building: $390,000−($490,000−(2 yrs×
$27,222))
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.
9.4.3 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, 2014. 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, 2014 $5,200,000
December 31, 2015 $4,600,000
December 31, 2016 $4,850,000
The adjustments will be recorded each year as follows:
General Journal
Dec 31 2014 Investment property . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Gain in value of investment property . . . . . 200,000
($5.2M − $5M)
Dec 31 2015 Loss in value of investment property . . . . . . . . 600,000

Investment property . . . . . . . . . . . . . . . . . . . . . 600,000
($4.6M − $5.2M)

($4.85M − $4.6M)
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.
9.5 Costs Incurred After Acquisition
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 addi-
tional 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
9.5. Costs Incurred After Acquisition 379
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 com-
ponent 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
General Journal
Accumulated depreciation – building . . . . . . . . 11,154
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,923
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Loss on disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,769
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 $87,000 ×1÷(1+.3) =
$66,923. If the asset has been depreciated for five years, then the accumulated
depreciation would be ($66,923 ÷ 30) × 5 = $11,154. The loss on disposal equals
the difference between the calculated, net carrying value and the proceeds received.
2. Purchase of the new assets

General Journal
Building improvements . . . . . . . . . . . . . . . . . . . . . . 87,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,000
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.
IFRS ASPE
Component accounting is required. An Significant and separable component
item of PPE is defined by the economic parts should be recorded as individual
benefits that are derived from it, not the assets where practicable. In practice,
physical nature of the item. this definition has led to less components
being reported under ASPE than IFRS.
Any revenue and expense incurred prior Any revenue or expense from using an
to the PPE asset being ready to use is item of PPE prior to its substantial com-
taken to profit or loss, as this is considered pletion is included in the asset’s cost.
incidental to the construction of the asset. Expenses are added to the asset cost
while revenues are deducted from the
asset cost.
Borrowing costs directly attributable to Directly attributable Interest costs may be
PPE acquisition, construction, or develop- capitalized if this is the company’s chosen
ment must be capitalized. accounting policy.
The cost of legal and constructive obliga- Only legal obligations for asset retirement
tions for asset retirement must be capital- need to be capitalized.
ized.
Chapter Summary 381
PPE items can be accounted for using the Only the cost model may be used for PPE.
cost or the revaluation models.
Investment properties can be accounted No separate standard for investment prop-
for using the cost or fair value models. erties. They fall under the same general
rule (i.e., the cost model) as other types of
PPE.
IAS 16.19 (IAS, 2003a) prohibits the in- S 3061.08 allows directly attributable over-
clusion of general overhead costs in the head costs to be included in the capital
capital cost of a property, plant, and cost of self-constructed property, plant,
equipment asset. and equipment assets.
The general capitalization criterion re- S 3061.14 allows for the capitalization
quires the presence of future economic of betterments. Betterments are costs
benefits flowing to the entity. However, incurred to improve the service capacity,
IAS 16.20 (IAS, 2003a) prohibits the cap- extend the useful life, improve the quan-
italization of redeployment, relocation, or tity or quality of output, or reduce the
reorganization costs. This excludes the operating costs of a property, plant, and
capitalization of some of the items that equipment asset.
could be classified as betterments under
ASPE.
Chapter Summary
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 system-
atic 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.
Chapter Summary 383
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 construc-
tion 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 capital-
ized. 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.
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 re-
quires 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.
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-boein
g-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
Exercises 385
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 ht

tp://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/inv
estorMedia/financialReports/WestJet-Second-Quarter-Report-2014.pdf
Exercises
EXERCISE 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 2015.
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 capital-
ized, describe how it would be reported.
EXERCISE 9–2
Argyris Mining Inc. completed construction of a new silver mine in 2015. 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, 2015, and the mine was completed on November
1, 2015. 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 2015.
EXERCISE 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.
EXERCISE 9–4
Prabhu Industries Ltd. recently exchanged a piece of manufacturing equipment for an-
other 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:
a. Prepare the journal entries required by each company to record the exchange,
Exercises 387
assuming the exchange is considered to have commercial substance.
b. Repeat part (a) assuming the exchange does not have commercial substance.
c. Repeat part (b) assuming the accumulated depreciation recorded by Prabhu is only
$5,000 instead of $10,000.
EXERCISE 9–5
Lo-Dun Inc. is a publicly traded financial services company. The company recently ac-
quired 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 negotia-
tion, 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.
EXERCISE 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:
a. Prepare the journal entry to record the purchase of the condo, assuming the com-
pany uses the deferral method to record the government grant.
b. Repeat part (a) assuming the company uses the offset method to record the gov-
ernment grant.
c. Determine the annual effect on the income statement for each of the above methods.
EXERCISE 9–7
Finucane Manufacturing Inc. owns a large factory building that it purchased in 2011. At
the time of purchase, the company decided to apply the revaluation model to the property;
the first revaluation occurred on December 31, 2013. On January 1, 2014, 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, 2014, 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, 2014 $1,250,000
December 31, 2015 $1,000,000
December 31, 2016 $1,150,000
Required: Prepare all the required journal entries for this property for the years ended
December 31, 2014 to 2016. 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.
EXERCISE 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, 2015, for $1,500,000. The appraised value on December 31, 2015, was $1,450,000
and the appraised value on December 31, 2016, was $1,625,000.
Required: Prepare the adjusting journal entries for this property on December 31, 2015,
and December 31, 2016.
EXERCISE 9–9
Sun Systems Ltd. operates a manufacturing facility where specialized electronic compo-
nents are assembled for use in consumer products. The facility was purchased in 2009
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.
Exercises 389
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 2015,
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 2009.
• 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 2015.
Assume all transactions were settled in cash.
Chapter 10
Depreciation, Impairment, and Derecognition of
Property, Plant, and Equipment
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 noncash, 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
391
392 Depreciation, Impairment, and Derecognition of Property, Plant, and Equipment
consumption of property, plant, and equipment assets.
LO 1: Identify the purpose of depreciation, and discuss the elements that are required
to calculate depreciation.
LO 2: Calculate depreciation using straight-line, diminishing-balance, and units-of-production

methods.
LO 3: Discuss the reasons for separate component accounting and the accounting prob-
lems that may arise from this approach.
LO 4: Calculate depreciation when partial periods or changes in estimates are required.
LO 5: Discuss indicators of impairment and calculate the amount of impairment.
LO 6: Identify the criteria required to classify an asset as held for sale.
LO 7: Prepare journal entries for assets held for sale.
LO 8: Discuss other derecognition issues.
LO 9: Identify the presentation and disclosure requirements for property, plant, and
equipment.
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.
Depreciable Amount
Useful Life
1.0 Definition
Methods of Calculation
2.0 Depreciation
Calculations
Separate Components
Depreciation,
Impairment, and Partial Period
Derecognition Calculations
of PPE
Revision of Depreciation
Accounting for
Impairment
3.0 Impairment
Cash-Generating Units
Held for Sale
4.0 Derecognition
Other Derecognition
Issues
5.0 Presentation
and Disclosure
6.0 IFRS/ASPE
Key Differences
A. ASPE Standards
for Impairment
10.1 Definition
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 sep-

arately. We will deal with each of these elements separately.
10.2 Depreciation Calculations
10.2.1 Depreciable Amount
The first element that needs to be determined for a depreciation calculation is the depre-
ciable 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
10.2. Depreciation Calculations 395
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.
10.2.2 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 10.2.1: 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.
10.2.3 Methods of Calculation
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:
Cost − Residual value

= Depreciation charge
Useful life
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:
$100,000 − $5,000
= $9,500 per year
10 years
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:
1
× 2 = Depreciation rate
Useful life
1
× 2 = 20%
10 years
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 ($13,422 × 20% = $2,684). 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:
$100,000 − $5,000
= $0.095 per box
1,000,000 boxes
Thus, if in a given year, the machine actually processed 102,000 boxes, the depreciation
charge for that year would be as follows:
102,000 × $0.095 = $9,690
In years of high production, depreciation will increase; in years of low production, depre-
ciation 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.
10.2.4 Separate Components
As noted in Chapter 9, IFRS requires PPE assets be segregated into significant compo-
nents. 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 signif-
icant component of the whole and then determine which components have similar char-
acteristics 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.
10.2.5 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.
10.2.6 Revision of Depreciation
As noted previously, many elements of the depreciation calculation are based on es-
timates. 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 re-
quires 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:
Remaining book value − Revised residual value

Remaining useful life
Thus, the calculation would be as follows:
$100,000 − ($9,500 × 2) − $2,000

= $15,800 per year
7 − 2 = 5 years remaining
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.
10.3 Impairment
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
10.3. Impairment 401
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.
10.3.1 Accounting for 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 partic-
ular 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 ($14,000 − $1,400 = $12,600). The carrying value is
$20,000 ($30,000 − $10,000). 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:
General Journal
Loss on impairment . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Accumulated impairment loss . . . . . . . . . . . . 5,000
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 de-
scribed in 10.7 Appendix A.
10.3. Impairment 403
10.3.2 Cash-Generating Units
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 investiga-
tion, 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 ($1,135,000 − $950,000). 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 recover-
able 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.
10.4 Derecognition
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.
10.4.1 Held for Sale
When management first makes the decision to sell a noncurrent asset rather than con-
tinue 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.

10.4. Derecognition 405
• 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 2010 and decides
in late 2015 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 2015, when the decision to sell the asset is
made, the following journal entry will be required.
General Journal
Asset held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000
Accumulated depreciation . . . . . . . . . . . . . . . . . . . 40,000
PPE asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
For Asset HFS: ($50,000 − $2,000)
In 2016, the asset is actually sold for net proceeds of $49,000. The journal entry to record
this transaction is as follows:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000
Asset held for sale . . . . . . . . . . . . . . . . . . . . . . . 48,000
Gain on sale of asset . . . . . . . . . . . . . . . . . . . . 1,000
Now, if in 2015, 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:
General Journal
PPE asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Note that we do not report the asset held for sale at its estimated realizable value ($65,000−
$2,000 = $63,000), as this is greater than the carrying value. When the sale occurs in
2016, the following journal entry would be required:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000
Loss on sale of asset . . . . . . . . . . . . . . . . . . . . . . . 11,000
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.
10.4.2 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.
10.5. Presentation and Disclosure Requirements 407
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.
10.5 Presentation and Disclosure Requirements
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 aban-
doned
• 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.
IFRS ASPE
The depreciable amount is calculated us- The depreciable amount is calculated us-
ing the asset’s residual value. ing 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 Only the cost model is allowed.
can be used.
Assessment for indications of impairment Impairment is tested only when circum-
should occur at least annually. stances indicate impairment may exist.
A one-step process to determine impair- A two-step process is used. Impairment
ment, based on comparing recoverable is tested first by comparing carrying value
amount with carrying amount, is used. with undiscounted cash flows. If impaired,
Recoverable amount is the greater of the loss is determined by subtracting the
value in use or fair value less costs to sell. fair value from the carrying amount. See
10.7 Appendix A for details.
Impairment loss can be reversed when Impairment loss cannot be reversed.
estimates change. However, amount of
reversal may be limited.
Assets that meet the criteria of held for Assets held for sale can be classified as
sale are classified as current. current only if the asset is sold before
financial statements are completed.
More extensive disclosure requirements Fewer disclosure requirements must be
must be met. met.
10.7 Appendix A: ASPE Standards for Impairment
Under ASPE 3063, a different set of standards is applied to the issue of PPE impair-
ment. 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
10.7. Appendix A: ASPE Standards for Impairment 409
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 impair-
ment 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:

General Journal
Although a separate accumulated impairment loss account has been credited here, it is
Chapter Summary 411
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.
Chapter Summary
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 pro-
portions 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 in-
put 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 differ-
ent 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 depreci-
ation charge for current and future periods. No adjustments are made to past period-
depreciation charges.
Chapter Summary 413
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 transac-
tion 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.
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.
References
CPA Canada. (2006) CPA Canada Handbook. Toronto, ON: CPA Canada.
International Accounting Standards (n.d.). In IAS Plus. Retrieved from http://www.iasp

lus.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/infodet
ail/about/investors/preliminaryFinalReport14.pdf
Exercises
EXERCISE 10–1
Exercises 415
Machado Inc. purchased a new robotic drill for its assembly line operation. The total
cost of the asset was $125,000, including shipping, installation, and testing. The asset
is expected to have a useful life of five years and a residual value of $10,000. The total
service life, expressed in hours of operation, is 10,000 hours. The total output the machine
is expected to produce over its life is 1,000,000 units.
The asset was purchased on January 1, 2015, and it is now December 31, 2016. In 2016,
the asset was used for 2,150 hours and it produced 207,000 units.
Required: Calculate the 2016 depreciation charge using the following methods:
a. Straight-line
b. Activity, based on units of input
c. Activity, based on units of production
d. Double declining balance
EXERCISE 10–2
Cortazar Ltd. purchased a used delivery van for $10,000 on June 23, 2015. The van is
expected to last for three years and have a residual value of $1,000. The company’s year-
end is December 31, and it follows the policy of charging depreciation in partial periods to
the nearest whole month of use.
Required: Calculate the annual depreciation charge and ending carrying value of the
asset for each of the following fiscal years using the straight-line method:
a. December 31, 2015
b. December 31, 2016
c. December 31, 2017
d. December 31, 2018
EXERCISE 10–3
Equipment purchased for $39,000 by Escarpit Inc. on January 1, 2013 was originally
estimated to have a five-year useful life with a residual value of $4,000. Depreciation
has been recorded for the last three years based on these factors. In 2016, the asset’s
condition was reviewed, and it was determined that the total useful life will likely be seven
years and the residual value $5,000. The company uses straight-line depreciation.
Required:
a. Prepare the journal entry to correct the prior years’ depreciation.

b. Prepare the journal entry to record the 2016 depreciation.
EXERCISE 10–4
Michaux Ltd. purchased an office building on January 1, 2001, for $450,000. At that time,
it was estimated that the building would last for 30 years and would have a residual value
of $90,000. Early in 2007, a significant modification was made to the roof of the building
at a cost of $30,000. This modification could not be identified as a separate component,
but it was believed that it would add an additional ten years to the useful life. As well, it
was estimated the residual value would be reduced to $50,000 at the end of the revised
useful life. In 2015, due to a collapse in the local property market, the residual value was
revised to nil. The useful life, however, was expected to remain as estimated in 2007. The
company uses the straight-line method of depreciation.
Required:
a. Calculate the annual depreciation that was charged from 2001 to 2006.
b. Calculate the annual depreciation that was charged from 2007 to 2014.
c. Calculate the annual depreciation that will be charged from 2015 onwards.
EXERCISE 10–5
In December 2015, the management of Bombal Inc. reviewed its property, plant, and
equipment and determined that one machine showed evidence of impairment. The fol-
lowing information pertains to this machine:
Cost $325,000
Accumulated depreciation to date $175,000
Estimated future cash flows, undiscounted $140,000
Present value of estimated future cash flows $110,000
Fair value $125,000
Costs of disposal $ 9,000
Exercises 417
Bombal Inc. intends to continue using the asset for the next three years, with no expected
residual value at the end of that period. Bombal uses straight-line depreciation.
Required:
a. Determine if the asset is impaired under IAS 36.
b. If impairment is indicated in part (a), prepare the necessary journal entry at Decem-
ber 31, 2015, to record the impairment.
c. Prepare the journal entry to record depreciation for 2016.
d. After recording the depreciation for 2016, management reassesses the asset and
determines that the fair value is now $120,000, the undiscounted future cash flows
are $110,000, and the present value of the estimated future cash flows is $90,000.
There was no change to the costs of disposal. Prepare the journal entry, if any, to
record the reversal of impairment.
EXERCISE 10–6
Repeat the requirements of the previous question, assuming the company reports under
ASPE 3063.
EXERCISE 10–7
Reyes Technologies Ltd. has defined its computer repair division as a cash-generating
unit under IFRS. The company reported the following carrying amounts for this division at
December 31, 2015:
Computers $55,000
Furniture $27,000
Equipment $13,000
The computer repair division is being assessed for impairment. At December 31, 2015,
the division’s value in use is $80,000.
Required:
a. Determine if the computer repair division is impaired, assuming that none of the
individual assets has a determinable recoverable amount.
b. Prepare the journal to record the impairment from part (a), if any.
c. Determine if the computer repair division is impaired, assuming that the computers
have a fair value less cost to sell of $60,000, but that none of the other assets have
a determinable recoverable amount.
d. Repeat part (c) assuming that the computers’ fair value less cost to sell is $50,000.
EXERCISE 10–8
Landolfi Inc. owns a property that has a carrying value on December 31, 2016, of $520,000
(cost $950,000, accumulated depreciation $430,000).
Required:
For each of the following independent situations, prepare the journal entry to record the
transaction. Assume that at no time prior to the transaction did the asset qualify as a held
for sale asset. All transactions occur on December 31, 2016.
a. The property was sold to Paz Inc. for $450,000.
b. The local government expropriated the property to provide land for an expansion of
the rapid rail transit line. Compensation of $750,000 was paid to Landolfi Inc.
c. Due to a toxic mould problem, the property was deemed unsafe for use and was
abandoned. Management does not believe there is any possibility of selling the
property or recovering any amount from it.
d. Landolfi Inc. donated the property to the local government for use as a future school
site. At the time of the donation, the fair value of the property was $600,000.
EXERCISE 10–9
Schulz Ltd. purchased a machine in 2012 for $65,000. In late 2015, the company made a
plan to dispose of the machine. At that time, the accumulated depreciation was $25,000
and the estimated fair value was $35,000. Estimated selling costs were $1,000. Assume
that the asset qualifies as a held for sale asset at December 31, 2015.
Required:
a. Prepare the journal entry required at December 31, 2015.

Exercises 419
b. On March 3, 2016, the asset is sold for $37,000. Prepare the journal entry to record
the sale.
c. Repeat parts (a) and (b) assuming that the estimated fair value on December 31,
2015, was $45,000 instead of $35,000.
Chapter 11
Intangible Assets and Goodwill
Tesla Patents to be Shared With Competitors
In an unprecedented move, Tesla announced in 2014 that it intended to share its

significant number of patents with all other companies making electric cars. This is a
radical departure from its previous strategy to apply for as many patents as possible
in light of its concern that the big car companies would copy Tesla’s technology. Tesla
would be no match for these companies with their huge scale manufacturing facilities
and their big budget sales and marketing. As it turned out, Tesla’s fears about the
big car companies copying Tesla’s technology did not materialize because the electric
vehicle market was not big enough to make the effort.
Since then, a new movement called “open source” has been gaining prominence in
today’s business world. Since the focus of Tesla Motors was to accelerate the growth
of sustainable transport—including electric cars—it follows that they would change
their philosophy from holding patents to sharing their technology with other electric
car companies. Moreover, the global vehicle market has now reached about two
billion cars, increasing the carbon crises concern held by many. This environmental
concern creates an opportunity for the electric car industry sector to take a bigger slice
of the car market, especially if like-minded companies such as Tesla band together
and share their technologies. The end result could be the development of a common
technology platform that would further the sustainable transport sector as a better
environmental alternative compared to hydrocarbon-based transportation, currently
the focus of most big car companies.
(Source: Musk, 2014)
LO 1: Describe intangible assets and goodwill and their role in accounting and business.
LO 2: Describe intangible assets and explain how they are recognized and measured.
2.1 Describe purchased intangibles and explain how they are initially measured.
421
422 Intangible Assets and Goodwill
2.2 Describe internally developed intangibles and explain how they are initially
measured.
2.3 Describe how intangible assets are subsequently measured.
2.4 Describe how intangible assets are evaluated for impairment and derecog-
nized.
LO 3: Describe goodwill and explain how it is recognized and measured.
LO 4: Identify the disclosure requirements for intangible assets and goodwill.
LO 5: Describe how intangible assets and goodwill affect the analysis of company per-
formance.
LO 6: Explain the similarities and differences between ASPE and IFRS for recognition,
measurement, and reporting for intangible assets and goodwill.
Introduction
Why did Tesla purposely share its valuable and closely guarded patent secrets with
its competitor electric car manufacturers? As the covering story explains, their largest
competition does not come from within their own electric vehicle industry sector—it comes
from the massive hydrocarbon-operated (i.e., gasoline, diesel) car market. If Tesla shares
its critical intellectual property, such as its patents, with other electric car manufacturers
at no cost, the electric car industry sector could strengthen enough to cause a shift in
consumers from hydrocarbon vehicles to electric. In short, it is all about increasing the
market share for electric cars. By sharing these valuable intangible assets within their
industry sector, it increases these odds significantly.
Tesla thinks they can use their patents, which are some of Tesla’s intangible assets, to
make a difference and create a shift in demand from hydrocarbon to electric-powered
vehicles. This must mean that there is a tremendous value regarding Tesla’s patents. As
intangibles assets, how might Tesla account for these patents? This chapter will take a
look at intangible assets and goodwill and how they impact business.
Similar to property, plant, and equipment (PPE) assets, intangible assets are long-lived,
non-monetary assets whose costs are capitalized and reported as long-term assets on the
statement of financial position/balance sheet (SFP/BS). But unlike PPE, intangible assets
have no physical presence. Patents and copyrights have often become the subject of
11.1. Intangible Assets and Goodwill: Overview 423
news headlines when competitor companies attempt to infringe upon them. Many costly
and prolonged court battles have occurred as a result. Significant values are associated
with these intangible assets, so it is critical that they be accounted for as realistically as
possible.
This chapter will focus on the various kinds of intangible assets and goodwill in terms of
their use in business, as well as their recognition, measurement, reporting, and analysis.
1.0 Intangible Assets

and Goodwill: Overview Purchased Intangible
Assets
2.0 Intangible Assets: Internally Developed

Initial Recognition Intangible Assets
and Measurement
Intangible Assets:
Intangible Assets Intangible Assets:

and Goodwill Impairment and
Derecognition
Initial Recognition
and Measurement
3.0 Goodwill
4.0 Disclosures of Intangible
Assets and Goodwill
5.0 Analysis
6.0 IFRS/ASPE
Key Differences
11.1 Intangible Assets and Goodwill: Overview
Consider how important video game developers such as BioWare, the creators of Dragon
Age, have become in this decade with their mass-market appeal for gaming software.
Their major long-term assets are not physical assets as is the case with other companies
that own mainly property, plant, and equipment. Instead, their assets are the software and
the unique software development teams who are inspired and talented enough to create
gaming products that are successfully marketed to millions of people around the world.
Software gaming programs are copyrighted, just like published books. The copyright may
have no physical presence but it has value, as will now be discussed.
In terms of accounting for intangible assets, IFRS, IAS 38 Intangible Assets (IFRS, 2014)
defines these as meeting three conditions:
• identifiable, non-monetary asset without physical substance

• controllable by the business (by purchase or internally created)
• from which future benefits are expected to occur.
Identifiable, in this case, means either being separable (can be sold, transferred, rented,
or exchanged) or arising from contractual or other legally enforceable rights. Intangi-
ble assets are non-monetary assets because they have inherent values based on their
use in business. Cash, on the other hand, is a monetary asset because its value is
based on what it represents since the paper the cash is printed on has very little value by
itself, as was discussed in the cash and receivables chapter.
Intangible assets are not to be confused with goodwill. If BioWare was to sell their entire
business to a third party for more than the sum of the fair values of their identifiable
assets net of liabilities (net identifiable assets), then the excess amount paid over the
net identifiable assets by the purchaser would be classified as goodwill. The additional
amount that the purchaser is willing to pay may be due to a brilliantly creative software
development team with extraordinary talents that has value to the purchaser. Even though
goodwill is inherently part of the purchase and has no physical presence, it is not classified
as an intangible asset. This is because it is not separately identifiable from the other
assets, nor does it have any contractual or other legally enforceable rights. For this reason
it does not meet the definition of an intangible asset and is therefore classified separately
as goodwill, which is discussed later in the chapter.
Some types of intangible assets are listed below.
• Patents, copyrights, databases, software, and website development costs

• Trademarks and trade names
• Franchise agreements’ initial fees and closing costs
• Purchased-only customer lists, brands, or publishing titles
In a Canadian context, intangible assets have the following characteristics:

11.2. Intangible Assets: Initial Recognition and Measurement 425
• Patents are sole rights granted by the Canadian Patent Office to exclude others
from making, using, or selling an invention. They expire after twenty years. Patents
limit competition and therefore they provide incentive for companies or individuals
to continue developing innovative new products or services. For example, pharma-
ceutical companies spend large sums on research and development, so patents are
essential to earning a profit.
• Copyrights grant exclusive legal right to the author to copy, publish, perform, film, or
record literary, artistic, or musical material. A copyright protects authors during their
lifetimes and for fifty years after that. A recent example of copyright infringement
involves Michael Robertson, CEO of the now-bankrupt MP3.com. The former chief
executive of the online music storage firm MP3Tunes was found liable in March
2014 for infringing copyrights for sound recordings, compositions, and cover art
associated with artists including the Beatles, Coldplay, and David Bowie (Raymond,
2014).
• Trademarks are a symbol, logo, brand, emblem, word, or words legally registered or
established by use as representing a company or product. Coca Cola is an example.
Trademarks are renewable after fifteen years, so they can have an indefinite life.
• Industrial design (ID) creates and develops concepts and specifications that improve
the function, value, and appearance of products and systems. Registration of the
design results in exclusive rights being granted for ten years.
11.2 Intangible Assets: Initial Recognition and

Measurement
Recognition as an intangible asset is based on both of these criteria being met:
1. the probability that benefits will flow to the business and
2. the asset cost can be reliably measured.
If these are not met, then the item is expensed when it is incurred.
If the three conditions of an intangible asset and the two recognition criteria above are
met, then the intangible asset is:
• initially measured at cost
• subsequently measured at cost (or measured using the revaluation model for IFRS)
• amortized on a systematic basis over its useful life (unless the asset has an indefinite
useful life, in which case it is not amortized). For IFRS, the intangible asset is tested
annually for impairment.
Intangible assets can be acquired:
• as a separate purchase
• as part of a business combination (either through the purchase of the business’s

assets or acquiring the controlling shares of the business)
• by an exchange of assets
• by a government grant
• by self-creation (internally developed)
11.2.1 Purchased Intangible Assets
Costs are capitalized to intangible assets the same way as is done for property, plant, and
equipment. As a basic review, capital costs include the acquisition cost, legal fees, and
any direct costs required to get the intangible asset ready for use. If intangible assets are
purchased with other assets, the cost is then allocated to each asset based on relative
fair values (basket purchase). Other costs, such as training to use the asset, marketing,
administration or general overhead, interest payable due to late payment for the asset
purchase, and any costs incurred after the asset is put into its intended use, are expensed
as incurred.
Like property, plant, and equipment, intangible assets that are purchased in exchange for
other monetary and/or non-monetary assets are measured at either the fair value of the
assets given up or the fair value of the intangible asset received, whichever is the most
reliable measure as long as there is commercial substance. When an exchange lacks
commercial substance, the assets received are measured at the lessor of the carrying
amount or the fair value of the assets given up.
If a company receives an intangible asset at no cost or for a nominal cost in the form of
a government grant such as a grant of timber rights, then the fair value of the intangible
asset acquired is typically assigned.
11.2.2 Internally Developed Intangible Assets
All internally developed intangibles activities to create new products or substantially im-
prove existing products are to be separated into a research phase and a development
phase for various costs incurred. Below is a summary of the two phases and their
accounting treatment (IFRS, 2014; IAS 38 Intangible Assets):
Research Phase: Development Phase:

All original and planned in- The application of research findings before commer-
vestigation activities includ- cial production begins. It includes designing, testing
ing evaluating and select- and constructing prototypes, models, pilot plants
ing products or processes chosen from the alternatives identified in the research
from a number of possi- phase, as well as costs for any new tools, templates,
ble alternatives. If there or castings.
is any uncertainty about
which phase is appropriate
for an activity, then the re-
search phase is used.
1) Technical feasibility of
completing the intangible
asset must be proven.
2) Management intention
exists to complete it for use
or for sale.
3) The entity must be able
IAS 38: the six criteria to use or sell it.
must ALL be met to be 4) Adequate resources to
capitalized, otherwise complete the development
costs are expensed as and to use or sell the intan-
incurred. gible asset exist.
5) Probably of future eco-
All costs are expensed as nomic benefits is clearly
incurred because the established and reason-
activities do not relate to ably certain, such as the
an identifiable product or existence of a market or
process. the usefulness of the in-
tangible asset to the entity.
6) Costs can be reliably
measured
Costs that are initially ex-
pensed because they do
not meet the six criteria
above cannot be capital-
ized at a later date.
Typical ineligible costs for Business start-up costs,

capitalization: training, advertising and
promotion, relocation, re-
organization costs or any
costs after asset is ready
for use/sale. Internally
generated branding or cus-
tomer lists are also ex-
cluded from capitalization
because they are indistin-
guishable from other busi-
ness costs.
Once six criteria are met, Any external or internal
direct costs that are eligi- costs directly attributable
ble: to the specific asset such
as direct materials and di-
rect labour (i.e., salaries
and benefits), as well as
other direct costs such as
engineering costs, and any
directly attributable over-
head costs.
Once the intangible asset
is ready for its intended
use, then any subsequent
costs are expensed and no
longer capitalized.
For ASPE, CPA Handbook, Sec. 3064, Goodwill and Intangible Assets (CPA Canada,
2016), allows a choice between simply expensing the costs for internally developed in-
tangibles or recognizing the intangible asset when certain criteria (similar to the criteria
above).
11.2.3 Intangible Assets: Subsequent Measurement
After the initial recognition and measurement, subsequent measurement is as follows:
• ASPE–Cost model (CM) only
• IFRS–Cost model (CM). If the intangible asset has its fair values determined in an
active market, then the Revaluation model (RM) can be used. The RM is not widely
used in actual practice since an active market for intangible assets usually does not
exist.
The accounting treatment under both models is applied the same way as is applied
to property, plant, and equipment (PPE). Since intangible assets rarely have an active
market to provide readily available fair values, discussions in this chapter will focus on the
cost model (CM).
Cost Model (CM)
• Asset is initially recorded upon acquisition at its cost.

• Subsequently, its carrying value will be at cost less accumulated amortization and
accumulated impairment losses since acquisition, if any.
• On disposal, its carrying value is removed from the accounts and any gain or loss
(sales proceeds minus the carrying value) is reported in net income.
An intangible asset with a limited useful life will be amortized over its estimated useful life,
similar to plant and equipment, as follows:
• Amortization can be calculated using the units of production or straight-line methods,

but usually assuming a residual value of zero (unless it can be sold to a third party).
The method to use is determined by using similar criteria to that used for plant and
equipment. Nearly all intangible assets are amortized using the straight-line method
with no residual value unless there is compelling evidence to prove otherwise.
• Estimating useful life considers criteria such as expected use of the assets, any lim-
its imposed by law, statute, or contract, and impact on the asset from obsolescence
and technology advances. If a patent has a legal life of twenty years but expects a
competing product to emerge in fifteen years, then the useful life would be the lesser
of the two, or fifteen years.
• Amortization begins and ends according to when the asset is ready for use and
when it is to be disposed of or sold.
• Amortization policy is reviewed annually (ASPE) or at the end of each fiscal year
(IFRS) in terms of asset’s useful life, amortization method, and residual value, if any.
• Changes in useful life, residual value (if any), and amortization method are consid-
ered to be changes in accounting estimates and accounted for prospectively.
• Intangible assets are reviewed for impairment at the end of each reporting period
(for IFRS), or whenever circumstances indicate that the carrying value of the asset
may not be recoverable (for ASPE).
If the intangible asset has an indefinite life, no amortization is recorded, but will be subject
to review at the end of each accounting period. Should this status change to a definite
life, it is treated as a change in estimate and accounted for prospectively. Indefinite life
assets are also subject to impairment reviews and adjustments, if applicable.
11.2.4 Intangible Assets: Impairment and Derecognition
The process of impairment and derecognition of intangible assets is similar to that of

property, plant, and equipment. Below is a summary of two models used for definite-life
and indefinite-life intangible assets.
ASPE Cost Recovery Impairment Model IFRS: Rational Entity Impairment Model
Assumes that the asset will continue to be Assumes that the asset will either continue
used. The asset is impaired only if the to be used or disposed of, depending upon
carrying value of the asset is more than which results in a higher return. The asset
the sum of the net future undiscounted is impaired only if the carrying value of the
cash flows from both the use and eventual asset is more than the asset’s recoverable
disposal of the asset. amount (a discounted cash flow concept),
being the higher of the value in use and the
fair value less costs to sell.
Definite-Life Intangible Assets
Impairment Only when events Impairment An assessment is
recognition and circumstances recognition made at the end of
indicate that the each reporting
carrying value may period as to
not be recoverable, whether there is
as determined by a any indication that
recoverability test. the asset is
impaired.
Recoverability test If the carrying value Recoverability test None
is greater than the
undiscounted
future cash flows,
then asset is
impaired and the
impairment loss is
calculated.
Impairment loss The asset carrying Impairment loss 1) Calculate the

value less fair recoverable amount
value. as the higher of
the value in use
and the fair value
less costs to sell.
2) If the asset
carrying value is
more than the
recoverable
amount, then the
asset is impaired
by the difference
between these two
amounts.
Impairment Not permitted Impairment If the recoverable
reversal reversal amount has
increased, then
reversal is allowed,
but not to exceed
the asset’s carrying
value excluding any
impairments.
Indefinite-Life Intangible Assets
Impairment Only when events Impairment Tested for
recognition and circumstances recognition impairment
indicate impairment annually.
is possible as
determined by a
fair value test.
Fair value test If the carrying value Fair value test None
is greater than the
fair value, then
asset is impaired
and the loss is
calculated.
Impairment loss Equal to the Impairment loss Same as for
difference resulting definite-life
from the fair value intangible assets
test. above.
Impairment Not permitted. Impairment Same as for
reversal reversal definite-life
intangible assets
above.
The entry for impairment for both ASPE and IFRS is:
General Journal
Loss on impairment . . . . . . . . . . . . . . . . . . . . . . . . . $$
Accumulated impairment losses, intangi- $$
ble asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated impairment losses is a contra
asset account.
Amortization calculation after impairment for both ASPE and IFRS is based on the ad-
justed carrying value after impairment, the revised residual value (if any), and the asset’s
estimated remaining useful life.
carrying value after impairment − revised residual value (if any)

Revised amortization =
Estimated remaining useful life
When an intangible asset is disposed of, the difference between the net proceeds and
the asset’s carrying value is the gain or loss reported in net income. The asset and its
accumulated amortization are removed from the accounts.
11.3 Goodwill
11.3.1 Initial Recognition and Measurement
Goodwill arises when one company acquires a controlling interest (i.e., greater than 50%)
of another business and pays more than the fair value of its net identifiable assets (total
identifiable assets – identifiable liabilities). This excess amount paid by the purchaser is
classified as goodwill. As discussed at the beginning of this chapter, since goodwill is not
a separately identifiable asset and has no contractual or other legally enforceable rights,
it does not meet the definition of an intangible asset. It is therefore classified separately
as goodwill on the SFP/BS. Also, a third-party purchase is the only circumstance where
goodwill can be recognized. This is due to the complexities of recognizing and measuring
internally generated goodwill, which lacks any arm’s-length third-party associations.
All the identifiable assets and identifiable liabilities received are initially recorded by the
purchaser at their fair values at the date of purchase. The difference between the sum
of the fair values and the purchase price (or the fair value of any consideration given up)
is classified and recorded as goodwill. Consideration can be cash or other assets, notes
payable, shares, or other equity instruments.
11.3. Goodwill 433
For example, on January 1, Otis Equipment Ltd. purchases the net identifiable assets
of Waverly Corp. for $40M cash and a short-term promissory note for $12M. Waverly’s
unclassified year-end balance sheet as at December 31 is shown below.
Waverly Corp.
Balance Sheet
December 31, 2014
(in $000s)
Assets Liabilities and shareholders’ equity

Cash $ 50,000 Accounts payable $ 85,000
Accounts receivable (net) 15,000 Mortgage payable due Dec 31, 2024 100,000
Inventory 35,000 Share capital 40,000
Building (net) 100,000 Retained earnings 5,000
Equipment (net) 25,000
Patent (net) 5,000
Total assets $230,000 Total liabilities and equity $230,000
To determine the amount of consideration (cash and short-term promissory note) to offer
Waverly, Otis completed a detailed fair value analysis of the net identifiable assets, as
shown below.
Fair Values
December 31, 2014
(in $000s)
Cash $ 50,000
Inventory 33,000
Building 125,000
Equipment 15,000
Patent 0
Accounts payable (85,000)
Mortgage payable, due Dec 31, 2024 (100,000)
Total fair value of net identifiable assets $ 50,000
Differences between fair values and the carrying values of the net identifiable assets are
common. For example, the accounts receivable may be adjusted because the bad debt
estimate was not sufficient. Inventory may be adjusted due to obsolescence or due to
a recent decline in prices from the supplier. Long-term assets values for property, plant,
and equipment are usually determined either by independent appraisals or from published
pricing guides such as those used for vehicles. Vehicles will lose value as they age, but
land and buildings can appreciate over time. The patent may have been assessed a zero
value because it was almost fully amortized and was due to expire the next year. Fair
values for current liabilities such as accounts payable are usually the same as their book
values. Long-term liabilities may require adjustments if interest rates have significantly
changed.
The total consideration given up by Otis is $52M combined cash and short-term promis-
sory note compared to the fair value of the net identifiable assets of $50M. The $2M
difference will be classified as goodwill. As previously stated, goodwill is not an identifiable
asset on its own but simply that portion of the purchase price not specifically accounted
for by the net identifiable assets. In other words, goodwill represents the future economic
benefits arising from other assets acquired in the business acquisition that cannot be
identified separately.
Otis would make a journal entry as shown below.
General Journal
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Short-term promissory note payable . . . . . 12,000
Mortgage payable . . . . . . . . . . . . . . . . . . . . . . . 100,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Any transaction costs incurred by Otis associated with the purchase would be expensed
as incurred.
There are many reasons why Otis was willing to pay an additional $2M to purchase
Waverly. Waverly may possess a top credit rating with its creditors, an excellent reputation
for quality products and service, a highly competent management team, or highly skilled
employees. These factors will positively affect the total future earning power and hence
the value of the business as a whole.
If Waverly accepted an offer from Otis of $49M and the fair values of the net identifiable
assets of $50M were re-examined and considered accurate, then the $1M difference
would be recorded by Otis as a gain (credit) from the acquisition of assets in net income.
This would be considered a bargain purchase.
11.3. Goodwill 435
11.3.2 Subsequent Measurement of Goodwill
Once purchased, goodwill is deemed to have an indefinite life and is therefore not amor-
tized but it is evaluated for impairment. Under IFRS, this is done annually and whenever
there is an indication that impairment exists. For ASPE this is only done whenever
circumstances indicate that an impairment exists.
Since goodwill is not a separately identifiable asset, it is allocated to reporting (ASPE) or

cash generating units (CGUs; IFRS) expected to benefit from the business acquisition on
the acquisition date.
For ASPE, after testing and adjusting the individual assets of the CGU as required,
impairment is then applied to the reporting unit as a whole similarly as for intangible
assets with an indefinite life. If the carrying value of the reporting unit is greater than its
fair value, then this difference is the impairment amount.
For IFRS, if the carrying value of the CGU is greater than the recoverable amount (which
is the higher of the CGU’s value in use or fair value less costs to sell) then this difference
is the impairment amount. Impairment is allocated first to goodwill (to an accumulated
impairment losses, goodwill account), with any further excess allocated to the remaining
assets’ carrying values in the CGU on a proportional basis.
Goodwill impairment reversals are not permitted for ASPE or IFRS.
For example, assume that Calter Ltd. purchased Turnton Inc. and identified it as a re-
porting unit (CGU). The goodwill amount that was recorded at acquisition was $40,000
and the carrying amount of the unit as a whole, including goodwill was $360,000. One
year later, due to an economic downturn in that industry sector, management is assessing
whether the unit has incurred an impairment of its net identifiable assets. The fair value
of the unit was evaluated to be $330,000. The direct costs to sell would be $9,300 and
the unit’s value in use is $340,000.
Under ASPE:
After testing and adjusting the individual assets within the unit, the unit as a whole was
evaluated at a fair value of $330,000 as stated in the scenario above.
Carrying amount of unit as a whole, including goodwill $360,000

Fair value of the unit 330,000
Goodwill impairment loss $ 30,000
The entry to record the loss is shown below.

General Journal
Accumulated impairment losses, goodwill 30,000
asset account.
The net carrying value for goodwill will be $10,000 ($40,000 − 30,000). Since individual
asset testing and adjustments within the unit was done prior to the evaluation of the unit
as a whole, the impairment amount would not exceed goodwill.
Under IFRS:
Carrying amount of CGU as a unit, including goodwill $360,000
Recoverable amount of unit 340,000
(Higher of value in use of $340,000
and fair value less costs to sell
330,000 − 9,300 = $320,700)
Goodwill impairment loss $ 20,000
Entry to record the loss is shown below.
General Journal
Accumulated impairment losses, goodwill 20,000
asset account.
The net carrying value for goodwill after the impairment is $20,000 ($40,000 − 20,000).
Had the impairment amount exceeded the $40,000 goodwill carrying value, the amount
of the difference would be allocated to the remaining net identifiable assets on a prorated
basis, since there had been no impairment testing of individual assets as was done for
ASPE above.
11.4 Disclosures of Intangible Assets and Goodwill
For reporting purposes, intangible assets are grouped together with similar other in-
tangible assets. Some examples of these classes are patents, copyrights, computer
software, or industrial designs. Most of the disclosures will be in the notes to the financial
statements. Disclosures for ASPE are more simplified than for IFRS. For each class,
some of the most important disclosures are listed below.
11.5. Analysis 437
• Identify if the intangible assets have a definite or indefinite life, or were purchased
or internally developed.
• Identify useful life, amortization policy and rate, the accumulated amortization for
definite-life assets, and carrying amount for both definite- and indefinite-life assets.
• Disclose amortization amounts included in the line items of the statement of income
or comprehensive income.
• Disclose the amount of research and development costs expensed through net
income.
• Reconcile the beginning and ending balances of each class of intangibles, includ-
ing acquisitions, increases in internally generated intangibles, amortizations, and
impairments.
• Goodwill is reported as a separate line item with its carrying value and impairments
amounts disclosed.
• Disclose capitalization policies.
11.5 Analysis
Analysis of financial statements will be affected by how intangible assets are accounted
for. For example, companies that follow ASPE can either capitalize or expense their
internally developed intangibles, depending upon company policy. More flexibility means
less comparability when evaluating performance with other companies within the industry
sector. Policy changes with regard to intangible assets are treated prospectively within
a company. This can also impact comparability within the company when analysing
performance trends over time. For IFRS companies, once the six conditions and criteria
are met for internally developed intangibles, they are to capitalize the asset. This results
in more comparability when analyzing performance.
Another issue involves company valuations as a whole. The SFP/BS does not always
capture the company’s true value. This in turn will affect performance evaluation within
the company and within its industry sector. Recall the discussion at the beginning of
this chapter regarding BioWare, whereby the company’s total value can increase due to
the development of creative software development teams with extraordinary talents or
perhaps a superior management team. Since these cannot be measured reliably, they
are not reported in any of the financial statements. There is no doubt that these attributes
are relevant and will positively affect the company’s total value, but without quantification
within the financial statements, they will likely have little impact on decision-making such
as what a creditor would be willing to loan the company to expand their markets, or what
additional monies a purchaser might be willing to pay to purchase the company as a
whole.
Item ASPE IFRS

(Sec. 3064) (IAS 38)
Intangible assets: Those development costs Costs separated into
internally developed meeting ALL the six research and
criteria in the development development. All research
phase may be capitalized costs are expensed.
or expensed. Those development costs
meeting ALL the six criteria
in the development phase
are to be capitalized:
1) technical feasibility
2) management intention
to complete
3) ability to use or sell
4) adequate resources
5) future economic
benefits and market or
usefulness exists
6) costs reliably
measureable.
Intangible assets: Cost model: measured at Policy choice to use either
subsequent cost less accumulated cost model (usually) or
measurement amortization (definite-life revaluation model (only if
assets only) and an active market exists).
impairment losses since
acquisition.
Intangible assets: For definite-life intangible For both definite-life and
impairment assets: if the carrying indefinite-life intangible
value is greater than the assets:
undiscounted future cash
flows, then asset is 1) Calculate the
impaired. The impairment recoverable amount as the
loss is calculated as the higher of the value in use
difference between the and the fair value less
carrying value and fair costs to sell.
value.
Chapter Summary 439
For indefinite-life intangible 2) If the asset carrying

assets: if carrying value is value is more than the
greater than fair value then recoverable amount, then
asset is impaired for that the asset is impaired by
amount. the difference between
these two amounts.
Impairment is not Impairment is reversible

reversible. but amount is limited to
asset’s carrying value had
no impairment occurred.
Disclosure of intangible Basic disclosures are Detailed disclosures are
assets and goodwill required such as reporting required for intangibles
intangible assets by class and goodwill. For each
with details about class, identify amortization
amortization policy and policy, impairment losses,
impairment losses. reconciliation of opening to
Goodwill impairment closing balances details,
details also disclosed. and capitalization policies.
Disclose research and
development costs that
were expensed.
(Sources: CPA Canada, 2016; IFRS, 2014)
Chapter Summary
LO 1: Describe intangible assets and goodwill and their role in

Intangible assets and goodwill can have significant balances reported in a company’s
SFP/BS. In order to be classified as an intangible asset, it must be identifiable, non-
monetary, without physical substance, be controllable by business, and with expected
future benefits. Some examples of intangible assets are patents, copyrights, trademarks,
and purchased customer lists. Goodwill, on the other hand, can only occur as a result of
a purchase of another company’s net identifiable assets. Any excess proceeds paid over
the total fair value of these net identifiable assets will be classified and reported separately
as goodwill.
LO 2: Describe intangible assets and explain how they are

recognized and measured.
To be recognized as an intangible asset for accounting purposes, there must be a prob-

ability that future benefits will accrue to the business and that they can be reliably mea-
sured. If not, then the item is expensed as incurred. Intangible assets can be acquired as
a separate purchase or as part of a business combination, in exchange for other assets,
as part of a government grant or be internally developed. Intangible assets are initially
measured at cost. Initial costs that can be capitalized to the asset are any direct costs
required to get the asset ready for use. Any costs incurred after the asset is put into use
are expensed.
Intangible assets that are internally developed are subject to more stringent criteria and
are separated into research and development phases. Research phase costs are ex-
pensed as incurred because there is no identifiable product or process yet. Development
phase costs meeting all of the six criteria can be capitalized. Initial costs that can be
capitalized are any direct costs required to get the asset ready for use. All other costs are
expensed and cannot be capitalized at a later date.
Once the asset is in use, it is usually subsequently measured at amortized cost or cost
(ASPE or IFRS) or, less often, using the fair-value based revaluation model (IFRS only).
Definite-life intangible assets are amortized on a systematic basis the same as property,
plant, and equipment. Indefinite-life assets are not amortized but the indefinite-life status
is subject to review.
Evaluation for impairment is undertaken at certain points over time for all intangible assets
the same as is done for property, plant, and equipment. For definite life intangibles, ASPE
evaluates for indicators of impairment only when circumstances indicate impairment is a
possibility as determined by a recoverability test that compares the carrying value with
the undiscounted future cash flows. If impaired, the asset’s carrying value is reduced to
equal the fair value at that date and the loss on impairment is reported in net income.
Impairment reversals are not permitted.
IFRS evaluates for indicators of impairment at the end of each year. There is no im-
pairment test. If impaired, the asset carrying value is reduced to equal the recoverable
amount (the higher of the value in use and the fair value less costs to sell). Impairment
reversals are limited and cannot exceed the asset’s carrying value without any impairment
adjustments.
For indefinite intangible assets, ASPE evaluates for indicators of impairment only when
circumstances indicate impairment is a possibility as determined by a fair value test that
compares the carrying value with the fair value. If impaired, the asset’s carrying value is
reduced to equal the fair value at that date and the loss on impairment is reported in net
income. As was the case for definite-life intangibles, impairment reversal is not permitted.
Chapter Summary 441
For IFRS, indefinite-life intangibles are treated the same ways as definite-life intangibles
regarding impairment evaluation and measurement.
Amortization is based on the adjusted carrying value after impairment, the revised resid-
ual value, and the estimated remaining useful life.
On disposal, the asset is removed from the accounts and any gain or loss reported in net
income.
LO 3: Describe goodwill and explain how it is recognized and

measured.
Goodwill can only arise from a third-party purchase of another company’s net assets.
Goodwill is calculated as the difference between the purchase price (e.g., cash, other
assets, notes payable, shares) and the fair value of the net identifiable assets; it is
reported separately as a long-term asset on the SFP/BS. The purchaser records all the
net identifiable assets at their fair values and any resulting goodwill on the SFP/BS as
at the purchase date. If the purchase price were to be less than the fair value of the
net identifiable assets, the difference would be credited as a gain from the acquisition of
assets in net income.
Goodwill is considered to have an indefinite life so it is not amortized. Goodwill is assigned

as part of a reporting or cash-generating unit (CGU), and the unit as a whole is assessed
for impairment using the same measurement criteria as for intangible assets with an
indefinite life. The only difference is that goodwill impairment reversals are not allowed for
either ASPE or IFRS.
LO 4: Identify the disclosure requirements for intangible assets and

goodwill.
For reporting purposes, intangible assets are usually grouped with other intangibles with
similar characteristics. For ASPE, the disclosures are simpler than for IFRS companies.
Most of the disclosures are made in the notes to the financial statements. Disclosures
include separate reporting into various classes for definite-life and indefinite-life intangi-
bles, with goodwill being reported separately. Amortization and capitalization policies,
amortization amounts, impairment assessments and amounts, and reconciliations of be-
ginning to ending balances for each class of intangible asset disclosures are also required.
Amounts expensed for amortization expense and research and development costs are
also disclosed.
LO 5: Describe how intangible assets and goodwill affect the

analysis of company performance.
Comparability is affected by the differences between how the accounting standards are
applied for purchased assets versus internally developed intangibles and goodwill for both
ASPE and IFRS companies. Moreover, any changes in accounting policies are treated
prospectively, making comparability within a company or between companies over time
more difficult. Valuation issues are significant with regard to intangible assets that have
been expensed due to not meeting the conditions and criteria identified in the ASPE and
IFRS standards to qualify as an asset. Since these are not reported on the SFP/BS,
valuation of these companies becomes increasingly more difficult.
LO 6: Explain the similarities and differences between ASPE and

IFRS for recognition, measurement, and reporting for intangible
assets and goodwill.
The differences between ASPE and IFRS arise regarding the following.
1. There is a choice to capitalize or expense internally developed intangible assets for

ASPE companies. For IFRS, there is no choice: if they meet the conditions and
criteria, then these expenses are to be capitalized.
2. Evaluation and measurement of impairment losses.
3. The extent of the required disclosures in the financial statements.
References
IFRS. (2015). International Financial Reporting Standards 2014. London, UK: IFRS
Foundation Publications Department.
Musk, E. (2014, June 12). All our patent are belong to you. Tesla [Blog]. Retrieved from
http://www.teslamotors.com/blog/all-our-patent-are-belong-you
Raymond, N. (2014, March 19). Ex-MP3tunes chief held liable in music copyright case.
Reuters. Retrieved from http://www.reuters.com/article/2014/03/19/us-mp3tunes-
infringement-idUSBREA2I29J20140319
Exercises 443
Exercises
EXERCISE 11–1
Indicate whether the items below are to be capitalized as an intangible asset or expensed.
Which account(s) would each item be recorded to?
a. Salaries of research staff
b. Market research
c. Costs to test prototypes
d. Borrowing costs for development of a qualifying intangible asset
e. Executive salaries for time spent on development of an intangible asset
f. Costs to launch a new product
g. Purchase cost of a patent from a third party
h. Product research costs
i. Costs internally incurred to create goodwill
j. Legal costs to successfully defend a patent
k. Purchase price of new software
l. Training costs for new software
m. Direct costs of special programming needed when purchasing new software
n. Costs incurred in forming a corporation for purposes of commercializing a new

product
o. Operating losses incurred in the start-up of a business to manufacture a patented

produce
p. The purchase cost of a franchise
q. The cost of developing a patent
r. The cost of purchasing a patent from an inventor
s. Legal costs incurred in securing a patent
t. The cost of purchasing a copyright

u. Product development costs
v. Consulting fees paid to a third party for advice on a research project
w. The cost of an annual update on payroll software
x. Interest or borrowing costs specifically identifiable with an internally developed in-

tangible asset
y. Materials consumed in the development of a product at the manufacturing stage for

an IFRS company
z. Materials consumed in research projects
aa. General borrowing costs on the company’s line of credit
ab. Indirect costs allocated to research and development projects
EXERCISE 11–2
Harman Beauty Products Ltd. produces organic aromatherapy hand soaps and bath oils
to retail health stores across North America. The company purchased the trademark and
patented recipes for this unique line of soaps and oils, called Aromatica Organica, five
years ago for $150,000. Each type of soap or oil is made from a secret recipe only known
to the head “chef” at Harman who distributes the ingredients for each type of soap or oil
to small groups of “cooks” who then combine the unknown ingredients into a small batch
of a particular type of soap or oil. These are then packaged and shipped to fill each order
placed by the retail stores through the colourful and user-friendly website developed by
Harman.
Required:
a. Identify any intangible assets that may appear on the company’s SFP/BS.
b. Discuss the importance of the intangible assets to the company’s business.
c. Why it is important to record intangible assets on a company’s SFP/BS?
EXERCISE 11–3
On January 1, 2015, a patent with a book value of $288,000 and a remaining useful life
of fourteen years was reported on the December 31, 2014 post-closing trial balance. In
2015, a further $140,000 of research costs was incurred during the research phase. A
Exercises 445
lawsuit was also brought against a competitor company regarding the use of a patented
process for which legal costs of $42,000 were spent. On September 1, 2015, the lawsuit
was concluded successfully and the courts upheld the patent as valid, so the competitor
would not be able to continue using the patented process. The company year-end is
December 31 and follows IFRS.
Required: What amount should be reported on the SFP at December 31, 2015, assuming
straight-line amortization?
EXERCISE 11–4
Indicate how the items below are to be reported as assets in the SFP/BS as at December
31, 2015:
a. January 1, copyright obtained for a book developed internally for $25,000, which is
estimated to have a useful life of five years. Assume the straight-line method for
amortization and that all costs were incurred on January 1.
b. January 1, copyright obtained for a book purchased from Athabasca University for
$35,000 cash with an indefinite useful life.
c. On January 1, 2015, an Internet domain name with an indefinite life was purchased
in exchange for a three-year, note. The market rate at that time was 8%. The
note is repayable in three annual principal and interest payments of $14,500 each
December 31.
EXERCISE 11–5
Trembeld Ltd. was developing a new product, and the following timeline occurred during
2015:
January 1 to March 31, 2015 incurred the following costs:
Materials $180,000
Direct labour 64,000
April 1, criteria to capitalize costs were met
May 1 to July 31, 2015, incurred the following costs:

Materials 270,000
Direct labour 86,000
Directly related legal fees 25,400
Borrowing costs 8,600
Required:
a. How would Trembeld account for the costs above if the company followed ASPE?
b. How would Trembeld account for the costs above if the company followed IFRS?
EXERCISE 11–6
Crellerin Ltd. has a trademark with a carrying value of $100,500 that has an expected
life of fifteen years. At December 31, 2015 year-end, an evaluation of the trademark was
completed. The following estimates follow:
Fair value $ 55,000

Fair value less costs to sell $ 50,000
Value in use $115,000
Undiscounted cash flows $152,000
Required:
a. Determine if the trademark is impaired as at December 31, 2015, assuming that

Crellerin follows ASPE and indicators of an impairment exist.
b. Determine if the trademark is impaired as at December 31, 2015, assuming that

Crellerin follows IFRS and trademark has been assessed for positive conditions of
impairment.
c. How would the answers to part (a) and (b) change if the trademark had an unlimited
expected life?
EXERCISE 11–7
Fredickson Ltd. purchased a trade name, a patented process and a customer list for $1.2
million cash. The fair values of these are:
Trade name $380,000
Patented process $400,000
Customer list $450,000
Required: Prepare the journal entry for the purchase.
EXERCISE 11–8
Exercises 447
Below are three independent situations that occurred for Bartek Corporation during 2015.
Bartek’s year-end is December 31, 2015.
i. On January 1, 2012, Bartek purchased a patent from Apex Co. for $800,000. The
patent expires on the same date in 2020 and Bartek has been amortizing the patent
over the eight years. During 2015, management reviewed the patent and deter-
mined that its economic benefits will last seven years from the date it was acquired.
ii. On January 1, 2015, Bartek bought a perpetual franchise from Amoot Inc. for $500,000.
On this date, the carrying value of the franchise on Amoot’s accounts was $600,000.
Assume that Bartek can only provide evidence of clearly identifiable cash flows for
twenty years but estimates that the franchise could provide economic benefits for up
to sixty years.
iii. On January 1, 2012, Bartek incurred development costs of $250,000. These costs
meet the six criteria, and Bartek is amortizing these costs over five years.
Required:
a. For situation (i), how would the patent be reported on the SFP/BS as at December
31, 2015?
b. For situation (ii), what would be the amortization expense for December 31, 2015?
c. For situation (iii), how would these development costs be reported as at December
31, 2015?
EXERCISE 11–9
On September 1, 2015, Verstag Co. acquired the net identifiable assets of Ace Ltd. for
a cash payment of $863,000. At the time of the purchase, Ace’s SFP/BS showed assets
of $900,000, liabilities of $460,000, and shareholders’ equity of $440,000. The fair value
of Ace’s assets is estimated at $1,160,000 and liabilities have a fair value equal to their
carrying value.
Required:
a. Calculate the amount of goodwill and record the entry for the purchase.
b. Three years later, determine if there is an impairment, and calculate the impairment
loss assuming that Verstag follows IFRS and that goodwill was allocated to one
cash-generating unit (CGU). The carrying value of the unit was $1,925,000, the fair
value was $1,700,000, the costs to sell were $100,000, and the value in use was
$1,850,000.
c. How would the answer for part b) be different if Verstag follows ASPE? Fair value is
$1,860,000.
EXERCISE 11–10
Indicate how each of the following items would be classified:
a. Excess of purchase price over the fair value of net identifiable assets of another
business
b. Research costs
c. Annual franchise fee paid
d. Organisations costs
e. Cash
f. Accounts receivable
g. Prepaid expenses
h. Notes receivable
i. Research and development acquired in a business combination
j. Leasehold improvements
k. Brand names
l. Music copyrights
m. Investments in affiliated companies
n. Film contract rights
o. Discount on notes payable
p. Property, plant, and equipment
q. Land
r. Development phase activities (meets the 6 criteria for development phase)

Exercises 449
s. Purchased trademarks
t. Excess of cost over fair value of net assets of acquired subsidiary
u. Costs of researching a secret formula for a product that is expected to be marketed

for at least fifteen years
EXERCISE 11–11
On January 1, 2014, Josey Corp. received approval for a patent from the Patent Office.
Legal costs incurred were $25,000. On June 30, 2015, Josey incurred further legal costs
of $35,000 to defend its patent against a competitor trying to sell a knock-off product. The
court action was successful. The patent has a life of twenty years.
Required:
a. What are the variables to consider in determining the useful life of a patent?
b. Calculate the carrying value of the patent as at December 31, 2014, and December
31, 2015.
c. Calculate the carrying value of the patent as at December 31, 2015, if management
decides on January 1, 2015 that the patent’s life is only fifteen years from the
approval date.
d. What are the accounting treatment and the issues if the patent was assessed to
have an indefinite life?
EXERCISE 11–12
Below is select information for the following independent transactions for Hilde Co., an
ASPE company:
i. On January 1, 2015, a patent was purchased from another company for $900,000.
The useful life is estimated to be fifteen years. At the time of the sale, the patent had
a carrying value on the seller’s books of $915,000. A year later, Hilde re-assessed
the patent to have only ten years’ useful life at that time.
ii. During 2015, Hilde incurred $350,000 in costs to develop a new electronic prod-
uct. Of this amount, $180,000 was incurred before the product was deemed to
be technologically and financially feasible. By December 31, 2015, the project was
completed. The company estimates that the useful life of the product to be ten years,
and earnings are estimated to be $3.6 million over its useful life. Hilde’s policy is to
capitalize any costs meeting the ASPE criteria.
iii. On January 1, 2015, a franchise was purchased for $1.8 million. In addition, Hilde
must also pay 2% of revenue from operations to the franchisor. For the year ended
2015, the revenue from the franchise was $5.6 million. Hilde estimates that the
useful life of the franchise is forty years.
iv. During 2015, the following research costs were incurred; materials and equipment of
$25,000; salaries and benefits of $250,000; and indirect overhead costs of $15,000.
(Assume a single entry in 2015 for these costs.)
Required:
a. For each independent situation above, prepare all relevant journal entries including
any adjusting entries for 2015 (and 2016 for situation i) for Hilde Co. Hilde’s year-end
is December 31 and follows ASPE.
b. Prepare a partial income statement and balance sheet for 2015, including all re-
quired disclosures. Income tax rate is 27%.
c. Explain how the accounting treatment for each of the situations above would differ if
Hilde was a public company that followed IFRS.
d. Explain how limited-life intangibles are tested for impairment for ASPE and IFRS
companies. How is the impairment calculated for each standard?
EXERCISE 11–13
On January 1, 2015, Nickleback Ltd. purchased a patent from Soriato Corp. for $50,000
plus a $60,000, five-year note bearing interest at 8% payable annually. Upon maturity a
single lump sum amount of $60,000 will be payable. The market-rate for a note of a similar
risk and characteristics is 9%. Nickleback estimates that the patent will have a future life
of twenty years. Nickleback follows ASPE.
Required: Prepare the journal entry for the patent purchase. (Hint: refer to chapter on
long-term notes receivable.)
EXERCISE 11–14
On January 4, 2015, a research project undertaken by Nasja Ltd. was completed and a
patent was approved. The research phase of the project incurred costs of $150,000, and
Exercises 451
legal costs incurred to obtain the patent approval were $20,000. The patent is assessed
to have a useful life to 2025, or for ten years. Early in 2016, Nasja successfully defended
the patent against a competitor, incurring a legal cost of $22,000. This set a precedent for
Nasja who was able to reassess the patent’s useful life to 2030. During 2017, Nasja
was able to create a product design that was feasible for commercialization, but no
more certainty was known at that time. Costs to get the product design to this stage
were $250,000. Additional engineering and consulting fees of $50,000 were incurred to
advance the design to the manufacturing stage. Nasja follows IFRS.
Required:
a. Prepare all the relevant journal entries for the project for 2015 to 2017, inclusive.
b. What is the accounting treatment for the engineering and consulting fees of $50,000?
EXERCISE 11–15
On December 31, 2015, a franchise that is owned by Horten Holdings Ltd. has a remain-
ing life of thirty-two years and a carrying amount of $1,000,000. Management estimates
the following information about the franchise:
Fair value 1,000,000

Disposal costs 45,000
Discounted cash flows (value in use) 1,100,000
Undiscounted future cash flows 1,200,000
Required:
a. Determine if the franchise was impaired at the end of 2015 and prepare the journal
entry, if any, if Horten follows IFRS.
b. Assume now that the recoverable amount was $950,000. Prepare the journal entry
for the impairment, if any (IFRS).
c. How would your answer in part (a) change if the fair value at the end of 2015 was
$1.35M?
d. Assume the amounts used for part (a). How would your answers change for parts (a)
to (c), if the franchise was estimated to have an indefinite life and last into perpetuity
(IFRS)?
e. How would your answers change for parts (a) to (c), if the company followed ASPE
and an indication of impairment existed?
f. How would your answer change for part (d) if the franchise was estimated to have
an indefinite life and last into perpetuity (ASPE)?
EXERCISE 11–16
On January 1, 2015, Boxlight Inc. purchased the net assets from Candelabra Ltd. for
$230,000 cash and a note for $50,000. On that date, Candelabra’s list of balance sheet
accounts was:
Carrying value Fair value – if different

than carrying value
Cash $ 55,000
Inventory 200,000
Land 15,000 $35,000
Buildings (net) 125,000 95,000
Equipment (net) 15,000 5,000
Patent (net) 25,000 0
Customer list (net) 5,000 0
Accounts receivable of $10,000 are shown net of the allowance for doubtful accounts.
Buildings, equipment, patent, and customer list are shown net of depreciation/amortization
of $75,000, 15,000, 5,000, and 1,000, respectively.
Required:
a. Prepare the journal entry to record the purchase.
b. What would Boxlight have considered when determining the purchase price for
$280,000?
c. On December 15, 2015, Boxlight suspected a possible impairment of the reporting

entity so it conducted an assessment of the net assets that had a carrying value
of $200,000 on that date. Management determined that the fair value of the net
assets, including goodwill, was $180,000. Determine if there was any impairment of
the reporting entity and record the journal entry, if any. Boxlight follows ASPE.
d. Assume now that Boxlight follows IFRS and assesses the cash-generating unit
annually for impairment. How would the answer in part (c) change, given the CGU’s
values as follows:
Exercises 453
Carrying amount $180,000

Fair value 160,000
Disposal costs 10,000
Value in use 170,000
e. How would your answer in (c) and (d) change if, one year later, there was an increase
in the fair value and recoverable amount to $190,000?
Solutions To Exercises
Chapter 2 Solutions
EXERCISE 2–1
Information asymmetry simply means that one party to a business transaction has more
information than the other party. This problem is demonstrated by the situation where
business managers know more about the business’s operations than outside parties (e.g.,
investors and lenders). The information asymmetry problem can take two forms—adverse
selection and moral hazard. With adverse selection, a manager may choose to act on
inside knowledge of the business in a way that harms outside parties. Insider trading
by managers using non-public knowledge may distort market prices of securities and
create distrust in investors. Accounting attempts to deal with the problem by providing
as much timely information to the market as possible. Moral hazard occurs when a
manager shirks or otherwise performs in a substandard fashion, knowing that his or her
performance as an agent is not directly observable by the principal (owner). Accounting
tries to deal with this problem by providing information to business owners that can help
assess management’s level of performance. Although the field of accounting does attempt
to solve these problems through the provision of high quality information, information
asymmetry can never be completely eliminated, so the accounting profession will always
seek ways to improve the usefulness of accounting information.
EXERCISE 2–2
Canada allows privately-owned businesses to use Accounting Standards for Private En-
terprise (ASPE) or International Financial Reporting Standards (IFRS), while requiring
publicly accountable enterprises to use IFRS. IFRS is partially or fully recognized in
over 125 countries as the appropriate accounting standard for companies that trade
shares in public markets. The main advantage of using a consistent standard around the
world is that investors can understand and compare investment opportunities in different
countries without having to make conversions or adjustments to reported results. This is
an important feature as markets have become more globalized and capital more mobile.
By requiring IFRS for publicly-traded companies, Canada has attempted to maintain the
competiveness of these companies in international financial markets. By allowing private
455
456 Solutions To Exercises
companies the option to report under ASPE instead, standard setters have created an
environment that could be more responsive to local needs and unique, Canadian business
circumstances. As well, many features of ASPE are simpler to apply than IFRS, which
may reduce accounting costs for small, non-public businesses.
The major disadvantage of maintaining two sets of standards is cost. The burden of
standard setters is increased, and these costs will ultimately be passed on to businesses
that are required to report. As well, having two sets of standards may create confusion
among investors and lenders, as public and private company financial statements may
not be directly comparable.
EXERCISE 2–3
The conceptual framework is a high-level structure of concepts established by accounting

standard setters to help facilitate the consistent and logical formulation of standards, and
provide a basis for the use of judgment in resolving accounting issues. This framework
is essential to standard setters as they develop new accounting standards in response to
changes in the economic environment. The framework gives the standard setters a basis
and set of defining principles from which to develop new standards. The framework is also
useful to practicing accountants, as it can provide guidance to them when interpreting
unusual or new business transactions. The framework gives practicing accountants the
tools and support to critically evaluate accounting treatments of specific transactions that
may not appear to fit into standard definitions or norms. Without a proper conceptual
framework, accounting standards may become inconsistent and ad hoc, and their ap-
plication may result in financial statements that are not comparable, resulting in less
confidence in capital markets.
EXERCISE 2–4
The two fundamental characteristics of good accounting information are relevance and
faithful representation. Relevance means that the piece of information has the ability
to influence one’s decisions. This characteristic exists if the information helps predict
future events or confirm predictions made in the past. Some relevant information may
have both predictive and confirmatory value, or it may only meet one of these needs.
Faithful representation means that the information being presented represents the true
economic state or condition of the item being reported on. Faithful representation is
achieved if the information is complete, neutral, and free from error. Complete information
reports all the factors necessary for the reader to fully understand the underlying nature
of the economic event. This may mean that additional narrative disclosures are required
as well as the quantitative value. Neutral information is unbiased and does not favour
one particular outcome or prediction over another. Freedom from error means that the
Chapter 2 Solutions 457
reported information is correct, but it does not have to be 100% error free. The concept
of materiality allows for insignificant errors to still be present in the information, as long as
those errors have no influence on a reader’s decisions. Although both relevance and faith-
ful representation need to be present for information to be considered useful, accountants
face difficulties in achieving maximum levels of both characteristics simultaneously. As a
result, trade-offs are often required, which may lead to imperfect information. Accountants
are also often faced with a trade-off between costs and benefits. It may be too costly to
guarantee 100% accuracy, so a little faithful representation may need to be given up to
maintain the relevance of the information. This means that the accountant will need to
apply good judgment in balancing the trade-offs in a way that maximizes the usefulness
of the information.
EXERCISE 2–5
The four enhancing qualitative characteristics are comparability, verifiability, timeliness,

and understandability. Comparability means information from two or more different busi-
nesses or from the same business over different time periods can be compared. Veri-
fiability means two independent and knowledgeable observers could come to the same
conclusion about the information being presented. Timeliness means that information
needs to be current and not out of date. The older the information, the less useful it
becomes for decision-making purposes. Understandability means that a reader with a
reasonable understanding of business transactions should be able to understand the
meaning of the accounting information being disclosed. Timeliness is often in conflict
with verifiability, as verification of information takes time. Financial statements are almost
always issued under deadlines; the optimal level of verification may not be achieved.
Likewise, understandability may be enhanced with more careful drafting of the supple-
mental disclosures, but time constraints may interfere with this function. Understand-
ability and comparability may both be influenced by the company’s need to keep certain
information confidential in order to avoid giving away a competitive advantage. All of
these characteristics may be influenced by matters of cost. Businesses will make rational
decisions by weighing the costs of certain actions against the benefits received. Cost
considerations may result in accounting information not achieving the maximum levels of
all of the qualitative characteristics. Balancing the trade-offs of these characteristics with
the cost considerations is one of the largest challenges faced by practicing accountants.
EXERCISE 2–6
a. A reduction of both assets and equity
b. An exchange of equal value assets

c. An exchange of assets of unequal value resulting in income and expense and a

resulting increase in equity (assumes goods are sold for an amount greater than
cost)
d. Recognition of an expense, resulting in a decrease in equity and a liability
e. An asset is received and an equal value liability is recognized
f. Recognition of an expense, resulting in a decrease in equity and a liability
g. An equal increase in an asset and equity
h. An equal increase in an asset and a liability
i. An exchange of assets of unequal value, resulting in income and an increase in

equity
j. A recognition of an expense, resulting in a decrease in equity, and a contra-asset
EXERCISE 2–7
An item is recognized in the financial statements if it: (a) meets the definition of an
element, (b) can result in probable future economic benefits to or from the entity, and
(c) can be measured reliably. These criteria can be applied as follows.
a. The company has received an asset, but the company has not yet achieved sub-
stantial performance of the contract. The contract will be performed as issues of the
magazines are delivered. Thus, the appropriate offsetting element to the asset is
a liability, as a future obligation is created. As each issue is delivered, the liability
is reduced and income can be recognized. The amount can be measured reliably,
as the cash has already been received and the price of each magazine issue has
already been determined.
b. The appropriate element here is the liability that is being created by the lawsuit.
Because the lawsuit results from a past event that creates a present obligation
to pay an amount in the future, the definition of a liability is met. It also appears
that the outflow of economic benefits is probable, based on the lawyer’s evaluation.
However, if there really is no way to reliably measure the amount, then the liability
should not be recognized. However, the lawyers should make a reasonable effort
based on prior case law, the facts of the case, and so forth, to see if an amount
can be reliably estimated. Even if the amount is not recognized, the lawsuit should
still be disclosed in the notes to the financial statements as this information is likely
relevant to those reading the financial statement.
c. An asset is normally created and income recognized when the invoice is issued.
The future economic benefit exists, is the result of a past event, and can be mea-
sured reliably, based on the terms of the contract. In this case, however, there is
some issue regarding the probability of realizing the future economic benefits. A
careful analysis of the situation is required to determine if recognition of an asset
is appropriate. Only the amount whose collection can be deemed probable should
be recognized. Even if the amount is not recognized, the contract should still be
disclosed in the supplemental information, as this information is likely relevant to
financial statement readers.
d. The question of whether this meets the definition of an asset needs to be addressed.
Is the goodwill being recorded a “resource controlled by the entity”? Goodwill, by
definition, is intangible, but it is not clear what exactly is generating the goodwill in
this case. It is difficult to say that this even meets the definition of an asset. If this
definitional argument is stretched, it would still be difficult to recognize the element,
as it is unlikely to pass the reliable measurement test. An asset based on the current
share price is not reliably measured, as share prices are volatile and transitory. No
recognition of the asset and corresponding equity amount is warranted in this case.
e. This does appear to meet the definition of a liability, as the past event (the drilling)
results in a present obligation (the requirement to clean up the site) in the future.
This type of liability should normally be recorded at the present value of the expected
outflow of resources in 10 years time, as this outflow is probable. The company
may have some difficulty measuring the amount, as they have no experience with
this type of operation. However, an estimate should be able to be made using
engineering estimates, industry data, and so forth. The other item that needs
to be estimated is the appropriate discount rate for the present value calculation.
Again, the company can use its cost of capital or other appropriate measure for this
purpose. This liability and an expense should be recognized, although estimation
will be required. Additional details of the method of estimation would also need to
be disclosed.
EXERCISE 2–8
The four measurement bases are historical cost, current cost, realizable (settlement)
value, and present value. Historical cost represents the actual transaction cost of an
element. This is normally very reliably measured, but may not be particularly relevant
for current decision making purposes. Current cost represents the amount required to
replace the current capacity of the particular asset being considered, or the amount
of undiscounted cash currently required to settle the liability. This base is considered
more relevant than historical cost, as it attempts to use current market information to
value the item. However, many items, particularly special purpose assets, do not have
active markets and are, thus, not reliably measured by this approach. Realizable value
represents the amount that an asset can currently be sold for in an orderly fashion (i.e.,
not a “fire-sale” price) or the amount required to settle a liability in the normal course of
business. Again, this has the advantage of using current market conditions, making it
more relevant than historical cost. However, as with current cost, active disposal markets
for the asset may not exist. As well, realizable value is criticized as being irrelevant in
cases where the company has no intention of disposing of the asset for many years.
Present value is, perhaps, the most theoretically justified measurement base. In this
case, all assets and liabilities are measured at the present value of the related future
cash flows. This measure is highly relevant, as it represents the value in use to the
organization. The problem with this approach is that it is difficult to reliably estimate the
timing and probability of the future cash flows. As well, determinations need to be made
regarding the appropriate discount rate, which may not always have a clear answer.
EXERCISE 2–9
Capital maintenance refers to the amount of capital that investors would want to be
maintained within the business. This concept is important to investors, as the level of
capital maintenance required may influence an investor’s choice as to which company to
invest in. The measurement of an investor’s capital can be defined in terms of financial
capital or physical capital.
Financial capital maintenance simply looks at the amount of money in a business, mea-
sured by changes in the owners’ equity. This can be measured simply by looking at
monetary amounts reported in the financial statements. The problem with this approach
is that it doesn’t take into account purchasing power changes over time. The constant
purchasing power model attempts to get around this problem by adjusting capital require-
ments for inflation by using a broadly based index, such as the Consumer Price Index.
The problem with this approach is that the index chosen may not accurately reflect the
actual level of inflation experienced by the company. Physical capital maintenance tries
to get around this problem by measuring the physical capacity of the business, rather
than the financial capacity. The advantage of this approach is that it measures the actual
productivity of the business and is not affected by inflation. The disadvantage of this
method is that it is not easy or cost-effective to measure the productive capacity of each
asset within the business.
Because each capital maintenance model involves trade-offs, the conceptual framework
does not draw a conclusion on which approach is the best. Rather, it suggests that end
needs of the financial statement users be considered when determining to apply capital
maintenance concepts to specific accounting standards.
EXERCISE 2–10
Principles-based standards present a series of basic concepts that professional accoun-

tants can use to make decisions about the appropriate accounting treatment of individual
transactions. Rules-based standards, on the other hand, are more prescriptive and
detailed. These standards attempt to create a rule for any situation the accountant may
encounter. The main advantage of principles-based systems is their flexibility. They allow
the accountant the latitude to apply judgment to deal with new situations or unusual
circumstances. This flexibility, however, can also cause problems for the accountant,
as there could be pressure to stretch the professional judgment in a way that creates
misleading financial statements. As well, the application of judgment in the preparation
of financial statement could result in reports that are not comparable, as other accoun-
tants may arrive at different conclusions for similar transactions. This suggests that
the verifiability characteristic may also be compromised. The main advantage of rules-
based approaches is the certainty and comparability offered by detailed rules. Readers
can have confidence that similar transactions are reported in similar ways. As well,
this may reduce the accountant’s professional liability, as long as the rules have been
applied correctly. The main disadvantage of the rules-based systems is their inflexibility.
Prescription of specific accounting treatments can result in financial engineering, wherein
new transactions are designed solely for the purpose of circumventing the rules. This
can create misleading financial reports, where the true nature of the transactions is not
reflected correctly. As well, overly detailed rules can create a problem of understandability,
not only for the readers, but even for the professional accountants themselves. As a
practical matter, all systems of accounting regulation contain both broad principles and
detailed rules. The challenge for accounting standard setters is to find the right balance
of rules and principles.
EXERCISE 2–11
Managers may attempt to influence the outcome of financial reporting for a number of rea-
sons. Managers may have bonus or other compensation schemes that are directly tied to
reported results. Managers are rational in attempting to influence their own compensation,
as they understand that compensation earned now is more valuable than compensation
that is deferred to future periods. Even if the manager’s compensation is not directly tied to
financial results, the manager may still have an incentive to make the company’s results
look as good as possible, as this would enhance the manager’s reputation and future
employment prospects. Managers will also feel pressure from shareholders to maintain a
certain level of financial performance, as public securities markets can be very punitive to
a company’s share price when earnings targets are not reached. Shareholders do not like
to see the price of the share fall drastically. On the other hand, shareholders also want to
have a realistic assessment of the company’s earning potential. These conflicting goals
may create a complicated dynamic for the manager’s behaviour in crafting the financial
statements. Managers are also influenced by the conditions of certain contracts, such
as loan agreements. Loan covenants may require the maintenance of certain financial
ratios, which clearly puts pressure on managers to influence the financial reports in a
certain fashion. Managers may also feel pressure to keep earnings low where there
are political consequences of being too profitable. This may occur when a company
has disproportionate power over the market, or where there is a public interest in the
operations of the business. The company does not want to demonstrate earnings that
are too high, as it risks attracting additional taxation, penalties, or other actions that may
restrict future business.
The pressures that managers feel to influence financial results will eventually find their way
to the accountant, as the accountant is ultimately responsible for creating the financial
statements. Whether the accountant is internal or external to the business, his or her
work must be performed ethically and professionally. The accountant must always act
with integrity and objectivity, and must avoid being influenced by the pressures that may
be exerted by managers or other parties. The accountant must demonstrate professional
competence and must keep client information confidential. The accountant should not
engage in any work that falls outside of the scope of that accountant’s professional ca-
pabilities. As well, the accountant must not engage in any behaviour that discredits the
profession. Although it is easy to describe the accountant’s professional responsibilities,
it is not always easy to put these concepts into practice. The accountant needs to be
aware of the pressures faced in the reporting environment, and may need to seek outside
advice when faced with ethical or professional problems. Ultimately, the accountant is a
key player in establishing the overall credibility of financial reporting, and financial markets
rely on this credibility to function in an efficient manner.
EXERCISE 2–12
The vice-president finance’s comments hint at a threat to my objectivity as financial con-

troller. The potential reward of the vice-president finance position should not influence
how I perform my professional duties. The specific issues identified by the vice-president
finance can be addressed as follows.
a. This lawsuit appears to meet the definition of a liability, as it is a present obligation

that results from a past transaction and will require a future outflow of economic
resources. As well, it appears to have satisfied the recognition criteria, as the
payment is probable and the amount can be estimated. This amount should be
accrued this year, although prior years’ financial statements do not need to be
adjusted. Further consultation with the lawyers is required to determine the most
reasonable amount to accrue within the range provided. Also, IFRS and ASPE use
different approaches to accounting for provisions based on a range of values.
b. A change in accounting policy should be disclosed in the notes to the financial

statements. However, the change should also be accounted for in a retrospective
fashion, where prior years’ results are restated to show the effect of the change on
those years. This retrospective treatment may result in a change in the effect on the
current year’s income. This treatment is necessary to maintain comparability with
prior years’ results.
c. Prepayments from customers appear to meet the definition of a liability, as they

represent a present obligation to deliver future resources to the customers (in this
case, products to be manufactured). The recognition criteria also appear to have
been met, so these amounts should be disclosed as liabilities. It is generally not
appropriate to net assets and liabilities together, as this distorts the underlying
nature of the individual financial statement elements.
d. It is unlikely that this even meets the definition of an asset, as it cannot be said that
we control the resource. Although we pay the research and development director’s
salary and likely have proprietary rights to his inventions, we cannot really say that
the resource, his knowledge, is controlled by the company. Even if we stretch
the definition of an asset here to include this knowledge, it still doesn’t meet the
recognition criteria, as there is no demonstration that the future flow of economic
resources is either probable or measurable.
e. The vice-president finance is indicating that year-end accounting adjustments need

to be considered for their effects on the debt-to-equity ratio. All of the accounting
treatments proposed by the vice-president finance would improve this ratio. How-
ever, all of the proposed accounting treatments are likely unsupportable under the
conceptual framework. It appears that the vice-president finance’s objectivity may
have been impaired by his requirement to prevent a debt covenant violation. It
is likely that the vice-president finance’s proposed accounting treatments will be
challenged by the company’s external auditors, which may create delays and other
problems in issuing the financial statements. This could also cause problems with
the bank. In performing my duties as the financial controller, I need to be aware of
the threats to my objectivity. Although there is no evidence of any ethical conflict yet,
I will need to perform my duties with integrity. If my actions do result in a conflict with
the vice-president finance, I will need to carefully consider my actions. I may need
to seek outside advice from my professional association and others, if necessary.
Ultimately, I must ensure that I do not prepare financial statements that are false or
misleading in any way.
Chapter 3 Solutions
EXERCISE 3–1
a. Income from continuing operations = Income from operations + Gain on sale of

held-for-trading investments – Income tax on income from continuing operations =
*
$125,000 + $1,500 − $34,155 = $92,345
* (125,000 + 1,500) × 27% = 34,155
Net income = Income from continuing operations – Loss from operation of discon-
tinued division (net of tax) – Loss from disposal of discontinued division (net of tax)
= $92,345 − $2,500 − $3,500 = $86,345
Other comprehensive income = Unrealized holding gain – OCI (net of tax) = $12,000
Total comprehensive income = Net income + other comprehensive income = $86,345+
$12,000 = $98,345
b. Under ASPE, other comprehensive income and comprehensive income do not ap-
ply.
EXERCISE 3–2
Quality of Earnings: In terms of earnings quality, there are issues. The company’s net
income includes a significant gain on sale of idle assets, which means that a sizeable
portion of earnings were not generated from ongoing core business activities. Wozzie
also changed their inventory policy from FIFO to weighted average, which is contrary
to the method used within their industry sector. This is cause for concern as it raises
questions about whether or not management is purposely trying to manipulate income.
A change in accounting policy is only allowed as a result of changes in a primary source
of GAAP or may be applied voluntarily by management to enhance the relevance and
reliability of information contained in the financial statements for IFRS. Unless Wozzie’s
inventory pricing is better reflected by the weighted average method, contrary to the other
companies in their industry sector, the measurement of inventory and cost of goods sold
may be biased.
Investing in the Company: Investors and analysts will review the financial statements
and see that part of the company’s net income results from a significant gain generated
from non-core business activities (the sale of idle assets) and will also detect the lower
cost of goods sold resulting from the change in inventory pricing policy disclosed in
the notes to the financial statements. As a result, investors will assess the earnings
reported as lower quality, and the capital markets will discount the earnings reported
to compensate for the biased information. Had Wozzie not fully disclosed the accounting
policy change for inventory, the market may have taken a bit longer to discount that portion
of the company’s net income due to lower quality information.
EXERCISE 3–3
Eastern Cycles’ sale of the corporate-owned stores to a franchisee would not qualify for
discontinued operations treatment because the corporate-owned stores are not a sepa-
rate major line of business. Under IFRS, a component of an entity comprises operations,
cash flows, and financial elements that can be clearly distinguished from the rest of the
enterprise, which is not the case as stated in the question information.
Under ASPE, selling the corporate-owned stores would also not qualify for discontinued
operations treatment. The corporate-owned stores are likely a component of the com-
pany, but the franchisor is still involved with the franchisees because Eastern Cycles
continues to provide product to them as well as advertising, training, and support. The
cash flows of Eastern Cycles (the franchisor) are still affected by those of the franchisee
since Eastern Cycles collects monthly fees based on revenues.
EXERCISE 3–4
a.
Bunsheim Ltd.
Common Comprehensive Retained Accumulated Other
Total Shares Income Earnings Comprehensive Income
Beginning balance as reported $ 707,000 $480,000 $ 50,000 $177,000
Correction of understatement in
travel expenses from 2014 of
$80,000 (net of tax of $21,600) (58,400) (58,400)
Beginning balance as adjusted $ 648,600 $480,000 $ (8,400) $177,000
Comprehensive income:
Net income 130,853 $130,853 130,853
Other comprehensive Income:
Unrealized gain – AFS investments** 25,000 25,000 25,000
Comprehensive income $155,853
Ending balance $ 759,453 $480,000 $ 77,453 $202,000
** net of tax of $5,000. May be reclassified subsequently to net income or loss
Net income = ($680,000 −$425,750 −$75,000) = 179,250 ×(1 −27%) = $130,853

Disclosures – prior period adjustments are to be reported net of tax with the tax
amount disclosed. Unrealized gain on AFS investments is to be disclosed net of
tax with tax amount disclosed and that it may be reclassified subsequently to net
income or loss.
b.
Bunsheim Ltd.
Balance, January 1, as reported $ 50,000

Correction for understatement in travel expenses
from 2014 of $80,000 (net of tax of $21,600) (58,400)
Balance, January 1, as adjusted (8,400)
Add: Net income 130,853
122,453
Less: Dividends 45,000
Balance, December 31 $ 77,453
EXERCISE 3–5
a.
Patsy Inc.
Partial Statement of Comprehensive Income
Income from continuing operations $1,500,000

Loss from operation of discontinued Calgary
division (net of tax of $52,500) $(122,500)
Loss from disposal of Calgary division
(net of tax of $37,500) (87,500) (210,000)
Net income 1,290,000
Other comprehensive income

Items that may be reclassified subsequently to
net income or loss:
Unrealized gain on Available-for-sale
investments (net of tax of $11,786*) 27,500
Total comprehensive income $1,317,500
Earnings per share

Income from continuing operations** $ 30.00
Discontinued operations (4.20)
Net income $ 25.80
* (27,500 ÷ (1 − 0.3) = $39,286 before tax. $39,286 − 27,500 = $11,786 tax)

**Continuing operations $1,500,000 ÷ 50,000; discontinued operations ($210,000 ÷ 50,000)
Required disclosures: Items reported at their net of tax amounts must also disclose
the tax amount. Earnings per share information related to income from continuing
operations and discontinued operations are required under IFRS but earnings per
share information related to comprehensive income are not required under IFRS.
b. Had Patsy followed ASPE, other comprehensive income and total comprehensive
income do not apply. Investments that are not quoted in an active market are
accounted for at cost. This also assumes that the discontinued operations meet
the definition of a discontinued operation under ASPE.
EXERCISE 3–6
Calculation of increase or (decrease) in shareholders’ equity:
Increase in assets: $41,670 + $15,800 + $218,400 − $46,500 + 14,000 = $243,370

Increase in liabilities: ($23,400) + 45,200 + $46,500 = 68,300
Increase in shareholders’ equity: $175,070
Breakdown of shareholders’ equity account:
Net increase $175,070

Increase in common shares $ 87,000
Increase in contributed surplus 18,600
Decrease in retained earnings due to dividend declaration (44,000) 61,600
Increase in retained earnings due to net income $113,470
To solve algebraically use the basic accounting equation:
Assets = Liabilities + Equity
Restated:
Change in assets = change in liabilities + change in equity

243,370 = 68,300 + X(equity)
X = 243,370 − 68,300 = $175,070 change in equity
Since equity is made up of common shares + contributed surplus + retained earnings =

$175,070 then:
Change in equity−change in common shares−change in contributed surplus+dividends =

change in retained earnings due to net income
175,070 − 87,000 − 18,600 + 44,000 = $113,470
EXERCISE 3–7
$575,000−$75,000 = $7.58 per share

66,000
EXERCISE 3–8
a.
Opi Co.
Income Statement
Revenues
Net sales revenue* $1,778,400
Rent revenue 23,400
Total revenues 1,840,800
Expenses
Selling expenses** 587,600
Administrative expenses*** 130,260
Total expenses 1,738,360
Income before income tax 102,440

Income tax 30,732
Income from continuing operations 71,708
Gain on disposal of discontinued operations –
South Division (net of tax of $8,268) 19,292
Net income $ 91,000
* $1,820,000 − $18,850 − $22,750 = $1,778,400

** $561,600 + $26,000 = $587,600
*** $128,700 + $1,560 = $130,260
Disclosure notes – COGS and most Other Revenue and Expense items are to be
disclosed separately. Discontinued operations items are to be separately disclosed,
net of tax, with tax amount disclosed.
Opi Co.
Retained earnings, January 1 as reported $338,000

Less error correction (net of tax of $4,050) 9,450
Retained earnings, January 1, as adjusted 328,550
Add: net income 91,000
419,550
Less: dividends 58,500
Retained earnings, December 31 $361,050
Prior period adjustments reported in retained earnings must be separately reported,

net of tax with tax amount disclosed.
b.
Opi Co.
Income Statement
Revenues
Net sales revenue* $1,778,400
Rent revenue 23,400
Expenses
Selling expenses** 587,600
Administrative expenses*** 130,260
Income before income tax 102,440

Income tax 30,732
Discontinued operations:
Gain on disposal of discontinued operations –
South Division (net of tax of $8,268) 19,292
Net income 91,000
Retained earnings, January 1 as reported 338,000
Less error correction (net of tax of $4,050) 9,450
Retained earnings, January 1, as adjusted 328,550
419,550
Less dividends 58,500
Retained earnings, December 31 $ 361,050
* $1,820,000 − $18,850 − $22,750 = $1,778,400

** $561,600 + $26,000 = $587,600
*** $128,700 + $1,560 = $130,260
Disclosure notes – COGS and most Other Revenue and Expense items are to be
disclosed separately. Discontinued operations items are to be separately disclosed,
net of tax, with tax amount disclosed. Prior period adjustments reported in retained
earnings must be separately reported, net of tax with tax amount disclosed.
EXERCISE 3–9
a.
Ace Retailing Ltd.
Statement of Income
Sales revenue $1,500,000

Less cost of goods sold 750,000
Gross profit 750,000
Less selling and administrative expenses 245,000
Other revenues and gains
Interest income $ 15,000
Gain on sale of held–for–trading investments 45,000 60,000
565,000
Other expenses and losses
Loss on disposal of equipment 82,000
Loss from warehouse fire 175,000 269,000
Loss from operations, net of income tax recovery of $76,950 208,050
Gain from disposal, net of income taxes of $31,050 83,950 124,100
Net income $ 91,980
Earnings per share

Income from continuing operations* $ 0.34
Discontinued operations** (0.31)
Net income $ 0.03
(rounded)
* ($216,080 − $82,000) ÷ 400,000 = 0.34

** ($124,100) ÷ 400,000 shares = (0.31)
b.
Ace Retailing Ltd.
Statement of Income and Comprehensive Income

Less cost of goods sold 750,000
Less selling and administrative expenses 245,000
Other revenues and gains
Interest income $ 15,000
Gain on sale of fair value – net income investments 45,000 60,000
565,000
Other expenses and losses
Loss from warehouse fire 175,000 269,000
Loss from operations, net of tax recovery of $76,950 208,050
Gain from disposal, net of tax of $31,050 83,950 124,100
Net income $ 91,980

Unrealized gain on Available-for-sale investments, net of
income tax of $5,022 13,578
Total comprehensive income $ 105,558
Earnings per share

Net income $ 0.03
(rounded)
* ($216,080 − $82,000) ÷ 400,000 = 0.34

** ($124,100) ÷ 400,000 shares = (0.31)
c.
Ace Retailing Ltd.

Net income $ 91,980

Unrealized gain on Available-for-sale investments, net of income tax of $5,022 13,578
d.
Ace Retailing Ltd.
Income Statement
Revenues
Interest income 15,000
Gain on sale of fair value–net income 45,000
Expenses
Cost of goods sold 750,000
Selling and administrative expenses 245,000
Loss from warehouse fire 175,000

Income tax 79,920
Loss from operations, net of income tax recovery of $76,950 208,050
Gain from disposal, net of income taxes of $31,050 83,950
124,100
Net income $ 91,980
Earnings per share

Net income $ 0.03
(rounded)
* ($216,080 − $82,000) ÷ 400,000 = 0.34

** ($124,100) ÷ 400,000 shares = (0.31)
e. Items are to be reported as Other Revenue and Expenses when using the multiple-
step format for the statement of income. These are revenues, expenses, gains, and
losses that are not realized or incurred as part of ongoing operations (for a retail
business in this case). Examples of items that do not normally recur in a retail
business are:
• Dividend revenue (from investments)

• Gain or loss on sale or disposal of current or long-term assets (i.e., investments,
property, plant, equipment, and certain intangible assets such as patents and
copyrights)
• Interest income or expense from receivables or investments
• Impairment losses on various assets not recorded through OCI
• Loss from fire, flood, and storm damages in areas not known for this activity
• Loss on inventory due to decline in NRV
• Rent revenue or other revenues not normally associated with the usual busi-
ness of the company
• Unrealized gains or losses on investments not recorded to OCI
Note that as a general rule, if the item is unusual and material, (consider size, nature,
and frequency), the item is presented separately but included in income from con-
tinuing operations. If the item is unusual but immaterial, the item is combined with
other items in income from continuing operations. So, there is a trade-off between
additional disclosures of relevant information and too much disclosure resulting
in information overload. Moreover, IFRS and ASPE reporting requirements vary
and the standards change over time, so different items may need to be separately
reported in one standard but not necessarily in the other standard. It is important
to check the standards periodically to ensure that the latest reporting requirements
are known.
EXERCISE 3–10
Vivando Ltd.
Income Statement (Partial)
Income from continuing operations before income tax $1,891,000*

Income tax 472,750
Income from continuing operations 1,418,250
Loss from operation of discontinued subsidiary
(net of tax of $17,000) $(51,000)
Loss from disposal of subsidiary (net of tax of $28,150) (84,450) 135,450
Net income $ 1,282,800
Earnings per share

Income from continuing operations $ 6.30
Discontinued operations (0.60)
Net income $ 5.70
*Income from continuing operations before income tax:

As previously stated $ 1,820,000
Gain on sale of equipment (92,000 − 33,400 − 75,000) 16,400
Settlement of lawsuit 180,200
Write-off of accounts receivable (125,600)
Restated $ 1,891,000
Note: The prior year error related to the intangible asset was correctly charged to opening
retained earnings.
EXERCISE 3–11
a.
Spyder Inc.
Income Statement
For the Year Ended September 30, 2015
Sales Revenue
Less: Sales discounts $ 21,000
Sales returns and allowances 87,220 108,220
Net sales revenue 2,591,680
Operating Expenses
Selling expenses:
Sales commissions expenses $136,640
Entertainment expenses 20,748
Freight-out 40,502
Telephone and Internet expenses 12,642
Depreciation expense 6,972 217,504
Administrative expenses:
Salaries and wages expenses 78,764
Supplies expense 4,830
Telephone and Internet expense 3,948
Miscellaneous expense 6,601 104,293 321,797
Other Revenues
901,005
Other Expenses
Income tax 262,742
Loss on disposal of discontinued operations –
Aphfflek Division (net of taxes of $14,700) 34,300
Earnings per share from continuing operations $ 4.94*
from discontinued operations (0.28)**
Net income $ 4.66
* $613,063 ÷ 124,000 common shares

** $34,300 ÷ 124,000
b.
Spyder Inc.
Statement of Changes in Shareholders’ Equity
Accumulated
Other
Common Retained Comprehensive
Shares Earnings Income Total
Beginning balance as reported $454,000 $215,600 $162,000 $831,600
Correction of error for depreciation
expense from 2014
(net of tax recovery of $7,434) (17,346) (17,346)
Beginning balance as restated 454,000 198,254 162,000 814,254
Comprehensive income:
Net income 578,763 578,763
Total comprehensive income 578,763 578,763
Dividends – common shares (12,600) (12,600)
Ending balance $454,000 $764,417 $162,000 $1,380,417
c.
Spyder Inc.
Income Statement
Revenues
Net sales revenue $2,591,680
Expenses
Sales commissions expense 136,640
Entertainment expense 20,748
Freight-out 40,502
Telephone and Internet expense* 16,590
Depreciation expense** 17,122
Salaries and wages expense 78,764
Supplies expense 4,830
Miscellaneous operating expense 6,601
Net income from continuing operations before income tax 875,805

Income tax 262,742
Loss on disposal of discontinued operations –
Aphfflek Division (net of taxes of $14,700) 34,300
Earnings per share from continuing operations 4.84***

from discontinued operations (0.28)****
Net income $ 4.56
* $12,642 + $3,948
** $6,972 + $10,150
*** ($613,063 − $12,600) ÷ 124,000 common shares
**** $34,300 ÷ 124,000
d.
Spyder Inc.
Net income $578,763

Unrealized gain on Available-for-sale investments (net of tax of $7,500) 17,500
Comprehensive Income $596,263
Chapter 4 Solutions
EXERCISE 4–1
Account name Classification
Preferred shares Cap
Franchise agreement IA
Salaries and wages payable CL
Accounts payable CL
Buildings (net) PPE
Investment – Held for Trading CA
Current portion of long-term debt CL
Allowance for doubtful accounts CA
Accounts receivable CA
Bond payable (maturing in 10 years) NCL
Notes payable (due next year) CL
Office supplies CA
Mortgage payable (maturing next year) CL
Land PPE
Bond sinking fund LI
Inventory CA
Prepaid insurance CA
Income tax payable CL
Cumulative unrealized gain or loss from an OCI investment AOCI
Investment in associate LI
Unearned subscriptions revenue CL
Advances to suppliers CA
Unearned rent revenue CL
Copyrights IA
Petty cash CA
Foreign currency bank account or cash CA
EXERCISE 4–2
a.
Aztec Artworks Ltd.

Assets
Current assets
Cash $ 143,000
Investments (held for trading at fair value) 135,000
Accounts receivable $ 332,000
Allowance for doubtful accounts (12,000) 320,000
Inventory (at lower of FIFO cost and NRV) $ 960,000
Inventory on consignment 20,000 980,000
Total current assets 1,608,000
Long-term investments:
Investment in bonds (held to maturity at amortized cost) 200,000
Bond sinking fund 100,000
Land held for investment (at cost) 200,000
500,000
Building under construction $ 220,000
Land (at cost) 220,000 440,000
Building (at cost) $1,950,000
Accumulated depreciation (450,000) 1,500,000
Accumulated depreciation (120,000) 380,000 2,320,000
Intangible assets:
Patents (net of accumulated amortization for $9,000) 21,000

Current liabilities
Bank indebtedness $ 18,000
Rent payable 120,000
Other payables 35,000
Income tax payable 80,000
Total current liabilities $ 923,000
Long-term liabilities:
Bonds payable (20-year 5% bonds, due August 31, 2020) 800,000
Pension obligation 210,000 1,010,000
Total liabilities 1,933,000
Paid in capital
Preferred, ($2, non-cumulative,participating–authorized
50,000, issued and outstanding, 20,000 shares) $ 900,000
Common (authorized, 900,000 shares; issued and
outstanding 700,000 shares) 700,000
Contributed surplus 430,000 2,030,000
Accumulated other comprehensive income 160,000 2,516,000
1 Cash balance, Dec 31 $ 225,000

Plus bank overdraft 18,000
Less bond sinking fund (100,000)
Adjusted cash balance, December 31 $ 143,000
2 Account receivable, Dec 31 $ 285,000

Plus AFDA 12,000
Plus credit balances to be separately reported 35,000
Adjusted balance, Dec 31 $ 332,000
3 Inventory, Dec 31 $ 960,000

Plus inventory on consignment 20,000
Adjusted balance, Dec 31 $ 980,000
Inventory, net realizable value, Dec 31 985,000
4 Land, Dec 31 $ 420,000

Less land held for investment (200,000)
Adjusted land, Dec 31 $ 220,000
5 Building Equipment
Balance, Dec 31 $1,500,000 $ 380,000
Plus accumulated depreciation 450,000 120,000
Adjusted balance, Dec 31 $1,950,000 $ 500,000
6 Goodwill, Dec 31 $ 190,000

Removed – internally generated goodwill cannot be recognized (190,000)
Adjust balance, Dec 31 $ –
7 Patents, Dec 31 $ 21,000

Accum. amortization for 3 years ($30,000 ÷ 10 × 3 yrs) $ 9,000
Retained earnings = ($501,000 + $20,000 consignment inventory − $190,000 goodwill adjustment −

$5,000 unrealized holding loss for trading investments = $326,000
OR ($4,449,000 − 1,933,000 − 2,030,000 − 160,000) = $326,000
b. Liquidity ratios:
Current ratio = 1,608,000 ÷ 923,000 = 1.74

Quick ratio = (143,000 + 135,000 + 320,000 = 598,000) ÷ 923,000 = 0.65
Activity ratios:
Accounts receivable turnover = 3,000,000 ÷ 320,000

= 9.38 times per year or every 38.9 days (365 ÷ 9.38)
Days’ sales uncollected = 332,000 ÷ 3,000,000 × 365
= 40.4 days
Inventory turnover = (3,000,000 × 60%) ÷ 980,000
= 1.84 times per year or every 198.4 days (365 ÷ 1.84)
Asset turnover = 3,000,000 ÷ 4,449,000
= 0.67 times
Comments:
In terms of liquidity, Aztec’s current ratio of 1.74 suggests at first glance that it can
meet its short-term obligations. However, when inventory and prepaid expenses are
removed, the ratio drops to .65, which is short of the general rule of 1:1 for quick
ratios. This may mean that inventory levels are too high. The inventory turnover
ratio below will confirm if this is the case or not.
Activity ratios, such as the accounts receivable turnover, measure how quickly ac-
counts are converted into cash. For Aztec, accounts receivable are collected every
38.9 days on average. Looking at days’ sales uncollected, if a guideline of 30–40
days to collect is considered reasonable, then Aztec is close to the top end of the 40-
day benchmark. Management would be wise to take steps to improve its receivables
collections somewhat.
Inventory turnover of every 200 days or so appears to be very low, which could
mean that too much cash is being tied up in inventory or there is too much obsolete
inventory that cannot be sold. A turnover ratio that is too high can signal inventory
shortages that may result in lost sales. A turnover ratio for each major inventory
category will help to determine if the situation is wide-spread or limited to a particular
inventory category.
Asset turnover for .67 times appears low but without industry standard ratios to use
as a comparison benchmark, ratios become less meaningful.
EXERCISE 4–3
a.
Johnson Berthgate Corp.

Assets
Current assets
Cash $ 131,000
Investments (held for trading at fair value) 120,000
Accounts receivable $ 330,000
Allowance for doubtful accounts (15,000) 315,000
Inventory (at lower of FIFO cost and NRV) 430,000
Total current assets 1,002,000
Long-term investments:
Investment in bonds (held to maturity at amortized cost) 190,000
Investment in available for sale securities at FV 180,000 370,000
Land (at cost) 170,000
Building (at cost) $ 660,000
Accumulated depreciation (50,000) 340,000 1,060,000
Intangible assets:
Patents (net of accum. amort. of $80,000 on a straight-line basis) 125,000
Franchise (net of accum. amort. of $45,000 on a straight-line basis) 115,000 240,000
Goodwill 30,000

Current liabilities
Commissions payable 90,000
Unearned consulting fees 13,000
Total current liabilities 583,000
Long-term liabilities:
Bonds payable (20-year 5% bonds, due December 31, 2020) 640,000
Note payable (3%, 5-year, due December 31, 2019) 587,559 1,227,559
Paid in capital
Preferred, ($3, non-cumulative, authorized 1200,
issued and outstanding, 800 shares) $ 80,000
Common (unlimited authorized, issued and
outstanding 260,000 shares) 520,000 600,000
Retained earnings* 236,441
Accumulated other comprehensive income 55,000 891,441
* 290,941−90,000+20,000 investment trading adj−10,000 inventory adj+NI of $25,500 = $236,441

Net income = (4,858,000 + 40,000 + 102,000 − 3,050,000 − 11,000 − 8,500 −

135,000 − 1,190,000 − 580,000) = $25,500
b.
Debt ratio = 1,810,559 ÷ 2,702,000 = 67.01%

Equity ratio = 891,441 ÷ 2,702,000 = 32.99%
Nearly 70% of all assets are provided by creditors, which is significant. Digging
deeper and looking at the current ratio for 1.72 (1,002,000 ÷ 583,000), it appears
that the current assets will adequately cover the current liabilities. It follows that
the $1.2M in long-term obligations is the true risk for this company. The company
may have to re-finance the note payable when comes due in 3 more years, or sell
off any assets not currently contributing to profit. Selling off long-term assets is
a reasonable step provided that the assets are idle and will not be used in the
foreseeable future to earn profits. This company’s debt ratio is high so it has very
little financial flexibility.
c. The credit balances in accounts receivable represent amounts owing to specific

customers. IFRS requires that significant credit balances be separated and reported
as a current liability.
Current ratio without separation of the credit 1,002,000 ÷ 583,000 = 1.72

Current ratio with separation of the credit (1,002,000+250,000)÷(583,000+
250,000) = 1.50
Managers may not be aware of the impact that the reporting requirement (to classify
credit receivables as current liabilities) can have on the current ratio. In this case, this
ratio has weakened significantly once the credit amount of $250,000 is reclassified
from a current asset to a current liability. If the company had a restrictive covenant
to maintain a current ratio of 1.7 times, this could spell disaster for the company
in two ways. First, creditors expect a restrictive covenant ratio to be maintained at
all times. If this ratio slips below that threshold, any short-term notes owing to the
creditor would become payable immediately as a demand loan. This would create
significant pressure to raise enough cash in a short period of time to make the single,
large payment. Second, if the debt owing to that creditor also includes any long-term
debt, the creditor could also force the company to reclassify the long-term balances
to current liabilities, driving the current ratio even lower. This might be all that it
takes to drive a marginally performing company into bankruptcy, which is a no-win
for either the company or its creditors.
The following are possible conditions or situations that would give rise to a credit
balance in accounts receivable customer accounts.
• Customers returned goods after the account was paid.

• A customer has overpaid an account in error.
• The company policy may be no cash refunds. Any returns would therefore be
credited to the customer account to be used later for a future purchase.
• Most of the accounting software applications apply customer prepayments (un-
earned revenues) as a credit balance in accounts receivable, since eventually
the actual amounts when owed by the customer at the time the goods and
services provided will be debited to the accounts receivable sub-ledger when
the invoice is prepared.
• On the basis of materiality, the credit balances, if insignificant, will likely remain
with the existing accounts receivable as small credit balances.
EXERCISE 4–4
a.
Hughey Ltd.
Assets
Current assets
Cash $ 250,000
Accounts receivable $ 1,015,000
Less allowance for doubtful accounts (55,000) 960,000
Inventory–at lower of FIFO cost and NRV 1,300,000
Prepaid insurance 40,000
Total current assets $2,550,000
Long-term investments
Investments, available for sale, of which investments
costing $800,000 have been pledged as security
for notes payable to bank 2,250,000
Land 530,000
Building 770,000
Equipment 2,500,000
Accumulated depreciation (1,200,000) 1,300,000 2,300,000
Intangible assets
Patents (net of accumulated amortization of $35,000) 25,000

Current liabilities
7% notes payable to bank, secured by
investments which cost $800,000; $ 600,000
Total current liabilities 1,800,000
Bonds payable, 25-yr, 8%, due December 31, 2025,
at amortized cost 1,100,000
Paid-in capital
Common shares; 100,000 shares authorized,
80,000 shares issued and outstanding 2,500,000
Retained earnings 1,330,000
Accumulated other comprehensive income 395,000* 4,225,000
* Opening balance of $245,000 + $150,000($2,250,000 − 2,100,000) for unrealized holding gain –

OCI on Investments–available for sale.
b. Patent annual amortization:

60,000 − 25,000 = 35,000 total amortization for the period January 1, 2010 to
December 31, 2016 or 7 years amortized since its purchase.
$35,000 ÷ 7 years = $5,000 per year
c. This company follows IFRS because it has classified and reported some of its
investments as available for sale (OCI) which is a classification only permitted by
IFRS companies. ASPE does not have this classification.
EXERCISE 4–5
Description Section Amount

Issue of bonds payable of $500 cash Financing 500
Sale of land and building of $60,000 cash Investing 60,000
Retirement of bonds payable of $20,000 cash Financing (20,000)
Current portion of long-term debt changed from $56,000 to $50,000 Financing *
Repurchase of company’s own shares of $120,000 cash Financing (120,000)
Issuance of common shares of $80,000 cash Financing 80,000
Payment of cash dividend of $25,000 recorded to retained earnings Financing (25,000)
Purchase of land of $60,000 cash and a $100,000 note Investing (60,000)
Cash dividends received from a trading investment of $5,000 Operating 5,000
Interest income received in cash from an investment of $2,000 Operating 2,000
Interest and finance charges paid of $15,000 Operating (15,000)
Purchase of equipment for $32,000 Investing (32,000)
Increase in accounts receivable of $75,000 Operating (75,000)
Decrease in a short-term note payable of $10,000 Operating (10,000)
Increase in income taxes payable of $3,000 Operating 3,000
Purchase of equipment in exchange for a $14,000 long-term note None: non-cash -
* The current portion of long-term debt for both years would be added to their respective long-term debt
payable accounts and reported as a single line item in the financing section.
EXERCISE 4–6
a.
Carmel Corp.
Balance Sheet
Assets
Current assets
Cash $ 247,600
Accounts receivable (net) * 109,040
Total current assets 356,640
Investment in land (at cost) 220,000

Land $200,000
Building (net) 87,200
Equipment (net) 198,000 485,200

Current liabilities
Current portion of long-term debt 32,000
Total current liabilities 87,200
Mortgage payable 110,200
Common shares $470,000
The required disclosures discussed in Chapter 3 that were missed were the AFDA,
the accumulated depreciation for the building and equipment, the interest rate, se-
curitization and due date for the mortgage payable classified as a long-term liability,
and the authorized and issued common shares in the equity section.
Calculations Worksheet:
Adjustments
Dr Cr Dr Cr
1
Cash $ 84,000 1,356,600 1,193,0002 247,600
Accounts receivable (net) 89,040 1,000,000 980,000 109,040
Investments – trading 134,400 134,400 -
Buildings (net) 340,200 225,000
28,000 87,200
Equipment (net) 168,000 50,000 20,000 198,000
Land 200,000 220,000 420,000
$1,015,640 $1,061,840
Accounts payable $146,000 900,000 809,200 55,200

Mortgage payable 172,200 30,000 142,200
Common shares 400,000 70,000 470,000
Retained earnings 297,440 8,000 105,000 394,440
$1,015,640 2,123,680 $1,061,840
Revenues $1,000,000 A/R 1,000,000

Gain 2,200 2,200
Total revenue 1,002,200
Expenses
Operating expenses 809,200 809,200
Interest expenses 35,000 35,000
Depreciation 48,000 48,000
Loss 5,000 5,000
897,200
Net Income $ 105,000 4,461,800 4,566,800
−105,000 net income

4,461,800 4,461,800 to retained earnings
b.
1
Cash increases due to 980,000 A/R collections, 136,600 proceeds from the sale of the trading
investments, 220,000 from the sale of the building and 20,000 from the issuance of additional common
shares = 1,356,600
2
Cash decreases due to 900,000 payments of accounts payable, 8,000 payment of cash dividends,
220,000 for additional land, and 65,000 for payments for the mortgage payable = 1,193,000
Carmel Corp.

Adjustments for non-cash revenue and expense
items in the income statement:
Depreciation expense $ 48,000
Gain on sale of investments (2,200)
Loss on sale of building 5,000
Decrease in investments – trading 136,600
Increase in accounts receivable ($109,040 − $89,040) (20,000)
Decrease in accounts payable ($146,000 − $55,200) (90,800) 76,600
Net cash from operating activities 181,600

Proceeds from sale of building ($225,000 − $5,000) 220,000
Purchase of land (220,000)
Net cash from investing activities 0

Reduction in long-term mortgage principal (30,000)
Issuance of common shares 20,000
Payment of cash dividends (8,000)
Net cash from financing activities (18,000)

Cash at beginning of year 84,000
Cash at end of year $ 247,600
Note:
• The purchase of equipment through the issuance of $50,000 of common shares

is a significant non-cash financing transaction that would be disclosed in the
notes to the financial statements.
• Cash paid interest $35,000
Had there been cash paid income taxes, this would also be disclosed.
c. Free cash flow:
Net cash provided by operating activities $ 181,600

Capital purchases – land (220,000)
Cash paid dividends (8,000)
Free cash flow $(46,400)
An analysis of Carmel’s free cash flow indicates it is negative as shown above.

Including dividends paid is optional, but it would not have made a difference in this
case. What does make the difference in this case is that the capital expenditures are
those needed to sustain the current level of operations. In Carmel’s case, the land
was purchased for investment purposes and not to meet operational requirements.
With this in mind, the free cash flow would more accurately be:
Net cash from operating activities $ 181,600

Capital purchases 0
Cash paid dividends (8,000)
Free cash flow $ 173,600
This makes intuitive sense and is supported by the results from one of the coverage
ratios.
The current cash debt coverage provides information about how well Carmel can
cover its current liabilities from its net cash flows from operations:
Net cash from operating activitites

Average current liabilities
Carmel’s current cash debt coverage is ($181,600 ÷ ((87,200 + 176,000) × 50%) =

1.38. The company has adequate cash flows to cover its current liabilities as they
come due and so overall, its financial flexibility looks positive.
In terms of cash flow patterns, Carmel has managed to more than triple its cash
balance in the year mainly from cash generated from operating activities, which
is a good trend. Carmel was able to pay $8,000 in dividends, or a 1.7% return.
If dividends are paid several times throughout the year, the return is more than
adequate to investors. Carmel also sold off its traded investments for a profit and
some idle buildings at a small loss to obtain sufficient internal funding for some land
that it wants as an investment. Carmel also managed to lower its accounts payable
levels by close to 60%. All this supports the assessment that Carmel’s financial
flexibility looks reasonable.
d. The information reported in the statement of cash flows is useful for assessing the
amount, timing, and uncertainty of future cash flows. The statement identifies the
specific cash inflows and outflows from operating activities, investing activities, and
financing activities. This gives stakeholders a better understanding of the liquidity
and financial flexibility of the enterprise. Some stakeholders have concerns about
the quality of the earnings because of the various bases that can be used to record
accruals and estimates, which can vary widely and be subjective. As a result, the
higher the ratio of cash provided by operating activities to net income, the more
stakeholders can rely on the earnings reported.
EXERCISE 4–7
Lambrinetta Industries Ltd.

Year Ended December 31, 2016

Adjustments
Depreciation expense* $ 25,500
Change in A/R 27,200
Change in A/P 11,900
Unrealized loss on investments–trading** 5,200
Investments purchased (12,000)
57,800
Net cash from operating activities 219,300

Sold plant assets 37,400
Purchase plant assets*** (130,900)
Net cash from investing activities (93,500)

Note issued**** 42,500
Shares issued for cash (81,600+37,400 in exch for land
– 130,900 ending balance) 11,900
Cash dividends paid***** (188,700)
Net cash from financing activities (134,300)
Net decrease in cash (8,500)

* $136,000 − 13,600 − 147,900

** $81,600 + 12,000 − 88,400
*** $345,100 − 51,000 − 425,000
**** $75,000 + 10,000 − 119,500 − 8,000
***** $314,500 + 161,500 − 287,300
Disclosures:
Additional land for $37,400 was acquired in exchange for issuing additional common
shares.
EXERCISE 4–8
a.
Egglestone Vibe Inc.


Net income $ 24,700
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation expense (Note 1) $ 55,900
Loss on sale of equipment (Note 2) 10,100
Gain on sale of land (Note 3) (38,200)
Impairment loss–goodwill 63,700
Decrease in accounts payable (28,200) (40,700)
Purchase of investments–available for sale (20,000)
Proceeds from sale of equipment 27,300
Purchase of land (Note 4) 62,400
Proceeds from sale of land 150,000
Net cash provided by investing activities 94,900
Cash flows used by financing activities
Payment of cash dividends (Note 5) (42,600)
Issuance of notes payable 10,500
Net cash used by financing activities (32,100)

Note: During the year, $160,000 in notes payable were retired by issuing common
shares.
Notes:
1. $111,800 − $15,600 + X = $152,100; X = 55,900

2. $27,300 − ($53,000 − $15,600)
3. $150,000 − $111,800
4. $133,900 − 111,800 + X = $84,500
5. Retained earnings account: $370,200 + 24,700 − X = $374,400; Dividend
declared but not paid = $20,500
Dividends payable account: $41,600 + 20,500 − 19,500 = $42,600 cash paid
dividends
b. Negative cash flows from operating activities may signal trouble ahead with regard to
Egglestone’s daily operations, including profitability of operations and management
of its current assets such as accounts receivable, inventory and accounts payable.
All three of these increased the cash outflows over the year. In fact, net cash
provided by investing activities funded the net cash used by both operating and
financing activities. Specifically, proceeds from sale of equipment and land were
used to fund operating and financing activities, which may be cause for concern if
the assets sold were used to generate significant revenue. Shareholders did receive
cash dividends, but investors may wonder if these payments will be sustainable over
the long term. Consider that dividends declared was $20,500, which was quite
high compared to the net income for $24,700. In addition, the dividends payable
account still had a balance payable for $41,600 from prior dividend declarations not
yet paid. All this adds up to increasing the pressure on the company to find enough
funds to catch up with the cash payments to investors. Egglestone may not be able
to sustain payment of cash dividends of this size in the long term if improvement
regarding its profitability and management of receivables, payables and inventory
are not implemented quickly.
Chapter 5 Solutions
EXERCISE 5–1
Scenario 1: Amount to be received = $80 × 36 months = $2,880
Allocate using relative fair values:
Phone: [500 ÷ (500 + (600 × 3))] × 2,880 = 626

Air-time: [(600 × 3) ÷ (500 + (600 × 3))] × 2,880 = 2,254
Therefore, $626 will be recognized immediately and $2,254 will be deferred and recog-
nized over the 3-year term of the contract.
Scenario 2: Amount to be received = ($100 × 24 months) + $300 = $2,700
Allocate using relative fair values:
Phone: [500 ÷ (500 + (600 × 2))] × 2,700 = 794

Air-time: [(600 × 2) ÷ (500 + (600 × 2))] × 2,700 = 1,906
Therefore, $794 will be recognized immediately and $1,906 will be deferred and recog-
EXERCISE 5–2
Scenario 1: Allocate using residual values:
Phone: 2,880 − (600 × 3) = 1,080

Air-time: 600 × 3 = 1,800
Therefore, $1,080 will be recognized immediately and $1,800 will be deferred and recog-
Scenario 2: Allocate using residual values:
Phone: 2,700 − (600 × 2) = 1,500

Air-time: 600 × 2 = 1,200
Therefore, $1,500 will be recognized immediately and $1,200 will be deferred and recog-
EXERCISE 5–3
Art Attack Ltd. (consignor)
General Journal
Finished goods inventory . . . . . . . . . . . . . . . . 58,000
To segregate consignment goods.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200
To record freight.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,700
Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . 3,400
Commission expense . . . . . . . . . . . . . . . . . . . . . . . 7,900
Consignment revenue . . . . . . . . . . . . . . . . . . . 79,000
To record receipt of net sales.

Inventory on consignment. . . . . . . . . . . . . . . . 48,160
To record COGS: [(58,000 + 2,200) x 80%]
The Print Haus. (consignee)
General Journal
Account receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,400
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,400
To record payment of advertising.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000
To record sales of consigned goods.
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000

Revenue from consignment sales . . . . . . . . 7,900
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,700
To record payment to consignor.
EXERCISE 5–4
January journal entry:
General Journal
Instalment accounts receivable . . . . . . . . . . . . . . 350,000
Deferred gross profit . . . . . . . . . . . . . . . . . . . . . 105,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245,000
Journal entry for September to December (to be repeated 4 times):
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,500
Instalment accounts receivable . . . . . . . . . . 87,500
Deferred gross profit (105 × 1/4) . . . . . . . . . . . . 26,250
Cost of goods sold (245 × 1/4) . . . . . . . . . . . . . . 61,250
Sales revenue (350 × 1/4) . . . . . . . . . . . . . . . 87,500
EXERCISE 5–5
October journal entry:

General Journal
Computer equipment. . . . . . . . . . . . . . . . . . . . . . . . 3,000
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . 3,000
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 250
Service revenue . . . . . . . . . . . . . . . . . . . . . . . . . 250
November journal entry:
General Journal
Service revenue . . . . . . . . . . . . . . . . . . . . . . . . . 250
December journal entry:
General Journal
Service revenue . . . . . . . . . . . . . . . . . . . . . . . . . 250
EXERCISE 5–6
a. Construction Contract
2015 2016
Costs to date (A) $20,000,000 $ 31,000,000
Estimated costs to complete project 10,000,000 0
Total estimated project costs (B) 30,000,000 31,000,000
Percent complete (C = A ÷ B) 66.67% 100.00%
Total contract price (D) 35,000,000 35,000,000
Revenue to date (C × D) 23,333,333 35,000,000
Less previously recognized revenue - (23,333,333)
Revenue to recognize in the year 23,333,333 11,666,667
Costs incurred the year 20,000,000 11,000,000
Gross profit for the year $ 3,333,333 $ 666,667
b. 2015 Journal Entry:

General Journal

To record billings.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000,000

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,333,333
2016 Journal Entry:
General Journal

To record billings.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000,000
Construction in progress . . . . . . . . . . . . . . . . . . . . 666,667

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,666,667
General Journal
Billings on construction . . . . . . . . . . . . . . . . . . . . . 35,000,000
Construction in progress . . . . . . . . . . . . . . . . . 35,000,000
To record completion.
EXERCISE 5–7
2016 2017 2018

Costs to date (A) $1,100,000 $ 3,400,000 $ 4,500,000
Estimated costs to complete project 3,200,000 1,000,000 -
Less previously recognized revenue - (1,330,160) (4,018,040)
Revenue to recognize in the year 1,330,160 2,687,880 1,181,960
Costs incurred the year 1,100,000 2,300,000 1,100,000
Gross profit for the year $ 230,160 $ 387,880 $ 81,960
b. Balance Sheet
Current assets
Accounts receivable 300,000*
Recognized contract revenues in excess of billings 718,040**
* calculated as 3,300,000 − 3,000,000 = 300,000

** calculated as (3,400,000 + 230,160 + 387,880) − 3,300,000 = 718,040
Income Statement
Contract revenues 2,687,880
Contract costs 2,300,000
EXERCISE 5–8
2015 2016 2017

Costs to date (A) $ 800,000 $2,400,000 $ 3,900,000
Estimated costs to complete project 2,100,000 1,600,000 -
Revenue to date (C × D) 965,650 2,280,000 3,800,000
Less previously recognized revenue - (965,650) (2,280,000)
Revenue to recognize in the year 965,650 1,314,350 1,520,000
Costs incurred the year 800,000 1,600,000 1,500,000
Gross profit (loss) for the year $ 165,650 (285,650) 20,000
Additional loss to recognize (NOTE) (80,000) 80,000
Gross profit (loss) for the year $ (365,650) $ 100,000
NOTE: Additional loss represents the expected loss on work not yet completed
(3,800,000 − 4,000,000) × 40% = 80,000
b. Journal Entries
General Journal

To record billings.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000
Construction expenses* . . . . . . . . . . . . . . . . . . . . . 1,680,000

Construction in progress . . . . . . . . . . . . . . . . . 365,650
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,314,350
* includes actual costs incurred plus additional loss to recognize
EXERCISE 5–9
a. Zero Profit Method

2015 2016 2017

Revenues recognized 800,000 1,600,000 1,400,000
Expenses 800,000 1,800,000 1,300,000
Gross profit (200,000) 100,000
b. Completed Contract Method
2015 2016 2017

Revenues recognized 0 0 3,800,000
Expenses 0 0 3,700,000
Gross profit 0 0 100,000
Loss on unprofitable contract (200,000)
Chapter 6 Solutions
EXERCISE 6–1
a. Cash $600,000
b. Cash equivalent $22,000
c. Cash advance received from customer of $2,670 should be included as a debit to

cash and a credit to a liability account
d. Cash advance of $5,000 to company executive should be reported as a receivable
e. Refundable deposit of $13,000 to developer should be reported as a receivable or a

prepaid expense
f. Cash restricted for future plant expansion of $545,000 should be reported as re-
stricted cash in noncurrent assets
g. The certificate of deposit of $575,000 matures in nine months so it should be re-

ported as a temporary investment
h. The utility deposit of $500 should be identified as a receivable or prepaid expense

from the utility company
i. The cash advance to subsidiary of $100,000 should be reported as a receivable

j. The post-dated cheque of $30,000 should be reported as a payment of receivable

when the post-date occurs; until the post-date, the $30,000 is classified as a receiv-
able
k. Details of the $115,000 cash restriction are to be separately disclosed in the balance
sheet with further disclosures in the notes to the financial statements indicating the
type of arrangement and amounts
l. Cash $13,000
m. Postage stamps on hand are reported as part of supplies or prepaid expenses
n. Cash $520,000
o. Cash held in a bond sinking fund is restricted; since the bonds are noncurrent, the
restricted cash is also reported as noncurrent
p. Cash $1,200
q. Cash $13,000
r. Cash equivalent $75,400
s. The NSF cheque of $8,000 should be reported as a receivable
EXERCISE 6–2
a. (Partial SFP):
Current assets
Cash and cash equivalent* $3,385,750
Restricted cash balance 175,000
Non-current assets
Cash restricted for retirement of long-term debt 2,000,000
Current liabilities
Bank indebtedness** 150,000
For Cash and cash equivalent*:

Commercial savings account – First Royal Bank ($575,000 − 175,000) $ 400,000
Commercial chequing account – First Royal Bank 450,000
Money market fund – Commercial Bank of British Columbia 2,500,000
Petty cash 1,500
Cash floats (5 × $250) 1,250
60-day treasury bill** 18,000
Currency and coin on hand 15,000
Cash reported on December 31, 2015 balance sheet as a current asset $3,385,750
** The treasury bill for $18,000 is to be classified as a cash equivalent because the original maturity
is less than 90 days.
*** The bank overdraft at the Lemon Bank for $150,000 is to be reported separately as a current
liability because there are no other accounts at Lemon Bank available for offset.
b. Other items classified as follows:
ii. The minimum balance at First Royal Bank of $175,000 is reported separately
as a restricted cash balance as a current asset cash balance. In addition, a
description of the details of the arrangement should be disclosed in the notes.
vii. The post-dated cheque for $25,000 is for a payment on accounts receivable
and should not be recognized until the cheque is deposited on January 18. It
will be held in a secure location until then.
viii. The post-dated cheque for $1,800 is for unearned revenue and will not be
recorded as unearned revenue until the cheque can be deposited on January
12. It will be held in a secure location until then. Revenue will be recorded and
unearned revenue offset when legal title to the goods passes to the customer
on January 20.
ix. Travel advances for $15,000 are to be reported as prepaid travel.
x. The $2,300 amount paid to the employee is to be reported as a receivable from
the employee. It will be offset when collected from salary in January.
xi. The treasury bill for $50,000 should be classified as a temporary investment
(current asset). It cannot be reported as a cash equivalent because the original
maturity exceeds 90 days.
xiv. Commercial paper should be reported as temporary investments (current as-
set).
xv. Investments in shares should be classified with trading securities (current as-
set) at their fair value of $4,060 ($4.06 × 1,000 shares).
EXERCISE 6–3
Partial classified balance sheet:

Current assets
Accounts receivable
Customer Accounts (of which accounts in the amount of
$30,000 have been pledged as security for a bank loan) $275,000
Other* ($2,500 + $6,000) 8,500 $283,500
Non-Current Assets
Accounts Receivable
Advance to related company** 30,000
Instalment accounts receivable due after December 31, 2016 50,000
* These items could be separately classified, if considered material.

** This classification assumes that these receivables are not collectible in the near term based on the fact
that they were advanced in 2010 and remain outstanding.
EXERCISE 6–4
a.
General Journal
July 1 Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Freight-out (operating expense) . . . . . . . . . . . . . 3,200
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
July 5 Sales returns and allowances . . . . . . . . . . . . . . . 9,000

(3 × $3,000)
July 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,890

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,110
For Sales discounts: (($120,000 − 9,000) ×
1%)
July 14 Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . 79,000

($1,500 × 50 + 4,000)
July 17 Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . 224,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,000
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 224,000
July 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,320

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,680
For Sales discounts: ($224,000 × 1.5% ×
50%), for Accounts receivable: ($224,000 ×
50%)
Aug 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,000

b. The implied interest rate on accounts receivable paid to Busy Beaver from Heintoch
within the 15-day discount period = 1% ÷ [(30 − 15) ÷ 365] = 24.33%. This means
that Heintoch would be using funds from the bank at a lower rate of 8% to save
24.33% interest on early payment of amounts owing to Busy Beaver. It is definitely
worthwhile to take advantage of the early payment discount terms in this case.
EXERCISE 6–5
a.
Calculation of cost of goods sold:
Opening inventory $ 35,000
Merchandise purchased 600,000
Less: Ending inventory 225,000
Cost of goods sold $410,000
Sales on account ($410,000 × 1.35) 553,500

Less collections deposited in bank 420,000
Uncollected balance 133,500
Balance per ledger 85,000
Unaccounted for shortage $ 48,500
b. Accounts receivable balance per ledger of $85,000 is less than estimated accounts
receivable of $133,500, suggesting that some accounts receivable collections may
have been received but not actually deposited to the company’s bank account.
Controls to help prevent theft include proper segregation of duties among the person
initially in receipt of the cheque, the person depositing it, and the person recording
the collection. Customers should be encouraged to pay by cheque so an audit trail is
maintained. A timely completion of the monthly bank reconciliation would help detect
if any cash was recorded as collected, but not actually deposited to the company’s
bank account.
EXERCISE 6–6
a.
General Journal
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 11,340
AFDA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,340
(($225,000 × 4%) + 2,340)
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 8,995

AFDA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,995
(141,000 × 1% + 53,500 × 3% + 10,500 ×
8% + 20,000 × 14%) = 6,655 + 2,340
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 2,160

AFDA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,160
(($225,000 × 2%) − 2,340)
b. An unadjusted debit balance in the AFDA at year-end is usually the result of write-
offs during the year exceeding the total AFDA opening credit balance. The purpose
of the AFDA is to ensure that the net accounts receivable is valued at net realizable
value on the balance sheet.
EXERCISE 6–7
a.
Balance, January 1, 2015 $ 575,000
Bad debt expense accrual (1% × ($16,000,000 × 0.75)) 120,000
695,000
Uncollectible receivables written off (40,000)
Balance, December 31, 2015, before adjustment 655,000
Allowance adjustment 155,000
Balance, December 31, 2015 $ 500,000
General Journal
Allowance for doubtful accounts . . . . . . . . . . . . . 155,000
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . 155,000
b. (Partial classified balance sheet as at December 31)

Current assets
Accounts receivable $50,950,000
Less allowance for doubtful accounts 500,000
Net accounts receivable 50,450,000
The net accounts receivable balance is intended to measure the net realizable value
of the accounts receivable at December 31.
c. The direct write-off approach is not in compliance with GAAP unless the amount of
the write-off is immaterial. Direct write-off does not match (bad debt) expense with
revenues of the period, nor does it result in receivables being stated at estimated
net realizable value on the balance sheet.
EXERCISE 6–8
a.
General Journal
May 1 2015 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228,676
Services revenue . . . . . . . . . . . . . . . . . . . . . . . . 228,676
PV = (0 PMT, 8 I/Y, 5 N, 336000 FV)
Dec 31 2015 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,196

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 12,196
($228,676 × 8% × 8 ÷ 12)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 19,270
([$228,676 + 12,196] × 8%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 20,811
([$228,676 + 12,196 + 19,270] × 8%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 22,476
([$228,676+12,196+19,270+20,811]×8%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 24,274
([$228,676 + 12,196 + 19,270 + 20,811 +
22,476] × 8%)
May 1 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336,000

Notes receivable*** . . . . . . . . . . . . . . . . . . . . . . . . . 8,297
Notes receivable*** . . . . . . . . . . . . . . . . . . . . . . 336,000
Interest income** . . . . . . . . . . . . . . . . . . . . . . . . 8,297
Interest = ([$228,676 + 12,196 + 19,270 +
20,811 + 22,476 + 24,274] × 8%) × 4 ÷ 12
(rounded)
** rounded so that the carrying value was equal to $336,000 at maturity

*** can be netted together into one amount for $327,703 credit
b. Using a financial calculator input the following variables:
Interest = +/- 228676 PV, 0 PMT, 5 N, 336000 FV

= 7.99 or 8% rounded
c. (Partial balance sheet):
Non-current assets
Notes receivable, no-interest-bearing, due May 1, 2020 $260,142*
* $228,676 + 12,196 + 19,270

Unamortized discount as at December 31, 2016, is $336,000 − 260,142 = 75,858.
As at December 31, 2019, the note would be classified as a current asset on the
SFP because the maturity date of May 1, 2020, is within the next fiscal year.
d. The fair value of the services provided can be used to value and record the transac-
tion, instead of fair value of the note received.
EXERCISE 6–9
a.
Scenario i:
General Journal
July 1 Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Dec 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
($120,000 × 5% × 6 months)
Scenario ii:
General Journal
Dec 31 Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625
($105,000 × 5% × 6 ÷ 12))
Scenario iii:
General Journal
PV = (1 N, 10 I/Y, 115000 FV)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 5,227
($104,545 × 10% × 6 months)
b.
Calculate interest from January 1 to July 1:
General Journal
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 5,228
($104,545 + $5,227 − $115,000)
Calculate the loss from impairment:
General Journal
July 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,250
Loss on impairment of notes receivable . . . . . 33,750
Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000
For Cash: (115,000 × 75%)
EXERCISE 6–10
a.
General Journal
Accumulated depreciation – equipment. . . . . . 65,400
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,000
Gain on sale of equipment . . . . . . . . . . . . . . . 878
For Accum. dep.: ($78,000 − $12,600)
PV = (0 PMT, 4 N, 7.5 I/Y, 18000 FV) = $13,478

Fair value of equipment (present value of note) $13,478

Carrying amount 12,600
Gain on sale of equipment $ 878
General Journal
Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . 1,011
First year interest: ($13,478 × 7.5%)
Dec 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Collection at maturity.
b. Since Harrison uses ASPE, either straight-line or the effective interest method can
be used for recognizing interest income. Below is the calculation using the straight-
line method. Interest income for $1,131 for each of the next four consecutive years
will be recorded.
General Journal
Dec 31 Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,131
Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,131
First year interest: ($18,000 − 13,478 =
$4,522 ÷ 4 yrs = 1,131)
EXERCISE 6–11
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472,000
Finance expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
For a. (800,000 × 3.5%)
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000
For b.
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,375
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509,375
For c. ($500,000 × 7.5% × 3 ÷ 12)
d. To be recorded as a sale under IFRS, both of the following conditions must be met:
i. The transferred assets risks and rewards of ownership have been transferred
to the transferee. This is evidenced by transferring the rights to receive the
cash flows from the receivables. Where the transferor continues to receive the
cash flows, there must be a contractual obligation to pay these cash flows to
the transferee without material delay.
ii. The transferee has obtained the right to pledge or to sell the transferred assets
to an unrelated party (concept of control).
To be recorded as a sale under ASPE, the control over the receivables has been
surrendered as evidenced by all of the following three conditions being met:
i. The transferred assets have been isolated from the transferor.

ii. The transferee has obtained the right to pledge or to sell the transferred assets.
iii. The transferor does not maintain effective control of the transferred assets
through a repurchase agreement.
e. Management would likely prefer the receivables transfer transaction to be treated

as a sale and derecognized from the accounts rather than a secured borrowing
because the company would not have to record and report the additional debt in the
SFP.
EXERCISE 6–12
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000
For Loss on sale: ($250,000 − $50,000)
EXERCISE 6–13
a.
General Journal
Feb 1 2015 Cash*. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 748,000
Due from Factor** . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
* $800,000 × (100% − 2.5% + 4%)

** $800,000 × 4%
b. Factoring the accounts receivable will improve the accounts receivable turnover ratio
immediately after recording the entry on February 1 because the average accounts
receivable amount in the denominator will decrease, making the ratio larger. For
example, if sales were $3.2M and accounts receivable before the sale was $1.8M,
then the turnover ratio would be 1.78 (3.2M ÷ 1.8M) compared to 3.2 (3.2M ÷ 1M).
If the calculation is made at the December 31 fiscal year-end, the balances of sales
and average accounts receivable would no longer be affected by this transaction,
and the accounts receivable turnover ratio would not be affected. This is because
time has passed and many of the accounts would have been collected by year-end,
had the company not sold them to a factor.
EXERCISE 6–14
a. i. Land in exchange for a note:
General Journal
Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 387,531
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000
PV = (0 PMT, 3 N, 11 I/Y, 530,000 FV) = $387,531

ii. Services in exchange for a note:
General Journal
Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 330,778
Service Revenue . . . . . . . . . . . . . . . . . . . . . . . . 330,778
Interest payment = $500,000 × 3% = $15,000

PV = (15000 PMT, 6 N, 11 I/Y, 500,000 FV) = $330,778
iii. Partial settlement of account in exchange for a note:
General Journal
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,257
PV = (12000 PMT, 5 N, 12 I/Y, 0 FV) = $43,257

b.
Instalment Note Receivable
Cash Interest Amortization Carrying Amount
Payment @ 12% of Note
$43,257 $6,809
Oct 1 – Dec 31 1,298* reduction
Jan 1 – Oct 1 $12,000 3,893** 6,809 36,448 in principal
Oct 1 – Dec 31 1,094
Jan 1 – Oct 1 12,000 3,280 7,626 28,822
Oct 1 – Dec 31 865
Jan 1 – Oct 1 12,000 2,594 8,541 20,281
Oct 1 – Dec 31 609
Jan 1 – Oct 1 12,000 1,825 9,566 10,715
Oct 1 – Dec 31 322
Jan 1 – Oct 1 12,000 964 10,715 –
* $43,257 × 12% × 3 ÷ 12
** $43,257 × 12% × 9 ÷ 12
Note – Some rounding differences will occur when
calculating interest.
General Journal
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,298
Oct 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 6,809*
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 3,893
* See schedule above for the reduction in the principal amount after the first payment was made for
$12,000.
c. From the perspective of Brew It Again, an instalment note reduces the risk of non-
collection when compared to a non-interest-bearing note. In the case of the non-
interest-bearing note, the full amount is due at the maturity of the note. The instal-
ment note provides a regular reduction of the principal balance in every payment
received annually. This is demonstrated in the effective interest table illustrated
above for the instalment note.
EXERCISE 6–15
a.
Net Credit Sales

Accounts Receivable Turnover =
Average Trade Receivables (net)
$1,022,020*
(Using credit sales) =
($123,000 + $281,760**) ÷ 2
= 5.05 times or about 72 days
* $1,865,000 × 54.8% = 1,022,020

** Opening balance $123,000 + 1,022,020 − 863,260 = 281,760 closing balance.
Note that the write-off of $12,500 does not affect net accounts receivable.
The average receivable is therefore about 72 days old (365 ÷ 5.05).
b. Credit sales are a better measure in the calculation of accounts receivable turnover
ratio since cash sales do not affect accounts receivable balances. On this basis,
Corvid Company’s accounts receivable turnover ratio has declined from the previous
year. The average number of days to collect the accounts was 62 days (365 ÷
5.85) compared to 72 days for 2015. This could be an unfavourable trend for future
liquidity, if customers continue to pay slowly. Corvid may want to consider offering
discounts for early payments of accounts or tighten their credit policy.
It should be noted that credit sales are not always available when performing analy-
sis and calculating the accounts receivables turnover ratio. When not available, the
figure of net sales should be used. As long as the calculation is done consistently
between years, or between businesses, the comparison will remain relevant.
EXERCISE 6–16
a.
Jersey Shores:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,143,750
Due from factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,500
Accounts Receivable . . . . . . . . . . . . . . . . . . . . 1,250,000
For Due from factor: ($1,250,000 × 5%), for
Loss on sale: ($1,250,000 × 3.5%)
Fast factors:
General Journal
Due to customer . . . . . . . . . . . . . . . . . . . . . . . . . 62,500
Financing revenue . . . . . . . . . . . . . . . . . . . . . . . 43,750
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,142,750
For Due to customer: ($1,250,000 × 5%), for
Financing revenue: ($1,250,000 × 3.5%)
b.
Jersey Shores:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,143,750
Due from factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,500
For Loss on sale: ($43,750 + $7,400)
EXERCISE 6–17
General Journal
July 11 Cash*. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Loss on sale of receivables** . . . . . . . . . . . . . . . . 46,000
Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . 14,000
* $400,000 × 95%
** $400,000 × 95% − $14,000 − $12,000 = $354,000 − $400,000 carrying value of accounts receivable =
$46,000
Chapter 7 Solutions
EXERCISE 7–1
Inventory would normally include the following items:

• Salaries of assembly line workers
• Raw materials
• Salary of factory foreman
• Heating cost for the factory
• Miscellaneous supplies used in production process
• Costs to ship raw materials from the supplier to the factory
• Electricity cost for the factory
• Depreciation of factory machines
• Property taxes on factory building
• Discounts for early payment of raw material purchases
• Salaries of the factory’s janitorial staff
All of these costs can be considered either direct costs or attributable overhead costs.
The CEO’s and sales team salaries would not be considered costs directly attributable to
the purchase and conversion of inventory.
EXERCISE 7–2
FOB Shipping FOB Destination

Owns the goods while in transit P S
Is responsible for the loss if goods are damaged P S
in transit
Pays for the shipping costs P S
EXERCISE 7–3
a. The company would allocate $150,000 of overhead at the rate of $150,000 ÷ 105,000
= $1.4286 per unit. As a practical matter, the company may choose to simply
allocate based on the standard rate of $1.50 per unit and record a small overhead
recovery through cost of sales. This would be reasonable as the volume produced
is close to the standard volume used to determine the rate.
b. The company would allocate $45,000 of overhead, using the standard rate of $1.50
per unit. The remaining overhead would need to be expensed. This is necessary to
avoid over-valuing the inventory.
c. The company would allocate $150,000 of overhead at the rate of $150,000 ÷ 160,000
= $0.9375 per unit. The standard rate cannot be used here, as it would over-absorb
the overhead cost into inventory.
EXERCISE 7–4
Date Purchase Sale Balance Balance of

Units
May 1 8 × $550.00 = $4,400 8
May 5 50 × $560.00 (8 × $550.00) + (50 × $560.00) = 58
$32,400
May 8 10 × $575.00 (8 × $550.00) + (50 × $560.00) + 68
(10 × $575.00) = $38,150
May 15 (8 × $550.00)+ (7 × (43 × $560.00) + (10 × $575.00) = 53
$560.00) = $8,320 $29,830
May 22 12 × $572.00 (43 × $560.00) + (10 × $575.00) + 65
(12 × $572) = $36,694
May 25 (23 × $560.00) = (20 × $560.00) + (10 × $575.00) + 42
$12,880 (12 × $572) = $23,814
Cost of Goods Sold for May = (8,320 + 12,880) = $21,200
Ending Inventory on May 31 = $23,814
EXERCISE 7–5
Date Purchase Sale Balance Average Balance of

Cost Units
May 1 8 × $550.00 = $4,400 8
May 5 50 × $560.00 (8 × $550.00) + (50 × 58
$560.00) = $32,400
May 8 10 × $575.00 (8 × $550.00) + (50 × $561.03 68
$560.00) + (10 ×
$575.00) = $38,150
May 15 15 × ($38,150 ÷ 68) = (53 × $561.03) = $561.03 53
$8,415.45 $29,734.55
May 22 12 × $572.00 (53 × $561.03) + (12 × $563.05 65
$572.00) = $36,598.55
May 25 23 × ($36,598.55 ÷ 65) = (42 × $563.05) = $563.05 42
$12,950.15 $23,648.40
Cost of Goods Sold for May = (8,415.45 + 12,950.15) = $21,365.60
Ending Inventory on May 31 = $23,648.40
EXERCISE 7–6
a. No grouping
Description Category Cost ($) Selling LCNRV

Price ($)
Brake pad #1 Brake pads 159 140 140
Brake pad #2 Brake pads 175 180 175
Total brake pads 334 320 315
Soft tire Tires 325 337 325

Hard tire Tires 312 303 303
Total tires 637 640 628
Total LCNRV = (315 + 628) = 943

Current carrying value = ($334 + 637) = 971
Adjustment required = (943 − 971) = (28)
Journal entry required:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
b. With grouping
Description Category Cost ($) Selling LCNRV

Price ($)
Total brake pads 334 320 320
Soft tire Tires 325 337

Hard tire Tires 312 303
Total tires 637 640 637
Only the brake pad category needs to be written down. Total adjustment required =
(320 − 334) = 14
Journal entry required:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
EXERCISE 7–7
NOTE: Positive amounts represent overstatements and negative amounts represent un-
derstatements.
Item Inventory A/R A/P Net Income

A (82,000) - (82,000)
B (4,000) - (6,000) 2,000
C (27,000) - - (27,000)
D (2,000) 3,500 - 1,500
Total (115,000) 3,500 (6,000) (105,500)
EXERCISE 7–8
a.
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,000
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
b. The journal entries would be the same, except any income statement accounts (cost
of goods sold and sales returns) would be replaced with an adjustment to retained
earnings.
EXERCISE 7–9
Inventory on January 1 $ 275,000
Purchases (net of returns) 634,000
Goods available for sale 909,000
Sales $955,000
Less gross profit (35% × $955,000) 334,250
Estimated cost of goods sold 620,750
Estimated inventory on March 4 288,250
Less undamaged goods (90,000 × (1 − 0.35)) (58,500)
Inventory damaged by fire $ 229,750
EXERCISE 7–10
Gross profit margin, by year:

2015: 3,058 ÷ 20,722 = 14.76%

2014: 2,831 ÷ 13,972 = 20.26%
The company’s sales increased significantly between 2014 and 2015. This appears to be
a positive result. The company’s gross profit also increased. However, the gross profit
margin decreased by 5.5%, which represents potential loss profits of approximately $1.1
billion on the current sales volume. To investigate further, one should look at budgets
and other management plans, as well as industry averages and competitor information.
It would also be useful to look at longer trends to see if this decline in profitability is
unique to this year or the sign of a longer term trend. Management explanations of the
declining margin percentage, contained in the annual report, should also be evaluated to
determine if the causes relate to slashing sales prices to increase volumes, increasing
cost structures, or some combination of the two. Other macroeconomic data may also be
useful in explaining the change.
Inventory Turnover Period, by year:
2015: [(2,982 + 1,564) ÷ 2 ÷ 17,164] × 365 = 48.34 days

2014: [(1,564 + 1,239) ÷ 2 ÷ 11,141] × 365 = 45.91 days
Inventory turnover has slowed from the previous year, indicating that goods are being
held longer. This is also indicated by the build up of inventory over the three year period.
Although the increased inventory may be reasonable as sales increase, the increase in
the turnover period could create cash flow problems if the trend continues. Again, other
comparative data is needed, such as budgets and industry averages, to evaluate the
meaning of this result.
Chapter 8 Solutions
EXERCISE 8–1
a. This investment will be classified as equity investments at cost less any reduction
for impairment, because these are equity investments that are not publically traded.
They would be reported as either current or long-term, depending upon the intention
of management to hold or sell within one year.
b. Journal entries
General Journal
Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . 50,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,500
(50,000 + (500,000 × 1%))
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125
Dividend revenue . . . . . . . . . . . . . . . . . . . . . . . . 1,125
(500 shares × $2.25)
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,430
Gain of sale of investments (net income) . 5,930
Other investments . . . . . . . . . . . . . . . . . . . . . . . 50,50
For Cash: (57,000 − (1% × 57,000))
c. To purchase the investment:

General Journal
Investments in shares – HFT . . . . . . . . . . . . . . . . 50,000
Brokerage fee expense . . . . . . . . . . . . . . . . . . . . . 500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,500
For Brokerage fee expense: (500,000 × 1%)
To receive the cash dividends:

General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125
(500 shares × $2.25)
Year-end adjusting entry to fair value for HFT investments:

General Journal
Investment in shares – HFT . . . . . . . . . . . . . . . . . 4,000
Unrealized gain on investments (NI) . . . . . . 4,000
($108 − $100 × 500 shares)
For sale of investment:

General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,430
Brokerage fee expense . . . . . . . . . . . . . . . . . . . . . 570
Gain on sale of investments (to net in- 3,000
come) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment in shares – HFT . . . . . . . . . . . . . . 54,000
For Cash: ($57,000 − 570), for Brokerage
fee expense: (57,000 × 1%), for Investment
in shares: (50,000 + 4,000)
No year-end adjustments are needed under the cost method.

d. Under ASPE, if the shares traded on an active market, they would be classified as
a short-term trading investment at fair value. The entries would be identical to the
ones in part (c) above, including the adjustment to fair values at year end.
EXERCISE 8–2
a. Using a business calculator present value functions, solve for interest I/Y when the
present value, payment, number of periods and future values are given:
PV = (PMT, I/Y, N, FV)
+/- 25,523PV = 1000 PMT, unknown I/Y, 10 N, 25000 FV = 3.745% (rounded)
b.
Face value of the bond $25,000
Present value of the bond 25,523
Bond premium $ 523
c. Journal entries for a HTM investment using amortized cost:

General Journal
Jan 1 2015 Investment in bonds – at amortized cost . . . . . 25,523
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,523

Investment in bonds – at amortized cost . 44
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 956
For Investment in bonds: (1,000 − (25,523 ×
3.75%))
Jan 1 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Jan 1 2023 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,250

Investment in bonds – at amortized cost 25,121
(see schedule below or alternative PC calcu-
lation) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gain on sale of investment . . . . . . . . . . . . . . . 129
For Cash: ($25,000 × 101)
Alternative calculation to the effective interest rate schedule below using a business
calculator and present value functions:
PV = 1000 PMT, 2 N, 3.745 I/Y, 25000 FV = 25,120.68 where N is 2 years left to
maturity.
EFFECTIVE INTEREST RATE SCHEDULE
Date Cash Received Interest Income Bond Premium Carrying Value

(4%) (3.745%) Amortization
Jan 1/15 25,523
Jan 1/16 1,000 956* 44 25,479
Jan 1/17 1,000 954 46 25,433
Jan 1/18 1,000 953 47 25,386
Jan 1/19 1,000 951 49 25,337
Jan 1/20 1,000 949 51 25,286
Jan 1/21 1,000 947 53 25,233
Jan 1/22 1,000 945 55 25,178
Jan 1/23 1,000 943 57 25,121 Date of sale
Jan 1/24 1,000 941 59 25,062
Jan 1/25 1,000 938 62** 25,000
Total $10,000 $9,477 $523 25,000
* 25,523 × 3.745%
** rounding
d. Total interest income is $9,477 − 941 − 938 = $7,598 after holding the investment
for eight out of ten years.
Total net cash flows for Smythe is (25,523) cash paid + ($1,000 × 8 years) + 25,250
cash received upon sale = $7,727 over the life of the investment.
The difference of $129.48 (7,597.52−7,727) is the gain on the sale of the investment
of $130 at the end of eight years. (The small difference is due to rounding.)
e. If Smythe followed ASPE, then the investment would be accounted for using amor-
tized cost. However, in this case, it would have a choice regarding the method
used to amortize the bond premium of $523 calculated in part (b). The choices are
straight-line amortization over the bond’s life or the effective interest rate method
shown in part (c). If the straight-line method was used, then the yearly amortization
amount would have been $523 ÷ 10 years or $52.30 per year for 8 years until the
bonds were sold in 2023. The interest income would be the same over the 8 years.
EXERCISE 8–3
a.
Face value of bond $100,000
Amount paid 88,580
Discount amount $ 11,420
The market value of an existing bond will fluctuate with changes in the market
interest rates and with changes in the financial condition of the corporation that
issued the bond. For example, a 9% bond will become more valuable if market
interest rates decrease to 8% because the interest payment is at a higher rate than
what investors would receive if they invested in a market that yielded only 8%.
In this case, the issued bond promises to pay 4% interest for the next 10 years in a
marketplace where interest has now risen to 5.5% for bonds with similar characteris-
tics and risks. This bond will now become less valuable because the market interest
rate has risen and investors would receive a higher return in the market than with
the 4% bond. When the financial condition of the issuing corporation deteriorates,
the market value of the bond is likely to decline as well.
b.
General Journal
Jan 2 Investment in bonds – at amortized cost . . . . . 88,580
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,580
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Investment in bonds – at amortized cost . . . . . 436
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 2,436
For Cash: (100,000×4%×6÷12), for Interest
income: (88,580 × 5.5% × 6 ÷ 12)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 2,448
For Interest income: ([$88,580 + $436] ×
5.5% × 6 ÷ 12)
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

c.
General Journal
Jan 2 Investment in bonds – at amortized cost . . . . . 88,580
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,580
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Investment in bonds – at amortized cost 571
(11,420 ÷ 20 time periods for interest paid)
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 2,571

For Cash: (100,000 × 4% × 6 ÷ 12)

Investment in bonds at amortized cost. . . . . . . 571
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 2,571
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

EXERCISE 8–4
General Journal
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 2,436
For Cash: (100,000×4%×6÷12), for Interest
income: (88,580 × 5.5% × 6 ÷ 12)
Sept 30 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,224
For Interest receivable: (100,000 × 4% × 3 ÷
12), for Interest income: ([$88,580 + $436] ×
5.5% × 3 ÷ 12)
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,224
([$88,580 + $436] × 5.5% × 3 ÷ 12)
EXERCISE 8–5
a. Imperial Mark will classify this investment as an investment in bonds – held-for-

trading (HFT) and will report the investment as a current asset.
b. Investment purchase:
General Journal
Mar 1 Investment in bonds – HFT . . . . . . . . . . . . . . . . . . 20,200
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 667
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,867
For Investment in bonds: (20,000 × 101), for
Interest receivable: ((20,000 × 5%) × 8 ÷ 12),
for Cash: (20,000 × 101) + unearned interest
from July 1 to Feb 28
Payment of interest using the effective interest rate (IFRS):
General Journal
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Investment in bonds – HFT . . . . . . . . . . . . . . 5
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 328
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . 667
For Cash: (20,200 × 5%), For Interest
income: (20,000 × 4.87% × 4 ÷ 12)
Interest accrual using the effective interest rate (IFRS):
General Journal
Dec 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Investment in bonds – HFT . . . . . . . . . . . . . . 8
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 492
For Interest receivable: (20,000 × 5% × 6 ÷
12), for Interest income: ((20,200 − 5) ×
4.87% × 6 ÷ 12)
Fair value adjustment at year-end:
General Journal
Dec 31 Investment in bonds – HFT . . . . . . . . . . . . . . . . . . 813
Unrealized holding gain in HFT bonds . . . . 813
For Investment in bonds: (21,000−(20,200−
5 − 8))
c. If Imperial Mark follows ASPE, it would classify the investment in bonds as Short-
Term Trading Investments, and report it as a current investment since management
intends to sell it. The alternate method to amortize the premium is using straight-line
method. The premium to amortize is the face value minus the investment cost over
the life of the bond or (20,000 − 20,200) = 200 ÷ 112 months = 1.79 per month.
The interest income at year-end would be the investment amount at the face rate of
interest minus the premium amortized using SL for that reporting period.
Investment purchase:
General Journal
Mar 1 Investment in bonds – at amortized cost . . . . . 20,200
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 667
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,867
For Investment in bonds: (20,000 × 101), for
Interest receivable: ((20,000 × 5%) × 8 ÷ 12),
for Cash: (20,000 × 101) + unearned interest
from July 1 to Feb 28
Interest payment using straight-line amortization of premium:
General Journal
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . 667
For Cash: (20,000 × 5%), for Investment
in bonds: ($1.79 × 4 months), for Interest
income: ((20,000 × 5%) − 7 − 667)
Interest accrual using straight-line method (ASPE):
General Journal
Dec 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 489
For Interest receivable: (20,000 × 5% ×
6 ÷ 12), for Investment in bonds: ($1.79 ×
6 months), for Interest income: (500 − 11)
Fair value adjustment at year-end:
General Journal
Dec 31 Investment in bonds – HFT . . . . . . . . . . . . . . . . . . 818
Unrealized holding gain in HFT bonds . . . . 818
(21,000 − (20,200 − 7 − 11))
EXERCISE 8–6
a. Halberton would classify this as an investment in shares – AFS, because even

though it may be for sale, there is no specific intention as to exactly when it will be
sold. The investment will be reported as a long-term asset because it is unknown
when it will be sold.
b. Purchase of investment:
General Journal
Investment in shares – AFS . . . . . . . . . . . . . . . . . 52,800
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,800
Dividend payment:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
(1,000 × $2.50)
Fair-value adjustment through OCI:
General Journal
Unrealized loss on AFS investments – OCI . . 2,800
Investment in shares – AFS . . . . . . . . . . . . . . 2,800
((1,000 × $50) − 52,800)
c. Sale entries – step 1 – first, record the fair value change to the investment and OCI:
General Journal
Investment in shares – AFS . . . . . . . . . . . . . . . . . 4,200
Unrealized gain on AFS investments – 4,200
OCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(54,200 − 50,000)
Step 2 – record the cash proceeds and remove the investment:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,200
NOTE – steps 1 and 2 are combined in the chapter illustrations. They have been
separated here for illustration purposes.
Step 3 – remove the OCI amount that related to the investment sold:
General Journal
Unrealized gain on AFS investments – OCI. . 1,400
Gain on sale of AFS investment . . . . . . . . . . 1,400
(54,200 − 52,800)
d. If Halberton followed ASPE, this investment would likely be classified as a short-

term trading investment with fair value adjustments at each reporting date, since
the investment for shares appears to have active market prices and the investment
is for sale (though no specific intention to sell exists at the moment). If the shares
were not publically traded, then the investment would likely be classified as an Other
Investment – at cost, with no fair value adjustments.
EXERCISE 8–7
General Journal
Feb 1 Investment – HFT – Xtra bonds . . . . . . . . . . . . . 532,500
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552,500
a. For Interest receivable: (500,000 ×
12% × 4 ÷ 12), for Cash: (532,500 +
accrued interest 20,000)
Apr 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Investment – Xtra bonds . . . . . . . . . . . . . . . . . 1,125
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 8,875
b. For Cash: (500,000 × 12% × 6 ÷ 12), for
Interest income: (532,500 × 10% × 2 ÷ 12)
Jul 1 Investments – HFT – Vericon bonds . . . . . . . . . 202,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203,500
c. For Investments in Vericon bonds:
(200,000 × 101), for Interest receivable:
($200,000 × 9% × 1 ÷ 12)
Aug 12 Investments – HFT – Bretin ACT shares . . . . . 177,000

Brokerage fee expense . . . . . . . . . . . . . . . . . . . . . 1,770
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,770
d. For Investments in Bretin ACT shares:
(3,000 × $59)
General Journal
Sep 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,000
Loss on sale of investment . . . . . . . . . . . . . . . . . . 2,275
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Investments – HFT – Xtra Corp. bonds . . . 106,275
e. For Cash: (($100,000 × 104) + (100,000 ×
12% × 5 ÷ 12)), for Investments in Xtra
Corp. bonds: (532,500 − 1,125 × (100,000 ÷
500,000))
Sep 28 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

f. For Cash: (3,000 × $0.50)
Oct 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 21,255
Investment – Xtra bonds . . . . . . . . . . . . . . . . . 2,745
g. For Cash: ($400,000 × 12% × 6 ÷ 12),
for Interest income: ((532,500 − 1,125 −
106,275) × 10% × 6.12)
Dec 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Investment – Vericon bonds . . . . . . . . . . . . . . 346
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 7,154
h. For Cash: ($200,000 × 9% × 6 ÷ 12),
for Investment in Vericon bonds: (202,000 ×
8.5%×5÷12), for Interest income: (202,000×
8.5% × 5 ÷ 12)
Dec 28 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,560

i. (3,000 × $0.52)
Dec 31 Investments – Bretin ACT shares . . . . . . . . . . . . 4,500

Unrealized gain on HFT investments (net 4,500
income) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
j. ($181,500 FV − $177,000)
Dec 31 Investments – Xtra bonds . . . . . . . . . . . . . . . . . . . 15,355

Unrealized gain in Xtra bonds . . . . . . . . . . . . 15,355
j. (532,500 − 1,125 − 106,275 − 2,745) =
422,355 − (400,000 face value × 101.75) =
15,355 gain
Dec 31 Unrealized loss in Vericon bonds . . . . . . . . . . . . 7,654

Investments – Vericon bonds . . . . . . . . . . . . 7,654
j. (202,000 − 346) =
201,654(200,000 face value × 0.97) =
7,654 loss
NOTE – An alternative treatment is to debit interest income at the date of purchase of

the bonds instead of interest receivable. This procedure is correct, assuming that when
the cash is received for the interest, an appropriate credit to interest income is recorded.
Consistency is key.
EXERCISE 8–8
a. Verex follows IFRS because only IFRS companies can account for investments
using the AFS classification.
b. Purchase of investment:
General Journal
Jan 1 Investment in shares – AFS . . . . . . . . . . . . . . . . . 136,750
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,750
(135,000 + 1,750)
Cash dividend declared:

General Journal
Oct Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,400
(140,000 × 10% × $1.10)
Year-end fair value adjusting entry:
General Journal
Dec 31 Investment in shares – AFS . . . . . . . . . . . . . . . . . 450
Unrealized gain in AFS investment – OCI 450
(137,200 − 136,750)
Sale entries – step 1 – first, record the fair value change to the investment and OCI:
General Journal
Feb 1 Investment in shares – AFS . . . . . . . . . . . . . . . . . 14,820
Unrealized gain on AFS investments – 14,820
OCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(7,000 × $12 − $580) − (7,000 × 9.80)
Step 2 – record the cash proceeds and remove the investment:

General Journal
Feb 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,420
(7,000 × $12) − $580
Step 3 – remove the OCI amount related to the investment sold:
General Journal
Feb 1 Unrealized gain on AFS investments – OCI. . 15,045
Gain on sale of AFS investment . . . . . . . . . . 15,045
((450 × 50%) + 14,820)
NOTE – steps 1 and 2 are combined in the chapter illustrations. They have been
separated here for illustration purposes.
EXERCISE 8–9
Other Comprehensive Income (OCI) = unrealized holding gain in AFS investments =

$350,000 − 320,000 = $30,000
Comprehensive Income (CI) = net income + OCI = $250,000 + 30,000 = $280,000
Accumulated Other Comprehensive Income (AOCI) = AOCI opening balance + OCI =

$15,000 + 30,000 = $45,000
EXERCISE 8–10
a. Entry for impairment:
General Journal
Jan 4 2016 Loss on impairment . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Investment in bonds – at amortized cost . 5,000
($200,000 − 195,000)
Note: For ASPE, the impaired value is the higher of the discounted cash flow using
the current market interest rate and the net realizable value (NRV) either through
sale or by exercising the company’s rights to collateral. Since the NRV information
is not available, the discounted cash flow using the current market interest rate is
the measure used to determine impairment.
Entry for impairment recovery:
General Journal
Jun 30 2016 Investment in bonds – at amortized cost . . . . . 5,000
Recovery of loss on impairment . . . . . . . . . . 5,000
b. Entry for impairment:
General Journal
($200,000 − 190,000)
Entry for impairment recovery:
General Journal
Jun 30 2016 Investment in bonds – at amortized cost . . . . . 10,000
Recovery of loss on impairment . . . . . . . . . . 10,000
c. Entry for impairment:
General Journal
($200,000 − 195,000)
Note: Equity investments for IFRS companies for which there is no active market,
and thus are measured at cost, use the present value of estimated future cash flows
discounted using the current market interest rate for impairment testing.
Entry for impairment recovery: no entry
Impairment reversals are only allowed for debt investments for IFRS companies.
EXERCISE 8–11
a.
General Journal
Investment in shares – HFT . . . . . . . . . . . . . . . . . 5,900
Unrealized gain on shares . . . . . . . . . . . . . . . 5,900
(15,000 + 24,300 + 75,000) − (17,500 +
22,500 + 80,200)
b.
General Journal
2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
Gain on the sale of shares . . . . . . . . . . . . . . . 2,400
Investment in shares – Warbler . . . . . . . . . . 22,500
Investment in shares – Shickter – 50% . . . 40,100
For Cash: (23,000 + 42,000)
c.
General Journal
Dec 31 2016 Unrealized loss on shares . . . . . . . . . . . . . . . . . . . 2,600
Investment in shares – HFT newline . . . . . 2,600
(17,500 + 40,100) − (19,200 + 41,000)
d. If Camille followed ASPE, these equity investments would be classified as Short-

Term Trading using fair values since there appears to be an active market for these
shares. The entries would be the same as those shown for parts (a), (b), and
(c). No impairment measurements are required since the investments are already
accounted for using fair values.
EXERCISE 8–12
a.
General Journal
Sep 30 2014 Investments in bonds – HFT . . . . . . . . . . . . . . . . 225,000
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 8,250
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233,250
11 ÷ 12)
Oct 31 2014 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 750
For Cash: (225,000 × 4%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Investments in bonds – HFT . . . . . . . . . . . . . . . . 5,850
Unrealized gain on investments (net in- 5,850
come) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
12), for Unrealized gain: ((225,000 × 102.6)−
225,000)
Mar 1 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234,300

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Investment in bonds – HFT . . . . . . . . . . . . . . 230,850
Gain on sale of bonds . . . . . . . . . . . . . . . . . . . 450
For Cash: (225,000 × 102.8 + 3,000), for
Interest income: (225,000 × 4% × 2 ÷ 12),
for Investment in bonds: ($225,000 + 5,850)
b.
Partial balance sheet
Current assets
Interest receivable $ 1,500
Investments in bonds – HFT (225,000 + 5,850) 230,850
Partial income statement

Other income
Interest income (750 + 1,500) $2,250
Unrealized gain on HFT investments 5,850
c. ASPE requires separate reporting of interest income from net gains or losses rec-
ognized on financial instruments (CPA Canada Handbook, Part II, Accounting Stan-
dards for Private Enterprises, Section 3856.52) whereas IFRS can choose to dis-
close whether the net gains or losses on financial assets measured at fair value and
reported on the income statement include interest and gains or losses, but it is not
mandatory. (For purposes of this text, the preferred treatment for either standard is
to separate unrealized gains/loss, interest income and dividend income separately
since some of the information is required when completing the corporate tax returns
for either ASPE or IFRS companies.)
d. The overall returns generated from the bond investment was $10,050, calculated as
follows:
Interest Oct 31, 2014 $ 750
Interest accrued Dec 31, 2014 1,500
Unrealized gain to Dec 31, 2014 5,850
Interest accrued Mar 1, 2015 1,500
Gain on sale of bonds Mar 1, 2015 450
Total investment returns (income and gains) 10,050
This return represents a 10.72% annual return on the investment [($10,050÷5 months×
12) ÷ $225,000]. This return is in excess of anything the company might be able to
earn in a typical savings account.
EXERCISE 8–13
a. December 31, 2015 entry:
General Journal
Bond investment at amortized cost . . . . . . . 22,000
($422,000 − $400,000)
Under ASPE, the carrying amount is reduced to the higher of the discounted cash
flow using a current market rate or the bond’s net realizable value NRV (which was
not provided in this question). Impairment reversals are permitted under ASPE for
both debt and equity instruments.
b. December 31, 2015 entry:
General Journal
Bond investment at amortized cost . . . . . . . 32,000
($422,000 − $390,000)
Under IAS 39, the carrying amount of a debt instrument is reduced to the discounted
remaining estimated cash flows using the historic discount rate. This impairment is
reversible since it is a debt instrument but impairment reversals are not permitted for
equity instruments for IFRS.
c. December 31, 2015 entry:
General Journal
Allowance for bond investment impair- 22,000
ment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
($422,000 − $400,000)
The investment account remains at its current carrying amount and it is offset by the
credit balance in the Allowance account.
EXERCISE 8–14
a.
Purchase of bonds:
General Journal
Jan 1 2015 Investment in bonds – HFT . . . . . . . . . . . . . . . . . . 236,163
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236,163
Present value calculation: PV = (20000 PMT,
8 N, 9 I/Y, 250000 FV) = $236,163
Interest payment:
General Journal
Dec 31 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Investment in bonds – HFT . . . . . . . . . . . . . . . . . . 1,255
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 21,255
(236,163 × 9%)
Fair value adjustment:

General Journal
Dec 31 2015 Investment in bonds – HFT . . . . . . . . . . . . . . . . . . 2,582
Unrealized gain on investment (net in- 2,582
come) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(236,163 + 1,255) =
237,418 carrying value−240,000 fair value =
2,582
Interest payment:
General Journal
Dec 31 2016 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 21,368
(236,163 + 1,255 = 237,418 × 9%)
General Journal
Dec 31 2016 Unrealized loss on investment (net income) . 23,118
Investment in bonds – HFT . . . . . . . . . . . . . . 23,118
(236,163 + 1,255 + 2,582 + 1,368 =
241,368 carrying value − (250,000 ×
87.3) market value = 23,118
Interest payment:
General Journal
Dec 31 2017 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 21,491
(236,163 + 1,255 + 1,368 = 238,786 × 9%)
General Journal
Unrealized gain on investment . . . . . . . . . . . 11,009
(236,163 + 1,255 + 2,582 + 1,368 − 23,118 +
1,491) = 219,741 carrying value−(250,000×
Interest payment:
General Journal
Dec 31 2018 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . 21,625
(236,163+1,255+1,368+1,491 = 240,277×
9%)
General Journal
Unrealized gain on investment . . . . . . . . . . . 15,875
(236,163 + 1,255 + 2,582 + 1,368 −
23,118 + 1,491 + 11,009 + 1,625) =
232,375 carrying value − (250,000 ×
b. Part (a) uses a fair value impairment model because the investments are re-measured
to their FV at each year-end, therefore there is no need to calculate a separate im-
pairment loss or recovery. If Helsinky had accounted for this investment at amortized
cost, the impairment model would change to an incurred loss model. When there
is objective evidence that the expected future cash flows have been significantly
reduced, an impairment loss is measured and recognized as follows:
• IFRS IAS 39. The loss is measured as the difference between the carrying
amount and the present value of the revised expected cash flows, discounted
at the historic discount rate.
• ASPE. The loss is measured as the difference between the carrying amount
and higher of the present value of the revised expected cash flows, discounted
at the current market discount rate and the estimated net realizable value of
the investment.
In all cases, the impairment losses can be reversed if the investment values in-
crease. Had the investment been an equity investment in shares for a company
following IFRS, no impairment reversal is permitted.
EXERCISE 8–15
a. IFRS:
Dec 31, 2014: No entry as there was no trigger or loss event in 2014.
General Journal
Dec 31 2015 Loss on impairment . . . . . . . . . . . . . . . . . . . . . . . . . 37,500
($87,500 − 50,000)
ASPE:
Dec 31, 2014: No entry as there was no trigger or loss event in 2014.
General Journal
($87,500 − 50,000)
b. IFRS:
General Journal
Dec 31 2014 Unrealized Gain or Loss (net income) . . . . . . . 5,000
Investments – HFT . . . . . . . . . . . . . . . . . . . . . . 5,000
($34 − $32) × 2,500 shares

Investments – HFT . . . . . . . . . . . . . . . . . . . . . . 17,500
($32 − $25) × 2,500 shares
ASPE:
General Journal
Investments – HFT . . . . . . . . . . . . . . . . . . . . . . 5,000
($34 − $32) × 2,500 shares

Investments – HFT . . . . . . . . . . . . . . . . . . . . . . 17,500
($32 − $25) × 2,500 shares
c. IFRS:
General Journal
Dec 31 2014 Unrealized Gain or Loss – OCI . . . . . . . . . . . . . . 7,500
Investments – AFS . . . . . . . . . . . . . . . . . . . . . . 7,500
($87,500 − 80,000)
This is an adjustment to FV at year end and not recognition of an impairment loss

because no trigger event has occurred in 2014.
For Dec 31, 2015, under IFRS, IAS 39, a trigger event has now occurred and an
impairment loss is required to be recognized. For AFS investments, impairment
losses must be transferred to net income including the related amounts in OCI,
whereas FV adjustments stay in OCI and AOCI.
Step 1 – record the FV change in the year to OCI:
General Journal
Dec 31 2015 Unrealized gain or loss – OCI . . . . . . . . . . . . . . . 30,000
Investments – AFS . . . . . . . . . . . . . . . . . . . . . . 30,000
($80,000 − 50,000)
Step 2 – transfer the total accumulated impairment in value from 2014 ($7,500) and
2015 ($30,000) to net income, as if the loss has been realized:
General Journal
Unrealized gain or loss – OCI . . . . . . . . . . . . 37,500
($87,500 − 50,000)
EXERCISE 8–16
a. Since Yarder’s shares were quoted in an active market, Sandar is required to apply
the Held-for-trading (HFT) classification to account for its investment. If the shares
were not quoted in an active market, the cost method would have been required.
Held-for-trading (HFT) – where the shares are traded in an active market:
General Journal
Jan 1 2015 Investments – HFT . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
(50,000 × 32%) = 16,000 shares × $25
Jun 30 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

($60,000 × 32%)
Dec 31 2015 Unrealized gain or loss . . . . . . . . . . . . . . . . . . . . . . 32,000

Investments – HFT . . . . . . . . . . . . . . . . . . . . . . 32,000
($25 − 23) × 16,000 shares
Cost method – where there is no active market for the shares:

General Journal
Jan 1 2015 Other investments – at cost . . . . . . . . . . . . . . . . . 400,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
(50,000 × 32%) = 16,000 shares × $25
Jun 30 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

($60,000 × 32%)
Dec 31, 2015: No entry required.
b. Equity method:
General Journal
Jan 1 2015 Significant influence investments . . . . . . . . . . . . 400,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
(50,000 × 32%) = 16,000 shares × $25
Jun 30 2015 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

Significant influence investments . . . . . . . . . 19,200
($60,000 × 32%)
Dec 31 2015 Significant influence investments . . . . . . . . . . . . 38,400

Investment income or loss . . . . . . . . . . . . . . . 38,400
($120,000 × 32%)
NOTE: Even though Sandar has significant influence over the operations of Out-
lander, companies that follow ASPE have a choice between the equity method and
the held-for-trading (active market), or the equity method and the cost method (no
active markets).
EXERCISE 8–17
a. Investee’s total net income = $60,000 ÷ 30% = $200,000
b. Investee’s total dividend payout = $200,000 × 15% = $30,000
c. Investor’s share of net income = $200,000 × 30% = $60,000
d. Investor’s annual depreciation of the excess payment for net capital assets is the
only other credit amount recorded in the T-account for $1,500
e. Goodwill = $900,000 × 30% = 270,000 − 290,000 = 20,000 − (1,500 × 10 years) =

5,000 to goodwill
f. Investor’s share of dividends = $30,000 × 30% = $9,000
EXERCISE 8–18
a. 2014:
General Journal
Investments – HFT . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500
Dividend Revenue (net income) . . . . . . . . . . 7,500
($25,000 × 0.30)
Investments – HFT . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Unrealized Gain or Loss (net income) . . . . 20,000
($400,000 − $380,000)
2015:
General Journal
Unrealized Gain or Loss (net income) . . . . . . . 40,000
Investments – HFT . . . . . . . . . . . . . . . . . . . . . . 40,000
($400,000 − 360,000)
b. Recall that comprehensive income is:

Net income + Other Comprehensive Income (i.e., FV gains/losses from AFS invest-
ments) = Comprehensive Income
With this in mind, comprehensive income will be the same amount as net income
because there is no Other Comprehensive Income (OCI) amount to report as the
investment is classified as HFT with unrealized gains and losses due to fair value
adjustments being recorded to net income. Had the investment been classified as
AFS, then the $20,000 fair value change would have been reported as OCI and not
in net income, thus increasing comprehensive income by $20,000 more than net
income in 2014, and by $40,000 in 2015.
c. 2014:
General Journal
Investment in associate . . . . . . . . . . . . . . . . . . . . . 380,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500
Investment in associate . . . . . . . . . . . . . . . . . . 7,500
($25,000 × 0.30)

($50,000 × 0.30)
Investment income or loss . . . . . . . . . . . . . . . . . . 2,000

($380,000 − 360,000 = 20,000 ÷ 10 years)
NOTE: there is no entry to adjust the investment to its fair value under the equity
method.
2015:
General Journal
($15,000 × 0.30)

NOTE: there is no entry to adjust the investment to its fair value under the equity
method.
d. Carrying amount of the investment:
Cost $380,000
Dividend received in 2014 (7,500)
Income earned in 2014 (15,000 – 2,000) 13,000
Loss incurred in 2015 (4,500 + 2,000) (6,500)
Carrying amount at December 31, 2015 $379,000
Fair value of investment at December 31, 2015 $360,000
Just because the fair value has dropped to $360,000 does not automatically mean
that the investment is impaired. Perhaps there has been a general market decline
and the decrease in value is considered temporary. If this is the case, no entries are
needed to recognize the decline.
If the assumption was that the drop in fair value of the investment represented an
impairment, then a journal entry to record an impairment is required. The loss is
equal to the difference between the investment’s carrying amount ($379,000) and its
recoverable amount ($370,000)—being the higher of its value in use and fair value
less costs to sell. Therefore, the impairment loss is $379,000 − $370,000 = $9,000.
General Journal
e. For part (c), if the investee had reported a loss from discontinued operations, all
entries would stay the same except for the entry recording the 2014 share of income.
This entry would change to reflect the investor’s share of the loss from discontinued
operations separately from its share of the loss from continuing operations because
separate reporting of discontinued operations is a reporting requirement for IFRS
and ASPE.
2014:
General Journal
Investment loss – loss on discontinued oper- 4,500
ations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
For Investment in associate: (50,000 × 30%),
for Investment loss: (15,000 × 30%)
Income Statement details:

Income from continuing operations $ 65,000
Loss from discontinued operations (15,000)
Net income $ 50,000
EXERCISE 8–19
General Journal
Significant influence investment . . . . . . . . . . . . . 600,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000
Cost of 35% investment $600,000

Carrying values:
Assets ($900,000 + 780,000) $1,680,000
Liabilities 225,000
1,455,000
× 35% 509,250
Excess paid over share of book value $ 90,750
Excess of $90,750 allocated to:
Assets subject to depreciation

[($1,050,000 − $900,000) × 35%] 52,500
Residual to goodwill 38,250
$90,750
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Significant influence investment . . . . . . . . . . 35,000
($100,000 × 0.35)
Significant influence investment . . . . . . . . . . . . . 78,750

($225,000 × 0.35)

Significant influence investment . . . . . . . . . . 5,250
($52,500 ÷ 10)
EXERCISE 8–20
a) ASPE b) IFRS (IAS 39)
i. Short-Term Trading Investment with fair AFS with unrealized gain/loss through
value through net income since an OCI since there is no specific inten-
active market exists. No separate tion to sell. Impairment adjustment
impairment evaluation needed since in- is possible if a trigger event occurs
vestment is adjusted to fair value. but no reversal allowed for AFS equity
investments.
ii. Other investment in equities at cost, AFS with unrealized gain/loss through
since no active market exists. (If active OCI since there is a long-term strategy
market exists, then fair value through regarding this investment. Impairment
net income option.) No fair value adjustment is possible if a trigger event
adjustments are done. Impairment occurs but no impairment reversal al-
adjustment is possible if a trigger event lowed for equity investments.
occurs. Impairment reversal is possible.
When 30% is obtained, management
will need to re-measure.
iii. Other investment at amortized cost HTM at amortized cost since this in-
since the intention was to originally hold vestment has been accounted for since
to maturity. No fair value adjustments the initial purchase at amortized cost.
are done. Impairment adjustment is Impairment adjustment is possible if
possible if a trigger event occurs. Im- a trigger event occurs. Impairment
pairment reversal is possible. reversal is possible.
a) ASPE b) IFRS (IAS 39)

iv. Other investment in equities at cost. AFS with unrealized gain/loss through
The FV of the shares is not a factor as OCI since there is no specific intention
they are being held to improve business to sell. Impairment adjustment is pos-
relations. No fair value adjustments are sible if a trigger event occurs but no
done. Impairment adjustment is possi- impairment reversal allowed for equity
ble if a trigger event occurs. Impairment investments
reversal is possible.
v. Short-Term Trading Investment with fair HFT with fair value through net in-
value through net income since the come. No separate impairment eval-
bonds trade on the market. Manage- uation needed since investment is ad-
ment intent is to sell as soon as the justed to fair value.
market price increases. No separate
impairment evaluation needed since in-
vestment is adjusted to fair value.
vi. Other investments at amortized since HTM at amortized cost since this invest-
the intention is to hold to maturity. No ment will be held until maturity. Impair-
fair value adjustments are done. Impair- ment adjustment is possible if a trigger
ment adjustment is possible if a trigger event occurs. Impairment reversal is
event occurs. Impairment reversal is possible.
possible.
vii. Short-Term Trading Investment since HFT with fair value through net in-
management intends to sell them within come since management intent is to
one year. No separate impairment sell within one year. No separate
evaluation needed since investment is impairment evaluation needed since in-
adjusted to fair value. vestment is adjusted to fair value.
Chapter 9 Solutions
EXERCISE 9–1
The following costs should be capitalized with respect to this equipment:

Cash price paid, net of $1,600 discount, excluding $3,900 of recoverable tax $ 78,400
Freight cost to ship equipment to factory 3,300
Direct employee wages to install equipment 5,600
External specialist technician needed to complete final installation 4,100
Materials consumed in the testing process 2,200
Direct employee wages to test equipment 1,300
Legal fees to draft the equipment purchase contract 2,400
Government grant received on purchase of the equipment (8,000)
Total cost capitalized 89,300
The recoverable tax should be disclosed as an amount receivable on the balance sheet.
The repair costs, costs of training employees, overhead costs, and insurance cost would
all be expensed as regular operating expenses on the income statement.
An alternative treatment for the government grant would be to defer it as an unearned

revenue liability and then amortize it on the same basis as the equipment depreciation.
EXERCISE 9–2
The following costs would be capitalized with respect to the mine:
Direct material $2,200,000

Direct labour 1,600,000
Interest (3,000,000 × 8% × 9 ÷ 12) 180,000
Less interest on excess funds (30,000)
Present value of restoration costs (FV=100,000, I=10, N=10) 38,554
Total cost capitalized 3,988,554
EXERCISE 9–3
With a lump sum purchase, the cost of each asset should be determined based on the
relative fair value of that component. The total fair value of the asset bundle is $250,000.
Therefore, the allocation of the purchase price would be as follows:
Specialized lathe (30,000 ÷ 250,000) × 220,000 = 26,400

Robotic assembly machine (90,000 ÷ 250,000) × 220,000 = 79,200
Laser guided cutting machine (110,000 ÷ 250,000) × 220,000 = 96,800
Delivery truck (20,000 ÷ 250,000) × 220,000 = 17,600
Total 220,000
EXERCISE 9–4
a.
Prabhu
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
Accumulated depreciation – old equip. . . . . . . 10,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Gain on disposal of equipment . . . . . . . . . . . 2,000
Zhang
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Gain on disposal of equipment . . . . . . . . . . . 6,000
b.
Prabhu
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Zhang
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
c.
Prabhu
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Loss on disposal of equipment . . . . . . . . . . . . . . 3,000
NOTE: Loss must be recorded, as the asset acquired cannot be recorded at an

amount greater than its fair value.
Zhang
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
EXERCISE 9–5
Transaction 1:
IFRS requires assets acquired in exchange for the company’s shares to be reported at
the fair value of the asset acquired. The list price is not relevant, as the salesman has
already indicated that this can be negotiated downward. If the $80,000 negotiated price
is considered a reliable representation of the fair value of the asset, this amount should
be used:
General Journal
Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Common shares . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
If the $80,000 price is not considered a reliable fair value, then the fair value of the shares
given up ($78,750) should be used, as the shares are actively traded.
Transaction 2:
The asset acquired by issuing a non-interest bearing note needs to be reported at its fair
value. As the interest rate of zero is not reasonable, based on market conditions, the
payments for the asset need to be adjusted to their present value to properly reflect the
current fair value of the asset.
General Journal
Office furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,284
Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,284
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
The note payable amount represents the present value of a $45,000 payment due in one
year, discounted at 9%.
EXERCISE 9–6
a. Deferral Method
General Journal
Office condo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625,000
Deferred grant . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000
b. Offset Method
General Journal
Office condo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000
c. The deferral method will result in annual depreciation expense of $625,000 ÷ 30

years = $20,833, with an offsetting annual grant income amount recognized = $90,000
÷ 30 years = $ 3,000 per year.
The offset method will result in an annual depreciation expense of $535,000 ÷ 30
years = $17,833 with no grant income being recognized.
The net difference in net income between the two methods is zero.
EXERCISE 9–7
General Journal

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,444
Dec 31 2014 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,444

(1,250,000 − (1,200,000 − 44,444))
NOTE: Depreciation expense = $1,200,000 ÷ 27 years remaining = $44,444
General Journal

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,077
Dec 31 2015 Revaluation surplus (OCI) . . . . . . . . . . . . . . . . . . . 201,923

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201,923
(1,000,000 − (1,250,000 − 48,077))
NOTE: Depreciation expense = $1,250,000 ÷ 26 years = $48,077
General Journal

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Dec 31 2016 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000

(1,150,000 − (1,000,000 − 40,000))
NOTE: Depreciation expense = $1,000,000 ÷ 25 years = $40,000
EXERCISE 9–8
General Journal
Dec 31 2015 Loss in value of investment property . . . . . . . . 50,000
Investment property . . . . . . . . . . . . . . . . . . . . . 50,000

EXERCISE 9–9
General Journal
Repairs and maintenance . . . . . . . . . . . . . . . . . . . 32,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Accumulated depreciation – building . . . . . . . . 16,302

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,696
Loss on disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92,394
The replacement of the boiler should be treated as the disposal of a separate component.
The original cost of the old boiler can be estimated as follows:
$125,000 ÷ (1 + 0.15) = 108,696
The old boiler would have been depreciated as part of the building as follows:
108,696 ÷ 40 years = 2,717 per year

2,717 × 6 years (2009–2014) = 16,302
(NOTE: per company policy, no depreciation is taken in the year of disposal)
The purchase of the new boiler should be treated as a separate component:

General Journal
Boiler . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,000
This cannot be identified as a separate component, but it does extend the useful life of
the asset, so capitalization is warranted.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . 15,332

Accumulated depreciation – building . . . . . 15,332
Original depreciation: $800,000 ÷ 40 years = $20,000 per year

Up to the end of 2014 = $120,000 (6 years)
Based on the journal entries above, revised depreciation is calculated as follows:
800,000 − 120,000 − 108,696 + 16,302 + 87,000

= 15,332
40 − 6 + 10 = 44 years
General Journal
Accumulated depreciation – boiler . . . . . . . 2,841
(125,000 ÷ 44)
NOTE: the boiler has been depreciated over the same useful life as the building (44
years). As this is a separate component, a different useful life could be determined by
management and used instead. Per company policy a full year of depreciation is taken in
the year of acquisition.
Chapter 10 Solutions
EXERCISE 10–1
a. Straight line:
125,000 − 10,000
= $23,000 per year (same for all years)
5 years
b. Activity based on input:

125,000 − 10,000
= $11.50 per hour of use
10,000 hours
2016 depreciation = $11.50 × 2,150 hours = $24,725
c. Activity based on output:

125,000 − 10,000
= $0.115 per unit produced
1,000,000 units
2016 depreciation = $0.115 × 207,000 units = $23,805
d. Double declining balance:

100
Rate = × 2 = 40%
5 years
2015 Depreciation: $125,000 × 40% = $50,000

2016 Depreciation:($125,000 − $50,000) × 40% = $30,000
EXERCISE 10–2
Depreciation rate (assume straight-line unless otherwise indicated):
10,000 − 1,000
= $3,000 per year
3 years
Depreciation per year calculated as follows:
2015: $3,000 × 6 ÷ 12 $1,500

2016: Full year $3,000
2017: Full year $3,000
2018: $3,000 × 6 ÷ 12 $1,500
Total depreciation: $9,000
(Note: in 2018, only 6 months depreciation can be recorded, as the asset has reached
the end of its useful life.)
EXERCISE 10–3
a. No journal entry is required as this is considered a change in estimate. Depreciation

will be adjusted prospectively only, with no adjustment made to prior years.
b. Original depreciation:
$39,000 − $4,000
= $7,000 per year
5 years
Depreciation taken 2013–2015 = $7,000 × 3 years = $21,000
Revised depreciation for 2016 and future years:
$39,000 − $21,000 − $5,000

= $3,250 per year
7 years − 3 years = 4
General Journal
EXERCISE 10–4
a. Depreciation from 2001–2006:
$450,000 − $90,000
= $12,000 per year
30 years
Total depreciation taken = $12,000 × 6 years = $72,000
b. Depreciation from 2007–2014:
$450,000 − $72,000 + $30,000 − $50,000

= $10,529 per year
30 − 6 + 10 years = 34
Total depreciation taken = $10,529 × 8 years = $84,232
c. Depreciation for 2015 and future years:
$450,000 + $30,000 − $72,000 − $84,232

= $12,453 per year
34 − 8 = 26 years
EXERCISE 10–5
a. Determine the recoverable amount:
Value in use = $110,000

Fair value less costs of disposal = $116,000
The recoverable amount is the greater amount: $116,000

Carrying value = $325,000 − $175,000 = $150,000
As the carrying value exceeds the recoverable amount, the asset is impaired by
$150,000 − $116,000 = $34,000
b.
General Journal
c. New carrying value = $150,000 − $34,000 = $116,000
$116,000 − 0
Depreciation = = $38,667
3 years
General Journal
d. Determine the recoverable amount:
Value in use $ 90,000

Fair value less costs to sell $111,000
The recoverable amount is the greater amount: $111,000

The carrying value is now $116,000 − $38,667 = $77,333
The asset is no longer impaired. However, the reversal of the impairment loss is
limited. If the impairment had never occurred, the carrying value of the asset would
have been:
Unimpaired carrying value on Jan 1, 2016 $ 150,000

Depreciation for 2016 (150,000 ÷ 3) (50,000)
Unimpaired carrying value at Dec 31, 2016 100,000
Therefore, the reversal of the impairment loss is limited to: $100,000 − $77,333 =
$22,667
The journal entry will be:
General Journal
Accumulated impairment loss . . . . . . . . . . . . . . . 22,667
Recovery of previous impairment loss . . . . 22,667
EXERCISE 10–6
a.
b. ASPE 3063 uses a two-step process for determining impairment losses. The first
step is to determine if the asset is impaired by comparing the undiscounted future
cash flows to the carrying value:
Undiscounted future cash flows: $140,000

Therefore, the asset is impaired.

The second step is to determine the amount of the impairment. This amount is the
difference between the carrying value and the fair value of the asset:

Fair value $125,000
Impairment loss $ 25,000
Thus, the journal entry will be:
General Journal
c. Depreciation will now be based on the new carrying value:
$150,000 − $25,000 = $125,000

$125,000 ÷ 3 years = $41,667 per year
General Journal
d. The carrying value is now $125,000 − $41,667 = $83,333. As this is less than the
undiscounted future cash flows, the asset is no longer impaired. However, under
ASPE 3063, reversals of impairment losses are not allowed, so no adjustment can
be made in this case.
EXERCISE 10–7
a. The total carrying value of the division is $95,000. The fair values of the individual
assets cannot be determined, so the value in use is the appropriate measure. In this
case, the value in use is $80,000, which means the division is impaired by $15,000.
This impairment will be allocated on a pro-rata basis to the individual assets:

Amount Loss
Computers $55,000 55/95 $8,684
Furniture 27,000 27/95 4,263
Equipment 13,000 13/95 2,053
95,000 15,000
b. The journal entry would be:
General Journal
Accumulated impairment loss – comput- 8,684
ers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated impairment loss – furniture . 4,263
Accumulated impairment loss – equip- 2,053
ment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c. The value in use ($80,000) is greater than the fair value less costs to sell ($60,000)
so the calculation of impairment loss is the same as in part (a) (i.e., $15,000).
However, none of the impairment loss should be allocated to the computers, as
their carrying value ($55,000) is less than their recoverable amount ($60,000). The
impairment loss would therefore be allocated as follows:

Amount Loss
Furniture $27,000 27/40 $10,125
Equipment 13,000 13/40 4,875
40,000 15,000
d. The impairment loss is still calculated as $15,000. However, this time the computers
are also impaired, as their carrying value ($55,000) is greater than their recoverable
amount ($50,000). In this case, the computers are reduced to their recoverable
amount and the remaining impairment loss ($15,000 − $5,000 = $10,000) is allo-
cated to the furniture and equipment on a pro-rata basis:

Amount Loss
Computers $55,000 $5,000
Furniture 27,000 27/40 6,750
Equipment 13,000 13/40 3,250
95,000 15,000
EXERCISE 10–8
a.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000
Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
b.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000
Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
Gain on disposal of asset . . . . . . . . . . . . . . . . 230,000
c.
General Journal
Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
Loss on abandonment of asset . . . . . . . . . . . . . . 520,000
d.
General Journal
Donation expense. . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000
Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
Gain on donation of asset . . . . . . . . . . . . . . . . 80,000
EXERCISE 10–9
a.
General Journal
Machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
b.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000
Gain on sale of asset . . . . . . . . . . . . . . . . . . . . 3,000
c.
General Journal
Machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000
Chapter 11 Solutions
EXERCISE 11–1
The items below are identified as capitalized as an intangible asset or expensed, with the
account each item would be recorded to.
a. Expense as research and development expense
b. Expense as advertising expense
c. Capitalize if the development phase criteria for capitalization are all met; else ex-
pense
d. If reporting under IFRS, then capitalize the borrowing costs if the development phase
criteria for capitalization are all met; else expense; if reporting under ASPE, then a
policy choice exists for both borrowing costs and research and development costs
e. Expense as salaries and wages expense

f. Expense as marketing expenses
g. Capitalize as part of the patent asset amount
h. Expense as research expenses
i. Expense to salaries, travel etc. as incurred
j. Capitalize as part of the patent asset amount

k. Capitalize as part of the software asset amount
l. Expense as training expenses
m. Capitalize as part of the software asset amount
n. Organization expense
o. Operating expense
p. Capitalized to the franchise asset
q. Under IFRS, will be capitalized only if the development costs meet all six development-
phase criteria for capitalization; under ASPE, may be capitalized or expensed, de-
pending on company’s policy when it meets the six criteria in the development stage
r. Capitalized to the patent asset
s. Capitalized to the patent asset
t. Capitalized to the copyright
u. Capitalized as development costs only if they meet all six development phase criteria
for capitalization.
v. Expensed to research and development expenses
w. Expensed on the income statement
x. Under IFRS, borrowing costs that are directly attributable to project that meet the
six development phase criteria are capitalized; under ASPE, interest costs directly
attributable to the project that meet the six development phase capitalization criteria
can be either capitalized or expensed as set by the company’s policies
y. Under IFRS, will be capitalized to the intangible asset only if the development costs
meet all six development-phase criteria for capitalization
z. Expensed to research and development expenses
aa. Expensed to interest expenses
ab. Expensed to research and development expenses
EXERCISE 11–2
a. Intangible assets likely include:
• purchased trademark Aromatica Organica and its related internet domain name
• purchased patented soap recipes
• expenditures related to infrastructure and graphical design development of Har-
man’s unique website through which the retailers review the product offerings
and place their orders.
b. The majority of Harman’s assets are intangible. They include the Aromatica Organ-
ica trademark, the patented soap and oil recipes, and the company’s own product
and ordering website. The intangible assets help to protect the revenues from
competitor companies so Harman can sell a unique product with a specific brand
name that customers recognize for its fine quality and through a unique website
developed by Harman.
c. The intangible assets meet the definition of an asset because they involve past and
present economic resources for which there are probable future economic benefits
that are obtained and controlled by Harman. Recording intangible assets on the
company’s SFP/BS provides users with relevant and faithfully representative infor-
mation about the company’s expected future economic benefits, as well as financial
statements that are complete and free from error or bias.
EXERCISE 11–3
Amortization
Jan 1 Carrying value 288,000 ÷ 14 years = 20,571
Sept 1 Legal fees 42,000 ÷ (4 months ÷ 160 months)* = 1,050
Total amortization for 2015 330,000 21,621
* September 1 was the date that the patent was legally upheld thus meeting the definition
of an asset subject to amortization. There are 4 months remaining in 2015 starting
September 1. If on January 1, 2015 there were 14 years remaining, then as at September
1, 2015, there would be 13 years + 4 months remaining. Converting this to months is
13 × 12 = 156 months + 4 months = 160 months. For 2015, there are 4 months to year-
end to amortize the legal fees, so 4 ÷ 160 months would be the prorated amount of the
legal fees capitalized for 2015.
Carrying amount as at Dec 31, 2015: 330,000 − 21,621 = $308,379
The accounting for the research expense of $140,000 is to be expensed when incurred
because it can only be recognized from the development phase of an internal project
when the six criteria for capitalization are met.
EXERCISE 11–4
(Partial SFP/BS):
Intangible assets
Copyright – definite life, 5 years (net of amortization for $5,000) $20,000
Copyright – indefinite life 35,000
Internet domain name* – indefinite life 37,368
Liabilities
Current liabilities
Current portion of long-term note payable** $12,431
Note payable, due January 1, 2017 $13,426
* PV (14500 PMT, 8 I/Y, 3 N)

** Amortization schedule:
Cash Payment Interest 8% Amortization Balance

37,368.00
Dec 31, 2015 14,500 2989.44 11,510.56 25,857.44
Dec 31, 2016 14,500 2068.60 12,431.40 13,426.04
Dec 31, 2017 14,500 1,073.96 (rounding) 13,426.04 0
(Partial income statement):
Amortization expense ($25,000 ÷ 5 years) $5,000
Note – item (b), purchased copyright and item (c), purchased Internet domain name have
indefinite useful lives so they would not be amortized.
EXERCISE 11–5
a. Under ASPE, Trembeld has the option either to expense all costs as incurred or
to recognize the costs as an internally generated intangible asset when the six
development phase criteria for capitalization are met. If Trembeld expenses all costs
as incurred, they will be expensed as research and development expenses.
Research and development expense* 634,000
*$180,000 + 64,000 + 270,000 + 86,000 + 25,400 + 8,600

If Trembeld chooses, it can capitalize all costs incurred after April 1. The costs
incurred prior to April 1 must be expensed as research and development expenses.
Intangible assets – development costs* 390,000
Research and development expense ($180,000 + $64,000) 244,000
* $270,000 + 86,000 + 25,400 + 8,600 = $390,000

Note: Under ASPE, once interest costs directly attributable to the acquisition, con-
struction, or development of an intangible asset meet the six criteria to be capital-
ized, they may be capitalized or expensed depending on the company’s accounting
policy for borrowing costs.
b. If Trembeld followed IFRS, all costs associated with the development of internally
generated intangible assets would be capitalized when the six development phase
criteria for capitalization are met. The costs incurred prior to the date the required
criteria were met would be expensed as research and development expense.
Intangible assets – development costs* 390,000
Research and evelopment expense ($180,000 + $64,000) 244,000
* $270,000 + 86,000 + 25,400 + 8,600 = $390,000
EXERCISE 11–6
a. Under ASPE
Recoverability test:
The undiscounted future cash flows of $152,000 < the carrying amount $100,500,
therefore the asset is impaired.
The impairment loss is calculated as the difference between the asset’s carrying
amount $100,500 and fair value $55,000.
In this case, the undiscounted future cash flows ($152,000) > Carrying amount
($100,500), therefore the asset is not impaired.
b. Under IFRS
If carrying amount $100,500 > recoverable amount $115,000 (where recoverable
amount is the higher of value in use $115,000 and fair value less costs to sell
$50,000), the asset is impaired.
The impairment loss is calculated as the difference between carrying amount $100,500
and recoverable amount $115,000.
In this case, the carrying amount $100,500 is < the recoverable amount of $115,000
so there is no impairment loss.
c. Under ASPE, for indefinite-life intangible assets:

If the carrying amount $100,500 > the asset’s fair value $55,000, then the asset is
impaired.
The impairment loss is calculated as $45,500 ($100,500 − $55,000).
Under IFRS, there is no impairment loss as the carrying amount of $100,500 < the
recoverable amount of $115,000 (where recoverable amount is the higher of value
in use and fair value less costs to sell).
EXERCISE 11–7
Fair Value % of Total × Cost = Recorded

Amount
(rounded)
Trade name $380,000 30.89% $1.2 million $370,680
Patented process 400,000 32.52% $1.2 million 390,240
Customer list 450,000 36.59% $1.2 million 439,080
$1,230,000 $1.2 million
General Journal
Intangible assets – trade names . . . . . . . . . . . . . 370,680
Intangible assets – patented process . . . . . . . . 390,240
Intangible assets – customer list . . . . . . . . . . . . 439,080
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000
Note: The asset purchase is to be capitalized using the relative fair value method and as-
sets separately reported so that the amortization expense can be separately determined
for each based on their respective useful life.
EXERCISE 11–8
a. At December 31, 2015, Bartek reports the patent:
Intangible assets
Patent $800,000
Accumulated amortization* 425,000
$375,000
* Amortization 2012 to 2014: $800,000 ÷ 83 years = $300,000

Amortization for 2015:
(Remaining carrying value − revised residual value)

Remaining useful life
(800,000 − 300,000) − 0 residual value

= 125,000
(7 − 3)
Accumulated amortization 2012 to 2015: (300,000 + 125,000) = $425,000
b. The amount of amortization of the franchise for the year ended December 31, 2014,
is $25,000: ($500,000 ÷ 20 years). Reason: Bartek should amortize the franchise
over 20 years which is the period of the identifiable cash flows. Even though the
franchise is considered as “perpetual,” the company believes it will generate future
economic benefits for only the next 20 years.
c. Unamortized development costs would be reported as $50,000 ($250,000 net of

$200,000 accumulated amortization) at December 31, 2015 on the SFP/BS.
Amortization for 2012 to 2015: $250,000 ÷ 5 years × 4 years = $200,000
EXERCISE 11–9
a.
Cash purchase price
$863,000
Fair value of assets $1,160,000
Less liabilities (carrying value = fair value) (460,000)
Fair value of net assets 700,000
Value assigned to goodwill $163,000
b. Under IFRS, the recoverable amount of the CGU of $1,850,000 (which is the greater
of the fair value, less costs to sell $1,600,000, and the value in use $1,850,000) is
compared with its carrying amount $1,925,000 to determine if there is any impair-
ment.
The goodwill is impaired because carrying amount of the CGU $1,925,000 > recov-
erable amount of the CGU $1,850,000. The goodwill impairment loss is $75,000
($1,925,000 − $1,850,000). A reversal of an impairment loss on goodwill is not
permitted.
c. Under ASPE, goodwill is assigned to a reporting unit at the acquisition date. Good-
will is tested for impairment when events or changes in circumstances indicate
impairment may exist. An impairment exists if the carrying amount of the reporting
unit $1,925,000 exceeds the fair value of the reporting unit $1,860,000. In this case
there is an impairment loss of $65,000 ($1,925,000 − $1,860,000). A reversal of an
impairment loss on goodwill is not permitted.
EXERCISE 11–10
a. Goodwill as a separate line item on the SFP/BS

b., c., d. Research costs, organization cost, and the annual franchise fee would be
classified as operating expenses
e., f., g., h. Cash, accounts receivable, notes receivable due within one year from
balance sheet date and prepaid expenses would be classified as current
assets
i. Intangible assets, if development criteria met at the acquisition date
j. Non-current assets in the tangible property, plant, and equipment section.
(Some accountants classify them as intangible assets on the basis that the
improvements revert to the lessor at the end of the lease and therefore are
more of a right than a tangible asset.)
k. Intangible assets
l. Intangible assets
m. Investments section on the SFP/BS
n. Intangible assets
o. Discount on notes payable is shown as a deduction from the related notes
payable on the SFP/BS as a liability
p., q. Long-term assets in the tangible property, under plant, and equipment
section
r. Intangible asset
s. Intangible asset
t. Goodwill as a separate line item on the SFP/BS
u. Expensed as part of research and development expense. (Development
expenses are expensed unless all six criteria for capitalization are met.)
EXERCISE 11–11
a. The determination of useful life by management can have a material effect on the
balance sheet as well as on the income statement. The following are the variables
to consider when determining the appropriate useful life for a limited-life intangible.
• The legal life for a patent in Canada is twenty years but management can deem
a shorter useful life based on
– the expected use of the patent
– economic factors such as demand and competition
– the period over which its benefits are expected to be provided.
• The estimated useful life of the patent should be based on neutral and unbiased
consideration of the factors above, which requires a degree of professional
judgment.
b. December 31, 2014:

Amortization: $25,000 ÷ 20 = $1,250
Carrying amount: $25,000 − $1,250 = $23,750
December 31, 2015:
Amortization: $1,250 + ($35,000 ÷ 18.5) = $3,142 (rounded)
Carrying amount: $23,750 + $35,000 − $3,142 = $55,608
c. Dec 31, 2014 carrying amount from (b): $23,750

2015 amortization: ($23,750 ÷ (15 − 1)) + ($35,000 ÷ 13.5) = $4,289 (rounded)
Carrying amount: $23,750 + $35,000 − $4,289 = $54,461
d. If it has an indefinite life, then do not amortize. If classified as indefinite life, manage-
ment must review useful life annually to ensure that conditions and circumstances
continue to support the indefinite life assessment. Any change in useful life is to
be accounted as a change in estimate, which is accounted for prospectively. Also,
management would have to test annually for impairment or whenever indicators of
such a possibility exist.
EXERCISE 11–12
a. Situation (i) Journal Entries:

General Journal
Jan 1 2015 Intangible assets – patents . . . . . . . . . . . . . . . . . . 900,000
Cash, accounts payable, etc.. . . . . . . . . . . . . 900,000
Dec 31 2015 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . 60,000

Accumulated amortization, patents . . . . . . . 60,000
(900,000 ÷ 15)

Accumulated amortization, patents . . . . . . . 84,000
((900,000 − 60,000) ÷ 10)
Situation (ii) Journal Entries:
General Journal
2015 Research and development expenses . . . . . . . 180,000
2015 Intangible assets – electronic product . . . . . . . 170,000


Accumulated amortization, electronic 17,000
product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(170,000 ÷ 10)
Situation (iii) Journal Entries:
General Journal
Jan 1 2015 Intangible assets – franchise . . . . . . . . . . . . . . . . 1,800,000
Cash, accounts payable, etc.. . . . . . . . . . . . . 1,800,000

Accumulated amortization – franchise . . . . 45,000
(1,800,000 ÷ 40)
Dec 31 2015 Franchise fee expense . . . . . . . . . . . . . . . . . . . . . . 112,000

($5.6 million × 2%)
Situation (iv) Journal Entries:
General Journal
2015 Research and development expenses . . . . . . . 290,000
($25,000 + 250,000 + 15,000)
b. Partial income statement:

Hilde Co.
Statement of Income (partial)
For the year ending December 31, 2015
Revenue from franchise $5,600,000

Expenses
Research and development expenses* $470,000
Franchise fee expense 112,000
Amortization expense** 122,000 704,000
Income from operations before taxes 4,896,000
Income tax expense 1,321,920
Net income $3,574,080
* ($180,000 + 290,000)
** ($60,000 + 17,000 + 45,000)
Partial balance sheet:
Hilde Co.
Balance Sheet (partial)
Intangible assets:
Intangible assets – patents $ 900,000
Accumulated amortization 60,000 $ 840,000
Intangible assets – electronic product 170,000
Accumulated amortization 17,000 153,000
Intangible assets – franchise 1,800,000
Accumulated amortization 45,000 1,755,000
Total intangible assets $2,748,000
Note: The balance sheet reporting requirement is to disclose the net amount for
each intangible asset separately, its related accumulated amortization, any accu-
mulated impairment losses, and a total for net intangible assets. With these re-
quirements in mind, an alternative reporting format for the balance sheet would be
to report the net amounts for each intangible asset as shown in the right-hand col-
umn with disclosure of the accumulated amortization, any accumulated impairment
losses and the net amount for each intangible asset in an additional schedule in the
notes to the financial statements.
c. Under IFRS, if the costs meet the six development phase criteria for capitalization,
then they are to be capitalized. Under ASPE, costs that meet the six development
phase criteria for capitalization may either be capitalized or expensed, depending
on the entity’s accounting policy. In this case, Hilde’s policy is to capitalize costs
that meet the criteria; therefore, the accounting entries would be the same as the
solution above.
Under IFRS there is an option to use the revaluation model for subsequent mea-
surement of intangible assets after acquisition if there is an active market for the
intangible assets. Refer to the chapter on property, plant, and equipment for details
about this model. In addition, under IFRS, an assessment of estimated useful life is
required at each reporting date.
d. Impairment testing for limited-life assets under ASPE:
Limited-life intangible assets would be tested for possible impairment whenever
events and circumstances indicate the carrying amount may not be recoverable. The
carrying amount of the asset is compared to undiscounted future net cash flows of
the asset, to determine if the asset is impaired. If impaired, the difference between
the asset’s carrying amount and its fair value will be the impairment amount. Under
ASPE, an impairment loss for intangible assets may not be reversed.
Impairment testing for limited-life intangibles under IFRS:
At the end of each reporting period, the asset is to be assessed for possible im-
pairment. If impairment is suspected, and the carrying amount is higher than the
recoverable amount (which is the higher of the value in use, and the fair value less
costs to sell), the asset is impaired. The impairment loss is the difference between
the asset’s carrying amount and its recoverable amount. Under IFRS, an impairment
loss may be reversed in the future, although the reversal is limited to what the asset’s
carrying amount would have been had there been no impairment.
EXERCISE 11–13
Entry:
General Journal
Intangible asset – patent . . . . . . . . . . . . . . . . . . . . 107,666
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,666*
For Intangible asset: ($50,000 + $57,666)
* Present value calculation:
PV = (4,800** PMT, 9 I/Y***, 5 N, 60,000 FV)

PV = $57,666 (rounded)
** $60,000 × 8%
*** PV calculations use the market rate while the interest payment of $4,800 uses the
stated rate.
EXERCISE 11–14
a.
General Journal
2015 Research and development expense . . . . . . . . 150,000
Intangible assets – patents . . . . . . . . . . . . . . . . . . 20,000

Amortization expense . . . . . . . . . . . . . . . . . . . . . . . 2,000

Accumulated amortization . . . . . . . . . . . . . . . 2,000
(20,000 ÷ 10 years (2015–2025))
2016 Intangible assets – patents . . . . . . . . . . . . . . . . . . 22,000

Amortization expense . . . . . . . . . . . . . . . . . . . . . . . 2,857

Accumulated amortization . . . . . . . . . . . . . . . 2,857
((20,000 + 22,000 − 2,000) ÷ 14)
2017 Research and development expense . . . . . . . . 250,000

Intangible assets – development costs . . . . . . 50,000

b. Under IFRS, costs associated with the development of internally generated intangi-
ble assets are capitalized when the six specific criteria for capitalization are met in
the development stage. The $250,000 must be expensed as it was incurred before
the future benefits were reasonably certain. Costs incurred after the six specific
criteria for capitalization are met, are capitalized. The $50,000 costs incurred in-
dicates the company’s intention and ability to generate future economic benefits.
As a result, the $50,000 would be capitalized as development costs. The $50,000
capitalized costs would be amortized over periods benefiting after manufacturing
begins.
EXERCISE 11–15
a. Impairment for limited-life under IFRS:

Carrying value: 1,000,000

Recoverable amount: higher of value in use and fair value less costs to sell
= higher of [$1,100,000 and ($1,000,000 − 45,000 = 955,000)] = 1,100,000
Carrying value is less than 1,100,000, therefore the franchise is not impaired.
b. Carrying value: 1,000,000
Recoverable amount: 950,000
Carrying value is more than the recoverable amount therefore the franchise is im-
paired by $50,000.
General Journal
Accumulated impairment losses – fran- 50,000
chise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c. Carrying value: 1,000,000

= higher of [$1,100,000 and ($1,350,000 − 45,000 = 1,305,000)] = 1,305,000
d. Under IFRS, indefinite-life intangible assets are tested for impairment annually (even
if there is no indication of impairment), which is the same as was done for limited-life
intangible assets. So the answers in parts (a) to (c) will not change because the
franchise has an unlimited life.
e. Under ASPE for limited-life intangibles, if there is reason to suspect impairment, then
management can complete an assessment of the franchise. If the carrying value
is greater than the undiscounted cash flows then it is impaired. The impairment
amount is the difference between the carrying value and the fair value.
Part (a) Carrying value: 1,000,000
Undiscounted future cash flow = 1,200,000
Part (b) Carrying value: 1,000,000
Recoverable amount (undiscounted future cash flows) = 950,000
Carrying value is more than the recoverable amount therefore the franchise is im-
paired by $50,000.
General Journal
Accumulated impairment losses – fran- 50,000
chise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Part (c) Fair value changed to $1.35 million. Fair value is not relevant for ASPE to
assess recoverability, so the answer does not change from part (b).
f. Part (a) Under ASPE, indefinite-life intangible assets are tested for impairment when
circumstances indicate that the asset may be impaired same as with limited-life
intangibles. However, the test differs from the test for limited-life assets. Here, a fair
value test is used, and an impairment loss is recorded when the carrying amount
exceeds the fair value of the intangible asset.
Carrying value: 1,000,000
Fair value: 1,000,000
Carrying value is equal to the fair value for 1,000,000; therefore the franchise is not
impaired.
Part (b) Under ASPE, the recoverable amount refers to undiscounted future cash
flows, which does not affect the impairment test for indefinite-life intangible assets,
which compares the carrying value to the fair value of the asset. The fair value
remains at 1,000,000, therefore the asset is not impaired.
Part (c) Carrying value: 1,000,000
Fair value: 1,350,000
Carrying value is less than the fair value for 1,350,000, therefore the franchise is not
impaired under ASPE for an indefinite-life asset.
EXERCISE 11–16
a.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,000
b. Payment of total consideration of $280,000 for Candelabra resulted in payment

for goodwill of $65,000. Goodwill is defined as an asset representing the future
economic benefits arising from other assets acquired in a business combination
that are not individually identified or separately recognized. In paying for goodwill of
$65,000, Boxlight may have considered the value of Candelabra’s established cus-
tomers for repeat business, the company’s reputation, the competence and ability
of its management team to strategize effectively, its credit rating with its suppliers,
and whether or not the company has highly qualified and motivated employees.
Together, these could make the value of the business, as a whole, greater than the
sum of the fair value of its net identifiable assets.
c.
Fair value 180,000
Impairment amount 20,000
Entry:
General Journal
Accumulated impairment losses – good- 20,000
will . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
d.
Carrying value: 180,000
= higher of [$170,000 and ($160,000 − 10,000 = 150,000)] = 170,000
Carrying value is greater than 170,000; therefore the franchise is impaired by $10,000
(180,000 − 170,000).
General Journal
Accumulated impairment losses – good- 10,000
will . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Note: Had the impairment amount exceeded the $65,000 goodwill carrying value,
the amount of the difference would be allocated to the remaining net identifiable
assets on a prorated basis.
e. For part (c), reversal of goodwill if impairment losses exist is not permitted under
ASPE. For part (d), reversal of goodwill impairment losses is not permitted under
IFRS.

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Intermediate Financial Accounting

Lyryx Learning Team

Table of Contents iii

1 Review of Intro Financial Accounting 1

Chapter 1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.1 Adjusting and Closing Entries . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.2 Merchandising Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.3 Inventory Costing Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.4 Bank Reconciliations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.5 Receivables Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.6 Long-Lived Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.7 Current and Long-Term Liabilities . . . . . . . . . . . . . . . . . . . . . . . . 3

1.8 Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Chapter 2 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2.1 Definition and Information Asymmetry . . . . . . . . . . . . . . . . . . . . . 7

2.3 How Are Standards Set? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2.4 The Conceptual Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.4.1 The Objective of Financial Reporting . . . . . . . . . . . . . . . . . . 12

2.4.2 Qualitative Characteristics of Useful Information . . . . . . . . . . . 12

2.4.3 Elements of Financial Statements . . . . . . . . . . . . . . . . . . . 15

2.4.5 Measurement Base . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

2.4.6 Capital Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2.5 Challenges in Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . 22

2.7 IFRS/ASPE Key Differences . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Chapter 3 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

3.1 Financial Reporting: Overview . . . . . . . . . . . . . . . . . . . . . . . . . 37

3.2 Factors that Influence Financial Reports . . . . . . . . . . . . . . . . . . . . 38

3.2.1 Accounting Year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

3.2.2 Changes in Accounting Estimates, Changes in Accounting Policy,

3.3 Financial Statements and Their Interrelationships . . . . . . . . . . . . . . . 43

3.3.1 Financial Statement Differences Between IFRS and ASPE . . . . . 47

3.4 Statement of Income and Comprehensive Income . . . . . . . . . . . . . . 47

3.5 Statement of Changes in Equity (IFRS) and Statement of Retained Earn-

3.6 Analysis of Statement of Income and Statement of Changes in Equity . . . 60

3.7 IFRS and ASPE Applicable Standards . . . . . . . . . . . . . . . . . . . . . 62

4 Financial Reports – Statement of Financial Position and Statement of Cash

Chapter 4 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

4.1 Financial Reports: Overview . . . . . . . . . . . . . . . . . . . . . . . . . . 78

4.2 Statement of Financial Position/Balance Sheet . . . . . . . . . . . . . . . . 80

4.2.1 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . 81

4.2.2 Factors Affecting the Statement of Financial Position/Balance Sheet

4.3 Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

4.3.1 Preparing a Statement of Cash Flows . . . . . . . . . . . . . . . . . 100

4.3.2 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . 111

4.3.3 Interpreting the Statement of Cash Flows . . . . . . . . . . . . . . . 113

4.4 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

Chapter 5 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

Chapter Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.2 Revenue Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

5.2.1 Risks, Rewards, and Control . . . . . . . . . . . . . . . . . . . . . . 145